WHAT TYPE OF LIABILITY PROTECTION DO YOU GET WITH AN LLC?
The main reason people form LLCs is to avoid personal liability for the debts of a business they own or are involved in. By forming an LLC, only the LLC is liable for the debts and liabilities incurred by the business—not the owners or managers. However, the limited liability provided by an LLC is not perfect and, in some cases, depends on what state your LLC is in.
Before you get started on your business venture, you should think about the following liability issues as an LLC owner:
* personal liability for your LLC’s debts
* personal liability for actions by LLC co-owners or employees related to the business
* personal liability for your own actions related to the business, and
* the LLC’s liability for other members’ personal debts.
- Personal Liability for Your LLC’s Debts
In all states, if you form an LLC to operate your business, and don’t personally guarantee or promise to pay its debts, you will ordinarily not be personally liable for the LLC’s debts. Thus, your LLC’s creditors can go after your LLC’s bank accounts and other property, but they can’t touch your personal property, such as your personal bank accounts, home, or car. Many creditors, however, don’t want to be left holding the bag if your business goes under so they will demand that you personally guarantee any business loans, credit cards, or other extensions of credit to your LLC. In that situation, you would be personally liable if your LLC’s assets fall short.
- Personal Liability for Actions by LLC Co-Owners and Employees
In all states, having an LLC will protect owners from personal liability for any wrongdoing committed by the co-owners or employees of an LLC during the course of business. If the LLC is found liable for the negligence or wrongdoing of its owner or employee, the LLC’s money or property can be taken by creditors to satisfy a judgment against the LLC. But the LLC owners would not be personally liable for that debt. The owner or employee who committed the act might also be personally liable for his or her actions but a co-owner of the LLC who was not involved in the act or wrongdoing would not be.
Example: While making a bread delivery to a local supermarket, Floyd, an employee of the Cheap Bakery, LLC, runs over and kills a brain surgeon in a crosswalk. It turns out Floyd was driving while drunk. Cheap Bakery is sued and found liable for its employee’s negligent actions while on the job. All of Cheap’s business property, assets, money, and insurance can be used to pay the judgment awarded to the surgeon’s heirs. Cheap LLC’s owners, however, are not personally liable for the LLC’s employee’s actions so their personal assets cannot be taken to pay any judgment against Cheap.
- Personal Liability for Your Own Actions
There is one extremely significant exception to the limited liability provided by LLCs. This exception exists in all states. If you form an LLC, you will remain personally liable for any wrongdoing you commit during the course of your LLC business. For example, LLC owners can be held personally liable if they:
- personally and directly injure someone during the course of business due to their negligence
- fail to deposit taxes withheld from employees’ wages
- intentionally do something fraudulent, illegal, or reckless during the course of business that causes harm to the company or to someone else, or
- treat the LLC as an extension of their personal affairs, rather than as a separate legal entity.
Thus, forming an LLC will not protect you against personal liability for your own personal wrongdoing that you commit related to your business. If both you and your LLC are found liable for an act you commit, then the LLC’s assets and your personal assets could be taken by creditors to satisfy the judgment. This is why LLCs and their owners should also always have liability insurance.
Example: Assume that two of the three owners of Cheap Bakery LLC (from the example above), knew that their driver was drunk, but let him make deliveries anyway. They can be sued and held personally liable by the brain surgeon’s heirs.
- Your LLC’s Liability for Members’ Personal Debts
An LLC’s money or property cannot be taken by creditors of an LLC’s owner to satisfy personal debts against the owner. However, instead of taking property directly, there are other things that creditors of an LLC owner can do to try to collect from someone with an ownership interest in an LLC. What is allowed varies state by state and includes, in order of severity, the following:
- getting a court to order that the LLC pay to the creditor all the money due to the LLC owner/debtor from the LLC (this is called a “charging order”)
- foreclosing on the owner/debtor’s LLC ownership interest, or
- getting a court to order the LLC to be dissolved.
None of these actions are good but some are much worse than others. If an LLC interest is foreclosed upon, the foreclosing creditor becomes the permanent owner of all the debtor-member’s financial rights, including the right to receive money from the LLC. If a court orders an LLC dissolved, it will have to cease doing business and sell all of its assets.
State LLC laws vary widely on how many of these steps creditors are allowed to take. All states allow creditors to obtain a charging order against an LLC owner’s interest. Many states limit creditors remedies to this first step (obtaining a charging order). Other states allow creditors to foreclose on the owner’s LLC interest or even order the LLC dissolved to pay off an owner’s debt (See, separate discussion on Charging Orders below).
- Single Member LLCs and Asset Protection
In some states, it’s not clear whether single member LLCs will receive the same liability protection from personal creditors of the LLC owner as multi-member LLCs. The rationale for limiting an LLC member’s personal creditor’s remedies to a charging order is to protect other LLC members from having to share management of their LLC with an outside creditor. There are no other LLC members to protect in a single member LLC so the rationale for limiting creditors’ remedies to a charging order doesn’t apply. For this reason, courts in some states have found that single member LLCs are not entitled to the charging order protection and creditors are entitled to pursue other remedies against the LLC member, including foreclosing on the member’s interest or ordering the LLC dissolved to pay off the debt.
- CALIFORNIA LLCS AND CHARGING ORDERS
Like all states, California allows creditors of LCC members to obtain a charging order to collect on a judgment obtained against an LLC member. A charging order directs the LLC to pay to the creditor any distributions of income or profit that would otherwise be distributed to the LLC member/debtor. Like most states, creditors with a charging order in California only obtain the owner-debtor’s financial rights and cannot participate in the LLC’s management.
Since a creditor with a charging order cannot participate in the LLC’s management, it cannot order the LLC to make a distribution or that the LLC be sold to pay off the debt. Frequently, creditors who obtain charging orders against LLCs end up with nothing because they can’t order any distributions and the LLC can choose not to make any.
Although a charging order is often a weak remedy for a creditor, it is not necessarily toothless. The existence of a charging order can make it difficult or impossible for an LLC owner/debtor or the other owners (if any) to take money out of an LLC business without having to pay the judgment creditor first.
- Creditors May Foreclose on California LLC Members
Unlike many other states, California’s LLC law does not provide that a charging order is the exclusive remedy of LLC members’ personal creditors. Rather, it allows a creditor to foreclose on the debtor-creditor’s LLC interest. Under this procedure, a court orders that the debtor-member’s financial rights in the LLC be sold.
The buyer at the foreclosure sale—often the creditor or other members of the LLC–becomes the permanent owner of all the debtor-member’s financial rights, including the right to receive money from the LLC or obtain a share of the LLC’s assets if it is dissolved. However, the buyer may not participate in the management of the LLC or order that any distributions of money or property be made. As a practical matter, getting a member-debtor’s LLC interest foreclosed upon can be an expensive and difficult undertaking; but, the ability to do so gives a creditor more leverage in dealing with the debtor. Often, the debtor/member or other LLC members will settle the claim to prevent the foreclosure.
- Dissolution Not Allowed
Like most states, California does not permit personal creditors of an LLC member to have a court order that the LLC be dissolved and its assets sold to pay off the creditor.
- One-Member California LLCs
The reason personal creditors of individual LLC owners are limited to a charging order or foreclosure is to protect the other members (owners) of the LLC. It doesn’t seem fair that they should suffer because a member incurred personal debts that had nothing to do with their LLC. Thus, such personal creditors are not permitted to take over the debtor-member’s LLC interest and join in the management of the LLC, or have the LLC dissolved and its assets sold without the other members’ consent.
This rationale disappears when the LLC has only one member (owner). As a result, court decisions and LLC laws in some states make a distinction between multi-member and single-member LLCs (SMLLCs). California is not one of these states. Nevertheless, whether, and to what extent, California SMLLCs are protected from outside creditors is not entirely clear. Moreover, in some cases the laws of other states that provide less protection to SMLLCs may be applied–for example, where a California SMLLC does business or owns property in another state. In addition, the protections that state LLC laws provide to SMLLCs might be ignored by the federal bankruptcy courts if the SMLLC owner files for bankruptcy.
If you are really concerned about protecting the assets in your California SMLLC against personal creditors, you should consider adding another member to your LLC. If you decide to do this, the second member must be treated as a legitimate co-owner of the LLC. If the second owner is added merely on paper as a sham, the courts will likely treat the LLC as an SMLLC. To avoid this, the co-owner must pay fair market value for the interest acquired and otherwise be treated as a “real” LLC member—that is, receive financial statements, participate in decision making, and receive a share of the LLC profits equal to the membership percentage owned.
- Forming Your LLC in Another State
You do not have to form your LLC in California even if it is the state where you live or do business. You can form an LLC in any state–for example, even though your business is in California, you could form an LLC in Nevada because it has a very debtor-friendly LLC law. As a general rule, the formation state’s LLC law will govern your LLC. Thus, forming an LLC in a state with a favorable LLC law, could provide you with more liability protection than forming it in California. However, doing so will increase your costs because you’ll have to pay the fees to form your LLC in the other state plus the fees to register to do business in California.
If limiting liability is extremely important to you, you may want to form your LLC in a state like Nevada, Delaware, or Wyoming that have very debtor-friendly LLC laws. But there is no guarantee that California or other courts in other states will always apply the law of the state where you formed your LLC, rather than the less favorable California LLC law. This is a complex legal issue with no definitive answer. Consult an experienced business lawyer for more specific information, applying your personal goals as the guiding force behind the LLC formation.
WFB Legal Consulting, Inc., A BEST ASSET PROTECTION Services Group–Lawyer for Business
Definition of Asset Protection Planning
Asset protection planning, means taking assets that are subject to creditors’ claims, called nonexempt assets, and re-positioning them as assets that are out of the reach of creditors’ claims, called exempt assets.
When to Begin Asset Protection Planning
Asset protection planning cannot begin when a judgment creditor is already on the horizon. State laws protect a judgment creditor against people who transfer their assets out of their names with the intent to hinder, delay, or defraud a creditor. In these situations, a court will see right through these “fraudulent” transfers and simply order that the transfers be reversed and the assets turned over to pay the creditor. Instead, asset protection planning must begin long before there is any sign of a lawsuit.
In order to put together a comprehensive asset protection plan, you will need to integrate two important goals:
- Your short term and long term financial goals, and
- Your estate planning goals.
Asset Protection and Your Financial Goals
In examining your short term and long term financial goals, you will learn about your current and future sources of income, how much money you will need to retire, and how much will be left over to pass on to your heirs through your estate plan after you die.
Once your financial goals have been examined and your financial plan is in place, you can review your current assets to determine if they are exempt from creditors and, if they are not, then re- position them to become exempt. A financial plan will also allow you to plan for positioning assets that you intend to acquire in the future to be protected from potential creditors.
Asset Protection and Your Estate Planning Goals
Once you have your financial plan in place, you will know your current net worth and an estimate of how much wealth you can expect to accumulate in the future. From this information, you will be able to create a comprehensive estate plan. This plan will address issues such as who will take care of you and your assets if you become mentally incapacitated, who will take care of your minor children if you die unexpectedly, and who will manage your assets and take care of your spouse or other family members after you die. Your estate plan can also encompass asset protection planning through the use of advanced estate planning techniques such as family limited liability companies and irrevocable trusts for you, your spouse, and your children or other beneficiaries.
Financial Planning and Estate Planning Result in Asset Protection
Once you have integrated your financial goals with your estate planning goals and positioned or re-positioned your assets to be protected from creditors, you will have a comprehensive asset protection plan in place. Then, if a creditor holding a judgment against you does show up at your front door, you will be in a better position to negotiate a quick settlement for pennies on the dollar.
The Most Common Asset Protection Mistake
Unfortunately, too many people learn far too late that asset protection planning is long term planning, not something that can be done as a quick fix. Simply, the time to put your asset protection plan together is long before a lawsuit is on the horizon.
Contribution by Kevin Kennedy
Simply put, a holding company is a business entity that exists solely to own other business entities. At first glance, this structure may seem like overkill, and in many situations it is. Owning a rental property in the name of a single properly established, maintained, and operated LLC will provide the LLC owner with limited liability for the potential debts and obligations associated with that property.
In several states (but certainly still less than half), this simple structure also does a great deal to protect the rental property from the debts and obligations of the LLC owner. In these states, if an LLC owner has some sort of judgment against him or her, the sole remedy available for a judgment creditor is the LLC owner’s interest in the LLC that owns the rental is something a “Charging Order.”
The Charging Order lets the judgment creditor step into the LLC owner’s shoes if and when the LLC makes a distribution of profit – but it doesn’t let that judgment creditor do much else. For that, and several other reasons, the Charging Order is a particularly weak remedy that many judgment creditors will simply decide not to pursue (or that they may be willing to walk away from for pennies on the dollar).
So, given the protections offered by a single LLC, when can a holding company, set up in a Charging Order State actually make sense?
1) You work in a profession that tends to get sued a lot (think doctors and engineers), and your rentals (and their associated LLC(s)) are located in a non-Charging Order State. In this situation, the holding company can be an effective barrier between the people who might sue you for malpractice and your property assets.
2) Even though you don’t work in a “high risk” profession, you are a bit of an asset protection junkie, so for you, because your assets and their associated LLC(s)) are located in a non-Charging Order State, the additional cost and paperwork of having another entity is worth the additional protection from personal creditors. Here, the holding company may have less practical effect than in number one above, but it will serve as that same barrier if you get tied up in a lawsuit you end up losing.
3) You are a bit of an asset protection junkie, and you like the idea having two layers of limited liability protection between the liabilities associated with your personal assets. In this situation, if a plaintiff in a lawsuit is for some reason able to pierce the corporate veil of the entity that owns the asset and get at the owner, they will find yet another corporate entity whose veil will also have to be pierced before they can access your personal assets to satisfy a judgment.
There is no one-size-fits-all-approach. The art and science of asset protection involves one cost/benefit analysis after another. Make sure you are seeking and following the advice of a knowledgeable professional who has your best interests at heart.
WFB LEGAL CONSULTING, INC.–A BEST ASSET PROTECTION Services Group
LAWYER for BUSINESS
5 WAYS TO PROTECT YOUR ASSETS
Make no mistake – bad things happen to good people all the time. You don’t have to be irresponsible or negligent to get sued. To protect what you have, it’s vital to take some defensive measures, to make it more difficult for creditors to seize your assets in the event you lose a lawsuit, have a judgment entered against you, or are forced into bankruptcy.
- Use Business Entities
There are a number of business entities to choose from, avoid and then seriously consider:
- Sole Proprietorships. Sole proprietorships offer no limit on personal liability. One mistake could cost you your home, depending on your state.
- General Partnerships. General partnerships are the worst. If your business partner has a personal dispute that has nothing to do with you and he or she loses a lawsuit, you two are joined at the hip. Technically, lawyers could come after you because of your partner’s actions.
- Limited Partnerships. Limited partnerships can help limit your liability. If you invest as a limited partner in a partnership, you cannot be sued for anything more than what you have invested in the business. The worst that can happen is that your investment will be wiped out. But lawyers cannot come after you personally to make good on a claim against the business. Here’s the catch: You can’t take an active role in running the business. If you do, you are a general partner, and your assets are fair game.
- Corporations. Corporations provide excellent asset protection for their owners. With the exception of cases of egregious fraud – such as if you fail to pay payroll taxes to the IRS, or if you do not treat your corporation as a separate entity from yourself – your personal assets cannot be stripped from you in the event that your business loses a lawsuit. There are two kinds of corporations: S corporations and C corporations. They are taxed differently and have different restrictions on ownership, but both provide similar asset protection for their owners.
- Limited Liability Companies. LLC’s also provide asset protection against business lawsuits for their owners, but with fewer restrictions on ownership than S corporations. They also allow their owners to choose whether to file federal taxes as a corporation or as a partnership. There is one major advantage LLCs have in some jurisdictions: charging order protection. If your corporation loses a suit, a judge could award a number of the shares of the business to the creditor. This gives them access to your books. With an LLC, even if the plaintiff gets a membership interest, he can’t force a distribution of cash, but he still gets taxed as if he received it. This “poison pill” can help you prevent a lawsuit or settle on favorable terms.
- Own Insurance
Some professions generate more exposure to liability than others. If you are a financial adviser, an OBGYN, a real estate agent, or a professional in any other field that generates a lot of lawsuits for malpractice, keep your errors and omissions coverage paid up, and, if you can afford to, invest in extra or expanded coverage. But don’t stop there – you also need to enact these kinds of coverages:
- Homeowners Insurance. helps cover you if someone is hurt on your property. Choose a deductible you can cover with your savings, and make sure liability coverage is adequate in case someone gets hurt on your property and decides to sue you.
- Commercial Liability Insurance. This type of insurance protects your business if someone gets hurt on the premises, or is injured as the result of an action by an employee.
- Worker’s Compensation Insurance. This is mandatory in most jurisdictions, including California. Worker’s compensation protects you and your workers alike by ensuring that there’s enough liquidity in place to take care of any employee who gets hurt on the job, and that the expenses don’t come out of your pocket.
- Auto Insurance. Don’t settle for the minimum legal liability coverage – additional coverage is usually affordable. Buy enough additional coverage for your auto insurance so that you will have meaningful protection in the event your vehicle is involved in an accident and generates a lawsuit. As a general rule of thumb, make sure your total liability coverage is at least equal to your total assets.
- Umbrella Coverage. is backup insurance that can be used in the instance that your other coverages are inadequate. In the event that your auto, homeowners, or other liability coverages are exhausted, umbrella coverage pays benefits up to the limit of the policy. For example, if you have $1 million in auto liability and get hit with a $2 million judgment, your umbrella policy will pick up the additional $1 million in coverage. Otherwise, the plaintiffs could start coming after you to seize assets for damages. Typically, these policies get underwritten for $1 to $5 million in face value. It’s usually very affordable.
- Long-Term Care Insurance. protects you against the financially devastating costs of in-home or nursing home care for chronic ailments, such as dementia, Alzheimer’s, strokes, paralysis, multiple sclerosis, spinal cord injuries, and the like. Medicare doesn’t provide much coverage for these afflictions, and most major medical insurance policies don’t provide any. Without long-term care insurance, you could be on the hook for more than $200 per day in nursing home costs. The longer you wait, the higher the premiums get. Additionally, you could develop an ailment that would preclude you from getting coverage, or at least make it prohibitively expensive. Alternatively, consider purchasing long-term care insurance for your parents if you’ll otherwise be on the hook for this expense.
- Use Retirement Accounts
Federal law provides unlimited asset protection to ERISA-qualified retirement plans, and up to $1 million in assets in an IRA in the event of bankruptcy. Some states provide even more protection to IRAs, though some states have opted out of the 2005 Bankruptcy Reform Act’s federal bankruptcy exemptions and exempt a lesser amount.
Check the laws in your state to see how much protection is provided to funds in these accounts. Speak to an attorney familiar with the laws in your state to determine whether creditors can opt between the state and federal exemption amounts.
If your state has a generous exemption, consider moving cash you won’t need until you reach at least age 59 1/2 into one of these protected entities. Bear in mind that you will be restricted by an annual contribution limit, which varies depending on the type of retirement plan. If you go over this limit or withdraw funds prior to age 59 1/2, you may be assessed penalties. Retirement accounts are excellent vehicles to protect long-term savings, and provide substantial tax benefits, but need to be thoroughly understood and used with care.
- Homestead Exemptions
Some states provide a lot of protection to home equity, which means that if you declare bankruptcy, the law prohibits courts from awarding home equity to creditors. In some states, state law protects an unlimited amount of home equity. Other states provide relatively little protection to home equity in the event of bankruptcy.
Examine how your home is titled. If you own your home with your spouse as tenants by the entirety, both you and your spouse own an indivisible interest in the home. If only one of you is named in a suit, creditors cannot force the other spouse to sell his or her interest in the house. Because the interest is indivisible, this can help you protect home equity where state law doesn’t provide a sufficient homestead exemption. Beware, this option is only available in some states, and it only applies to your personal residence, not investment property. Other forms of titling include tenancy in common and joint tenancy with rights of survivorship.
The way you have a property titled can have profound ramifications in the event that a creditor makes an attempt to seize it. Always speak to a lawyer for specifics concerning your situation.
Asset protection trusts are available in several US states, such as Nevada, Delaware and Alaska and foreign countries, such as the Cook Islands and Nevis. Their purpose is to keep assets out of the hands of creditors.
Assets placed inside the trust can be kept beyond the reach of the creditors of the trust beneficiary (the one who has the right to receive the money from the trust). A creditor is, in this instance, someone who won a lawsuit against you.
The settlor is the one who establishes the trust. When the trust is established you decide whether you will also be a beneficiary or the trust.
There are trust that are not self-settled such as children’s trust where you set up the trust for the benefit of your children. Laws are drafted such that neither your creditors nor your children’s can touch trust assets.
Then there are self-settled trusts where you establish the trust and maintain beneficial interest in the trust. In jurisdictions, such as the Cook Islands, Nevis and in US states such as Nevada, South Dakota, Delaware and Alaska you can form the trust, maintain beneficial interest, and statutorily enjoy protection from seizure.
Over the past 20 years, billions of dollars have been placed inside of offshore trusts. There are some choice foreign jurisdictions that have very favorable self-settled asset protection trust laws, the chief of which is the Cook Islands.
In 1997 Alaska attempted to stop some of the outflow of funds and enacted self-settled trust statutes. Afterwards, Nevada, Delaware and South Dakota followed suit. Nevada and South Dakota are the two standouts with the most favorable statutes, mainly because the assets can be shielded in as little as 6 months from the date of reasonable discovery of transfer of assets into the trust. For example, publish the transfer of assets into the trust in a small local newspaper and the assets are protected half a year later.
Before these statutes went into place the only self-settled spendthrift trusts. A spendthrift trust is one in which the trustee can prevent creditors from taking trust funds and can keep a young beneficiary, for example, from wasting the money in the trust or spending it too quickly.
Focusing on Nevada, here are some benefits of the Nevada Spendthrift Trust NRS 166.020.
- The State of Nevada does not impose personal or corporate income tax.
- If formed properly, a Nevada Irrevocable Spendthrift Trust is currently not subject to income taxes of other States if the Nevada Spendthrift Trust is qualified to do business in the other state or states.
- A Nevada Spend Thrift Trust is only subject to Federal Income Tax.
- The Settlor can change beneficiaries, or subsequently add other beneficiaries at any time. The Settlor does not need to notify any beneficiary past or present, the state of Nevada, or the Federal Government.
- In Nevada, the rights and privileges of a Spendthrift Trust are clearly defined by statute and do not depend on court decisions or interpretations for the validity of the Trust.
- State of Nevada does not charge registration fees, annual reporting fees or any other recurring fess charged for the Trust to remain valid. In addition, the Trusts are also not required to maintain a Resident Agent in the State of Nevada.
Generally…. Nevada, Delaware and Alaska Asset Protection Trusts
If the one who formed the trust, referred to as the grantor or settlor, is also a trust beneficiary, the trust can potentially provide asset protection if the following is also true about the trust:
- It is irrevocable
- It has an independent trustee (not a blood relative, controlled employee or agent of yours).
- It does not require distributions of income or principal (Instead, the payouts are subject to the trustee’s judgment.)
