Note: The following is an excerpt from the introduction to the article as published in The Tax Lawyer. Author citations have been omitted for brevity. Tax Section members may read the article in its entirety in Adobe Acrobat format.
Entity Identity: The Taxation of Quasi-Separate Enterprises
Stephen B. Land*
Many of the fundamental questions of the tax law can be posed by applying the great interrogatory pronouns to income: how much is there, who should be taxed on it, when should it be recognized, where should it be sourced, what should be its character? This Article asks a different sort of question, of entities: How many?
Usually, it’s an easy question. Each corporation, partnership, LLC, or trust that is a distinct entity under its governing law is treated as a single separate entity for federal income tax purposes. But exceptions come quickly to mind: a transparent entity or grantor trust with a single owner is treated as a branch of that owner, even though it is legally separate; a contractual profit-sharing arrangement can be viewed as a separate entity that is a partnership for tax purposes, and can even elect corporate status under the “check-the-box” regulations; and a portion of an entity may be treated as a separate corporation if it constitutes a taxable mortgage pool.
More interesting questions arise when a set of enterprises share some, but not all, characteristics of a single entity. A variety of domestic and foreign statutes allow business trusts and limited liability companies to establish separate cells or series, each of which can issue equity and debt instruments backed only by its own pool of assets. Corporations lacking separate series commonly issue nonrecourse debt backed only by specified assets and, less commonly, issue tracking stock or structured notes that are entitled to a return calculated by reference to specified assets. Conversely, legally separate entities might align themselves by stapling their equity interests to ensure parallel ownership, or by establishing equalization arrangements designed to ensure that their equity interests maintain fixed relative values.
In each of these cases, determining whether there is one entity or many for tax purposes is absolutely fundamental, since so much else depends on it. Yet guidance is more sparse than one would expect, given the frequency with which these questions arise. The arrangements described here are commonly, though not always, set up for commercial reasons having nothing to do with tax avoidance. The parties deserve to know how they will be viewed by the tax authorities.
This Article discusses some of the tax issues associated with a variety of these arrangements for creating “quasi-separate” enterprises. It does not attempt to do so comprehensively; rather, the goal is to explore those aspects of these arrangements that are most relevant to the question whether they should be treated as separate entities, with a view to seeing whether the lessons learned in one area can be usefully applied to another.
The Article concludes with a discussion of general principles that should guide the development of rules for determining when two enterprises should be treated as parts of a single entity and when they should be treated as separate entities. In the interest of clarity, significant weight should be given to the formal trappings of the arrangements, even though this means that economically similar arrangements may be treated dissimilarly. To the extent that opportunities for abuse exist, they are best addressed in the context of the particular tax rules that are being applied.
*Stephen B. Land is a member of the New York Bar and a partner in the firm of Linklaters LLP, New York, New York.