On September 13, 2010, the Internal Revenue Service (IRS) issued proposed regulations (the “Proposed Regulations”) on the federal income tax classification of certain “series organizations” (e.g., certain domestic series limited liability companies, series partnerships, series trusts, protected cell companies and similar arrangements, and certain foreign series or cell companies engaged in the insurance business). If adopted in their current form, these new rules will require that for federal income tax purposes, each series within affected series organizations be treated as an entity formed under local law, resulting in such series being treated as a separate entity (i.e., as a separate corporation, partnership, disregarded entity or trust). While the Proposed Regulations are not yet effective, any affected series organization formed after September 14, 2010 (or that is not entitled to a limited grandfather exception), and that is classifying its series in a manner not in accord with the Proposed Regulations, will be required to change the federal income tax treatment of such series if the Proposed Regulations are finalized, with general tax principles applying to such conversion. Accordingly, holders of interests of both existing and newly formed series LLCs, LPs, trusts, cell companies, segregated asset companies and similar organizations should carefully review the Proposed Regulations and consult with their tax advisors on their potential impact on the current (and potential future) federal income tax classification of the series within such entities.
Which Organizations Are Affected by the Proposed Regulations?
The Proposed Regulations apply to all domestic series organizations, and to certain foreign series organizations engaged in an insurance business. For this purpose, a “series organization” is an entity that establishes and maintains (or under which is established and maintained) a series, with this definition intending to encompass a variety of series limited liability companies, series partnerships, series trusts, protected cell companies, segregated cell companies, segregated portfolio companies and segregated account companies. The Proposed Regulations define a “series” as a segregated group of assets and liabilities established pursuant to a “series statute” by agreement of a series organization. As noted by the IRS, Delaware, Illinois, Nevada, Oklahoma, Tennessee, Texas, Utah and Puerto Rico have enacted series LLC statutes, with Delaware also having enacted statutes for series LPs and series trusts.
A “series statute” is a state or foreign statute that provides for the organization and establishment of a series and explicitly (1) permits its members or participants to have rights, powers or duties with respect to a series; (2) provides for separate rights, powers or duties with respect to specified property or obligations; and (3) provides for the segregation of assets and liabilities such that no non-governmental debts and liabilities of the series organization or of any other series are enforceable against the assets of a particular series. Thus, the vast majority of existing series entities will be subject to the rules of the Proposed Regulations when ultimately adopted. However, to the extent that an entity having series is not formed pursuant to a “series statute” (whether intentionally or because the relevant statute does not satisfy the above three requirements), the Proposed Regulations will not apply, and the characterization of the entity and of its series will continue to be determined under general tax principles.
What Is the Consequence of the Proposed Regulations?
Once effective, the Proposed Regulations will require that the series of a qualifying “series organization” be classified for federal income tax purposes as an entity formed under local law, potentially resulting in such series being characterized as a separate entity under the existing federal income tax entity classification regulations. In other words, notwithstanding the total number of members owning an interest in a series LLC, a series of the LLC having only a single member would likely be classified for federal income tax purposes as a disregarded entity, and as a partnership where the series had multiple members. Similarly, in the context of a series trust, each series of the trust would have to be separately analyzed under the Proposed Regulations for whether each series constitutes an “investment” or “business” trust.
While the Proposed Regulations may create some administrative nuisance for series entities as they review their existing tax elections and the tax classification provisions of their organizational documents, this clarity of tax treatment is generally a good thing. For example, in the series trust analysis mentioned above, while each series must be separately analyzed under the “investment/business” trust regime once the Proposed Regulations are finalized, it would also be true that the failure of one series to qualify as an “investment trust” would not automatically impact the “investment trust” classification of its other series.
What Should Be Done Today in Light of the Proposed Regulations?
Members, participants and managers of existing and soon-to-be-formed series organizations should carefully review the Proposed Regulations and consult with their tax advisers on the potential impact of these rules on the current (and potential future) federal income tax classification of the series within such entities. While the Proposed Regulations are not yet effective, any affected series organization formed after September 14, 2010 (or that does not qualify for a limited grandfather exception contained in the Proposed Regulations), and that is currently classifying its series in a manner not in accord with the Proposed Regulations, will be required to change the federal income tax treatment of such series if and when the Proposed Regulations are finalized, with general tax principles applying to such conversion (e.g., under the rules for partnership or corporate divisions, as applicable). Further, many existing organizational documents for series LLCs, LPs and trusts may have terms that conflict with or otherwise do not reflect the substance of the Proposed Regulations, and may require revision and amendment prior to their further use.