Over the past 20 years, tens of thousands of attorneys have established limited liability companies (LLCs) or family limited partnerships (FLPs) as part of an outside business to own real estate, or for estate planning; but most often for wealth protection purposes.
The bad news is simple: most LLCs and FLPs are not as protective as their creators believe them to be because their controlling agreement is missing key provisions, or they have not kept up the entity properly on an annual basis. Unfortunately, many do not understand a key fact of the law that if the LLC or FLP is not set up or maintained properly, it will not enjoy the protective benefits that it was intended to provide.
There are three common problems we have seen in our clients’ LLCs and FLPs. In some cases, we have seen one or more of these problems surface. Even one weakness, though, could be enough to threaten all of the benefits the entity is designed to provide.
We mention annual formality compliance first because it is probably where most clients fail with regard to their entities. Simply put – if you are not having at least an annual review of the following areas (and this is a partial list), then the entity may not get the respect from the law if it is ever challenged. Such annual compliance should include at least (partial list):
[sws_pullquote_right] Also see: A Common Tax Mistake Could Be Costing You Thousands Annually [/sws_pullquote_right]
An LLC or FLP is only as protective or tax-beneficial as its language dictates – and we have found that most LLCs or FLPs are lacking here as well. Let’s use an analogy of a will. First you want the will to be valid from a legal perspective – proper signatures, witnesses etc. This is precisely the weakness of many LLCs and FLPs regarding their ongoing legal requirements. Even if that is properly managed, then, like a will, the LLC or FLP is only as effective as the language in its operational document. A will might dictate that all assets go to one family member, to all family members or all to charity etc. Similarly, an LLC or FLP can be written to maximize discounting for gift tax purposes or not. It may be written for solid protection against outside lawsuits…or not. Specifically on the lawsuit protection perspective, there are a number of key provisions that an LLC or FLP should have. We will describe just two of them here.
Language on Distributions
If an attorney wants their LLC or FLP to effectively provide a solid shield for LLC/FLP assets against outside lawsuits, then proper language regarding distributions is critical. It is especially important that the language not lock in the LLC manager or managing member or FLP general partner to make distributions evenly. This can be problematic if there is ever a lawsuit or judgment creditor against the LLC or FLP owner(s). Nonetheless, in the typical LLC and FLP “form” agreements, this problematic language is the standard boilerplate. This can be a significant weakness and may undermine the entire purpose of the entity for the client and his/her family.
Language on Involuntary Transfers
In our estimation, 80 percent of LLC and FLP agreements do not have adequate provisions regarding involuntary transfers. In other words, what exactly are the rights of a judgment creditor (i.e., successful lawsuit plaintiff) against an LLC or FLP owner’s interests? Most often, the only LLC or FLP language related to this issue is regarding the ability of the owner to transfer their interests voluntarily – and may be quite permissive. If this is the only language related to the issue, a judge may very well interpret that permissiveness to the situation to allow a successful plaintiff to become an owner, have voting rights, and even to take control of the LLC or FLP. Even worse, if the LLC or FLP is completely silent on the issue, then the judge has even more leeway.
Ideally, an LLC or FLP defines exactly what occurs in the event of a judgment creditor getting a court order against an owner’s interest, or similar involuntary-type of transfer. The language should define not only what circumstances give rise to the clause but also restrict the rights of such an involuntary transferee to the greatest extent of the relevant statute. This is crucial to take advantage of the strongest “outside risk” protections that an LLC or FLP can afford. Without this language, the entity is certainly not ideally protected.
In the case where the LLC or FLP will own personal property that can be held in any state (i.e., securities portfolio), as opposed to an asset that is fixed in one location (i.e., real estate), one has a choice to create the entity in any of the 50 states. There are three to four top states from a protection perspective, and state fees and taxes are also a factor. For some clients, estate tax planning may dictate other states as preferable. Regardless, the important point is that an LLC or FLP does not need to be created in the client’s home state and should be positioned properly depending on the entity’s purpose.
LLCs and FLPs can be fundamental tools for business planning, asset protection planning, family wealth planning, estate planning and more. Nonetheless, these tools are only as strong or weak as their operating documents and ongoing compliance management.
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David B. Mandell, JD, MBA, is a consultant, attorney and author of over 10 books on legal, tax and financial issues, including Wealth Secrets of the Affluent, published by John Wiley & Sons, Inc., the largest business book publisher in the world. He is a principal of the financial consulting firm OJM Group www.ojmgroup.com along with Jason M. O'Dell, MS, CWM, who is also a principal and author. They can be reached at 877-656-4362 or email@example.com.