Federal Taxation Developments Blog : Federal Taxation Lawyer & Attorney : Fox Rothschild Law Firm : Federal Income Taxation & Tax Litigation

On September 13, 2010, the Service, in REG-119921-09, issued somewhat landmark  proposed regulations concerning the classification for Federal tax purposes of a series of a domestic series limited liability company (LLC), a cell of a domestic cell company, or a foreign series or cell that conducts an insurance business. The proposed regulations provide that, whether or not a series of a domestic series LLC, a cell of a domestic cell company, or a foreign series or cell that conducts an insurance business is a juridical person for local law purposes, for Federal tax purposes it is treated as an entity formed under local law. Classification of a series or cell that is treated as a separate entity for Federal tax purposes generally is determined under the same rules that govern the classification of other types of separate entities.

Background

Certain states, including Delaware, Illinois, Iowa, Nevada, Oklahoma, Tennessee, Texas, Utah and Puerto Rico,have statutes providing for series LLCs. A series LLC statute allow an LLC to establish separate series. Although series of a series LLC generally are not treated as separate entities for state law purposes and, thus, cannot have members, each series has “associated” with it specified members, assets, rights, obligations, and investment objectives or business purposes. Assuming the series LLC is properly documented, the debts, liabilities, and obligations of one series generally are enforceable only against the assets of that particular series and not against assets of other series or of the series LLC.

Certain jurisdictions have enacted statutes providing for entities similar to the series LLC. For example, certain statutes provide for the chartering of a legal entity (or the establishment of cells) under a structure commonly known as a protected cell company, segregated account company or segregated portfolio company (cell company). A cell company may establish multiple accounts, or cells, each of which has its own name and is identified with a specific participant, but generally is not treated under local law as a legal entity distinct from the cell company. The assets of each cell are statutorily protected from the creditors of any other cell and from the creditors of the cell company.

Prior to the issuance of the proposed regulations, the Service acknowledged that little guidance exists as to whether for Federal tax purposes a series (or cell) is to be treated as an entity separate from other series or the series LLC (or other cells or the cell company, as the case may be), or whether the company and all of its series (or cells) should be treated as a single entity. In response to a request for comments, the Service and the Treasury were, in general, in agreement that series and cells should be treated as separate entities for Federal tax purposes where established under a statute with provisions similar to the series LLC statutes currently in effect in several states.

Treas. Reg. §301.7701-1(a)(1) provides that the determination of whether an entity is separate from its owners for Federal tax purposes is a matter of Federal tax law and does not depend on whether the organization is recognized as an entity under local law. Treas. Reg. §301.7701-1(a)(2) provides that a joint venture or other contractual arrangement may create a separate entity for Federal tax purposes if the participants carry on a trade, business, financial operation, or venture and divide the profits therefrom.

However, a joint undertaking merely to share expenses does not create a separate entity for Federal tax purposes, nor does mere co-ownership of property where activities are limited to keeping property maintained, in repair, and rented or leased.

Classification as a Separate Entity for Federal Tax Purposes

Whether an organization is an entity separate from its owners for Federal tax purposes is a matter of Federal tax law and does not depend on whether the organization is recognized as an entity under local law.  Treas. Reg. §301.7701-1(a)(1). In Moline Properties, Inc., 319 U.S. 436 (1943) , the Supreme Court opined that where a corporation was formed for a purpose that is the equivalent of business activity or the corporation actually carries on a business, the corporation remains a taxable entity separate from its shareholders. Although entities that are recognized under local law generally are also recognized for Federal tax purposes, a state law entity may be disregarded if it lacks business purpose or any business activity other than tax avoidance. See Bertoli, 103 T.C. 501 (1994) ; Aldon Homes, Inc., 33 T.C. 582 (1959) . In the landmark partnership tax cases, Culbertson, 337 U.S. 733 (1949) and Tower,327 U.S. 280 (1946) , a partnership exists for Federal tax purposes where  the parties in good faith and acting with a business purpose intended to join together to conduct an enterprise and share in its profits and losses. See also Madison Gas & Elec. Co., 633 F.2d 512, 514 (7th Cir. 1980); Luna,  42 T.C. 1067, 1077-78 (1964) . On the other hand, the Service has ruled that a co-ownership does not rise to the level of an entity for Federal tax purposes if the owner employs an agent whose activities are limited to collecting rents, paying property taxes, insurance premiums, repair and maintenance expenses, and providing tenants with customary services. See Rev. Rul. 75-374, 1975-2 CB 261; Rev. Rul. 79-77 1979-1 CB 448; Rev. Proc. 2002-22, 2002-1 C.B. 733 (ruling guidelines on co-ownership of property as not constituting a partnership).  See also National Securities Series-Industrial Stocks Series, 13 T.C. 884 (1949), acq. 1950-1 C.B. 4. Compare. Union Trusteed Funds , 8 T.C. 1133 (1947) (series funds organized by a state law corporation could not be treated as if each fund were a separate corporation). See also §851(g)(rules for series funds of a RIC) and §§816(a) and 831(c) for definitions of an “insurance company”.

