THE SERIES LLC: FURTHER LIMITING LIABILITY WITHIN THE LLC OR CREATING LIABILITY IN THE BUSINESS ORGANIZATION ARENA? ONLY TIME WILL TELL HEATH OBERLOH

THE SERIES LLC: FURTHER LIMITING LIABILITY WITHIN THE LLC OR CREATING LIABILITY IN THE BUSINESS ORGANIZATION ARENA? ONLY TIME WILL TELL HEATH OBERLOH From its origins in Delaware, the Series LLC structure has now been adopted in a handful of states. While the Series LLC provides some unique benefits, those who implement the Series LLC structure encounter a world filled with uncertainties. Some of those uncertainties include whether the internal liability shields between series will be respected, how a series will be treated in the bankruptcy context, how a series will be taxed, and how a series would be treated under the UCC. These uncertainties have been aggravated by the lack of uniformity among the states that have adopted the Series LLC structure. While some attempts at uniformity have been made, planners are currently stuck with the proverbial chicken and the egg conundrum: clarity and certainty may only come with increased use of the Series LLC structure, while increased use may only come with additional clarity and certainty. This article will explain the Series LLC structure and its uncertainties, examine the efforts at uniformity, and explore how the Series LLC could be implemented in South Dakota. I. BACKGROUND Series LLCs have been described in a multitude of ways, from the future of the unincorporated form 1 to an attractive nuisance that will lure clients and advisors to economic disaster. 2 As with most things in life, the truth likely lies somewhere in the middle. This article will briefly describe what a Series LLC is, some of the benefits provided by the Series LLC structure, as well as some of the risks involved with the structure. It will then briefly explore the attempts that the American Bar Association and the Uniform Laws Commissioners have taken to Copyright 2016. All Rights Reserved by Heath Oberloh and the South Dakota Law Review. Heath Oberloh is a Partner with the law firm of Lindquist & Vennum, LLP, in its Sioux Falls office. His practice focuses on business planning and estate planning, regularly working with family owned businesses and family owned farms to address their succession and estate planning concerns. Heath also works with families seeking to take advantage of South Dakota s favorable trust and asset protection laws. He enjoys explaining the many benefits of South Dakota trust situs and developing and implementing a plan to accomplish the family s goals. Heath is active in the Sioux Falls Estate Planning Council and Business Law Committee of the South Dakota State Bar, where he helped draft legislation to update South Dakota s limited liability company statutes and currently serves on the Series LLC subcommittee. 1 Wendell Gingerich, Series LLCs: The Problem of the Chicken and the Egg, 4 ENTREPRENEURIAL BUS. L.J. 185,185 (2009). 2 Terence F. Cuff, Delaware Series LLCs and Transactional Practice-Part 2, 38 REAL EST. TAX N. 170, 170 (2011). 1

provide uniformity. Finally, it will look briefly at what the future may hold for Series LLCs in South Dakota. A Series LLC is basically a limited liability company with internal compartments called series or cells. 3 The assets of each series are shielded from the liabilities of the other series and the LLC itself. Each series of the LLC may have separate members, managers, assets and liabilities, business purposes, or investment objectives. Conceptually, a Series LLC is like wrapping multiple LLCs inside one legal wrapper. Series LLCs were initially created in Delaware for use in the mutual fund industry. 4 By using Series LLCs, fund managers were able to reduce the regulatory burdens on their portfolios by allocating specific investments or models inside separate series. Since that time, their use has slowly developed in other areas as well, particularly in regulated industries such as the captive insurance industry. II. SERIES LLCS: PURPOSES AND BENEFITS The main benefit of the Series LLC is the ability to segregate assets and their associated liabilities into separate series that shield the liabilities of one series from the assets of another series, all while maintaining the administrative simplicity and efficiency of a single LLC. Series LLCs can be used to separate different lines of business, different categories of assets, or other differing risk levels within an organization. For example, a trucking company may create a Series LLC and hold each semi-truck or trailer in a separate series to protect the liabilities associated with one truck or one driver from the other company assets. Owners of multifamily housing units may establish a Series LLC to compartmentalize the risks associated with multiple 3 For purposes of this article, references to a series will be references to the individual protected series; references to the Series LLC or LLC will refer to the LLC itself as opposed to the individual series. 4 Ann E. Conaway & Peter I. Tsoflias, The Delaware Series LLC: Sophisticated and Flexible Business Planning, 2 MICH. J. PRIVATE EQUITY & VENTURE CAP. L. 97, 101-02 (2012). 2

