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.

Hypothetical Case

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?

Scary Answer

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.

“MARRIED … WITH LLCs” – When One or Both Spouses Are LLC Members

Have you ever tried to research the ways limited liability companies (LLCs) and the owners (called “members”) are treated when one spouse is the sole member or both spouses are members? This is one of many confusing areas of LLC law that lots of people are unfamiliar with (including, presumably, Al Bundy).

In this article, we try to clear the thicket a bit and provide a better idea of the different options. We also include a couple of handy charts to help out.

To start with, it’s necessary to distinguish the two major forms of property ownership in the United States: separate property and community property. This will necessarily be over-generalized, as the laws vary somewhat from state to state. (You may want to stop me right here and ask: “Wait a minute – aren’t we were talking about LLCs, not property?” Well, your interest in an LLC is property, personal property not real property.)

In a separate property (sometimes called ‘equitable distribution’) state, separate property is that property acquired before marriage or by gift or inheritance during marriage. The remaining property, called ‘marital property’ (or occasionally and confusingly, ‘community property’) is all other property acquired during the marriage.

Marital property can be held in the name of either or both spouses, but their respective ownership of that property is not necessarily equal. In a divorce the court can divide up that property in any manner it deems equitable, given the circumstances of the two spouses.

In a community property state, of which there are nine (plus Alaska, which allows couple to opt in to community property ownership), separate property is defined in a manner similar to that of the other states (see above). Everything else is community property, in which the spouses do have equal ownership. Thus, in a divorce, the community property is divided equally between the two spouses, subject to certain modifications for things like child support.

With that introduction, let’s lay out the similarities and differences in how LLCs are treated when one of the members is married or when both spouses are members. We’ll look at several features of LLCs:

• Management right – who has the right to manage the membership interest and the LLC?
• Economic rights – who has the equity ownership interest, the right to distributions, etc.?
• Tax status (federal income tax) – how are the LLC and the membership interests classified?
• Asset protection – which ownership type is better for asset protection purposes?

Note that these charts assume the LLC is set up during marriage.

Separate Property State

	Named Member
	One Spouse (SMLLC)	Both Spouses
Management Right	Named spouse only (with some exceptions)	Each spouse (as modified by operating agreement, otherwise by state LLC statutes)
Economic Rights	Named spouse only (subject to power of equitable division by court, in divorce)	Each spouse (as modified by operating agreement, otherwise by state LLC statutes) (also subject to equitable division)
Tax Status (federal)	Disregarded entity* (reported on Form 1040 Schedule C)	Partnership** – no disregarded entity status (but may elect corporation or S corporation tax status)
Asset Protection	Less	More
* Means no separate tax return is filed for the LLC; everything is reported on Form 1040 Schedule C. ** Means a separate Form 1065 tax return is required.

Community Property State

	Named Member
	One Spouse (SMLLC)	Both Spouses
Management Right	Named spouse only (with some exceptions)	Each spouse (as modified by operating agreement, otherwise by state LLC statutes)
Economic Rights	Named spouse (subject to other spouse’s community property interest)	Both spouses equal under community property law (but can ownership be other than 50/50?)
Tax Status (federal)	Disregarded entity (reported on Form 1040 Schedule C)	Partnership* by default, but can elect disregarded entity status (or may elect corporation or S corporation tax status)
Asset Protection	Less	More (but additional steps needed to override community property presumption)
* Means no separate tax return is filed for the LLC; everything is reported on Form 1040 Schedule C. ** Means a separate Form 1065 tax return is required.

Following are a few remarks about each of the four categories in the charts above.

Management rights – Note first that the LLC can be designated as ‘manager-managed.’ If it is, then even if only one spouse is the named member, the other spouse or a third party can be named as a manager. Second, if there is a two-spouse LLC, the management provisions under the LLC statutes may create ambiguous or awkward situations with the spouses. For these and other reasons, it is better to have an operating agreement that designates one spouse as manager or designating both spouses and providing procedures for decision-making and succession.

Economic rights – In a community property state, can ownership of the LLC ever be other than 50/50? That is, can the operating agreement provide for uneven sharing of economic rights, and what would that mean legally? Would this convert the LLC to a partnership for federal tax purposes? Also, in an equal-sharing LLC with two members that are not spouses, it is always advisable for the operating agreement to provide a buy-sell type of mechanism to handle a proposed sale or transfer by one member and to address potential deadlocks. But in a two-spouse LLC, the marital properly laws usually will take precedence over such buy-sell provisions.

Federal (income) tax status – The “check the box” Treasury Regulations don’t specifically contemplate a spousal-owned LLC as a disregarded entity. In a separate property state, a two-spouse LLC would be deemed to be a partnership under the classifications contained in the Regulations. In a community property state, the result would be unclear, because the spouses’ equal interest in the membership make it appear more like a single interest. The IRS dealt with this situation in Revenue Procedure 2002-69, stating that a community property spousal LLC can elect to be a disregarded entity; absent an election, the LLC presumably would be a partnership.

Asset protection – Single member LLCs (SMLLCs) are fundamentally more susceptible to a veil-piercing attack, as compared to a multiple member LLC. Why? Mainly because it is more difficult to maintain the separation between the entity and its owner. (See our article, Business Asset Protection – How Well Does It Work?)

What about protecting the assets of the LLC from a creditor of a member? In most states, the SMLLC is more probably more vulnerable than a multiple member entity, because in the latter, there is a second economic owner who can object to the transfer of the membership interest to the creditor. In a community property state, is a two-spouse LLC a single member or multiple member entity? (We’re referring here to state law, not federal income tax.) It is advisable to have an agreement between the spouses that the interests are separate property to reinforce the intention that the LLC have two distinct members. Having an operating agreement that covers this situation is also a key element of this protection.