The LLC Ode: Creative Planning with LLCsJacob Stein Esq.
January 15, 2008 — 2,604 views
From the time limited liability companies (“LLCs”) came into prominence, practitioners have been lauding and working to maximize their wonderful benefits. What follows is a summary of some of the great asset protection, business flexibility and tax advantages of LLCs, and their creative uses.
The Charging Order Protection
Liability protection is one of the main reasons for forming a legal entity. LLCs protect business owners from lawsuits directed against the entity, and also protect the assets within the LLC from lawsuits directed against the members. This is often referred to as outside-in versus inside-out asset protection. Protection of the entity’s assets from lawsuits directed against the members, afforded by the so-called charging order protection, is one great advantage LLCs have over corporations. (Corporations offer liability protection only if the lawsuit is directed against the corporation, not if the lawsuit is directed against the shareholder.)
The charging order limits the creditor to an economic interest in the LLC without transferring the membership interest itself or any control over the entity to the creditor. As a result, the creditor often ends up receiving phantom income (no cash is being distributed to the creditor, but income is allocated to the creditor for tax purposes).
It is possible that the charging order protection is available only to multi-member LLCs. Clients with single-member LLCs desiring to maximize the protection of the assets within the entity from lawsuits directed against the sole member should consider adding on additional members. These new members need to have a capital interest in the LLC, but not necessarily a profits interest.
For LLCs set up by family members (and who are on good terms with each other), a “poison pill” provision should also be considered. A poison pill provision usually allows either the LLC itself or other members to buy-out the debtor-member for a nominal amount of money. The poison pill has the effect of substituting the debtor-member’s membership interest with a nominal amount of cash, which limits the assets that a creditor can collect against. In some cases the poison pill provision eliminates the need for charging order protection, and that is particularly effective when the LLC is holding depreciable real estate and passing through losses.
The charging order protection is critical for businesses with valuable assets (for example, real estate, significant A/R, contracts, or intellectual property). Service businesses, such as consulting firms, generally have no assets to protect, and the charging order protection is less critical.
Delaware Series LLCs
Similar to corporations, LLCs generally protect owners from lawsuits directed against the entity. However, the assets within the entity are not protected from such lawsuits and the creditor of the LLC may be able to reach the entity’s assets. Accordingly, instead of placing all assets in one LLC, practitioners advise clients to form multiple LLCs, placing a single asset in each LLC.
For a client that owns a couple pieces of real estate (or other business assets) this structure works well. For a client with a multitude of assets the fees and costs of setting up dozens of entities add up quickly. Delaware series LLCs (“Series LLCs”) are a creative solution.
Under Delaware law, a single LLC can have assets placed within separate series (akin to compartments) and an asset placed in one series is protected against the liabilities arising in a different series (provided separate books and records are kept for each series). Series LLCs have been around for quite a while and work amazingly well. In addition to the liability limitation, Series LLCs offer the added flexibility of having different managers and members in each series. For federal (and California) income tax purposes practitioners can choose whether to file one tax return for all series or a separate one for each. In practice, a single return is filed and series are tracked solely from a bookkeeping standpoint.
The frequent question from clients and practitioners is: does California recognize Series LLCs? That is an obviously important question that appears to be clearly resolved in the California statutes. Under California law a foreign LLC that registers to do business in California will continue to be governed by the laws of the foreign jurisdiction where it is organized (see below). This means that Delaware law will continue to apply to a Series LLC registered in California.
As an example, a client who has 40 parcels of real estate in California each owned through a separate LLC would be forced to pay $32,000 a year in California minimum franchise taxes, legal fees varying widely but of significant amount, and tax return preparation fees for 40 partnership returns.
As an alternative, the client will form a Series LLC and then register it with the California Secretary of State. Although the LLC has 40 series with each one holding a separate real property parcel (and each separate from the rest for liability purposes), only one LLC is being registered in California. This should reduce the California franchise tax from $32,000 to $800. Only one LLC agreement is drafted and only one tax return is filed.
Each parcel of real property is then titled into a specific series of the LLC. Separate books and bank accounts are maintained for each series. Everyone walks happily into the sunset.
Protection of Business Assets
Many clients own successful businesses with substantial assets. If the business is exposed to risks and liabilities, the assets of the business are also exposed to risks and liabilities. This is best illustrated by an example.
Tireco, Inc. owns a patent to the world’s most amazing automobile tire. Tireco also manufactures and sells the tire. If a Tireco tire ever disintegrates the lawsuit will be directed against the company that manufactured and sold the tire – Tireco. The lawsuit, assuming it is successful and exceeds the insurance coverage, would reach Tireco’s assets (including the very valuable patent) and possibly place it in bankruptcy.
The solution for Tireco is to manufacture and sell the tires and form another LLC to own the patent, with a non-assignable licensing agreement between the two entities. This way, if there is a lawsuit against Tireco the creditor would not be able to reach the patent.
