BILL ANALYSIS SENATE JUDICIARY COMMITTEE Senator Ellen M. Corbett, Chair 2009-2010 Regular Session SB 392 Senator Florez As Amended April 21, 2009 Hearing Date: April 28, 2009 Business & Professions Code; Corporations Code GMO:jd SUBJECT Limited Liability Companies: Licensed Contractors DESCRIPTION This bill would allow a limited liability company to render contractor's services that are "professional services" otherwise prohibited by the Beverly-Killea Limited Liability Company (LLC Act), by authorizing the issuance of a contractor's license to the company under the Business and Professions Code. Among other requirements, this bill would provide that a contractor-LLC obtain and maintain a $1,000,000 insurance policy or place on deposit or escrow $1,000,000 dollars plus an additional $100,000 per licensee in excess of five employed by the LLC, up to $5,000,000 in total insurance, escrow, or deposit. In addition, if the LLC is suspended, each member of the LLC who is licensed as a contractor would be liable for up to $1,000,000 in damages occurring as a result of the licensed activities of the LLC during the suspension. Under these conditions, a qualifying individual or group may form an LLC and obtain a contractor's license as an LLC. Except for the liability coverage requirements stated above, SB 392 would treat a limited liability company in the same manner as a corporation relative to the issuance, renewal, suspension, reissuance, or termination of a contractor's license. BACKGROUND Generally, a limited liability company is a legal entity formed under a statutory scheme (in California, the Beverly-Killea Limited Liability Company Act) that allows one or more owners to (more) SB 392 (Florez) Page 2 of ? conduct a business without any owner having personal liability for the obligations of the business. The salient nontax characteristics of a limited liability company (LLC) are limited liability for its owners (as in a corporation) and freedom to structure management rights and financial interests in the entity in virtually any configuration the parties wish (as in a partnership). An LLC most often elects to be treated as a partnership for income tax purposes, so that the income, gains, losses, deductions, and credits of the LLC generally will flow through to its members for reporting on their personal tax returns, the distribution depending on the terms of the LLC agreement, not necessarily the ownership interest of the individual members. Until the creation of LLCs, the limited partnership and the subchapter S corporation were the primary forms of business entity used to achieve the tax status and limited liability features now offered by the LLC. Each of those forms has its drawbacks, but the LLC can provide the advantages of both without the disadvantages of either. A limited partnership allows pass-through tax treatment, flexibility in financial structuring, and limited liability for the partners (as long as they do not take part in the control of the business), but requires one person (the general partner) to be fully liable for the obligations of the business. Unlike a limited partnership, no LLC member need be personally liable for the company's obligations, and yet each member is permitted to manage the company and to take part in the control of the business without losing the member's limited liability. (Corp. Code Secs. 17101, 17150.) Although an S corporation allows pass-through tax treatment and limited liability for all owners, S corporation status limits the parties' flexibility in structuring their financial arrangements because of the requirements that the corporation have no more than one class of stock and that items of income, gain, loss, deduction, or credit be distributed among shareholders on a pro rata basis. Furthermore, only individuals, estates, certain types of trusts, and certain tax-exempt organizations are permitted to be S corporation shareholders, and an S corporation will lose its pass-through tax treatment if an ineligible entity becomes a shareholder. An LLC, on the other hand, can have different classes of ownership, and income, gain, loss, and other items may be SB 392 (Florez) Page 3 of ? allocated disproportionately to ownership without affecting the LLC's pass-through tax treatment. Any person can be a member of an LLC (thus sidestepping the restrictions on shareholders in the case of an S corporation). While LLCs may generally engage in any lawful business activity (except banking, insurance, or trust company operations), the Beverly-Killea Limited Liability Company Act prohibits a foreign or domestic limited liability company from rendering professional services in this state unless expressly authorized under applicable provisions of law. "Professional services" are those services for which a license, certification, or registration is required under specified statutes. In 1995, SB 513 (Calderon, Ch. 679, Stats. 