The Internal Affairs Doctrine

⇒ This doctrine resolves conflicts of state law amongst corporations.

⇒ According to the doctrine, the laws of an entity’s state of organization governs the entity’s internal affairs.

⇒ This is understood to include the governing of relationships between shareholders and management and establishing a shareholder’s limited liability for corporate debts.

⇒ While the management and shareholders voluntarily agreed to form a relationship under the state of organization’s laws, the doctrine seems a lot more questionable for third-party claims against shareholders because of such claims’ frequently involuntary nature.

⇒ Despite the same, the application of the doctrine is firmly established in law.

Some states codified certain aspects of the internal affairs doctrine.  In terms of North Carolina’s statutes, Delaware’s laws (in example above) would govern the series LLC’s internal affairs and its managers and members’ liability. However, a disclaimer follows the law: The internal affairs doctrine is not allowed to bestow greater rights to the Delaware series than Nort Carolina law imposes on North Carolina LLCs.  This is a blow to the viability of internal shields’ protection against third-party claims.

North Carolina courts would most likely argue that internal shields grant privileges to the Delaware series LLC that is far beyond those authorized for North Carolina LLCs before they will accept that series merely provide the tools for managing internal affairs under Delaware law.  This issue remains unresolved and ads to the general uncertainty.

There are even more concerns about series LLCs, some originating from their uncertain tax classifications.  One of the questions is about the significance of a series structure in identifying relevant business entities under the classification regulations of Sec.7701.

These regulations allow a business entity excluding per se corporations, to elect its federal tax classification. A multi-member business enterprise can choose to be treated as a corporation or a partnership. A single-member business entity can choose treatment as either a corporation or a disregarded entity.

A series can have its own members, assets, liabilities, and purpose within a master LLC.  The question is whether the master LLC, the series or both, constitute a business entity or entities that can elect tax classifications.

Regulations define a business entity regarding classification.  Any entity recognized for federal tax purposes that is not a trust or a specially treated entity is a business entity.

The existence of a business entity is unconnected with the entity’s status under state law. The entity can even result from a contractual arrangement to carry on a trade, business, financial operation or a venture and divide the resulting profits.

The regulations make it clear that mere co-ownership of property does not warrant an entity separate from its owners, even for leased or rented property.

Several alternative conclusions are supportable about what entities exist for classification purposes relative to the diverse relationship within a series LLC structure.  Three seem especially noteworthy:

⇒ The tax system might consider a series structure as insignificant. This means that a master LLC’s tax classification can be determined irrespective of whether the series was established under state law.  Alternatively, the LLC can be treated as a single business entity.

⇒ Also, the tax system might decide that each series is wholly-owned by an umbrella master LLC.  When no election was made,  the series can be disregarded, which means that it would not be separated from the master LLC. Hence the LLC will be classified based on its member’s elections.  It would recognize multiple business entities, but the master LLC would be considered the sole owner of each series.

⇒ Of course, the system might consider the master LLC and all its series as separate business entities and recognize ownership as established by state law. Hence, it would permit independent determinations of respective tax classifications. So the tax classification would stem from the treatment of LLCs by state law.

Position of The IRS

Informally, the IRS ruled consistently with alternative three above.  Accordingly, each series determines its classification separately for federal tax purposes.

In Ruling 200803004, the IRS considered a business trust composed of three portfolios treated as separate regulated investment companies to reorganize as a series LLC. Each portfolio would form a series in a master LLC.  Each series would have its own assets, liabilities, and earnings, as well as its own objectives, policies, and separate unique owners.

The IRS concluded very quickly that each series constituted a business entity. They based it on the assertion that classification as a disregarded entity, partnership, or corporation depended on the owners and their election of that series.

The IRS view in the above ruling was based on previous court rulings that found that separate-entity treatment was appropriate in the context of series structures.  The IRS merely extended the prior treatment of series trusts to series LLCs.  Whether it is justified cannot be ascertained from the decision or the rulings.  It can be assumed that they found a significant enough separation in the situation concerning regulated investment companies to classify the various series as separate taxable entities.

While the above ruling embraces the idea that a series LLC can consist of various taxable entities, it is an open question whether this classification would be applied consistently. Shared ownership and business objectives might affect a series’s separateness, which forms the basis for separate treatment for tax purposes.

The same goes for a series used only to protect assets from creditors without participating in additional activities.  A series that merely holds property as a bankruptcy-remote vehicle might not qualify as a separate business entity to elect its tax classification.

Despite the ruling above, the IRS is still studying which factors affect the classification of series LLCs.  It cannot be assumed that a series LLC will always qualify as a separate taxable entity.

History teaches us that if the IRS issues classification guidance,  many states will pass series LLC legislation.  Uncertainty prevents state legislatures from doing so at the moment.  Over the past eleven years, only two states enacted multi-member LLC legislation before the IRS classified the same as partnerships in Rev.Rul.88-76;25.   After that, all the states classified the same as partnerships within eight years.

Before the check-in-the-box legislation classified them as disregarded entities in 1997,  few states authorized single-member variations of an LLC.  After they did,  every state followed and approved them. However, even if no more series legislation comes from the states, you still have to consider the impact of series LLCs on tax planning.

Some series will no doubt be classified as separate taxable entities. This will provide taxpayers with new opportunities and challenges if they operate their businesses in LLCs.  After the check-the-box regulations, many people had become comfortable with single-member LLCs functioning as tax-nothings ¾ legal entities disregarded for tax purposes. Series LLCs offer potential as ‘tax-something’ ¾ with limited state recognition that is regarded as separate entities for tax purposes IF MULTIPLE MEMBERS OWN THEM.  These affect tax planning irrespective of potential future state laws.

These other taxable entities via series are easy to create and bring a new dynamic into tax planning for small businesses, especially, despite the increased compliance burden.  It provides another viable option for small enterprises and the less practical separate legal entity holding structure used by sophisticated taxpayers.

A series LLC should appeal to many enterprises for tax purposes, irrespective of internal shields’ end status.  It will help taxpayers who would have been willing to operate a business in a single LLC for the sake of its outside-in and inside-out protection, despite a lack of internal security.