The traditional Texas LLC has long been a favorite of real estate investors and others, especially after limited partnerships were made subject to the Texas franchise tax in 2007. Investors who formerly created investment structures based on limited partnerships (with a corporation as general partner) then shifted their focus to LLCs, which are cheaper to file and less complicated to manage and maintain. New filings at the Secretary of State reflect that formation of other types of entities is down significantly, while LLCs compose the majority of new filings. It is not an exaggeration to say that for most smaller-scale real estate investors the limited partnership and the corporation appear to be languishing. The LLC has largely taken their place.
A newer type of LLC—the series LLC—has been available in Texas since 2009 (see Chapter 101, Subchapter M of the Business Organizations Code). The series LLC is an excellent way for real estate investors to own multiple assets since it allows for the sorting of individual properties into separate compartments that are isolated and insulated from one another.
Series LLCs (which were born in 1990 with the Delaware Business Trust act) were initially designed to cater to the mutual fund and asset securitization industries. Series entities have since shown their worth in real estate investing and are now available in at least thirteen jurisdictions (Delaware, Texas, Nevada, Alabama, the District of Columbia, Illinois, Iowa, Kansas, Missouri, Montana, Tennessee, Utah, and Puerto Rico). Our preference is for Texas and Nevada, which have similar statutes. The series LLC is an idea whose time has come, particularly for real estate investors who wish to acquire multiple properties while avoiding complex structures with numerous entities.
This article discusses structural and operational details of a series LLC as they relate to an asset management and protection program. Note that it is not necessary to implement the series aspect of a series company unless and until one is ready to do so; until then the company operates exactly the same as a traditional LLC. Accordingly, there is no downside to electing to form a series LLC rather than a traditional LLC, even if there is no immediate intention to implement the series feature of the company.
What is a series company?
A series LLC allows an investor to hold assets and liabilities within separate cells or series which effectively operate as sub-companies. However, the series are not stand-alone legal entities in their own right—at least not technically according to Section 101.603 of the Business Organizations Code (the “BOC”)—but in many respects they act as if they are. An individual series is statutorily empowered to file and defend lawsuits; enter into contracts; buy, sell and hold title to property; grant liens and security interests; and “exercise any power or privilege as necessary or appropriate to the conduct, promotion, or attainment of the business, purposes, or activities of the series.” BOC §101.605(5). A series can obtain its own EIN if it chooses and be treated separately for federal tax purposes. A series may (but is not required) to have its own bank account. A series can (and should) operate under its own assumed name granted by the local county clerk. Additionally, BOC Section 1.201(b)(27) has now been amended to include a series within the definition of a legal “person.” Given all of these characteristics, declaring that a series is not technically a stand-alone legal entity may be a distinction without a difference, at least most of the time.
Note that the Texas Comptroller, for its purposes, states that a “series LLC is treated as a single legal entity. It pays one filing fee and registers as one entity with the Texas Secretary of State. It files one franchise tax report as a single entity, not as a combined group, under its Texas taxpayer identification number.”
The series LLC shares characteristics with the traditional LLC, including the benefit of informal management, an effective liability shield, and pass-through taxation; but a series LLC also has the ability to segregate and compartmentalize assets and liabilities within individual series. This offers significant protection and operational flexibility.
How does a series LLC differ from a traditional LLC? The answer is found in one word: exposure. In the case of a judgment against a traditional company, all assets of the LLC are available for purposes of satisfying that judgment. Not so with a series LLC. If a series is sued, liability is contained within that series and does not spill over to other series or the company at large.
The Texas series LLC (like traditional Texas LLCs, corporations, and limited partnerships) is governed by Chapter 101 of the BOC. Changes made to the BOC in 2009 (including authorization of the series LLC) along with subsequent improvements have made it a model of progressive legislation and improved Texas’ already deserved reputation as an excellent place to do business and engage in asset protection. There is no longer any good reason to go to another state to form an LLC unless one is specifically looking for an extra layer of protection by virtue of physical and jurisdictional distance.
BOC Sections 101.601 and 101.602 read:
Section 101.601. Series of Members, Managers, Membership Interests, or Assets
(a) A company agreement may establish or provide for the establishment of one or more designated series of members, managers, membership interests, or assets that:
(1) has separate rights, powers, or duties with respect to specified property or obligations of the limited liability company or profits and losses associated with specified property or obligations; or
(2) has a separate business purpose or investment objective.