properties, with each housing unit or complex owned by an individual series, while being able to manage all the properties as one business entity. Estate planners may use Series LLCs, with each series owning a separate asset such as a parcel of farm ground, to allocate specific series to specific beneficiaries at death. The uses available for Series LLCs are likely limited only by the imagination of business people and their lawyers (and of course, government regulation). Without the Series LLC structure, the current preferred method for segregating liabilities is the formation of multiple single-member LLCs owned by a parent LLC or multiple LLCs under common ownership. While the administration of those multiple LLCs is by no means a herculean task, the annual filing fees, bookkeeping, tax returns and other filings can add up to a significant expense. Currently, the benefit of segregating potential liabilities from unrelated assets is often weighed against the administrative cost of establishing and maintaining multiple LLCs. The availability of Series LLCs would drastically alter that current analysis. III. UNCERTAINTY SURROUNDING SERIES LLCS Similar to when Wyoming sparked the LLC revolution in 1977, there is substantial uncertainty surrounding the Series LLC structure. Since Delaware first approved it in 1996, only a handful of states have adopted the series LLC structure. 5 In addition, states have taken different approaches to how a Series LLC is formed and to the protections afforded to each 5 Currently, Alabama, Delaware, District of Columbia, Illinois, Iowa, Kansas, Missouri, Montana, Nevada, Oklahoma, Puerto Rico, Tennessee, Texas and Utah specifically authorize the formation of series LLCs and provide liability protection between each series. See ALA. CODE 10A-5A-11.01 (West 2016); DEL. CODE ANN. tit. 6, 18-215 (West 2016); D.C. CODE ANN. 29-802.06 (West 2016); 805 ILL. COMP. STAT. ANN. 180/37-40 (West 2016); IOWA CODE ANN. 489.1201 (West 2016); KAN. STAT. ANN. 17-76,143 (West 2016); MO. ANN. STAT. 347.186 (West 2016); MONT. CODE ANN. 35-8-304 (West 2016); NEV. REV. STAT. ANN. 86.296 (West 2016); OKLA. STAT. ANN. tit. 18, 2054.4 (West 2016); P.R. LAWS ANN. tit. 14, 3967 (West 2016); TENN. CODE ANN. 48-249- 309 (West 2016); TEX. BUS. ORGS. CODE ANN. 101.601(West 2016); UTAH CODE ANN. 48-3a-1201 (West 2016). 3

series. This lack of widespread adoption and lack of uniformity are the main reasons for much of the uncertainty surrounding Series LLCs. 6 A. NOTICE TO THOSE DOING BUSINESS WITH THE SERIES LLC One of the main issues with which commentators and states have wrestled when it comes to Series LLCs is how to achieve the asset protection and ease of administration objectives while still providing notice to those that are doing business with one or more series. Delaware law allows any LLC to create a protected series simply by providing for separate series in its operating agreement, by titling assets in the names of the respective series, and by including a notice in the certificate of formation that the LLC may have multiple series. 7 With this structure, the public is given notice that the LLC may have multiple series, but very little notice need be provided about the actual series or the assets owned by the series. Thus, it is difficult for third parties to know anything about the series with which they are actually dealing. For example, if a party is about to enter into a transaction with an LLC that has indicated on its certificate of formation that it may have multiple series, the party will have no additional notice regarding which series will be assuming the risks and liabilities relating to the transaction. Thus, it is very difficult for the party to assess the likelihood of performance by the LLC without additional due diligence by the third party with respect to the particular series with which it will be contracting. Illinois has taken the approach that each series must make a separate public filing, which will provide notice to any third parties doing business with that series. The public notice, however, requires additional expenses in the form of filing fees. Illinois has attempted to address this issue by charging a higher initial filing fee for a Series LLC, as compared to regular LLCs, 6 Minnesota, North Dakota, and Wisconsin appear to permit the formation of series LLCs but do not provide any specific liability limitation for individual series. MINN. STAT. ANN. 322B.03.44 (West 2015); N.D. CENT. CODE ANN. 10-32.1-02.48 (West 2016); WIS. STAT. ANN. 183.0504 (West 2016). California has indicated it will allow individual series of LLCs formed in other states to operate in California. CAL. CORP. CODE 17712.01 (West 2016). 7 DEL. CODE ANN. tit. 6, 18-215(b). 4

