Legal Persons and Creditors' Rights

There are nine basic tax and legal “persons.” These “persons” also represent the basic ways to hold title to assets. Here is this list of players:

(1) Individual & Sole Proprietorship;
(2) Corporate (For Profits and Non-profit);
(3) Trust;
(4) Co-tenancy;
(5) Partnership;
(6) Limited Liability Company;
(7) Retirement plan;
(8) Custodian under UGMA or UTMA; and
(9) Estate.

Individual Ownership

Individual ownership does not add any asset protection. There is nothing to insulate you from creditors. You are exposed to the world of creditors.

Sole Proprietorship

The sole proprietorship form of business does not add any asset protection. If your business fails, business creditors have full recourse against all your assets.

From an asset protection viewpoint, a corporation is a better business entity. A corporation can protect personal assets from business obligations and creditors. If pass through taxation is desired, an S corporation can be adopted. However, many small business owners are unsophisticated and do not appreciate the benefits of asset protection.

Corporate

Corporations are powerful asset protection tools. When structured and maintained properly, the owners of a corporation (and its officers and directors) are not personally liable for its operations or debts. This means that an investor in the corporation only stands to lose the money or property that they put into the corporation.

However, even corporations can have an Achilles’ heel. Creditors can “pierce the corporate veil” and impose personal liability when basic formalities are not observed.

Trusts

Trusts are used for many different purposes and come in a wide variety of formats. Some trusts are used solely for probate avoidance and estate or income tax savings. There are also trusts that are designed for protection against judgment creditors. Still others try to combine all these objectives.

Co-Tenancy

Co-tenancy (or co-ownership) is common where more than one person owns an asset. However, there are various types of joint ownership of property and how you hold property with others directly impacts asset protection and tax liability.

Tenancy in Common

A tenancy in common is an undivided interest that can be transferred during life or death. Each co-tenant can sell, mortgage, will, or otherwise dispose of their interest in the property. Any of these acts can be done without the consent of the other tenant-in-common.

Since a tenant-in-common owns their interest separate and apart from the other co-tenants, this would at first appear to be an asset protection advantage. The creditors of one co-tenant would only be able to reach that co-tenant’s interest and not the interests of other tenants-in-common. However, tenant-in-common interests are undivided interests and once a creditor obtains such an interest they can bring an action to force a sale of the property and divide the proceeds. If the creditor elects not to force a sale of the property , you end up with a stranger for a co-owner.

Trusts

Trusts are used for many different purposes and come in a wide variety of formats. Some trusts are used solely for probate avoidance and estate or income tax savings. There are also trusts that are designed for protection against judgment creditors. Still others try to combine all these objectives.

Co-Tenancy

Co-tenancy (or co-ownership) is common where more than one person owns an asset. However, there are various types of joint ownership of property and how you hold property with others directly impacts asset protection and tax liability.

Tenancy in Common

A tenancy in common is an undivided interest that can be transferred during life or death. Each co-tenant can sell, mortgage, will, or otherwise dispose of their interest in the property. Any of these acts can be done without the consent of the other tenant-in-common.

Since a tenant-in-common owns their interest separate and apart from the other co-tenants, this would at first appear to be an asset protection advantage. The creditors of one co-tenant would only be able to reach that co-tenant’s interest and not the interests of other tenants-in-common. However, tenant-in-common interests are undivided interests and once a creditor obtains such an interest they can bring an action to force a sale of the property and divide the proceeds. If the creditor elects not to force a sale of the property , you end up with a stranger for a co-owner. 

Joint Tenancy with Right of Survivorship

Joint tenancy offers little asset protection. Creditors of any joint tenant can reach at a tenant’s interest in the property. Once the interest is seized, creditors can force a sale of the property.

Joint tenancy is when two or more people take title to an asset and at death the asset automatically goes to the survivor or survivors. It is a simple and inexpensive way to pass property. There is no probate or other legal proceeding involved. A will does not affect joint tenancy property because the joint tenancy title supersedes the will. However, where there is no intent to transfer the property to the survivor, complications can arise.

Partnership

While a partnership is commonly defined as an association of two or more persons to carry on as co-owners of a business for their joint profit, there are two basic partnership formats - general and limited.

General partnerships are partnerships in which each partner involves himself in the management of the company. Each general partner has joint and several liability for the actions of any other partner within the scope of the partnership business.

Limited partnerships have both general and limited partners. General partners manage the entity and limited partners are not permitted to participate in the day-to-day management of the company. However, limited partners generally have their liability limited to their capital investment.

Family Partnerships

Family limited partnerships have become a popular asset protection tool. Assets that are attractive to creditors are made unattractive by transferring them to a family partnership in return for general and limited partnership interests.

