Tax Aspects of Series LLCs

About the Authors:

Allen Sparkman practices at Sparkman + Foote LLP in Houston and Denver.

The series concept arose in Delaware when that state in 1988 adopted its Business Trust Act (changed to Statutory Trust Act in 2001). 12 Del. Code §3801(g). This statute provided a framework for trusts utilized for asset securitization and the organization of investment companies.

Extension of Series Concept to LLCs

Today, the series trust remains actively utilized in the mutual fund and asset securitization applications, and we are seeing the use of the series in other situations. In 1996, a few years after it enacted its Business Trust Act, Delaware enacted the first statutory series LLC provisions at the same time that it added series provisions to its limited partnership statute.

The Delaware LLC Act states:

A limited liability company agreement may establish or provide for the establishment of 1 or more designated series of members, managers, limited liability company interests or assets. Any such series may have separate rights, powers or duties with respect to specified property or obligations of the limited liability company or profits and losses associated with specified property or obligations, and any such series may have a separate business purpose or investment objective. 6 Del. Code §18-215(a).

If notice and record-keeping requirements in the statute are satisfied, the Delaware statute provides:

[T]he debts, liabilities, obligations and expenses incurred, contracted for or otherwise existing with respect to a particular series shall be enforceable against the assets of such series only, and not against the assets of the limited liability company generally or any other series thereof, and, unless otherwise provided in the limited liability company agreement, none of the debts, liabilities, obligations and expenses incurred, contracted for or otherwise existing with respect to the limited liability company generally or any other series thereof shall be enforceable against the assets of such series. 6 Del. Code §18-215(b).

Individual Series Generally not a Separate State Law Entity

Generally, the entity for state law purposes is the LLC itself and not the series within the LLC. Stated differently, the series within the LLC is not a separate entity under the laws of the state of Delaware. Although an individual series of a Delaware series LLC has "the power and capacity to, in its own name, contract, hold title to assets (including real, personal and intangible property), grant liens and security interests, and sue and be sued" (6 Del. Code §18-215(c)), a series may not enter into a merger or conversion. Delaware permits a "domestic limited liability company" to enter into a merger or conversion. 6 Del. Code §18-209(a). Further, Delaware defines a "limited liability company" and a "domestic limited liability company" as "a limited liability company formed under the laws of the State of Delaware and having 1 or more members." 6 Del. Code §18-101(6). A series within a series LLC is not "formed" under Delaware law but rather pursuant to the limited liability company agreement of the series LLC. Members are not admitted as members of an individual series but, rather, are members of the series LLC and are "associated" with one or more series and may or may not have any economic interest in the series LLC itself other than an interest in one or more series. 6 Del. Code §18-215(e)-(k). Some states, namely Kansas, Illinois, and Iowa, and the District of Columbia, have considered this issue and have permitted (but not required) that a series within a series LLC to be a separate entity. Six of the current 10 domestic series LLC statutes, however, are like Delaware, in which a series within a series LLC is not a separate entity.

Tax Issues - Background

Before some clarity appeared with the issuance of the Proposed Regulations discussed below, commentators speculated that the eventual federal tax treatment of series LLCs would be to treat the individual series as separate entities. The predicted tax treatment flowed from cases and rulings holding that the separate series of an investment fund or of a business trust were distinct taxable entities. National Securities Series-Industrial Stock Series v. Commissioner, 13 T.C. 884 (1949), acq., 1950-1 C.B. 4. PLR 200803004; PLR 200544018; PLR 200303019; PLR 9847013.

Federal Taxation - the Proposed Regulations

Proposed federal tax regulations would treat each series within a series LLC as a separate entity for federal income tax purposes. Proposed Reg. §30.7701-1, 75 Fed. Reg. 55,699 (2010) (the "Proposed Regulations"). Each series would be classified as a partnership, disregarded, or as an association taxable as a corporation. The Proposed Regulations state a beneficial rule in that they will allow the same income tax classification that would apply if separate juridical LLCs were established. The Proposed Regulations apply to series created by "series organizations" pursuant to "series statutes." Proposed Reg. §301.7701-1(a)(5)(viii)(A) defines these terms such that each of the nine state series LLC statutes and the District of Columbia series LLC statute is a "series statute" within the meaning of the Proposed Regulations.

Classification of the Juridical LLC

The preamble to the Proposed Regulations states:

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.

