Understanding & Drafting
LLC Operating Agreements
(with WealthDocx®)
A presentation for the WealthCounsel® Forum
in Denver
October 12, 2011
Peter J. Parenti, JD, LL.M (taxation)
Agenda
• Intro to LLCs - background & law
• Overview of structural options: Types of LLCs
• Members and managers
• Jurisdiction considerations
• Uses of LLCs (gifting, asset protection, going concerns)
• Tax treatment & design options
• Transferring interests: buy-sell provisions in (VERY) brief
• A look at the WealthDocx® Interview
• WDx coming attractions
• Discussion/Wrap-up
Housekeeping
•Agenda timing - we probably got it
wrong
•Speak up! This is a conversation,
too.
•About the breaks?
•Ideas welcome!
Intro to LLCs
•Creatures of state statute
•Extremely flexible
•Few record keeping requirements
•Origins in partnership law
•Limitation on liabilities
(VERY jurisdiction-specific)
Intro to LLCsOrigins of
LLC law
•1822 NY Statute - enable investors to
limit liability exposure to investments
(birth of LPs)
•1916 - ULPA finalized; created
uniform law for managing LP
relationships, defining creditor rights
•1976 - Revised ULPA (RULPA) finalized
Intro to LLCsOrigins of
LLC law
• 1977 - Wyoming enacts first state LLC
law
• Eventually enacted in all 50 states
(far from uniform)
• 1995 - ULLCA finalized, amended
1996.
• 2006 - fully revised; dubbed “ReULLCA”
Intro to LLCsOrigins of
LLC law
•Now - Re-ULLCA substantially
adopted in:
•ID, IA, NE, WY
•Re-ULLCA pending in:
•D.C., IN, KS, UT
Intro to LLCs
About Re-ULLCA
•Elevated importance of operating
agreement
•Not-for-profit LLCs okay
•More management flexibility
(boards)
•Explicit duties of loyalty, due care
•Analogous to corporate directors
Intro to LLCs
About Re-ULLCA
•“Shelf” LLCs valid
•Charging order as exclusive
statutory remedy
•Foreclosure right on charging
orders
•(Judicial limitations may remain)
Interlude:
What’s a Charging Order?
•Charging order (protection): refers
to creditor’s statutory relief against
debtor member; does not admit
creditor as LLC member; equals
assignee interest (financial rights
only)
•Treated very differently in various
jxns
Intro to LLCsA few key
terms
•Inside Liability: claims arising
against the LLC, or among the
members in the LLC
•Outside Liability: claims arising
against a member from non-LLC
related activity
Intro to LLCs
•Separate legal entity - a legal
“person”
•LLCs have own rights, limitations,
creditors, etc.
•Members have no interest in
underlying property; own interest
in entity itself
•Operational life not limited to
members’ lives (making
succession planning essential)
Intro to LLCs
•Not subject to corporate record
keeping requirements
•No “minutes” requirements,
bylaws, regular meetings of
interest holders, etc.
•Beware of this trap!
Intro to LLCs
The players
• Manager (or managing partner/s)
• Oversees operations of LLC
• May be a member (but need not be)
• Unlike GP, has no liability for LLC
liabilities
• Duties imposed by law, operating
agreement
• Entitled to compensation for services
Intro to LLCs
The players
• Members
• Own interests in LLC
• No liability for LLC activities
• No right to participate in
management/operation (except
managing members)
• Restrictions on transferability of interest
• May (or may not vote) on LLC issues
Intro to LLCs
The players
• Assignees
• No ownership right; financial interest only
• No right to vote on anything
• No liability for LLC activities
• No right to participate in
management/operation (except managing
members)
• Often arises with invalid transfer of
membership interest or judgement
Structural Options
• Two basic forms:
• Multi-member LLCs (MMLLC)
• Tax as partnership, S-corp, C-corp
(sole prop. only if members are H&W)
• Single-member LLCs (SMLLC)
• Tax as sole prop./Disregarded
Entity (DE), S-corp, C-corp (not as
p’ship b/c no “partner”)
Structural Options
•Member-managed: one or more (not
necessarily all) members serve as
managers
•Manager-managed: appointed
manager(s), not necessarily members
•Managers may be individuals or
entities
Structural Options
•Our general preference...