- It has a spendthrift clause
The above are generally accepted requirements for self-settled spendthrift trusts. Moreover, the statutes of the modern US trusts of this type also state the following:
- That the trustee needs to be someone who lives in the state where the trust is regulated or a bank or trust company that is licensed in that state.
- That some or all the trust assets are in that state (such as a bank account)
- The trust documentation and the administration must be in the state
US-Based Asset Protection Trust May Have Challenges in Bankruptcy
This is where the offshore trust shines above the domestic trusts. Bankruptcy is a federal action. The federal government has jurisdiction across all states. A domestic asset protection trust can survive bankruptcy with assets intact. That is because federal bankruptcy law obligates the courts to recognize exemptions provide for under various state laws.
However, many rulings are by the judge’s gut feeling about the case. Once a judgment is rendered the judgment creditor can start seizing assets of the debtor even before an appeal is ruled upon. Once assets are seized and you have no resources left to pay an attorney, it may be difficult to find legal counsel to protect and defend you for free during the appeal process.
So, when there is a bankruptcy, which state’s laws apply? If the court rules that Nevada or Delaware law applies because that is where the business or real property is located, the trust will shield the assets from bankruptcy.
As of this moment in legal time, the results cannot be forecast. Naturally, the judgment creditor will present arguments that support his position. The judge can rule either way. Because of the tremendous advantages offered by the Nevada asset protection trust one thing is certain: when there are significant resources at stake, the creditor is going to challenge the legitimacy of the trust.
However, if the trust is in a foreign jurisdiction such as the Cook Islands and the assets inside the trust are in a foreign bank account, the properly drafted trust deed has proven itself worthy to shield funds from creditors time and time again. On the other hand, if the assets are in the US, domestic assets, such as real estate, businesses and personal property, a domestic asset protection trust is one of the best tools available.
An unpublished Court of Appeals case in California: Kilker v. Stillman, 2012 WL 5902348 (Cal.App. 4 Dist., Unpublished, Nov. 26, 2012).
Having endured attacks on the integrity of foreign asset protection trusts, in particular those from the Cook Islands, this case illustrates the vagaries of the us legal system and should be a clear warning to those same “doubters” of the potential pitfalls of a domestic asset protection planning in the U.S – particularly when measured against the well-established laws of the Cook Islands.
This case illustrates some important aspects that planners and their clients need to be wary of when putting in place a domestic asset protection plan, whereas the same concerns do not apply with regards setting up in an offshore foreign jurisdiction such as the Cook Islands.
While the court could have invalidated the structure the debtor used under several equitable legal theories, the court in the Kilker case made a determination as to whether there was a fraudulent transfer of property under the California Uniform Fraudulent Transfers Act (“UFTA”).
- It was a case of a leaking swimming pool built by its Homeowners on advice given by a Soils Engineer. The Homeowners successfully sued the Engineer, and moved to enforce judgment. After the pool was installed but years before any problem with the pool was detected, the Engineer had transferred assets to a Nevada domestic asset protection trust which he established without the help or advice from a lawyer. T
- The Homeowners alleged that the Engineer’s transfer of an office building to the Trust was a fraudulent transfer under the UFTA. The Homeowners also claimed that the Trust was the alter ego of the Engineer. The engineer occupied the office building without a lease and rent free. In other words, none of the regular commercial formalities were employed. Moreover, when asked in his deposition to give the reason why he transferred his assets to an asset protection trust, the Engineer testified he did so for asset protection.
- The Trial Court found that the Engineer was the alter ego of the Trust, and that the office building had been fraudulently transferred to the Trust as per the UFTA. The real kicker to the case though is that the Trial Court found that even though there was no existing “claim” at the time the Engineer made his transfers, the transfer was a fraudulent transfer because the Engineer made the transfers for the stated purpose of defeating the collection rights of unknown future claimants who might come along later.
From an asset protection point of view, this judgment has far reaching ramifications. Indeed, if you’re in the business of advising on wealth preservation or estate planning for those in high risk occupations and opt for the use of domestic asset protection trusts, (in preference to a foreign asset protection trust), then you need to be, well…worried.
Understandably, the Engineer and Trust appealed the Trial Court decision and argued that the fraudulent transfer laws are not meant to encompass claims against future, unknown creditors. But the Court of Appeals rejected the notion that the UFTA is limited to only existing creditors:
The statute does not include the terms ‘future creditor’ or ‘future potential creditors’ . . . and does not require that, from the debtor’s perspective, a creditor who challenges a transfer as fraudulent under the UFTA to have been reasonably foreseeable as the debtor’s creditor before pursuing remedies under the UFTA. Furthermore, the statute does not require that the debtor intended to hinder, delay, or defraud the specific creditor who challenges a transfer of an asset as violative of the UFTA. On the contrary, section 3439.04, subdivision (a) provides that a current creditor can challenge a transfer as fraudulent, regardless whether that creditor had a claim at the time of the transfer, if that creditor can prove, inter alia, the transfer was made to hinder, delay, or defraud any creditor.
By comparison in the Cook Islands, there is no grey area when it comes to the issue of “future creditors” versus “present creditors”. Section 13B of the International Trust Act 1984 is very clear as to the rules to determine this important issue.
*Please be advised that this communication is for general public informational use only and does not establish an attorney-client relationship. For more information, please contact WFB Legal Consulting, Inc.—A BEST ASSET PROTECTION Services Group at (949) 413-6535.
A professional corporation is a special type of corporation which some state laws allow for that works like a limited liability partnership- that is, it’s a corporation owned and operated by licensed professionals, such as attorneys, accountants or doctors. With a professional corporation, each owner/shareholder has limited liability about any acts undertaken by other owners or the corporation itself. This is no different from the limited liability that applies to all other corporations. However, where there is a difference is that an owner/shareholder remains personally liable for any of their own misconduct. For example, if one owner commits malpractice and the business is subject to some judgment because of this, that owner is personally liable to the extent the corporation cannot cover the judgment.
In many states, professionals who want to incorporate their practice must form a special type of corporation called a professional corporation or professional services corporation. These professional corporations are usually similar to regular corporations, but have certain special requirements. California requires certain professionals, such as lawyers, dentists, optometrists, doctors, certified public accountants, psychologists, and psychiatrists, to create a professional corporation rather than the traditional corporation. Unlike many other states, California does not allow professionals to form a limited liability company or professional limited liability company. In California, professionals must form either a professional corporation or a registered limited liability partnership.
Single Profession Only Requirement
In California, professional corporations are governed by the Moscone-Knox Professional Corporation Act (Ca. Corp. Code Sections 13400-13410). Unless an exception applies, California professional corporations can be formed only to provide professional services (including secondary services) within a single profession. A professional service is defined as any service that requires a license issued by a California state regulatory licensing board, state court, or similar agency. To provide services, all California professional corporations must have a currently effective certificate of registration issued by the governmental agency regulating their profession.
Professional corporations are also governed by the governmental agency that is responsible for overseeing the profession they engage in. For example, the agency may have limitations on the professional corporation’s choice of name and require the professional corporation’s bylaws to specify who can be officers and own shares of the professional corporation.
Professional corporations must comply with applicable rules in the California Business and Professions Code. These rules vary by profession, but they all require that only licensed persons can be shareholders of a professional corporation. Check for any other applicable rules for your profession in the California Business and Professions Code.
Unless an exception applies, a shareholder must be licensed in the profession that the professional corporation is engaged in. However, other licensed professionals may be officers, shareholders, directors, or professional employees in specified professions, if the total number of shares owned by these other licensed professionals is not more than 49 percent of the corporation’s total shares. To see a complete list of licensed individuals who may own shares in any type of professional corporation, see Ca. Corp. Code Section 13401.5.
Corporate Director Requirements
Officers and directors of professional corporations generally must be licensed to perform the professional activity that the corporation is engaged in. Unless the corporation has less than three shareholders, California professional corporations must have at least three directors on their board. If you have only one shareholder, that shareholder can also be the only director and can also serve as the president and treasurer of the corporation. The other officers of the corporation in that situation need not be licensed professionals. A professional corporation which has only two shareholders can have those two shareholders also appointed as the only two directors. Those two shareholders between them can fill the offices of president, vice president, secretary, and treasurer of the corporation.
The name of a professional corporation in California must comply with rules governing the profession and any name requirements issued by the licensing agency for that profession. It also must be distinguishable from the name of any other business entity on file with the California Secretary of State. (See Cal. Corp. Code § 13409 for name requirements.)
You can request a free initial check on the availability of your professional corporation’s name by mailing a completed Name Availability Inquiry Letter to the California Secretary of State’s office in Sacramento. Email or online inquiries are not currently accepted. A name can be reserved for a period of 60 days by using a Name Reservation Request Form. Fees and instructions for reserving a name are included on the form, which is available on the California Secretary of State’s website.
Forming a Professional Corporation
To form a professional corporation in California, you must file articles of incorporation with the California Secretary of State, along with applicable filing fees. There is a specific form for professional corporations on the California Secretary of State’s website (go to the Business Entities page and click on the Forms, Samples & Fees link to find the form). Follow the instructions provided with the form for completing and filing your articles of incorporation. Your articles must include the corporate name, corporate purpose, corporate agent for service of process, corporate street address and mailing address, and number of stock shares. If an individual person is listed as the agent for service of process, the agent’s California street address must be included, along with a California street address (not a post office box address) where documents may be served. The articles must contain a statement that the corporation is a professional corporation under California law.
The corporation must file a Statement of Information, along with applicable filing fees, within 90 days of filing the articles of incorporation and then annually thereafter during the applicable filing period. The filing period is defined as the calendar month in which the original articles of incorporation were filed and the previous five calendar months.
LAWYER FOR BUSINESS: WFB LEGAL CONSULTING, INC.—A BEST ASSET PROTECTION SERVICES GROUP
THE S-CORP AND PARTNERSHIP PERSPECTIVE OF AN LLC
An LLC can be a great stepping stone for a new business owner if the owner sees a potential for growth and the need to save on Self-Employment tax, or the owner has some liability exposure from the operation and needs a formal entity to legitimize the business.
In this situation an LLC can be a great starting place and even help keep costs down. This type of structure typically involves a Single-Member LLC. A SMLLC is a 100% owned LLC by a one individual (or entity) and offers a unique cost saving benefit. The owner gets asset protection, yet no extra tax return. The owner can report the operations of the LLC on the owner’s tax return. If the owner is an individual, the owner can choose to make an S-Election retroactively to the beginning of any tax year without a timing problem.
By the way, filing an LLC isn’t simply filing a single piece of paper with the State. It’s important for the owner to treat the formation and maintenance of an LLC similar to that of a corporation in order to receive the same type of protection.
An LLC is also excellent for partnerships. It protects a partner from the actions of the other partner and allows for more efficient tax planning. In fact, the LLC creates a mechanism to document all of the agreements and terms for their partnership. Far too many business owners partner with others on a hand shake, email or some scribbles on a lunch napkin.
An LLC can be used on the ‘operations side’ with the partners each having their individual ownership held by an S-Corp. This allows each partner to take additional tax write-offs, utilize the S-Corp for other sources of revenue, and most importantly establish their own payroll levels to save on Self-Employment taxes, or even create a 401k or health plan.
The ownership of the LLC could also be put in the name of the trust of a partner. After a partner has stepped up to the plate with asset protection by way of the benefits of an LLC, the partner should also be thinking of family, loved ones, or charities, and who would inherit their share of the LLC upon their passing.
Again, one can see that simply clicking a button on an incorporation website can do more harm than good without some comprehensive planning. The possibilities of an LLC can be extremely powerful and helpful in a well-designed tax and asset protection plan. However, without any coordinated planning the LLC may not even be worth the paper it’s printed on and actually create unseen costs.
LLC’S AND LIMITED LIABILITY PROTECTION: A PRIMER FOR THE SMALL BUSINESS OWNER
Contribution by Kevin Kennedy
The LLC or an s-corporation are typically the preferred business entities of choice for the entrepreneur / small business owner. This article focuses on the LLC. An LLC typically consists of Owner/Member(s) and a Manager(s), although an LLC could be setup as Member-Managed. One reason for its popularity is that the LLC provides limited liability for the Member(s) and Manager(s). Hence, the purpose of this article is to help the small business owner recognize the benefits and the limitations of the limited liability that an LLC provides to the owner(s) and manager(s). First, the Owner/Member:
LLC Owner/Member Liability
- Cash Investment (Capital Contribution). An Owner/Member of an LLC is always at risk to lose their cash investment in the business. An LLC cannot prevent that. If the business fails, the Owner(s)/Member(s) lose(s) their cash. But that is typically the extent of their exposure.
- Liability to the Other Owners/Members. Typically, except for criminal acts or gross negligence, an Owner/Member is not personally liable to the other Owner(s)/Member(s) of the LLC.
- Liability to Third Parties under Contract Law. Generally, a contract signed by the LLC on behalf of the LLC Manager(s) does not expose an Owner/Member to personal liability. However, this is only true if the contract does not require a personal guaranty, e.g., in the context of a business loan or other financing. In such an event, the Owner/Member who personally guarantees the loan will be personally liable for the debt obligation.
- Liability to Third Parties under Tort law. An Owner/Member of an LLC is not liable for a tort committed by the Company or under the direction of the LLC Manager, or for a tort committed by the LLC Manager acting outside the scope of the Manager’s authority. However, an LLC is not a license for an Owner/Member to act criminally or even negligently, especially if the LLC is such that the Owner/Member is also the LLC Manager and/or has direct dealings with third parties on behalf of the LLC, such as if the LLC is Member-Managed. In such a situation, if the Owner/Member has in fact taken action that results in a tort against a third party, there can be personal liability.
- Liability to Third Parties as a Professional. If the Owner(s)/Member(s) of an LLC is/are licensed professionals, such as doctors, lawyers, accountants, etc., an LLC will not protect from malpractice and related negligence. This is a good example of how insurance is always important regardless of the form of business.
The manager(s) of an LLC is also protected from liability in certain respects, similar to the CEO or Chairman of a corporation. The policy behind this protection is so a company can recruit the best and brightest individuals to manage and run the day-to-day operations of the company without being exposed to personal liability:
LLC Manager Liability
- Liability to the Owners/Members under Fiduciary Law. Typically, the LLC Manager has a fiduciary duty to the Company and therefore serves the interest of the Owners/Members as a whole. If the LLC Manager breaches that fiduciary duty, there can be liability. In short, a fiduciary duty means a duty of care and a duty of loyalty. In the case of duty of loyalty, that means a duty to subordinate self-interest to the interest of the LLC, such that any conflict of interest must be disclosed, although a conflict of interest that has been disclosed can typically be waived in the LLC Operating Agreement.
- Liability to Third Parties under Contract Law. A Manager who signs a contract in its role as Manager on behalf of the LLC has no personal liability to the other party(ies) to the contract. But as mentioned previously, this is only true if the LLC Manager does not personally guarantee the contract, whether the contract is a loan, lease, etc., and only if the LLC Manager is authorized to enter into such a contract on behalf of the LLC.
- Liability to Third Parties under Tort Law. Typically, a Manager is indemnified by the LLC for actions the Manager takes that are within the scope of her role as Manager. This is one of the benefits of having an LLC because it allows a Manager to run the business without fear of personal liability. But, a Manager may be held personally liable for criminal action and intentional actions that are outside the scope of its authority.
As you can see, LLC liability is not as simple as it is sometimes described. Also, this article is focused on personal liability of LLC Owners and Managers. The liability of the Company is another matter, such as when the actions of an employee of the Company result in liability for the Company under the legal principle of Respondeat Superior, which is Latin for, “don’t hire dummies” (it’s actually Latin for, “let the master respond.”) But fortunately, with an LLC or other business entity type that limits the liability of the owners, only the Company and not the Owner is liable for the negligent actions of the employees.
However, beware that in rare situations, an LLC will be disregarded by a judge in a lawsuit involving the business. If that happens, all of the benefits of the LLC discussed herein are also disregarded. This might happen if the LLC is being used to perpetuate a fraud, circumvent the law, or some other illegitimate purpose. This also might happen if the LLC is setup to be insolvent, i.e., not adequately capitalized, or personal and business interests are commingled to the extent that the LLC has no separate identity.
Also, please note that some of what has been discussed herein can be modified in the LLC Operating Agreement, except where prohibited by law. Additionally, LLC’s are typically governed under state law, which are not uniform across the Country.
In sum, the LLC provides liability protection but it is not the end-all, be-all and should be used in concert with insurance in all its forms, e.g., liability, errors & omissions, etc. Our office regularly assists small business owners and real estate investors with all of the questions that should be asked when considering an LLC.
CAN A CORPORATION BE A MEMBER IN AN LLC?
Starting and running a business as an LLC (Limited Liability Company) offers some advantages to business owners who want liability protection, taxation flexibility, and credibility without complexity. Next to a sole proprietorship, it’s the business legal structure that’s least complicated and void of cumbersome formality. But if you’ve already formed or are forming a corporation, can that entity be a member of your LLC? And what could that accomplish for you?
Most states allow for other types of business entities (not only individuals) to serve as members of LLCs. Generally, there are very few restrictions limiting a corporation from being an LLC member. A corporation doesn’t even have to be incorporated in the same state as the one in which the LLC is organized.
In What Situations Does It Make Sense?
By having your corporation as a member of your LLC, you create an additional level of ownership, which may enable you to offer traditional perks such as retirement plans and give you added protection from liability. Like individuals who are members/owners of LLCs, corporate LLC owners can also take advantage of pass-through federal tax treatment.
Probably the most common situation in which a corporation will serve as the member of an LLC is in the scenario of a business owner creating a holding company and an operating company. The holding company owns all of the business assets and then leases them to the operating company, which uses them to run the business. In such a situation, a corporation could be the holding company and be a member of the LLC, which would be the operating company.
What Restrictions and Requirements Apply?
Although most states don’t place many requirements on members of an LLC, some do more closely regulate membership in a professional limited liability company (PLLC). Members of PLLCs (LLCs formed to offer professional services) often must be licensed professionals in their fields, therefore preventing corporations from serving as members of PLLCs.
Depending on which state you operate in, you may or may not need to disclose who your LLC’s members are. While some states don’t mandate an LLC to disclose its members, others demand that the LLC disclose its managers—so if an LLC is member-managed, it needs to disclose its members. Where required to disclose its membership, an LLC with a corporation that is a member will need to provide the corporation’s name, physical address and percentage of ownership in the LLC.
According to the State of California Franchise Tax Board, an LLC may be owned by any combination of individuals or business entities. There are no restrictions on ownership in the California statute and the California Corporations Code provides that “any” applicant can reserve a name for future registration as an LLC.
Furthermore, it is important to recognize that where a combination of ownership interests exist, California law requires that the members of a multiple-member LLC enter into an operating agreement prior to filing the articles of organization; the business must keep a copy of the current agreement at all times. Failure to have a copy of the agreement is one factor considered in piercing the veil of limited liability.
Currently, California Corporations Code sections 1502 and 2117 require every California corporation and foreign corporation qualified to do business in California to file with the California Secretary of State the following information biennially: The names and complete business or residence addresses of its chief executive officer, secretary and chief financial officer (or, if the executive officers use other titles, the information of the officers performing comparative duties). However, If you form a manager-managed LLC in California, you do not have to disclose the members’ names in the Articles of Organization or the Statement of Information. These are the documents that are publicly filed with the Secretary of State. It is therefore up to your manager(s) whether you disclose the members’ names on any websites or in the course of the company’s business.
BUSINESS ENTITY MISTAKES THAT INCREASE YOUR LEGAL RISK
The right business entity will allow you to keep more of your income through proper taxation and also avoid legal issues that could threaten your assets.
Here are common mistakes made by small business owners when forming their business entities—and ways to make sure you’re minimizing taxes and strengthening your legal protections by doing it right.
- Using the incorrect legal entity. There are several types of entities that small business owners use. There are pros and cons to each, but many businesses have the incorrect entity. More than 22 million businesses operate as a sole proprietorship, which provides almost no legal protection or tax benefits. It’s critical to assess your needs and make sure you have the best entity for you and your business.
- Forming your entity in another state. Often business owners are told by a friend, colleague, attorney or CPA that Delaware and Nevada are the best states for structuring your business if you’re looking for anonymity and legal protection. Unfortunately, this often creates a challenge getting a bank account or funding. There are specific ways to structure your business to allow for complete asset protection as well as maximum tax benefits without the drawbacks of out-of-state incorporation.
- Putting multiple businesses under one entity. You may be doing your best to diversify your business interests and revenue streams. Unfortunately, many business owners put several different businesses they operate in the same entity. This is a major risk. Each business needs to have its own separate entity. But if the entities are structured correctly, you will still have just one tax return to file each year.
- Cutting corners with entity documentation. Who do you think is best to create a legal entity structure? Would you have a tax accountant draft legal documents? Unfortunately, it’s becoming common to have a CPA or tax professional draft these legal documents or to use some website that offers barebones entity formation at a discount. When a business entity has been drafted with the minimum paperwork, it provides very little legal protection and no real tax benefits. This is a common issue that can be easily resolved by having a legal team that specializes in asset protection law draft and file your entity documents.
- Inadequate Capitalization. The assets of the corporation are inadequate to reasonably cover prospective liabilities. An entity should not be incurring liabilities in the company which it cannot reasonably re-pay. For example, running the company into a big hole with a lot of debt without a reasonable or foreseeable plan to pay off the debt could ultimately backfire. The courts and judges aren’t stupid. If they think you are just running up debt, to ultimately ‘bankrupt’ the company, they could easily stick you ‘personally’ with the bill.
- Commingling of Assets between the Entity and the Owners, or Among Different Entities. Each entity has a separate legal existence and this separation should include its assets. An asset of the entity, for example a company car, should not be used for personal activities, and should not be used for a different entity’s business without proper documentation (e.g. a lease). Keep separate checking accounts for each business and for you personally, and do not pay personal expenses out of business accounts, or the debts of one business entity out of another business entity’s account.
- Failure to Properly Maintain Corporate Records, Minutes, and Status. Operating under a corporation is not the same thing as operating as a sole proprietorship, but instead requires adherence to corporate formalities which include the holding of annual meetings, preparation of minutes, resolutions, and following the rules as specified in the corporate documents
- Holding Out that an Individual is doing ‘business’ rather than the Entity. All contracts and business of the entity should be signed and entered into by the entity itself, and signatures by individuals should be made as the representative (i.e. President, CEO, Manager, etc.) of that entity. Individuals should not be entering into obligations in their own name without reference to the entity (unless a personal guaranty is intended). Advertisements, business cards, stationary, websites, oral statements to customers, etc. should be clear that the business is being operated under an entity with limited liability (i.e. Corp., Inc., LLC, etc.).
- Diversion or Concentration of Assets in one Entity and Liabilities in Another. A close counterpart to #1 above, piercing the corporate veil has also been used when an old corporation with debts merely closes and transfers its assets to a new corporation, or if one entity is being used to accumulate assets, while another is being used to accumulate debts. Such manipulation of assets and debts could result in the new corporation being liable for the debts of the old corporation.