(b) A series established in accordance with Subsection (a) may carry on any business, purpose, or activity, whether or not for profit, that is not prohibited by section 2.003.
Section 101.602. Enforceability of Obligations and Expenses of Series Against Assets
(a) Notwithstanding any other provision of this chapter or any other law, but subject to Subsection (b) and any other provision of this subchapter:
(1) the debts, liabilities, obligations, and expenses incurred, contracted for, or otherwise existing with respect to a particular series shall be enforceable against the assets of that series only, and shall not be enforceable against the assets of the limited liability company generally or any other series; and
(2) none of the debts, liabilities, obligations, and expenses incurred, contracted for, or otherwise existing with respect to the limited liability company generally or any other series shall be enforceable against the assets of a particular series.
(b) Subsection (a) applies only if:
(1) the records maintained for that particular series account for the assets associated with that series separately from the other assets of the company or any other series;
(2) the company agreement contains a statement to the effect of the limitations provided in Subsection (a); and
(3) the company’s certificate of formation contains a notice of the limitations provided in Subsection (a).
It is not just the quantity of LLC documentation that matters but its quality and sophistication. LLC documents should contain asset protection clauses and provisions from the very beginning of the formation process. One should never be satisfied with filing a minimalist form and leaving it at that. These are seldom adequate for any serious asset protection purpose, and they certainly fall short in the context of a series LLC. Formation documents can and should be several pages long, including reference to such matters as series specifications, notice of restrictions on sale or transfer or membership interests, and division of membership interests into Class A and Class B. Since the certificate of formation is a filed document and public record, creditors are put on notice from the outset that this particular company is the real thing.
In the case of a series LLC the Business Organizations Code Section 101.604 requires that the certificate of formation contain a “notice of limitation on series liability.” It is recommended that the COF go into considerable detail on this, clearly stating that each series is independent and not responsible for the debts and liabilities of other series or the company at large.
The company agreement governs internal operations. It should not be confused with the organizational meeting of members. Although the content of these two documents may occasionally overlap, they are conceptually different and are designed to address separate items and issues. Both are required to fully document the LLC.
Series LLC documents should include:
(1) the Certificate of Formation (“COF”);
(2) a comprehensive company agreement (also called an operating agreement);
(3) the minutes of the first meeting of members (organizational meeting);
(4) signed and issued membership certificate(s);
(5) signed consent by the registered agent; and
(6) warranty deeds and bills of sale conveying assets into the LLC or its individual series.
All of these documents should be organized and kept in a company book with labeled tabs.
Benefits of Simplicity and Economy
Lawyers are frequently asked “How many LLCs do I need, and how many properties can I safely hold in one LLC?” The series LLC eliminates these issues, at least up to a point. Our answer to the first question is most often “One LLC or perhaps two if you choose a two-company structure in order to separate assets from activities.” Our response to the second question is “No more than 20 or so properties should be held in a single LLC, even a series LLC.” This is our arbitrary, but informed, opinion. The statute permits an infinite number of series, but prudence suggests that even a series company should have some limit on the number of properties it owns. When an investor has filled Series A through Series Z—that’s 26 properties—it is past time to consider forming another holding entity. Asset protection is a cautious enterprise.
What if an investor has only one property or business to put into the company? Should he or she still consider a series LLC? Perhaps the question should be “Why not?” since there are no significant additional up-front costs and one can delay implementation or activation of series until an appropriate time. Until series are created or made operational, the company behaves exactly the same as a traditional LLC.
It is not necessary that one already have multiple properties or businesses in order to form a series LLC. If real estate investment or multiple businesses are in one’s future, it may be wise to go ahead and establish a series LLC at the outset, so that leases, contracts, accounts, and so forth can all be established in a way that is consistent with a series structure. Otherwise, it will be necessary later to use assignments or bills of sale to move these items into individual series.
Those averse to the idea of multiple series may elect to form a traditional LLC, which continues to be useful for a single investment or business purpose. A traditional LLC is also suitable to act as a management company.
