Cell Companies

Segregating “dangerous” assets and businesses into separate entities away from other assets, especially “safe” assets, is always a good idea from an asset protection point of view. For example, an individual who owns a gas station and a rental home should not own both within the same entity. Further, an individual with a large amount of liquid assets (cash, securities, etc.) to protect should not hold those assets in the same entity as a business.

Best practices would dictate that every distinct business or major business asset be segregated into a different limited liability entity. In an ideal situation, someone with 18 rental properties would have 18 separate LLCs, one for each property. However, this is not always practical because of administrative costs and government fees that must be paid for each LLC. What can such a business owner do to protect his assets from liabilities unrelated to those assets in a cost-effective way?

 

Cell Companies

Cell companies constitute one of the fastest growing segments of the captive industry. Known by various names depending on the domicile, Protected Cell Companies, Segregated Cell Companies, Segregated Portfolio Companies, Segregated Cell Partnerships, Separate Account Companies, Sponsored Captives, Leased Capital Captives, etc., these entities have a common, but unique set of attributes and operational characteristics, including the necessary protection for each participant’s assets.

Despite being a relative newcomer, the flexibility of cell  companies have caused their diversify uses. Cell companies are used to securitize insurance risk against catastrophic losses, for example; their very structure also makes them an ideal entity for the cost-effective operation of umbrella mutual funds.

Incorporated Cell Companies

The Incorporated Cell Company (ICC) permits cells to be incorporated into separate entities.

An effective asset protector and privacy enhancer

Cell companies have — in concert with other entities — been used to construct what has been called “an impenetrable wall” against creditors and prying eyes. Whilst these claims can only be tested by time, this novel use of a cell companies for asset protection and financial privacy is an interesting approach and a valuable piece of intellectual property.

Cell companies began, as is typical of business innovation, with contracts that “ring-fenced” sets of assets from creditors’ claims against related assets. However, only a statute could provide the necessary certainty and predictability. It is therefore not surprising that the next step was the enactment of “protected cell company” statutes, first in the early 1980s in Bermuda, and then in 1997 in Guernsey. The statutes helped provide a foundation for the all-important bankruptcy protection of the individual cells. The enactment of these statutes was encouraged by the flexibility inherent in unincorporated business forms.

Cell companies and Captives

Since 1997, the segregated-cell legislation varies from domicile to domicile, but often the relationship between the policyholders in the cell and the captive owner is established through a shareholder agreement. The captive owner issues preferred shares to those renting the cells, which allows the renter to share in the performance of the cell through dividends if the cell turns a profit.

In some countries,  in addition to a segregated cell, there’s another similar option, called separate account. A separate account typically is used for annuity and life insurance scenarios. There’s no issuing of shares, and benefits are delivered by way of the policy wording, as opposed to being returned through shareholder dividends. It’s very suited for more simple situations where you have a group of affinity owners who aren’t interested in being shareholders.

Vermont, the largest U.S. captive domicile, has one of the stricter segregated-cell laws. In this state, a segregated cell, or “sponsored captive” as it is known in Vermont, must be owned by a traditionally licensed insurance company, a traditionally licensed reinsurance company or a Vermont captive insurance company. Vermont requires a minimum capital and surplus of $1 million. That’s more capital than Vermont requires for its other captives. For instance the statutory minimum of a pure captive in Vermont is $250,000, and for an association captive, it’s $750,000.

International jurisdictions may require less capital. For instance, Bermuda’s capitalization requirements range from $120,000 to $100 million, the Cayman Islands’ capitalization requirements range from $120,000 to $360,000 and Guernsey requires a minimum of 100,000 pounds sterling.

Series LLC

If you consider using holding and operating companies in a multiple-entity business structure, some US limited liability company (LLC) statutes  allows for the establishment of different classes of interests, including voting and nonvoting interests. These statutes generally allow a single LLC to house multiple separate entities. Thus, the holding entity and each operating entity can be formed within a single LLC. Each unit can have separate owners and its own classes of ownership interests. Each unit can own its own assets and incur its own liabilities. Each unit should have its own accounting system, which could simply consist of separate files within a single accounting system. Importantly, the recordkeeping must be done as if each entity were organized as a separate LLCIn order to maintain the legal distinction among the series, a Series LLC must maintain records documenting the assets and liabilities of each series; from a practical perspective, records should be kept as though each series were a separate entity,  meaning the debts, liabilities, obligations and expenses of one series cannot be enforced against another series of the LLC or against the LLC as a whole. Each series can hold its own assets, have its own members, conduct its own operations and pursue different business objectives, but remain insulated from claims of members, creditors or litigants pursuing the assets of or asserting claims against another series.

