CLASSIFICATION FOR FEDERAL TAX PURPOSES
Almost all states (including New Jersey and New York) have enacted Limited Liability Company("LLC") legislation. Properly structured, an LLC offers limited liability to all investors combined with the benefits of flow-through taxation. In order to obtain these benefits, an LLC must be classified by the Internal Revenue Service ("IRS") as a partnership, rather than as an association taxable as a corporation.
Under existing IRS regulations,an entity will be classified and taxed as a partnership for federal purposes if it has two or fewer of the following "corporate" characteristics: (i) limited liability; (ii) continuity of life; (iii) centralized management; and (iv) free transferability of interests. If an entity has three or more corporate characteristics, it will be classified as an association and will be taxed as a corporation. Until recently, the application of these characteristics to LLCs had not yet been defined.
In response to the rapid growth in LLC legislation, the IRS recently issued Revenue Procedure 95-10 which provides specific guidance as to the classification of LLCs for federal tax purposes. Pursuant to this Revenue Procedure,taxpayers may obtain an advance ruling as to whether or not a particular LLC will be classified and taxed as a partnership. Revenue Procedure 95-10 applies to ruling requests received by the IRS on or after January 17, 1995.
Prior to the issuance of Revenue Procedure 95-10, the IRS had issued a series of Revenue Rulings classifying LLCs on a state-by state basis. For the most part, these rulings concluded that LLCs formed under a particular state statute could be classified as partnerships or as associations, depending on the provisions adopted in the LLC's operating agreement. While these rulings were helpful in understanding the various provisions of state LLC statutes, they left open the overall parameters of LLC classification for federal tax purposes.
Revenue Procedure 95-10 defines those parameters and, although its stated purpose is to outline the procedure for making advance ruling requests, it essentially provides a "safe-harbor" for partnership tax treatment of LLCS. While the issuance' of these guidelines should give greater comfort to LLC investors, careful drafting of the LLC operating agreement remains critical.
LLC MEMBERS SUBJECT TO EMPLOYMENT TAX
Until recently, the application of the self-employment tax to distributions from an LLC was unclear. However, at the end of 1994, the IRS issued proposed regulations which basically extend the application of the self-employment tax in the partnership context to LLCS. The effective date of the proposed regulations will be the member's first tax year beginning on or after the date
final regulations are published.
In general, a partner in a partnership is subject to self-employment tax on his distributive share of partnership profits plus any guaranteed payments received. An exception exists for limited partners who are permitted to exclude their distributive share of partnership profits (other than guaranteed payments for services actually rendered and to the extent the payments are shown to be remuneration for services).
The proposed regulations provide that a member an LLC will generally be subject to self-employment tax on his distributive share (whether or not distributed) of income or loss from any trade or business carried on by the LLC. The proposed regulations make clear that LLC members do not, as a general rule, fit within the exclusion available to limited partners in a partnership.
However, a member will be treated as a limited partner for purposes of the exclusion described above if: (i) the member is not a manager of the LLC, and (ii) the entity could have been formed as a limited partnership rather than an LLC in the same jurisdiction and the member could have qualified as a limited partner in that partnership under applicable law. The second prong of this test would require an analysis of the nature and extent of the member's activities with respect to the management of the LLC. Essentially, in order to qualify for the exclusion available to limited partners, LLC members must be passive investors.
