When a person owns an asset in his or her name it is typically available to a creditor in a lawsuit unless the asset enjoys an exemption from creditors under state law. A person identified as owning valuable real property or investments may be viewed as a “deep pocket” target for litigation. Proper planning results in the individual owning relatively little in his or her name (or in his or her revocable living trust) in order to be a less inviting target.
Form of title, and state law, are critical factors in determining creditor or debtor rights. In some states, marital rights in property may affect the rights of some creditors to claim it, for example. Assets protected by bankruptcy laws are exempt from creditor claims. Even when bankruptcy is not filed, certain types of assets are protected under bankruptcy laws and exemptions. Each state has its own rules about what assets are exempt under the bankruptcy laws. Learn more about forming a Wyoming Limited Liability Corporations here.
All other assets are non-exempt assets. Non-exempt assets are the only assets a creditor can attach in a lawsuit. Non-exempt assets are the usual type of assets transferred into an LLC to accomplish an asset protection goal.
If an individual owns real estate and someone is injured on that real estate, the injured party can make a claim or sue the owner of the real estate. If the value of available liability insurance, coupled with the value of the real estate, is not enough to satisfy the claim, the injured creditor can obtain any other non-exempt assets owned by the real estate owner. This is called an “inside” liability.
Savvy real estate owners protect themselves by creating a business entity to own the real estate. Should a third party injury occur, it is the entity that will be liable to the injured party, because the entity is the owner of the property. The creditor can execute their judgment against the assets owned by the responsible LLC. A member of the entity is insulated from further claims since there is no personal liability, only entity liability. A member would only be personally liable if the “LLC veil” is pierced (i.e. the entity disregarded as a sham) or if the member entered into a personal guarantee against the risk.
Suppose the real estate owner creates a business entity and contributes real estate to it. Then the owner is involved in a car accident, and an injured third party sues the owner. Let’s assume further that the auto insurance coverage is not enough to satisfy the claim. The creditor can then look to other assets owned by the owner of the car to satisfy the claim. However, since the real estate is owned by the LLC, the creditor has no ability to levy against it.
An LLC can protect assets from personal lawsuit creditors. When a judgment is entered against a member individually, that individual member’s personal creditor generally cannot seize any assets of the LLC. Creditors of an individual member usually only have some rights to distributions from the LLC should any occur. Rights would not typically include any right to manage the WY LLC or to demand that distributions be made from it or to vote the LLC interest. LLC law generally provides a creditor with only one way to collect a judgment; this is what is referred to as a “charging order.”
A charging order allows the creditor to seize LLC distributions actually made. But there is no way for the creditor to force a distribution. The creditor would be forced to wait until a distribution was actually made to the debtor-member.
An LLC agreement generally allows withholding of LLC distributions to members in order to accumulate revenue for the reasonable needs of the LLC. This would increase the members’ capital accounts. Moreover, under IRS rules, even if a creditor didn’t receive distributions, the creditor may be required to pay the income tax associated with the LLC interest that is subject to the charging order. This leaves the creditor in the unenviable position of paying taxes on money not received.
Fraudulent transfers (also called fraudulent conveyances) are an issue in asset protection planning because creditors often claim that the property was transferred after the claim arose. The definition of a fraudulent transfer is fairly broad. A fraudulent transfer is usually a transfer that is made before or after the claim arose with the intent to defraud, hinder, or delay a known or likely creditor. Intent is generally presumed, leaving the defendant with the burden of proof that there was no fraudulent intent, and it is extremely difficult to prove a negative such as this. Courts look at “badges of fraud” including the transfer of non-exempt assets, a transfer for less than full and fair consideration, with insolvency as a consequence of the transfer. If the court determines that there was a fraudulent transfer within the applicable statute of limitations it can set aside the transfer.
The key to avoiding fraudulent transfer problems is the timing of transfers to an LLC or other asset protection entity such as a domestic or offshore asset protection trust. An asset protection system must be in place before a claim arises in order to get the best possible result. This is not to say that estate and asset protection planning cannot be done under threat of a claim. However, if a claim has arisen additional design and planning issues will need to be considered.
If a creditor has a legitimate complaint against the LLC itself, the LLC is the party sued. The creditor may satisfy its judgment with LLC assets and/or insurance. Remember this rule: A creditor can always get to the owner of an asset, and the creditor can also generally get to other assets owned by the owner. If the LLC owns real estate, a judgment creditor of the LLC can levy on the real estate. If that is all the LLC owns, then there are no other assets for the creditor to get, but if the LLC owns many assets, they would all be at risk. This arrangement will not work in all states, however, so LLC members should consult with counsel to obtain more information before implementing an arrangement of this nature.
