REVENUE RULE 94-6

1994-1 C.B. 314, 1994-3 I.R.B. 11.

Internal Revenue Service
Revenue Ruling

CLASSIFICATION OF ALABAMA LIMITED LIABILITY COMPANY

Published: January 18, 1994

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

Classification of Alabama limited liability company. Because of the flexibility accorded by the Alabama Limited Liability Company Act, an Alabama 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 Alabama 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 Alabama Limited Liability Company Act (Act), Ala.Code §§ 10- 12-1 through 10-12-61 (Supp.1993). M is authorized under its articles of organization to engage in any and all business activity permitted by the laws of Alabama. M has 25 members. Three of the members, A, B, and C, are the elected managers under M's articles of organization.

Section 10-12-22 of the Act provides that, except to the extent that the articles of organization or an operating agreement provide otherwise, management of an LLC is vested in its members. An LLC may, in its articles, provide for the management of the LLC by one or more managers who are elected by the members. Absent a contrary provision in the operating agreement, managers are elected, removed, and replaced with the consent of more than one- half the number of members.

Section 10-12-20 of the Act provides that except as otherwise provided in the Act, members are not liable for debts, obligations, or liabilities of the LLC, whether arising in contract, tort, or otherwise, or for the acts or omissions of any other member, manager, agent, or employee of the LLC. When an LLC provides professional services, section 10-12-45 provides that a member will only have personal liability in connection with that member's performance of professional services on behalf of the LLC.

Section 10-12-6 of the Act provides that a membership interest in an LLC is personal property. Section 10-12-32 provides that unless otherwise provided in the operating agreement, a membership interest in an LLC is assignable in whole or in part. Assigning an interest does not of itself dissolve the LLC and does not entitle the assignee to exercise any management rights. An assignment only entitles the assignee to the financial rights to which the assignor otherwise would be entitled. Section 10-12-33 provides that unless otherwise provided in the operating agreement, an assignee of an LLC interest may become a member only if the other members unanimously consent. A member ceases to be a member or to have the power to exercise any rights of a member when any assignee of the member's entire interest becomes a member with respect to the assigned interest.

Under M's operating agreement, a membership interest is assignable in whole or in part. Upon the assignment of a membership interest in M, M's operating agreement provides that the assignee of the interest will not become a member of M without the consent of all of M's remaining members.

Section 10-12-37 of the Act provides that an LLC is dissolved upon the occurrence of any of the following events: (1) events specified in the articles of organization or operating agreement; (2) by the unanimous written consent of all members; (3) an event of dissociation of a member, unless there are at least two remaining members (or at least one remaining member and a new member is admitted) and the business of the LLC is continued within 90 days by the written consent of all remaining members or as otherwise stated in the articles of organization; (4) when the LLC is not the successor LLC in the merger or consolidation with one or more LLCs or other entities; or (5) the entry of a decree of judicial dissolution.

Section 10-12-36 of the Act defines an event of dissociation of a member, unless otherwise provided in the operating agreement, to include 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.

M's articles of organization provide that M dissolves upon the death, retirement, resignation, expulsion, bankruptcy, or dissolution of any of M's members unless there are at least two remaining members and the business of the LLC is continued within 90 days after the occurrence of the event of dissociation by the written consent of all remaining members.

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 the Act and M's articles of organization, unless there are at least two remaining members and the business of M is continued by the consent of all remaining members within 90 days after the event of dissociation, 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. 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 within 90 days after the event of dissociation 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 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.

Except as otherwise provided in the Act, the members of an LLC are not liable for the debts, obligations, or liabilities of the LLC, whether arising in contract, tort, or otherwise, or for the acts or omissions of any other member, manager, agent, or employee of the LLC. 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. Under section 10- 12-45 of the Act, the members 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 that member's interest to another person who is not a member of the organization. However, the assignee does not become a member and does not acquire all the attributes of the member's interest in M unless all of the remaining members approve the assignment. 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 Alabama Limited Liability Company Act, an Alabama 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, 1993-21 I.R.B. 4 (concerning Delaware limited liability companies). M, the Alabama 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 N. Carlson of the Office of Assistant Chief Counsel (Pass-throughs and Special Industries). For further information regarding this revenue ruling contact Scott N. Carlson on (202) 622-3050 (not a toll-free call).