How to Avoid Sabotaging your Limited Liability Company or S-Corporation – Part II
Part I of this article covered the top three mistakes people make that sabotage their Limited Liability Company or S-Corporation – not properly completing the creation of the entity, improper asset ownership, and not operating the company properly to respect its separateness.
In this second installment, we will cover mistakes four through seven– failure to isolate sources of liability, choosing the wrong legal entity, forgetting the number one asset protection tool, and failing to understand what asset protection is really all about.
4. Failure to Isolate Sources of Liability
This is another very common mistake best explained by an example. Bill and Mary own and operated a small manufacturing business. They own the building where they operated their plant, delivery trucks, and some expensive machinery that are critical to their operations.
Bill and Mary created an LLC and transferred the real estate, the equipment, and the vehicles to the entity. They set everything up properly and kept all their business affairs separate from their personal affairs. They followed the rules. A few years later, they were sued by an unhappy customer. They disputed the lawsuit but the customer won a court judgment. The plaintiff then proceeded to place a lien against their real estate, and started proceedings to seize their equipment to raise cash to pay their judgment. Next, they filed a foreclosure action on the real estate.
If Bill and Mary had set up four LLC’s instead of one, then they would have been in a very different situation. One LLC would have been for ownership of the plant, a second for the equipment, a third for the vehicles, and a fourth would have been the operating entity. This isolation of each component of their business in separate LLC’s would have protected each one from claims related to the other. A lawsuit against the operating company would not have put the equipment, vehicles, and real estate at risk. A lawsuit from a collision involving a company truck would likewise not expose the operating company, equipment, and real estate. The company would be in a much better position to negotiate a settlement to preclude a lawsuit or to pay a judgment at a reduced amount.
You do not have to be a business owner for this to apply to you. We commonly see people who own multiple investment properties and hold them all in one common LLC or S Corp. Each piece of real estate should be owned in a separate LLC.
5. Choosing the Wrong Legal Entity
Corporations that make a Sub-S Election (S Corps) protect company owners from liability for company obligations. That’s what is described as “keeping the inside creditors in”. If you have an S Corp, does the entity also keep the “outside creditors out” of the company? Or is your company exposed to risk from plaintiffs who have a court judgment against you personally?
If someone has a court judgment against you on a personal claim, then all your personally owned assets would be at risk to pay that claim. So, if you owned 1000 shares of Procter & Gamble stock, the creditor could use court proceedings to seize that stock and sell it to pay your debt.
In this respect, your stock in your small, closely held S Corp business is at risk just like your P&G stock. A creditor armed with a court judgment can actually take over your rights as a shareholder. If you are the majority or sole shareholder, that could include firing you as an employee, selling company assets, or dissolving the company to raise cash to pay your debt on the lawsuit judgment. It could mean collecting dividends (profits) from the company instead in your place.
Thus, there is no outside creditor protection from an S Corp which makes that entity less attractive than an LLC from an asset protection perspective. But there may be tax related and other concerns that make an S Corp a better fit from case to case. Is it necessary to sacrifice outside creditor protection of a business in order to get those S Corp advantages?
The answer is that an LLC can elect to be treated like it is an S Corp for income tax purposes. This is a relatively easy process done with the IRS. Talk to your CPA about the pros and cons and how to make the election.
6. Forgetting the Number One Asset Protection Tool
Setting up an LLC or S Corp for your business or investment real estate does not mean that you can ignore prudent business practices. A prudent business owner will insure his or her business from all foreseeable risks, and layer on a personal umbrella liability policy for personal assets in addition to auto and home insurance. The S Corp or LLC is still needed because not every risk in business is insurable. Plus, claims can exceed policy limits. If a claim is covered by insurance, then the lawsuit protection of your business entity and all the other issues mentioned above are never called into question.
7. Failure to Understand What Asset Protection with an LLC/S Corp is Really About
Some people believe that if they get personally sued, their LLC owned business or property is totally immune from paying a judgment against them for reasons not related to the LLC. It is true that the assets of the company will be protected from the judgment holder. However, the LLC owner will be frozen from the company’s property and from cash distributions of profits.
Asset protection planning for business and property owners involves “inside liability claims” and “outside liability claims”. Planning for inside liability claims relates to lawsuits arising from the business or property of the LLC. The creditor can only collect against the assets of the entity, not the owner’s assets or other business entities.
An outside liability claim is one where the owner of the company is sued and the plaintiff with a court judgment seeks to collect the judgment against the company’s assets. The LLC prevents the creditor with a claim against the owner from taking over control or ownership of the business. But the creditor is not without its remedies.
A plaintiff with a court judgment against an LLC will be able to get what is known as a Charging Order against the company from a court. This means that if and when there are distributions of property or money from the company intended for the owner, the plaintiff gets the money or property instead of the owner, until the judgment is fully satisfied, plus interest.
If the LLC does not make the creditor go away, then what is the benefit of having the LLC? If state law applicable to the LLC says that the member interest in an LLC cannot be foreclosed on (which means seized by the plaintiff and/or sold), then the LLC owner can simply operate the company and stop taking distributions of cash or property. The plaintiff would have nothing to take under the Charging Order. This puts the LLC owner in a better position to either prevent a lawsuit from being filed, or to negotiate a significantly reduced payment to settle a judgment. This is because a lawsuit is only as good as what the plaintiff can collect on a judgment.
It is critical to planning with an LLC that you create your LLC under the law of a state that clearly, without any doubt or room for interpretation, makes a charging order a creditor’s sole remedy on a judgment against an LLC member. Ohio is one of several states that has enacted legislation to this effect.
Know what to expect when you create an LLC or S Corp. Research your state’s law first. Conduct your business in an ethical manner and observe all applicable laws. Asset protection planning should be viewed as a safeguard to protect you and your family from economic disaster as a result of human error, and not as a way to avoid accountability.
Asset protection planning is a good idea for any business owner or rental property owner. When done correctly, it can be effective. But there are traps and landmines for the uninitiated and amateurs in this area. Assistance from a qualified lawyer is the best way to protect your business, your livelihood, your family, and your future.
This article is intended for educational purposes only, and is not meant to be a thorough and exhaustive discussion of all relevant planning and legal issues. Do not take action in sole reliance on this article. Consult a qualified lawyer in your state of residence.
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