Conversion of Traditional LLCs
It is possible to convert an existing traditional LLC to a series LLC by means of a certificate of amendment. Unfortunately, nearly all of the company documentation of the traditional company (organizational minutes, company agreement, etc.) will need to be replaced so there is little in the way of cost savings, except for a lower filing fee. Note that this approach is not recommended unless the existing traditional company is free of baggage such as debts, tax liabilities, contractual obligations, pending or threatened litigation, and the like. Otherwise, it is advisable to start a new entity that is unencumbered by such burdens.
Insulation of Each Series
A series LLC contains individual series in which properties or businesses can be held separately and apart from the assets held by other series and by the company at large. In other words, each series may contain a separate rental property (a common arrangement); or, alternatively, by way of example, Series A could contain a rental fourplex; Series B could contain a strip center; Series C could contain a business that buys and sells real estate notes; and so on. The important point is that each series is insulated from the other as well as from assets and liabilities held by the company at large.
A point of clarification here: a series LLC can still own property without a series designation, as an asset of the company at large. For example, property transferred into “ABC LLC” would become a general company asset, even if the company is a series LLC, because no specific series is named in the transfer.
Let’s return to the main distinction between a traditional LLC and a series LLC. Suppose there is a foreclosure on a property contained in Series A, and there is a deficiency at the foreclosure sale (i.e., the property sold for less than the amount owed the lender). The lender then sues and obtains a deficiency judgment. Assuming that the series company and its transactions were properly structured, the judgment would be enforceable only against Series A assets, not against the assets of Series B, Series C, or the assets of the company at large. This is not true of a traditional LLC which holds its properties in a collectively vulnerable pool. All by itself, this is a compelling reason to establish a series LLC rather than a traditional LLC.
Good record keeping is both important and required. In fact, series insulation is preserved only so long as “records maintained for that particular series account for the assets associated with that series separated from the other assets of the company or any other series.” Tex. Bus. Orgs. Code Sec.101.601(b)(1). In other words, records must be maintained “in a manner so that the assets of the series can be reasonably identified by specific listing, category, type, quantity, or computational or allocational formula or procedure.” Tex. Bus. Orgs. Code Sec. 101.603(b). Implicit in the statute is the idea that assets and liabilities of a series can and should be separate both from the assets and liabilities of other series and those of the company at large. Commingling among these categories should be avoided.
Series record keeping is not as daunting as it may sound. A simple coding system for company assets and expenditures (all within a single checking account) would satisfy the statutory requirement of reasonableness. It is not necessary to establish a bank account for each series in order to comply with Section 101.603(b)—although a real estate investor may decide to take this step if the properties held by each series are significantly and substantively different, either operationally or in terms of tax treatment. One account for the entire company is more common.
As always, records should be kept in anticipation of litigation, particularly litigation that includes piercing allegations, since such allegations (abusive though they may be in non-fraud situations) are common. Internal documents that reasonably identify the activities of each series are therefore important from the standpoint of preparing for litigation.
BOC Section 101.605(3): “A series . . . has the power and capacity, in the series’ own name, to hold title to assets of the series, including real property, personal property, and intangible property.” The individual series are, in a practical sense, sub-companies and there is technically no limit to the number of series a company can have, although prudence might dictate that there is a reasonable limit to the number of properties one might to hold in a single LLC – even a Texas Series LLC.
Prudent asset protection practice suggests that one should think carefully before “mixing and matching” entirely different assets or businesses within the same company, even a series company. Generally speaking, one should not place an enterprise into a series of an LLC that:
(1) is significantly different in kind or nature than other assets or series of the company, it being the recommendation of nearly all asset protection advisors that “like should be kept with like” within the same entity;
(2) creates a much higher level of liability or potential for lawsuits than assets in other series;
(3) has a significantly different debt structure (involving blanket development loans, personal guarantees, and the like) than assets in other series;
(4) receives significantly different tax treatment from assets in other series or is involved in a payment plan with the IRS;
(5) mixes management functions with holding functions within the same entity (it is a core principle of asset protection that these functions should be entirely separated into different entities); or
(6) falls into the category of a “single purpose entity” (“SPE”). Such an asset or enterprise is usually better placed in a separate stand-alone LLC altogether. Examples of SPEs are restaurants, retail outlets, strip centers, apartment complexes, unique financial or technology investments, etc. These are better placed in a separate, stand-alone LLC dedicated to that purpose. In other words: merely because the BOC permits entirely different enterprises to be contained within the same company does not mean that one actually should do so. Individual circumstances and goals must be closely examined and evaluated.
