Generally speaking, most accountants and CPAs who help clients with the choice of entity focus on the tax aspect of each entity. That makes sense, but in order to help clients make fully informed decisions about what entity to choose, “personal” asset protection should be discussed as well.
What is “personal” asset protection? It’s when someone takes steps to protect all of their valuable assets from creditors.
What assets should be protected? The major ones are a personal residence (which is the most difficult asset to protect, brokerage accounts, vacation properties and business interests (such as S or C corporation stock or a limited liability company).
People need “personal” asset protection to protect them from negligence lawsuits such as a car accident. You may have heard that texting and driving are more dangerous than drinking and driving. Even so, millions of Americans text and drive multiple times a day. There are few people you’ll run into who, if they are being truthful, won’t admit to that “oh my gosh” moment when they look up from texting only to see a bike rider they almost ran over, or they nearly swerve into oncoming traffic, or even just run a red light or a stop sign.
Advisors need to be looking out cautiously for their clients as well. As an advisor, make sure you’re aware of the best entity selection for businesses related to “personal” asset protection. Limited liability companies (LLCs) are the entity for personal asset protection.
Let me get off the board two entities that should never be used to run a business (they aren’t even entities) — they are sole proprietorships and true partnerships. Neither provides personal asset protection or limited liability from business activities.
Let’s now examine the asset protection features of S and C corporations. Both entities protect a business owner’s personal assets from the liability of the business itself. For example, if the business put out a defective product that caused harm, the business owner’s personal brokerage account or vacation property would not be at risk. The exception to this is piercing the corporate veil, which is rare.
But what if the business owner is driving to dinner, texts someone while on his or her phone, causes a car crash, and is sued for negligent driving? What can the creditor go after? All the business owner’s assets, which include S or C corporation stock.
How did the S or C corporation work from a personal asset protection point of view? Not well.
What about an LLC? If the LLC is set up properly, using the same car crash example, the creditor is not going to be able to go after the business owner’s interest in the LLC.
What makes LLCs so special when it comes to personal asset protection? They’re the remedy a court can fashion when a creditor tries to go after the asset.
With an S or C corporation, the creditor could ask the judge to force a sale of stock to satisfy the judgment or force profits of the corporation to go to the creditor. With a properly set up LLC, a judge will not be able to force the sale of the business owner’s interest or force distributions that would go to the creditor.
With a properly set up LLC, a judge will only be able to give the creditor what is known as a “charging order,” which essentially gives the creditor nothing but the ability to sit around and wait for a distribution that may never come. The business can continue as normal and pay the business owner a salary, fund his or her pension, etc.
What does it mean to have an LLC set up correctly? Not every state’s LLC statute has what I call the magic language. That language would say the “sole remedy” a creditor can receive when going after someone’s interest in an LLC is a charging order.
Additionally, the LLC needs to be multimember. Single-member LLCs, while simple and cheap, have been seen by some courts as a legal fiction and set aside for asset protection purposes.
What if your state doesn’t have the magic language in its LLC statute? No problem. You just form it in one of the states that do and then have it filed to do business in your state.
What states have the magic language? There are more and more each year as other states have gotten tired of losing fee revenue to states that do offer it. They include states like Nevada, Delaware, Arizona, Michigan and many more.
But what about entity selection for tax purposes? The unique thing about an LLC is it can be taxed as a partnership, S or C corporation. You just have to file the appropriate forms to make it so.
While taxes may be the primary focus for CPAs who help clients with entity selection, they’re just one element that needs to be considered. A second element that needs to be considered when helping clients with entity selection is asset protection. Arguably, asset protection is an even more important element to consider. If you choose to add asset protection as an element in your entity selection process, a multimember LLC set up in the correct state should be the entity of choice.
