Nevada LLC's Book - Asset Protection Law

The limited liability company (LLC) was first used in Wyoming in 1977. Since then it has become the vehicle of choice for businesses asset protection and is widely used for estate planning. LLCs are organized under state statute that:

Create the LLC,
Endows it with a legal existence separate from its members,
Shields all it’s members from personal liability,
Governs the it's operations, and
Determines how and when it will terminate

An LLC is a hybrid between a partnership and a corporation. It combines the corporate advantage of limited liability with the pass-through tax advantage of a partnership. LLC members can participate in management and still have limited liability. LLC profits and losses pass through to the members for taxation purposes.

In Rev. Rul. 95-37, the IRS ruled that an existing partnership may be converted, tax-free, to an LLC (if the LLC qualifies for partnership tax treatment). Such a conversion can be done without terminating the partnership's taxable year (the LLC is simply treated as a continuation partnership) and without need to obtain a new Federal Employer Identification Number.

The LLC is based upon an important principle—the freedom to contract. Members agree among themselves how the LLC is to be run and how the LLC “contract” is to be drafted and that “contract”, if it does not contravene state law will be upheld in court. The operating agreement of an accounting firm in which distributions are based on a formula that looks to client origination, is a different document from that of a real estate venture in which a developer is serving as manager and is receiving an incentive interest. The particulars of the deal in question must be addressed in the operating agreement drafted for that deal. An asset protected LLC should be drafted to:

Remember, the LLC Operating is most important when you and/or the LLC is attacked. It is then that the cleverly drafted language of an Asset Protected LLC shines.

Example: Assume there are five equal participants in an LLC which has $100,000 in it ready to be distributed. If a creditor of your client has a Charging Order (lien) on your client’s membership interests, they, not your client will get the $20,000 (20%) distribution. If this was a family owned LLC, the family could decide to withhold distributions so the creditor would get nothing. But here, the other four Members want their distributions. Can the LLC distribute to the four but not to your client? The answer is; the Operating Agreement is a contract, the following should be drafted:

“Any other provision of this Agreement notwithstanding, the Manager shall not make any distribution of Available Cash or in Kind to a Member whose interest is being charged pursuant to a charging order, or whose interest is otherwise being pursued in a collection action by any third-party. In the event of a charging order or a collection action the Manager is authorized to make all distributions solely to the other Members; provided, however, that the Member whose interest is being charged shall vest in the distribution (i.e., Available Cash shall be distributable to such Member, but shall not be actually distributed until the collection action is terminated).”

An LLC combines the benefits of the FLP with those of a corporation by affording the limited liability of a corporation and the pass-through tax aspects of an FLP, thereby avoiding the double taxation of a C corporation.

Most LLCs are associations of two or more persons who carry on a business and divide its profits.

There is a uniform statute for LLCs. [Uniform Limited Liability Company Act (1996) (ULLCA).] However, the LLC law of each state is different.

In 1997, the IRS issued regulations that allowed an LLC to choose whether it wanted to be taxed as a partnership or a corporation by filing Form 8832 and "checking the box" as to which type of taxable entity it wanted to be. These regulations also allowed one-owner LLCs to be ignored as separate taxable entities for tax purposes. Single person LLCs are taxed as sole proprietorship.

The regulations provide that a newly formed "eligible entity" will be treated by default as a partnership, unless it’s members elect corporate tax treatment. A one-person LLC, will be treated as not being an entity that is separate from its owner, its existence will be ignored unless it’s member elects corporate tax treatment.

Unlike a family limited partnerships (FLPs) where the General Partner can be held liable for damages caused by the FLP, no member of an LLC has personal liability for LLC debts solely as a result of being a member.

The LLCs governing instrument can, but (unlike FLP agreements) do not have to designate persons with management authority. If they do, those persons are called “managers.”

Managers may or may not be members of the LLC, depending on the requirements of the governing instruments and local law. [ULLCA §101(10) (“Manager” means a person, whether or not a member of a manager-managed company, who is vested with authority under Section 301”).]

If no manager is designated, the authority to operate the company is vested in the members. ULLCA §101(11) .“Manager-managed company” means an LLC which is so designated in its articles of organization; ULLCA §101(12). “Member-managed company” means an LLC other than a manager-managed company.

A member owes a duty of loyalty and a duty of care to the other members and the managers. [ULLCA §409 (general standards of member’s and manager’s conduct).]

One-person LLCs are similar to sole proprietorships with a degree of asset protection. [See §10:33, Single Person LLCs—Disregarded Entities.] An LLC with no other members is a “see-through” entity for federal tax purposes unless the member affirmatively requests to be taxed as a corporation. The member files a Schedule C as a sole proprietor with his or her federal income tax return, and uses the name of the LLC on the Schedule C itself. All states allow one-owner LLCs.

A multi-member LLC may have one or more non-managing members and one or more managing members, or all members participate in management, or an outside manager who is not a member, a non-member manager. [ULLCA Comment to §404.]

An LLC may be formed under any state’s law. However, a contract or tort action is usually governed by the law of the place where the act took place.

For example, even though an LLC is established in Nevada, if the interest holders reside outside Nevada, the business is controlled outside of Nevada, and the tort or contract action arose outside Nevada, then the law where the act took place will most likely apply.

However, there is confusion concerning which states’ law will apply, I, as a California lawyer, will in most cases recommend that the client use a Nevada (or Delaware ) LLC. The law is uncertain and the creditor is interested in collecting what is due him. He is not interested in making new law. I believe the Nevada or Delaware LLC will give my clients more negotiating clout.

If a member files for bankruptcy, state law may require that the LLC dissolve unless the Operating Agreement states otherwise. [See ULLCA §601.]

The entity will then be liquidated unless the required percentage of remaining members elects to continue the business. [See ULLCA §802.]

If the members elect to continue, the bankruptcy trustee may be entitled to the value of the estate’s interest.

The bankruptcy court may sell the member’s interest. [See Bankruptcy Code §363 (governing all chapter 11 asset sales, except for sales proposed as part of a reorganization or liquidating plan).] However, the purchaser will be an assignee and not a substituted member. The LLC can continue its business without becoming a part of its member’s bankruptcy proceeding.

Since the entity is not involved with a member’s bankruptcy, the planner may structure the client’s business dealings with the other members in such a fashion that the business is not affected by one of the other member’s financial predicaments.

A bankrupt member’s interest in an LLC is forfeited to the bankruptcy trustee because the operating agreement is not an executory contract. [In re Ehmann, 319 B.R. 200 (Bankr. D. Ariz. 2005).]

Members control the LLC. Generally, state law requires only a majority to liquidate (though the drafter is free to select a higher percentage). [ULLCA §801 (stating that an LLC is dissolved upon the consent of the number or percentage of members specified in the operating agreement).]

An LLC could have two classes of interest, Classes A and B. The holders of Class A might possess 99 percent of the voting power and 1 percent of the equity; the holders of B would possess 1 percent of the voting rights and 99 percent of the equity. Senior family members, even if all they own is a Class A interests, can keep total control and management of the LLC while removing 99% of the LLC from their estate.

An S corporation can have only two classes of stock. The differences between the two classes can only be voting rights. [IRC §1361(b)(1)(D) & (c)(4).]

There are many rules regarding who can be S corporation shareholders. If these rules are violated, the S status terminates and the corporation is taxed as a C.

For example, S stock cannot be held by a foreigner or an LLC or an FLP, or in a trust that is not a grantor trust.

LLCs can have unlimited members, while S corporations are limited to 100 shareholders. [IRC §1361(b)(1)(A).]

You can use an LLC in many of the same situations you would use an FLP. The asset protection aspects of an LLC are similar to those of an FLP. [For more on the asset protection comparisons, see §10:32.]

However, one major difference between an FLP and an LLC is that with an LLC there is no need for a general partner (an individual personally liable for FLP debts). In addition, LLC’s members can actively participate in management without jeopardizing their limited liability.

An LLC allows its members to actively participate in the management of the company without jeopardizing the members’ limited liability. [ULLCA §404; ULLCA §303 (liability of members and managers).]

An LLC eliminates the need for a “general partner” (an individual or entity personally liable for LLC debts and obligations) because members and managers of an LLC are not liable for its debts and obligations unless they are liable by other rules of law. [ULLCA §303 (liability of members and managers).]

