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USE OF LLCS IN ASSET PROTECTION AND ESTATE PLANNING

By Shannon L. Post

1. Why Are LLCs so Special?

a. What do LLCs offer over other entities? Why are we focusing on LLCs?

i. Revocable Trusts

1. Pros:

a. Probate avoidance

b. Incapacity of the grantor

c. Privacy

d. Flexible vehicle

2. Cons:

a. No liability protection

ii. Irrevocable Trusts

1. Pros:

a. Only vehicle that completely removes an asset from

your estate

2. Cons:

a. Loss of flexibility and control

b. Cannot easily modify, alter, or amend

c. Cannot easily terminate

iii. Limited Partnerships

1. Pros:

a. Many of the same benefits as LLCs

b. Flexible

c. Pass-through taxation

2. Cons:

a. General Partners have potential liability

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i. Use of corporate general partners allows you

to limited liability exposure, but increases

the expense of operating your entity and you

must follow corporate formalities.

iv. Corporations

1. Pros:

a. Strong limited liability

2. Cons:

a. Must respect and follow corporate formalities

b. Double taxation

2. Management of LLCs.

a. Management of LLCs occurs in two ways.

i. Member-Managed

ii. Manager-Managed

b. Under a manager-managed structure, management is completely

segregated from ownership.

c. A manager-managed structure is the most common form of management

for LLCs used in estate planning.

i. This structure may be very useful where families have a “head”

owner or where generation 1 (“G1”) wants to bring in other owners

but are not ready to relinquish control to the next generation.

3. Using LLCs in Estate Planning.

a. Transferring assets from one generation to the next.

i. Ability to Retain Control

1. LLC operating agreements are very flexible.

2. Members may be given voting or non-voting interests.

Therefore, children (“G2”) or grandchildren (“G3”) may be

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given non-voting interests which account for a majority of

the value of the LLC, but provide for no voting or

operational control.

3. Management may be left in the hands of G1, while

transferring a majority of the units (and value of the assets)

to G2 or G3.

ii. Transfer Restrictions

1. The LLC operating agreement may restrict a member’s

right to sell their membership interest or unilaterally

withdrawal from the LLC.

2. Placing transfer restrictions in the LLC operating

agreement may help to protect assets from creditors as well

as from children or other heirs who may not make the best

financial decisions.

iii. Ease of Transferring Hard to Divide Assets

1. LLCs may simplify the process of dividing assets.

2. For example, if you had a family vacation home, rather

than deeding the property as joint tenants or tenants-in-

common to your children, you may transfer an equal

number of LLC units to your children.

iv. Out-of-State Property

1. Ancillary Probate

a. When you hold property in more than one state, you

will have to probate your will in each state in which

you are not domiciled.

b. Time-consuming

c. Extra expenses

d. May require court intervention

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2. If you had transferred the property to an LLC prior to

death, upon your death, the LLC would continue to hold the

property. The decedent’s LLC units will pass to the next

generation or heirs, with no ancillary probate necessary.

4. Using LLCs for Asset Protection.

a. Business owners who desire additional liability protection

i. Worried about lawsuits in excess of insurance limits

ii. Worried about a piercing of the corporate veil

b. Individuals desiring to preserve and protect wealth for themselves and the

next generation

5. What Types of Assets Should be Transferred to an LLC?

a. Marketable securities

b. Real property

c. Personal property- vehicles, artwork, etc.

d. Proceed with Caution:

i. If an asset requires registration, you must actually register or retitle

assets in the name of the LLC.

ii. If you are transferring real estate,

1. Be sure to check with your lender to see if consent is

required. A transfer without lender consent may be an

event of default under the terms of your mortgage.

2. Be sure to check with your insurance broker as a transfer of

real property to an LLC may require a change to your

insurance policy.

6. Valuation Discounts.

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a. Application of discounts will allow you to transfer a larger percentage of

assets to the next generation tax-free.

b. Valuation discounts may result in a significant decrease in value—

sometimes up to 50%, although typically discounts range from 20-40%.

c. Discount for Lack of Control

i. The minority interest discount.

ii. There should be a reduction in an LLC’s unit value due to a

member’s lack of ability to exercise his or her control over the

LLC.

iii. Therefore, a discount should apply when transferring units from a

managing member or a member with a majority interest to a non-

managing, minority member.

d. Discount for Lack of Marketability

i. Closely-held companies should sell at a discount to actual value

because of the additional costs, increased uncertainty and longer

time horizons required to sell such interests.

ii. Therefore, an additional discount may apply when transferring

privately-held company interests that are subject to transfer

restrictions.

e. Proceed with Caution:

i. With large transfer tax exemptions now available, you must

compare the estate tax savings of utilizing valuation discounts

against the option of preserving the income tax basis of an asset.

1. Transfer Tax Exemptions are now at:

a. $11,400,000 for single persons

b. $22,800,000 for married couples

ii. Would a step up in basis at death be more valuable to you than a

valuation discount?