Charging Orders

Most state partnership laws limit a creditor’s remedy against a limited partner to obtaining a charging order . Such an order permits the creditor to assume the debtor partner’s position with respect to income and distributions but gives the creditor no management or liquidation rights.

Limited Liability Company

A limited liability company (LLC) is an unincorporated business entity, established under state law, in which all owners have limited liability. The primary advantage of a LLC is that, without incorporation, owners are protected from personal liability for debts of the entity. Unlike a limited partnership, where at least one general partner is personally liable, with a LLC none of the personal assets of any of the owners is subject to creditor or tort claims. In addition, with a LLC, limited liability remains whether or not the owner actively participates in the affairs of the business.

Now, some states, notably Delaware, [Delaware Code, Title 6, Subtitle II, Sec. 18-215] have amended their LLC laws to allow "series LLCs." Several other states have enacted similar LLC provisions, including Illinois, Iowa, Nevada, Oklahoma, and Utah.

A series LLC is a single LLC that divides itself into a "series" of separate divisions, each of which must keep a separate set of books, but with each such division or series operating a separate business, with its own separate limited liability, so that if the business of one series goes bankrupt, the other series or divisions of the LLC are not liable for its losses. In effect, each such "series" of an LLC is like a separate legal entity, with regard to legal liability, but only one LLC exists, thus creating only one set of taxes, tax filings, etc.

Each "series" can even have different members, managers, and ownership percentages and can make distributions to its members while other members of the LLC receive none. However, legal experts are divided, so far, as to whether other states will respect such series LLCs established under the laws of, for instance, Delaware. Also, it is not yet clear whether the IRS will allow such an LLC to file a single partnership tax return, or will treat each separate series as a separate partnership, with tax returns required for each. 

PROS AND CONS OF LIMITED LIABILITY COMPANIES:

Major benefits of LLCs over the traditional business entities that were available up till now (corporations, partnerships and sole proprietorships) include the following:

  • Unlike a general partnership, owners of an LLC have limited liability; and, unlike limited partners in a limited partnership, they do not lose their limited liability if they actively participate in management.
  • Under the IRS "check-the-box" regulations, a business that is currently a sole proprietorship is also able to change to LLC form and thus obtain limited liability, with no tax consequences or added tax compliance requirements of any kind, as the IRS will now, in effect, ignore the existence of the one-owner LLC for income tax purposes.
  • Like a regular corporation (a C corporation), an LLC provides limited liability to its owners, but taxable income or losses of the business will generally pass through to the owners (but any such losses may not always necessarily be deductible, due to the "at-risk" and "passive loss" limitations of the tax law).
  • An LLC is more like an S corporation, in that it provides for a pass-through of taxable income or losses, as well as limited liability, but can qualify in many situations where an S corporation cannot, since an S corporation cannot:
  • Also, LLC owners may be able to claim tax losses in excess of their investment, such as on certain leveraged real estate investments, which would not ordinarily be possible in the case of an S corporation or even a limited partnership.
  • LLCs are (generally) simpler entities to maintain than corporations. An LLC is required to file its "articles of organization," which are similar to articles of incorporation, but the operational similarities tend to end there. It is also a good idea for an LLC to have a written operating agreement, which spells out how the company is to be operated, much like a partnership agreement. However, from that point on, the LLC is governed by its operating agreement, and there is generally no need for any of the tedious corporate formalities such as minutes of meetings, resolutions and annual meetings of the shareholders ("members" in the case of an LLC). This operating flexibility, in addition to freedom from corporate level income tax (except in the few states that impose state income taxes on them) makes the LLC a highly advantageous form of doing business for the closely-held or family-owned business.
  • On the other hand, the federal tax treatment of LLCs is no longer uniformly favorable. Perhaps unintentionally, a partnership tax law provision that was added in the Revenue Reconciliation Act of 1993 may adversely impact professional service firms that are organized as LLCs, rather than as true partnerships. Under the 1993 tax law amendments, certain payments made by partnerships to outgoing partners (for "goodwill" or "unrealized receivables") are no longer deductible to the partnership, except when made to a general partner in a service partnership, such a a law or medical partnership.

    Since LLCs, if properly organized, are treated as partnerships for income tax purposes, this 1993 law applies equally to professional service firms that are either LLCs or partnerships.... With one important Catch-22: Since an LLC has NO general partners (all of its partners have limited liability, like limited partners), then NO payments (for goodwill, etc.) by an LLC to buy out one of its members can qualify as deductible under the 1993 tax law change. This can be a serious tax disadvantage for a professional service firm that operates as an LLC, rather than as a partnership. (Furthermore, some states with LLC laws do not allow professional service firms to operate in the LLC form.)

