Understanding & Drafting LLC Operating Agreements (with WealthDocx®) A presentation for the WealthCounsel ® Forum in Denver October 12, 2011 Peter J. Parenti,

Understanding & Drafting LLC Operating

Agreements (with WealthDocx®)

A presentation for the WealthCounsel® Forumin Denver

October 12, 2011Peter J. Parenti, JD, LL.M (taxation)

Agenda• Intro to LLCs - background & law

• Overview of structural options: Types of LLCs

• Members and managers

• Jurisdiction considerations

• Uses of LLCs (gifting, asset protection, going concerns)

• Tax treatment & design options

• Transferring interests: buy-sell provisions in (VERY) brief

• A look at the WealthDocx® Interview

• WDx coming attractions

• Discussion/Wrap-up

Housekeeping

•Agenda timing - we probably got it wrong

•Speak up! This is a conversation, too.

•About the breaks?

•Ideas welcome!

Intro to LLCs

•Creatures of state statute

•Extremely flexible

•Few record keeping requirements

•Origins in partnership law

•Limitation on liabilities(VERY jurisdiction-specific)

•1822 NY Statute - enable investors to limit liability exposure to investments (birth of LPs)

•1916 - ULPA finalized; created uniform law for managing LP relationships, defining creditor rights

•1976 - Revised ULPA (RULPA) finalized

Intro to LLCsOrigins of LLC law

•1977 - Wyoming enacts first state LLC law

•Eventually enacted in all 50 states (far from uniform)

•1995 - ULLCA finalized, amended 1996.

•2006 - fully revised; dubbed “Re-ULLCA”


•Now - Re-ULLCA substantially adopted in:

•ID, IA, NE, WY

•Re-ULLCA pending in:

•D.C., IN, KS, UT


Intro to LLCsAbout Re-ULLCA

•Elevated importance of operating agreement

•Not-for-profit LLCs okay

•More management flexibility (boards)

•Explicit duties of loyalty, due care

•Analogous to corporate directors

Intro to LLCsAbout Re-ULLCA

•“Shelf” LLCs valid

•Charging order as exclusive statutory remedy

•Foreclosure right on charging orders

•(Judicial limitations may remain)

Interlude:What’s a Charging

Order?•Charging order (protection):

refers to creditor’s statutory relief against debtor member; does not admit creditor as LLC member; equals assignee interest (financial rights only)

•Treated very differently in various jxns

•Inside Liability: claims arising against the LLC, or among the members in the LLC

•Outside Liability: claims arising against a member from non-LLC related activity

Intro to LLCsA few key terms

Intro to LLCs•Separate legal entity - a legal “person”

•LLCs have own rights, limitations, creditors, etc.

•Members have no interest in underlying property; own interest in entity itself

•Operational life not limited to members’ lives (making succession planning essential)

Intro to LLCs

•Not subject to corporate record keeping requirements

•No “minutes” requirements, bylaws, regular meetings of interest holders, etc.

•Beware of this trap!

Intro to LLCsThe players

• Manager (or managing partner/s)

• Oversees operations of LLC

• May be a member (but need not be)

• Unlike GP, has no liability for LLC liabilities

• Duties imposed by law, operating agreement

• Entitled to compensation for services


• Members

• Own interests in LLC

• No liability for LLC activities

• No right to participate in management/operation (except managing members)

• Restrictions on transferability of interest

• May (or may not vote) on LLC issues


• Assignees

• No ownership right; financial interest only

• No right to vote on anything

• No liability for LLC activities

• No right to participate in management/operation (except managing members)

• Often arises with invalid transfer of membership interest or judgement

Structural Options• Two basic forms:

•Multi-member LLCs (MMLLC)

• Tax as partnership, S-corp, C-corp (sole prop. only if members are H&W)

• Single-member LLCs (SMLLC)

• Tax as sole prop./Disregarded Entity (DE), S-corp, C-corp (not as p’ship b/c no “partner”)

•Member-managed: one or more (not necessarily all) members serve as managers

•Manager-managed: appointed manager(s), not necessarily members

•Managers may be individuals or entities

Structural Options

•Our general preference...