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7. Mistakes to Avoid & Precautions to Take When Establishing LLCs.

a. Internal Liability Protection v. External Liability Protection.

i. Internal Liability

1. The goal of using an LLC is to trap business or asset

liabilities inside the entity, so that the member does not

become personally liable for such liabilities.

ii. External Liability

1. The goal of using an LLC is to insulate and protect its

assets from the creditors of individual members.

b. You over-estimate the internal asset protection and limited liability

protection provided by your LLC.

i. Your lender demands a personal guarantee.

ii. A lawsuit is filed against the LLC and its member(s) individually.

iii. An accident occurs on personal use property.

1. In such instances, you must use a multi-layered approach to

asset protection, such as ensuring that you have appropriate

insurance to achieve adequate asset protection.

c. You formed your LLC in the wrong state and, consequently, have over-

estimated the external asset protection and limited liability protection

provided by your LLC.

i. Charging Order Protection

1. Provides protection against creditors of a debtor member

who are seeking assets, including those of the LLC, to

satisfy a debt or judgment.

2. The protection is based on state statute.

3. Generally, all statutes provide that the assignee judgment

creditor is only entitled to receive distributions to which the

debtor member would have been entitled.

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4. Generally, with charging order protection, assignment does

not dissolve the entity or entitle the creditor or assignee to

become a member or exercise any rights of a member.

5. The Benefits of Charging Order Protection:

a. The creditor is only an assignee of the debtor

member’s interest and has no right to participate in

the management of the entity or to vote the debtor

member’s interest.

b. The creditor will only receive LLC distributions

which, absent the charging order, would have been

distributed to the debtor member.

i. In a family or closely-held LLC the debtor

member or a relative may have control over

distributions.

ii. Distributions may be made infrequently or

in insignificant amounts making the

charging order an unattractive remedy to the

creditor.

c. The charging order only creates a lien on LLC

distributions.

i. The debtor member may still be able to

benefit from the LLC through loans or

guaranteed payments.

d. The creditor shall be liable for the membership

interest’s share of the LLC income, even if no

distributions are actually made by the LLC.

e. The operating agreement for the LLC may contain

provisions for a purchase option when a member’s

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interest becomes subject to a charging order or if a

member is forced into or declares bankruptcy.

6. Issues that May Arise with Charging Orders:

a. May disrupt plans for significant distributions or

even distributions for tax payments.

b. If the creditor is a federal government agency it

may not feel compelled to negotiate a quick

settlement and it will not be deterred by negative

income tax consequences.

c. The frequent use of loans (or disproportionate

distributions) may negate one’s ability to use

valuation discounts.

d. If there is a purchase option provision, the LLC may

have to liquidate assets to buy-back the debtor

member’s interest.

ii. Proceed with Caution:

1. Not all statutes are alike!

2. Foreclosure Remedy:

a. Foreclosure is usually a remedy that is granted by

statute under the applicable LLC act.

b. In some states, the judgment creditor may obtain a

court order that the debtor-member’s LLC

membership interest be foreclosed upon resulting in

the creditor becoming the permanent owner of all

the debtor-member’s financial rights. Madison

Hills Limited Partnership II v. Madison Hills, Inc.,

644 A.2d 363 (Conn. App. 1994).

c. Some states take this a step further and, if a

foreclosure remedy is available, allow the judgment

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creditor to force a sale. Crocker National Bank v.

Perroton, 208 Cal. App. 3d 311, 255 Cal. Rptr. 794

(Cal. App. 1st Dist. 1989).

d. Note, however, that some courts have allowed

foreclosure even where the remedy was not

specifically provided for by statute. Id.

e. Certain states, including Delaware, have eliminated

foreclosure as a remedy under its statute:

i. Section 18-703(d) of Title 6 of the Delaware

LLC Act provides that:

“The entry of a charging order is the

exclusive remedy by which a judgment

creditor of a member or a member’s

assignee may satisfy a judgment out of the

judgment debtor’s limited liability company

interest and attachment, garnishment,

foreclosure or other legal or equitable

remedies are not available to the judgment

creditor, whether the limited liability

company has 1 member or more than 1

member.”

3. Single-Member LLCs

a. The public policy behind the charging order remedy

is to balance a judgment creditor’s rights against a

need to avoid a disruption or liquidation of the

LLC’s business.

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b. Many courts have argued that this public policy

factor is not present in the case of a single member

LLC.

i. The seminal case on this issue is Olmstead

v. Federal Trade Commission, 44 So. 3d 76

(Fla. 2010), where the Florida Supreme

Court determined that a charging order was

not the exclusive remedy for the judgment

creditor of the owner of a single member

LLC.

ii. The Eleventh Circuit Court of Appeals,

certified the following question to the

Florida Supreme Court: “Whether, pursuant

to F.S. §608.433(4) [the then-current

charging order statute], a court may order a

judgment-debtor to surrender all ‘right, title

and interest’ in a debtor’s single member

limited liability company to satisfy an

outstanding judgment?”

iii. The Florida Supreme Court broadened the

question and asked whether Florida law

allowed such actions.

