Response
June 23, 1992
June
23, 1992
XXXXX,
Attorney at Law
Dear
XXXXX:
This
letter is in response to your request for an advisory opinion dated XXXXX and
your supplementary material dated June 18, 1992, concerning the Utah State Tax
Commission's position on the tax status of limited liability companies in the
state of Utah.
It
is the position of the Utah State Tax Commission that companies organized
pursuant to the provisions of Utah Code Ann. 48-2b-101 et seq., the "Utah
Limited Liability Company Act" are to be accorded the same income tax
treatment as a partnership.
Our
opinion appears to be consistent with the Internal Revenue Services' private
letter ruling of XXXXX dealing with a related subject matter.
Please
contact me if I can provide you with further assistance.
For
The Commission,
Roger
O. Tew
Commissioner
June
19, 1992
Roger
O. Tew
Commissioner
Utah
State Tax Commission
Heber
M. Wells Bldg., 5th Floor
160
East 300 South
Salt
Lake City, Utah 84134
Re:
Tax Status of Limited Liability Companies in Utah
Dear
Commissioner Tew:
Pursuant
to our discussions, this letter will supplement my firm's earlier request for
an advisory ruling concerning the tax status of limited liability companies
("LLC") in Utah. A copy of the original request is attached for your
convenience.
As
you will recall, the original request suggests that a business entity organized
pursuant to the provisions of Utah Code Ann. § 48-2b-101 et seq., the
"Utah Limited Liability Company Act" ("ULLCA"), should be
accorded the same treatment for state income tax purposes as a partnership.
Subsequent to that request, two relevant events have occurred about which you
should be apprised.
First,
in response to a July 19, 1991, ruling request submitted by XXXXX on behalf of
one of our clients, the Internal Revenue Service issued a Private Letter Ruling
(the "Ruling"), dated February 6, 1992, holding that the subject LLC,
which was organized pursuant to the ULLCA, lacks the corporate characteristics
of "continuity of life" and "free transferability of
interests," and therefore, will be classified as a partnership for federal
income tax purposes. A copy of the ruling is attached.
The
Ruling is based upon an IRS conclusion that "continuity of life" is
not present where a LLC will terminate upon the death, retirement, resignation,
expulsion, bankruptcy, or dissolution of a member or upon the occurrence of any
other event that terminates the continued eligibility for membership of a
member in the LLC, unless the business of the LLC is continued by the consent
of the remaining members entitled to receive a majority of the capital of the
LLC under a right to do so stated in the articles of organization or the
operating agreement. The IRS held in the Ruling that the subject LLC lacks
"continuity of life" because the LLC's operating agreement provides that
it will terminate upon the occurrence of one of the enumerated events unless
there are at least two remaining members and all remaining members agree to
continue the business.
The
IRS also concluded that "free transferability of interests" is not
present where state law and a LLC's operating agreement provide that a member's
interest may be transferred or assigned only with the consent of the
nontransferring members which hold a majority of the nontransferred profits of
the LLC and where they further provide that if consent is not given, the
transferee shall have no right to participate in the management of the business
and the affairs of the LLC. The IRS held in the Ruling that the subject LLC
lacks "transferability of interests" because its operating agreement
limits transferability of interests in the fashion described, above.
Second,
the Utah Legislature amended the ULLCA during its 1992 general session by
enacting House Bill No. 387, "Limited Liability Company Act
Amendments." The majority of the amendments made in House Bill No. 387
relate to non-tax issues, however, Section 11 of House Bill No. 387 amends §
48-2b-137 of the ULLCA, dealing with dissolution of a LLC, to provide Utah
LLC's greater flexibility in "failing" the "continuity of life"
characteristic. These amendments were patterned after the provisions of Texas
law recently approved of in an IRS Private Letter Ruling issued to a
Texas-organized LLC. A copy of that ruling is attached. In that Private Letter
Ruling, the IRS indicated that the corporate characteristic of "continuity
of life" is not present where Texas law and the subject LLC's operating
agreement provide that the LLC would be dissolved only upon the bankruptcy of
the LLC's manager which was a corporation. The IRS classified the Texas LLC as
a partnership for federal income tax purposes because it lacked the
characteristics of "continuity of life" and "free
transferability of interests.
