MISSOURI ENTITY ORGANIZED TO BUY, HOLD, AND SELL OIL AND GAS ROYALTY INTERESTS IS CLASSIFIED AS A PARTNERSHIP.

Rev. Rul. 88-79

ISSUE

Is O, a trust formed under Missouri law by associates to carry on business, properly classified for federal tax purposes as an association or as a partnership under section 301.7701-2(a) of the Procedure and Administration Regulations?

FACTS

Six individuals formed an organization, O, in Missouri, under the terms of an Agreement styled "Royalty Trust Agreement" (Agreement). O was formed for the purpose of buying, holding, and selling oil and gas royalty interests. The six individuals, referred to in the Agreement as the managers, contributed cash to O in exchange for certificates of beneficial interest. The managers of O collectively have substantial assets other than their interests in O. Certificates of beneficial interest were sold also to members of the general public pursuant to a public offering registered with the Securities and Exchange Commission. The agreement refers to these public investors as participants. The certificates of beneficial interest represent the right to share in the profits and losses of O and the right to a share of the assets of O upon its liquidation. The managers own 10 percent of the certificates of benefits interest, and the participants own the remaining 90 percent.

The Agreement provides that the investment activity of O is to be controlled and managed solely by the managers. The managers will determine the timing and amount of distributions from O to the certificate holders. Although the Agreement designates a commercial bank to serve as a trustee of O, the trustee does nothing more than hold legal title to the assets of O. The managers may replace the trustee with another bank at any time.

Although the Agreement provides that the participants cannot take part in the management of O, they are allowed to vote on two matters. First, any amendment of the Agreement is effective only if it is approved by a vote of the participants. Second, as explained below, the participants are allowed to vote on whether O should continue in operation following the death, insanity, bankruptcy, resignation, or retirement of a manager. In voting on these matters, each participant is allowed one vote for each certificate of beneficial interest held by that participant, and a majority of the total number of votes cast is required to approve either matter. The Agreement provides that O is to continue in operation for a period of 20 years unless it is terminated at an earlier date. The managers, by vote of a majority in number, can terminate O at any time. Further, O will terminate upon the death, insanity, bankruptcy, retirement, or resignation of any manager unless all remaining managers (there must be at least one remaining manager) agree to continue O, and the participants, by a majority vote, agree to continue O. Neither the death, insanity, or bankruptcy of any participant nor the admission, withdrawal, or substitution of a participant will cause O to terminate. Upon the termination of O, the managers will wind up the business of O, liquidate O's assets, and distribute the proceeds.

If the remaining managers and the participants agree to continue O following the death, insanity, bankruptcy, retirement, or resignation of a manager, the agreement provides that the certificates of beneficial interest held by the former manager, or the personal representative of the former manager's estate, are to be purchased by O. The purchase price is to be equal to the share of liquidation proceeds that the former manager, or personal representative, would have received if O had terminated upon the death, insanity, bankruptcy, retirement, or resignation of the manager.

Upon the death of a participant, the agreement requires that O purchase the deceased participant's certificates of beneficial interest at a formula price. Furthermore, at any time after O has been in operation for two years, a participant may require that O purchase that participant's shares at a formula price, provided O has sufficient cash.

The agreement provides that a manager may not transfer, sell, or assign that manager's certificates of beneficial interest without the written consent of all other managers. A participant, on the other hand, can freely assign the certificates of beneficial interest to another, but the assignee can become a substitute participant only with the consent of a majority by number of the managers. The failure or refusal of the managers to admit any such assignee as a substitute participant does not affect the rights of the assignee to share in the profits and losses of O or to share in the assets of O upon its liquidation. An assignee who is not admitted as a substitute participant, however, is not entitled to vote upon the two matters upon which participants are allowed to vote.

The Agreement provides that the managers are personally liable for the debts and obligations of O to the extent they exceed and are not satisfied out of O's assets. The participants are not liable for the debts and obligations of O. The participants are not obligated to contribute additional funds to O. Missouri does not have a specific statute dealing with business trusts. Case law, however, indicates that the "common law trust" or "business trust" is a recognized business form in Missouri. See, e.g., Plymouth Securities Co. v. Johnson, 335 S.W. 2d 142 (Mo. 1960) (a suit in equity for removal of trustees); Darling v. Buddy, 318 Mo. 784, 1 S.W. 2d 163 (1927) (involving the liability of owners of a business trust for the debts of the organization). Furthermore, the above-cited cases indicate that the provisions of the Agreement will be effective under Missouri law to establish the rights and obligations of the certificate holders among themselves and with the public at large.

LAW AND ANALYSIS

For purposes of federal taxation, 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 regulations.

Section 301.7701-4(a) of the regulations states that the term "trust" as used in the Internal Revenue Code refers to an arrangement created by will or by an inter vivos declaration whereby trustees take title to property for the purpose of protecting or conserving it for certain beneficiaries. Section 301.7701-4(b) explains that business trusts are not classified as trusts for purposes of the Code because they are not simply arrangements to protect or conserve property for the beneficiaries. Rather, business trusts are created to enable persons to associate together in a joint business venture for profit. Consequently, business trusts are classified as either partnerships or associations by reference to the principles set forth in sections 301.7701-2 and 301.7701-3.

