Copyright by John T Reed
One of the most common questions I get from readers is whether they should incorporate, form a limited liability company, use an S corporation, and so forth.
This is a manifestation of the asset-protection movement which has arisen in recent years as people have heard about more and more lawsuits that successfully stretch the law to cover more and more situations.
The short answer is there is no answer. Each form of ownership has advantages and disadvantages. You need to pick the one where the combination of advantages and disadvantages best match your needs—both now and in the future.
Unfortunately, the list of advantages and disadvantages for each ownership form is multiplied for each area of law pertinent to the activity. For example, an LLC has one list of advantages and disadvantages for federal income taxes, another for state real estate law, another for college financial aid, another for eligibility for Medicaid, another for pension planning, another for bankruptcy planning, and so forth.
To make the decision correctly, you would have to consult with a competent lawyer from each pertinent specialty. That list includes, but is not limited to:
- federal income tax law
- state income tax law
- state tort law
- federal laws pertinent to real estate
- securities laws (possibly)
- bankruptcy planning
- estate planning
- pension planning
- elder law
- college financial aid law
- landlord-tenant law
- partnership law (possibly)
- trust law with some entities
- divorce or family law
- foreign law if your entity will be created in a foreign country like the Cayman Islands
- HUD law
- business law
- construction law (possibly)
- criminal law (possibly)
- environmental law
- labor law
- finance/debt collection law
- social security law (surprisingly complex and nutty—sometimes imposing a 100% tax on your earnings)
Can you really check with lawyers in all those specialties? As a practical matter, no. It would take too much time and money. And guess what! Even if you could, it would leave you worse off because their advice would conflict. Some would say to use an LLC because of the advantages and disadvantages in their area while another would say go with sole proprietorship because of the advantages and disadvantages in his area.
Who would resolve the conflicts? No one. In medicine, general practitioners and pharmacists resolve some conflicts. But there is no one in medicine to resolve specialty conflicts like a surgeon who recommends surgery for your cancer and a radiologist who recommends radiation treatment. General practitioners can resolve some general conflicts. But they do not oversee surgeons and radiologists.
And in the legal profession, there is not even a general practitioner at all. You’re on your own, baby.
One recommendation I make is to stand up at your local property owners meeting and ask if anyone has tried using an LLC (or whatever entity you are considering) and what good and bad experiences they had as a result. That’s not as good as consulting the nonexistent legal general practitioner, but it would be helpful enough to be worth doing.
There is also the issue of life changes. I took an estate-planning course once. As it progressed, I got madder and madder at the attorney who taught it. He kept saying things like, “If you die first, this structure is best. But if your spouse dies first, this other structure is best.”
“How are you supposed to know who’s going to die first,” I asked.
“You can’t,” he said, adding that there were special laws pertaining to people dying from long-term illnesses that prevented you from changing things during such an illness to get better inheritance-tax treatment.
“So what good is this information you are giving us,” I asked. He had no answer saying only that he was not responsible for the law.
If you look at the list of legal specialties above, you will see some relate to life changes like divorce and death and birth of children. That adds yet another dimension and more lists of advantages and disadvantages. What is the best ownership form depends in many cases on your health, your spouse’s health, whether you have kids, the health of your marriage, whether you have partners, need for college financial aid, and so forth.
Like I said, what ownership form you should use is so extremely complex that probably no one in the history of the universe has done a proper analysis to answer the question. It would take a squad of lawyers, a super lawyer to resolve conflicts, and a crystal ball to do it.
You think corporations protect you from liability? What about the guy I talked to who got sued, won, but had to pay $160,000 in attorney fees. “Why didn’t you act as your own attorney” I asked. “I couldn’t,” he said. “They sued my corporation and the law does not allow the non-lawyer owner of corporate stock to represent the corporation.”