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Under newly enacted 7701(o), This newly issued Notice provides interim guidance regarding the codification of the economic substance doctrine, for any transaction to which the economic substance doctrine is relevant, the transaction shall be treated as having economic only in instances where: (i) the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer’s economic position; and (ii) the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into the transaction.

Section 7701(o)(5)(A) defines the “economic substance doctrine” as the common law doctrine under which income tax benefits (as well as corresponding costs) with respect to a transaction are not allowable if the transaction does not have economic substance or lacks a business purpose. Both tests have to be met. 

Section 7701(o)(5)(C) states that the determination of whether the economic

substance doctrine is relevant to a transaction shall be made in the same manner as if

section 7701(o) had never been enacted. With respect to individuals, however, section

7701(o)(5)(B) states that the two-prong analysis in section 7701(o)(1) applies only with respect to a transaction entered in as part of a trade or business or an activity engaged

in for the production of income. Transaction, per §7701(o)(5)(D), includes a series of transactions.

Section 7701(o)(2)(A) provides that a transaction’s potential for profit shall be

taken into account in determining whether the requirements of section 7701(o)(1) are

met only if the present value of the reasonably expected pre-tax profit is substantial in

relation to the present value of the claimed net tax benefits. For purposes of computing

pre-tax profit, §7701(o)(2)(B) provides that the Secretary shall issue regulations

treating foreign taxes as a pre-tax expense in appropriate cases.

The Act also added §6662(b)(6), which provides that the accuracy-related penalty imposed under §6662(a) applies to any underpayment attributable to any disallowance of a claimed tax benefit because of a transaction lacking economic substance (within the meaning of §7701(o)) or failing to meet any similar rule of law (collectively a § 6662(b)(6) transaction). The Act also added section 6662(i), that increases the accuracy related penalty from 20% to 40% for any portion of an underpayment that is attributable to one or more §6662(b)(6) transactions which were not adequately disclosed on the return or statement attached to the return. In addition, §6662(i)(3), also a new provision, provides that certain amended returns or any supplement to a return shall not be taken into consideration for purposes of section 6662(i).

The Act amended §6664(c) so that the reasonable cause exception for underpayments found in §6664(c)(1) shall not apply to any portion of any underpayment attributable to a § 6662(b)(6) transaction. The Act similarly amended  §6664(d) so that the reasonable cause exception found in § 6664(d)(1) shall not apply to any reportable transaction understatement (within the meaning of §6662A(b)) attributable to a § 6662(b)(6) transaction. The Act further revised §6676 so that any excessive amount (within the meaning of §6676(b)) attributable to any §6662(b)(6) transaction shall not be treated as having a reasonable basis.

After providing a summary of the new “clarification” of the economic substance test, the Notice states that for transactions entered into on or after March 31, 2010, the IRS will apply §7701(o)’s two-prong conjunctive test. In determining whether a transaction has a

sufficient nontax purpose to satisfy the requirements of §7701(o)(1)(B), the Service announced that it will apply cases under the common-law economic substance doctrine pertaining to whether the tax benefits of a transaction are not allowable because the transaction lacks a business purpose. The Service will therefore challenge transactions where the taxpayer asserts that either the business purpose test or economic tests are applicable.

