The dangerous charm of the Series LLC

Transcription

1 The dangerous charm of the Series LLC A s of the date of this article, eight states (Delaware, Illinois, Iowa, Nevada, Oklahoma, Tennessee, Utah, and Texas) have amended their LLC statutes to allow for the formation of a series LLC. The series LLC is a type of limited liability company whose formation documents establish one or more designated series of members, managers, interests, or assets. by Christopher S. McLoon and Margaret C. Callaghan This article focuses on the LLC with one or more designated asset series. In such an LLC, one or more members may be associated with one or more asset series, but not any other. For example, assume Anne, Bill, and Charlie are members of Acme LLC, a series LLC. Anne and Bill, but not Charlie, are associated with the assets of Series Blackacre, while Charlie and Bill, but not Anne, are associated with the assets of Series Whiteacre. If Acme LLC follows statutory requirements in its state of formation, the series LLC statutes provide that the assets and liabilities of Series Blackacre are segregated from the assets and liabilities of Series Whiteacre. Maine lawmakers are set to begin drafting a new LLC statute soon, and may be tempted to incorporate into the new statute the series LLC model as adopted by some other states. 1 At first glance, the benefits of such an entity seem obvious. In theory, investors would save filing fees and legal and administrative costs by forming m a i n e b a r j o u r n A L F A L L

2 only one LLC, and would enjoy the organizational flexibility and liability protection offered by the ability to set up separate series for various business purposes under the umbrella of the parent LLC. 2 Upon further investigation, however, significant uncertainties and risks inherent to the series LLC structure become apparent. This article will summarize certain aspects of those risks, and explain why the series LLC structure is very often an inappropriate tool for the general business practitioner. If Maine does include the series LLC concept in its new LLC statute, business law practitioners are cautioned to use the form only after careful consideration and planning, and to advise clients to do the same. Potential Uses for the Series LLC The unique structure of the series LLC is particularly well suited for certain types of businesses. The most common use of the series LLC is for mutual funds. The series LLC format allows for the parent LLC to file a single registration under the Investment Company Act of 1940, and then establish separate funds using the various underlying series. (Using the series LLC in the mutual fund context may not pose the same types of risks as those faced by other businesses, because a mutual fund does not incur debt, and therefore owners/ investors would not be subject to a substantial risk of liability if the series structure is not respected for state law purposes.) Another potential use for the series LLC is in the context of a real estate management or development business that will operate various properties or development projects, and may wish to segregate ownership rights and liabilities among the various projects. Licensed or regulated businesses may be able to use the series LLC to operate separate businesses under a single license or regulatory approval. The series LLC may also be a useful tool for businesses with multiple assets under different ownership, such as a taxi cab or mobile home business. In each of these scenarios, the ability to provide for diversity of ownership, segregation of liability, and Christopher S. McLoon is a partner in Verrill Dana s business law group. He practices tax law, and business law with a focus on unincorporated entities. He is co-chairman of the LLC Act drafting subcommittee of the MSBA s Business Section. Margaret C. Callaghan is an associate in Verrill Dana s business law group, where she practices general business law, with a focus on transactions and securities matters. She is a member of the LLC Act drafting subcommittee of the MSBA s Business Section. streamlined administration, combine to make the series LLC seem like an ideal business entity. Most obvious of the advantages presented by the series LLC is the savings the business may recognize in state filing fees (other than in Illinois, which requires a separate filing and payment of an associated fee upon the establishment of each series). More significantly, the business may save in legal costs attributable to document preparation and other start-up activities if only a single LLC operating agreement is required. 3 In the context of a real estate development business, the series LLC may provide an opportunity to avoid sales or transfer taxes among the series. Other, non-real estate assets also may be more easily and efficiently transferred among series. Finally, it appears that the need to observe corporate-type formalities might be limited in the series LLC model, further saving in administrative and possibly legal costs. Uncertainty Although these potential cost and time savings are attractive, it must be remembered that they are truly potential savings only. The primary drawback to the series LLC model is that it is new and untested, and is therefore an extremely risky entity choice. A recent Westlaw search of all federal and state cases in the United States yielded only one reported decision that discussed legal issues concerning the series LLC, 4 and that decision s discussion is not a central holding of the case. A host