COLORADO LLCs ARE PARTNERSHIPS FOR FEDERAL TAX PURPOSES.

Rev. Rul. 93-6

ISSUE

Is M, a Colorado limited liability company, classified for federal tax purposes as an association or as a partnership?

FACTS

M is organized as a limited liability company pursuant to the provisions of the Colorado Limited Liability Act (Act), Colo. Rev. Stat. secs. 7-80-101 through 7-80-913 (1990). M is authorized under its articles of organization to engage in any and all business and activity permitted by the laws of the State of Colorado. M has five members, each of whom is elected as a manager of M.

Section 7-80-401(1) of the Act provides that management of the limited liability company's business and affairs is vested in a manager or managers. Section 7-80-402 provides that managers shall be elected at each annual meeting. All managers must be elected annually unless the articles provide for staggered two or three year terms.

Section 7-80-705 of the Act provides that members and managers are not liable under a judgment, decree, or order of a court, or in any other manner, for a debt, obligation, or liability of the limited liability company.

Section 7-80-702(1) of the Act provides that the interest of each member in a limited liability company constitutes the personal property of the member and may be transferred or assigned as provided in the operating agreement. However, if all of the other members of the limited liability company other than the member proposing to dispose of the member's interest do not approve of the proposed transfer or assignment by unanimous written consent, the transferee of the member's interest has no right to participate in the management of the business and affairs of the limited liability company or to become a member. The transferee is only entitled to receive the share of profits or other compensation by way of income and the return of contributions, to which that member otherwise would be entitled.

Section 7-80-801 of the Act provides that a limited liability company organized under the Act is dissolved upon the occurrence of any of the following events: (1) when the period fixed for the duration of the company expires; (2) by the unanimous written agreement of all the members; or (3) upon the death, retirement, resignation, expulsion, bankruptcy, or dissolution of a member or the occurrence of any other event that terminates the continued membership of a member in the limited liability company, unless there are at least two remaining members and the business of the limited liability company is continued by the consent of all the remaining members under a right to do so stated in the articles of organization within 90 days after the termination. Under M's articles of organization, upon the withdrawal of a member, the consent of all the remaining members must be obtained to continue the business of M.

LAW AND ANALYSIS

Section 7701(a)(2) of the Internal Revenue Code provides that the term "partnership" includes a syndicate, group, pool, joint venture, or other unincorporated organization, through or by means of which any business, financial operation, or venture is carried on, and which is not a trust or estate or a corporation.

Section 301.7701-1(b) of the Procedure and Administration Regulations states that the Code prescribes certain categories, or classes, into which various organizations fall for purposes of taxation. These categories, or classes, include associations (which are taxable as corporations), partnerships, and trusts. The tests, or standards, that are to be applied in determining the classification in which an organization belongs are set forth in sections 301.7701-2 through 301.7701-4.

Section 301.7701-2(a)(1) of the regulations sets forth the following major characteristics of a corporation:

(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. Whether a particular organization is to be classified as an association must be determined by taking into account the presence or absence of each of these corporate characteristics.

Section 301.7701-2(a)(2) of the regulations provides that an organization that has associates and an objective to carry on business and divide the gains therefrom is not classified as a trust, but rather as a partnership or association taxable as a corporation. It further provides that characteristics common to partnerships and corporations are not material in attempting to distinguish between an association and a partnership. Since associates and an objective to carry on business and divide the gains therefrom are generally common to corporations and partnerships, the determination of whether an organization that has these characteristics is to be treated for tax purposes as a partnership or as an association depends on whether there exists centralization of management, continuity of life, free transferability of interests, and limited liability.

Section 301.7701-2(a)(3) of the regulations provides that if an unincorporated organization possesses more corporate characteristics than noncorporate characteristics, it constitutes an association taxable as a corporation.

In interpreting section 301.7701-2 of the regulations, the Tax Court, in Larson v. Commissioner, 66 T.C. 159 (1976), acq., 1979-1 C.B. 1, concluded that equal weight must be given to each of the four corporate characteristics of continuity of life, centralization of management, limited liability, and free transferability of interests.

In the present situation, M has associates and an objective to carry on business and divide the gains therefrom. Therefore, M must be classified as either an association or a partnership. M is classified as a partnership for federal tax purposes unless the organization has a preponderance of the remaining corporate characteristics of continuity of life, centralization of management, limited liability, and free transferability of interests.

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 the organization, continuity of life does not exist. Section 301.7701-2(b)(2) provides that an agreement by which an organization is established may provide that the business will be continued by the remaining members in the event of the death or withdrawal of any member, but the agreement does not establish continuity of life if under local law the death or withdrawal of any member causes a dissolution of the organization.

Under the Act, unless there are at least two remaining members of M and the business of M is continued by the consent of all the remaining members, M is dissolved upon the death, retirement, resignation, expulsion, bankruptcy, dissolution of a member or occurrence of any other event that terminates the continued membership of a member of the company. If a member of ceases to be a member of M for any reason, the continuity of M is not assured because all remaining members must agree to continue the business. Consequently, M lacks the corporate characteristic of 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 any group of persons that does not include all the members) has continuing exclusive authority to make the management decisions necessary to the conduct of the business for which the organization was formed.

Section 301.7701-2(c)(2) of the regulations provides that the persons who have this authority may, or may not, be members of the organization and may hold office as a result of a selection by the members from time to time, or may be self-perpetuating in office. Centralized management can be accomplished by election to office, by proxy appointment, or by any other means which has the effect of concentrating in a management group continuing exclusive authority to make management decisions.

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 the decisions. For example, in the case of a corporation or a trust, the concentration of management powers in a board of directors or trustees effectively prevents a stockholder or a trust beneficiary, simply because that person Is a stockholder or beneficiary, from binding the corporation or the trust.

Under the Act, the management of a limited liability company is vested in managers elected by the company's members. The elected managers may or may not be members of the company, and may or may not include all members of the company. Members, by sole virtue of being members, do not possess managerial authority. Although all of M's members are elected managers of M, M nevertheless possesses centralized management, because, as provided by the Act, authority to make management decisions rests solely with the five members in their capacity as managers rather than as members.

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 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 claims.

Under the Act, the members of M are not liable for M's debts, obligations, or liabilities. Consequently, M possesses the corporate characteristic of limited liability.

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 the 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. 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 the member's substitute all the attributes of the member's interest in the organization. The characteristic of free transferability does not exist if each member can, without the consent of other members, assign only the right to share in the profits but cannot assign the right to participate in the management of the organization.

Under the Act, a member of M can assign or transfer that member's interest to another who is not a member of the organization. However, the assignee or transferee does not become a substitute member and does not acquire all the attributes of the member's interest in M unless all the remaining members approve the assignment or transfer. Therefore, M lacks the corporate characteristic of free transferability of interests.

M has associates and an objective to carry on business and divide the gains therefrom. In addition, M possesses the corporate characteristics of centralized management and limited liability. M does not, however, possess the corporate characteristics of continuity of life and free transferability of interests.

HOLDING

M has associates and an objective to carry on business and divide the gains therefrom but lacks a preponderance of the four remaining corporate characteristics. Accordingly, M is classified as a partnership for federal tax purposes.

DRAFTING INFORMATION

The principal author of this revenue ruling is John Kramer of the the Office of Assistant Chief Counsel (Passthroughs and Special Industries). For further information regarding this revenue ruling, contact Mr. Kramer on (202) 622-3060 (not a toll-free call).