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ASSET PROTECTION FOR BUSINESS OWNERS

James C. Mulder
attornery at law

How To Protect Your Assets With Limited Liability Companies

Background

Limited Liability Companies first appeared in the United States in, of all states, Wyoming in 1977. But Wyoming didn't invent LLCs, the concept actually originated in Germany and in some Latin American countries which called them "limitadas". Some US oilmen liked the limitada concept in Panama and sought out the friendly legislature of Alaska to enact a limited liability company statute. Alaska didn't pony up, but Wyoming did and the rest is history. Texas adopted its first Limited Liability Statute in 1991. Now all 50 states and the District of Columbia have adopted LLC statutes.

Formation

A Limited Liability Company, or LLC, is an entity created under state law by the filing of a Certificate of Formation with the Secretary of State. Many people attempt to form their LLC online with the Secretary of State, which is easy to do. It is also easy to make mistakes this way as you don't have the benefit of an experienced attorney advising you. You also need a Company Agreement under which the LLC is to be operated. You can't get this from the Secretary of State. The Company Agreement needs to be very carefully drafted if the LLC is to be used to its potential, especially if it will be taxed as an S corporation, which is usually the case.

LLCs are easier to operate than a corporation, provided a comprehensive Company Agreement is in place. There is no requirement for annual minutes like there is for corporations.

Taxation

An LLC with two or more owners by default is taxable as a partnership, i.e. a flow-through entity for income tax purposes. This means that owners receive their portion of income tax attributes of the LLC. The LLC will file an IRS form 1065 income tax return but does not pay income taxes. But IRS requires all individual owners of an LLC that is taxed as a partnership to have all profits taxes as earned income and owners are not entitled to a wage or salary. An LLC may instead elect taxation as a C or S corporation. Similarly, a single owner LLC may be taxable as a disregarded entity (schedule C on his or her 1040) or as a C or S corporation but not as a partnership. If the sole owners are a married couple in a community property state, the IRS considers it a single owner LLC. It is imperative that the LLC not be taxed as a partnership or sole proprietorship as neither can provide wages to the owner(s). Wages are specifically exempt from attachment by a creditor, but profits from a sole proprietorship or partnership would be subject to a charging order, thereby preventing you to receive money for the work you produce for the LLC.

Asset Protection - Basic

Under state law, an LLC has certain features that protect the member (owner) from any liability for the debts and liabilites of the company, unless the member was personally involved or gave a personal guaranty.

An LLC also provides significant protection from the judgment creditors of the individual owners of the LLC for something outside of the LLC, if a judgement is entered against the owner after the creation of the LLC for something unrelated to it.

The LLC statutes provide asset protection by dictating the rights of an owner's creditor. Creditors of an owner have no right to become an owner, to demand company assests, or to compel distributions. Texas law provides that a judgment creditor's SOLE remedy is a charging order from a court to charge the owner's interest in the LLC with a requirement that if a distribution is to be made to the owner, it is to be made to the creditor. That is a big if and there is no obligation to make distributions to an owner, provided the Company Agreement is drafted properly. And as stated previously, a creditor can not attach a wage due an owner of an LLC, but it must be taxed as a corporation.

An owner of a corporation has no such protection in law. An individual owner of the stock in a corporation who has a judgment against him or her can lose his stock and consequently, the company if he had controlling interest. For companies and for individuals with assets at risk to a future creditor, the asset protection features of the LLC clearly favor utilizing this form of business operation.

For accumulation of profits received from the business that are not spent on living and not invested in exempt assets, a separate individually owned LLC is warranted to protect those savings and investments from a future creditor.

Other Advanced Tips

The preferred solution for holding different types or investments that are not protected by state exemptions is to form a Texas Series LLC to be a holding company and have it own one or more subordinate series limited liability companies. An asset protection design can involve wholly owned subordinate series LLCs (taxable as disregarded entities) to hold risky assets, or to conduct business activities that have an inherent risk. By insulating a risky asset or business activity from the rest of the assets and non-risky business activities, only that particular series LLC contains the risk and therefore this plan protects the other series LLCs and its assets and the Owners from attachment. In a real estate scenario, the series LLC is the owner of one single property, so only that property would be at risk.

You should create your own "Bank" Series holding LLC to be the lender to any other series LLCs for operating capital and take a lien back against the series LLC assets to secure the loan. A creditor of the series LLC will have to pay off the loan to your Bank Holding LLC first before satisfying its judgment.

How Many LLCs Should I Have?