An entity formed under local law is not always recognized as a separate entity for federal tax purposes. Treas. Reg. §30.7701-1(a)(4). Moreover, classification of an organization as an entity separate from its owners is a matter of federal tax law, not local law. Treas. Reg. §301.7701-1(a)(1).

Even if a series LLC has multiple economic members, if all of those members are associated with one or more series and have no economic interest in the LLC apart from their interest in one or more series, the series LLC itself will be treated as having no economic members. For federal tax purposes, the ownership of interests in a series and of the assets associated with a series is determined under general tax principles based on who is entitled to the benefits and burdens of the series or assets. A series organization is not treated as the owner for federal tax purposes of a series or of the assets associated with a series merely because the series organization holds legal title to the assets associated with the series. Proposed Reg. §30.7701-1(a)(5)(vi). As stated in the preamble to the Proposed Regulations:

A series organization is not treated as the owner of a series or of the assets associated with a series merely because the series organization holds legal title to the assets associated with the series. . . . [T]he series will be treated as the owner of the assets for Federal tax purposes if it bears the economic benefits and burdens of the assets under general Federal tax principles. Similarly, for Federal tax purposes, the obligor for the liability of a series is determined under general tax principles.

In general, the same legal principles that apply to determine who owns interests in other types of entities apply to determine the ownership of interests in series and series organizations. These principles generally look to who bears the economic benefits and burdens of ownership [citations omitted]. Furthermore, common law principles apply to the determination of whether a person is a partner in a series that is classified as a partnership for Federal tax purposes under §301.7701-3. See, for example, Commissioner v. Culbertson, 337 U.S. 733 (1949); Commissioner v. Tower, 327 U.S.280 (1946).

The general default rule under the tax classification regulations is that a domestic entity formed under a non-corporate statute will be classified as a partnership if it has two or more owners and will be disregarded if it has only one owner. Such an entity may elect to be taxed as a corporation. Treas. Reg. §30.7701-2. An otherwise disregarded single-owner entity will be regarded for certain employment and excise tax matters, however. Treas. Reg. §30.7701-2(c)(2)(iv) and (v). A special rule provides that an entity will be classified as a corporation if it is a state-chartered bank that is federally insured. Although some states now permit banks to be formed as limited liability companies, the author knows of no state that would allow a series of a series LLC to be a bank.

Reporting as Single Entity Currently Permitted

The Proposed Regulations are only proposed; a series LLC therefore could report now as single entity but would have to switch to separate reporting if the Proposed Regulations are finalized as written unless the transitional rule in the regulations applies. The principal conditions of the transitional rule that will most often apply to a series of a domestic series LLCs are:

  • The series must have been established prior to September 14, 2010;
  • The series (independent of the series organization or other series of the series organization) must have conducted business or investment activity on and prior to September 14, 2010;
  • No owner of the series treats the series as an entity separate from any other series of the series organization or from the series organization for purposes of filing any federal income tax returns, information returns, or withholding documents in any taxable year;
  • The series and series organization had a reasonable basis (within the meaning of IRC §6662) for their claimed classification; and
  • Neither the series nor any owner of the series nor the series organization was notified in writing on or before the date final regulations are published in the Federal Register that classification of the series was under examination (in which case the series' classification will be determined in the examination).

If otherwise applicable, the transition rule will not apply on and after the date 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 organization (or series). For purposes of the preceding sentence, the term interest means:

  1. In the case of a partnership, a capital or profits interest; and
  2. In the case of a corporation, an equity interest measured by vote or value.

Effects of Switching to Reporting as Separate Entitles

The switch from reporting as a single entity would be considered a conversion from a single entity to multiple entities for federal tax purposes. Depending on the single entity tax classification before the switch, the switch could have adverse tax consequences. If the pre-switch single entity was classified as a corporation, the switch could be a taxable liquidation of the corporation. If the pre-switch entity was classified as a partnership, the effect of the switch on partnership liabilities would have to be considered.

Proposed Regulations as Substantial Authority

Even though the Proposed Regulations are only proposed, for a taxpayer who reports in accordance with the Proposed Regulations, however, they are "substantial authority." Treas. Reg. §1.6662-4(d)(3)(iii). Note, however, as discussed below, the Proposed Regulations do not apply for purposes of employment taxes or employee benefits and, therefore, would not be substantial authority for a taxpayer's treatment of those matters in a series LLC.

