Asset protection is NOT just for business owners. It reaches into all aspects of wealth preservation and estate planning.
However, you might say that business owners are on the front lines of this battle because the act of offering services to the general public can be a risky proposition.
So, this article will focus on asset protection for business owners and businesses, and will also offer some guidelines for non-business owners, retirees and families alike.
What is an Asset?
I submit that you should define an asset as anything you own that has value. So your run of the mill stocks, bonds, mutual funds, bank accounts, cash value life insurance, and all other financial investments are considered assets.
Personal property such as guns, knives, coins, and stamps are also assets, as are all vehicles even if they are declining in value.
Among your most valuable assets are probably real estate and your business interests.
It is worth mentioning that in contrast to your assets, liabilities are defined as anything you owe to 3rd parties in the form of loans payable, security interests, mortgages and the like.
Why Assets Protection Planning?
Why asset protection planning is necessary is a critical question that is often not taken seriously. The answer is simple and can be answered in one word: RISK or people may want to try to take your stuff.
We all face risk because we live in a litigious society MEANING that it people tend to file a lot of lawsuits in the USA. Aside from the fact that Americans might just be a combative lot, there are a couple of other important reasons for large number of lawsuits.
First, plaintiff’s lawyers typically work on a contingency fee and this means that they can be hired effortlessly with no money up front without much at stake.
Second, our legal system does NOT as a rule require that the loser pay the winner’s legal fees.
These 2 factors result in a large number of frivolous lawsuits. However, to defend these same lawsuits usually requires a hefty deposit with a reputable defense attorney.
Who is at risk?
If you’ve guessed that getting up in the morning and driving down the street generates risk, you would be correct, as does entering into contracts, leasing real property, and offering services to the general public as a going business concern.
Some activities generate more risk than others, such as construction and excavation companies verses your local friendly bookstore. However, all business activities create some risk of legal exposure.
There are two kinds of liability for businesses that I like to call “inside liability” and “outside liability”.
Inside liability refers to potential lawsuits that may be brought by customers, clients, supplies, vendors and other contracting parties.
Outside liability refers to lawsuits brought by 3rd parties against the business or the owner’s other personal assets. This concept will be discussed in more detail below.
What happens if you’re sued?
The results of a lawsuit of any kind are not pleasant for the participants. Legal papers known as a “complaint” are served through a formal process and if you fail to answer then a civil judgment is entered against you by “default”.
Otherwise, the complaint initiates a lengthy fact finding process that includes all kinds of questioning either written or verbal. This discovery culminates in a trial where either a judge or jury decides your fate.
Whether the civil judgment is entered by default or the court, they are usually enforceable against you for around 20 years and accrue a statutory rate of interest during that period.
Those seeking to enforce the judgment can dig into a nasty assorted bag of tricks which include liens upon your assets, garnishing your wages, or placing charging orders on your business entities.
Asset Protection for Business Entities
If you’ve spent any time building a business, it is most likely one of your most valuable assets. Your first line of defense against civil litigation and the unsettling series of events discussed above is a properly formed and well maintained business entity.
Business entities may ALSO be used for investments such as real estate or other hard assets.
The term “business entity” refers to a legal organization that is set up under the laws of a country or state that offers a way for a business to operate independently of any one person.
This entity will also create asset protection for the owners by shielding them from personal legal attacks related to business matters.
To create a business entity in the United States, a document must be filed with a secretary of state (of any of the 50 states) and this creates a new “legal person” or “entity” for a business or investment venture. Other formalities are usually required such as creating minutes from an organizational meeting.
Common types of business entities are limited liability companies, corporations, and limited partnerships and sometimes the various entities are multi-layered or combined.
Types of Business Entities for Business Formation and Asset Protection
Limited Liability Companies
A limited liability company (“LLC”) is arguably the most flexible entity to hold an ongoing business or investment. This is the most common entity for real estate investors due to the flexibility and favorable tax treatment AND is arguably the most favorable for asset protection purposes.
The first LLC laws were enacted in Wyoming to facilitate a type of business entity that offers both the flexibility of a partnership with the legal protection of a corporation. LLCs have evolved since that time to become a favorable asset protection strategy to corporations in many jurisdictions.
At present, some of the best states to form LLCs (just as a guide for your own research) are Wyoming, South Dakota, Delaware, and Alaska. These four states have various strong points and there are other favorable jurisdictions, so this could be the subject of debate among asset protection attorneys.
More important than the ever-evolving options available in asset protection states are the general reasons why these states are favorable. I do not recommend a particular jurisdiction because doing so involves a complex set of considerations and a full understanding the unique circumstances of the individual. However, if you understand why some states may be more favorable, you can do your research.
