On September 13, 2010, the Service, in REG-119921-09, issued somewhat landmark proposed regulations concerning the classification for Federal tax purposes of a series of a domestic series limited liability company (LLC), a cell of a domestic cell company, or a foreign series or cell that conducts an insurance business. The proposed regulations provide that, whether or not a series of a domestic series LLC, a cell of a domestic cell company, or a foreign series or cell that conducts an insurance business is a juridical person for local law purposes, for Federal tax purposes it is treated as an entity formed under local law. Classification of a series or cell that is treated as a separate entity for Federal tax purposes generally is determined under the same rules that govern the classification of other types of separate entities.
Certain states, including Delaware, Illinois, Iowa, Nevada, Oklahoma, Tennessee, Texas, Utah and Puerto Rico,have statutes providing for series LLCs. A series LLC statute allow an LLC to 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. Assuming the series LLC is properly documented, the debts, liabilities, and obligations of one series generally are enforceable only against the assets of that particular series and not against assets of other series or of the series LLC.
Certain jurisdictions have enacted statutes providing for entities similar to the 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, segregated account company or segregated portfolio company (cell company). A cell company may establish multiple accounts, or cells, each of which has its own name and is identified with a specific participant, but generally is not treated under local law as a legal entity distinct from the cell company. The assets of each cell are statutorily protected from the creditors of any other cell and from the creditors of the cell company.
Prior to the issuance of the proposed regulations, the Service acknowledged that little guidance exists as to whether for Federal tax purposes a series (or cell) is to be treated as an entity separate from other series or the series LLC (or other cells or the cell company, as the case may be), or whether the company and all of its series (or cells) should be treated as a single entity. In response to a request for comments, the Service and the Treasury were, in general, in agreement that series and cells should be treated as separate entities for Federal tax purposes where established under a statute with provisions similar to the series LLC statutes currently in effect in several states.
Treas. Reg. §301.7701-1(a)(1) provides that the determination of whether an entity is separate from its owners for Federal tax purposes is a matter of Federal tax law and does not depend on whether the organization is recognized as an entity under local law. Treas. Reg. §301.7701-1(a)(2) provides that a joint venture or other contractual arrangement may create a separate entity for Federal tax purposes if the participants carry on a trade, business, financial operation, or venture and divide the profits therefrom.
However, a joint undertaking merely to share expenses does not create a separate entity for Federal tax purposes, nor does mere co-ownership of property where activities are limited to keeping property maintained, in repair, and rented or leased.
Classification as a Separate Entity for Federal Tax Purposes
Whether an organization is an entity separate from its owners for Federal tax purposes is a matter of Federal tax law and does not depend on whether the organization is recognized as an entity under local law. Treas. Reg. §301.7701-1(a)(1). In Moline Properties, Inc., 319 U.S. 436 (1943) , the Supreme Court opined that where a corporation was formed for a purpose that is the equivalent of business activity or the corporation actually carries on a business, the corporation remains a taxable entity separate from its shareholders. Although entities that are recognized under local law generally are also recognized for Federal tax purposes, a state law entity may be disregarded if it lacks business purpose or any business activity other than tax avoidance. See Bertoli, 103 T.C. 501 (1994) ; Aldon Homes, Inc., 33 T.C. 582 (1959) . In the landmark partnership tax cases, Culbertson, 337 U.S. 733 (1949) and Tower,327 U.S. 280 (1946) , a partnership exists for Federal tax purposes where the parties in good faith and acting with a business purpose intended to join together to conduct an enterprise and share in its profits and losses. See also Madison Gas & Elec. Co., 633 F.2d 512, 514 (7th Cir. 1980); Luna, 42 T.C. 1067, 1077-78 (1964) . On the other hand, the Service has ruled that a co-ownership does not rise to the level of an entity for Federal tax purposes if the owner employs an agent whose activities are limited to collecting rents, paying property taxes, insurance premiums, repair and maintenance expenses, and providing tenants with customary services. See Rev. Rul. 75-374, 1975-2 CB 261; Rev. Rul. 79-77 1979-1 CB 448; Rev. Proc. 2002-22, 2002-1 C.B. 733 (ruling guidelines on co-ownership of property as not constituting a partnership). See also National Securities Series-Industrial Stocks Series, 13 T.C. 884 (1949), acq. 1950-1 C.B. 4. Compare. Union Trusteed Funds, 8 T.C. 1133 (1947) (series funds organized by a state law corporation could not be treated as if each fund were a separate corporation). See also §851(g)(rules for series funds of a RIC) and §§816(a) and 831(c) for definitions of an “insurance company”.
