While generally we view the recent Florida Supreme Court decision (Olmstead v. Fed.Trade Comm’n, SC08-1009, 6/24/10) with foreboding and trepidation, there is a silver lining in this case which provides some certainty in what type of business organization should be utilized by a potential debtor. Before discussing this landmark case, it is important to review a little history on business organizations.
Almost everyone is familiar with corporations. They have been with us a long time and when new entities are formed (especially when formed by accountants and many attorneys) they are often in the corporate form. The corporate form is the standard form used for professional entities (P.A.). The major problem with operating an entity as a corporation is that the shareholder’s creditor has the right to attach and foreclose on the stock (thus becoming an actual shareholder). Some businesses have in place stock redemption or stock cross-purchase agreements to provide for ease in liquidating the potential creditor’s interest. Unfortunately, most of these agreements provide for immediate payments to the creditors (low hanging fruit for a creditor). Alternatively, if the creditor’s shares are not redeemed, few clients like the prospect of a creditor being a co-owner in the business (with respect to a P.A., the creditor’s stock interest must be liquidated, otherwise the P.A. is dissolved–unless the creditor is also a similarly licensed professional).
As an alternative to being exposed as a P.A. or ordinary corporations, many higher net worth clients and those who have risk concerns (professionals, real estate developers, builders, etc.) elect to operate their business as a limited liability company (LLC) or a professional limited liability company (PL). Operating as an LLC has in fact become the most popular form of doing business. One reason for the popularity of the use of the LLC format was the IRS allowing the members to decide how the members wanted to be taxed (with multiple members it was possible to be taxed as a regular corporate (C Corporation, filing a Form 1120) or as a tax flow-through entity as an “S” Corporation (filing a Form 1120S) or a partnership (filing Form 1065).
The other and most significant attraction to using an LLC was the asset protection aspects of owning a membership interest. The LLC Act provides that a member can not assign their membership interest without the other members approving the transfer and a creditor of a member is given the right to petition the court for a charging order. A charging order limits the rights of the creditor/assignee to obtain distributions that the debtor member might receive from the LLC (of course, once this charging order is obtained the manager of the LLC, typically the debtor, withholds distributions). Even if the profits of the LLC were not distributed, the manager would provide a K-1 to the creditor informing them and the IRS of the phantom (retained and not distributed) income that was taxable to the creditor). Also, with only a charging order the creditor never becomes a member and thus can never control the company (including no right to fire the debtor manager). Since the LLC Act was derived from the partnership statutes (the charging order provisions were identical until 2005) many advisors felt that the two appellate court decisions in the partnership arena which gave the creditors of a partner the exclusive creditor remedy of a charging order would apply to a multiple member LLC (astute advisors never recommended single member LLC in part because we wanted to track the partnership laws as much as possible and to give vitality to the limitations in the LLC Act involving an assignee not becoming a member unless approved by the other members–the only exception was frequently a multiple member LLC will own the sole membership interest of a subsidiary LLC and the subsidiary LLC could be treated as a disregarded entity for tax purposes).
Unfortunately, the Florida Supreme Court was presented with a very difficult decision. While, the LLC Act places restrictions on transfer of membership interests (requiring other member’s approval) should such restrictions apply when dealing with a single member LLC? After all, there are no other members to protect from an involuntary transfer. Also, the court was faced with a debtor who had fraudulently sold bogus credit cards to unsuspecting consumers.
The Supreme Court in a divided opinion held that the charging order remedy provided in Fla. Stat. §608.433(4) is not the sole remedy for a judgment creditor against a debtor’s interest in a single-member LLC. The court also held that the creditor of a member of a single-member LLC has all the normal rights of a creditor as provided by Fla. Stat. §56.061 (includes the right to levy and sell).
While this decision might make sense in the context of a single-member LLC, where the member has the authority to freely transfer their membership interest (the statutory restrictions on seeking another member’s approval is essentially inapposite), there are two positions taken by the court which concerns us.
