Rev. Rul. 93-93, 1993-2 C.B. 321, 1993-42 I.R.B. 13.

Internal Revenue Service
Revenue Ruling

CLASSIFICATION OF ARIZONA LIMITED LIABILITY COMPANY

Published: December 27, 1993

26 CFR 301.7701-2: Associations.
Classification of Arizona limited liability company. Because of the flexibility accorded by the Arizona Limited Liability Company Act, an Arizona limited liability company may be classified as a partnership or as an association taxable as a corporation depending upon the provisions adopted in the limited liability company's articles of organization or operating agreement.

ISSUE

Is M, an Arizona limited liability company, classified for federal tax purposes as an association or as a partnership under section 7701 of the Internal Revenue Code?

FACTS

M is organized as a limited liability company (LLC) pursuant to the provisions of the Arizona Limited Liability Company Act (Act), Ariz.Rev.Stat.Ann., Title 29, Chapter 4, sections 29-601 through 29-857 (1992). M is authorized under its articles of organization to engage in any and all business activity permitted by the laws of Arizona. M has 25 members. Three of the members, A, B, and C, are the elected managers under M's articles of organization.

Section 29-681.A of the Act provides that unless the articles of organization provide that management of the LLC is vested in one or more managers, management of the LLC is vested in its members, subject to any provision in an operating agreement restricting or enlarging the management rights or responsibilities of one or more members or classes of members. Section 29-681.B provides that if the articles of organization provide that management of the LLC is vested in one or more managers, management of the LLC is vested in a manager or managers, subject to any provision in an operating agreement restricting or enlarging the management rights or responsibilities of one or more managers or classes of managers or reserving specified management rights to the members or classes of members. A manager shall be designated or elected and may be removed or replaced in the manner provided in an operating agreement.

Section 29-651 of the Act provides that, except as provided in the Act, a member, manager, employee, officer or agent of an LLC is not liable, solely by reason of being a member, manager, employee, officer, or agent, for the debts, obligations and liabilities of the LLC whether arising in contract or tort, under a judgment, decree or order of a court or otherwise.

Section 29-841 of the Act provides that a professional LLC means an LLC organized under Chapter 4 of the Act for purposes that include rendering one or more categories of professional services.

Section 29-846 of the Act provides that Chapter 4 of the Act shall not alter any law applicable to the relationship between a person performing professional services and a person receiving those services, including liability arising out of those professional services. Each member, manager or employee performing professional services shall remain personally liable for any results of the negligent or wrongful acts, omissions or misconduct committed by him or any person under his direct supervision and control while performing professional services on behalf of the limited liability company. The liability of a member, manager or employee of a limited liability company is several only, and a member, manager or employee is not vicariously responsible for the liability of another member, manager or employee unless such other member, manager or employee was acting under his direct supervision and control while performing professional services on behalf of the limited liability company.

Section 29-732.A of the Act provides that an interest in an LLC is personal property and, except as provided in an operating agreement or under article 11 of Chapter 4 of Title 29, concerning professional LLCs, may be assigned in whole or in part. The assignment of an interest in an LLC does not dissolve the LLC or entitle the assignee to participate in the management of the business and affairs of the LLC or to become a member or to exercise the rights of a member, unless the assignee is admitted as a member as provided in section 29-731.

Section 29-731.B.2 of the Act provides that after an LLC's initial articles of organization are filed, a person who is an assignee of all or part of a member's interest in an LLC may become a member on the approval or consent of all members or of any one or more members who have the right under an operating agreement to admit additional members. Section 29-731.B.3 provides that if the person is an assignee of an interest in the LLC of a member who has the power under an operating agreement to grant the assignee the right to become a member, the assignee may become a member on the exercise of the power in compliance with all conditions limiting the member's exercise of the power. Pursuant to section 29-731.B.2, M's operating agreement provides that for an assignee of an interest in M to become a member, all the members of M must consent to the admission of the assignee as a member.

Section 29-781.A of the Act provides that an LLC organized under the Act is dissolved on the occurrence of the first of the following: (1) at the time or on the happening of the events specified for dissolution in the articles of organization or an operating agreement; (2) the written consent to dissolve by all members; (3) an event of withdrawal of a member unless the business of the LLC is continued by one or more managers or members pursuant to a right to continue stated in an operating agreement or, if an operating agreement does not provide a right to continue, by agreement or consent of all of the remaining members within 90 days after the event of withdrawal; (4) entry of a judgment of dissolution under section 29-785; or (5) acquisition by a single person of all outstanding interests in the LLC.

