Limited Liability Company Creating a New Class of Equity

By way of example, you and three other persons own equal shares in a limited liability company (LLC) that is taxed as a partnership and that has only one class of shares outstanding (Class A). You and the other members of the LLC would like to create three new classes in addition to the currently outstanding Class A shares. These would be Class B, C and D, each of which will have rights, preferences, privileges and restrictions that differ from each other and from Class A shares. In addition, you and the other members will be permitted to convert, on a one-to-one basis, A shares into B, C or D shares, B shares into D shares, C shares into B or D shares, and D shares into B shares. You would like to know the tax consequences of these proposed changes.

Assuming that no member's proportionate share of the LLC's capital will be changed by any of the proposed conversions, and that each member's share of the LLC's liabilities will stay the same, no taxable exchange will result and no gain or loss will have to be recognized. Also, no termination of the LLC will result.

However, in setting up an LLC with more than one membership class, there are some important practical limitations that must be kept in mind. If, for example, the difference between LLC ownership classes amounts to a disproportionate allocation of an LLC item (gain, loss, deduction, income, etc.), the allocation will be disregarded unless it stands up under some complicated rules that IRS calls "the substantial economic effect test." Therefore, in order to determine the effects of the conversion, it is necessary to carefully review all of the proposed terms of Classes A, B, C and D to make sure that their differing rights, preferences, privileges and restrictions will stand up under the substantial economic effect test.