Choice of Entity from an Asset Protection Point of View
By: Roccy DeFrancesco, JD | Co-Founder: The Asset Protection Society
Recently “Accounting Today” published an article titled: The Tax Pros and Cons of S-Corp Status for Small Businesses.
I agreed wholeheartedly with the conclusion that an S-Corp is a good choice for many business owners from a tax perspective. What was missing from the article, and the reason I asked Accounting Today if I could write this article, was a look at entities from a “personal” asset protection point of view.
Generally speaking, most accountants/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:
-Personal residence (which is the most difficult asset to protect)
-Business interests (such as S- or C-Corporation stock or a Limited Liability Company)
Why do people need “personal” asset protection?
To protect from negligence lawsuits such as your garden variety car accident.
You may have heard the statistic that texting and driving is 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 where they look up from texting only to see a bike rider they almost ran over or the fact they swerved into oncoming traffic or even just ran a red light or a stop sign.
This article wasn’t written to judge people, it was written to help advisors who give them advice make sure they are aware of the best entity selection for businesses as it relates 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 and outside the scope of this article.
But what if the business owner is driving to dinner, texts someone while on his/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? It’s 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 setup 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 setup 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/her pension, etc.
What do I mean when I say the LLC needs to be set up correctly?
Not every state’s LLC statute has what I call the magic language. That language would say something like the following: 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 multi-member. 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. States like Nevada, Delaware, Arizona, Michigan, and many more.
But what about entity selection for tax purposes?
The unique thing about an LLC is that it can be taxed as a partnership, S-, or C-Corporation. You just have to file the appropriate forms to make it so.
To sum up, the article about using S-Corporations for tax purposes makes complete sense. But taxes are just one element in the selection process when determining what entity to choose. Arguably a more important element is the asset protection features of the entity and there is only one choice of entity when it comes to asset protection and that’s a multi-member LLC set up in the correct state.
If you are interested in asset protection, go to our free 50-state asset protection chart indicating if IRAs, life insurance, and annuities are protected in your state as well as the homestead exemption laws.