•Don’t rely on default member
management; draft manager
provisions into agreement
•When appropriate, use entity
manager (i.e. Management Trust)
Structural Options
“Special Purpose” LLCs
• Wyoming Close LLC
• Member w/d only with consent of all other
members
• Return of capital only with unanimous
consent
• W/D member may only demand cash as
return of capital
• LLC dissolved only by unanimous consent
Structural
Options“Special
Purpose” LLCs
• Nevada Restricted LLC
• Assets in LLC may not be w/d during
restricted period
• Limited access intended to drive
discounts, further frustrate creditors
• Articles of Organization must opt in to
restricted statute & state lock-in period
Structural
Options“Special
Purpose” LLCs
•Professional LLCs (PLLCs)
•Enables professional practice to
enjoy limited liability &
administrative ease of LLC
structure
•Not all states, not all practices
Structural
Options“Special
Purpose” LLCs
• Series LLCs
• Assets, members, liabilities shielded
within various series (isolating claims)
• Proper record keeping essential
• Valid in 9 states (see list in outline, p.
12)
• Beware jurisdictional nuances
(e.g.,CA franchise tax on each series!)
Structural
Options“Special
Purpose” LLCs
• “Family” LLCs (FLLCs)
• All members in same family (or entities
controlled by or FBO family members)
• Not legally different than business LLCs
• Beware tendency to cut corners! (we’ll
cover in detail under §2036 discussion)
LLC Tax Choices
•LLC tax flexibility...
•Disregarded entity/sole proprietor
•Partnership (Subchapter K)
•Subchapter S corporation
•Subchapter C corporation
LLC Tax Choices
Sole Prop./Disregarded Entity
•Wholly owned by one individual, or
•Wholly owned by H&W
(Note: DOMA applies)
•“Disregarded” as separate taxpaying
entity under Fed. Income Tax Laws
•Pass-through treatment
LLC Tax Choices
Sole Prop./Disregarded Entity
•Pass-through...
•All income, gains, losses, pass
through entity (not separately
taxed); items taxed as if held by
individual owner
•Subject to tax treatment at
owner’s level
LLC Tax Choices
Sole Prop./Disregarded Entity
•Pass-through...
•Contributions/distributions of
property not taxable event
•LLC debts and expenses may be
taken as deduction for owner
LLC Tax Choices
Sole Prop./Disregarded Entity
•Benefits:
•Simplicity
•Flexible use of assets
•Inside basis step-up on 3d party
acquisition
•Limited Liability
LLC Tax Choices
Sole Prop./Disregarded Entity
•Limitations:
•No employee equity benefits
(ESOPs, ISOs)
•No choice of tax year (calendar
only)
•All earning subject to SelfEmployment Tax (SET)
LLC Tax Choices
Partnership (Sub-K)
• Roots in “aggregate” theory:
• Separate legal entity, but taxed as an
“aggregation” of individuals.
• Results in pass-through treatment;
entity not separately taxed
• Flexible allocation options per ULPA,
RULPA, IRC §704(b) Special Allocations
(discussed in greater detail in next
section)
LLC Tax Choices
Partnership (Sub-K)
• Partnership tax treatment available for
LLCs following Rev. Rul. 88-76
• LLCs had to meet requirements of
the old Kintner Regulations
• Much easier with newer “check the
box” Regulations
• (Kintner & check the box discussed
in next section)
LLC Tax Choices
Partnership (Sub-K)
•Benefits:
•Pass-through tax treatment
•Flexible allocation of gain & loss
•Inside basis step up on sales or
transfers at death (IRC § 754)
LLC Tax Choices
Partnership (Sub-K)
• Limitations:
• No employee equity benefits (ESOPs,
ISOs)
• Certain events can trigger gain from
sale of interests, deemed termination
of LLC
• Disproportionate distributions can
trigger unwanted tax consequences
LLC Tax Choices
Subchapter S
• Pass through entity treatment
• More stringent requirements for who can
participate
• Only one class of stock
• No more than 100 shareholders
• Must be U.S. citizens or residents
• Generally no entities, except QSSTs,
some estates, 501(c)(3)s
LLC Tax Choices
Subchapter S
• No special allocation; pro-rata only
• No IRC §754 Elections
• Post-formation contributions of capital
triggers gain to contributor
• Distribution of property to member
triggers gain
• Member may include LLC debt only to
extent of actual loans by member to LLC
LLC Tax Choices
Subchapter S
•Benefits:
•Pass-through tax treatment
•Fairly clear rules for restricted
stock & stock options for
members (IRC §421)
•Limited Liability
LLC Tax Choices
Subchapter S
•Limitations:
•Restrictions on eligible equity
participants (often not an issue)
