How charging orders work

One day, finally getting a break from the constant demands of the restaurant you started and built, you drive to the supermarket and accidently hit someone with your car. Sure, the woman mindlessly walked in front of you and you only barely bruised her, but that means nothing when she shows up to court in a neck brace. The jury, sympathetic to the woman’s plight, finds in her favor, and you now owe this woman more than your insurance covers and more than you can afford. After wiping out your family’s savings, your equity in your home, and your kid’s college funds, you still come up short.

But the bad news gets worse if the restaurant you’ve spent the past four years building is structured as a corporation. Your ownership interest (stock) in that corporation is considered a personal asset of yours, and the judgment creditor is therefore allowed to foreclose on it. Before you know it, your corporate account’s been frozen, and you’re holding a fire sale of your kitchen equipment to satisfy the debt. Your company is toast.

Now imagine a different scenario: Instead of forming your restaurant as a corporation, you formed it as a limited liability company. When you are sued, the plaintiff can’t foreclose on your business, but instead can only obtain a charging order against your LLC. This means that she has no say in the day-to-day operation of the business and can only wait patiently with her hand out, should you decide to issue her profit distributions. And why would you ever do that?

Economic rights versus other rights

To better understand charging order protection, you should know that a member can have two rights in an LLC: economic rights, or the right to receive profit allocations and distributions from the company; and other rights, which include the right to vote on important matters or be involved in the day-to-day management of the business. Assuming that your operating agreement allows for it, charging order protection grants only economic rights to the assignee under most state laws. In other words, the creditor has no choice but to shut her trap, sit back, and receive whatever distributions you decide to grant her. You could stop profit distributions altogether, and the creditor would have no say in the matter.

This is the worst possible situation for your judgment creditor, because while you are withholding profit distributions from her, she is still required to pay taxes on that allocated share of the profits. This is called phantom income, which I dive into in Chapter 14, and it usually isn’t a good thing. In this case, however, it works in your favor, and you can easily force your creditor to end up with nothing except the pleasure of paying down your tax bill. It’s funny how this arrangement can make even the most bull-headed creditors call up, ready to negotiate an extremely favorable settlement!

Of course, considering that her attorney would know that trying to seize membership interests in an LLC is a losing proposition, it’s unlikely that she would risk suing you at all. But who knows? Maybe that fake neck brace cut off circulation to her brain. I discuss charging order protection and this strategy in more detail in Chapter 17.

When formed and maintained properly, LLCs always hold up in court. When creditors see that you have shielded your assets with an LLC, they very rarely go through the hassle of taking you to court. And avoiding a lawsuit is always better than winning one, or, as legendary Chinese strategist Sun Tzu wrote, “The best battle is the battle that is won without being fought.”

No ownership restrictions

Back in the day, if you wanted liability protection and a form of pass-through taxation, you were resigned to forming an S corporation. As I describe at length in Chapter 3, S corporations are just basic corporations with a special tax election that you can file with the IRS. Unfortunately, they also come with severe limitations as to the number and types of owners the business may have. For example, S corporations are limited to 100 or fewer owners (shareholders), and these owners cannot be other companies or non–U.S. citizens. Additionally, they can have only one class of ownership — meaning that all owners must be treated equally.

LLCs, on the other hand, have no such problems. You can issue as many shares as you want to any other entity or individual of any nationality. (However, as individual as your pets may be, they don’t count!) You can also structure the ownership however you like using membership classes. You can give preference to certain owners when it comes to profit distributions, or you can allow some owners certain voting rights that others don’t get.

LLCs also offer a lot of leeway as to how individual ownership is structured. For example, each member can be subject to his own buy-sell agreement that dictates the rules and restrictions on his individual membership interest, including what should happen to that member’s interest should he pass away or get a divorce. Trust me, the last thing you want is to wake up one day with a dearly departed member’s crazy son as your new partner. These rules can vary from member to member if you so choose. I discuss buy-sell agreements in Chapter 12.

No management restrictions

When it comes to the management of the business, an LLC can be managed by

• Its members: When you select member management for your LLC, all of the business’s members have an equal say in the day-to-day operations, no matter their ownership percentage (unless you state otherwise in the operating agreement). They all have an equal right to sign contracts and enter into debts on behalf of the business. If you don’t want one of your members to have this sort of power, then member management is definitely not for you.

• Separate managers: These folks may or may not hold a stake in the company. Most companies that have more than two or three operating members choose manager management. When you elect manager management, you can have as many of your members be managers as you want; however, not all of them have to be managers if you don’t want them to be.

