J & N REALTY, INC.

Advanced Asset Protection and Tax Planning with LLCs  

Historically, corporations have been the favored choice of entity for businesses, but that is no longer true today. The shift began in 1977 when Wyoming introduced the limited liability company into the United States. In 1994, California followed suit. LLCs quickly soared in popularity, primarily because they combine the best elements of a corporation (limited liability for all owners, centralized management, and potentially unlimited duration) and a limited partnership (economic flexibility and pass-through taxation). However, in addition to these clear benefits, LLCs offer other critical advantages—in particular, the charging order protection and flexibility in business asset protection—that practitioners should not overlook. 

LLCs, like corporations, generally shield their owners from entity-level liabilities. Corporate shareholders are protected from personal liability by the common law principle that a corporation is a separate legal person (and one person is not liable for the obligations of another person), and LLC members are similarly protected by the California LLC statutes (which are derived from the same common law principle). As an example, if either a corporation or an LLC owns an apartment building and a tenant slips, falls, and sues, the lawsuit is directed against the corporation or the LLC (absent piercing-the-veil arguments) and not against the individual owners of the entity. The difference between the liability protection of a corporation and an LLC arises in the context of lawsuits and claims directed against the owners of these entities. The shares of stock of a corporation are a personal asset that is not exempt from claims of creditors under California statutes and case law. This means that a creditor holding a judgment against a corporate shareholder may be able to seize the shareholder’s shares of stock, and, given a sufficient ownership interest, liquidate the corporation and gain access to its assets. Consequently, while a corporation generally protects shareholders from lawsuits directed against the corporation, it does not necessarily protect corporate assets from lawsuits directed against the shareholders. This distinction is usually referred to as outside-in versus inside-out asset protection. 

Creditors of LLC members have no such open path to seizing membership interests. Under California law (and in most other states), the exclusive remedy available to a creditor to satisfy its judgment against an LLC membership interest is the charging order. The charging order evolved as a means of collecting monies from a debtor-partner without disrupting the partnership business or effecting an injustice on the solvent partners. This rationale applied initially only to general partnerships in which every partner was involved in carrying on the business of the partnership; it did not apply to corporations because of their centralized management structure. Over the years, the charging order protection was extended to limited partnerships and to LLCs. 

Traditionally, the framework of the charging order has always been to grant the creditor an economic interest in the entity (partnership or LLC) without transferring any of the debtor’s voting or management rights. The charging order constitutes a lien on the debtor-member’s “assignable” membership interest. The protection of the charging order is twofold: 1) it is merely a lien, not a levy (the underlying asset—the LLC interest—is not transferred to the creditor), and 2) it only applies to the “assignable” membership interest. Because the charging order is merely a lien, the creditor can never vote the charged interest, make any management decisions, or gain access to the LLC books and records. This is consistent with the historical framework of charging orders. Also, the creditor has no ability to transfer the underlying membership interest unless the creditor forecloses on the interest. 

Because the charging order is a lien, until there is a foreclosure of the membership interest of the debtor-member, the only value that the creditor can obtain from the LLC is the interception of the distributions of property from the LLC to the debtor-member. Assume that a LLC generates $1 million of cash flow for the year, and 20 percent of that is distributed to the debtor-member. If a creditor has a charging order, the $200,000 goes to the creditor. To determine whether a membership interest is assignable, one must turn to the statute or to the LLC’s operating agreement, if there is one. By default, the statute provides that a membership interest may be assignable only if the majority of the members not transferring their interest consent to the assignment. This would mean that in a two-person LLC (with equal interests), the nondebtor-member would have to consent to the assignment. If the other member is a spouse, a friend, or a family member, the charging order, as a creditor’s remedy, may lose all its viability. 

The presence of an operating agreement can greatly enhance the charging order protection, because the LLC statutes allow members to override the default statutory provision of assignability of interests in the operating agreement. Most operating agreements drafted today provide that only the economic interest in the LLC may be assigned but not the entire membership interest. The economic interest component grants its holder the right to receive distributions of cash and property from the LLC and the right to receive allocations of gain, loss, income, and deductions.  This means that voting and management rights, as well the right to access the LLC’s books and records, are nonassignable. This also means that if the debtor-member controls the LLC (because of sufficient voting power or by virtue of being the manager), he or she may take the simple expedient of ceasing to make distributions from the LLC, and the creditor will not be able to get any assets out of the LLC. 

