LLC LAW UPDATE 36th Annual Gulf Coast Estate Planning Conference September 22, 2015 John Johnny F. Lyle, III Adams and Reese LLP 11 North Water Street, Suite 23200 Mobile, Alabama 36602 251-433-3234 johnny.lyle@arlaw.com
TABLE OF CONTENTS I. HISTORY OF THE LIMITED LIABILITY COMPANY... 1 A. Background... 1 B. Wyoming and Florida Legislation... 1 C. Revenue Ruling 88-76... 1 D. Jurisdictions Adopting Legislation... Error! Bookmark not defined. II. DIFFERENCES BETWEEN THE ACT AND PRIOR LLC LAW... 2 A. Introduction... 2 B. Application... 3 C. Definitions... 3 D. Rules of Construction... 4 E. LLC Agreement; Scope; Function; and Limitations... 4 F. LLC Agreement; Effect on Third Parties and Relationship to Writings Effective on Behalf of LLC... 5 G. Formation... 5 H. Power to Bind Limited Liability Company... 6 I. Sharing of and Right to Distributions Before Dissolution... 7 J. Discretion and Oversight of the LLC... 7 K. Effect of Dissolution... 8 L. Series Provisions... 8 III. 2015 AMENDMENT... 10 A. Internal Affairs Doctrine... 10 B. Use of the Term Partnership... 11 i
C. Wrongful Distributions... 11 D. Applicability... 11 ii
LLC LAW UPDATE I. HISTORY OF THE LIMITED LIABILITY COMPANY A. Background A limited liability company ("LLC") is a hybrid-type entity having features taken from both the corporation and partnership areas. In general terms, an LLC (i) allows the protection of limited liability to its members, (ii) allows active participation in management by its members, and (iii) permits classification of the organization as a partnership for tax purposes. B. Wyoming and Florida Legislation The first LLC legislation was enacted in 1977 in Wyoming. Although the Internal Revenue Service (the IRS ) issued a private letter ruling that an LLC formed under Wyoming law would be classified as a partnership for tax purposes 1, regulations were later proposed to deny classification as a partnership for any entity in which no member had personal liability for debts of the organization. 2 Later, however, the IRS withdrew the proposed regulations to have a special study undertaken as to the proper classification of LLCs. After withdrawal of the proposed regulations, Florida next followed with LLC legislation in 1982, taken primarily from the Wyoming statute. C. Revenue Ruling 88-76 Based on an LLC established under Wyoming law, the IRS ruled, in Revenue Ruling 88-76, that the entity should be classified as a partnership for Federal income tax 1 PLR 810682, Nov. 18, 1980. 2 Prop. Treas. Reg. 301.7701-2, 45 Fed. Reg. 75,709 (1980). 1
purposes. 3 After this ruling was issued, other states began to consider and adopt LLC legislation. D. Alabama Alabama adopted its first LLC legislation in 1993. That Act was amended in 1997 to allow for single members LLCs and some other small changes. The LLC Act was modified again in 2010 when Alabama moved to a hub and spokes system, with the hub being provisions common to all entities, and the spokes being those pertaining to a particular entity type. Most recently, Alabama enacted the Alabama Limited Liability Company Law of 2014 (the Act ), which went into effect on January 1, 2015. The Act was further modified in 2015 with some changes made for technical corrections and other reasons. II. DIFFERENCES BETWEEN THE ACT AND PRIOR LLC LAW A. Introduction The Act was passed in March of 2014. The purpose of the new Act was to make Alabama s LLC law more consistent with partnership law and Delaware s LLC law. One of the primary focuses of the Act is freedom of contract and more reliance on the LLC agreement. Some significant changes, which are discussed in detail below, include the recognition of oral LLC agreements, notice filing as opposed to substantive filing, greater flexibility in the management structure, and the recognition of series LLCs. 3 1988-2 C.B. 370 2
B. Application Prior to January 1, 2017, the Act only governs LLCs formed on or after January 1, 2015, and LLCs formed before January 1, 2015 which elect to be governed by the Act. An LLC formed and existing under the Act may conduct its affairs, carry on its operations, and exercise the powers granted by the Act in any state, foreign country, or other jurisdiction. After January 1, 2017, the Act governs all LLCs. C. Definitions The following definitions in the Act are changed from prior law: 1. Certificate of formation replaces articles of organization. 2. Limited liability company is defined as a domestic LLC only and does not include foreign LLCs. 3. Limited liability company agreement replaces operating agreement. Also, there is a change within the definition from being only a written agreement under the prior law to written, oral, or implied in the new definition. It is now presumed there is always an LLC agreement, which impacts the default rules in the Act. 4. Transfer was added to accommodate the use of the word transfer throughout the Act, which will also be useful to the practitioner due to conformity with other Alabama unincorporated acts. 5. Transferee was added to conform to the usage of transferable interest. 6. Transferable interest was added to replace the definition of financial rights to conform the Act to the Alabama Uniform Limited Partnership Law of 2010. 3