but then charging a smaller additional fee for each series filing. 8 Thus, the filing fees associated with a Series LLC with two series is still less than the filing fees relating to creating two LLCs. B. SERIES LLCS OPERATING IN STATES WITHOUT SERIES LLC LEGISLATION Another area of uncertainty relates to how a Series LLC and its series would be treated in a state that has not enacted Series LLC legislation. One area where this uncertainty arises is in the context of standing in state courts. For example, would a series that has been granted a mortgage on real estate in a non-series LLC jurisdiction be allowed to foreclose on the mortgage, or would the LLC be the proper party? Would a series have standing to sue to enforce a contract in a non-series LLC jurisdiction? Perhaps a more important issue arises if a series is sued in a state without Series LLC legislation. In that situation, the state may not respect the internal liability shields between series provided in the state of formation, thus putting all the assets of the LLC at risk to creditor claims. Currently, Alabama, Delaware, District of Columbia, Illinois, Iowa, Kansas, Missouri, Montana, Nevada, Oklahoma, Puerto Rico, Tennessee, Texas, and Utah specifically authorize the formation of Series LLCs and limit claims against a series to the assets of the respective series. 9 Series LLCs that conduct business outside those states are potentially subjecting the assets of the entire LLC to the liabilities of a particular series. That risk alone will typically overshadow the administrative and cost saving benefits of the Series LLC. In addition, several states statutes include references to Series LLCs but do not include any reference as to whether the assets of a series are protected from claims against other series. 10 Thus, if a Series LLC is formed in those states or conducts business in those states, the assets of 8 805 ILL. COMP. STAT. ANN. 180/50-10.b (West 2016). The initial fee for a series LLC is $750 plus $50 for each series filing compared to $500 for a regular LLC. Id. 9 See supra note 5. 10 Minnesota, North Dakota, and Wisconsin appear to permit the formation of series LLCs but do not provide any specific liability limitation for individual series. See supra note 6 and accompanying list of states. 5

the entire LLC may be at risk. Because of these risks, in instances where the LLC or any of its series will be conducting business in, or subject to litigation in, a state that has not yet authorized internal liability among the series of an LLC, the benefits of the Series LLC are often outweighed by the potential risks. C. BANKRUPTCY TREATMENT Another area of uncertainty relates to how a Series LLC or an individual series would be treated in bankruptcy. Only a United States person is permitted to file for bankruptcy protection. 11 The U.S. Bankruptcy Code does not currently include LLCs in its definition of the term person. 12 The courts, however, have allowed LLCs to file for bankruptcy protection, largely because LLCs are distinct legal entities that are similar to corporations or partnerships, which are specifically included in the definition of person. 13 In the case of In re ICLNDS Notes Acquisition, the Northern District of Ohio Bankruptcy Court examined the following four factors and concluded that an LLC was similar to those entities: (1) the protection from personal liability for owners/managers of the LLC; (2) the ability of an LLC to be organized for any lawful purposes; (3) the ability of owners to exercise control over the LLC in proportion to their ownership; and (4) the treatment of the entity as a partnership by the IRS. 14 Based on those factors, the ICLNDS court allowed an LLC to file for bankruptcy protection, and its reasoning has been largely followed. 15 The determination of whether a series would be authorized to file bankruptcy apart from the LLC or the other series would likely be determined upon those same factors. Based on the structure of Series LLCs under most states laws, a series is protected from the liabilities of 11 11 U.S.C. 109 (2012). 12 Id. 101. 13 In re ICLNDS Notes Acquisition, LLC, 259 B.R. 289, 292-93 (Bankr. N.D. Ohio 2001). 14 Id. 15 Id. 6