Taking the term “assignable” a step further, if the operating agreement provides that the membership interests in the LLC are nonassignable, the charging order remedy becomes meaningless. In drafting the LLC charging order statute, the California legislature departed significantly from the limited partnership charging order statute (the progenitor of the LLC statute). The limited partnership statute charges the entire limited partnership interest, but then makes the creditor an assignee (i.e., an economic interest holder). 

Thus, in a limited partnership context, the creditor can never receive less than an economic interest, whereas in an LLC setting, the creditor may not even get that much. It is unclear why the legislature created this apparent loophole for debtor-members but not for debtor-partners. One possible reason is that LLC members are allowed to actively participate in the management of the entity, and limited partners are not allowed any active participation. 

In most business dealings it would not be possible for practitioners to make LLC interests entirely nonassignable. Clients want to retain flexibility and ability to dispose of their LLC interests. However, in family settings or for LLCs established solely for liability protection purposes, it may be possible either to prevent assignability altogether or to so limit it as to make the charging order remedy of little value to the creditor. 

The charging order statute allows the creditor to foreclose on the debtor-member’s membership interest “subject to the charging order.” The section further provides that the buyer at a foreclosure sale has the rights of an assignee. An assignee is limited to being an economic interest holder, without any voting or management rights. Because only an assignable interest is subject to the charging order, it appears that the foreclosure remedy is severely limited if 1) there is a well-drafted operating agreement that restricts assignability of interests, or 2) there is no operating agreement but the majority of the nondebtor members do not consent to the assignment. Even without either of these features, by granting the buyer of the foreclosed interest the rights of assignee, the debtor-member is able to retain all voting and management rights, and, consequently, control over the LLC. 

Prior to the foreclosure, a debtor-member may redeem his or her membership interest. The statute does not specify that the interest must be redeemed at fair market value. This leaves room for drafters to insert various favorable redemption provisions into the operating agreement, such as a poison pill. Once a creditor forecloses on the membership interest, the charging order lien is converted into an actual interest in the LLC. When that happens, the cash flow of the LLC on account of the economic interest now owned by the creditor becomes distributable to the creditor. If the cash flow is distributable to the creditor, then all the tax consequences of the ownership of that economic interest are properly allocable to the creditor.  It is possible that the LLC will generate taxable income and pass it through to the creditor, even if the creditor receives no distributions. Given these adverse income tax consequences, foreclosure may often be disadvantageous to the creditor or to a buyer of an economic interest in an LLC at a foreclosure sale. 

Single-member LLCs deserve special attention in the charging order analysis. It may be argued that given the historical framework of charging orders, their protection should not extend to single-member LLCs (there are no other “partners” to protect from the creditor). One bankruptcy court has so held in a well-reasoned opinion. However, the California charging order statutes make no distinction between single member and multimember LLCs. Further, the California Supreme Court held that the charging order protection would apply in a case in which all the partners of a limited partnership were the debtors of a single creditor. The creditor had argued to no avail that because there were no “innocent” (nondebtor) partners to protect, the charging order protection should not apply. 

To date, there are no California cases analyzing the efficacy of charging orders on single-member LLCs. Attorneys should caution their clients that if they are seeking to maximize their charging order protection, they should form multimember LLCs or add new members to existing LLCs. These new members would need to have some membership interest in the LLC. This allows for some flexibility because of the somewhat loose definition of the membership interest in the statutes. For example, the additional member may have only a capital or a profits interest in the LLC, but not necessarily both. If an LLC has two spouses as the only members, and the interests in the LLC are community property of the spouses, the LLC would probably not enjoy the protection of a multimember LLC. Under the community property laws, if either spouse is a debtor, the creditor will be able to charge the LLC interests of both spouses. This would mean that there would be no nondebtor members to protect with the charging order. 

In sum, regardless of the assignability of interests or whether or not the creditor forecloses, in the event of a charging order, a debtor-member stands to lose only his or her economic interests in the LLC, but never voting, management, or access-to-information rights. The charging order protection is critical for businesses with valuable assets (for example, real estate, significant accounts receivable, contracts, or intellectual property). However, it is less critical for service businesses, such as consulting firms, that generally have no assets to protect. 

