Corporations and LLC's: Charging Orders and the Differences in Protection
|I always say that when choosing a business entity, you must evaluate the tax advantages and disadvantages BUT ALSO the level of liability protection.|
LET’S EXAMINE A COMMON SITUATION: Many attorneys recommend the corporation to their clients. For the most part, corporations will provide good protection from ‘traditional liabilities’. In other words, if the business is sued for its business activities, then I consider this a ‘traditional liability’ situation. In most instances (a properly set up and maintained corporation) will protect the owners from personal liability.
Most attorneys (myself included), who stay up-to-date with court precedents and how creditors (and collection attorneys) actually work, will tell you that a multi-member LLC will usually provide enhanced benefits. Here are a few reasons:
Less Formality = Less Mistakes
The corporation requires annual meetings and has a number of rules which create a ‘forced’ management structure. For example, every corporation is made up of a ‘tri-parte’ management structure (tri-parte means 3 levels). This means that all corporations will have to ‘force’ or channel operations through this structure of directors, officers, and shareholders. The trouble with small to mid-sized businesses is that the same person or perhaps a handful of people must occupy all of these positions. This can create confusion and more opportunity for error. The limited liability company (LLC) is simpler to operate because state law does force this ‘tri-parte’ structure upon LLC owners and employees.
LLC’s (unlike corporations) are not required to have annual meetings. Although we think LLC meetings are a good idea, you probably won’t lose your protection if you forget to have a meeting. These simplicities mean less technicalities and less confusion. It also means that there will be less mistakes available for an attorney to use against you when trying to ‘pierce’ the entity in order to hold its owners personally liable.
Charging Order Protection
Alright, let’s move forward to another VERY IMPORTANT issue. I am going to say that this is perhaps the KEY REASON why an LLC is favored in most situations. The LLC will protect you from business liabilities but it can also protect your business from personal liabilities. DID YOU CATCH THAT? We said the LLC will protect you personally from business liabilities, BUT IT CAN ALSO protect your business from personal liabilities. Ok, enough word manipulation…let’s look at a concrete example:
EXAMPLE: Let’s say that you are driving and taking your family to the park on a Sunday afternoon. Negligently, you tap someone who is crossing the street and they are slightly injured. The injured person finds a sharp and hungry personal injury attorney who ‘milks’ the case for every penny. They sue you for $1,000,000 and win. Your insurance pays out the $500,000, but there is still $500,000 owed. What happens next? The answer will depend on whether you have a corporation or LLC.
Did you know that once a judgment is obtained against you, the attorney may pass the case on to a collections specialist (an aggressive attorney who handles collections)? These attorney’s are very knowledgeable and may only focus on collections – in other words, they know the ropes. This attorney would go to the judge and request a Write of Execution. With this writ they many visit your residence or office (with the local sheriff) and begin seizing personal assets. The problem is the corporate stock shares are personal property. As a result, generally they can seize 100% of corporate stock shares.
Now you may say...’Wait a minute, my business was not involved in the accident”. “I was taking my family to the park on a Sunday”. Understand, the creditor is not trying to enter your corporation through the front door, but through the back door! Have you ever heard the _expression, “He who has the gold makes the rules?”. I don’t always agree with this, but in this situation, let’s say, “He who has the stock shares makes the rules”. In other words, if the creditor seizes your stock shares they can vote to dissolve or end the corporation. As a result, any assets in the corporation must be ‘distributed’ to you personally.
Now you may ask, “Why would anyone want to break up my corporation?”. THE REASON: Once the corporation is dissolved the assets of the corporation will be distributed to you, the owner. GUESS WHAT? Now the collection attorney will have more money to satisfy the rest of the judgment (the $500,000 still owed). Remember we discussed the importance of protecting your business from personal liabilities? The corporation won’t do that very well because of this reason: Stock shares are personal property. They can be seized if you have a personal judgment against you.
The same thing can happen if you are doing business in a corporation made up of 2 or more parties. In such an instance, a creditor who obtains enough shares could vote to dissolve the company or they could become a substituted owner. You see, you can’t control the actions of all your co-owners all the time. For this reason, there is undue risk when corporations are used (especially if there is more than one owner!).
Learn To Avoid These Traps Before They Happen!
I am a licensed attorney and attend training conferences each year to keep up with my required hours of continuing legal education. I can tell you that while I love to learn about all the updates and nuisances of setting up companies…I know that the real benefit comes from understanding how collection attorneys work. The goal is to learn what tricks they use to tear companies apart. Believe me, most will foam at the mouth when they learn the business owner is using a corporation. They are not so pleased to learn the business owner is an LLC or other ‘partnership-style’ entity.
So at this point you may be wondering how the LLC is different. This is a complex issue, but generally we can say that the laws of all states (except Pennsylvania and Nebraska) have included special rules for LLCs which allows them to be protected in this type of situation. In other words, if we had the same facts in which you hit someone on the way to the park on a Sunday and $500,000 of the judgment was not covered by your insurance, the creditor would generally not be able to gain control of your LLC. The creditor also could not vote to end the LLC, could not force a ‘distribution’, and could not break up the LLC. The creditor would be limited to a court order called a ‘charging order’.
So what is a charging order? The charging order is a specific court order that first must be granted by the judge. It is a court order which says that if any money is passed on to the owner who was involved in the accident, this money must first go to the creditor until the debt is paid off. The only problem is that the creditor does not have the right to force the LLC to make this payment. This means that the creditor could wait a very long time for such payment to be made. If your LLC is run by parties who are ‘friendly’ to your situation, they may choose to stop all distributions made to you. State law limits a creditor’s collection efforts to this charging order. Second, once the creditor obtains the charging order they may have to pay taxes on money that the LLC made, but which was not distributed to you (we call this ‘phantom income’).
What does all this mean? Generally it puts you in a much better position if such an event occurs, since it may force the creditor to try to settle the judgment debt or just drop the collection efforts. At the very least it can help keep your business intact. If you were using a corporation the end result would likely be the end of the company. If an LLC was used, managed correctly, and its owners properly reserved this charging order limitation then the result will be quite different.
A Few More Points To Consider
Here are a few other things to consider: An LLC will need to have more than one member in order to ensure this type of protection. Let’s also say that in community property states it may be useful to have someone other than your spouse (family member or close friend) own a small percentage interest in the LLC. The community property states are: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin.
Second, you must make sure that the LLC is run and managed in the correct manner. None of these protections will hold up in court unless you truly become a MASTER of good business practices and learn how to keep up with LLC formalities.
|The author, Darius M. Barazandeh, Esq. is a licensed attorney in the state of Texas. In addition to his legal knowledge he has a Masters Degree (M.B.A.) in Business Finance and brings experience from numerous fields including tax sale investing, real estate construction, corporate finance, and business consulting. Frustrated by the lack of realistic information regarding tax foreclosure sales and other investments, he is "unlocking the secrets" to many of these creative investment methods with his unique 'clear cut' writing style, attention to detail, and legal knowledge. |
Information contained within this article was not intended to be, nor should it be taken by the reader as legal, financial or tax advice. The above article was written for educational purposes only. If the services of a Texas attorney, or real estate mentor or coach are desired, please contact Darius Barazandeh or seek the services of another professional.
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