The corporation or LLC provides pretty ironclad protection in a contract. For example, if a lender loans money to your corporation, it generally cannot come after you personally if the corporation defaults on the loan. By signing the agreement, the other party has agreed to just have a relationship with your entity.
On the other hand, institutional lenders and lawyer know that, too. So they routinely go on alert when they see a corporation or LLC and deal with it by requiring you to sign personally on the loan not just as an officer of the corporation or LLC.
But in a tort where someone is damaged by your negligence, for example, you can’t say, “You have to sue my corporation.” The tort victim never signed a contract agreeing to that. They were just minding their own busiess when you hurt them. They can hold you responsible.
Entity must always hire a lawyer
So the guy described above protected his assets from being taken by the guy who sued him. But he did that by winning, not asset protection. However, not only did he not protect $160,000 of his assets from going to his attorney, the very asset-protection scheme he chose—incorporating—was responsible for him losing $160,000 of his assets.
Small businessmen and landlords routinely represent themselves in court. This makes sense because their litigation tends to be repetitive and simple—evictions, collections, etc.. But in many states, you can only represent yourself in court if you own your business or rental properties as a sole proprietorship. In those states, if you are in litigation as an LLC or corporation or some such, you have to hire an attorney for every nickel-and-dime legal matter.
There is also the fact that you can protect your assets to an extent with liability insurance. Incorporating or using some other entity is not the only option.
Then there was the subscriber to my newsletter who formed an LLC only to learn that while individual heirs get stepped-up basis when they inherit property, that rule does not apply to heirs who are members of the LLC that the decedent owned. That would jack the taxes they would have to pay upon the death of the father way up. He had been giving $10,000 worth of interest in the LLC to each of his kids annually under the Uniform Gift to Minors Act. Also, the LLC would have forced the subscriber to include his heirs who were part owners of the LLC in his pension plan.
He promptly got rid of the LLC structure.
Manager of LLC
Another LLC owner got sued as an individual. He said you can’t sue me as an individual. I am protected from that by my LLC. The court said, “No. You’re not.” The court said he could be sued as an individual not as the owner of the LLC, but as its manager.
An owner of, say, Ford Motor stock, cannot be sued as an individual because Pinto gas tanks explode. But a duplex you rent out ain’t Ford motor. In the typical case of a landlord or other small businessperson, you are not only the owner of the stock in your closely-held corporation, you are also the guy making the day-to-day decisions that caused the person to sue you. With Ford, you are a passive investor. But when you own and operate buildings or a small business, you are active, not passive. Using a corporation or LLC and hiring a property manager would not change that.
It’s not enough to just set up a corporation or LLC, you have to act like a corporation or LLC every day. If you just set it up then ignore it, your litigation opponent will say it’s your alter ego (Latin for other self) and the court will agree and ignore the structure and treat you as if you had never incorporated or formed an LLC.
All the little crap you have to do to behave like a corporation or LLC is costly and time-consuming. For example, you would typically have to pass a corporate resolution to buy another building. All bank accounts must be kept separate and corporate and LLC accounts must never be used for personal or other non-corporate matters. Etc. etc.
Note that I did not list asset protection as a legal specialty that you need to consult. Why not? There is no such specialty. The American Bar Association has “sections” for the various specialties. They have no Asset-Protection Section.
Why not? Because many, if not most, asset-protection strategies are of questionable legality and ethicality. Think about it. The basic idea is to use the law to protect you from the law. The law does not like that. It is possible that you could lose a judgment in a trial, then be in the same court in front of the same judge with regard to your refusal to pay the judgment. How do you think the judge will like that? He won’t.
Everyone says asset protection is to protect them from “frivolous lawsuits.” In the eyes of the law, there is no such thing as a frivolous lawsuit other than those they toss out at an early stage.