The Operating Agreement 

Attorneys can further enhance the liability protection afforded by LLCs by properly drafting the operating agreement. There are two important planning points. First, if the LLC agreement provides that the manager must make all distributions to members on a pro-rata basis, then distributions have to be made either to all members or none. This means that if one member is pursued by a creditor holding a charging order, protecting that member would mean withholding distributions from all members of that LLC. 

Consequently, LLC agreements should be drafted to deal with this potential problem. One possible solution is to allow the manager to make distributions to all other members, and not the debtor-member.  A second potential solution is to include a poison-pill provision in the LLC agreement. A poison-pill provision usually gives either the LLC itself or the nondebtor members the right to buy out the debtor-member for a nominal amount of money. The poison pill has the effect of substituting the debtormember’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 poison pill should be implemented only for family-setting LLCs in which the family members are on good terms with each other. 

Practitioners should note that while these tactics are consistent with the LLC statutes, California courts have not ruled on any challenges to them. Clients should be informed about this lingering uncertainty. 

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 these 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. At times, lenders also require borrowers to hold collateral in so-called special purpose (bankruptcy remote) entities, with each entity holding a separate piece of collateral. For a client who owns only a few real estate (or other business) assets this structure works well. However, for a client with a multitude of assets, the fees (such as the minimum franchise tax imposed on each entity) and costs of setting up dozens of entities add up quickly. 

Series LLCs are a creative solution. The concept of the series LLCs has been adopted from the offshore mutual fund industry, where segregated portfolio companies and protected cell companies have existed for quite some time. These concepts exist in countries such as Guernsey, British Virgin Islands, Bermuda, the Cayman Islands, Mauritius, and Belize. In the United States, the concept of a series LLC exists in Delaware, Oklahoma, Iowa, Illinois, and, most recently, in Nevada. Delaware is the most frequently used jurisdiction for creation of domestic series LLCs. In Delaware, a single LLC can have assets placed within separate series (akin to compartments). 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 and the assets of each series are accounted for separately). Delaware also allows each series the added flexibility of having different managers and members. 

For federal (and California) income tax purposes, practitioners can usually 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. 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. This means that Delaware law will continue to apply to a Delaware series LLC that is registered in California. 

To understand the value of a series LLC, consider a client who has 40 parcels of real estate in California. If each parcel is owned by the client through a separate LLC, the client would be forced to pay $32,000 a year in California minimum franchise taxes ($800 per entity), varying legal fees to establish each entity, and tax return preparation fees for 40 partnership returns. Instead, the client may form a single 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 actually registered in California. This will 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. If the client acquires additional properties in the future, no changes need to be made to the LLC operating agreement. He or she would simply need to title the new properties into new series and create new books and records for the new series. 

In addition, series LLCs arguably offer even more protection than multiple LLCs. Whereas multiple LLCs owned by the same members may be treated as alter egos, the Delaware series LLCs statute specifically prohibits treating series as alter egos. It should be noted that treatment of series LLCs in bankruptcy is uncertain, as a bankruptcy court would not be bound by the Delaware series LLC statute and could order substantive consolidation. 

Another caveat is that the Franchise Tax Board has issued revised instructions for Form 568 (the form filed for LLCs) to provide that “each series in a Delaware series LLC is considered a separate LLC.” However, the position of the FTB finds no support under the California statutes. (It is also not clear why the instructions are limited to only Delaware series LLCs.) California statutes define a “limited liability company” as an entity that is organized under the California Limited Liability Company Act, and a “foreign limited liability company” is defined as an entity organized under the laws of a foreign state or country. The statutes provide, further, that in order to form a limited liability company, articles of organization shall be filed with the secretary of state. An LLC simply cannot be created without the consent of a secretary of state of some state. Because no articles of organization are ever filed for a series of a limited liability company—the series are simply a bookkeeping concept—a series of an LLC should never be a limited liability company under California law. 

