Chapter 16
Using LLCs to Cover Your Ass(ets)
IN THIS CHAPTER
Recognizing who can come after your assets
Understanding how LLCs protect your assets
Looking at some easy asset protection strategies
This chapter very well may be the most important one you read. After all, why would you want to work so hard to build your future only to have someone else take most of it away? If you think this chapter doesn’t apply to you just because you observe good business practices, think again! Lawsuits have gotten out of hand in this society, and no one is exempt. Owning something valuable puts you at a much higher risk than even the shadiest businessman. After all, the term frivolous lawsuits exists for a reason; lawsuits don’t need to be soundly based or even well-intentioned.
A lot of people are looking to get something for nothing. Unfortunately, hardworking folks like you, who have built up a sizeable nest egg, are a target. Aside from buying expensive insurance policies that, when it comes down to it, may or may not have your back, the only thing that you can really do to protect yourself is to plan ahead and structure your assets so they’re safe. Doing so now is important because it’s too late when you’re in a lawsuit. From here on out, you must take steps to protect your assets every time you save money, start a new venture, register intellectual property, make any big purchases, get married, plan your estate, and so on.
Because LLCs have dual liability protection (where the company is also protected from the owner’s personal lawsuits), they’ve been a cornerstone of asset protection strategies. LLCs are such a big piece of the puzzle that when an attorney sees that you’ve taken concrete steps to protect your assets with an LLC or a trust, they’ll often advise their clients not to sue you in the first place.
In this chapter, I show you how to protect your assets for the rest of your life by forming an LLC and safely owning high-risk assets (assets that are very likely to be sued) while protecting everything else you’ve worked for.
Knowing the Dangers: What Can Happen without LLC Protection
More than 40 million lawsuits are filed in the United States each year, and the numbers keep growing. By far, the most litigious country, litigation has become a way of life for Americans; the collective mindset is shifting to that of “get somethin’ for nothin’,” and small businesses — the lifeblood of the American dream — can pay a heavy price. Although a large corporation can cover the costs of an everyday lawsuit relatively easily, these legal fees may be debilitating to a small business or individual investor. Sadly, too many large companies and shady business people use this difference in affordability as a (very effective) way to eliminate their smaller competitors.
The Small Business Administration recently released a study finding that 53 percent of small businesses get sued every year. Considering these small businesses are making $71,000 per year on average, they simply cannot afford these lawsuits. And although businesses tend to get sued most often, you’re also likely to be sued personally. The law of averages says you’ll be sued four times in your lifetime. And that’s at today’s numbers; can you imagine tomorrow’s? As hard as paying the $75,000 legal bill on a frivolous lawsuit can be for a small business, it can be even harder for an individual.
Often, attorneys tie in asset protection with estate planning. Although protecting your estate is imperative — making sure that it actually makes it to your kids and not into the hands of some Joe Schmo who tripped over a sprinkler on your front lawn — estate planning doesn’t really have much bearing on protecting your assets from litigators. In other words, just because you have an estate plan does not necessarily mean that your assets are protected while you’re alive.
Lawyers and creditors come calling
The saddest thing about lawsuits is that even if you win, you lose. A lot of these lawyers who take on frivolous cases work on a contingency basis, meaning they don’t charge the client unless they win the case. So, ultimately, you may be the victor, but unless you’ve countersued (costing even more legal fees), you’ll be the one paying your attorneys for the privilege of proving you did nothing wrong. Legal fees for defending a frivolous case can easily amount to hundreds of thousands of dollars, which can be debilitating for a small business.
The only way to protect against having to pay outrageous sums of money for seemingly petty arguments is to stay out of court in the first place. I’m not saying that you should settle a lawsuit brought against you. I’m saying that you should make your assets either unapparent or unattractive to the wolves that are scoping them out. LLCs can do just that.
The IRS stakes a claim
If you aren’t at enough risk from lawsuits and creditors (see the preceding section), remember that you still have to worry about the IRS. When given the right authority, the IRS can impact your financial life more than any individual creditor can. Regarding your personally-held assets, the IRS gets free reign, including seizing your belongings and bank accounts to cover your taxes, interest, and penalties.