So, what makes Wyoming, for example, a good LLC asset protection jurisdiction? Understanding this concept also brings the need to understand some basic LLC terminology.
First, as mentioned above, there is a difference between “inside liability” and “outside liability” for business owners.
When someone associated with your business sues your business, this is inside liability.
When a personal creditor who is unrelated to your business sues your business in order to levy upon your business assets, this is outside liability.
LLCs are advantageous for both “inside liability” and “outside liability” due to what we call “charging order protection”.
Charging Order Protection
Charging order protection for LLCs is embodied in a state’s laws. Charging order protection is like garnishment order protection for businesses.
Garnishment is when a creditor wants to take a portion of your wages to satisfy a judgment, and most states limit how much they can take.
Charging order protection means that if a creditor obtains a judgment against you personally, they cannot place a lien on your LLC membership interest but must be satisfied with a charging order. The Charging order simply states that the creditor is allowed to receive income being paid from the LLC to the member.
However, a meeting of the members can result in a decision that no income will be paid to that member, and the creditor is essentially out of luck at that point. Most states offer charging order protection for LLCs and yet the key is the state’s history of backing up the protection.
In a state like Wyoming, there is a long history of enforcing the sanctity of the LLC and upholding the charging order protection against creditors even if the LLC only has one member (single member LLCs).
In weaker jurisdictions, the courts may have allowed single member LLCs to be invaded by creditors, as in Florida, so this reduces confidence in the asset protection favorability of that state.
In addition to charging order protection, an effective LLC should also have an operating agreement because this document can say whether a creditor is intended to have any rights at all.
Most folks who file a quickie LLC “on line” do not understand this concept, and this is where an asset protection attorney earns his big bucks.
The operating agreement is also like a partnership agreement in that it determines the obligations of the various members, and I highly recommend that any partnership includes an LLC with a well-prepared operating agreement, having personally observed a fair amount of partnership fallout during my legal tenure.
So, LLCs are often a great option for business asset protection due to the ease of setup and the flexibility they offer. LLCs are much more flexible than corporations because the relationship between the members can all be determined by contract just like a partnership and yet the liability protection of the members is much higher than in a partnership.
LLCs are also available in foreign jurisdictions such as Nevis or the Cook Islands. An advantage to these jurisdictions is that the charging order protection may even more powerful as these entities are technically beyond the reach of U.S. courts. However, a disadvantage might be the cost of administration and the fact that these entities are perceived as a blatant asset protection move with a business purpose taking second.
General Partnership vs. LLC
In contrast to an LLC, a general partnership will make you 100% liable for the actions of your partner and expose your personal assets to the creditors of your partnership even if you partner acts without your authorization.
A general partnership is simply an agreement between 2 or more individuals to engage in a mutual business venture. However, without the protection of a business entity, unlimited liability will follow.
LLCs address this problem because your liability for your partner’s business decisions only extends to your assets held by the LLC in most cases. LLCs are also just as easy to manage as partnerships for income tax filing and other purposes because they can be treated either as a sole proprietorship, partnership or S corporation.
All of the above is to say that there is an array of advantages to using a properly formed LLC, which includes a solid operating agreement, for asset protection and business protection purposes.
I would be remiss if I did not add that you need to follow all business formalities if you’re operating your own LLC or you need to pay someone to help you do it. Formalities include filing initial organizational meeting minutes and thereafter filing annual meeting minutes every year. You should keep an LLC book and document business changes, especially significant changes such as the addition of a new member.
A corporation may be described as a “more established” and “more formal” older brother to the LLC. A corporation is filed similarly to an LLC in that articles of incorporation are filed with the secretary of state in the state of incorporation and every state provides for the filing of corporations, as it is an important incentive for local businesses as well as an important revenue stream.
For a traditional or large organization, a corporation offers the most advantages due to the tax laws and the ability to sell securities, go public, etc.
The downside is that, in many jurisdictions, the corporation is also easier for creditors to attack because corporate stock has traditionally been subject to judgment liens and creditors have historically been able to force the sale of corporate stock in order to satisfy judgments. However, in some state legislatures have undertaken efforts to update corporate laws in order to provide more asset protection for corporations akin to the charging order protection discussed above for LLCs.
Adding “charging order type protection” for corporations in order to make corporations more like LLCs from an asset protection standpoint appears to be a trend in state law changes. Even if your state laws have not updated the asset protection benefits available to corporations, there is still asset protection for corporations because it is a separate legal entity and not the individual shareholder who is engaging in the business of the corporation.
Referring to our earlier definition of “inside liability” versus “outside liability”, asset protection for corporations is solid for inside liability and perhaps “not so solid” for outside liability protection in many jurisdictions.
