Using Series LLCs for Real Estate

A. What is a Series LLC? Advantages and Disadvantages

??????????A series limited liability company, or Series LLC, is a form of limited liability company that provides liability protection across multiple series “units” or “cells.” The idea is to protect each cell or series unit from being subjected to liabilities arising from the activities of other cells or units in the series. The primary advantage of a series LLC theoretically is that this form of ownership might reduce the costs and administrative burdens associated with creating a separate LLC for each parcel of property owned. This same cost advantage may be used to separate out the liability of different business functions associated with the overall operation. Each unit or cell within the series can own distinct assets, incur separate liabilities, and have different managers or members. The Series LLC may be used as a tool for real estate investors or property management companies with multiple properties.

????????The Series LLC initially was introduced in the mutual fund industry to avoid the need for multiple SEC filings for difference classes of funds. The idea was to allow one entity to file for all the funds under one umbrella SEC filing, and thus permit the individual funds to be managed separately. The pro-business state of Delaware adopted the first Series LLC law in 1996. Other states soon followed. Missouri adopted its Series LLC law in 2013. See, §347.186.[1]?By one recent count, nineteen states plus the District of Columbia and Puerto Rico now allow for some form of Series LLC.

??????Under Missouri’s version of the Series LLC Act, an operating agreement for a “Master LLC” may establish or provide for the establishment of a designated series of members, managers, or limited liability company interests with separate rights, powers and duties. See, §347.186.1. To the extent permitted in the Master operating agreement, any such series may have a separate business purpose or investment objective.?Id.?And each unit or cell in the series may, in its own name, contract, hold title to assets, grant security interests, sue and be sued or otherwise exercise the powers of any other limited liability company. §347.186.2(4). Yet it remains unclear under the law if each series is considered to be a separate entity for some purposes but not others.

??????????Missouri does not impose separate filing fees associated with units or cells in the same series. The articles of organization for each separate series of the LLC authorized under §347.186 must comply with each of the general requirements for the articles of organization of an LLC under §347.039. See, §347.039.2. Mechanically, this means that the members must file a traditional set of articles of organization for the Master LLC and then file as an attachment a Form LLC-1A for each unit or cell within the series. But the Secretary of State does not impose a new filing fee for each Form LLC 1A. Instead, the filing fee of $105 for the Master LLC also will cover all the attachments.[2]

????By the same token, each separate member of a series authorized to operate under §347.186 for a foreign limited liability company must produce the same general information imposed on all foreign limited liability companies under §347.153. But just like with a Missouri Series LLC, a foreign limited liability company with a Master LLC may file as an attachment a Form LLC-4 for each unit or cell within the series. And the Missouri Secretary of State does not impose a new filing fee for each Form LLC-4. The same filing fee of $105 will apply as it would for any foreign limited liability company seeking to register to do business in Missouri. So, for both domestic and foreign LLCs operating with separate series cells or units, Missouri does significantly reduce the fees for state filing requirements.

???????Because the Series LLC is a new kind of entity, the Missouri lawyer can look to no controlling body of case law on the subject. The Series LLC thus creates its own unique sets of risks:

·??????Bankruptcy:??It is unclear if a separate series cell or unit may file its own separate bankruptcy petition under federal bankruptcy law. This risk raises important questions for investors if the financial aspects of the transaction should deteriorate.

·??????Real Estate:??HUD does not recognize Series LLCs. And some title companies may be hesitant to issue a title policy for a Series LLC that owns property in a state that does not recognize Series LLCs. Another question is whether the Series LLC can be used as a device to move assets around without incurring transfer taxes, reassessment, or other consequences of a transfer to a third party. It remains uncertain if regulatory authorities will permit the use of the Series LLC for such creative purposes.

·??????Secured Transactions under Article 9 of the UCC:??Although Missouri explicitly allows cells or units in a series to grant security interests, the identity of the debtor in such a transaction may be uncertain. This is an area where the question of whether the series is a separate legal entity under Missouri law could become important. If the series is not considered a separate entity from the Master LLC, the lender is put in a quandary over what constitutes an effective financing statement. The lender may insist on listing the Master LLC as the debtor on its UCC-1, instead of the individual series unit or cell.

