A properly formed company is recognized as a separate legal entity with its own Federal tax ID Number. Undergoing this process brings several asset protection benefits. Limited Liability Companies protect assets in two ways. The first is the protection of personal assets from business creditors. This is referred to as the corporate veil. The second is the protection of business assets from personal creditors.
Most states provide little or no protection in this regard, thus placing your business at risk. Wyoming LLCs do provide this second type which is called charging order protection.
Enjoying these benefits is not as simple as only filing Articles of Organization with the Secretary. Rather, the LLC must be funded and care taken to obey other corporate formalities, e.g. annual meetings and a proper set of books. Interested in asset protection? Visit our page on Wyoming Trusts here.
The Limited Liability Company (LLC) is a legal entity or “person,” separate from its members, managers, any officers, and employees. One advantage of doing business in the LLC entity form is to prevent LLC obligations from becoming the obligations of its limited members, managers, officers, and employees. To accomplish this goal, it is essential that the separate existence of the LLC be recognized and respected.
Any business done by the LLC should be conducted in the LLCs name to preserve its status as a legal person. Business should not be conducted by the individuals involved in their individual capacity, but only in their business capacity, such as “Member.”
It is important that receipts and disbursements flow through the correct entities. For example, if rent is received by the LLC from a property owned by the LLC, the rent should be deposited in the LLC’s account. Business transactions must always be done through business, not personal, accounts. Please find a fuller list of LLC requirements here.
What About Property Transferred to the LLC?
It is extremely important that LLC property is clearly understood to be that of the LLC and not that of any individual member, manager, or officer. The LLC is not simply a separate pocket of its members. It is a distinct legal entity. The failure of the members, managers, and officers of a Limited Liability Company to recognize that their LLC’s cash or other assets are not theirs could cause significant and unpleasant encounters with the IRS, and could invalidate asset protection features of the LLC.
Any assets transferred to the LLC become the property of the LLC and must be treated as LLC property. Insurance policies for fidelity bonds, liability insurance coverage, and property coverage should be obtained in the name of the LLC. If there will be liability coverage for individuals as well as for the LLC, the individuals should be added as additional insureds.
For instance, if the LLC distributes money or assets, this must be done: As wages or salary (for management fees); or A distribution of profits taxable to the member; or As a loan (loans from an LLC to its members are extremely suspect to the IRS, and unless completely documented have a questionable chance of surviving an IRS audit). Likewise, cash or property made available to the LLC by its members will either be considered a contribution to capital or a loan, and all loans should be properly documented. Properly documented, this also means that the note should be signed and should bear a market interest rate.
An LLC can protect assets from personal lawsuit creditors. When a judgment is entered against a member individually, that individual member’s personal creditor generally cannot seize any assets of the LLC. Creditors of an individual member usually only have some rights to distributions from the LLC should any occur. Rights would not typically include any right to manage the company or to demand that distributions be made from it or to vote the LLC interest. LLC law generally provides a creditor with only one way to collect a judgment; this is what is referred to as a “charging order.”
A charging order allows the creditor to seize LLC distributions actually made, but there is no way for the creditor to force a distribution. The creditor would be forced to wait until a distribution was actually made to the debtor-member.
An LLC agreement generally allows withholding of LLC distributions to members in order to accumulate revenue for the reasonable needs of the LLC. This would increase the members’ capital accounts. Moreover, under IRS rules, even if a creditor didn’t receive distributions, the creditor may be required to pay the income tax associated with the LLC interest that is subject to the charging order. This leaves the creditor in the unenviable position of paying taxes on money not received.
Most state laws make a charging order the “sole” remedy for a creditor of a limited member. Some states have provided that the charging order is the “exclusive” remedy. The judgment creditor could collect the debtor’s share of any income distributed by the LLC.