another series and can be organized for any lawful purpose. A series will typically be controlled by its owners in proportion to their ownership, much like partnerships or corporations. Finally, the IRS has issued proposed regulations indicating that it intends to classify a series as a separate entity for tax purposes, so long as it is deemed a separate entity for state law purposes. 16 So, it appears the critical factor in the analysis will be whether a series is deemed to be a separate legal entity by the court. Under those state statutes where a series is a separate legal entity that can sue and be sued in its own name, a bankruptcy court judge may well allow a series to file for bankruptcy protection apart from the remaining series. Series LLCs formed in states where the statutes are silent on the separateness issue will have a much more difficult time establishing the separateness of each series. 17 Additionally, in some states where a series is given the right to sue and be sued, the state will not issue a separate certificate of good standing for each series. This may lend support to the argument that a series in those states is not a separate legal entity, and would thus not be granted bankruptcy protection. In addition, as noted by one commentator, even in those states that define a series as a separate legal entity, a series cannot exist independent of its LLC. 18 If the existence of a series is dependent upon the existence of another entity, i.e., the LLC, how then can the series be a distinct legal entity? Until clarity is provided by Congress or the bankruptcy courts, organizers of Series LLCs will be venturing into uncharted waters. If the LLC is forced to file bankruptcy, rather than the series, all assets of all series will be exposed to the creditors of the series. D. CORPORATE GOVERNANCE OF SERIES LLCS 16 Series LLCs and Cell Companies, 75 Fed. Reg. 55699-01 (proposed Sept. 14, 2010) (to be codified at 26 C.F.R. pt. 301). 17 See supra note 6 and accompanying list of states. 18 Amanda J. Bahena, Series LLCs: The Asset Protection Dream Machines?, 35 J. CORP. L. 799, 820 (2010). 7

Another area of uncertainty is in the area of corporate governance. Most states require each series to maintain separate records and bank accounts. Beyond that mandate, however, guidance regarding the governance of a Series LLC is limited. Questions relating to whether multiple series can share insurance coverage, employees, billing services, human resource services, payroll services, bookkeeping, and other administrative support services are unanswered. One of the major benefits of the Series LLC is the administrative cost savings as compared to a multiple LLC structure. Some of the factors that courts often rely upon in the context of veil piercing of LLCs or corporations, however, are the lack of formal separation between entities or failure to respect corporate formalities. If an LLC spreads administrative resources across multiple series, that very benefit may be a factor in a court s veil piercing analysis. Absent further guidance from courts or legislatures, this interplay is a potential minefield for Series LLCs. E. TAX TREATMENT OF SERIES LLCS The tax treatment of a series, both at the state and federal level, is also an area of uncertainly. As referenced above, the IRS has issued proposed regulations indicating an intent to treat a series as a separate entity for tax purposes so long as the series is deemed a separate entity under applicable state law. 19 If finalized, these proposed regulations would remove one level of uncertainly by allowing a series to elect to be treated as a disregarded entity (if it has only one owner), a partnership, or a corporation, just as LLCs are allowed to do. Even if those regulations are finalized, however, questions relating to employment taxes and retirement programs remain unanswered. 19 Series LLCs and Cell Companies, 75 Fed. Reg. 55699-01 (proposed Sept. 14, 2010) (to be codified at 26 C.F.R. pt. 301). 8