In
light of this supplementary authority, I request the Utah State Tax Commission
issue an advisory ruling that a LLC organized under the ULLCA be treated as a
partnership for purposes of Utah income and franchise tax purposes.
Please
contact me should you require further information.
Respectfully,
XXXXX
February
6, 1992
This
is in reply to a letter dated July 19, 1991, on behalf of P, requesting a
ruling on the classification of P as a partnership for federal income tax
purposes.
The
information submitted states that P was organized as a limited liability
company pursuant to the provisions of the Z Limited Liability Company Act. P
has three members.
Section
301.7701-2(a)(1) of the Procedure and Administration Regulations sets forth six
corporate characteristics to be considered in determining whether an
organization is properly classified as an association taxable as a corporation:
(1) associates, (2) an objective to carry on business and divide the gains
therefrom, (3) continuity of life, (4) centralization of management, (5)
limited liability, and (6) free transferability of interests.
Section
301.7701-2(a)(1) of the regulations provides that an organization will be
treated as an association if the corporate characteristics are such that the
organization more nearly resembles a corporation than a partnership. Section
301.77012(a)(2) provides that characteristics common to partnerships and
corporations are not material in attempting to distinguish between an
association and a partnership. Because associates and an objective to carry on
business and divide the gains therefrom are generally common to both
corporations and partnerships, an organization such as P that has such
characteristics will be classified as a partnership if it lacks at least two of
the remaining corporate characteristics. Section 301.7701-2(a)(3).
Rev.
Rul. 88-76, 1988-2 C.B. 360, holds that the Wyoming limited liability company
considered therein is classified for federal tax purposes as a partnership
because it lacks the corporate characteristics of continuity of life and free
transferability of interests.
Section
301.7701-2(b)(1) of the regulations provides that if the death, insanity,
bankruptcy, retirement, resignation, or expulsion of any member will cause a
dissolution of the organization, continuity of life does not exist. Section
301.7701-2(b)(2) provides that an agreement by which an organization is
established may provide that the business will be continued by the remaining
members in the event of the death or withdrawal of any member, but such
agreement does not establish continuity of life if under local law the death or
withdrawal of any member causes a dissolution of the organization. Thus, there
may be a dissolution of the organization and no continuity of life although the
business is continued by the remaining members.
Z's
limited Liability Company Act provides that a limited liability company will be
dissolved upon the death, retirement, resignation, expulsion, bankruptcy, or
dissolution of a member or upon the occurrence of any other event that
terminates the continued eligibility for membership of a member in the limited
liability company, unless the business of the limited liability company is
continued by the consent of the remaining members entitled to receive a
majority of the capital of the limited liability company under a right to do so
stated in the articles of incorporation or operating agreement. P's operating
agreement provides that it will be dissolved upon the occurrence of one of the
above described events of dissolution, unless there are at least two remaining
members and all the remaining members agree to continue the business of P.
Because P will terminate upon the occurrence of one of the above described
events of dissolution, unless the business of P is continued by the consent of
all the remaining members, continuity of life does not exist.
Under
section 301.7701-2(e)(1) of the regulations, an organization has the corporate
characteristic of free transferability of interests if each of the members or
those members owning substantially all of the interests in the organization
have the power, without the consent of other members, to substitute for
themselves in the same organization a person who is not a member of the
organization. In order for this power of substitution to exist in the corporate
sense, the member must be able, without the consent of other members, to confer
upon the member's substitute all the attributes of the member's interest in the
organization.