As a second guideline, Notice 2010-62 provides that the IRS will continue to analyze when the economic substance doctrine will apply in the same fashion as it did prior to the enactment of §7701(o). Therefore, if legal authorities, prior to the enactment of §7701(o), provided that the economic substance doctrine was not relevant to whether certain tax benefits are allowable, the IRS will continue to take the position that the economic substance doctrine is not relevant to whether those tax benefits are allowable. The IRS anticipates that the case law regarding the circumstances in which the economic substancedoctrine is relevant will continue to develop. Consistent with §7701(o)(5)(C), codification of the economic substance doctrine should not affect the ongoingdevelopment of authorities on this issue.

Third, Notice 2010-62 states that the Treasury Department and the IRS do not

intend to issue general administrative guidance regarding the types of transactions to

which the economic substance doctrine either applies or does not apply. Inotherwords, there will be no “angel list” of approved transactions as many tax professionals had hoped for.

Fourth, in calculating  the net present value of the reasonable expected pre-tax profit under §§7701(o)(1)(A) and (B), the IRS will take into account the taxpayer’s profit motive only if the present value of the reasonably expected pre-tax profit is substantial in relation to the present value of the expected net tax benefits that would be allowed if the transaction were respected for Federal income tax purposes. In performing this calculation, the IRS will apply existing relevant case law and other published guidance. Query, however, what is the discounted rate in computing present value, and what costs are allowable as directly related?

Fifth, Notice 2010-62 restates that §7701(o)(2)(B) grants the Secretary with authority to issue regulations requiring foreign taxes to be treated as expenses in computing the pre-tax profit in certain appropriate instances. Until such regulations are issued, the Notice states that §7701(o) does not restrict the ability of the courts to consider the appropriate treatment of foreign taxes in economic substance cases.

Sixth, as to disclosure issues, the Notice declares that unless a transaction is a reportable transaction per Treas. Reg. §1.6011-4(b), the adequate disclosure requirements of §6662(i) will be met where disclosure is made on a timely filed original return (determined with regard to extensions) or a qualified amended return (as defined under Treas. Reg. § 1.6664-2(c)(3)) the relevant facts affecting the tax treatment of the transaction. If a disclosure would be considered adequate for purposes of §6662(d)(2)(B) (without regard to §6662(d)(2)(C)) prior to the enactment of codification of economic substance it will be deemed to be adequate for purposes of §6662(i). The disclosure will be considered adequate only if it is made on a Form 8275 or 8275-R, or as otherwise prescribed in forms, publications, or other guidance subsequently published by the IRS

consistent with the instructions and other guidance associated with those subsequent

forms, publications, or other guidance.

Disclosures made consistent with the terms of Rev. Proc. 94-69 also will be taken into account for purposes of  §6662(i). However, where a transaction lacking economic substance is a reportable transaction, as defined in Treas. Reg. § 1.6011-4(b), the adequate disclosure requirement under section 6662(i)(2) will be satisfied only if the taxpayer meets the disclosure requirements described earlier in this paragraph and the disclosure requirements under the §6011 regulations. In other words, a taxpayer will not meet the disclosure requirements for a reportable transaction under the  §6011 regulations by only attaching Form 8275 or 8275-R to an original or qualified amended return.

Finally, Notice 2010-62 states that the Service  will not issue a private letter ruling or determination letter regarding whether the economic substance doctrine is relevant to any transaction or whether any transaction complies with the requirements of section 7701(o).

The Notice is effective as of the enactment of §7701(o), March 10, 2010.

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In PLR 201034004, the National Office of the Internal Revenue Service issued a favorable ruling to the taxpayer’s proposed issuance of financial statements and supplemental information containing disclosures of a subsidiary's income on a LIFO and non-LIFO basis to the taxpayer's creditors and shareholders. Rulings requested and granted. Taxpayer plans to issue reviewed (as opposed to audited) consolidated financial statements with unique characteristics, and asked the National Office to rule that the LIFO conformity requirements wouldn't be violated under such circumstances. More specifically, The taxpayer asked for a favorable ruling that such financial disclosures will not violate the LIFO conformity rule under §472 and the corresponding regulations. The Service ruled favorably.

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