Any business with significant assets should consider this strategy. Taken a step further, one can see how each significant asset of a business can be insulated using a Series LLC, with a separate licensing agreement (if appropriate) running from each series to the operating entity.
Picking the Best Jurisdiction
California law specifically provides that a foreign LLC registered to do business in California will continue to be governed by the laws of the foreign jurisdiction where it is organized. In this context, foreign means any jurisdiction other than California, including sister-states. That is why a Series LLC works in California.
Jurisdiction shopping for LLCs is relatively simple if one knows the client’s objectives. For tax minimization, if the LLC is taxed as a partnership its state of formation is irrelevant to a member residing in California. California would tax any resident member on its allocable income. If the LLC is taxed as a corporation, Nevada may be a good choice but only if the business is either located in Nevada, or it has no easily ascertainable physical location (such as Internet-based business). A Nevada corporation doing business in California will always be subject to California taxes (notwithstanding the claims of various promoters of Nevada corporations that would like us to believe that Nevada corporations (or in our case LLCs) will avoid all taxes, provide “bulletproof” asset protection and possibly improve our complexion). (This author cannot stress enough how ineffective Nevada privacy and secrecy laws are as an asset protection tool.) From a tax planning standpoint, many foreign jurisdictions (such as the Caymans) should also be considered for LLCs taxed as corporations, especially for Internet-based businesses.
If a non-California jurisdiction is being considered (we are looking for structural flexibility, low cost, business friendly laws) both Delaware and Nevada are good choices.
LLCs are wonderful tax planning vehicles. They may be taxed as corporations, partnerships or disregarded for tax purposes. In practice, single-member LLCs are usually disregarded, whereas multi-member LLCs are generally treated as tax partnerships.
Because LLCs are usually tax partnerships, contributions and distributions are generally tax-free, and the partnership tax planning opportunities abound. In the partnership tax context LLCs can be effectively used to structure leveraged partnership and tracking allocation transactions, to generate multiple losses and to strip basis on distributions and redemptions. LLCs also make it easier to allocation non-recourse loans to all the members and to plan for deficit capital account exit strategies. In short, LLCs taxed as partnerships offer all the income tax advantages of limited partnerships, no general partner exposure and none of the corporate tax disadvantages.
In California, spouses who own LLC interests as community property and are the only members can pick and choose whether the LLC will be treated as a partnership or as a disregarded entity for income tax purposes. This makes it easier for spouses who own real estate through a disregarded LLC to complete 1031 exchanges (there is no risk that the real estate interests will be reclassified as partnership interests).
Some clients have existing businesses that are organized as corporations and are looking for the charging order protection of the LLC. If the corporate exit tax is too high the corporation may be kept in place and an LLC (preferably multi-member) substituted as the sole corporate shareholder. While tax problems remain, at least the client has liability protection.
If the corporation has made an S election, then the top-tier LLC should be a disregarded entity. However, if an LLC is a disregarded entity it means that it either has only one member, or a husband and wife are holding membership interests as community property. Either structure minimizes the effectiveness of the charging order protection. In that case, an LLC formed in a foreign jurisdiction and elected to be treated as a disregarded entity would offer the client tax neutrality and a better degree of asset protection.
The author’s preferred alternative solution is to form a new LLC, check-the-box to tax the LLC as a corporation (even making an S election if necessary), and then merge the existing corporation into the LLC. From a tax standpoint the transaction is treated as a tax-free reorganization (if structured correctly), and from a liability standpoint assets are now owned by an LLC providing charging order protection.
In some (hopefully) rare circumstances corporations are advisable as the right entity for a tax reason. If that is the case, and the charging order protection is still desired, the solution would be similar to the one immediately above - form an LLC and elect to tax it as a corporation. This results in corporate tax treatment for federal and California tax purposes, and LLC treatment for asset protection purposes. Some wonderful planning can be achieved through the use of this tax law/state law distinction of entity classification.
The above listed advantages of LLCs are just a sampling of what these entities have to offer and how they may be used. It is no wonder that they have quickly become the default entity of choice for many practitioners, from tax planning to estate planning to asset protection.
For more information about various advanced asset protection and tax planning ideas and structures, log on to www.maximumassetprotection.com.
Jacob Stein Esq.
Mr. Stein is a partner with the law firm Boldra, Klueger and Stein, LLP, in Los Angeles, California. The firm's practice is limited to asset protection, domestic and international tax planning, and structuring complex business transactions. The firm's goal is to provide the highest quality legal work that is usually associated with only the biggest law firms, in a boutique firm setting. Jacob received his law degree from the University of Southern California, and his Master's of Law in Taxation from Georgetown University. Mr. Stein has been accredited by the State Bar of California as a Certified Tax Law Specialist and is AV-rated (highest possible rating) by Martindale-Hubbell.