Z's
Limited Liability Company Act further provides that an interest of a member in
a limited liability company may be transferred or assigned as provided in the
operating agreement. However, if the nontransferring members entitled to
receive a majority of the nontransferred profits of the limited liability
company do not approve of the proposed transfer or assignment, the transferee
of the interest of the member shall have no right to participate in the
management of the business and affairs of the limited liability company or to
become of member. The transferee shall be entitled to receive only the share of
profits or other compensation by way of income and the return of contributions
to which that member otherwise would be entitled P's operating agreement
further provides that no transferee, designee or legal representative of a
member shall become a substitute member without the consent of a majority, by
sharing ratios, of the non-transferring members. In the event such consent is
not granted, the transferee has no right to participate in the management of
the business and affairs of P and is entitled only to receive the share of
profits or other compensation by way of income and the return of contributions
to which that member would otherwise be entitled. Accordingly, free
transferability of interests does not exist.
Therefore,
based on the information submitted and representations made, and provided that
P is organized and operated in accordance with applicable Z statutes pertaining
to limited liabilities companies that the agreement is enforceable under the
laws of Z and that there is no change to the agreement, P will be classified as
a partnership for federal income tax purposes.
Except
as specifically ruled upon above, no opinion is expressed as to the federal
income tax consequences of the transaction described above under any other
provision of the Code.
A
copy of this letter should be attached to the next tax return filed by P. A
copy is enclosed for that purpose.
This
ruling is directed only to the taxpayer who requested it. Section 6110(j)(3) of
the Code provides that it may not be used or cited as precedent.
Sincerely
yours,
XXXXX
Hal
Hansen
Chairman
Utah
State Tax Commission
Heber
M. Wells Bldg., 5th Floor
160
East 300 South
Salt
Lake City, Utah 84134
Re:
Request for advisory ruling on tax status of limited liability companies
Dear
Chairman Hansen:
On
behalf of the law firm XXXXX, I request the Utah State Tax Commission issue an
advisory ruling that a business entity organized pursuant to the provisions of
Utah Code Ann. § 48-2b-101 et seq., the "Utah Limited Liability Company
Act" ("ULLCA"), will be classified as a partnership for state
income and franchise tax purposes. This request for an advisory ruling is made
with the understanding that should the Tax Commission issue an adverse advisory
ruling, this request may be converted to a formal request for declaratory
ruling pursuant to Utah Code Ann. § 63-46b-21 and Rule R861-1-5A.1Q, Utah
Administrative Code, in which case, we would be accorded all rights to due
process of law set forth in Utah Code Ann. § 63-46b-1 et seq., and otherwise.
I. BACKGROUND.
A. General.
A
limited liability company ("LLC") is a new hybrid form of business
entity intended to combine the corporate characteristic of limited liability
with the operational flexibility and "flow-through" tax consequences
generally associated with the partnership form of organization. Investors have
previously sought these same benefits by organizing as S Corporations or as
limited partnerships, however, neither form of business has fully satisfied
investor needs. For instance, notwithstanding its special tax treatment, an S
Corporation is, nonetheless, a corporation, subject to the operational
formalities imposed upon all corporations and also subject to restrictive
federal tax rules such as those limiting the number and type of shareholders.
Similarly, limited partnerships have not proven to be a panacea for investors
because the limited partners are not, under some circumstances, completely
insulated from personal liability. In addition, limited partners are unable to
fully participate in the day-to-day operations of the partnership without
jeopardizing the limited nature of their liability.
B. Historical development.
Limited
liability company provisions were first enacted in 1978 by the state of
Wyoming. According to some commentators, Wyoming's law was precipitated by
concerns of oil and gas drilling investors who, during Wyoming's oil boom of
the late 1970's, became disenchanted by their inability as limited partners to
actively manage their investment, but who still desired the limited liability
protection and "flowthrough" tax consequences available to them as
limited partnerships or as S Corporations. Wyoming's law was largely ignored as
a viable business option, however, when the Internal Revenue Service adopted a
"no rule' policy concerning the federal income tax status of limited
liability companies. In 1988, after rescinding its "no rule" policy,
the Internal Revenue Service issued Revenue Ruling 88-76, I.R.B. 1988-38, in
which it ruled that a company organized under Wyoming's limited liability
company laws would be classified as a partnership for federal income tax
purposes.
