One of the most important decisions business owners make is the structure used for the company. Corporations, partnerships, and sole proprietorships – these are just some of the options available. However, limited liability corporations (LLCs) offer what may be the most versatile combination of protection and growth potential, which is why it’s so frequently recommended.
Of course, business owners must understand how LLCs work to determine if this structure is right for their needs. In this post, we’ll discuss how LLCs protect assets, common mistakes when it comes to signing legal documents as part of an LLC, and what series LLCs are.
How LLC Asset Protection Works
What an LLC does is create a wall between owners and the business for liability purposes. This comes in handy when someone is sued. A lawsuit could be filed against the LLC itself. We call this an inside attack. Alternatively, a lawsuit could happen against an owner. We call that an outside attack.
All LLCs and all states provide liability protection from inside attacks. However, they vary a bit when it comes to outside attacks. An outside attack is when an owner is personally sued by someone seeking assets within the LLC. For instance, maybe an owner is involved in an at-fault car accident and the injured party sues intending to claim LLC assets as damages.
LLCs create a liability wall between owners and the business itself. An LLC will make distributions of cash to owners as it does business and makes profits. Suppose an owner is sued and loses. The plaintiff gets a judgment against the owner, and to collect that judgment, the court awards them what’s called a charging order.
A charging order essentially halts distributions to the owner from the LLC. Instead, those distributions would go to the judgment creditor. However, if the LLC doesn’t make any distributions, the creditor would receive no money. If it does make distributions, they all go to the creditor until the judgment is satisfied. This is an unfortunate situation because owners have no control over when or if an LLC makes distributions.
There is a way around this, though. Suppose instead of investing directly in the initial LLC, an owner first set up another one, and then that LLC invested in the second business. This creates multiple walls between assets and creditors, effectively buffering them because the owner has direct control over when and if their wholly-owned LLC makes distributions.
Superficially, this sounds like a positive outcome. However, it only works in states with laws that favor LLCs. Some states take a different view and enact restrictive laws that limit the protections offered by this business structure. Roughly two-thirds of US states offer good asset protection laws, while one-third do not.
How does this play out in reality? Let’s consider a brief example. Imagine you have a business, and it is held in an LLC. That LLC has two partners. One of those partners is committed to ethical practices. The other is not. The unethical partner is sued, and the court grants a charging order. In states with strong asset protection laws, the LLC’s interests are protected. The unethical business partner is spared the brunt to protect the business and the innocent partner.
In states with less robust asset protection laws, the judgment creditor could conceivably step in and take the ownership position in the LLC if the charging order isn’t sufficient to satisfy the judgment quickly. This situation does not change over time – the original partner is permanently out, and the innocent partner is stuck in a situation that had nothing to do with them.
The Number of Members Matters
The asset protection situation varies based on state laws, individual situations, and the number of members within the LLC. Why is that, though?
Suppose we have a case where an LLC interest in a charging order can be foreclosed upon as we saw in that last example. There is no other partner to own the LLC. When that interest is taken away, the judgment creditor who took the interest now gets to step into that member’s shoes and become the member and own that entire LLC. They get the business, not just the economic interest but the profits. They get to run it themselves.
To illustrate this situation, here is some language from Maryland’s court. Maryland has less robust asset protection laws. The court says that if it’s foreclosed on, and they get an assignment of that economic interest, but there are no remaining members, they get the entire interest. The same situation applies to single-member organizations.
We have a variety with the rest of the states. Five states (Delaware, Wyoming, Nevada, South Dakota, and Alaska) have enshrined in their LLC Acts that a charging order is the exclusive remedy for single-member LLCs. The other states with strong asset protection laws have remained silent on the matter.
Whether the single member states are protected in most of these is up in the air. A lot of this comes down to the courts determining what is right and wrong within a given situation and context. Other states look at the purpose of the charging order, which is to protect that innocent partner, and say, well, there is no innocent partner in a single-member LLC, so there’s no reason to protect them.
Some courts have ruled that this charging order protection simply shouldn’t apply to single-member LLCs. Texas has a couple of cases where someone in a single-member LLC has lost their interest this way. However, there has been language in other cases, one with a multi-member LLC and one with a divorce case, suggesting the same logic that if there’s no innocent partner to protect, the charging order protection shouldn’t apply.
Some states, specifically New Hampshire and Florida, have said they won’t protect single-member LLCs. Given that Florida aligns so closely with other states with strong asset protection laws, this is a confusing situation. What happened in Florida? It was Olmstead versus the FTC.
This was a federal case involving a man named Sean Olmstead. He came up with a scheme to offer a free credit card to people with bad credit or no credit, so they could pay money and get approved to use this particular credit card. This card was only good for buying products in an online store that Sean Olmstead ran. The FTC got wind of this, and they sued Mr. Olmstead in federal court and won a $10 million judgment. Sean Olmstead said you can’t touch me because all my assets are in all these single-member Florida LLCs.
The court ignored that and simply granted foreclosure of all these LLC interests. Olmstead appealed, arguing that the Florida LLC statute says that the judgment creditors are just supposed to get a charging order. The ruling was appealed to the 11th Circuit, and the 11th Circuit punted the issue to the Florida Supreme Court.
The Florida court ruled to allow the foreclosure of Olmstead’s interests. One of the judges on the court dissented and said, “Wait a second. If it’s not the exclusive remedy for single-member LLCs, it’s also not for multi-member LLCs because there’s no distinction made in the Act.” So overnight, Florida went from having robust asset protection laws to a weaker position. This caused all kinds of panic. However, a year and a great deal of panic later and the Florida Supreme Court readjusted its stance. The court decided that the charging order is the sole and exclusive remedy by which a judgment creditor can satisfy the judgment against someone with an LLC except as provided in sections four and five.
