REVENUE RULE 94-79

1994-2 C.B. 409, 1994-51 I.R.B. 7.

Internal Revenue Service
Revenue Ruling

CLASSIFICATION OF CONNECTICUT LIMITED LIABILITY COMPANY

Published: December 19, 1994

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

Classification of Connecticut limited liability company. Because of the flexibility accorded by the Connecticut limited liability company may be classified as a partnership or 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 Connecticut 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 Connecticut Limited Liability Company Act (Act), 1993 Conn. Acts 93-267 (Reg.Sess.), as amended by 1994 Conn. Acts 94-217 (Reg.Sess.). M is authorized under its articles of organization to engage in any and all business activity permitted by the laws of Connecticut. M has 25 members. Three of the members, A, B, and C, are the elected managers under M's articles of organization.

Section 21 of the Act provides that unless the articles of organization provide for management of an LLC by a manager or managers, management of an LLC is vested in its members. An LLC may, however, provide for the management of the LLC by one or more managers who are designated or elected by the members. Managers may be designated or elected, removed, and replaced in the manner provided in the operating agreement.

Section 19(a) of the Act provides that except as provided in section 19(b), members and managers are not liable, solely by reason of being a member or manager, or both, 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.

Section 19(b) of the Act provides that nothing in the Act shall be interpreted to limit the law presently in effect applicable to the professional relationship and liabilities between the person furnishing the professional services and the person receiving the services, provided that any member, manager, agent, or employee of an LLC rendering professional services shall be personally liable only for negligent or wrongful acts or misconduct committed by that person, or by any person under that person's direct supervision and control, while rendering professional services on behalf of the LLC.

Section 35 of the Act provides that a membership interest in an LLC is personal property. Section 36 of the Act provides that, except as provided in the operating agreement, an LLC membership interest may be assigned in whole or in part. An assignment of an interest does not entitle the assignee to participate in the management of the business and affairs of the LLC or to become or to exercise the rights of a member. An assignee that has not become a member shall only be entitled to receive, to the extent assigned, the share of distributions to which the assignor would otherwise be entitled with respect to the assigned interest.

Section 38 of the Act provides that, unless otherwise provided in the operating agreement, an assignee of an LLC interest may become a member only upon the consent of at least a majority in interest of the members other than the assignor.

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

Section 42 of the Act provides that an LLC is dissolved upon the occurrence of any of the following events: (1) events specified in writing in the articles of organization or operating agreement; (2) the written consent of at least a majority in interest of the members; (3) an event of dissociation of a member, unless there are at least two remaining members and the business of the LLC is continued by the consent of at least a majority in interest of the remaining members or as otherwise provided in writing in the operating agreement; or (4) entry of a decree of judicial dissolution under section 43 of the Act.

Section 41 of the Act defines events of dissociation to include the death, incompetency, withdrawal, removal, bankruptcy, or dissolution of a member.

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 there are at least two remaining members and the remaining members owning a majority of the profits interests and a majority of the capital interests owned by all of M's remaining members agree to continue the business 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 the 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 operating agreement, unless there are at least two remaining members and the business of M is continued by the consent of the remaining members owning a majority of the profits interests and a majority of the capital interests owned by all of M's remaining members, M is dissolved upon the death, incompetency, withdrawal, removal, 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 there must be at least two remaining members and a majority in interest of the remaining members must agree to continue the business. See Rev. Proc. 94-46, 1994-28 I.R.B. 129. 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 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) 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 and managers of an LLC 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. 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 19(b) of the Act, each member would only have personal liability in connection with the performance of professional services on behalf of M by that member or by any person under that 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) 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 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 a majority in interest 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 Connecticut Limited Liability Company Act, a Connecticut 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 Connecticut 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 David McDonnell of the Office of Assistant Chief Counsel (Passthroughs and Special Industries). For further information regarding this revenue ruling contact Mr. McDonnell on (202) 622- 3050 (not a toll-free call).

Rev. Rul. 94-79, 1994-2 C.B. 409, 1994-51 I.R.B. 7.