Recent legislation, combined with protections historically available in Texas, make Texas one of the best locations in the U.S. for protecting assets from creditor claims.
Texas has now joined seven other states in permitting the creation of a series limited liability company (LLC). A series LLC permits one LLC to be created with multiple “cells” or series. Each series serves as a sub-LLC and permits the LLC to serve as an umbrella entity with the ability to partition its assets and liabilities among the various series or cells. Each sub-LLC can have different assets, liabilities, and managers. In other words, each sub-LLC performs like a separate entity. A firewall is created between each series with the profits, losses, and liabilities of each series legally separate from the other series. The structure is similar to a parent corporation with subsidiaries but without the expense, formalities, and potential heavy taxation.
For a real estate investor, this can have substantial positive effects. Assume, for instance, an investor owns four duplexes and a couple of single family residences. She has heard some of the horror stories about creditors and wants to protect her assets as much as possible.
Prior to the series LLC, her choices involved creating multiple entities, such as LLCs, to hold her property or forming one such entity and placing all of the properties in one LLC. If she places all of the properties in one LLC, a claim arising out of one of the properties would place all of the properties at risk because they are all owned by one LLC.
If the investor forms six separate LLCs, the liability arising from each property can be contained within each LLC, but the investor has the cost of creating and maintaining six separate entities.
With a series LLC, the investor can create one LLC with six series or sub-LLCs and place one property in each series. The risks associated with each investment property can now be contained within each of the six series.
The Texas statute is very new. It became effective in September, 2009. The statute provides that the liabilities of series are enforceable only against the assets of the series and not against the parent LLC generally, if
(a) the owner keeps separate accounting records for each series and accounts for the assets of a series separately from the assets of any other series or the LLC generally,
(b) the operating or company agreement states the liability limitations, and
(c) the certificate of formation gives notice of the limitations on liability.
Each series may in its own name sue and be sued, contract, and hold title to its assets, including real estate and personal property.
Within the recent past, Texas law was also modified to limit a creditor to a charging order against an ownership interest in an LLC and preventing the creditor from actually taking an investor’s interest in an LLC. I know this concept is confusing. Let me explain by contrasting the difference between a creditor claim against the ownership interest of an investor in a corporation and an LLC.
If an investor owns an interest in a corporation and a creditor gets a judgment against the investor personally, the law allows the creditor to actually take the ownership interest of the investor in the corporation. That means that the creditor becomes a shareholder in the corporation and is now entitled to the significant legal protections the law affords any shareholder. This could include the right of the creditor to force the dissolution of the corporation placing all six of our hypothetical investor’s properties within reach of the creditor.
With an LLC, the creditor cannot actually take the investor’s LLC ownership interest but is limited to a charging order. A charging order is a court order which states that if there are any distributions from the LLC to the investor-owner, the creditor gets the distribution. With a charging order, the creditor will probably not be able to actually force an distribution or a dissolution of the LLC. He simply has the right to receive the distribution if one is made.
Assuming that the LLC is controlled by friendly parties, there will likely be no distributions made while the creditor has a charging order. Additionally, once the creditor obtains the charging order the creditor may have to pay taxes on money that the LLC earns, even if it was not distributed. This is a serious problem for a creditor with a charging order.
These two changes in Texas law, along with significant tax advantages of an LLC and the reduced record keeping and formalities required to maintain an LLC, make it hands down the entity choice for small real estate investors and perhaps for some larger deals.
Since series LLCs are very new and we have no court interpretations of the law. Until the courts have reviewed and construed the new law, we will not know exactly how the courts will view these entities.
There are also unresolved issues concerning taxation. However, it is clear that these entities can provide substantial benefit to investors and will likely become very popular as real estate investment entities.