Issue 95-1 A periodic newsletter of the Association of Limited Liability Companies January, 1995 "Association of Limited Liability Companies" and "ALLC" are service marks and "A.L.L.C. ALERT" is a trademark of the Association of Limited Liability Companies David S. Neufeld, Executive Director & Editor 1000 Thomas Jefferson Street, N.W. Suite 600 Washington, D.C. 20007 (202) 965-6565 fax (202) 965-4839 ----------------------------------------------------------------------------- Preliminary LLC Survey Results During 1994 ALLC (TM) members and others were requested to complete for themselves and, where appropriate, to request clients to complete, a survey seeking to ascertain who are using LLCs, for what reasons, and how. The results are still preliminary, and must still be fully analyzed. Among the responses we received we have the following notable facts: *LLCs are operating in every state, including those still without LLC statutes. *The single largest category of business activity among respondents is real estate holdings. Farming was another large category. Very few firms among respondents are engaged in manufacturing. *One third of the LLCs responding are "family LLCs." *91.3% of the respondents have between 2 and 10 members, with at least one claiming over 50 members. *Not a single LLC with a US business activity has a non-resident alien member and only one has a foreign operating company. One attorney whose responses were in a form that prevented tabulation claimed to have formed thousands of LLCs, all of which are doing business outside the US, and none of which have a single US person as a member. *53.8% of the respondents employ or expect to employ between 3 and 10 persons, with 4.4% employing over 50. *While, as might be expected, the value of contributed capital is all over the ballpark, three respondents will be doing business with over $10,000,000 of contributed capital. *68% of the respondents are member-managed as opposed to manager-managed. *As might be expected, the vast majority of respondents would have chosen another form of flow through entity, with 71% opting for one type of partnership or another and 21% going with an S corporation. Surprisingly high are the 4.7% who would have gone for the C corporation. Full results will be tabulated shortly, with a full report available at that time to General and Sustaining Members. Report on Meeting with Ways & Means Chief Tax Counsel Before the 104th Congress took their seats, the ALLC (TM) had an opportunity to have an exclusive meeting with James Clark, the incoming Chief Tax Counsel to the House Ways & Means Committee. In short, our meeting put us at ease concerning the possibility of negative federal legislation specifically aimed at LLCs. As you may recall, the Select Revenue Matters subcommittee staff had indicated at the start of the 103rd Congress that the subcommittee would be examining the issue of LLCs and whether Congress should get involved if they represent a revenue drain. With the new Congressional leadership, Mr. Clark told us, the Select Revenue Matters subcommittee will be dissolved, and therefore there would not be any vehicle within Ways & Means to do the type of investigation Select Revenue Matters was contemplating during the 103rd Congress. Also, Mr. Clark made it clear to us that both Ways & Means Chairman William Archer and House Majority Leader Dick Armey favor tax integration. The inference is that they would be disinclined to create a double tax scheme with LLCs where none exists already, and therefore would likely not disrupt the partnership tax treatment of LLCs. Evidence of this is the Freedom and Fairness Restoration Act ("FFRA") proposed by Rep. Armey during the 103rd Congress, before the Contract with America was announced. The FFRA, received without much fanfare from a Republican member during a Democrat controlled Congress, among other things proposed a flat 17% tax on all net business income without taxing the shareholders on dividends received. Whatever may become of this proposal, it speaks volumes about the fate of LLCs for the near future. New Bankruptcy Act Includes LLP Partner Protection Whereas it has heretofore been unclear under federal bankruptcy law whether a partner in a registered limited liability partnership could hide behind his state law shield in a federal bankruptcy proceeding for a bankrupt LLP, new law clarifies that such partners are protected. Section 212 of the Bankruptcy Reform Act of 1994 (H.R. 5116; Vol. 140, No. 142-II Cong. Rec. at H10757 (Oct. 4, 1994)) changes 11 U.S.C. 723(a) to provide that general partners are not necessarily personally liable for all of the debts of the partnership if they would not be liable under a state law such as an LLP act. See the Committee Report, at H10767-H10768: "[t]his section clarifies that a partner in [an LLP] would only be liable in bankruptcy to the extent a partner would be personally liable for a deficiency according to the [LLP] statute under which the partnership was formed." Internal Revenue Service Has a Busy Year-End; ALLC to Testify Adopting many of the suggestions presented to them by the ALLC (TM), the Internal Revenue Service, as promised and as expected, issued at the end of December both a proposed regulation answering some of the questions about LLCs and self-employment tax and its LLC classification revenue procedure. Proposed SECA Tax Regulation: In EE-45-94, the Service proposes an amendment to the Income Tax regulations that implements a methodology