I always say that when choosing
a business entity, you must evaluate the tax advantages and disadvantages
BUT ALSO the level of liability protection. LET’S LOOK AT A COMMON TRUTH:
Many attorneys recommend the corporation to their clients. For the most
part, corporations will provide good protection from ‘traditional
liabilities’. In other words, if the business is sued for its business
activities, then I consider this a ‘traditional liability’ situation. In
most instances (a properly set up and maintained corporation) will protect
the owners from personal liability.
Most attorneys (myself
included), who stay up-to-date with court precedents and how creditors (and
collection attorneys) actually work, will tell you that a multi-member LLC
will usually provide enhanced benefits. Here are a few reasons:
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LESS FORMALITY = LESS
MISTAKES: The corporation requires annual meetings and has a number of
rules which create a ‘forced’ management structure. For example, every
corporation is made up of a ‘tri-parte’ management structure (tri-parte
means 3 levels). This means that all corporations will have to ‘force’
or channel operations through this structure of directors, officers, and
shareholders. The trouble with small to mid-sized businesses is that the
same person or perhaps a handful of people must occupy all of these
positions. This can create confusion and more opportunity for error. The
limited liability company (LLC) is simpler to operate because state law
does force this ‘tri-parte’ structure upon LLC owners and employees.
LLC’s (unlike corporations) are not required to have annual meetings.
Although we think LLC meetings are a good idea, you probably won’t lose
your protection if you forget to have a meeting. These simplicities mean
less technicalities and less confusion. It also means that there will be
less mistakes available for an attorney to use against you when trying
to ‘pierce’ the entity in order to hold its owners personally liable.
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CHARGING ORDER PROTECTION:
Alright, let’s move forward to another VERY IMPORTANT issue. I am going
to say that this is perhaps the KEY REASON why an LLC is favored in most
situations. The LLC will protect you from business liabilities but it
can also protect your business from personal liabilities. DID YOU CATCH
THAT? We said the LLC will protect you personally from business
liabilities, BUT IT CAN ALSO protect your business from personal
liabilities.
Ok, enough word
manipulation…let’s look at a concrete example:
EXAMPLE: Let’s say that you
are driving and taking your family to the park
on a Sunday afternoon. Negligently, you tap someone who is crossing the
street and they are slightly injured. The injured person finds a sharp
and hungry personal injury attorney who ‘milks’ the case for every
penny. They sue you for $1,000,000 and win. Your insurance pays out the
$500,000, but there is still $500,000 owed. What happens next? The
answer will depend on whether you have a corporation or LLC.
Did you know that once a
judgment is obtained against you, the attorney may pass the case on to a
collections specialist (an aggressive attorney who handles collections)?
These attorney’s are very knowledgeable and may only focus on collections –
in other words, they know the ropes. This attorney would go to the judge and
request a Write of Execution. With this writ they many visit your residence
or office (with the local sheriff) and begin seizing personal assets. The
problem is the corporate stock shares are personal property. As a result,
generally they can seize 100% of corporate stock shares.
Now you may say...’Wait a
minute, my business was not involved in the accident”. “I was taking my
family to the park on a Sunday”. Understand, the creditor is not trying to
enter your corporation through the front door, but through the back door!
Have you ever heard the expression, “He who has the gold makes the rules?”.
I don’t always agree with this, but in this situation, let’s say, “He who
has the stock shares makes the rules”. In other words, if the creditor
seizes your stock shares they can vote to dissolve or end the corporation.
As a result, any assets in the corporation must be ‘distributed’ to you
personally.
Now you may ask, “Why would
anyone want to break up my corporation?”. THE REASON: Once the corporation
is dissolved the assets of the corporation will be distributed to you, the
owner. GUESS WHAT? Now the collection attorney will have more money to
satisfy the rest of the judgment (the $500,000 still owed). Remember we
discussed the importance of protecting your business from personal
liabilities? The corporation won’t do that very well because of this reason:
Stock shares are personal property. They can be seized if you have a
personal judgment against you.