- Not holding assets in the name of the Corporation/LLC. If you want the corporate veil to protect you when you own rental properties (especially when using an LLC), you better make sure the entity is on title to the property and NOT you personally. Otherwise stated, remember the entity owns the asset, not you! Confirm that the title, insurance policy, and property tax records, etc… reflect the entity as the owner. As an aside, don’t stress about the ‘due on sale clause’ with a mortgage. You are still personally liable for the mortgage and signed for it, but in practice the property can and should be transferred to an LLC when it is a rental property, so long as the underlying ownership doesn’t change.
- Doing nothing. Your business is growing—maybe faster than you expected. That is a great problem to have! However, you have to properly structure your business to legally protect yourself and get the maximum tax benefit.
CHALLENGES CONFRONTING EVERY BUSINESS PARTNERSHIP
Building a relationship with a business partner requires just as much work as any marriage. By being aware of the challenges you will face, you can be prepared to confront issues such as differences in management styles, personal habits and financial equity and overall commitment.
- Different management styles.
Different management styles don’t have to be a big problem. Some partnerships take on parental dynamic: one is a disciplinarian who is task-oriented, slightly distant and intent to get things done. The other is laissez-faire, relatable and prioritizes a ”chill” company culture over a well-oiled machine. In the best case scenario, one lays down the law and keeps the ship on course, while the other keeps employees happy.
Unfortunately, sometimes this backfires: the taskmaster might be tired of having to manage her own business partner; the other might feel overwhelmed by having to be a boss. Or, both partners might be pure “idea people” unaccustomed to telling others what to do and unable to step up to the plate, or they might both be highly disciplined control-freaks. This is a difficult problem. It takes time and energy to establish a balance.
- Personal habits.
In the early stages of a new company, the rules for maintaining a work-life balance don’t really apply for founding members. Those who have offices can expect to stay there well past traditional quitting time. A lot of people can’t take the pressure. There’s a huge range of different vices and vulnerabilities that can jeopardize a business partnership, especially if there are no other employees: substance abuse, alcohol, lapses in ethics, and mental health issues.
As everyone has their own coping mechanisms, there’s no clear way how handle these types of obstacles except on a case-by-case basis. It’s important that both partners keep an open mind, give each other time and space when necessary, learn to recognize triggering moments, and not interfere until asked or until it becomes necessary (including legal liabilities).
- Financial problems and equity.
Another struggle many partnerships face is the nature of the partnership. After all, not every team is split 50/50. The founder might be willing to put up all the money and just needs tech or business help to get it off the ground. In this case, how is equity divided? How is the secondary partner valued? Are the guidelines absolutely clear to both parties involved? These questions should be addressed at the end of the courting period, but it’s eminently important that there are no lingering tensions going forward.
- Setting boundaries.
If partners become best friends there’s a chance that every decision or disagreement could be taken personally. Best friends who become business partners can face unexpected situations that compromise their professional and personal relationship.
On the other hand, best friends who know each other really well might understand how to keep each other motivated and how to balance work and each other’s strengths and weaknesses while maintaining a unified vision.
- Commitment levels.
Much like issues over equity and financial contribution, it’s necessary to be perfectly clear on what each partner is looking for. One might just be in it for the experience, but not willing to put in the time and dedication required. Maybe they want in but keep their day job, invest little money, or lack needed skills outside of their own specialization.
This will become harder to navigate as the startup experiences ups and downs. A partner who is excited in the first month might not be as excited by the seventh month.
- Disparities in skills and roles.
Entrepreneurs understandably seek partners who are at least as experienced as themselves to jumpstart the business but that doesn’t always happen. After all, they’re asking someone to quit their day job, take a huge salary cut (if they’re lucky enough to get a salary!) and live on their savings to follow a vision that hasn’t been actualized yet. Few established professionals are willing to take these risks. Then it becomes a matter of finding anyone willing with the kind of qualifications you’re looking for.
Eventually, this means that while it’s a learning process for both parties, it’s more of a learning process for one person and no one wants to be, or work with, a co-founder who can’t keep up with the company. Look for a business partner with a demonstrated ability to work hard for long hours, and a keen willingness to learn new skills and experiment with ideas.
Building a relationship with a business partner requires just as much work as any marriage. By being aware of the challenges you will face, you can be prepared.
ASSET PROTECTION OBJECTIVES: PART OF TODAY’S ESTATE PLANNING REQUIREMENT?
Trends in estate planning has always been precipitated by the desire for asset protection, largely enforced by external forces, such as the increasingly litigious nature of our society, a high divorce rate, a trend toward increasing spousal forced inheritance rights at death, a high estate tax rate, and over the last several decades, an enhanced ability for the elderly and disabled to qualify for governmental resource benefits. However, a high percentage of estate plans still give only a modicum of attention to this issue. Estate planners should not view asset protection as just a facet of an expanded practice, but as an important goal for a high percentage of their estate planning clients.
The principal theme here is the manner in which asset protection can be achieved through the careful crafting of trust documents. Therefore, one must understand the need for achieving flexibility in trust provisions. This flexibility is attained by finding a way to give the Trustee broad authority to make discretionary distributions to multiple beneficiaries; giving the Trustee broad investment authority; giving family members limited powers of appointment to alter the disposition of trust assets upon trust termination; and in providing for the proper altering of trust provisions by authorizing a Special Trustee to make appropriate trust amendments. The overall goal is to minimize, as much as possible, the substantive differences between outright ownership versus a beneficial interest in trust assets, without significantly compromising important asset protection principals.
ASSET PROTECTION EROSION:
In the absence of the appropriate estate planning techniques, there can be a diversion of estate assets to third parties, thereby reducing the amount of assets available and thus adversely affecting the amount of assets that are able to be passed to other family members at death. One type of diversion that can quickly erode the value of an estate is a creditor claim.
There are three main subcategories of creditor claims. One such subcategory is tort claims, such as a negligence claim. Annual litigation costs in the United States are estimated at $400 billion. Although estimates vary, the average American can expect to be sued approximately 2-3 times during his/her lifetime. Some of these risks either may not be insurable or insurance may not be sufficient to cover many of the large judgments which are being rendered. Moreover, many view large liability policies as being a “magnet” for litigation.
A second category of creditor claims is contract claims. Contract liabilities can arise in various contexts, including the commercial area, consumer debt, vicarious partnership liabilities, or from personal guarantees.
A third type of creditor claim is a governmental claim. Many income tax liabilities may not only be unforeseen, but substantial in nature. Substantial liability risk also is present under governmental regulations designed to achieve social policy or environmental goals, such as the Occupational Safety and Health Act (“OSHA”) and the Comprehensive Environmental Response, Compensation and Liability Act (“CERCLA”). These acts allow the government to impose substantial fines and environmental “clean up” costs, respectively. Spousal claims may also result from a claim incident to a divorce or separate maintenance decree. Premarital agreements, depending upon applicable state law, may afford substantial asset protection in some states, but in other states may be able to be set aside if a court determines its provisions to be inequitable. In all jurisdictions, they must be comprehensively drafted to afford protection and are subject to litigation with regard to any ambiguities.
Estate taxes may also extract a substantial portion of one’s estate at death. Unless a state in which the decedent died or the decedent has property having a situs in another state having an estate or inheritance tax, this extraction is primarily in the form of federal estate taxes at a high marginal rate (40%) on estates over the $5.43 million applicable exclusion amount for 2015.
METHODS OF ACHIEVING CREDITOR PROTECTION:
The manner in which such protection is achieved with respect to creditor claims is principally through one of six techniques: 1) maximizing the assets which are exempt from the claims of creditors; 2) transferring assets not exempt from creditor claims to a spouse; 3) transferring assets to entities such as limited liability companies (LLCs) or family limited partnerships (FLPs); 4) creating a trust for the benefit of the settlor (the person creating the trust); and 5) creating a lifetime or testamentary trust for the benefit of a spouse, children or other beneficiaries; and 6) creating an irrevocable trust to be the recipient of the Grantor’s assets upon the Grantor’s death by virtue of a beneficiary designation.
- CONVERSION OF NON-EXEMPT ASSETS TO EXEMPT ASSETS:
California law exempts certain assets from the claims of creditors. A list of the appropriate exemption statutes can be found here: http://www.ocelderlaw.com/pdfs/California.pdf
By converting non-exempt assets, into exempt assets, they can be protected from the claims of creditors. Make sure you consult with an attorney when attempting to interpret these statutes.
- TRANSFER OF ASSETS TO A SPOUSE DURING LIFETIME:
Typically, spouses are not liable for the debts of their spouses, unless agreed to in writing, e.g., under a promissory note co-signed by both spouses. An exception is what is called the “doctrine of necessaries,” in which a spouse can be held liable for the basic living needs of a spouse in the event a debt arises with regard to such “necessaries” (normally uninsured health needs), and the creditor has been unable to satisfy the debt through litigation ultimately attaching the assets of the debtor spouse. Consequently, absent a creditor claim which could cause the transfer to be deemed a fraudulent conveyance, non-exempt assets normally can be transferred as part of the estate planning process to a spouse and thus gain protection from the creditor claims of the transferring spouse.
- USE OF FLPS AND LLCS:
A third method of asset protection is to transfer assets to an entity affording protection under statutory law from the claims of creditors. For example, transferring assets to a corporation or limited liability company (LLC) can afford protection from personal liability and for what is termed vicarious liability, i.e., the actions or negligence of other employees or members of the corporation of LLC. A member still remains personally liable for the member’s own actions, however all corporate or LLC assets would be subject to liability claims for the actions of personnel in the furtherance of the business purpose of the entity. A member’s personal assets would be protected from such claims.
Normally, creditors who consider attaching an LLC or FLP interest to satisfy a personal liability claim of a member or partner can only receive what is termed a “charging order”, i.e., the right to receive distributions if and when the other members of the LLC or general partners of the FLP decide to make distributions. Nevertheless, creditors normally cannot compel a distribution of LLC or FLP assets to the member or partner, nor force a liquidation of the LLC or FLP. Further, following the attachment of an LLC or FLP interest to satisfy a claim or judgment of a member or partner, creditors will “step into the shoes” of the member or partner for income tax purposes. This normally results in the creditor being taxed upon the member’s or partner’s share of income of the LLC or FLP, even if such income is not distributed and retained in the LLC or FLP for business purposes. Consequently, a creditor is normally quite reluctant to attach or execute upon a member’s or partner’s interest in an LLC or FLP to satisfy a personal liability of the member or partner.
USE OF “DELAWARE BUSINESS TRUST”:
The laws of Delaware permit the creation of an entity similar to an FLP or LLC in its structure called a “Delaware business trust.” A “Delaware business trust,” like an FLP or LLC, can be favorably taxed as a partnership. Moreover, the beneficial interest of its beneficiaries who contributed property to the trust may be transferred. However, unlike an interest in an FLP or LLC, a creditor of a trust beneficiary cannot attach the interest and get the benefit of a “charging order” in the event later distributions are made out of the trust. These entities must be set up under the laws of the state of Delaware. Accordingly, the benefits of creating an LLC or FLP, or a “Delaware business trust” for the purpose of limiting the ability of a creditor to satisfy a claim against a member or partner for a personal “outside the business purpose” claim, must be balanced against its attendant costs, possible tax liabilities, and organizational complexities.
- CREATION OF IRREVOCABLE TRUST FOR GRANTOR’S BENEFIT:
The fourth strategy is to transfer assets into an irrevocable trust for the benefit of a trust beneficiary or beneficiaries. However, the laws of most states frown upon a settlor transferring assets to an irrevocable trust for the benefit of the settlor (the person creating the trust). Such trusts are termed “self-settled” trusts, as they are created by the settlor (also sometimes referred to as the “grantor”) for the benefit of the settlor. Due to public policy considerations incorporated into common law or under state statutes, most states, proscribe the ability of a settlor to transfer assets owned by the settlor, which were subject to the claims of a spouse or creditor of a settlor prior to the transfer, into an irrevocable trust. The idea is that the irrevocability of the trust which creates an entity separate and apart from the settlor, protects the trust assets from creditor claims while the settlor simultaneously continues to enjoy a beneficial interest in the trust assets. Assets in these trusts normally remain subject to most claims of the creditors of the Grantor, however, at least to the extent that the assets of the trust are distributable to the Settlor/Grantor, even in the Trustee’s discretion.
In recent years, laws have been enacted in some states (e.g., Alaska, Rhode Island, Nevada and Delaware) to provide significant creditor protection to settlors of certain types of “Grantor Trusts” created and maintained (by requiring a local Trustee) in their states. The potential enforcement of creditor protection in the laws of these states, such as the additional expenses incurred in creating such “out of state” trusts as well as the degree of creditor protection truly afforded by creating a trust which has a more favorable creditor protection situs than under the laws of the state of the Grantor (such as an Alaskan trust created by a California domiciliary), is candidly not yet well settled.
- IRREVOCABLE TRUST FOR THE BENEFIT OF THIRD PARTY:
The laws of all states are much more favorable with regard to creditor protection for claims against a trust beneficiary if the trust beneficiary did not create the trust for his or her benefit. These so-called “third party” trusts are created when an individual transfers asset to an irrevocable trust which is either created during lifetime or at death under a testamentary trust (created under a Will or Revocable Trust). Properly drafted, such “third party” trusts can provide for the needs of the trust beneficiaries, while at the same time substantially protecting assets from the claims of the beneficiaries’ creditors or a spouse of a beneficiary.
The reason these types of trusts are treated much more favorably than “self-settled” trusts with respect to claims of the creditor of trust beneficiaries is that the assets in the trust were not owned by the beneficiaries and subject to the claims of their creditors prior to the transfer. Protection from creditor claims in “third party” trusts is achieved through the inclusion of what is termed a “spendthrift clause” in the trust instrument. “Spendthrift clauses” preclude a creditor of beneficiary from attaching trust assets to satisfy a claim a creditor may have against a beneficiary (e.g., a tort or contract claim), including a claim of a spouse of a beneficiary (including that of a subsequent spouse of a surviving spouse of the person creating the trust), such as otherwise might result from a divorce or forced inheritance claim following the beneficiary’s death.
Moreover, such statute provides that a spendthrift provision, which restrains involuntary or voluntary transfers of the beneficiary’s interest, may be created simply stating that the assets are being held in a “spendthrift trust.” With regard to discretionary distributions, such clauses are valid even if the Trustee has abused the Trustee’s authority in not making a required distribution. However, if the beneficiary is serving as sole Trustee, distributions to the beneficiary must be limited to the beneficiary’s health, education, maintenance and support needs for the trust estate to be afforded asset protection against the beneficiary’s creditors. The only exception to such asset protection is for mandatory distributions of income or principal if such distributions have not been made within a reasonable amount of time.
Assets left in “third party” trusts, when properly drafted, may also be excluded from a beneficiary’s estate for federal and state death tax purposes (although trust assets may be subject to the possibility of a “generation-skipping tax” in larger estates). Likewise, the assets of a properly drafted “third party” trust normally should not be considered a resource to trust beneficiaries so as to disqualify such beneficiaries from Medicaid, SSI, or other types of otherwise available government benefits. Thus, the trust assets may be made “supplemental to governmental benefits” in providing for support, maintenance and health needs not provided for governmental resources.
- CREATING AN IRREVOCABLE TRUST TO BE THE RECIPIENT OF THE GRANTOR’S ASSETS:
Individuals who desire a cohesive estate plan which avoids probate, provide for a fiduciary to administer their assets, and perhaps leave assets in trust for family members for asset protection reasons, could create an irrevocable trust which is minimally funded during lifetime, say with ten dollars. The trust would not provide for the payment of any debts or taxes of the decedent in the same manner as a revocable trust. The provisions of the irrevocable trust would only include provisions addressing the disposition of their assets following death. Following the death of the Grantor, the irrevocable trust would become fully funded with the vast majority of the individual’s assets having a beneficiary designation naming the trust as primary beneficiary on such assets. Should the individual desire to subsequently change the trust provisions, same could be done through a Special Trustee or perhaps better, by simply creating a new irrevocable trust with the more desirable provisions and change all beneficiary designations to the trustee of the subsequent trust. It is also desirable for the individual to also create a second revocable trust having a very modest amount of assets. Following the Grantor’s death, such trust could provide for the payment of the decedent’s debts, taxes and post-death administration expenses, and perhaps provide for the distribution of tangible personal property items. The remainder would be distributed in the same manner as assets in the irrevocable trust, with provisions allowing such remainder of the trust estate held in trust to be merged with similar trusts created under the irrevocable trust for the same beneficiaries. Having an additional revocable trust, in addition to the irrevocable trust, should diminish any argument, however weak, that the irrevocable trust was simply a substitute revocable trust and thus should remain subject to the claims of the decedent’s creditors. Limiting the amount of assets in the revocable trust should limit the exposure to third party claims of the decedent’s assets to the assets held in the revocable trust.
A substantial amount of asset protection can be obtained through comprehensive estate planning using sophisticated techniques. There is a significant exposure in today’s litigious environment to creditor claims, including the claims of spouses. When a married couple is dividing assets in the estate planning process, asset protection objectives and strategies should be taken into consideration. In addition, the use of trusts, rather than outright distributions, should also be considered to afford beneficiaries to whom property would otherwise be given outright a substantial measure of asset protection from third party claims. In situations where assets are already owned outright and the owner is in need of asset protection, an LLC or FLP should be considered in order to convert assets into an LLC or FLP interest which is far less desirable to creditors. In more egregious circumstances where potential claims are severe and greater immunity from creditor claims is desired, a domestic “out of state” trust in a state jurisdiction having protective laws with respect to” self-settled” trusts may be considered.
In all situations when there are asset transfers during lifetime designed to afford asset protection, the opinion of knowledgeable legal counsel should be obtained to ensure that any such transfers or conveyances do not constitute “fraudulent conveyances” which violate applicable state or federal law and are therefore not only legally voidable by creditors and bankruptcy trustees, but also which could preclude the debts of the transferor from being discharged in bankruptcy.
You can form a California LLC with just one owner.
You should consider forming an LLC if you plan to run a business and are concerned about personal exposure to lawsuits or debts arising from your business. For example, if you decide to open a store-front business that deals directly with the public, you may worry that your commercial liability insurance won’t fully protect your personal assets from potential slip-and-fall lawsuits or from claims by your suppliers for unpaid bills. Running your business as an LLC may help you sleep better, because it instantly gives personal asset protection against these and other potential claims against your business.
Corporations also provide this protection from personal liability. Which is better? For many small businesses, the relative simplicity of the LLC makes it the better choice.
However, corporate taxation is very different from the taxation of LLCs, and this can be a deciding factor in which type of business you form. For instance, if your business will hold property such as real estate that’s likely to increase in value, an LLC may make more sense, because corporations and their shareholders are subject to a double tax (both the corporation and the shareholders are taxed) on the increased value of the property when the property is sold. On the other hand, corporate income tax rates start out as low as 15%, so having the corporation rather than the owners taxed on some of the income may make sense.
Not all businesses can operate as LLCs. Businesses in the banking, trust, legal and insurance industries, for example, are typically prohibited from forming LLCs. California additionally prohibits professionals such as architects, accountants, doctors, and licensed healthcare workers from forming LLCs.
In addition, some businesses are so small that the fees and paperwork involved in setting up and running an LLC just aren’t justified, especially in California, where both LLCs and corporations must pay an $800 annual tax to the Franchise Tax Board. Remember, commercial liability insurance policy can only shield your business assets sufficiently. However, insurance does not cover unpaid business debts and will not protect your personal assets.
In California, you create an LLC by filing “articles of organization” with the Secretary of State’s office and paying a filing fee. You’ll also need an LLC operating agreement, though it doesn’t get filed with the Secretary of State. Your operating agreement explicitly states the rights and responsibilities of the LLC owners. An operating agreement clarifies the business arrangement between the owners and governs how your LLC will be run. If you don’t create a written operating agreement, the LLC laws of your state will govern the inner workings of your LLC and this could pose problems concerning how and by which desired members the company is operated.
After articles of organization have been filed and you have an operating agreement, your LLC is official, but you will still need to obtain the licenses and permits that all new businesses must have to operate. These may include a business license (sometimes also referred to as a “tax registration certificate”), a federal employer identification number, a sellers’ permit, and perhaps even a zoning permit. Forming an LLC does not exempt you from any of these requirements that apply to all businesses.
Federal taxes: The IRS does not impose taxes on the LLC; LLC income is reported on the members’ individual tax returns.
State taxes: You must pay an annual LLC tax to California’s Franchise Tax Board (FTB) within 3-1/2 months of formation. That tax is currently $800 per year. After the year of formation, the tax is due by April 15 each year, assuming your LLC has a calendar tax year. This tax must be sent to the Franchise Tax Board with FTB Form 3522, Limited Liability Company Tax Voucher, available at http://ftb.ca.gov.
If your LLC’s net annual income exceeds $250,000, you may be required to pay an additional “fee” with your annual tax return, Form 568, Limited Liability Company Return of Income. Like individual tax returns, your LLC tax return is due by April 15 of each year (assuming a calendar tax year). You can also find Form 568 on the Franchise Tax Board’s website at http://ftb.ca.gov.
Self-employment taxes: LLC members (owners) who are active in the business will probably have to pay self-employment taxes on their share of LLC profits — just as partners in a partnership do. Fortunately, an LLC member can deduct, as a business expense, half of the self-employment taxes paid. (Members in manager-managed LLCs may not have to pay self-employment taxes if they are not active in the business; if you are in this situation, consult a tax adviser to see if you should pay self-employment taxes.)
California does not require you to file a written operating agreement, but you shouldn’t consider starting business without one. Here’s why an operating agreement is necessary:
- It helps to ensure that courts will respect your personal liability protection by showing that you have been conscientious about organizing your LLC.
- It sets out rules that govern how profits will be split up, how major business decisions will be made, and the procedures for handling the departure and addition of members.
- It helps to avert misunderstandings among the owners over finances and management.
- It allows you to create your own operating rules rather than being governed by the default rules in your state’s LLC laws, which might not be to your benefit.
Forming an LLC in a different state than the one in which your business will operate?
You can form an LLC in any state, regardless of whether your business will be there or if any members live there. But if you form an LLC out of state, you will probably still need to qualify your LLC to do business in your home state. This means you’ll have to file additional paperwork and pay additional fees. If you don’t register to do business in another state when required, you won’t be able to enforce contracts in that state. You will also need to maintain a “records office,” where you keep legal, financial, and tax records, in the state where you form your LLC.
Be ready for some state tax complications if you form your LLC in a state that’s different from the state where all of its members live. For one thing, the LLC members might have to pay personal income taxes in the other state on LLC income. At best, you might get credit for those taxes in your home state and not have to pay twice. At worst, you might have to pay taxes you wouldn’t have had to pay at home.
Other state taxes vary from state to state, and might influence your choice of location for an LLC. An LLC, like any business, has to pay franchise taxes, sales and use taxes, other transaction and excise taxes, and employment, property, and transfer taxes.
Keep in mind California won’t let professionals (such as accountants, architects, and massage therapists) form LLCs. Professionals who are not allowed to form an LLC in California can form a registered limited liability partnership (RLLP) or a professional corporation.