Overview of Series LLC Statutes and Cell Company Statutes
While Treas. Reg. §301.7701-1(a)(1) provides that state classification of an entity is not controlling for Federal tax purposes, the characteristics of series LLCs and cell companies under state law are important factors in determining whether the series and cells generally are separate entities for Federal tax purposes. Individual series, in general , are not treated as separate entities for state law purposes. However, in Illinois and Iowa, a series is treated as a separate entity to the extent provided in the series LLC's articles of organization. Under Delaware’s series LLC statute, each series may have separate rights, powers, or duties with respect to specified property or obligations of the LLC or profits and losses associated with specified property or obligations, and any such series may have a separate business purpose or investment objective. Further, the debts, liabilities, obligations, and expenses of a particular series of the Delaware series LLC are enforceable against the assets of that series only, and not against the assets of the series LLC generally or any other series of the LLC, and, unless the LLC agreement provides otherwise, none of the debts, liabilities, obligations, and expenses of the series LLC generally or of any other series of the series LLC are enforceable against the assets of the series, provided that certain “separateness” type requirements are met.
The explanation contained in the proposed regulations provides further details of the Delaware statute as well as the series LLC versions in Illinois and Iowa. Some states, it is further noted, have enacted series provisions outside of the LLC statutes. For example, Delaware has enacted series limited partnership provisions (6 Del. C. §17-218). In addition, Delaware's statutory trust statute permits a statutory trust to establish series (12 Del. C. §3804). Both at are nearly identical to the corresponding provisions of the Delaware series LLC statute with respect to the ability of the limited partnership or trust to create or establish separate series with the same liability protection enjoyed by series of a Delaware series LLC.
All of the series LLC statutes contain provisions that grant series certain attributes of separate entities. This includes separate business purposes, investment objectives, members, and managers. Again, the assets of a particular series are not subject to the claims of creditors of other series of the series LLC or of the series LLC itself, provided that certain record-keeping and notice requirements are observed. Finally, most series LLC statutes provide that an event that causes a member to cease to be associated with a series does not cause the member to cease to be associated with the series LLC or any other series of the series LLC. All state statutes limit the powers of series of series LLCs. For example, a series of a series LLC may not convert into another type of entity, merge with another entity, or domesticate in another state independent from the series LLC.
Insurance Statutes for Cell Companies, Segregated Account Companies or Segregated Portfolio Companies.
As with the series LLC statutes, various forms of the cell type structure have been enacted, including by certain foreign countries such as Guernsey, Jersey, Bermuda and the Cayman Islands. Under those statutes, as under the series LLC statutes described above, the assets of each cell are segregated from the assets of any other cell. The cell may issue insurance or annuity contracts, reinsure such contracts, or facilitate the securitization of obligations of a sponsoring insurance company. Rev. Rul. 2008-8, 2008-1 C.B. 340 looks at whether an arrangement entered into between a protected cell and its owner possesses the requisite risk shifting and risk distribution to qualify as insurance for Federal income tax purposes.
Description of the Proposed Regulations
The proposed regulations announce that for Federal tax purposes, a domestic series, whether or not a juridical person for local law purposes, is treated as an entity formed under local law. With one exception, the proposed regulations do not apply to series or cells organized or established under the laws of a foreign jurisdiction. The one exception is that the proposed regulations apply to a foreign series that engages in an insurance business.
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 is determined under Treas. Reg. §301.7701-1 and general tax principles. The proposed regulations further provide that the classification of a series that is recognized as a separate entity for Federal tax purposes is determined under Treas. Reg. §301.7701-1(b).
The proposed regulations define a series organization as a juridical entity that establishes and maintains, or under which is established and maintained, a series. A series organization includes a series limited liability company, series partnership, series trust, protected cell company, segregated cell company, segregated portfolio company, or segregated account company.
The proposed regulations define a series statute 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 (1) members or participants of a series organization to have rights, powers, or duties with respect to the series; (2) a series to have separate rights, powers, or duties with respect to specified property or obligations; and (3) 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.
The proposed regulations define a series 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 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. However, the term “series” does not include a segregated asset account of a life insurance company, which consists of all assets the investment return and market value of which must be allocated in an identical manner to any variable life insurance or annuity contract invested in any of the assets. Treas. Reg. §1.817-5(e).
