L.A. Bar Members Suggest Ways To Classify LLC Owners As Partners.

Members of the Los Angeles County Bar Association have suggested ways to classify LLC owners as general partners or limited partners for purposes of various provisions of the tax code.

The bar members suggest using a uniform or global approach to classifying LLC owners. Under current proposed regulations, they note, a member-manager would be treated as a general partner eligible to be appointed as tax matters partner. The members suggest that the LLC should be able to designate any LLC owner as the tax matters partner.

The L.A. Bar members also recommend specific regulatory language for determining whether an LLC owner is a limited or general partner with regard to rules governing losses under section 465(c)(7)(D), farming syndicates under section 464, cash accounting prohibitions under section 448, passive activity losses under section 469, and payments to retiring partners under section 736.

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LOS ANGELES COUNTY BAR ASSOCIATION

PROPOSAL TO AMEND VARIOUS REGULATIONS

[1] This proposal was prepared principally by Sanford Holo, At-Large Member of the Executive Committee of the Taxation Section of the Los Angeles County Bar Association. Substantial contributions and helpful comments were made by Clayton J. Vreeland, Chair of the Pass- Through Entities Committee of the Taxation Section of the Los Angeles County Bar Association. /2/

Contact Person: Sanford Holo

EXECUTIVE SUMMARY

[2] The limited liability company ("LLC") is a form of ownership gaining wide popularity throughout the United States. These entities are generally designed to be taxed as partnerships under the Internal Revenue Code ("Code"). Yet, because various Code provisions and regulations refer to "general partner" or "limited partner" and do not use descriptive titles applicable to LLC equity owners, the application to LLC owners of such references is uncertain.

[3] Both the Treasury and the Internal Revenue Service on one hand, and tax professionals on the other, are aware of the importance of clarifying how LLC owners would be treated under various federal tax provisions. This paper provides suggestions for determining how to classify LLC owners as "general partners" or "limited partners" for purposes of various provisions of the Code and regulations.

[4] This paper proposes the utilization of a uniform, "overall" or "global" approach to classifying LLC owners for purposes of interpreting and applying various COMPLIANCE provisions of the Code and regulations. With respect to various SUBSTANTIVE tax provisions of the Code and regulations, however, this paper proposes specific regulatory changes that are tailored to the legislative purposes underlying each such provision and that would cause those regulations to apply to LLC owners in a manner that achieves the underlying purposes of the relevant Code provisions more fully than would be possible using a uniform "global" approach. Furthermore, the specific changes suggested do not increase regulatory complexity significantly more than would a "global" approach with respect to those substantive tax provisions.

DISCUSSION

[5] The Treasury has proposed regulations under section 1402(a)(13) and section 6231(a) of the Code, that would classify LLC owners as "general partners" or "limited partners" for purposes of those sections, and the Internal Revenue Service has indicated great interest in getting comments on this section-by-section approach to the classification of LLC owners and alternatives for classifying LLC owners. Various articles discuss these proposed regulations. One article has set forth a discussion of various approaches to the application of statutory and regulatory provisions to LLC owners and has concluded that an "overall" approach works best, i.e., the best solution is the use of one definition of "general partner" and "limited partner" for all federal income tax purposes. /3/

[6] Each of these approaches has merit and can be used to classify LLC owners. In proposing regulatory changes for this purpose, we have considered the ease of administration of any new rules as well as the purposes behind the various Code sections affected by the suggested changes.

REASONS FOR CHANGE

[7] Changes to various regulations are essential if LLC owners are to be properly and predictably classified as general partners or limited partners for purposes of various provisions of the Code.

[8] In compliance matters, i.e., matters in which administrative procedures are prescribed in order to establish a particular relationship between a taxpayer and the government or to fulfill a requirement for communication between the two, the parties themselves are able to create and define appropriate persons to so interact. No substantive external purpose need be satisfied. In such instances, it is appropriate to devise and implement rules of a general nature that are easy to understand and apply. On the other hand, where specific purposes behind particular substantive tax provisions must be served, each of those particular provisions must be analyzed, and any solution to a question relating to any of those provisions must take the underlying purpose or purposes of such provision into account.

[9] Accordingly, as noted above, this paper proposes that the "overall" approach be used in connection with those regulations dealing with various compliance matters, while recommending that section-by-section "tailored" changes be made to various other substantive regulations where the classification of LLC owners as general partners or limited partners is necessary.