LLC membership interests and securities
If any of your members will not be active in the LLC or if you choose manager-management for your LLC, you may need to comply with federal and state securities procedures when setting up your LLC. (If you’ll be the sole owner of your LLC and you don’t plan to take investments from outsiders, your ownership interest in the LLC will not be considered a “security” and you don’t have to concern yourself with these laws.)
Membership interests in a manager-managed LLC might be classified as securities because non-managing members may be investing their money in a business in which they are not actively participating.
A security is defined as an investment in a profit-making enterprise by an investor who is not running the company. If a person invests in a business with the expectation of making money from the efforts of others, that person’s investment is generally considered a “security” under federal and state law. Conversely, when a person will rely on his or her own efforts to make a profit (that is, he or she will be an active participant in the LLC), that person’s ownership interest in the company will not usually be treated as a security.
If your LLC’s membership interests are considered securities, you must get an exemption from the state and federal securities laws before the initial owners of your LLC invest their money. If you don’t qualify for an exemption to the securities laws, you must register the sale of your LLC’s ownership interests with the U.S. Securities and Exchange Commission (SEC) and with your state.
Fortunately, smaller LLCs usually qualify for securities law exemptions. For example, SEC rules exempt the private sale of securities from registration if all owners reside in one state and all sales are made within the state; this is called the “intrastate offering” exemption.
Another federal exemption covers “private offerings.” A private offering is an unadvertised sale that is limited to a small number of people (35 or fewer) or to those who, because of their net worth or income earning capacity, can reasonably be expected to be able to take care of themselves in the investment process. Most states have enacted their own versions of these popular federal exemptions.
Forming an LLC does not take the place of obtaining a business license, tax registration certificate, or other required business permits. An LLC merely creates an ownership setup that limits the owners’ personal liability.
Like a corporation, an LLC is meant to be a permanent legal entity, and it will exist and incur taxes and fees, whether or not you are actively operating a business, until you take legal steps to dissolve it. If you decide to discontinue business as an LLC, you must file a certificate of cancellation and possibly a certificate of dissolution with the Secretary of State. In addition, certain franchise tax requirements must be met before you can dissolve your business.
Delaware Statutory Trusts and Other Creations of State Law
Contribution by: Kevin Kennedy
More than ever before, clients have asked about forming a Delaware Statutory Trust, sometimes known as a Delaware Business Trust. They might be a real estate investor in California, or a small business owner in Arizona. But how will California treat a Delaware Statutory Trust? What about your state? This is an essential question that should be answered before forming such an entity.
When used appropriately, the Delaware Statutory Trust is an effective entity for its flexibility and liability protection. It has many benefits as provided by state statute under the Delaware Statutory Trust Act of 2002, which superseded the Delaware Business Trust Act of 1988. A few of the benefits are:
1. Liability Protection. It offers beneficial owners of the trust the same liability protections that Delaware law provides to stockholders of a Delaware corporation.
2. Asset Protection. It also limits the creditors of the beneficial owners of the trust in the same way a limited partnership or other charging order protection entity prevents personal creditors from liquidating or obtaining the trust assets.
3. Contractual Flexibility. The Delaware Statutory Trust Act, which created the Delaware Statutory Trust, provides maximum freedom of contract. This means that in the trust agreement, the parties are able to agree as between themselves on management rights, economic rights, liability/indemnification, etc.
4. Ease of Formation and Maintenance. The process and fees in forming and maintaining the Delaware Statutory Trust are reasonable. A certificate of trust is filed with the Office of the Secretary of State of Delaware. A trust agreement must be drafted but it is not required to be filed with the State of Delaware. There are no annual fees in Delaware for such a trust. It is not subject to Delaware’s franchise tax.
5. In Delaware, it offers privacy to the beneficial owners of the trust.
6. Trust Series. Delaware law permits the trust agreement to establish separate series of the trust, which may each have its own objective, beneficial interests, trustees, managers, assets, and liabilities.
7. Flexible Tax Treatment. A Delaware Statutory Trust can be taxed as a corporation, a partnership, or a trust.
However, it requires a Delaware Trustee. It is also important to note the distinction between a business trust created at common law (by the courts), sometimes referred to as a Massachusetts Business Trust, and a statutorily created trust. The Delaware Statutory Trust falls in the latter category because it is a creature of statute, so even if your state recognizes business trusts at common law, this does not automatically suggest that a court in your state is going to recognize a Delaware Statutory Trust with all of its benefits described above. Although a Delaware Statutory Trust is a powerful business structure and may be appropriate for structured finance transactions and other financial transactions, this might only true in Delaware or another state that has adopted it own statutes which create a statutory trust, e.g., Kentucky. This is similar to other states which, in order to attract businesses, or for other reasons that are specific to their state, have passed laws that create unique types of business entity structures or that create incentives to do business in that state. Here are a few examples:
• Tennessee and Nevada are among about thirteen states that passed laws which allow for the creation of Series LLC’s. But unless you plan to own rental(s) or do business in a state that recognizes the Series LLC, it is not productive to form a Series LLC.
• Illinois, Florida, and a few other states have laws that allow for the creation of land trusts. Although a land trust, where used appropriately, can provide a measure of privacy and ease of transferability, it could be unproductive to form or use a land trust in a state that does not have laws that recognize such a trust.
• Some states do not assess corporate income tax, as is the situation in Florida, Texas, Nevada, and a few other states. But unless you are actually doing business in Nevada, Nevada’s zero corporate income tax will not help you.
Even if a state recognizes another state’s common law or statutory business trusts, the process to register it into that state can be time consuming and costly. For instance, Arizona will recognize another state’s business trust; however, in order to register a business trust in Arizona the trust must be: registered with the Arizona Corporation Commission, recorded in each County where real property is located (if the trust owns real estate), and receive approval from the State Banking Department.
Delaware Statutory Trusts in 1031 Exchanges
Even if your state will recognize a Delaware Statutory Trust, if your intent is to use the trust in connection with a 1031 exchange, as this is a common use for such a trust, be sure it meets the requirements of Rev. Rul. 2004-86 to be considered a trust and not a business entity type. Otherwise, the beneficial interests of the trust are treated as interest in a partnership or corporation and would not constitute valid like-kind Replacement Property under IRC §1031.
Delaware Statutory Trusts in California
Business trusts are generally recognized under common law in California, but this does not mean a California court will accept a Delaware Statutory Trust with all of its statutorily created benefits – it could disregard some of those features that are not common to other business trusts in California.
As it concerns taxes and California’s franchise tax, under California law, Section 23038(b)(2)(A) of the Revenue and Taxation Code, California appears to define “corporation” to include business trusts for tax purposes. Any business trust doing business in California is treated as a corporation under California law, and thus presumably subject to California’s franchise tax, unless, under federal law, it has elected to be taxed as a partnership. If a trust is considered a non-business trust, it is probably not subject to California’s franchise tax. Under California’s definition of a business trust in Section 23038, a non-business trust is a trust arrangement established for the mere purpose of the conservation of assets, to collect and disburse fixed, periodic income, or to secure an obligation. While having your trust characterized as a non-business trust might avoid California’s franchise tax, such a characterization might not be favorable in terms of limiting liability of the trust parties, as explained below.
On the issue of limiting liability in California, if a California court decides to recognize the Delaware Statutory Trust and all of the liability protections established by Delaware statutes, the Delaware Statutory Trust will be a powerful entity to utilize in California because of the benefits outlined above. It is unclear under what circumstances, if any, a California court would do that. Until that happens, a California court would likely construe such a trust as either: (a) a common law business trust, in which some liability protection could be provided, but not to the extent of a Delaware Statutory Trust; or (b) a non-business trust, e.g., a probate trust, in which no liability protection or asset protection will be afforded to any of the parties to the trust, other than through a spendthrift clause. There are many bankruptcy court cases in California in which the judge has to decide, based on the facts, whether a trust is a business trust or a non-business trust. Each situation requires an analysis by a competent attorney of these complex issues.
Therefore, before you rush to form a Delaware Statutory Trust, so as to avoid a state’s fees, for example, California, be sure to understand: (1) whether your state will recognize such a trust/business entity with all of its benefits created under a foreign state’s statutes, and (2) the tax and liability ramifications of such a trust.
CHOOSING A STATE FOR BEST ASSET PROTECTION
CHOOSING A STATE FOR INCORPORATION?
As you decide whether to form a corporation or LLC, also consider options for the state in which you will incorporate. The cost, taxation and corporate laws vary from state to state, making some states advantageous for certain small business owners.
Choosing your home or another state:
Incorporating your business in the state where your company is physically located is called home state incorporation. No matter if your business is aC corporation, S corporation, Limited Liability Company (LLC), Limited Liability Partnership (LLP), Limited Partnership (LP) or Non-Profit Corporation, you must pay filing fees to the state when incorporation documents are filed, and will be subject to ongoing requirements and fees imposed by that state. Some business owners mistakenly think they will save money by incorporating in a state with low fees, even if their company is neither located nor conducts business in that state. Keep in mind that companies incorporated in one state but doing business in another state(s) must register to transact business (foreign qualify) in those state(s).
Weighing advantages: state statutes & taxation requirements:
When deciding your company’s state of incorporation, research those states’ corporate or LLC statutes to determine if any may be best for you.
• Consider how corporations and LLCs are taxed by each state and the taxation requirements imposed on foreign-qualified businesses, if foreign qualification is necessary for you. Does a state impose an income tax on corporations and LLCs? Does it have a minimum tax or a franchise tax?
• The added costs of fulfilling the ongoing and taxation requirements imposed by the state of incorporation and state(s) of foreign qualification often outweigh the perceived benefits of incorporating outside the home state.
• Try calculating your company’s projected revenue for its first few years of existence and then evaluate states in terms of the true amount of taxes required, to see if there may be an advantage.
THE APPEAL OF DELAWARE & NEVADA?
Delaware and Nevada are two states in which some small business owners opt to incorporate a business. They offer unique advantages for certain types of businesses.
Some potential advantages of incorporating your business in Delaware include:
• Delaware’s business law is one of the most flexible in the country.
• The Court of Chancery focuses solely on business law and uses judges instead of juries.
• For corporations, there is no state corporate income tax for companies that are formed in Delaware but do not transact business there (but there is a franchise tax).
• Taxation requirements are often favorable to companies with complex capitalization structures and/or a large number of authorized shares of stock.
• There is no personal income tax for non-residents.
• Shareholders, directors and officers of a corporation or members or managers of an LLC don’t need to be residents of Delaware.
• Stock shares owned by persons outside Delaware are not subject to Delaware taxes.
Some potential advantages to forming a corporation or LLC in Nevada include:
• Nevada has no state corporate income tax and imposes no fees on corporate shares.
• There is no personal income tax or any franchise tax for corporations or LLCs (but initial and annual statement fees and business license fees apply).
• Shareholders, directors and officers of a corporation or members or managers of an LLC don’t need to be residents of Nevada.
Remember, if you form in Delaware or Nevada but you transact business in another state, it is likely that you will have to foreign qualify your business in that state.
For questions about the best state of incorporation for your business, or to determine if you need to foreign qualify in another state, please—talk to an attorney.
DOES SWEAT EQUITY WORK THE SAME WAY IN A LLC AND S-CORPORATION?
In the context of an S corporation, sweat equity represents the value of a particular shareholder’s capital contribution and relative ownership interest in a corporation when it is formed. For example, if the S corporation has three shareholders, two might invest cash in the business while the third agrees to contribute his services to the new corporation. If everyone agrees as to the value of the services, the relative ownership stakes can be assigned up front.
The shareholders can assign a fixed value on the sweat equity at the startup phase and decide how much ownership interest the owner should get in exchange for his services up front. However, once the shares of stock that represent each shareholder’s ownership interest are distributed, the valuation of the sweat equity contribution is fixed and cannot be changed later. For example, if it is decided that an owner gets 33 percent of the outstanding stock in exchange for his work done for the company, that share allocation can’t be changed retroactively, even if the shareholder provides inadequate services or stops doing work for the company prematurely. To avoid these types of issues, rather than value all sweat equity up front, a better way to value ongoing labor contributions is by assigning a reasonable hourly rate to the shareholder’s time working on the company’s behalf. This means his ownership stake will increase over time as he makes his contribution to the company, and it prevents common disputes from arising regarding the quality or extent of services rendered.
As for the LLC scenario, a sweat equity member (the person trading sweat for equity) is in effect earning dollars that she is trading for a percentage ownership in the business (her capital contribution). This is a complex issue that has important tax implications. In the simplest terms, the dollars earned are taxed when the ownership is vested and the tax will be based on the value of the percentage ownership in the LLC at the time. For example, say the LLC was formed by a member who contributed $50,000 for 50% ownership and a sweat equity member who contributes one year’s future services valued at $50,000 for 50% ownership. The $50,000 is compensation for services and is considered taxable income. This can have a sizeable impact on the sweat equity’s tax burden. Moreover, if the company never proves profitable, it’s much like paying tax on phantom income.
SUDDENLY SINGLE? HOW TO PROTECT YOUR FINANCES:
(Six steps to take to help protect your finances if you are widowed or divorced.)
Losing a spouse through death or divorce can be emotionally devastating and is often a difficult time in which to make important life decisions. Yet it’s typically when many financial matters require your immediate attention, such as handling retirement assets, learning to budget on one income, making sure you’re properly insured, or figuring out your Social Security benefits.
To help avoid making emotionally driven and even potentially harmful financial decisions, it’s important to be prepared should you find yourself suddenly single. Here are six important action steps that can help protect your personal finances.
1. Update your financial accounts.
When you lose a spouse, whether through death or divorce, you’ll likely need to change the registrations on any financial accounts that are owned jointly. Such ownership changes typically require certain documentation.
If you’re widowed, you need to provide your financial institutions with copies of your spouse’s death certificate in order to shift accounts from joint ownership into your own name. In a divorce, changing ownership requires first determining how you’ll divide jointly owned assets (typically, through court orders and/or divorce agreements) and then securing any signatures and guarantees required by your financial institutions.
A word of caution: Pay attention to the conditions under which you divide assets and/or shift ownership. You could face significant tax burdens when splitting up highly appreciated assets, or risk losses by selling in volatile markets. You should consult your tax adviser.
2. Divide or roll over retirement assets.
Pension and retirement account assets have their own set of rules when it comes to shifting ownership from one spouse to the other, or splitting the assets.
Death of a spouse
Generally, upon the death of the account owner, retirement account assets pass directly to the beneficiary(ies) (often the spouse, for those who were married) designated on the account. This is why keeping your beneficiary designations up to date on all retirement accounts—such as 401(k)s, 403(b)s, and IRAs—is critical. Even if your will makes provisions for your retirement assets, your beneficiary designations supersede them.
As for IRAs, the surviving spouse is usually entitled to his or her spouse’s IRA assets, even if no beneficiary is named. If you inherit your spouse’s IRA and roll it over into your own IRA, you must start taking minimum required distributions (MRDs) from the account when you turn 70½. You could face a 10% early withdrawal penalty if you take out money before age 59½. Alternatively, you could roll the money into an inherited IRA, begin taking MRDs based on your own life expectancy, and not be subject to the 10% early withdrawal penalty if you are younger than age 59½. This might be a good option if you want to keep the money growing tax deferred as long as possible.
Retirement assets are often split up as part of a divorce settlement through a qualified domestic relations order (QDRO). A QDRO is a legal arrangement that either recognizes an alternate payee’s right to receive (in this case the ex-spouse) or assigns to that alternate payee all or a portion of his or her former spouse’s retirement account balance and/or pension benefits. IRAs are divided through a one-time distribution from one spouse’s IRA into the other spouse’s IRA, without income tax or early withdrawal penalties. But this must be a court-approved transfer; otherwise, the distribution is treated as taxable to the original account owner, while the spouse on the receiving end gets the money tax free.
3. Adjust your income and budget.
Chances are, when you’re suddenly single, you may be taking a cut in your income, so you may need to adjust your budget accordingly. Start by listing your essential expenses (housing, food, insurance, transportation, etc.) and your discretionary expenses (dinners out, vacations, clothing, etc.). Try to match reliable sources of income (salary, Social Security, pension, etc.) to your essential expenses and see where you might trim your discretionary spending. If you’re near retirement or are already retired and fear an income shortfall, you might consider creating a guaranteed1 source of income by purchasing an income annuity. These products can turn a portion of your retirement savings into a source of reliable income that you can’t outlive.
4. Evaluate your insurance needs.
What you’ll have and what you’ll need for insurance can change dramatically when you lose a spouse through death or divorce. It’s important to take a careful look at all the different types of insurance that are available to see where you may need to adjust your coverage. Be sure to review:
Life insurance: If you are the surviving spouse and the beneficiary on your deceased spouse’s life insurance policy, you will typically receive the proceeds tax free. But if you are still caring for children, you may want to either purchase or increase your own life insurance coverage to make sure they will be protected in the event of your death.
If you divorce, you have to consider (1) changing the beneficiary on your life insurance if it is currently your ex-spouse, and (2) purchasing or modifying your coverage to adequately protect your children if either you or ex-spouse dies.
Health insurance: Even if your spouse carried your family’s health insurance coverage, you can continue to maintain it for a period of time, whether you are divorced or become widowed.
Through the Consolidated Omnibus Budget Reconciliation Act (COBRA), if you’re going to lose health benefits (because of death, divorce, job loss, etc.), you can continue coverage for up to 36 months—so long as you pay the premiums, which can be up to 102% of the cost to the plan.
Because COBRA coverage is expensive in many cases and doesn’t last indefinitely, you may want to check out other insurance options, whether through your own employer or by evaluating individual plans available through the Affordable Care Act (ACA).
Disability insurance: We all hope we will never need it, but disability insurance is one of the least understood and most useful ways of protecting ourselves and our loved ones. What if you were injured or sick and couldn’t go to work? Disability insurance is designed to protect you and your loved ones against lost income.
Long-term-care insurance: If you’re in your 50s or older, you may want to consider buying long-term- care insurance to help keep potential costs of nursing home stays and home health care from depleting your income resources if you become seriously ill or injured.
5. Review your credit.
When you’re suddenly single, your credit can be among your most valuable assets—so protect it wisely. After divorce or the death of a spouse, you may want to request a copy of your credit report to take inventory of all the accounts that are open in your name and/or jointly with your former spouse.
If you’re divorced, you’ll want to close joint credit accounts and shift to single accounts so that an ex-spouse’s credit score won’t affect your credit rating. If you’re widowed, contact all three credit bureaus (Experian, Equifax, and TransUnion) to let them know that your spouse has passed away, to keep others from falsely establishing credit in his or her name.
Unfortunately, a surviving spouse is often responsible for paying the deceased spouse’s credit card bills, whether these were joint or individual accounts. It’s always worth calling the credit card company, however, to negotiate better payment terms if necessary.
6. Maximize Social Security benefits.
Here’s some good news: Even if you’re now on your own, Social Security recognizes that you were once part of a married couple, and offers benefits to both surviving and ex-spouses. Widows and ex-spouses are generally entitled to 50% of their former spouse’s Social Security benefits, if those benefits would be greater than their own Social Security benefits.
As a surviving spouse, you can receive full Social Security benefits at your full retirement age or reduced benefits as early as age 60. A disabled widow or widower can get benefits as early as age 50.
If you’re divorced, you could be eligible for Social Security benefits, based on your ex-spouse’s record, if those benefits would be greater than your own retirement benefits. However, your ex-spouse must be eligible for Social Security benefits, and generally you must be unmarried and at least 62 years old.2 In addition, you must have been married for at least 10 years. You can’t avoid the turmoil that comes with divorce or the death of a spouse, but recognizing how your personal finances might change could help you make thoughtful, rather than rushed, decisions and provide more solid financial ground as you transition to being single.
DISSOLVING YOUR BUSINESS–LEGALLY
Here are the main steps you’ll need to take to shut your business down legally and minimize the risk to your personal assets: •Vote to close the business •Dissolve your business with the government •Cancel permits, licenses, and fictious business names •Pay your taxes and debts •Notify your creditors, employees, and customers If you have been doing business as a corporation or limited liability company, you need to officially dissolve your entity so that you are no longer liable for business taxes or filings in your state. Officially dissolving your business also puts creditors on notice that your entity can no longer incur business debts. Your state corporations or LLC unit — usually a division of the secretary of state — should have the necessary forms. For instance, a California corporation must submit to the California Secretary of State a “certificate of dissolution” and a “certificate of election to wind up and dissolve.” These forms set out the disposition of your business’s debts and liabilities, the distribution of your business assets, and how you and your co-shareholders elected to dissolve your business. LLCs have to file similar documents (sometimes called “articles of dissolution”). In some states, before you will be allowed to formally dissolve your business, you may also be required to obtain a “tax clearance” or “consent to dissolution” from your state tax board, declaring that all of your business taxes have been paid. No matter what kind of business you have, you should cancel any kind of permit or license you hold with the state or county — you don’t want anyone else to use your seller’s permit or business name, for instance — that could make you responsible for any taxes and penalties incurred after you no longer operate the business. If you have a seller’s permit or business license, contact the agency that issued the permit or license and cancel it. Likewise, if you’ve been using a fictitious or assumed business name, file an “abandonment” of the name and publish it in a local newspaper — contact your county clerk’s office for a form.
FREQUENTLY ASKED QUESTIONS ABOUT THE CALIFORNIA LIMITED LIABILITY COMPANY (LLC). ARE YOU FAMILIAR WITH WHAT THEY OFFER?
What is a California Limited Liability Company (LLC)? A California limited liability company (LLC), sometimes called a limited liability corporation, is a hybrid of the Partnership and Corporation. The LLC, if properly formed and maintained, offers its members personal limited liability protection (like a corporation) and pass-through tax treatment (like a partnership). California offers three types of LLCs: (1) a single member LLC; (2) a multi-member member managed LLC; and (3) a multi-member manager managed LLC. The LLC is created when proper Articles of Organization are filed with the Secretary of State, and all the organizational fees are paid. California imposes additional post-creation requirements, including the filing of a Statement of Information.
Can anyone form a California LLC? No. Pursuant to California law (California Corporations Code §17002), a limited liability company may engage in any lawful business except banking services, insurance services, and trust company business. In addition, a California LLC is prohibited from providing professional services that must be rendered pursuant to a license, or certification by the Business & Professions Code, or the Chiropractic Act. California Corporations Code Section 17375. Certain professionals, such as: doctors, dentists, lawyers, accountants, architects, real estate brokers, general contractors, chiropractors, etc., are precluded from conducting business through a California LLC.
Can a nonresident alien own a percentage of an LLC? Yes, unlike a California S-corporation, which prohibits a non-resident alien shareholder, a California LLC can have a non-resident alien member. However, if a California LLC has one or more members who are nonresidents of California, the LLC must file with the California Franchise Tax Board (FTB) a list of all such members, their taxpayer identification number, and each member’s consent to the jurisdiction of California on FTB on Form 3832 and Form 568.