• Intentionally does something fraudulent or illegal or reckless that harms the LLC or someone else; or

• Treats the LLC as an extension of himself rather than as a separate legal entity.

If an LLC interest is sold or charged, the assignee does not have the right to participate in management without the consent of other members. [ULLCA §502 (a transferee is not entitled to exercise the rights of a member); ULLCA §503 (a transferee who does not become a member is not entitled to participate in the management); ULLCA §504 (a charging order is the exclusive remedy for a judgment creditor).]

[For more on charging orders, see §§10:100 et seq. For partnerships, see Chapter 9, Family Limited Partnerships.]

The valuation of LLC interests is similar to the valuation of FLP interests. The interests are similarly discounted for gift and estate tax purposes.

However, since LLC members are more involved in management than are FLP limited partners, membership interests most likely will not receive as deep a discount.

Nevada has created a new type of LLC and FLP (herein called “entities”). These new entities are called "restricted", see NRS 86.161. A restricted entity is an ordinary Nevada LLC or FLP that elects to be "restricted" in its articles of organization. This election imposes restrictions on the entity's ability to make distributions. The statute provides that unless otherwise provided in the entities articles, a restricted entity shall not make any distributions to its members until 10 years after the date of formation of the entity. Existing entities can by amendment of their articles become restricted LLC).

The rationale behind NRS 86.161 is Internal Revenue Code §2704(b), which provides that when valuing an interest in an entity for gift tax purposes, the liquidation restrictions contained within the entity’s operating agreement have to be disregarded if the entity is owned by family members both before and after the transfer. Code §2704(b)(3)(B) provides however that a restriction that is imposed by state law cannot be ignored. Nevada believes that these restricted entities will attract estate planners seeking larger valuation discounts for transfers of entity interests between family members. As these restriction can be removed by amending the entity's operating agreement should distributions be wanted, these restricted entities should draw business to Nevada..

• Protect assets from the senior (and junior) family members’ creditors and lawsuits. A creditor, who attaches an LLC’s interest, may be required to pay tax on LLC gains without receiving income from the LLC (a reverse tax shelter). [See Rev. Rul. 77-137.]. These is called the “K-0 by K-1”. The K-1 is the IRS form that tells the “charging” creditor the proportionate amount of taxable income on which he needs to pay tax.

• Shift income out of higher bracket into lower bracket family members’ tax stream.

• Remove assets from the senior member’s estate for estate tax purposes—often at substantially discounted values for transfer tax purposes. NOTE: However, special structuring is required to accomplish this. [See §§10:110 et seq. See Strangi, 115 T.C. No. 35 November 30, 2000 (Strangi I), Estate of Strangi v. Commissioner, T.C. Memo. 2003-145 (2003) (Strangi II), Estate of Strangi v. Commissioner, No. 03-60992, (5th Cir. 2005) (Strangi III).]

• Make transferring LLC interests easier than the members could transfer undivided interests in the underlying assets.

The following drafting suggestions can improve the asset protection aspects of an LLC:

Each holder of a Membership Interest has the right to vote his proportionate interest in the LLC with respect to all matters which all Members have a right to vote under this Agreement or by law.

The term “majority in interest” will mean that more than 50 votes out of 100 votes that may be cast will be determinative of a given matter.

The term “85 percent in interest of the Members” will mean that at least 85 votes out of the total 100 votes that may be cast will be determinative of a given matter.

The term “unanimous consent of all Members” will mean that 100 votes out of the 100 votes that may be cast will be determinative of a given matter.

It is the primary intent of the LLC to retain funds in amounts determined in the sole discretion of the Manager to meet the needs of its business. No Member shall have the right to demand distributions of LLC funds or assets.

The LLC has disclosed, and the Member acknowledges, that the transferability of the Interests are severely limited and that the Member must continue to bear the economic risk of this investment for an indefinite period. These securities are not SEC registered or registered under any state securities law. They cannot be sold unless they are registered or an exemption from such registration is available.

• Both FLP interests and LLC interests are personal property. The underlying LLC and FLP assets are protected from creditor attachment. [ULLCA §201, Comment (stating that members are generally not proper parties to suits against the company).]

• Litigants and creditors of an LLC member or FLP partner may obtain a charging order. [ULLCA §504(a) (stating that a judgment creditor of a member of an LLC may get a charging order).]

• In some states, but not all, the court may order a foreclosure upon the interest subject to the charging order. [Cal. Corp. Code §17302(b) (stating that the court may order a foreclosure on the membership interest subject to a charging order); ULLCA §504 (stating that a court may order a foreclosure of a lien on a distributional interest subject to a charging order); ULPA §703 (stating that a charging order constitutes a lien on the judgment debtor’s transferable interest).] For states that do not allow foreclosure see §10:104, below.

The Uniform Partnership Act forbids an execution sale of a partner’s interest to satisfy a non-partnership debt. [UPA §28.]

This concept, which is the basis of the charging order, is derived from an old English case in which Lord Justice Lindley described the execution sales procedure as follows:

When a creditor obtained a judgment against a partner, the sheriff went to the partnership, seized everything, stopped the business, drove the solvent partners wild. . . . A more clumsy method of proceeding could hardly have grown up.

However, a sole member LLC has no non-debtor members to protect. Therefore, it has been held that the charging order limitation serves no purpose. [See In re Ashley Albright, 291 B.R. 538 (Bankr. D. Colo. 2003) (stating that the result would be different if there had been non-debtor members in the LLC).] Therefore, one-person LLCs can be risky for asset protection and should only be used in certain situations (e.g., (i) to own a personal residence or (ii) be owned 100% by another entity). At the first indication of serious trouble, the LLC will collapse into a more protective entity or be owned 100% by an asset protection trust (foreign or domestic). Using a trust as the owner, leaves the client with no ownership interest his creditor can attach. [For tax aspects of a one-person LLC, see §10:126.]

To avoid the adverse results reached bankruptcy in, In re Ashley Albright, it has been suggested to have a small membership percentage owned by the member’s living trust. Although it would be an easy step for a court to impute that interest to the debtor member, if a single person LLC needs to be used (to hold a personal residence), I see no harm in taking this extra step. However, consider the implications of the following statement by the Albright bankruptcy court:

To the extent a debtor intends to hinder, delay or defraud creditors through a multi-member LLC with "peppercorn" co-members, bankruptcy avoidance provisions and fraudulent transfer law would provide creditors or a bankruptcy trustee with recourse.

A second adverse bankruptcy case was In re A-Z Electronics, LLC, 350 B.R. 886 (Bkrtcy. D. Idaho 2006). The bankruptcy court said:

Where a single member files bankruptcy while the other members of a multi-member LLC do not, . . . the bankruptcy estate is only entitled to receive the share of profits or other compensation by way of income and the return of contributions to which that member would otherwise be entitled.

In this Idaho case the court stated that when a person who is the only member of an LLC files for personal bankruptcy, the bankruptcy trustee steps into his shoes and can exercise management powers over the LLC to the same extent the single member could.

In Olmstead, 2010 WL 2518106 (July 6, 2010), the debtor was the member of a single-member Florida LLC. The creditor sought to attach and sell the debtor's membership interest. Florida’s charging order statute provides that an assignee of a membership interest may become a member only if all of the other members consent. The court ruled that this statute did not prevent the seizure of the member's interest because where there is only one member; there are no other members who can object. Moreover, the rationale for the charging order limitation is not present if there is only one member. When there is more than one member, permitting a creditor of one member to access the assets of the LLC would disrupt the investment and the business of the innocent non-debtor members. [See Brown Janson & Co. v. Hutchinson & Co., supra]. But there are no "innocent" non-debtor members in single person LLCs. It should be noted, that Florida's does not make the charging order the sole remedy.

In Olmstead, the Court of Appeals certified the following question to the Florida Supreme Court: “Whether, pursuant to Fla. Stat. § 608.433(4), a court may order a judgment-debtor to surrender all “right, title and interest” in the debtor’s single-member limited liability company to satisfy an outstanding judgment.” That is, is “reverse veil piercing” permitted. The case's holding is that F.S. 608.433 (4) allows a court to order a debtor to surrender "all right, title, and interest" in the debtor's single-member LLC to satisfy an outstanding judgment, unlike many other states where the sole remedy is a charging order. Although the case was based on a single-member LLC, the cases rationale could extend to multi-member LLCs. The Florida statute is unique and not applicable in most states.