•Only one class of equity
participation (often IS an issue)
•Possible to accidentally lose S-corp
status by invalid transfer
LLC Tax Choices
Subchapter C
• NOT Pass through; entity taxed as separate
taxpayer
• Entity taxed on gains (deductions on
losses)
• Members taxed on distributions
• Treated under “Entity theory”:
• Entity is legal owner of property
• Shareholders only own interest in entity
LLC Tax Choices
Subchapter C
•Benefits:
•Required for publicly-traded
entities
•Clear rules for employee benefits
•Multiple levels of stock ownership
•Limited Liability
LLC Tax Choices
Subchapter C
•Limitation:
•Double taxation (entity +
shareholder) can be very costly
Overview of Asset
Protection Issues
•Basic asset protection issues
•Inside Liability - Claims against the
entity itself; claims among the
members (“inside” the company)
•Outside Liability - Claims against a
member from “outside” (i.e., a
third party creditor)
Overview of Asset
Protection Issues
•Liability limitation by statute
•Inside liability: Members not
personally liable for claims against
LLC
•Exposure limited to interest in LLC
•LLC itself responsible for claims
against entity
Overview of Asset
Protection Issues
•LLC should contain adequate
assets/maintain adequate insurance
to satisfy legitimate claims
•Failure to maintain sufficient assets
may lead to veil pierce, trigger
equitable relief
Overview of Asset
Protection Issues
•Outside liability: Non-debtor
members not liable for claims
against other members
•Judgment creditor’s relief against
debtor member is limited to the
charging order
•Obtains rights of assignee:
financial rights only
Asset Protection
How clients mess it up
• No protection from:
• Claims arising before LLC formed
• Malfeasance
• “Super creditors” (IRS, SEC, EPA, FTC)
• Veil pierce if LLC not treated like real
entity, alter ego, etc.
• Remedies vary greatly by jurisdiction
Asset Protection
Designing LLC for Protection
•Entity manager
•Voting restrictions
•Limitation on withdrawal from entity
•Limit ability to demand distributions
•Limit on transfer of interests
Asset Protection
Designing LLC for Protection
• Mandatory additional capital
contributions
• Redemption of interest subject to
charging order
• Multiple layers of entities (e.g., LLC
owned by series of other trusts, LLCs,
corp.)
• Isolating assets, liabilities
• Multiple entities, series LLCs
Asset Protection
Designing LLC for Protection
•Limit on liquidation provisions
•Convertible interest (e.g.,
“downgrade” to limited interest in
case of claim etc.)
•NOTE: restrictions also can drive
down valuation, open arguments for
inclusion under §2036
Charging Orders
See outline §2.09 & Part V
•No access to “non-economic rights”
(e.g., voting, rights to information,
rights to manage)
•No right to force liquidation or
distributions
•Liable for ratable income, gain, tax
liability (i.e., “phantom income”)
Charging Orders
• Strength of protection depends on
jurisdiction (see table at Part XIV of
outline)
• Some explicitly prohibit foreclosure,
equitable remedies
• Not likely available for SMLLCs
• Intended to protect non-debtor
members from becoming unwitting
partners with others’ creditors
(Olmstead, Albright)
Charging Orders
•Recall - Re-ULLCA would statutorily
allow foreclosure of charging order!
•Business-friendly states should
consider cutting from LLC law
Charging Orders
•Functions as lien against debtor’s
LLC interest
•Distribution allocation to debtor
member pays to creditor/assignee
•Assignee treated as substituted
partner/member for income tax
purposes (Rev. Rul. 77-137)
Dealing with
Charging Orders
• Disproportionate distributions
• Breach of fiduciary duty?
• Making loans to members
• Document it!
• Limit distributions to contributing members
• Establish different classes of
members/partners
• Preferred & common (not for S-corps)
Asset Protection
•LLCs/entities best with other tools
•Adequate liability insurance
•Statutory exemptions
•Vary dramatically by state
•Separate property trusts
Fighting Fraudulent
Conveyance Claims
•Interests reasonably reflect member
value contributed (equivalent value)
•Adequate insurance to cover claims
•Adequate assets left OUTSIDE of
entity (maintain solvency)
•Preserve entity for other
partners/members (fairly weak)
Funding the LLC
•State law issue:
Funding in entity name, or
is name of manager required?
Funding the LLC
•Business interests
•Transfer existing business by
assignment of stock, stock power,
etc.
