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AMBRECHT & ASSOCIATESDelaware Series LLC or LP:
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One downside to isolating assets inside separate classes is that while the partnership agreement or LLC Operating Agreement can provide that the liabilities of each respective class are kept entirely separate – and such agreement will be valid as among partners/members – the provision will likely not be much of a defense as to third-party claimants against the partnership or LLC itself. In general, California does not have laws to isolate liabilities by classes of partners. The best that can be done under California law is to provide that each class is responsible for its liabilities and will indemnify each other class from any claims or liabilities. Enter the "series" concept. Law that first was adopted in Delaware in the mid-1990's (and now has been adopted in several other states including Nevada, Illinois, Iowa, Tennessee, Oklahoma, Utah, with variations in Kentucky, Missouri and Wisconsin) introduces the idea of establishing separate "series" within the LLC or limited partnership context. The series concept for entities originally developed out of the series concept applicable to securities, and the desire to segregate the assets and liabilities of each separate series of security yet all under the umbrella of one entity (LLC or LP, or a Delaware Statutory Trust). More recently the use of series LLCs or partnerships has expended to entities owning assets other than securities, such as real property. There is much discussion in the legal community, along with uncertainty, as uses of series entities develops. Under Delaware law (and similar to that of Nevada and Illinois), when the entity is set up to have separate series and assets are isolated within each individual series (provided the bookkeeping and income and expenses are maintained as segregated with each respective series), then the Delaware statute provides that liabilities and claims from others will be restricted to only that particular series. (One of the uncertainties is that these statutes have not been tested as to liability issues in any reported appellate-level court cases yet.) The Delaware Statute (section 18-215(b)) for series LLC's provides that when the series requirements are met, "then the debts, liabilities, obligations and expenses incurred, contracted for or otherwise existing with respect to a particular series shall be enforceable against the assets of such series only, and not against the assets of the limited liability company generally or any other series thereof, and, unless otherwise provided in the limited liability company agreement, none of the debts, liabilities, obligations and expenses incurred, contracted for or otherwise existing with respect to the limited liability company generally or any other series thereof shall be enforceable against the assets of such series." The Delaware Statute (section 17-218(b)) for series limited partnerships reads similarly. A more recent change in the Delaware statutes now allow provided, unless otherwise limited by the LLC or LP Agreement, that a "shall have the power and capacity to, in its own name, contract, hold title to assets (including real, personal and intangible property), grant liens and security interests, and sue and be sued" (Delaware Statute (section 18-215(c)) for LLCs, and Delaware Statute (section 17-218(c)) for limited partnerships. California Statutory TreatmentCalifornia statutes have not yet adopted the series structure for California entities, but such legislation is in the drafting stage. However, present California law already respects the structure of a foreign entity. California law provides that it will look to the laws of the foreign state under which a foreign LLC is organized as to governance of the LLC, the LLC's internal affairs and the liability and authority of its managers and members ( California Corporations Code section 17450(a)). (See also State Farm Mutual Auto Ins. Co. v. Sup. Ct. (2003) 114 Cal.App.4th 434; In Re Sargent Technology, Inc. (N.D. 2003) 278 F.Supp.2d 1079.) Hence, the laws of the jurisdiction will affect the manner of tax reporting and liability exposure as to each series. (For example, the Illinois LLC series statute is more explicit in that if the LLC series provisions so provide, each series may be treated as a separate legal entity.) Further, the 2006 Legislature gave formal recognition to "a series limited liability company formed under the laws of a jursidiction that recognizes such a series" in revision of Business & Professions Code section 16601 (re sale of goodwill and interests in entities) where the definitions of "business entity," "owner of a business entity" and "ownership interest" add this series LLC language, and section 16602.5 (re non-compete agreements upon dissolution of a LLC or termination of a membership interest) where this language was also added to the statute. Both statutory amendments were effective January 1, 2007. As a further step, inasmuch as California law is familiar with classes but not with series, all of the Delaware series agreements drafted by our office use both the Delaware "series" language as well as the California "class" language in an attempt to maximize the benefits of both state's laws. California Franchise Tax Board OpinionLLCs in California are taxed a minimum $800 per year for the privilege