LAW FIRM'S CONVERSION TO LLC DOESN'T AFFECT PARTNERSHIP TAX STATUS.

UIL Number(s) 0446.03-00, 0448.00-00, 0708.01-00, 0721.00-00, 7702.02-00

                                             Date: September 15, 1993

This ruling is in reply to a letter dated August 17, 1993, and prior correspondence, requesting a ruling concerning the consequences of converting P from a general partnership to a Z limited liability company, LLC. Specifically, p and its successor, LLC, requested rulings concerning the following: (1) the appropriate classification of LLC under section 7701 of the Internal Revenue Code; (2) whether the conversion will cause a termination of P under section 708; (3) whether the conversion will cause gain or loss to be recognized under section 721; and (4) whether LLC will be permitted to use the cash method of accounting under sections 446 and 448.

FACTS

Based on representations made and information submitted, P has been converted to LLC. Prior to the conversion, P was engaged in the practice of law, and LLC will be continuing the identical line of business. P used the cash method of accounting; and for each of the last 24 years, P has reported taxable income, as opposed to losses. Furthermore, LLC's members do not expect LLC to ever have losses. The owners of P contributed their interests in P to LLC in exchange for the same percentage ownership interests in LLC.

The members of LLC will engage in the practice of law and participate in various management activities. These management activities will involve voting on the following issues: the admission or expulsion of members; the compensation of members; the determination of whether a member has become disabled; the decision of whether to invite a member over the age of seventy to practice law; the election of the Management committee; and the amendment of the Member Control Agreement under which LLC is operated. Further, each member will, in varying degrees, participate in the following management activities attributable to the practice of law: handling client relations; supervising services provided to clients; billing, collecting, and negotiating fees; participating in business marketing directives; staffing projects, including the selection and use of specialists; supervising, training, and evaluating LLC employees; and managing non-lawyer staff.

Also, P and its successor, LLC, have made the following representations: (1) no C corporations, other than personal service corporations within the meaning of section 448(d)(2), will be members of LLC; (2) for purposes of the classification analysis, LLC possesses both limited liability and centralization of management; (3) at no time has P or will LLC offer to sell interests in itself in an offering required to be registered with a federal or state agency; registration includes any requirement under federal or state law to register the offering where failure to register the offering would result in a violation of the applicable federal or state (regardless of whether the offering is in fact registered); in addition, an offering is required to be registered with a federal or state agency if, under the applicable federal or state law, failure to file a notice of exemption would result in a violation of the applicable federal or state law (regardless of whether the notice is in fact filed); and (4) LLC's principal purpose will be to engage in the practice of law, and LLC will not be employed for any tax evasion motive.

The Z Limited Liability Act (the Act) provides that the transfer of financial and governance rights are handled by two separate provisions. These provisions permit members to transfer their financial rights in whole or in part unless a restriction on the assignment of financial rights is imposed in the articles, operating agreement, by a resolution adopted by the members, or by an agreement among or other written action by members or among them and the LLC. Such a restriction is not binding with respect to financial rights reflected in the required records before the adoption of the restriction, unless the owners of those financial rights are parties to the agreement or voted in favor of the restriction. A member may, without the consent of any other member, assign governance rights, in whole or in part, to another person already a member at the time of the assignment. Any other assignment of any governance rights is effective only if all the members, other than the member seeking to make the assignment, approve the assignment by unanimous written consent unless the articles of organization provide for written consent by fewer than all the members. As permitted with financial rights, further restrictions on the assignment of governance rights are permitted in the articles, operating agreement, etc. In addition, provisions under the professional corporations statute apply, and these provisions limit the transfer of shares to other qualified professionals, i.e., attorneys.

Article XI of the LLC Member Control Agreement (Agreement) provides that LLC interests may be freely transferred to other members. However, LLC interests may not be transferred to non-members without the written consent of a majority in interest.

