The Delaware LLC Statute--The Entity Within an Entity

April 13, 2006

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If you consider using holding and operating companies in a multiple-entity business structure, the Delaware limited liability company (LLC) statute provides for incomparable flexibility and simplicity in operating LLCs. It clearly allows for the establishment of different classes of interests, including voting and nonvoting interests.

It also allows 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 LLC.

The designation of the units, or "series" of separate entities within the single LLC as they are referred to in the statute, 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 Delaware.

It is essential that the registration be done properly to separate liability among the entities. Consistent with the flexibility in the Delaware LLC statute, each unit does not have to be funded. They can be held in abeyance for future use.

Warning

Remember, professionals can form an LLC, limited liability partnership (LLP) or a corporation only if all of the owners are licensed within the same profession. Keep this in mind if you're a professional forming a holding entity and an operating entity.

Only the operating entity has to meet this requirement. The holding entity, which will contain nearly all of the wealth of the business, will not be engaged in the practice of any profession. Thus, children or other family members, for example, can still be co-owners of the holding company, even when it is formed by professionals. This allows the use of a family LLC as an estate planning tool. However, in this case, the professional would have to form each entity directly, because the holding entity could not be the owner of the operating entity.

If the entities were being formed within a single LLC in Delaware, the holding entity would have to be formed as a separate LLC in this situation. Each operating entity could still be formed within the single LLC.

Obviously there are additional costs involved in creating two entities rather than one. However, the Delaware concept of an entity within an entity, embodied in its LLC statute, can significantly lessen these costs. Moreover, these costs, which really are relatively modest, represent a type of inexpensive insurance against the risk of loss.

Work Smart

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. Large corporations now sell accounts receivable in this way.

The holding company is completely 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.

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 can use a version of this strategy in withdrawing assets from the operating entity.