I find that, in an effort to shield their assets from liability, some clients want to limit the number of assets owned by each entity, and, in an effort to give themselves additional insulation from personal liability, some of the larger, more sophisticated clients want to use a multi-layered ownership approach to place one or more entities between the operating/owning company and the individual shareholders or members.
There are virtually unlimited variations of ownership structures, but, I will limit my focus to some practical issues to consider when deciding whether to own assets in one entity or multiple entities, and I will use LLCs as the chosen entity for ease of reference.
The chart (INSET) is a very basic example that will give you a general idea of the concepts at issue.
At first glance, it seems obvious that Mr. Smith would get more asset protection by separating the assets and holding each asset in a separate LLC. The liability of that particular LLC effectively should be limited to the assets it owns, so the fewer assets it has, the less potential exposure. In the multiple LLC ownership example, if a someone slips and falls at the XYZ Supply Co. retail building and sues the owner of the property (in this example, InvestCo 2, LLC), the only asset at risk in the lawsuit would be the retail building, not both the warehouse and the retail building. Whereas, in the single LLC ownership example, both the warehouse and the retail building (in this example, both owned by InvestCo 1 LLC) would theoretically be exposed in the lawsuit.
While greatly oversimplified for illustrative purposes, this analysis is technically correct in a purely legal sense. But it fails to consider a number of practical issues.
If separating Mr. Smith’s two primary assets and owning them in separate LLCs effectively limits each asset’s exposure to liability, shouldn’t the same analysis hold true if Mr. Smith had 22 warehouses and 46 retail locations? In that case, from an asset protection standpoint, wouldn’t it be better if he owned each of the 68 properties in a separate LLC? The correct answer on a law school exam may be different than the correct answer in real life.
By forming and operating too many entities, clients are often much more likely to fail to follow the “corporate formalities” and could, then, end up losing the protection afforded by the entities. If the owner does not treat the entities as having separate, independent identities, a crafty plaintiff’s attorney could argue that a court should “pierce the corporate veil” and try to get to the assets of the individual owner.
Ammunition used by plaintiff’s attorneys to try to make this argument could include co-mingling funds between different entities, not reasonably capitalizing each entity, not properly executing documents on behalf of the entities, or not maintaining separate bank accounts or separate books and records. From a practical perspective, these things are more likely to occur if an owner has to keep up with 10 entities rather than two.
Additionally, maintaining many different entities can often result in much higher administrative costs. These costs could result from maintaining separate books and records, the need for more administrative labor, preparing and maintaining agreements between the different entities and having different employees employed by one or more of the entities.
When deciding how many entities to use, clients should consider whether the administrative burdens outweigh the benefit. If clients maintain adequate insurance, they should have good liability protection without having to hold every single asset in a separate entity. They also should not allow the use of separate entities to cause them to reduce their insurance to an imprudently low level.
There is no question there are many benefits (in addition to limitation of liability exposure) to using a different entity for different assets, such as the ability to segregate assets by type, use or geographic location, the ability to help avoid inadvertent cross-collateralization of a borrowing entity’s assets and the ability to maintain varying ownership interests and/or investors in different properties.
It is no surprise that single purpose entities (SPEs) have become so common in recent years. However, while using multiple entities can be a prudent ownership structure, it is not always the best strategy, and, like anything else, it can be taken too far and result in unanticipated consequences. Many factors, including the type of business, the number of assets, the administrative costs, whether the business has employees and the ability to observe corporate formalities, should be taken into consideration before deciding if multiple entities should be used, and, if so, how many.
» Bridgforth Rutledge is a business attorney who focuses on commercial real estate, including sales, leasing and financing. He serves as a partner in Phelps Dunbar LLP’s Jackson office.
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