The answer to this question is found in W. Ryan Fowler’s article Entanglement Theory, which follows. You will also want to read PF Shield’s articles regarding the asset protection benefits of multi-member LLCs and DEMMLLCs.
NOTE: Because of the similarities in charging order protection for both Limited Liability Companies (LLCs) and Limited Partnerships (LPs), any mention of either LPs or LLCs in this article should be considered to include both entity types.
As we’ve seen from the bankruptcy case In re: Ashley Albright, a single member LLC is sometimes susceptible to losing its charging order protection. However, although very rare, even multi-member LLCs sometimes find their charging order protection compromised. Fortunately, multi-member LLCs can be reinforced against this threat through the utilization of Entanglement Theory® (a phrase coined by the author.)
Before discussing Entanglement Theory®, we must examine the circumstances in which a multi-member LLC’s charging order protection fails. Besides In re: Ashley Albright three other cases are relevant to this topic. The first two, Crocker National Bank v. Perroton, (208 Cal. App. 3d 1(1989)) and Hellman v. Anderson, (233 Cal. App. 3d 840 (1991)) come from California district courts. In both these cases, the court decides to ignore a limited partnership’s charging order protection because, the court ruled, charging order protection was originally enacted as a means of protecting the non-debtor partners, and to insure that partnership business is not interrupted1, not so that a debtor partner can escape paying his debts. In both cases the partnership interest could be transferred to the creditor without causing an interruption in partnership business. As a result, the courts on both occasions decided that charging order protection did not apply, and the partnership interest was transferred to the creditor. Although the court only allowed this transfer with the other partners’ consent in Crocker v. Perroton, in Hellman v. Anderson the court allowed the transfer without the consent of the non-debtor partners. Although these cases currently only apply in California, they set a precedent that may be imitated in other courts nationwide.
Another situation in which charging order protection may fail is found in a very recent bankruptcy proceeding, In re: Ehmann (2005 WL 78921 (Bankr. D. Ariz. (2005)). In this proceeding, the court ruled that the debtor’s LLC membership interest in Fiesta Investments, LLC was forfeit to the bankruptcy estate due to the fact that the LLC’s operating agreement was a non-executory contract. Under bankruptcy law, an executory contract would include an agreement wherein the member and the LLC have reciprocal obligations. Such an executory contract would be subject to §§365(c) and (e) of the Bankruptcy Code (Title 11 U.S.C.), which would uphold the limitations of state or other applicable law. The court makes it clear however, that §§365 (c) and (e) do not apply to non-executory contracts when it states:
“The Court here concludes that because the operating agreement of a limited liability company imposes no obligations on its members, it is not an executory contract. Consequently when a member who is not the manager files a Chapter 7 case… the limitations of §§ 365(c) and (e) do not apply.”
If an operating agreement is non-executory, the LLC interest would instead be subject to Title 11 U.S.C. §§541(a) and (c)(1). As the court noted:
“Code § 541(c)(1) expressly provides that an interest of the debtor becomes property of the estate notwithstanding any agreement or applicable law that would otherwise restrict or condition transfer of such interest by the debtor. All of the limitations in the Operating Agreement, and all of the provisions of Arizona law on which Fiesta [Investments LLC] relies, constitute conditions and restrictions upon the member’s transfer of his interest. Code § 541(c)(1) renders those restrictions inapplicable. This necessarily implies the Trustee has all of the rights and powers with respect to Fiesta that the Debtor held as of the commencement of the case.” [Emphasis is mine.]
Although there was plenty in Fiesta Investments, LLC’s operating agreement that obligated the LLC and its manager to the debtor, there was nothing that obligated the debtor to perform any service or make any contribution to the LLC. Therefore, the operating agreement was non-executory, and the debtor’s membership interest was forfeit, statutory charging order protection notwithstanding.
In light of the above cases, there is yet another situation wherein charging order protection may be circumvented. That is where all members of the LLC are debtors to the same creditor. In this situation, the underlying reasons for charging order protection (as noted in all of the cases referenced in this article, save In re: Ehmann) would not apply to the fact pattern, and therefore a court could conceivably disregard charging order restrictions.
To summarize, we can see that the following factors may jeopardize the charging order component of an asset protection plan:
- The LLC is a single member LLC – this is especially dangerous.
- The LLC’s operating agreement is non-executory in nature (however this should only be a problem in bankruptcy.)
- The forfeiture of a debtor’s membership interest to a creditor would not interrupt partnership business.
- All members of the LLC become a debtor of the same creditor.
It is obvious that if we wish to structure an LLC for maximum asset protection, we must effectively counter the above pitfalls. These pitfalls are sidestepped with the utilization of Entanglement Theory®. Entanglement Theory® is the process of “entangling” the relationships of various LLC members with the LLC and each other (in connection with their obligations and rights to benefit from LLC membership) so that if a particular member of the LLC was taken out of the picture, then the business of the LLC, and the interests of the other members, would be significantly impaired. Obviously, if there is only one member in an LLC, there is no one else to become entangled with, so the first thing we must do is make an LLC multi-member. There is no real obstacle to doing this with what would otherwise be a single member LLC, since a grantor trust can easily be added as 2nd member, which would preserve its disregarded entity status if such status is desired for tax reasons. However, we’ll discuss shortly how a disregarded entity multi-member LLC (DEMMLLC) may not benefit as fully from Entanglement Theory® application as a standard multi-member LLC would.
