Business Entities That Fail to Protect Your Clients
The title of this article is a question I get frequently. In most scenarios, the answer is NO. Your client won’t be able to get to their money or profits in the business. Usually, they’ll lose access to their assets, or possibly lose them entirely if they face a judgment.
Don’t let this happen to your clients. The way a business entity or asset protection plan is set up will determine what kind of lifestyle the owners will have if a partner is sued personally.
I can’t tell you how many times distressed business owners come to us after learning that their entity structure isn’t protecting them as they thought it would. Often, the entity was set up by a generalist CPA long ago, or the owner used an online program or artificial intelligence. When it comes to personal asset protection, entity choice and structure matters, and too many owners may have chinks in their armor.
Most entrepreneurs know to keep their business and personal lives separate. But corporations, limited partnerships, limited liability companies and trusts aren’t created equal when it comes to personal asset protection. Don’t rush this decision.
Illustrative Example
Let’s say a couple you’ve worked with for years has long owned a family corporation. They’re about to retire. They spend most of their time in Florida, which has great asset protection for retired clients, but they still have a summer home up north. They’re still connected to the family business, even though their oldest son is running day-to-day operations. They have a revocable trust for probate avoidance and have completed some preliminary estate tax avoidance by gifting their son some of their non-voting shares of company stock. They were looking forward to the next chapter in life until things changed on a dime.
A few weeks after arriving in Florida, the couple’s other son came for a visit with his new fiancée. One night, the young couple asked to borrow the couple’s car (owned jointly by mom and dad) to go to dinner.
After enjoying plenty of wine at dinner, the couple stopped at a local hotspot for a few more drinks. As the bar closed, the son knew he was too intoxicated to get behind the wheel. But instead of calling an Uber, his fiancée said she could drive. Unfortunately, she didn’t see a local doctor and his wife walking across the street. She hit and killed the wife and left the doctor maimed for life. The doctor and his wife left their three small children at home.
Who gets sued? Because your client owned the car jointly and the son and fiancé had very few assets, your client, with the deep pockets, gets sued.
Although your client had insurance and an umbrella policy, the umbrella doesn’t cover the doctor’s lost income, medical bills, loss of consortium and pain and suffering. Combined with the loss of life, your client’s liability is huge. Creditors subpoena your client’s assets, which show your client’s shares in their corporation, their liquidity, all their real estate and all their income coming from that same company.
If a lawsuit is filed and the plaintiffs succeed with a judgment, your client’s biggest asset, their corporate stock shares, are at risk. Many owners don’t realize that the stock of their family-owned corporation is 100% attachable by a judgment creditor because it is personally owned and lacks any statutory protection from personal creditors. It also doesn’t matter if your client’s revocable trust owned the stock because a revocable trust doesn’t provide any asset protection.
After enforcing (aka “perfecting”) their judgment against the share of the corporation, the judgment creditor, the doctor’s family and his wife’s estate, has the legal authority to take over the ownership and control of the corporation. Overnight, your client loses their golden goose, the business they spent their lifetime building, including all the cash and equipment inside the corporation. Meanwhile, the livelihoods of your client and their older son, who has dedicated his life to the family business, are in jeopardy because the business now has a new majority partner, the creditor, with all the voting control.
Why an LLC Isn’t Enough
I know what you’re thinking: the scenario above wouldn’t happen to my clients because I always recommend LLCs for their ownership structure. Just know that if the LLC is a single-member LLC, in most cases (other than an operating LLC in Wyoming, Delaware, South Dakota and Nevada) membership interests or units in a single-member LLC would have the same attachments rights as a corporation: none. If, however, your clients use multi-member LLC’s, your situation may be a bit better, but the final outcome still won’t be pretty.
In most states (other than Colorado), ownership in a multi-member LLC comes with a layer of protection called a “charging order.” In the best states, the charging order is the exclusive remedy available to a judgment creditor against a membership interest. That means, contrary to a corporation, a judgment creditor doesn’t have the authority to take over ownership of an LLC. But it does mean they can sit outside the entity for the life of the judgment (20 years in Florida) with the right to receive all distributions meant for your business owner clients. This means mom and dad still have legal title (ownership) of the LLC membership interest, but they have lost the equitable rights to take distributions. That means they can no longer live off the company’s profits until the judgment is satisfied.
The parents and son now owe a “duty of loyalty and care” to their own LLC (where they have legal ownership). But that also includes their personal judgment creditor (who has an equitable interest), where they can’t use company assets for personal benefit or gain.
Some attorneys will claim the owners can just make loans to themselves, but that can trigger a “self-dealing” or “unclean hands” argument by the judgment creditor. If the owners tried to funnel the money out in some way without paying the judgment creditor, they, and potentially anyone who assists them, could be hit with a fraudulent conveyance charge for knowingly delaying or defrauding a known creditor. In most circumstances, all distributions to members would have to be made in accordance with ownership. That means for mom, dad or the son to receive profit distributions, each would have to receive their rightful share. So, for the son to get his share of the profits, mom and dad would have to lose theirs.
Buy-Sell Agreements Aren’t Bulletproof
Maybe you’re not worried about the scenario above because you advise your clients to sign comprehensive buy-sell agreements. Maybe you hold their hands to make sure their buy-sell agreements provide for an immediate right of first refusal, or first option, to protect the business and other partners from a hostile takeover. In my experience, most buy-sells are focused heavily on death (because of life insurance sales) but are very thin on other triggers. How does an individual get rid of a personal judgment creditor? They file for bankruptcy. Well, in many buy-sell agreements, a mandatory buyout is triggered if a member files for personal bankruptcy. This is common to protect the business and other members from having a bank or creditor as a new owner.
However, if the buy-sell gives other members the option to purchase and they choose not to exercise it, the company will have to buy out the member who is going through bankruptcy. A partner’s personal bankruptcy may trigger a catastrophic liquidity event for the company, the other partners or the client. That’s because the company and other members may have to liquidate the company’s reserves to buy out the partner, thus leaving the company cash-strapped. Plus, the money used to buy out the partner would then be attached by the charging order. Now your client has lost all their equity to the judgment creditor or bankruptcy court.
Entity creation, formation and ownership are essential to a successful business operation and asset protection strategy. Your client’s assets, livelihood and family harmony are too important to rely on standard boilerplate forms or document services. Take the time to get it right with a qualified professional.