Now, although the IRS is part of the government — especially where individuals are concerned — it’s subject to a few rules, all of which you can use to your advantage. When the IRS deals with an LLC, it must follow the same laws and restrictions as most creditors, except with a little bit more knowledge and disclosure. For instance, if the IRS goes after you personally, it can’t seize your interests in the LLC and liquidate your company. It can only lay claim to your economic interest and must wait for you to pay out. This aspect is unique to the limited liability company due to the charging order protection benefit of LLCs I mention throughout this chapter.
Now, keep in mind that the charging order protection your LLC provides can depend heavily on the state it is registered in. While the best way to get the most up-to-date information on your state’s statutes and case law regarding charging order protection is to speak with a lawyer licensed in that state, I have put together a basic overview for each state on your Dummies Portal at www.corpassure.com/dummies/liability-protection. (The password onesmartdummy.)
You never want to hide your assets from the IRS (that’s tax evasion), and you shouldn’t have to. Your asset protection plan should be so solid that the IRS doesn’t have the ability or, better yet, the justification to easily go after your assets to settle an IRS debt.
Liens are lurking
Some lawyers are really good, and the worst thing that can happen is to get sued by one of them without having any sort of asset protection plan in place. Imagine you get taken to court over a contract dispute, and the attorney talks the judge into placing a prejudgment lien on your assets; now, you can’t move, touch, or transfer your assets or even conduct business with them until the lawsuit has been decided.
Say the amount of the lien covers the entire amount due on a ten-year contract, which is pretty hefty. Your assets don’t quite cover it, so your bank account is attached to the lien, and you aren’t even able to write checks. If this happens, you may have a hard time buying necessities, such as payroll and accounts payable for your business or gas and food for your family, but the worst thing of all is that you most likely won’t be able to pay your attorney to defend the case. Eek! Sadly, this can push you to settle immediately and for unfavorable terms.
You aren’t necessarily in the clear even if you get through the lawsuit without a prejudgment lien. If you win the lawsuit, you’re okay, but what if you lose? Say someone gets a judgment on you for more than you can afford to pay at the moment. Unless you can immediately write a check for a big chunk of change, the judgment creditor can request a post-judgment lien placed on your assets, which leaves your bank account completely frozen. Your home, rental property, savings account, mutual funds, CDs, and kid’s college fund are frozen and can be liquidated to pay the lien.
You don’t have to lose a lawsuit to have a judge impose a lien. Anyone can request a lien on your assets, including creditors or the IRS.
Getting the Best Asset Protection with LLCs
Some asset protection plans just try to hide your assets from prying creditors and potential plaintiffs. Although that should be the first line of defense, it isn’t nearly enough. You see, if you do get dragged into court, you’ll probably be subpoenaed for the information or asked about it while on the stand. In either case, you shouldn’t lie. If you do, you’ll have much more to lose than your assets; you can lose your freedom by going to jail.
If predators see that you have hordes of cash and real estate sitting in an LLC, they very well may not go after the assets in the first place. Why? Because LLCs are very tough nuts to crack. And the predators know this. They also know that if you’re smart enough, you can trap them in a situation where they’re paying out money for you.
Complex trusts are even better (not sure if you want to add this), but as you can bifurcate the ownership and keep the beneficiaries private, no one can find out who the trust owner of the trust is, and the trustee is the fiduciary, so it’s much more powerful than an LLC and offers a much stronger level of protection.
Have some extra money to work with a lawyer to create a custom structure to protect your personal assets? I say, “Go for it!”. A good asset protection lawyer can set up special types of trusts in conjunction with your LLCs to lock down everything you have worked so hard to build.
Setting up a Fort Knox for your personal assets
The states know that many fewer businesses would be started if entrepreneurs were forced to put their livelihoods at stake every time they began new ventures. Therefore, certain entity types are afforded limited liability, which protects the owners and managers of the business from being held personally responsible for the debts, obligations, and misdeeds of the business. Out of all the entities, LLCs offer the most comprehensive form of this protection (hence the name limited liability company).
An LLC protects you from the liabilities you inevitably come across during normal, everyday business. Should your business get sued or go bankrupt, your personal assets (home, car, investments, and so on) and other businesses (if they’re in different LLCs) can’t be taken away. Only the assets included in the LLC that got sued are at risk.