of being able to do business in the State of California, also pay a gross receipts fee/tax (which has been held to be unconstitutional but the Legislature has now amended the statutes so the fee/tax continues) and file a Form 568 Liability Company Return of Income. In terms of income tax reporting, the U. S. Treasury Dept. has not issued specific guidance on series LLCs or series limited partnerships, so there is a variance in how the series LLCs are reporting their taxes. Per our several inquiries we find some accountants report all series and the LLC as one LLC and some report separately for each separate series. Inasmuch as Delaware law (or the law of another state of formation) is to be respected in California under Corporations Code section 17450(a), and given this variance in income tax reporting, many California practitioners hoped to have their cake and eat it too – to have only one $800 annual tax assessed for the entire LLC as a whole, but to be able to report income taxes separately for each separate series (inasmuch as assets are isolated) so that the $250,000 threshold for the gross receipts tax would have to be met by each separate series, and not by the LLC's combination of the receipts of all the series together. At present, FTB is giving the latter but not the former. The FTB affirms that California recognizes a series LLC. (See FTB Publication 689 revised February, 2007). That publication also restates the FTB's position first announced in their March/April 2006 Tax News (online at http://www.ftb.ca.gov/professionals/taxnews/tn_06/03_04.html), in the "Ask the Advocate" column, regarding taxation and registration of Series LLCs in California. As revised FTB Publication 689 puts it, the FTB acknowledges that classification of a business entity for California tax purposes is the same as the classification for federal tax purposes; but with the IRS not currently issuing any guidance on whether a series within a Series LLC is a separate entity or part of a single Series LLC entity, and ignoring the law of the state in which the LLC is organized (see above), the revised FTB Publication 689 states that the FTB currently takes the position that a series within the Series LLC will be considered a separate business entity if: (1) the holders of interests in that series are limited to the assets of that series upon redemption, liquidation, or termination, and may share in the income only of that series; and (2) under state law, the payment of the expenses, charges, and liabilities of that series is limited to assets of that series. Each series that is a separate business entity and registered or doing business in California must file their own California tax return, pay the annual tax, and may be subject to a fee based on total annual income." The good news, of course, is FTB is clearly ready to recognize the separate ownership, assets and liabilities of each individual series. California Revenue & Taxation Code section 17942(b)(2) gives the FTB authority to determine the total gross receipts of "all the commonly controlled limited liability company members if it [FTB] determine that multiple limited liability companies were formed for the primary purpose of reducing fees payable under this section," i.e., the gross receipts tax. In an interesting reverse of this section, FTB is taking a "commonly controlled" LLC which includes several series and is breaking them up into separate LLCs for taxing purposes. Apparently FTB has decided to forego the combined gross receipts tax and instead desires to collect an $800 annual tax per series rather than for the entire LLC as a whole. This FTB opinion appears to direct that each separate series of an LLC doing business in California should register as a separate LLC with the California Secretary of State. This requirement is not contained in any California statute or regulation, and has not been promulgated by the California Secretary of State. In light of Delaware law that is clear that a series LLC is one entity, which law is applicable to California by California Corporation Code section 17450(a), what kind of admission would a practitioner who separately files for each series be making? Additionally, what is the meaning of the FTB opinion for a single member series LLC where all income is reported on the member's Schedule C and not on a FTB Form 568? Furthermore, this holding is inconsistent with California law and prior FTB practice which has has historically recognized classes of partners, and does also recognize classes of LLC members (e.g., Corporations Code section 17102 as to LLCs), and such classes may have separate owners, separate assets, and separate accounting (but without the third-party restriction on liabilities which the series adds), wherein the FTB has never interpreted classes as creating separate entities? When a series is also designed to be a class under California law, does this change the FTB's interpretation? At minimum, the FTB ruling should be revised to take into account whether each series is structured under relevant state law to be a separate entity and report separately for federal income tax purposes, or whether only one entity is created and is reported as one entity for federal income tax purposes. California Board of Equalization OpinionThe Board of Equalization issued an opinion letter dated March 29, 2002 (Ann. C 200.0375.025) directly addressing the applicability of the Delaware