Section 29-733 of the Act provides that, except as approved by the written consent of all members at the time, a person ceases to be a member of an LLC on the occurrence of any of the following events of withdrawal: (1) the member withdraws from the LLC as provided in section 29-734; (2) on assignment of all the member's interest and admission of one or more of the assignees as a member; (3) the member is expelled as a member pursuant to the articles of organization or an operating agreement; (4) unless otherwise provided in an operating agreement, the member does any of the following: (a) makes an assignment for the benefit of creditors, (b) files a voluntary petition in bankruptcy, (c) is adjudicated as bankrupt or insolvent, (d) files a petition or answer seeking for himself any reorganization, arrangement, composition, readjustment, liquidation or similar relief under any statute, law or rule, (e) files an answer or other pleading admitting or failing to contest the material allegations of a petition filed against him in a bankruptcy, insolvency, reorganization or similar proceeding, (f) seeks, consents to or acquiesces in the appointment of a trustee, receiver or liquidator of the member or of all or any substantial part of the member's property; or (5) if a member is a natural person, the member's death, or the entry of an order or judgment by a court of competent jurisdiction adjudicating the member incompetent to manage the member's person or the member's estate. Under M's operating agreement, M will dissolve upon the occurrence of an event of withdrawal of a member, unless a majority in interest of the members agree or consent to continue the business of M.

LAW AND ANALYSIS

Section 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.

Section 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.

Section 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.

Section 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.

Section 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 section 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.

In the present 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 M has a preponderance of the remaining corporate characteristics of continuity of life, centralization of management, limited liability, and free transferability of interests.

Section 301.7701-2(b)(1) of the regulations provides that if the death, insanity, bankruptcy, retirement, resignation, expulsion, or other event of withdrawal of a general partner of a limited partnership causes a dissolution of the partnership, continuity of life does not exist; furthermore, continuity of life does not exist notwithstanding the fact that a dissolution of the limited partnership may be avoided, upon such an event of withdrawal of a general partner, by the remaining general partners agreeing to continue the partnership or by at least a majority in interest of the remaining partners agreeing to continue the partnership. See Glensder Textile Co. v. Commissioner, 46 B.T.A. 176 (1942), acq., 1942-1 C.B. 8.

In Glensder Textile, the court concluded that a limited partnership lacked continuity of life because upon the death, retirement, or incapacity of a general partner, the remaining general partners would have to agree to continue the partnership, and there was no assurance that they would do so. The court noted that the contingent continuity of a partnership was not analogous to the chartered life of a corporation, which continues regardless of the death or resignation of its directors or stockholders. Section 301.7701-2(b)(1) of the regulations provides that a limited partnership lacks continuity of life even though a dissolution may be avoided by at least a majority in interest of the remaining partners agreeing to continue the partnership. Although the regulation and Glensder Textile specifically address the dissolution of a limited partnership, the contingent continuity of life concept reflected in the regulation and Glensder Textile applies in classifying LLCs.

Under the Act, unless the business of the LLC is continued by one or more managers or members pursuant to a right to continue stated in the operating agreement, an LLC is dissolved upon the expulsion, withdrawal, death, incompetency, or bankruptcy of a member or occurrence of any other event that terminates the continued membership of a member in the LLC, unless all the remaining members agree or consent to continue within 90 days after the event of withdrawal. M's operating agreement provides that M will dissolve upon the occurrence of any event that terminates the continued membership of a member in M, unless within 90 days a majority in interest of the remaining members of M agree to continue the business. If a member of M ceases to be a member for any reason, the continuity of M is not assured because a majority in interest of the remaining members must agree to continue the business. Consequently, M lacks the corporate characteristic of continuity of life.

Section 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 the members) has continuing exclusive authority to make management decisions necessary to the conduct of the business for which the organization was formed.

Section 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.

Section 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 articles of organization, M is managed by its elected managers A, B, and C. Therefore, M possesses the corporate characteristic of centralized management.

Section 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.

Furthermore, if M were a professional LLC described in section 29-841 of the Act, the members would not be liable for the debts of, or claims against, M. Under section 29-846, a member would only have personal liability in connection with that member's performance of professional services on behalf of M or for the acts of those under the member's direct supervision and control. Therefore, in that situation, M would also possess the corporate characteristic of limited liability.

Section 301.7701-2(e)(1) of the regulations provides that 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. 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 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, except as provided in the operating agreement, a member of M can assign that member's interest to another person who is not a member of the organization. Under M's operating agreement, the assignee does not become a member and does not acquire all the attributes of the member's interest in M unless all the remaining members consent to the admission of the assignee as a member. 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 characteristics of centralized management and limited liability. M does not, however, possess the corporate characteristics of continuity of life and free transferability of interests.

HOLDING

Because of the flexibility accorded by the Arizona Limited Liability Company Act, an Arizona limited liability company may be classified as a partnership or as an association taxable as a corporation depending upon the provisions adopted in the limited liability company's articles of organization or operating agreement. See, e.g., Rev. Rul. 93-38, 1993-21 I.R.B. 4 (concerning Delaware limited liability companies). M, the Arizona LLC considered in this ruling, is classified as a partnership for federal tax purposes because it has associates and an objective to carry on business and divide the gains therefrom but lacks a preponderance of the four remaining corporate characteristics.

DRAFTING INFORMATION

The principal author of this revenue ruling is Stephen J. Coleman of the Office of Assistant Chief Counsel (Passthroughs and Special Industries). For further information regarding this revenue ruling, contact Stephen J. Coleman on (202) 622-3060 (not a toll-free call).

Rev. Rul. 93-93, 1993-2 C.B. 321, 1993-42 I.R.B. 13.