•Don’t rely on default member management; draft manager provisions into agreement

•When appropriate, use entity manager (i.e. Management Trust)

Structural Options

Structural Options“Special Purpose” LLCs• Wyoming Close LLC

• Member w/d only with consent of all other members

• Return of capital only with unanimous consent

• W/D member may only demand cash as return of capital

• LLC dissolved only by unanimous consent

• Nevada Restricted LLC

• Assets in LLC may not be w/d during restricted period

• Limited access intended to drive discounts, further frustrate creditors

• Articles of Organization must opt in to restricted statute & state lock-in period

Structural Options“Special

Purpose” LLCs

•Professional LLCs (PLLCs)

•Enables professional practice to enjoy limited liability & administrative ease of LLC structure

•Not all states, not all practices


Purpose” LLCs

• Series LLCs

• Assets, members, liabilities shielded within various series (isolating claims)

• Proper record keeping essential

• Valid in 9 states (see list in outline, p. 12)

• Beware jurisdictional nuances(e.g.,CA franchise tax on each series!)


Purpose” LLCs

• “Family” LLCs (FLLCs)

• All members in same family (or entities controlled by or FBO family members)

• Not legally different than business LLCs

• Beware tendency to cut corners! (we’ll cover in detail under §2036 discussion)


Purpose” LLCs

LLC Tax Choices

•LLC tax flexibility...

•Disregarded entity/sole proprietor

•Partnership (Subchapter K)

•Subchapter S corporation

•Subchapter C corporation

LLC Tax ChoicesSole Prop./Disregarded Entity

•Wholly owned by one individual, or

•Wholly owned by H&W(Note: DOMA applies)

•“Disregarded” as separate taxpaying entity under Fed. Income Tax Laws

•Pass-through treatment


•Pass-through...

•All income, gains, losses, pass through entity (not separately taxed); items taxed as if held by individual owner

•Subject to tax treatment at owner’s level


•Pass-through...

•Contributions/distributions of property not taxable event

•LLC debts and expenses may be taken as deduction for owner


•Benefits:

•Simplicity

•Flexible use of assets

•Inside basis step-up on 3d party acquisition

•Limited Liability


•Limitations:

•No employee equity benefits (ESOPs, ISOs)

•No choice of tax year (calendar only)

•All earning subject to Self-Employment Tax (SET)

LLC Tax ChoicesPartnership (Sub-K)

•Roots in “aggregate” theory:

•Separate legal entity, but taxed as an “aggregation” of individuals.

•Results in pass-through treatment; entity not separately taxed

•Flexible allocation options per ULPA, RULPA, IRC §704(b) Special Allocations (discussed in greater detail in next section)


•Partnership tax treatment available for LLCs following Rev. Rul. 88-76

•LLCs had to meet requirements of the old Kintner Regulations

•Much easier with newer “check the box” Regulations

• (Kintner & check the box discussed in next section)


•Benefits:

•Pass-through tax treatment

•Flexible allocation of gain & loss

•Inside basis step up on sales or transfers at death (IRC § 754)


•Limitations:

•No employee equity benefits (ESOPs, ISOs)

•Certain events can trigger gain from sale of interests, deemed termination of LLC

•Disproportionate distributions can trigger unwanted tax consequences

LLC Tax ChoicesSubchapter S

• Pass through entity treatment

• More stringent requirements for who can participate

• Only one class of stock

• No more than 100 shareholders

• Must be U.S. citizens or residents

• Generally no entities, except QSSTs, some estates, 501(c)(3)s


• No special allocation; pro-rata only

• No IRC §754 Elections

• Post-formation contributions of capital triggers gain to contributor

• Distribution of property to member triggers gain

• Member may include LLC debt only to extent of actual loans by member to LLC


•Benefits:

•Pass-through tax treatment

•Fairly clear rules for restricted stock & stock options for members (IRC §421)



•Limitations:

•Restrictions on eligible equity participants (often not an issue)

•Only one class of equity participation (often IS an issue)

•Possible to accidentally lose S-corp status by invalid transfer

LLC Tax ChoicesSubchapter C

• NOT Pass through; entity taxed as separate taxpayer

• Entity taxed on gains (deductions on losses)

• Members taxed on distributions

• Treated under “Entity theory”:

