VIRGINIA LLCs ARE PARTNERSHIPS FOR FEDERAL TAX PURPOSES.

Rev. Rul. 93-5

ISSUE

Is M, a Virginia limited liability company, classified for federal tax purposes as an association or as a partnership?

FACTS

M is organized as a limited liability company pursuant to the provisions of the Virginia Limited Liability Company Act (Act), Va. Code Ann. sections 13.1-1000 through 13.1-1073 (Michie 1991). M is authorized under its articles of organization to engage in any and all business and activity permitted by the laws of the State of Virginia. M has 25 members, including A, B, and C who are the elected managers under M's articles of organization.

Section 13.1-1022 of the Act provides that except to the extent that the articles of organization or an operating agreement provides for management of a limited liability company by a manager or managers, management of a limited liability company is vested in its members. Unless otherwise provided in the articles of organization or an operating agreement, the members of a limited liability company vote in proportion to their contributions to the limited liability company, as adjusted from time to time to reflect any additional contributions or withdrawals.

Section 13.1-1024 of the Act provides that managers are elected by the members, and unless otherwise provided in the articles of organization or an operating agreement, any vacancy occurring in the office of manager is filled by a majority vote of the members.

Section 13.1-1019 of the Act provides that, unless otherwise provided in the articles of organization, no member, manager, or other agent of a limited liability company has any personal obligation for any liabilities of a limited liability company, whether the liabilities arise in contract, tort, or otherwise, solely by reason of being a member, manager, or agent of a limited liability company.

Section 13.1-1038 of the Act also provides that a membership interest in a limited liability company is personal property. Section 13.1-1039 of the Act states that unless otherwise provided in the articles of organization or an operating agreement, a membership interest in a limited liability company is assignable in whole or in part. An assignment of an interest in a limited liability company does not of itself dissolve the limited liability company. An assignment does not entitle the assignee to participate in the management and affairs of the limited liability company or to become or to exercise any rights of a member. The assignment entitles the assignee to receive, to the extent assigned, only any share of profits and losses and distributions to which the assignor would be entitled. Except as provided in the articles of organization or an operating agreement, a member ceases to be a member upon assignment of his or its entire membership interest. Section 13.1-1040 of the Act provides that an assignee of an interest in a limited liability company may become a member only if the other members unanimously consent.

Section 13.1-1046 of the Act provides that a limited liability company formed under the Act is dissolved upon the occurrence of any of the following events: (1) at the time or on the happening of the events specified in the articles of organization or an operating agreement; (2) by the unanimous written consent of the members; (3) by the death, resignation, expulsion, bankruptcy, or dissolution of a member or occurrence of any other event that terminates the continued membership of a member in the limited liability company, unless the business of the limited liability company is continued by the unanimous consent of the remaining members; or (4) by the entry of a decree of judicial dissolution when it is not reasonably practicable to carry on the business in conformity with the articles of organization and any operating agreement. Under M's articles of organization, upon the withdrawal of a member, the consent of all the remaining members must be obtained to continue the business of M.

LAW AND ANALYSIS

Section 7701(a)(2) of the Internal Revenue 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 there from 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 which has these characteristics is to be treated for tax purposes as a partnership or as an association depends on whether there exists 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 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) of the regulations provides that if the death, insanity, bankruptcy, retirement, resignation, or expulsion of any member will cause a dissolution of the organization, continuity of life does not exist. Section 301.7701-2(b)(2) provides that an agreement by which an organization is established may provide that the business will be continued by the remaining members in the event of the death or withdrawal of any member, but the agreement does not establish continuity of life if under local law the death or withdrawal of any member causes a dissolution of the organization.

Under the Act, unless the business of M is continued by the consent of all the remaining members, M is dissolved upon the death, resignation, expulsion, bankruptcy, or dissolution of a member or 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 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 which 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, a limited liability company 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 and the articles of organization, 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) of the regulations 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, a member of M can assign or transfer that member's interest to another who is not a member of the organization. However, the assignee or transferee does not become a substitute member and does not acquire all the attributes of the member's interest in M unless all the remaining members approve the assignment or transfer. 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

M has associates and an objective to carry on business and divide the gains therefrom but lacks a preponderance of the four remaining corporate characteristics. Accordingly, M is classified as a partnership for federal tax purposes.

DRAFTING INFORMATION

The principal author of this revenue ruling is D. Lindsay Russell of the Office of Assistant Chief Counsel (Passthroughs and Special Industries). For further information regarding this revenue ruling, contact Mr. Russell on (202) 622-3050 (not a toll-free call).