1995) authorized the establishment of limited liability partnerships (LLPs) for licensed attorneys and licensed accountants, provided the LLP purchased a liability insurance policy or maintained bank deposits of at least $100,000 per limited liability partner (or an aggregate of not less than $500,000 for fewer than five partners and not more than $5 million for all others). Only partnerships with a net worth of $10 million or more were allowed to become LLPs. In 1998, the statute allowing professional LLPs (Bus. & Prof. Code Sec. 16956) was extended to architects, under the same conditions as accountants and attorneys, for a trial period of ten years (AB 469, Cardoza, Ch. 504, Stats. 1998). In 2006, the repeal date for architects was extended to 2012 and the liability coverage requirement was increased to $1,000,000 for partnerships of five or fewer licensees, and an additional $100,000 per additional licensee up to a maximum of $5,000,000. (AB 2914, Leno, Ch. 426, Stats. 2006.) In 2007, SB 414 (Corbett, Ch. 80, Stats. 2007) updated the liability coverage requirement for accountants and attorneys to that applicable to architects. Under the Beverly-Killea LLC Act, unless permitted by the Business and Professions Code, an LLC cannot provide professional services. To date, only attorneys, accountants, and architects are permitted to operate as LLPs under the conditions specified for liability coverage. Last year, SB 1225 (Harman, Ch. 114, Stats. 2008) allowed a private cemetery that is an LLC to operate as a licensed cemetery authority to own the cemetery and to provide services by professionals licensed under the Business & Professions Code. SB 1225, however, prohibited licensees of professional services rendered in connection with the operations of a cemetery authority from having any ownership SB 392 (Florez) Page 4 of ? interest in the LLC. This bill would establish the rules by which a limited liability company may provide services as a licensed contractor. CHANGES TO EXISTING LAW Existing law , the Beverly-Killea Limited Liability Company (LLC) Act, prohibits domestic and foreign limited liability companies from rendering professional services in California. (Corp. Code Sec. 17375.) Existing law defines "professional services" as "any type of professional services which may be lawfully rendered only pursuant to a license, certification, or registration authorized by the Business and Professions Code, the Chiropractic Act, or the Osteopathic Act." (Corp. Code Sec. 13401(a).) Only attorneys, accountants, and architects have been authorized to render professional services as limited liability entities in California. This bill would authorize the State Contractors' License Board to issue a contractor's license to a limited liability company provided a qualifying member of the LLC is licensed as a contractor and the LLC meets all other requirements such as bonding and solvency of the LLC, and compliance by the LLC with the liability insurance requirements, as specified. This bill would treat a limited liability company and a corporation similarly as to the licensing process, as well as the renewal, suspension, reissuance, and termination of the license for specified reasons in the Business and Professions Code. This bill would provide that notwithstanding the prohibition under the LLC Act against a limited liability company providing professional services unless pursuant to a license, certification or registration, an LLC may render services if the applicable provisions of the Business and Professions Code authorize a limited liability company to hold that license, certificate or registration. COMMENT 1. Stated need for the bill The author states: SB 392 (Florez) Page 5 of ? The existing contractors' license law is archaic as most states in the country allow an LLC to hold a contractor's license ? the current law is an impediment to established nationwide businesses doing business in California. The LLC form of business has [the] needed flexibility for distribution of profits and losses separate from control and ownership which benefits commerce with no foreseeable detriment. The Contractors' State License Law ("CSSL") (sic) was adopted in 1929, long before adoption of the Beverly-Killea Limited Liability Company Act. Thus, at the time the CSSL was adopted, the legislature did not have the option of inserting LLC's into its provisions. The exclusion of LLC's from the CSSL was not a calculated decision. Fourteen (sic) years after passage of the LLC Act, LLC's comprise an indelible part of the business landscape in California and throughout the United States. This bill is necessary so that LLCs may be utilized in the construction industry just as they are in countless other industries throughout California. Notably, this is already the case in other States. Of the 29 states that license or regulate contractors, only California imposes a complete ban on operating as an LLC. LLCs are a desired entity for construction companies, as they are with many other industries, primarily because LLCs provide the flexibility to distribute profits and losses to owners without double taxation, in a manner similar to corporations electing "S" status under the Internal Revenue Code, but without the shareholder qualifications ? This flexibility as to the identity of shareholders is coveted for achieving estate planning objectives ? This improved estate planning and profit sharing flexibility will have no negative impact on consumers of construction services in California. An LLC provides liability protection for the personal assets of owners equivalent to, but not more than , that afforded a corporation. 