Category: Business asset protection

HOLDING LLC MEMBERSHIPS THROUGH SINGLE-MEMBER LLCs—A TRAP FOR THE UNWARY?

By , January 11, 2011 8:50 am

In my LLC practice, I often run across LLCs whose ultimate owners hold their LLC memberships through single-member LLCs.  They do this because they think that they are obtaining two significant benefits—greater anonymity as LLC owners and an extra layer of statutory liability protection.

EXAMPLE.  Arthur Able and Bill Baker are equal members of AB, LLC.  AB, LLC, in turn, holds real estate with a fair market value of $1 million.  Arthur holds his AB membership directly in his own name.  Bill holds his through a single-member LLC named “Cosmic Holdings, LLC,” of which he is the sole member.

I think the above ownership structure creates a serious trap for Bill.  One of major benefits of holding property in an LLC is that all U.S. LLC acts except that of Pennsylvania provide LLCs and their members with statutory charging order protections.  (And I understand that Pennsylvania case law provides charging order protections for Pennsylvania LLCs and their members.) 

I will write about charging order protections at greater length in future posts.  However, in essence, LLC statutory charging order provisions provide that if a creditor holds an unsatisfied judgment against a member of a multi-member LLCs on the basis of a claim unrelated to the LLC’s business:

  • The creditor may obtain a lien (a “charging order”) against the LLC on the debtor-member’s right to receive distributions of LLC profits, requiring the LLC to distribute to the creditor any LLC profits it would otherwise distribute to the member to the extent of the judgment.
  • However, the creditor may not levy on the debtor-member’s voting rights or other management rights in satisfaction of the claim.

In my view, the fact that LLC statutes provide for charging order protections and that corporations do not is the single greatest business organization law advantage of LLCs over corporations.    

To explain:  In the above example, Bill, as noted, holds his ownership in AB through a single-member LLC.  What this means as a practical matter is that if Bill accidentally but negligently runs over and kills a brain surgeon on business unrelated to the LLC and the brain surgeon’s estate obtains a $20 million judgment against him, the estate can levy on his single-member LLC membership; it can obtain Bill’s voting rights; and, by exercising deadlock voting power, it can force the LLC to sell its assets and distribute Bill’s share of the proceeds to the estate.  This is because charging order protections only protect LLC members; they do not protect the members of single-member LLCs that are members of multi-member LLCs.

By contrast, assume that Arthur is the AB member accidentally killing the brain surgeon.  In this situation, charging order protections will enable the estate to obtain a charging order against AB, LLC; but, because Arthur holds his membership in AB directly, the estate cannot obtain Arthur’s voting rights and thus cannot force AB’s dissolution.

In short:  Think long and hard before advising your LLC formation clients to hold their memberships in multi-member LLCs through single-member LLCs.  First, your client will thereby lose charging order protections.  Second, as a practical matter, he won’t need a second liability shield; so why bother with a single-member LLC?  Third, in any law suit, the “anonymity” he thinks he will obtain through his single-member LLC will quickly turn out to be worthless.

WHAT SHOULD BE YOUR GOALS IN DRAFTING THE OPERATING AGREEMENT OF A “SUBSIDIARY SINGLE-MEMBER LLC”?

By , December 22, 2010 9:13 am

In the last post in this blog, dated November 27, 2010, I discussed the potential business asset protection value for many privately owned companies that presently hold their assets and conduct their business through a single entity of adopting a new two-entity parent/subsidiary structure. In this restructuring, the subsidiary should be a single-member LLC taxable as a “disregarded entity.”

In implementing this restructuring, what should be your goals in drafting the operating agreement between the parent and the single-member LLC? I suggest you should have the two main goals summarized below:

1. You should draft the operating agreement so as to provide the parent company and its owners and relevant employees with a clear and comprehensive statement of the legal and tax structure of the single-member LLC, including, especially, its financial and management structures. This statement will be indispensable to the single-member LLC’s managers in administrating and operating the LLC. It may also be indispensable in dealing with third parties that deal with the single-member LLC, such as federal and state tax auditors and potential lenders.

2. To minimize the risk of veil-piercing, you should make clear in the operating agreement the essential separateness of the parent and the single-member LLC. The operating agreement can do much to accomplish this goal—e.g., by documenting the compliance of the LLC with the anti-veil-piercing “adequate capitalization” requirement and by providing in its management provisions that all day-to-day decisions of the single-member LLC will be made by its own internal managers and not by the parent.

However, it may be also be useful for this anti-veil-piercing purpose to formalize, in the operating agreement or in separate intercompany agreements, all other arrangements between the parent and the single-member LLC—e.g., arrangements, if any, for centralized accounting and marketing.