IRS addresses LLC issues in Delaware statute and cash-basis accounting.
In Rev. Rul. 93-38, the Service ruled on two factual situations dealing with the Delaware Limited Liability Company Act. Unlike so-called "bullet proof" statutes that do not allow changes to the statute in areas that might affect the classification as a partnership, the Delaware law contains numerous provisions that can be modified by an LLC agreement. In this ruling, the IRS examined two factual situations involving Delaware LLCs. The Service classified the first situation as a partnership, concluding that the LLC lacked a preponderance of the corporate characteristics: 1. Continuity of life: The LLC's continuity was not assured because after the termination of a member, all remaining members would have to agree to continue the business. 2. Centralization of management: Because the LLC agreement vested the entity's management in all of its members, the corporate characteristic of centralized management was absent. 3. Limited liability: The LLC did possess the corporate characteristic of limited liability under the state LLC law. 4. Free transferability of interests: Although a member could assign or transfer an interest to a nonmember, the assignee or transferee would not become a substitute member and would not acquire all of the attributes of the member's interest unless all of the remaining members approved the assignment or transfer; thus, there was no free transferability of interests.
In the second situation, the Delaware LLC was ruled to be an "association for tax purposes." 1. Continuity of life: Pursuant to the LLC agreement, the entity would continue under all circumstances without the approval or consent of any member or manager. 2. Centralization of management: The LLC was managed by its elected managers in accordance with the LLC agreement. 3. Limited liability: Same results as in the first situation. 4. Free transferability of interest: The approval or consent of any other member or manager was not a prerequisite to an effective substitution of parties pursuant to an assignment or transfer of a member's interest to a nonmember.
Thus, in Delaware, the terms of the LLC agreement dictate the type of entity for tax purposes. Care will need to be used to avoid an unwanted tax result by careless drafting.
Cash basis accounting for LLC
In Letter Ruling 9321047, the IRS has ruled on the conversion of a law practice from a general partnership to an Arizona LLC. As part of this ruling, the Service allowed the law firm to continue using cash basis accounting.
Under Sec. 446(c), a taxpayer may compute taxable income under the cash method of accounting. Sec. 448(a) provides that in the case of (1) a C corporation with more than $5 million in gross receipts, (2) a partnership that has a C corporation as a partner and has more than $5 million in gross receipts, or (3) a tax shelter, taxable income will not be computed under the cash method. Sec. 448(d)(3) provides that the term "tax shelter" has the meaning given the term by Sec. 461(i)(3), i.e., any enterprise if interests in such enterprise have been offered for sale in any registered offering; any syndicate (within the meaning of Sec. 1256(e)(3)(B)); and any tax shelter (as defined in Sec. 6662(d)(2)(C)(ii)). Sec. 1256(e)(3)(B) provides that "syndicate" means any "partnership or other entity (other than a corporation which is not an S corporation) if more than 35 percent of the losses of such entity during the taxable year are allocable to limited partners or limited entrepreneurs (within the meaning of section 464(e)(2))." Under Sec. 464(e)(2), "limited entrepreneur" means "a person who (A) has an interest in an enterprise other than as a limited partner, and (B) does not actively participate in the management of such enterprise."
"Syndicate" is also defined to include entities in which more than 35 % of the losses are allocated to "limited entrepreneurs." If an LLC member is not viewed as a limited partner, the member could be viewed as a limited entrepreneur if the member does not actively participate in the management.
After an examination of the facts, the IRS ruled that the professional LLC could continue to use the cash basis of accounting.
As a law firm operating as a professional LLC, the entity would not be a C corporation and the partnership would not have C corporation partners (except in the case of personal service corporations). Thus, the LLC would not be prohibited from using the cash basis of accounting if it was not a tax shelter.
The Service ruled that the entity was not a tax shelter under Secs. 448(d)(3) and 461(i)(3)(A) because no interests had been offered for sale in a registered offering.
The IRS ruled that the LLC was not an "enterprise" for purposes of Sec. 461 (i) (3)(A) since it had not in the past nor would it ever in the future offer interests in itself required to be registered.
The Service also ruled that the LLC was not a "syndicate" under Sec. 1256(e)(3)(B). The members of the LLC would continue to engage in the practice of law and participate in the various management activities set out in the ruling. Based on these management activities, the IRS concluded that the active participation requirements to avoid "syndicate" status were met and the entity was not a syndicate. An important point in this ruling was that the five-man management committee did not own over 65% of the practice and the other lawyer/members were ruled to have sufficient involvement in management to avoid the classification as a syndicate.
Lastly, the Service ruled that tax avoidance was not present under Sec. 6662(d)(2)(C)(ii).
Based on this analysis of the definition of a "tax shelter," the IRS ruled that the entity was not a tax shelter and concluded that it was not prohibited from using the cash method of accounting.
IRS rulings are beginning to settle the tax issues involving the use of LLCs. These rulings appear to be taking a practical approach to answering questions related to the new entity. Hopefully, we will continue to receive this guidance from the Service on a timely basis.
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|Title Annotation:||limited liability companies|
|Author:||McKoy, Lawrence W.|
|Publication:||The Tax Adviser|
|Date:||Aug 1, 1993|
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