I encounter many business owners that have formed their business as a limited liability company (LLC) and think they have protected themselves from creditors. Many of them think that since their business is in an LLC that they have protected it. It is true that putting your business in an entity will provide the owners with protection from a creditor of the business, but all of the assets of the business are still fair game for such a creditor. As I have discussed before, consideration needs to be given as to how many assets are vulnerable to the business and how they might be structured to better protect them from a business claim. This is also true of real estate investors who really aren't operating a business, if all they do is collect rents. This type of income is considered passive income and not subject to earned income self employment and Medicare taxes, but they are just as vulnerable to a tenant claim as an operating business is to any other claim from its products or services. I am talking about here is structuring the "business" assets in such a way as to limit a creditor of the "business" from forcing a liquidation of all of those assets.

Here is a common example.

Real Estate Investor

Mr. Smith owns 5 single-family rent houses and two duplexes in one LLC. Each one has its own mortgage, but the equity in each property is building up. All properties are rented and Mr. Smith is the only one involved in collecting rents and taking care of tenant problems. In other words, he doesn't have any employees or property managers. Mr. Smith does have a bank account in the LLC name and is depositing all lease payments in this account. Some of the leases however are in his name as Landlord, not the LLC. Several problems are present here:

  • Mr Smith has all his eggs in one basket.
     
  • Mr. Smith is the named landlord on one or more leases
     
  • How does Mr. Smith have his property insurance on these rental properties listed with his P&C insurance company?

Regarding 1 above, if one tenant has a claim against the Landlord, if it is Mr. Smith on the lease, even though he transferred the property to his LLC, he may have some "splaining" to do and could be held personally liable. Furthermore, should the claim be large enough to exceed his insurance coverage, if the insurance company decides it is an insured claim, or if the claim is not covered, the equity in all 7 properties are at risk to satisfy this one claimant. The property that gave rise to the claim may have a large mortgage against it, but maybe one or more of the other 6 properties have little mortgages, thereby making them a prime target to pay off the claim, not the one in which the claim arose.

Regarding 2 above, once the LLC became the owner of the property, Mr. Smith should have notified his Tenants that the new landlord is the LLC and all rent checks should be made out to it.

Regarding 3 above, if his insurance company does not have the LLC as a listed insured, there will be no coverage. I see many clients that try to get by with adding other properties to them personally and think that they will save premiums, but if the insurance company does not show the LLC as owner, there is no coverage.

What should Mr. Smith do? Well. he could set up a Series LLC as a holding company and create a Series LLC for each property each to be owned by the holding company. By doing this he can use the holding LLC as a private bank and let it get a second lien on all of the properties by lending money to each series LLC to take care of expenses and even mortgage payments. What this will do is eventually make the holding LLC as the first lien holder on all properties. Now if a claim occurs, only one property and its equity will be at stake and that equity can be very minimal with proper planning and time.

Business Owner

Mr. Smith owns a business called XYZ Manufacturing. It is a Texas corporation taxed as a C corporation. It owns its plant where XYZs are manufactured. The land and buildings are worth $1,000,000. The company also owns equipment used in manufacturing XYZs that are worth $2,000,000. The company also has utilized the patents of the owner since inception to manufacture XYZs. The company has 40 employees working in 2 shifts.

What are the asset protection risks of this business?

  • A major risk exposure is the potential loss of the $3,000,000 worth of plant, land, buildings and equipment to a products liability suit.
     
  • A disgruntled employee that has a potential sexual harassment or equal opportunity suit.
     
  • Additionally, if the company doesn’t carry workers compensation insurance, unlimited liability for an employee who gets hurt on the job.
     
  • Possible loss of the patents to a creditor.
     
  • If the owner were to get sued for a personal liability, his stock could be attached and the creditor gain total control of the business.

What should Mr. Smith do? Well, he could set up a Series LLC as a holding company and create a Series LLC for the land and building, for the equipment, for the patents and other intellectual property and finally one to operate the business, hire the employees and do all things that could create a liability. Each series to be owned by the holding company. By doing this he can use the holding LLC as a private bank and have it lend the money needed to operate the business to keep the business “lean”. There would be a UCC and security agreement lien on all of the assets of the business including accounts receivable. By lending money to each series LLC to take care of expenses, operating capital and even third party bank loan payments, the holding company eventually becomes the first lien holder on all assets. Now if a claim occurs, it should only be brought against the operating company and since it doesn’t own anything of value that is not pledged to the holding company “bank”, the exposure to loss should be very minimal with proper planning and time.

There are potential significant income tax implications to this planning if the business has been operating for a long time and care is imperative in implementing this plan.

For more information on the basics of asset protection for your business or family, contact WealthKeepers today at 713.461.9699 or info@WealthKeepers.net