There are several legitimate strategies that can protect your personal assets from creditors and lawsuits. The following are levels of asset protection from the most basic and inexpensive, to the most complex, costly and often times most effective.
Level 1: Insurance Policies
There are good insurance companies on the market, and it is important to continually review coverage, rates and the quality or rating of the insurance carrier.
Level 2: Entity Protection
Forming a business entity such as a corporation or limited liability company to operate a business or hold assets is the most traditional form of asset protection. These structures generally protect owners from liabilities arising from their business operations or real estate ventures.
Level 3: Family Limited Partnerships and Irrevocable Trusts
These entities protect an individual’s personal assets from personal actions that may create liability. Assets placed in family limited partnerships or irrevocable trusts normally don’t create liability themselves. Family limited partnerships and irrevocable trusts are created to protect assets from claims coming from other areas. A family limited partnership is a very affordable and excellent asset protection tool. By using a corporation or limited liability company as the general partner, family members can participate as limited partners and make it difficult for creditors or claimants to liquidate the property.
Level 4: Fixed Annuities
Certain types of annuities have become a common strategic mechanism to protect liquid assets from volatility in the stock market and are specifically protected from the claims of creditors in several states.
Level 5: Self-Settled Trusts
Several states have recently enacted laws allowing for domestic asset protection trusts. These trusts have been patterned after offshore planning techniques and provide similar protection.
Level 6: Off-Shore Planning
As an asset protecting planning device, foreign situs trusts are generally considered to be superior to domestic trusts for several reasons. Foreign trusts enhance the ability to retain more benefits and control, they are less likely a target for domestic creditors due to geographical and jurisdictional factors, and trust law in the right foreign jurisdiction is usually more specific and protective. This type of planning is more expensive as well.
Common Liability Issues in Business and How to Avoid Them
Over 80 million lawsuits are filed every year in the United States. If you are in business you should be thinking about the risks involved. The following are some of the most common pitfalls that lead to liability and lawsuits for small business owners and how to avoid them.
Pitfall # 1: Doing Business as a Sole Proprietor
Most people who go into business do so as a “sole proprietor.” This means that they are doing business as an individual or a “d.b.a.” (doing business as). This scenario offers no asset protection and few tax benefits. If the business is sued, all of the personal assets of the individual are at risk. For a small cost, you can form a corporation to operate your business. If it is properly maintained, a corporation will shield your personal assets if the business is sued or files bankruptcy.
Pitfall # 2: Doing Business as a General Partnership
Doing business with a partner is even worse than doing business as a sole proprietor. A “partnership” is formed when two or more people decide to do business together for profit. It does not require a formal partnership agreement or the filing of any official documents, although it is often done that way. A partnership can be created even if the parties did not intend it. The main problem with general partnerships is that each partner is liable for the actions of any other partner. When any partner commits the partnership to a contract, the partnership and the other partners are all liable. If a partner is negligent or incurs a debt on behalf of the partnership, the other partners are also liable. If you intend to do business with partners, consider a corporation or other limited liability entity.
Pitfall # 3: Using a Corporation Improperly
A corporation provides protection only if you use it properly. Many people pay an attorney hundreds of dollars to setup a corporation, then they take the corporation’s minute book and stick it in the closet. A corporation will not shield you from personal liability if you do not follow corporate formalities. If the IRS audits the business, it can set aside the corporation and hold you personally liable for the taxes! At least once a year you should have your attorney and/or tax advisor review your corporate records and practices.
Pitfall # 4: Personal Guarantees
In some situations, such as a bank loan or line of credit, you must sign personally. Often vendors will request that you sign a personal guarantee of a corporate liability. If they are not extending you credit, you should simply refuse. For example, if a landlord requests a personal guarantee on a lease, offer a larger security deposit instead. Or, you can negotiate so that after two years of prompt payment, your personal guarantee is not necessary. If you choose to sign personally on an obligation, do not make the mistake of allowing your spouse to co-sign with you. Unless your spouse is involved in your business, there is no reason for a vendor or bank to require your spouse’s personal guarantee.
Pitfall # 5: Failure to Maintain Adequate Insurance
Insurance will protect you in most circumstances. If you keep the minimum insurance, increase the liability limits. You can usually double your liability insurance for a relatively small amount. Keep in mind that if your insurance is not adequate to cover the claim, the injured party can go after your personal or unincorporated business assets for the difference. Insurance also gives you an attorney in an event you are sued, even if the claim is settled before trial. Even if the lawsuit is completely unwanted, the insurance company will provide you with a lawyer, saving you thousands of dollars. Insurance does not cover all disputes, so consider a “prepaid legal plan,” especially if you have your own business.
Pitfall # 6: Sexual Harassment in the Workplace
If you own a company with employees be aware of what goes on. Even if you don’t personally engage in any conduct which is harassing in nature, you can be sued if your company permits a “hostile” environment. Make certain you have written company policies that are given to all of your employees that specifically state that sexual harassment will not be tolerated. Set up an internal complaint and investigation procedure within your company. Immediately investigate and resolve any issues within your company, especially those that involve people of the opposite sex.
