Through the looking glass: status liability and the single member and series LLC perspective.

• Author: Bishop, Carter G.
• Position: Limited liability company

Until the release of Revenue Ruling 88-76, only two states adopted limited liability company legislation, Wyoming in 1977 and Florida in 1982. In 1975, Alaska rejected adoption of the first limited liability company legislation based on concerns regarding the tax classification of a limited liability company. When Revenue Ruling 88-76 resolved those concerns, all fifty states and the District of Columbia adopted legislation by 1996, only eight years later. Revenue Ruling 88-76, however, did not resolve whether a single-member limited liability company should be classified as a sole proprietorship or a corporation. That matter was not resolved until 1997 with the release of the check-the-box regulations. Again, within a few years all states had amended their limited liability company legislation to permit a single-member limited liability company. Further still, while Delaware adopted series limited liability company legislation in 1996, the check-the-box regulations did not address the classification of a series within a limited liability company. Since 1996, only six other states have followed suit. The 2008 release of Private Letter Ruling 200803004 classifying a series in the same manner as any other business entity under the check-the-box regulations signals a potential amendment of those regulations to embrace the series. If so, once again, all remaining states might be expected to provide for a series.

These enormous events raise important transparency questions regarding where disregarded entities exist for state law purposes. Stated another way, what is the state of member status liability in these forms? As this article explores, the tax classification and state statutory amendments have given rise to a proliferation of these forms while failing to address fundamental state law liability concerns that separate owners from the obligations in these forms.

1. INTRODUCTION

   Important historical moments are recorded in different forms. Time and context frame watershed events, even those heuristic in nature. This symposium, "Limited Liability Companies at 20," is an epistemological exploration and story separating fact from fiction and the lessons to be learned from the meteoric rise of the limited liability company in the past twenty years. Specifically, what learning has developed since the Internal Revenue Service (Service) released the landmark Revenue Ruling 88-76 (1) classifying a Wyoming limited liability company (2) as a partnership for federal income tax purposes? (3) All of us who participated in the Symposium are enormously grateful to the talented contributors, many of whom were responsible for the development of the limited liability company in the time frame examined.

   To those more interested in the present and less in history, the twenty-year time frame may be less than obvious. The fundamental assumption is that Revenue Ruling 88-76 and the revised approach of the so-called "check-the-box" (CTB) federal tax regulations (4) released in 1997 had a profound, unprecedented, and perhaps unpredictable impact on the future development of unincorporated business organizations. Until that time, the corporation was unquestionably the dominant entity of choice for an operating business. Limited partnerships were utilized for single purpose investment ventures such as real estate and general partnerships for service firms such as law and accounting. In both cases, all general partners were personally liable for the debts and obligations of the partnership by status alone. While misconduct might also create personal liability, that same liability created status liability for other general partners simply because they were general partners. As a result, the corporation was the primary if not the exclusive choice where all owners, regardless of number, were free from status liability and hence were not personally liable for the debts and obligations of the entity simply because they were owners. In order to mitigate untoward double taxation effects, a corporation could elect to be taxed as a Subchapter S corporation eliminating in most regards the corporate level entity tax and taxing the entity determined income and loss directly to the owners.

   All this was about to change in 1978 when Wyoming adopted state legislation enabling the creation of a new business form--the limited liability company. The new form promised corporate limited liability for all owners while eliminating the entity tax even more completely than the corporate Subchapter S election. But this revolutionary idea caught the attention of the Treasury Department that sensed decimation of the corporate tax base. In response, the Treasury undertook a study to determine whether an unincorporated entity with corporate limited liability could or should be classified other than as a corporation. Tax law had already predetermined that a publicly traded partnership would be taxed as a corporation regardless of its non-corporate form. After an exhaustive ten-year study, the Treasury conceded that indeed corporate styled limited liability was not an inviolate characteristic of the corporate form. The rush of statutory enactments accelerated, and the rush for Treasury rulings confirming non-corporate tax classification grew proportionately. Ultimately, in the 1997 CTB regulations, the Treasury simply threw in the towel and acknowledged that any entity not formed under a corporate statute would not be classified as a corporation.

   The deal was sealed. Every state now has first, second, or even third generation limited liability company acts. (5) The limited liability company has become the entity of choice for non-publicly traded business of every degree. A few odd characteristics and externalities have developed over time, and two in particular are the subject of this article. While single-shareholder corporations were and are quite common, single-member limited liability companies were not common prior to 1997. The CTB regulations classify such entities as a tax nothing. But a federal tax nothing remains a state law something. This dual identity crisis continues to create situational conflict and is contextually explored according to the subject of the confusion. Also, while every state enables a single-member limited liability company, only a few enable a series limited liability company. Like an investment trust with series, a series limited liability company is a single limited liability company with assets and liabilities barricaded in separate internal series, each with a distinct liability shield. If respected, the multiple internal liability shields dispense with forming several limited liability companies for the same purpose. This article is their story.

2. LLC TAX CLASSIFICATION HISTORY

   Limited liability company tax classification has long and important roots impacting state legislative adoptions and hence the proliferation of the entity itself. As discussed below, Alaska rejected limited liability company legislation in 1975 largely because of tax concerns. Similar legislation was adopted in 1997 in Wyoming and then in 1982 in Florida. Use of the entity, however, was severely retarded by the uncertainty regarding the tax classification of the entity as a partnership or corporation. Not until the release of Revenue Ruling 88-76 (6) classifying a Wyoming limited liability company with at least two members as a partnership did states quickly embrace limited liability company legislation.

   Even then, state statutes other than Texas required a limited liability company to have two or more members so that it could be classified as a partnership rather than a corporation. The single-member limited liability classification as a sole proprietorship or corporation was not addressed in Revenue Ruling 88-76 because Wyoming legislation did not permit the formation of a limited liability company with only one member. This question was in limbo for nearly another ten years until the release of the CTB regulations, applicable for tax years beginning after January 1, 1997. The CTB regulations resolved the tax classification of a single-member limited liability company by treating it as a sole proprietorship with a liability shield.

   Once again, the series limited liability company was not addressed in either Revenue Ruling 88-76 or the CTB regulations. The issues was addressed only recently in a 2008 private letter ruling. Because a private letter ruling is not binding authority, the status of the series limited liability company remains a cloud over state enactments and use. While Delaware enacted the first series legislation in 1996, only six states have followed suit and even then the concept is not heavily utilized because of the tax classification cloud. The discussion below traces the historical significance of these events.

   1. Tax Classification of a Multiple Member LLC

      A few states and the practicing bar enthusiastically embraced the early development of the limited liability company as a principled alternative to corporation and partnership entity forms (7) even before the release of the 1988 ruling and the 1997 CTB regulations. (8) The early roots of limited liability company legislation reach to Alaska. In 1975, the Hamilton Brothers Oil Company in Denver, Colorado, unsuccessfully sought adoption of limited liability company legislation in Alaska. (9) The company was familiar with South American limitadas (10) and thought that entity structure would be useful in the United States. The new entity was to provide state revenue from filing fees and annual taxes. (11) The early efforts were dashed, however, when the legislation failed to be enacted even after a Service tax classification ruling was sought. (12) Apparently the legislative uncertainty and debate focused on the tax classification issue. (13) Hamilton Oil refused to give up and shifted its legislative efforts to oil-rich Wyoming where in 1977, notwithstanding the same Alaska...