2. The Beverly-Killea LLC Act: why professional services are not a permitted business Since its enactment, the rationale for the Beverly-Killea LLC Act's exclusion of professional services from the business that an LLC may undertake has been that service providers who harm SB 392 (Florez) Page 6 of ? others by their misconduct, incompetence, or negligence should not be able to limit their liability by operating as an LLC or limited liability partnership and thus potentially become judgment proof. California's Limited Liability Partnership (LLP) law, however, has always sought to strike a balance between allowing professional licensed service providers to operate in a mode offering both tax and liability-limiting advantages while preserving to an appropriate degree the ability of a party injured by professional negligence to recover damages for that injury. Thus, an insurance requirement has always been imposed upon professional licensees wishing to operate as an LLP. Because of the limited liability attributes of an LLP, an injured person can no longer rely on the joint and several liability of the partners and their personal assets, but must look to the assets of the LLP. To ensure adequate but not necessarily complete recovery in all claims, the insurance requirement is added as a condition of being able to operate as an LLP. Thus, even if the LLP has few assets because the profits are regularly distributed to its members, the required insurance is available to pay tort damages. Thus, current law authorizes attorneys, accountants, and architects, all of whom provide professional services under the Business and Professions Code, to organize themselves as LLPs and to provide professional services, so long as the LLP maintains a net worth of at least $10 million, and obtains liability insurance coverage or maintains bank deposits of $1 million for partnerships of five or fewer licensees and an additional $100,000 for each additional licensee up to a maximum of $5 million for all others. These figures were updated last year by SB 414 (Corbett). Limited liability partnerships are required to register with the Secretary of State, and LLP partners are only personally liable for those torts in which they personally participated and are not jointly and severally liable for any other torts or debts of the partnership. This bill would authorize the State Contractors' License Board to issue to a limited liability company (LLC) a license to provide contactor services, if the LLC meets the liability coverage requirements provided in the bill (and meets other licensing requirements). Last year, SB 1337 (Correa) would have done the same, but without requiring the LLC to provide any additional liability coverage in the event of damages to a SB 392 (Florez) Page 7 of ? consumer. That bill died in this Committee. In the same session, SB 1225 (Harman, Ch. 114, Stats. 2008) permitted an LLC to obtain a license as a cemetery authority provided it conformed to the insurance requirements for professional LLPs and provided no licensee practicing his or her profession becomes an owner-member of the LLC. If SB 392 is enacted, contractors would be the first of 54 professional and semi-professional licensee groups that, until now, could not be an LLC providing those services. As mentioned above, LLCs protect owners from liability to consumers yet allow them full control to operate and manage the business and distribute profits as they wish. Especially because contractors provide services that encompass not only large public and private projects but also small home-improvement projects ranging from a minor roof repair to full reconstruction of a fire-damaged home, an incompetent or negligent contractor could wreak havoc on a consumer's life, with the consumer having no recourse if something goes wrong. Thus, without the insurance coverage now provided under SB 392, last year's bill to allow an LLC to be licensed as a contractor (SB 1337), failed in this committee. SB 392 essentially cures the defect in SB 1337. 