According to a survey of state tax departments conducted by the American Bar Association ( ABA ), each of the states that responded indicated they would either follow the IRS proposed regulations regarding classification of series., would give them substantial weight, or were undecided. 20 Only Texas has taken the contrarian view and intends to treat all series as one taxpayer. 21 The implication of California s decision to treat each series as a separate entity is that it will assess its $800 per year franchise tax on each series authorized to do business in California. 22 Questions remain regarding how other taxes, such as sales tax, use tax, and transfer taxes, will impact individual series. For example, will each series need its own sales and use tax number, or will the LLC be allowed to consolidate those activities? Will sales, use, or transfer taxes be generated on transactions between, or services provided to, related series? Each of those questions will need to be examined in the context of the respective state. F. SERIES LLCS INTERPLAY WITH UCC ARTICLE 9 A final area of uncertainty relates to the proper identification of the debtor in transactions that are governed by Article 9 of the Uniform Commercial Code ( UCC ). The first area of complexity is proving how collateral is titled, in the name of the LLC or an individual series. Under most state statutes, a series is not required to title property owned by the series in the name of the series; a series need only separately account for series assets or keep records that can reasonably identify [the series ] assets. 23 It may be difficult for a lender to become comfortable with collateral owned by a series if the property is not titled in the name of the series. Once the issue of ownership is resolved, the next question is how to list the debtor on 20 J. Leigh Griffith & James E. Long, Series LLCs December 2013 Update on Recent State Legislative and Taxation Developments, 55 TMM 83, at 12 (2014). 21 Id. 22 Id. at 3. 23 DEL. CODE ANN. tit. 6, 18-215(b) (West 2016). 9

transaction documents; specifically, would the financing statement reference the LLC as the debtor or the series? The final question relates to where the financing statement would be filed. Because an LLC is a registered organization under the UCC, if assets are held by the LLC, then the creditor would file its financing statement in the state in which the LLC is organized. 24 If however, the debtor is a series, the series may not meet the definition of a registered organization, in which case the financing statement would be filed, not in the state of organization, but in the state of the series chief executive office. 25 If the LLC owner is cautious and only operating in its state of formation, this leads to the same result. If a series of a Delaware LLC operates in Illinois, however, the question becomes more difficult. This uncertainty will affect lenders and may lead them to file financing statements in multiple jurisdictions. It will also affect parties purchasing the assets of such a series, and will make due diligence on those transactions more important and time consuming. III. ATTEMPTS AT SERIES LLC UNIFORMITY As has been noted, there is a significant amount of uncertainty surrounding the Series LLC structure, and a significant amount of that uncertainty relates to the lack of uniformity amongst the states. In an attempt to address that lack of uniformity, the Uniform Laws Commission ( ULC ) originally examined the Series LLC structure in 2006 when it was crafting the Revised Uniform Limited Liability Company Act ( RULLCA ), but ultimately declined to include Series LLC provisions in that model act. Subsequently, the ABA drafted a prototype Series LLC act in 2011, which included Series LLC provisions and was similar to the Delaware 24 U.C.C. 9-102(71) (AM. LAW INST. & UNIF. LAW COMM N 2014). 25 Louis G. Hering & R. Jason Russell, Series LLCs, 4 PRACTICAL L. J. 44 (2012). 10

