NASE Blogs

PROTECT YOUR PERSONAL ASSETS FROM BUSINESS DEBTS

Thursday, March 24, 2011

The issue:  Let’s assume your business has debts it can’t pay and you are successfully sued.  Now your creditor has a court judgment against your business.  If that creditor takes and sells your business assets and the debt is still not paid, can that creditor also take possession of your personal assets (your home, car, savings, etc.) and sell them?  The answer depends mostly on what type of business entity you own.  Is your business entity a sole proprietorship, a partnership, an LLC, a corporation, or some other entity?   Here are the general guidelines that will tell you how much protection for your personal assets you can expect from various kinds of business entities.

 

Sole Proprietorship:

A sole proprietorship offers no protection for the owner’s personal assets.   If you are a sole proprietor you are personally responsible for the debts and obligations of your business.  So if there is a successful lawsuit against your sole proprietorship and your business assets aren’t sufficient to pay the debt your creditors can also attempt to take your personal assets.   

 

General Partnerships:

General partnerships offer no protection for the partners’ personal assets.  All general partners share liability, jointly and severally, for all partnership debts.  If you are a general partner and there is a successful lawsuit against your partnership a creditor can take not only the assets belonging to the partnership’s business but if the debt is still not paid that creditor can also take your personal assets and the personal assets of all of the other partners.  In such circumstances, after taking the business assets, creditors will usually next try to take assets from the partner having the most assets or the most liquid assets, or both. 

 

Limited Partnerships:

All limited partnerships have at least one general partner and many have more than one.  In addition, limited partnerships have at least one limited partner and most have a number of limited partners.  In a limited partnership the general partners are usually responsible for management of the business and are also liable for the debts of the partnership just as they would be in a general partnership.  If a creditor has taken the assets of a limited partnership but is still owed and you are a general partner of that partnership the creditor can also attempt to take your assets and the assets of all of the other general partners.   Limited partners, on the other hand, generally enjoy limited liability.  In other words, if you are a limited partner your maximum liability for a partnership debt is the extent of your investment in the business and a creditor cannot take your personal assets.  Be cautious however: If you are a limited partner you should be careful about the degree to which you become involved in management of the limited partnership.  The general rule in most jurisdictions is that if you are a limited partner but your behavior reasonably leads a person doing business with you to believe that you are a general partner you can become liable to that person for some or all of the limited partnership’s debts and obligations.  If you become a limited partner the best idea is to let the general partners do virtually all of the partnership business while you avoid appearing to have management responsibilities.

 

Limited Liability Company, or LLC:

The owners of a Limited Liability Company are called “members”.  The members of an LLC having more than one member enjoy liability protection under the umbrella of the LLC.  That means that a creditor with a court judgment against an LLC can take the assets of the LLC but cannot take the personal assets of the members.  In some jurisdictions there are even statutes providing that the typical reasons relied upon by courts that find a corporate shareholders’ assets to be available to a judgment creditor (known as piercing the corporate veil) cannot be used by the courts to allow a creditor to take an LLC member’s assets (pierce the LLC veil).   You should be aware that members of member-managed LLCs and managers of manager-managed LLCs have obligations and a duty of loyalty to the other members/managers of the LLC and failure to meet these obligations and duties can result in liability to the other members/managers.   

 

Single-Member Limited Liability Company, or SMLLC:

Beginning in about 2003 courts in various states began to make a distinction between LLCs with only one member and LLCs having more than one member.  In an important recent case a Florida court allowed a creditor having a court judgment against a single-member LLC to take possession of the member’s entire interest in the LLC.  As the new owner of the LLC that creditor was then free to do whatever it wanted to with the business.  When considered together with decisions from courts in other states this result suggests that the general trend is for courts to strip SMLLC members of their personal asset protection.  If you are considering forming an LLC you should strongly consider forming it with at least one other member to avoid the possibility that a court in your state might rule that your single-member LLC is not protected from being taken by a creditor having a court judgment.  If you already own a single-member LLC you probably should consider adding one or more additional members.  Before you do anything, find out what the laws of your state say about modifying LLCs.  If you proceed, be sure you have a well-thought-out agreement with the new member(s) regarding each member’s liabilities and above all, consult an attorney with substantial experience in business matters. 

