A. Creative Asset Protection Planning with LLCs

1. 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. 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 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 (such as the minimum franchise tax imposed on each entity) and costs of setting up dozens of entities add up quickly. Series LLCs (“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 been in existence for quite some time. These concepts exist in such countries 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,[1] Oklahoma,[2] Iowa,[3] Illinois[4] and most recently in Nevada.[5] The Delaware statute is the most frequently used jurisdiction for creation of domestic series LLCs.

Title 18, Delaware Code, Section 18-215(a) provides:

A limited liability company agreement may establish or provide for the establishment of 1 or more designated series of members, managers or limited liability company interests having separate rights, powers or duties with respect to specified property or obligations of the limited liability company or profits and losses associated with specified property or obligations, and any such series may have a separate business purpose or investment objective.

Section 18-215(b) provides:

…if separate and distinct records are maintained for any such series and the assets associated with any such series are held…and accounted for separately from the other assets of the limited liability company, or any other series thereof, and if the limited liability company agreement so provides, and if notice of the limitation on liabilities of a series as referenced in this subsection is set forth in the certificate of formation of the limited liability company, then the debts, liabilities, obligations and expenses incurred, contracted for or otherwise existing with respect to a particular series shall be enforceable against the assets of such series only, and not against the assets of the limited liability company generally or any other series…[Emphasis added.]

In Delaware, and similarly in other jurisdictions that have adopted this concept, 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).[6] Each series also has 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[7] 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.[8] This means that Delaware (or Nevada) law will continue to apply to a Series LLC 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, he 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 registered in California. This will reduce the California franchise tax from $32,000 to $800.[9] 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 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 Series LLCs statutes specifically prohibit treating series as alter egos. It should be noted that treatment of Series LLCs in bankruptcy is uncertain. A bankruptcy court would use the applicable state law as its primary point of reference, but it would not be bound by the state law. Consequently, a bankruptcy court may order substantive consolidation.

Another caveat is that the Franchise Tax Board (“FTB”) 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.” 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,[10] and a “foreign limited liability company” is defined as an entity organized under the laws of a foreign state or country.[11] 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 where the LLC is organized, even if California laws are at odds with the other jurisdiction.[12] In the case of a Series LLC, all the series comprise one limited liability company, not 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 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.[13]

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 is an untenable argument.[14]

Debtors frequently favor holding title to real estate in an alternate name. This way, simple title searches under the debtor’s name will not turn up any real estate that is titled differently. The Series LLC can offer this “advantage” to the debtor as each series can bear a different name. This will make it more difficult for a creditor to lien on the debtor’s real estate. Further, creditors will often first evaluate the benefit of pursuing a specific debtor by examining the debtor’s assets. If it appears that the debtor does not possess a great deal of worth, may be the creditor will forbear from suing. By titling real estate in the names of different series, a potential creditor running a simple title search will not find any assets, and may decide to forego the lawsuit.

2. Use of Foreign LLCs

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.[15] In this context, foreign means any jurisdiction other than California, including sister-states. That is why 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 minimization, if the LLC is taxed as a partnership or a subchapter S corporation,[16] 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 subchapter C corporation, jurisdictions like 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[17] or it has no easily ascertainable physical location (such as Internet-based business).

For liability protection many look to jurisdictions like 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.

Another advantage of using a truly foreign LLC for asset protection purposes is that the legal battle moves offshore. With respect to LLCs, even if they hold U. S. real estate, the applicable law is always the law of the jurisdiction where the LLC is organized. Various offshore jurisdictions are more protective of LLC members than U. S. jurisdictions, such as restricting the creditors solely to the charging order, and respecting single-member LLCs as separate entities.

A foreign LLC also presents the creditor with the disadvantage of the increased costs of litigation, as the proceeding may have to be brought in a foreign country to either obtain a judgment or collect on a judgment.

Care should be exercised in the types of assets that the foreign LLC will own. For example, unless the foreign LLC is a single-member LLC and is disregarded for tax purposes, it cannot hold S corporation stock.

Clients often seek to protect corporate assets from creditor claims which may be prohibitive from a tax standpoint if the corporation is liquidated. Even with an S corporation, there will be an “exit” tax to the extent the corporation has appreciated assets. Transferring the stock of the corporation to a single-member LLC that is disregarded for tax purposes may be the best solution. Because there is some uncertainty as to how much protection domestic single-member LLCs afford, a foreign jurisdiction with a track record of respecting single-member LLC may be preferable.

3. 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. This is best illustrated by an example.

Tireco, Inc. owns a patent to 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 Tireco, as the manufacturer and seller of the tire. 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 is for Tireco to continue to manufacture and sell the tires but to form a separate LLC to own the patent, with a non-assignable licensing agreement between the two entities. If a lawsuit is filed against Tireco, 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.

---

[1] Section 18-215 of the Delaware Limited Liability Company Act.

[2] Section 18-2054.4 of Oklahoma Limited Liability Company Act.

[3] Title XII, Subtitle 2, Chapter 490A.305 of Iowa Statutes.

[4] Illinois Compiled Statutes, Chapter 805, Section 37-40.

[5] Nevada Revised Statutes Section 86.291.

[6] Section 18-215 of the Delaware Limited Liability Company Act.

[7] Even if separate capital accounts are maintained for each member’s interest in each series.

[8] Corp. Code Section 17450(a).

[9] Because all forty properties are now aggregated on one tax return, the LLC may become subject to the California gross receipts tax imposed on LLCs. To avoid that, a Delaware series limited partnership may be used instead of a Series LLC. If the client already has multiple LLCs each paying the maximum gross receipts tax, converting the existing LLCs to one Series LLC will result in one gross receipts tax.

[10] Corp. Code Section 17001(t).

[11] Corp. Code Section 17001(q).

[12] Corp. Code Section 17450(a) and (b).

[13] Revenue and Taxation Code Section 17941(a).

[14] Based on the author’s correspondence with the FTB legal counsel, the FTB is apparently confused between the distinction of when the LLC will be broken down into multiple “tax partnerships” for income tax purposes, and whether it can be deemed to constitute multiple LLCs for non-income tax purposes.

[15] Corp. Code Section 17450(a).

[16] A limited liability company can file the IRS Form 8832 to elect to be taxed as a corporation, and then make a subchapter S election.

[17] If an entity is organized in Nevada (for instance), but is doing business in California, California will always tax that business on its income apportionable to California, regardless of the state of organization or type of entity.