Editor: Michael Dell, CPA
LLCs & LLPs
The IRS has issued proposed regulations that would treat, for federal tax purposes, a series of a domestic series limited liability company (LLC), a cell of a domestic cell company, and a foreign series or cell that conducts an insurance business as an entity formed under local law, regardless of whether the entity is treated as a juridical person for local law purposes (REG-119921-09). Subject to a generous transition rule, these proposed regulations will generally become effective when they are published as final regulations in the Federal Register.
Series LLCs were first introduced in Delaware in 1996, and since then a number of states have enacted statutes to create entities, such as LLCs, that may establish series. These statutes are often referred to as series LLC statutes. In addition, certain jurisdictions have enacted statutes providing for entities similar to a series LLC. For example, certain statutes provide for the chartering of a legal entity (or the establishment of cells) under a structure commonly known as a protected cell company, a segregated account company, or a segregated portfolio company (cell company).
The preamble to the proposed regulations provides background on series LLCs:
In general, series LLC statutes provide that a limited liability company may establish separate series. Although series of a series LLC generally are not treated as separate entities for state law purposes and, thus, cannot have members, each series has “associated” with it specified members, assets, rights, obligations, and investment objectives or business purposes. Members’ association with one or more particular series is comparable to direct ownership by the members in such series, in that their rights, duties, and powers with respect to the series are direct and specifically identified. If the conditions enumerated in the relevant statute are satisfied, the debts, liabilities, and obligations of one series generally are enforceable only against the assets of that series and not against assets of other series or of the series LLC.
The insurance codes of many states and foreign jurisdictions also have statutes allowing for the creation of a protected cell company, which is a legal entity with multiple accounts or cells. With a protected cell company, assets placed within a cell are statutorily protected from the creditors of any other cell. In addition, while the cells will frequently issue stock (typically, a preferred stock of the protected cell company that is based on the performance of the specific cell), they are not treated as legal entities distinct from the protected cell company.
In Notice 2008-19, the IRS requested comments on proposed guidance to address issues that arise if protected cell arrangements entered into by a cell are insurance for federal tax purposes—specifically (1) the status of such a cell as an insurance company and (2) some of the consequences of a cell’s status as an insurance company.
In the preamble to the proposed regulations, the IRS and Treasury note their general agreement with the recommendation that series and cells should be treated as separate entities for federal tax purposes if formed under a statute with provisions similar to those governing the series LLC in effect in several states.
Under the proposed regulations, a series organized or established under the laws of the United States or of any state, whether a juridical person for local law purposes, would be treated as an entity formed under local law. In addition, a series organized or established under the laws of a foreign jurisdiction would be treated as an entity formed under local law if the arrangements and other activities of the series, if conducted by a domestic company, would result in classification as an insurance company under Secs. 816(a) or 831(c).
The determination of whether a series that is treated as a local law entity under the proposed regulations is recognized as a separate entity for federal tax purposes would be made under Regs. Sec. 301.7701-1 and general tax principles. Potential classifications of a series include disregarded entity, partnership, and corporation (an entity that qualifies as an insurance company under Secs. 816(a) or 831(c) would be a per se corporation).
The proposed regulations do not address the entity status or filing requirements of series organizations for federal tax purposes. The IRS is requesting comments concerning whether a series organization should be recognized as a separate entity for federal tax purposes if it has no assets and has engaged in no activities independent of its series.
Notably, the proposed regulations do not describe how a series should be treated for federal employment tax purposes.
The proposed regulations provide definitions for a series organization, a series statute, and a series.
A series organization is defined as a juridical entity that establishes and maintains, or under which is established and maintained, a series. A series organization includes a series LLC, series partnership, series trust, protected cell company, segregated cell company, segregated portfolio company, or segregated account company.
A series statute is defined as a statute of a state or foreign jurisdiction that explicitly provides for the organization or establishment of a series of a juridical person and explicitly permits:
- Members or participants of a series organization to have rights, powers, or duties with respect to the series;
- A series to have separate rights, powers, or duties with respect to specified property or obligations; and
- The segregation of assets and liabilities such that none of the debts and liabilities of the series organization (other than liabilities to the state or foreign jurisdiction related to the organization or operation of the series organization, such as franchise fees or administrative costs) or of any other series of the series organization are enforceable against the assets of a particular series of the series organization.
