Planning With LLCs
LLCs Offer Asset Protection, Business Flexibility, and Tax Advantages
By Jacob Stein, Esq
the time limited liability companies came into prominence,
practitioners have been working to maximize their asset protection,
business flexibility and tax advantages, among other benefits.
Liability protection is a main
reason for forming an LLC. The LLC protects the members from lawsuits
directed against the entity [California Corp. Code Sec. 17101(a)] and
protects the assets within the LLC from lawsuits against the members.
This is often called an outside-in versus inside-out asset protection.
Protection of the
entity’s assets from lawsuits against the members, afforded by the
so-called charging-order, is an advantage LLCs have over corporations
[California Corp. Code Sec. 17302(a)]. Corporations offer liability
protection only if the lawsuit is directed against the entity, not if
it’s directed against the shareholder.
charging order limits the creditor to an economic interest in the LLC
without transferring the membership interest or any control over the
entity to the creditor. As a result, the creditor often receives
phantom income—no cash is distributed to the creditor, but income is
allocated to the creditor for tax purposes.
California statutes extend charging-order protection to all LLCs,
whether multi-member (more than one person or entity holds a membership
interest) or single-member [California Corp. Code Sec. 17302(a)], be
aware that one court has found that charging orders do not apply to
single-member LLCs [In re Albright, 291 B.R. 538 (Bankr. D. Colo.
with single-member LLCs that want to maximize the protection of the
entity’s assets from lawsuits against the sole member should consider
adding members. The new members must have a capital interest in the
LLC, but not necessarily a profit interest [California Corp. Code Secs.
17001(x) and (z)].
LLCs set up by family members, a so-called poison pill provision should
be considered. This provision usually allows either the LLC or other
members to buy out the debtor-member for a nominal amount.
poison pill has the effect of substituting the debtor-member’s
membership interest with a nominal amount of cash, which limits the
assets a creditor can collect against. In some cases the provision
eliminates the need for charging-order protection, which is
particularly effective when the LLC is holding depreciable real estate
and is passing through losses.
charging-order protection is critical for businesses with valuable
assets, such as real estate, significant accounts receivable, contracts
or intellectual property. Service businesses, such as consulting firms,
generally have no assets to protect, and the charging-order protection
is less critical.
corporations, LLCs generally protect owners from lawsuits directed
against the entity. But the assets within the entity are not protected
from such lawsuits and the creditor of the LLC may be able to reach the
rather than place all assets in one LLC, practitioners usually advise
clients to form multiple LLCs, placing a single asset in each LLC.
structure works well for a client who owns a couple pieces of real
estate or other business assets, for example. But for a client with
many assets, the fees and costs of setting up dozens of entities add up
quickly. In these cases, Delaware Series LLCs are a creative solution.
Delaware law, a single LLC can have assets placed within separate
series (akin to compartments) and 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. [Sec.
18-215, Delaware Limited Liability Company Act].
addition to the liability limitation, Series LLCs offer the added
flexibility of having different managers and members in each series.
For federal and California tax purposes, practitioners can choose
whether to file one tax return for all series or a separate return for
each. In practice, a single return is filed and each series is tracked
solely from a bookkeeping standpoint.
The frequent question from clients and practitioners is: Does California recognize Series LLCs? The short answer is yes.
California Corp. Code Sec. 17450(a), 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.
Foreign refers to any jurisdiction other than California, including other states.
This would indicate that Delaware law applies to a Series LLC registered in California.
The benefits of a Delaware Series LLC can be seen in the following example.
client with 40 parcels of real estate in California, each owned through
a separate LLC, would have to pay $32,000 a year in California minimum
franchise taxes, significant legal fees varying and tax return
preparation fees for 40 partnership returns.