  For example, say you are raising money for your new enterprise. Although you want your investors to profit from the business’s success, you don’t want them to have a say in the day-to-day operations. To achieve this, you form a manager-managed LLC and elect yourself as the only manager. As members without management authority, the investors have limited say in the day-to-day operations of the business. This is a really good strategy for creative projects like movies as a way to keep the investors from running wild on the set.

When establishing your LLC, you state in your articles of organization whether your company will be designated member-managed or manager-managed. I discuss the ins and outs of selecting the members and managers of your LLC in Chapter 10.

Most states give you heaps of leeway in prescribing exactly how your company is managed. You can create multiple management groups and multiple management roles. You can also restrict some nonmanaging members from voting or having any say whatsoever, including who is chosen to manage the company. All these types of details are up to your discretion and simply need to be laid out in the LLC’s operating agreement.

The fact that you can specify separate managers is a trademark of LLCs that helps separate them from other entities, such as sole proprietorships and general partnerships. In a general partnership, all the members are owners, and all are equally (and personally!) liable for the business. A limited partnership can have members who also manage the business; however, it doesn’t have any sort of limited liability protection. I indulge your curiosity on these (in my opinion) inferior entity types in Chapter 3.

The management aspect is one reason LLCs work well in estate planning. You can place your assets in an LLC with the kids as the full owners (members) and yourself as the manager. This way, you still control the company, while your kids can receive profit distributions. Upon your death, the assets are still in their name, and a new manager is elected.

LLCs are definitely not one size fits all; they need to be customized to your particular business needs. All this customization happens in the operating agreement, making it the most important document you’ll ever write in regard to your business. I cannot emphasize that fact enough. If you don’t have an operating agreement, your state’s default rules apply, and I promise you that they won’t give you much more than a headache. This doesn’t mean that you should pull up a shoddy fill-in-the-blank operating agreement on the Internet and use that, either. Those generic forms are mostly antiquated, are not state specific, and likely won’t address all your needs. In Part 3 of this book, I go into detail on how to create a custom operating agreement for your LLC.

Making your selection

The default tax status for LLCs with more than one member is partnership tax status. If you want to elect any other form, you must file a Form 8832: Entity Classification Election with the IRS. You can download a copy of the IRS form (including instructions) at www.irs.gov/uac/Form-8832,-Entity-Classification-Election.

When filing Form 8832, you can elect the new form of taxation retroactively up to 75 days. Under certain circumstances, the IRS may even allow you to elect a different form of taxation retroactively up to three years and 75 days, however it’s best to make your election on time.

After you file Form 8832 and elect a different form of taxation for your LLC, you are stuck with that chosen method of taxation for five years (called the 60-month rule). In Chapter 14, I discuss potential ways to get around this rule, but because changing may not be possible, I suggest that you take some time to choose your form of taxation wisely. Turn to Chapter 8 for assistance in choosing your form of taxation.

Single-member LLCs and the IRS

A single-member LLC (an LLC with only one member) is automatically considered by the IRS to be a disregarded entity and, by default, is taxed exactly as it would be if it were simply a sole proprietorship. This doesn’t affect the basic liability protection of the LLC, but it does change the tax rules.

A single-member LLC has fewer options when it comes to electing a form of taxation. Because it’s not technically a partnership, the IRS restricts it from electing partnership taxation. In this case, you have three options:

• You can do nothing and be taxed as a disregarded entity.
• You can elect to be taxed as a corporation by filing a Form 8832: Entity Classification Election with the IRS.
• You can elect S corporation taxation by filing Form 2553: Election by a Small Business Corporation. Keep in mind that if you choose to be taxed as an S corporation, you’ll be subject to the same membership limitations as S corporations.

If you are a single-member LLC and want to be taxed as a partnership, you can always issue a small percentage of your company to a trusted friend or family member and avoid this situation entirely. Or, as an alternative to bringing friends or family on board, you have the option of forming a corporation — with you as the sole shareholder — and having the corporation be your partner in the LLC. If you live in a state in which forming a corporation is a costly endeavor, you can always form your corporation in a less-expensive, tax-free state, such as Nevada. You pay about $125 per year in registration fees; however, your LLC gets the benefit of partnership taxation.

Nevada is a great state for forming a “partner” corporation because of the privacy it offers. You see, Nevada doesn’t require you to disclose who the shareholders of a corporation are. This privacy is beneficial if for some reason you don’t want anyone to know that the partner in your LLC is actually, well, you.