Furthermore, asset-protection schemes do not protect you from lawsuits. They protect you from judgments. And I guarantee you there is no such thing as a frivolous judgment in the eyes of the law. The court would tell you that the judgment you are complaining is frivolous was decided by a judge or jury. “If it was so frivolous,” the judge would ask, “how come you lost? How come you were not able to get it tossed out of court for violation of the various laws and rules against frivolous lawsuits like Federal Rules of Civil Procedure 11 and 12b(6) or comparable state laws and rules?”
It is generally against the law to do anything for the purpose of “hindering or delaying creditors.” But that is part of what asset-protection schemes are supposed to do. That’s why there is no Bar Section on the subject.
There is also a violation of the law called fraudulent transfer in anticipation of bankruptcy. That is the transfer of assets away from yourself or your entity so they are out of the reach of your creditors. Such transfers are legal if you get fair market value for the asset. For example, if you are on the verge of going bankrupt, you can sell your house for fair market value. The reason is that whether the money is in the form of a house or cash does not matter to the creditors. In fact, they would prefer cash.
What you cannot do is sell the house to your wife or another friend or relative or related entity for nothing (usually called “putting it into your wife’s name”) or for less than its fair market value. If you were allowed to do that, you could hide money from creditors by pretending you no longer had it when in fact you simply still have it in the form of an unwritten loan to the friend, relative, or other entity.
In addition to being against the law and subjecting you to penalties, another action courts take in cases of fraudulent transfer in anticipation of bankruptcy is to bring the property in question back into the bankrupt’s estate. In other words, they undo the fraudulent transfer.
The only asset protection I know of that is legal, ethical, and has no history of being undone is bankruptcy planning, particularly, homestead exemptions and pension-plans exemptions. Bankruptcy planning means putting as many of your assets as possible into asset categories that your state lets you keep when you go bankrupt. The most notable exemptions are homestead exemptions in some states and pensions in some states.
In Florida and Texas and several other states, you can keep your home when you declare bankruptcy and there is no dollar limit on how much it can be worth. Instead, they have acreage limits, typically one acre in an urban area and hundreds of acres in a rural area. When former Texas governor John Connolly went bankrupt in Texas, he got to keep his homestead ranch of some 300 acres as I recall.
That only works in those states. In other states, there is typically a homestead exemption, but it is much smaller and has a dollar limit.
Depending upon your state bankruptcy exemptions, your pension might be something you could keep even if you went bankrupt. The most famous example of that is O.J. Simpson who went bankrupt when he lost a wrongful death suit brought by the parents of Ron Goldman and Nicole Brown Simpson. Simpson’s NFL pension pays him $50,000 a month. And the Goldmans and Browns cannot touch a penny of it. They tried and the judge chewed out their attorney for trying. The law is clear.
Again, states differ.
Should you move to come under the best pension or homestead bankruptcy exemptions? Yes, if asset protection is a big deal to you. If you are not willing to move, it must not be such a big deal. But I guarantee you that you will regret it in the extreme if you have to go bankrupt and you are forced to do so in a less advantageous state.
The basic idea of offshore entities is that they are less willing than U.S. courts to let your creditors get at your assets. However, they are not unwilling. Such a law would brand the country in question an international outlaw.
The value of offshore entities, if there is any, is that they make it harder for your creditors to sue. They have to hire a attorney in some nutty island country. The nutty island countries who cater to this business also tend to have very short statutes of limitations. That is, they will not let your creditors sue you after a year or two.
But some of those countries have been pressured by the U.S. to cut the crap. Others do not like criminals using them to hide from responsibility for their actions. Then there was the U.S. judge who put a rich real estate guy and his wife in jail when they refused to pay a judgment creditor saying their money was out of their control in a foreign trust. The judge did not believe them and, lo and behold, once they were put in jail, they suddenly found a way to get the money and pay off the judgment.
Generally, the courts are hostile to asset-protection schemes other than mainstream bankruptcy panning, elder care planning, tax planning, and the like. Trying to use other ways to avoid having to pay a judgment after you lose in court is generally illegal and unethical.
John T. Reed