The cases involving bankruptcy courts and single member LLCs revolve around the issue of whether a bankruptcy trustee succeeds to the management rights of the LLC, and therefore, is able to dissolve the LLC and distribute its assets to the bankruptcy estate and make the assets available to pay creditors.

Because of Albright and the trend in the bankruptcy court, if your client needs to use a single member LLC, discuss its potential consequences if he files for bankruptcy or his creditors place him into an involuntary bankruptcy.

Two person LLCs and FLPs are business and investment vehicles. If you place your home therein, you are in effect stating that your home is a business or investment property and, if the protection is to hold up, you need to pay rent. Rent will be non-deductible by you and income to the FLP or LLC, causing tax issues. Single person LLC “disregarded entities” can be used to protect your home without the need to pay rent; they are simply “disregarded” for all but asset protection purposes.

As a home as a personal asset should not be placed into a 2 personal LLC and as there is concern about one person LLC, your home could be placed into a Qualified personal residence trust (QPRT). See Chapter 4 Section ______.

The IRS states that Single member LLCs are to be “disregarded” for income tax purposes. You file a Schedule C (self employment) just like a sole proprietor, yet you may have considerable protection from liability.

Its advantage is simplification of record keeping. You can take money out of your business anytime, you can co-mingle money, and you can avoid filing as a corporation. A disregarded entity generally makes business life easier. You must still document income and expenses and retain documentation to back it up.

The Tax Court issued a defeat to the IRS regarding estate tax minimization using a single member LLC, ruling that a single member LLC is a separate entity for gift tax purposes. A transfer of the LLC in steps that were designed to obtain a minority discount was held to be appropriate. [Pierre, Suzanne v. Commissioner, 133 T.C. No. 2 (August 24, 2009).] Inn the gift tax arena, the one person LLC’s entity envelope should not be disregarded. Gifts of interests in a single-member LLC were treated for federal gift tax purposes as transfers of interests in the entity rather than as transfers of proportionate shares of the underlying assets owned by the single-person disregarded entity.

The IRS argued that, because the taxpayer elected to treat her LLC as a disregarded entity, she was properly treated as transferring undivided interests in the LLC’s assets rather than interests in the LLC itself.

Multi-Member LLCs have many of the asset protection features of a family limited partnership. [For FLPs, see Chapter 9, Family Limited Partnerships.]

LLC creditors can pursue a lawsuit against all of the assets held by the LLC. For this reason, care must be taken to avoid mixing safe assets (stocks, bonds, and cash) with dangerous assets (apartment complexes and businesses).

Sometimes it is advisable to create more than one LLC, or a combination of LLCs and FLPs, to avoid the domino effect that an LLC generated judgment could cause to all the assets held within one vehicle.

For those who do not want to lose even one property, we can use the equity strip technique. Once placed into an asset protected LLC, your creditors cannot take your property. However, your property’s equity can still be attached by those injured by the property itself. Use the equity strip technique to protect your home or other property in depth by removing all equity from the property via a “Lien LLC”.

Procedure to Doubly Protect Your Home. Deed your home to the low lawsuit-prone spouse as his or her Sole and Separate Property. The place the home into a “disregarded” LLC owned solely by the low lawsuit-prone spouse. With a “lien” LLC, we remove all equity from the property. If you are sued, you do not own the house. If your spouse is sued, the LLC owns the home. If the LLC which owns the home is sued, it has no equity; Lien LLC has “stripped” it out.

For this diagram, see “Figure 10-40 Inside Liability-Claims Against the LLC.pdf” in the “Diagrams” folder on your CD.

Neither managing nor non-managing members have personal liability for injury or damages caused by the LLC. [ULLCA §303.] If a creditor prevails against a member, that creditor can not get the member’s assets, but can only charge the LLC membership interest. [ULLCA §504.] The creditor of a member cannot get at the LLC’s underlying assets.

Mark and Judy are married and own a business. They have two children Ron and Rhonda. Mark is in a high risk profession, Judy is a teacher. They put all of their business and investment assets into an LLC in exchange for managing and non-managing interests (these interests were held by each of them as sole and separate property). They then placed a significant portion of their non-managing interests into an irrevocable spendthrifted, discretionary trust for their children.

Several years after the plan was implemented, Mark was sued for professional malpractice and suffered a $10 million judgment. Since Mark’s assets are predominately his LLC interests, the creditor can obtain only a charging order and hope that Mark’s wife will make distributions. If Mark’s wife does not make distributions, the creditor might foreclose on Mark’s interests (if allowed by state law). However, even after foreclosure, the creditor is limited to either waiting for Mark’s wife to make distributions or selling the interest at a considerably . dounted price. In addition the creditor must consider the impact of the “K-0 by K-1” [See Rev. Rul. 77-137].

• California [Cal Corp C §17302 (stating that a court may order a foreclosure on the membership interest subject to a charging order)].

• The Uniform Code [ULCCA §504 (stating that a court may order a foreclosure of a lien on a distributional interest subject to the charging order)]

• Corporate articles of incorporation are LLC “Articles of Organization.” [See §10:53.]

Thus, similar to forming a corporation, formation of an LLC requires filing articles of organization with the Secretary of State. [See ULLCA §§202 & 204.]

• Stronger Asset Protection. A creditor must take additional steps to satisfy a claim against an offshore LLC member. For example, if a Cook Island LLC has a Cook Island manager, the creditor must litigate in the Cook Islands to obtain a court order over the Cook Island manager that directs the manager to distribute LLC assets. The cost of foreign litigation serves as a hurdle for a creditor to overcome.

• Superior Charging Order Protection. For example, in many offshore jurisdictions a charging order is the sole remedy provided, even against a one member LLC. [In contrast, see §10:107.]

• U.S. Assets. If a foreign LLC owns assets located within the U.S., a U.S court could attach those LLC assets for the creditor’s benefit. Since many offshore jurisdictions do not recognize U.S. judgments, should a U.S. court recognize their laws? The foreign LLC should consider holding its movable assets outside U.S.

• U.S. Members. Even if the LLC and its manager are beyond the jurisdiction of the U.S. court system, a U.S. court would have jurisdiction over the U.S. member. As a result, the U.S. court could order a foreclosure sale of his LLC interest. This raises several questions:

An LLC may be formed under any state’s law. Selecting the state may involve the following considerations:

Form the LLC in a jurisdiction that prohibits limited partners from withdrawing capital, except as provided in the operating agreement.

For valuation discount purposes, do not include provisions that make it easier to liquidate the LLC than under state law. [Treas. Reg. §25.2704-2(d) Ex. (3) (1992).]

Consider whether the governing state imposes any out of the ordinary tax on LLC income.

For example, California imposes a gross receipts tax. [Cal Rev & Tax C §17942.] plus an $800 minimum franchise tax, regardless of the size of the LLC. Since this tax is based on gross receipts, the LLC can is taxed even if the business operates at a loss.

Nevada has created a “Restricted” LLC. [See NRS 86.161.] A Restricted LLC is a Nevada LLC that elects to be “restricted” by checking the box in its Articles of Organization. Once checked, statute imposes restrictions and limitations on the LLC’s ability to make distributions. Unless otherwise provided in its Articles of Organization, a Restricted LLC shall not make distributions to its members with respect to their membership interests until 10 years after the date of formation of the LLC, provided the LLC has remained a Restricted LLC.

IRC §2704(b) provides that when valuing an interest in an entity for gift tax purposes, the liquidation restrictions in the LLCs operating agreement have to be disregarded if the LLC is owned by family members both before and after the transfer. IRC §2704(b)(3)(B) provides, however, that a restriction that is imposed by state law cannot be ignored.

Nevada hopes that with Restricted LLCs, it will attract the business of those seeking greater valuation discounts for transfers between family members.

An LLC does not come into existence until the Articles of Organization have been filed.

The Articles of Organization are the founding documents of the LLC. Since the Articles of Organization are the controlling provisions, conflicting provisions in other LLC forms or documents (e.g., the Operating Agreement, member agreements, or LLC resolutions) have no significance.

The provisions that are required in an LLC’s Articles of Organization vary in different states. However, most states require that an LLC’s Articles of Organization contain at least the following information:

• The name and address of a registered agent in the state of filing. This must be a physical address.

• The signature of the Organizer or person filing the Articles of Organization.

Some states also require that the Articles of Organization list the name and address information for each LLC member.