First, the court reasoned that the last significant change in partnership law (the Florida Revised Uniform Limited Partnership Act of 2005, RULPA) which added to the old charging order language (Fla. Stat. §620.1703(3) a special subparagraph that stated that the charging order “provides the exclusive remedy (emphasis by the Supreme Court) by which a judgment creditor of a partner or partner’s transferee may satisfy a judgment out of the judgment debtor’s transferable interest in the partnership” was significant since the legislature never changed the identical charging order language in the LLC Act. The court interpreted the failure of the legislature to act in the LLC area an implicit acknowledgment that the charging order was not the exclusive remedy. The dissenting judges made it clear that absolutely no inference can be derived by the legislature failing to act in one area of law. The reality is that if the court had examined how the RULPA was promulgated and the legislative history it would have been clear that the legislature was only faced with considering a more modern limited partnership law–not any other business organization.
Second, the court reasoned that a creditor generally has all the remedies afforded to them under Fla. Stat. §56.061 which provides “stock in corporations ... shall be subject to levy and sale under execution.” The court stated that “An LLC is a type of corporate entity, and an ownership interest in an LLC...is reasonably understood to fall within the scope of “corporate stock”. The court misinterpreted the separate business structure of an LLC. The LLC is not a “type of corporate entity” (in oral arguments a few justices mistakenly called the LLC a Limited Liability Corporation). Just like the limited partnership, the LLC is a legislative created new business entity with detailed statutory provisions and restrictions. As the dissenting judges observed in their dissent the majority opinion ignored “the plain language of the statute”. Essentially, the court gutted the LLC Act. They ignored the previous interpretations of the charging order language by other courts (that had ruled on the language in the partnership context) and they ignored the restrictions on assignability. Thus, while the LLC is a creature of legislative enactment, the court ignored the enactment.
However, not all is lost in this decision. First, even if the holding is extended to multiple member LLCs (clearly the reasoning of the court raises concerns, as the dissenting judges concluded “The majority opinion now eliminates the charging order remedy for multimember LLCs under its theory of “nonexclusivity” which is a disaster for those entities.”), multiple member LLCs with creditor/bankruptcy proof operating agreements and buy-sell provisions will be effective in making the interest less desirable for a creditor (for example, poison pill provisions applicable just to involuntary transfers in an operating agreement). Also, it is crucial that the operating agreement be designed with affirmative duties required of its members (thus creating an executory contract for bankruptcy purposes). With such an operating agreement in place the creditor would still be foolish to attempt to go after the membership interest.
Second, for those debtors wanting absolute certainty, the Supreme Court has spoken, the limited partnership statute does provide an “exclusive remedy” of a charging order to creditors of a partner. For those willing to pay the extra costs (the initial filing fee for a limited partnership is $1000.00 (vs. $125.00 for an LLC) and our charges to prepare the LLLP is an extra $600.00; the annual renewal fee of $500.00 (vs. $137.50 for an LLC), the choice of entity is clear, a limited partnership. In most cases we actually utilize a LLLP, a limited liability limited partnership, where the general partner of a limited partnership has no personal liability).
For those who have an existing P.A., Inc., or LLC the additional cost of conversion is $600.00 (If the other entity is an “S” corporation for income tax purposes the “S” election will terminate in this type of conversion.). For those clients who utilize multiple existing LLCs, the LLLP can be superimposed as the holding company for the LLCs. Also, in any entity restructuring the parties must be aware of the Fraudulent Transfer statute in Florida as well as the 2 year fraudulent transfer provisions of the bankruptcy law.
In conclusion, no matter what course a debtor might select the Olmstead case presents a need to revisit existing business entities. And with respect to those who desire maximum certainty in their asset protection planning, the Supreme Court has spoken: use a LLLP.
To learn more on how to protect your business interests, please call 561-967-2772.
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