Corporations
and Limited Liability Companies (LLC’s): Charging Orders and the
Differences in Protection!
By: Darius M. Barazandeh,
Attorney at Law / M.B.A.
I always say that when choosing a business
entity, you must evaluate the tax advantages and disadvantages BUT ALSO the
level of liability protection. LET’S EXAMINE A COMMON SITUATION:
Many attorneys recommend the corporation to their clients. For the most
part, corporations will provide good protection from ‘traditional
liabilities’. In other words, if the business is sued for its
business activities, then I consider this a ‘traditional liability’
situation. In most instances (a properly set up and maintained
corporation) will protect the owners from personal liability.
Most attorneys (myself included), who stay
up-to-date with court precedents and how creditors (and collection
attorneys) actually work, will tell you that a multi-member LLC will usually
provide enhanced benefits. Here are a few reasons:
- LESS FORMALITY = LESS MISTAKES:
The corporation requires annual meetings and has a number of rules which
create a ‘forced’ management structure. For example, every
corporation is made up of a ‘tri-parte’ management structure (tri-parte
means 3 levels). This means that all corporations will have to ‘force’
or channel operations through this structure of directors, officers, and
shareholders. The trouble with small to mid-sized businesses is
that the same person or perhaps a handful of people must occupy all of
these positions. This can create confusion and more opportunity for
error. The limited liability company (LLC) is simpler to operate
because state law does force this ‘tri-parte’ structure upon LLC
owners and employees.
LLC’s (unlike corporations) are not
required to have annual meetings. Although we think LLC meetings are a
good idea, you probably won’t lose your protection if you forget to have a
meeting. These simplicities mean less technicalities and less
confusion. It also means that there will be less mistakes available for
an attorney to use against you when trying to ‘pierce’ the entity in
order to hold its owners personally liable.
- CHARGING ORDER PROTECTION: Alright,
let’s move forward to another VERY IMPORTANT issue. I am going to
say that this is perhaps the KEY REASON why an LLC is favored in most
situations. The LLC will protect you from business liabilities but
it can also protect your business from personal liabilities. DID
YOU CATCH THAT? We said the LLC will protect you personally from
business liabilities, BUT IT CAN ALSO protect your business from
personal liabilities.
Ok, enough word manipulation…let’s look
at a concrete example:
EXAMPLE:
Let’s say that you are driving and taking your family to the park
on a
Sunday afternoon. Negligently, you tap someone who is crossing the
street and they are slightly
injured. The injured person finds a sharp and hungry personal injury
attorney who ‘milks’ the case for every penny. They sue you for
$1,000,000 and win. Your insurance pays out the $500,000, but there is
still $500,000 owed. What happens next? The answer will depend on
whether you have a corporation or LLC.
Did you know that once a judgment is obtained
against you, the attorney may pass the case on to a collections specialist
(an aggressive attorney who handles collections)? These attorney’s
are very knowledgeable and may only focus on collections – in other words,
they know the ropes. This attorney would go to the judge and request a
Write of Execution. With this writ they many visit your residence or
office (with the local sheriff) and begin seizing personal assets. The
problem is the corporate stock shares are personal property. As a
result, generally they can seize 100% of corporate stock shares.
Now you may say...’Wait a minute, my
business was not involved in the accident”. “I was taking my family
to the park on a Sunday”. Understand, the creditor is not trying to
enter your corporation through the front door, but through the back
door! Have you ever heard the _expression, “He who has the gold makes
the rules?”. I don’t always agree with this, but in this situation,
let’s say, “He who has the stock shares makes the rules”. In
other words, if the creditor seizes your stock shares they can vote to
dissolve or end the corporation. As a result, any assets in the
corporation must be ‘distributed’ to you personally.
Now you may ask, “Why would anyone want to
break up my corporation?”. THE REASON: Once the corporation is
dissolved the assets of the corporation will be distributed to you, the
owner. GUESS WHAT? Now the collection attorney will have
more money to satisfy the rest of the judgment (the $500,000 still
owed). Remember we discussed the importance of protecting your business
from personal liabilities? The corporation won’t do that very well
because of this reason: Stock shares are personal property. They can be
seized if you have a personal judgment against you.
The same thing can happen if you are doing
business in a corporation made up of 2 or more parties. In such an
instance, a creditor who obtains enough shares could vote to dissolve the
company or they could become a substituted owner. You see, you can’t
control the actions of all your co-owners all the time. For this
reason, there is undue risk when corporations are used (especially if there
is more than one owner!).
LEARN
TO AVOID THESE MISTAKES AND TRAPS BEFORE
THEY
HAPPEN!
I am a licensed attorney and attend training
conferences each year to keep up with my required hours of continuing legal
education. I can tell you that while I love to learn about all the
updates and nuisances of setting up companies…I know that the real benefit
comes from understanding how collection attorneys work. The goal is to
learn what tricks they use to tear companies apart. Believe me, most
will foam at the mouth when they learn the business owner is using a
corporation. They are not so pleased to learn the business owner is an
LLC or other ‘partnership-style’ entity.
So at this point you may be wondering how the
LLC is different. This is a complex issue, but generally we can say
that the laws of all states (except Pennsylvania and Nebraska) have included
special rules for LLCs which allows them to be protected in this type of
situation.
In other words, if we had the same facts in
which you hit someone on the way to the park on a Sunday and $500,000 of the
judgment was not covered by your insurance, the creditor would generally not
be able to gain control of your LLC. The creditor also could not vote
to end the LLC, could not force a ‘distribution’, and could not break up
the LLC. The creditor would be limited to a court order called a
‘charging order’.
So what is a charging order? The
charging order is a specific court order that first must be granted by the
judge. It is a court order which says that if any money is passed on to
the owner who was involved in the accident, this money must first go to the
creditor until the debt is paid off. The only problem is that the
creditor does not have the right to force the LLC to make this
payment. This means that the creditor could wait a very long time for
such payment to be made. If your LLC is run by parties who are
‘friendly’ to your situation, they may choose to stop all distributions
made to you. State law limits a creditor’s collection efforts to this
charging order. Second, once the creditor obtains the charging order
they may have to pay taxes on money that the LLC made, but which was not
distributed to you (we call this ‘phantom income’).
What does all this mean? Generally it
puts you in a much better position if such an event occurs, since it may
force the creditor to try to settle the judgment debt or just drop the
collection efforts. At the very least it can help keep your business
intact. If you were using a corporation the end result would likely be
the end of the company. If an LLC was used, managed correctly, and its
owners properly reserved this charging order limitation then the result will
be quite different.
A
FEW OTHER POINTS TO CONSIDER:
Here are a few other things to
consider: An LLC will need to have more than one member in order to
ensure this type of protection. Let’s also say that in community
property states it may be useful to have someone other than your spouse
(family member or close friend) own a small percentage interest in the LLC. The
community property states are: Arizona, California, Idaho, Louisiana,
Nevada, New Mexico, Texas, Washington and Wisconsin.
Second, you must make sure that the LLC is
run and managed in the correct manner. None of these protections will
hold up in court unless you truly become a MASTER of good business practices
and learn how to keep up with LLC formalities.
To learn more about how you can become a
MASTER of good business practices, create, run, and maintain an ‘iron
clad’ LLC please see Mr. Barazandeh’s, Wealth Building LLC ™.