for determining if LLC members are subject to the self-employment tax ("SECA tax"). This amendment, by adding regulation section 1.1402(a)-18, states that as a general matter if an individual is a member of an LLC that is treated as a partnership for federal tax purposes, that individual's net earnings from self-employment is to include his or her distributive share of LLC income or loss. However, those members who are not managers in an LLC that could have been formed as a limited partnership in the same jurisdiction will be treated as limited partners under regulation section 1.1402(a)-13. In other words, non-manager members in an appropriate LLC could, as could limited partners in a limited partnership, escape SECA tax on their distributive share of LLC income (and would not have their self-employment income reduced by the LLC's loss). A manager is defined as a person who, alone or together with others, is vested with the continuing exclusive authority to make the management decisions for the LLC. If there are no elected or designated managers, all members will be treated as managers. As explained in the Explanation of Provisions, the requirement that the LLC be formed in a jurisdiction in which a limited partnership could have been formed requires the distributive shares of LLC income of all members of foreign LLCs to be subject to SECA tax (also, their LLC loss could potentially reduce SECA tax). The only previous official comment on SECA tax and LLCs was in the context of PLR 9432018 where the Service conclusively stated that members of a law firm LLC would not be exempted from SECA tax under regulation section 1.1402(a)-13. It is unclear whether the result in PLR 9432018 was reached because all members were stated to be involved in management or because members of personal service LLCs, whether managers or not, will always be subject to SECA tax. The latter approach is similar to a proposal made in President Clinton's ill-fated Health Care Reform Bill. If the former, then the non-management members in a professional firm that is ruled by a select few of the members (and still passes muster for cash method accounting purposes) should avoid SECA tax on their share of firm income. In meetings and communications with IRS officials, the ALLCț has introduced the methodology adopted in the proposed regulations, viz. classifying LLC members as analogous to general or limited partners when attempting to apply provisions that on their face apply only to partnerships and that treat general partners differently than limited partners. Hearings on this proposed rule are scheduled for June 15, 1995, with written submissions due by May 25, 1995. The ALLCț Board is planning to present testimony and would like to hear from members about their thoughts and concerns. Classification Ruling: In Rev. Proc. 95-10 the Service has given its long awaited guidance on what will pass muster for an advance ruling that an LLC will be treated as a partnership for federal tax purposes. The Service will issue advance rulings only to LLCs with (1) at least two members, (2) in which the member-managers (for a ruling that the LLC lacks continuity of life or free transferability) or the assuming members (for a ruling that the LLC lacks limited liability) have at least a one percent interest in each material item of the LLC's income, gain, loss, deduction or credit during the entire existence of the LLC (subject to certain exceptions and qualifications), and (3) in which the member- managers (for a ruling that the LLC lacks continuity of life or free transferability) or the assuming members (for a ruling that the LLC lacks limited liability) have a minimum capital account balance equal to the lesser of one percent of total positive capital account balances or $500,000 (subject to certain exceptions and qualifications). Once these threshold requirements are met, the Service will rule that the LLC lacks the enumerated corporate characteristics under the following circumstances: (1) Continuity of Life: where the members designate managers from among themselves, the LLC will be deemed to lack COL where there is a potential dissolution upon the occurrence to any member-manager (so long as it applies to all member-managers equally) of any (but not necessarily all) dissolution events so long as the dissolution events selected provide a meaningful possibility of dissolution. The decision to continue must be made by a majority of the remaining members. Where there are no designated managers, the dissolution event is to be applied to all of the members. (2) Free Transferability: where the members designate managers from among themselves, the LLC will be deemed to lack FT if all members, or at least those owning a 20% or greater interest, may convey membership attributes only with the consent of a majority of the non-transferring member- managers. Where there are no designated managers, the consent of the majority of all members is required. In a major policy shift, majority is deemed to mean majority of capital and profits (using the definition of majority in interest in Rev. Proc. 94-46 that has heretofore applied only to COL), a majority of capital or profits, or per capita. The power to withhold consent will be given deference only if it constitutes a meaningful restriction on transfers. This would bring into suspicion both the situation where the LLC members are all in the same economic family, and the situation where the consent may not be unreasonably withheld. (3) Centralization