EXPLANATION OF PROPOSALS

COMPLIANCE MATTERS

SECTION 6231

[10] The Treasury has proposed regulations with respect to this section. /4/ Under the proposal, a "member-manager" of an LLC will be treated as a "general partner" eligible to be appointed as "Tax Matters Partner". The basis for this definition is stated to be that such person should have the necessary authority and access to records needed to act in the desired capacity.

[11] We recommend that Prop. Treas. Reg. section 301.6231(a)(7)-2 not be promulgated as a final regulation and that instead the following sentence be added at the end of Prop. Reg. section 301.6231(a)(7)-1(b)(1):

"For purposes of section 6231(a)(7) and this subparagraph, a

A. Such person is a general partner in the partnership

B. Such person actively participates in the management or

C. The partnership is an LLC in which such person owns an

[12] We submit that LLC owners should be able to designate any LLC owner as Tax Matters Partner. LLC owners can make an informed decision on this matter and provide their designee with the tools and information he/she needs to properly act in this capacity. Such a designation could be made in the Operating Agreement. This approach gives the entity the opportunity to take its specific characteristics into account. At the same time, in any specific case, the authority of the appointee would be easy to verify and thus be acceptable to the government.

OTHER COMPLIANCE PROVISIONS

[13] A great number of the regulatory references to "general partner" involve compliance matters, i.e., the filing of returns or statements which must be signed by a "general partner". /5/ As one commentator has pointed out, /6/ these references focus on the authority of a person of a particular status to perform the described function.

[14] While the Treasury or the Internal Revenue Service may look to the authority of a particular class of persons because of that person's general law status, we submit that the government can "define" or "approve" that authority or authorize any person it wishes to bind the partnership with respect to tax matters. /7/ Thus, we submit that any LLC member authorized by the LLC or under the applicable organizational statute should be in the acceptable class in these compliance situations.

[15] With respect to these provisions, the LLC should be able to designate any owner to perform one or more of the compliance functions required by those provisions if authorized, for example, in the Operating Agreement. Again, if the entity permits a particular member to so act, even if not a "manager", the government should be able to respect that designation without any negative consequences. In the absence of such a specific designation, any owner with authority under applicable state law should be within the class permitted to act on behalf of the LLC.

[16] A variant on this approach would be to have the designation of a particular LLC owner or owners, for one or more particular compliance purposes, set forth on a form or schedule attached to the tax return of the entity. Such a form could specify the various specific provisions for which an owner or owners might be authorized and permit the LLC to designate such authorized persons for those particular compliance purposes.

IMPORTANT SUBSTANTIVE TAX PROVISIONS

SECTION 448

[17] This section provides rules for determining whether or not certain taxpayers are prohibited from using the cash receipts and disbursements method of accounting. Under the current regulations, a "syndicate" in which more than 35% of the losses during the taxable year are allocated to "limited partners" or "limited entrepreneurs" /8/ is within the statutory prohibition. A "limited entrepreneur" is defined as one who has an interest in the enterprise "other than as a limited partner" and who does "not actively participate in the management of the enterprise." /9/ Furthermore, even if an interest is owned by a limited partner it will not be treated as so owned if certain active participation requirements are met. /10/

[18] Here, because of the latter provisions, whether LLC owners are "limited partners" is essentially irrelevant. "Active participation" of LLC owners is the important characteristic for determining whether the LLC is or is not prohibited from using the cash receipts and disbursements method. Thus, if LLC owners are clearly excluded from the "limited partner" definition, the LLC owners will still be limited entrepreneurs unless they pass the active participation test of the temporary regulations.

[19] We suggest the following sentence be added to "Temp. Reg. section 1.448-1T(b)(3), after the first sentence thereof:

"For purposes of this paragraph (b)(3), a person is a 'limited

[20] The foregoing definition of "limited partner" excludes LLC owners. Therefore, the application of section 448 to an LLC will turn on whether the LLC owners meet the "active participation" test as set forth in the regulations. Thus, the appropriate criteria will be utilized in determining the applicability of this section to a particular LLC and there will be no undue complications in the administration of this section. The existing tests will continue to determine which entities are within and which are without the statutory definition of "syndicate."

SECTION 464

[21] This section contains rules regarding the limitation on certain deductions for "farming syndicates", /11/ and the capitalization of certain expenditures. /12/ The definition of "farming syndicate" is key to the application of this section. The term is defined as a partnership or enterprise, other than a corporation which is not an S corporation, engaged in a trade or business of farming that may allocate more than 35% of the losses during any period to limited partners or limited entrepreneurs. A "limited entrepreneur" is defined as one who has an interest in the enterprise other than as a limited partner and who does not actively participate in management of the enterprise.

