Category: Accounting Periods & Methods Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com IRC 448(a)(3) requires a tax shelter to use the accrual method of accounting. IRC Section 448(d)(3), by reference to IRC Section 461(i)(3), defines the term tax shelter as follows. 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. In regard to the issue of whether a security is required to be registered with appropriate state or federal authorities, Regulation Section 1.448-1T(b)(2) provides as follows. 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 from registration would result in a violation of the applicable federal or state law (regardless of whether the notice is in fact filed). According to one commentator, the California Limited Liability Company Act contains a bias towards treating LLC interests as securities. Under the Act, an LLC interest will be a security unless the person claiming the exemption can prove that every member of the LLC is actively engaged in the management of the LLC. In order to trigger the limitation on use of the cash method of accounting under Section 448, it is necessary A) that the interest in question be deemed a security under state or federal law; and B) the security be offered for sale in an offering required to be registered with any state or federal agency having the authority to regulate the offering of securities for sale. The commentary you sent to me seems to gloss over the fact that there are two separate statutory requirements. The commentary seems to imply that if an LLC interest is a security, the restrictions of Section 448 automatically apply. It seems clear to me that this is not the case. For the moment, assume the LLC interest in question is indeed a security under California and/or federal law. Does conversion of a two-person general partnership into a limited liability company with members consisting of these same two people constitute an offering of the LLC interests for sale? If so, does that offering require registration or the filing of a notice of exemption from registration? Obviously these are securities law questions, but I wonder if this same issue has ever been addressed in the context of IRC Section 448. There are about four dozen private letter rulings regarding conversion of general partnerships into LLC's. All these rulings contain a blanket factual representation that the taxpayer never has and never will offer securities for sale such that registration is required under federal or state law. See, for example, PLR's 9432018 and 9630012.The point is these rulings really do not address the issue of what constitutes offering for sale. It should also be noted that letter rulings in their published form are stripped of many explicit facts, oftentimes including the state in which the LLC was formed. Accordingly, it is not possible to know if any of these many rulings involve California LLC's. GCM 39781 (2/8/89) does address the issue of what constitutes offering for sale asserting that the legislative history of Sections 448 and 461(i) implies that the phrase offering for sale should be defined as the SEC defines that phrase. Letter Ruling 8837068 also has the same holding. The context of the ruling is a conversion of a corporation (apparently publicly held) into a partnership. Here, the corporation filed Form S-14 with the SEC in connection with the conversion. A prospectus of the partnership units accompanied the registration statement. The taxpayer presented various arguments as to why the conversion should not be deemed an offering for sale. Included was the argument that a conversion into a new legal form of doing business with the same owners is not an offering for sale of the interests in the new legal entity. PLR 8837068 goes on to cite the version of SEC Rule 145 applicable at the time which seems to indicate that a change in form that requires consent of the existing corporate shareholders constitutes an offering of securities for sale for purposes of federal securities law. Assume for a moment that one accepts the premise that the legislative history of Sections 448 and 461(i) does in fact require that the phrase offering for sale should be defined as the SEC defines that phrase. In the two rulings cited above, the SEC clearly had jurisdiction over the transaction. The taxpayers in question were required to file a registration statement, Form S-14, with respect to the transaction in question. In contrast, suppose that the transaction in question is exempt from SEC jurisdiction for some reason. Does the SEC Rule 145 standard apply even though the SEC does not have jurisdiction over the matter? Although such an interpretation could be possible, it seems to me illogical and unwarranted. It seems to me the right answer should be a determination should be made under the rules of whatever agency has jurisdiction over the transaction in question. If the matter were litigated, however, a court could certainly reach the conclusion that the SEC rules should apply even though the SEC might not have jurisdiction. In the end, there is no way to know with certainty. I suggest the following course of action. 1) Have a securities attorney render an opinion as to whether the LLC interests in question are securities under California law. What is the standard of active participation in management? Does the father meet that standard? 2) Irrespective of the outcome of the first opinion, assume the LLC interests are found to be securities under California law. Get a separate opinion from a securities attorney as to A) whether registration would be required under any state or federal securities laws; and B) if no registration is needed, would it be necessary to file a notice exemption from registration with any state or federal agency. 3) Put the risks set forth above to your client in writing, and very strongly advocate seeking a private ruling from the IRS. |