Do I need an attorney to form an LLC? No but YES, while an attorney is not a legal requirement, online formation services and document providers will typically only provide you with fill-in-the-blank forms (form Operating Agreement, form Organization Minutes, and form Membership Interest documents), which unfortunately eliminates the main benefit of the LLC – the ability to customize the relationship of the members. These online services also often leave the members to operate the LLC with little or no instruction, which in a majority of cases causes the LLC members to lose their personal limited liability protection, thus exposing each of the members to potential personal liability for the LLC’s debts and obligations. “Would you go to a nurse, instead of a doctor, for cardiac surgery?” But the reality is most people will not see a lawyer until they are forced to hire a litigation attorney, or bankruptcy attorney, who informs them that they could have protected their personal assets, but didn’t.
Most attorneys, especially civil litigators, have a lot to gain from owners of companies (especially LLCs and Corporations) who fail to form and operate their business with the required formalities because instead of spending a few hundred dollars a year with a business attorney or corporate attorney to dot the i’s and cross the t’s, now the individual is going to spend $10,000 to $50,000 to defend a lawsuit, and still face the real probability of not only having to file a company bankruptcy, but a personal bankruptcy as well.
The reason for the custom documents is to provide, amongst a multitude of other things, (1) detailed instructions on how to run and operate the LLC; (2) qualifications as to who can be a manager of the LLC; (3) restrictions on which members/managers can bind the limited liability company; (4) provisions to reduce the likelihood of disputes among the members; and (5) a mechanism to resolve disputes or a deadlock among the members without costly litigation (at least where possible).
What are some the advantages and disadvantages to forming a California LLC? A California limited liability company (LLC) is probably the most flexible entity choice in terms of management and structuring economic sharing arrangements among the members. A California LLC also offers the following advantages:
- Personal limited liability protection for all members, such that unless a member personally guarantees a debt or obligation, or fails to form or maintain the LLC properly, the member may not be held personally liable for the LLC’s debts and obligations.
- Pass-through tax treatment to eliminate the potential for double taxation like a partnership and an S-Corporation.
- No restrictions on permitted members, such that non-resident aliens and corporations can be members of a California limited liability company (unlike an S–Corporation).
- Less burdensome local and state reporting requirements than those required by an S-Corporation.
- Less upkeep and maintenance than a typical corporation.
- Much greater flexibility than an S-Corporation when it comes to management; a California LLC can be structured to be managed by either its members (member-managed LLC) or an elected centralized management team (a manager-managed LLC) and the Operating Agreement can be drafted in such a manner that the members right to remove managers is limited.
- Much greater flexibility than an S–Corporation when it comes to income and loss distribution; for example, where one owner agrees to contribute all of the cash needed for the business, and another owner agrees to contribute his time or services by working full-time for the LLC, the parties might want to structure a preferred cash-on-cash return to the money partner. This can be easily done with an LLC, but would be very difficult to accomplish with an S-Corporation.
- Much greater flexibility when it comes to structuring the voting and profit participation rights of the LLC members. For example if a corporation is owned by two shareholders (one who owns 60% of the shares and the other 40% of the shares), the two shareholders would still have equal voting rights on the board of directors even though one shareholder is entitled to 60% of the profit and the other 40% of the profit. With a California LLC, the two owners can provide for a 60-40 profit split and voting split, which is very difficult to do with an S-Corporation.
- And, for the sole proprietor seeking to form a single member LLC, the ultimate benefit is that the owner of the LLC will not be required to file an additional tax return – just a Schedule C while simultaneously benefiting from the personal limited liability protection afforded to the member of an LLC.
Unfortunately many of the advantages offered by the California LLC are lost when an LLC is formed online, or by an inexperienced practitioner who only provides Basic form Articles of Organization and a basic LLC Operating Agreement. Nevertheless, despite the many advantages, the LLC does suffer from some drawbacks.
What are the main disadvantages to operating a business through a California limited liability company (LLC) Despite the many advantages outlined above, a California limited liability does suffer from some minor drawbacks. The first disadvantage to a California LLC is the fact that many accountants still have difficulty with the laws surrounding the LLC (e.g. a single member LLC does not need to file any special return, just a Schedule C). The second drawback to a California LLC is the additional tax imposed by the California Franchise Tax Board. A California LLC is not only required to pay the minimum $800 franchise tax imposed on California corporations, but also a tax on its gross revenues exceeding $250,000. The third drawback, if the second weren’t enough, to a California LLC is the fact that many of the advantages afforded by a California LLC can only be realized in a customized LLC Operating Agreement (25 to 70 pages) which typically takes twice the time to prepare than an S-Corporation, and generally costs twice as much. The fourth drawback to the California LLC is the fact that certain tax deductions afforded to a California corporation is not available to a California LLC.
While the LLC may be more difficult and costly to properly form than a corporation because of the need for a detailed Operating Agreement, it is much more flexible in terms of structure and management, less burdensome in terms of local and state reporting requirements, and requires less upkeep and maintenance than a California S corporation. Thus while more difficult, and in turn more expensive to have properly formed, in the long run it is probably less costly to maintain if your businesses gross revenues will not exceed $500,000 a year.
What Is The Difference Between a Member-Managed LLC and a Manager-Managed LLC? When all of the members directly manage the limited liability company (“LLC”), it is a member-managed LLC. By contrast, when the members elect or appoint some of the members to be managers to manage the LLC, it is a manager-managed LLC. Your Articles of Organization, or Operating Agreement, should specify which management method best suits your needs.
In which state should I form my LLC? You should probably form a LLC in your home state (assuming that is where you will be conducting your business from), just as you should probably incorporate in your home state. If you file your Articles of Organization in another state to save fees or to take advantage of a different state’s particular laws, then you will also have to register (qualify as a foreign LLC) in the state where the actual business activity is conducted to preserve your limited liability protection. This in effect will create double fees, the requirement to file two sets of state tax forms, and often will subject the LLC to the laws of your home state anyway. California, for example, will impose its laws on any LLC, regardless of where it is organized, that operates in California.
There is one caveat. If you are forming a real estate holding LLC then you should form the LLC wherever the property to be owned by the LLC is located.
Is a California LLC required to hold meetings of its members or managers, like corporations? No, but to maintain your personal limited liability protection, to prevent the imposition of the alter-ego theory, and to limit disputes between and among the members we strongly suggest meetings be held at least annually.
Is an LLC required to maintain certain documents at its principal place of business? YES. Pursuant to California Corporation’s Code § 17058, a California LLC is required to maintain the following documents at its principal place of business:
- A copy of the Articles of Organization, and all amendments.
- A copy of the LLC’s Operating Agreement, and any amendments.
- An alphabetical list of the full name and last known home address of each member of the LLC and that member’s contribution and the share in profits and losses.
- If the LLC is a manager-managed LLC, a current list of the full name and business or residence address of each manager.
- A copy of the completed SS-4 Form used to acquire a taxpayer identification number must be kept for 5 years.
- A copy of the LLC’s financial statements must be kept for the past 6 years.
- A copy of the LLC’s federal, state, and local income tax returns and reports, must be kept for the past six years.
- The LLC’s minutes, or written consents, as they relate to the internal affairs of the LLC must be kept for the past four fiscal years.
- If the LLC owns, or hold’s title to any real estate, a true copy of business records relevant to the amount, cost, and value of all property that it owns, possesses, or controls.
Who votes in an LLC? Typically all of the members. However, remember that with a California LLC, unlike a corporation, the members voting interests and profit distribution can be structured in any way the member’s desire.
How is an LLC Managed? An LLC may be managed by all of its members or by selected managers. Again, one of the greatest advantages to the LLC is the flexibility it affords. If the LLC is to be managed by its members, it operates much like a partnership. Each member has an equal say in the decision making process of the company. By contrast, if the LLC is to be managed by managers elected by the members, the managers will act in a capacity similar to a corporation’s board of directors. These managers are in charge of the affairs of the LLC. Management by all the members (member-managed LLC) is the normal default, but sometimes it is better to have a manager-managed LLC.
How are new members admitted to the LLC? The procedure for admitting new members should be established in the Operating Agreement. Since the Operating Agreement can be formed or structured in any way the LLC members’ desire, it should be reviewed to determine the appropriate procedure.
Can I sell my member interest in an LLC? By default, in California no one can become a member of an LLC (either by transfer of an existing membership or the issuance of a new one) without the consent of a majority voting interest of the members (excluding the person acquiring the membership interest). However the Articles of Organization, and the Operating Agreement, can restrict the sale of member shares in almost any manner (e.g., only to predefined transferees, only after the LLC has refused to purchase the shares, etc…). Your Operating Agreement should therefore be carefully reviewed, preferably by an attorney, to determine if and how your membership interest can be transferred or sold.
How can I dissolve, or close down, a California LLC? To close down, or dissolve a California limited liability company, the members must stop engaging in any and all business, file a final tax return with the Franchise Tax Board, and file a notice of cancellation and dissolution with the Secretary of State within 12 months of filing the final tax return.
Partnerships can be the best thing that ever happened to your business, or the worst if entered into improperly. Thus, don’t be afraid of a ‘partnership’, but just be committed to documenting it properly and considering all of the issues.
The Partnership Agreement and setting up the proper entity/structure for the partnership is the single most important step in the partnership process, maybe even more important than analyzing the merits of the project within the partnership itself. You could have the most potentially successful money-making idea in the world, but if the foundation for the partnership is faulty, the business will ultimately fail.
Here is a checklist of considerations when entering into a partnership that should be helpful:
Contributions of Capital. What in time, money and assets is each partner contributing to the partnership? This includes the initial contributions as well as additional contributions that may be necessary to continue operating the business in the future.
Rights to Distributions, Profits, and Losses. Any right of a member to receive discretionary or mandatory distributions, which includes a return of all or any of the members’ contributions, needs to be clearly and specifically set forth in the Partnership Agreement. Moreover, both limited and general partners should be concerned as to whether or not, and how, profits and losses will be allocated by the partnership. There is a difference between distributions of moneys and allocations of profits and losses on the tax return.
Percentage of Ownership. It is absolutely critical to consider your ownership percentage in relationship to the other partners. Control of the business is what will ultimately determine your personal return on your investment.
Dissolution. The Partnership Agreement should indicate the events upon the happening of which the partnership is to be dissolved and its affairs wound up. An exit strategy for the business as a whole, as well as the individual comings and goings of partners is often overlooked. It is easy to get things started.
Form of Doing Business. Choosing the right type of entity is critical when entering into a partnership. For example, an S-corporation may be extremely beneficial to the partners to save on self-employment tax. On the other hand, a Limited Liability Company could be more flexible and allow for special allocations of profit, loss and voting rights. From a liability perspective, it cannot be emphasized enough that setting up the proper entity is extremely important to prevent unnecessary exposure and liability to the various partners.
Security. If you are a silent partner or even a participating partner, please make sure there are checks and balances in place for the management of the cash and assets in the business. Make sure that your partner cannot run with the money and if he or she does, there is protection in the partnership agreement for acts of fraud and the requisite fiduciary requirements.
Representation. Have a competent and honest attorney either represent the company, or have each partner obtain his or her own attorney to review the partnership documents and address all of the above issues, as well as the individual and specific needs of you and your partner’s particular situation.
Authorization to Managers/Officers. Have a very clear list and understanding of what the managers or officers of the business are authorized to do on behalf of the company. Furthermore, there should be a description of each partner’s responsibilities and duties so each partner knows what to expect from each other.
The above is certainly not a comprehensive list of all of the issues you should consider when forming a partnership, however I feel strongly that it is a ‘good start’. Please make sure that you are sitting down with your partner or partners discussing the best case AND the worst case scenarios.
Contribution: Mark Kohler
A franchise business is a business in which the owners, or “franchisors”, sell the rights to their business logo, name, and model to third party retail outlets, owned by independent, third party operators, called “franchisees”. Franchises are an extremely common way of doing business. In fact, it’s difficult to drive more than a few blocks in most cities without seeing a franchise business. Examples of well-known franchise business models include McDonalds, Subway, UPS, and H & R Block. In the United States, there are franchise business opportunities available across a wide variety of industries.
Investing in a Franchise Business
To invest in a franchise, the franchisee must first pay an initial fee for the rights to the business, training, and the equipment required by that particular franchise. Once the business begins operating, the franchisee will generally pay the franchisor an ongoing royalty payment, either on a monthly, quarterly, or annual basis. This payment is usually calculated as a percentage of the franchise operation’s gross sales.
After the contract has been signed, the franchisee will open a replica of the franchise business, under the direction of the franchisor. The franchisee will not have as much control over the business as he or she would have over their own business model, but may benefit from investing in an already-established, name brand. Generally, the franchisor will require that the business model stay the same. For example, the franchisor will require the franchisee to use the uniforms, business methods, and signs or logos particular to the business itself. The franchisee should remember that he or she is not just buying the right to sell the franchisor’s product, but is buying the right to use the successful and tested business process.
The Franchise Disclosure Document (FDD) is a legal document that franchisors must furnish to prospective franchisees, by law. The Federal Trade Commission (FTC) is the regulatory body that enforces it. That makes it kind of a big deal. The FDD contains information…facts and figures on the franchise business opportunity, and is provided to help you analyze the offering. You, as a prospective owner of a franchise, must receive the FDD at least 14 days before you are asked to sign any contract or pay any money to the franchisor or an affiliate of the franchisor. You have the right to ask for and get a copy of the disclosure document once the franchisor has received your application and agreed to consider it.
Finally, many times the following question is asked of me: “I’m starting a franchise with a partner and want to form an LLC? Do I need a partnership agreement and then also a LLC?” The answer is that there is no need for “partnership” agreement after an LLC is formed, but rather an operating agreement containing party (unit owners’) rights, obligations, and a dissolution procedure. This is will be paramount. In fact, you may also want a buy-sell agreement for corresponding units owned, unless buy-sell options are fashioned within the operating agreement itself.
WHAT IS A FOREIGN LLC/CORPORATION– WHEN DO I NEED TO REGISTER MY COMPANY IN ANOTHER STATE?
Many business owners and investors doing business in multiple states often wonder whether their company, which is set up in one state, also needs to be registered into the other state(s) where they are doing business. This registration from your state of incorporation/organization into another state where you also do business is called a foreign registration. In analyzing whether you need to register your out of state company in a state where you do business or own property it is helpful to understand two things: First, what does the state I’m looking to do business in require of out of state companies; and Second, what is the penalty for failure to comply.
WHEN DO I NEED TO REGISTER?
A survey of a few state statutes on foreign registration of out of state companies shows that a typical requirement for out of state registration is when the out of state company is deemed to be “transacting business” in the other state. So, the next question is, what constitutes “transacting business”? The state laws vary on this but here are some examples of what constitutes “transacting business” for purposes of foreign registration filings.
- Employees or storefront located in the foreign registration state.
- Ownership of real property that is leased in the foreign registration state. Note that some states (e.g. Florida) state that ownership of property by an out of state LLC does not by itself require a foreign registration (e.g. a second home or maybe land) but if that property was rented then foreign registration is required.
Here is an example of what does not typically constitute “transacting business” for foreign registration requirements.
- Maintaining a bank account in the state in question.
- Holding a meeting of the owners or management in the state in question.
So, in summary, the general rule is that transacting business for foreign registration requirements occurs when you make a physical presence in the state that results in commerce. Query:, do you have employees or real property in the state in question that generates income for your company? If so, you probably need to register. If not, you probably don’t need to register foreign. Note that there are some nuances between states and accordingly, you should always verify a particular state’s requirements.
WHAT IS THE PENALTY IF I DON’T REGISTER?
Second, what is the penalty and consequence for failing to file a foreign registration when one is required? Many company owners fear that they could lose the liability protection of the LLC or corporation for failing to file a foreign registration, but most states have a provision in their laws that indicates, “A member [owner] of a foreign limited liability company is not liable for the debts and obligations of the foreign limited liability company solely by reason of its having transacted business in this state without registration.” A similar provision to this language was found in Arizona, California and Florida, but this provision is not found in all states. However, many states impose negative consequences to companies that fail to register foreign. Here is a summary of some of those consequences.
- The out of state company won’t be recognized in courts to sue or bring legal action in the state where the business should be registered as a foreign company.
- Penalty of $20 per day that the company was “transacting business” in the state when it should have been registered foreign into the state but wasn’t. This penalty maxes out at $10,000 in California. Florida’s penalty is a minimum of $500 and a maximum of $1,000 per year of violation. Some states such as Arizona and Texas do not charge a penalty fee for failure to file.
- The State where you should have registered as a foreign company becomes the registered agent for your company and receives legal notices on behalf of your company. This is problematic because it means you may not get notice to legal actions or proceedings affecting your company and it allows Plaintiff’s to sue your company and to send notice to the state without being required to send notice to your company.
- In addition to the statutory issues written into law there are some practical issues you will face if you’re out of state company is not registered in a state where you transact business. For example, some county recorders in certain states won’t allow title to transfer into your out of state company unless the LLC or corporation is also registered foreign in the state where the property is located.
In summary, you should register your company as a foreign company in every state where you are “transacting business”. Generally speaking, transacting business occurs when you have a storefront in the foreign state, employees in the foreign state, or property that produces income in the foreign state. Failure to file varies amongst the states but can result in penalties from $1,000 to $10,000 a year, as well as a failure to receive legal notices and/or be recognized in court proceedings. Bottom line, if you are transacting business outside of your state of incorporation/organization you should register as a foreign entity in those other state(s) to ensure proper legal protections in court and to avoid costly penalties for non-compliance.
ASSET and ESTATE PROTECTION Planning– What are the “Pros” and “Cons” of “Transmuting” Property Owned by a Married Couple in California?
Thanks to James B. Creighton for his meaningful contribution.
Married couples who reside in California have the opportunity to accumulate community property, separate property, quasi-community property, or some combination of the three. Sometimes a married person may wish to convert his or her separate property to the community property of the married couple or even to the separate property of the other spouse. Such a conversion of one spouse’s separate property to the community property of the couple or the separate property of the other spouse is known as a TRANSMUTATION of the character of the property, i.e., transmutation is the process by which the property rights of married persons are changed.
If either or both spouses intend(s) to transmute the character of property that either or both of them own(s), it is advisable that they do so via a written agreement. Such agreements are used for a variety of estate planning purposes. For example, it may be desirable in a long-term marriage to convert the property that a wife inherited from her family to the community property of the wife and her husband to achieve a “stepped-up” basis in the property at the time the first of the spouses dies. (“Basis” means the “starting value,” or what you paid for the property, when calculating the gain from a sale of property. For example, if you pay $250,000 for a piece of real property that you later sell, your “basis” in the property, for purposes of calculating the gain on the later sale, is $250,000. A “stepped-up” basis means an increase in that “starting value,” which will ultimately reduce the amount of capital gains tax that will be owed when the property is eventually sold.) By converting property in this manner, the married couple and their beneficiaries avoid unnecessary capital gains upon the spouses’ respective deaths by receiving a double step-up in the basis (on both halves) of their newly created community property; one step-up in basis on the entire property occurs upon the death of the first spouse and another step-up in basis on the entire property occurs upon the death of the second spouse. (By contrast, property held in joint tenancy receives only a step-up in basis on the one-half of the property that was owned by the first spouse to die; the basis in the property owned by the surviving spouse is NOT “stepped-up.”) Below, I discuss some of the primary advantages and disadvantages of transmuting one’s property.
Advantages of Transmutation.
Let say, for example, that Gwen has a much larger estate than her husband, Chris. In the estate planning context, it might be advisable for Gwen to transmute some of her separate property to Chris’ separate property (i.e., to give Chris some of her separate property), so that Chris can take full advantage of the federal estate tax exemption known as the applicable exclusion amount. The applicable exclusion amount is the amount of property that a person can transfer at his or her death free of federal estate tax. If the cumulative value of Chris’ estate is less than the applicable exclusion amount, then Gwen might consider transmuting some of her separate property to Chris’ separate property, thereby increasing the size of Chris’ estate. Then, when Chris dies, his estate can more fully use this important federal estate tax exemption, which would result in an overall reduction in estate taxes on the couple’s family (because Chris has maximized the size of his estate, while not exceeding the applicable exclusion amount, and Gwen has minimized the amount by which her estate exceeds the applicable exclusion amount by giving Chris some of her property).
In other situations, it may be necessary to transmute property so that the actual ownership of the property reflects the couple’s intentions. For example, if both spouses agreed that one of them should take legal title to real property in his/her name alone to more easily complete the financing of the property, but their ultimate intent was that both of them own the property as community property, then the spouses must remember to transmute the property from the one spouse who took legal title alone to both spouses as their community property. In the case, Marriage of Brooks and Robinson (2008) 169 CA4th 176, 86 CR3d 624, the real estate agent recommended that just the wife take legal title to the couple’s residence because this would make it easier to borrow against the property (i.e., take out a mortgage on the property). The husband agreed, and the wife took legal title to the home in her name alone, as her separate property. The couple used the husband’s earnings from his employment for the down payment. In addition, the husband made payments on the mortgages that were secured by two deeds of trust. Unfortunately, the couple decided to divorce and the true ownership of their home became a matter of dispute. The court held that since the wife had the husband’s consent to take legal title to the family home in her name alone, the home was NOT the community property of both spouses, but instead was presumed to be the wife’s separate property. Although the court explained that this presumption could be overcome by clear and convincing evidence that the legal title on the deed was not the couple’s intent, unfortunately for the husband, the facts that the legal title to the home was taken in this manner to facilitate financing and that the down payment and subsequent payments on the mortgages were traceable to the husband’s community property earnings were not sufficient to overcome the presumption that legal title was conclusive as to ownership of the property. The court concluded that the home was the wife’s separate property. Now, few, if any, married couples would expect that following the advice of a real estate agent that one spouse take legal title to the property to make financing the property easier would result in a court deciding that the spouse on title is the sole owner of the property. They could have avoided this result by signing a Transmutation Agreement that clearly explained their intentions. Such an agreement would have provided the clear and convincing evidence that was needed to overcome the title presumption so that both spouses would have owned their home as they intended, i.e., as their community property.
Disadvantages of Transmutation.
In harmonious and fully functional families, transmutations of property can achieve a number of estate and tax planning advantages for the spouses and their intended beneficiaries (e.g., their children).
However, anyone who is thinking of transmuting his or her real property or substantial personal property should always seek legal assistance before doing so. Not to do so would invite peril. For example, let’s say Margaret’s husband, Tom, used $170,000 of his separate property cash to purchase 2,000 shares of Google stock at $85 per share when it went public in August 2004. The shares of stock were then deposited into a newly opened Charles Schwab account and the title to the account read, Margaret and Tom, Joint Tenants with Right of Survivorship (JTWROS). By taking title to the brokerage account in this way, Tom made a gift of $85,000 of his separate property cash to Margaret (as her separate property), which she then used to purchase 1,000 shares of Google stock. Right? It certainly looks that way. However, the couple did not want to pay an attorney to draft a transmutation agreement and they certainly didn’t want to pay two more attorneys to review the agreement with them. So, neither Margaret nor Tom signed such an agreement.
Now, over six years later, Margaret and Tom are getting divorced, due to irreconcilable differences. The Google stock is trading at $595.00 per share, meaning that the initial $170,000 investment is now worth $1,190,000! And, guess what? Tom claims that he never intended to make any gift of his cash to Margaret. He claims that he put her on title to the Schwab account for convenience only—in case something happened to him and she needed to access the account—and not because he intended her to own half of the Google stock in the account. Of course, Margaret argues that Tom clearly intended to transmute $85,000 of his separate property cash Margaret’s separate property.
