Series LLC tax issues.
Uncertain Tax Treatment
Despite these potential opportunities, series LLCs may raise tax issues. From a Federal income tax perspective, the question is whether a series LLC should be treated as an umbrella LLC with subsidiary disregarded entities, or as multiple unrelated LLCs. If the interests of a series are treated as owned directly by the LLC members for Federal income tax purposes, then adverse tax consequences could result from using series LLCs.
For instance, a cornerstone of subchapter K is that a contribution of assets is generally not taxable, unless the contributing partner is relieved of liabilities in excess of the contributed property's basis or the partnership is an "investment company" under Sec. 721(b). However, treating a series LLC as individual tax partnerships may trigger gain on formation.
Example: Individuals J and K integrate their businesses by contributing the business assets to separate series of a Delaware LLC treated for Federal tax purposes as separate partnerships. Under Rev. Rul. 99-5, J and K are likely deemed to have sold half of their interests in the contributed business assets to each other before forming the partnerships. The deemed swap results in J and K recognizing half of the gain on the assets of both businesses.
Changes to a Series LLC
Similar problems may confront a Delaware LLC considering whether to add or eliminate a series. Either procedure is simple under Delaware law. To add an LLC series, the LLC need only amend its LLC agreement and file a certificate of amendment with the Delaware Secretary of State. To eliminate a series, it applies to the Delaware Court of Chancery. However, LLC members who view tile series partition as a shield against state law liability and who do not consider the Federal tax ramifications may face additional unexpected gain on adding or eliminating a series. Again, the problem stems from the prospect of having multiple partnerships, rather than just a single state law entity (as seen on paper).
Eliminating a series: If a Delaware LLC with two series is treated as two partnerships for Federal tax purposes, changing to a single tax partnership by eliminating the series would likely be a partnership merger under Sec. 708; see Regs. Sec. 1.708-1(c) In certain situations, a merger may produce a disguised sale under Sec. 707(a)(2)(B), such as when a series LLC, whose members have varying interests in different series, distributes the proceeds of a nonqualified liability to its members. In this situation, the LLC might have avoided triggering gain by baying the members guarantee their pre-merger shares of the debt. However, because eliminating a liability partition appears to be purely a state law event, the LLC members may be unaware that their actions can carry potentially serious Federal tax ramifications.
Adding a series:Just as eliminating a state law liability partition carries Federal income tax consequences under the partnership merger rules, the addition of a new series may cause similar problems. If the new series is a separate partnership for Federal income tax purposes, the change from a single tax partnership to multiple tax partnerships by adding a new series is likely a partnership division under Sec. 708. This could result in gain recognition if the series treated as the divided partnership held Sec. 704(c) property contributed by one of its members. On the deemed creation of the new partnership, the Sec. 704 regulations would treat the interests received in the new partnership as substitute Sec. 704(c) property. Because the interests in that new partnership would then be deemed distributed to both the Sec. 704(c) contributing and noncontributing partners, the contributing partner would recognize gain on the Sec. 704(c) amount contributed to the other partner.
Creating a new series also could trigger gain recognition under Sec. 737, which presumably would apply if the resulting partnership, rather than the divided partnership, held the Sec. 704(c) property. The transfer of the Sec. 704(c) property could also restart the Sec. 704(c)(1)(B) seven-year period during which contributions and distributions are restricted.
This result seems to make sense from a Federal tax perspective. The LLC has forfeited its ability to force the gain from the assets of one series onto the contributing member, having shifted that member's share of gain onto its interest in the other series. However, the result is unexpected from the perspective of a nontax outsider, who views the LLC members as being in the exact economic positions they were with the two businesses. Although a liability partition is now in place, the nontax outsider would not expect this to have any tax consequences, as the partnership may not even have any liabilities.
These brief examples illustrate the potential tax consequences of series LLCs. Additional issues beyond the scope of this item include the effect of a series on (1) calculating a member's basis in the LLC, (2) making allocations under Sec. 752 and (3) determining loss availability under Sees. 465 and 469. The IRS has indicated informally that it is considering whether to issue future guidance on series LLCs. Until it does, however, this useful planning tool requires careful consideration.
CRAIG GERSON, J.D., WASHINGTON, DC
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|Title Annotation:||limited liability companies|
|Publication:||The Tax Adviser|
|Date:||Jul 1, 2004|
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