Section 301.7701-3 of the regulations explains that the term "partnership" is broader in scope than the common law notion of partnership. The term "partnership" includes an unincorporated organization, that is not an association under section 301.7701-2, in which two or more persons engage in any business, financial operation, or venture for profit.

Section 301.7701-2(a)(1) of the regulations defines an "association" as any organization whose characteristics require that it be classified for tax purposes as a corporation rather than as a partnership or as a trust. The regulations list six factors ordinarily found in a corporation that, taken together, distinguish it from other organizations. These are associates, an objective to carry on business and divide the gains therefrom, continuity of life, centralization of management, liability for corporate debts limited to corporate property, and free transferability of interests.

Section 301.7701-2(a)(3) of the regulations explains that an unincorporated organization is not classified as an association unless it has more corporate characteristics than noncorporate characteristics. The regulations further explain that because associates and an objective to carry on business and divide the gains therefrom are generally common to both partnerships and corporations, those two factors are not considered in determining whether an organizations has a preponderance of corporate characteristics. The regulations provide, therefore, that if an unincorporated organization is to be classified as an association rather than as a partnership, it must have three of the four characteristics that are not common to both types of organizations.

Under the terms of the Agreement, O has associates and an objective to carry on business and divide the gains therefrom, and, therefore, O is not classified as a trust for tax purposes. Rather, it is classified as a partnership or as an association by reference to the above-cited corporate resemblance tests. Section 301.7701-4(b) of the regulations. To be classified as a partnership rather than as an association, O cannot have more than two of the following corporate characteristics continuity of life, centralization of management, free transferability of interests, and limited liability. Section 301.7701-2(a)(2) and (3) of the regulations.

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 an organization, continuity of life does not exist. This regulation further states that if the retirement, death, or insanity of a general partner of a limited partnership causes a dissolution of the partnership, unless the remaining general partners agree to continue the partnership or unless all remaining members agree to continue the partnership, continuity of life does not exist. For this proposition, the regulations cite Glensder Textile Co. v. Commissioner, 46 B.T.A. 176 (1942), acq., 1942-1 C.B. 8.

Although Glensder Textile deals specifically with dissolution of a limited partnership, the standard set forth in that case for determining the presence or the absence of continuity of life is applicable in classifying O. Under the terms of the Agreement, if a manager of O ceases to be a member of O for any reason, the continuity of O is not assured, because all remaining managers must agree to continue O, and they must obtain the approval of a majority of the participants. As a result, O lacks 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 members) has continuing exclusive authority to make the management decisions necessary to the conduct of the business for which the organization was formed without ratification by the members of such organization. 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 such decisions. Though an organization formed as a limited partnership generally does not have centralized management, centralized management ordinarily does exist in a limited partnership if substantially all the interests in the partnership are owned by the limited partners.

Under the Agreement, the managers of O have continuing exclusive authority to make the management decisions that is similar to the authority vested in general partners in a limited partnership. Further, the participants of O, who resemble the limited partners in a limited partnership in that they are not authorized to participate in any management decisions, own substantially all of the interests in O. Therefore, O has centralized management.

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 organizations 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 a substitute all the attributes of the member's interest in the organization.

The participants own substantially all of the interests in O. Under the Agreement, a participant; can assign that participant's certificates of beneficial interest to another, but the assignee does not become a substitute participant and does not acquire all of the attributes of the assignor's interest in O except with the consent of a majority by number of the managers. Accordingly, O does not have free transferability of interests.

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 the 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.

If an organization is formed as a limited partnership, then, under section 301.7701-2(d)(1) of the regulations, personal liability will generally exist with respect to the general partners. Section 301.7701-2(d)(2) explains further, however, that a general partner of a limited partnership will not be considered to have personal liability for the debts of the limited partnership if that general partner does not have substantial assets (other than the interest in the limited partnership) that could be reached by a creditor of the limited partnership and if that general partner is merely a dummy acting as the agent of the limited partners.

Although paragraph (2) of section 301.7701-2(d) of the regulations deals specifically with general partners in limited partnerships, the standard set out in that paragraph for determining the presence or absence of limited liability is applicable in classifying O because O resembles a limited partnership in that some, but not all, of its members (the participants) have limited liability under local law.

Under the Agreement, the managers are personally liable for the debts and obligations of O to the extent they exceed the assets of and are not satisfied out of those assets. Moreover, the managers of O collectively have substantial assets other than their interest in O. Hence, O does not have limited liability.

HOLDING

O has associates and an objective to carry on business and divide the gains therefrom and therefore, O is classified as a partnership or as an association rather than as a trust. Because O does not have more than two of the remaining four corporate characteristics, O is classified as a partnership for federal tax purposes. No inference is intended concerning the application of section 7704 of the Code to O.

DRAFTING INFORMATION

The principal author of this revenue ruling is Tom Lyden of the Individual Tax Division. For further information regarding this revenue ruling contact Mr. Lyden on (202) 566-3158 (not a toll-free number).