Series LLCs in business and tax planning.

• Author: Walberg, Glenn
• Position: Limited liability companies

With the advent of series limited liability companies (LLCs), businesses face more options and complexity in making choice-of-entity decisions. Eight states currently authorize series structures for LLCs; (1) however, series LLCs have been used infrequently due largely to uncertainty about what protection they provide against liabilities and how they are treated for tax purposes. Despite these present uncertainties, series LLCs hold promise as favorable entities for business and tax planning.

Guidance about the classification of series LLCs is on the IRS's business plan. If such guidance reduces uncertainty about their tax treatment, more states might adopt series LLC legislation and correspondingly reduce uncertainty about their liability protection. Therefore, practitioners should familiarize themselves with current planning opportunities and issues related to series LLCs in anticipation of heightened interest by clients as the federal and state governments explore these entities.

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Series LLCs

A series LLC is a "master" LLC with one or more series of members, managers, interests, or assets. Although contained within the master LLC, each series can have separate rights, powers, and duties with respect to specific property and liabilities and can have separate business purposes and investment obiectives. The series may also have common members with identical ownership interests, common members with varying interests, or different members with unrelated interests--one series could even own an interest in another series. Accordingly, it is possible for each series to function as the equivalent to a freestanding legal entity such that a series, depending on state law, could contract, own property, and sue or be sued in its own name. For example, a retail furniture store that offers Customer financing could place the retail operations in one series and the financing operations in another series within a single master LLC. The retail operations series and the financing operations series could then each have separately identifiable owners, managers, assets, liabilities, and business purposes.

The eight states with series LLC legislation envisioned that, with properly established and maintained series, creditors could enforce the liabilities of one series only against the assets of that series. The assets of the master LLC and any other series would remain outside the reach of such creditors. A series structure thus helps wall off assets and liabilities within a master LLC. In the context of the example above, a series structure could prevent a furniture manufacturer, which might seek payment for goods delivered to the retail operation series, from enforcing a retail-related liability against the assets of either the master LLC generally or the financing operation series specifically.

The use of series within a single LLC offers commonly perceived advantages over the well-established practice of forming multiple legal entities to segregate as sets and liabilities. First, depending on a state's filing fees, the costs to organize and maintain a series LLC are often less than comparable costs for multiple entities. Second, a series LLC might require fewer unique organizational documents than multiple entities, particularly where the series have common members with identical interests. Finally, an LLC might find it easier and quicker to add a new series than to organize an entirely new entity. These economies of scale advantages might encourage the placement of real estate parcels, for example, in series of an LLC rather than in separate legal entities, such as multiple LLCs under an LLC holding company.

Liability Concerns

Despite those potential advantages, many advisers hesitate to recommend series LLCs due to their uncertain ability to contain liabilities within a series. An LLC generally provides a good external shield between the LLC and its members. Like a corporation, an LLC provides inside-out asset protection insofar as a creditor of the LLC (inside) generally cannot seek satisfaction of a liability from the members (outside). Unlike a corporation, an LLC also provides outside-in asset protection such that restrictions on the transferability of LLC interests generally limit creditors of members to taking an economic interest in distributions from an LLC. With a mere economic interest, a creditor cannot force distributions from an LLC, so the assets of the LLC (inside) remain protected from the liabilities of its members (outside). Because states authorized series LLCs by amending their existing LLC statutes, a series LLC and its members should similarly enjoy the benefits of an external shield relative to that series.

Greater uncertainty surrounds a series LLC's ability to construct internal shields between series or between a series and its master LLC. As noted above, the series LLC legislation intended to restrict the reach of creditors of one series to assets of that series. Regardless of that intention, courts might refuse to respect the internal shields and permit creditors to recover from assets of any series or the master LLC. This prospect of ineffective internal shields makes advisers wary of series LLCs.

Respect for Internal Shields

Courts in states with series LLC legislation presumably will respect internal shields. Given that the legislatures in Delaware, Illinois, Iowa, Nevada, Oklahoma, Tennessee, Texas, and Utah prescribed internal shields, (2) courts in those states generally should respect them. Such courts might nevertheless be amenable to (1) disregarding the shields for improperly formed series and series unable to account for their assets or (2) piercing internal shields where necessary to achieve justice, such as for inadequately capitalized series. Accordingly, the formation and maintenance of a series structure requires an exercise of reasonable diligence. Unfortunately, many business owners attribute informality to LLCs and are unaccustomed to maintaining documentation, such as records to substantiate the assets attributable to a particular series. These owners and their advisers must recognize that adherence to series LLCs formalities--akin to the demands placed on corporations--is necessary to achieve protection from internal shields in any state.

For many advisers, a more significant question exists about whether courts in other states will respect the internal shields of series LLCs. A series LLC organized in one of the states with series LLC legislation could foreseeably face claims of creditors in other jurisdictions. For example, a series LLC duly organized in Delaware could face a personal injury lawsuit from the activities of a series in North Carolina. Whether a North Carolina court would respect the internal shields established by Delaware law raises an unresolved choice-of-law question, which could affect an adviser's choice-of-entity recommendation.

The Internal Affairs Doctrine

A determination of applicable law will likely reflect the internal affairs doctrine, which developed to resolve state law conflicts relative to corporations. The doctrine basically states that the laws of an entity's state of organization will govern the entity's internal affairs. (3) In a corporate context, the doctrine has been understood to govern relationships between management and shareholders as well as to establish a shareholder's limited liability for a corporation's debts. The doctrine seems well justified for disputes between management and shareholders, given that they voluntarily consented to the relationship under the laws of the state of organization. The doctrine seems more questionable for third-party claims against shareholders due to the often involuntary nature of such claims, yet the doctrine's application remains firmly established in the corporate context under case and statutory law.

States have codified aspects of the internal affairs doctrine in their LLC statutes. North Carolina statutes (like other state statutes) provide that in the example above, the laws of Delaware would govern the internal affairs of the...