of legal and tax issues concerning the series LLC have never been litigated or considered by the relevant judicial or regulatory authorities. Several of the unresolved issues concerning series LLCs challenge the legitimacy of the very features that make the entity an attractive option at first glance. Although the following questions have not yet been resolved by courts or regulatory authorities, it is possible to analyze the issues and make comparisons to questions whose outcome has been resolved. Unresolved Questions and Other Risks Limited Liability The primary advantage of the series LLC model is that it provides a business the ability to segregate assets and shield them from each others liability, all under the umbrella of a single business entity. Choice of law questions present serious threats to this promise of limited liability, however. Given that (as of this writing) only seven states authorize the series LLC in their F A L L m a i n e b a r j o u r n A L 2 2 7

3 LLC statutes, the question arises of whether other, non-series LLC jurisdictions will recognize the inter-series limitations on liability purportedly offered by the series LLC. This question is of particular concern with respect to claims involving creditors and other third parties who may not have adequate notice of the segregation of assets and liabilities in a series LLC, as opposed to claims between series or series LLC members. For example, consider the situation of Voyager LLC, a series LLC organized in Maine (assuming that Maine has amended its LLC statute to permit the formation of series LLCs). Voyager LLC has three series: Series N, which owns a ship called the Niña; Series P, which owns a ship called the Pinta; and Series S, which owns a ship called the Santa María. The members of Series N are Christopher and Popeye, but not Bluto. The members of Series P are Christopher and Bluto, but not Popeye. Christopher is the sole member of Series S. Imagine that the Niña, while sailing in Casco Bay, collides with a luxury yacht, causing $500,000 in damages. In theory, if the parties have been observing the proper formalities relating to capitalization and bookkeeping, etc. (see the discussion in Veil Piercing, below), the liabilities incurred by the Niña should be limited to the assets of Series N only. Bluto should have no exposure at all, because his involvement in Voyager LLC is limited to his membership interest in Series P. However, what if the Niña heads south and crashes into a yacht near Marblehead, and Massachusetts law doesn t recognize the series LLC form? A Massachusetts court may disregard the asset and liability segregation among the series, which would put the Pinta and the Santa María at risk, as assets that the court would deem to be owned by the parent LLC, Voyager. Veil Piercing The prospect of administrative efficiencies is another of the most appealing features of the series LLC. A practitioner may be tempted to advise his or her client that with the series LLC, the client will be able to manage a variety of assets and diversify ownership of those assets, all while using a single entity structure, and therefore save time and money on accounting, legal, and administrative costs and efforts. The problem with this advice is that no one knows what type or amount of accounting and other formalities must be observed in order to preserve liability segregation among the series and avoid the piercing of the liability veil. The Delaware statute (on which most of the other series LLC statutes are based) provides that in order for the limitation of liability to apply to the extent of the assets of a series alone, the records maintained for each series must account for the assets associated with such series separately from the other assets of the limited liability company, or any other series thereof. 5 The same section of the statute elaborates on the type of record-keeping that is required to meet the standard for limited liability: Records maintained for a series that reasonably identify its assets, including by specific listing, category, type, quantity, computational or allocational formula or procedure (including a percentage or share of any asset or assets) or by any other method where the identity of such assets is objectively determinable, will be deemed to account for the assets associated with such series separately from the other assets of the limited liability company, or any other series thereof. 6 Although this language provides some rough guidance, it is still not clear exactly what type of record keeping is sufficient to provide the limited liability protection, or what practices would be insufficient, and would therefore expose a client to greater than anticipated liability. Unfortunately, as noted earlier, there is no case law on which to rely for further guidance, so the best practical advice from a practitioner to a client would be to maintain the strictest possible accounting and other record-keeping standards in order to maximize the chances of the limited liability being respected. Once a client understands that he or she will need to maintain the same or greater level of record-keeping practices for each series as would be used for a separate entity, the appeal of the series LLC model diminishes significantly. Title One of the uses for which the series LLC seems especially well suited is the real estate management or development company. Given the appeal of this potential use of the series LLC, it is especially important to know whether a series has the legal capacity to hold title to real estate. Amendments to the Delaware LLC statute adopted in 2007 provide that Unless otherwise provided in a limited liability company agreement, a series shall have the power and capacity to, in its own name, contract, hold title to assets (including real, personal and intangible property), grant liens and security interests, and sue and be sued. 7 This new language appears to settle the question of whether a series has the capacity m a i n e b a r j o u r n A L F A L L