CD10-3 Nevada Article Organization for a sample form and instruction produced by the office of the Nevada Secretary of State for Articles of Organization for an LLC. [See http://sos.state.nv.us/business/forms/pdf/NRS86FormDomesticpk.pdf]

The LLC Operating Agreement is similar to corporate bylaws or a partnership agreement.

In the absence of an Operating Agreement, state law controls. Even with an Operating Agreement, the state LLC act provides default rules defining the rights of members for areas on which the Operating Agreement is silent.

Many states do not require that the Operating Agreement be in writing. However, the Operating Agreement can contain many provisions needed to turn a regular LLC into an asset protected LLC and therefore it should be in writing. [See I. General Points].The LLC Operating Agreement generally contains the following information:

• How new members are admitted, how interests are transferred, and how members are withdrawn.

Most states require that an LLC have a Registered Agent who maintains a registered office within the state of formation. This Registered Office may be at an address that is different from the LLC’s business address (as where the LLC’s business office is not located within the state).

Most often, the client may act as registered agent for his limited liability company. However, the registered agent address as stated in the Articles of Organization must be within the state of formation. If the client does not reside in the state in which his LLC was formed, he must have either a friend or company act as his registered agent in the state where the LLC is filed.. Furthermore, the registered agent address may not be a post office box.

The purpose of the registered agent is to provide potential claimants against the LLC with a designated person who is authorized to receive service of process.

Most banks require a copy of the Articles of Organization and Federal Employer ID Number to open a bank account.

If the LLC’s operations or activities are conducted in a jurisdiction other than the one in which it was formed, the LLC may be required to obtain a certificate of authority from the foreign jurisdiction to do business there. [See ULLCA §1002.]

However, an LLC may not be considered to have transacted business in another jurisdiction unless its activities rise to the level of carrying on a business in that jurisdiction. [See ULLCA §1003 (identifying activities not constituting transacting business).]

Nevertheless, it is advisable to conduct member meetings to be sure that members are in agreement with the LLC’s business.

If the Operating Agreement is silent, state acts provide default rules giving certain rights to LLC members.

Generally, a certain percentage of members have to consent to actions that have a significant effect on the LLC and its members. [See ULLCA §404.]

The LLC should provide a successor managing member in case the managing member dies, becomes bankrupt, or has his or her interest charged or foreclosed upon by creditors.

The Uniform Act provides a list of events that will cause an LLC to be dissolved, including the death, withdrawal, resignation, expulsion, bankruptcy, or dissolution of a member. [ULLCA §801 (noting in a comment that these rules may be modified by an operating agreement).]

One of the critical distinctions between LLCs and FLPs is that the death of a limited partner in an FLP does not cause a dissolution of the entity, whereas in some states (or as provided in the Operating Agreement), the death of an LLC member may cause the dissolution of an LLC.

Unless otherwise provided in the operating agreement, a member may dissociate from a limited liability company at any time. [ULLCA §602(a).]

However, member dissociation is not an event of dissolution of an LLC unless otherwise specified in it’s operating agreement. [ULLCA §603. See §801(a)(1) (dissociation from an at-will company that does not dissolve the company causes the dissociated member’s distributional interest to be immediately purchased under Article 7).]

Even if the operating agreement prohibits dissociation, members are still able to withdraw, but they may be liable for damages to the extent provided in the organizational documents. [ULLCA §602(c).]

For tax purposes, an LLC will be terminated if no part of any business, financial operation, or venture of the LLC continues to be carried on by any of its members. [IRC §708(b)(1)(A).]

State LLC statutes generally provide that on dissolution, the LLC’s business will be wound up and liquidated, unless the business is continued by the vote of the members (or as set forth in the operating agreement or, if the agreement is silent, by a vote of all remaining members. [See ULLCA §802 (LLC continues after dissolution).]

Absent a contrary provision in the operating agreement, a member can assign his interest. [ULLCA §501(b) (providing that a distributional interest may be transferred in whole or in part).]

An assignment doesn’t dissolve the LLC or entitle the assignee to become a member or exercise any management rights. [ULLCA §502 (a transfer entitles the transferee to receive only the distributions to which the transferor would be entitled).]

State laws differ, but generally an assignee receives the same rights as an assignee of a FLP interest would have. That is, the rights to:

The assignee does not have the right to participate in the LLCs affairs unless the other members consent, and the assignee may not be owed a fiduciary duty by the managing member or other members.

Until the assignee becomes a substituted member, the assignor member continues to be a member and therefore exercises all rights and powers of a member, except to the extent those rights and powers are now held by the assignee. [See ULLCA §§502-503. But see IRC §2036(a)&(b) (estate tax deemed ownership rules regarding incomplete gift).]

An LLC is taxed like a partnership and treated like a corporation. Should it want, it can be taxed like a corporation.

A member should use LLC assets only under a rental or lease arrangement. All filings and registrations should be undertaken, a written Operating Agreement entered into, tax returns filed, and the assets of the LLC must not be commingled and treated as if they are assets of the managing member.

In most states, LLCs require fewer formalities than a corporation, so that it is more difficult to pierce the veil of an LLC. In this aspect, an LLC is similar to a “close” corporation, which is able to operate with minimal formalities and is more difficult to pierce.

Nevertheless, there are many formalities with which LLCs must comply. [See, e.g., Cal Corp C §17058 (identifying various records that an LLC must maintain).]

The members of an LLC may be: individuals, corporations, FLPs, custodianships for children, and trusts (foreign and domestic).

Similar to who may be a partner of an FLP, the flexibility of who may be a member of an LLC is quite unrestricted compared to who may be a shareholder of an S Corporation. All S corporation stockholders must be individuals, estates, specifically described organizations, or grantor trusts domestic or foreign. [See instructions for IRS Form 2553 regarding who may elect to be an S corporation.] In 2008, the IRS issued several Private Letter Rulings (200816002, 200816003, and 200816004) to the effect that an S corporation will not lose its "S" status if it has a shareholder that is a single-member LLC, provided that the LLC is a "disregarded entity" for tax purposes (meaning that it has not elected corporate tax treatment) and is owned by an individual.

An individual managing member is not personally responsible for LLC liabilities.

If the assets of the LLC are comprised of “dangerous” assets (e.g., apartment complexes), and if a major mishap occurs with one of these assets, the managing member could not be attacked. However, all of the assets in that LLC would be at risk. [To prevent even those assets from being at risk, see Chapter 12, Techniques & Examples.]

When a corporation is a Managing member, a creditor of a shareholder who attaches the statutorily prescribed percentage of stock, could dissolve or control the corporation. If the corporation was the LLC’s Manager, he could potentially control the LLC.

Donors could give interests to an irrevocable protective trust established for the benefit of family members.

Since the interests given away are usually either non-managing or non-voting interests), the donor maintains control. The donor might still be able to exercise control over the interest given away by appointing a friendly trustee or a friendly protector.

To provide an interest in an LLC to a minor, either of the following forms may be used:

[See Uniform Gifts to Minors Act, and Uniform Transfers to Minors Act. See also IRC §§2503(b)&(c).]

Provide that several “innocent” persons (such as children, aside from the initial husband and wife) be made members of the LLC. A sole member LLC has no non-debtor members to protect. The charging order limitation serves no purpose. However, a court has stated that the result would be different if there had been non-debtor members in the LLC. [In re Ashley Albright, 291 B.R. 538 (Bankr. D. Colo. 2003).]

To prevent the court from holding managing members liable to non-managing members for a financial return on their investment, the LLC Operating Agreement should state that:

• Members will only look to LLC assets for distributions, and repayment of contributions and loans.

• No member shall have the right to hold managers liable upon dissolution of the LLC for these items.

This may be accomplished with the following sample clause in the LLC Operating Agreement:

Members shall look only to LLC assets for payment of any debts or liabilities owed by the LLC to its Members and for the return of Member capital. If LLC assets remaining after the payment of its debts and liabilities to persons other than Members are not sufficient to return the Members’ capital, the Members shall have no recourse against any other Members.

One of the advantages of the charging order procedure is the income tax consequence to the creditor who obtains a charging order. The creditor may find that he does not receive an income distribution, but is required to pay income taxes on undistributed profits. [See §10:102.]

Earnings shall be distributed at least annually, except those funds which, at the sole discretion of the managing members, are reasonably reserved for the conduct of the LLC business.