3. Professional v. nonprofessional services: Attorney General Opinion The LLC Act prohibits an LLC from rendering professional services and defines professional services as those requiring a license, certification, or registration under the Business and Professions Code, the Chiropractic Act, or the Osteopathic Act. (Corp. Code Sec. 17375.) In 2004, the Attorney General (AG) issued an opinion, in response to a request from the Secretary of State, on the question of whether a business that provides services requiring a license, certification, or registration pursuant to the Business and Professions Code may conduct its business as a limited liability company. The AG opinion concluded that "a business that provides services requiring a license, certification, or registration pursuant to the Business and Professions Code may conduct its activities as a limited liability company if the services rendered require only a nonprofessional, occupational license." (Op. No. 04-103, 87 Ops. Cal. Atty. Gen. 109 (July 23, 2004).) The AG opinion is quite clear on this point: an LLC is not SB 392 (Florez) Page 8 of ? permitted to render professional services, and an LLC would be permitted to perform "nonprofessional occupational services" without violating the Beverly-Killea LLC Act. However, the opinion also recognized that for some purposes, the term "professional services" has been broadly construed to include more than the traditionally considered "learned" professions such as medicine, law, or engineering, but includes such skilled services such as plumbing. (Amex Assurance Co. v. Allstate Ins. Co. (2003) 112 Cal.App.4th 1246, 1252; Hollingsworth v. Commercial Union Ins. Co. (1989) 208 Cal.App.3d 800, 806.) Thus, the question for licensed contractors is whether or not the services they render are professional services otherwise prohibited by the Beverly-Killea LLC Act from being rendered by a limited liability company. If the services are professional, then the LLC Act prohibits a limited liability company, though licensed under the Business and Professions Code as a contractor, from rendering contracting services. This bill attempts to get around the question by simply authorizing the issuance of a contractor's license to a limited liability company under the Business and Professions Code, and stating that "notwithstanding [Corp. Code] Section 17375" a limited liability company may render services that may be lawfully rendered only pursuant to a license, certificate or registration authorized by the Business and Professions Code if applicable provisions of the Business and Professions Code authorize a limited liability company to hold that license. The logic is circular, but the bill does contain consumer protections, in the form of the requirements for insurance or escrow deposits imposed on contractor-LLCs. 4. Liability coverage in addition to contractor's bonding requirements An applicant for a contractor's license must pass a written examination designed to show that the applicant possesses the necessary degree of knowledge of building, safety, health, and lien laws of the state and of the administrative principles of the contracting business as the board deems necessary for the safety and protection of the public. The examination must be taken by an individual or a qualifying responsible managing employee, or by a general partner or qualifying responsible managing partner or employee (if the applicant is a copartnership or limited partnership), or by a responsible managing officer or responsible managing employee (if the SB 392 (Florez) Page 9 of ? applicant is a corporation) or, under SB 392, by a responsible managing member of the LLC. The applicant must also show evidence of solvency (i.e., has an operating capital of greater than $2,500) and good moral character, as well as documentation of experience in a particular class of contractor's license, particularly if the experience is from out of state. Under current law, the State Contractor's Licensing Board may issue a license to an individual, a partnership, a corporation, or a joint venture that has met the requirements enumerated above. SB 392 would add a limited liability company to this list, with the board treating a license applicant in almost all respects as a corporation, including that the qualifying individual must own at least a 10% ownership interest in the LLC in order to qualify for the license for the LLC. The board requires, as a condition precedent to the issuance, renewal, or maintenance of a license, the licensee to have on file a contractor's bond in the sum of $12,500, at least $7,500 of which is dedicated for the benefit of a homeowner with a homeowner improvement contract for his or her personal family home, and whose home was damaged as a result of a violation. The rest of the $12,500 is available for payment to any person damaged by a violation or by fraud in the performance of a construction contract, any employee damaged by nonpayment of wages, any person damaged by the licensee's failure to pay employee's fringe benefits or other compensation. The board may increase this pre-licensing bond to twice the value under specified conditions. In addition, a licensee who is not the sole proprietor, a general partner, or a joint venture licensee is required to post a "qualifying individual's bond" in the amount of $12,500, of which $7,500 is reserved for the damaged homeowner as described above, and the rest available to other beneficiaries named above (employee, other persons). This bond may be waived if the qualifying individual owns 10% or more of the corporation's stock. Under SB 392, an LLC would be required to post, in addition to the total of $25,000 in bonds, at least $1,000,000 in insurance coverage or escrow deposit, for the benefit of homeowners and other consumers damaged by the contractor licensee. 