Using a Series LLC, that same client can reduce its California franchise tax to $800.
the client’s LLC has 40 series, with each holding a separate real
property parcel (and each separate from the rest for liability
purposes), only one LLC is registered in California. Further, only one
LLC agreement needs to be drafted and only one return needs to be filed.
all 40 properties are 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 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.
parcel of real property is then titled into a specific series of the
LLC. Each series would have separate books and bank accounts.
If a business is exposed to risks
and liabilities, so are its assets. For example, Tireco Inc. owns a
patent to, and manufactures and sells, the world’s most amazing
automobile tire. If one of its tires ever disintegrates, the lawsuit
will be directed against the company, as it is the manufacturer and
If the lawsuit is
successful and exceeds the insurance coverage, it would reach Tireco’s
assets—including the valuable patent—and possibly place Tireco in
solution is to manufacture and sell the tires and form another LLC,
owned by Tireco’s shareholders, to own the patent, with a
non-assignable licensing agreement between the two entities. This way,
the creditor can’t reach the patent if there is a lawsuit against
can see how 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.
tax minimization, if the LLC is taxed as a partnership, where it is
formed is irrelevant to a member residing in California, which taxes
any resident member on its allocable income.
If the LLC is
taxed as a corporation, Nevada may be a good choice, but only if the
business is located there or has no easily ascertainable physical
location, such as an internet-based business. Keep in mind that a
Nevada corporation doing business in California will always be subject
to California taxes.
a tax-planning standpoint, many foreign jurisdictions (such as the
Caymans or Nevis) should be considered for LLCs taxed as corporations.
are many reasons for picking one jurisdiction over another. For
example, California does not allow anyone licensed under the Business
and Professions Code to practice their profession through an LLC, while
some other states allow that.
LLCs may be taxed as corporations,
partnerships or disregarded for tax purposes. In practice,
single-member LLCs usually are disregarded, whereas multi-member LLCs
generally are treated as tax partnerships.
Since LLCs are
usually tax partnerships, contributions and distributions are generally
tax-free and the partnership tax planning opportunities abound. LLCs
can be used to structure leveraged partnerships and tracking allocation
transactions, generate multiple losses and strip basis on distributions
also make it easier to allocate non-recourse loans to all members and
plan for deficit capital account exit strategies.
short, LLCs taxed as partnerships offer all the tax advantages of
limited partnerships, no general partner exposure and none of the
corporate tax disadvantages.
California, spouses who own LLC interests as community property and are
the only members, can choose whether the LLC will be treated as a
partnership or a disregarded entity for income tax purposes (Rev. Proc.
2002-69). This makes it easier for spouses who own real estate through
a disregarded LLC to complete Sec. 1031 exchanges, as there is no risk
that the real estate interests will be reclassified as partnership
clients have existing businesses that are organized as corporations and
are looking for the charging-order protection of the LLC. If the
corporate exit tax is too high the corporation may be kept in place and
an LLC (preferably multi-member) substituted as the sole corporate
shareholder. While tax problems remain, the client has charging-order
the corporation has made an S election, then the top-tier LLC should be
a disregarded entity, which means it either has only one member or a
husband and wife are holding membership interests as community
property. Either structure minimizes the charging-order protection
that case, an LLC formed in a foreign jurisdiction and elected to be
treated as a disregarded entity, would offer the client tax neutrality
and a better degree of asset protection. It is likely that some foreign
jurisdictions would offer more charging order- protection to
single-member LLCs than domestic states.
alternate solution is to form a new LLC, elect to tax it as a
corporation (even making an S election if necessary) and merge the
existing corporation into the LLC. From a tax standpoint, the
transaction is treated as a tax-free reorganization, and from a
liability standpoint, assets are now owned by an LLC providing
are circumstances when corporations are the right entity for tax
reasons. If that’s the case, and the charging-order protection is still
desired, the solution would be similar to the one above––form an LLC
and elect to tax it as a corporation. This results in corporate tax
treatment for federal and California tax purposes, and LLC treatment
for asset protection purposes.
are just some of the benefits of LLCs, which have quickly become the
default entity of choice of practitioners for everything from tax
planning to estate planning to asset protection.
Jacob Stein, Esq.is
a certified tax law specialist and partner with Boldra, Klueger &
Stein, LLP in Los Angeles. He also is an instructor with the California
CPA Education Foundation. You can reach him at firstname.lastname@example.org.
©2005 California Society of Certified Public Accountants. For reprint permission, contact Aldo Maragoni, communications manager.