New Rules for Delaware LLCs with Real Estate Holdings by Joseph L. Saka, CPA/PFS
Posted on October 24, 2019
Savvy real estate developers and investors have long relied on the Delaware Limited Liability Company Act (DLLCA) to provide them with a flexible and tax-friendly solution for purchasing and holding real property. In planning for the future, current and prospective Delaware LLCs and their members should recognize that the state recently made amendments to the law, which can significantly impact their lending agreements and protections of privacy and legal liabilities.
Why Incorporate in Delaware?
Approximately half of all public companies and more than 60 percent of Fortune 500 businesses are incorporated as Delaware LLCs despite having no physical address or assets located in the state.
Under Delaware’s favorable tax and business laws, LLCs are treated as partnerships for tax purposes. All of their owners/members enjoy the benefit of pass-through income, which is subject to federal income tax only once at the individual partner level. Not only does this spare LLC members from the expense of paying a second level of tax at the entity level, but it also creates a legal separation between the members’ personal assets, debts and liabilities and those of the LLC. Therefore, owners/members are protected from the legal liabilities, losses and claims filed against the LLC entity and are not at risk of losing any of their personal assets. As an added level of protection and privacy for their members, Delaware LLCs are not required to publicly list the names and addresses of their owners.
What’s New for Delaware LLCs in 2019?
Two critical changes to the Delaware LLC Act that affect real estate entities and their lenders, include 1) allowing existing Delaware LLCs formed before Aug. 1, 2018, to, for the first time, divide themselves into two or more separate LLCs and allocate their partnership interests, assets and liabilities interests among the resulting companies without incurring tax consequences; and 2) permitting Delaware LLCs to form protected and registered series LLC companies after Aug. 1, 2019.
Division of Existing Delaware LLCs
There are many reasons why a Delaware LLC may choose to divide itself into two or more separate LLCs. It may plan to reorganize or facilitate a spin-off or a sale without dissolving the original LLC or requiring a legal transfer or distribution of assets, rights, properties and related liabilities. An existing LLC making a division may survive and become a “resulting company”, or it may simply cease to exist after a division. In either case, the LLC should be aware that divisions of existing entities may result in the imposition of state and local transfer taxes, depending on where their real estate is located.
To effectuate a division, a majority of a Delaware LLC’s members must first approve and adopt a “plan of division” that details how it will allocate its assets and liabilities among the resulting division companies. These plans, which are not required to be filed with the state, are meant to help creditors and lenders of the dividing LLC identify and pursue the correct resulting company to which their original claims have been assigned.
For example, the language in the DLLCA specifies that mortgages and other liens on real estate will remain “preserved” and in effect regardless of a future division. Creditors also receive the reassurance that a division will not affect the current or future personal liabilities of any members of the original dividing company, and any debts and liabilities of the dividing company that are not allocated under the plan will become the “joint liabilities of all the division companies, including the surviving company.” If a court of law determines that a division and allocation is fraudulent, each resulting division company, including the surviving company, “shall be jointly and severely liable on account of such fraudulent transfer notwithstanding the allocations made in the plan of division.”
Under certain circumstances, lenders may request changes to the language of existing loan documents, credit agreements and even existing LLC operating agreements in order to restrict divisions and protect them from risks of borrower default. In all instances, the dividing LLC will need to file with the state of Delaware both a certificate of division and certificates of formation for each of the resulting companies.
Registered Series of Delaware LLCs
For more than two decades, Delaware LLCs have been permitted to establish one or more series of members, managers, interests and assets in order to shield the assets of a given series from creditors’ claims against the debts, obligations and other liabilities of those LLCs or any of their other LLC series. However, lenders have not been eager to make loans to a series, which historically has not been recognized as a “registered organization” by the Uniform Commercial Code (UCC). This, combined with differing state laws, made it difficult for creditors and lenders to perfect their security interests in a particular series. If a borrower defaulted, the creditors lacked the leverage needed to seize collateral.
With Delaware’s recent amendments to its LLC law, applicable entities formed in the state may continue to establish “protected series” with internal shields limiting the liabilities of the LLCs or other series LLCs, or they may create “registered series” of members, managers, limited liability company interests or assets of an LLC, which is legally recognized by the Uniform Commercial Code (UCC). This change clarifies that a creditor’s security interest in the relevant collateral of a registered series can be perfected with Delaware serving as the jurisdiction of organization and perfection filing.
Registered series LLCs may convert to protected series LLCs and vice versa. One note of distinction, however, is that a registered series can merge into one or more registered series of the same LLC, thereby combining the assets and liabilities of two registered series. A protected series may not take this action.
Delaware LLCs continue to be a viable structure for taxpayers to own and hold real estate. With the enactment of recent amendments to the state’s LLC Act, it behooves LLC to engage in strategic planning under the direction of experienced accounting professionals.
About the author: Joseph L. Saka, CPA/PFS, is CEO of Berkowitz Pollack Brant, where he provides a full range of income and estate planning, tax and business consulting and compliance services, and financial planning expertise to entrepreneurs, high-net-worth families and family companies and business executives in the U.S. and abroad. He can be reached at the CPA firm’s Miami office at (305) 379-7000 or firstname.lastname@example.org.
Information contained in this article is subject to change based on further interpretation of tax laws and subsequent guidance issued by the Internal Revenue Service.