Here is an example of a situation real estate lawyers encounter often: a client wants to put an investment cash account into the same entity as liability-rich rental properties. While this can technically be done, it is just not prudent. There is not an asset protection advisor on the planet who would suggest that doing so is a good idea.
Banking with a Series LLC
Banks have differing policies and levels of familiarity with respect to series LLCs. These entities were adopted in Texas in 2009 and have been around in other states long before that, so there is really no excuse for a “business banker” at any major bank not to have knowledge of them—and yet lawyers hear about this occasionally. Local and regional banks present more difficulties than major banks.
There is no difference, operationally or legally, between a bank account that is opened for a traditional LLC and a bank account that is opened in the name of a series LLC for the company at large. They look the same. Individual series may also have their own accounts. The legal basis for this is found in Business Organizations Code Sec. 101.601(20)(b): “A series established in accordance with Subsection (a) may carry on any business, purpose, or activity, whether or not for profit, that is not prohibited by Sec. 2.003.”
Anyone establishing a bank account must of course provide a taxpayer identification number. So how many TINs does one need for a series LLC? Usually just one, for the company at large, and this is how most real estate investors operate. However, if the individual series are operating as independent businesses, and need a dedicated account, then a series may also obtain its own TIN. If the company uses an alphabetical designation for its series (i.e., Series A through Z), then there is at least the potential for 27 different TINs—one for each of the series and another for the company at large.
The quickest way to secure an EIN is from the IRS website (www.irs.gov). Alternatively, one may complete the IRS hard-copy SS-4 form and mail or fax it to Internal Revenue Service, Attn: EIN Operations, Cincinnati, OH 45999 (fax number 859-669-5760). An EIN may be also be obtained by calling (800) 829-4933 between 7:00 a.m. and 10:00 p.m. Monday through Friday. Note that the EIN application requests that the applicant list a “responsible party” along with that party’s social security number. The reason that many lawyers decline to obtain an EIN for a client is that they (understandably) do not want to list themselves as the responsible party.
Whether a bank will open an account for an individual series of an investor’s company is not a matter of legality. It is definitely allowed by law. Banks, however—for their own individual (and occasionally inscrutable) underwriting reasons—choose what kind of accounts to open, what loans to make, and so forth. These are private business decisions on the part of the bank. No bank is obligated to open any sort of account if it does not want to. Your remedy is to choose another bank.
Federal Tax Returns
An LLC is required to file its own annual federal income tax return unless the company (and its series, if the LLC is a series company) is treated for federal income tax purposes as a “disregarded entity.” A “disregarded entity” is disregarded as an entity that is separate from its owner for federal income tax purposes. Under the IRS default rules for entity classification, IRS Reg. Sec. 301.7701-3(b), a single-member LLC is automatically disregarded and a multi-member LLC is automatically taxed as a partnership. In a case where a natural person (Form 1040 filer) is the only LLC member, the activities of the disregarded entity are reported on the taxpayer’s Form 1040—Schedule C. In a community property state like Texas, a husband and wife who wholly own an LLC as community property have the option of either receiving disregarded or partnership treatment. IRS Rev. Proc. 2002-69.
Alternatively, your CPA may assist you in filing the entity classification election to receive tax treatment other than that provided by the default rules (accomplished by means of Form 8832). The other option for a single-member LLC is being classified as an association taxable as a “C” corporation (in which case the entity would file Form 1120—a “U.S. Corporation Income Tax Return”); or an “S” corporation (in which case the entity would file Form 1120S—a “U.S. Corporation Income Tax Return for an S Corporation”). A multimember LLC may also elect to be classified as an association taxable as a “C” or an “S” Corporation. Unless there is a compelling business reason to elect “C” corporation status that is well researched, this status should not be elected for most real estate investors. In general, according to IRS regulations, once an entity has made its tax election, an election may not be changed for 60 months.
