Limited Liability Companies: Ready for Prime Time?

Volume IV, Number 3 – May/June 1995 

LIMITED LIABILITY COMPANIES
Are They Ready For [Asset Protection] Prime Time?

BACKGROUND

Limited liability companies are being utilized more and more as one state after another adopts a version of a limited liability company statute. A Uniform Limited Liability Company Act was proposed in August, 1994, but as of this writing, no state has adopted it. In this issue, we’ll examine the advantages and shortcomings of the limited liability company (“LLC”), their tax treatment, and whether LLC’s are a viable alternative to the limited partnership in asset protection planning.

The common characteristics of the LLC are that its owners are called “members”, it is governed by an “operating agreement,” “articles of organization,” and “regulations,” and it may be managed on a day-to-day basis by a “manager” or “managers”.

DRAWBACK OF OTHER ENTITY FORMS

One of the principal drawbacks of the limited partnership is that the general partner is personally liable for the debts of the entity (“inside-out” liability). This should be of no concern where the “business” of the partnership consists of holding investment assets, such as cash, stocks, bonds, and other securities, or where the general partner has instituted other sophisticated measures to protect his or her personal assets. However, where the business of the limited partnership consists of an active trade or business, or holding real property, and the general partner’s other personal assets are not otherwise protected, planners often utilize the device of a corporate general partner owned by the person who would otherwise be an individual general partner as a means to insulate that individual from the partnership’s internal debts and exposures. This technique places that person in essentially the same position (exposure-wise) as a limited partner. Is there a simpler way to accomplish this?

As an alternative to the limited partnership/corporate general partner structure, it may be necessary or desirable to use a corporate entity form in a particular business transaction or operation to limit the owners’ exposure to entity debts. An S corporation would ordinarily be desirable to avoid the potential double taxation inherent in a C corporation, and to permit a flow-through of tax attributes to the owners. Under our tax law, however, if a corporation, nonresident alien, or certain type of trust is to be a shareholder, the entity cannot qualify as an S corporation. Is there a solution to this dilemma?

Along comes the LLC, which essentially places its owners in the position of a “limited partner” or “shareholder” in terms of limited exposure to the debts of the entity, and it essentially provides the same flow-through tax effects as an S corporation without restriction as to who may be an owner, but is it the panacea it’s cracked up to be?

ASSET PROTECTION ASPECTS

Although the various limited liability company statutes are far from uniform, many do contain a charging order provision identical to that found in the Revised Uniform Limited Partnership Act (“RULPA”) (See, AP NEWS, Vol. IV, No. 1. Recall that the charging order is the only remedy available to a creditor of a partner, and that it prevents the creditor from reaching the assets held in the partnership, and from foreclosing on the partner’s ownership interest in the partnership.

Since the protective aspects of the limited partnership are primarily derived from the uniform charging order provision, it would follow that a limited liability company established in a state whose LLC laws contained a charging order provision identical to the RULPA provision would provide identical protection. It may be premature to reach that conclusion; however, at least with respect to those states whose LLC statutes include the RULPA-like charging order provision, the foundation seems to be in place for the use of the LLC as an asset protection vehicle. What is missing, however, is a body of case law such as exists with respect to limited partnerships.

TAX CONSEQUENCES

The Internal Revenue Service has issued numerous rulings addressing the federal income tax consequences of LLC’s established under various state laws. An LLC established in one state may be treated as a partnership for federal income tax purposes, and an LLC established in another state may be treated as a corporation or as a partnership for such purposes (depending upon the provisions of its organizational documents).

Perhaps as a reflection of the hybrid nature of the entity, at least one state (Florida) treats an LLC as a corporation, while the Internal Revenue Service will treat the same LLC as a partnership! If adding certainty to our planning is one of the goals in asset protection, we can probably do without this type of confusion.

CONCLUSION

As discussed above, a general partner in a limited partnership is personally liable for the debts the limited partnership. Thus, from such an “inside-out” exposure perspective, the LLC is prima facia superior to the limited partnership, in that no LLC member is exposed to the internal liabilities of the LLC, which may be particularly important where the entity will hold an asset such as real estate, which is capable of generating its own liability.

The use of the LLC in asset protection, however, will likely be restricted until a uniform statute is adopted in a majority (if not all) of the states. Otherwise, unless the activities and property ownership of the LLC will be restricted to only include states which recognize the LLC, the treatment of an LLC member vis-a-vis his creditors and the creditors of the LLC will be uncertain in a state which does not have an LLC statute or a statute recognizing LLC’s established in other states. Such uncertainty is contrary to one of the primary purposes of asset protection – to reduce or eliminate risk.

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