you own a company that manufactures widgets. Assume the company put out defective widgets into the stream of commerce that caused millions of dollars in damages and ultimately many lawsuits with verdicts against the company.
What is the liability of the shareholders, officers, and employees of the company in the above example? None. This is why corporations are used, i.e., to limit liability.
Types of Creditors. There are two main types of creditors: “Inside” and “Outside.”
Inside creditor. This is a creditor who has its exclusive remedy as one against the assets of the corporation.
Example:
Let’s use the widget example. Assume you own 100% of the stock of the company that puts defective widgets into the stream of commerce. Assume the company is sued and loses a $10,000,000 jury verdict because of these widgets.
In this example, the creditor is stuck going after only after assets inside or owned by the company and cannot go after your personal assets and are considered an “inside” creditor (this is the very reason corporations are used for asset protection purposes).
Outside creditor. This is a creditor who can go not only after a corporation’s assets, but your individual personal assets as well.
Example:
Assume you had a summer party at your lake house that has a 20 step staircase going down to a beach. Assume the hand rail used on the staircase to get down to the beach was not in working order. Assume that when someone used the handrail to go down to the beach it broke and that your friend tumbled down the stairs and sustained significant injuries (including a head injury).
The injured friend could sue you personally and go after “all” of your personal assets and therefore is considered an “inside” creditor.
Limited Liability Companies (LLCs),
Family Limited Liability Companies (FLLCs) and
Family Limited Partnerships (FLPs)
LLCs, FLLCs and FLPs are “the” tools to use when it comes to asset protection. The following material will give you the reasons from A-Z as to why an LLC, FLLC, or FLP is used by most of the asset protection gurus around the country when advising clients.
For future use in this section of the book, we will use LLC interchangeably as a term that stands for all three entities (LLC, FLLC, and FLP). For asset protection purposes, each entity works the same.
What is an LLC and How Does it Function? LLCs were first introduced in 1976 and have increased steadily with their popularity each year since their introduction. FLPs had been around for years prior to the LLC and were the traditional workhorse of asset protection and estate planning experts. But the FLP had limited applicability to a traditional business, which most of the time did not involve family members or friends, and left the general partner of the FLP liable for all debts and liabilities of the partnership.
LLCs were designed to bring together a single business organization with the best features of the pass-through income tax treatment of a partnership and the limited liability of owners in a corporation.
From a corporate operations standpoint, an LLC functions similarly to an S- or C-Corp in many ways.
Differences between LLCs and S- or C- Corporations:
1) Unlike an S- or C-Corp, instead of issuing “stock” (and stock certificates) to the owners, each owner simply owns a percent (%) interest in the LLC.
2) For tax purposes, an LLC can be treated like a sole proprietorship, partnership, S-, or C-Corp. The creator(s) of an LLC make an election of how they would like the LLC treated from a tax standpoint. If an election is not made, a default tax status will be taken by the state, which differs from state to state. For a more detailed discussion on formimg the proper entity to minimize income taxes, please see the Business Management section of this book.
3) Non-uniform income distributions. In an LLC, the members can vote to divide up the income differently than by member interest. In an S- or C-Corp, the income “distributed” (which is different than W-2 income of the employees) must be distributed in a pro-rata manner by the amount of stock everyone owns. So, if you owned 25% of the stock in an S- or C-Corp, you must get 25% of any distributions. In an LLC, the parties can vote to divide up the distributions any way they see fit.
There is minimal applicability to many companies when talking about different distributions. However, in a consulting company where one member’s worth to the LLC is significantly higher than the others, the members can vote to distribute to that key member more in the way of distributions than his/her member interest would call for on a percentage basis.
Similarities between LLCs and S- or C-Corporations
LLCs are treated the same from a corporate liability standpoint as S- or C-Corps in that professionals providing professional services still have personal liability when giving advice. LLCs also provide the standard corporate protection to shareholders and directors for negligence actions against the LLC itself.
Major Difference between an LLC and an S- or C-Corporation
The Charging Order
What is a Charging Order? A charging order is the ONLY* remedy a court of law can give a creditor who is trying to obtain the assets of a debtor when the assets are in an LLC or limited partnership. A charging order DOES NOT allow creditors to sell assets of the LLC or to force distributions of income. The best way to illustrate what a charging order does is to use an example. (Always check your state statute to make sure there have been no changes in the law since the publishing of this book.)
Example:
Creditor, Mr. Lucky, sues and obtains a $3,000,000 judgment against a professional athlete for an auto accident. The athlete has $1,000,000 worth of auto coverage and has the rest of his major personal assets owned by an LLC of which he owns 100%.
Mr. Lucky asks the court for satisfaction, and asks the court to have the athlete turn over the assets in his LLC to him. The court tells Mr. Lucky that the only remedy the court can give her is a “charging order.”
What does the charging order get Mr. Lucky in the above example? Only the right to pay the taxes on income generated in the LLC. (Explained below)
* Only a handful of states have solid charging order statutes. When using an LLC as an asset protection tool, it is vital to set one up in a state where a charging order is deemed the “sole” remedy of a creditor.
What a creditor cannot get with a charging order
1) A charging order does not transfer the interest in the LLC to the creditor or force the debtor to sell his/her interest and turn over the sales proceeds to the creditor.
2) A creditor cannot force the LLC to sell assets.
3)
