A Primer on Asset Protection Law: Part 1
Asset Protection for Businesses and Business Owners
Many of our clients are already business owners or are entrepreneurially-minded individuals who are considering starting a new venture. When counseling with these clients, there are a variety of asset-protection issues that seem to come up on a regular basis. Why should I incorporate or organize a separate legal entity for my business? Which entity type should I use? What else can I do to protect my business and my personal assets? As the first part in our Primer on Asset Protection, we want to explain a few of the fundamental concepts:
Do I even need to form a separate legal entity?
Some business owners operate their business without ever organizing a separate legal entity. These business owners may reserve a trade name or operate with a DBA (which stands for “doing business as…”), but they don’t form a separate legal entity to operate their business. These types of businesses are generally referred to as sole proprietorship (if there is one business person) or partnerships (if there are multiple partners in the business). For small businesses with very little risk, this may be an acceptable option that allows you to avoid unnecessary filing fees or attorney costs. However, this provides no asset protection to you or your business.
By formally organizing a business entity, an investor/owner can create a separate entity to assume the risk of the business enterprise. The risks of the business can therefore be “insulated” so that the business’s creditors can only look to the business itself for payment. That way business investors know that any funds they have invested in the business are at risk, but if the business itself fails to meet any of its obligations, the investors can avoid being personally responsible for the liabilities of the business.
What Entity Should I Use?
Forming a legal entity is an important step in limiting your liability and protecting both your personal and business assets. However, not all entity types provide the same level of asset protection. While there are entire books written about the legal issues involved in making this choice, there are a few key issues that everyone should understand when deciding what type of entity to use for their business.
First, it is important to understand the two main ways that business entities provide asset protection:
- Inside-Out Protection: protects business owners (shareholders, members, limited partners) from the liabilities of the business. (Most entity types provide this type of protection.
- Outside-In Protection: protects the entity assets from the personal liabilities of the owners
Corporations were created by statute hundreds of years ago to provide Inside-Out Protection to investors or shareholders. The basic idea was that if shareholders could be assured that they would not be held personally responsible for the liabilities of a business, they will be more likely to invest their money. With these investments, companies could attract more investors and engage in business ventures that would be too uncertain or expensive for one person to pursue alone.
While corporations provide great inside-out protection, they do not provide any outside-in protection. This is because a shareholder’s personal creditors can generally obtain a judgment against the shareholder and then take the shareholder’s shares in the business in order to satisfy a debt. With enough shares, the creditor (now a shareholder) can vote to dissolve or liquidate the business and take its share of the business assets.
This is one of the reasons LLC’s have emerged as the entity of choice for many new business owners. LLCs generally provide both inside out and outside-in protection. In several states, including Arizona and Nevada, state law limits the creditors of an LLC’s owners to what is known as a “charging order.” This means that if a creditor obtains a judgment against a member of an LLC, that creditor has the right to receive funds as they are distributed from the LLC to its members, but does NOT provide the creditor any opportunity to control the operations of the LLC or to force a liquidation of the LLC’s assets.
A Special Note About Single-Member LLCs: Arizona and Nevada (along with several other states) have enacted statutes directing that a “charging order” is the sole remedy that a judgment creditor can use against the member of an LLC.
In other states, with similar statutes, courts have distinguished between single-member LLC’s and multi-member LLC’s and have allowed judgment creditors to force the liquidation of an LLC that was owned by a single member.
To date, no Arizona or Nevada court has made this determination, but most experts agree that a multi-member LLC is still a safer way to ensure outside-in protection, protecting the LLC assests from future creditors of its members.
Limited Partnerships can also offer both types of asset protection to most of the members, but generally require that at least one partner (this partner is known as the “general partner”) to be liable for all of the liabilities of the business. Arizona and Nevada do now allow for limited liability partnerships (sometimes also referred to as Registered Limited-Liability Partnerships) in which even the general partners(s) can also have limited liability.
Ordinary Partnerships (which do not require any formal organization and can sometimes be created accidentally) do not provide any liability protection. All partners are fully liable for all of the liabilities of the underlying business. Accordingly, if you running a business together with other partners, you would be wise to meet with a qualified attorney to ensure that you are have not unknowingly created a general partnership that may subject you to unknown liabilities of your partner and/or your partner’s business decisions.
Of course, there are other issues to consider as well when determining what type of entity to use for your business. For example, corporations and partnerships are treated very differently under the U.S. tax laws while an LLC can opt to be taxed as a partnership or a corporation. Additionally, each state has a different set of requirements for maintaining the proper status of a corporation vs an LLC vs a Limited Partnership. In Arizona, for example, corporations, must file an Annual Report each year, while LLCs only have to file documents when there has been a change in ownership structure. Owners should also consider their future funding sources or exit strategies. For example, many entrepreneurs who plan to attract venture capital or sell shares to the public will opt for a corporation instead of an LLC because many sophisticated business parties prefer working with corporations due to their long legal history and well-established case law. At the same time, some closely-held family businesses will opt for a family limited partnership structure as a part of an estate tax planning strategy.