The better course of action would have been for Tom and Margaret to have entered into a written transmutation agreement. Clearly, in this case, the cost of assistance from attorneys would have easily been outweighed by the value of the stock Tom and Margaret are fighting over.
A couple cannot transmute property solely for estate planning purposes and not for marital dissolution purposes.
Courts in two important cases have held that a transmutation agreement made for estate planning purposes is also valid and must be used for purposes of divorce as well. In short, there is no such thing as a transmutation of property only for estate planning purposes.
WHAT IS A JOINT VENTURE AGREEMENT & WHEN TO USE IT
A Joint Venture Agreement (aka, “JV Agreement”) is a document many business owners and investors should become familiar with. In short, a JV Agreement is a contract between two or more parties where the parties outline the venture, who is providing what (money, services, credit, etc.), what the parties responsibility and authority are, how decisions will be made, how profits/losses are to be shared, and other venture specific terms.
A joint venture agreement is typically used by two parties (companies or individuals) who are entering into a “one-off” project, investment, or business opportunity. In many instances, the two parties will form a new company such as an LLC to conduct operations or to own the investment and this is usually the recommended path if the parties intend to operate together over the long term. However, if the opportunity between the parties is a “one-off” venture where the parties intend to cease working together once the agreement or deal is completed, a joint venture agreement may be an excellent option.
For example, consider a common JV Agreement scenario used by real estate investors. A real estate investor purchases a property in their LLC or s-corporation and intends to rehab and then sell the property for a profit. The real estate investors finds a contractor to conduct the rehab and the arrangement with the contractor is that the contractor will be reimbursed their expenses and costs and is then paid a share of the profits from the sale of the property following the rehab. In this scenario, the JV Agreement works well as the parties can outline the responsibilities and how profits/losses will be shared following the sale of the property. It is possible to have the contractor added to the real estate investors s-corporation or LLC in order to share in profits, but that typically wouldn’t be advisable as that contractor would permanently be an owner of the real estate investor’s company and the real estate investor will likely use that company for other properties and investments where the contractor is not involved. As a result, a JV Agreement between the real estate investors company that owns the property and the contractor’s construction company that will complete the construction work is preferred as each party keeps control and ownership of their own company and they divide profits and responsibility on the project being completed together.
While a new company is not required when entering into a JV Agreement, many JV Agreements benefit from having a joint venture specific LLC that is created just for the purpose of the JV Agreement. This venture specific LLC is advisable in a couple of situations. First, where the parties do not have an entity under which to conduct business and which will provide liability protection. In this instance, a new company should be formed anyways for liability purposes and depending on the parties future intentions a new LLC between the parties may work well. Second, where the arrangement carries significant liability, capital, or other resources. The more money, time, and liability involved in the venture will give more reason to having a separate new LLC to own the new venture and to isolate liability, capital, and other resources. A $1M deal or venture could be done with a JV Agreement alone, however, the parties would be well advised to establish a new entity as part of the JV Agreement. On the other hand, if the venture is only a matter of tens of thousands of dollars, the costs of a new entity may outweigh the benefits of a separate LLC for the venture.
There are numerous scenarios where JV Agreements are used in real estate investments, business start-ups, and in other business situations. Careful consideration should be made when entering into a JV Agreement and each Agreement is always unique and requires some special tailoring.
By: Mat Sorensen, Attorney & Author of The Self Directed IRA Handbook
CAN YOU RELOCATE YOUR LLC TO ANOTHER STATE?
Limited liability companies that relocate face similar choices to corporations but with more options for handling things organizationally:
1. You can continue the LLC in the old state and register to do business as a foreign LLC in the new state. Doing so means duplicate annual report and/or franchise tax fees. It can also complicate tax filing and reporting for the LLC and its members.
2. Liquidate the LLC in the old state and form an LLC in the new state. Liquidating an LLC does not entail any federal tax consequences. Since the LLC is a pass-through entity, it does not report any gain from liquidation.
3. Form an LLC in the new state and have members (owners) contribute membership interests from the original LLC.
4. Form an LLC in the new state and merge the existing LLC into it. This is viewed as a continuation of the old LLC and no new federal EIN is required. There are also no immediate tax consequences, provided LLC members from the old state continue to own at least a 50% interest in the capital and profits of the LLC in the new state.
WHY KEEPING YOUR HOME ADDRESS PRIVATE COULD BE THE SMARTEST DECISION YOU’VE EVER MADE
Contributed credit By Mark J. Kohler
Protecting your home from a lawsuit and protecting your identity from the public are two very different things. Truth be told, I’ve written and spoken a lot more about protecting your home, than hiding your home address. In fact, I have written numerous articles on the asset protection strategies of how to protect your home.
I suppose the reason why I have focused on home protection, rather than privacy, is because the asset protection topic is actually much easier to address. One of those many pieces of private information, is sharing our home address.
A SHOCKING EXAMPLE: I recently met an acquaintance who on a cruise shared their credit card to rent some recreational vehicles, and when the operators credit card machine didn’t operate properly at this island location, the parties quickly agreed that my friend would wire or transfer money when he got back to the mainland. The contract was tight and the arrangement legitimate and understandable. However, upon his return, due to international banking issues, it was proving difficult to transfer the funds. Nevertheless, within a week he was close to having the problem resolved and the money transferred. But to his SHOCK, there was a knock on his door one late night and the ACTUAL tour operators from this little island, who he recognized from the tour 10 days earlier, were standing on his front door demanding payment at that very moment. After accusations and a tense situation, my friend was able to calm them down and resolve the situation. Yet, the damage was done. My friend realized how precarious and easy it was for someone to find where he lived and confront him in front of his family. He was now a changed man when it came to his privacy concerns. How many of us could envision something like this happening? I’m sure all of us can. I certainly can envision a disgruntled tenant, renter or even client knocking on my private residence. It’s scary for many of us to think where our address is posted publicly and how easy it would be for someone to find it.
Here are just a few tips to consider when starting the process of protecting your home address from the public:
- Start to study and read books on privacy protection. There is a lot of great information out there on privacy websites, blogs and newsletters.
- Realize that if you can’t push the ‘reset button’ and move to a new address, the process is going to be painstaking, difficult and potentially impossible. Your address is in places you may never be able to remove.
- Thus, if you are able to move or planning on moving in the future, make sure you implement a plan to keep that new address private in every possible pay (one of the easiest ways is to start fresh and never give out your address in the first place).
- Basic rule of thumb: NEVER give out your home address unless absolutely necessary to a government agency, and then there are even ways to avoid doing so.
- Establish a P.O. Box or CMRA (commercial mail-receiving agency) and NEVER receive mail or packages at home. Use the address everywhere possible, including the billing for your utilities and at the doctor’s office.
- Place your home into a Trust wherein your name and address are nowhere to be found.
- Set up a privacy entity to hold title to your vehicles and other assets that would typically use your home address.
- Stay committed and don’t give up. One slip and your whole process may be sacrificed to a simple cable bill or something of that nature.
Please realize I’m not suggesting that every person needs to start trying to hide their home address and commit their lives to privacy protection. However, a little more caution could go a long way. In fact, I’m certainly aware that some, if not many of you, may be serving as your own Registered Agent for your company and your home address is “out there”. This is a fascinating area of study for me and I’m discussing the topic more frequently with my clients.
The major take away for me. Identity theft and privacy are becoming more and more something we need to take seriously. Get a plan that fits your needs and situation.
Guest post written by Orrit Hershkovitz
Imagine this: You were married for the first time at age 42, after embarking on a successful career and amassing assets approaching $5 million, the majority of which you kept in bank and brokerage accounts in your sole name. During the marriage, you continued to deposit your earnings into those accounts which you had opened prior to the marriage. Unfortunately your marriage began to deteriorate early on, and you decided to file for divorce just before your fourth wedding anniversary. Your lawyer advises you that the funds in your pre-marital accounts could be deemed “marital property” (or “community property,” if you live in one of the nine community property states, i.e., Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin) and subject to distribution upon divorce.
Why, you ask? If I opened the accounts prior to the marriage and continued to maintain them in my sole name, aren’t they my separate property? Not necessarily.
In all jurisdictions, most property that is acquired during the marriage and before the execution of a separation agreement or the commencement of a matrimonial action is deemed marital or community property, regardless of the form in which title is held. This means that in the absence of a pre-nuptial or post-nuptial agreement that defines the property differently, property that is acquired from the date of marriage until a separation agreement is executed or a divorce action is filed will be subject to distribution, regardless of how the property is titled.
In all states, separate property is exempt from distribution, provided that it is not “transmuted,” or converted, into marital or community property. Separate property generally includes:
1. Property acquired before the marriage;
2. Property that is inherited;
3. Gifts received by one spouse from a third party;
4. Compensation for personal injuries sustained by a spouse during marriage (except for the portion of the award that compensates the spouse for loss of earning capacity during the marriage);
5. Property acquired in exchange for, or the increase in value of, separate property, except to the extent that such appreciation is due in part to the contributions or efforts of the other (non-titled) spouse; and
6. Property described as separate property by written agreement of the parties.
Transmutation can occur when separate assets are commingled with marital assets, such as in the example above, or when separate property is placed in the parties’ joint names. It is presumed in those instances that the separate property owner intended to gift a beneficial interest in the property to the recipient spouse and thus to transform the character of the property from separate to marital.
The presumption may be rebutted by a showing that the property was commingled for purposes of convenience only and not due to any intent to convert the funds into a marital asset. But the longer separate and marital funds co-exist in the same account, the more difficult that becomes to prove.
So what can you do to keep your separate property separate?
Sign a pre-nuptial—or maybe, a post-nuptial.
First, consider entering into a pre-nuptial agreement prior to marriage, to clarify how property will be divided upon your death or divorce. If you are already married, you may enter into a post-nuptial agreement (one type of which is known as a “transmutation agreement” in community property states). Both pre-nuptial and post-nuptial agreements are used to keep property separate and outside of the marital or community estate.
Be aware, however, that some states apply a higher level of scrutiny to post-nuptial agreements and others may not recognize them at all. That is because each spouse has a fiduciary duty not to take unfair advantage of the other. Parties who enter into pre-nuptial agreements have not yet acquired any rights as spouses or parents, whereas once a couple is married, both parties have well-defined rights to support and the division of property. In all cases, courts will want to ensure that the agreement was negotiated in good faith, preferably with each party represented by his or her own counsel, and that it is fair and conscionable both at the time it is signed and at the time of divorce.
Keep separate property really separate.
Second, do not commingle separate property with marital or community property if you do not intend that it be divided between you and your spouse upon your death or divorce. Generally, this means that separate funds should not be transferred to marital or community property accounts, and funds earned after marriage should not be transferred to separate property accounts. New accounts should be opened to receive income earned after marriage.
Additionally, separate funds should not be used to purchase assets during the marriage or to pay for household expenses, and income earned after marriage should not be used to pay for separate debts (such as student loans) or to maintain separate property. To the extent possible, the border between marital or community property, on one side, and separate property, on the other, should not be breached.
Pay attention to record keeping.
Third, keep accurate and complete records to establish the separate character of your property and, if available, its value as close as possible to the date of marriage. If you own real estate, for instance, maintain copies of the deed to the property and/or the HUD-1 Settlement Statement (a document that provides an itemized listing of the funds that are payable at closing). Ownership of stock may be shown by formation documents, corporate records, or minutes, in the case of closely-held entities, or brokerage statements or trade confirmations, in the case of publicly-traded companies.
Bank and brokerage account statements should be kept from the date of marriage not only to establish the status and value of separate property as of that date, but also to enable the tracing of separate property funds should they become commingled with marital or community funds during the marriage. Other documents that should be kept (or obtained) include appraisals; tax returns; bills of sale; notes or cards evidencing gifts; and trusts, wills, and other probate
Be aware, however, that the increase in value of your separate property during the marriage may be subject to distribution upon divorce, especially if such appreciation resulted from your active efforts, such as your management of a stock portfolio or business. If the appreciation is “passive” – that is, due to market forces or to the efforts of one or more third parties – it is less likely to be divided.
If you own a business, take additional steps.
If you have an ownership interest in a business, there may be additional measures you can take to protect your interest (not to mention the stability of the business itself), particularly in the absence of a prenuptial or postnuptial agreement. Buy-sell, operating, and other agreements, for instance, may be structured to restrict a former spouse from having an ownership interest in the business.
If you and your spouse (or soon-to-be spouse) are business partners, you can agree that in the event of a divorce, one of you must leave the business and sell his or her stock back to the other. In that instance, the agreement should provide for a method to determine the value of the selling spouse’s ownership interest, a schedule for payment, and the source of funds to be used for the purchase. Additional precautions include transferring your separate property, including your ownership interest in the company, into a domestic or foreign asset protection trust (except in the case of a S Corporation, whose stock only certain types of trusts can own). The property held by the trust should not be subject to distribution upon divorce, but a court could nonetheless take such property into consideration in determining who gets what and how much of the divisible property.
Short of avoiding marriage altogether, you cannot guarantee the preservation of separate property. By following the above steps, however, you will make it more likely that your separate property will be protected in the event of your divorce.
LIABILITY INSURANCE AND ENTITY LIABILITY PROTECTION:
I am often asked how liability insurance is different from entity liability protection. Liability insurance is purchased from an insurance company to cover claims against the business. Business entities such as limited liability companies (LLC’s) and corporations provide limited liability protection, which prevents creditors from seizing the business owners’ assets.
Business owners do not realize that liability insurance and entity liability protection serve two different purposes. Both liability insurance and limited liability protections help to minimize the risk of financial losses as a result of a lawsuit.
One in three small businesses are sued or threatened with a lawsuit, which makes proper planning and liability protections extremely important.
WHAT IS THE KEY DIFFERENCE BETWEEN LIABILITY INSURANCE AND ENTITY LIABILITY PROTECTION?
Liability insurance protects the assets of the business while a limited liability entity protects the assets of the owners.
Liability insurance is purchased from an insurance carrier and protects the assets of the business (such as equipment, real estate, surplus funds, investments, etc.) in the event of a claim or lawsuit. Entity liability protection comes from forming a business entity that separates the business assets from the owners’ personal assets (such as their homes, vehicles, retirement accounts, savings accounts, etc.).
WHAT IS LIABILITY INSURANCE?
Liability insurance is purchased from an insurance carrier and provides coverage for claims or lawsuits against the business. Insurance comes in many forms, but the most common types of policies covering lawsuits include:
- General liability insurance – also known as an umbrella policy, a general liability policy protects against common legal issues due to accidents, injuries, and claims of negligence.
- Product liability insurance – companies that manufacture or sell retail products may be responsible for the safety of those products. Common areas of risk include a product that causes personal injury or harm.
- Professional liability insurance – also called errors and omissions insurance (E&O), professional liability insurance protects against mistakes made by service providers that harm the clients. Malpractice and negligence are common causes of action. Some professionals are required to carry professional liability insurance, such as physicians.
Liability insurance is an important consideration for small business owners. Even if the business is not making huge profits, often times the money is well spent for peace of mind.
DRAWBACKS OF LIABILITY INSURANCE
There are several key drawbacks to liability insurance including:
- Coverage exclusions – there are a number of ways that an insurance policy would not cover a specific claim, the most common of which are the following:
- The policy does not cover the specific nature of the claim. Policies commonly list certain types of claims that are excluded from coverage. For instance, many professional liability carriers do not cover certain services that are deemed to be high risk.
- Depending on the type of coverage, a claim can occur outside of the period of coverage. Often times, incidents do not develop into claims for many months or even years later. A policy may not cover claims that were in development prior to the policy going into effect.
- There is always the risk that the carrier finds a technicality which they use to base a denial of coverage such as if a policy holder does not follow the carrier’s guidelines or comply with their procedures. A common cause of coverage denial is when the policy holder provides incomplete or inaccurate information on the application for insurance.
- Policy limits – policies have two limits, per incident and aggregate. The limits of a policy are expressed with two numbers; the first being the limit per incident and the second being the aggregate limit (for instance $500,000/$1,500,000). Any claims that occur over this amount may be the responsibility of the business to pay.
- Per incident policy limits – per incident is the maximum amount the policy will pay per claim. If the limit is $500,000 and the claim is for $1,000,000 then the business may be responsible for the difference.
- Aggregate policy limits – aggregate limits are the maximum amount a policy will pay over the course of a policy period. If the limits are $1,500,000 then the carrier will only pay that amount for all claims and the policy holder may be responsible for all claims that occur after the aggregate limits are reached.
If the insurance policy does not cover the entirety of the claim, creditors will typically pursue the assets of the business as the next source to cover the claim. If the business doesn’t have sufficient assets either, creditors could come after the personal assets of the business owners.
With these inherent drawbacks to liability insurance policies, insurance often times does not provide complete protection. Not only is it important to obtain adequate insurance coverage, but it’s also important to create backup protections in case the insurance policy is not enough.
Business owners should always consider entity liability protection to decrease their risk of experiencing personal financial losses.
ENTITY LIABILITY PROTECTION
A limited liability entity such as an LLC or Corporation provides liability protection for the business owners. Business entities prevent creditors from coming after the personal assets of the owners including their homes, cars, savings and retirement accounts, etc. The entity forms a “corporate veil” that shields the owners from liability risk provided that the entity is setup and maintained properly.
Here is an example: Let’s suppose a company makes a mistake and a client is harmed. The client sues the company, wins the lawsuit, and is awarded $400,000. Say the insurance policy has limits of $250,000 per incident, which means it would not cover the entire claim. In this case, the plaintiffs may choose to pursue the remaining $150,000. If the business does not have assets to cover the remainder, the plaintiffs could come after the owners. If the owners are operating as a general partnership and not a limited liability entity, then they could be held responsible for paying the $150,000. If they are operating under a limited liability entity, then it would be difficult for the plaintiffs to successfully recover any money from the business owners.
LIMIT ON ENTITY LIABILITY PROTECTION
A business entity protects the owners’ personal assets but does not protect the business assets. The business entity would help prevent creditors from being able to seize the personal assets of the owners but will not prevent creditors from coming after the business assets. In the above example, if the business has assets, creditors could use those assets to cover the remainder of the claim not covered by insurance. However, the point is that personal assets will be protected.
CONCLUSION: WHAT LIABILITY PROTECTIONS DO I NEED?
It is important to consider obtaining adequate business insurance coverage and setting up entity liability protection as a further safeguard. Since obtaining liability insurance or forming a business entity alone does not provide complete protection, it is wise to consider both.
UNLIMITED LOWDOWN ON LIMITED LIABILITY COMPANIES (LLC)
An LLC is a newer form of business entity. It has advantages over corporations and partnerships. The LLC’s main advantage over a partnership is that, like the owners (shareholders) of a civil law corporation, the liability of the owners (members) of an LLC for debts and obligations of the LLC is limited to their financial investment. However, like a general partnership, members of an LLC have the right to participate in management of the LLC, unless the LLC’s articles of organization and operating agreement provide that the LLC is to be managed by managers.
For California income tax purposes, an LLC with more than one member will be classified as a partnership, and an LLC with a single individual member will be treated as a sole proprietorship, unless the LLC chooses to be classified as a corporation for income tax purposes. To be taxed as a corporation, the LLC files an election on a Form 8832, Entity Classification Election, with the Internal Revenue Service. California treats the LLC and its owners for income tax purposes in the same manner the LLC is treated for federal tax purposes.
- An LLC may have one or more owners, and may have different classes of owners. In addition, an LLC may be owned by any combination of individuals or business entities. An LLC that is taxable as a partnership can achieve both conduit tax treatment and limited liability protection under civil law, similar to an entity taxable as an S corporation. However, an LLC taxable as a partnership does not have the ownership restrictions that apply to entities taxable as S corporations.
- If the LLC has a single member, it will be disregarded as separate from its owner, and will be treated as a sole proprietorship or a division of its owner, unless it elects to be taxable as a corporation.
- In general, all the owners (members) are shielded from individual liability for debts and obligations of the LLC.
- An LLC is formed by filing “articles of organization” with the California Secretary of State prior to conducting business.
- Forming an LLC is simpler and faster than forming and maintaining a civil law corporation.
- LLCs do not issue stock and are not required to hold annual meetings or keep written minutes, which a corporation must do in order to preserve the liability shield for its owners.
- Either before or after filing its articles of organization, the LLC members must enter into a verbal or written operating agreement. A formal, written agreement is advisable.
- An LLC is typically managed by its members, unless the members agree to have a manager handle the LLC’s business affairs.
- Generally, members of an LLC that are taxed as a partnership may agree to share the profits and losses in any manner. Members of an LLC classified as a corporation receive profits and losses in the same manner as shareholders of a corporation legally organized as such.
- An LLC’s life is perpetual in nature. However, the members may agree to a date or event of termination.
- All LLCs classified as corporations that organize in California, register in California, conduct business in California, or receive California source income, must file California Form 100. The California Form 100 must be filed by the 15th day of the 3rd month after the close of the LLC’s taxable year.
- The LLC will be taxed at the corporate tax rate of 8.84 percent and will be subject to a minimum tax of $800.
- All LLCs classified as partnerships or disregarded entities that organize in California, register in California, or conduct business in California, must file California Form 568 Limited Liability Company Return of Income. California Form 568 must be filed by the 15th day of the 4th month after the close of the LLC’s taxable year.
- An LLC required to file Form 568 pays an annual tax of $800, and may be subject to an LLC fee based on total income from all sources derived from or attributable to the state of California. The annual tax is due by the 15th day of the 4th month of the taxable year, and is paid using CA Form 3522, Limited Liability Company Tax Voucher.
- In addition, an LLC filing Form 568 which has members who are not residents of California must file FTB 3832, Limited Liability Company Nonresident Members’ Consent with Form 568. FTB 3832 is signed by the nonresident individuals and foreign entity members to show their consent to California’s jurisdiction to tax their distributive share of income attributable to California sources. The LLC must pay the tax for every nonresident member who did not sign a FTB 3832.
If the Limited Liability Company is classified as a corporation and files California Form 100, the following estimated tax guidelines apply.
- The estimated tax is payable in four installments.
- Installments are due and payable on April 15, June 15, September 15, and December 15.
- Corporations complete Form 100-ES to report their estimated taxes.
- Additionally, members may have to make estimated tax payments for their own reporting purposes.
If the Limited Liability Company is classified as a partnership or disregarded entity and files California Form 568, the following estimated tax guidelines apply:
- Estimated LLC fee is due by the 15th day of the 6th month.
- Members may have to make estimated tax payments for their own reporting purposes.
The LLC treated as a partnership may be required to withhold taxes if the partnership distributes California source taxable income to a nonresident member. For more information about partnership withholding, see FTB 1017.
NEW LLC ACT
On January 1, 2014, a new limited liability company act becomes law in California. The new act, the California Revised Uniform Limited Liability Act (the “new law”), replaces the current law known as the Beverly-Killea Act (the “prior law”). While the new law leaves most of the prior law substantially intact, this article discusses the key changes that the new law will impose.
Application of the new law.
