IRS Proposes Separate Entity Treatment for a Cell

(co-authored with Janel C. Frank)

In Sept. 14, 2010, the Internal Revenue Service (IRS) released proposed regulations that clarify that a single series may be treated as an entity separate from a series organization for federal income tax purposes, even if it is not recognized as a separate entity under local law. The proposed regulations were issued, in part, to expand on Notice 2008-19, which requested comments for establishing when a cell of a cell company should be treated as an insurance company for federal income tax purposes. The proposed regulations apply more broadly to a series of a series limited liability company, a cell of a cell company, and a segregated account and portfolio of a segregated account company (except for segregated asset accounts of a life insurance company which are subject to special treatment under section 817). The proposed regulations do not apply to an individual cell that is organized under the laws of a foreign jurisdiction unless the cell is engaged in an insurance business. Under the proposed regulations, an individual cell will be treated as a separate entity for federal income tax purposes if the cell qualifies as an “insurance company” under the Internal Revenue Code. Significantly, the proposed regulations provide transitional relief for cells that were organized before Sept. 14, 2010, if certain factors are satisfied.

General Rules

In general, the proposed regulations recognize that the treatment of an entity separate from its owners for federal tax purposes is a matter of federal income tax law and not local law.2 Consequently, an individual cell of a cell company is treated “as if” the cell were an entity formed under local law, even though the cell may not be recognized as a separate entity under the organizing state statute. Under the statutes of most states, the assets and liabilities of each individual cell must be segregated such that the debts and liabilities of one cell may not be enforced against assets of any other cell or against the cell company itself. Although segregation of assets and liabilities is required under most state statutes, the proposed regulations provide that the failure to segregate the assets and liabilities of an individual cell will not defeat treatment as a separate entity for federal income tax purposes. In fact, one cell may guarantee the debts and liabilities of another cell, without jeopardizing its treatment as a separate taxable entity.

Application to Insurance Cell

According to the proposed regulations, treatment of an individual cell as a separate insurance company for federal income tax purposes depends upon federal tax law. Under section 7701(a)(3), an arrangement that qualifies as an insurance company must be treated as a corporation. Under sections 816(a) and 831(c), a company qualifies as an insurance company if more than half of the business engaged in during the taxable year is the issuing of insurance or annuity con- tracts or the reinsurance of risks underwritten by an insurance company. Consequently, under the proposed regulations, a cell whose business activity qualifies it as an insurance company under the Internal Revenue Code will be treated as a corporation and a separate taxable entity for federal income tax purposes.