Further, California statutes provide that a foreign limited liability company registering to do business in California will continue to be governed by the laws of the jurisdiction in which the LLC is organized, even if California laws are at odds with the foreign jurisdiction.  Delaware (and, similarly, in other states that allow for the creation of series) treats the series LLC as one limited liability company, not as multiple limited liability companies. Consequently, the FTB’s position that each series is a separate LLC appears to be in conflict with the California statutes. Moreover, the concept of series exists solely to segregate liabilities among the various assets of an LLC. Series exist only on the LLCs’ books and records, and a series LLC can be identical to a regular LLC, except for the segregation of liabilities. The fact that a state allows one to segregate liabilities within one LLC should not mean that each series is treated as a separate legal entity. For minimum franchise tax purposes, California can impose the annual $800 tax only on an LLC itself, and not on the separate series of a single LLC. 

Consider this fact pattern: A regular Delaware LLC owns properties in California and is registered in California for several years. The Delaware certificate of formation is amended to allow the creation of series. Assume no other changes are made to the LLC. The only difference between the LLC before and following the amendment of the certificate of formation is liability segregation. Based solely on that distinction, the FTB would now assess against this LLC multiple franchise taxes. That appears to be an untenable argument.  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 in which it is organized. Therefore, a series LLC should work in California—noting, however, that a California court has yet to opine on series LLCs. 

Jurisdiction shopping for LLCs is relatively simple if one knows the client’s objectives. For tax purposes, its state of formation is irrelevant to a member residing in California if the LLC is taxed as a partnership or a subchapter S corporation. California would tax any resident member on its allocable income. If the LLC is taxed as a subchapter C corporation, jurisdictions such as Nevada or South Dakota (or even some foreign countries that do not impose an income tax) may be good choices because there are usually no corporate income taxes in these jurisdictions. However, this will work only if the business is either located in that jurisdiction or has no easily ascertainable physical location (such as Internet-based business). For liability protection, many look to jurisdictions such as Delaware and Nevada, domestically, and such foreign jurisdictions as the Island of Nevis or St. Vincent and the Grenadines (both in the West Indies) that have an established history of making it difficult for creditors to pierce the corporate veil of an LLC. 

Protection of Business Assets Another way LLCs may be used to limit liability exposure is to form multiple (or series) LLCs to own separate, distinct portions of a business. If the business is held in one entity, all the assets of the business are exposed to risks and liabilities arising out of all the various business assets and operations. For example, assume that a corporation owns a patent for an automobile tire and also manufactures and sells the tire. If a tire becomes defective and results in damage, the lawsuit will be filed against the corporation as the manufacturer and seller of the tire.  The lawsuit, assuming it is successful and exceeds the insurance coverage, would reach the corporation’s assets—including the very valuable patent—and possibly place it in bankruptcy. 

The solution is for the corporation to continue to manufacture and sell the tires but to form a separate LLC to own the patent, with a nonassignable licensing agreement between the two entities. If a lawsuit is filed against the corporation, the creditor would not be able to reach the patent. Note, however, that this protection may be undone by a successful alter ego challenge or substantive consolidation in a bankruptcy proceeding. Any business with significant assets should consider forming a separate LLC for each distinct segment of its business or to hold valuable assets. Taken a step further, 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. 

In addition to liability protection, LLCs are wonderful tax planning vehicles. They may be treated as corporations (if they have one or more members), partnerships (if they have multiple members), or disregarded (if they have a single member) for tax purposes. In practice, single-member LLCs are usually disregarded, whereas multimember LLCs are generally treated as tax partnerships. Because LLCs are usually tax partnerships, contributions and distributions are generally tax-free, and partnership tax planning opportunities abound. Members are allocated nonrecourse liabilities for basis purposes, allowing them to absorb more losses (one of the primary tax reasons why real estate is never owned through corporate entities).  

There are no restrictions as to the ownership of LLCs (S corporations are restricted as to the number and type of shareholders), and no restrictions as to their economic structures (S corporation can only have one class of economic interests). 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 Section 1031 exchanges, since 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 a multimember LLC) 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, the top-tier LLC should be a disregarded entity (otherwise the LLC would be a prohibited shareholder, destroying the S election).  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 much higher degree of asset protection. 

Perhaps a preferable alternative for existing corporations is to form a new LLC, file IRS Form 8832 and 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, with the LLC surviving. 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 rare circumstances in which corporations remain the right entity for a tax reason but charging order protection is still desired, the solution would be similar: 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 significant planning opportunities can be created through the use of this distinction between federal tax law and state law. These advantages are just a sampling of what LLCs 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.