Thinking About Chartering Your Boat? Consider Forming A Limited Liability Company

[vc_row][vc_column][vc_column_text]Copyright © 2017 Law Office of Alexander T Gruft

Overview:

Chartering is a term for the “hiring” out a boat.  Some owners charter their boat on an occasional basis to help with running costs.  Others make arrangements with a charter management company to arrange bareboat and crewed yacht charters for them.  Either way, if you are thinking about chartering your boat, you should be aware of the many applicable rules and regulations if you want to avoid getting yourself in deep water.

Whatever the type of charter arrangement, chartering can expose you to significant risk if you fail to plan and take sensible precautions.

With that in mind, one option to consider is to place your boat in a limited liability company.  This article is a basic overview of how to set up an LLC.  Before you make the decision to set up an LLC, consult with an attorney or a tax professional to determine if this scenario is suitable for your situation.

The following discussion provides a general overview of the steps in setting up the LLC and the implications of having ownership of a boat in an LLC.

  1. Chose a name for your LLC. The name of your LLC must comply with the rules of your state’s LLC division (typically found within the secretary of state’s office).  While requirements differ from state to state, generally:
  • The name cannot be the same as the name of another LLC on file with the LLC office;
  • The name must end with an LLC designator, such as “Limited Liability Company” or “Limited Company,” or an abbreviation of one of these phrases (such as “LLC,” L.L.C.,” or “Ltd. Liability Co.”); and
  • The name cannot include certain words prohibited by the state, such as Bank, Insurance, Corporation or City.

Besides following your state’s LLC naming rules, you must make sure your name will not violate another company’s trademark. Typically, the name of the LLC will be the name of the owner’s boat.

Once you have found a legal and available name, you generally do not need to register it with the state.  When you file your articles of organization, your business name will be automatically registered.

  1. Where to File. Some states offer LLCs more financial advantages than others, and that means you should carefully weigh your options before filing.  Filing in your home state may be a good option for owners who have a home, physical presence (i.e. work and/or slip), and conduct the vast majority or all of their business, i.e. chartering, in their home state.  If you meet these criteria, your best option may be to file in your home state to save money annually because the LLC will not have to register as a “foreign LLC” if it conducts business in that state.  Note that “doing business” generally requires an active business presence if not a physical office.  Also, an LLC that does business in its state of filing does not need to find and pay a registered agent to represent its interests within that state.  Another popular choice for those forming an LLC continues to be Delaware.  Delaware has a solid reputation as one of the most business-friendly jurisdictions in the country. Notably, Delaware does not tax out-of-state income, which can mean an enormous tax savings for Delaware LLCs that do little or no business in the state itself.  In addition, its initial filing fees and franchise taxes are quite low.  Other favorable jurisdictions are Nevada and Wyoming.

 

  1. Filed Articles of Organization. After settling on a name, you must prepare and file “articles of organization” with your state’s LLC filing office.  While most states use the term “articles of organization” to refer to the basic document required to create an LLC, some states call it a “certificate of formation” or “certificate of organization.”  One disadvantage of forming an LLC instead of a partnership or a sole proprietorship is that you will have to pay a filing fee when you submit your articles of organization.  In most states, the fees are modest—typically around $100.  A few other states cost more.  California, for example, charges an $800 annual tax on top of its filing fee.  You will likely have to list the name and address of a person, usually one of the LLC members, who will act as the LLC’s “registered agent,” or “agent for service of process.”  The agent is the person designated to receive legal papers in any future lawsuit involving the LLC.

 

  1. Creating an LLC Operating Agreement. Even though operating agreements need not be filed with the LLC filing office and are rarely required by state law, it is essential that you create one.  In an LLC operating agreement, you set out the rules for the ownership and operation of the business.  A typical operating agreement includes:
  • The members’ percentage interest in the business;
  • The members’ rights and responsibilities;
  • The members’ voting power;
  • How profits and losses will be allocated;
  • How the LLC with be managed;
  • Rules for holding meetings and taking votes; and
  • “Buy-sell” provisions, which determine what happens if a member wants to sell his or her interest, dies, or becomes disabled.

 

  1. Liability Protection. For the LLC to provide any special protection against legal liability, the LLC must exist for a legitimate business purpose rather than simply to hold ownership in a boat.  If the boat is the company’s sole asset and the company has no business purpose, a plaintiff’s attorney may be able to “pierce the corporate veil” and pursue the members personally as if the business entity did not exist.  If a legitimate business purpose for the company exists, the LLC can act as a shield to protect your personal assets from liabilities associated with the business conducted by the LLC.
  2. Single Member LLCs. Many boat owners will be setting up an LLC with themselves, or themselves and a spouse, as the sole owner (members).  An LLC with one owner, or in a community property state with a married couple as owners, is called a single-member LLC.  A single-member LLC will be treated as a “disregarded entity” for federal income tax purposes (unless it formally elects to be treated as a corporation), and thus its profits or loss will be reported on an individual member’s Schedule C as if it were a sole proprietorship.  This will save the member time and money in connection with the preparation of income tax returns because the separate LLC entity need not file tax return.  Note however, that the member will have to use his or her own social security number when registered a boat with the United States Coast Guard unless the LLC obtains a federal Employer Identification Number.

