Recently issued proposed regulations on domestic series limited liability companies should help give taxpayers and their advisors a bit more confidence in using series LLCs as a method of dividing a business venture into a variety of units to accomplish a variety of objectives.
The proposed regulations (NPRM REG-119921-09) help remove a major uncertainty that had been built into using series LLCs: Will the Internal Revenue Service treat each series unit established by the LLC as a single entity formed under local law and as a separate entity for federal tax purposes?
The commitment from the IRS under the proposed regulations to generally treat an LLC and its series units together as separate entities under federal tax law should make those taxpayers that have avoided series LLCs out of caution reconsider their benefits now.
CURRENT STATUS
Series LLCs have been used to varying degrees to facilitate various businesses over the past several years, with those operating within the financial industry, insurance, energy and real estate sectors leading the way - ever so cautiously. Advocates of series LLCs see the new regulations as an attempt by the IRS to give series LLCs equal footing with a master LLC type of arrangement, within which an upper-tier LLC owns one or more lower-tier LLCs. Many practitioners are hopeful that the use of series LLCs will expand as a result.
Despite optimism over the expansion of series LLCs into different business operations, the primary limit to the progress of this business structure may not be the IRS as much as state laws themselves. It is not clear whether the IRS action will spur the remaining states without series LLC statutes to adopt them. What is clear, however, is the continuing importance of looking to individual state series LLC law to determine rights and obligations.
CREATURES OF STATE LAW
To date, eight states, including Delaware, allow LLCs to establish series LLCs, consisting of the LLC and several units, series or cells. Like basic LLCs in the past that started with only a handful of states, the popularity of series LLCs is likely to catch the attention of other state legislatures.
A series LLC is a subset of a "series organization," which can be any legal entity recognized under state or foreign law that establishes and maintains a series of units. It can be an LLC, partnership or trust. In certain industries, such as insurance, the series are also referred to as protected cells.
Under state law, the series units established by an LLC generally are not treated as separate entities (except in Iowa and Illinois). However, in all cases, the assets of one series unit are protected from the liabilities of the LLC or any other series unit.
In addition to gaining the advantage of separate liability, series LLCs help arrange capital investments in similar projects, such as in developments of several parcels of land, into separate profit and risk units. Series LLCs that are run under a single umbrella LLC also provide a useful mechanism to simplify administration and reduce costs, while isolating assets and liabilities of each entity within the series.
SCOPE OF REGULATIONS
The Internal Revenue Service regulations piggyback on the concept of each series unit being considered a separate entity under state law. The regulations treat each series unit as a local law entity that may be a separate federal tax entity under the classification regs in Treasury Regulations Section 301.7701-1. Each such series unit is further defined in the regulations as a segregated group of assets and liabilities that is established, pursuant to a "series statute," by agreement of a "series organization."
As a domestic series unit that is treated as a separate entity for federal taxes, each such entity may therefore make an election under the check-the-box classification regs to determine whether it is a partnership, corporation or disregarded entity. Generally, most series entities elect partnership status, although single owners within a series may elect disregarded entity treatment.
MORE SPECIFICS
The IRS regulations apply to a series statute (state or foreign law) that allows an entity to establish a series and that permits:
Members or participants of a series organization to have rights, powers or duties regarding the series;
A series to have separate rights, powers or duties with respect to specified property or obligations; and,
The segregation of assets and liabilities, so that none of the liabilities of the series organization or of any other series unit can be enforced against the assets of a particular series unit.
The IRS's view is that the members' association with one or more particular series is comparable to direct ownership in the series. If the conditions of the statute are satisfied, the liabilities of one series generally are enforceable only against the assets of that series.
Other features of a series statute are that:
Each series unit must have separate books and records;
The members of a series unit are not liable for the unit's obligations; and,
Members of a unit are treated as owning an interest in only that unit, and have no rights in the assets or income of any other unit.
