LLCs are frequently used to hold assets because of the availability of charging order protection against outside liabilities. Both LLCs and corporations provide asset protection for “inside liabilities,” that is, if a liability is created inside by that entity (e.g. the entity enters into a contract), the corporate veil will generally protect the owners of that entity from being liable for that entity’s debts. However, if the owners of the entity incur a liability “outside” of the entity (e.g. you get into a car accident having nothing to do with your entity), an LLC would be preferable to a corporation due to the availability of the charging order protection as illustrated below and discussed in this article from Mark Kohler:
The charging order laws vary depending on the state and this area is ever changing. At this time, states generally fall into three categories as far as the strength of their charging order protection laws. In states such as Wyoming, Arizona, and Texas with the strongest charging order laws, a charging order against the LLC owner’s interest is the sole remedy for a creditor seeking to attach the LLC interest to satisfy a judgment. In these states, ALL a creditor would get with a charging order is a right to receive any distributions made to the debtor/owner IF the LLC makes a distribution. The creditor would not get any management, ownership, or voting rights with a charging order. Other states that are more “middle of the road” such as Washington, California, Hawaii, and Illinois allow for the creditor to also take the next step and foreclose on the charging order, but those states are also clear that getting a charging order and foreclosure are the exclusive remedies for a creditor seeking to satisfy a judgment against a debtor’s interest in an LLC. Finally, states like Colorado, Indiana, Massachusetts, New York, and Missouri do not expressly limit a creditor’s rights to the charging order or foreclosure and so the jury is out on whether a creditor in these states could seek additional remedies such as forcing a dissolution of the LLC.
One of the primary goals of asset protection is to make it as difficult as possible for any creditor to reach your assets and the LLC is an important tool in that regard. While we cannot generally control the charging order laws of a state nor can we always predict which state’s laws will apply in any given lawsuit (see, our article on what state law applies here, we can control the internal structure and rules in our LLCs to enhance the charging order protection. If the purpose of your LLC is to protect an asset from your outside liabilities, you may want to consider some of the following strategies to enhance the charging order protection of your LLC.
Use Multiple Layers with a Holding Company
If you live in a state that has poor charging order protection, you may consider setting up a COPE (Charging Order Protection Entity) entity in a state like Wyoming that has strong charging order protection as illustrated and discussed below:
https://www.youtube.com/watch?v=xAkA8QxbGvU
Keep in mind that setting up an LLC in Wyoming, for example, does not guarantee that a court outside of Wyoming would apply their favorable laws so make sure you discuss your options with a professional.
Make your LLC a multiple member LLC
In 2010, Florida became the first state to declare that the charging order does not apply to single member LLCs. This was based on the principles underlying a charging order which historically was to prevent an innocent partner or partnership from being adversely affected by having a debtor/partner’s interest being turned over to a creditor. When there is only one member, there is no partner or partnership to protect and (so the argument goes) the charging order should not apply. In reaction to the Florida case, a small minority of states who want to be known for asset protection such as Delaware, Wyoming, and Nevada enacted laws specifically extending charging order protection to single member LLCs. However, in the wide majority of other states that do not have a specific statute or case law extending charging order protection for single-member LLCs, this is an open question. Therefore, it may be advisable in these majority of states to form your LLC as a partnership to maintain the charging order protection but consult with a professional to discuss the implications especially issues relating to partnership and tax law.
Moreover, don’t expect that putting your brother in as a 1% silent partner will necessarily enhance charging order protection. Ideally, your partner should be a partner in the true sense of the word (i.e. equal contributions, rights to vote, manage, make decisions, receive distributions, etc.) in order to not be viewed as a sham.
Place Restrictions on Distributions and Transfers
Many operating agreements will have some restrictions on transferring interests in the LLC and typically provide for automatic distributions especially around tax time which generally makes sense, but from an asset protection standpoint, provisions that require the LLC to distribute profits just guarantee that the creditor will be receiving a distribution. In general, a creditor has a right to reach anything the debtor has a right to receive and it is preferable from an asset protection standpoint that the debtor does not anticipate receiving distributions. Placing restrictions or conditions on authorizing distributions (e.g. conditioning distributions upon the vote of other members or the manager) makes it less likely a creditor will get anything and can, therefore, neutralize the impact if, in fact, a charging order is issued.
Poison Pill
If the other members of your LLC are friendly, insert a buy-out clause that is triggered upon specified collection action that grants the other (non-debtor) partners the right to buy out the debtor’s interest in the LLC at a preset (usually nominal) price. Obviously, you wouldn’t want to sell your partnership interest to a stranger and so this is usually an option only if your partners are family or close friends.
This list is certainly not exhaustive and other options do exist to make life difficult for a creditor who holds a charging order on your LLC. However, keep in mind that no asset protection strategy is 100% guaranteed, nor is there a one size fits all approach. Although there can be asset protection benefits with proper planning, there can also be consequences as well which is why you should always go over these details with a professional to determine what is right for you.