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North Bay Business Journal

Monday, December 5, 2011, 6:00 am

New court rulings jeopardize asset protection benefits of single-member LLCs

By Jeffrey H. Lerman

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    If you own a single-member limited liability company (“SMLLC”) and live in a community property state, recent developments now make it prudent for you to seriously consider adding at least one more member to your LLC with an appropriate change in your Operating Agreement, discussed below. 

    Many investors have chosen to hold their assets in an SMLLC because they invest either by themselves or with their spouse (a husband and wife are currently viewed as a “single member” in community property states). 

    A primary benefit investors seek when choosing to own their assets through an SMLLC is asset protection. However, recent cases and legal commentary now strongly suggest the asset protection benefit of an SMLLC may not be so certain. While I hasten to add that I am not aware of any published California court ruling on this issue yet, there have now been enough court decisions published in other states to give fair warning that, if and when the asset protection features of an SMLLC are tested in a California courtroom, we should not be surprised if the court follows that trend and allows a creditor to pierce the corporate veil of the SMLLC.

    I don’t agree with the court’s reasoning and other legal commentators have also been critical of the courts’ reasoning.  I think it’s unfair to the independent investor, the smaller investor, and the “mom and pop” investor.  The practical effect of this trend, in general, is to give greater asset protection to the larger investors who have a deal large enough for two or more partners.  This is just the latest “kick ‘em when they’re down” insult to the smaller investors, many of whom are already suffering through the worst financial crisis of their lives due to this real estate downturn.

    However, this is the new reality with which SMLLC investors must now deal. So, what does this mean to you? What can you do to regain the asset protection benefits you seek?

    You could and should add at least one more member to your LLC.  When you do that, it is important to keep the following in mind:

    1. The larger the interest the second member has, the better.  While no court has yet stated the minimum percentage the second member must have to pass muster as a legitimate multi-member LLC, one court has already warned that adding a second member with a “peppercorn” or very small interest will not be enough. Several commentators have speculated that a 5-10% interest may be sufficient, but until a court rules on this specific issue, therein lies yet another risk.
    2. Be sure the second member pays fair market value for the interest acquired.  If, for example, 5% of your company is worth $10,000 and you give 5% to your child for $1,000, you could be deemed to have a fraudulent transfer.
    3. When you add a second member, your LLC will need a new Operating Agreement that sets forth the terms and conditions governing the member relationship.  There are a host of new issues that arise when you have more than one member, issues that did not exist in your SMLLC, and you must clearly and unambiguously document how those issues will be dealt with.  

    If you follow these three guidelines, you can once again enjoy the peace of mind that the “corporate veil” is intended to provide to business owners.

    •••

    Jeffrey H. Lerman’s Lerman Law Partners LLP is in San Rafael and provides solutions in real estate investment law, estate planning and business litigation. He can be reached at 415-454-0455 and jeff@lermanlaw.com.

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    Comments

    1 Comment

    1. December 5, 2011, 10:56 am

      by IKE DEVJI

      Great points all Jeff. As an asset protection attorney I’ve also seen the members of multi-member LLCs held jointly and severally liable for business litigation issues by overzealous CA courts in violation of all reason and precedent.

      Regardless of the SM/MML question and the absolutely VITAL formalities you mentioned including business purpose we always tell clients with these concerns that they must have layers of well crafted tools or structures that are appropriate for each asset and “fund” each of these tools with the right asset. I.E. Whether it’s single or multi-member, an LLC is still the wrong place for your personal residence, etc.

      Ike Devji, J.D.


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