Article: When One is Better Than Many: The Series LLC

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Article: When One is Better Than Many: The Series LLC

Postby Riser Adkisson LLP » Sun Jul 12, 2009 11:16 am

Article: When One is Better Than Many: The Series LLC

by Jay Adkisson and Chris Riser

Segregating “dangerous” assets and businesses into separate entities away from other assets, especially “safe” assets, is always a good idea from an asset protection point of view. For example, an individual who owns a gas station and a rental home should not own both within the same entity. Further, an individual with a large amount of liquid assets (cash, securities, etc.) to protect should not hold those assets in the same entity as a business.

Best practices would dictate that every distinct business or major business asset be segregated into a different limited liability entity. In an ideal situation, someone with 25 rental properties would have 25 separate LLCs, one for each property. However, this is not always practical because of administrative costs and government fees that must be paid for each LLC. What can such a business owner do to protect his assets from liabilities unrelated to those assets in a cost-effective way?

Enter the series LLC. The LLC acts of Delaware, Iowa and Oklahoma provide for the creation of separate protected “cells” (‘series’) within one limited liability “container” (the series LLC) without the need to create separate entities, thus avoiding the inefficiencies associated with multiple related entities. [1] The Delaware LLC Act is the LLC act most often used for series LLCs and is the act used for discussion purposes in this article.

The Delaware LLC Act provides that the liabilities of a particular series are enforceable only against the assets of that series. The Act also provides that classes or groups of members can be established, having whatever rights the LLC agreement says they have.

The combination of these two provisions allows a series to function in many ways as a separate entity for practical purposes. The series LLC concept is similar in function to segregated portfolio companies and protected cell companies designed for the mutual fund and captive insurance industries in a number of offshore and onshore jurisdictions.

The Act allows an LLC agreement to designate series of members, managers or LLC interests that have separate rights and duties with respect to specific LLC property or obligations. So, each series can be tied to specific assets and can also have different members and managers.

Each series can have its own separate business purposes. A series can be terminated without affecting the other series of the LLC. A series can make distributions to its own members without regard to the financial condition of the other series.

Most importantly, the Act provides that debts, liabilities and obligations incurred, contracted for or otherwise existing with respect to a particular series are enforceable against that series only, and not against the assets of the LLC generally or any other series of the LLC.

In order to obtain inter-series liability protection, each series must be treated separately and the public must be put on notice of the liability limitation by the inclusion of the series limitations in the LLC’s Certificate of Formation filed with the Delaware Secretary of State. Records must be kept for each series and the assets of each series must be held and accounted for separately. The separate holding and accounting required may be in the LLC’s records, so long as separate and distinct records are maintained for each series. However, the safest practice would be to segregate and separately hold series assets titled, to the extent possible, in the name of each series (e.g., “ABC LLC, Series X”).

Federal tax law rather than state law determines the existence of an entity for tax purposes. In many cases, the members of each series of an LLC will be identical. In such cases, it is fairly certain that the series LLC as a whole will be treated as a single tax entity for federal tax purposes. On the other hand, if the series of an LLC have the same members, or identical or similar membership rights, or similar business purposes, each series may be treated as a separate LLC for income tax purposes.

In both cases, however, there should be only one filing with a state’s secretary of state for the LLC (rather than for the individual series). Furthermore, in most cases, there should be only one state franchise (or similar) tax filing.

Practical Uses of the Series LLC

The most obvious use for the series LLC is to hold multiple parcels of real property in liability-segregated cells. Owners of small commercial or residential properties may find the series LLC particularly appealing. This is especially true in states with high minimum franchise taxes. Forming and maintaining a number of separate LLCs may cost several thousand dollars in the year of formation and several thousand dollars each subsequent year. Using a series LLC with each property held by a separate series may save several thousand dollars in startup costs and another several thousand dollars a year in ongoing administrative and state tax costs.

