Chinks in the Armor: Current Trends in Limited Liability Company Structure After Olmstead
From corporations to limited partnerships and limited liability companies, developing trends in the law shape the dynamics of an entity’s limited liability. Certain corporate forms provide more protection from outside creditors than others. This article will examine a few of these entities and see where chinks in the armor exist, allowing outside creditors to reach seemingly protected assets.
Insulation Against Inside Liabilities
For over 100 years, we have witnessed the existence of corporations. One of the main benefits of a corporation is to use an entity to own assets or operate a business and shield corporate owner(s)’ other assets from third-party claims against the entity. We call this “insulation against inside liabilities.” When we go beyond this infrastructure and “pierce the corporate veil,” the question arises: Do such claims against the corporation reach its shareholders? The answers lie in the instrumentality rule and identity rule.
The instrumentality rule requires a plaintiff to prove the following three elements against shareholders: 1) complete dominion and control of the entity’s policy and business practices; 2) use of such control to commit fraud or wrongdoing, breach of a legal duty, or a dishonest or unjust act; and 3) such control and breach of duty proximately caused injustice or loss.1 One example of a dishonest or unjust act for proof of the second element occurs when shareholders use control to avoid personal liability that an individual previously assumed.2 When two corporations are really controlled as an entity due to common owners, officers, directors, or shareholders, the identity rule generally governs.3 A court will also use the identity rule to pierce the corporate veil when two corporate entities fail to observe corporate formalities.4
Limited liability companies (LLCs), which have only been around since 1982, gained popularity in Florida after the 1999 repeal of the Florida corporation income tax on an LLC’s income and later repeal of the Florida intangible tax on an LLC’s interests. Limited liability limited partnerships (LLLPs) arose when the legislature amended the LLLP statute to provide for limited liability protection for all partners, including general partners rather than partial limited liability formerly available.5 A Connecticut court held under the appropriate circumstances it could pierce the corporate veil of an LLC and hold members personally liable to third parties. In Stone v. Frederick Hobby Associates II, LLC, No. CV 000181620S, 2001 WL 861822 at *10 (Conn. Super. Ct. July 10, 2001), the court found, based on the facts, the “instrumentality and identity rules” allowed the court to pierce the veil of an LLC and hold individual members personally liable.
When one considers the big picture of piercing the veil of a corporation, LLC, or LLLP, a secondary question arises: How does a court pierce the veil of a subsidiary? A recent Florida case held that to pierce the veil of a subsidiary, a plaintiff must prove the subsidiary is a mere instrumentality of the parent company, and the parent company organized and used its subsidiary to mislead or perpetrate a fraud on creditors.6
The court in Litchfield Asset Management Corp. v. Howell, 799 A.2d 298 (Conn. App. Ct. 2001), allowed “reverse veil piercing” or piercing the veil against a subsidiary. The court in Litchfield determined a judgment creditor could access an LLC’s assets against the LLC’s sole member.7 After the court entered judgment against the debtor in her individual capacity, she set up two LLCs and contributed cash to both. The Litchfield court noted the LLCs never operated a business, made distributions, or paid salaries. Moreover, the debtor used the LLC’s assets to pay personal expenses and make interest-free loans to family members. The court held that the debtor used control over the LLCs to perpetrate a wrongdoing against creditors, disregarded corporate formalities, and exceeded her management authority (via loans to family members). The court ordered reverse piercing of the LLCs.
Litchfield demonstrates certain flaws inherent in use of a single-member LLC as an asset protection vehicle. For example, in situations like Litchfield, a creditor’s attorney may file a complaint alleging fraud and invoke the veil-piercing remedy, allowing the judgment creditor to circumvent normal judgment collection procedures codified in the LLC act.8 One such procedure is charging of the member’s interest in the LLC.9
Insulation Against Outside Liabilities
Limited partnerships and LLCs share certain asset protection features against outside liabilities, such as a creditor. One key feature occurs when a limited partner cannot satisfy a creditor. The creditor’s only available remedy may be to secure a charging order against a partner’s limited partnership or membership interest income.10 A charging order gives the creditor the right to receive all distributions from the LLC related to the debtor’s interest thereon until such time as the debt is satisfied. Because limited partnerships and LLCs similarly insulate debtors from outside liabilities, the protection of the charging order concept should extend to LLCs in Florida.
In 2005, a Florida Bar task force successfully provided the Florida Legislature with a revised form of the Florida Revised Uniform Limited Partnership Act of 2005. Under RE-FRULPA, the exclusive remedy for a judgment creditor of a limited partnership is a “charging order.”11 LLCs currently enjoy the protection of “charging orders,” but not as an exclusive remedy.