By establishing your new business or placing your existing business in an LLC, you sign your company up for the most cost-effective, ironclad insurance policy around. A business insurance policy may still have a role in keeping the business itself from having to pay for its own misdeeds. However, insurance policies are only effective in lawsuits arising from product or service liability and usually don’t pay out to unsatisfied creditors if the company can’t meet its debt obligations. Also, whereas insurance companies can be wishy-washy about paying out, the LLC is pretty fail-safe.
The one exception to the normal protection of LLCs is professional limited liability companies (PLLCs) because personal responsibility is essential to being a licensed professional. I discuss this unique entity type at length in Chapter 2.
If you want to use an LLC to protect your personal assets, you must do so in advance, not after being sued. Unfortunately, at that point, it’s always too late. If only they had spent some time planning, such as reading this book and/or working with a lawyer beforehand, they could’ve saved everything.
Although an LLC shields you from being held personally responsible for minor negligent acts, it does nothing for egregious criminal acts or willful misconduct. Also, the LLC offers some protection against certain government creditors, such as the IRS, with one main exception: As a member or manager of an LLC, you can be held personally responsible for failing to pay payroll taxes. In some states, LLC members are also responsible for paying past wages to employees the business has left hanging without a paycheck.
Taking charge of charging order protection
Many moons ago, when a creditor obtained a judgment against a partner of a partnership, the creditor could simply take the partner’s interest in the business (and, proportionally, all related assets) and liquidate them to get paid, often leaving a ravaged business in their wake. Clearly, this scenario wasn’t fair to the other innocent partner(s) in the partnership, who were just going about their business when everything they worked for was destroyed!
To remedy these unfair acts, the courts amended the laws so that partners in an LLC, unlike owners of corporations, have another layer of liability protection called charging order protection. A member can have two rights in an LLC: economic rights (the right to receive profit allocations and distributions from the company) and other rights (which include the right to vote on important matters or be involved in managing the day-to-day business) — charging order protection grants only economic rights to the assignee, unless the operating agreement specifies otherwise. In other words, the creditor has no choice but to shut their trap and sit back and receive whatever distributions you grant them. You can stop profit distributions altogether, and the creditor has no say in the matter. Read on to find out how this arrangement works.
Remember that the charging order protection your LLC offers can vary from state to state, so read up on your state’s specific laws before relying on it as the cornerstone of your asset protection strategy. As a starting point, I’ve outlined each state’s basic charging order protection standards, which you can access on your Dummies Portal at www.corpassure.com/dummies/liability-protection. (The password onesmartdummy.)
An LLC’s veil of liability protection isn’t infallible. If you don’t take certain measures to establish and maintain that your LLC isn’t simply an extension of you (your alter ego), a court can disregard the LLC and allow the plaintiff or creditor access to your personal assets. This situation is called piercing the veil of liability protection. In Chapter 19, I show you ten important steps you can take to protect your veil of limited liability.
Seeing how corporations leave you vulnerable
To understand how a lack of charging order protection can leave you vulnerable, consider the example of Josh, who started a business, J.R. Marine, Inc., when he was only 23. He borrowed some money from his grandfather by selling him a 5 percent share in the business to get started. He was smart and good with numbers, and the business grew steadily over the years. Ten years in, J.R. Marine had taken over the market. It was good timing, too, because Josh had just met the love of his life and was eager to start a family.
One day, he was in the local supermarket’s parking lot and accidentally backed into a woman’s car. The woman was friendly; they traded insurance information, and he helped her on her way. Two months later, Josh was served with a lawsuit. The single mother claimed she was severely injured in the accident and couldn’t work to support her four kids. She was suing Josh for wages and emotional trauma.
Josh found a decent litigation attorney and was forced to slap down $20,000 as a retainer to defend the case. Four months later, the case went to trial. They were counting on a settlement, but the woman wouldn’t budge. Josh had to pay another $40,000 for attorney fees. At trial, Josh couldn’t believe how the woman’s attorney made him seem like the big, wealthy, bad guy who thinks he can “drive all over” a struggling cocktail waitress/single mother who can’t afford to feed her kids and now will never get ahead in life. The woman, wearing a neck brace, cried on the stand. Her attorney asked the jury to “do the right thing.” Of course, their idea of the “right thing” was to award the woman more than $2.5 million of Josh’s money.
