Protecting Personal Assets through an LLC: Does it Always Work?

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I had an interesting conversation with a new client the other day about asset protection. We were discussing whether you really could make yourself personally untouchable by third-party creditors.

Ultimately, I think that the average person can make it very hard to be touched by creditors, but I’m not sure if untouchable is always possible. Here’s why:

If you owe someone money personally and can’t repay them, your personal assets (house, car, boat, savings account, stock portfolio, business ownership etc.) are at risk in a collection proceeding. If those assets are held in a protected entity like an LLC (limited liability company) they are much harder to reach. Most states have laws that say a person’s LLC or LP (limited partnership) interests are not immediately subject to seizure and liquidation by a creditor. Instead the creditor can put something called a Charging Order – which is just like an attachment on your wages – and says literally, “You may still own those assets, but any profit generated from them is mine until your debt is paid off.”

What makes the Charging Order so effective is that often times there is profit generated by a business, but for whatever reason it isn’t distributed. Perhaps the business needs to hang onto the profit to expand or to purchase some new equipment. However, as far as the IRS is concerned, your share of that “phantom” profit is subject to taxation, whether or not the LLC ever cut you a check. That’s because of the flow-through tax nature of LLC and LP income (S Corp too, but that’s a different story for another day). So now your creditor gets a K-1 from the LLC showing that the LLC was profitable, your share was 50% or whatever … and no money is being distributed. Your creditor is left in the unpleasant position of having to report that phantom income on its tax return and paying the taxes on it.

It’s even better with an LLC holding personal assets. In this case there’s generally no income, so no phantom profit, or phantom tax. But there’s also no chance that your creditor will get repaid, at least not through that particular Charging Order.

Sounds good, and it is good – most of the time. This phantom income aspect is what usually brings creditors to the table to settle … they don’t want a legal bill, a tax bill and NO money from you to show for it. However, it’s not the end of the story.

Most states allow LLC interest to be foreclosed, where a creditor has a valid Charging Order and there has been no movement towards repayment. If the interest is foreclosed, it is transferred to the creditor, along with control of all the assets held inside.

In addition, most Operating Agreements have language that allow the other members to kick you out if you get into that kind of trouble. After all, they’ve got a business to run and this could potentially interfere in how that happens. In that case, your interest would be bought out by the LLC or the other members, and if the Charging Order was already in place, those proceeds would probably wind up in the hands of your creditor.

Even so, there are still options. If you’ve got a decent homestead allowance in your state, that can eat up a chunk of equity in your house that isn’t touchable, except by the bank and the IRS. You can also draw down any lines of credit to further diminish your equity and make foreclosing on that LLC interest uneconomic.

All of these things take time and money. Certainly the longer and harder you make it for someone to liquidate your personal assets, the more likely they are to settle. And there are some even more complex asset protection strategies that can come into play which can draw things out further. However all of these strategies are going to cost you plenty, as well. There could well come a day when you are the one contacting your creditor with a white flag and a settlement offer.

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