The designation of the units, or “series” of separate entities within the single LLC as they are referred to in the statutes, must be done in the articles of organization. This designation serves as constructive notice that each unit is a separate legal entity and that, accordingly, the other units are not liable for its debts. When the single LLC registers to do business in the owner’s home state, or wherever it will conduct operations, this registration will also serve as constructive notice in those states, as the registration is a link to the original articles that were filed in one of the Series LLC Statue states noted above.

As a cautionary note, although Series LLCs are often used in real estate businesses and can be applied in other industries, do not attempt to create this kind of multiple entity before getting expert legal counsel. There is no case law to guide in their care and feeding.

It is essential that the registration be done properly to separate liability among the entities. Consistent with the generally flexible in most Series LLC statutes, each unit does not have to be immediately funded. They can be held in abeyance for future use.

Series LLC Savings

The Delaware Series LLC business form reduces the fees incurred in creating and maintaining separate business entities for different ventures or investments. Only one filing fee is required to form a Series LLC regardless of the number of series it contains, rather than the multiple fees that would be required to create separate entities. In addition, a Series LLC is treated as one entity for franchise tax and registered agent fee purposes, meaning that it is assessed one  annual tax and one registered agent fee, rather than the separate tax and fee that would otherwise be applied individually to separate LLCs.

The Delaware LLC Operating Agreement of a Series LLC  may provide for any number of series. The Certificate of Formation for a Series LLC must specifically note, however, that the LLC is divided into distinct series and that the assets and obligations of a series are attributable only to that series. Additional series can be added or series can be terminated at any time by an amendment of the LLC Operating Agreement.

The central advantage of the Series LLC is a reduction in the organizational costs of a establishing numerous entities.  In addition to purely a monetary consideration, this raises a paperwork and hassle consideration which is why some people will choose the Series LLC structure. But a Series LLC is unlikely to recieve reduced audit and administration costs.

Asset Protection

In order to obtain inter-series liability protection, each series must be treated separately and the public must be put on notice of the liability limitation by the inclusion of the series limitations in the LLC’s Certificate of Formation filed with the Delaware Secretary of State. Records must be kept for each series and the assets of each series must be held and accounted for separately. The separate holding and accounting required may be in the LLC’s records, so long as separate and distinct records are maintained for each series. However, the safest practice would be to segregate and separately hold series assets titled, to the extent possible, in the name of each series (e.g., “ABC LLC, Series X”).

Some uncertainity

Although increasingly popular, there is a certain degree of uncertainty surrounding the Series LLC form. For example, the legal separation of the assets and liabilities of each series in a Series LLC has not been tested in court.

A series LLC statute effectively instructs courts to keep the liabilities separate as long as the members have followed the formalities and record-keeping rules. The problem with the series provisions is that while trying to settle the veil-piercing issue, they raise a host of other issues. For example, the owner of a boat allegedly owned by a Delaware series LLC was barred from suing for breach of warranty because the court could not figure out whether the series was enough of an entity to be able to sue—or whether it even had rights under the sales contract. Also, does the withdrawal from a particular series of its sole member threaten the survival of the larger entity even if the other specific series still have members? What liability protection does a series LLC offer in countries or states that do not recognize series LLCs, or in other bankruptcy court? Perhaps most importantly, what is the effect of not following precisely the requisite series formalities? Will the court automatically pierce the veil to reach sister entities, thereby converting the series “shield” back into a sort of sword?

Although some US states law clearly provides for legal separation of series, it is unclear whether courts in other states and/or jurisdictions would recognize a legal separation of assets and liabilities within what is technically a single entity. Therefore, a court in another jurisdiction could determine not to recognize the legal separation afforded under some US state law.

California law does not allow for a Series LLC to be formed in California. However, a Series LLC that is formed under the laws of another state may register with the California Secretary of State and transact business in California.

An entity formed in one state cannot do business in another state unless it is first “qualified” to do business in the non-formation state by filing an application with the Secretary of State of the non-formation state. Usually, this application must include a fee that is about the same as if you had just formed the entity in the non-formation state in the first place. However, without qualifying to do business in the non-formation state, the entity will not be able to hold real estate or qualify for licenses, etc., and may later get hit for penalties for not qualifying.