Since income may be held in the LLC at the sole discretion of the managing member, distributions may be capable of being stopped when there is a creditor with a charging order. However, if distributions have been payable for the past 10 years, will a court permit those distributions to cease solely because a creditor with a charging order has arrived?

The LLC operating agreement could also state that the Members agree that if one Member has a charging order against his interest, then when a distribution is made, his share shall be placed on account with the LLC, vested in the Member, but not payable until after the charging order is removed. [See I. General Points].

Care must be exercised not to be in a situation where a client cannot pay his living expenses or taxes. If no distributions are made to one member, no distributions, without specially drafted understandings in the LLC Agreement, can be made to any member. [See I. General Points].

To lessen this situation, the LLC agreement may provide for a “guaranteed salary” to a less vulnerable managing member. By approval of the majority of the members, this “guaranteed salary” may be increased or decreased.

The LLC operating agreement could also state that the members agree that if one member has a charging order against his interests then, when a distribution is made, his share shall be placed on account with the LLC, vested in the member, but not payable until after the charging order is removed.

To the strictest degree permitted by state law, the operating agreement should not permit a member to dissolve or liquidate the LLC.

If members can dissolve the LLC, it is possible that their creditors may be able to dissolve the LLC, and it is certain that a trustee in bankruptcy will be able to dissolve the LLC.

The LLC shall only be dissolved upon the date designated by the Manager with the unanimous written consent of the Members.

If the member files for bankruptcy, state law may require that the LLC dissolve unless the Operating Agreement states otherwise. [See §10:63.]

Therefore, the Operating Agreement should state that Bankruptcy does not cause dissolution, such as with the following clause:

The LLC can be dissolved only upon the occurrence of an event described in this Article. The filing for bankruptcy by any Managing or non-managing Member will not cause this LLC to dissolve.

However, the transfer rules are very much like the rules that apply to transfers of partnership interests. That is, an assignee only becomes a member if the organizational documents so allow or all members consent. [ULLCA §503 (Rights of Transferee).]

Therefore, the LLC should be drafted so that an assignee cannot become a substituted member without the unanimous consent of all of the members. This prevents a creditor from becoming anything more than an assignee.

No Assignee shall have the right to become a Substitute Member all Members (except the assigning Member) have consented in writing to the admission of the Assignee as a Substitute Member.

In a community property state, if the clients are concerned with the possibility of a lawsuit and do not want one of them being sued and 100% of the LLC’s Membership interests becoming subject to a charging order, they might consider (after discussion of loss of full tax step-up in basis at death) re-title their interests as follows:

This protects against losing both Managing Members and against giving a bankruptcy trustee the chance to try to force the dissolution of the LLC.

Gifting assets directly to the younger generation, and then the younger generation contributing the assets for interests. However, this approach can lose the valuation discount created by transferring LLC interests. [For more on transfers and valuation discounts, see §§10:110 et seq.]

A quitclaim is not advised because it may make it more difficult for the LLC to transfer the property.

Since only business or investment property should be placed into the LLC, LLCs should not be used to protect a personal residence. If a contributor continues to use property (such as a home), then he or she must pay rent to the LLC. Rent is not tax-deductible to the client, but the income to the LLC is taxable. This LLC income then is taxable to the LLC members through the K-1 according to their percentage ownership.

The personal residence can be protected by placing it into a one-person LLC. [For asset protection aspects of a one-person LLC, see §10:33; for tax aspects of a one-person LLC, see §10:126.]

The transfer of tangible personal property should be documented by a bill of sale and the LLC should pay for insurance on these items (as it should pay insurance for each parcel of real estate it owns).

Generally, no capital gain is recognized when an individual transfers appreciated assets to an LLC in return for an LLC interest. [IRC §721(a).] However, this general rule does not apply when the LLC is deemed an investment company. [IRC §721(b).]

The investment company rules were designed to prevent individuals from diversifying their holdings without paying capital gains tax.

[For more on Investment Company Rules, see Chapter 9, Family Limited Partnerships.]

Gain may be triggered if the liabilities assumed by the LLC upon transfer exceed the basis of the property transferred. [IRC §752(b).]

Assets that would otherwise be attractive to creditors are rendered unattractive by transferring them to an LLC in exchange for interests therein. Following the transfers, the transferor owns interests in the LLC rather than the transferred assets.

A judgment creditor’s remedy against a member of an LLC is to obtain a charging order. The charging order directs the LLC that all distributions that would have gone to the debtor-member must instead go to the creditor. After the charging order is issued, the debtor-member becomes a “non-distribution” member and is not entitled to receive distributions or liquidating proceeds until the order is satisfied. Instead, the LLC must deliver to the creditor any money or property that would otherwise be distributed to the debtor-member.

However, if the LLC agreement gives the manager discretion as to when and how much to distribute to the members, the manager may decide not to make distributions when a member has creditor problems. If there are no distributions, then the creditor with the charging order gets nothing from the LLC, but a tax problem [See §10:102, Taxation of “Charging” Creditor.].

The LLC members do not owe a duty to the holder of a charging order because there is no fiduciary relationship between them. The holder of the order is a mere assignee and has not been substituted into the LLC. [See Kellis v. Ring, 92 Cal. App. 3d 854, 859-860, 155 Cal. Rptr. 297 (1979) (assignee cannot bring an action for breach of fiduciary duty).]

The charging order protection to its members will be limited if the following components are present:

[For more on the Charging Order procedure, see Chapter 9, Family Limited Partnerships.]

The key ULLCA provisions regarding the procedure for creditor remedies are as follows:

A distributional interest in a limited liability company is personal property and may be transferred in whole or in part. [ULLCA §501.]

A court may charge the distributional interest of the judgment debtor to satisfy a judgment. [ULLCA §54(a).]

A charging order constitutes a lien on the judgment debtor’s distributional interest. [ULLCA §54(b).]

A transferee (an asignee) is not entitled to participate in management. The only rights of a transferee are to receive the distributions the transferor would otherwise have been entitled to, receive a limited statement of account, and seek a judicial dissolution. [ULLCA §503.]

A purchaser at a foreclosure sale has the rights of a transferee. [ULLCA §704.]

A transferee’s application right may be modified by an operating agreement. [ULLCA §801.]

A court, may also order a foreclosure of a lien on the interest subject to the charging order. [ULLCA §801.]

Although a creditor with a charging order may get no money, he may get something that he does not want: an income tax liability.

Although for state law purposes a creditor is not recognized as a substituted partner, for federal tax purposes a judgment creditor with a charging order in the situation described in Rev. Rul. 77-137, is treated as a substituted partner in place of the debtor. [Note: This ruling concerned a charging order on limited partnership interests. However, the results are most likely the same for LLCs.]

As a result, a judgment creditor of an LLC has the tax consequences resulting from ownership without the capacity to force either the dissolution of the LLC, or distributions from it. Many call this the K-O by K-1. On the other hand, if there is a distribution so that the creditor receives income from the FLP, then the income the creditor receives reduces the amount of the debtor’s debt and the debtor has paid his debt without paying tax because the tax was levied on the creditor. [Rev. Rul. 70-195, 1970-1 CB 265 (payments made to creditors of taxpayer included in taxable income).]

For a creditor to collect from a debtor who has assets in an LLC, the creditor must:

• Finally, if no distributions are forthcoming, apply to the court to foreclose on the debtor membership interest.

Even when the process is completed, the creditor still is not able to attach LLC assets and may find that he is being taxed on income he may never receive.

The following states limit creditors to a charging order (either by statute or caselaw) as their sole remedy against assets held in an LLC. That is, foreclosure is not allowed in:

South Dakota
Tennessee
Virginia

Although there are many benefits to the charging order procedure, LLCs are not the panacea that some believe.

A court may require that a business purpose be a principal purpose for the creation and funding of an LLC. An LLC is a business entity. In the absence of such a purpose, a creditor’s remedy may not be limited to obtaining a charging order. [See In re Turner, 335 B.R. 140, 147-48 (Bankr. N.D. Cal. 2005) (stating that an entity may not be created with no business purpose and personal assets transferred to them with no relationship to any business purpose, simply as a means of shielding them from creditors).]

• The creditor may be less willing to settle on terms favorable to the debtor when he understands that his remedies extend beyond a charging order.

• The charged interest can be sold at a discount, and if the debtor realizes less than the interest is worth, what he realizes reduces the amount remaining owed to him. This means that a substantial portion of the judgment indebtedness could remain post-sale.