series LLC to California's property tax system. The specific questions was whether California would recognize the isolation of ownership, profits, and liabilities within each respective series for purposes of determining whether a change in ownership (which triggers reassessment) occurs on contribution of assets to the LLC if, within each respective series, proportional ownership interests are retained. The BOE legal advisory opinon held that yes, the Revenue & Taxation Code section 62(a)(2) proportional interest exclusion would apply to the series LLC where proportional interests had been retained within each respective series. Note that BOE legal staff have also expressed the same as to classes of interests in partnerships. Although the taxpayer raised the question in the BOE letter as to whether each separate series would be treated as a separate "entity" in California, that was not a determination BOE needed to directly address in order to address the property tax issue, and it was not specifically addressed in that opinion. California Public Utilities Commission RulingIn Decision 04-05-051 dated May 27, 2004, and filed April 5, 2004, the PUC reviewed the application of a corporation (Teligent Services, Inc., subsidiary of Teligent, Inc.) providing telecommunications services in California, for approval of a stock purchase transaction resulting in a change of ownership and control of Teligent, Inc., wherein Series A of Aspen Capital Partners, L.P., a Delaware limited partnership, would become the holder of approximately 95.31% interst in Teligent, Inc. The purpose of the PUC review was to be sure Series A of Aspen met the PUC requirements and that the transaction was suitable. The Decision recites that Series A itself does not have a separate Certificate of Limited Partnership on file in Delaware (i.e., it is not a separate entity) but recites the language from Aspen's certificate that "each series of limited partnership interests has separate rights, powers and duties with respect to the property and obligations of Aspen and the associated profits and losses. Entities that hold a partnership interest in Apsen -- Series A do not necessarily hold an interest in Aspen." The decision found that Series A provided financial evidence to meet the PUC financial requirements (i.e., the series alone -- no financial information or partnership interests of the LP as a whole was reference in the Decision, only the financial standing and ownership interests of Series A). The Decision also found that the proposed transaction was in the public interest and so the application was granted. Federal Income Tax GuidanceAs mentioned above (under the FTB discussion), the U. S. Treasury Dept. has not issued specific guidance on reporting of series LLCs or series limited partnerships. Nevertheless, there is a body of federal partnership tax law relevant to the question. (Note that if an LLC elects to be taxed as a corporation, that law would apply). It would seem that within the parameters of the state law applicable to where the series entity was formed, that one could structure the entity in such a way as to either be taxed as one entity (all series together), or have one or more series taxed separately, by structuring the entity to meet current IRS guidelines. 1. Classes. In terms of having different classes of partnership interests, Subchapter K of the Internal Revenue Code anticipates that each partner's total interest in the partnership will be reported as a whole, and each partner's basis in the partnership is determined as a whole, without respect to distinctions of the types of interests held, such as general or limited interests, or other classes. (See Rev. Rul. 84-52, 1984-1 C.B. 175; Rev. Rul. 84-53, 1984-1 C.B. 159; PLR 8350006.) Indeed, Internal Revenue Code section 702 states, "In determining his income tax, each partner shall take into account separately his distributive share . . . ." Such share is to be accounted for each "partner," not based on class, such as general or limited partnership interests, or other classes. Therefore, insofar as a series may be identified with and interpreted solely within the framework of a class, this would would be authority for reporting the entire LLC with all series together as one entity. On the other hand, we have also seen a CPA report by classes by designating each partner on the K-1 as "Joe Smith-Class A," "Joe Smith-Class B," etc., using the same SSN for Joe Smith on both. 2. Member as "Tax Owner." However, while classes are apparently not intended to be reported separately, it may be the case that items of income or liability applicable to a particular asset may, for federal income tax purposes, be the responsibility of an individual partner (the "tax owner") and not the partnership (the "legal owner"). Revenue Ruling 55-39, 1955-1 C.B. 403, dealing with marketable securities, held: Where, as here, the [partnership] agreement provides that certain property is acquired and held for the account of a particular partner, and all of the incidents of ownership, including the right to be credited with income and profits therefrom and all rights of control, are in him, such property cannot qualify as jointly owned property. Some legal and tax practitioners are concerned that Revenue Ruling 55-39 may apply to a series LLC (or series limited partnership) to require each separate series to file a separate partnership return. However, it is not