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Corporations and Limited Liability Companies (LLC’s): Charging Orders and the Differences in Protection!
by: Darius Barazandeh
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 LOOK AT A COMMON TRUTH:
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!).
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.
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.
To learn more about how you can become a
MASTER of good business practices, create, run, and maintain
an ‘iron clad’ LLC please see Mr. Barazandeh’s, Wealth
Building LLC ™ course at
http://www.theinformedinvestor.com and
http://www.attorneysecrets.com.
I want to wish you all the best in your business and email me
if you ever need help:
taxenterprises@yahoo.com
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