• The purchaser will have the right to receive distributions until the LLC is dissolved. A charging order only permits the creditor to receive distributions until the judgment is satisfied.

§10:106 Non-Executory Charging Orders, Bankruptcy, and Operating Agreements

If the member has no duty to perform any service or make any contributions to the LLC, the operating agreement is non-executory and the member debtor could end up forfeiting his membership in a bankruptcy case despite charging order protection.

Furthermore, in order to insure that the operating agreement is executory, the partners should:

It has been held that the charging order limitation serves no purpose with a single member LLC because there are no other parties’ interests affected. [In re Ashley Albright, 291 B.R. 538 (Bankr. D. Colo. 2003) (the bankruptcy trustee became a substituted member; the court stated that the result would be different if there had been non-debtor members in the LLC). See §10:33.]

In re Ashley Albright suggests that the door has been opened to penetration of multi-member LLCs where there are no non-debtor members to protect. The next case may very well be the LLC where the only members are a husband and wife. In that situation, who are the “innocent” “non-debtor” members that need to be protected?

The LLC is a contract, and all members may agree that they do not want to be disturbed by having a bothersome charging creditor disturbing their peace of mind. The members can thus place into their Agreement that the LLC can “redeem” the charged interests.

Purchase or LLC redemption of a charged or foreclosed interest for less than fair market value could be viewed as a fraudulent transfer. Some believe that the LLC Operating Agreement can set out an agreed among the members redemption price. Others believe it is best to wait for a public auction to buy the charged or foreclosed membership interests. I believe that an LLC who’s Operating Agreement contains a price and terms for amembership redemption, will be in a stronger negotiating position then an LLC which lacked such a clause.

A major benefit of an LLC is that the value of the LLC’s assets is reduced for estate tax purposes. [See §10:128.]

Originally, there was little difference between an LLC designed for asset protection and one designed to achieve valuation discounts for estate planning purposes. However, the Fifth Circuit Court of Appeals has provided a ruling favorable to the IRS, declaring that assets transferred to an FLP would be included in the estate at their full value. [Strangi, 115 T.C. No. 35 November 30, 2000 (Strangi I), Estate of Strangi v. Commissioner, T.C. Memo. 2003-145 (2003) (Strangi II), Estate of Strangi v. Commissioner, No. 03-60992, (5th Cir. 2005) (Strangi III).]

Strangi has caused considerable changes to the LLC’s design to be made if valuation discounts are the goal. In many cases, these changes are detrimental to asset protection design goals.

An appraisal is critical to support valuation discounts. Two appraisals are needed:

The first appraisal is an appraisal of the assets held by the LLC. Sometimes these underlying assets themselves can be discounted from their face value. For example, the following might be discounted:

• Non-negotiable note or interest on a note lower than market or under secured promissory notes)

The second appraisal is an appraisal of the individual LLC interests. These interests may be discounted for:

• Other restrictions imposed on the interests by the LLC’s operating agreement.

If the interests that are being appraised have the power to liquidate the LLC, then (subject to any fiduciary duty the holder may have to other members not to liquidate the LLC), the LLC will most likely be appraised at a liquidated value (the value of its assets) rather than a going concern value.

There are rules regarding attribution of ownership that would attribute to members the interests held by other family members for purpose of valuing the interests. [See Rev. Rul. 93-12.]

Property transferred from a living trust, if not first transferred back into the grantor’s name, will be drawn back into the grantor’s estate if the grantor dies within 3 years of making the gift. [PLR 8609005.] This could have disastrous consequences on the manner in which the discount is calculated.

If the appraiser is retained by an attorney (and not by the client), then the work-product of the appraiser may fall within the attorney-client privilege and therefore not be obtainable by the IRS.

Appraisals support reasonable equivalent value for purposes of avoiding fraudulent conveyances to family members who purchase interests to avoid them falling into creditor’s hands.

However, irrespective of the appraisal, such a sale will be suspect because it is to insiders.

The insiders may want to bid for the interests from a public or bankruptcy sale where the price is likely to be lower, and the nature of the sale will cause the price to be less suspect.

Interests that possess voting control may be valued at a premium for estate and gift purposes, even though the value of the voting premium may be offset by the fiduciary duty that the majority owes to the minority holders.

The Chapter 14 Special Valuation Rules [26 USC §§2701 et seq.] were added to combat manipulation of values in family owned business entities.

The anti lapse rules determine whether a gift has been made and the value of the gift when family members control the entity both before and after the lapse. [IRC §§2704(a)(1)&(b)(1).]

Contractual restrictions rules do not apply unless the control exists before the transfer. [IRC §2704(b)(1)(B).] But see §10:25-Valuation and Restricted LLCs

An LLC with more than one member may be taxed either as a partnership or as a C or S corporation. For federal income tax purposes, the classification is determined under the check-the-box rules. [See §10:125.]

The organizer of a multi-member LLC most often wants it to be taxed as a partnership. Others may want it taxed as a corporation as it does have advantages over an actual corporation. The use of a corporate taxed LLC structure may enhance asset protection. A creditor can get a corporations stock. LLC interests can only be charged (and perhaps foreclosed). In addition, the LLC laws permit a more flexible entity than does the corporate form.

For LLCs electing to be treated as partnerships, the FLP income tax rules generally apply. [IRC §6031.]

An LLC files only an information return that reports the items of LLC income and loss, and apportions each item between its members.

Each member receives a K-1. [IRC §6031.] The IRS then taxes each member on that member’s share of gain or loss without regard to whether the LLC has actually distributed cash or property. [IRC §702(a).]

An LLC terminates for tax purposes if there is a sale or exchange of 50% or more of its total interests. [IRC §708(b)(1)(B).]

Gifts, bequests and inheritances, and contributions in exchange for interests are not sales or exchanges under these rules.

Check to see whether your state of organization applies any added taxation to an LLC.

In California, an LLC that is taxed as a partnership must pay an entity level tax based on the “total income” reportable to California for the tax year. [Cal Rev. & Tax Code §17942(a).]

California defines “total income” as worldwide gross income, plus the cost of goods sold, paid, or incurred in connection with the LLC’s business. [Cal Rev. & Tax Code §17942(b)(1).] In 2006, the tax ranged from $900 to $11,790. [Cal Rev. & Tax Code §17942(a).]

A San Francisco Superior Court ruled unconstitutional the Gross Receipts Tax imposed on California LLCs. [Northwest Energetic Services, LLC v. California Franchise Tax Board, CGC-05-437721 (SF Sup. Ct., Mar. 3, 2006).]

The transfer of real property to an LLC can raise issues of triggering “due on sale” mortgage clauses and transfer taxes.

In California, a Proposition 13 issue may be raised if the transfer is not properly structured.

Under Proposition 13, there is a $1,000,000 appraised value exemption to and from the donor’s children. However, Proposition 13 is triggered by a gift of over 50% of an LLC. Thus, a parent may want to gift 51% of a property to the children, then both parents and children contribute their share of the property to the LLC, and then the parents gift the remaining 49% of the LLC to their children. This can be done without incurring a step-transaction concern. [1987 Stats., ch 48 §2.]

Controversy regarding the classification of entities has been eliminated for the most part by the “check-the-box” choice of entity regulations.

These regulations generally permit most non-corporate, non-publicly traded business entities with at least two members to elect for federal income tax purposes to be treated as either a partnership or a corporation. [IRC §7701.]

No election is required to establish an LLC’s status as a partnership. A domestic partnership or LLC with more than one owner will be taxed as a partnership under federal law unless the owners elect otherwise pursuant to the check-the-box rules. [Treas. Reg. §301.7701-3.]

Almost all states allow domestic LLCs and similar entities with two or more members or partners to default into partnership tax status, in conformity with the check-the-box regulations.

Those that do not follow this policy may still apply the four-factor federal entity classification rules in effect before 1997. These factors are: (1) continuity of life, (2) centralization of management, (3) liability for corporate debts limited to corporate property, and (4) free transferability of interests. [See Larson v. Commissioner, 66 T.C. 159 (1976) (noting that an entity needs three out of four corporate characteristics to be taxed as a corporation).]

Unless it elects to be treated as a corporation, a single-member LLC will be treated as a sole proprietorship (a “disregarded” entity for tax purposes).

That is, under the entity classification regulations of the “check-the-box” rules, single-owner pass-through entities are disregarded for federal tax purposes. The assets and liabilities of one-person LLCs are treated as assets and liabilities of its owner. [Treas. Reg. §301.7701-3.]

