REVENUE RULE 93-38

1993-1 C.B. 233, 1993-21 I.R.B. 4.

Internal Revenue Service
Revenue Ruling

CLASSIFICATION OF DELAWARE LIMITED LIABILITY COMPANY

Published: May 24, 1993

§ 7701. Definitions, 26 CFR 301.7701-2: Associations.

Classification of Delaware limited liability company. The Delaware Limited Liability Company Act contains numerous provisions that can be modified by a limited liability company agreement; accordingly, depending on the provisions of the limited liability company agreement, a Delaware limited liability company can assume the characteristics either of a corporation or of a partnership for federal tax purposes.

ISSUES

Are M and N, Delaware limited liability companies, classified for federal tax purposes as associations or as partnerships under § 7701 of the Internal Revenue Code?

FACTS

Situation 1. M is organized as a limited liability company (LLC) pursuant to the provisions of the Delaware Limited Liability Company Act (Act), Del.Code Ann. tit. 6, §§ 18-101 through 18-1106 (1992). M is authorized under its articles of organization to engage in any and all business activity permitted by the laws of the State of Delaware. M has 25 members.

§ 18-402 of the Act provides that unless otherwise provided in a limited liability company agreement (LLC agreement), the management of an LLC is vested in its members in proportion to the current percentage or other interest of members in the profits of the LLC owned by all of the members. An LLC agreement may, however, provide for the management, in whole or in part, of an LLC by a manager who is chosen by the members in the manner provided in the LLC agreement. M's LLC agreement provides that M's management is vested in its members.

§ 18-303 of the Act provides that except as otherwise provided in the Act, the debts, obligations, and liabilities of an LLC, whether arising in contract, tort, or otherwise, are solely the debts, obligations, and liabilities of the LLC; and no member or manager of an LLC is obligated personally for any debt, obligation, or liability of the LLC solely by reason of being a member or acting as a manager of the LLC.

§ 18-701 of the Act provides that an LLC interest is personal property. § 18-702(a) of the Act states that an LLC interest is assignable in whole or in part except as provided in an LLC agreement. The assignee of a member's LLC interest has no right to participate in the management of the business and affairs of an LLC except as provided in an LLC agreement and upon (1) the approval of all of the members of the LLC other than the member assigning the member's LLC interest, or (2) compliance with any procedure provided for in the LLC agreement. § 18-702(b) of the Act provides that unless otherwise provided in an LLC agreement, (1) an assignment entitles the assignee to share in profits and losses, to receive distributions, and to receive an allocation of income, gain, loss, deduction, or credit or any similar item to which the assignor was entitled, to the extent assigned, and (2) a member ceases to be a member and to have the power to exercise any rights or powers of a member upon assignment of all of the member's LLC interest. § 18-704(a) of the Act provides that the assignee of a member's LLC interest may become a member as provided in an LLC agreement and upon (1) the approval of all of the members of the LLC other than the member assigning the member's LLC interest, or (2) compliance with any procedure provided for in the LLC agreement. M's LLC agreement provides that an assignee must receive the unanimous consent of the remaining members to participate in the management of the business and affairs of M and to become a member of M.

§ 18-801 of the Act provides that an LLC is dissolved upon the first to occur of the following: (1) at the time specified in an LLC agreement or 30 years from the date of the formation of the LLC if no time is set forth in the LLC agreement, (2) upon the happening of events specified in an LLC agreement, (3) by the written consent of all members, (4) by the death, retirement, resignation, expulsion, bankruptcy, or dissolution of a member or the occurrence of any other event that terminates the continued membership of a member in the LLC unless the business of the LLC is continued either by the consent of all of the remaining members within 90 days following the occurrence of any terminating event or pursuant to a right to continue stated in the LLC agreement, or (5) by the entry of a decree of judicial dissolution under the Act. M's LLC agreement does not provide for a right to continue following the death, retirement, resignation, expulsion, bankruptcy, or dissolution of a member.