of Management: CM will be found lacking if the statute or operating agreement (consistent with the statute) provides that members all participate in management in their capacity as members. If there are designated managers and the managers own less than 20% of the total interests in the LLC in the aggregate, the LLC will be found to have CM. If they own more than 20% in the aggregate and the facts and circumstances support such a finding, the Service will find CM lacking. (4) Limited Liability: If, consistent with the controlling state statute, at least one member validly assumes liability for all of the LLC's debts and has, together with other assuming members, net worth of at least 10% of the total contributions to the LLC for the life of the LLC, or can demonstrate that it has substantial assets available to creditors, the Service will rule that the LLC lacks limited liability. Ruling Requests and Classification Audits Material If you have any information concerning LLC classification audits or ruling requests which you would be willing to share with the ALLC (TM) (redacted if you like) please send them to us. These would provide a tremendous resource for our archives, adding great value to our network. MIPS Subject to Subtle IRS Attack Monthly Income Preferred Shares, or MIPS, have proven to be an attractive means for obtaining public capital for several companies. MIPS are effectively a security sold by a finance subsidiary of a US corporation, which then on-lends the funds to its parent. The parent pays interest to the finance subsidiary, which may pay monthly dividends to its preferred share investors. MIPS in the past have been set up as limited partnerships, but more recently have been organized as either offshore (often Turks & Caicos or Cayman Islands) limited life companies or domestic limited liability companies. (For the purpose of this discussion, both limited liability companies and limited life companies will be referred to as LLCs and treated interchangeably, as the partnership classification issues are identical for both). As a flow through entity, the investors are allocated distributive shares of the interest income, which keeps its character. If the investors are non-US persons, the interest income should be received free of the 30% (or lower treaty rate) interest withholding tax to which non-US persons would otherwise be subject, as the interest would be classified as interest paid on as portfolio debt. Later distributions would be a non-taxable event for US tax purposes. Several MIPS interests in LLC are trading on, or are approved for listing on, the New York Stock Exchange, including those for finance LLCs for ConAgra, Texaco, Enron, Capital Re and USX. The mechanism utilized by these LLCs, and others, to obtain partnership tax treatment despite being publicly traded is to have corporate subsidiaries of the parent become managing members of the LLC. The subs take a 20% share and assume the LLC's obligations. In this manner the LLC passes the classification test on the basis of lacking continuity of life, limited liability, and centralized management and yields on free transferability. MIPS have been besieged by the Treasury and the Service both directly and more subtly. At center stage rages the debate as to whether the loan from the parent to the LLC is debt or equity, as is evident from Notice 94-47, 1994-19 I.R.B. 9 and a memorandum dated March 24, 1994 from the New York law firm of Sullivan & Cromwell to Deputy Assistant Treasury Secretary Samuel Sessions and others. More indirectly is the approach the Service is taking in other recent developments, including the partnership anti-abuse proposed regulations and the LLC/SECA Tax proposed regulations (described above). While these regulations may not be specifically aimed only at MIPS (and in conversations with IRS officials they officially deny they are), reading between the lines it is clear that the Service had MIPS on their radar screens when these were drafted. Partnership Anti-abuse regulations: Newly adopted regulations under section 701 provide two mechanisms for the Service to attack the use by taxpayers of partnerships in manners inconsistent with the principals of Subchapter K. Briefly, one mechanism is set forth at Regulation Section 1.701-2(b), which states: "if a partnership is formed or availed of in connection with a transaction a principal purpose of which is to reduce substantially the present value of the partners' aggregate federal tax liability in a manner that is inconsistent with the intent of Subchapter K, the Commissioner can recast the transaction for federal tax purposes." The other mechanism is that "[t]he Commissioner can treat as an aggregate of its partners in whole or in part as appropriate to carry out the purpose of any provision of the Internal Revenue Code. . . ." Regulation Section 1.701-2(e)(1). As applied to MIPS, it is possible to envision the IRS treating the LLC as an aggregate of its members under the second of the two approaches. The argument could be that the US parent corporation is effectively making deductible payments to equity investors because it, through subsidiaries, is a member of an LLC and that it would not have been able to deduct these payments if the investors had invested in the parent company's equity directly. See examples 1 and 2 under section 1.701-2(e). LLCs and SECA Tax: As described above, all members, even passive members, of LLCs formed in foreign jurisdictions would be subject