A husband and wife are able to classify the entity as either a partnership or a disregarded entity, and the IRS will not challenge this classification if the entity is a qualified entity. [Rev. Proc. 2002-69.]

A husband and wife may continue to classify the entity as disregarded even if they transferred all of their interests to a revocable trust. [Priv. Ltr. Rul. 200339026 (June 23, 2003).]

However, if the business entity is owned as part separate and part community property, the choice permitted by Rev Proc 2002-69 is not available.

[See also Rev. Ruls. 99-5 & 99-6 (discussing the federal income tax consequences of a single-member disregarded LLC acquiring a second member, and of a two-member LLC becoming a single-member LLC).]

Non-manager members are generally treated similarly to limited partners, and subject to passive loss rules.

Passive losses are generated by passive activities, such as a trade or business in which the taxpayer does not materially participate. Material participation in an activity must be regular, continuous, and substantial.

Passive losses cannot be used to offset income from wages, dividends, and interest.

It is not clear whether managers will be treated as general partners and, therefore, not subject to the passive loss rules. If not so treated, then they must materially participate in the business of the LLC to avoid the passive loss rules. One way of doing this is participating for more than 500 hours each year. [See Treas. Reg. §1.469-5T(a) (Material participation - temporary).]

The gift and estate taxation and valuation discounts of an LLC are similar to those of FLPs. The IRS applies the same provisions [IRC §§2703 & 2704] to challenge transfer tax valuation discounts for LLC interests as it does to challenge FLP discounts.

However, unlike limited partners, LLC members have voting rights (unless the operating agreement states otherwise). Therefore the discount for minority interest should be less than for an FLP as limited partners have fewer rights than LLC members. Transfers at death should be eligible for discounts.

Audits of FLPs and LLCs are the primary focus for many gift and estate tax IRS attorneys. The IRS theories for attacking LLC valuation discounts are similar to those used to challenge FLP discounts. The primary attack is under the economic substance doctrine, and additional attacks, may be considered under IRC §§2703, 2704, & 2036. [See FSA (Field Service Advice) 200049003 (Sept. 1, 2000).]

Gifts of LLC interests constitute “present interests” and thereby qualify for the gift tax annual exclusion. [Treas. Reg. §25.2503-3(b).]

If parents put additional property into an LLC they must on a proportionate basis receive more LLC interests and then make gifts of those interests in order to take advantage of the present interest gift exception.

Be sure that parents receive an appropriate amount of interests considering the fact that the interests are subject to “discounts.”

If the parents allow all partners to benefit by the additional contribution, they will be making a future interest gift, and will not be able to use the gift tax annual exclusion. [See Treas. Reg. §25.2511-1(h)(1).]

In the alternative, they could make gifts of the property directly to their children (thereby potentially losing the valuation discount), and then all parties could contribute the property to the LLC.

Beware of the “step transaction” doctrine, an IRS argument for frustrating plans of taxpayers. This doctrine permits the IRS to ignore the form of a transaction if it is one in a series of steps in an overall transaction. The doctrine has commonly been applied to transactions that are in form tax-free in order to re-characterize them as taxable sales.

The IRS used the doctrine to treat a two-step transaction, consisting of a taxable stock purchase and a subsequent merger, as an integrated transaction qualifying as a tax-free reorganization. [Rev. Rul. 2001-46, 2001-42 I.R.B. 1.] The ruling demonstrates that the doctrine can be argued either way by the IRS.

Retention of certain powers over transferred interests will render a gift incomplete, and the gift will then be included in the donor’s estate for estate tax purposes. [IRC §§2036-2038 (deemed ownership rules apply if a decedent retains effective ownership or beneficial use or the power to affect enjoyment of the property).]

Leases of property from the LLC must be at a fair market rental and be properly documented. Failure to do so will render the gifts of LLC interests ineffective for estate tax purposes. [See Estate of Du pont v. Comm’r, 63 TC 746, 761-766 (1975).]

A managing member who gifts interests but retains the income from the gifted interests will find that the interests are still in his estate.

Similarly, if interests are transferred, but the managing member takes a large management fee, the IRS may consider the fee to be a disguised payment of income from the transferred interests. [See IRC §2036(a)(1).]

A disadvantage of an LLC is that, unlike an S corporation, all earned income of an LLC is subject to self employment tax.

With an S corporation, some of earned income can be paid as dividends and no self employment tax is due. This can prove to be a disadvantage when using the LLC as an operating business.

Proposed IRS 1997 regulations (which have never been finally adopted) would have treated members of an LLC like limited partners in a limited partnership, so that certain members of an LLC would not be subject to self-employment tax on their distributive share of earnings from the LLC.

An LLC can shift income from a high-income wage earner to children, grandchildren, parents, or other family members in a lower tax bracket. [See IRC §704(e)(1) (stating that a person is a partner whether or not the interest was derived by purchase or gift).]

Caveat: The current Kiddie Tax affects children under 19, and dependent full-time students under 24.

For this diagram, see “Figure 10-130 LLCs Can Shift Income to Lower Tax Brackets.pdf” in the “Diagrams” folder on your CD.

Some of the ways to shift income to an entity and, in effect, to children and parents, are:

• The LLC may lease equipment to businesses or professions owned by the parents.

• Other income producing property or assets may be transferred from the parents to the LLC, thus shifting the income to the entity and, in effect, to the children or others who are in a lower tax bracket.

Grantor Retained Annuity Trusts (GRATS) and LLCs

A GRAT is one of the most powerful and tax efficient wealth transfer tools available today. A GRAT allows a person to share the future appreciation of an asset with the next generation with virtually no gift tax. A GRAT is a trust with a specific life or term, i.e., 5 years, 10 years, etc. The grantor transfers assets to the GRAT and retains an interest in the trust. This income interest will be stated as an annuity percentage of the original assets transferred to the GRAT. Each year the GRAT will pay the grantor the required payment. At the end of the GRAT term, any remaining assets will be distributed to the named beneficiary or beneficiaries. The gift will be calculated using the subtraction method. The present value of the annuity payments to the grantor will be subtracted from the original value of the assets placed into the GRAT. The term of a GRAT can be as short as two years or as long as the grantor chooses. However, if the grantor dies during the GRAT term, the IRS says “the technique fails and the assets inside the GRAT are included in the taxable estate”. For this reason, most GRATs are kept to shorter term.

• Reduce the value of their estate for gift tax purposes because of the effect of multiple valuation discounts. The LLC interests are discounted then further discounted by placing them into the GRAT.

For asset protection purposes the GRAT creates fractionalized interests, the remainder interest is no longer subject to the donor’s predators.

For this diagram, see “Figure 10-140 Funding a GRAT With an LLC.pdf” in the “Diagrams” folder on your CD.

The amount of the gift is the value of the remainder interest on the day the gift is made. This is calculated actuarially by reference to tables and interest rates published monthly by the IRS. [IRC §7520.]

All of the appreciation on the property transferred into the GRAT plus the cash flow not distributed by the GRAT is outside the donor’s estate.

Upon termination of the GRAT in accordance with its predesigned number of years, the interests are transferred to the designated remaindermen, without any transfer tax being imposed.

If the donor dies during the term of the GRAT, the value of the property transferred (plus its appreciation) is drawn back into the donor’s estate. However, any gift tax paid on the creation of the GRAT is restored. Because of this restoration, there really is no penalty to the donor if this technique is used (other than the costs incurred in structuring the transaction).

One strategy is to create several GRATs with several different periods. This way a premature death does not adversely affect the entire plan.

The success of the GRAT is in large part dependent on whether the return on the trust assets outperforms the rate published monthly by the IRS (the “7520 rate”).

However, the GRAT allows a double discount that can work quite well. For example:

• If the actual asset in the LLC is worth $3,000,000 and it is yielding 10% ($300,000), and

• Then the GRAT would receive an asset worth $2,000,000 and generating the same $300,000 it was generating before, thus the GRAT had an asset generating 15%.

The discount of one-third almost guarantees that the result will outperform the 7520 rate.

The GRAT is exempted from the estate freeze rules of Chapter 14. [See §10:117.]

The payout is calculated as a fixed sum based on the initial contribution and no further contributions may be made.

Commutation (the right to distribute to the donor as a lump-sum his interest free of the trust) must be prohibited in the GRAT, and no payments may be made to others.

