If you are in real estate and own several rental properties, or you own several different companies. There is a new, not so new kid on the block, which deals with these types of businesses really well. They are called Series LLC’s.
LLC is an acronym for limited liability company. A limited liability company is a hybrid type of legal structure that provides the limited liability features of a corporation and the tax efficiencies and operational flexibility of a partnership. The "owners" of an LLC are referred to as "members." Depending on the state, the members can consist of a single individual (one owner), two or more individuals, corporations or other LLCs.
The IRS does not view an LLC as a separate tax entity, so the business itself is not taxed. Instead, all federal income taxes are passed on to the LLC's members and are paid through their personal income tax. While the federal government does not tax income on an LLC, some states will.
You have to make an election on the way that you want to pay tax. If you make no election at all and you are a single-member LLC you are treated as a disregarded entity for tax purposes, and must claim your income or expense on Schedule C or Schedule E. If you are a multi-member LLC and you do not make an election, then you are taxed as a partnership. An LLC can elect to pay tax as a C-Corporation. To elect a classification, an LLC must file Form 8832. This form is also used if an LLC wishes to change its classification status. There is always the possibility of requesting S-Corporation status for your LLC.
Limited Liability. Members are protected from personal liability for business decisions or actions of the LLC. This means that if the LLC incurs debt or is sued, members' personal assets are usually exempt. This is similar to the liability protections afforded to shareholders of a corporation. Keep in mind that limited liability means "limited" liability - members are not necessarily shielded from wrongful acts, including those of their employees.
Liability being the main concern, when I meet with a client that owns a couple of rental properties, I always look at the properties from a liability perspective. If rentals are held in your personal name, and something happens to one of the properties, then the rest of the properties held in your personal name are at risk. There is no separation of liability. You wouldn’t want to hold a rental property in a corporation for any reason because the rules of corporations do not translate well to the real estate business. It is always my recommendation to form an LLC to hold the real estate. We are looking at this situation purely from a liability standpoint. Your tax obligation on rental properties will always be the same regardless of whether your properties are held personally or in an LLC.
In the past if you owned several rental properties, you would always have to separate each rental by forming a separate LLC. Then one day the great State of Delaware invented something called Series LLCs.
The Delaware LLC Act provides for the creation of separate “series” within an LLC whose debts and other liabilities are enforceable against that series alone. The Act also provides that classes or groups of members can be established, having whatever rights the LLC agreement says they have. The combination of the two provisions allows a series to be treated in many ways as a separate LLC. Thus, the series provisions in the Delaware LLC Act allow for the creation of separate protected “cells” within one limited liability “container” without the need to create separate entities, thus avoiding the inefficiencies associated with multiple related entities.
The Act allows an LLC agreement to designate series of members, managers or LLC interests that have separate rights and duties with respect to specific LLC property or obligations. So, each series can be tied to specific assets and can also have different members and managers. If the various series within an LLC have different members or different membership rights, each series may be treated as a separate LLC for income tax purposes, eliminating some of the administrative advantage of the series LLC.
Each series can have its own separate business purposes. A series can be terminated without affecting the other series of the LLC. A series can make distributions to its own members without regard to the financial condition of the other series.
Most importantly, the Act provides that debts, liabilities and obligations incurred, contracted for or otherwise existing with respect to a particular series are enforceable against that series only, and not against the assets of the LLC generally or any other series of the LLC. However, to obtain this protection, each series must be treated separately. Books and records must be kept for each series and the assets of each series must be held and accounted for separately.
Since Delaware enacted this law a few other states have fallen suit.
- Delaware (Limited Liability Company Act)
- District of Columbia
- Montana (Montana Limited Liability Act)
- Nevada (Nevada Revised Statutes)
- North Dakota
- Puerto Rico
The most obvious use for the series LLC is to hold multiple parcels of real property in liability-segregated cells. Consider Tom and Jill, who own ten small rental properties, each worth between $70,000 and $150,000. Forming and maintaining ten separate LLCs would cost several thousand dollars in the year of formation and several thousand dollars each subsequent year. Instead, Tom and Jill might form a Series LLC and transfer each property by deed to a separate series. They would achieve their goal of segregating the properties for asset protection purposes while saving several thousand dollars in startup costs and another several thousand dollars a year in ongoing administrative costs.
