The “Alter Ego” Asset Protection Hole

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I just read a new case that broke through an asset protection plan a gentleman had set up to protect his personal residence. The case didn’t break any new ground, but it was a great reminder of just how important it is to follow corporate formalities to maintain a corporate asset protection plan.

The case involved a gentleman who’d been through a tough marriage breakup. He had bought the property shortly after separating, using money, his wife claimed, that had been wrongfully received through selling assets that were supposed to be part of their divorce settlement. In an attempt to keep the house away from his wife, he had titled the property into a corporation.

Unfortunately, even though the corporation had been properly created, it wasn’t being operated as an independent entity. The owner had:

  • comingled funds, by opening a business bank account but using it to pay his personal expenses, and paying property-related expenses personally
  • obtained homeowners insurance for the property at the corporation’s expense, but named himself as the personal beneficiary
  • took the mortgage deduction for the property on his personal return
  • filed a personal insurance claim for damage done to the property by a hurricane
  • filed a homestead over the property claiming it as his principal residence
  • left the property to his girlfriend in his Will, and
  • as soon as his divorce was final, stopped filing tax returns for the corporation
  • the corporation’s charter lapsed for non-payment of renewal fees on several occasions
  • on at least one occasion where the charter was lapsed, the owner purported to transfer the property to someone else

In addition, the owner was the sole shareholder, officer and director of the corporation. The corporation had no business, or money. Evidence showed that for years the corporation had a $5 balance in its checking account. The down payment for the property came from the owner, as the corporation couldn’t qualify for a loan. And, finally, the owner paid no rent to the corporation for the property, even though he lived in it for almost 25 years. He had made one payment for $36,000 at one time for something titled “arrears,” but when the corporation’s books were audited, other amounts recorded as rent were actually payments for other things.

This was a small aspect of a much larger case involving the owner, his personal bankruptcy, and several claims of fraud. However, at the end of the day the court had no problem breaking through the corporate veil. In this case, there really was no veil. The corporation was nothing more than an “alter ego” for its owner. It operated improperly, keeping limited records, failing to file tax returns, and often was dissolved by the state for failing to keep up its annual requirements. The owner comingled funds, and treated the property as his own personal property – to the point of trying to give it away in his Will.

Most of this case to me seemed pretty routine. To preserve the corporate veil, you have to be diligent in making sure your business operates independently from you, and vice versa. But there were a couple of things I found really interesting.

First, I’m not sure why the individual in question put the property into a corporation. From a tax perspective it’s a bad move – appreciating assets are treated very unfavorably in a corporation. In fact, C Corporations don’t even get a capital gains rate – they pay tax on capital gains at their regular tax rate.

The second thing that struck me as odd was the choice of a corporation from an asset protection standpoint. While most states have laws on their books that protect your interests in an LLC (or a limited partnership) from creditors, those same laws don’t apply to your shares in a corporation. In a lawsuit you could lose your shares – and through them, all of the assets held in the corporation.

There only only a couple of instances where I’d suggest using a corporation, and they involve foreign, non-US residents. The lack of real asset protection is the hole – the back door a creditor can come through to gain access to your assets. Yet both Diane and I still see plenty of people with this type of an asset protection strategy in place. If you’ve got an asset protection strategy that involves putting real estate or other assets in a corporation, it might be an idea to have it reviewed. You may not be as safe as you think you are.

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