Corporations provide the necessary shield of liability for operating business assets and are the most common vehicles selected for business operations. The corporate form is a more traditional form of doing business and most business operations that have hard assets like equipment and produce products utilize the corporate form.When it comes to investment assets, however, the LLC is the entity of choice. If it is a pass through entity for tax purposes because it is either a disregarded entity, taxed like a proprietorship if it is a single member LLC, or a pass through entity taxed like a partnership if it is a multi-member LLC.
In talking about liability protection we have to differentiate between Inside Creditors and Outside Creditors. Basically, Inside Creditors are those creditors who have claims against the entity that contains the assets itself. Most business owners and professionals are not only concerned with protection from Inside Creditors, but are also worried about Outside Creditors who attempt to enforce claims against the business owner or professional personally. Many business owners and most professionals face the risk of having claims directed against them personally.
Example of an inside claim
If a business owner or professional has a rental property and places that property within an LLC, then if someone gets hurt at the rental property, the claim can only be directed against the LLC and the owner’s personal assets are, therefore, protected from such inside claims. In fact, inside debt protection in and of itself is of major importance, and should be addressed by placing all real estate assets except for your personal residence within an LLC.
Example of an outside claim
If there is a malpractice lawsuit against a doctor, attorney or business professional, then there is a claim against that individual personally. If the alleged victim gets a judgment then they will attempt to go against the assets in the LLC or LP. The claimant doesn’t go directly after the assets in the beginning.
With respect to outside claims, it is important to understand the benefits of Charging Order protected entities such as LLCs and Limited Partnerships. If a creditor has a judgment against the owner/member of an LLC, the creditor’s remedy is to obtain a Charging Order against the debtor member’s interest in the LLC. A Charging Order is a like a garnishment of wages in that it attaches to the economic right of the debtor member to receive distributions from the LLC. Once the creditor has a Charging Order in place, then any distribution to the debtor member must be paid to the creditor. The benefit to the debtor member of the LLC is twofold:
- It limits the creditor from attacking the actual assets of the LLC.
- The creditor has to wait until distributions are actually made from the LLC.
In a properly drafted Operating Agreement of the LLC, the manager will have the complete discretion to withhold making distributions. Therefore, the creditor remedy of the Charging Order is effectively rendered toothless.
The problem is in many states the law or the courts allow the creditor much more leeway with respect to enforcing creditor’s remedies. Accordingly, it is important that the business owner or professional utilize an LLC from a state jurisdiction that has a more beneficial Charging Order law. Nevada, Wyoming and Arizona are such jurisdictions.