Federal tax classification of entities with zero-equity members.

Zero-equity members are not uncommon, especially in a foreign context. In fact, countless German businesses operate through an entity called a GmbH & Co KG. A U.S. acquirer of a German group is likely to end up owning several GmbH & Co KGs and needs to know how to classify them for U.S. tax purposes.

In Letter Ruling 200201024, one "member" of a two-member domestic limited liability company (LLC) did not meet the minimum membership requirements for the "check-the-box" rules under Regs. Sec. 301.7701-3. The member had no interest in the LLC's capital, did not share in the company's profits or losses and had no management rights or responsibilities. Its sole purpose was to prevent the other member from placing the LLC into bankruptcy on its own volition. As a result, for classification purposes, the LLC was a disregarded entity or "tax nothing" under the default rule for domestic entities under Regs. Sec. 301.7701-3(b)(1). According to this regulation, a domestic eligible entity (i.e., an entity other than a per se corporation) that does not file an election for treatment as a corporation would be a partnership if it has two or more members, or a disregarded entity if it has a single owner.

A GmbH & Co KG is a limited partnership (Kommanditgesellschaft) for German tax and legal purposes. Typically, it has one limited partner, a corporation that owns 100% of the partnership capital, and one general partner (also a corporation (or "GmbH")) with no equity interest and no share in the company's profits and losses. In most instances, this general partner is the limited partner's wholly owned subsidiary. Unlike the zero-equity LLC member in Letter Ruling 200201024, the general partner of a GmbH & Co KG has unlimited liability for the partnership's debts and is responsible for managing the entity. However, in light of Letter Ruling 200201024 and prior rulings, it is far from certain whether the zero-equity general partner qualifies as a member under the check-the-box regulations.

The question of membership is relevant regardless of whether the GmbH & Co KG makes a check-the-box election. It is true that it may always elect corporation treatment, but the number of members determines the availability of an election for treatment as either a partnership or as a disregarded entity (Regs. Sec. 301.7701-2(a) and -3(b)(1)). The number of members is even more important under the default rule for foreign entities (Regs. Sec. 301.7701-3 (b) (2) (i)), under which a foreign eligible entity would be a:

* Corporation, if all members have limited liability;

* Partnership, if it has two or more members and at least one member has unlimited liability; or

* Disregarded entity, if it has a single owner with unlimited liability.

Thus, under this default rule, if a foreign entity's general partner is denied member status, it might be classified as a corporation, because the only qualifying member(s) would supposedly have limited liability.

The regulations are silent as to whether the term "member" is defined under U.S. or foreign law, although the existence of a foreign entity's limited liability is generally determined under foreign law (Regs. Sec. 301.77013(b)(2)(ii)). However, an argument for similar treatment to determine membership appears weak because, unlike the liability rules, both the domestic and the foreign entities must meet the membership requirement. If no explicit rule to the contrary exists, it would seem more likely that the IRS would apply the standards set forth in Regs. Sec. 301.7701-1 (a) (1), which provide that "[w]hether an organization is an entity separate from its owners for federal tax purposes is a matter of federal tax law."

To determine the requirements for "true" membership for U.S. tax purposes, prior rulings provide some guidance. For instance, relying on Luna, 42 TC 1067 (1964), Rev. Rul. 75-31 held that a person with no present or future "interest in any item of income, gain, loss, deduction, credit or capital ... receipts, investments or other property" in the partnership was not a partner for Federal income tax purposes.

However, Rev. Proc. 91-13 (which provided a checklist for taxpayers requesting letter rulings on limited partnership classification under the pre-check-the-box regulations) asked: "Will at least one general partner contribute, or has at least one general partner contributed, substantial services in its capacity as a partner, apart from services for which guaranteed payments under section 707(c) of the Code are made?"

In addition, there is a substantial body of case law indicating that filing a partnership return prevents a member from denying partner status; see McManus, 583 F2d 443 (9th Cir. 1978), and Smith, TC Memo 1978-416.

It is unclear to what extent these pre-check-the-box rulings and cases continue to apply. However, the trend seems to be that even under the check-the-box rules, a member of a business entity must have some interest in the benefits and bear some risk of loss; see McKee, Nelson & Whitmire, Federal Taxation of Partnerships and Partners, Sec. 3.02[5][a], n. 69. Letter Ruling 200201024 follows in these footsteps.

Based on the available authority, a zero-equity general partner of a typical GmbH & Co KG is probably not a member for Federal tax classification purposes. Thus, if the entity desires partnership treatment, the general partner should obtain some interest in the company's income or loss, rendering the GmbH & Co KG a partnership by default.

However, for an entity to obtain classification as a corporation, simply relying on the "disappearance" of the zero-equity member may not be enough. Not recognizing the general partner completely distorts the foreign entity's character for satisfying the U.S. entity-classification regulations. Of course, unlimited liability undeniably continues to exist and the disregarded general partner continues to provide management services for the GmbH & Co KG, regardless of these regulations. Also, an argument can be made that the limited partner should be deemed to absorb the disregarded (and wholly owned) general partner's liability for U.S. tax purposes. Such a result is hardly the regulation's desired effect.

An entity can safely resolve this doubt only by making an affirmative check-the-box election for corporation treatment for U.S. tax purposes and not rely on the default rules.

FROM MARTIN H. KARGES, LL.M., AND LEONARD D. LEVIN, J.D., NEW YORK, NY

Pamela Packard, CPA
Vice Chairman
Tax Services
BDO Seidman LLP
New York, NY