At first, Josh thought he was okay; after all, he didn’t have too much money in his bank account. However, he did have his J.R. Marine, Inc. stock, a corporation, which is considered a personal asset. Before long, the business was seized. They liquidated the inventory, the building, everything, just to pay off his judgment. Josh’s livelihood and all his assets were destroyed.
If J.R. Marine, Inc. had been J.R. Marine LLC, Josh might not have been sued in the first place. As I note throughout this chapter, attorneys know that LLCs are notoriously hard to get to, and the smart ones will avoid them at any cost. When the waitress’s personal-injury lawyer did an asset search to determine whether Josh had any seizable assets, he would’ve seen that Josh’s business (or his share of the business) was held in an LLC.
Remembering that even charging order protection comes with rules
Charging order protection can be fantastic. However, you do have to play by a few rules, which I explain in the following sections. For charging order protection to be effective, you should have certain provisions in your LLC’s operating agreement that provide for it. Don’t leave it up to your state’s laws to be in your favor when it comes to this. I show you how to draw up an ironclad operating agreement throughout Part 3 of this book.
You also need to make sure your state’s laws have it locked down as the default remedy for judgments, taking into account the type of business your LLC is engaged in. For example, if your state only allows LLCs to be formed for “any business purpose,” this can have ramifications if your LLC’s sole purpose is holding real estate or some other non-business venture. Peruse your state’s laws regarding both of these on your Dummies Portal.
Though guarding your LLC’s charging order protection may seem overwhelming or troublesome, it’s worth it. By taking a few days to educate yourself and/or hiring a qualified attorney to draft your LLC’s operating agreement, you can establish an LLC that will provide an indomitable safe harbor for your business for years to come. In addition to taking into account your state’s laws regarding the “purpose” of your LLC and its specific rules on charging order protection, there are a few other steps you need to take to make sure that you get the best dual-liability protection your LLC has to offer.
You must be a true partnership
Over the years, some people have argued that because there isn’t another partner in the partnership who needs protection, charging orders shouldn’t be applicable for single-member LLCs. Most states have drafted laws against this. However, if you’re a single-member LLC operating in Nevada, Delaware, Florida, or Alaska, you face a drawback: your LLC is not guaranteed charging order protection in some way or another. In these states, this precedent should make you wary of forming an LLC for any sort of business or asset protection purposes with only one member. In community property states, adding your spouse as a second member doesn’t count, so I recommend issuing a small percentage of your LLC to a close friend or relative as a safeguard (preferably someone who isn’t your crazy Uncle Joe).
One of the best lawsuit prevention traps that LLCs offer in conjunction with charging order protection is forcing the tax liabilities of the LLC’s distributions on the person or company holding the charging order on your membership interests. However, this deterrent only works if your LLC has elected some form of pass-through taxation. So, though corporate taxation may appeal to you for other reasons (see Chapters 7 and 13), you may want to think twice before electing corporate taxation for your LLC because it doesn’t allow taxes to be passed through.
Membership can’t be freely transferrable
Charging order protection relies heavily on restricting membership from easy access to the other rights — the management and control of the business. Each state has a default statute that dictates how membership interests are to be transferred and which rights are afforded to the new member (which is, on average, pretty restrictive). However, all states also give you some leeway, allowing you to lay out your own set of rules in your LLC’s operating agreement. Just be careful that you aren’t using this extra rope to hang yourself by allowing the free transference of membership shares and, in the process, inadvertently destroying your own charging order protection. When drafting your operating agreement, keep an eye out for this potential problem. In Chapter 8, I give you some suggestions for special rules and provisions you can add to the operating agreement to doubly uphold charging order protection for your LLC.
Your LLC must be manager-managed
Using charging order protection is a really powerful strategy for LLCs; however, a common mistake is for member-managed LLCs to rely on this strategy. The manager determines the profit and loss allocations, so if the LLC is manager-managed, then a creditor stepping in as a member may be able to actually determine these allocations on their own (depending on the operating agreement and the judge’s decision). To avoid this risk entirely, don’t make your LLC member-managed. Even if all the current members are managing, you should still designate your LLC as manager-managed; then name all the current members as individual managers.
If you require your LLC to be member-managed for some reason, then you can mitigate these risks with specific provisions in your operating agreement. In this case, it’s a good idea to work with an attorney who specializes in LLCs and asset protection to help you draft your operating agreement to account for this.