A charging order entitles the creditor to distributions (not management fees, loans, or sale proceeds) made to the debtor Member. For this purpose the creditor is given a status that is the equivalent of an assignee of the debtor member’s interest. The IRS (Rev. Ruling 77-137) is read by many commentators to suggest that the assignee should receive a K-1 statement showing the assignee’s share of LLC income, even if no distributions of cash are made from the LLC. Since the LLC is a pass-through entity for income tax purposes, the debtor’s share of undistributed income may be taxed to the judgment creditor even though the debtor did not receive the LLC income. This type of income is sometimes referred to as “phantom income.”
The possibility of “phantom income” can provide a strong disincentive for someone who sues a person owning interests in an LLC or a strong incentive to settle early. If the creditor’s share of phantom income is a significant amount, it may throw the creditor into a higher tax bracket, and could even force the creditor to pay more in income tax in a year than he actually received in income.
Some creditors will not be deterred by a charging order. Some creditors have significant loss carry-forwards that they will never be able to use. These potential creditors are rare. A creditor with a tort judgment is the more common creditor of a limited member. When we consider who the most likely creditors might be and their commitment to forcing settlement or receiving an award, the typical creditor will usually be deterred by the tax consequences of a charging order.
Since the charging order might not be a deterrent for that particular potential future creditor, consider an asset protection trust to hold LLC units. The trust is not the same legal person as the member being sued and would not even be a proper party to the lawsuit or claim. Remember that an asset protection trust needs to be created and funded before the potential liability occurs or becomes reasonably known for the best protection.
A homestead should normally be kept out of the LLC because of the tax advantages available to owners of a homestead residence (the homestead exemption for property taxes). If the homestead is transferred into the LLC, fair market rent must be paid to the LLC. Also, in many states, there are homestead exemptions that protect part or all of a personal residence from creditor claims. These exemptions may be large or relatively inconsequential, depending on state law.
There are some situations where you might want the homestead to go into the LLC. If the home value is high, the loss of the homestead exemption might cost considerably less in the long run when compared to any estate tax savings. Also, if the creators of the LLC don’t mind paying rent (which could further reduce their taxable estate), then putting the homestead in the LLC could work. Generally however, it is best to leave the homestead out of the LLC.
Non-business tangible personal use personal property, like furniture, jewelry, collectibles, and the like should be kept out of the LLC. Since most clients prefer to continue to use their personal property, they should keep it out of the LLC in order to avoid having to rent it from the LLC.
Cars and other motor vehicles that are used for personal use should also be kept out of the LLC. A motor vehicle can produce tremendous personal liability for the owner of the vehicle if an auto accident happens. By keeping vehicles out of an LLC, our clients avoid having to rent the vehicles from the LLC, and also protect the LLC itself from incurring liabilities that can exist for owners of motor vehicles.
Annuities, IRAs, and other qualified retirement plan funds, should be kept out of the LLC since these items must be personally owned for certain tax purposes. Transfer of these assets to an LLC would result in adverse immediate income taxes. However, there are often ways to incorporate those assets into LLC planning.
Transfer of Specific Assets to the LLC
Investment assets should go into the LLC. These assets include but are not limited to:
- Investment real estate;
- Stocks, bonds, mutual funds, money market accounts, and CDs;
- Business interests like shares of a closely held corporation (but not shares of an S corporation), partnership interests, and Limited Liability Company membership interests (be sure to check partnership, LLC, shareholder, and other agreements that might restrict the transferability of closely held business interests);
- Notes receivable, and mortgages and trust deeds given as security for notes; and
- Life insurance not owned by irrevocable gifting trusts or irrevocable life insurance trusts.
The value of all assets transferred to the LLC in Wyoming must be determined at the time of contribution to the LLC. Assets that do not have a readily ascertainable value, such as real estate, notes receivable, business interests in closely held companies or LLCs, may need to be appraised by a qualified appraiser.