    Professional firms will often find it preferable to operate in the form of professional corporations, and S corporation status, rather than as LLCs, since all the earnings of a professional LLC will generally be subject to self-employment tax. If operating as an S corporation, only the salaries paid will be subject to FICA taxes (at the same rate as self-employment tax), and any remaining profit that is earned by the S corporation will be subject only to income tax, not to self-employment or FICA taxes, provided that the amount of salaries paid is not unreasonably low and subject to treatment as tax avoidance by the IRS.

    Another disadvantage of an LLC is that an LLC may need to file as a tax shelter if it has members who are treated as limited partners or “limited entrepreneurs” (persons who are not limited partners but who do not actively participate in the LLC's management).

    In addition, some states, which have corporate income taxes or franchise taxes based on income, treat LLCs as corporations for state income tax purposes. This can result in double state taxation of income in such states, if you distribute income, since the distributions will be treated as taxable dividends to the recipients, after being taxed once already at the LLC level, or, in a state like Tennessee, which has no general personal income tax, can result in at least one layer of state tax on income, which would not otherwise be incurred with either a regular partnership or a sole proprietorship.

    Also, some states impose other income-based taxes at the entity level on LLCs, just as for corporations, such as the Michigan Business Tax or the Illinois Personal Property Replacement Tax. Other business entity gross income or net income taxes such as in Washington, D.C., Washington state, New York City, New Hampshire, Texas, Kentucky, Ohio, and Washington (state), also apply equally to LLCs and to some or all other unincorporated businesses, as well as to corporations. New Mexico and Hawaii also impose gross receipts taxes that are in place of sales taxes.

    Even with the above drawbacks, LLCs seem to have many advantages that almost guarantee a continued boom in their popularity in coming years.

    Retirement Plan

    Retirement plans can be great asset protection devices depending on local state law. Many states exempt private retirement plans from execution or other legal process by judgment creditors (e.g., Calif. CCP 704.115). These provisions typically exempt from judgment creditors all amounts held or controlled by a private retirement plan for payment of retirement benefits. Some statutes even continue the exemption after the amounts are distributed to plan participants.

    In some protected jurisdictions, a distinction is made between private retirement plans maintained by corporations and self-employed plans maintained by sole proprietors and partners (e.g., Calif. CCP 704.115(e)). Appropriate state law should be consulted.

    Retirement Fund Protection in Bankruptcy

    While the U.S. Supreme Court has previously held, in Patterson v. Shumate , 112 S. Ct. 2242 (1992), that ERISA qualified plans were exempt from creditors in bankruptcy, the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 expanded the bankruptcy protections previously available for a debtor's retirement funds by providing a new federal exemption for retirement funds held in any of several types of tax-favored plans or accounts.

    Under the Act, all debtors in bankruptcy can get an exemption for retirement funds to the extent that those funds are in a fund or account that is exempt from taxation under: 401 (i.e., qualified defined benefit and defined contribution plans, including 401(k) plans); 403 (i.e., including qualified annuity plans and tax-sheltered (403(b)) annuities); 408 (i.e., including traditional IRAs, SEP-IRAs, and SIMPLE IRAs); 408A (i.e., Roth IRAs); 414 (including qualified governmental plans); 457 (i.e., including deferred compensation plans of state or local governments or tax-exempt organizations); or 501(a) (i.e., which exempts specified types of organizations from federal income tax). The most essential requirement for an exemption for retirement funds is that the plan or account (i.e., listed above) be tax-qualified as provided for under the new Act. And, other than tax-qualification and the $1 million cap on the IRA exemption, the new federal exemption is not subject to any other regular restrictions or conditions.

    Custodianship

    Custodianship is generally used for holding title on behalf of minors and is based on two uniform acts. The first is the Uniform Gifts to Minors Act (UGMA). This permits adults (often parents) to hold title to bank accounts, insurance, and securities on behalf of minors (their children). The assets that can be held in this manner are restricted. The second is the Uniform Transfer to Minors Act (UTMA). This act permits any property to be held for the minor.

    Both acts simplify family income and gain shifting. They permit a gift to be made to a minor with an adult serving as custodian. Custodian accounts under either of the uniform acts should be good asset protection tools assuming completed gifts are made. Even though the custodian can exercise control over the assets in the account, such control is exercised in a fiduciary capacity.

    Estate

    On an individual's death, a probate estate will typically be established. While most consider probate a time consuming and expensive process, probate can offer substantial asset protection.

    Probate courts have traditionally viewed the protection of spouses and family members as more deserving than that of creditors ( Hurlimann v. Bank of America , 141 CA 2d 801 (1956)). Most probate statutes bar creditor claims not filed within the time provided by law. This period is generally 4 to 6 months after the executor is appointed and notice given to creditors. The disadvantage, however, is that your estate must typically give actual written notice to all known creditors to invoke this protection.