New York Partnership Law Sec. 121-1500 provides that a professional partnership without limited partners may register as a limited liability partnership (RLLP) by registering with the NYS Department of State. The IRS has ruled that this registration results in seamless transformation into an entity classified as a partnership for federal tax purposes, and without termination under IRC Sec. 708(b). Rev. Rul. 95-55, IRB 1995-35.
In order to be classified as a partnership rather than as a corporation, Treasury Regulations require that the entity in question not “resemble” a corporation. There are four corporate “characteristics” which must be examined in this inquiry. If the entity in question has more than two corporate characteristics, it is deemed to resemble a corporation and will be taxed as such.
Those corporate characteristics are (1) continuity of life (a corporation continues indefinitely); (2) centralization of management (corporate powers are vested in a board of directors); (3) limited liability (shareholders are not normally liable for the debts of the corporation); and (4) free transferability of interests (shares of stock may be freely bought or sold).
The Ruling proceeds to analyze the resulting New York RLLP and concludes:
Since (1) every partner of the RLLP may bind the partnership, the RLLP lacks the corporate characteristic of centralization of management; (2) no person may become a partner in the RLLP without the consent of all of the partners, the RLLP lacks the corporate characteristic of free transferability; (3) no partner is personally liable for the debts or obligations of the partnership, the RLLP possesses (rather than lacks) the corporate characteristic of limited liability; and (4) the RLLP is dissolved by operation of law by the express will of any partner, the RLLP lacks the corporate characteristic of continuity of life. Therefore, since the RLLP possesses only one of four corporate characteristics (i.e., limited liability), the Ruling concludes that the RLLP is classified as a partnership for federal tax purposes.
The second part of the Ruling addressed the issue of whether registration of the general partnership as an RLLP would result in a termination of the partnership under IRC Sec. 708(b).
The Ruling states that registration of an RLLP results in an exchange under IRC Sec. 721, similar to where a general partnership converts to a limited partnership. The Ruling concludes that since no new tax entity is formed, the RLLP must secure the consent of the Secretary before changing its accounting method, pursuant to IRC Sec. 446(e).
Since New York’s Limited Liability Company (LLC) statute is “flexible,” the operating agreement may deviate from the default provisions provided in the statute. Rev. Proc. 95-10 provides guidance as to when it will issue a letter ruling requesting classification of an LLC as a partnership for tax purposes. IRB 95-3, 20. [Note: this ruling would also apply to RLLPs.]
Generally, the IRS will rule that the LLC lacks the corporate characteristic of free transferability of interests if majority approval is required for a transfer of a member’s interest. Centralized management will be lacking even if the members designate members as managers, provided the member-managers own at least 20% of the total interests in the LLC. Continuity of life will be absent only if the LLC terminates upon the death, retirement, or resignation of a member. [However, if a majority vote of the remaining members is required to keep the LLC alive, then a favorable ruling seems possible.]
The upshot of these rulings is that significant latitude exists when drafting the operating agreement. This latitude assures that the business objectives of the members can be achieved while preserving partnership tax treatment for the entity.