Situation 2. The facts for N are the same as for M except as follows: First, N's LLC agreement provides that management of N is vested in managers that are elected by the members on an annual basis. A, B, and C, who are members of N, are the elected managers. Second, N's LLC agreement provides that the assignee of a member's LLC interest may participate in the management of the business and affairs of N and become a member of N after the assignee provides N with written notice of the transfer. Consent of the remaining members to the assignment is not required. Third, N's LLC agreement provides that the entity shall continue following the death, retirement, resignation, expulsion, bankruptcy, or dissolution of a member, or the occurrence of any other event that terminates the continued membership of a member in N.

LAW AND ANALYSIS

§ 7701(a)(2) of the Code provides that the term "partnership" includes a syndicate, group, pool, joint 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 a corporation.

§ 301.7701-1(b) of the Procedure and Administration Regulations states that the Code prescribes certain categories, or classes, into which various organizations fall for purposes of taxation. These categories, or classes, include associations (which are taxable as corporations), partnerships, and trusts. The tests, or standards, that are to be applied in determining the classification in which an organization belongs are set forth in sections 301.7701-2 through 301.7701-4.

§ 301.7701-2(a)(1) of the regulations sets forth the following major characteristics of 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) liability for corporate debts limited to corporate property, and (6) free transferability of interests. Whether a particular organization is to be classified as an association must be determined by taking into account the presence or absence of each of these corporate characteristics.

§ 301.7701-2(a)(2) of the regulations provides that an organization that has associates and an objective to carry on business and divide the gains therefrom is not classified as a trust, but rather as a partnership or association taxable as a corporation. It further provides that characteristics common to partnerships and corporations are not material in attempting to distinguish between an association and a partnership. Since associates and an objective to carry on business and divide the gains therefrom are generally common to corporations and partnerships, the determination of whether an organization that has these characteristics is to be treated for tax purposes as a partnership or as an association depends on whether there exist centralization of management, continuity of life, free transferability of interests, and limited liability.

§ 301.7701-2(a)(3) of the regulations provides that if an unincorporated organization possesses more corporate characteristics than noncorporate characteristics, it constitutes an association taxable as a corporation. In interpreting § 301.7701-2 of the regulations, the Tax Court, in Larson v. Commissioner, 66 T.C. 159 (1976), acq., 1979-1 C.B. 1, concluded that equal weight must be given to each of the four corporate characteristics of continuity of life, centralization of management, limited liability, and free transferability of interests.

Situation 1. In this situation, M has associates and an objective to carry on business and divide the gains therefrom. Therefore, M must be classified as either an association or a partnership. M is classified as a partnership for federal tax purposes unless the organization has a preponderance of the remaining corporate characteristics of continuity of life, centralization of management, limited liability, and free transferability of interests.

§ 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. § 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 the agreement does not establish continuity of life if under local law the death or withdrawal of any member causes a dissolution of the organization.

Under the Act, unless the business of M is continued by the consent of all the remaining members or by a right to continue stated in the LLC agreement, M is dissolved upon the death, resignation, expulsion, bankruptcy, or dissolution of a member or the occurrence of any other event that terminates the continued membership of a member in the company. M's LLC agreement does not provide for any other right to continue. If a member of M ceases to be a member of M for any reason, the continuity of M is not assured because all remaining members must agree to continue the business. Consequently, M lacks the corporate characteristic of continuity of life.

§ 301.7701-2(c)(1) of the regulations provides that an organization has the corporate characteristic of centralized management if any person (or group of persons that does not include all of the members) has continuing exclusive authority to make management decisions necessary to the conduct of the business for which the organization was formed.

§ 301.7701-2(c)(2) of the regulations provides that the persons who have this authority may, or may not, be members of the organization and may hold office as a result of a selection by the members from time to time, or may be self perpetuating in office. Centralized management can be accomplished by election to office, by proxy appointment, or by any other means that has the effect of concentrating in a management group continuing exclusive authority to make management decisions.

§ 301.7701-2(c)(4) of the regulations provides that there is no centralization of continuing exclusive authority to make management decisions, unless the managers have sole authority to make the decisions. For example, in the case of a corporation or a trust, the concentration of management powers in a board of directors or trustees effectively prevents a stockholder or a trust beneficiary, simply because that person is a stockholder or beneficiary, from binding the corporation or the trust.