In
XXXXX, the Utah State Legislature enacted House Bill No. 221 (1991), the Utah
Limited Liability Company Act," now codified in Utah Code Ann. § 48-2b-1
et seq., thereby joining Wyoming, Colorado, Kansas, and Florida as only the
fifth state in the nation to allow a business to organize as a LLC. Subsequent
to Utah's action, Virginia, Texas, and Nevada also enacted similar legislation
during XXXXX. Many other states are currently considering similar legislation.
C. Treatment under federal law.
The
IRS holding in Revenue Ruling 88-76 is premised upon an analysis of Internal
Revenue Code provisions which describe and define certain business organizations
in order to classify them for federal income tax purposes.
As
previously explained, the purpose of forming a LLC is to operate in a business
form that would allow for a "flowthrough" of tax benefits, similar to
a partnership. Pursuant to Internal Revenue Code § 7701(a)(2)
("I.R.C."), the term "partnership" includes a
"syndicate, group, pool, venture, or other unincorporated organization,
through or by means of which any business financial operation, or venture is
carried on, and which is not a trust or estate or corporation." LLC
legislation is designed to authorize the formation of an entity that is not a
trust, estate, or corporation and which would otherwise be classified as a
partnership.
Pursuant
to § 7701(a)(3) I.R.C. a "corporation" includes "associations,
joint-stock companies, and insurance companies." Entities that may be
classified as corporations for federal income tax purposes are described in
Treasury Regulation § 301-7701-2(a)(1) as possessing the following
characteristics: (1) associates; (2) an objective to carry on a business and
divide the gains therefrom; (3) continuity of life, (4) centralization of
management; (5) liability for corporate debts limited to corporate property,
and (6) free transferability of ownership interests. Treasury Regulation
301-7701-2(a)(2) then directs that the analysis regarding the classification of
a business entity should disregard those corporate characteristics held in
common with partnerships; e.g. the characteristics of "associates"
and "an objective to carry on a business and divide the gains
therefrom." Whether an entity is classified as a corporation will,
therefore, depend upon an analysis of the four remaining corporate
characteristics. Finally, Treasury Regulation § 301-77012(a)(3) provides that a
business entity will not be classified as a corporation unless it possesses a
preponderance, e.g. more than fifty percent, of the four remaining corporate
characteristics. Judicial interpretation of these regulations further direct
that each of the four characteristics must be weighted equally.
In
Revenue Ruling 88-76, the Internal Revenue Service held that an entity
organized under Wyoming's LLC laws lacked "a preponderance of the four
remaining corporate characteristics" and was "classified as a partnership
for federal tax purposes." The Internal Revenue Service has subsequently
issued private letter rulings to entities organized under the limited liability
laws of the states of Colorado, Florida, and Kansas, arriving at similar
conclusions. XXXXX has submitted a private letter ruling request on behalf of
one of its clients which has formed a LLC under the ULLCA and anticipates a
favorable ruling in the near future.
D. Treatment under state law.
The
state tax consequences of a LLC under Utah law should not differ from the
federal tax consequences discussed, above.
First,
when the ULLCA was first considered by a House Standing Committee during the
1991 general session of the Utah Legislature, Commissioner G. Blaine Davis
appeared on behalf of the Utah State Tax Commission and reported to the
Committee that the Tax Commission did not oppose the proposed legislation and
that the Tax Commission agreed that a LLC organized under the then proposed
ULLCA would be taxable as a partnership under Utah law.
