Choosing the right tactic, techniques and form is critical in protecting your assets.
Many of us still believe that we can just sit behind the corporate shield and our assets are protected. Using corporations, LLCs and the like is really just the beginning.
Here are some of the types of corporations to avoid for protecting your assets.
Partnerships are the worst entity you could possibly be involved in from an asset protection standpoint. A partnership provides all of the headaches and personal liability of a sole proprietorship (see paragraph below), with the added twist of having a partner who creates an even greater liability. In a partnership, each partner is liable for all the actions and debts of the other partners. If one partner takes out a loan on behalf of the partnership, even without the permission of the other partners, all partners are on the hook. This also includes cases involving individual actions. For example, if one partner sexually harasses an employee and the business is sued for sexual harassment, the suit is against the partnership, and all partners have personal liability. This form of corporation is not advised for protecting your assets
This is the second worst way to own or run a small business.
A sole proprietorship exists when someone operates a business without filing to have that business recognized as a legal corporate entity. With a sole proprietorship, there are no barriers between the business conducted and the person owning the business. This is dangerous because if a sole proprietor acting on behalf of his business commits negligence in his duties for the business that causes injury to a third person, the sole proprietor is then personally liable for any and all injuries to that third person. There is no reason for anyone ever to be a sole proprietorship because protecting your assets is a serious matter.
Businesses mainly incorporate in order to avoid personal liability for the negligent actions of the corporation. This includes limited liability of the corporate shareholders, in addition to individual liability of the employees of the company. However, there is one important exception to the limited liability. This is in the area of personal services. Personal service liabilities include work that is done for or on behalf of clients by doctors, attorneys, accountants, and financial planners. The exception means that a physician who treats or operates on a patient cannot hide behind the corporate veil normally providing limited liability for owners and employees working in the normal course of business. If a patient sues for malpractice, the physician is named individually because the personal liability cannot be removed by incorporating.
Now here are the best tools to use for asset protection: They are Limited Liability Companies (LLCs), Family Limited Liability Companies (FLLCs) and Family Limited Partnerships (FLPs).
In this article, the term “LLC” will be used interchangeably as a term that stands for all three entities. For asset protection purposes, each entity works in the same way.
Briefly, LLCs were designed to bring together a single business organization containing the best features of the pass-through income tax treatment of a partnership and the limited liability of owners in a corporation. LLCs also provide the standard corporate protection to all shareholders and directors for any negligent actions against the LLC itself. LLCs are treated the same from a corporate liability standpoint as S- or C-corporations. For instance, doctors still have personal liability if they commit malpractice and a patient sues. However, there are major differences between LLC’s and Corporations as it relates to asset protection.
This difference involves the role of a “charging order”. A charging order is typically the only remedy a court can give to a creditor who is trying to get the assets of a debtor when the assets are in an LLC or limited partnership. A charging order does not allow creditors to sell the assets of the LLC or force any distributions of income. This is very useful in protecting your assets.
Here is an example: Assume that a patient sues and obtains a judgment against a doctor for $3 million. The doctor has $1 million in medical malpractice coverage, and all the rest of his major personal assets are in an LLC, of which he owns 100%. The patient petitions the court for satisfaction, requesting the doctor is ordered to turn the assets in his LLC over to him, but the court informs the patient that because the assets are in an LLC, the only remedy it can give to him is a charging order.
What does the patient get with this charging order? Something completely unanticipated and unwanted: Only the right to pay taxes on any income generated in the LLC but not distributed (Revenue Ruling 77-173).
Assuming that the patient manages to obtain a charging order against the doctor’s LLC, which owns his $1 million brokerage account and $1 million vacation home in Florida and further assuming the doctor earns dividend income of $25,000 a year from the brokerage account and earns a rental income of $20,000 a year, the doctor would be taking home the total $45,000 as income from the LLC to invest or spend it as he sees fit. This form of corporation is very useful in protecting your assets.
Because of the charging order, the doctor will leave the income in his LLC at the end of the year, which will trigger income taxes due by the patient. Because the patient has no desire to pay any taxes on income that he did not receive, the patient will immediately release the charging order. If there is ever a distribution from the LLC, the patient would get that money, but no creditor wants to continue paying taxes on income not received in the hope that distributions will be made at a much later date. No defendant would make any distributions until the charging order is released. The standoff usually ends with the frustrated creditor dropping the charging order (before the tax bills start coming, of course.) This is a good method of protecting your assets.
Once again; a creditor cannot force distribution of the LLC’s assets or income. The power of an LLC is derived from the fact that a creditor can only obtain a charging order against the LLC.
Look back at what happens in an S- or C-corporation involved in a similar lawsuit. If a client’s assets are held in an S- or C-corporation, the judge has a few remedies to satisfy a creditor’s request. First, the court can order the sale of a debtor’s interest in an S- or C-corporation to satisfy the judgment. Second, the court can order the ownership interest of a debtor in an S- or C-corporation transferred to the creditor. Either way, the defendant’s assets in an S- or C-corporation can be reached.
There could be a problem with single-member LLC’s in some states. Although these single-member LLCs have been used for some time now, it is wise to have another person as a 5% owner of an LLC. This setup prevents a creditor from arguing that an LLC without more than one owner should not be able to hide itself behind a charging order. If this issue is a concern for protecting your assets in your state, then it is suggested you use an FLP, which does not have the same potential exposure, or use an LLC, where the state statute dictates the charging order as the sole remedy for the creditor.
It should be noted that many types of assets, beyond financial accounts, can be held inLLCs. A good candidate is real estate (typically rental or vacation property). Other libelous assets are the vehicles whose involvement in an accident could create liability for other client assets. For example, a boat worth as little as $10,000 could result in massive costs to the rest of the estate if the owner of the boat drinks, drives and then injures another boater or swimmer. Almost any vehicle can be put into an LLC, including cars, boats, airplanes, jet skis, and snowmobiles. The decision to put any of these in an LLC is a matter of how much money the client wants to spend on protecting his assets and the value of the assets. Typically, each LLC costs between $1,500 and $2,500 to establish. It is recommended using separate LLCs for assets with significant value.
Everyone should be able to achieve asset protection goals domestically by setting up LLCs. However, for some people, adding offshore planning does add an extra layer of protection. Nevertheless, it should be understood that offshore planning will cost more money and add a level of complexity. However a properly implemented offshore plan should be able to be explained in simple and easy to understand terms.
A word of caution is that you should not consider these types of trusts because you heard from a friend or read somewhere that offshore asset protection is the way to go. Another misnomer is that you can move assets in order to save on or avoid federal income tax. This is simply not true. There are asset protection wizards employing offshore asset protection trusts as their main tool. This is generally a one size fits all practitioner and you should be very cautious. These asset protection practitioners have been know to use offshore trusts when their client commits fraud by moving his or her assets offshore. Their claim is a U.S. court will not be able to gain control of the money; therefore, all assets will be safe from all creditors. Again, this is simply not true.