The Act also provides that an LLC dissolves upon the occurrence of a number of different events, including death, insanity, bankruptcy, retirement, resignation, or expulsion of any member. However, an LLC is not dissolved and is not required to be wound up by reason of any event that terminates the continued membership of a member if (A) either there are at least two remaining members or a new member is admitted and (B) the existence and business of the limited liability company is continued by the consent of all the remaining members under a right to consent stated in the articles of organization and the consent is obtained no later than 90 days after the termination of the continued membership or under a separate right to continue stated in the articles of organization.

Furthermore, the Act provides that members of a Z LLC may enter into a written agreement that relates to the control of or the liquidation, dissolution, and termination of the LLC. Such an agreement is valid if the agreement is signed by all persons who are then the members of the LLC, whether or not all the members have voting power.

Article IX of the Agreement provides that members may consent to avoid dissolution within 90 days after the occurrence of a dissolution event. To avoid dissolution, a majority in interest of the remaining members must consent to avoid dissolution. If this consent is obtained, LLC will not dissolve and the business will continue. However, if this consent is not obtained, LLC will dissolve.

Article X of the Agreement discusses agreements to continue the business following dissolution. Article X provides that in the event that a majority in interest of the remaining members fail to give their consent to avoid dissolution or upon the expiration of the thirty year duration of LLC, each member acknowledges that it may, but is not obligated to, agree after the dissolution that LLC shall transfer its assets and liabilities to a successor professional limited liability company which will continue the business of LLC. However, article X does not provide for business continuation agreements made in advance of a dissolution event.

LAW AND ANALYSIS

Section 7701 of the Internal Revenue Code sets forth definitions to be used in determining the classification of an organization for federal tax purposes. Organizations are classified as associations taxable as corporations, as partnerships, or as trusts. The classification of any particular organization is determined under the tests and standards set out in sections 301.7701-2, 301.7701-3, and 301.7701-4 of the Procedure and Administration Regulations.

Section 301.7701-2(a)(1) of the regulations sets forth six characteristics ordinarily found in a pure corporation which, taken together, distinguish it from other organizations. These are: (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.

Section 301.7701-2(a)(2) of the regulations provides that characteristics common to partnerships and corporations are not material in attempting to distinguish between an association and a partnership. Because associates and an objective to carry on business and divide the gains therefrom are generally common to corporations and partnerships, an organization such as LLC that has these characteristics will be classified as a partnership if it lacks at least two of the remaining characteristics. Section 301.7701-2(a)(3) of the regulations.

Rev. Rul. 88-76, 1988-2 C.B. 360, holds that the Wyoming limited liability company considered therein is classified for federal tax purposes as a partnership because it lacks the corporate characteristics of continuity of life and free transferability of interests.

Section 301.7701-2(b)(1) of the regulations provides that an organization has continuity of life if the death, insanity, bankruptcy, retirement, resignation, or expulsion of any member will not cause a dissolution of the organization. On the other hand, 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.

Because the Act and the Member Control Agreement provide for the dissolution of LLC upon the death, insanity, bankruptcy, retirement, resignation, or expulsion of any member, unless the business of LLC is continued by the consent of a majority in interest of the remaining members, continuity of life does not exist.

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 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. In order 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 his substitute all the attributes of his interest in the organization. Thus, the characteristic of free transferability of interests does not exist in a case in which each member can, without the consent of other members, assign only his right to share in profits but cannot so assign his rights to participate in the management of the organization.

Under the Act and Member Control Agreement, a majority in interest of the members of LLC must consent to a transfer before a member of LLC can transfer attributes of membership to non-members. Accordingly, LLC lacks free transferability.

LLC has associates and an objective to carry on business and divide the gains therefrom. Also, LLC lacks the corporate characteristics of continuity of life and free transferability. Therefore, provided that LLC remains in conformity with the Act and Member Control Agreement, LLC is prospectively classified as a partnership for federal tax purposes. See Rev. Proc. 86-12, 1986-1 C.B. 534.

