“Avoid lawsuits beyond all things; they pervert your conscience, impair your health, and dissipate your property.” – Jean de la Bruyere
As I explained last week, you may want to consider establishing a business entity like a corporation or a limited liability company (LLC) if you’re a real estate investor, an independent contractor, or a small-business owner. These entities can help make your business less risky and more financially rewarding.
Corporations (S Corps. and C Corps.) typically provide good protection against “traditional liabilities.” In other words, if your business is sued for something related to its business activities, a properly set up and maintained corporation should protect the owners from personal liability.
Yet most attorneys will tell you that a multi-member LLC will usually provide enhanced benefits – for two important reasons:
1. Fewer opportunities for error.
A corporation is more complicated than the LLC. For one thing, it must hold annual meetings. State law also requires it to abide by a number of rules that create a “forced” three-level management structure. This means all operations must be channeled through directors, officers, and shareholders. In a small- to mid-sized business, the same person or handful of people must occupy all of these positions – which can create confusion and increased opportunities for error.
On the other hand, state law does not force such a complex management structure upon the LLC. And, though it’s a good idea to hold an annual LLC meeting, it’s not a legal requirement. You probably won’t lose your protection if you forget to have one. This means fewer technicalities to deal with, less confusion, and fewer potential mistakes for an attorney to use against you when trying to “pierce” your business entity to hold you personally liable.
2. Greater protection against creditors.
Perhaps the main reason an LLC is favored in most situations is that it will not only protect you from your business’s liabilities… it can also protect your business from your personal liabilities.
Let’s say you are driving your family to the park on a Sunday afternoon. Along the way, your car “taps” someone who is crossing the street and he is slightly injured. The injured person finds a personal injury attorney who tries to milk the case for every penny. They sue you for $1,000,000… and win. Your insurance only pays out $500,000, so you still owe $500,000.
What happens next? The answer depends on whether you have a corporation or an LLC.
What usually happens in a case like this is that the attorney passes the case on to a collections specialist – an aggressive attorney who really knows the ropes. He can, for example, go to the judge and request a Writ of Execution. With this writ, a creditor may visit your residence or office (with the local sheriff) and begin seizing your personal assets.
If you have a corporation, he may also be able to seize up to 100 percent of your corporate stock shares… because your corporate stock shares are considered personal property. If the creditor gains control of your company by seizing enough of your shares, he can then vote to dissolve the corporation. Assets in the corporation would then be distributed to you (and your co-owners) personally. And then the creditor could grab those assets up to the $500,000 you still owe him.
But this can’t happen if you have an LLC – because the laws of all states (except Pennsylvania and Nebraska) have included special rules that allow LLCs to be protected in a situation such as this.
The creditor would generally not be able to gain control of your LLC. He also could not vote to end it, nor force a distribution of assets. He would be limited to a “charging order.”
A charging order is an order granted by a judge that says any money passed on to a business owner by the business must first go to the creditor… until the debt is paid off. BUT, the creditor does not have the right to force an LLC to make this payment. So he could wait a very long time for any such payment – especially if the people running the LLC are sympathetic to your situation. They could choose to stop distributions made to you altogether.
What’s more, once the creditor gets the charging order, he may even have to pay taxes on money the LLC made but which was not distributed to you.
Let’s say you’re a 50 percent owner of an LLC that makes $1 million in profits and the managers decide not to distribute any of those profits to you. The creditor can’t seize your $500,000 share of the profits, because it wasn’t distributed… but he could be forced by the IRS to recognize it as “phantom income” and find himself with a tax bill in the neighborhood of $150,000 or more.
Establishing your business as an LLC can almost act as a “poison pill” against questionable lawsuits, and it can put you in a much better negotiating position if you’re ever sued. The prospect of getting a big tax bill without any cash could spur the other party to settle the judgment debt or just drop his collection efforts. At the very least, it will help keep your business intact.[Ed. Note: Darius Barazandeh is a licensed attorney and real estate investor who holds an MBA. At 7:00 p.m. Eastern Time tonight and Thursday, Main Street Millionaire editor Justin Ford will interview Darius during a teleseminar titled “Attorney’s Secrets of the Wealth-Building LLC.” Be among the first 150 people to register for the call, and you can listen in absolutely free.]