If you are a single-member LLC, you are not eligible to elect partnership taxation on Form 8832.

Simply wearing a suit doesn’t make you a professional

Now, just because you are a professional at something and happen to be licensed doesn’t mean that this legal “professional” designation applies to you. For instance, in some states, architects are considered professionals, but in other states they are not. To give you an idea of which types of services typically fall into this category, here is an excerpt from the Connecticut statute (Sec. 33-182a) governing the definition:

“Professional service” means any type of service to the public that requires that members of a profession rendering such service obtain a license or other legal authorization as a condition precedent to the rendition thereof, limited to the professional services rendered by dentists, naturopaths, chiropractors, physicians and surgeons, physician assistants, doctors of dentistry, physical therapists, occupational therapists, podiatrists, optometrists, nurses, nurse-midwives, veterinarians, pharmacists, architects, professional engineers, or jointly by architects and professional engineers, landscape architects, real estate brokers, insurance producers, certified public accountants and public accountants, land surveyors, psychologists, attorneys-at-law, licensed marital and family therapists, licensed professional counselors and licensed clinical social workers.

The states differ so widely on which professions are required to be licensed that you could be required to operate as a PLLC in one state while being a standard LLC in another state. Therefore, if you think that professional licensing rules may apply to you, it’s important to check your state’s laws on the issue before filing your limited liability company. To make this research as easy as possible for you, I aggregated all the state laws governing licensed professionals on a private site especially for Dummies readers. Check it out at www.docrun.com/dummies. The password is onesmartdummy.

Different liability protection

A licensed professional generally has a much bigger impact on his individual clients than, say, the manufacturer of a mundane household product. The effects of an accountant failing to do his job properly are much more profound than the outcome of your bath soap not delivering on its promise. Because personal responsibility is a mainstay of being a licensed professional, the states want to make sure that these professionals don’t shirk responsibility for their negligent acts by hiding themselves — and their assets — behind the liability protection of a corporation or an LLC.

Just like regular LLCs, a professional LLC protects you personally from debts and lawsuits against the business, with one major exception: Most states do not allow liability protection to extend to malpractice claims. Before you balk, think for a minute: Can you imagine what would happen if an irresponsible doctor were able to operate without malpractice insurance without fear of consequences? Assuming that she had the forethought to protect her business assets in another entity, nothing substantial would be at stake. She’d simply form another entity and continue on her way, leaving hurt patients in her wake.

If you’re a licensed professional, this sort of liability is a serious concern, so professional liability insurance is a must. Often referred to as malpractice insurance, it indemnifies professionals from their mistakes. If you are a licensed professional, you’d be crazy not to have it.

Also, when one of the partners in a PLLC is liable for negligent acts while practicing her profession, the rest of the partners usually do not share in her personal liability. Assuming that they took no part in the negligence, their assets should remain safe. This provision not only protects your personal assets should your partner accidentally slip up during surgery, but it also keeps your malpractice claims separate so that your premiums don’t rise if your partner screws up. This protection is a huge benefit over operating as a general partnership, in which you are jointly, personally responsible for your partners’ mistakes.

Although the personal liability protection of professional LLCs is somewhat different from that of standard LLCs, charging order protection (the second layer of liability protection unique to LLCs) remains intact. I discuss charging order protection in more detail in Chapter 17.

Restrictions on ownership

All states have pretty strict restrictions on who can own and operate a professional LLC. Many states restrict membership in professional LLCs to individuals in the licensed profession. For instance, if a legal practice decides to operate as a professional LLC, then non-lawyers cannot hold an interest in that practice. Some states require only a 50 percent majority of licensed professionals. Others allow previously licensed and retired practitioners to be members, and some allow heirs and/or beneficiaries to inherit membership interests upon the death of a licensed practitioner member.

For example, here is an excerpt from Florida Statute 621.09 (2) governing ownership restrictions for professional LLCs:

No person shall be admitted as a member of a limited liability company organized under this act, unless such person is a professional corporation, a professional limited liability company, or an individual, each of which must be duly licensed or otherwise legally authorized to render the same specific professional services as those for which the limited liability company is organized. No member of a limited liability company organized under this act shall enter into any type of agreement vesting another person with the authority to exercise any of that member’s voting power in the limited liability company.