• Entity is legal owner of property

• Shareholders only own interest in entity


•Benefits:

•Required for publicly-traded entities

•Clear rules for employee benefits

•Multiple levels of stock ownership



•Limitation:

•Double taxation (entity + shareholder) can be very costly

Overview of Asset Protection Issues

•Basic asset protection issues

•Inside Liability - Claims against the entity itself; claims among the members (“inside” the company)

•Outside Liability - Claims against a member from “outside” (i.e., a third party creditor)


•Liability limitation by statute

•Inside liability: Members not personally liable for claims against LLC

•Exposure limited to interest in LLC

•LLC itself responsible for claims against entity


•LLC should contain adequate assets/maintain adequate insurance to satisfy legitimate claims

•Failure to maintain sufficient assets may lead to veil pierce, trigger equitable relief

•Outside liability: Non-debtor members not liable for claims against other members

•Judgment creditor’s relief against debtor member is limited to the charging order

•Obtains rights of assignee: financial rights only


Asset ProtectionHow clients mess it up

•No protection from:

•Claims arising before LLC formed

•Malfeasance

•“Super creditors” (IRS, SEC, EPA, FTC)

•Veil pierce if LLC not treated like real entity, alter ego, etc.

•Remedies vary greatly by jurisdiction

Asset ProtectionDesigning LLC for Protection

•Entity manager

•Voting restrictions

•Limitation on withdrawal from entity

•Limit ability to demand distributions

•Limit on transfer of interests

Asset ProtectionDesigning LLC for Protection•Mandatory additional capital

contributions

• Redemption of interest subject to charging order

•Multiple layers of entities (e.g., LLC owned by series of other trusts, LLCs, corp.)

• Isolating assets, liabilities

•Multiple entities, series LLCs

Asset ProtectionDesigning LLC for Protection

•Limit on liquidation provisions

•Convertible interest (e.g., “downgrade” to limited interest in case of claim etc.)

•NOTE: restrictions also can drive down valuation, open arguments for inclusion under §2036

Charging OrdersSee outline §2.09 & Part V

•No access to “non-economic rights” (e.g., voting, rights to information, rights to manage)

•No right to force liquidation or distributions

•Liable for ratable income, gain, tax liability (i.e., “phantom income”)

Charging Orders• Strength of protection depends on

jurisdiction (see table at Part XIV of outline)

• Some explicitly prohibit foreclosure, equitable remedies

• Not likely available for SMLLCs

• Intended to protect non-debtor members from becoming unwitting partners with others’ creditors (Olmstead, Albright)

Charging Orders

•Recall - Re-ULLCA would statutorily allow foreclosure of charging order!

•Business-friendly states should consider cutting from LLC law

Charging Orders

•Functions as lien against debtor’s LLC interest

•Distribution allocation to debtor member pays to creditor/assignee

•Assignee treated as substituted partner/member for income tax purposes (Rev. Rul. 77-137)

Dealing with Charging Orders

• Disproportionate distributions

• Breach of fiduciary duty?

• Making loans to members

• Document it!

• Limit distributions to contributing members

• Establish different classes of members/partners

• Preferred & common (not for S-corps)

Asset Protection

•LLCs/entities best with other tools

•Adequate liability insurance

•Statutory exemptions

•Vary dramatically by state

•Separate property trusts

Fighting Fraudulent Conveyance Claims•Interests reasonably reflect member

value contributed (equivalent value)

•Adequate insurance to cover claims

•Adequate assets left OUTSIDE of entity (maintain solvency)

•Preserve entity for other partners/members (fairly weak)

Funding the LLC

•State law issue:Funding in entity name, oris name of manager required?

Funding the LLC

•Business interests

•Transfer existing business by assignment of stock, stock power, etc.