4 to hold title. However, it is still unclear whether a series is a separate legal entity for purposes of Delaware law, which may present problems for title insurers, claimants, and other stakeholders (this lack of clarity regarding the entity status of a series also raises additional issues, discussed elsewhere in this article). Although the Delaware statute affirmatively states that a series LLC is a distinct legal entity, 8 the statute remains silent on the entity status of the individual series. As of the date of this article, there is virtually no case law to consult for clarification. In the only opinion that seems to shed any light on the matter an unpublished opinion (slip copy only) by a Maine federal magistrate judge interpreting the Delaware LLC statute the magistrate stated that, in the context of the facts at issue, I do not find that [the series in question] was an entity at all, but merely a series of interest of [the parent LLC]. 9 This lone voice in the wilderness of authority certainly hinders the argument that the series should be treated as a separate entity, but the precedential value of the case may be limited. Whether or not a series is a distinct legal entity having all the rights and obligations attendant to such status remains an open question, yet to be definitively resolved by the courts in Delaware or elsewhere. Creditors Rights and Bankruptcy The discussion above relating to whether or not a series is a distinct legal entity may have some bearing on another set of unresolved questions concerning the series LLC: how does Article 9 of the Uniform Commercial Code apply to the series LLC, and how should the series be treated in bankruptcy? The most fundamental question is how a putative secured creditor can perfect a security interest in an asset held by a series, i.e. which entity is the debtor for purposes of filing a financing statement? For example, what if Christopher takes out a loan in the name of Series S, in order to redecorate the captain s berth in the Santa María? If Christopher fails to make timely payments on the loan, the lender should be limited to recourse against the assets of Series S only. Assume, however, that the lender takes a security interest in all assets of the borrower to secure the loan. Even if the loan documents specify that Series S is the borrower, Bluto and Popeye should be prepared for the possibility that a court might interpret that blanket security interest as reaching all the assets of Voyager LLC, especially if the lender is in a jurisdiction that doesn t recognize the series LLC. Turning to the law of bankruptcy, for a specific series to file a petition in bankruptcy apart from the other series or the parent LLC, it would need to be considered a person under federal bankruptcy law. 10 The Bankruptcy Code definition of person includes an individual, partnership, or corporation. 11 No one knows whether one or more of those categories could be construed to include a series, meaning that series and their stakeholders may not be able to avail themselves of the protections offered by the bankruptcy process. After Christopher defaults on the loan used to redecorate the Santa María, would Series S be permitted to file a petition in bankruptcy? If so, would the automatic stay apply to Series S only or to the other series of Voyager LLC and Voyager itself? Similarly, it is unclear how the various constituents of a series LLC should be represented in a bankruptcy case. Would Bluto and Popeye be adverse parties entitled to separate representation from each other, Christopher, and Voyager LLC? What voting rights, if any, would series owners have in a bankruptcy case? What risks to the LLC members, series owners, and the series assets would be posed by the laws of substantive consolidation and fraudulent conveyance? Creditors rights would no doubt be heavily weighed in any court analysis of these issues. It should be noted in this context that the Delaware LLC statute does not require notice filings when a series is formed, nor does it require other types of notice to third parties regarding the series structure, or identification of the assets that may be segregated in various series. This lack of notice is likely to take on enhanced significance if a dispute involves the law of a non-series jurisdiction. Management Another unresolved question bearing significant risks to clients interested in the series LLC has to do with the management rights and obligations associated with a series. The Delaware statute provides that [a] limited liability company agreement may establish or provide for the establishment of one or more designated series of members, managers, limited liability company interests or assets. 12 Presumably, this means that a series, as well as the parent LLC, may have a manager or managers. If Christopher is the manager of both Series N and Series S, would he be subject to a claim for breach of duty of loyalty if he leases the Niña to Series S for less than fair market value? Although it is possible to speculate that duty of loyalty and conflict of interest questions involving a series manager would be handled similarly to the way they would be handled between separate LLCs with shared managers, clients are unlikely to wish to become the test case for such a theory. F A L L m a i n e b a r j o u r n A L 2 2 9

