Introduction

On September 13, 2010, the Internal Revenue Service (“IRS”) issued proposed regulations that clarify the treatment for Federal tax purposes of the individual series, cells, or accounts established by organizations such as series limited liability companies, series partnerships, series trusts, protected cell companies, segregated cell companies, segregated portfolio companies, and segregated account companies (the “Proposed Regulations”). While the Proposed Regulations are welcome and provide useful guidance, they leave unanswered several major questions.

As described below, the Proposed Regulations provide that such an individual series, cell, or account will be treated for Federal tax purposes as a separate local law entity if such series cell or account is organized or established under a statute that meets certain requirements. The Proposed Regulations generally apply only to series, cells, and accounts organized or established under the laws of the United States or any of the States. The Proposed Regulations apply to foreign series, cells, or accounts only if such series, cells, or accounts are engaged in insurance businesses.

The effective date of the Proposed Regulations will be the date final regulations are published. However, the Proposed Regulations include a transitional rule, described below, for series, cells, and accounts that were formed and conducted business or investment activities before September 14, 2010, and that meet certain other requirements.

Background

Several US states and foreign countries have enacted statutes that authorize the formation of organizations that can create individual series, cells, or accounts, each of which may own distinct assets, incur separate liabilities, have different managers and members, and be protected against liability for the debts and obligations of the organization and the other series, cells, or accounts established by the organization.1 These statutes generally provide that the individual series, cells, or accounts are not treated as separate legal persons for local law purposes.2  

There is little guidance regarding the Federal tax treatment of these individual series, cells, or accounts. As explained in the preamble to the Proposed Regulations, whether the individual series, cells, or accounts are treated as separate legal persons for local law purposes is not controlling for Federal tax purposes and the characteristics of the series, cells, or accounts under their governing statutes are an important factor in analyzing whether they should be treated as separate entities for Federal tax purposes. Determining the Federal tax treatment of such series, cells, or accounts is complicated by the fact that, as explained in the preamble to the Proposed Regulations, the statutes grant the individual series, cells, and accounts some of the attributes of separate legal entities, but none of the statutes grant the individual series, cells, or accounts all of the attributes of independence that entities recognized as separate legal persons under local law generally possess. Moreover, the statutes are not uniform with respect to the local law rights of the individual series, cells, or accounts, such as the rights of an individual series, cell, or account to contract, hold property, sue, or be sued in its own name.  

In Notice 2008-19,3 the IRS announced that it would issue guidance setting forth the circumstances under which a cell of a protected cell company would be treated for Federal tax purposes as an insurance company separate from any other entity. The purpose of the guidance was to ensure that the entity classification and Federal tax elections of protected cell companies be legally correct and administrable, given that the statutes chartering protected cell companies differ among jurisdictions and that cell arrangements differ among taxpayers because of variations in contract terms. The IRS also requested comments on the need for future guidance concerning series limited liability companies and cell companies that do not involve insurance. The comments generally recommended that series and cells should be treated as separate entities for Federal tax purposes if they are established under statutes similar to the series organization statutes in effect in several states.  

The Proposed Regulations

The Proposed Regulations provide that a “series” organized or established by a “series organization” under a domestic “series statute” is treated for Federal tax purposes as a separate entity formed under local law, regardless of whether the series is treated as a separate juridical person for local law purposes. The Proposed Regulations also provide that a series organized or established under a foreign series statute is treated for Federal tax purposes as a separate entity formed under local law if the arrangements and activities of the foreign series would result in it being classified as an insurance company for Federal tax purposes if it were a domestic company (i.e., if more than half of the foreign series’ business is the issuing or reinsuring of insurance or annuity contracts). A domestic series that is treated for Federal tax purposes as a separate entity will be subject to classification for Federal tax purposes as a trust, corporation, association, partnership, or disregarded entity under the same rules that apply to other types of entities that are treated as separate entities for Federal tax purposes. A foreign series that is treated as a separate entity under the Proposed Regulations will be treated as a corporation for Federal tax purposes because insurance companies are treated for Federal tax purposes as per se corporations that cannot elect to be classified as partnerships or disregarded entities.

The Proposed Regulations define a “series” as a segregated group of assets and liabilities established by a series organization pursuant to a series statute. The Proposed Regulations define a “series organization” as legal person that establishes and maintains, or under which is established and maintained, a series. Series organizations include series limited liability companies, series partnerships, series trusts, protected cell companies, segregated cell companies, segregated portfolio companies, and or segregated account companies.

The key to the Proposed Regulations is the definition of a “series statute.” A “series statute” is defined as a statute that provides for the establishment of a series by a series organization that explicitly permits: (1) specified members or participants of the series organization to have rights, powers, or duties with respect to one or more specified series; (2) each series to have separate rights, powers, or duties with respect to specified property or obligations; and (3) the segregation of the assets and liabilities of the series organization and the individual series such that the assets of each individual series are protected against liability for the debts or liabilities of the series organization and the other individual series. As explained in the preamble to the Proposed Regulations, the IRS and Treasury believe that the classification of domestic series should be based on the characteristics they are permitted to have under the applicable enabling statute, and not the characteristics they actually possess. Thus, it is not relevant under the Proposed Regulations whether a series fails to elect or qualify for liability limitations under the series statute or whether the assets, business purpose, investment objective, management or ownership of a series overlaps with that of the series organization or any of the other series.  