1. The Florida Supreme Court

concluded that the Florida LLC Act

had not specifically displaced other

remedies available to judgment

creditors.

2. The Florida Supreme Court focused

on the lack of exclusivity language in

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the Florida LLC statute and

compared it to both the Florida

Revised Uniform Partnership Act

and Florida Revised Uniform

Limited Partnership Act which did

contain exclusive remedy language.

3. The Florida Supreme Court stated

that this discrepancy showed that the

legislature’s failure to include such

language in the LLC statute was not

inadvertent.

iv. After the decision in Olmstead, the Florida

legislature modified §608.433 to make clear

that the holding in Olmstead does not apply

to multiple-member LLCs, and that the sole

and exclusive remedy for a judgment

creditor of a member of a multiple-member

LLC is a charging order.

v. Florida House Bill 253—The “Olmstead

Patch”

1. In 2011, a new subsection (5) was

added to §608.433, which provides:

“Except as provided in subsections

(6) and (7), a charging order is the

sole and exclusive remedy by which

a judgment creditor of a member or

member’s assignee may satisfy a

judgment from the judgment debtor’s

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interest in a limited liability

company or rights to distributions

from the limited liability company.”

2. The intended purpose of subsection

(5) was to eliminate any question

about the scope of the remedies

available to judgment creditors and

the exclusive remedy language of the

revised charging order provision was

to apply to all Florida LLCs, not just

multiple-member LLCs.

3. However, the statute also carved out

exceptions to the general rule of

charging order exclusivity in

§608.433 subsections (6) and (7),

which applied only to single-member

LLCs.

vi. In 2013, the Florida legislature enacted the

new Florida Revised Limited Liability

Company Act codified in Chapter 605 of the

Florida Statutes and, as of January 1, 2015,

repealed the LLC Act under Chapter 608.

vii. However, the Revised Act under Chapter

605 did not change the rules relating to

charging orders and the changes made under

the Olmstead Patch remain unchanged.

c. In response to Olmstead, certain states, including

Delaware, amended their statutes to make clear that

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a charging order is the sole remedy available to

judgment creditor regardless of whether there is one

or more members in an LLC.

i. Again, compare the language of Section 18-

703(d) of Title 6 of the Delaware LLC Act

to that of the Olmstead Patch:

1. “The entry of a charging order is the

exclusive remedy by which a

judgment creditor of a member or a

member’s assignee may satisfy a

judgment out of the judgment

debtor’s limited liability company

interest and attachment, garnishment,

foreclosure or other legal or

equitable remedies are not available

to the judgment creditor, whether the

limited liability company has 1

member or more than 1 member.”

d. The best practice if you are establishing a single-

member LLC is to form the entity in a state where

the charging order statute expressly applies to

single-member LLCs.

4. Husband and Wife Owned LLCs

a. Some commentators have expressed concern that a

charging order statute would be ignored in the case

of an LLC owned by a husband and wife, especially

if the judgment is entered against both spouses.

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b. The concern is that a husband and wife may be

treated as one economic unit—or a single-member.

c. When forming an LLC to be owned by a husband

and wife, you should perform an analysis similar to

that of a single-member LLC.

d. Again, the best practices would be to add additional

members (children, for example) or to form your

LLC in a state where the charging order statute

expressly applies to single-member LLCs.

5. Bankruptcy

a. Section 541(c)(1) of the Bankruptcy Code provides

as follows:

“Except as provided in paragraph (2) of this

subsection, an interest of the debtor in property

becomes property of the estate under subsection

(a)(1), (a)(2) or (a)(5) of this section,

notwithstanding any provision in an agreement,

transfer instrument, or applicable nonbankruptcy

law —

(A) that restricts or conditions transfer of such

interest by the debtor; . . . .”

b. Courts have held that section 541(c)(1) of the

Bankruptcy Code negates the provisions of the

charging order statute that would treat the

bankruptcy trustee as an assignee and not a

member. In re Ehmann, 319 B.R. 200 (Bankr. D.

Ariz. 2005).

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c. Courts have even gone as far as granting the

receiver or trustee the right to dissolve and liquidate

the LLC in order to satisfy creditor claims. In re

Smith, 185 B.R. 285 (Bankr. S.D. Ill. 1995).

d. Section 541(c)(1) of the Bankruptcy Code may even

negate a provision in the LLC operating agreement

requiring the purchase of the debtor member’s

interest.

i. This determination hinges on whether the

LLC operating agreement is an executory

agreement.

ii. The purchase option provisions in the LLC

operating agreement may be negated unless

the operating agreement is an executory

contract.

1. Under federal bankruptcy laws,

executory contracts are those where

the obligations of both parties are so

far unperformed that the failure of

either party to complete performance

would constitute a material breach

and excuse the performance of the

other.

2. Unfortunately, most courts have held

that LLC operating agreements are

not executory. Id.; In re Garrison-

Ashburn, LC, 253 B.R. 700 (Bankr.

E.D. Va. 2000); and In re the IT

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Group, Inc., 302 B.R. 483 (D. Del.

2003).