Your records must be in order
Like regular liability protection (which protects the owners from the debts of the business), charging order protection depends on your maintaining a proper separation of your LLC from yourself and keeping your records in an orderly manner. This doesn’t just mean having a comprehensive operating agreement (see Chapters 8 and 9); it also means having the proper documentation for all major moves your LLC makes, like taking on members, varying allocations, etc. Chapter 12 is devoted to record keeping.
Another potential pitfall that could eliminate all your LLC’s liability protection, not just charging order protection, is commingling your funds. If you use your LLC as a personal piggy bank and don’t treat it as a separate entity, the courts will do the same when the time comes, and you’ll be left personally footing the bill.
Exploring Strategies for Increased Security
Protecting your assets is so simple that I challenge you to come up with one good reason why you shouldn’t do it — not later in the year, not in a couple of months, but now. Asset protection strategies only work if you do them before ever getting into trouble. After you’re sued by a creditor (or if the IRS is after you), you can’t transfer your assets into an LLC to protect them. Otherwise, you can be found guilty of fraudulent conveyance of assets, which means you set up your asset protection plan to defraud your creditors and prevent a specific claim. In this case, not only will you hand over your assets to the creditor on a silver platter, but you also may face some pretty steep fines and maybe even some jail time.
In the following sections, I go over a few simple strategies that you can use now to start protecting your assets:
- Using a nominee to make it harder for others to find your assets
- Using multiple LLCs to segregate your assets from one another so that if one asset, such as a piece of property, is engaged in a lawsuit, the others are safe from seizure
- Forming two companies in different states to separate your business’s assets from the actual operations of the company
Note: A lot of asset protection strategies also play into estate planning. If you want to pass on your assets to your loved ones, or even just incorporate a trust for protecting your personal assets, then Chapter 16 is written especially for you. And if you are looking for specific strategies related to real estate, see Chapter 17, where I do a deep dive into protecting your real estate investments while also keeping your tax bill low.
Electing a nominee to protect yourself with privacy
Privacy is the first line of defense when it comes to asset protection. If people don’t think you have anything, then they won’t bother suing you in the first place. The saying goes, “Own nothing, control everything,” but that doesn’t mean that just because people will try to take your things, you shouldn’t own and enjoy the finer things in life. You work hard and deserve to enjoy the fruits of your labor. And even if the world can see that you have money, you can keep people from knowing where it is. That’s where privacy comes in handy.
Some states, such as Wyoming, protect the privacy of the LLC’s members. This protection means that the members don’t need to be publicly listed in the articles of organization or the annual reports your company files with the secretary of state; only the managers have to be listed. If the members don’t need to be listed in your state, you can hire a nominee to serve as your LLC’s manager. A nominee is a person who can truthfully state on the stand that they’re unrelated and unknown to you. Doing that ensures that your name — as the owner of the LLC — remains private and not public record. You can hire a nominee from a nominee company, usually for less than $500 per year. Keep in mind, though, that this move only works if your LLC is manager-managed.
If you’re in a state that doesn’t allow privacy protection for members, consider forming an LLC in another state that does allow it and having that entity be the member of your operating LLC that is on public record. Remember, this will result in an extra tax return that you’ll have to pay for each year, along with the extra maintenance fee of that other entity.
After you have a nominee manager in place, unless you broadcast to the world that you own the LLC, people won’t even think to look into the issue further. Your name won’t be on public record, and unless they ask you directly, creditors will have no way of knowing that you’re even associated with the LLC.
Now, privacy is only your first line of defense, and it will not work with the federal government, including the IRS. Luckily, being open and honest with the IRS does not undermine your privacy in other ways, as your tax filings and the information you share with the feds are not public record.
If your LLC is currently member-managed, you are holding the membership personally, and you are desirous of privacy, you need to amend your articles of organization to make your LLC manager-managed. Otherwise, most states will require you to list your members (namely, you) on your annual report — which is public record.
Privacy won’t fully protect you. It’s not a strategy in and of itself, per se, but more like an add-on. If you solely use a manager nominee and think you’re completely protected, you’ll get the shock of your life when you get dragged into court. The lawyers will ask you about your assets, and at that point, you have two choices: Give up the goods or perjure yourself. Considering that perjury is a pretty serious criminal offense, I would take door No. 1 — and that leads to you revealing the location of your assets so they can be taken.