[22] We suggest the following changes in the proposed regulations under Section 464:

1. The title to Prop. Treas. Reg. 1.464-2(a)(3) be revised to

2. The following sentence be added at the beginning of the

"For purposes of this section, a person is a 'limited

[23] As was the case with respect to section 448, the labels of the owners of the enterprise are irrelevant. The important factor is "active participation". The above definition excluding LLC owners from the definition of "limited partner" puts the focus on that "active participation" requirement. Applying this test will correctly determine whether an LLC is within or without the statutory definition of "farming syndicate." In addition, there is no increased difficulty in the administration of this section.

SECTION 465

[24] This section limits the amount of losses recognizable to individuals and certain C corporations engaged in certain activities to the extent of their aggregate "at-risk" amounts as of year end. /13/ A taxpayer is "at-risk" for borrowed amounts to the extent he/she is personally liable for the payment or the extent to which he/she has pledged property as security for the borrowed amount. /14/ Certain "qualifying businesses" of qualified C corporations are not subject to the section 465 limitations. A special rule set forth in section 465(c)(7)(D) applies to taxpayers that are partners in partnerships. If a C corporation taxpayer is a "qualified corporate partner" (and other tests are satisfied), the taxpayer's proportionate share of the active business of the partnership is treated as the activity of that taxpayer. Thus, the partnership's activities can be attributed to the C corporation and exempted from the section 465 limitations as a qualifying business of the qualified C corporation. A corporation must be a "general partner" of the partnership in order to be a "qualified corporate partner" in the partnership.

[25] We recommend the following new regulation be adopted under section 465:

"PARTNERSHIPS IN WHICH THE TAXPAYER IS A QUALIFIED CORPORATE

[26] The key factor in the applicability of section 465 is the taxpayer's exposure to risk of loss, i.e., potential liability. Therefore, an LLC owner should be included within the definition of "general partner" for these purposes only if such taxpayer has the same exposure to liability that a general partner in a state law partnership has. The foregoing regulation requires an LLC owner to have such exposure, and the regulatory change carries out the statutory purpose of this section.

SECTION 469

[27] This section provides that, except as provided in regulations, a limited partner can never "materially participate" in an activity. /15/ This provision is based on the premise that if a limited partner were active enough to meet the material participation requirement he/she would lose his/her limited liability protection due to such activity, i.e., he/she would be deemed a general partner, so that all this provision does is present taxpayers who have not materially participated anyway from claiming that they have. However, due to changes in the limited partnership acts of many states, /16/ that premise is no longer correct. Furthermore, the definition of "limited partner" in the regulations is based upon the partner's limited liability /17/ rather than restrictions under state law on the ability of the partner to materially participate in the activity of the entity.

[28] In recognition of the purposes of section 469 as discussed above, we suggest the following be added at the end of Treas. Reg. section 1.469-5T(e)(3)(ii):

"For purposes of this paragraph (e)(3)(ii), an individual is a

(A) Such individual is a general partner under state

(B) The liability of such individual for the debts of the

(C) Such individual is not personally liable for the

[29] The focus of these additions to the existing regulations is the expansion of the definition of "general partner", as applicable under section 469, to accommodate owners of LLCs. Part (C) of the above addition includes LLC owners so that such owners are not automatically within the definition of "limited partner" because of the limited liability available to LLC owners.

[30] Moreover, this change leaves the other relevant test under this section applicable to LLC owners. Each LLC owner must still meet the "material participation" test in order to be excluded from the limitations of section 469.

SECTION 736

[31] As noted in the paper presented by Mr. Glenn E. Dance in this forum in 1995, the application of section 736 to LLC owners requires clarification. /18/

[32] Under the current provisions of section 736, payments to a retiring or deceased member of a partnership are characterized as distributions (section 736(b) payments), or as guaranteed payments or distributive shares of income (section 736(a) payments). Payments generally are treated as section 736(b) payments. /19/ If the retiring or deceased partner is a general partner, however, and capital is NOT a material income-producing factor for the partnership, the payments to the departing partner for his share of partnership goodwill are treated as 736(a) payments, not 736(b) payments. /20/

[33] In order to provide for the application of this section to LLC owners, we suggest the following amendments to Prop. Treas. Reg. section 1.736-1:

1. Renumber subparagraphs (4), (5), (6) and (7) of Prop. Treas.

2. Add the clause "Subject to the limitations contained in

3. Add the following new subparagraph (4) after subparagraph (3)

"(4) Payments shall be treated as paid for a partner's

(i) capital is not a material-income producing factor

(ii) the retiring or deceased partner was a general

Solely for purposes of section 736(b)(3) and this

[34] As Mr. Dance pointed out, the deductibility of payments to a general partner of a service type partnership is premised on the fact that such payments are compensation to a departing partner for past services which created partnership goodwill. Thus, the most important factor in the definition of "general partner" within this section is that particular partner's degree of activity in the business operation of the entity. Such involvement as an owner justifies the characterization as deductible compensation when that partner departs the partnership. At the same time, that partner's participation in management or personal liability for entity obligations are not relevant factors in providing for this exception to the general rule of section 736.

