Federal Tax Status of a Series Limited Liability Company

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1 Page 1 of 6 Checkpoint Contents Tax News Journal Preview (WG&L) Business Entities (WG&L) Federal Tax Status of a Series Limited Liability Company, Business Entities (WG&L) LLCs Federal Tax Status of a Series Limited Liability Company Author: Steven E. Grob and Norman J. Hannawa Steve Grob is a member and Norman Hannawa is an associate of the law firm of Dykema Gossett PLLC, in Detroit, Michigan. This article marks the first appearance of the authors in these pages. A series limited liability company (SLLC) is an entity that provides limited liability protection to the owners of each entity in the series. The federal tax status of an SLLC and each of its series has been uncertain. However, a recent private letter ruling gives us some guidance about the federal tax treatment of an SLLC by holding that each series will be viewed as a separate tax entity and, based upon its characteristics and elections, will have its own tax status independent of each other series. Several states have enacted SLLC statutes. In 1996, Delaware enacted the first SLLC statute, and it continues to be one of the more developed statutes. 1 Illinois also has a well developed SLLC statute. 2 Iowa, Nevada, Oklahoma, Tennessee, and Utah have also enacted SLLC statutes. 3 The basic concept of an SLLC is that its single operating agreement establishes separate series similar to separate LLCs, each with its own objectives, voting rights, management, and liability. One reason for the use of a series is to reduce administrative costs incurred by organizing separate entities. Several examples include holding one manager and shareholder or member meeting for all of the entities in the series; filing one registration document for entities required to register with the Securities Exchange Commission; and reducing formation and maintenance costs by allowing the creation of additional series simply by using the provisions of the operating agreement without requiring the filing of separate organization documents with the state. 4 Although SLLCs can provide businesses with cost and administrative benefits, it appears that few businesses have utilized the SLLC structure, possibly due to the fact that there is little statutory or case law, or administrative guidance on the treatment of SLLCs and until now the federal tax status of an SLLC has been uncertain. The IRS recently issued Ltr.Rul , which appears to be the first ruling on the taxation of an SLLC. It holds that each series of an SLLC is a separate entity for federal tax purposes. This article explores the tax treatment of SLLCs prior to Ltr. Rul , the rationale behind treating each series as a separate entity, and what Ltr. Rul is all about. Possible Treatment of an SLLC Prior to Ltr. Rul , neither Congress, the courts, nor the Service had provided any guidance on the federal tax classification of an SLLC. The regulations establish mandatory classification for federal tax purposes for some entities and a procedure for electing a tax classification for other entities. If an entity meets the requirements of Reg , -3, and -4,. it is not subject to mandatory tax classification and it has the option to choose to be classified as either (i) a disregarded entity if it has only one owner or a partnership if it has more than one owner or (ii) a corporation. The entity must be: Separate from its owners. A business entity. An eligible entity, and not a per se corporation. (A per se corporation is any one of seven categories of business entities described in the regulations that is subject to the corporate income taxation rules of the Code and is not entitled to elect its tax classification. A business entity that is not a per se corporation is an eligible entity. An LLC is not a per se corporation.)

2 Page 2 of 6 The threshold question to determine the tax classification of an SLLC is whether each series is treated as a separate entity. Prior to Ltr. Rul , it appeared that SLLCs could be classified in different ways, including: (1) Each series of an SLLC could be treated as a separate entity. (2) The SLLC could be treated as a parent company that is the sole owner of each of its series that is taxed as a disregarded entity, in which case the SLLC and all of its series could be treated in the aggregate as a single entity. Assuming that each series could be taxed separately, there was further uncertainty before Ltr. Rul as to whether all of the series must have the same tax classification. Authority for Separate Entity Treatment Whether an organization is a separate entity from its owners for federal tax purposes is a matter of federal law and does not depend on whether the organization is recognized as an entity under local law. Reg (a). However, the Service has indicated that for classification purposes, federal tax law requires a factual determination of the status of the entity under state law, including its rights and obligations. 5 Taxation of a Series Trust. Although prior to Ltr. Rul the Service had issued no guidance regarding the separate entity status of an SLLC, there is long-standing authority that each series in a series trust is a separate entity for federal tax which, in turn, cites the National Securities 6 case as base authority and repeats the Tax Court's tacit characterization of each series of a series trust as a separate taxpayer). 7 Also, in numerous private letter rulings, the Service has ruled that the several series of a single trust may be considered distinct taxable entities and separate taxpayers. 8 All of these rulings cite National Securities and Rev. Rul , C.B Based on National Securities, Rev. Rul , and the numerous rulings (cited in note 8, supra),. some of the common elements under which the Service will treat each series as a separate entity include: (1) Each series consists of a separate pool of assets, liabilities, and a stream of earnings. (2) The holders of interests of a series may share in the income only of that series. (3) The holders of interests in each series are limited to the assets of that series on redemption, liquidation, or termination. (4) The payment of the expenses, charges, and liabilities of each series is limited to that series' assets. (5) The creditors of each series are limited to the assets of that series for recovery of expenses, charges, and liabilities. (6) Each series has its own investment objectives, policies, and restrictions. (7) Votes of holders of interests are conducted by each series separately with respect to matters that affect only that particular series, except to the extent the Investment Act of 1940 requires shares to be voted as a single class of shares. Ltr. Rul The Service issued a private letter ruling to a group of insurance company taxpayers that were reorganizing their mutual fund operations as a Delaware SLLC in which it implicitly ruled that each series of the SLLC is a separate entity for federal income tax purposes and each series is entitled to choose its own entity classification independent of the classification of other entities in the series. Facts and Representations. The letter ruling involved a Massachusetts business trust (the Trust ) organized under the laws of the Commonwealth of Massachusetts that operated as an open-end management investment company, commonly known as a mutual fund, registered under the Investment Company Act of 1940, as amended (the 1940 Act ). Beneficial interests in the Trust were divided into shares. Under authority granted in the Trust's Declaration of Trust,. Trustees of the Trust divided its shares into several portfolios (or series of shares). Each Trust Portfolio was separate from other Trust Portfolios. Each Trust Portfolio was taxed as a separate RIC under Section