5. Liability in the event of suspension, unless in substantial compliance SB 392 (Florez) Page 10 of ? As is the case with other professionals allowed to exist as limited liability entities, non-compliance with the insurance or escrow deposit requirements could trigger the suspension of the limited liability company's contractor's license. In this eventuality, this bill would provide that each member shall be liable up to $1,000,000 for damages or injuries resulting from acts and omissions of the LLC in providing contracting services. A safe harbor would be provided in that, pursuant to Section 7031, substantial compliance, which requires good faith efforts to comply, would exonerate the LLC members from such liability. This additional coverage for liability is required for the benefit of damaged consumers who would otherwise have no recourse if an injury occurs during the time of suspension. In the case of a sole proprietor, a damaged consumer may attempt recourse against the contractor's personal assets. As well, the consumer has recourse against a partner in the case of a partnership, or a general partner in case of a limited partnership. If the contractor is a corporation, the consumer may go after the corporate assets, or try to pierce the corporate veil to reach the shareholders' assets. There is a long line of cases allowing the corporate veil to be pierced to remedy wrongs inflicted by corporations on others. Cases involving LLC veil-piercing have just recently reached the higher courts of other states that have had LLC statutes longer than California. Although some courts have suggested that veil-piercing liability will be the same for members of LLC's as for shareholders in a corporation (See, e.g., Kaycee Land and Livestock v. Flahive, 2002 WY 73 (Wyo.2002)) especially if there was an inadequate capitalization and representations that other entities would be responsible for the LLC's debt, there are other courts that would provide more protection for the LLC (See Bonner v. Brunson (2003) 262 Ga.App.521, 585 S.E.2d 917, cert. denied, (Jan. 12, 2004), suggesting that the veil of an LLC should not be pierced absent an "abuse" of the LLC). Some states have LLC statutes that expressly provide for application of the corporate veil-piercing standard to LLCs, e.g., Colorado, Georgia, and Montana. Under the Beverly-Killea LLC Act, no person who is a manager or officer or both a manager and officer of an LLC is personally liable for any debts, judgments, or obligations of the LLC. A manager may however agree to be personally liable if this is set out in the LLC's articles of organization or other writing. SB 392 (Florez) Page 11 of ? (Corp. Code Sec. 17158.) As to the personal liability of other members of the LLC, the LLC Act is silent; thus, it is not clear that it would be easy to reach assets of LLC owners, who benefit from the tax advantages as well as the shield provided to their personal assets in the course of managing their business with much less formalities than a corporation, to remedy wrongs done to consumers. SB 392 would remove this uncertainty, at least when the LLC is in suspension, by making the members liable for up to $1,000,000 in damages during that period. Support : None Known Opposition : None Known HISTORY Source : Associated General Contractors of California and AGC-San Diego Related Pending Legislation : None Known Prior Legislation: SB 141 (Beverly, Chapter 57, Statutes of 1995) would have added numerous categories of state regulated professional service providers to the types of businesses that could operate as LLCs. However, opponents of SB 141 and that bill's sponsor were unable to agree as to whether or not professional or licensed LLC service providers should carry adequate insurance to ensure their financial ability to respond to legal judgments for contract or tort claims. Consequently, those additional classes of businesses were amended out of SB 141 prior to its enactment. SB 1337 (Correa, 2008) was similar to SB 392, but lacked the insurance and/or escrow deposit requirements for the LLC and its members. The bill died in this committee. AB 2401 (Miller, 1996) would have allowed contractors to operate as LLCs. The bill died in this committee. ************** SB 392 (Florez) Page 12 of ?