Valuation of the LLC
In addition to the appraisal of the underlying assets contributed to the LLC, a qualified business appraiser or evaluator must also value the Wyoming LLC units when the units are gifted or sold and also in the event of the death of the owner of the units. The valuation, or business appraisal, is needed to justify any valuation discounts claimed in connection with gifting, in order to substantiate the positions taken on Federal Gift Tax Returns. A comprehensive appraisal is appropriate in the event of a challenge by tax authorities or in the event of litigation. You should use a competent, well-qualified appraiser or evaluator who will produce a thoughtful, comprehensive and intelligible appraisal or valuation report. An inexpensive appraisal may ultimately cost you far more than an appraisal report produced by a reputable business appraiser. You should plan to pay for the expertise needed for a competent appraisal.
We use the following criteria in recommending appraisers:
The appraiser must have a good reputation for quality work in the field of appraisals. We depend on other law firms to tell us about their experience with appraisers. We must have favorable reports about the appraiser’s work from other trusted professionals.
It may be appropriate to have the appraiser hired by the attorney to maintain the attorney-client privilege on communications between the appraisers, your legal advisors, and you. Since the communications between the law firm and the appraiser could affect the valuation adjustments determined by the appraiser, we often suggest that the information communicated be protected by attorney-client privilege. Therefore, the law firm often retains the appraisers on behalf of the client.
We prefer to recommend appraisers with specific experience in family entities, with a successful track record for audits, and even those who have been hired by the IRS . There are many business appraisers who prepare valuation reports, but some have not valued family entities or been through an audit on the valuation issue.
Ownership & Title
When a person owns an asset in his or her name it is typically available to a creditor in a lawsuit unless the asset enjoys an exemption from creditors under state law. A person identified as owning valuable real property or investments may be viewed as a “deep pocket” target for litigation. Proper planning results in the individual owning relatively little in his or her name (or in his or her revocable living trust) in order to be a less inviting target.
Form of title, and state law, are critical factors in determining creditor or debtor rights. In some states, marital rights in property may affect the rights of some creditors to claim it, for example. Assets protected by bankruptcy laws are exempt from creditor claims. Even when bankruptcy is not filed, certain types of assets are protected under bankruptcy laws and exemptions. Each state has its own rules about what assets are exempt under the bankruptcy laws. Learn more about
All other assets are non-exempt assets. Non-exempt assets are the only assets a creditor can attach in a lawsuit. Non-exempt assets are the usual type of assets transferred into an LLC to as part of an asset protection strategy.
If an individual owns real estate and someone is injured on that real estate, the injured party can make a claim or sue the owner of the real estate. If the value of available liability insurance, coupled with the value of the real estate, is not enough to satisfy the claim, the injured creditor can obtain any other non-exempt assets owned by the real estate owner. This is called an “inside” liability.
Savvy real estate owners protect themselves by creating a business entity to own the real estate. Should a third party injury occur, it is the entity that will be liable to the injured party, because the entity is the owner of the property. The creditor can execute their judgment against the assets owned by the responsible LLC. A member of the entity is insulated from further claims since there is no personal liability, only entity liability. A member would only be personally liable if the “LLC veil” is pierced (i.e. the entity disregarded as a sham) or if the member entered into a personal guarantee against the risk.
Suppose the real estate owner creates a business entity and contributes real estate to it. Then the owner is involved in a car accident, and an injured third party sues the owner. Let’s assume further that the auto insurance coverage is not enough to satisfy the claim. The creditor can then look to other assets owned by the owner of the car to satisfy the claim. However, since the real estate is owned by the LLC, the creditor has no ability to levy against it.
Fraudulent transfers (also called fraudulent conveyances) are an issue in asset protection planning because creditors often claim that the property was transferred after the claim arose. The definition of a fraudulent transfer is fairly broad. A fraudulent transfer is usually a transfer that is made before or after the claim arose with the intent to defraud, hinder, or delay a known or likely creditor. Intent is generally presumed, leaving the defendant with the burden of proof that there was no fraudulent intent, and it is extremely difficult to prove a negative such as this. Courts look at “badges of fraud” including the transfer of non-exempt assets, a transfer for less than full and fair consideration, with insolvency as a consequence of the transfer. If the court determines that there was a fraudulent transfer within the applicable statute of limitations it can set aside the transfer.