Section 721(a) of the Code provides that no gain or loss shall be recognized to a partnership or to any of its partners in the case of a contribution of property to the partnership in exchange for an interest in the partnership.

Rev. Rul. 84-52, 1984-1 C.B. 157, considers the federal income tax consequences of the conversion of a general partnership into a limited partnership. Each partner's total percentage interest in the partnership's profits, losses, and capital remained the same after the conversion. Further, the business of the general partnership continued to be carried on after the conversion. Rev. Rul. 84-52 treats the conversion as an exchange under section 721 of the Code and concludes that the general partnership is not terminated for purposes of section 708. Rev. Rul. 84-52 relies on section 1.708- 1(b)(1)(ii) of the regulations which provides that a transaction governed by section 721 is not treated as a sale or exchange for purpose of section 708.

Assuming that P was properly classified as a partnership, we conclude the following: (1) Pursuant to section 721 of the Code, no gain or loss will be recognized by P, LLC, or their members by reason of the conversion of P into LLC, except as provided in section 752; and (2) LLC will be treated as a continuation of P, and thus, there will be no termination of the partnership entity under section 708 of the Code by reason of the conversion.

Sections 446 and 448 of the Code govern the determination of whether LLC will be permitted to use the cash method of accounting. However, this analysis is derived in part from the above determination that LLC is appropriately classified as a partnership under section 7701.

Section 446(a) of the Code provides that taxable income shall be computed on the basis of which the taxpayer regularly computes his income in keeping his books.

Section 446(b) of the Code provides that if no method of accounting has been regularly used by the taxpayer, or if the method used does not clearly reflect income, the computation of taxable income shall be made under such method as, in the opinion of the Secretary, does clearly reflect income.

Section 446(c) of the Code provides that, subject to the provisions of (a) and (b), a taxpayer may compute taxable income under any of the listed methods of accounting, including the cash method.

Section 448(a) of the Code provides that, except as otherwise provided in this section, in the case of a (1) C corporation, (2) partnership which has a C corporation as a partner, or (3) tax shelter, taxable income shall not be computed under the cash receipts and disbursements method of accounting.

Section 448(b)(2) of the Code provides that paragraphs (1) and (2) shall not apply to a qualified personal service corporation, and such a corporation shall be treated as an individual for purposes of determining whether paragraph (2) of subsection (a) applies to any partnership.

Because LLC is classified as a partnership for tax purposes, the first limitation of section 448(a), concerning C corporations, does not apply. Further, the members of LLC represent that LLC will not have a C corporation (except for a C corporation that is a personal service corporation) as a member, rendering the second limitation inapplicable. Thus, LLC is not prohibited from using the cash method of accounting if it is not a tax shelter.

Section 1.448-1T(b)(1)(i) provides that the term "tax shelter" means any enterprise (other than a C corporation) if at any time (including taxable years beginning before January 1, 1987) interests in such enterprise have been offered for sale in any offering required to be registered with any federal or state agency having the authority to regulate the offering of securities for sale.

Section 1.448-1T(b)(2) provides that for purposes of paragraph (b)(1)(i) of this section, an offering is required to be registered with a federal or state agency if, under the applicable federal or state law, failure to register the offering would result in a violation of the applicable federal or state law (regardless of whether the offering is in fact registered). In addition, an offering is required to be registered with a federal or state agency if, under the applicable federal or state law, failure to file a notice of exemption would result in a violation of the applicable federal or state law (regardless of whether the notice is in fact filed).

Since the members of LLC have represented that neither P nor LLC was ever or will ever be required to register with any federal or state agency having the authority to regulate the offering of securities for sale (as defined by section 1.448-1T(b)(2), LLC is not a tax shelter under section 1.448-1T(b).