•Consider segregating operations, receivables, assets in separate entities

Funding the LLC

•Business equipment

•Transfer by assignment, bill of sale

•Lease to operating LLC

•Planning opportunity - gift business equipment LLC to children’s trusts, lease payments fund trust without additional gift

Funding the LLC

•Cash

•Transfer by retitling account into LLC name

•Proper TIN/EIN for account (use LLC’s)

Funding the LLC

•Installment notes

•Transfer by assignment, lien transfer (with notice)

•If note is tax deferred (IRC §453), later transfer of LLC interest triggers tax on deferred gain

Funding the LLC•Life insurance

•LLC-owned as alternative to ILIT

•May not get full removal from estate, but may get reduction

•Exception to transfer-for-value rule - transfer to insured or “partner” of insured(IRC §101(a)(2)(B))

Funding the LLC• Life insurance - annual gifts thru LLCs

• Pay premium gift to LLC:

•More accounting intensive (managing capital accounts, paying premiums)

• Capital account “Crummey” powers

•Grant immediate w/d right like ILIT Crummey

Funding the LLC

•Marketable securities

•Gifted shares held by partnership at death of partner retain original basis

•Must comply with IRC §§351(e) and 721(b)

•Transfer account by registration

Funding the LLC

•Closely-held securities

•Must comply with bylaws of company

•IRC §1244 (small business) stock loses tax favorable treatment

Funding the LLC

•S-Corp stock

•Partnership not permitted shareholder; will convert to C-corp taxation for corp

•BUT - LLC wholly owned by permitted shareholder may own S-corp stock

Funding the LLC• Real estate

• Environmental concerns - support entity management, especially if LLC business generates contaminants (agribusiness, pharmaceuticals, etc.)

• Make sure donor pays reasonable rents for use of contributed property

• Potential property tax increase(CA Props. 13, 58)

Funding the LLC

•Encumbered property

•Contribution likely triggers due-on-transfer clause

•If encumbrance > basis, transfer to LLC triggers gain

Funding the LLC•Personal residence

•Make sure donor pays reasonable rents for use

•Likely loss of homestead exemption (avoid in jxns w/ adequate homestead protection)

•Consider transfer to LLC with retained LE

Funding the LLC

•Retirement Accounts

•DON’T DO IT! Transfer loses tax deferral, accelerates tax liability

Funding the LLC

•Layering entities to isolate high-risk assets (planes, cars, ATVs, boats)

•Another opportunity for series LLCs

Family LLCs

•Often used to achieve tax-leveraged transfers (thru discounted interests)

•Pure tax motives generally fail

•Structure the FLLC (or FLP) carefully & treat as business

FLLCs

• Non-tax benefits (& objectives)

• Protect family assets

• Provide structure to train children how to manage wealth

• Create framework for asset management

• Maintain predictability, control

• Consolidate assets & institutionalize investment strategy

FLLCs• Non-tax benefits (& objectives)

• Preserve “heirloom assets”, vacation properties, etc.

• Provide more efficient transfers (LLC interests instead of fractionalized assets)

• Protect family wealth from children’s divorces

• Provide planning flexibility

FLLC or FLP?• LLC provides asset protection to all; LP must

have general partner, who is exposed (LLC 1, LP 0)

• LP and LLC interests generally not subject to foreclosure; charging orders only (tie; LLC 2, LP 1)

• More case history for LPs (LLC 2, LP 2)

• Possible §2704(b) valuation issue for LLC if transfer restrictions stricter than state law (no point; depends on state law)

Members, Managers, and

Entity Managers•GP or managing member

responsible for operations

•GP personally liable for entity liabilities (LPs; not LLCs)

•In both cases, management fees appropriate for services rendered

Management

•Individuals or entities as managers?

•In LP, individual exposed to GP liability; may protect with entity

•Much less of an issue depending on asset mix

•In LLC, no exposure to manager liability

•In both cases, entity provides greater continuity of life

• Corporation as manager

• Perpetual existence

• Compensation paid to directors of management corp

•Other benefits (stock options, etc.) available

• Tax choice of entity discussion applies

Management

•Corporation as manager

•Considerable complexity

•Tax returns, bylaws, meeting formalities

•Shareholders (use RLT)

•Concerns about piercing corporate vale.

Management

• Management Trust

• Revocable or irrevocable grantor trust

• Client may serve as trustee

• Client should not be beneficiary

• May receive compensation for management services, but shouldn’t be entitled to any beneficial interest

• As grantor trust, no additional tax return required

Management

• LLC as manager (or GP)

• Must provide perpetual existence; avoid unplanned termination of management LLC (thus terminating main entity)

• May have compensated employees (unlike management trusts)

• Tax flexibility (sole prop., partnership, S-corp, C-corp)

• May situs in any jxn(think asset protection, reliable case law)

Management

WealthDocx®LLC Assembly

Coming Attractions

ETHICS BONUS(time permitting)

Ethical Issues

• Significant issues common to estate planning

• Potentially compounded with HNW/asset protection, & gifting strategies

• Are you competent?