The Exclusivity of the Charging Order Remedy
Under RE-FRULPA, in an action against a limited partnership, charging orders provide an exclusive remedy when a judgment creditor’s rights equal those of an assignee to the extent charged.12 F. S. §608.433 provides similar protection for LLCs. However, unlike limited partnerships, under F.S. §620.1703, a charging order is not the sole remedy against an LLC interest.13
In an LLC, the rights of a creditor under a charging order equal those of a transferee and cannot reach management and other partners’ rights.14 The rights of the charging order holder extend only to the judgment debtor/partner’s rights to distributions.15 In this scenario, the rights of the charging order holder are analogous to those of a wage garnishor. The charging order represents a lien on the judgment-debtor’s distribution rights. Such a right is the judgment-debtor’s transferrable interest. A court cannot order other remedies for a judgment creditor who attempts to satisfy a judgment out of the judgment debtor’s interest in the limited partnership.16 This includes remedies of foreclosure on the partner’s interest in the limited partnership or a transferee’s transferable interest and a court order for directions, accounts, and inquiries that the debtor general or limited partner might have made.17
Certain state statutes and precedent provide for the foreclosure and sale of an LLC or limited partnership interest. In such a situation, the buyer takes the position of an assignee and shares no member or partner rights. For example, in Crocker National Bank v. Perroton, 208 Cal. App. 3d 1 (Cal. Dist. Ct. App. 1989), the California district court of appeal considered whether a charged limited partnership interest was subject to foreclosure and sale. The court determined that when the creditor has a “charging order,” all partners other than the debtor agree to sale and the judgment remains unsatisfied, a court can authorize sale of the debtor’s partnership interest.18
The Nigri v. Lotz, 453 S.E.2d 780 (Ga. Ct. App. 1995), decision illustrates the importance of the incorporation state in the entity selection process. As in Nigri, if the applicable limited partnership statute and case precedent do not make the charging order the sole remedy, the court may use other means to enforce the charging order, such as foreclosure of a partner’s interest.19 In Nigri, the Georgia court of appeals considered whether a charged limited partnership interest was subject to foreclosure and sale.20 The court held that a trial court may enforce a charging order through foreclosure of a partner’s interest, especially when it appears distributions under the charging order will not pay off the judgment debt within a reasonable period of time.21 The court concluded whether a judicial sale of the charged partnership interest is appropriate in aid of a charging order lies within a trial court’s discretion.22
Despite the ultimate decision in Nigri, the court raised an argument of concern. Noting the Uniform Limited Partnership Act (ULPA) and the Uniform Partnership Act (UPA) governed the limited partnership in Nigri, the court of appeals stated the UPA contained a provision which prohibited the sale of a charged interest, while the ULPA did not.23 The court determined the purpose underlying the inability to sell and transfer a partner’s charged interest under the UPA was fear of disruption as the creditor-assignee could seek judicial dissolution of the partnership.24 The court distinguished foreclosures of limited partnership interests since the assignee of a limited partnership interest cannot seek judicial dissolution under the ULPA.25 The bankruptcy court in In re Albright, 291 B.R. 538 (Bankr. D. Co. 2003), advanced the same argument. The bankrupt sole member in Albright sought to thwart the trustee’s ability to reach the LLC’s assets and use them for her own obligations.26 The LLC member argued that according to the charging order, the only relief available to the trustee was receipt of distributions.27 The court rejected the charging order defense on grounds that the remedy served to protect nondebtor members of a multi-member LLC from judgments against a debtor member.28 Thus, in a single-member entity in which no nondebtor members existed, the trustee could take on a managerial position in the LLC in place of Albright.29
In a single-member LLC, different considerations shape how a court applies liability rules. For example, in Albright, the court concluded a charging order’s purpose was to protect other LLC members from sharing governance responsibilities with a judgment creditor.30 The court found single-member LLCs with only one managing member were not protected since no other members existed.31 In Albright, a judgment creditor could, thus, obtain governance rights.32
The Albright caveat — a Ch. 7 liquidated bankruptcy. Upon the debtor’s bankruptcy filing, she effectively transferred her membership interest to the estate.33 With no other existing members, the bankruptcy trustee became a substituted member.34 Thus, the same result would not necessarily occur in favor of a creditor.35 Certain elements of the LLC’s statutory structure, including the charging order and requirement that the current owner approve new members, lose their rational support when viewed in the single-member LLC context.36 Thus, Albright should not apply to multi-member LLCs.37