3 Page 3 of 6 The Trust reorganized into an SLLC under the laws of Delaware (the Series LLC ). Each Trust Portfolio reorganized into a corresponding portfolio of the Series LLC (an LLC Portfolio ). Like the Trust, the Series LLC will operate as an open-end management investment company, or mutual fund, registered under the 1940 Act. Beneficial interests in the Series LLC will be divided into shares of LLC member interests. The taxpayers represented that, after the reorganization, certain LLC Portfolios that will have only one shareholder (collectively, the Type D Portfolios ) will not elect pursuant to Reg to be taxed other than as an entity disregarded as an entity separate from its owner. If a Type D Portfolio thereafter sells shares to one or more additional owners, it will have at least two members and will not elect. to be taxed other than as a partnership. The taxpayers represented that certain other LLC Portfolios, each of which currently has more than one shareholder (collectively, the Type P Portfolios ), will not elect pursuant to Reg to be taxed other than as a partnership. The taxpayers represented that certain LLC Portfolios will elect to be treated as associations taxable as corporations, effective from the date of formation of such LLC Portfolios (collectively, the Type C Portfolios ). The taxpayers also represented that, following the reorganization, the Series LLC may, in the future, establish and designate one or more additional LLC Portfolios. Any such additional LLC Portfolios will engage in the same business operations and satisfy the same representations of Type P, Type D, or Type C Portfolios. Holdings of the Letter Ruling. The Service ruled that after the reorganization: (i) each Type C Portfolio will be classified as an association taxable as a RIC unless it makes an election to be treated otherwise, (ii) each Type D Portfolio will be classified as an entity disregarded as an entity separate from its owner unless it makes an election to be treated otherwise, (iii) each Type P Portfolio and each Type D Portfolio, if shares in such Type D Portfolio are sold to one or more additional owners, will be classified as a partnership unless it makes an election to be treated otherwise, and (iv) each Type P Portfolio and each Type D Portfolio that is classified as a partnership will not be treated as a publicly traded partnership. 10 The IRS further ruled that any additional portfolios established by the SLLC in the future, which will engage in the same business operations and satisfy the same representations of Type P, Type D, or Type C Portfolios, will be properly classified as (i) a partnership if such portfolio has two or more owners unless it makes an election to be treated otherwise, (ii) a disregarded entity if such portfolio has a single owner unless it makes an election to be treated otherwise, or (iii) an association taxable as a RIC if such portfolio elects to be so treated unless it thereafter makes an election to be treated otherwise. Although the IRS did not rule that each series of the Series SLLC is a separate entity, the letter ruling treated each series as a separate entity that is entitled to elect its tax classification under Reg , -3, and -4, and the IRS allowed multiple types of entity classifications within the Series LLC, which would not be possible unless each series is a separate entity. Therefore, the IRS has implicitly ruled that it will treat each series of an SLLC as a separate entity. Although the facts of the letter ruling involved particular types of taxpayers (i.e., mutual funds used to fund variable annuity and life insurance contracts), its analysis and holdings should be broadly applicable to SLLCs conducting other types of activities. Suggested Framework for Structuring an SLLC to Satisfy Separate Entity Factors Technically, Ltr. Rul is the IRS's holding only on the transactions described therein and another taxpayer may not rely on the letter ruling. 11` Nevertheless, the Delaware statute, the IRS's prior rulings on series trusts, and Ltr. Rul provide a blueprint for organizing an SLLC with increased certainty that the IRS will treat each series as a separate entity. It is recommended that an SLLC be organized in one of several particular states and it include certain provisions in its operating agreement. The Delaware Statute. Because the SLLC is a relatively new type of state law entity and few states have established SLLC statutes, it is recommended that an SLLC be organized in one of the states that have passed an SLLC statute. The Delaware Limited Liability Company Act includes a provision that deals specifically with SLLCs. Del. Code Ann. tit. 6, (the Delaware Statute ). Although other SLLC statutes may also be used, the Delaware statute has this advantage: The IRS ruled in Ltr. Rul that each series of a Delaware SLLC is a separate entity. 12 The Delaware Statute states that an SLLC's operating agreement may provide for the establishment of a designated series of members, managers, or LLC interests having separate rights, powers, or duties with respect to specified property or obligations of the SLLC or profits and losses associated with specified property or obligations. See Del.