5 Similarly, we don t know what happens when a member of a series opts to withdraw from the series. If Christopher withdraws from Series N, would he be required to forfeit any rights in Series P or S, or in Voyager LLC? Securities Securities transfer, registration, and disclosure requirements for series LLCs are yet another unresolved area of law. The lack of clarity surrounding the entity status of the series as compared to the parent results in a number of questions. Do ownership interests in a series constitute a security separate from ownership in the parent for federal securities law and Blue Sky purposes? Rule 12d1-1 of the Securities Exchange Act of 1934 suggests that securities of a series (if that is what ownership interests in a series are) would not be covered by the registration of the parent s securities if the securities of the series have different terms from the parent. However, assuming the terms of the securities are the same, if Voyager LLC files a Form D with the SEC, could Christopher sell interests in Series S in reliance on Voyager s Regulation D exemption? Compliance with federal and state exemption rules in the event of transfers of series interests could be extremely complex. In addition, it seems nearly impossible for a putative issuer to provide the necessary disclosure of material risks to a prospective investor given all of the unresolved questions associated with the series LLC structure. Taxation Series LLCs present significant tax risks as well, as it is not clear which among the constituent parts of a series LLC is the taxpayer: the parent, the series, or some combination. The characterization of a series in an LLC for tax purposes has not yet been established by the Internal Revenue Service, 13 although the IRS has ruled in one instance that each series of a series LLC will be characterized as a separate business entity. 14 It should be noted that whether an organization is a separate entity for federal tax purposes is a matter of federal tax law, not state law. 15 Thus, although earlier in this article we explored the question of whether a state treats a series as a separate entity for various purposes, the answers to those questions would not be controlling for federal income tax purposes. The IRS may one day rule that each series of a series LLC formed under a particular jurisdiction s LLC statute (for example, Delaware) should be a separate business entity for income tax purposes. In making such a ruling, the IRS may draw support from the fact that the Delaware series LLC resembles in material ways several series business structures in which each series is treated as a separate business entity for federal income tax purposes. The first such structure is the series investment trust. In the National Securities 16 case, the Tax Court held that each series of a single investment trust was a separate entity for federal income tax purposes. A few years later, the IRS issued Revenue Ruling , 17 confirming the National Securities holding. The series LLC also resembles a regulated investment company with more than one fund. Under Internal Revenue Code Section 851(g), each of the funds (a series fund) of a regulated investment company is treated as a separate corporation for tax purposes. Finally, the IRS has proposed that divisions of insurance corporations called Protected Cell Companies, which resemble series LLCs in that each cell contains segregated assets and liabilities, will be treated as separate tax entities if they have certain characteristics. 18 While the Series LLC structure is superficially similar to these other structures, there are also differences that may lead the IRS not to treat the series as a taxpayer. It is possible that series would not be considered separate entities if it is the case in a given series LLC that each series is owned by the same persons in identical shares. In such an arrangement, the structure could well be characterized as one tax partnership. This outcome would not be possible in a regulated investment company (an entity qualifying under Subchapter M and classified as a corporation), structure, a Protected Cell structure, or an investment trust structure. So, while it seems the IRS and some other taxing authorities have issued some rulings 19 that indicate that each series of a series LLC will be treated as a separate entity for tax purposes, and the series LLC structure is superficially similar to other business structures in which each series is treated as a separate business entity, it would be unwise to assume that such a ruling would apply in every case. The rulings cannot be cited as precedent, and differences in state law or business structure may make reliance on the rulings and comparisons to other business structures inappropriate. If the IRS determines that a series is a separate business entity, the series will be characterized under the check the m a i n e b a r j o u r n A L F A L L