D. Rules of Construction Section 10A-5A-1.06 states that it is the policy of Alabama to give maximum effect to the principles of freedom of contract and to the enforceability of LLC agreements. This section is a very important change to LLC law in Alabama. This follows the Delaware model and gives even more latitude for members to define their rights and obligations. It also puts a burden to make sure the parties explicitly provide for how they want their relationship to be governed. E. LLC Agreement; Scope; Function; and Limitations This Act provides that the LLC agreement governs relations among the members and between the members and the LLC. To the extent the LLC agreement does not otherwise provide, the Act governs. The Act also provides that to the extent a member or other person owes duties to an LLC, that member s or other person s duties may be expanded, restricted, or eliminated by a written LLC agreement; however, the implied contractual covenant of good faith and fair dealing may not be eliminated. A written LLC agreement may also limit or eliminate any and all liabilities for breach of contract and breach of duties (including fiduciary duties) of a member or other person, however it may not limit or eliminate liability for any act or omission that constitutes a bad faith violation of the implied contractual covenant of good faith and fair dealing. This marks a significant change from prior LLC law as to the duties owed by members. The members are now permitted to waive all duties (fiduciary duties included), provided the waiver must be in writing in the LLC agreement. However, it is a common law concept that 4
every contract has an implied covenant of good faith and fair dealing and this implied contractual covenant cannot be waived or limited. F. LLC Agreement; Effect on Third Parties and Relationship to Writings Effective on Behalf of LLC Pursuant to the Act, an LLC agreement may provide rights to any person, including a person who is not a party to the LLC agreement. Prior LLC law did not address whether an operating agreement could provide rights to third parties, but that is now explicitly acceptable. The Act also provides that if a writing has been delivered by an LLC for filing, such as a certificate of formation, and it conflicts with a provision of the LLC agreement, then the LLC agreement prevails as to members, dissociated members, and transferees; and the filed writing prevails as to other persons to the extent they reasonably rely on the writing. Previously, Alabama provided that if there was a conflict between the articles of organization and the operating agreement, the articles controlled. Under the new Act, the LLC agreement controls as between the members, which is a significant change in the law. G. Formation The Act provides that the certificate of formation need only set forth: the name of the LLC; the address of the registered office; the name of the registered agent at the registered office; a statement that there is at least one member of the LLC; 5
if applicable, a statement that the LLC may have one or more series of assets; and any other matters the members determine to include therein. This changes the certificate of formation from one of providing substantive provisions to a notice filing. All substantive provisions are to be provided for in the LLC agreement, not in the certificate. The LLC agreement governs the LLC, and the certificate of formation does not, and thus the drafter is taking a risk by including additional information in the certificate. Placing additional information in the certificate of formation does not enable an LLC to expand, contract, or eliminate the non-waivable provisions governing LLC s that are set forth in the Act. The Act also provides an LLC agreement shall be entered into either before, after, or at the time of filing of the certificate of formation and may be made effective as of the filing of that certificate, or at any other time or date provided in the LLC agreement. Note that the Act requires each LLC to have an LLC agreement and that the Definitions section of the Act allows for oral or implied LLC agreements. This is a significant change from prior LLC law, which provided that an LLC may have an operating agreement. H. Power to Bind Limited Liability Company The Act provides that no person shall have the power to bind the LLC except to the extent the person is authorized to act as the agent of the LLC pursuant to the LLC agreement, to the extent the person is authorized to act as the agent of the LLC pursuant to the Act, or to the extent provided by law other than the Act. This section is new and 6
marks a fundamental shift from prior LLC law. Under the prior LLC Law, certain parties were granted express authority to act for and on behalf of the LLC (e.g. members in member-managed LLC s and managers in manager-managed LLC). This section eliminates any statutorily imposed agency powers that existed under prior LLC law, thus giving the members much more freedom to agree upon appropriate governance structures. Agency powers can arise under the terms of the LLC agreement, by consents of the members, or under the law of agency. I. Sharing of and Right to Distributions Before Dissolution The Act provides that all members shall share equally in distributions made by an LLC before its dissolution and winding up. This is different from the prior LLC law in that the Act does not address profits and losses, but rather addresses distributions. Since LLCs may be taxed in a variety of manners, it was determined to be inappropriate to address profits and losses. J. Discretion and Oversight of the LLC The Act states that the LLC agreement may provide that the activities and affairs of the LLC shall be under the direction, and subject to the oversight, of its members, one or more managers, or such other governance structure as provided in the LLC agreement. The Act further states that if the LLC agreement does not specify who shall direct the activities of the LLC, then the activities and affairs of the LLC shall be under the direction, and subject to the oversight, of its members. This provision of the Act shifts the focus away from management by members or managers and focuses on decision making rather than agency power. The terminology utilized is direct the activities and affairs 7
