Estate Planning Newsletter
IRS Issues Proposed Regulations on Delaware Series LLC
Limited Liability Companies (“LLCs”) are a form of business ownership which is a separate legal entity much like a corporation. An LLC is treated like a partnership for tax purposes and like a corporation for liability purposes. Characteristics of an LLC include the following:
- The members of an LLC cannot be held personally liable for the debts of the LLC, unless the members have signed a personal guarantee for the debt.
- The profits, losses and expenses of the LLC flow through the LLC to its members, avoiding double taxation of corporate and individual tax; and
- The LLC is generally not subject to the record-keeping requirements of corporations (i.e., holding meetings, maintaining formal minutes, and recording resolutions.)
Advantages of the Delaware Series LLC
In 1996, Delaware amended its Limited Liability Company Act to allow the designation of a “series” of ownership interests within one LLC, thereby allowing separate assets to be held in separate series within one LLC. The profits and losses of each series are separated from the other series. Delaware Series LLCs offer the following benefits:
- Instead of forming multiple LLCs to segregate the liabilities associated with various assets, one Delaware Series LLC may be formed, resulting in reduced legal, accounting and administrative costs, in forming and maintaining one entity as opposed to multiple LLCs.
- The liabilities associated with certain assets may be segregated into a separate series, thereby insulating the liability of that asset from the other series, and the assets of the LLC in general; it prevents someone suing one series of the LLC from being able to go after the assets of the other series.
- Flexible equity compensation for employees based on the performance or success of the series they work for, rather than the performance of the LLC’s entire operations.
- Tax-free transfers within the LLC. For example, Smith and Jones form a Delaware Series LLC together, Smith contributes property A and Jones contributes property B, thereby creating Series A and B. Smith and Jones each own 50 percent of Series A and 50 percent of Series B and their capital accounts in each series are equal. Smith should be able to exchange his interest in Series A for Jones’ interest in Series B on a tax-free basis. The exchange shifts the capital associated with each series, but since there is no overall net capital shift from one member to another, there is arguably no gain.
Series Legislation Not Yet Adopted in Some States
Not all states allow for the formation of series LLCs; however, many states that do not permit a series LLC to be formed within the state will recognize a series LLC that is validly formed in another state. For example, California does not allow series LLCs to be formed in California, but will respect a validly formed Delaware Series LLC that qualifies to do business in California.
Uncertainty in Some States
In those states that have not adopted legislation allowing for the formation of series LLCs, the amount of asset protection given to a series LLC is uncertain. Some commentators have noted that these states are unlikely to give a series LLC the same level of asset protection given in states that have specifically adopted the series legislation, largely because creditors in states that have not adopted the legislation would not have adequate notice that their rights and remedies in enforcing an action against a series LLC may be limited.
Another area of uncertainty in those states that have not adopted legislation recognizing series LLCs is the area of taxation. In many such states, it is unclear whether the operation of one series in a state will subject the entire LLC to taxation in that state, or if the income of only that series will be subject to taxation in that state.
IRS Issues Proposed Regulations on Delaware Series LLCs
In January of 2008 the IRS issued a Private Letter Ruling stating that federal tax classification is determined for each series independently. In September of 2010, the IRS issued proposed regulations regarding the federal tax treatment of series or “cells” within a series LLC. The proposed regulations treat each cell as a separate entity formed under local law, regardless of whether or not the state law treats each cell as a separate legal entity. For example, if a series LLC has two cells, one with two partners and one with one partner, the first cell will be treated as a partnership for federal tax purposes, and the second cell will be treated as a disregarded entity.
While the proposed regulations offer guidance and clarity to taxpayers, they also offer an additional level of complexity for LLC series owners, as each cell will be required to file separate tax returns and annual statements with the IRS.
Weigh Advantages against Uncertainty
The Delaware Series LLC may offer the advantages of increased asset protection from creditors and the reduction of legal, accounting and administrative costs and taxes. However, in those states that have not adopted legislation allowing for the formation of series LLCs, there exists uncertainty in the actual level of asset protection offered, as well as the amount of potential tax savings. As more states adopt legislation recognizing the formation of series LLCs, and as further guidance from the IRS and courts become available as cases begin to test the series concept, the series LLC may become a familiar choice of entity.
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