Many people think that great asset protection comes through using "corporations." However, what most people don't realize is that there are several different types of corporations and limited liability companies. Depending on which entity is chosen, both the asset protection and tax consequences could be different. Here are some of the types of corporations to avoid.

Sole proprietorship. This is the second worst way to own or run a small business . A sole proprietorship exists when someone operates a business without filing to have that business recognized as a legal corporate entity. With a sole proprietorship, there are no barriers between the business being done and the person owning the business. This is bad, because if a sole proprietor acting on behalf of his business commits negligence in his duties for the business that causes injury to a third person, the sole proprietor is then personally liable for any and all injuries to that third person. There is no reason for anyone ever to be a sole proprietorship.

Partnership. Partnerships are the worst entity you could possibly be involved in from an asset protection standpoint. With a partnership, you get all of the headaches and personal liability of a sole proprietorship, with the additional twist of having a partner who can make them even more of a liability.
In a partnership, each partner is liable for all the actions and debts of the other partners. If one partner takes out a loan on behalf of the partnership, even without the permission of the other partners, all partners are on the hook. This also includes cases involving individual actions. For example, if one partner sexually harasses an employee and the business gets sued for sexual harassment, the suit is against the partnership, and all partners have personal liability.

Corporation. Businesses mainly incorporate in order to avoid personal liability for the negligent actions of the corporation. This includes limited liability of the corporate shareholders, in addition to individual liability of the employees of the company
However, there is one important exception to the limited liability that goes along with corporations. This is in the area of personal services. Personal service liabilities include work that's done for or on behalf of clients by doctors, attorneys, accountants, and financial planners. The exception means that a physician who treats or operates on a patient can't hide behind the corporate veil normally providing limited liability for owners and employees working in the normal course of business. If a patient sues for malpractice, the physician is named individually, because the personal liability cannot be removed by incorporating.

Now here are the best tools to use for asset protection: They are Limited Liability Companies (LLCs), Family Limited Liability Companies (FLLCs) and Family Limited Partnerships (FLPs). In this article, the term "LLC" will be used interchangeably as a term that stands for all three entities. For asset protection purposes, each entity works in the same way.

Briefly, LLCs were designed to bring together a single business organization containing the best features of the pass-through income tax treatment of a partnership and the limited liability of owners in a corporation. LLCs also provide the standard corporate protection to all shareholders and directors for any negligence actions against the LLC itself.
LLCs are treated the same from a corporate liability standpoint as S- or C-corporations. For instance, doctors still have personal liability if they commit malpractice and a patient sues. But there is a major difference between an LLC and a corporation that relates to asset protection. This difference involves the role of a “charging order”.
A charging order is typically the only remedy a court of law can give to a creditor who is trying to get the assets of a debtor when the assets are in an LLC or limited partnership. A charging order doesn't allow creditors to sell the assets of the LLC or force any distributions of income.

Here is an example: Assume that a patient sues and obtains a judgment against a doctor for $3 million. The doctor has $1 million in medical malpractice coverage, and all the rest of his major personal assets are in an LLC, of which he owns 100%. The patient petitions the court for satisfaction, requesting the doctor be ordered to turn the assets in his LLC over to him. But the court tells the patient that because the assets are in an LLC, the only remedy it can give to him is a charging order.

What does this charging order get the patient? Something completely unanticipated and unwanted: Only the right to pay the taxes on any income generated in the LLC but not distributed (Revenue Ruling 77-173). Assuming that the patient manages to obtain a charging order against the doctor’s LLC, which owns his $1 million brokerage account and $1 million vacation home in Florida. And further assuming the doctor earns dividend income of $25,000 a year from the brokerage account and rental income of $20,000 a year. The doctor would be taking home the total $45,000 as income from the LLC and invests or spends it as he sees fit.

Because of the charging order, the doctor will leave the income in his LLC at the end of the year, which will trigger income taxes due to the patient. Because the patient has no desire to pay any taxes on income that he didn't receive, the patient will immediately release the charging order. If there is ever a distribution from the LLC, the patient would get that money, but no creditor wants to continue to pay taxes on income not received in the hope that distributions will be made at some much later date. And no defendant would make any distributions until the charging order is released. The standoff usually ends with the frustrated creditor dropping the charging order (before the tax bills start coming, of course.)

So, once again, a creditor cannot force distribution of the LLC's assets or income. The power of an LLC is derived from the fact that a creditor can only obtain a charging order against the LLC.

Now look back at what happens in an S- or C-corporation involved in a similar lawsuit. If a client's assets are held in an S- or C-corporation, the judge has a few different remedies to satisfy a creditor's request. First, the court can order a debtor's interest in an S- or C-corporation sold to satisfy the judgment. Second, the court can order the ownership interest of a debtor in an S- or C-corporation transferred to the creditor. Either way, the defendant's assets in a S- or C-corporation can be reached. There is a potential problem with single-member LLCs in some states. Although these single-member LLCs have been used for some time now, it’s wise to have another person as a 5% owner of an LLC. This setup prevents a creditor from arguing that an LLC without more than one owner should not be unable to hide itself behind a charging order as the sole remedy. If this issue is a concern in your state, then its suggested you use an FLP, which doesn't have the same potential exposure, or use a Nevada LLC, where the state statute dictates the charging order as the sole remedy for the creditor.

It should be noted that many types of assets, beyond financial accounts, can be held in LLCs. Real estate (typically a rental or vacation property) is a good candidate. So are vehicles whose involvement in an accident could create liability for other client assets. For example, a boat worth as little as $10,000 could result in massive costs to the rest of the estate if the owner of the boat drinks, drives and then injures another boater or swimmer. Almost any vehicle can be put into an LLC, including cars, boats, airplanes, jet skis, and snowmobiles. The decision to put any of these in an LLC is a matter of how much money the client wants to spend and the value of the assets. Typically, each LLC costs between $1,500 and $2,500 to establish it. Its recommended you use separate LLCs for assets with significant value.

Everyone should be able to achieve asset protection goals domestically by setting up LLCs. However, for some individuals, adding offshore planning may be considered an extra layer of protection. But it should be understood that offshore planning is more expensive and more complex. First, no one should be thinking of these trusts because they heard from a friend or read somewhere that offshore asset protection is the only way to go to protect their assets. And if they hear that they can move their assets in order to save on or avoid entirely federal income tax, they should run away! There are asset protection gurus who employ offshore asset protection trusts as their main tool., because even if their client commits fraud when moving his or her assets offshore, a U.S. court of law won't be able to gain control of the money. Therefore, it will be safe from all creditors.

It should be noted that, technically, the client has no control over the disbursement from the trust. As a result, a U.S. judge cannot demand the client bring the money back to the United States to satisfy a judgment. So, if anyone has $750,000 or more in a brokerage account, they are getting to the point where the benefits of offshore protection may start to justify the substantial costs The legal work costs as between $20 - to $30,000 to set up an offshore asset protection trust.

If you would like more information regarding asset protection, trusts, family limited partnerships or the subject of this article please call or email our office.