In re Ehmann, 319 B.R. 200 (Bankr. D. Ariz. 2005), involved a recent bankruptcy court decision in which the court allowed a Ch. 7 bankruptcy trustee to step in the shoes of a bankrupt member of an Arizona LLC as a full member without assuming the assignee status of a transferee, which state law and the operating agreement required. There, the debtor’s parents set up a multi-member family LLC and distributed significant funds to themselves and their children but not the debtor/bankruptcy trustee.38
In order to mitigate the Ehmann issue, tax planners recommend 1) drafting the LLC operating agreement or operating agreement as an “executory contract” for bankruptcy law purposes and provide entity owners’ ongoing obligations; 2) mandatory capital calls; 3) service obligations; 4) noncompetition obligations; and 5) partnership or membership interests with owners of a trust or tenants by the entirety.39
In the single-member LLC context, how does a Ch. 11 bankruptcy proceeding differ from a Ch. 7 proceeding? Recent court decisions involving pending Ch. 11 bankruptcy actions relied entirely on bankruptcy law and held that in a single-member LLC, all debtor’s interests became the bankruptcy estate’s property and subject to the trustee’s sole and exclusive authority.40
The Florida Supreme Court case of Federal Trade Commission v. Olmstead, 528 F.3d 1310 (11th Cir. 2008), provides an interesting analysis of how to reach single-member LLC assets in a fraud scenario. Olmstead involved two people who used an “S” corporation and single-member LLC to run a credit card scam.41 The defendant agreed to appointment of a receiver over the LLC who was directed to “conserve, hold and manage, preserve the value of, and prevent the unauthorized transfer, withdrawal, or misapplication of the entities’ assets.”42 The Federal Trade Commission (FTC) later obtained a $10 million judgment against the individuals and their original company.43 The FTC then moved to compel defendants to surrender their single-member LLC interests to the receiver.44 The district court granted the motion, and the receiver sold the LLC’s assets and paid the FTC the proceeds.45 The appellate court in Olmstead certified the following question to the Florida Supreme Court: “Whether, pursuant to Florida Statute section 608.433(4), a court may order a judgment-debtor to surrender all ‘right title and interest’ in the debtor’s single-member limited liability company to satisfy an outstanding judgment?”46
The Florida Supreme Court held that a charging lien is not the sole remedy against a single-member LLC. It cited the “emptiness” of the charging lien when there are no other members to protect and/or obtain the approval to become a member. More importantly, the decision stated that the LLC statute did not have the “sole and exclusive” language that the limited partnership statute contained. Although the opinion spoke only to single-member LLCs, this last line of reasoning does not bode well for multi-member LLCs, but it does indicate that charging orders against limited partnership interests are the creditors’ sole remedy.
On September 29, 2010, the U.S. District Court of Appeals for the 11th Circuit concluded that, based on the Florida Supreme Court’s decision in Olmstead, a court may order a judgment-debtor to surrender all “right, title and interest” in the debtor’s single-member LLC to satisfy a judgment creditor’s claims.47 Now we have federal appellate law to add to the Florida Supreme Court, as well as the four bankruptcy cases that all do away with the “soleness” of the charging order as a remedy for creditors against single-member LLCs.
Single-member LLCs Treated as Separate Entities
Can the IRS get a tax lien against a single-member LLC? An assessment against a single-member owner of an LLC does not result in an enforceable IRS tax lien against the LLC’s assets.48 In one case, the IRS treated a disregarded single-member LLC as a separate entity in order to apply the small partnership exception to TEFRA audit rules.49
As an interesting aside, in Revenue Ruling 77-137, the Internal Revenue Service ruled that a limited partnership entity’s K-1 must be reported by a limited partnership interest assignee, even when the partnership agreement provided an assignee may not become a substituted limited partner without the general partners’ consent.50 This rule, applied to an LLC, gives a creditor a strong inducement against foreclosure, if documents fail to provide for minimum tax distributions.
A final thought regarding Florida law: RE-FRULPA currently provides the charging order as a sole remedy. Such exclusivity binds Florida courts as we move into the future. Unfortunately, LLCs do not share such tight protection. The new Florida Bar task force redrafting the LLC statute will review this inconsistency. But until a change takes place in the law, enough chinks in the armor of the LLC exist to allow outside creditors through. Thus, the safer structure in such a situation is a limited liability limited partnership.
While Olmstead is still fresh on our minds, consider the following planning thoughts:
1) Issue additional shares of the LLC so that the LLC is a multi-member LLC and not a single-member LLC. The only caveat is that the Olmstead case infers that the charging order is not the sole remedy against a multi-member, either, because the statute is improperly drafted. Assuming that the new statute goes through as currently drafted, it should be resolved by the middle of this year. However, in the meantime, you still have the question of whether it is the sole remedy based on the dicta in Olmstead.