to self-employment tax on their distributive shares of LLC income if the proposed regulation is finalized as proposed. Thus any US person who is a member of a Turks & Caicos LLC or a Caymans LLC and is not a manager could have the added burden of self- employment tax. LLC Classification Ruling: Rev. Proc. 95-10 provides, among other things, that an LLC will be deemed to lack the corporate characteristic of limited liability for advance ruling purposes if one of the members assumes the LLC's obligations, but only if the underlying LLC statute expressly authorizes assumption of debts by a member. LLCs formed in foreign jurisdictions will typically find that the LLC statute for such jurisdiction does not have such express authorization. Thus, many foreign LLCs will not qualify for a ruling that it lacks limited liability for advance ruling purposes. While limited to advance rulings, this does not bode well for substantive determinations after the fact. Nothing here suggests that the Service would be successful on any of these arguments, but only that it appears that the Service is posturing itself for attack. The ALLC (TM) will take every opportunity it can to contribute to the development of this issue as opportunities arise. We look to our members to provide guidance and input to the Board to help us develop our approach, if any. Foreign Tax Credit Proposed Regs May Expand Rev. Rul. 71-141 to LLCs Regulations proposed under section 902 now define a "domestic shareholder" for purposes of the deemed paid foreign tax credit as a "domestic corporation, other than an S corporation . . . , that owns directly at least 10 percent of the voting stock of the foreign corporation at the time the domestic corporation receives a dividend from that foreign corporation." Proposed regulation section 1.902- 1(a)(1). Revenue Ruling 71-141, 1971-1 C.B. 211, allows two 50 percent domestic corporate general partners of a domestic general partnership to claim the 902 deemed paid credit from a foreign corporation in which the partnership owned 40 percent of the voting stock. The Service is considering under what other circumstances a section 902 credit with respect to stock held by a partnership, LLC, or other pass-through entity should flow through to a domestic corporation that is a partner in the partnership or member of the LLC. The Service is seeking comments, in particular how it should administer any proposed expansion of Rev. Rul. 71-141 in this manner. The ALLC (TM) will be submitting comments. Any input by ALLC (TM) members would be welcome. Complete Analysis of LLC Revenue Rulings Available Tom Rutledge of the Louisville, Kentucky law firm of Ogden, Newell & Welch has prepared a chart listing each revenue ruling issued by the IRS through the end of 1994 and describing the treatment of each corporate characteristic analyzed therein. A copy of this exhaustive and excellent 8 page chart is available to all Sustaining and General Members without charge. Thank you Tom. State Legislative Developments HAWAII--An LLC bill passed the House during the last session but was being held in the Senate until the session expired. Apparently Hawaii does not have the money to be allocated to administrative functions associated with new programs. As the LLC bill will generate new filings with the Secretary of State state regulators apparently feel that new computers and other administrative facilities are required. Yet without the funds to meet these needs the Senate refused to pass legislation that mandates such expenditures. (Far be it for us to comment on Hawaii's internal affairs, but we do not understand why Hawaii cannot apply filing fees paid by new LLCs against the costs of administering the program, as other states have done.) In the interim the legislature became aware of the Uniform LLC Act and considered dropping the bill passed by the House in favor of the Uniform Act. When the new session began this month both bills--the bill that passed the House and the Uniform Act, without modification--were introduced. Allen Sakai of Honolulu predicts that this could delay passage of any bill by one to two years. In other news from Hawaii, Allen reports that the new securities administrator is of the opinion that foreign LLCs can do business in Hawaii if they wanted to without the need to qualify. VERMONT-- It would be "optimistic" to expect an LLC bill, which will be introduced when the session begins this month, to be passed by April, 1995, the date the legislature adjourns, according to John Shullenberger of Vermont. It is more likely that both houses will not be able to pass a bill until mid- 1996. MASSACHUSETTS--S.72, sponsored by Senator Pines, has taken its first step by being referred to the House Ways and Means Committee. H.546, sponsored by Rep. Scaccia, apparently has been buried in a study (#5081) in the Joint Rules Committee. PENNSYLVANIA--Act 106 of 1994 (SB 1059), the Pennsylvania Limited Liability Company Act, was signed by Gov. Casey on December 7, 1994, and will become effective on February 5, 1995. Now for the bad new--as reported here in prior issues, Pennsylvania will tax LLCs as corporations for state tax purposes, with the exception of professional firms, which will pay an annual fee of $300 per member for each member who is a Pennsylvania resident. NEW YORK--The LLC Act which was passed this past July, and became effective at the end of October, provides for no entity level tax, but a $50/member filing fee (counting members on the last day of the taxable year), with a minimum of $325 (how does one get to $325 in increments of $50?) and a maximum of $10,000 imposed on every LLC and LLP with income derived from New York sources. 