The Internal Revenue Service (the “IRS”) on September 14, 2010 published proposed regulations (the “Proposed Regulations”) that would treat each “series” of a domestic “series organization” as a separate entity for federal tax purposes. This treatment would apply regardless of whether the series is treated as a separate legal entity under local law. With one exception for foreign series engaged in an insurance business, the Proposed Regulations would not apply to foreign series. The Proposed Regulations are expected to become effective on the date that final regulations are published in the Federal Register; while we do not expect this to occur in 2010, it is not known when such publication will occur. Once final regulations are adopted, separate entity treatment of affected series would be mandated, unless a series qualifies for a grandfathering exception described below. The Proposed Regulations thus would provide some certainty (at least with respect to domestic series entities and, to a limited degree, certain foreign series) in an area that previously offered no certainty.
Under the Proposed Regulations, a “series organization” is a juridical entity that estab-lishes and maintains series or under which series are established and maintained, and may include a series limited liability company, series partnership, series trust, protected cell com-pany, segregated cell company, segregated portfolio company or segregated account company.
The Proposed Regulations define a “series” as a “segregated group of assets and liabilities” that is established by agreement of a series organi-zation pursuant to a “series statute.” The Proposed Regulations explicitly exclude a segregated asset account of a life insurance company from the term “series.”
A “series statute” is a statute of a state or foreign government that explicitly provides for the establishment of series of a juridical entity and explicitly allows: (i) members or partici-pants of a series organization to have rights, powers, or duties with regard to the series; (ii) series to have separate rights, powers or duties with regard to specified property or obligations; and (iii) segregation of assets and liabilities so that none of the debts and liabilities of the other series or the series organization (other than organizational or operating liabilities to the jurisdiction of organization) may be enforced against the assets of a series of the series organization.
The Proposed Regulations provide that an election, agreement or other arrangement that permits the liabilities of other series or the series organization to be enforceable against the assets of a particular series will not affect the separate entity treatment mandated by the Proposed Regulations. Thus, the fact that one series guarantees the debt of another series within the same series organization generally would not cause the series to cease to be treated as a separate entity for federal tax purposes. Also, the failure by a series to comply with record keeping requirements for the limitation of liability under the relevant series statute would not affect the separate entity status of the series for federal tax purposes.
The Proposed Regulations state that, for federal tax purposes, ownership of interests in a series and its assets is determined under general tax principles. General tax principles generally look to who bears the economic benefits and burdens of ownership. Thus, although local law may require a series organization to hold legal title to the assets of a series, the series would be treated for federal tax purposes as the owner of the assets if it bears the economic benefits and burdens of ownership under general federal tax principles.
The Proposed Regulations do not address the entity status for federal tax purposes of a series organization or, specifically, whether a series organization is recog-nized as a separate entity if it has no assets and engages in no activities separate from its series.
Also, as noted above, the separate entity treatment mandated by the Proposed Regulations would not apply to foreign series that do not conduct an insurance business. With regard to such foreign series, the preamble to the Proposed Regulations states simply that, until further guidance is issued, entity status “will be determined under applicable law.” Given that the preamble also concedes that, under current law, “there is little specific guidance” regarding the entity status of a series for federal tax purposes, the treatment of foreign series that do not conduct an insurance busi-ness appears to remain uncertain.
Other issues not addressed by the Proposed Regulations include (i) the treatment of a series for federal employ-ment tax purposes and (ii) whether a series may be an employer and related employee benefits issues.
Effective Date; Grandfathering Exception
The Proposed Regulations generally would apply on the date that final regulations are published in the Federal Register. A grandfather rule would allow certain series not to be treated as separate entities following this effective date if certain conditions are satisfied. Specifi-cally, these conditions would be satisfied if: (i) the series was established prior to September 14, 2010 (that is, the date that the Proposed Regulations were published in the Federal Register); (ii) on and prior to September 14, 2010, the series (apart from the series organization or any other series) conducted business or investment activity, or, in the case of a foreign series, more than half of the business of the series consisted of issuing insurance or annuity contracts or reinsuring risks underwritten by insurance companies; (iii) in the case of a foreign series, the classification of the series was relevant pursuant to the entity classification Treasury Regulations and more than half of the business of the series consisted of issuing insurance or annuity contracts or reinsuring risks underwritten by insurance companies for all taxable years beginning with the taxable years beginning with the taxable year that includes September 14, 2010; (iv) no owner of the series treats it as an entity separate from the other series or the series organization for the purposes of filing federal income tax returns, information returns or withholding documents in any taxable year; (v) the series and the series organization had a reasonable basis (within the meaning of section 6662 of the Internal Revenue Code) for their claimed classification; and (vi) neither the series nor any owner of the series nor the series organization was notified in writing on or prior to the date that final regulations are published in the Federal Register that the classification of the series was under examination (in which case the classification of the series will be determined in the examination). This grandfather rule would cease to apply, however, on the date that 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 percent or greater interest in the series or series organization.
Any taxpayer that does not qualify for the grandfather rule (or becomes ineligible for the grandfather rule due to a change in ownership) and has been treating series differently from what would be required when final regulations become effective will be required to change such treatment to conform to the requirements of the regulations. The consequences of converting from one entity to multiple entities would be determined pursuant to general tax principles, as the Proposed Regulations do not provide for non-recognition treatment.
New Reporting Requirement
The Proposed Regulations would impose an additional, annual reporting requirement upon series organizations and each of their series. The specific requirements of this new reporting obligation are yet to be determined by the Treasury Department and the IRS.
Request for Comments
The Treasury Department and the IRS have requested comments on the Proposed Regulations, as well as certain issues that the Proposed Regulations do not currently address (for example, the treatment of foreign series that do not conduct insurance businesses). Such comments must be received by December 13, 2010.