Some states also restrict who can and cannot be managers of a PLLC. Make sure to check your state’s laws for restrictions pertaining to your business. To make your life a tad bit easier, you can read the most current laws for each state at www.docrun.com/dummies. The password is onesmartdummy.

Restrictions on business activities

Like the ownership restrictions described in the preceding section, professional LLCs are statutorily confined to transacting only the sort of business or service for which the licensed professionals who own it are licensed. I’m not sure why the states set this restriction. Perhaps they don’t want things to get too muddy, so the sightline of personal responsibility remains clear.

I, for one, don’t like cages. Anything that restricts me drives me crazy. If you’re like me, then you’re probably thinking, “Nobody’s going to tell me what business I can and cannot engage in!” (Note: This does not apply to drug-runners or those who club baby seals for a living.) If you’re the entrepreneurial sort and, say, want to develop a software solution for your client base, you can’t do it through your professional LLC. Luckily, I can offer you an easy solution: Simply form another, nonprofessional entity to manage your other business objectives.

Forming a professional LLC

Forming a professional LLC isn’t difficult. The process is roughly the same as forming a standard LLC (which I outline in detail in Chapter 6), with a few major exceptions:

• You may need to show that you and your other members have been approved by your industry’s licensing board before being able to operate under your professional LLC. In most states, you have to attach to your articles of organization a copy of the members’ professional licenses and/or include in the articles the members’ license numbers obtained from the state licensing board.
• One or more of the licensed professionals usually has to sign the articles of organization. Unless you are preparing and filing your articles of organization yourself, getting the articles to a qualified member may cause significant lag time compared with forming a standard LLC, for which a third party can usually file the documents by signing as the organizer.
• You may have to add a special designation at the end of your business name that identifies your company as a professional LLC. While the options vary somewhat from state to state, the required designation is usually a Professional Limited Liability Company, a PLLC, P.L.L.C., or PLLC. Some states also allow such designations as Limited, Ltd., or Chartered.
• Your business name cannot make reference to any services other than the services for which your PLLC’s members are licensed. In some states, such as Nevada, the law is even more strict: Your business name must contain the last name of one or more of the PLLC’s current or former members.

In states where the last name of a professionally licensed member is required, you can often still operate under a different name. You simply file a fictitious firm name statement (also called a DBA) with your local country clerk. I show you how to do so in Chapter 4.

The differences don’t end after you finally have your professional LLC filed. Throughout this book, I advocate the importance of the LLC operating agreement. A PLLC is just as much, if not more, in need of a comprehensive and ironclad operating agreement to govern it. Your personal assets depend on it!

Due to the nature of the PLLC, your operating agreement will vary substantially from the operating agreement of a standard LLC. Because operating agreements for professional LLCs are very customized to your specific circumstances and state laws, you may want to work with a lawyer (make sure that she is proficient in and experienced with PLLCs!), or you can contact my office at DocRun (www.docrun.com), and I’ll get you going in the right direction.

Segregating your assets in a series LLC

I’m a big believer in forming a different entity for each of your assets (real estate, intellectual property, and so on) so that you can segregate each asset from the lawsuits and liabilities of the others. For example, if you own a taxi company, a common practice is to place each vehicle or two in its own limited liability company. That way, if an accident occurs, the liability is confined to the one or two vehicles in that LLC, and the rest of the business and its assets remain secure. Same goes for real estate investments: If all your property is in only one LLC, then if a renter sues you and a judgment is awarded, all your properties are at risk of seizure. This isn’t the case if you segregate each property.

I get hammered with questions daily from clients who have heard of the series LLC and are interested in using this hot new entity type for their asset protection so that they don’t have to form and manage a bunch of separate LLCs. This is a common misconception. You see, you want each cell to be treated as a separate entity from the others — each one should have its own operating agreement and bank accounts, should prepare separate financial statements, and should file separate tax returns. Otherwise, you run the risk of the liability protection failing between one cell and another.

So if you want each cell to be treated as a completely separate LLC, then why not just form completely separate LLCs? What’s the benefit of a series LLC, anyway? Well, the answer is … not much. In some states, in which series LLCs are recognized, you can get away with paying only one filing fee (for the umbrella LLC) instead of the many fees you would have to pay if you went the traditional route of forming multiple LLCs.

But this is a benefit only if your LLC exists in one of these few states and doesn’t transact business in one of the many states with less favorable laws. Let me give you an example: Say you have a couple of rental properties in California and you want to place each property in its own cell of a series LLC. You form the series LLC in Delaware (because California doesn’t allow for the formation of series LLCs). Then, when you go to register in California, you learn that these states’ laws are different — California requires each cell to be registered separately. This means that you’re still paying the $800 annual minimum franchise tax for each cell, and all of that savings you were betting on goes out the window.