Pitfall # 7: Using “Independent” Contractors
If you regularly pay “contract” employees, you may be at risk. If your “independent contractor” commits a negligent act and a third party is injured, you can be held liable. It doesn't matter whether you thought the individual was an independent contractor or an employee. The law presumes an individual to be an employee by balancing some of the following factors:
• Did the individual work your hours or his?
• Did he use your tools or does he have his own?
• Does he do work for other people, or just for you?
• Did you personally supervise the work?
• Did you pay him daily, weekly or upon completion?
• Was there a written contract?
These are only some of the factors, but you can get a general idea of what factors are relevant. If a court considers the individual to be your employee, you are responsible for his actions.
Pitfall # 8: Failure to “Get it in Writing”
Always leave a paper trail. Whenever you speak with someone at a company, the IRS or any governmental organization, get it in writing. If they won’t give it to you in writing, send them a “self-serving” follow-up letter summarizing your conversation. Their failure to object to its contents may be deemed an admission of what the letter states. Keep a copy in your file in case you have to prove the oral conversation in court. Remember, it’s not what happens, it’s what you can prove in court
Pitfall # 9: Opening Your Mouth Too Wide
If you are involved in what could potentially be a lawsuit, think before you act. Do not write offensive letters to your adversary stating your legal positions. Successful litigation involves some element of surprise. State firmly, but vaguely, that you intend to pursue your legal remedies.
Pitfall # 10: Owning All of Your Assets in One Business Entity
Don’t place all of your eggs in one basket. While a corporation or limited liability company may shield your personal assets from business liabilities, it will not shield the business’s own assets. If your business entity has a substantial amount of debt-free equipment or real estate, consider spreading out the risk. Create one or more corporations or limited companies to hold title to the assets, then have your business lease the assets back. John D. Rockefeller once said, “Own nothing, but control everything.” The more assets your business owns, the more likely it will be sued.
The limited liability company (LLC) is one of the best forms of doing business in the United States. The LLC combines the limited liability of a corporation with the pass through taxation of a partnership. LLCs are great tools for small operating businesses. While LLC’s don’t provide some of the fringe benefits available with a C-corporation, the flexibility and simplicity of ownership make it the ideal tool for a small company looking for liability protection.
LLCs are made up of members who act in a similar capacity to shareholders in a corporation. Corporations can even be a member or manager of an LLC. This allows greater flexibility than an S-corporation which places restrictions on the number of shareholders and who can be a shareholder. An LLC is considered a separate and distinct legal entity from its members. The members buy interest in the LLC with cash, property, services or the promise of payment. There can be different designations of members based on active decision makers or passive investors. If the LLC is managed by its members than it is considered “member managed”. If the LLC chooses to hire an outside manager or designate the position to a member then the LLC is considered “manager managed”.
Managing Your LLC
How the LLC is going to be managed usually depends on the long-term outlook for the company. If there are only a few active members in the LLC then you might want to have the LLC “member managed”. If you are operating multiple ventures out of one company with active and passive members then you might be better off hiring a professional manager or electing an active member to be the manager to avoid any unnecessary conflict when it comes to decisions made by the LLC. Some people will choose to have a corporation act in the capacity of the manager for the LLC. This allows income to be split between the LLC and the corporation, usually causing a favorable tax outcome.
LLCs offer flexibility in the way they are taxed. LLCs can choose to be taxed as a partnership or as a corporation. When an LLC doesn’t make an election the IRS will automatically tax the entity as a partnership, which means all the profits and losses will pass through to the member’s personal income tax return.
Flexibility in Distributions
Another benefit to having an LLC is the flexibility in distributing profits and losses to the members. Distributions of the LLC can be based on the total amount of membership interest each member has, it can be based on the amount of work the members put into the company, or a number of other flexible distribution formulas. For example, if you started a computer programming business with a partner and you contributed all the capital and your partner was the brains behind the programming but didn’t have any money, you might decide to allocate a greater percentage of the distribution to you for a few years until you receive some of your investment back and then reevaluate the situation.
Why You Would Use An LLC
Let’s say you want to buy some rental property but you know how risky it is to have tenants. So you decide to form an LLC and have the LLC buy the property. This prevents you from being held personally liable if the LLC were ever sued. For another example, a small group of family, friends or business associates decide to start a small consultation firm. Instead of forming a partnership which adds risk to everyone involved they decide to form an LLC. This provides limited liability to everyone. In addition some people are buying ownership with cash while others are going to be providing their services. Since you can adjust the distribution in the operating agreement, the people who contribute cash are going to get a higher percentage of distributions than the people who are providing services. Suppose you already own a corporation but you want to buy some property personally that the company might be using in the future. So you form an LLC and have the LLC purchase the property. In a few months the corporation decides it needs that property to expand, so the corporation leases the property from the LLC. This allows you to sell the property in the future without having to pay the additional tax generated by selling a piece of property in a corporation. You can convert a sole proprietorship or a partnership to an LLC. In many cases it’s simply a matter of forming the LLC and transferring assets in exchange for a membership interest which is not a taxable event.