Delaware Series LLC

by John C. Murray
© 2004. All rights reserved.

In 1996, the DLLC Act was amended to permit an LLC agreement to provide for the establishment of designated series of specified property or operations with separate business purposes or investment objectives, such that the debts, liabilities and obligations relating to a particular series would be enforceable only against the assets of such series and not against the assets of the LLC generally or the assets of any other series. See Del. Code Ann. tit. 6, §18-215(a) and (b). (In Illinois, the Secretary of State's Business Law Advisory Committee has been studying the concept of series LLCs for more than two years, and a draft bill amending the Illinois LLC Act to permit formation of series LLCs will be submitted to the 2005 session of the Illinois General Assembly.)

Each series is essentially a separate "cell" or "mini-LLC" within the LLC itself, with separate members, managers, assets and liabilities, and business interests. The LLC and not the series will be treated as the legal entity under Delaware law. Theoretically, the LLC could avoid the debts of the LLC altogether by allocating all the LLC assets to the various series within the LLC.

The assets of a particular series are protected from enforcement action against the assets of the LLC or any other series if (1) the LLC agreement provides for the establishment of one or more series, (2) separate and distinct records are maintained for each series and its assets are accounted for separately from the other assets of the LLC or any other series (and the LLC agreement so provides), and (3) notice of such limitation of liability is set forth in the LLC's certificate of formation. See Del. Code Ann. tit. 6, §18-215(b). However, a member or manager may agree to be obligated personally for any or all of the debts, obligations, and liabilities of one or more series. See Del. Code Ann. tit. 6, §18-215(c).

Consistent with the general LLC goals of freedom of contract and flexibility, the LLC agreement can create numerous series within the LLC to accomplish diverse business objectives. The LLC agreement can provide for the future creation of additional classes or groups of members or managers not previously outstanding within a series, and also can provide for the taking of any action, including the amendment of the LLC agreement, without the vote or approval of any member or manager or class or group of members or managers. See Del. Code Ann. tit. 6, §18-215(d).

Furthermore, unless otherwise provided in the LLC agreement, any event that causes a member to cease to be associated with a series will not, in itself, cause such member to cease to be associated with any other series or terminate the member's interest in the LLC, or cause the termination of the series even if the member was the last surviving member associated with the particular series. See Del. Code Ann. tit. 6, §18-215(i).

Upon application of a manager or member of a series, the Delaware Court of Chancery may decree the termination of the series "whenever it is not reasonably practicable to carry on the business of the series in conformity with a limited liability agreement." See Del. Code Ann. tit. 6, §18-215(l). The DLLC Act also permits a foreign LLC that is properly registered to do business in the State of Delaware to provide, in its LLC agreement, for the establishment of a designated series of members, managers or LLC interests (provided that the application for registration as a foreign LLC so states) and for the limitation of liability for the debts, liabilities and obligations of a particular series to the assets of that series. See Del. Code Ann. tit. 6, §18-215(m).

The statutory scheme created by §18-215 of the DLLA radically changes how an operating entity can protect its assets from creditors. Each of the series of assets in a series LLC can operate independently of the LLC in general and any other series, and avoid their liabilities. The principals of an LLC should be able to freely transfer assets and ownership interests from one series to another. However, there are still potential risks -- and uncertainty -- with respect to such issues as tort-liability protection, fiduciary duties, avoidance of sales taxes and documentary transfer taxes, and property reassessments. The following constitute some of the unresolved issues raised by the creation of series within an LLC:

1. May an asset or group of assets be used in connection with the business activities of two or more series within an LLC? Can an allocation of values and liabilities be established, and if so on what basis? (For example, what if the activities of several series are conducted from the same premises?).
2. Must actual title to an asset or assets of a particular series be held in the name of the series or is it permissible simply to designate the particular series assets in the books and records of the LLC?
3. Since the only required notice of limitation of liability of the series appears in the LLC's certificate of formation filed with the Delaware Secretary of State's office, creditors doing business with the LLC may have no actual knowledge of such limited liability unless they are so informed by members or managers of the LLC (at some level, such members and managers may have an affirmative duty not to deliberately conceal such liability limitations or mislead creditors). Potential creditors must therefore carefully review the LLC's filed certificate of formation, and perhaps require that a specified manager or member (or managers or members) personally guarantee the series' debt to the creditor.
4. The limitation-of-liability provisions of a series LLC may be challenged under the laws of a foreign jurisdiction if the LLC has operations outside Delaware.
5. Does the creation of more than one series within an LLC constitute a "partnership" for tax purposes? Based on separate allocations of sharing ratios and economic benefits and risks by two or more individuals or entities among separate series, the IRS may argue that there are "two tax partnerships" rather than a "single tax partnership."
6. Series LLCs may be established in an attempt to avoid sales taxes, which may lead to challenges by state taxing authorities. For example, California imposes a tax on the gross receipts of an LLC (capped at $4,500 per year). California also imposes an $800 minimum income tax on each LLC.
7. In connection with sales and purchases of property (including like-kind exchanges under § 1031 of the Internal Revenue Code), tax planners may attempt to avoid unfavorable income-tax, transfer-tax, and sales-tax consequences by transferring the property and the purchase price (or separate properties that otherwise do not meet the time or type-of-property constraints of IRC § 1031) to a single-member LLC. The LLC would then establish two series, one of which contains as its sole asset the property contributed by the seller (of which the buyer becomes the sole member or the holder of a 99% interest), and the other of which includes as its sole asset the purchase price or the otherwise non-complying "like-kind" property (of which the seller or exchanger becomes the sole member or the holder of a 99% interest). Although some tax planners may argue that such a transaction is merely a permissible contribution of assets to an LLC that should be taxable as a "single partnership" with special allocations, others may argue that the transaction is in substance a sale or exchange and is subject to applicable income and sales taxes. With respect to taxes on the sale or exchange of real property, many jurisdictions exempt transfers to a wholly owned LLC. However, state taxing authorities may seek to challenge such transfers (whether or not transfers to LLCs are statutorily permissible), or else act to legislatively close the perceived "loophole" by amending state statutes to tax transfers into and out of series LLCs. See Terence Floyd Cuff, Series LLCs and the Abolition of the Tax System, Business Entities, p.26 (2000).
8. Will the limited-liability provisions with respect to each series protect the series (or the LLC) with respect to environmental contamination of series or LLC property?
9. The interplay between the federal Bankruptcy Code and Delaware corporate and LLC law may create some interesting issues. For example, will a series be eligible (apart from the LLC) to file (or have filed against it) a bankruptcy petition? Will LLC series be subject to separate claims classification or entitled to vote separately on plan confirmation? Will fraudulent-conveyance issues arise with respect to inter-series guarantees? Will § 1111(b) of the Bankruptcy Code (which allows a secured creditor with a nonrecourse loan to elect to treat its claim as being with recourse against the debtor) apply to creditors whose recourse is limited to the assets of a particular series? Will multiple committees (and consultants and professionals) be required for LLCs with more than one series? Will separate counsel be required for each series (as opposed to the LLC's counsel) to protect the separate interests of each series?

Although the use of a series LLC appears to offer unlimited planning opportunities, many legal and tax issues remain unresolved. There is not as yet an established body of case law regarding these issues, and the attorneys, consultants and investors who establish series LLCs should proceed cautiously and conservatively. The principals of the LLC should obtain expert tax and legal advice when forming one or more series within the LLC as provided in the DLLC Act. With respect to real estate investments, the segregation of assets may be problematical where the LLC is the sole title-holder of record. While separate mortgages with respect to each series could be recorded, title would necessarily remain in the LLC as the recognized legal entity. Perhaps the loan documents could limit recourse with respect to a particular property to a particular series. However, with respect to "carveouts" to nonrecourse provisions in the loan documents with respect to specific "bad acts" of the LLC borrower or a particular series, the lender should require that the LLC agreement be amended to specifically provide for the personal liability of a designated member or manager (or members or managers) for such carveouts.

A one commentator has noted, "[a] significant benefit of the series LLC is the ability to transfer members, change membership ownership interests and transfer assets without resorting to external transfers, conversions, and mergers. Such internal transfers would avoid . . . transfer, conversion and merger issues . . . including transfer tax and real property tax reassessments. The series LLC is an intriguing device and its evolution should be carefully monitored for application to real estate investments." Robert R. Nix II, Capturing the Benefits of the Limited Liability Company - Use of Transfers, Conversions, Mergers and Legislated Enhancements," The ACREL Papers, The American College of Real Estate Lawyers (2000), at Tab 13. See also Craig A. Gerson, Memorandum: Taxing Series LLCs, TAX MANAGEMENT MEMORANDUM (BNA) (2004).

A separate series within an LLC cannot hold title in its own name because it is not a separate legal entity for ownership purposes under the Delaware statute, i.e., the statutory language regarding series LLCs does not speak in terms of "separate ownership" but rather in terms of segregating assets and liabilities (and management) within the LLC. This provides for separate "charging" of liabilities within specific series if the operating agreement and certificate of formation for the "master" LLC so provide, separate records are kept, and separate accounts are maintained for each series. Theoretically, all the assets of an LLC could be put into one (or more) series, and all the liabilities of an LLC into another series (or more than one series). However, there is no case law yet in Delaware on series LLCs, and there could be a "substantive consolidation" claim made, or the court could undo the arrangement if there is no valid business reason. Also, because it is unclear as to if (and to the extent) other states will uphold the validity of the Delaware series structure, it would be prudent to be conservative on title issues involving series LLCs. The structure may be used in an attempt to avoid real property transfer taxes, by simply shifting ownership of LLC assets to separate series within the LLCs, which have different members and management. However, the Delaware transfer-tax statute applies to any transfer of more than 75% of the beneficial interests in an entity.

The certificate of formation or operating agreement would establish the authority of the manager of a particular series to bind the master LLC (subject to applicable series liability limitations) and execute documents (including deeds, mortgages, etc.) on its behalf. But the "master" LLC should be the title holder (or mortgagor), perhaps with the designation, "held as property of _________." Of course, when dealing with the Delaware series LLC structure, careful attention must be paid to the certificate of formation and the operating agreement, and the ability to shift assets and liabilities among different series.

In light of the foregoing, unless there is some overriding business purpose, it may be prudent to just create separate LLCs instead of separate series within the master LLC for real-estate ownership purposes.

First American