So should your entity make an S Corporation election rather than stick with the default position of a disregarded entity? It depends. One CPA we work with says “If the IRS considers the client as dealer (doing this business for their livelihood), then their business income is subject to self-employment tax. The S Corporation election can be used to minimize that. If classified as a dealer, none of the gains are considered capital gains. It’s all considered ordinary income, subject to the tax rate the individual is in, plus self-employment tax. I usually recommend this for people flipping property on a regular basis.” Every real estate investor should consult his or her CPA for advice relating to one’s specific circumstances.
Series IRS Returns
Should a series file its own tax return? Not usually, but it may. If a series has its own EIN, activities that are different from other series, and/or a different membership structure, a separate annual federal income tax return may be best. Let your CPA know that the U.S. Treasury Department has proposed regulations, 26 C.F.R. pt. 301 (Sept. 14, 2010), which state that the IRS will treat individual series as separate entities—each of which may elect “pass through” tax treatment if the established criteria are met. The Journal of Accountancy states that “the tax treatment of the series will then be governed by the check-the-box regulations (Treas. Reg. Sec. 301.7701-1 through 301.7701-3). . . . The IRS decided that the factors supporting separate entity status for series outweigh the factors in favor of disregarding series as entities. . . . They specifically looked at the fact that the rights, duties, and powers of members associated with a series are direct and specifically identified. They also noted that individual series may have separate business purposes and investment objectives. The IRS concluded that these factors are sufficient to treat domestic series as entities formed under local law.” Among other things, this means that individual series will have their own K-1 (www.journalofaccountancy.com/Web/20103328.html).
The IRS offers a helpful online tax workshop for new businesses designed to help small business owners learn their tax rights and responsibilities.
Texas Franchise Tax
As for Texas taxes, the Comptroller of Public Accounts sends a notice to new filers of the date on which the first state franchise tax report is due (May 15th). It will also show the LLC’s state taxpayer number (which is different from the file number at the Secretary of State’s office). The letter will also ask that you complete an online Tax Accountability Questionnaire within 30 days.
A Texas margin tax return must be filed with the Comptroller even if the company has no income. It is due by May 15th of the year following formation. Many new companies are eligible to file the No Tax Due Information Report (Form 05-163) if the LLC is a passive entity as defined in Tax Code section 171.0003; if it has annualized income less than the statutory threshold ($600,000); if the company has zero Texas gross receipts; or if the company is a real estate investment trust (“REIT”) as defined by Tax Code section 171.0001(c)(4). If your company does not fall into one of these categories, one will likely be filing the EZ Computation Report (Form 05-169).
The Franchise Tax Reduction Act of 2015 (Tax Code sec. 171.002 and sec. 171.1016) reduced the franchise tax rate for most businesses to .75% of the taxable margin. The rate for entities engaged in retail or wholesale businesses was reduced to .375%. All subject to change, of course.
For owners of more than one Texas registered entity, it will likely be necessary to include an Affiliate Schedule (Form 05-166). This is an unsettled area. The Comptroller is inclined to take the self-serving view that all real estate ventures with common ownership are “affiliated” for purposes of assessing the margin tax. Investors with multiple, varied interests know this is nonsense.
This foregoing tax information has been intentionally brief. Even though basic tax information has been presented for general purposes, our firm does not give tax advice so the information provided here is not a substitute for ongoing advice and guidance from a good CPA who is a regular member of the investor’s team. All new LLC owners should consult a CPA concerning the best way to handle their new company for federal and state tax purposes. Certain tax benefits may be available but are not automatic.
The Comptroller’s Public Information Report (PIR)
The annual filing of a Public Information Report (the “PIR,” form 05-102) is required by the Comptroller. It is due by May 15th of the year following formation. It is a simple form. The PIR requires disclosure of the names of each current “officer, director, or member” of the LLC. This is different from the Certificate of Formation which called for the names of the initial managers, not members. Since LLCs do not have directors, that is not an issue; however, one needs to supply the name of any person or entity who is a member, a managing member, or a nonmember manager. This of course has implications for any anonymity strategy an investor may have.
Visit the Comptroller’s website at comptroller.texas.gov. to view resources available. Their phone number is (800) 252-1381.
