November 28, 2014
By: Diane Kennedy, CPA www.USTaxAid.com
Let’s start with the basics. When it comes to business structures, there is the good, the bad and the ugly.
The bad is the Sole Proprietorship (or Schedule C). You’ll risk everything you own if something goes wrong in the business. You’ll pay extra tax (15.3%) on net income. You can’t build business credit. And, you have a much higher risk of IRS audit. As you probably figured out, we don’t like Sole Proprietorships for businesses.
The ugly is the general partnership. In this case, you have the higher tax of the Sole Proprietorship and you risk everything you own if something goes wrong. Plus, you’ve got liability for anything stupid your partner might do.
The good business structures are limited partnerships, S Corporation and C Corporation. And the limited liability company (LLC) is often the best of all. It is a tax chameleon, allowing you to elect how you want to be taxed. The LLC also provides asset protection both ways. In other words, your personal assets are safe from any lawsuits that may come from the business. And, it will also protect the LLC units against a personal lawsuit. In the case of an S Corporation or a C Corporation, your personal assets are protected against business judgments. But, your shares in the corporation would be fair game if you were sued personally.
That means an LLC electing S Corporation tax treatment (LLC-S) provides better asset protection than just a straight S Corp.
The Series LLC is kind of a hybrid that grew out of the popularity of the LLC. In this case, there is a ‘mother ship’ or the actual Series LLC that is set up. There are then subsidiary cells that can be set up as part of the Series LLC. The only thing is, the cells are separate. Or, at least that’s what we thought. More on that later.
The beauty of the Series LLC, assuming it works like it is supposed to, is that you can set up an unlimited number of subsidiary cells without having to register them with the state. That means there is a whole lot less cost. And, because you don’t need to publicly register them, there is ultimate privacy. You also can set up the cells yourself, without needing to pay professional fees. Unfortunately, the alternative for cost-conscious investors is to just put all their eggs in one basket and put all of their business assets at risk.
The IRS came out with tax rules on the cells a few years ago and that seemed to be the seal of approval for this new type of structure. The cells could elect how they were to be taxed, just like any other type of LLC.
There was still concern in some areas, though, because the Series LLC had not been proven in court. Would the cells hold up? And, as we were wondering that, a significant court case occurred that might change everything.
Before I go into the details, let me cut to the chase. If you have a Series LLC right now, this isn’t the end of the world. But you do need to read the details of the court case I’m about to discuss or talk to someone who has knowledge about it. I can’t emphasize this last part enough. I’ve seen people saying it doesn’t matter (WRONG! It does!), and I’ve seen people trying to dismiss this just as a jurisdictional problem. They try to say that such a thing would never happen in ABC state. I don’t think you can say that either.
The case I’m talking about started because of the recession. Glenn Alphonse had a mortgage with WMC Mortgage Corporation. WMC next sold the mortgage to Series 2010B. Series 2010B then sold the note to Deutsche Bank and Deutsche Bank foreclosed.
Series 2010B is a subsidiary cell from a parent company, Arch Bay Holdings LLC. This is where the Series LLC part of this comes into play.
Alphonse felt that it was not a legal foreclosure because of robo-signing issues and so he sued Series 2010B and its parent Arch Bay Holdings LLC in federal court. Now, it gets tough. A subsidiary cell of a Series LLC should be a legal entity on its own. And the court really didn’t know what to do. I want to say this again. It should have been a slam dunk. If a subsidiary cell of a Series LLC has clearcut asset protection it should have been thrown out. But it wasn’t. Instead it was kicked back to U.S. District Court to make a decision on what to do. And the District Court just looked at the facts of the underlying lawsuit and didn’t answer the Series LLC question.
This is an important case for Series LLCs because it demonstrates that the courts aren’t ready to accept what we all thought was certain – the asset protection ability of the subsidiary cells.
I’ve heard the Series LLC issues divided into two categories: Contractual and Non-Contractual.
First, there are situations where the members have agreed to something, or there has been an agreement between a member and the Parent. In those cases, the Series LLC is a good fit. You have a contract and that seems to be well supported.
Second, there are situations involving parties who have not contracted with the company. For example, an external creditor could care less whether you have a parent or a subsidiary cell. They just want to make sure they get paid. In that case, can the creditor cross through the lines? Based on the court’s inaction in Alphonse, we are left with some uncertainty and that’s never good if you have an investment or business.
Now, here’s the big question. Does a Series LLC work? Should you have one? I still have mine, but I’m carefully looking at what I’m doing within each subsidiary. I have already moved some of the subsidiary cells into their own stand-alone LLC. The annual cost is higher, but if we’re talking about a big potential liability, the cost is small.
I recommend that you talk to an expert who really understands the underlying costs. Don’t get someone’s free opinion or ask the question on an open forum. Business structure planning is always an important step in building your wealth.