Second,
a LLC operates in much the same fashion as a partnership formed under state
law. In light of that fact, the IRS has ruled, at least with regard to LLC's
organized under Wyoming's limited liability company laws, that they will be
taxable as a partnership under federal law. The IRS has issued similar private
letter rulings to LLC's organized pursuant to the laws of other states.
Pursuant to Utah Code Ann. § 59-10-301, "[a] partnership is not subject to
the tax imposed by this chapter. Persons carrying on business as partners are
liable for the tax imposed by this chapter only in their separate or individual
capacities." LLC's should be similarly treated, with LLC members liable
for the income tax imposed under chapter 10 in their separate or individual
capacities.
Third,
for purposes of Utah's corporate franchise and income tax, a LLC organized
pursuant to the ULLCA fails to meet the basic definition of the term
"corporation" defined in Utah Code Ann. § 59-7-101(3), consequently,
Utah's corporate franchise and income tax should not apply.
E. Conclusion.
In
conclusion, we believe that the there is sufficient authority for the Tax
Commission to rule on this advisory ruling request and to conclude that a LLC
formed pursuant to the ULLCA will be taxable as a partnership under Utah law.
Please
feel free to contact me should you have any questions.
Respectfully
XXXXX
XXXXX
P
= Limited
N
= Limited
M
= Co.
Dear
XXXXX:
This
is in reply to your letter dated November 15, 1991, and prior correspondence,
submitted on behalf of P, requesting a ruling on the classification of P as a
partnership for federal income tax purposes and certain rulings on the merger
of N, a Texas limited partnership into P.
P
will be organized under the laws of the State of Texas as a limited liability
company pursuant to the Texas Limited Liability Company Act (the
"Act"). It is proposed N will
be merged into P. By reason of the
merger, N will cease to exist, P will succeed to all of N's assets and
liabilities, and N's partners will become the members of P.
The
managing general partner of N is M, a corporation. M will become the manager of P.
P
has associates and an objective to carry on business and divide the gains
therefrom. Section 301.7701-2(a)(2) of
the Procedure and Administration Regulations.
Therefore, in order to be classified as a partnership, P must lack at least
two of the following corporate characteristics: continuity of life, centralization of management, limited
liability, and free transferability of interests. Section 301.7701-2(a)(3) of the regulations.
An
organization has the corporate characteristic of free transferability of
interests if each of its members or those members owning substantially all of
the interests in the organization have the power, without the consent of other
members, to substitute for themselves in the same organization a person who is
not a member of the organization.
Section 301.7701-2(a)(a) of the regulations.
Article
4.05.A. of the Act provides, in part, that unless otherwise provided by the
company's regulations, a membership interest is assignable in whole or in part;
an assignment of a member's interest does not entitle the assignee to become,
or to exercise rights or powers of a member; an assignment entitles the
assignee to receive distributions, to which the assignor was entitled, to the
extent those items are assigned; and until the assignee becomes a member, the
assignor member continues to be a member and to have the power to exercise any
rights or powers of a member, except to the extent those rights or powers are
assigned. Article 4.07.A. of the Act
provides, in part, that an assignee of a membership interest may become a
member if and to the extent that the company's regulations so provide; or all
members consent.
Section
8.01(a) of P's regulations provides, in part, that except as specifically
provided in section 8.01, no disposition of an interest in P shall be effected without
the consent of (i) the manager, or (ii) if the manager is not a member or if
the manager is the member making such disposition, a majority interest. Any attempted disposition by a person of an
interest or right, or any part thereof, in or in respect of P other than in
accordance with 8.01 section shall be, and is declared to be null and void ab
initio.
Section
8.01(b) of P's regulations provides, in part, that notwithstanding the
provisions of Section 8.01(a), the interest of any member in P shall be
transferable without the consent of the manager or any of the members if (i)
the transfer occurs by reason of or incident to the death, dissolution,
divorce, liquidation, merger or termination of the transferor member, and (ii)
the transferee is a permitted transferee as defined in section 8.01(b) or P's
regulations.