•Consider segregating operations,
receivables, assets in separate
entities
Funding the LLC
•Business equipment
•Transfer by assignment, bill of sale
•Lease to operating LLC
•Planning opportunity - gift
business equipment LLC to
children’s trusts, lease payments
fund trust without additional gift
Funding the LLC
•Cash
•Transfer by retitling account into
LLC name
•Proper TIN/EIN for account (use
LLC’s)
Funding the LLC
•Installment notes
•Transfer by assignment, lien
transfer (with notice)
•If note is tax deferred (IRC §453),
later transfer of LLC interest
triggers tax on deferred gain
Funding the LLC
• Life insurance
• LLC-owned as alternative to ILIT
• May not get full removal from
estate, but may get reduction
• Exception to transfer-for-value rule
- transfer to insured or “partner” of
insured
(IRC §101(a)(2)(B))
Funding the LLC
• Life insurance - annual gifts thru LLCs
• Pay premium gift to LLC:
• More accounting intensive (managing
capital accounts, paying premiums)
• Capital account “Crummey” powers
• Grant immediate w/d right like ILIT
Crummey
Funding the LLC
•Marketable securities
•Gifted shares held by partnership
at death of partner retain original
basis
•Must comply with IRC §§351(e)
and 721(b)
•Transfer account by registration
Funding the LLC
•Closely-held securities
•Must comply with bylaws of
company
•IRC §1244 (small business) stock
loses tax favorable treatment
Funding the LLC
•S-Corp stock
•Partnership not permitted
shareholder; will convert to C-corp
taxation for corp
•BUT - LLC wholly owned by
permitted shareholder may own Scorp stock
Funding the LLC
• Real estate
• Environmental concerns - support entity
management, especially if LLC business
generates contaminants (agribusiness,
pharmaceuticals, etc.)
• Make sure donor pays reasonable rents
for use of contributed property
• Potential property tax increase
(CA Props. 13, 58)
Funding the LLC
•Encumbered property
•Contribution likely triggers dueon-transfer clause
•If encumbrance > basis, transfer
to LLC triggers gain
Funding the LLC
• Personal residence
• Make sure donor pays reasonable
rents for use
• Likely loss of homestead exemption
(avoid in jxns w/ adequate
homestead protection)
• Consider transfer to LLC with
retained LE
Funding the LLC
•Retirement Accounts
•DON’T DO IT! Transfer loses tax
deferral, accelerates tax liability
Funding the LLC
•Layering entities to isolate high-risk
assets (planes, cars, ATVs, boats)
•Another opportunity for series
LLCs
Family LLCs
•Often used to achieve tax-leveraged
transfers (thru discounted interests)
•Pure tax motives generally fail
•Structure the FLLC (or FLP) carefully
& treat as business
FLLCs
• Non-tax benefits (& objectives)
• Protect family assets
• Provide structure to train children how to
manage wealth
• Create framework for asset management
• Maintain predictability, control
• Consolidate assets & institutionalize
investment strategy
FLLCs
• Non-tax benefits (& objectives)
• Preserve “heirloom assets”, vacation
properties, etc.
• Provide more efficient transfers (LLC
interests instead of fractionalized assets)
• Protect family wealth from children’s
divorces
• Provide planning flexibility
FLLC or FLP?
• LLC provides asset protection to all; LP must
have general partner, who is exposed (LLC 1, LP
0)
• LP and LLC interests generally not subject to
foreclosure; charging orders only (tie; LLC 2, LP
1)
• More case history for LPs (LLC 2, LP 2)
• Possible §2704(b) valuation issue for LLC if
transfer restrictions stricter than state law (no
point; depends on state law)
Members, Managers,
and Entity Managers
•GP or managing member
responsible for operations
•GP personally liable for entity
liabilities (LPs; not LLCs)
•In both cases, management fees
appropriate for services rendered
Management
•Individuals or entities as managers?
•In LP, individual exposed to GP
liability; may protect with entity
•Much less of an issue depending
on asset mix
•In LLC, no exposure to manager
liability
•In both cases, entity provides
greater continuity of life
Management
• Corporation as manager
• Perpetual existence
• Compensation paid to directors of
management corp
• Other benefits (stock options, etc.)
available
• Tax choice of entity discussion applies
Management
•Corporation as manager
•Considerable complexity
•Tax returns, bylaws, meeting
formalities
•Shareholders (use RLT)
•Concerns about piercing corporate
vale.