The Proposed Regulations provide that for Federal tax purposes, the ownership of interests in a series and of the assets associated with a series is determined under general Federal tax principles, which generally look to who bears the economic benefits and burdens of ownership. Accordingly, a series organization is not treated for Federal tax purposes as the owner of a series or the assets associated with a series merely because the series organization holds legal title to the assets associated with the series.  

Because a series may be treated as a separate entity for Federal tax purposes, but may not be a separate entity under local law, the IRS and Treasury have determined that each series organization and its series should file an annual statement containing information needed by the IRS to ensure the proper assessment and collection of tax. The IRS and Treasury are considering the information to be provided in such annual statements and have requested comments on what information should be included.  

Effective Date

The Proposed Regulations will apply on the date final regulations are published. Taxpayers that are treating series differently for Federal tax purposes than such series are required to be treated under the final regulations will be required to change their treatment of the series. Depending on how taxpayers are treating a series organization and its series for Federal tax purposes, such a change may result in taxable events to the series organization or its owners.  

The Proposed Regulations, however, also provide a transitional rule that generally allows a series and a series organization to continue to be treated as a single entity for Federal tax purposes if: (i) the series was established and conducted business or investment activities before September 14, 2010; (ii) no owner of the series has treated the series for Federal tax purposes as an entity separate from other series or the series organization; (iii) the series and the series organization had a reasonable basis for treating the series and series organization as a single entity; and (iv) neither the series organization nor any owner of the series or series organization is notified in writing before final regulations are published that the classification of the series is under examination in an audit. In the case of a foreign series covered by the Proposed Regulations, the transition rule further requires that for all taxable years beginning with the taxable year that includes September 14, 2010: (i) the Federal tax classification of the series affected the liability of any person for US Federal tax or information reporting purposes; and (ii) 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. The transition rule ceases to apply to a series on the date that persons who were not owners of the series or the series organization on September 13, 2010 own, in the aggregate, a 50 percent or greater interest in the series or the series organization.  

Conclusions

The Proposed Regulations provide a simple test for determining the separate entity status of an individual series in a series organization for Federal tax purposes—the series will be treated for Federal tax purposes as a separate local law entity if the series is organized under a domestic statute that permits the series to own distinct assets, incur separate liabilities, have different managers and members, and be protected against liability for the debts and obligations of the series organization and the other series. In the case of a series organized or established under foreign law, the only added requirement is that the series be engaged in activities that would cause it to be treated as an insurance company for Federal tax purposes if it were a domestic company.

Although the general rule of the Proposed Regulations is simple, the Proposed Regulations do not address a number of significant issues. An important unresolved issue is how taxpayers should treat series that are organized or established after September 13, 2010 and before the date final regulations are published. Such series are not eligible for the transition rule in the Proposed Regulations and a change in the Federal tax classification of such series upon the effective date of the final regulations could have adverse tax consequences to the series organization and its members. Thus, it would be advantageous for taxpayers to treat series organized or established after September 13, 2010 as separate local law entities for Federal tax purposes. The Proposed Regulations, however, do not provide that taxpayers can rely on the Proposed Regulations for periods before the effective date of the final regulations. Since the IRS and Treasury have stated in the preamble to the Proposed Regulations that they believe the factors supporting separate entity status outweigh the factors in favor of disregarding series as separate entities, it is not clear why the Proposed Regulations do not allow taxpayers to rely on the Proposed Regulations for periods before the effective date of the final regulations.  

Another major issue that is not addressed in the Proposed Regulations is the treatment of series for Federal employment tax purposes. As explained in the preamble to the Proposed Regulations, the treatment of a series as a separate entity for Federal tax purposes raises substantive and administrative issues regarding the treatment of the series as an “employer” for Federal employment tax purposes. The preamble to the Proposed Regulations requests comments on how a series that is treated for Federal tax purposes as a separate entity will be treated for state and Federal employment tax purposes.  

Another significant issue that is not addressed by the Proposed Regulations is the treatment of foreign series that are not engaged in insurance businesses. The preamble to the Proposed Regulations states that until further guidance is issued, the entity status of a foreign series that does not conduct an insurance business will be determined under applicable law. We understand that the IRS and Treasury have concerns that check-the-box elections to classify individual foreign series may be used to shift foreign tax credits. This concern does not apply to foreign series that are treated for Federal tax purposes as insurance companies because insurance companies are required to be treated as corporations for Federal tax purposes and are not eligible for check-the-box classification. The IRS and Treasury request comments on how non-insurance company foreign series should be treated for Federal tax purposes.

The Proposed Regulations also fail to address the Federal tax treatment of series organizations. Series organizations are treated as legal persons for local law purposes and entities that are treated as legal persons for local law purposes are generally treated as entities for Federal tax purposes. The IRS and Treasury request comments on whether a series organization that has no assets and engages in no activities independently of its series should be disregarded as an entity for Federal tax purposes.