Reporting Requirements

The Proposed Regulations contain reporting requirements. Each series (unless disregarded) and series organization (if recognized as an entity for tax purposes and not disregarded) would be required to file the appropriate income tax returns. In addition, Proposed Regulation §301.6011-6(a) would require each series (whether or not disregarded) and each series organization (whether or not disregarded and, apparently, whether or not treated as an entity for tax purposes) to file a statement for each taxable year with respect to the series or series organization as prescribed by the IRS. Proposed Regulation §301.6071-2(a) would require that such statements be filed by March 15 of the year following the period for which the statement is made.

Scope of Proposed Regulations

The Proposed Regulations do not address foreign entities (except for insurance businesses), employment taxes, or employee benefits. The preamble to the Proposed Regulations discusses several perceived problems that could arise if a series is treated as a separate entity for employment tax purposes, including:

  • Substantive and administrative issues that allegedly arise from the treatment of a series as a separate person for federal employment tax purposes.
  • The series structure would make it difficult to determine whether the series or the series organization should be considered the employer with respect to the services provided.
  • The structure of a series organization could also affect the type of employment tax liability - 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 would be subject to FICA tax on the employment wages and self-employment tax on the member income.
  • How would the wage base be determined for employees, particularly if they work for more than one series in a common line of business?
  • How would the common paymaster rules apply?

Perceived Problems if a Series is Treated as a Separate Entity for Employment Tax Purposes

It is not clear what exactly the drafters of the Proposed Regulations thought might be necessary "to make [a series] an employer for Federal employment tax purposes." Statutory provisions cited in the preamble use the term "person" in referring to employers. Moreover, the relevant employment tax provisions sometimes use additional terms to describe who can be an "employer." Thus, IRC section 3121(h) defines "American employer" as, inter alia, an "employer which is . . . (3) a partnership, if two-thirds or more of the partners are residents of the United States or (5) a corporation organized under the laws of the United States or of any State." Unless a series is disregarded, under the Proposed Regulations, it will be either a partnership or an association taxable as a corporation for federal tax purposes. Moreover, Treas. Reg. §31.3121(d)-2(b) states that "an employer may be . . . a corporation, a partnership, . . . an association, or a syndicate, group, pool, . . . or other unincorporated organization, group, or entity." It would not appear difficult to fit a series within that definition. Finally, the Internal Revenue Code defines the term "person" to "mean and include . . . a . . . partnership, association, company, or corporation, and provides that "the terms 'includes' and 'including' when used in a definition contained in this title shall not be deemed to exclude other things otherwise within the meaning of the term defined." IRC §§ 7701(a) (1), 7701(c). Again, it appears that an individual series if not disregarded would be a partnership or corporation within the meaning of the IRC definition of "person."

Although there may be some circumstances in which it is not at first apparent who the employer is, an examination of the facts should almost always lead to a clear result, or at least as clear a result as is obtained in ambiguous employment situations outside of series entities. Moreover, it is unclear how a situation in which a worker would be considered to be the employee of more than one series is any different from the issues that arise if a worker is the employee of two or more separate juridical entities under some degree of common control or the situation that arises when an individual is an employee of one entity and also a member of an LLC that is under common control with the first entity. The U.S. Department of Labor recognizes that whether two or more employers who employ the same individual are jointly liable for all federal wage and hour requirements or each employer is only liable with respect to the employee's service for that employer is a highly fact-based determination that does not necessarily depend on there being common control among the employers. WH Publication 1297 - United States Department of Labor Employment Standards Administration Wage and Hour Division, "Employment Relationship Under the Fair Labor Standards Act."

It strikes the author as somewhat disingenuous to ask how the common paymaster rules would work. The common paymaster rules allow certain commonly controlled corporations to use one of the corporations to pay employees who work for more than one of the controlled corporations, applying one wage base, etc. Treas. Reg. §31.3121(s)-1. The common paymaster rules apply only to corporations. It seems likely to the author that the great majority of series that are treated as separate entities for federal tax purposes will either be disregarded entities or will be partnerships for tax purposes. The common paymaster rules as currently written would have no application to such series, except possibly to a series that, because disregarded, was treated as a division of a corporation. It would seem to be a useful project for the Treasury Department to revise the common paymaster regulations so that they would apply to all entities that are under common control as defined therein, whether or not incorporated.