and Texas statutes, which at the time, were silent with respect to the separate entity status of a series. In 2011, on the heels of the release of the ABA prototype, the ULC formed a committee to study whether Series LLC provisions should be added to RULLCA. A drafting committee was formed in 2012, and has released several drafts for discussion, most recently in January 2016. 26 The draft model act provides for a liability shield between each series if a public filing is made for each series and if the assets of the series are owned and associated with the series prior to the occurrence of the facts giving rise to the claim against the series. For assets to be associated with a series, the series must create and maintain a record that (i) describes the property sufficient to permit a reasonable person with no connection to the LLC or series to identify the property and distinguish it from property owned by the LLC or another series; and (ii) states when and from whom the property was acquired. 27 If assets are not associated with a series, those assets are subject to claims by creditors of the LLC or another series. Even if the assets are associated with a series, the liability shield can be overcome in situations of traditional veil piercing (i.e., vertical piercing) or affiliate liability, which is basically horizontal piercing between related entities. Keeping with its past comments, the ULC has adopted a model that imposes more public notice and record keeping requirements than most of the current state statutes. IV. FUTURE OF SERIES LLCS IN SOUTH DAKOTA 26 UNIF. LTD. LIAB. CO. PROTECTED SERIES ACT (NAT L CONF. OF COMM RS OF UNIF. STATE LAWS, Draft 2016), http://www.uniformlaws.org/shared/docs/series%20of%20unincorporated%20business%20entities/2016jan_subea _Mtg%20draft.pdf. 27 Id. 301, 402. It is not clear what, if any, additional benefit this when and from whom record keeping requirement would provide to third parties doing business with a series. In addition, the author is not aware of any requirement under general LLC law that requires a normal LLC to keep such records, begging the question as to why additional record keeping requirements would be required for a Series LLC. 11

We end with what the future holds for Series LLCs in South Dakota. A subcommittee of the South Dakota Bar Association s Business Law Committee has been formed to examine Series LLCs and make a recommendation to the Business Law Committee regarding whether Series LLCs should be authorized in South Dakota and if so, the approach to be adopted. Early discussions have indicated the subcommittee believes that South Dakota should authorize Series LLCs. The structure fits with one of South Dakota s goals of being business friendly. While the structure is certainly not a fit for all purposes, the structure can provide benefits to our agricultural community, real estate developers, and others in our business community that are currently not available in South Dakota. As more states authorize Series LLCs, it is important for South Dakota to offer the structure as well. Series LLCs could also benefit South Dakota s trust industry. The structure would allow families with South Dakota trusts to segregate high risk assets or concentrated assets in separate series. It could also allow the family to establish a structure where different family members or advisers could serve as managers or advisers of the investments in specific series. Finally, it will allow trusts from other jurisdictions that already hold assets inside a Series LLC to more easily move their situs to South Dakota. Because of those benefits, it is likely that the subcommittee will recommend the authorization of Series LLCs in South Dakota. The larger and more difficult question relates to the specific implementation of the Series LLC structure in South Dakota. The trend in Series LLC legislation, as seen in the Illinois statutes and the ULC draft model act, is to provide for more public notice of individual series through public filings for each series. It is likely that South Dakota will follow this approach in some way as it provides more notice to the public, which the subcommittee believes is important. It also gives more support to the separateness of the series, which becomes important in the tax 12

and bankruptcy context. It should also help resolve the question as to whether the series is a registered organization under the UCC. Prior to the most recent revisions to the ULC draft model act, the record keeping requirements in the various Series LLC statutes did not materially vary. In light of the association provisions included in the recent ULC drafts, however, the subcommittee will need to examine the wisdom of the heightened record keeping requirements contained in that model act and whether those requirements should be implemented in South Dakota. V. CONCLUSION The ability to compartmentalize liabilities among individual series and manage those series under one LLC is an attractive structure for many businesses. Due in large part to the lack of adoption of the Series LLC structure by the states, planners are currently faced with many uncertainties relating to the Series LLC structure, including whether a series will have standing to sue in a non-series LLC state, whether the liability shield between individual series will be respected in a non-series LLC state, whether a series can file bankruptcy apart from the LLC, how a series will be taxed, and how a series gets treated under the UCC. Whether Series LLCs usher in the future of business planning or are the harbinger of disaster, or anything in between, the fact remains that they are at South Dakota s doorstep and the state may soon welcome them in. While uncertainties remain, it is important to become familiarized with the risks and benefits associated with the Series LLC structure and be able to analyze those risks and benefits for clients. 13