Under the Act, an LLC may be managed either by an elected manager or managers or by its members. Under the LLC agreement, M's management is vested in all of its members; therefore, M lacks the corporate characteristic of centralized management.

§ 301.7701-2(d)(1) of the regulations provides that an organization has the corporate characteristic of limited liability if under local law there is no member who is personally liable for the debts of, or claims against, the organization. Personal liability means that a creditor of an organization may seek personal satisfaction from a member of the organization to the extent that the assets of the organization are insufficient to satisfy the creditor's claim.

Under the Act, the members of M are not liable for M's debts, obligations, or liabilities. Consequently, M possesses the corporate characteristic of limited liability.

§ 301.7701-2(e)(1) of the regulations provides that 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. 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 of the attributes of the member's interest in the organization. The characteristic of free transferability does not exist if each member can, without the consent of the other members, assign only the right to share in the profits but cannot assign the right to participate in the management of the organization.

Under the Act, a member of M can assign or transfer that member's interest to another person who is not a member of the organization. However, under M's LLC agreement, the assignee or transferee does not become a substitute member and does not acquire all of the attributes of the member's interest in M unless all of the remaining members approve the assignment or transfer. Therefore, M lacks the corporate characteristic of free transferability of interests.

M has associates and an objective to carry on business and divide the gains therefrom. In addition, M possesses the corporate characteristic of limited liability. M does not, however, possess the corporate characteristics of continuity of life, free transferability of interests, and centralized management.

Situation 2. N has associates and an objective to carry on business and divide the gains therefrom. Therefore, N must be classified as either an association or a partnership. N is classified as a partnership for federal tax purposes unless the organization has a preponderance of the remaining corporate characteristics of continuity of life, centralization of management, limited liability, and free transferability of interests. Like M in Situation 1, N possesses the corporate characteristic of limited liability.

§ 301.7701-2(b)(1) of the regulations provides that an organization has continuity of life if the death, insanity, bankruptcy, retirement, resignation, or expulsion of any member will not cause a dissolution of the organization.

Under the Act, unless the business of N is continued by the consent of all of the remaining members or by a right to continue stated in the LLC agreement, N is dissolved upon the death, resignation, expulsion, bankruptcy, or dissolution of a member or the occurrence of any other event that terminates the continued membership of a member in the company. N's LLC agreement provides that N shall continue under all circumstances without the approval or consent of any member or manager. Consequently, N possesses the corporate characteristic of continuity of life.

Under the Act, an LLC may be managed either by an elected manager or managers or by its members. Under the LLC agreement, N is managed by its elected managers A, B and C; therefore, N possesses the corporate characteristic of centralized management.

Under the Act, a member of N can assign or transfer that member's interest to another person who is not a member of the organization. Moreover, under N's LLC agreement, an assignee of an interest in N becomes a substitute member and acquires all of the attributes of the member's interest in N by the assignee providing written notice to N. The approval or consent of any other member or manager is not required for the substitution to be effective. Therefore, N possesses the corporate characteristic of free transferability of interests.

N has associates and an objective to carry on business and divide the gains therefrom. In addition, N possesses the corporate characteristics of continuity of life, centralized management, limited liability, and free transferability of interests.

HOLDINGS

The Delaware Limited Liability Company Act contains numerous provisions that can be modified by an LLC agreement; accordingly, depending on the provisions of the LLC agreement, a Delaware LLC can assume the characteristics either of a corporation or of a partnership for federal tax purposes. In the factual situations presented above:

(1) M has associates and an objective to carry on business and divide the gains therefrom but lacks a preponderance of the four remaining corporate characteristics. Accordingly, M is classified as a partnership for federal tax purposes.

(2) N has associates and an objective to carry on business and divide the gains therefrom and possesses all four of the remaining corporate characteristics. Accordingly, N is classified as an association for federal tax purposes.

DRAFTING INFORMATION

The principal author of this revenue ruling is D. Lindsay Russell of the Office of Assistant Chief Counsel (Passthroughs and Special Industries). For further information regarding this revenue ruling, contact Mr. Russell on (202) 622-3050 (not a toll-free call).

Rev. Rul. 93-38, 1993-1 C.B. 233, 1993-21 I.R.B. 4.