6 box regulations. 20 Under those regulations, a single-member entity can choose to either be disregarded for federal tax purposes, or treated as an association (i.e. a corporation). If the entity has two or more members, it can elect to be treated as a partnership or an association. If the entity fails to make an election, it will be treated either as a disregarded entity (if a single-member entity) or a partnership by default. 21 On the other hand, if the IRS determines that a series is not a taxpayer, the parent LLC will file a return and treat the tax items of the underlying series as its own. In either case, whether each series is treated as a separate entity or not, the business structure presents challenging tax planning, drafting, and compliance issues. If each series is treated as a separate entity, any transfers of property or cash between the series would have tax consequences, implicating Internal Revenue Code sections 704(c) (contributed property), 707(b) (gain or loss on transfers to controlled partnerships), 731 (gain/loss on distributions), 737 (gain or loss on distributions of contributed property), and others. For example, if Christopher and Bluto agree to transfer one of the Pinta s cannons from Series P to Series S, for use on the Santa María, the transaction would be treated as a distribution from Series P to Christopher. It s possible that this transaction would be of no immediate income tax consequence under Code Section 731, which generally treats interim distributions of property as nontaxable to the transferee. 22 However, if Bluto had originally contributed the cannon to Series S when its fair market value exceeded Bluto s adjusted basis in the cannon, and if the distribution of the cannon occurred within seven years of the date of Bluto s contribution, Bluto (not Christopher) will realize gain on the distribution equal to the amount of built-in section 704(c) gain in the property at the time of the contribution. If the parent LLC is the only entity for tax purposes, careful attention would need to be paid to allocation and distribution provisions to ensure compliance with the substantial economic effect rules of Internal Revenue Code section Conclusion In concept, the series LLC model has much to recommend it. Clients would surely be interested in an entity form that allows them to segregate assets, liability, management, and ownership rights, all within a single business structure. Unfortunately, as a closer analysis reveals, the risks of the series LLC far outweigh its possible advantages. Chief among these risks are its uncertain promises of liability segregation, administrative ease, and cost savings. We suggest that general practitioners use caution if they decide to suggest the formation of a series LLC in order to meet the client s desire to separate assets and ownership. 1. An LLC Act drafting committee of the Maine State Bar Association is reviewing several LLC statutes and model acts to produce a draft revised LLC Act for Maine. The authors are members of this drafting committee. 2. For convenience, we describe the series LLC in this article as having a parent, and series that underlie the parent. However, certain commentators have suggested that this description is misleading, as the parent may not exist for tax or other purposes, and in any case it s not clear that the parent is an entity with superior ownership of the series, as this terminology implies. The Delaware series LLC statute (6 Del. Code Ann. Tit ), upon which most of the other series LLC statutes are based, uses the terms the series and the limited liability company generally. 3. Each series must provide for its own allocations, distributions, management provisions (including those relating to fiduciary duties, exculpation, and indemnities), and member access to information. In the absence of these provisions, such terms are left to the applicable LLC statutes and/or common law. So, the potential savings on document drafting may not be that great, unless each series expressly adopts uniform provisions applicable to all series of an LLC. 4. GxG Management LLC v. Young Bros. and Co., Inc., 2007 WL (D.Me.). 5. Del. Code Ann. Tit (b). 6. Id. 7. Del. Code Ann. Tit (c). 8. Del. Code Ann. Tit (b). 9. GxG Management, LLC v. Young Bros. and Co., Inc WL (D.Me.) (order on motion to amend judgment in GxG Management LLC v. Young Bros. and Co., Inc., 2007 WL (D.Me.)) U.S.C. 109(a) U.S.C. 101(41). 12. Del. Code Ann. Tit (a). 13. The determination will actually be made by the IRS chief counsel s Pass-Throughs and Special Industries branch and the Treasury Department s Office of Tax Policy. 14. Internal Revenue Service Private Letter Ruling Treasury Regulations (a). 16. National Securities Series-Industrial Stock Series v. Commissioner, 13 T.C. 884 (1949), acq C.B Revenue Ruling , C.B Revenue Ruling , I.R.B. 266 (February 4, 2008). 19. The Massachusetts Department of Revenue issued a letter ruling (Letter Ruling 08-2) on February 15, 2008, holding that each series of a Delaware series LLC will be separately classified for Massachusetts income tax purposes in accordance with its federal classification. It is quite likely that IRS PLR was issued to the same taxpayer that obtained Letter Ruling Perhaps less noteworthy because it does not relate to income taxes, the California Franchise Tax Board treats each series of a foreign series LLC (California law does not permit the formation of series LLCs), as a separate LLC for franchise tax filing and assessment purposes. 20. Treasury Regulation Treasury Regulation (b)(1). 22. Christopher may realize gain under Code section 737 if he contributed section 704(c) property to Series P within the 7 year period ending on the date of the distribution. 23. See Treasury Regulation (b)(1)(i). F A L L m a i n e b a r j o u r n A L 2 3 1