Sections 4 & 5
What do sections four and five say? Essentially, these sections state that if a limited liability company has only one member, then the purchaser or the judgment creditor who forecloses obtains the entire interest, not merely the rights of a transferee, meaning not merely the economic rights, they get to become the member, and the person whose interest was sold ceases to be the member. Florida encoded in their LLC Act that the charging order does not protect single-member LLCs. They can be foreclosed on and completely taken away by a judgment creditor.
Piercing the Veil
Piercing the veil applies to both inside attacks and outside attacks. If there’s a lawsuit on either side, and the plaintiff wins, they can go back and ask the court to ignore the liability protection offered by the LLC. That’s called piercing the veil. What they’re going to do is argue that this LLC was not legitimate. It needed to be appropriately maintained. It was just a glorified bank account.
How to Prevent Piercing the Veil
Piercing the veil could be the death of an LLC. How do you prevent that? The bottom line is to maintain your LLC as a distinct business from yourself. An LLC is an entity; from a legal standpoint, it’s a person. When Mitt Romney was running for president and said corporations are people, it caused an uproar. From a legal standpoint, he was correct.
Corporations are treated as people under the law. They can own property, they can sue, they can be sued, and they even have First Amendment rights. Legally, these are people. However, to maintain your LLC, you must ensure it exists as a distinct person from yourself.
Unfortunately, we must avoid several dangerous behaviors that are all too common among business owners.
- Failing to distinguish between yourself and the business. There must be a real, practical difference between you and your business. When clients pay, they cannot make the check out to you. Likewise, you cannot simply append “LLC” to your personal name on the check before depositing it in your business bank account. Doing so tells the court that you and your business are a single entity, like a sole proprietorship.
- Not using the business’s legal name. If a business is named Epic Events, LLC, the owner must use Epic Events, LLC, not Epic Events or some other derivative. If someone wants to use the name Epic Events, they need to file an assumed name or a DBA to do business as that other name.
- Not signing documents properly. You must understand how to create a signature block and sign in your capacity as a manager or managing member of the LLC, and not as you personally.
- Commingling funds. You cannot commingle personal and business funds. The LLC must pay you a salary and any money beyond that must be held in the LLC’s accounts. Commingling funds tells the court that you and your business are the same entity.
- Ignoring formalities. LLCs are less formal than corporations; they don’t have as many rigid formalities. You can write away a lot of the formalities in your operating agreement. However, whatever formalities are called for in your LLC Act or company agreement, you should follow. Not doing so tells the court that you do not take your business seriously and that it is not well-maintained.
- Not following the company agreement or the LLC Act. Again, if you set rules for yourself, follow them. If the state sets rules for your LLC, follow them.
- Undercapitalizing the entity. Undercapitalizing means running a business in such a way that it creates liabilities the business cannot cover. If you start taking on obligations, the business will only pay off in a reasonable scenario. A court will look at that and say the owners undercapitalized this entity and probably did it on purpose, thereby excluding the business from liability protection.
A Note on Signatures
One of the biggest mistakes a business owner can make is not creating an effective, accurate signature block. They might sign a contract with just the business name or might use their personal name without any notation of their position in the business. Both can land the owner in hot legal water.
So, what is an accurate signature block? Ultimately, it’s relatively simple. Your signature block should include:
- Your name
- Your position in the company or authority to sign the document
- The name of the business
- The business’s location
It could look something like this:
Smith Investments, LLC
An Indiana Limited Liability Company
Bob Smith, Manager
However, the signature will change as the LLC grows. It should always clearly show the identity of the business, the identity of the signer, and the signer’s position within the company.
Series LLCs
Series LLCs debuted about 20 years ago and have been very popular since that time. They can be very beneficial, but they can also be very confusing. To help potential owners understand the tremendous utility and protection here, let’s consider a very simplified illustration of how they work.
Let’s take a rental property owner who owns several houses, as well as other assets, like a vehicle, jewelry, and money in the bank. Someone in one of those rental houses slips and falls, injuring themselves in the process. They file a lawsuit against the property owner and the owner’s assets are all at risk.
However, if that owner had put the rental properties into an LLC and done everything by the book, the only assets at risk in the case of a lawsuit are those that the LLC owns – the rental properties themselves.
The law allows owners to take things a step further. In this example, owners could take each rental home and place it within a separate LLC that operated independently of the others. In this instance, the injured party suing would only be able to access the assets in a single LLC – one property.
The problem is that as you buy more and more properties, the number of LLCs also grows. That adds complexity, cost, and hassle. A series LLC simplifies things.
A series LLC is essentially what would happen if the owner put all the rental properties into a single LLC but then broke that up into individual divisions. Each division is a separate series. This offers the same level of protection owners would have received from having multiple LLCs but without the dramatically increased overhead and management hassles involved.
While series LLCs have been around for over two decades, they’re only legal in 21 states. Some lenders and other financial institutions also avoid them. Business owners interested in the benefits offered by series LLCs should verify that they are accepted in the states where they want to do business and that the financial organizations they work with accept them.
In Conclusion
Starting an LLC is just the beginning. If you want to ensure the success of your business, you need a team of professionals around you to guide you. This could include compliance reporting, taxes, state planning, asset protection, and even securities. If you need any help, have any questions about what you’ve seen, or just want to ensure your business is set up for success, contact Crowdfunding Lawyers.