Understanding the Asset Protection Benefits of an LLC

What is an LLC?

LLC is the abbreviation for “Limited Liability Company”.  The LLC is basically an upgrade to the C-corporation, and its baby brother the S-Corp.  Prior to the LLC small businesses basically had to subject themselves to the double taxation of the C-corporation, or make an S-Corp election which had severe restrictions on ownership.  Also both the C and S corp forms had no real asset protection features as shares of either corporation could easily be seized by a court to satisfy a judgement. By the mid 1970’s, as the litigation crisis was just starting to get rolling, it was clear that a new form of legal entity was needed.

Wyoming answered the call in 1977 with the creation of the Limited Liability Company Act.  The advantages of the LLC are a significant improvement over the old corporate forms.

Advantages of the LLC

The LLC created an ownership class of “members” instead of shareholders.  This meant that there were no shares of stock that could be seized by a court.  This made it much more difficult for a creditor to reach the assets of the LLC interest held by a member.  The LLC also allowed for the membership interest to have severe restrictions on them, especially in the case of a creditor attempting to reach assets.  This was a huge benefit from an asset protection standpoint. Basically, a creditor with a judgement against a member of an LLC is entitled to the limited remedy of a charging order.  This has the effect of stopping the creditor at the door and radically changing the leverage of the debtor.  This was a far cry from the days when the court could just seize your corporate shares.

The LLC also solved the double taxation issue of the C-corp by qualifying as a pass-through tax entity.  This means that an LLC files, at most, only an informational tax return (IRS form 1065), and that the members of the LLC are able to recognize any profit or loss on their personal return directly, with no extra layer of taxation.  The restrictions on ownership which plagued the S-corp were also completely solved.  LLC membership interests may be held by individuals, companies, limited partnerships and even other LLCs.

Another benefit is the capacity to make the LLC owned by just a single member.  This is ideal for individuals who own assets such as real estate, businesses or even a boat or airplane.  It allows for protection as well as simple tax reporting since single member LLC’s can be completely disregarded for tax purposes.  This means not even the informational Form 1065 need be filed.

The net effect is that the LLC was such a massive improvement that it quickly gained popularity and by the mid 1990’s most other states had followed suit and created their own LLC statutes.

Limitations of the LLC

The LLC has few limitations and drawbacks.  However, the States have begun to differentiate themselves as to just how serious they are about the asset protection features.  As the case law has developed in some states we have seen courts disregard the “charging order only” remedy and directly reach LLC assets to satisfy a creditor. One example was the Olmstead Case in FL, where the court determined that since the LLC was single member, there was no harm in accessing LLC assets.  The “Single Member LLC Exception” has become a major concern and in many states there is significant discomfort by planners to even use the Single Member LLC.

In all States, especially those like California which have shown a consistent propensity to disregard the asset protection features of all types of legal entities, there is the very real concern that a judge may simply disregard the LLC altogether and determine that it was the “alter-ego” of the member and hence bypass the LLC statutes (and the charging order protection) altogether.

These concerns have given rise to a more serious look at the various jurisdictions.  States like Arizona, Wyoming and Nevada have taken pains to increase the protections of the LLC and specifically to clarify that even a single member LLC enjoys the charging order only remedy.  Additional, the offshore world has gotten into the act and created LLC statutes that are arguably stronger than even the best of the U.S. jurisdictions.  For example the Nevis LLC statute is crystal clear that the charging order is the exclusive remedy for all LLC’s.  Add to that the fact that the charging order in Nevis has only a 3 year life and is non-renewable and you have perhaps the best LLC statute in the world.

Conclusion

The bottom line is that, used properly, the LLC is a fantastic way to hold risky assets like real estate, planes, boats, businesses and even cash and investments.  Especially when combined with the power of an international protection tool like Bridge Trust®.