As of January 1, 2014, the new law will generally apply to all limited liability companies (“LLCs”) organized or registered in California. However, there are a couple of noteworthy exceptions from the new law’s general applicability. First, the new law provides that the laws of the state in which a foreign LLC is organized govern that LLC’s organization and internal affairs, the authority of its members and managers and the liability of its members and managers for its debts, obligations and other liabilities. Second, the new law provides that the prior law governs contracts entered into by an LLC, its members and/or its managers prior to January 1, 2014. Given that an LLC’s operating agreement is both the LLC’s governing document and a contract among an LLC’s members and/or managers, it is uncertain whether operating agreements entered into prior to January 1, 2014 are governed by the new law or by the prior law. It would appear contrary to the intent of the new law to exempt certain operating agreements because doing so would impose two sets of laws on some LLCs – i.e., the prior law with respect to its operating agreement and the new law with respect to all other LLC matters. In light of the likelihood that the new law applies to all operating agreements (even those entered into prior to January 1, 2014), it is important for members and managers to have their counsel review the new law’s implications on their operating agreements and matters of general LLC governance.
Conflicts between Operating Agreements and Articles of Organization.
Contrary to the prior law, the new law provides that if there is a conflict between the terms of an LLC’s operating agreement and its articles of organization, the operating agreement will control. However, to the extent a third party reasonably relies on the articles of organization (presumably without knowledge of any inconsistency with the operating agreement), the new law provides that the articles of organization will control over the operating agreement with respect to such third parties. Further, if an LLC is to be manager-managed, both the articles of organization and the operating agreement must expressly provide that the LLC is manager-managed. Accordingly, members and managers should review their operating agreement to verify that it meets the new law’s requirements for the intended management structure.
Required Approval for Certain Major Decisions.
Unless expressly provided otherwise in the LLC’s operating agreement, the new law requires the unanimous consent of the members to carry out any of the following acts: (i) selling, leasing, exchanging, or otherwise disposing of all, or substantially all, of the LLC’s property outside the ordinary course of business, (ii) entering into a merger or conversion, (iii) undertaking any act outside the ordinary course of the LLC’s activities and (iv) amending the operating agreement for the LLC. Under the prior law, absent a lower voting threshold established in the LLC’s articles of organization or operating agreement, unanimous member approval was required only for amendments to the articles of organization and the operating agreement. Under the new law, if such decisions and actions are to require only the approval of the manager(s) or fewer than all of the members, the operating agreement must expressly so provide. Therefore, to the extent practicable, parties dealing with an LLC should request to review the LLC’s operating agreement to confirm that the person, whether a member or manager, representing the LLC has proper authority under the new law to enter into the contemplated transaction.
While the prior law only provides that the fiduciary duties of a manager to the LLC and its members are those of a partner to a partnership, the new law clarifies, and perhaps broadens, a manager’s fiduciary duties to include the duties of loyalty and care. Under the new law, the duties of loyalty and care and any other fiduciary duty of a manager cannot be eliminated but may be modified to some extent. For example, the members can identify in an operating agreement specific activities that do not violate the duty of loyalty if doing so is not “manifestly unreasonable.” The new law also implies that the duty of care may be modified in an operating agreement, provided that such modification does not unreasonably reduce the duty of care.
Note, that any modification of the manager’s fiduciary duties under both the prior law and the new law requires the informed consent of the members. Under certain circumstances, members may be deemed to have accepted an LLC’s operating agreement even if such member has not signed the LLC’s operating agreement. For example, in cases where a member becomes a member of an LLC by way of a conversion or merger of the LLC, he or she may be deemed to have accepted the operating agreement of the surviving LLC. However, the new law provides that a member’s deemed acceptance of an operating agreement is not a member’s informed consent to the modification of a manager’s fiduciary duties in such operating agreement. The practical take away is that managers and members of an LLC should require all new members to acknowledge in writing their consent to any modification of the manager’s fiduciary duties upon their admission into the LLC, including admission in connection with the conversion or merger of an LLC.
Unless the operating agreement provides otherwise, the new law requires the LLC to indemnify members of a member-managed LLC and managers of a manager-managed LLC as long as the person being indemnified has complied with his or her duties under the new law. The prior law permitted the LLC to indemnify any person but did not go as far as the new law to mandate indemnification. Accordingly, managers and members should consider, and consult with their counsel, whether any limitations or requirements should be placed on the mandatory indemnification under the new law.
Limitation of Members and Managers’ Liability for Monetary Damages
. While the prior law addresses the limitation of liability to third parties, it does not expressly address the limitation of a member or manager’s liability to the LLC or the other members. The new law clarifies that members and managers cannot eliminate their liability to the LLC and the other members for money damages for the following acts: a breach of the duty of loyalty, the receipt of a financial benefit to which the recipient was not entitled, excess distributions, intentional inflictions of harm to a person or the LLC or intentional violations of criminal law. However, under the new law, an operating agreement may eliminate or limit a member or manager’s liability to the LLC and the other members under other circumstances.
In light of the new law’s enactment, managers and members of LLCs should revisit their operating agreements and, with appropriate advice from counsel, make necessary amendments to conform their operating agreements to the new law. Likewise, parties transacting business with LLCs should be wary of how the new law affects the LLC’s governing documents and the authority of persons acting on behalf of such LLCs.
In general, a buyer can acquire a target company in one of three ways: asset purchase, stock purchase or merger. Asset acquisitions by definition constitute an assignment of the target company’s contracts to the buyer. Stock acquisitions do not violate anti-assignment provisions because the target company remains the same legal entity—and a party to the non-assignable agreement—before and after the sale. Mergers do not lend themselves to such a straightforward analysis. Only one of two legal entities survives a merger transaction, with the surviving entity assuming all of the extinguished entity’s assets, rights and liabilities.
DO YOU KNOW THESE 5 THINGS ABOUT LIMITED PARTNERSHIPS?
BASIC INFORMATION: General Partners and Limited Partners. Every Limited Partnership consists of at least one general partner and one limited partner. The general partner has decision-making authority and is also responsible for the liabilities of the limited partnership. The limited partners participate in the sharing of profits and losses but do not have a voting interest. Because the general partner is subject to liability of the LP, the general partner is usually a company that does not hold significant assets. The limited partner is not responsible for the liabilities of the LP. The general partner may be an operating S-Corp or a shell company LLC, while the limited partner may be an individual or even a trust.
LIMITED PARTNERSHIPS AND ASSET PROTECTION: Limited partnerships provide some form of asset protection only for the limited partners of the LP against the activities of the LP. For example, if there is a judgment against the LP, that creditor cannot go after the limited partners. In addition, if an owner of an LP has a judgment against him/her personally, that creditor cannot go after the assets in the limited partnership. Instead, the creditor is given a charging order that only entitles it to the assets or income that the LP decides to distribute to the owner of the limited partnership who has the judgment entered against him/her. As a result, the assets of the limited partnership are protected from the personal activities/liabilities of the owner. While some states offer this same liability protection to LLCs (protect the entity from the owners actions), most states do not.
HOLD RENTALS IN AN LLC: The following assets are commonly held by LPs: brokerage/investment accounts; second homes; valuable personal property, and raw land. An LP, however, generally should not hold rental real estate, because the tax rules applicable to LP’s limit an owner’s ability to fully take advantage of certain tax losses.
CANADIANS LOVE LPS FOR REAL ESTATE: While LLCs are great for U.S. Citizens, they cause corporate taxes in Canada for Canadian residents. As a result, Canadians who own rental real estate in the U.S. should use an LP to hold their properties as opposed to an LLC. The LP profits flow through to Canada and are only subject to personal level taxes and are not subject to Canadian corporate taxes. LLC income, on the other hand, flows to Canada and is subject to both corporate and personal taxes.
LIMITED PARTNERSHIPS FOR RAISING MONEY: Limited partnerships are often used to raise funds because under the LP structure, the general partner (the one usually raising the funds) has authority to run the LP while the investors or limited partners do not have a voting right or interest. Because the LP structure places the control in the hands of the person raising the funds, the LP is presumed to be a security for securities law purposes and as a result a securities law attorney should be consulted as to the proper filings and disclosures necessary to raise funds and sell limited partnership interests to investors.
FICTITIOUS BUSINESS NAMES & BUSINESS MYTHS
Sometimes called a Fictitious Business Name, a Doing Business As “DBA”, an assumed business name, or a trade name—these filings let the public know the true owner of a business. I’ll be using DBA and Fictitious Business Name interchangeably here.
The DBA or Fictitious Business Name designation was created as a form of consumer protection, to prevent unscrupulous business owners from operating under a different name to avoid legal issues. When a business files a DBA, it’s typically printed in the local newspaper, so the community can see who is behind the business.
Who needs to file a DBA?
There are two circumstances when your business needs to file a DBA registration:
1: If you are a sole proprietor or general partnership conducting business using a name that’s different from your own name. For example, if John Doe wants to open a bar called Bar for Brew, he would need to file a DBA. In some places, you’re able to use your name plus a description of your product/service without filing a DBA. For example, if John Doe wanted to open a bar called John Doe’s Bar, he may not have to file a DBA. If your business name implies a group (i.e. The Doe Group) or you just use your first name (i.e. John’s Bar) however, then you’ll have to file a DBA.
2: If you have incorporated or formed a limited liability company (LLC) and are operating the business under a name that is different from the name of the company or LLC. For example, let’s say that John Doe’s Bar, LLC also wants to operate under the name JohnsBar.com, the LLC would then need to file for a DBA for JohnsBar.com. Likewise, if John Doe wanted to expand into bar supplies, then John Doe’s Bar, LLC would need to file a DBA to do business as John Doe’s Bar Supplies.
The benefits of a DBA
The main benefit of filing a DBA registration is it will keep you in compliance with the law. For sole proprietors, a DBA lets them use a typical business name without creating a formal legal entity (i.e. corporation or LLC). This is typically the least expensive way to legally conduct business under a different business name.
Filing a DBA gives the sole proprietor the freedom to use a business name that helps market their products or services, as well as create a separate professional business identity. However, be advised that a DBA doesn’t protect your business name from being used by others. For that, you will need to seek trademark protection.
For sole proprietors, filing a DBA is required to open a bank account and receive payment in the name of your business. Most banks will not allow you to open an account without receiving a copy of your filed DBA.
For an LLC or corporation, a DBA lets the company operate multiple businesses without having to create separate legal entities for each business. For example, if you plan on opening a series of websites, boutique shops, or restaurants, you might want to set up one corporation with a relatively generic name and then file a DBA for each website, shop, or restaurant. This will help you control costs and paperwork, while still expanding your business.
How to File a DBA
Specific requirements for filing a DBA vary from state to state, county to county. In some states, you register your DBA with the State Secretary of State or other state agency. In many states, registration is handled at the county level and each county may have different forms and fees for the process.
The Small Business Administration (SBA) offers a chart outlining the different requirements for fictitious name filings state by state. Some states also require that you publish a notice in your local newspaper and then submit proof that you have fulfilled the publication requirement. Turning to a professional legal document filing service can take the complexity out of the process and make sure that you’re following your county and state requirements as outlined.
Deadline to File
DBAs should be filed before any business is conducted using the fictitious business name. Some jurisdictions will allow you to file within a short time period of first using the name. However, since a DBA is usually a prerequisite to opening a bank account for the business or using the name in contracts, it is best to get it done upfront. It’s an affordable process and will keep your business in good legal standing from the start. It does nothing however in the way of providing sound legal asset protection standing alone.
Here are common myths about closing a business:
1. You Don’t Need to Formally Close Your Business
Simply shutting down your website and stopping orders should signify that your business is done, right? Wrong. If you don’t take formal steps in closing your business, you can still be charged fees and be required to submit tax returns to the IRS, as well as an annual report to the state. Find out what your specific city or region requires in order to close a business.
2. Your Business Structure Will Go Away if You’re Inactive
Contrary to what many think, your LLC or corporation will continue to exist until you formally dissolve it by filing your Articles of Dissolution. The government will continue to consider your business entity alive and kicking, and charge you taxes and require you to fill out paperwork until you notify the proper authority that you’re no longer in business.
3. You’re Not Responsible for Any Business Debt Once You Shut Down
You absolutely are fiscally responsible for any outstanding invoices or debts you owe as a business. If you don’t have the money to pay your creditors, unless you’ve set up a business structure that separates you from your business (such as a corporation), you may be personally responsible to pay those debts. You may consider bankruptcy at this point, if your debt is too great.
4. You Can Do What You Want with The Remaining Money in the Bank
If you have business partners or shareholders, that money is legally theirs, and you must divide it up amongst them. Even if there weren’t laws about this, it’s simply good business to do your best by those that supported you and your company.
5. You Won’t Owe Taxes Once You Close Your Doors
Before you take that money you’d set aside to pay your annual taxes and spend it on a blowout holiday, read on: you are responsible for paying any taxes you accrued while you were in business. Whether you shut down your business in January or December, you will owe payroll and sales tax for the months your company was still in operation, even if it’s not now.
DISCLAMER: The information provided by WFB Legal Consulting, Inc. in this newsletter is disseminated for educational purposes only, and is not to be construed as legal advice. Do not take any action, postpone any action, or decline to take any proposed action based on this information without first engaging the representation of a licensed attorney at law in your State of residence.
Every buyer of a small business should consider the following three key legal issues when acquiring a business.
1. Buy Assets and Not Liabilities. Most small business purchases are done as what are called “Asset Purchases”. In an Asset Purchase the buyer of the business acquires the assets of the business only. The assets include the goodwill, name, equipment, supplies, inventory, customers, etc. According to the terms of a properly drafted Asset Purchase Agreement, the assets do not include the prior owner’s business liabilities (the known or unknown). Under an Asset Purchase the buyer typically establishes a new company which will operate the business. This new company is free from the prior company’s liabilities and actions. A “Stock Purchase” on the other hand occurs when the buyer acquires the stock or LLC units of the existing business.
There are a few downsides to acquiring a business under a stock purchase. First, if you buy the stock or units of an existing company then you get the existing assets AND the existing liabilities of the acquired company. Since a new buyer hasn’t operated the business it is impossible for them to accurately quantify the existing liabilities. The second downside to a Stock Purchase is that the new owner of the company takes the current tax position of the departing owner when it comes to writing off equipment and other items in the company at the time of purchase. The downside to this is that the seller of the business may have already fully written off these items leaving the new business owner with little business assets to depreciate (despite a significant financial investment). If, on the other hand, the buyer acquired the “assets” in an Asset Purchase the buyer would depreciate and expense those assets as the new business owner chooses and in the most aggressive manner possible.
Bottom line, an Asset Purchase has less liability risk and has better tax benefits that will allow the buyer to generate better tax write-offs and deductions over the life of the business.
2. Negotiate For Some Seller Financed Terms. Many small business purchases include some form of seller financed terms whereby the seller agrees to be paid a portion of the purchase price over time via a promissory note. Seller financing terms are excellent for the buyer because they keep the seller interested and motivated in the buyer’s success since business failure typically means that the buyer wont be able to fully pay the seller. If the seller gets all of their money at closing then the seller is typically less interested in helping transition the business to the new owner as the seller has already been paid in full.
Also, if the seller misrepresented something in the business during the sale that results in financial loss to the buyer, the buyer can offset the loss or costs incurred by amounts the buyer owes the seller on the note. In sum, the seller financed note gives the buyer some leverage to make sure the value in the business is properly and fairly transferred.
3. Conduct Adequate Due Diligence. While it may go without saying that a buyer of a business should conduct adequate due diligence, you would be surprised at how many business purchases occur simply based on the statements or e-mails of a seller as opposed to actual tax returns or third party financials showing the financial condition of the business. A few due diligence items to consider are; get copies of the prior tax returns for the company, get copies of third party financials, make the seller complete a due diligence questionnaire where the seller represents the condition of the business to the buyer (similar to what you complete when you sell a house to someone). A lawyer with experience in business transactions can help significantly in conducting the due diligence and in drafting the final documents.
Buying an existing business is not only a significant financial commitment but is also a significant time commitment. Make sure the business is something worth your time and money before you sign and make sure you get a well drafted set of purchase documents to sign.
An interesting case has shown that the infiltration of do-it-yourself (DIY) “services” has now filtered down to other professions potentially bringing with it, the practice of law without a license, and potentially causing a ripple effect down to the consumer. While for the last several years now, consumers have been attempting to save money by tackling their own needs by way of the DIY phenomenon, the case at the site below lights up a red flag as to the potential dangers in doing so–both to other professions and the consumer.
Note: A non-attorney planner who put together a QPRT escapes strict liability only because the clients knew the QPRT was defective and failed to take action to fix it. Had there not been this subsequent intervening event, the financial planner would have been STRICTLY liable for the Estate’s losses simply because he was not an attorney, and his E&O policy would very likely have excluded coverage.
Although the financial planner wins, this case is exactly why non-attorneys should not engage in legal planning (though so many CPAs and CFPs, etc., strangely feel compelled to do).
THE CA FRANCHISE TAX EXEMPTION FOR LLC’s
If you have a 401K; If you enjoy buying real property; and if you enjoy LLC liability protection, you’ll want to read this article about how you can safely/legally avoid the $800 per year franchise tax that comes with owning an LLC. See the full article at the link below:
BEST ASSET PROTECTION: INHERITED IRA’S ARE NO LONGER “PROTECTED ASSETS”
A recent Supreme Court decision has now “declassified” inherited IRA’s from asset protection status. This makes the need for specialized trusts dealing with this issue all the more imperative. Remember, there is every good reason to link your estate and asset protection planning by seeking out a LAWYER for BUSINESS who can navigate you around perceived obstacles. Please see the nuts and bolts of the decision at the link below.
NEW MISS. ACT ALLOWS YOU TO SET UP A TRUST FOR YOUR BENEFIT WITH ITS BEST ASSETS PROTECTED FROM FUTURE CREDITORS.
You know, I have always been a big proponent of advising clients about the interaction between asset protection and estate planning. In particular, I’ve always been fascinated with the domestic asset protection trust, typically referred to as a, “DAPT.” Interestingly, Alaska was the first US jurisdiction to enact laws allowing this type of protection, shortly followed by Delaware, Nevada, and South Dakota.
While the following article is very well done and speaks to inter- jurisdictional potential, there are nevertheless two exceptions to the general rule, which may create a conflict of law. One is where a state will not recognize laws of sister states that violate its own public policy, and the second is when the trust owns real property, such property can be governed by the law of the jurisdiction where the property is located. While the full faith and credit clause of the Constitution of the United States provides that each state must give full faith and credit to the laws of every state, this generally means that if a court from another state refuses to recognize the protection of a DAPT and enters a judgment for a creditor, the creditor may be able to enforce the judgment against the trustee of the DAPT, even if that trustee is located in the DAPT jurisdiction.
Read this article, and if you are in the market for such a trust, or simply need to have more questions answered concerning its application, contact me or another lawyer for business who is proficient in both estate planning and asset protection principles.
THE CORPORATE VEIL – AVOID PIERCING YOUR PROTECTION TO INSURE YOUR BUSINESS SURVIVAL
As some of you know, I am an associate professor at a law school in Los Angeles County. One of the subjects that I teach is business associations, which incorporates all facets of agency, partnership and corporate law. In the past few weeks, I’ve been teaching my students about the corporate veil and the protection it provides small businesses if implemented correctly. While on the subject, I thought it might be prudent to pass on some helpful tips in this month’s newsletter.
Clearly, the principal purpose for incorporating your business is to avoid personal liability for any debts or potential liabilities your business may incur. The most widely held entities established by small business owners include corporate structures, limited partnerships to some extent and limited liability companies, otherwise known as LLC’s.
Generally speaking, creditors may only pursue the assets which make up the business entity that has been formed, thereby insulating the personal assets of the business owner. The term “corporate veil” has generally been applied to the insulation of personal assets by way of the corporate structure. Nevertheless, there are instances when a creditor may attempt to reach the personal assets of the business owner by, in fact, piercing this veil of protection. While it is wise to be sure of the law’s application in the particular state in which you reside, some general overall principles should be helpful here in making sure that your entity’s veil is not pierced.
1. Inadequate Capitalization: this potential problem could be the death knell for your entity. If you do not personally, or through some form of financial capitalization, possess money which will cover the debts and, potentially, claims of liability at the time you form your business entity, a potential claim could prove that your entity was really never realistically formed in the first place. Accordingly, make sure you have enough funds on hand to adequately capitalize your business entity prior to thinking about formation.
2. Use Your Company Name: make sure that you use your company name on each and every contract you utilize with customers or clients, including vendors. I also referenced the fact that a prior newsletter that you should never offer a personal guarantee for any potential debts incurred by the entity. Accordingly, make sure you get in the habit of using your specific and company name when executing all business contracts.
3. NO Commingling of Assets: never, and I mean never, mix company assets with personal assets. Make sure you have a business operating account that documents all funds coming in and out of your business. When you make a salary distribution to yourself, for example, this then becomes taxable income and is transferred into your personal account by way of a check or some form of electronic banking perhaps. Never use company funds to purchase personal items until the salary distribution has been taken.
4. Alter Ego Theory: always make sure that no one can claim that your business entity is merely your own alter ego. Your books must be kept in terms of providing adequate minutes and documenting annual meetings that occur concerning company business. If you do not follow specific corporate formalities, someone may allege that you established what amounts to a phony entity specifically for purposes of avoiding personal liability.
5. Pre- Entity Promotions: finally, prior to the formation of your business entity, do not enter into any contracts or make any representations or acknowledge, that a company to be formed will incur debts or provide products or services that include business negotiations being considered prior to the entity’s actual formation. This may cause unwanted financial problems in the future which may cause personal liability, especially if you are forming an entity with other individuals who are unaware of your representations.
S-CORP vs. LLC 101: IMPORTANT KEY DISTINCTIONS
The LLC and S Corporation: key differences
Both the LLC and S corporation are well-liked among accountants and small businesses because of their “pass-through” tax treatment. Unlike a C corporation, both of these structures do not pay taxes on business profits; rather profits are passed along to the owner(s) and reported on their individual tax returns. Moreover, both structures separate the owners from the business and provide liability protection.
However, there are some differences between the two. For example, an LLC is typically much easier to run from an administrative standpoint. There are fewer state filings and forms, lower start-up costs, fewer formal meetings and documentation than there are with a C or S corporation. This conceivably could be advantageous to small business owners who don’t want to be bothered with excess paperwork.
The LLC also offers more flexibility in how owners can allocate a percentage of profits and losses among its owners. Example: you start a business with a friend and you each own 50% of the business. One year, your friend has something come up in her personal life and doesn’t spend as much time on the business as you have. You both ultimately decide that the fair thing to do would be to give you 60% of the profits for the year. If you had formed an S corporation, you would both still be taxed based on the percentage of your ownership (i.e. you would be taxed on 50% of the profits; your fellow shareholder on 50%, even though you might have agreed to a different “arrangement”). Conversely, the LLC does give you the flexibility to determine how you want to allocate your business’ profits so that each owner canl be taxed accordingly.