The next thing we must do is ensure that the LLC operating agreement is executory in nature. It goes without saying that there are many considerations that must be made when drafting an operating agreement, in order to ensure that the highest possible degree of asset protection is obtained. Such considerations are without the scope of this article, yet we’ll explore a few ideas for making such an agreement executory. In re: Ehmann shows us that an LLC agreement is executory when the members have the following obligations:
- Ongoing obligations to contribute cash to the entity;
- Ongoing obligations to contribute non-managerial services or other forms of capital to the entity, or;
- Ongoing obligations to manage the entity.
The easiest way to accomplish this is to require every LLC member to receive at least a 1% interest (or, even better, a greater than 5% interest) in exchange for either of the following:
- A promissory note, issued to the LLC, to act as a manager of an LLC. The longer the management period, the better, as long as the term of the management contract is in line with the objectives of all LLC members. If possible, I recommend a management contract of as close to 30 years as is feasible. This is because once the obligation is fulfilled, the operating agreement may no longer be considered executory! Keep in mind that if the LLC engages in activities that expose it to possible liability, then every LLC manager should also be another limited liability entity, such as an offshore or domestic LLC, or a domestic LP.
- For non-managing members, a promissory note to contribute cash in exchange for a 1% or greater membership interest is an ideal way to make the LLC operating agreement executory. As with management contracts, I recommend you make the term of this promissory note as long as possible. I recommend you read the section of this Guide entitled “The Power of the Promissory Note” for ideas on how to structure a knockout promissory note that would have real economic substance, yet hold little value to any creditor who gained possession of it. Remember to make the cash value of the promissory note equivalent to the value of the membership interest you receive in exchange for the note.2
- A non-managing member of an LLC may also promise to act in an advisory or consulting role to the LLC or its manager for a specific number of years in exchange for a membership interest. If a limited partner is doing this with an LP, be careful to consult with state law to make sure this does not violate the permissible actions of a limited partner.
In reference to the above three options, I recommend that a non-managing member issues two promissory notes to the LLC, each in exchange for a 1% or greater LLC interest. One promissory note would be tied to a required cash contribution. The other would be tied to a promise to act as an advisor. A promissory note to make future cash contributions is ideal because it will be easy to track and prove in court that such contributions were actually made, which would thus substantiate the note’s validity. In contrast, it may be more difficult for a member to verify that he is making good on his promise to act as an advisor to the LLC. However, a promise to advise the LLC has its own benefits, because it would ensure that a transfer of a member’s interest would impair the LLC’s business. This is because a member-advisor would have certain skills and also be intimately involved with the LLC’s operations. If a creditor of the member attempts to argue in court that the LLC as a whole will not suffer if the member’s interest is transferred to the creditor, the members of the LLC can counter that such a transfer would relieve the debtor-member’s obligation to act as an advisor to the LLC (or make his obligation non-enforceable), which would in turn hinder the operations of the LLC. Even if the creditor then argues that it would be willing to replace the debtor member as an advisor (which is extremely unlikely), the non-debtor members could argue that the debtor-member is more qualified to act as an advisor than the creditor, because the debtor-member is more familiar with the details of the LLC’s operation.
Lastly, we must make sure that never, under any circumstance, could all members of the LLC personally become debtors of the same creditor. This could be done one of the following ways:
- Make sure at least one of the LLC members is never exposed to liability. This is best accomplished by making one of the members a trust, LLC or other entity that only engages in “safe” activities, or;
- Make sure that at least one member is not an insider or affiliate of any other member under the U.F.T.A. Also, it is best for this member to live in a different state than the other members. This would make it highly unlikely that this member would ever be personally listed as a defendant on the same lawsuit as another member. With this in mind, make sure that the LLC is not member managed. Otherwise, a plaintiff suing the LLC could name all of the members as co-defendants, claiming each one was responsible for mismanagement of the LLC, which led to the tort offense.
Can a Disregarded Entity Multi-Member LLC (DEMMLLC) Utilize Entanglement Theory®?