Certain series statutes provide that the series liability limitation provisions do not apply if the series organization or series does not maintain records adequately accounting for the assets associated with each series separately from the assets of the series organization or any other series of the series organization. The IRS and the Treasury Department considered whether a failure to elect or qualify for the liability limitations under the series statute should affect whether a series is a separate entity for Federal tax purposes. However, limitations on liability of owners of an entity for debts and obligations of the entity and the rights of creditors to hold owners liable for debts and obligations of the entity generally do not alter the characterization of the entity for Federal tax purposes.
Importantly, the proposed regulations provide that 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 record keeping requirements for the limitation on liability available under the relevant series statute, will not prevent a series from meeting the definition of “series” in the proposed regulations. For example, a series generally will not cease to be an entity under the proposed regulations simply because it guarantees the debt of another series within the series organization.
The proposed regulations treat a series as created or organized under the laws of the same jurisdiction in which the series is established. Because a series may not be a separate juridical entity for local law purposes, this rule provides the means for establishing the jurisdiction of the series for Federal tax purposes.
Pursuant to Treas. Regs. §301.7701-1(b), §301.7701-2(b) a series is recognized as a separate entity for Federal tax purposes. Therefore, a series that is itself described in Treas. Reg. §301.7701-2(b)(1) through (8) would be classified as a corporation regardless of the classification of the series organization.
The proposed regulations also provide that, for Federal tax purposes, ownership of interests in a series and of the assets associated with a series is determined under general tax principles.
While there is a fair amount of detail and nuance involved in this area, much of which involves statute comparisons and varying treatment of the same matter, the Service and the Treasury concluded that the proposed regulations treat domestic series generally or Federal tax purposes as entities formed under local law. Because Federal tax law, and not local law, governs the question of whether an organization is an entity for Federal tax purposes, it is not dispositive that domestic series generally are not considered entities for local law purposes. Still, the thought was the factors supporting separate entity status for series outweigh the factors in favor of disregarding series as entities separate from the series organization and other series of the series organization. Specifically, managers and equity holders are “associated with” a series, and their rights, duties, and powers with respect to the series are direct and specifically identified. Also, individual series may (but generally are not required to) have separate business purposes and investment objectives.
By attempting to treat domestic series ownership in a uniform manner, the proposed regulations are more administrable and preferable to engaging in a case by case determination of the status of each series that would require a detailed examination of the terms of the relevant statute. Finally, the IRS and the Treasury Department believe that a rule generally treating domestic series as local law entities would be consistent with taxpayers' current ability to create similar structures using multiple local law entities that can elect their Federal tax classification pursuant to Treas. Reg. §301.7701-3.
The IRS and the Treasury Department announced that domestic series should be classified as separate local law entities based on the characteristics granted under the particular series statute. However, except as specifically stated in the proposed regulations, a particular series need not actually possess all of the attributes that its enabling statute permits it to possess.
It should be noted that the proposed regulations do not address the entity status for Federal tax purposes of a series organization. Specifically, the proposed regulations do not address whether a series organization is recognized as a separate entity for Federal tax purposes if it has no assets and engages in no activities independent of its series. 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.
Classification of a Series that is Treated as a Separate Entity for Federal Tax Purposes
If a domestic series or a foreign series engaged in an insurance business is treated as a separate entity for Federal tax purposes, Treas. Reg. §301.7701-1(b) applies to determine the proper tax classification of the series. Still, the proposed regulations do not provide how a series should be treated for Federal employment tax purposes. If a domestic series is treated as a separate entity for Federal tax purposes, then the series generally is subject to the same treatment as any other entity for Federal tax purposes. For example, a series that is treated as a separate entity for Federal tax purposes may make any Federal tax elections it is otherwise eligible to make independently of other series or the series organization itself, and regardless of whether other series (or the series organization) do not make certain elections or make different elections.
Entity Status of Series Organizations
The proposed regulations do not address the entity status or filing requirements of series organizations for Federal tax purposes. A series organization generally is an entity for local law purposes. An organization that is an entity for local law purposes generally is treated as an entity for Federal tax purposes.
Continuing Applicability of Tax Law Authority to Series
Notwithstanding that a domestic series or a foreign series engaged in an insurance business is treated as an entity formed under local law under the proposed regulations, the Commissioner may under applicable law, including common law tax principles, characterize a series or a portion of a series other than as a separate entity for Federal tax purposes. Series covered by the proposed regulations are subject to applicable law to the same extent as other entities. Thus, a series may be disregarded under applicable law even if it satisfies the requirements of the proposed regulations to be treated as an entity formed under local law.