·??????Tax Treatment of Series LLCs:??A new Treasury Regulation treats each individual series within a Master LLC as a separate tax entity for federal income tax purposes regardless of whether or not the unit or cell is treated as a separate entity under state law.[3]?This rule creates some measure of certainty and appears to allow each series to be treated separately for tax purposes as a disregarded entity, a partnership, or a corporation.[4]??But the tax law is still evolving in this area, so the Series LLC may face some unanswered questions over consolidated tax returns, federal employment tax liability, the entity status of the Master LLC and the Series LLC as a whole, as well as liability for sales and use taxes.?

??????With all the risks associated with the Series LLC, an open question is whether the benefits outweigh the risks beyond the continued advantages for SEC filing in the mutual fund industry. Missouri does offer significant savings in filings costs. And Missouri provides explicit benefits in protecting the units or cells from liability for other units or cells within the same series. Yet this explicit protection may be lost if the cell or unit operates in another state that does not contain the same Series LLC protection. And because of the multiple uncertainties as the law evolves, investors may prefer the safer but perhaps more expensive course of creating separate LLCs to perform the same functions. Those who are interested in exploring a Series LLC in Missouri should consult with experienced legal counsel and a tax advisor and give careful consideration to the potential risks.

B. Compartmentalization Strategies

????????The Missouri version of the Series LLC Act protects the units or cells from the liability of other units or cells in the series or of the Master LLC. In other words, the debts, liabilities, and obligations incurred, contracted for, or otherwise existing for a particular series “shall be enforceable against the assets of that series only, and not against the assets of the limited liability company generally or any series thereof.” See, §347.186.2(1). Yet this liability protection under the statute presumes that each unit or cell in the Series LLC has been properly compartmentalized. Commentators have offered opinions on how to minimize the chances of one series being held liable for the liability of the entity as a whole or another unit or cell within the series. Because the law is so new in this area, no recognized body of case law offers guidance on whether these kinds of strategies will be successful.??Subject to that important caveat, here are few common strategies to consider:

·??????Maintain separate bank accounts for each unit or cell in the series.

·??????Sign all contracts, deeds, notes, and other legal documents solely in the name of the unit or cell in the series. For example, sign the contract, deed, or note as “X, LLC, Y Series only.”

·??????Make sure that any separate loans between different units or cells and the Master LLC are properly documented.

·??????Conduct any transactions between different units or cells in an arms length manner. So, for example, it is important to use fair market value analysis supported by proper appraisals.

·???????Keep all the assets and operations of each unit or cell separate from the others. Each asset of the Master LLC should be owned by only one unit or cell in the series. Avoid naming two or more units or cells as co-owners of the same property.

·??????Make sure that each unit or cell is adequately capitalized. This strategy is designed to avoid attempts by creditors or other third parties to pierce the veil of series ownership.??

C.??Identifying Managers, Members and Cells

??????????As a general proposition, the operating agreement for the “Master LLC” may establish or provide for the establishment of a designated series of members, managers, or limited liability company interests with separate rights, powers and duties. See, §347.186.1. To the extent permitted in the Master operating agreement, any such series may have a separate business purpose or investment objective.?Id.??With that in mind, the operating agreement may draw the following types of distinctions in identifying managers, member and cells or units within a series:

·??????The agreement may provide for classes or groups of members or managers associated with a series, giving such members or managers relative rights, powers and duties as the operating agreement may provide. The agreement may make provision for the future creation of additional classes or groups or series as might be justified as circumstances change. And the operating agreement may provide that the rights, powers and duties of some members or classes are superior to or subordinate to others within the same series. See, §347.186.5(1).

·??????Under the agreement, each particular unit or cell within the series may be managed by certain identified member or members, or by the manager or managers who may be selected by the members within that series. Unless otherwise provided in the operating agreement, each series unit or cell presumptively will be managed by the members associated with that series. See, §347.186.5(2).

·??????The agreement may grant to all or certain identified members or managers, or to a specified group or class of members or managers, the right to vote separately or with all or any class or group of members associated with that series. The operating agreement theoretically could provide that any member or class of group associated with a particular series will have no voting rights or ability to participate in the management of the series. Yet such nonvoting members or classes or groups may still have ownership rights. §347.186.5(3).

