By now most investors are aware that Limited Liability Companies (LLCs) are designed to help insulate the owner (member) of the LLC from the liabilities that may arise on an investment property held within the LLC. What has drawn confusion and massive amount of debate is whether or not an investor should create a Series LLC to protect not only the member of the LLC from the harm, but also have the ability to separate each property into its own “cell” so the liability from one property doesn’t affect all of the other investment properties. The concept behind the Series LLC is great but there can be some hidden dangers lurking under the surface for the uniformed.
An LLC is a Bucket
An LLC is really nothing more than a “bucket” that helps prevent the holder of the bucket from being drenched by water splashing around in the bucket. In this case, the water is liability. However, the water in the bucket can become tainted, although it doesn’t directly harm the holder, all of the water inside is now bad. The question often becomes, do if I need a separate LLC for each investment property? My answer to that question is the classic attorney weasel answer of “it depends.” It depends upon the investor’s level of personal risk tolerance. In a perfect world every property would be in its own LLC thereby protecting all of the other investment properties from harm, but as a practical matter, this is often not feasible from an initial and annual cost standpoint. Even though I don’t charge myself to create an LLC, I don’t have an LLC for each property because of the fees associated with each state. One potential avenue that has developed over the last dozen years is what is known as a Series LLC. The principal behind the Series LLC is that it is no longer necessary to form multiple LLCs to hold different investment properties. Instead of having all of the water mixed together in the bucket, the Series LLC bucket holds the water in several “balloons” called cells; if one balloon pops the other balloons remain unharmed.
LLCs Are State Specific
LLC formation and levels of protection are governed under state laws. Each state has its own specific level of protection that it will provide an LLC. Typically, the differences center on the level of protection that assets within an LLC will have if the member of the LLC is sued personally. These protections are found within the State’s statutes or case law. A perfect example of the different levels of protection is found in the states that offer charging order protection versus states that offer judicial foreclosure as a remedy. A court in a state that offers only a remedy of a charging order prevents the member of the LLC from losing the investment assets within the LLC if he or she gets sued personally. A charging order is basically a lien on the member’s interest, if funds are distributed out of the LLC the holder of the charging order is entitled to the distribution. However, the charging order does not allow for the holder to participate in the business or force distribution. A state that provides for judicial foreclosure will allow the courts to have the discretion to pierce into the LLC and attach those investment assets to satisfy a personal judgment against the member. In the majority of states, depending on if they are charging order or judicial foreclosure states, if an injury occurs inside of the LLC, only the LLC assets are at risk and the member of the LLC is not subject to personal liability exposure. However, there are a handful of states that allow the assets inside of the LLC to be protected from each other. These states are: Delaware, Iowa, Illinois, Nevada, Oklahoma, Tennessee, and Utah. Wisconsin has a modified version of the Series LLC law.
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The Benefit of the Series LLC
In the states that have Series LLC statutes, the benefit arises in being able to have one LLC that is broken up into different component “cells” to isolate injuries from one property from spreading over to the other properties held within the separate cells. Each cell can have different members so this increases the flexibility by having different ventures with other investors within one Series LLC. Another distinguishing feature is that each cell will have its own name, contracts, accounts, and as of a private letter ruling published by the IRS in 2008, each series can have its own tax status. Thus, the Series LLC gives great flexibility of being able to create one LLC instead of multiple LLCs subject to multiple fees to the state where the Series LLC is created. However, before the investor jumps on the Series LLC bandwagon there is a very important question that needs to be asked.
Where Is the Investment Property?
If an investor has an LLC created in one state but has rental property or is wholesaling in another state, he or she must file their LLC to conduct business in that state. There is no way around it. If you own property and create an LLC, you are doing business in the state where the property is located.
Blindsided by Fees
This is known as a foreign filing. If the investor does not foreign file the LLC, the state could impose penalties and the LLC will not be able to avail itself to the protections of that state’s legal system. In several states, including California, it can be a very expensive process to either create the LLC or foreign file LLC to do business in that state. On the surface, Series LLCs seem very attractive to those investors who live in states like California where it costs $800 per year per LLC for the privilege of doing business in California. If an investor has 5 properties in California and he or she wants to create 5 LLCs, the annual fee for California will be $4,000. Unfortunately, the investor is often duped into believing that by creating a Series LLC in a state such as Nevada or Delaware they can avoid this $4,000 annual fee to California because the $800 fee will only be charged once. This is not the case. The California Franchise Tax Board has specifically stated that each series in the LLC will have to pay the $800 fee. Now the investor is worse off financially because not only does the investor have to pay California $4,000, but he or she has to pay Nevada or Delaware it’s fees, the fees to the resident agent, and the fees to maintain the necessary business presence in the state of origin.
Will it be Respected in the Morning?
Remember, LLCs are governed by State law, therein lies all of the conversation about Series LLCs. If the investor creates a Series LLC, will the separate distinct cells and added protection be respected in the state where the property is located when that state doesn’t have statutes allowing for Series LLCs? The problem is we just don’t know. There hasn’t been any case law on whether or not a state like California will offer the protections of the Series LLC. So the investor is taking a big gamble on whether or not the Series LLC is actually going to provide the protections promised. A lot of the internal protections may come down to notice: Was the party that was dealing with the LLC put on notice that he or she were dealing with a separate series and only the assets within that particular cell would be attachable? This potential lack of respect should definitely cause the investor to pause before going with the Series LLC.
Lack of Formality
Each cell within the Series LLC is treated as a separate business. That means that each cell within the LLC has to be treated as a separate business. Each cell has its own distinct name, its own distinct bank account, its own distinct book keeping and accounting requirements, and from a transaction standpoint, it needs its own contracts, letter head, business cards, etc. Therefore, even in the states that allow Series LLCs, if the investor fails to follow these formalities the separate cells may not be protected from an injury arising on one of the investment properties.
Look Before You Leap
The idea behind the Series LLCs is a great one: Consolidate all activities in one LLC to cut down on costs of forming multiple LLCs to protect the different investment assets. Unfortunately, it is currently uncertain whether this benefit will be realized in the states that do not recognize Series LLCs. It is important that the potential pitfalls of additional fees, lack of respect and formality requirement are properly weighed against the promised benefit when determining whether or not to create the Series LLC. Until there is some definitive law in the other states, I’m going to let the uninformed test the waters for me.