A series is defined as “a segregated group of assets and liabilities that is established pursuant to a series statute by agreement of a series organization.” A series includes a series, cell, segregated account, or segregated portfolio, including a cell, segregated account, or segregated portfolio that is formed under the insurance code of a jurisdiction or is engaged in an insurance business.
An election, agreement, or other arrangement that permits debts and liabilities of other series or the series organization to be enforceable against the assets of a particular series, or a failure to comply with the recordkeeping requirements for the limitation on liability available under the relevant series statute, will be disregarded for purposes of the definition of a series.
The proposed regulations would clarify that, except as specified in the proposed regulations, a particular series does not need to possess all the attributes that its enabling statute permits it to possess. The proposed regulations would also clarify that until further guidance is issued, the entity status of a foreign series that does not conduct an insurance business is determined under applicable law.
The proposed regulations provide that the IRS may, under applicable law, characterize a series or a portion of a series as other than a separate entity (i.e., disregard a series under applicable law if it has no business purpose other than tax avoidance).
Determination of Jurisdiction and Ownership
The proposed regulations would treat a series as created or organized under the laws of the jurisdiction in which it is established; for federal tax purposes, jurisdiction of the series would be determined under this rule. The proposed regulations also provide that, for federal tax purposes, ownership of interests in a series and the assets associated with a series is determined under general tax principles. The same legal principles that generally apply to determine who owns interests in other types of entities (i.e., who bears the economic benefits and burdens of ownership) would apply to determine who owns interests in series and series organizations.
Effect of Local Law Classification on Tax Collection
If federal or local law allows a creditor to collect a liability attributable to a series from the series organization or other series of the series organization, the proposed regulations would allow the series organization and other series of the series organization to be considered the taxpayer from whom the tax assessment may be collected. Under the proposed regulations, if a creditor is allowed to collect a liability attributable to a series organization from any series of the series organization, a tax liability may be collected directly from a series of the series organization by administrative or judicial means.
To provide the IRS with certain identifying information to ensure the proper assessment and collection of tax, the IRS and Treasury propose requiring the series organization and each series of the series organization to file an annual statement providing the IRS with certain identifying information. They request comments on what information should be required and the time for filing. They are currently considering requiring identifying information for the series organization and each of its series, the jurisdiction in which it was formed, and how the assets of the series are held (and by whom).
Effective Date and Transition Rule
The proposed regulations would likely apply on the date final regulations are published in the Federal Register. Generally, when final regulations become effective, taxpayers that are treating series differently for federal tax purposes than series are treated under the final regulations will be required to change their treatment. The preamble to the proposed regulations indicates that if a change in treatment is required, general tax principles will apply.
For example, if a series organization and its series had been treated as a single partnership for federal tax purposes and are required to convert to multiple partnerships upon recognition of the series organization’s series as separate entities, the partnership division rules of Sec. 708 might apply. In such a situation, the preamble warns that gain might be recognized under Sec. 704(c)(1)(B) or Sec. 737. Similarly, Secs. 355 and 368(a)(1)(D) provide rules that govern certain divisions of a corporation. The division of a series organization into multiple corporations may be tax free to the corporation and to its shareholders; however, if the corporate division does not satisfy one or more of the requirements in Sec. 355, the division may result in taxable events to the corporation, its shareholders, or both.
The proposed regulations include an exception for a series organization established prior to publication of the proposed regulations that treats all series and the series organization as one entity. If the requirements for this exception are satisfied, the series may continue to be treated together with the series organization as one entity for federal tax purposes after issuance of the final regulations. Specifically, the requirements for this exception would be satisfied if:
- The series was established prior to the date of publication of the proposed regulations in the Federal Register (September 14, 2010);
- The series (independent of the series organization or other series of the series organization) conducted business or investment activity or, in the case of a foreign series, more than half the business of the series was the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies, on and prior to September 14, 2010;
- The series was established under a foreign statute, the series’ classification was relevant (as defined in Regs. Sec. 301.7701-3(d)), and more than half the business of the series was issuing insurance or annuity contracts or reinsuring risks underwritten by insurance companies for all tax years beginning with the tax year that includes September 14, 2010;
- No owner of the series treats the series as an entity separate from any other series of the series organization or from the series organization for purposes of filing any federal income tax returns, information returns, or withholding documents for any tax year;
- The series and series organization had a reasonable basis (within the meaning of Sec. 6662) for their claimed classification; and
- Neither the series, any owner of the series, nor the series organization was notified in writing on or before the date final regulations are published in the Federal Register that classification of the series was under examination (in which case the series’ classification will be determined in the examination).