Management
• Management Trust
• Revocable or irrevocable grantor trust
• Client may serve as trustee
• Client should not be beneficiary
• May receive compensation for
management services, but shouldn’t be
entitled to any beneficial interest
• As grantor trust, no additional tax return
required
Management
• LLC as manager (or GP)
• Must provide perpetual existence; avoid
unplanned termination of management LLC
(thus terminating main entity)
• May have compensated employees (unlike
management trusts)
• Tax flexibility (sole prop., partnership, S-corp,
C-corp)
• May situs in any jxn
(think asset protection, reliable case law)
WealthDocx®
LLC Assembly
Coming Attractions
ETHICS BONUS
(time permitting)
Ethical Issues
• Significant issues common to estate planning
• Potentially compounded with HNW/asset
protection, & gifting strategies
• Are you competent?
• Who is client?
• Adequate representation for all parties?
• Conflict of interest?
• Enabling fraud?
Ethical Issues
Are you competent?
•Model Rule 1.1 elements:
•Relative complexity & specialized
nature of engagement
•Lawyer’s experience
•Training, experience in specific area
•Feasibility/advisability of referring
to other counsel
Ethical Issues
Are you competent?
• Getting competent
• Through study
• Through co-counsel with more
experienced attorneys
• When law is unsettled, attorney must do
adequate study to provide sound counsel
• If uncertain, document preparation &
competency carefully
Ethical Issues
Who is your client?
•Specify with engagement
letter/agreement
•Consider stating (in writing) who
is not your client (e.g., other
family members, partners)
•Representing client as individual,
or entity created? Both?
Ethical Issues
Duty to Inform
• Document your recommendations in writing
• Use care to comply with Circ. 230
• Don’t make promises of asset protection
elements, discounts
• Document issues discussed, not specific
outcomes
• Alert clients of advantages/risks of
planning, failing to plan
Ethical Issues
Engagement Letters
• Specify in writing:
• Identity of client (and non-clients)
• Scope of services to be performed
• Specifically excluded services (to prevent
misunderstanding)
• Fee arrangement, payment schedule
(including refundable portions if client
terminates)
• Other probable costs (filing fees, etc.)
Ethical Issues
Conflicts of Interest
• Often avoidable by good engagement
letter
• NOTE:
Rule 1.7 prohibits representing client if
directly adverse to another client,
unless lawyer reasonably believes
representation will not adversely affect
client relationship, and both clients
consent after consultation
Ethical Issues
Conflicts of Interest
• Waiving conflicts • Notify nature of conflict in writing to all
“potential clients”
• Notify of remedies if conflict presents
problem
• Obtain signatures from all involved
• Conflicts will ebb and flow during
engagement; revisit periodically to avoid
problems for clients, attorney
Ethical Issues
Criminal or Fraudulent Activity
•Model Rule 1.2(d) - lawyer shall not
counsel client to engage or assist
client in conduct lawyer knows is
criminal or fraudulent; may discuss
legal consequences of any proposed
course of conduct
Ethical Issues
Criminal or Fraudulent Activity
•Civil and criminal penalties
•Document communications carefully
•Affidavit of Solvency
•Designed to provide attorney “CYA”
•Sworn statement by client that they
retain adequate assets outside of
entity; not insolvent by engagement
Ethical Issues
Liability
•To Client:
•Duty
•+ Breach of duty
•+ Proximate cause
•+ Damages
•= tort claim for malpractice
Ethical Issues
Liability
•Generally not liable for failed asset
protection plan if implemented
correctly & according to prevailing
law
•May be liable to others if creditor
can establish that atty complicit in
rendering client insolvent, facilitating
fraud, etc.
Ethical Issues
Liability
•To third parties
• In family/business engagements,
consider notifying in writing who you
do represent
•Liability may still attach despite lack of
privity (see next slide)
•Punitive damages possible for
facilitating fraud
Ethical Issues
Liability
•To what extent was transaction
intended to affect claimant?
•Was harm foreseeable?
•Degree of certainty of claimant’s
injury?
•Causation
•“Moral blame” for attorney conduct?
•Policy to prevent future harm?
Ethical Issues
Liability
•Criminal penalties
•If BK court can establish complicity
in defrauding creditors, client and
attorney may be prosecuted
•Fraud, or as aiding and abetting
fraud
•Money laundering
Ethical Issues
Liability
•Criminal penalties
•Withdraw from representation in
writing, disaffirm work product
Ethical Issues
• Clear, consistent, written communication
• Ethical issues arise throughout engagement,
not just at beginning
• Do homework, set appropriate expectations
in writing, deliver on agreed-upon services
• As “situations on the ground” change,
communicate clearly and in writing with all
affected
• No substitute for clear, copious notes