However, once an entity qualifies to do business in the non-formation state, it basically becomes subject to the non-formation state’s laws. So, if an LLC is formed in Delaware, and qualifies to do business in California so that it can own real estate in California, then that LLC becomes subject to California law as least as the California courts will be concerned. Thus, the California courts will presume that they will apply California law to all disputes regarding the entity — with one exception.

The exception is that as to the internal governance of the LLC, the courts of the non-formation state (California in our example) will normally apply the law that is either designated in the LLC’s operating agreement, or the laws of the formation state (Delaware) if it makes sense to do so (such as if the LLC is doing business in Delaware or several other states in addition to California).

Internal governance usually means disputes between members as to how the LLC is owned or operated, and does not include disputes with creditors or third-parties who are not signed on to the operating agreement. That brings us to the trouble with Series LLCs.

While the non-Series state (California) might apply the Series legislation of Delaware to internal disputes among the members, the non-Series state is very unlikely to apply the Series-legislation as to creditors, claimants, and other third-parties who did not agree to be bound by the Series legislation. And, after all, why should they be bound to the limitations of a Series LLC when they didn’t agree to be bound, and their elected legislature has not adopted such legislation? In other words:

  • The Series provisions are likely to work between members of the LLC, even if they are all in California.
  • The Series provisions are highly unlikely to work in the non-Series state against creditors and claimants who did not sign a consent to be bound by the Series provisions, and probably none will have by the time they sue.
  • The Series provisions have a slim chance of working for tenants who sign a lease provision which says that in the event of a dispute they must respect the Series limitations.

The qualification-to-do-business problem is why corporations, LLCs, and other entities formed in other states probably don’t offer any advantages over those formed in the state where property will be held or business conducted, since effectively all you are doing is doubling your formation fees and non-formation law will apply anyhow. If you are going to hold property or do business in California, you are better off using a California entity to do it, since you’ll have to pay the same fees and California law will apply to it anyhow.

On the bright side, more states are considering Series legislation (Illinois just adopted it), and California will probably have it within a couple of years. But, there are almost no planners who understand these entities very well — maybe less than a dozen nationwide — and even if the legislation is passed you might have a hard time finding a planner who is sophisticated enough to know how they work and how to navigate around the extremely complex tax issues involved with these entities.

Note that if even if the Series provisions don’t stand up, the entity should be treated as an ordinary LLC.

Tax tratment

The US Internal Revenue Service has not stated whether a unit within a master LLC is generally a separate entity from the master LLC and other units for tax purposes. However, it has treated units of a master (Series) LLC as separate tax entities in one private letter ruling. The California Franchise Tax Board has taken the position that if each unit has the features listed above under the laws of the state where the Series LLC was formed, then each unit will be treated as a separate entity for filing and tax purposes. In that case, the same filing guidelines and estimated taxes that apply to a regular LLC will apply to each unit of a Series LLC. However, many states have not provided concrete guidance on the effect of the series distinction for state tax purposes.

State laws differ. For example, Delaware considers a Series LLC a single entity for tax purposes. However, the California Franchise Tax Board has determined that each cell of a Delaware Series LLC must be treated separately. A Delaware Series LLC doing business in California reports and pays taxes for each series.
Consult a professional tax advisor with knowledge and experience of Series LLC tax treatment see if a Series LLC is right for your business.

When the members of each series of an LLC will be identical,  the series LLC as a whole will be probably treated as a single tax entity for federal tax purposes.

 

Series LLC Operating Agreement

The standard LLC Operating Agreement will not meet the requirements for your Series LLC. A Series LLC Operating Agreement must specifically provide for the establishment of various series with differing assets, and separate liabilities. The Series LLC Operating Agreement should make clear that each series will own separate assets, have separate rights and powers as set forth in the Operating Agreement, as well as have separate investment or business purposes. In addition, the Series LLC Operating Agreement should establish a designated series of members, managers or LLC interests having separate rights, powers, or duties with respect to specified property or obligations of the LLC or profits and losses associated with specified property or obligations.

It is extremely important to have a properly prepared Operating Agreement to fit the needs of your Series LLC and meet the requirements of the relevant state Series LLC statute.

Larger Series LLCs

Strategies that rely on the use of an operating entity and a holding entity also are used by large businesses. For example, one of the fast growing areas in corporate finance is called “securitization.”

A corporation, the operating company, sells its receivables to a second corporation, which is created as the holding company. The only real asset of the holding company is the receivables it purchases. The holding company sells stock to the public, in effect allowing the public to buy an interest in the receivables, through the purchase of the stock. This is termed securitization. This trend started with the sale of mortgages by banks, an ironic choice of words in today’s economic environment! Large corporations now sell accounts receivable in this way.