Another use for the series LLC might be to facilitate an equity compensation program in a business with multiple divisions. If each division were segregated into a separate series, the LLC could give the key employees of each series some sort of equity interest tied to that series only rather than equity interests in the entity as a whole. That rewards employees at productive divisions and protects them from the potential downside of another division.
Yet another use for the series LLC might be to make a de facto transfer that avoids gain that would otherwise be recognized on a transfer from one LLC to another LLC. Consider the following example: Tim & Allan contribute adjacent tracts of land to T&A, LLC and develops most of the land. A few years later, they want to sell the remaining undeveloped land, worth $1 million, to Fred for a shopping center. Tim & Allan want T&A, LLC to get some cash out of the deal, but they also want a piece of the shopping center action. If T&A, LLC contributes the property to a new LLC formed with Fred, TAF, LLC, in exchange for TAF, LLC interests and cash, the cash distribution would be taxable to Tim & Allan under Section 707(a)(2)(B) of the Internal Revenue Code as a taxable exchange of appreciated property for cash.
Instead, T&A, LLC creates a new series within T&A, LLC, the Shopping Center Series, issues the Shopping Center Series interests 10% each to Tim & Allan, and 80% to Fred, and transfers the land to the Shopping Center Series. Fred contributes $2 million to T&A, LLC, of which $1.5 million is designated for the Shopping Center Series. If T&A, LLC is respected as a single tax partnership (i.e., the Shopping Center Series is not treated as a separate partnership for tax purposes), the current income tax gain to Tim & Allan on the cash portion of the land exchange that otherwise would have been triggered in a transfer to a new LLC will have been avoided. In addition, since the transfer of the land was entirely inside the LLC, depending on local law, there may be no real estate transfer tax on the transfer whereas there may have been tax on the transfer of the land to a new LLC. This is cutting edge planning with no guarantees, of course, but the possibilities are exciting and the tax issues can be addressed reasonably.
The series LLC (SLLC) includes a master or umbrella LLC and other LLCs which are separated from each other for liability purposes. Each LLC has assets separate from the others, while the master LLC controls all the LLCs in the series. Each unit has its own owners (members), and is liable only for its own debts and obligations. A series LLC has been compared to a corporation with several subsidiaries.
Another company that would benefit from a Series LLC is a property management company that owns several properties. Each property could be a cell under a parent LLC. A business with several different product lines or services can isolate liabilities of each from the others.
The benefits of Series LLC's are obvious reduced startup cost. Only one filing fee is required, and a professional can set up the parent and cells at less cost than setting up multiple LLCs.
- Protection of Assets. Assets of each cell are protected from judgments against assets in other cells.
- Less Administration. You can set up as many LLC's as you want, but each would be separate and would have to be administered separately. A series LLC allows you to save on administrative time and expenses.
- Less Complex than Corporation/Subsidiary Structure. A series LLC doesn't have the same complexities of taxes, structure, and formalities (corporate records, for example) as a corporation with subsidiaries.
- Less Sales Tax. Depending on the regulations in your state, the rent paid by one cell to another cell in the series might not be subject to sales tax. Check with your state on this issue.
- Only one state registration. Only the parent LLC must be registered with the state, which means fewer legal costs and registration fees. It also means only one annual or biennial fee is needed for the series.
- Only one tax return. Only the parent LLC is required to file a tax return, which includes all the cell LLCs. Of course, this is going to be a complicated tax return, so you will need a tax preparer who is experienced with this type of return.
As you can see Series LLC’s are amazing creatures.
Craig Smalley is the managing partner of CWSEAPA®, LLP, which is an accounting and financial firm located in Delaware, Florida, and Nevada. Craig has been Admitted to Practice Before the Internal Revenue Service, is a Certified Estate Planner™, and is a Certified Tax Resolution Specialist™. Craig specializes in taxation and IRS representation all the way through the United States Tax Court. Form more information visit www.cwseapa.com, call 1-844-CWSEAPA, or email him at email@example.com
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