To the extent that GRATs are grantor trusts, they may be funded with S corporation stock.

The generation skipping tax is not available in the GRAT situation. Consequently, the remainder interest should not be given to a grandchild.

The computation of the gift tax on a $1 million asset in a sample GRAT is as follows:

Some states now allow "series" LLCs. Series LLCs [so it is said but there is, as yet, no confirming caselaw] can be utilized to isolate the risks of each venture to the capital invested in that LLC. A series LLC is a single LLC that divides itself into a "series" of divisions. Each "series" is a separate legal entity, with regard to liability, but only one LLC exists, thus creating only one set of taxes, tax filings, etc.

Each "series" can have different members, managers, and ownership percentages and can make distributions to its members while other members of the LLC receive none. However, it is not clear, whether non-series states will respect series LLCs or whether the IRS will allow such an LLC to file a single tax return, or a tax return will be required for each. California has already decided that Delaware "series" LLCs that do business in California will be treated as multiple LLCs, so that each will be subject to the California $800 minimum franchise tax.

Many issues have been raised concerning Series LLCs. How will a Series LLC be treated for tax purposes? How will bankruptcy courts respond? Will Series LLCs be respected in states that have not adopted Series LLC statutes? And will courts, particularly federal courts and those in states without a Series LLC statute, respect the internal liability shield of a Series LLC?

The IRS in P.L.R. 2008 WL 163064 (Jan. 18, 2008), issued the first private letter ruling concerning the tax treatment of a Series LLC. The IRS ruled that series of a Series LLC would be treated as separate taxable entities.

We appear to be at the same point of uncertainty we were when Wyoming unveiled the first LLC statute. Cautious practitioners are advised tom wait for caselaw before utilizing an untested vehicle

An LLC," is a business entity that combines the pass-through taxation of a partnership or sole proprietorship with the limited liability of a corporation. LLC owners report profits and losses on their personal tax returns; the LLC itself is a pass-through, not a separate taxable entity. All LLC owners/members are protected from personal liability for business debts. If the business is involved in a lawsuit, only the assets of the business are at risk. Creditors usually can't reach the assets of the LLC members.

LLC owners are not personally liable for the LLC's liabilities. A creditor of the LLC cannot pursue LLC members assets to pay LLC debts. LLCs and partnerships are similarly taxed. The owners of both report income or losses on their personal tax returns; the business itself does not pay tax. Both LLCs and partnerships file Form 1065 informational returns with the IRS (Form 1065).

Does A Limited Liability Company Offer A Less Protection Than A Regular Corporation?

By legislative design, an LLC requires less ongoing paperwork and required procedures than a corporation. A corporation requires its shareholders to have regular annual meetings. The corporation has by-laws which require a board of directors be set up to govern. This board of directors probably should meet regularly. The board of directors also needs to elect and monitor the officers (president, vice presidents, treasurer and so on) who run the day-to-day operations of the corporation.

Another feature is the LLC “charging orders.” Creditors may be able to gain ownership of the shares you own in a corporation. If a creditor gains ownership of a majority of the shares of your corporation, he controls it. However, creditors cannot gain ownership of your LLC interest. Usually the best they can do is obtain a “charging order.” A charging order (a lien) says that if the LLC distributes money, that money should go to the member’s charging order creditor. However, a creditor can’t get money from the LLC unless the LLC decides to make a distribution. If the LLC decides not to distribute money, creditors won’t get anything

Does An LLC Have To Hold Meetings?

Not unless the LLC's operating agreement requires meetings. This is a key advantages of an LLC; fewer formalities, less paperwork and less chance that the members will accidentally violate the law and thereby lose their liability protection.

You should consider forming an LLC if you are concerned about personal exposure to lawsuits or debts arising from your business.

Some professions cannot be operated as an LLC. For example, physicians, dentists, lawyers and accountants. When state law doesn't allow a professional to operate his or her business as an LLC, state law usually allows the professional to operate as a professional limited liability company or PLLC. PLLC usually do not provide the same level of legal protection as a regular LLC. PLLC do not allow professionals within the PLLC to avoid malpractice risks.

Yes. Converting a sole proprietorship to an LLC protect your personal assets without changing the way your business is taxed. In some states you file a "certificate of conversion, in some you must publish a notice in a local newspaper that the partnership is being terminated and in others you need to transfer all identification numbers, licenses, and permits to the name of your new LLC.

In most states, by filling "articles [or certificate] of organization" with your state's filing office and paying a filing fee. Although not legally required in most states, if you are concerned with asset protection it is best to have an LLC operating agreement prepared Operating agreements set forth the rights and responsibilities of LLC members. If you don't, state laws govern.

Can Someone Who Isn't A US Citizen Form An LLC?

You can, even if you are not a US citizen or permanent resident. If you are a non-US citizen or permanent resident, the LLC will often have a duty to withhold taxes from remittances paid to you.

Why Do I Need And Where Can I Locate A Registered Agent?

The state you set up your LLC wants to know the name of a person or entity (a registered agent) within the state whom the state can contact if and when it needs to communicate with the LLC (e.g. serve process). If you're setting up an LLC in the state in which you reside, you can be your own registered agent.

An LLC is not a separate entity from its members for tax purposes. LLCs do not pay taxes, its members pay taxes on their allocated share of profits (or deduct their share of business losses) on their personal tax returns. LLC owners can elect to have their LLC taxed like a corporation..

An LLC that meets all the eligibility criteria may elect to be treated as an S corporation.

Can My LLC Have An Unlimited Lifespan?

Yes. Recent changes to the IRS code have promoted changes in state laws permitting LLCs to be created with an unlimited life.

Asset protection considerations usually dictates that each business be placed into its own LLC. By doing so you protect the individual businesses from each others' risks. Without holding each business in a separate LLC, you could lose if one is the subject of a major lawsuit.

One common planning strategy is a tiered structure. In a tiered structure, you set up a parent, or holding, LLC. The parent would then own the individual "child" LLCs. These "child" LLCs conduct the business operations.

If you are a real estate investor who wants to use LLCs to protect your personal assets, you want to put each individual real estate property into a separate LLC. If you put each individual property into an individual LLC, if something goes bad with one property, the liability is contained in that one LLC and does effect your properties in other LLCs.

As an alternative to five LLCs for five properties, you may want to setup a "parent" holding company LLC. You would own the holding LLC and the holding LLC would own the "child" LLCs that own the actual investment properties.

I regular LLC is a business and/or an investment vehicle. Your home is a personal asset. If you place it into a business and/or investment vehicle your home should be held for business or investment. You should pay the LLC rent. As rent to a home is non tax deductible to you and taxable to the LLC you have created a tax issue. In addition by placing your principal residence inside of LLC you do not own it personally and you lose the Section 121 "Exclusion of Gain on Sale of Principal Residence" tax benefit of excluding up to $250,000 of gain if you're single or up to $500,000 of gain if you're married, on the sale of your principal residence as long as you've lived in and owned the home for at least two of the preceding five years.

If you own your principle residence through a single-member LLC, the single LLC gets disregarded for tax purposes. This disregarding should mean that the LLC doesn't cause you to lose the Section 121 exclusion benefit and it can hold a personal use property.

In a community property state the IRS has stated that husband and wife will be considered one. If you are married in a non community property (where husband and wife are considered 2 people) you can still use a single person LLC by each spouse owning your individual shares of your principal residence through single member LLCs.

Most states' LLC don't require a written operating agreement. However, for maximum asset protection, you should have one. Operating agreements helps to ensure that courts will respect your personal liability and it allows you to create your own contractual operating rules rather than being governed by your states default rules.

What Is The Difference Between A "Member" And A "Manager" Of An LLC?

A member is an owner and is similar to a stockholder of a corporation. A manager is a person chosen by the members to manage the LLC and is similar to a director of a corporation. A manager can also be a member.

Nevada LLCs Book - Chapter 10

Does An LLC Have To Hold Meetings?

Can Someone Who Isn't A US Citizen Form An LLC?

You can, even if you are not a US citizen or permanent resident. If you are a non-US citizen or permanent resident, the LLC will often have a duty to withhold taxes from remittances paid to you.

Why Do I Need And Where Can I Locate A Registered Agent?

Can My LLC Have An Unlimited Lifespan?

What Is The Difference Between A "Member" And A "Manager" Of An LLC?

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