Failure to Pay the Texas Taxes
Failure to pay Texas taxes will result in an LLC’s right to transact business, as well as the right to sue and defend itself in Texas courts, being forfeited. If the company’s right to transact business is lost, then the company’s officers, directors, partners, members or owners may become liable for debts of the entity, including taxes, penalties and interest, which are incurred after the due date of the report and/or payment—a highly undesirable result. See Tex. Tax Code §§ 171.251, 171.2515, 171.252, 171.256. For future reference, to determine if the company is in good standing with the Texas Comptroller, call (800) 252-1281 or go to https://comptroller.texas.gov/.
There is no annual filing required of LLC’s at the Secretary of State’s office.
Title Insurance and Assumed Names
Some title companies and lenders are new to transactions involving specific series, so this is an evolving area at the level of practice. For instance, title companies typically require a certificate of good standing for an LLC, whether traditional or series. Title companies can be obsessive about this. We have even encountered title companies that demand a certificate of good standing for specific series. This reflects a misunderstanding of the law and the series concept. Since series are created privately, without necessity for public notice or state filing, no official method exists for establishing that a series (as opposed to the company at large) is in good standing. Some lawyers argue that the statute should be amended to provide for registration of series and therefore the ability of the state to determine if a particular series is in good standing or not. We oppose this idea on anonymity and asset protection grounds. As much company activity as possible, including the creation of series, should be kept out of the public records. Amending the statute to require series registration and good standing would only serve to make Texas a less attractive asset protection destination.
One should also expect that a title company will require that an assumed name certificate be filed indicating that the company is doing business by and through one of its series—e.g., “ABC LLC DBA Series A.”
Anticipate that a title company will also require a company resolution evidencing both the creation of a series and its authority to enter into the subject transaction—not a problem since these are simple documents to prepare. It may also be necessary to educate the title company (and possibly its attorney) as to the fact that series are empowered by statute to hold title to real property and grant liens (see Tex. Bus. Orgs. Code Sec. 101.605(3), (4)), although this has become less common as use of series entities has spread and title companies have become more comfortable insuring title held by individual series.
Title companies often demand a copy of the company agreement, a demand we resist whenever feasible. Company agreements are private, proprietary documents that are not usually the business of anyone but members of the company.
Tax Versus Legal Considerations in Asset Protection
One should distinguish between asset protection (generally) and asset protection structures (specifically) that are approached from a legal versus a tax point of view.
An asset protection lawyer is primarily focused on likely courtroom outcomes—specifically avoiding adverse ones involving large monetary judgments, since a large judgment can be an extinction event for a small business—unlike a slightly higher tax bill. Focusing on avoiding liability and lawsuits, and the protection of non-exempt assets in the event of a judgment . . . that is what an asset protection lawyer does.
Approaching entity formation and deal structuring from a purely tax-driven perspective is a different avenue entirely, often employed by CPAs who may have no experience in a courtroom and lack knowledge concerning the vulnerability of assets. A narrow tax-driven approach may not always be entirely consistent with a conservative legal approach.
In some cases, the legal and tax perspectives coincide. In others, an investor may have to decide where the emphasis is going to be: saving on taxes or maximizing protections on the legal side. It may not always be feasible to maximize both sets of considerations. One can build a cruise liner or a battleship, but probably not both in the same vessel. My money is on the battleship, which is far more useful in the event pirates show up.
Separating Assets from Activities: The Two-Company Structure
Our recommended asset protection structure for long-term real estate investors involves two LLCs, a shell management company (which can be a traditional LLC) and a holding company (a series LLC). The fact that the holding company (formed in either Texas or Nevada) does not enter into contracts or business dealings makes its assets beyond reach in most cases. Few investors or business persons need anything more complex than a two-company structure, although there may be good reasons to vary or customize this model as circumstances require.
Information in this article is provided for general informational and educational purposes only and is not offered as legal advice upon which anyone may rely. The law changes. No attorney-client relationship is created by the offering of this article. This firm does not represent you unless and until it is expressly retained in writing to do so. Legal counsel relating to your individual needs and circumstances is advisable before taking any action that has legal consequences. Consult your tax advisor as well.
Copyright © 2020 by David J. Willis. All rights reserved. Mr. Willis is board certified in both residential and commercial real estate law by the Texas Board of Legal Specialization. More information is available at his website, www.LoneStarLandLaw.com.