2) Leave the state. However, the use of single-member entities in states with clearer language — such as Delaware or Wyoming — may not be as safe as you think. No rulings have been held in these states, but it is pretty clear that the bankruptcy courts in Albright, Ehman’s, etc . are not going to recognize the single-member LLC to protect against creditors. With all the discussion going on around the country about Olmstead, it may well be that the courts are not going to recognize a single-member LLC under state law either, so if you are going to leave, leave the country.
3) Hold the interest in a single-member LLC as tenants by the entirety between husband and spouse. It is strongly recommended that you issue a single certificate, labeled husband and wife as tenants by the entirety, and draft an operating agreement that clearly states the entity as a single-member entity, and there is no distinguishment between voting, profits and losses, or capital as between the spouses. Lastly, the personal tax returns of the spouses should be filed jointly disregarding the entity and recognizing all the income as if the entity were disregarded. In Florida, this should protect the assets against the creditor of one of the spouses and should be disregarded for tax purposes. However, you still have the following problems that occur:
• Client is single.
• Prenuptial or client may simply not want to share the ownership with his or her spouse.
• The judgment is against both spouses.
• If the wrong spouse dies.
• This arrangement may not fit with your estate planning goals when you are trying to set up separate assets in each spouse’s name to fund the unified credit shelter trust. Of course, if you have enough to fund that trust for each spouse with other assets, it is not as much of a problem.
4) The best alternative seems to be to use an “LLLP.” Convert to or begin with an LLLP. The Olmstead court indicated that the “sole and exclusive” language of the LLLP statute was sufficient to protect the entity against debtors. This entity is a little more expensive and requires a partnership tax return. The only problems here are that you must have a real second member, and you must identify the general partner. The first problem is mostly a business question. As for the second, it can be a corporation, an LLC, or an individual. The creditor can take the interest of a corporation or an LLC and thereby own the general partner’s interest, but an individual general partner may be best because the creditor can only obtain a charging lien against his or her interest, and the individual is protected from inside liability by electing to become an LLLP. Further, if the individual is married, the general partner interest could be held as tenants-by-the-entireties, which should avoid the charging lien entirely. After that, the creditor is a mere “assignee” and cannot affect the company business without the consent of the other partners. And the other partners can replace the general partner unless restricted by the partnership agreement, so in drafting the agreements, make sure to provide for the remaining partners to do so in the event of such an assignment.
Continued Uses for Single-member LLCs
The following uses presume that there is little or no need for protection against outside creditors:
1) As firewalls between the shareholder and another interest. For instance, in a tenancy in common (TIC), rather than taking the owner’s undivided interest in the name of the individual and subjecting the person to liability, it is better to hold the interest in a single-member LLC so that it not only provides for protection from liability coming from the property, but also the entity is disregarded so it can use the entity to effect a tax-free exchange under §1031. This LLC can also be held jointly as tenants by the entirety as discussed above. Although this does not obviate Olmstead, it is better than holding the TIC in the individual’s name.
2) Firewalls between subsidiaries and parent. When used as subsidiaries of a parent holding company, LLCs sometimes are used to create firewalls between the subsidiaries and the parent. The only time the Olmstead issue would arise would be debt at the parent level, which should be manageable if the parent is a simple holding company holding the subsidiaries.
3) Bankruptcy remote entities. The LLC is a good choice to serve as a bankruptcy remote entity. This means that the interest in capital and profits would be owned by the borrower, but a nonprofit/capital interest is owned by a lender or its nominee. That interest is a second class of membership interest, which only has the right to vote against such things as bankruptcy, lawsuits, adding additional debt, etc., which the lender would like to prevent.
1 See Stone v. Frederick Hobby Assocs. II, LLC, No. CV 000181620S, 2001 WL 861822 at *8 (Conn. Super. Ct. July 10, 2001).
3 Id. at *9.
5 Fla. Stat. §620.81002 (2010).
6 17315 Collins Ave., LLC v. Fortune Dev. Sales Corp., 34 So. 3d 166 (Fla. 3d D.C.A. 2010); see also Dania Jai-Alai Palace, Inc. v. Sykes, 450 So. 2d 1114 (Fla. 1984) (“improper conduct” also required); Baldwin v. Bill & Carolyn Ltd. P’ship, No. BAP.NO. EO-05-114, 2006 WL 2034217 at *1 (B.A.P. 10th Cir. 2006).
7 Litchfield Asset Mgmt. Corp. v. Howell, 799 A.2d 298 (Conn. App. Ct. 2001).
8 Fla. Stat. §621.02 (2010). Professional Service Corporations and Limited Liability Company Act, Ch. 621, §621.02 (2010); see Fla. Stat. §608.701 (2010).