LLCs have traditionally been more effective for outside liability protection due to the charging order protection discussed earlier in this chapter, and thus, if a 3rd party who is unrelated to the business sues an LLC, they cannot place a lien upon and force a sale of the membership interest. That same 3rd party may be able to place a lien and force a sale on corporate stock due to the lack of charging order protection for corporations.
It is important to check your state’s laws to determine if your corporate laws have been updated to provide this protection from 3rd party lawsuits.
Best States For Asset Protection
At present, some of the best states to form corporations (just as a guide for your own research) are the ever present Delaware, with Nevada always in hot pursuit.
Delaware tends to be favorable because all disputes involving the internal workings of DE corporations are brought in the Delaware Court of Chancery. This forum for obvious reasons tends to be business friendly.
A Nevada corporation may also offer great advantages due to their tradition of strong charging order protection for the shareholders. Nevada also affords a high degree of anonymity.
C Corp or S Corp
Other key consideration for corporations are whether they will be classified for tax purposes as a traditional “C corporation” or “S corporation”, see S Corp vs C Corp
A C corporation is usually appropriate for larger organizations or raising capital, whereas the latter is usually favorable for small businesses due to the avoidance of “double taxation”. This decision can be a bit complicated and relies upon expert tax advice. C corporations are taxed at the corporate level and the individual dividends and income paid to shareholders are also taxed.
S corporations allow income to pass directly to the owners; however, there are other tax benefits for C corporations that may outweigh the drawbacks. The other considerations concern whether different classes of shares may be needed, as this privilege is only reserved for C corporations.
The limited partnership (LP) has historically been well known in real estate investor circles because it allows one person to control the partnership (the general partner) and other partners to contribute funds and participate in profits (the limited partners). Traditionally, this structure has also placed all of the liability of the general partner for decisions made and actions taken on behalf of the partnership.
So, for asset protection purposes, the limited partners of the LP are NOT liable for the business action of the general partner, who is essentially making all of the business decisions of the LP.
An LP is filed in the state of organization, similar to LLCs and corporations, by filing a certificate of limited partnership. The partnership may be governed by a limited partnership agreement in the same way that an operating agreement is utilized for an LLC.
The LP was popular in the 1980s when tax sheltered investments were extremely popular, but all of this changed when President Reagan ushered in changes to the U.S. tax code.
The current trend is to use LLCs instead of limited partnerships because a controlling partner doesn’t need to assume unlimited liability and all of the other purposes of a limited partnership may be accomplished by allocating different “classes” of membership interest in the LLC. LLCs are often much less expensive to file than a limited partnership.
Other Asset Protection Strategies
In addition to business entities, there are a number of other areas of asset protection to know. These protections can vary by location depending upon state laws.
For example, most states offer some protection for the family home under some kind of homestead laws. These protection vary wildly with states like Texas and Florida offering a high level of protection and states like California offering much less.
Similarly, most states offer some asset protection for the cash value of life insurance policies as well as annuities.
Under ERISA (federal law) retirement accounts are also afforded asset protection and this is also usually echoed or strengthened under the state’s laws.
How assets are titled is another way to provide asset protection.
For example, in Florida if your assets are titled as husband and wife (tenancy by the entireties) they will be protected from a creditor who seeks recovery from one of the spouses.
Irrevocable trusts (“asset protection trusts”) are also a common asset protection strategy and could be the subject of a future article.
Asset protection trusts are used to protect individuals and business entities alike and are especially effect when a blend of asset protection and estate planning goals are intended.
For example, a wealthy individual can transfer a large asset or pile of money into an asset protection trust located in Delaware prior to entering into a new marital relationship. In doing so, the wealthy person created an non-marital asset that would not be subject to a future divorce.
At the same time, that wealthy person moved a substantial asset outside of his or her estate for federal estate tax planning purposes. Business entities can be placed inside of asset protection trusts if a blended strategy is desired that involves the entity.
For example, a Wyoming trustee can hold the 100% interest of a Wyoming LLC among other assets that are titled in the trust.
Other popular jurisdictions for asset protection trusts in the U.S. are Nevada, Alaska, South Dakota and Wyoming. It is important to become familiar with the pros and cons of each jurisdiction if you’re considering this option AND not to just rely upon the attorney or trustee making the sales pitch.
Other Business Considerations Related to Asset Protection
Good business entity planning also concerns important issues such as business continuation succession planning, family business succession planning, and buy-sell agreements because it is critical to decide what will happen to the business entity interest upon the disability or death of a member or shareholder.
Of course, estate planning is also a major part of your business entity and asset protection plan.
Remember, it is important to consider your business objectives AND the asset protection benefits when deciding what entity will best serve your business or will best protect your investment assets.