Another use for the series LLC is to facilitate an equity compensation program in a business with multiple divisions. With each division segregated into a separate series, the LLC can give the key employees of each series some sort of equity interest tied to that series only rather than equity interests in the entity as a whole. This rewards employees at productive divisions and protects them from the potential downside of other divisions.

Another use for the series LLC is to facilitate the combination of business operations of distinct businesses. For example, rather than undertaking a traditional merger, two companies wishing to join forces might form a series LLC, with each company contributing its assets to a separate series, or with the owners of each company contributing their ownership interests to a separate series. The LLC agreement and series agreements could be drafted to determine exactly which rights and responsibilities are shared and which are maintained separately. The series LLC provides a unique and very flexible framework for this sort of business combination.

Finally, yet another use for the series LLC is to facilitate joint ownership of aircraft and watercraft. The flexibility in fashioning series interests can be helpful in customizing a joint ownership arrangement. While ownership of a boat by a series LLC should be relatively straightforward, FAA rules about fractional ownership of aircraft and entity ownership and operation of aircraft are quite complex. Expert aviation law advice and expert series LLC advice are crucial for anyone considering using a series LLC to own an aircraft.

Do Series LLCs Work In Non-Series LLC States?

An entity formed in one state cannot do business in another state unless it is first "qualified" to do business in the non-formation state by filing an application with the Secretary of State of the non-formation state. Usually, this application must include a fee that is about the same as if you had just formed the entity in the non-formation state in the first place. However, without qualifying to do business in the non-formation state, the entity will not be able to hold real estate or qualify for licenses, etc., and may later get hit for penalties for not qualifying.

However, once an entity qualifies to do business in the non-formation state, it basically becomes subject to the non-formation state's laws. So, if an LLC is formed in Delaware, and qualifies to do business in California so that it can own real estate in California, then that LLC becomes subject to California law as least as the California courts will be concerned. Thus, the California courts will presume that they will apply California law to all disputes regarding the entity -- with one exception.

The exception is that as to the internal governance of the LLC, the courts of the non-formation state (California in our example) will normally apply the law that is either designated in the LLC's operating agreement, or the laws of the formation state (Delaware) if it makes sense to do so (such as if the LLC is doing business in Delaware or several other states in addition to California).

Internal governance usually means disputes between members as to how the LLC is owned or operated, and does not include disputes with creditors or third-parties who are not signed on to the operating agreement. That brings us to the trouble with Series LLCs.

While the non-Series state (California) might apply the Series legislation of Delaware to internal disputes among the members, the non-Series state is very unlikely to apply the Series-legislation as to creditors, claimants, and other third-parties who did not agree to be bound by the Series legislation. And, after all, why should they be bound to the limitations of a Series LLC when they didn't agree to be bound, and their elected legislature has not adopted such legislation? In other words:

(1) The Series provisions are likely to work between members of the LLC, even if they are all in California.

(2) The Series provisions have a slim chance of working for tenants who sign a lease provision which says that in the event of a dispute they must respect the Series limitations (but, considering California's heavy consumer- and tenant-protection statutes, I wouldn't bet on it).

(3) The Series provisions are highly unlikely to work in the non-Series state against creditors and claimants who did not sign a consent to be bound by the Series provisions, and probably none will have by the time they sue.

The qualification-to-do-business problem is why corporations, LLCs, and other entities formed in other states probably don't offer any advantages over those formed in the state where property will be held or business conducted, since effectively all you are doing is doubling your formation fees and non-formation law will apply anyhow. If you are going to hold property or do business in California, you are better off using a California entity to do it, since you'll have to pay the same fees and California law will apply to it anyhow.

On the bright side, more states are considering Series legislation (Illinois just adopted it), and California will probably have it within a couple of years. But, there are almost no planners who understand these entities very well -- maybe less than a dozen nationwide -- and even if the legislation is passed you might have a hard time finding a planner who is sophisticated enough to know how they work and how to navigate around the extremely complex tax issues involved with these entities.

Note that if even if the Series provisions don't stand up, the entity should be treated as an ordinary LLC.
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