[35] The foregoing regulatory change incorporates the general statutory requirements and further defines "general partner" in terms of the level of services rendered to the partnership by the departing partner. This change looks to the rendition of services which have been a material factor in producing entity income. In addition, since "partner", as defined in the Internal Revenue Code, includes an LLC owner, this definition encompasses qualified LLC owners.

SECTION 1256

[36] Because Section 1256 incorporates section 464(e)(2) by reference, the above change to proposed Treas. Reg. section 1.464- 2(a)(3) should also provide a suitable solution with respect to the application of section 1256 to LLC owners.

SECTION 1402

[37] This section was also discussed by Mr. Dance in his paper presented in 1995. He pointed out that the proposed regulations would apply in a much easier fashion if "limited partner" was specifically defined.

[38] The specific labels are the critical distinction in this section and the results under the section are based upon whether a taxpayer is a "general partner" or a "limited partner". Thus, the definitions of those classes of taxpayers should be based upon characteristics which are important for self-employment tax purposes. As Mr. Dance points out, the important factor is the level of the participation and involvement of the taxpayer in the entity's activities.

[39] Therefore, we suggest that the following Treas. Reg. section 1.1402(a)-18(b) be adopted:

"(b) Solely for purposes of section 1402(a)(13), the

[40] We further recommend that Prop. Treas. Reg. section 1.1402(a)-18(c)(3) be deleted because, with the above formulation of the regulation, that prior regulation would no longer be necessary.

[41] The suggested language above is intended to encompass appropriate LLC owners within the definition of "limited partner" based upon the most important relevant factor, i.e., the level of participation in the activities of the entity. The focus of proper categorization is such participation, or the lack thereof, not the existence or non-existence of personal liability.

[42] In addition, the suggested change provides a mechanism whereby the LLC entity can determine how to characterize the income of a particular owner for purposes of completing each K-1 which it is required to prepare.

FOOTNOTES

/1/ These comments represent the individual views of the members of the Taxation Section who prepared them. They do not represent the position of the Los Angeles County Bar Association or the Taxation Section.

/2/ Although the participants on the project might have clients affected by the rules applicable to the subject matter of this paper and have advised such clients on applicable law, no such participant has been specifically engaged by a client to participate on this project.

/3/ Steven G. Frost, "Square Peg, Meet Round Hole: Classifying LLC Members as 'General Partners' or 'Limited Partners' for Federal Tax Purposes," 73 Taxes 676 (December 1995).

/4/ Prop. Treas. Reg. section 301.6231(a)(7)-2.

/5/ For example, Treas. Regs. section 1.42-2(d), 1.1441-6(e), 1.1445-2(b), 1.1445-3(b), 1.1445-5(b), 1.1445-5(c), 1.6049-5(b); Temp. Reg. section 1.1445-11T(d), 1.6038B-1T(b), 1.6081-2T(b), 301.6224(c)-2T(b), Prop. Reg. section 301.6224(c)-2(b).

/6/ Frost, supra note 3, at 708.

/7/ See Prop. Reg. section 301.6231(a)(7)-1 and Temp. Reg. section 301.6237-(a)(7)-1T. See also Frost, infra, p. 703.

/8/ Temp. Reg. section 1.448-1T(b)(3).

/9/ Id.

/10/ See Temp. Reg. section 1.448-1T(b)(3); Code sections 464(c)(2) and 1256(e)(3)(C).

/11/ Section 464(a).

/12/ Section 464(b).

/13/ Section 465(a).

/14/ Section 465(b)(2).

/15/ Section 469(h)(2).

/16/ See Frost, supra note 3, at 682-84.

/17/ Treas. Reg. section 1.469-5T(e)(3)(B).

/18/ Proposals For Treating Certain Limited Liability Company Members as "General Partners" or "Limited Partners" For Tax Purposes. Glenn E. Dance, 1995 Washington, D.C. Delegation, Los Angeles County Bar Association and State Bar of California Taxation Section.

/19/ Section 736(b)(1) and (2).

/20/ Section 736(b)(3).

END OF FOOTNOTES