Only in rare situations do the benefits of series LLCs outweigh the risks. After all, the series LLC is a new type of business structure, and most states don’t quite know what to do with it. Series LLCs lack legal precedent (which means that their effectiveness hasn’t been tested in a court of law), and although the states that allow for their formation provide for that special barrier of liability protection between the different cells in their statutes, you have no guarantee that other states will agree. And if you form your series LLC in Delaware and register it to transact business in California for the purpose of holding California real estate, then your court case will probably be subject to California law — which, in this case, isn’t a good thing!

Some states might recognize series LLCs, but this doesn’t mean that they need to recognize the liability protection between the cells. Having a series LLC in a state that doesn’t have specific laws clearly stating that each cell is treated separately is a pretty big risk.

So, is saving a few hundred bucks really worth it? Without the liability protection of a series LLC being tried and verified by a court of law, you are signing yourself up to be the test dummy if you are ever dragged into court. The irony is that, in the end, using an entity that’s meant to save you fees may be the very thing that ends up costing you everything!

Forming a series LLC

If you’re really set on going with a series LLC, it’s much easier to form than you may realize. The process is very similar to forming a regular LLC. In most states, you simply file the same articles of organization as you would for a regular LLC and add a provision that allows for the formation of series or cells within the company.

From there, the series LLC essentially exists in your company operating agreement. As you can imagine, series LLCs require much different operating agreements than standard LLCs, and because the rules governing your LLC can vary from cell to cell, the length of your operating agreement will probably closely correspond to the number of cells you have in your LLC. Delaware state law does not cap the number of cells (series) that an LLC may have, which means that you could end up with one exorbitantly long operating agreement.

As of the publishing of this book, you can form a series LLC in the following states:

Additionally, Minnesota, North Dakota, and Wisconsin allow for the creation of series LLCs but don’t offer a liability shield among cells.

Maintaining a series LLC

Series LLCs aren’t bad for the businesses they were intended for — structured investments — but relying on liability protection holding up among the cells concerns me, especially for high-liability ventures such as real estate. But if you’re absolutely intent on using a series LLC for your assets or operating business and are willing to take the risk, this section shows you how to maintain it in order to maximize your chances in court.

The first thing you need to understand is that series LLCs exist primarily in the operating agreement, and, given the flexible nature of the LLC, you have tremendous leeway as to how you structure each cell/series. If you want to add or remove cells, you simply amend your operating agreement. Your original filing (your articles of organization) remains unchanged.

If your series LLC ever ends up being scrutinized by a court of law, what you have written in your operating agreement is all that will uphold the insular nature of the liability protection among the various cells. Therefore, however you choose to structure your operating agreement, make sure that it’s rock solid.

When you’ve established that your operating agreement is as comprehensive and cohesive as it possibly can be, you need to simply be a series LLC. If the cells of your series LLC are intended to replace separate LLCs, then you need to act in accordance with that plan. For all intents and purposes, each cell should be treated as a separate entity, complete with a separate set of books, records, and financials; a separate bank account; individual contracts; and so on. This includes having an additional, separate operating agreement for each cell.

Most, if not all, states allow you to elect whether your entire LLC is treated as a single taxpayer or each cell is treated as a separate taxpayer. As an example, here is the statute from Illinois that addresses the topic of taxation:

Series of members, managers or limited liability company interests. (b) … A series with limited liability shall be treated as a separate entity to the extent set forth in the articles of organization. Each series with limited liability may, in its own name, contract, hold title to assets, grant security interests, sue and be sued and otherwise conduct business and exercise the powers of a limited liability company under this Act. The limited liability company and any of its series may elect to consolidate their operations as a single taxpayer to the extent permitted under applicable law, elect to work cooperatively, elect to contract jointly or elect to be treated as a single business for purposes of qualification to do business in this or any other state.

Since the last edition of this book was published, the IRS has ruled that each cell in a series LLC is treated as a separate entity for tax purposes. Each cell can have a separate tax ID number, elect a different form of taxation, and file a separate tax return. If the series LLC cell has elected partnership taxation, you should also file separate Form 1065s and issue separate Schedule K-1s to that cell’s members at the end of each fiscal year. Doing so helps to further establish the segregation of the cells in your series LLC.