This exception would cease to apply on the date any person or persons who were not owners of the series organization (or series) prior to September 14, 2010, own, in the aggregate, a 50% or greater interest in the series organization (or series). For this purpose, the term “interest” means, in the case of a partnership, a capital or profits interest and, in the case of a corporation, an equity interest measured by vote or value.
This transition rule does not apply to any determination other than the entity status of a series. Thus, the rule does not reach questions of tax ownership of a series or series organization or qualification of a series or series organization conducting an insurance business as a controlled foreign corporation.
These proposed regulations are helpful and welcome because they provide some certainty on the classification of series LLCs. Notably, the proposed regulations recognize that not all series LLC statutes are identical and define the term “series statute” broadly to encompass series statutes that grant series certain attributes of separate entities.
Importantly, since a number of questions had been raised about the entity classification of series LLCs prior to these proposed regulations, there is a generally favorable transition rule allowing taxpayers that are currently treating series LLCs as a single entity to continue that treatment, provided certain requirements are met.
Joint Ventures, Partnerships, and Corporations
The treatment of series as separate entities provides flexibility in structuring investments, as each series of a series LLC can be classified as a separate partnership or a separate corporation for federal tax purposes. While the members will be treated as owning partnership interests or corporate stock in each series for federal tax purposes, members can make varied investments in each series without having to make investments in several separate state law entities.
The transition rule is important because it prevents the proposed regulations from causing partnership divisions under Sec. 708 or corporate divisions under Sec. 355 when taxpayers are treating series LLCs as a single entity for federal tax purposes. Taxpayers relying on the transition rule need to be cognizant that a transfer, in the aggregate, of at least a 50% interest in the series organization (or series), as determined with respect to a capital or profits interest, causes the transition rule no longer to be available and could cause a partnership division. Similarly, taxpayers relying on the transition rule must be mindful that a transfer, in the aggregate, of at least a 50% interest in the series organization (or series), as determined with respect to an equity interest measured by vote or value, causes the transition rule no longer to apply and could cause a corporate division.
Protected cell companies have evolved into a very useful tool to manage insurance risks. Because of their flexibility, these companies have been used in a variety of ways to address different insurance risk management needs. For example, protected cell companies have been used by “rent-a-captive” insurance companies, group captives, securitizations under National Association of Insurance Commissioners’ Regulation XXX and Guideline AXXX, health care organizations, etc. Companies that have entered into insurance arrangements with protected cell companies should evaluate the insurance arrangement in light of the proposed regulations.
There are two common approaches used to determine the tax status of protected cell companies. Under one approach, the company is viewed as one corporation consisting of all the cells of the protected cell company. Under the second approach, each cell is viewed as a separate corporation. The proposed regulations would adopt a different approach similar to that contained in Notice 2008-19. Each cell that qualifies as an insurance company for federal tax purposes is treated as a separate corporation. Domestic cells that do not qualify as an insurance company for federal tax purposes can be classified as disregarded entities, partnerships, or corporations.
The proposed regulations leave many practical questions unanswered. The preamble to the regulations notes that insurance-specific guidance may still be needed to address the issues identified in Notice 2008-19 and for issues that may arise for protected cell companies that previously reported in a manner inconsistent with the regulations. Some of these issues include:
- How are protected cell companies to be treated?
- How are foreign cells that do not qualify as insurance companies to be treated?
- What are the tax implications when a cell is treated as a separate corporation in one year when it qualifies as an insurance company but not as a separate corporation in a following year when it does not qualify as an insurance company? Is the change in status a taxable or a tax-exempt transaction? How will the cell’s tax attributes be treated as a result of the change in status?
- Will the participant in a cell be required to report information to the cell company to determine the cell’s status?
- Will an equity interest in a cell that qualifies as a separate corporation be treated as preferred stock or common stock?
The proposed regulations, if adopted, will present many transitional issues for cell companies to consider. Many protected cell companies have adopted the position that all the cells are part of the protected cell company. Protected cell companies will have to decide whether to continue this treatment under the exception in the transition rules. In other instances, protected cell companies have adopted the position that each cell is a separate corporation. Under the proposed guidance, these companies will have to determine which cells qualify as insurance companies and must be treated as separate corporations and which cells are to be considered part of the protected cell company.
Michael Dell is a partner at Ernst & Young LLP in Washington, DC.
For additional information about these items, contact Mr. Dell at 202-327-8788 or email@example.com.