A participant of a series organization may include an officer or director of the series organization who has no ownership interest in the series or series organization, but does have rights, powers or duties regarding the series. The service advises that ownership of interests in a series, and of assets associated with a series, is determined under general tax principles, based on who bears the economic benefits and burdens of the interest or assets, not who holds legal title to the assets.
RELIEF FROM STATE LAW
The regulations allow series LLCs more slack than is permitted under certain state rules. The IRS stated that a series unit would still qualify as a series, even though under the state statute, or at the series' election, the series unit is liable for obligations of other series units or of the series organization. For example, a statute may collapse the liability if the series units do not properly maintain separate records and accounts.
Nevertheless, the IRS also indicated that if a creditor were able to collect a series unit's liability from another series unit or from the series organization, the agency would collect the tax from the other unit or the organization. The same will apply if a creditor can collect a series organization's liability from a series unit.
The IRS also decided that a particular series does not have to possess all of the attributes permitted by its enabling statute. For example, a series unit can be separate for federal tax purposes even if its business purpose, investment objective or ownership may overlap with that of another series unit or of the series organization itself.
MORE COMPLIANCE WORK
The IRS is in the process of creating a new annual reporting statement to be filed by the series organization and each series unit, to provide identifying information that will ensure the proper assessment and collection of tax. It is being drafted as a stand-alone statement due March 15 of each year.
UNANSWERED ISSUES
The regs do not address the entity status of the series organization, where it has no assets and engages in no activities independent of its series. The regs also do not address a foreign series, because they raise novel federal income tax issues that are still being considered.
Because of what the IRS calls "the complexity of the issues," the proposed regs do not address whether a series unit is an employer or how the series should be treated for federal employment tax purposes. The regs also do not address the ability of a series to maintain an employee benefit plan. However, a series that can maintain a plan may be aggregated with related entities under Code Sec. 414.
The IRS clearly is not finished with guidance on series LLCs. In its preamble to the regulations, the IRS requests comments on a number of issues, including the classification of a series organization and foreign cells, employment tax issues, employee benefit issues, and reporting requirements. Some practitioners have said that they would particularly like to see guidance on how to determine the owners of an individual series.
PITFALLS
The series LLCs should not be considered a slam-dunk choice in any situation. Pitfalls should be evaluated carefully. In addition to those unanswered questions on which the IRS is requesting comments, other recent concerns have also been raised. They include whether states will see a revenue opportunity in assessing fees on each series unit, whether consolidated yet separate recordkeeping is worth the additional expense, whether the identity of each series member will be respected in each state in which the LLC does business, and whether a bankruptcy court will be as quick to recognize separate liability among series LLCs when creditors are making a case for a unified approach.
MANDATORY TREATMENT
Under the category of "Be careful what you wish for," taxpayers should beware of circumstances in which a series LLC is useful, but single-entity tax treatment might nevertheless be more desirable. Although the proposed regulations are generally favorable for most taxpayers, practitioners should be advised that the IRS has created a treatment for series LLCs that is no longer optional.
Although the regs are labeled "proposed," make no mistake that the IRS has set a definite course with their issuance. In doing so, Sept. 14, 2010 (the date on which the proposed regulations were released), appears to be critical, with series established prior to that date allowed to continue to be treated as a single entity (that includes the series organization) only if:
The series conducted business;
No series owner treats a series unit as separate; and,
The classification of the series is not under examination.
Further, the IRS warns that when the regs become final, taxpayers properly treating a series organization as one entity with its series units up to that point may be required to treat each series as a separate unit going forward.
CONCLUSION
Recent proposed regulations issued by the IRS on series LLCs go a long way in encouraging their use in a variety of business situations. Nevertheless, much uncharted territory remains. It will be mapped by a combination of developing state laws, additional IRS guidance and novel uses by taxpayers that will challenge or at least test the application of existing and developing rules.
George G. Jones, JD, LL.M, is managing editor, and Mark A. Luscombe, JD, LL.M, CPA, is principal analyst, at CCH Tax and Accounting, a Wolters Kluwer business.