Employee Benefit Plans

The preamble to the Proposed Regulations state that to the extent a series may maintain an employee benefit plan, the aggregation rules and employee leasing rules of Internal Revenue Code Section 414 will apply. The author does not see any reason why a series should not be able to maintain an employee benefit plan on its own. As the preamble to the Proposed Regulations states, the analysis whether the series is properly maintaining the plan should be the same analysis that is made when any entity that is under common control with a number of other entities maintains an employee benefit plan.

Federal Taxation - Equity Compensation in Series LLCs

Controversy existed for many years in court decisions and the approach of the IRS with respect to whether the receipt of an interest solely in future partnership profits is a taxable event. The IRS provided some clarity for planning purposes in Rev. Proc. 93-27, 1993-2 C.B. 343, as clarified by Rev. Proc. 2001-43, 2001-34 I.R.B. 1. Rev. Proc. 93-27 declares that the receipt of a profits interest in exchange for services in a partner capacity, or in anticipation of becoming a partner, will not be treated as taxable event to either the recipient partner or the partnership. Rev. Proc. 93-27 provides that a "profits interest" is anything other than a capital interest, and a "capital interest" is "an interest that would give the holder a share of the proceeds if the partnership's assets were sold at fair market value and then the proceeds were distributed in a complete liquidation of the partnership." However, Rev. Proc. 93-27 does not apply if (a) the profits interest relates to a substantially certain and predictable stream of income from partnership assets; (b) if within two years of receipt the partner disposes of the profits interest; or (c) if the profits interest is a limited partnership interest in a publicly traded partnership.

Series LLCs present unique issues because of Rev. Proc. 93-27's provision of its applicability:

If a person receives a profits interest for the provision of services to or for the benefit of a partnership in a partner capacity or in anticipation of being a partner, the Internal Revenue Service will not treat the receipt of such an interest as a taxable event for the partner or the partnership (emphasis added).

Assume a Delaware series LLC that has three series. Two of the series are classified as partnerships, and the third is disregarded for income tax purposes. As we know, under the Delaware series LLC statute, a person is not admitted as a member of a series. Membership admission occurs at the series LLC level, and members of the series LLC may be "associated" with one or more series. Any membership interest that is intended to be a profits interest will necessarily have to be issued by the series LLC. If the profits interest is issued to an individual who will have an economic interest only in one of the series, the series LLC presumably may "associate" that profits interest with that series. Fortunately, the Proposed Regulations contain provisions that appear to minimize these possible problems. As noted above, the Proposed Regulations state that "for Federal tax purposes, the ownership of interests in a series and of the assets associated with a series is determined under general tax principles." Prop. Reg. §301.7701-1(a)(5)(vi). In addition, the preamble to the Proposed Regulations also contains several helpful statements, including that "common law principles apply to the determination of whether a person is a partner in a series that is classified as a partnership for Federal tax purposes under §301.7701-3" and "[T]axpayers that establish domestic series are placed in the same position as persons that file a certificate of organization for a state law entity."

Accordingly, if the Proposed Regulations are finalized substantially as proposed, the author believes that the issuance of a profits interest by the juridical LLC that is associated with a series should be treated as the issuance by the series if that series is classified as a partnership. A problematic situation would arise, however, if the holder of the profits interest was the only person with an economic interest in the series. Such series would be disregarded for income tax purposes unless it elected to be taxed as a corporation, and the issuance of that profits interest likely would be viewed as an interest in a sole proprietorship or a corporation and therefore taxable under IRC §83.

State Tax Issues are Evolving

The comptroller of the State of Texas apparently intends to treat a series LLC as a single entity for franchise tax purposes. The state bar Tax Section has recommended that each series be treated as a separate entity for margin tax purposes to avoid causing the difference that would otherwise result with respect to aggregating entities for margin tax purposes. Separate entities that are under common control do not have to file as a combined group unless they are engaged in a unitary business. However, under the comptroller's approach, all series created under the same series LLC will in effect be combined for margin tax purposes even if the series are not engaged in a unitary business.

The California Franchise Tax Board has announced it will treat each series within a series LLC as a separate LLC, thus subjecting each series to minimum $800 annual franchise tax.

Additional Resources

For related materials on this topic, please refer to the following.

Business Law Section 2013 Spring Meeting Programs

Practical Estate Planning and Wealth Management with LLCs
2:30 PM - 4:30 PM, Thursday, April 04, 2013
Columbia 4, Terrace Level, Washington Hilton Hotel
LLCs, Partnerships and Unincorporated Entities; Chair - Allen Sparkman

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