Doug Cornelius .com

Charities should not use a limited liability company to hold real estate in Massachusetts. Robert E. Cowden wrote an article about this in the November/December 2007 issue of the Boston Bar Journal.

The Massachusetts Appellate Tax Board ruled that even though a piece of property was owned by a single member limited liability company, whose sole member was a charitable corporation, the property did not qualify for property tax exemption. CFM Buckley/North, LLC v. Board of Assessors of the Town of Greenfield.

The Third Clause of M.G.L. c.59, s.5 provides for a property tax exemption for a charitable organization, which is defined as:

(1) a literary, benevolent, charitable or scientific institution or temperance society incorporated in the commonwealth, and (2) a trust for literary, benevolent, charitable, scientific or temperance purposes if it is established by a declaration of trust executed in the commonwealth . . . . [emphasis added]

The Appellate Tax Board found that a limited liability company is not “incorporated” and therefore does not qualify for the exemption.

On a similar note, other protections for charitable organizations may be jeopardized if they use a limited liability company to hold some of their real estate assets.

For instance, the Dover Amendment M.G.L. c.40A, s.3 provides that:

No zoning ordinance or by-law shall regulate or restrict the interior area of a single family residential building nor shall any such ordinance or by-law prohibit, regulate or restrict the use of land or structures for religious purposes or for educational purposes on land owned or leased by the commonwealth or any of its agencies, subdivisions or bodies politic or by a religious sect or denomination, or by a nonprofit educational corporation. . . .

Also the charitable liability cap in M.G.L. c.231, s.85K is applicable to:

corporation, trustees of a trust, or members of an association that said corporation, trust, or association. . . .

A limited liability company may not be able to take advantage of these protections.

Last week I noted the story and decision of City of Springfield Code Enforcement v. Concerned Citizens for Springfield, Inc., et al. in which Housing Court Judge William H. Abrashkin ordered the individual manager (Shalom Segelman) of the property owning limited liability company to pay $1.3 million in relocation costs for the tenants in the sub-standard apartment complex.

After reviewing the case, it is not clear whether the judge was piercing the liability shield of the LLC or carving an exception to the liability shield.

M.G.L. C. 156C s. 22 provides that no “. . . member or manager of a limited liability company shall be personally liable, directly or indirectly, including, without limitation, by way of indemnification, contribution, assessment or otherwise, for any such debt, obligation or liability of the limited liability company solely by reason of being a member or acting as a manager of the limited liability company.” This is the liability shield for a limited liability company.

Judge Abrashkin looks to the definition of owner under the State Sanitary Code (105 CMR 400) that imposes obligations on the owner. The code has a very broad definition of owner:

“Owner means every person who alone or severally with others:

(1) has legal title to any dwelling, dwelling unit, mobile dwelling unit, or parcel of land,vacant or otherwise, including a mobile home park; or
(2) has care, charge or control of any dwelling, dwelling unit, mobile dwelling unit or parcel of land, vacant or otherwise, including a mobile home park, in any capacity including but not limited to agent, executor, executrix, administrator, administratrix, trustee or guardian of the estate of the holder of legal title; or
(3) is a mortgagee in possession of any such property; or
(4) is an agent, trustee or other person appointed by the courts and vested with possession or control of any such property; or
(5) is an officer or trustee of the association of unit owners of a condominium.

Each such person is bound to comply with the provisions of these minimum standards as if he were the owner. Owner also means every person who operates a rooming house.”

My reading of Judge Abrashkin’s decision is that this definition of owner is an exception to the liability shield of M.G.L. C. 156C s. 22.

I disagree with a statement in the Judge’s analysis: “Had this complex gone in the other direction Mr. Segelman would, rightly, have insisted upon reaping the rewards. With the benefits go the burden, and this one falls unavoidably, upon Mr. Segelman.”

One the basic paradigm’s of investing in real estate (and any business) is being able to limit your losses. If I went out and bought a share of Boston Properties, Inc. (BXP) I would pay the $104.37 that it costs (as of this morning). I have unlimited upside. The stock could triple in value and pay out enormous dividends. My downside is limited to the $104.37 that I paid for the share. As a shareholder, I would never expect to get a bill to contribute more capital to Boston Properties because one of their buildings is in disrepair.

I expect the same treatment if I were an individual investor in a limited liability company that directly owned an apartment building. I know my initial capital is at risk, but I should not have to put additional capital in (unless I agreed to under the limited liability company agreement). I could lose all of my investment. But I should not have to lose more than my investment.

That being said, there are some exceptions to this liability shield. In real estate, there is CERCLA’s ability to look through entity for liability due to environmental contamination. (You can read this article by Daniel M. Darragh of Buchanan Ingersoll & Rooney PC on Indirect Owner/Operator Liability Under CERCLA). There is also the equitable remedy of piercing the corporate veil.