In addition, section 448(d)(3) of the Code refers to section 461(i)(3) of the Code for the definition of "tax shelter." This paragraph provides that a "tax shelter" means: (A) any enterprise (other than a C corporation) if at any time interests in such enterprise have been offered for sale in any offering required to be registered with any federal or state agency having the authority to regulate the offering of securities for sale; (B) any syndicate (within the meaning of section 1256(e)(3)(B)) and (C) any tax shelter (as defined in section 6662(d)(2)(C)(ii)).

LLC will not be an "enterprise" for purposes of section 461(i)(3) of the Code so long as it does not offer interests in itself for sale in any offering required to be registered with any federal or state agency having the authority to regulate the offering of securities for sale. Since P and LLC have represented that P has never made such an offering and that LLC will not ever make such an offering, LLC is not an enterprise.

Section 1256(e)(3)(B) of the Code provides that any partnership or other entity (other than a corporation which is not an S corporation) is a "syndicate" if more than 35 percent of the losses of such entity during the taxable year are allocated to limited partners or limited entrepreneurs. Therefore, LLC's classification as a syndicate depends on how its members are classified and how its losses allocated.

Section 464(e)(2) of the Code provides that the term "limited entrepreneur" means a person who has an interest in an enterprise other than as a limited partner and does not actively participate in the enterprise's management. In determining whether an interest in an entity is held by a limited partner or a limited entrepreneur, section 1256(e)(3)(C) of the Code provides that such an interest is not held by a limited partner or limited entrepreneur if (1) for any period if during such period such interest is held by an individual who actively participates at all times during such period in the management of such entity, (2) for any period such interest is held by the spouse, children, grandchildren, and parents of an individual who actively participates at all times during such period in the management of such entity, (3) if such interest is held by an individual who actively participated in the management of such entity for a period of not less than 5 years, (4) if such interest is held by the estate of an individual who actively participated in the management of such entity or is held by the estate of an individual described in clause (2), or (5) if the Secretary determines (by regulations or otherwise) that such interest should be treated as held by an individual who actively participates in the management of the entity, and that such entity and such interest are not used (or to be used) for tax-avoidance purposes.

The members of LLC have represented that they will continue to engage in the practice of law and participate in the various management activities set forth above. Based on these representations, we conclude that LLC meets the active participation requirements of sections 464(e)(2) and 1256(e)(3)(C) of the Code, and therefore, LLC is not a syndicate.

Section 6662(d)(2)(C)(ii) of the Code defines a tax shelter as any arrangement whose principal purpose is the avoidance or evasion of federal income tax. Because the members of LLC represent that (1) they will participate in management of LLC, (2) LLC will be organized to engage in the practice of law, and (3) LLC will not be organized for any federal income tax avoidance motive, LLC is not a tax shelter.

Based upon the above representations and analysis, we conclude that LLC is not prohibited from using the cash method of accounting.

CONCLUSIONS

Based solely on the representations made and the information submitted, we conclude the following: (1) provided that the organization and operation of LLC is in accordance with the applicable statute of Z, LLC will be classified as a partnership for purposes of federal income taxation; (2) assuming P was properly classified as a partnership for federal tax purposes, the conversion of P into LLC will not cause a termination of P under section 708, nor will the conversion cause gain or loss to be recognized under section 721, except as provided in section 752; and (3) LLC will be permitted to use the cash method of accounting under sections 446 and 448.

No opinion is expressed as to the tax treatment of the transactions under other provisions of the Code and regulations or about the tax treatment of any conditions existing at the time of, or effects from, the transactions that are not specifically covered by the above ruling. In addition, no opinion is expressed concerning whether P is properly classified as a partnership prior to the conversion of P into LLC.

This ruling is subject to the requirements set forth in Rev. Proc. 89-12, 1989-1 C.B. 798 to the extent applicable. If the requirements of Rev. Proc. 89-12 fail to be met at any time, this ruling will have no force or effect.

This ruling is directed only to the taxpayer who requested it. Section 6110(j)(3) of the Code provides that it may not be used or cited as precedent.

                                   Sincerely yours,