dispositive. The 1969 case of Phillps v. U.S., 414 F.2d 1366, held that the partnership was the owner of tax-exempt bonds, not the partner who contributed the bonds, notwithstanding that the tax-exempt interest was specially allocated to that partner. BNA's Tax Management Memorandum, Vol. 44 No. 21, October 20, 2003, "Virtual Distributions: America Is Ready!" by Philip Tretiak and John Ohrn, contains an illuminative discussion of the principles involved in determining whether an individual partner, as opposed to the partnership, should be deemed the "tax owner." The focus of this analysis is on "whether enough of the benefits and burdens of ownership of a particular asset have been transferred so that the transferee is respected as the tax owner." They review the case law giving various factors in different contexts for a benefits and burdens analysis, and include a discussion of the applicability of agency law as held in the U.S. Supreme Court case of Commr. v. Bollinger 485 U.S. 340 (1988) [note that Rev. Rul. 55-39 is a pre-Bollinger ruling]. This BNA Memorandum essentially provides a checklist for structuring a transaction to cause an individual partner to be the "tax owner" of a particular asset (i.e., taxed to the individual partner rather than the partnership, which retains legal ownership). It would seem that the same principles might also carry over to a series. 3. Each Series a Separate Taxpayer. If desired, a series LLC could be to be structured so that each series would be deemed a separate entity under the U.S. Treasury Regulations. Each series should have a profitable business, specific business purpose, separate management, and not be merely created to serve merely in a protective or conservation function such as a trust. See discussion in Tax Analysis Special Report, "An Initial Inquiry into the Federal Tax Classification of Series Limited Liability Companies," by Charles T. Terry and Derek D. Samz, contained in Tax Notes, March 6, 2006.** That Report includes an analysis of the Illinois series LLC statutes and concludes that the statutes "allows only one logical conclusion to be drawn. Individual series created under the [Illinois series LLC statutes] are definitely business entities separately from the parent LLC and should be treated as such for federal tax purposes." (However, Michael G. Schinner and Michael Powlen, "Multistate Series LLC Practice" [28 CEB Bus L Rep 117, March 2007] do not interpret the Illinois statutes as narrowly. Our reading of the Illinois legislation indicates that each series may be treated as a separate entity of certain requirements are met.) Statutes in jurisdictions such as Delaware and Nevada, rely heavily on the formation documents for the series LLC or LP, and these can be structured to meet the federal tax requirements to treat each separate series as a separate taxpayer, if desired. California's FTB opinion referred to above is based on the case of National Sec. Series-Indus. Stock Series v. Comm'r. (1949) 13 TC 884, which dealt with separate series of a single investment trust (while the court was not addressing directly the question of whether each series was a separate taxable entity, the opinion assumes that each is.) (See also PLR9819002 and 9721007 for IRS recognition of separate series in a business trust.) The FTB opinion is also based on Revenue Ruling 55-416 (re regulated investment companies). (See FTB Form 568 Booklet Instructions revised 2/2/06.) Further discussion on these authorities and this line of analysis is contained in BNA's Tax Management Menorandum Vol. 45, No. 4, February 23, 2004, "Taxing Series LLCs" by Craig A. Gerson.** Gerson also gives examples of how treating LLC series as individual tax partnerships may trigger gain upon formation of the series LLC, or creation or elimination of a particular series. 4. Each Series a Disregarded Entity. The Terry & Samz Tax Analysis Report include a discussion, particularly in light of TAM 200540010, of the possibility of each separate series as being classified as a disregarded entity for federal tax purposes, each owned by the umbrella LLC. This possibility is also discussed in the Gerson BNA Tax Management Memorandum. Conclusion. Until specific guidance comes from the U.S. Treasury Dept. as to federal tax reporting, and any further development regarding the California FTB position, the choice of state law and careful structuring of the series LLC will be paramount. In the end, regardless of how the entity is structured to achieve the desired tax reporting, it is advisable to have the accounting maintained both: (a) as separate accounts for each particular class or series (done for liability and "piercing the corporate veil" protection purposes, for Delaware law purposes for a series, and to keep all profits and liabilities strictly within the respective class or series which may be required for property tax purposes if there are any California real property assets, and now will be required for FTB purposes under the current FTB opinion); and (b) for the entity as a whole, all classes or series combined, allocated to each partner's pro-rata interest in the whole partnership or LLC (used for federal income tax reporting if all is reported on one IRS Form 1065, although it would be a good idea that the 1065 return and the K-1's have attachments also showing the allocated among the different series or classes).
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