Avoiding Fraudulent Transfer Problems
The key to avoiding fraudulent transfer problems is the timing of transfers to an LLC or other asset protection entity such as a domestic or offshore asset protection trust. An asset protection system must be in place before a claim arises in order to get the best possible result. This is not to say that estate and asset protection planning cannot be done under threat of a claim. However, if a claim has arisen additional design and planning issues will need to be considered.
If a creditor has a legitimate complaint against the LLC itself, the LLC is the party sued. The creditor may satisfy its judgment with LLC assets and/or insurance. Remember this rule: A creditor can always get to the owner of an asset, and the creditor can also generally get to other assets owned by the owner. To help short circuit this process, you should consider establishing a Wyoming Trust. If the LLC owns real estate, a judgment creditor of the LLC can levy on the real estate. If that is all the LLC owns, then there are no other assets for the creditor to get, but if the LLC owns many assets, they would all be at risk. This arrangement will not work in all states, however, so LLC members should consult with counsel to obtain more information before implementing an arrangement of this nature.
To avoid the danger of “all eggs in one basket” an LLC may be structured with subordinate entities to own “risky” assets, i.e. those that create liability. The preferred solution is for the LLC to own one or more subordinate limited liability companies. An asset protection design can involve wholly-owned subordinate LLCs (taxable as disregarded entities) to hold risky assets. Since this is the lawsuit risk faced by the LLC, the LLC contains the risk and protects both the other LLC assets and the General Member. The LLC is the property owner, so only the assets of the LLC would be at risk. This arrangement will not work in all jurisdictions, so LLC members should consult with counsel to obtain more information before implementing an arrangement of this nature.
A creditor has three potential outcomes from a successful claim. The creditor could hope to receive LLC units, could wait until the LLC is liquidated to collect the liquidation value available, or could obtain a charging order.
Can the Creditor Obtain a Member’s LLC units?
LLC units are personal non-exempt property and as such would appear to be collectible. Can the creditor really get the LLC units? Since status as a member depends on the terms of the agreement, a debtor-member would first have to get permission from the other members before making the transfer to a creditor, an unlikely result. A creditor might be an assignee, but that is merely a right to receive distributions, not a right to exercise LLC rights such as voting.
Since a member has no right to take assets from the LLC, the creditor does not have the right to take assets from the LLC either. The creditor could sue the member, get a judgment, and wait until the LLC is liquidated to collect it as that member collects his or her share of the liquidated assets. If the LLC is set up to last for 50 years with a 50-year option, the creditor might not collect for almost 100 years. That is a long time to wait. Will the creditor be willing to wait years, even decades, to be able to collect? For most people, waiting until liquidation to collect is not a viable option.
So What Do Creditors Do?
Many creditors prefer to settle the lawsuit rather than dealing with a charging order and facing the risk of phantom income. The LLC helps to level the litigation playing field by forcing a creditor to spend at least the same amount of money pursuing the claim, as the debtor will spend defending it. With the addition of asset protection trust planning, the situation shifts even more in favor of settlement on favorable terms for the client.
Creation of subordinate limited liability companies (LLCs) to own risky property can be an effective tool to contain the damages resulting from a lawsuit involving the property that created the liability. Using LLCs to insulate risky assets from safe assets will make a lot of sense for individuals who have personal risk, or who serve as General Partners of limited partnerships. Risky assets held in a separate or subordinate LLC do not contaminate the safe assets held in the LLC itself, or in other LLCs, so long as the entities are operated properly.
Similarly, use of an appropriate entity Manager is an added level of protection for persons serving in that capacity. The use of an asset protection entity makes certain that no individual is exposed to personal liability. Protecting a Manager and protecting the assets of the LLC from any potential joint liability goes hand in hand. Learn about additional Wyoming LLC Benefits such as their privacy and anonymity .
Maintaining Proper Insurance Coverage
Adequate liability insurance coverage for the LLC is critical. First, insurance coverage means that defense counsel will be provided. Second, insurance is the carrot that will make some creditors settle their claims in short order. Insurance proceeds provide an easy alternative to costly litigation with uncertain results.