On September 13, 2010, the US Treasury Department and the Internal Revenue Service released proposed regulations (REG-119921-09) classifying series limited liability companies (LLC), cell companies, segregated portfolio companies, segregated account companies, and similar structures for federal tax purposes. The regulations propose that the organizing entity and each collection of assets and liabilities underneath the organizing entity are considered separate entities for federal tax purposes and independently classified. Stated differently, a single series LLC or similar state law entity consists of multiple classifiable entities for federal tax purposes. The proposed regulations apply only to domestic entities and foreign entities in an insurance business. They do not apply to foreign entities in businesses other than insurance.
A series LLC or similar entity is formed under a state law that allows the organizing entity to have separate series within its structure hold different assets and liabilities, have different business purposes, and share its economic benefits differently. Notwithstanding the series’ ability (depending on the specific state law) to hold its own assets and liabilities, have its own business objectives, and associate with specific members, it is not a separate entity for state law purposes. Series LLCs appeal to taxpayers seeking to insulate multiple assets from cross-liability in a single legal entity as well as taxpayers interested in offering equity holders the ability to invest directly in specific assets held by the series LLC.
Under the proposed regulations, both the state law legal entity (defined as the “series organization”) and the underlying segregated assets and liabilities (defined as the “series”) are treated as classifiable entities for federal tax purposes. As classifiable entities, both the series organization and the series are subject to the existing classification rules found in the Treasury Regulations. In general, the Treasury Regulations provide that a passthrough entity with a single owner is either taxed as a corporation or as an entity disregarded from its owner, while an entity with multiple owners is either taxed as a corporation or as a partnership. The Treasury Regulations employ a mostly elective scheme, such that a taxpayer may elect the entity’s tax classification. However, special classification rules may apply, such as the Treasury Regulations mandating the classification of an insurance company as a corporation.
The proposed regulations do not address the threshold classification issues, such as when an entity is a business entity and when an entity may be taxed as a partnership. For example, a series organization may form multiple series to hold all of the assets and incur all of the liabilities of the organization. The proposed regulations do not provide any bright-line rules as to whether the series organization itself is a business entity that should be classified under the Treasury Regulations. Instead, the preamble to the proposed regulations directs taxpayers to the common law to determine whether the entity is a business entity. The common law surrounding entity classification goes back 70 years and generally provides a facts and circumstances test that is hard to apply with certainty. Further, the preamble discusses the possible filing requirements for the series organization, stating that even if it is a business entity it may not need to file a tax return due to the income limitations. Moreover, the proposed regulations do not discuss how taxpayers should determine the tax owners of a series organization or of a series, leaving taxpayers with the same need to apply the common law entity classification rules to each series. In sum, taxpayers are left to determine for themselves (1) whether the series organization itself is a business entity, (2) whether the series organization and/or the series have multiple owners for federal tax purposes, and (3) if so, the filing requirement. As a practical matter, taxpayers may find themselves filing “zero” returns for the series organization and or series as a protective measure.
Because the proposed regulations apply the general classification rules to the series organization and the series, it is possible to structure the series organization and series in the manner that best suits the taxpayer subject to the existing uncertainty surrounding entity classification discussed above. For example, if the taxpayer is interested mainly in segregating liability, it could structure the series organization as a partnership and the series themselves as disregarded entities. On the other hand, if the taxpayer wants to independently market and sell different interests in different assets while using the same management team and legal entity, it could structure the series as separate partnerships with the series organization not classified as a business entity. Thus, the proposed regulations provide taxpayers with flexibility by applying the general classification rules, subject to the existing uncertainty in determining the tax owner of a business entity.
The proposed regulations do not address insurance-specific guidance, including transition issues for cell companies, employment tax guidance and employee benefits guidance. The preamble to the proposed regulations contemplates various scenarios where a series and/or the series organization could be considered the employer for federal tax purposes. However, the taxpayer is left to provide answers to all the issues raised.
Procedurally, the proposed regulations require each series and series organization to file a new series annual statement for each taxable year containing identifying information of the series and series organization. This statement will be designed to resolve any disparity created by a series organization and its series being treated as a single entity under local law but as separate entities under federal tax law and related reporting purposes and to ensure that the proper amount of tax is collected and assessed. Finally, the proposed regulations contain a grandfather rule, whereby a previously established series organization may continue to treat the series organization and the series as one entity for federal tax purposes.