Delaware Series LLC
The limited liability company (LLC) has fast become the business entity of choice in the U.S. The LLC allows business owners to achieve limited liability for debts of the business while being taxed on a relatively unrestricted passthrough basis.
The LLC also provides protection to its owners for debts unrelated to the business in that LLC property and LLC interests themselves generally cannot be directly seized or attached by creditors of debtor members. Instead, such creditors are limited to a “charging order” issued by a court requiring the LLC to divert payments to the debtor member to the creditor.
However, the charging order does not provide the creditor with voting rights, such as the right to vote for a distribution. If no distributions are made to the debtor member, neither are distributions made to the creditor. Furthermore, in some cases, the creditor may be taxable on the debtor member’s share of LLC income, whether he receives a distribution or not. Thus the charging order is not a particularly attractive remedy for a creditor.
Segregating “dangerous” assets and businesses into separate entities away from other assets, check 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 shouldn’t own both within the same entity. Neither should an individual with a large amount of liquid assets (cash, securities, etc.) to protect hold the cash 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 isn’t 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 Delaware series LLC. The Delaware LLC Act provides for the creation of separate “series” within an LLC whose debts and other liabilities are enforceable against that series alone. 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 the two provisions allows a series to be treated in many ways as a separate LLC. Thus, the series provisions in the Delaware LLC Act allow for the creation of separate protected “cells” within one limited liability “container” without the need to create separate entities, thus avoiding the inefficiencies associated with multiple related entities. The concept is similar in function to the segregated portfolio companies and protected cell companies designed for the mutual fund and captive insurance industries in Bermuda, Guernsey, the Cayman Islands, Mauritius and Belize.
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. If the various series within an LLC have different members or different membership rights, each series may be treated as a separate LLC for income tax purposes, eliminating some of the administrative advantage of the series LLC.
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. However, to obtain this protection, each series must be treated separately. Books and records must be kept for each series and the assets of each series must be held and accounted for separately. Finally, in order that the public knows that it is dealing with a series LLC, it must be put on notice by the inclusion of the series limitations in the LLC’s Certificate of Formation filed with the Delaware Secretary of State.
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. Consider Bob and Nancy, who own ten small rental properties, each worth between $50,000 and $100,000. Forming and maintaining ten separate LLCs would cost several thousand dollars in the year of formation and several thousand dollars each subsequent year. Instead, Bob and Nancy might form a Delaware series LLC and transfer each property by deed to a separate series. They would achieve their goal of segregating the properties for asset protection purposes while saving several thousand dollars in startup costs and another several thousand dollars a year in ongoing administrative costs.
Another use for the series LLC might be to facilitate an equity compensation program in a business with multiple divisions. If each division were segregated into a separate series, the LLC could 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. That rewards employees at productive divisions and protects them from the potential downside of another division.
Yet another use for the series LLC might be to make a de facto transfer that avoids gain that would otherwise be recognized on a transfer from one LLC to another LLC. Consider the following example: Dan & Ed contribute adjacent tracts of land to D&E, LLC and develops most of the land. A few years later, they want to sell the remaining undeveloped land, worth $1 million, to Fred for a shopping center. Dan & Ed want D&E, LLC to get some cash out of the deal, but they also want a piece of the shopping center action. If D&E, LLC contributes the property to a new LLC formed with Fred, DEF, LLC, in exchange for DEF, LLC interests and cash, the cash distribution would be taxable to Dan & Ed under Section 707(a)(2)(B) of the Internal Revenue Code as a taxable exchange of appreciated property for cash.
Instead, D&E, LLC creates a new series within D&E, LLC, the Shopping Center Series, issues the Shopping Center Series interests 10% each to Dan and Ed, and 80% to Fred, and transfers the land to the Shopping Center Series. Fred contributes $2 million to D&E, LLC, of which $1.5 million is designated for the Shopping Center Series. If D&E, LLC is respected as a single tax partnership (i.e., the Shopping Center Series is not treated as a separate partnership for tax purposes), the current income tax gain to Dan & Ed on the cash portion of the land exchange that otherwise would have been triggered in a transfer to a new LLC will have been avoided. In addition, since the transfer of the land was entirely inside the LLC, depending on local law, there may be no real estate transfer tax on the transfer whereas there may have been tax on the transfer of the land to a new LLC. This is cutting edge planning with no guarantees, of course, but the possibilities are exciting and the tax issues can be addressed reasonably.
In addition to Delaware, several other states now have series LLC laws, including Illinois, Iowa, Nevada, Oklahoma, Tennessee, Texas, and Utah. Riser Adkisson LLP has considerable experience in using series LLCs to achieve the goals of its clients, particularly in the area of real estate investment. If we can help you or your clients, call Chris Riser at 706-552-4800 or send an e-mail message to criser (at) riserlaw.com