In his order, Judge Abrashkin did not discuss any of the factors for piercing the corporate veil. So I am left to assume that the Massachusetts state sanitary code is an exception to the limited liability of an entity.

The ABA approved the new Uniform Act on Limited Liability Companies [Press Release] updating the 1996 Act. Limited Liability Companies still dominate the ownership structures of real estate assets.

Here are the highlights:

1. In the 2006 Act, the operating agreement determines whether a company is manager-managed or member-managed. In the 1996 Act the kind of management is determined in the certificate of organization. If the agreement is silent, the company is a member-managed company by default. Leaving this decision to the agreement allows the company to determine and re-determine its management structure more flexibly. A third-party creditor may seek affirmation of a manager’s or a member’s authority before doing business with the company and practice indicates does so without checking the official record for the certificate. In addition, certificates of authority may be filed to provide notice that only certain members or managers in a company are entitled to do business on behalf of the company.

2. There is no requirement that a company’s operating agreement be in writing in either the 1996 or 2006 Act. However, the definitions “record” and “signature” establish that any statute of frauds requirement within the 2006 Act may be satisfied with electronic records and signatures. The 1996 Act does not recognize electronic records or signatures.

3. A member may not transfer his or her membership in a company, unless the operating agreement makes it possible. The only interest that may be transferred is called the “distributional interest” in the 1996 Act and the “transferable interest” in the 2006 Act. In the 2006 Act, a “transferable interest” is generally any right to distributions that a member has under the operating agreement. The operating agreement may impose restrictions on a right to transfer. However, the certificate of organization may provide that a “transferable interest” is freely transferable under the 2006 Act. If it does, the transferable interest may be certificated in the same manner any investment security is, and is likely to be a security under Article 8 of the Uniform Commercial Code.

4. In both the 1996 and the 2006 Acts, members owe a duty of care to each other. The duty in the 1996 Act is to refrain from conduct that is grossly negligent or reckless conduct, intentional misconduct or knowing violation of law. In the 2006 Act, the standard is ordinary care (care that a person in a like position would reasonably exercise) subject to the business judgment rule.

5. Under both the 1996 and 2006 Acts, the operating agreement governs the relationships between members and members and managers (if any). The 1996 Act, however, provides that the duty of loyalty and the duty of care may not be eliminated in the operating agreement. But the operating agreement may specify those acts and transactions that do not violate the duty of loyalty, so long as not manifestly unreasonable. In the 2006 Act, the operating agreement may eliminate the duty of loyalty or duty of care, provided that eliminating them is not “manifestly unreasonable.” The agreement may not authorize intentional misconduct or knowing violations of law, as well.

6. The 1996 Act does not expressly address the issue of indemnification of members or managers, but the 2006 Act does. It provides for indemnification as a statutory matter. But the operating agreement may alter the right to indemnification, and may limit damages to the company and members for any breach except for breach of the duty of loyalty or for a financial benefit received to which the member or manager is not entitled.

7. The 1996 Act makes no provision for companies that are initially organized without members. There must be at least one member upon filing the certificate of organization. In the 2006 Act, a member does not necessarily need to be named at least 90 days from the day the certificate is filed. There is a limited ability, therefore, to create what are called “shelf” companies.

8. One issue that especially vexes limited liability company law is the rights creditors of members have in the assets of the company. The 1996 Act restricts creditors’ interests to a member’s distributional interest and provides a judgment creditor with a “charging order” as the only method of executing against that interest. The resultant lien may be foreclosed and sold in a judicial foreclosure sale. The 2006 Act further requires a finding: that payment may not be made within a reasonable time, before a court orders foreclosure of the lien. This finding is not required in the 1996 Act. In addition, the 2006 Act makes it absolutely clear that a purchase in a foreclosure sale does not make the purchaser a member.

9. In the 1996 Act dissociation (resigning from membership) of a member by express will triggers an obligation to buy the interest of that member in an at-will or term company. Failure to buy may subject the company to a judicial dissolution and winding up of the business. The 2006 Act provides no obligation to buy out a dissociating member, nor a ground based upon failure of a buyout for judicial dissolution. The company has greater stability under the 2006 Act, notwithstanding any dissociation of a member.

10. The 1996 Act provides members with the right to file a derivative action on behalf of a company alleging certain kinds of misfeasance on the part of the company by its management. Under the 2006 Act, the company may form a “litigation committee” to investigate claims asserted in a derivative action. This stays the litigation while the committee does its investigation. The objective of the investigation is to determine if the litigation is for the good of the company. The litigation committee ultimately reports to the court with a recommendation to continue with the plaintiff or the committee as plaintiff, or to settle, or to dismiss.

11. The 1996 Act allows no right of direct action against the company on behalf of a member as a plaintiff. The 2006 Act provides for direct action.

This link will take you to a copy of the Act.
This link is to a copy of the Act in Word.