To avoid the danger of “all eggs in one basket” an LLC may be structured with subordinate entities to own “risky” assets, i.e. those that create liability. The preferred solution is for the LLC to own one or more subordinate limited liability companies. An asset protection design can involve wholly-owned subordinate LLCs (taxable as disregarded entities) to hold risky assets. Since this is the lawsuit risk faced by the LLC, the LLC contains the risk and protects both the other LLC assets and the General Member. The LLC is the property owner, so only the assets of the LLC would be at risk. This arrangement will not work in all jurisdictions, so LLC members should consult with counsel to obtain more information before implementing an arrangement of this nature.
A creditor has three potential outcomes from a successful claim. The creditor could hope to receive LLC units, could wait until the LLC is liquidated to collect the liquidation value available, or could obtain a charging order.
LLC units are personal non-exempt property and as such would appear to be collectible. Can the creditor really get the LLC units? Since status as a member depends on the terms of the agreement, a debtor-member would first have to get permission from the other members before making the transfer to a creditor, an unlikely result. A creditor might be an assignee, but that is merely a right to receive distributions, not a right to exercise LLC rights such as voting.
Since a member has no right to take assets from the LLC, the creditor does not have the right to take assets from the LLC either. The creditor could sue the member, get a judgment, and wait until the LLC is liquidated to collect it as that member collects his or her share of the liquidated assets. If the LLC is set up to last for 50 years with a 50-year option, the creditor might not collect for almost 100 years. That is a long time to wait. Will the creditor be willing to wait years, even decades, to be able to collect? For most people, waiting until liquidation to collect is not a viable option.
Most state laws make a charging order the “sole” remedy for a creditor of a limited member. Some states have provided that the charging order is the “exclusive” remedy. The judgment creditor could collect the debtor’s share of any income distributed by the LLC.
A charging order entitles the creditor to distributions (not management fees, loans, or sale proceeds) made to the debtor Member. For this purpose the creditor is given a status that is the equivalent of an assignee of the debtor member’s interest. The IRS (Rev. Ruling 77-137) is read by many commentators to suggest that the assignee should receive a K-1 statement showing the assignee’s share of LLC income, even if no distributions of cash are made from the LLC. Since the LLC is a pass-through entity for income tax purposes, the debtor’s share of undistributed income may be taxed to the judgment creditor even though the debtor did not receive the LLC income. This type of income is sometimes referred to as “phantom income.”
The possibility of “phantom income” can provide a strong disincentive for someone who sues a person owning interests in an LLC or a strong incentive to settle early. If the creditor’s share of phantom income is a significant amount, it may throw the creditor into a higher tax bracket, and could even force the creditor to pay more in income tax in a year than he actually received in income.
Some creditors will not be deterred by a charging order. Some creditors have significant loss carry-forwards that they will never be able to use. These potential creditors are rare. A creditor with a tort judgment is the more common creditor of a limited member. When we consider who the most likely creditors might be and their commitment to forcing settlement or receiving an award, the typical creditor will usually be deterred by the tax consequences of a charging order.
Since the charging order might not be a deterrent for that particular potential future creditor, consider an asset protection trust to hold LLC units. The trust is not the same legal person as the member being sued and would not even be a proper party to the lawsuit or claim. Remember that an asset protection trust needs to be created and funded before the potential liability occurs or becomes reasonably known for the best protection.
Many creditors prefer to settle the lawsuit rather than dealing with a charging order and facing the risk of phantom income. The LLC helps to level the litigation playing field by forcing a creditor to spend at least the same amount of money pursuing the claim, as the debtor will spend defending it. With the addition of asset protection trust planning, the situation shifts even more in favor of settlement on favorable terms for the client.
Adequate liability insurance coverage for the LLC is critical. First, insurance coverage means that defense counsel will be provided. Second, insurance is the carrot that will make some creditors settle their claims in short order. Insurance proceeds provide an easy alternative to costly litigation with uncertain results.
Creation of subordinate limited liability companies (LLCs) to own risky property can be an effective tool to contain the damages resulting from a lawsuit involving the property that created the liability. Using LLCs to insulate risky assets from safe assets will make a lot of sense for individuals who have personal risk, or who serve as General Partners of limited partnerships. Risky assets held in a separate or subordinate LLC do not contaminate the safe assets held in the LLC itself, or in other LLCs, so long as the entities are operated properly.
Similarly, use of an appropriate entity Manager is an added level of protection for persons serving in that capacity. The use of an asset protection entity makes certain that no individual is exposed to personal liability. Protecting a Manager and protecting the assets of the LLC from any potential joint liability goes hand in hand.