REVENUE RULE 94-51

1994-2 C.B. 407, 1994-32 I.R.B. 11.

Internal Revenue Service
Revenue Ruling

CLASSIFICATION OF NEW JERSEY LIMITED LIABILITY COMPANY

Published: August 8, 1994

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

Classification of New Jersey Limited Liability Company. Because of the flexibility accorded by the New Jersey Limited Liability Company Act, a New Jersey 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 New Jersey 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 New Jersey Limited Liability Company Act (Act), N.J.S.A. 42:2B-1 to -70 (1994). M is authorized under its operating agreement to engage in any and all business activity permitted by the laws of New Jersey. M has 25 members. Three of the members, A, B, and C, are the elected managers under M's operating agreement.

Section 27 of the Act provides that, unless otherwise provided in an operating agreement, the management of an LLC is vested in its members in proportion to the then current percentage or other interest of members in the profits of the LLC owned by all of the members; the decision of the members owning more than 50 percent is controlling. However, if an operating agreement provides for the management, in whole or in part, of an LLC by a manager, the management of the LLC, to the extent so provided, is vested in the manager. The manager will be chosen by the members in the manner provided in the operating agreement. M's operating agreement grants exclusive management authority to its designated managers.

Section 23 of the Act provides that except as otherwise provided by the Act, no member, manager, employee or agent of an LLC shall be obligated personally for any debt, obligation or liability of the LLC, or for any debt, obligation or liability of any other member, manager, employee or agent of the LLC, by reason of being a member, or acting as a manager, employee or agent of the LLC.

Section 43 of the Act provides that an LLC interest is personal property. Section 44a of the Act provides that an LLC interest is assignable in whole or in part except as provided in an operating agreement. Section 44a further provides that 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 operating agreement and upon: (1) the approval of all of the members of the LLC other than the member assigning the LLC interest; or (2) compliance with any procedure provided for in the operating agreement. Section 46a of the Act provides that an assignee of an LLC interest may become a member as provided in an operating agreement and upon: (1) the approval of all of the members of the LLC other than the member assigning the LLC interest; or (2) compliance with any procedure provided for in the operating agreement.

Under M's operating agreement, upon the assignment of a membership interest in M, the assignee of the interest has no right to participate in the management of M or become a member of M without the written consent of all of M's members other than the assignor member.

Section 48 of the Act provides that an LLC is dissolved and its affairs will be wound up upon the first to occur of the following: (a) at the time specified in an operating agreement, or 30 years from the date of the formation of the LLC if no time is set forth in the operating agreement; (b) the happening of events specified in an operating agreement; (c) the written consent of all members; (d) the death, retirement, resignation, expulsion, bankruptcy, or dissolution of a member or 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 either by the consent of all the remaining members within 90 days following the occurrence of any event or pursuant to a right to continue stated in the operating agreement; or (c) the entry of a decree of judicial dissolution under section 49 of the Act. 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 following the occurrence of the event all of the remaining members of M agree to continue the business.

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 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) 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 the Act, 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 M unless the business of M is continued either by the consent of all the remaining members within 90 days following the occurrence of any such event or pursuant to a right to continue stated in the operating agreement. 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 all of the remaining members of M agree to continue the business. Thus, if a member of M ceases to be a member of M for any reason, the continuity of M is not assured because all 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 its operating agreement, M is managed exclusively 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.

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 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, a member of M can assign or transfer that member's interest to another who is not a member of the organization. However, under M's operating agreement, the assignee or transferee does not become a member or have a right to participate in the management of M, and, therefore does not acquire all the attributes of the member's interest in M unless all the remaining members consent. 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 New Jersey Limited Liability Company Act, a New Jersey 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 or operating agreement. See, e.g., Rev. Rul.. 93-38, 1993-1 C.B. 233 (concerning Delaware LLCs). M, the New Jersey 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 John Kramer of the Office of Assistant Chief Counsel (Passthroughs and Special Industries). For further information regarding this revenue ruling, contact John Kramer on (202) 622- 3060 (not a toll-free call).

Rev. Rul. 94-51, 1994-2 C.B. 407, 1994-32 I.R.B. 11.