            Summary of LLC asset protection:  The asset protection offered by an LLC having more than one member is generally believed to be good and in some cases, even better than the asset protection offered by a corporation.  However, LLC asset protection in general has not been thoroughly tested in every state and because of recent court decisions asset protection offered by a single-member LLCs is highly suspect. 

 

Limited Liability Partnership, or LLP:

This somewhat uncommon entity is similar to an LLC.  It is formed when a general partnership files an application with the secretary of state registering the partnership as a Limited Liability Partnership.  It offers the partners the same protection from personal liability as does an LLC or a corporation.  Unlike partners in a general partnership, if you are a partner in an LLP you are not liable for partnership debts or for other obligations of the partnership.  Nor, as a partner in a LLP, are you liable for the acts and omissions of any other partner of the partnership.  You are, however, liable for your own acts or omissions and for wrongful acts and omissions of any person under your direct supervision and control, such as an employee of the LLP. 

 

Limited Liability Limited Partnership, or LLLP:

Not all jurisdictions “recognize” this type of partnership.  Where it is recognized this type of partnership is usually created by filing an application that includes a statement that a limited partnership has “elected” to be an LLLP.  The result of filing this LLLP election is that instead of the general partners having joint and several liability for partnership debts the general partners have asset protection and neither they nor the limited partners are liable for the debts and obligations of the partnership.  LLLC asset protection for general partners is similar to the protection enjoyed by the members of an LLC.  In a jurisdiction where this type of entity is not recognized the entity will probably be treated like a limited partnership and will have only the same liability protections as a limited partnership. Recently some states have begun to “recognize” LLLPs formed in other states.

 

CORPORATIONS AND S-CORPORATIONS:

The general rule, and the result of most lawsuits against corporations, is that personal assets belonging to stockholders of a corporation cannot be taken to pay the debts or other obligations of the corporation.  Similarly, the personal assets of directors and officers cannot be taken to satisfy corporate debts or obligations.  The most common problem that arises with respect to asset protection resulting from owning corporate stock it is that from time to time courts have allowed plaintiffs to “pierce the corporate veil” of protection and attach personal assets of shareholders.  However, these “veil piercings” are almost always the result of one or more of the following:  The corporation failed to observe its own formalities such as having annual meetings, keeping corporate records, filing annual reports, was undercapitalized, mingled assets with its shareholders, shareholders used corporate property for personal reasons, or was clearly formed for the purpose of defrauding creditors.  Absent any of these issues corporations offer good asset protection for stockholders.  S-Corporations differ from ordinary corporations only in that they pay no taxes on corporate income which is, instead, passed through to stockholders.  Otherwise S-Corps are essentially the same as ordinary corporations and offer the same asset protection.

 

WHAT’S THE BEST ENTITY TO OWN WHEN YOU (not your business) GET SUED?

Here the issue isn’t that someone might sue your business.  The issue is that you own stock in a corporation and someone who has successfully sued you might want to take some or all of your corporate stock.   In some states that creditor can obtain a second court order that forces the corporation to transfer your stock to them.  That creditor will then have all of the rights you had including, among others, the right to inspect the corporate books and sometimes even the right to force the corporation to buy them out.  If you owned enough stock to control the corporation that creditor might even be able take over your controlling position.  The situation under LLC statutes is usually different:  LLC statutes usually limit a judgment creditor by saying that the creditor can only take income that would otherwise have been distributed to you.   In other words, the judgment creditor doesn’t get anything unless the LLC distributes income to its members.  Perhaps more importantly, you don’t lose your membership or its rights and the LLC can accumulate capital and pay daily expenses so it can continue to do business as usual.  If the LLC decides not to make distributions for an extended period the creditor gets nothing during that time.  Under these circumstances creditors are more likely to settle or don’t bother seeking the second court order.  Because of these circumstances and because corporation stockholders pay taxes both on corporate earnings and then again when they receive dividends LLCs are more and more often the business entity of choice.