Accordingly,
P lacks the corporate characteristic of free transferability of interests.
Article
6.01 of the Act provides, in part, that except as otherwise provided in the
company's regulations, a limited liability company shall be dissolved upon the
death, retirement, resignation, expulsion, bankruptcy, or dissolution of a
member or the occurrence of any other event which terminates the continued
membership of a member in the limited liability company, unless there is at
least one remaining member and the business of the limited liability company is
continued by the consent of the number of members or class thereof stated in
the articles of organization or the company's regulations or if not so stated,
by all remaining members.
Section
10.01 of P's regulations provides, in part, that P shall be dissolved and its
affairs shall be wound up upon M or any subsequent transferee of all or a
portion of M's interest as a member in P shall become a bankrupt member;
provided, however, that if this event shall occur and there shall be at least
one other member remaining, P shall not be dissolved and the business of P
shall be continued, if all members so agree.
Since
P will be dissolved upon the bankruptcy of M or any subsequent transferee of
all or a portion of M's interest, unless the remaining members consent to
continue the organization, P lacks the corporate characteristic of continuity
of life. Section 301.7701-2(b) of the
regulations.
Because
P will lack the corporate characteristics of free transferability of interests
and continuity of life, P will not have more corporate than noncorporate
characteristics.
Therefore,
provided that the organization and operation of P is in accordance with the
applicable Texas statute, P will be classified as a partnership for federal tax
purposes.
Section
708 of the Internal Revenue Code provides that a partnership is considered to
be continuing if it is not terminated.
A partnership is terminated if (a) no part of any business, financial
operation, or venture of the partnership continues to be carried on by any of
its partners in a partnership, or (2) within a 12 month period there is a sale
or exchange of 50 percent or more of the total interest in partnership capital
and profits.
Section
1.708-1(b)(1)(ii) of the Income Tax Regulations provides, in part, that a
contribution of property to a partnership does not constitute a sale or
exchange for purposes of section 708 of the code.
Section
721(a) of the Code provides the general rule that no gain or loss if recognized
by a partnership of any of its partners upon the contribution of property to
the partnership in exchange for an interest therein.
Rev.
Rul. 84-52, 1984-1 C.B. 157, considers the federal income tax consequences of
the conversion of a general partnership interest into a limited partnership
interest in the same partnership. In
Rev. Rul. 84-52, X was formed as a general partnership with equal partners A,
B, C, and D. The partners propose to
convert the general partnership into a limited partnership, with A and B as
limited partners, and C and D as both general partners and limited
partners. Each partner's total percent
interest in the partnership's profits, losses, and capital will remain the same
when the general partnership is converted into a limited partnership. The general partnership's business will
continue after the conversion.
Rev.
Rul. 84-52 treats the conversion as an exchange under section 721 of the Code
and holds, in part, that because the business of X will continue after the
conversion and because under section 1.708-1(b)(1)(ii) of the regulations, a
transaction governed by section 721 is not treated as a sale or exchange for
purposes of section 708, X will not be terminated under section 708.
Therefore,
provided N is properly classified as a partnership for federal income tax
purposes and that there is no change in the partners' shares of N's liabilities
as a result of the conversion, no gain or loss will be recognized by P, N or
any of the members by reason of the merger.
Assuming
that N is properly classified as a partnership for federal income tax purposes,
P will be treated as a continuation of N and there will no termination of N as
a partnership under section 708 of the Code.
Except
as specifically ruled upon above, no opinion is expressed on the federal tax
consequences of the transaction described above under any other provision of
the Code.
A
copy of this letter should be attached to the next tax return that reflects
this transaction.
This
ruling is directed only to the taxpayer who requested it. Section 6110(j)(3) of the Code provides that
it may not be used or cited as precedent.
In
accordance with the power of attorney on file, we are forwarding a copy of this
to M.
Sincerely
yours,
Office
of the Assistant Chief Counsel