• Who is client?

• Adequate representation for all parties?

• Conflict of interest?

• Enabling fraud?

Ethical IssuesAre you competent?

•Model Rule 1.1 elements:

•Relative complexity & specialized nature of engagement

•Lawyer’s experience

•Training, experience in specific area

•Feasibility/advisability of referring to other counsel

Ethical IssuesAre you competent?

• Getting competent

• Through study

• Through co-counsel with more experienced attorneys

• When law is unsettled, attorney must do adequate study to provide sound counsel

• If uncertain, document preparation & competency carefully

Ethical IssuesWho is your client?

•Specify with engagement letter/agreement

•Consider stating (in writing) who is not your client (e.g., other family members, partners)

•Representing client as individual, or entity created? Both?

Ethical IssuesDuty to Inform

• Document your recommendations in writing

• Use care to comply with Circ. 230

• Don’t make promises of asset protection elements, discounts

• Document issues discussed, not specific outcomes

• Alert clients of advantages/risks of planning, failing to plan

Ethical IssuesEngagement Letters

• Specify in writing:

• Identity of client (and non-clients)

• Scope of services to be performed

• Specifically excluded services (to prevent misunderstanding)

• Fee arrangement, payment schedule(including refundable portions if client terminates)

• Other probable costs (filing fees, etc.)

Ethical IssuesConflicts of Interest

•Often avoidable by good engagement letter

•NOTE: Rule 1.7 prohibits representing client if directly adverse to another client, unless lawyer reasonably believes representation will not adversely affect client relationship, and both clients consent after consultation

Ethical IssuesConflicts of Interest

• Waiving conflicts -

• Notify nature of conflict in writing to all “potential clients”

• Notify of remedies if conflict presents problem

• Obtain signatures from all involved

• Conflicts will ebb and flow during engagement; revisit periodically to avoid problems for clients, attorney

Ethical IssuesCriminal or Fraudulent

Activity

•Model Rule 1.2(d) - lawyer shall not counsel client to engage or assist client in conduct lawyer knows is criminal or fraudulent; may discuss legal consequences of any proposed course of conduct

Ethical IssuesCriminal or Fraudulent

Activity•Civil and criminal penalties

•Document communications carefully

•Affidavit of Solvency

•Designed to provide attorney “CYA”

•Sworn statement by client that they retain adequate assets outside of entity; not insolvent by engagement

Ethical IssuesLiability

•To Client:

•Duty

•+ Breach of duty

•+ Proximate cause

•+ Damages

•= tort claim for malpractice


•Generally not liable for failed asset protection plan if implemented correctly & according to prevailing law

•May be liable to others if creditor can establish that atty complicit in rendering client insolvent, facilitating fraud, etc.


•To third parties

• In family/business engagements, consider notifying in writing who you do represent

•Liability may still attach despite lack of privity (see next slide)

•Punitive damages possible for facilitating fraud


•To what extent was transaction intended to affect claimant?

•Was harm foreseeable?

•Degree of certainty of claimant’s injury?

•Causation

•“Moral blame” for attorney conduct?

•Policy to prevent future harm?


•Criminal penalties

• If BK court can establish complicity in defrauding creditors, client and attorney may be prosecuted

•Fraud, or as aiding and abetting fraud

•Money laundering


•Criminal penalties

•Withdraw from representation in writing, disaffirm work product

Ethical Issues• Clear, consistent, written communication

• Ethical issues arise throughout engagement, not just at beginning

• Do homework, set appropriate expectations in writing, deliver on agreed-upon services

• As “situations on the ground” change, communicate clearly and in writing with all affected

• No substitute for clear, copious notes

Documents

Understanding & Drafting LLC Operating Agreements (with WealthDocx®) A presentation for the WealthCounsel ® Forum in Denver October 12, 2011 Peter J. Parenti,