 

PROFESSIONAL ENTITY OPTIONS:

By law, professionals such as doctors, accountants, engineers and attorneys can’t limit liability for their own personal negligence.  However, in most states a group of professionals can form limited liability partnerships, professional limited liability companies, or professional corporations.  There are generally limitations on who can own shares, serve on the board and/or as officers of such corporations and state licensing laws may impose additional restrictions.  However, other than for personal negligence, these entities protect their owners from liability in the same fashion as they do for non-professionals.

 

Other personal asset protection - EXEMPT PROPERTY:

Every state has “exempt property laws” that keep at least some personal property from being taken by a creditor with a judgment.  These often antiquated laws are supposed to protect individuals from losing assets vital to basic living (home, a car, retirement income, etc.) but with some exceptions depending on the state where you live, the asset protection offered by exempt property laws is usually minimal.  Here’s a list of some of the assets most commonly protected and an indication of the amount of value protected:

- An automobile - or sometimes the value of an automobile ($1,500);

- General household items ($500- $750);

- Jewelry ($1000);

- Tools of a trade ($500);

- Life insurance if the policy has not matured, or its loan value, etc. ($5,000);

- Social security or veteran or public assistance benefits or unemployment compensation;

- Payments from a stock bonus, annuity or any kind of retirement account.

- Homestead property:  Homestead exemption laws typically prevent the forced sale of a home to meet the demands of creditors.  These laws usually provide that a homestead must be the primary residence and no exemption can be claimed on any other property even outside the state.  In some states homestead protection is automatic.  In many states, however, the homeowner must file a claim for homestead exemption with the state, and will not receive homestead protection until this has been done. The protection usually disappears if the homeowner moves but doesn’t file for a homestead exemption for the new home. There are often exceptions to homestead protection including most commonly: The need to sell the home to satisfy a mortgage, mechanics or similar liens or, in some states, sale of the home to pay delinquent property taxes.

 

INSURANCE:

In addition to protecting your personal assets with the appropriate business entity you can get additional protection for both your business and your personal assets from some kinds of liability by carrying sufficient liability insurance.  In addition, you should carry adequate casualty insurance both personally and for your business.   

 

PERSONAL LIABILITY FOR ONE’S OWN ACTS: 

A somewhat common misconception is that by doing business under the umbrella of a corporation, LLC or similar entity an individual has complete protection of his or her own personal assets from a judgment creditor.   This is not true.  No form of business entity protects you from liability for your own personal negligence or deliberate wrongdoing.  Even if you are insured and your personal assets are protected from being taken by an individual having a judgment against your business you remain responsible for your own actions and if you are found guilty of personal wrongdoing your personal assets can be taken by someone who successfully sues you personally.

 

A Footnote:  Where to Form A New Business:

In some cases you might consider forming a corporation or LLC in a state other than where you plan to locate your business.  Many choose Delaware because it has well-developed and very favorable laws with respect to most corporate issues.  Other states advertise other advantages such as no state income tax or complete confidentiality.  No matter where you form your business you will have to register it with the state where your company is located and you will be subject to that state’s laws and regulations including payroll and income taxes.  If you do business in several states there may be additional issues depending on the nature of your business.  If you form your business in another state you will have to have a registered agent in that state and you will also have to have a mailing address and a mail-forwarding service there.  The minimum fees for these services in most cases will usually be in the neighborhood of $1000.00 per year or more.  Absent some specific need, there is probably little or no advantage to forming your business anywhere other than where it will be located. 

Comment

  1. RadEditor - HTML WYSIWYG Editor. MS Word-like content editing experience thanks to a rich set of formatting tools, dropdowns, dialogs, system modules and built-in spell-check.
    RadEditor's components - toolbar, content area, modes and modules
       
    Toolbar's wrapper 
     
    Content area wrapper
    RadEditor's bottom area: Design, Html and Preview modes, Statistics module and resize handle.
    It contains RadEditor's Modes/views (HTML, Design and Preview), Statistics and Resizer
    Editor Mode buttonsStatistics moduleEditor resizer
      
    RadEditor's Modules - special tools used to provide extra information such as Tag Inspector, Real Time HTML Viewer, Tag Properties and other.