658(c)(3), Tax Law. The filing fee is doubled for all LLCs and LLPs with New York City source income. 1304-C(b), Tax Law. Query--Is there a de minimis amount of New York (State and City) income, or does the filing fee kick in with the first dollar of New York income? CALIFORNIA--The governor of California signed the LLC Act into law at the last moment, on September 30, 1994. It is effective immediately. An interesting reason for the cliff-hanger--apparently as there were other bills amending these same sections of the law; if they were signed in the wrong order they would cancel each other out. Hence the LLC bill had to be the last bill in that series signed. State Securities Developments Connecticut--The Connecticut Department of Banking released an Interpretative Release on August 24, 1994 (person to contact-Jeffrey Halperin, (203)566-4560) stating that each LLC will be analyzed on a case-by-case basis to determine "when and under what circumstances ownership interests in an LLC will be considered securities" under Connecticut law. Initially the Department will apply the investment contract analysis as set forth in SEC v. W.J. Howey, Inc. 328 U.S. 293 (1946), with the fourth prong of the test--"that the return on the investment must be derived substantially from the efforts of others"--the focus of the Department's analysis. It will be presumed that interests in LLCs run by elected "manager-members" are securities whereas interests in "member-member" LLCs (LLCs run by members in their capacity as members) are presumed not to be securities, based on Williamson v. Tucker, 645 F.2d 404 (5th Cir. 1981). A copy of this Interpretive Release is available to Sustaining and General Members at no charge. All States--The CCH Blue Sky Reporter, at 6551, lists the states with LLC statutes and how they treat LLCs for state securities law purposes. LLCs on The Internet Professor Larry Ribstein, co-author of Ribstein and Keatinge on Limited Liability Companies and Professor of Law at George Mason University Law School, Professor Tom Geu, Associate Professor of Law at the University of South Dakota Law School, and John DeBruyn, an attorney in Denver, have organized an LLC and LLP forum (newsgroup? bulletin board?) on the Internet. This forum handles a wide range of subtopics dealing with LLCs and LLPs, including creditors rights, real estate development, securities, estate planning and tax issues. The conference will also collect feedback from individual lawyers and local and state bar groups on the Uniform LLC Act. Any interested lawyer with an Internet connection can join the LLC forum by sending an e-mail message to listserv@usa.net with the following as the first line of the body of the message to join the group: sub lnet-llc Jane Doe (substitute your name for Jane's). Additional information about the list and its moderators is available on sign-up or by e-mail by sending the following message: info lnet-llc. Uniform Act Available--to obtain the latest stylized version of the Uniform LLC Act send the following message to mailserver@chicagokent.kentlaw.edu: begin send ullca95.txt send ullcatoc.txt end "ullca95.txt" is a plain (ASCII) copy of the latest stylized version of the plain (ASCII) copy of the table of contents for the ULLCA. To see what other ULLCA documents are available, send the following message address: begin index ullca end To see other uniform act drafts, send the following message to the same add begin get index index uniform end Questions should be directed to Larry Donahue at: Ldonahue@chicagokent.kent Your Help is Needed Input Requested by Agencies. In responding to ongoing IRS, NASAA and other agency requests for information and input, the ALLC (TM) needs to know what issues are troubling you and your clients and the directions you would like to see these agencies take. Any Sustaining or General Members who would like to participate in this process should call or write our office with your suggestions. Preparation for Our Testimony and Comments. Many of you have compiled information for presentation to your own state legislatures or for other reasons that may prove useful to us in preparing our testimony before, our comments to, and in our meetings with, government bodies. This may include the number of LLCs in your state, revenue loss estimates, the composition of the LLCs in your state (e.g. percentage that are professional firms), use by foreign investors, etc. Any data will be helpful. Please send it to our office immediately. All information is potentially beneficial to others within the network and may provide fodder for the ALLC ALERT (TM). Please keep those cards, letters and calls coming. BENEFITS OF MEMBERSHIP CLEARINGHOUSE MEMBER ($100 annual dues) *Access to a nationwide network of businesses and professionals with a variety *Access to the information clearinghouse *The ALLC ALERT (TM) *1 year subscription to the LLC Reporter (TM) (a $250 value) GENERAL MEMBER ($500 annual dues) *All of the above *Participation in the LLC policy debate *Special briefing memoranda, including reports on meetings with public official *2 year subscription to the LLC Reporter (TM) (a $400 value) SUSTAINING MEMBER ($5,000 annual dues) *All of the above *Guaranteed seat on the Board of Directors *3 year subscription to the LLC Reporterț (a $550 value)