Although the single-member LLC may be more convenient, it may undercut liability protection and allow “piercing of the corporate veil” because it is not separate entity from its owner.  To avoid this issue, you can do one of two things: (i) create at least a two-member LLC with sufficient legal documentation (including an operating agreement and annual company minutes, etc.) to reflect that the two-member LLC is indeed a separate entity and has been treated as such; or (ii) set up a holding or parent company in a state that gives the single-member LLC the same protection as a multi-member LLC (Wyoming, Nevada and Delaware) to own the LLC and require a plaintiff to fight their way through another state before getting to the single-member LLC owned by the “parent.”

  1. LLC Benefits When Selling a Boat. In California, the purchase of a corporation or an LLC that owns a boat as its sole asset is not subject to the assessment of sales or use tax.  This is because sales and use tax are not assessed on the purchase of corporate securities or the purchase of part or all of a business entity.  Also, when the business entity is sold, there is no change in the title or ownership of the company’s assets.  Since the boat is still owned by the LLC, there was no purchase or sale of the boat and nothing to assess sales or use tax against.

The owner should be aware of the step transaction doctrine.  The basic idea behind this judicially created doctrine is that the tax results of a series of steps in a transaction should be determined based on the overall transaction.  A taxing authority (the Board of Equalization in California) will scrutinize a transaction under this doctrine to determine whether an owner set up an LLC with a boat as its sole asset simply to sell the LLC a short time later to a buyer wishing to avoid sales or use tax.  To avoid this, the LLC should already have been established for a significant amount of time before the entity is sold and the entity must have a legitimate business purpose.

Owners should also be aware that the sale of an entity, as opposed to the boat itself, adds a layer of complexity to the transaction.  Many buyers are not familiar with LLC or corporations and may be hesitant to buy one with its attendant risks and potential liabilities.

  1. Transfer the Boat to the LLC. If the LLC did not purchase the boat, you will need to transfer the boat to the LLC and register it in the LLC’s name.  If the owner financed the purchase of the boat, the transfer of title from the individual owner to the LLC may trigger an acceleration clause in a promissory note or preferred mortgage.  Most notes have language stating that if any or all of the interest in the boat is transferred without the lender’s prior approval, the lender has the right to require immediate payment of the entire note balance.  In most cases, the lender has no incentive to consent to the transfer into an LLC because it would limit their recourse if you stopped paying on the loan.  Nevertheless, you should advise your lender of the transfer to avoid a default on the loan.  The lender may accept a guarantee from the individual owner to protect against the risk of having to pursue the LLC.  There is also a possible tax implication in the transfer to the LLC even though you are the sole owner of the LLC because the LLC is a separate legal entity from the owner.  This will depend on a myriad of different factors and is a good reason to have an attorney or tax professional assist with the transfer.
  2. While an LLC may provide some liability protection, there is no substitute for adequate insurance on the boat to protect your assets.  There are many forms of insurance applicable to the marine industry.  Hull insurance is written with the expectation of insuring the hull of the vessel.  One provision of a hull insurance policy, dealing with “constructive total loss”, is of particular interest. In the event of a total loss of the vessel, the hull insurance will pay off either the “stipulated value” if it is an agreed or stipulated value policy, or the “fair market value” of the vessel as determined according to proof.  However, if the vessel is not totally destroyed but the cost of repair or restoration would exceed some specified percentage of the agreed or stipulated value of the vessel at the time of loss, then it is deemed a constructive total loss and the entire proceeds of the policy are payable.  Some policies provide that payoff in the event of constructive total loss is an option at the discretion of the underwriter and that the underwriter may elect to repair.  That provision can create a conflict between the insured and the underwriter particularly if there is major damage which will require substantial time to repair.

The protection and indemnity insurance form, or “P & I” as it is more commonly called, is equivalent to the general liability form of policy on automobiles. Like the hull policy, the P & I policy should be read carefully and any question about its contents or the meaning of its paragraphs should be addressed to competent insurance brokers.  Like the hull policy form, the P & I form is interpreted through a great deal of history and therefore should be carefully read and understood since some of its clauses do not necessarily mean what they appear to say on their face.  If the yacht owner employs crew or is engaged in passenger carrying operations, the yacht owner must be careful to ensure that there are adequate liability insurance coverages for passengers and crew members. Because of the high cost of seaman injury claims, employing crew members will undoubtedly adjust premiums rates considerably.  Passenger carrying activity will also adjust insurance rates.  The vessel owner should be certain that all conditions of the policy are met.  Any unsatisfied condition may give rise to a policy which is not of any force and effect or may be voidable at the election of the underwriter.  Insurance forms and terminology can be confusing so it is important that a yacht owner consult with a broker and/or attorney to ensure a clear understanding of the risks that are covered by the particular policy.[/vc_column_text][/vc_column][/vc_row]

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