Setting up multiple LLCs: The more, the merrier!
With an LLC, your business is protected from you, and you’re protected from your business. But what protects your business from itself? When your business is sued, the creditors may not be able to go after your personal assets, but they can still go after the business’s assets! You can fix that.
Any business or property that operates directly with the public is at risk of being sued. If you have all your business assets in your operating company and you get sued, all your business assets can be seized. The same goes for personal assets. If you own ten properties and put them all in the same LLC, and then someone slips and falls on your first property and sues you, everything in that LLC is up for grabs — all ten properties.
The best and easiest way to protect what’s yours is by insulating each of your major assets in its own LLC. Doing so can be somewhat costly, but on large assets, it’s a small price to pay. For instance, New York taxi cab companies often place each taxi in a separate LLC. That way, if one driver gets into an accident and the cab company gets sued, only one cab can be seized and liquidated to pay off the claim. That LLC can then be dissolved, and the taxi company still stands. You don’t have to worry about million-dollar judgments now!
Make sure you aren’t already facing a lawsuit when setting up a structure like this one. If you are sued and then transfer entities to different LLCs to protect them from the creditor, you’re engaging in a fraudulent conveyance. Not only will it not hold up in court, but it could also land you in jail in some jurisdictions.
Following the dual-entity strategy
Having one or more separate LLCs hold each of your business’s primary assets is super common in the business world. This approach is often referred to as a dual-entity strategy (and yes, I agree it’s a bit of a misnomer since it often involves more than one LLC). This protection strategy is my favorite by far; in addition to keeping your assets safe, you also save on some of your state and local taxes. Also, you can set up your business(es) this way, no matter the tax or management structure.
An example of how dual entities work
Say you decide to start a local pizza delivery company. You live in the high-tax state of California. In this case, you form your LLC in the state of California (not much you can do about this; if you’re located there, you have to register and pay taxes there, no matter what), but you then place all your assets, such as your pizza ovens, cash registers, and so on, into a Wyoming LLC that has elected corporate taxation (see Chapter 7 to find out how to make tax elections). For extra protection, you make this Wyoming LLC a completely private entity by hiring a nominee (see the “Electing a nominee to protect yourself with privacy” section earlier in the chapter).
Your Wyoming LLC owns the assets and then leases them to your California LLC (your operating company that deals with the customers, vendors, and so on). This way, your company’s assets are 100 percent protected. Why? Because they’re in a completely separate entity. Your California LLC controls the assets but doesn’t own them, which is the most powerful position to be in. If your California company gets into a legal predicament — for example, if a customer gets injured — the inquiring attorney will see that it’s completely devoid of assets. Even if they find out you own the Wyoming LLC, they’ll have a hard time doing anything about it.
If you choose to use this strategy, make sure the lease between the California LLC and the Wyoming LLC is legitimate. You need to write up a contract and pay a reasonable leasing fee to the Wyoming LLC every month or quarter. This step may seem like a pain in the butt, but believe me; it ensures your strategy is legitimate if you ever go to court.
The tax advantages
One of the main reasons you should form your LLC in Wyoming is that Wyoming has absolutely zero taxes — zero business taxes, zero franchise taxes, and zero personal income taxes — zilch. And you have to elect corporate taxation on that Wyoming LLC because if you try this plan with an LLC with pass-through taxation, your assets are still protected, but the profits flow through to you personally, and you have to pay taxes on them in whatever state you live in (which in the case of our example, is California).
So, here’s how the tax reduction goes. If you have $100,000 in profit at the end of the year that you want to keep in the company, you can have the profit go to your Wyoming LLC as a lease payment for the use of the assets instead of having it flow through to you and your partners and paying state and federal taxes on it. This $100,000 payment is a legitimate tax deduction, eliminating your LLC’s profit. After the money is in your Wyoming LLC, it’s only taxed at the federal corporate tax rate (which is usually just above 21 percent), as opposed to the personal income tax rate (which can be 35 percent or more!). This strategy is great if you want to save money for assets or other business-related items.
Wyoming isn’t the only state with a favorable tax climate. In Chapter 4, I list other pro-business states and show you how to select the one that works best for you.