and oversight, which does not imply the ability to bind the LLC. The drafters purposely avoided the term management, which might imply that the default rule is concerned in some way with the authority to bind the LLC. The Act allows the LLC agreement to continue the traditional member-managed and manager-managed forms of governance, but also allows for much greater flexibility for the members to determine other forms of governance for the LLC. As a result, it becomes very important to set out in the LLC agreement the intended governance structure. K. Effect of Dissolution The prior LLC law s obligation to file articles of dissolution has been eliminated. The Act provides for a statement of dissolution, but the filing of such a statement is optional, rather than mandatory as was the rule under prior LLC law. This change will have the effect of making certificates of existence less meaningful. L. Series Provisions The ability to form a series LLC is now available under the Act. In many respects, a series LLC is similar to the formation of a parent LLC that in turn owns 100% of several other LLCs. However, with a series LLC, only one state law entity is actually formed with the filing authorities. A series LLC has within it multiple cells or divisions which constitute separate series. Each of these cells can operate independently from the LLC itself including holding its own assets and engaging in its separate business. In addition, the debts and liabilities associated with a series may be kept separate from other series and from the LLC itself. The key to ensuring the separateness is for the LLC to be 8
diligent in maintaining separate records such that the assets and liabilities of the series can be reasonably identified and segregated. Each series can also have separate governance structures and may have a different sharing of economic rights. It is important to note that a series does not have separate members; only the LLC itself has members. However, each series can have differing members associated with the series. It is possible that a member may not have any economic interest in the LLC itself other than its association with one or more series within the LLC. The members associated with each series may differ from series to series. One of the advantages of the series LLC is administrative simplicity in creating the structure. For example, only one certificate of formation is filed for the LLC notwithstanding the separation of operations, assets and/or liabilities among the series. However, there are several disadvantages which currently make it difficult to utilize the series LLC structure. One such example is the question of how the series would be treated in states where a series LLC is not currently available. From a liability standpoint, would the separateness of each series be respected or would the series be disregarded and all of the assets and liabilities be deemed to be owned as an integrated whole by the series LLC itself? 4 In addition, there is very little in the way of uniformity among states that do permit series LLCs which creates the potential for problems. Another disadvantage involves the lack of case law to provide guidance with respect to series LLCs. As a result of these uncertainties, it is very important to ensure that the LLC agreements with respect 4 Note the amendment to 10A-5A-1.05 discussed in Article III, Section A below. 9
to the series LLC and with respect to each series provide clear guidance where possible. This makes the formation of the series LLC more time-consuming and, accordingly, more expensive. It is also very important that a robust compliance and internal record-keeping program be implemented. One other area where there is uncertainty with respect to series LLCs involves taxation. The IRS has issued proposed regulations to provide guidance as to series taxation for federal income tax purposes. 5 Under the proposed regulations, each series is treated as a separate entity for federal income tax purposes. As a result, each series can make the same elections that a regular LLC can make i.e. classified as a partnership if there is more than one member associated with the series, to be disregarded if it has only a single member associated with the series, or to be taxed as a C or S corporation. The proposed regulations do not address foreign entities, employment taxes or employee benefit plan issues. Obviously, there are also a number of state tax implications that arise with the series LLC which remain unclear in many instances. III. 2015 AMENDMENT An amendment to the Act (the Amendment ) was signed by the governor on May 14, 2015. The Amendment clarifies certain portions of the Act, as discussed in greater detail below. A. Internal Affairs Doctrine The Amendment addresses the internal affairs doctrine found in 10A-5A-1.05 in order to clarify that an LLC s state of formation controls: 5 Prop. Treas. Reg. 301.7701-1. 10
the LLC s organization and internal affairs; the liability of a member for debts, obligations and other liabilities of the LLC; the authority of the members and agents of the LLC; and the availability and liability of the assets of a series for the obligations of another series. B. Use of the Term Partnership The Amendment clarifies that the use of the word partnership in any chapter or Title of the Alabama Code, other than the Act, the Alabama General Partnership Law, the Alabama Limited Partnership Law, and Chapter 14A of Title 40 (revenue and taxation) includes LLCs. C. Wrongful Distributions The Amendment provides that members are only liable for wrongful distributions under 10A-5A-4.06 to the extent they actually receive such wrongful distributions. D. Applicability Section 10A-5-A-12.01 was amended in order to fix a gap created by the Act. As noted above, the Act only applies to LLCs formed after January 1, 2015, or those formed before January 1, 2015 that elect to be governed by the Act. On January 1, 2017, the Act will apply to all LLCs. The 2010 Business and Nonprofit Entities Code provides that initial members do not have to be listed in the certificate of formation. However, the Act provides that the certificate of formation must state that there is at least one member of the LLC, although the member does not have to be identified. There was concern that when the Act applies January 1, 2017, there will be a requirement that the certificate of 11
formation state that it has at least one member, but for the last five years, many LLCs do not list a member. The Amendment fixes that gap. IV. FUTURE CHANGES 12