Nevertheless, there is a critical advantage of an S corporation with regard to taxes. The S corporation gives you more flexibility in how earnings are paid to the owners. Example: with an LLC, the entire net earnings are passed along to the owner(s) in the form of self-employment income and are consequently subject to self-employment tax for Social Security and Medicare. However, with the S corporation, you have the option of dividing up earnings into wages/salaries versus passive income in the form of distributions. Only the wages/salaries are subject to the FICA tax for Social Security and Medicare. The “passive” distributions are not. IMPORTANT NOTE: keep in mind that as an owner working in your business, you must pay yourself a reasonable salary for the job you do. You cannot get away with giving yourself a $40,000 annual salary and taking $175,000 in distributions, for example.
Merging the LLC and S Corporation
You can also set up your business as an LLC and then make the election to have it treated as an S corporation by the IRS. From a legal perspective, your company is an LLC, not a corporation. That means you still get all the advantages of the LLC in terms of fewer filings with the state, as well as less paperwork and lower costs all around. Nevertheless, in the IRS’s eyes, your business is an S corporation. You get the pass-through of income just like a sole proprietorship or partnership, and you get the added flexibility of distributing some of the company’s income as distributions not salary— potentially saving on Social Security/Medicare (i.e. SECA/FICA) taxes.
The “How to” for setting up an S Corporation
If you’re interested in electing S corporation tax treatment for an LLC, there are certain restrictions for who can form an S Corporation. Shareholders must be legal residents of the U.S. and must be individuals (not partnerships or corporations). To file for S corporation treatment, you’ll need to file Form 2553 with the IRS. Please consult with your accountant or CPA. There are strict deadlines for when it needs to be filed. A new company has 75 days from the date of its incorporation (or LLC formation) to file.
BEST ASSET PROTECTION AND THE FAMILY SAVINGS TRUST
An increasingly popular tool used for asset protection and estate planning is known as The Family Savings Trust. The term is broadly descriptive of a trust designed specifically to hold and protect a variety of assets against lawsuits and business risks. It can be very flexible in form and allows for the accomplishment of most important asset protection and estate planning goals.
Expanding Asset Protection Laws
Perhaps due to the difficult economic times, and widespread outrage against perceived abusive lending practices by financial institutions and questionable collections tactics by their attorneys, the law in most states is moving in a more favorable and permissive direction for asset protection planning. As long as the planning is not intended to defraud creditors, avoid spousal or child support obligations or violate existing laws against Fraudulent Transfers, there are now opportunities to achieve varied asset protection and estate planning goals within a reasonably simplified structure.
At last count 12 states had adopted specific laws expanding the permissible uses of asset protection trusts. These laws now generally permit an individual to protect assets in a qualified trust even while drawing income or principal from the trust. Although the effectiveness and usefulness of the law differs in each state, the trend itself is positive and is dramatically increasing the available planning strategies. Similar favorable results can be achieved for residents of most other states within the existing statutory framework and case law.
Protecting Your Home and Other Assets
Based on these new laws and advances in technique, the purpose of the Family Savings Trust (FST) is to combine the best features of domestic and even offshore arrangements within a single trust entity. Since the FST is intended to hold a variety of assets, appropriate language should be included which addresses the particular issues associated with each asset to be placed in the FST. For example, if you wish to protect the equity in your home from any future potential claim, the FST will contain specific language to protect the residence while preserving the tax benefits associated with the home (mortgage interest, property taxes, avoidance of gain in sale) and make sure that the property can be refinanced or sold at any time in the future. If your assets consist mostly of savings and brokerage accounts and depending upon your goals and the circumstances of your case, the FST may be designed to permit you to retain the level of management and continued enjoyment of your property that you wish. For instance the trust may permit you to serve as a trustee and special beneficiary with current rights to income and principle. Alternatively, you earn enough from your practice to maintain your lifestyle without current need for the income from your savings. You may choose to set aside and accumulate your future savings until retirement, when your liability risk has diminished substantially. If you do not need to use the current income from your investments while you are practicing, this type of arrangement may provide excellent protection with maximum flexibility.
Many physicians have membership interests in existing LLCs which in turn may own related businesses or real estate investments. If these interests are valuable, or may be in the future, the FST can be drafted to protect these particular assets from “charging order” or foreclosure by a creditor or a plaintiff with a legal judgment. Similarly business assets such as accounts receivable and equipment can be shielded by the FST if these are important assets in your practice.
BEST ASSET PROTECTION IDEAS FROM BLOOMBERG NEWS
The maneuvers are getting fresh scrutiny from officials in states including New York, which is losing an estimated $150 million a year through such tax avoidance. As fewer Americans pay the estate tax and top earners in New York and California owe more state income taxes, wealth planners say their clients are looking for new ways to escape those levies. See full article at link below.
SOME INSIDE INFORMATION ON OFFSHORE ASSET PROTECTION
Individuals, such as doctors, real estate developers, and business owners are exposed to the perils of personal liability from lawsuits, personal guarantees, and other financial risks. These individuals have been the focus of marketing and solicitations from financial institutions, attorneys and financial advisers lauding the virtues of offshore irrevocable trusts to protect their assets. However, this may not always provide the BEST ASSET PROTECTION.
What the advertising and promotional material fail miserably in providing is a true picture of how creditors have used the courts in the United States to defeat many of the benefits offshore trusts might have offered at one time. Creditors have learned tricks, such as cutting a debtor off from access to the assets in an offshore irrevocable trust, that frustrate the asset protection intent of the offshore scheme.
The Ultra Trust offers asset protection that is far superior to offshore trusts without subjecting a person to the risk of contempt citations, bankruptcy, fraud allegations, or criminal sanctions. There are several reasons why the Ultra Trust irrevocable trust is a better choice than offshore irrevocable trusts for asset protection.
Creditors Have U.S. Courts on Their Side
Creditors learned that chasing assets hidden in irrevocable trusts in foreign countries rarely meets with favorable results from courts and laws that favor protecting their nation’s ability to attract U.S. investments. Undeterred, creditors turned to courts and laws in the United States for help
Assets transferred to a properly created, implemented, and funded irrevocable trust are owned by the trust and managed by a trustee. The creator of the trust is no longer the owner of the assets. This is true whether the trust is domestic or offshore.
Courts have taken the position that a trustee or a settlor in the U.S. is subject to the jurisdiction of American laws regardless of where the trust and the assets are located. Even where a foreign trustee has been used, creditors have obtained injunctions and asset seizure orders against the settlor and anyone living in the U.S. who might be the recipient of benefits from the trust. In fact, a man transferred assets to a Bahama Trust with the help of his attorney The attorney had suggested an irrevocable trust. The man had judgments against him over ten years later. The courts ruled that the state law applied, not Bahama law, and ordered him to turn over the trust assets. The man fled the country and both he and his lawyer were indicted for obstruction of justice and conspiracy to obstruct justice.
As reported in Forbes magazine, the widow and children of an offshore irrevocable trust settlor was effectively barred from enjoying the benefits of the assets locked away offshore through a series of forfeiture orders and contempt proceedings against her. While the assets might be safe from the reach of creditors, contempt orders against settlors or beneficiaries in the U.S. are highly effective creditor weapons.
Uniform Trust Code Supports UltraTrust as Asset Protection Vehicle
According to article 5 of the Uniform Trust Code published by the National Conference of Commissioners on Uniform Laws, the creditors of a settlor of an irrevocable trust can only enforce their claims against distributions to or on behalf of the trust settlor.
The Uniform Trust Code recognizes the right of a settlor to retain a limited power of appointment while retaining the protection of the trust’s assets from the claims of creditors. Estate Street Partners requires full consideration to transfer property to the trust to protect its integrity and avoid challenges by creditors.
Asset Protection Is a Legitimate Estate Planning Device
Offshore irrevocable asset protection trusts have become associated with schemes to defraud creditors. Federal disclosure laws target people with offshore accounts because of the widespread illegal, fraudulent and unethical practices that have come to light within the last decade. Offshore accounts must now be reported on personal income tax returns, and foreign financial institutions are being pressured by the federal government to comply with U.S. laws by reporting transactions involving American citizens.
Domestic irrevocable trusts are used extensively for legitimate estate planning purposes and can be effective in asset protection when prepared in consultation with a financial planner and an attorney knowledgeable and experienced in preparing irrevocable trusts for asset protection. The UltraTrust has proven itself as an effective estate-planning tool that surpasses offshore asset protection trusts with specific language complying with current federal and state laws and IRS regulations. Rather than circumvent the law, UltraTrust uses the language of the laws to protect settlors and their assets.
Contact UltraTrust Before Risking Your Money Offshore
Creditors and the IRS are winning the battle against irrevocable offshore asset protection trusts. Contact UltraTrust to learn how your assets can be safely and lawfully protected without having to leave the country.
Source: Forbes, “The one foreign asset protection trust ‘win’ turns out to be a dud,” Jay Adkisson, April 25, 2013.
Source: The National Conference of Commissioners on Uniform State Laws, “Trust Code Summary,” 2013.
LIMITED LIABILITY OF MEMBERS AND MANAGERS; PERSONAL LIABILITY UNDER AGENCY LAW
An LLC generally shields its members from liability for the company’s obligations. However, there are circumstances in which members may be held personally liable for the LLC’s obligations. Here are a few examples:
- If a member has an oral side agreement to reimburse the LLC for payments made on a note, which he or she signed in their capacity as a member of the LLC, the individual may be held personally liable.
- 2. When signing contracts or other obligations, members should always include their title (e.g., Chief Executive Officer) and the LLC’s name. This will ensure that any breach of contract claims against the member individually will be dismissed, especially when there is no evidence that the member intended to be personally liable. Any contractual obligations assumed by the LLC belong to the entity, not the individual signatories or the LLC’s members. Individuals who sign a contract that indicates title but does not name the LLC, may bind themselves instead of the LLC on the contract (by virtue of the individual’s failure to respond to a specific discovery request, for example). However, If the signature block of the contract states the name of the company without the “LLC” designation, a court may still consider the variance too insignificant to find the individual signatory personally liable. This finding is further supported if there is no evidence that the other party to the contract was ever misled about the company’s identity as an LLC. However, a person who knowingly omits “LLC” in the signature block is liable for any indebtedness, damage, or liability caused by the omission. Even when an individual signs a contract as president of the LLC, a court may hold the individual personally liable if the contract includes personal guarantee language. The bottom line: contracts should never include personal guarantee language and signature blocks should always include 1) the signing person’s title and 2) the company’s name, including the “LLC” designation.
- Members of an LLC who personally participate in tortious conduct (bad acts) of the company may be held personally liable for the consequences of their conduct. Members or managers may be personally liable if they, in their individual capacities, damage someone else’s contractual or business relationships. For example, if a member makes a down payment under a contract of the LLC to purchase real estate and uses a personal check that bounces, he is personally liable for the bad check. An agent or an officer who participates in the commission of a tort is liable whether or not he is acting on behalf of another or the LLC. Even if officers and agents of the company are not participating “hands on” at every step, they may be held personally liable for violations. This liability is not based solely on their membership in the LLC. Rather, it is the fact that they are present and participating in the operation of the company while a violation is being committed (either by them or the company) that incurs the liability. The LLC’s members are not, however, always liable for bad acts of another person associated with the company: if an employee commits a tort without approval or knowledge of the member, then the member may remain insulated by the LLC.
- As for negligent conduct, a manager of an LLC may be held personally liable for approving, directing, actively participating in, or cooperating in the company’s negligent conduct.
- An LLC’s officers may be held personally liable if they are acting on behalf of the company, and the company, through bad faith misrepresentation, breaches a contract.
Remember, where the protection of a business entity like an LLC is nullified, Agency Law principles come into play to evaluate the application of liability. Under the Restatement Second of Agency, authority to do an act can be created by written or spoken words or other conduct of the principal which, reasonably interpreted, causes the agent to believe that the principal desires him to act on the principal’s account. Protect the distribution of authority by visiting:
BEST ASSET PROTECTION LAWYER FOR BUSINESS: CHANGES IN THE LAW THAT TAKE EFFECT FOR LLC’s IN CA.
California’s new LLC Act takes effect on January 1, 2014. I have always been a big proponent of Operating Agreements and the absolute need for legal counsel. Take a long peak at this interesting article emphasizing the interaction between agreements and amendments to those agreements going forward. http://www.lexology.com/library/detail.aspx?g=a2ec9555-6d21-41a1-8868-5442deec0caa
BEST ASSET PROTECTION LAWYER FOR BUSINESS
CHARGING ORDER PROTECTION:
Both LLC’s and Corporations will generally shield their owners (i.e. Members or Shareholders respectively) from liabilities incurred inside the LLC or Corporation. For example, if an LLC owns an apartment building and a tenant in the apartment slips, falls, & sues, the lawsuit would be directed at the entity (i.e. the LLC) and not the individual owners of the LLC (absent piercing the veil arguments). The same personal liability shield would apply to shareholders of a corporation as to debts or liabilities incurred inside that corporation.
The primary difference between the liability protections of a corporation versus an LLC arises in the context of liabilities and claims directed specifically at the owners of these entities. Lawyers call this “outside liabilities” because the claim or liability occurs outside of the entity.
For example, if the owner of a corporation is involved in an auto accident unrelated to the business of the corporation and the injured party obtains a judgment against the owner personally, the judgment creditor may be able to obtain a “turnover order” from a court ordering the owner of the corporation to “turn over” his/her shares in the corporation to satisfy the judgment.
On the other hand, depending on the state, a judgment creditor of a member of an LLC does not automatically have the right to order the LLC member to turn over his/her membership interests.
The exclusive remedy available to a judgment creditor in many states as to interests in an LLC is a “charging order. This is essentially a lien on the member’s interest in the LLC, and unless the state allows for foreclosure of this lien, the only value that a creditor gets from a charging order is any distribution of property from the LLC to that debtor-member.
Since the LLC can usually control the amount of distributions to a member, this can be a significant impediment for a judgment creditor and one of the reasons that WFBLC generally recommends LLC’s for rental properties, land, and any sort of liquid assets, as opposed to a corporation.
Furthermore, there can be many onerous tax ramifications by trying to hold assets in a corporation and the LLC can be much more flexible. The ‘trick’ in this entire process is to ensure the following:
CHOOSE THE RIGHT ENTITY
In some states a Limited Partnership may be a better choice than a Limited Liability Company. It will depend on the type of asset, the tax ramifications, and the rules for charging orders in that state.
CHOOSE THE CORRECT STATE: THE PROPER OWNERSHIP STRUCTURE FOR THE ENTITY
Are you going to own this entity with a master or ‘parent’ holding company, are you going to have your revocable living trust in the mix, etc… A lot of people set up the wrong entity as the ultimate owner for their assets that can again cause tax problems, even though it may provide superior asset protection. There is a balance that usually requires the input of an experienced lawyer and/or tax professional.
NOT GETTING RIPPED OFF
Many ‘incorporation services’ and self-professed asset protection gurus will claim that Nevada is the panacea for all asset protection, and also sell one-size fits all structures. Not always the case. It can be expensive to unravel a bad structure, and the money spent on the front end is a loss.
In summary, you must ‘tailor’ your asset protection plan to you. Charging Order protection is real and it really works. But if the proper structure isn’t established and maintained, it won’t be worth the paper it is printed on.
Be cautious of one-size fits all non-lawyer companies, and get a second opinion if something sounds too good to be true or you have an uneasy feeling in your stomach.
Call THE BEST ASSET PROTECTION Services Group—WFB LEGAL CONSULTING, Inc.– to set up a personal consultation over the phone in any state to tailor a plan for you.
A common tax strategy used by small business owners is the salary/dividend or salary/net income split. This strategy can only be executed in an S-corporation where a business owner can pay themselves a portion of income in salary and a portion of income in dividend or net profit. The goal is to pay as little salary as possible (and as much net income as possible) in order to minimize the amount of self-employment taxes that are due.
This strategy cannot be utilized in a C-corporation, an LLC or sole proprietorship. Keep in mind that this method cannot be used in passive business structures, such as real estate businesses which produce rental income. This “passive” income is exempt from self-employment tax and therefore it is not necessary to implement the income splitting technique herein discussed.
Simply, the strategy is implemented by “splitting” the income that is payable to the S-corporation owner into two categories: salary and net income (or “dividend”). The reason this splitting of income is advantageous is that net income received by the S-corporation owner is not subject to the 15.3% self-employment tax that is otherwise due and payable on salary. For every $10,000 of income an S-corporation owner can classify as net income in contrast to salary, the business owner will save $1,530. Bear in mind, however, that after roughly $100,000 of salary is taken, the savings of pushing additional income to net income is reduced because the self-employment tax rate then drops to 2.9%. Nevertheless, it may certainly still be worth implementing.
When this strategy was first implemented, some taxpayers decided to just pay all of their income out as net income and elected to take no salary or wages. Therefore, they paid no self-employment tax. This was challenged by the IRS, which resulted in Revenue Ruling 59-221. This ruling stated that a business owner who renders services to their business must take “reasonable compensation” for the services so rendered. Be aware of the following general guidelines and practices:
- FULL TIME WORKING BUSINESS OWNERS SHOULD TAKE A LARGER PORTION OF SALARY TO NET INCOME THAN PART TIME WORKING BUSINESS OWNERS. If the business owner is involved full time in the business, more salary will be required. If the business owner’s involvement is part time or if they are involved in other businesses, a much lower salary can be justified.
- DON’T TAKE A SALARY THAT IS BELOW THE SALARY PAID TO LOWER LEVEL EMPLOYEES IN YOUR BUSINESS.
- IT IS RECOMMENDED THAT YOU TAKE A SALARY THAT IS AROUND THE INDUSTRY AVERAGE FOR A PERSON OF SIMILAR EXPERIENCE IN YOUR TYPE OF BUSINESS.
As a general rule, I recommend that business owners take at least 1/3 of their income as salary and pay self-employment tax on that amount. Taking a large portion of income from your business as net income rather than salary, will allow a tax savings each year that you will come to appreciate.
Presented by: BEST ASSET PROTECTION Services Group
WFB Legal Consulting, Inc.
BUY-SELL AGREEMENTS: WHAT ARE THEY and WHEN and HOW TO USE THEM
When we use the term Buy-Sell Agreement, we are not talking about a contract in which you promise to buy a business. Rather, the Buy-Sell Agreement of which we are speaking here, is a binding contract among the owners of your business that controls the buying and selling of ownership interests in the business.
The major benefits of adopting such an agreement are as follows:
- It may be that you are working with and sharing control of your company with a less experienced individual who buys the interest of a departing owner.
- It may be that you are forced to work with a spouse or other family member of a deceased or divorced owner. Here the possibility exists that this individual will lack the necessary business skills or the right personal qualities for working with both you and your other fellow owners.
- Should you leave the company or pass away, you or your survivors may possess a very small business interest which no third party wants to purchase and, moreover, for which no other insider (other owners in the business) will offer you a fair price.
- Likewise, you and your co-owners may argue with a departing co-owner or the inheritors of that co-owner over what price should be paid for the interest that now belongs to someone else. A buy sell agreement will avoid an angry deadlock in this regard.
Here is an example of the advantages of a Buy-Sell Agreement:
Tom and Jerry form a small Corporation each owning 50% of the corporate stock. While they don’t perceive problems in the future, they elect not to bother with a Buy-Sell agreement. However, several years later, Tom and Jerry disagree over how to expand the business. Tom therefore decides to sell his shares to Joey, whom Jerry has never met. An impasse is quickly reached on management issues and the business is deadlocked without profitability moving forward.
A Buy-Sell Agreement can prevent this from happening by giving the owners the power to prevent by giving the owners the power to prevent unwanted third parties from buying into the company. Sometimes this is accomplished by giving remaining owners the opportunity to meet any third-party offer, a provision which is referred to as the “right of first refusal.” Likewise, a Buy-Sell Agreement can give surviving owners the power to purchase the interest of an owner who has died if the surviving owners don’t want the inheritors of the deceased to become involved as co-owners of the business.
Remember, however, that although a Buy-Sell Agreement can benefit most small businesses, there are specific situations where one is not essential, such as where you are 100% owner of the business; where you own the business with your spouse only; and where you own a business with one of your children. With respect to your spouse, however, it might indeed be prudent to employ such an agreement if you haven’t been married for a lengthy period of time, or if your future with your spouse seems to be on tenuous grounds.
BEST ASSET PROTECTION SERVICES GROUP: WFB Legal Consulting, Inc.
*Please be advised that this communication is for general public informational use only and does not establish an attorney-client relationship. For more information, please contact WFB Legal Consulting, Inc.—a BEST ASSET PROTECTION Services Group at (949) 413-6535.
This short expose briefly focuses on different types of business entities and gives some insight as to which one might be better suited to general goals and situations. You should always consult with a business lawyer who can than better fashion the entity that is right for your particular business.
Professional corporations, known as PCs, are available options to those in certain occupations. This structure is available to accountants, lawyers, medical professionals, architects, and engineers. Although PCs don’t offer the level of personal liability protection of S corps or LLCs, this structure does protect owners from malpractice claims filed against other associates. PCs must usually be approved by the state agency that licenses the professionals. Remember, PCs will not protect you against malpractice suits, but will eliminate your liability for claims directed at your associates.
An S Corp is much like an LLC. Net profits in an S corporation are “distributed” to stockholders, who then add these profits to their personal income for tax reporting purposes. S corps are similar to all other corporations, except for this tax issue. Other corporate requirements–holding regular management meetings, for instance–are identical to all other corporations, be they a single stockholder company or Microsoft. You create your corporation in the usual manner, as specified by your state regulations, and subsequently “elect” to be taxed as an individual, thereby creating an S Corp for IRS purposes.
Limited Liability Company
An LLC functions like a standard corporation in many ways, including personal asset protection, but is much less complex to organize, file, document, and manage. LLCs combine the best features of partnerships and corporations, offering limited liability to owners, while dividing up profits among the partners. Similar to S corporations, you enjoy protection for your personal assets regardless of financial or operating problems that may befall the LLC. In most cases, company creditors cannot seize the assets of the owner/members. Like a classic partnership, LLCs must file an IRS form 1065, which displays the ownership percentages of the members, for taxable income distribution.
Liability Protection Warning
There are some situations that may jeopardize your personal asset protection offered by corporations or LLCs. Small businesses often endure this problem because the owner(s) are frequently asked to give “personal guarantees” for loans, leases, and other obligations. When you agree to provide a personal guarantee of corporate debt, your assets–homes, autos, bank/investment accounts–are legally at risk. Other actions, such as performing illegal activities or injuring someone else, can also allow a court to remove the personal asset protection offered by corporations and LLCs.
The Best Option
Professionals can choose to use an S Corp or an LLC, in addition to forming a PC. The malpractice protection offered by a PC is often the most important consideration, particularly for accounting and medical professionals. If you are not a “professional,” and if your company is a one-person entity or a partnership, the LLC is often the best choice to receive the personal asset protection you want without complex corporate necessities. Should you want to attract more stockholders however, but yet plan to keep your company private (no public stock offerings)–an S Corp is often the best choice.
*Please be advised that this communication is for general public informational use only and does not establish an attorney-client relationship. For more information, please contact WFB Legal Consulting, Inc.—A BEST ASSET PROTECTION Services Group at (949) 413-6535.