4 Code Ann. tit. 6, (a). The Delaware Statute also provides that any such [LLC] series may have a separate business purpose or investment objective. Id. It further provides that the debts, liabilities and obligations, and expenses incurred, contracted for, or otherwise existing with respect to a particular series can be enforceable against the assets of such series only, and not against the assets of the limited liability company generally or any other series, if notice of this limitation on liability of a series is included in the SLLC's certificate of formation. Del. Code Ann. tit. 6, (b). These provisions of the Delaware Statute are factors in support of separate entity status under the Service's rulings with respect to series trusts. SLLC Operating Agreement. Based on Ltr. Rul , National Securities, Rev. Rul , and numerous private letter rulings (see note 8, supra), each series of a Delaware SLLC having the characteristics of a separate entity pursuant to the terms of its operating agreement and under Delaware law should be treated as a separate entity for federal income tax purposes. To assure greater certainty that the Service will treat each series as a separate entity, it is recommended that the operating agreement of an SLLC include the following provisions (which are permitted under the Delaware Statute). Separation. Each series will consist of a separate pool of assets, liabilities, and stream of earnings. Ownership. The members of each series may share in the income only of that series, and the ownership interest of the members in a series will be limited to the assets of that series upon redemption, liquidation, or termination of such series. Liabilities. The payment of the expenses, charges, and liabilities of a series is limited to that series' assets and the creditors of each series are limited to the assets of that series for recovery of expenses, charges, and liabilities. Also, Del. Code. Ann. tit. 6, (b), provides that if the limited liability company agreement so provides and other conditions are met: the 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. (Emphasis added). Separate Business. Under Del. Code. Ann. tit. 6, (a), the operating agreement can also provide: Page 4 of 6 A limited liability company agreement may establish or provide for the establishment of 1 or more designated series of members, managers or limited liability company interests having 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. (Emphasis added). Voting. Under Del. Code. Ann. tit. 6, (e), votes of members may be conducted by each series separately with respect to matters that affect only that particular series. State Taxation of an SLLC. Obviously, Ltr. Rul does not address the state taxation of an SLLC. This leaves some uncertainty in that regard. However, as practitioners know, many states expressly follow the federal entity classification rules. Conclusion To date, the use of SLLCs has not been widespread. However, in certain situations an SLLC can offer significant benefits over multiple LLCs. One reason for a reluctance to use an SLLC may have been the uncertainty over its federal tax status. While such uncertainty has not been completely eliminated, with the Service's issuance of Ltr. Rul it has been greatly reduced. That letter ruling (1)determined that each series is a separate entity for tax classification and (2) permitted an SLLC to be comprised of a combination of entities having different tax classifications (disregarded entities, partnerships, and corporations). Although other taxpayers may not absolutely rely on the letter ruling, they can take some comfort in its holdings and may want to follow its facts to the extent possible. 1 Del. Code. Ann. tit. 6,

5 Page 5 of ILCS 180/37-40(a). Iowa Code 490A.305; Nev. Rev. Stat. Ann (1)(e), 18 Okl. St ; Tenn. Code Ann ; Utah Code Ann ; Wis. Stat. Ann See Marsico, Current Status of the Series LLC, J. Passthrough Entities (Nov./Dec. 2006); see also McLoughlin & Ely, Series LLCs: Many State Tax Questions Are Raised but Few Answers Are Yet Available, 9 BET 36 (Jan./Feb. 07). 5 6 See FSA (4/27/01) TC 884 (1949) Rev. Rul , CB 416, involved the issue of whether amounts paid to shareholders of a RIC, representing their proportionate part of net income received or receivable up to the date of surrender of their shares for redemption, should be included in determining whether the company has distributed to its shareholders as taxable dividends at least 90% of its net income for the taxable year for the purpose of determining whether the company may obtain the benefits provided in Section 362(b) of the Internal Revenue Code of See, e.g., Ltr. Ruls , , , , , , , , , , , , , , ), , , , , , , , , , Some of these rulings involved the classification of entities, and others addressed other issues while acknowledging the separate existence of multiple series of a series trust. 9 Under Subchapter M of the Code, a RIC is a partial flow-through entity because it is not subject to federal income tax on the part of its net ordinary income and net realized capital gains that it distributes to its shareholders. 10 Prior to issuing Ltr. Rul , the Service had issued a no rule policy generally providing that it would not rule on whether a partnership is a publicly traded partnership.. See Rev. Proc , section 3.01(65), IRB 112. Although not specifically relevant to the tax treatment of an SLLC, the IRS did carve out an exception from its no ruling policy for rulings specifically pertaining to portfolios (the term used in Ltr. Rul to describe a series of the Series LLC) supporting variable contract arrangements of life insurance companies See Rev. Proc , IRB 1, sections and One advantage of the Illinois series LLC statute is that it specifically treats each series as a separate entity under state law.. See 805 ILCS 180/37-40(b)..

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