·??????The agreement may specify conditions under which the manager of a series will cease to be a manager. But unless otherwise, specified, this removal of a manager may not necessarily cause the manager to cease to be a member of the Master LLC. §347.186.5(5).

·??????Unless otherwise provided in the agreement, any event that causes a member to cease to be a member of one series does not necessarily cause the member to cease to be a member of the Master LLC or any other series. §347.186.5(6).

·??????Similar to any ordinary LLC, the operating agreement may impose restrictions, duties and obligations on members or any series thereof in matters of internal governance. So for example, the agreement may make provisions for capital contributions, restrictions on transfers, restrictive covenants on noncompetition, non-solicitation, or confidentiality, fiduciary duties, rights of first refusal or buy-sell obligations. §347.186.5(7).

D. Handling Multiple Investors/Partners

?????????The structural options allowed under a Master LLC operating agreement demonstrate the potential complexities for multiple investors. Will there be different groups of classes applicable to some units or cells, but not others? Will some investors have voting and management rights, but not others? Will some members or groups of members have rights superior to or subordinate to others in the same series? How will the individual units in the series be taxed? Are the organizers structuring the LLC as a series as a means of awarding equity participation to those managing more profitable units or cells? From a practical standpoint, when multiple investors are involved in the formation of the Series LLC, the investors must have separate counsel to protect their respective interests. And each lawyer must have sufficient skill to navigate the uncertainties inherent in this new form of Series LLC ownership.??The lawyer should not undertake this kind of project without experience and appreciation for the risks. This article is not designed to answer all these questions. But hopefully it will serve as a warning to multiple investors of the risks they undertake before the rules of the Series LLCs are more firmly established.?

E.??Profit/Loss Distributions

???????????The use of the more traditional limited liability company boomed when the IRS allowed the newly created entity to be taxed as a partnership and not as a corporation.[5]?And the LLC movement expanded again when the IRS issued its treasury regulation to allow small business owners operating as an LLC to “check the box” and decide for themselves how they wished to be taxed.[6]?By contrast, the Series LLC continues to be plagued by tax and legal uncertainties. These inherent uncertainties have slowed the progression toward this new novel form of business ownership. As noted earlier, a new Treasury Regulation is adding a measure of certainty by treating each individual series within a Master LLC as a separate tax entity for federal income tax purpose regardless of whether or not the unit or cell is treated as a separate entity under state law. This rule allows each series to be treated separately for tax purposes as a disregarded entity, a partnership, or a corporation.[7]?Yet the Series LLC still faces unanswered questions over consolidated tax returns, federal employment tax liability, the entity status of the Master LLC and the Series LLC as a whole, as well as liability for sales and use taxes. With all the unresolved tax implications, the investors in any Series LLC must consult with a competent tax advisor in deciding how to treat profit or loss distributions.?

F.??Dispute Resolution

????????Because of the potential for conflicts, the members or managers of any Series LLC should consider including mediation or arbitration provisions in the Master operating agreement. And the scope of the mediation or arbitration must be broad enough to cover potential disputes within any series or over the general operation of the Master LLC. The organizers must address in the agreement whether the dispute resolution procedures in one series may exclude the members or managers of the Master LLC, or those members or managers of the other units or cells. The danger is that a dispute within one series may draw unaffected parties into the conflict.?

???????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????Daniel R. Schramm, L.L.C. (2022)

[1]?All statutory references to the Missouri Series LLC Act are to RSMo (Cum. Supp. 2013).?

[2]See, Schedule of Fees and Charges published by Missouri Secretary of State on its website at?www.sos.mo.gov.?

[3]?26 C.F.R. §301.7701-1 (2014).

[4]?See, Private Letter Ruling 200803004 (Jan. 18, 2008).

[5]?In 1988, the IRS issued a Revenue Ruling declaring that a Wyoming LLC could be taxed as a partnership.??(Rev. Rul. 88-76, 1988-2 C.B. 360.)

[6]?Treas. Reg. 301.7701-1-3. The final “check the box” regulation became effective January 1, 1997. (61 Fed. Reg. 66584 Dec. 18, 1996).

[7]?See,?26 C.F.R. §301.7701-1 (2014). See also, Private Letter Ruling 200803004 (Jan. 18, 2008).