The holding company (the master LLC so to speak) is insulated from liability for all of the activities of the operating company that created the accounts receivable. Commentators have said that, if it were not for the creation of a holding entity, securitization could not work, because the risk of liability exposure from the operating entity’s activities would be too high to enable this kind of stock offering to the public. (Commentators or false prophets…that’s for history to determine.)

At this same time, the operating entity has protected its assets against the claims of its creditors. Cash that is brought in from the sales of the receivables is quickly drawn off to pay the operating entity’s expenses, including the salaries of its owners. The small business owner might use a version of this strategy in withdrawing assets from the operating entity, but only after careful thought and planning.

Uses of the Series LLC

The most obvious use for the series LLC is to hold multiple parcels of real property in liability-segregated cells. Owners of small commercial or residential properties may find the series LLC particularly appealing. This is especially true in states with high minimum franchise taxes. Forming and maintaining a number of separate LLCs may cost several thousand dollars in the year of formation and several thousand dollars each subsequent year. Using a series LLC with each property held by a separate series may save several thousand dollars in startup costs and another several thousand dollars a year in ongoing administrative and state tax costs.

Another use for the series LLC is to facilitate the combination of business operations of distinct businesses. For example, rather than undertaking a traditional merger, two companies wishing to join forces might form a series LLC, with each company contributing its assets to a separate series, or with the owners of each company contributing their ownership interests to a separate series. The LLC agreement and series agreements could be drafted to determine exactly which rights and responsibilities are shared and which are maintained separately. The series LLC provides a unique and very flexible framework for this sort of business combination.

Another use for the series LLC is to facilitate an equity compensation program in a business with multiple divisions. With each division segregated into a separate series, the LLC can give the key employees of each series some sort of equity interest tied to that series only rather than equity interests in the entity as a whole. This rewards employees at productive divisions and protects them from the potential downside of other divisions.

Finally, yet another use for the series LLC is to facilitate joint ownership of aircraft and watercraft. The flexibility in fashioning series interests can be helpful in customizing a joint ownership arrangement. While ownership of a boat by a series LLC should be relatively straightforward, FAA rules about fractional ownership of aircraft and entity ownership and operation of aircraft are quite complex. Expert aviation law advice and expert series LLC advice are crucial for anyone considering using a series LLC to own an aircraft.

 

Hedge Fund Series LLC

Most hedge funds are structured as either limited partnerships or as limited liability companies (LLCs). Some hedge funds, however, are structured as series limited liability companies.

Hedge fund managers can have the asset protection features of many disparate entities, but under one umbrella. For instance a manager may have a very risky program and a very conservative program. Normally a manager would not want to combine these programs because the risky program could potentially wipe out the assets of the conservative program. The manager could use the series LLC to offer each program as part of an overall management package and the potential investors could choose the amount of their investment which would be allocated to each program.

Another example of how the Series LLC is used in the hedge fund industry is with the very large asset management companies and other players like the investment banks. In essence these groups will use the Series LLC as a way to white label programs by other management companies. The way that this typically works is that a large management company will offer say 25 different programs under the series umbrella. Each program will be a separate series which will be managed by another management group. The fees will be dictated by what the offering documents state and will usually be split between the sponsor of the series LLC and the manager of the individual series. In this way the large asset management company can offer their clients a wider range of instruments than they normally would be able to and can also keep the assets within their programs.

Key Features

  • The Series LLC form is the some US states’s version of the cell or segregated portfolio companies.
  • The Series LLC includes multiple series in a single LLC, with separate rights, powers, and duties for each partition or cell:
  • A Series LLC is sometimes used as a holding company for intangible assets or tangible assets like real estate.
  • A Series LLC permits a single entity to have multiple and separate liability-insulated cells with more than one series of members or managers.
  • Each unit has its own owners (members) and may be managed separately from the master LLC and other units.
  • Each unit must maintain separate books and records.
  • As with a regularly formed LLC, the owners (members) of each unit are not financially responsible for the unit’s debts and obligations.
  • A unit may conduct part of the business of the master LLC, or may conduct a wholly different business.
  • Each unit has its own assets and liabilities. The members of each unit are treated under the laws of the state where the master LLC is formed as owning an interest in only that unit, and have no rights as members of one unit in the assets or income of any other unit.
  • Each unit is liable only for its own debts and obligations. In general, creditors of one unit may only make claims against the assets of that unit.
  • Costs associated with maintaining separate entities are greatly reduced.