The short answer to this question is technically yes, although the structure may not pass a judge’s “smell test”. This is the biggest obstacle to utilizing Entanglement Theory® with a DEMMLLC. Remember that a major tenet of asset protection is that if there’s not a valid reason for everything you do, besides pure asset protection, then a judge may look at an entity’s structure with suspicion and start thinking of ways to rationalize calling the entity a sham or saying it lacks economic substance. An example of a DEMMLLC that might not pass the smell test is this:
John sets up an LLC where he is one member, and the other member is an irrevocable grantor living trust designed for probate avoidance, with John as grantor and beneficiary and his wife Jane as trustee. He sets himself up as the manager of the LLC, and the trust issues a promissory note to LLC, to contribute $1,000 cash each year for 30 years in exchange for a 5% membership interest. This is proportional to the total value of capital contributions to the LLC, which is $600,000. According to this scenario, we have structured a DEMMLLC (per IRS Revenue Ruling 2004-77), since John is the only underlying taxpayer
If a judge looked at the above scenario, he might ask:
As is typical with living trusts, assets are gifted to the trust. In this case, the LLC membership interest is no exception to the rule, as it was gifted into the trust. Why then would the trust, which received the membership interest as a gift, be required to contribute cash to the LLC in exchange for such interest?
Even if the trust is irrevocable, John is the trust’s beneficiary until he dies (as is often the case with living trusts.) So if John is receiving all the benefit from the trust’s membership interest and also his own interest, then why did he obligate the trust to contribute capital to the LLC? Why couldn’t he just put additional cash into the LLC whenever he thought it was appropriate?
The problem we are running into with DEMMLLCs is that a DEMMLLC by its nature only has one taxpayer, and correspondingly typically only one person benefits from LLC profits. Furthermore, a problem with using a grantor trust (necessary to maintain DEMMLLC status) is that assets, including LLC membership interests, are usually gifted into a trust instead of being exchanged for a promissory note. In contrast, a non-disregard entity multi-member LLC consists of individuals who have an actual reason to compel the other members to make contributions to the LLC; that is, to make sure the other members pull their fair share of the burden of capitalizing the company so that it may generate more profit, which will in turn ensure that each member receives a higher profit in proportion to their LLC interest. Therefore, the typical goals of a DEMMLLC conflict with the utilization of Entanglement Theory®, while the goals of multi-member LLCs that are not taxed as disregarded entities are usually in harmony with such utilization.
Although a trust can be a valid additional member as part of an Entanglement Theory® application, it only makes sense to do this if the trust is non-grantor, and unfortunately non-grantor trusts cannot be used to structure a DEMMLLC. However, if an individual has no one else he wishes to “go into business with” when forming an LLC, then a non-grantor trust may be used in an Entanglement Theory® application while also passing the smell test. An example of such a scenario is as follows:
John forms an LLC where he is one member, and the other member is an irrevocable non-grantor children’s trust designed to benefit his six year old son, with John as grantor and an impartial third party as trustee. The trust promises to manage the LLC for fifteen years (when his son turns twenty-one and the trust subsequently terminates), in exchange for a 50% membership interest, which is valued at $300,000. John also contributes $270,000 to the LLC in exchange for a 45% interest, and issues a promissory note to contribute $2,000 a year to the LLC for fifteen years, in exchange for an additional 5% interest.
Of course we now must ask ourselves: what are John’s reasons for doing things in this manner, besides asset protection? The reasons are as follows:
- In lieu of gifting, by having the trust exchange management services for a 50% membership interest, John avoids paying a gift tax on a $300,000 gift, which he may have had to pay had he gifted the membership interest to the trust. The trust is then entitled to 50% of LLC distributions, which will accumulate in the trust until John’s son turns 21.3
- John is able to split income from the LLC between him and the children’s trust, thus potentially lowering his income tax liability while also allowing his son to receive benefit from LLC profits.
Because we have valid reasons for this structure, other than pure asset protection, we have applied Entanglement Theory® to an entity that should pass the smell test if it was ever scrutinized in a legal proceeding.
Footnotes
Note that this observation was also made by the Colorado District Bankruptcy Court in the In re: Ashley Albright case. See Single Member vs. Multi-Member LLCs in chapter 2 of this guide for more information.
On a tangential note, a trap for a would-be creditor/transferee of a membership interest that is tied to a promissory note to contribute cash would be to draft the LLC operating agreement so that, if any transfer occurs (voluntary or involuntary) the promissory note would be accelerated so that the entire note payment would be immediately due and payable. Failure to pay such note within 30 days (the likely outcome, since what creditor would want to obtain a membership interest and then immediately be required to contribute cash to the LLC?!) would then result in a complete forfeiture of such membership interest to the other members. The other members could then gift the interest back to the original owner, but this should only be done a significant time after the original creditor threat has passed. Although it is questionable as to whether the liability for the promissory note would transfer to the recipient of a mere assignment of economic rights tied to the LLC interest (per a charging order), a complete transfer of such interest would almost certainly activate such a provision in the agreement. For more ideas on how to lay traps for creditors, see the section in this Guide entitled “Laying a Trap for Creditors to Make Them Cry “Uncle!”
The author has not explored whether this scenario will trigger or avoid other tax liability, only that it will avoid gift tax. If John has already made significant gifts, which exceeded his lifetime gift tax credit, then he could thus avoid an extremely high gift tax rate (48%) for which he would otherwise be liable. This would certainly mean a greater overall net savings, regardless of other tax consequences as a result of the transaction.