Business Asset Protection – How Well Does It Work?
When you are starting a business, you may read about setting up a business entity through which you will conduct your business. A big reason for doing so is to protect your personal assets from exposure to potential liabilities and claims involving the business.
You probably will consider starting a limited liability company (LLC) or corporation to house the business. In that regard, there are two main areas of concern for protecting assets – the assets of the owner or owners of the business entity and the assets held within the entity itself.
Protecting the Owners’ Personal Assets – known as ‘Piercing the Veil’
What Is It?
You’ve probably heard of the concept known as “piercing the corporate veil” or simply “piercing the veil.” But what exactly is ‘piercing the veil’ and how does it work?
The basic “black letter law” is that the owner or owners of a corporation or LLC are not liable for the debts and liabilities of and claims against the entity. This is the liability “veil” or “shield” of the entity. ‘Piercing the corporate (or LLC) veil’ is a legal principle sometimes used by courts to ignore that liability shield. What happens is that a creditor or claimant alleges the entity is being used for fraud or some other wrongful action affecting the creditor. If the court agrees, it might permit the creditor to satisfy its judgment against the assets of the owners of the corporation or LLC.
When Would a Court Permit It?
Courts look at various factors to decide whether the “veil” should be pierced, including:
- “Shell or Zombie Entity” – Not having capital or business assets appropriate to operate the entity
- “Personal Piggy Bank” – Where the owners commingle personal and company funds or assets, or perhaps consistently fail to deal with the entity on an arms-length basis
- “Winging It” on books and records – Absent or inadequate company records, including minutes or resolutions (probably not as applicable to an LLC as a corporation) and also accounting records
- “Operating Agreement? Bylaws? What Are Those?” – Not having decent internal documents: LLC operating agreement or, for corporations, bylaws and Board resolutions
The preceding factors more or less boil down to a failure to respect the corporation or LLC as a legal entity separate from the owners. The common theme running through all of the factors is this: Is the LLC or corporation truly a separate entity from its owner(s) – or is the distinction blurred?
Sadly, many if not most owners do not take proper care to maintain the distinction.
Protecting the Assets of the Business
Now let’s look at whether a personal creditor of the owner can take over the company and sell the assets of the company to satisfy a judgment. This is a bit more involved than the discussion of piercing the veil.
Let’s say you have a plumbing business and you just went and set up your own LLC or corporation. A little later, the company owns trucks and equipment and has a customer list and other business assets, all worth $250,000.
Tragically, you are involved in a terrible car accident (personal, not company) and incur a court judgment of $1 million. Your insurance covers $300,000, leaving a personal liability of $700K.
The plaintiff (judgment creditor, in legal parlance) will now go sniffing around to see what personal assets you have. You have equity in your home (in excess of the homestead exemption) plus other assets besides your stock or LLC interest, which together are worth $250,000. Therefore, your total business and personal assets are $500,000.
So, can the judgment creditor take your stock or LLC interest and take over your position in the company? If so, and if you have the sole or a controlling interest, can the creditor sell the assets and use the proceeds to satisfy the judgment?
Under most creditor rights laws, the creditor can attach and levy against – i.e. take ownership of – stock in a corporation. If you’re the sole shareholder of the corporation, your company is essentially toast and the creditor can come in and sell the assets. The same thing could happen if you’re more than a 50% shareholder.
With an LLC, things are not quite as clear. That’s partly because the LLC statutes provide the creditor a specific remedy, called a “charging order.” Borrowed from partnership law, the charging order allows the creditor to step in and get distributions from the LLC in your place. The charging order is sort of a cross between a lien and a garnishment.
But different from a corporation, in some states it is not clear whether the creditor can take over your LLC interest and become a member of the LLC. If so, and if your interest is the sole or majority interest in the LLC, the creditor may be able to sell the assets.
In other states, the LLC laws offer at least partial protection against this result. Those laws limit the creditor’s remedy to the charging order. Questions remain on whether this limitation completely prevents the creditor from taking additional actions against the judgment debtor’s LLC interest.
Your success defending against the creditor’s attack can depend on how carefully you set up the LLC. Recall in our hypothetical facts, you just went out and set it up yourself. If you are the only member (a single member LLC), the creditor’s odds improve. If you end up filing bankruptcy, the bankruptcy trustee very likely will prevail.