REVENUE RULE 94-30

1994-1 C.B. 316, 1994-19 I.R.B. 6.

Internal Revenue Service
Revenue Ruling

CLASSIFICATION OF KANSAS LIMITED LIABILITY COMPANY

Published: May 9, 1994

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

Classification of Kansas limited liability company. Because of the flexibility accorded by the Kansas Limited Liability Company Act, a Kansas 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, a Kansas limited liability company, classified for federal tax purposes as an association or as a partnership under s 7701 of the Internal Revenue Code?

FACTS

M is organized as a limited liability company (LLC) pursuant to the provisions of the Kansas Limited Liability Company Act (Act), Kan.Stat.Ann. sections 17-7601 to 17-7652 (Supp.1993). M is authorized under its articles of organization to engage in any and all business activity permitted by the laws of Kansas. M has 25 members. Three of the members, A, B, and C, are the elected managers under M's articles of organization.

Section 17-7612 of the Act provides that unless otherwise provided in the articles of organization or the operating agreement, the management of the LLC is vested in its members with each member having one vote, except that if the articles of organization provide for the management of the LLC by a manager or managers, the management of the LLC may be vested in a manager or managers who is chosen by the members in the manner prescribed by the articles of organization or the operating agreement of the LLC.

Section 17-7620 of the Act provides that neither the members of an LLC nor the managers of an LLC are liable under a judgement, decree, or order of a court, or in any other manner, for a debt, obligation, or liability of the LLC.

Section 17-7617 of the Act provides that the interest of a member in an LLC is personal property. Section 17-7618 of the Act states that an interest of a member in an LLC may be transferred or assigned as provided in the operating agreement. That section of the Act further provides, however, that if all of the other members of the LLC other than the member proposing to dispose of the member's interest do not approve of the proposed transfer or assignment by unanimous written consent, the transferee of the assigned interest has no right to participate in the management of the business and affairs of the LLC or to become a member. The transferee of the assigned interest is 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.

Under M's operating agreement, the transferee of an assigned interest does not become a member and does not have a right to participate in the management of the business and affairs of M, unless all members of M other than the member seeking to transfer the interest approve of the proposed transfer or assignment by unanimous written consent.

Section 17-7622 of the Act provides that an LLC organized under the Act shall be dissolved upon the occurrence of any of the following events: (1) when the period fixed for the duration of the company expires; (2) by the unanimous written agreement of all the members; or (3) by the death, retirement, resignation, expulsion, bankruptcy or dissolution of a member or upon the occurrence of any other event which terminates the continued membership of a member in the LLC, unless the business of the LLC is continued by the consent of all the remaining members or under a right to continue stated in the articles of organization of the LLC.

Under M's articles of organization, upon the death, retirement, resignation, expulsion, bankruptcy or dissolution of a member, or upon the occurrence of any other event which terminates the continued membership of a member in the LLC, the consent of a majority in interest of the remaining members must be obtained to continue the business of M and prevent the dissolution of M.

LAW AND ANALYSIS

Section 7701(a)(2) 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 §§ 301.7701-2 through 301.7701-4.

Section 301.7701-2(a)(1) 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) 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) provides that if an unincorporated organization possesses more corporate characteristics than noncorporate characteristics, it constitutes an association taxable as a corporation.

In interpreting s 301.7701-2, 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 the organization 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) 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) 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 M's articles of organization, unless the business of M is continued by consent of a majority in interest of the remaining members, M is dissolved upon 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 company. Thus, if a member of M ceases to be a member of M 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) 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) 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) 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 M's 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) 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 an LLC providing professional services, the members would not be liable for the debts of, or claims against, M. Each member would only have personal liability in connection with that member's performance of professional services on behalf of M. Therefore, in that situation, M would also possess the corporate characteristic of limited liability.

Section 301.7701-2(e)(1) 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 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 and M's operating agreement, a member of M can assign or transfer that member's interest to another who is not a member of the organization. However, 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. 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 Kansas Limited Liability Company Act, a Kansas LLC may be classified as a partnership or as an association taxable as a corporation depending upon the provisions adopted in the LLC's articles of organization or operating agreement. See, e.g., Rev. Rul. 93-38, 1993-1 C.B. 233 (concerning Delaware LLCs). M, the Kansas 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 Scott Carlson of the Office of Assistant Chief Counsel (Passthroughs and Special Industries). For further information regarding this revenue ruling, contact David McDonnell on (202) 622-3050 (not a toll-free call).

Rev. Rul. 94-30, 1994-1 C.B. 316, 1994-19 I.R.B. 6.