9 Fla. Stat. §608.433 (2010). Professional Services Corporations and Limited Liability Companies, Ch. 621 §621.8504 (2010); see also Klein v. Weidner, No. 08-3798, 2010 WL 571800 at *8 (E.D. Pa. Feb. 17, 2010) (reverse pierce where LLC improperly used to perpetrate injustice against creditor); Postal Instant Press, Inc. v. Kaswa Corp., 162 Cal. App. 4th 1510 (Cal. Ct. App. 2008) (reverse pierce allowed with “alter ego” doctrine after alternative available remedies found inadequate).
10 Fla. Stat. §620.1703 (2005).
11 See Rights of Creditor of Partner or Transferee.
Fla. Stat. §620.1703 (2010).
12 Fla. Stat. §620.1703(3) (2010); RE-FRULPA section citation providing judgment creditor exclusive remedy is charging order and rights are of an assignee to extent charged.
Fla. Stat. §620.8504 (2010).
13 See Right of an Assignee to Become Member.
Fla. Stat. §608.433 (2010).
14 Fla. Stat. §§608.432 and 608.433(4) (2010).
15 Fla. Stat. §608.433(4) (2010).
16 Fla. Stat. §620.1703(3) (2010).
18 Id. See also Hellman v. Anderson, 233 Cal. App. 3d 840 (Cal. Ct. App. 1991) (consent of nondebtor partners not always required when no undue interference with partnership business exists).
19 Nigri v. Lotz, 453 S.E.2d 780, 782-783 (Ga. Ct. App. 1995).
25 Id. Similarly, other states with statutes or precedent allowing foreclosures include California, Colorado, Connecticut, Georgia, Hawaii, Idaho (effective July 1, 2010), Illinois, Iowa, Kansas, Kentucky, Maryland, Missouri, Montana, Nebraska, New Hampshire, Ohio, South Carolina, Utah, Vermont, and West Virginia. States not allowing foreclosure include Alabama, Alaska, Arizona, Delaware, Florida, Minnesota, New Jersey, North Carolina, North Dakota, Oklahoma, South Dakota, Tennessee, Texas, Virginia, and Wyoming.
26 In re Albright, 291 B.R. 538 (Bankr. D. Co. 2003).
37 See also In re Ehmann, 319 B.R. 200 (Bankr. D. Ariz. 2005); Crocker Nat’l Bank v. Perroton, 208 Cal. App. 3d 1 (Cal. Dist. Ct. App. 1989); cf. Revised Model LLC Act,
Fla. Stat. §621.02 (2010) (permits foreclosure on multi-member LLC interest as in Perroton and Nigri, 453 S.E.2d 780 at 782-783); see also The Florida Bar task force drafting the new Florida LLC Act and reviewing single- and multi-member issues.
38 In re Ehmann, 319 B.R. 200 (Bankr. D. Ariz. 2005).
39 In Florida, “tenants by the entirety” gives property owners significant asset protection, as husband and wife theoretically own 100 percent of the asset, which forbids one spouse’s creditor from seizing the property. Exceptions are joint debt and when a nondebtor spouse dies with an action pending against the debtor spouse.
40 In re Modanlo, 412 B.R. 715 (Bankr. D. Md. 2006), aff’d 266 Fed. Appx. 272 (2008); In re A-Z Electronics, LLC, 350 B.R. 886 (Bankr. D. Idaho 2006).
41 Federal Trade Comm’n v. Olmstead, 528 F.3d 1310 (11th Cir. 2008).
47 Federal Trade Comm’n v. Olmstead, 621 F.3d 1327 (11th Cir. 2010).
48 IRS CCA 200338012, 2003 WL 22208688, §82.01.00-00 Trust Fund Taxes: Collection (Sept. 19, 2003); IRS CCA 200235023, WL 1999524, §6331 Levy and Distraint (Aug. 30, 2002).
49 See IRS CCA 200250012, 2002 WL 31781355, §6231 Definitions and Special Rules (December 13, 2002).
50 Rev. Rul. 77-137, 1977-1 CB 178.
Domenick R. Lioce , a partner with Nason, Yeager, Gerson, White & Lioce, P.A., is an AV-rated lawyer who practices in the areas of tax research and planning, general business law, corporate law, and trusts and estates. He received a J.D. from Florida State University, holds a masters of accountancy, a B.S. in accounting and finance, and is a certified public accountant.
This column is submitted on behalf of the Tax Section, Guy E. Whitesman, chair, and Michael D. Miller and Benjamin Jablow, editors.