Applicability to Organizations that Qualify as Insurance Companies
Although the proposed regulations do not apply to a series organized or established under the laws of a foreign jurisdiction, an exception is provided for certain series conducting an insurance business. Under this exception, a series that is organized or established under the laws of a foreign jurisdiction is treated as an entity if the arrangements and other activities of the series, if conducted by a domestic company, would result in its being classified as an insurance company. Thus, a foreign series would be treated as an entity if more than half of the series' business is the issuing or reinsuring of insurance or annuity contracts. Further guidance is expected in this area.
Effect of Local Law Classification on Tax Collection
There are differences in local law governing series (for example, rights to hold title to property and to sue and be sued are expressly addressed in some statutes but not in others) that may affect how creditors of series, including state taxing authorities, may enforce obligations of a series. The proposed regulations thus provide that to the extent Federal or local law permits a creditor to collect a liability attributable to a series from the series organization or other series of the series organization, the series organization and other series of the series organization may also be considered the taxpayer from whom the tax assessed against the series may be collected pursuant to administrative or judicial means. Further, when a creditor is permitted to collect a liability attributable to a series organization from any series of the series organization, a tax liability assessed against the series organization may be collected directly from a series of the series organization by administrative or judicial means.
Employment Tax and Employee Benefits Issues
Application of the employment tax requirements, as per the preamble to the proposed regulations, will depend principally on whether the workers are employees, and, if so, who is considered the employer for Federal income and employment tax purposes. In general, an employment relationship exists when the person for whom services are performed has the right to control and direct the individual who performs the services, not only as to the result to be accomplished by the work but also as to the details and means by which that result is accomplished. See Employment Regs. §§31.3121(d)-1(c)(2), 31.3306(i)-1(b), and 31.3401(c)-1(b).
An entity must be a person in order to be an employer for Federal employment tax purposes. See §§ 3121(b), 3306(a)(1), 3306(c), and 3401(d) and §31.3121(d)-2(a). The entity must also satisfy the criteria to be an employer under Federal employment tax statutes and regulations for purposes of the determination of the proper amount of employment taxes and the party liable for reporting and paying the taxes. Treatment of a series as a separate person for Federal employment tax purposes would create the possibility that the series could be an “employer” for Federal employment tax purposes. The Service and Treasury stated that the series structure would make it difficult to determine whether the series or the series organization is the employer under the relevant criteria with respect to the services provided.
The structure of a series organization could also affect the type of employment tax liability. For example, if a series were recognized as a distinct person for Federal employment tax purposes, a worker providing services as an employee of one series and as a member of another series or the series organization would be subject to FICA tax on the wages paid for services as an employee and self-employment tax on the member income. Note further that, if a domestic series were classified as a separate entity that is a business entity, then, under |Treas. Reg. §301.7701-3, the series would be classified as either a partnership or a corporation. While a business entity with one owner is generally classified as a corporation or is disregarded for Federal tax purposes, such an entity cannot be disregarded for Federal employment tax purposes. Treas. Reg. §301.7701-2(c)(2)(iv).
Once the employer is identified, a variety of additional issues surfaces including who would be responsible persons for the trust fund recovery penalty under §6672. In light of these issues, the proposed regulations do not currently provide how a series should be treated for Federal employment tax purposes. Obviously, the Service and the Treasury need more time to sort out these troubling and perplexing issues.
Various issues arise with respect to the ability of a series to maintain an employee benefit plan, including issues related to those described above with respect to whether a series may be an employer. The proposed regulations do not address these issues. However, to the extent that a series can maintain an employee benefit plan, the aggregation rules under §§ 414(b), (c), (m), (o) and (t), as well as the leased employee rules under §414(n), would apply. In this connection, the IRS and Treasury Department expect to issue regulations under §414(o) that would prevent the avoidance of any employee benefit plan requirement through the use of the separate entity status of a series.
Proposed Effective Date
These regulations generally 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 of series. In this situation, a series organization that previously was treated as one entity with all of its series may be required to begin treating each series as a separate entity for Federal tax purposes. General tax principles will apply to determine the consequences of the conversion from one entity to multiple entities for Federal tax purposes. The regulations include an exception for series established prior to publication of the proposed regulations that treat all series and the series organization as one entity.