The same thing can happen if you
are doing business in a corporation made up of 2 or more parties. In such an
instance, a creditor who obtains enough shares could vote to dissolve the
company or they could become a substituted owner. You see, you can’t control
the actions of all your co-owners all the time. For this reason, there is
undue risk when corporations are used (especially if there is more than one
owner!).
I am a licensed attorney and
attend training conferences each year to keep up with my required hours of
continuing legal education. I can tell you that while I love to learn about
all the updates and nuisances of setting up companies…I know that the real
benefit comes from understanding how collection attorneys work. The goal is
to learn what tricks they use to tear companies apart. Believe me, most will
foam at the mouth when they learn the business owner is using a corporation.
They are not so pleased to learn the business owner is an LLC or other
‘partnership-style’ entity.
So at this point you may be
wondering how the LLC is different. This is a complex issue, but generally
we can say that the laws of all states (except Pennsylvania and Nebraska)
have included special rules for LLCs which allows them to be protected in
this type of situation.
In other words, if we had the
same facts in which you hit someone on the way to the park on a Sunday and
$500,000 of the judgment was not covered by your insurance, the creditor
would generally not be able to gain control of your LLC. The creditor also
could not vote to end the LLC, could not force a ‘distribution’, and could
not break up the LLC. The creditor would be limited to a court order called
a ‘charging order’
So what is a charging order? The
charging order is a specific court order that first must be granted by the
judge. It is a court order which says that if any money is passed on to the
owner who was involved in the accident, this money must first go to the
creditor until the debt is paid off. The only problem is that the creditor
does not have the right to force the LLC to make this payment. This means
that the creditor could wait a very long time for such payment to be made.
If your LLC is run by parties who are ‘friendly’ to your situation, they may
choose to stop all distributions made to you. State law limits a creditor’s
collection efforts to this charging order. Second, once the creditor obtains
the charging order they may have to pay taxes on money that the LLC made,
but which was not distributed to you (we call this ‘phantom income’).
What does all this mean?
Generally it puts you in a much better position if such an event occurs,
since it may force the creditor to try to settle the judgment debt or just
drop the collection efforts. At the very least it can help keep your
business intact. If you were using a corporation the end result would likely
be the end of the company. If an LLC was used, managed correctly, and its
owners properly reserved this charging order limitation then the result will
be quite different.
Here are a few other things to
consider: An LLC will need to have more than one member in order to ensure
this type of protection. Let’s also say that in community property states it
may be useful to have someone other than your spouse (family member or close
friend) own a small percentage interest in the LLC. The community property
states are: Arizona, California, Idaho, Louisiana, Nevada, New Mexico,
Texas, Washington and Wisconsin.
Second, you must make sure that
the LLC is run and managed in the correct manner. None of these protections
will hold up in court unless you truly become a MASTER of good business
practices and learn how to keep up with LLC formalities.
To learn more about how you can
become a MASTER of good business practices, create, run, and maintain an
‘iron clad’ LLC please see Mr. Barazandeh’s,
Wealth Building LLC ™.
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The author, Darius M.
Barazandeh, Esq. is a licensed attorney in the state of Texas. In
addition to his legal knowledge he has a Masters Degree (M.B.A.) in
Business Finance and brings experience from numerous fields
including tax sale investing, real estate construction, corporate
finance, and business consulting. Frustrated by the lack of
realistic information regarding tax foreclosure sales and other
investments, he is "unlocking the secrets" to many of these creative
investment methods with his unique 'clear cut' writing style,
attention to detail, and legal knowledge.
Current Membership Includes:
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Real Estate, Probate, and Trust Law Division of the Texas Bar Association
-
Business Law Division of the Texas Bar Association
-
Taxation Division of the Texas Bar Association
-
Environmental and Natural Resources Division of the Texas Bar Association
-
Alternative Dispute Resolution Division of the Texas Bar Association
-
Consumer Law Division of the Texas Bar Association
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