An asset protection blueprint is critical in protecting the assets that you will accumulate from your growing business and cash flow it produces. Unfortunately, most successful entrepreneurs never schedule this critical part of their overall business planning. Don’t let your 12-15 hours days of hard work go down the drain when there are steps to protect you and your family.
This is the time of the year to review your asset protection plan, especially considering there are over 80-million lawsuits filed every year in the United States, and they may rise in the upcoming year due to the economic conditions and political uncertainty.
There are several important questions you must ask yourself when it comes to protecting your current and future net worth.
- Are you protected if your business is sued at the operating level? Do you have all your “business financial eggs” in one entity basket?
- Do you have “safe assets” unrelated to your at-risk assets? If so, are they protected?
- What would happen if you were sued at the personal level, unrelated to your operating business? Would you lose control of your company (this is a big one)?
- Even if you are an LLC and your partner is sued, would that disrupt the operating company?
- Does your living trust hold valuable assets that would be in jeopardy if you were sued personally?
- Do you have adequate insurance?
- Is real estate (not your residence) out of your name personally?
- Does your residence have a lot of equity? If so, is it protected?
- If you have a partner, do you have a buy/sell agreement?
- Do you have legal agreements with your independent contractors, employees and joint venture partners?
Let’s address some key points about each group, so you can take the necessary steps to protect your assets in 2019 and beyond!
Are You Protected if Your Business was Sued at the Operating Level? Do You have all Your “Business Financial Eggs” in One Entity Basket?
Are you running two or more profitable businesses out of one entity? If one gets sued, will you lose all your business assets? I would not quickly assume your business insurance policy (if you even have one) will kick in 100% to protect you. Make sure you understand the loopholes in the insurance policy. If you are operating two or more businesses that aren’t really making it, that is a different subject. One entity may be fine. But if you have a successful e-commerce, cannabis, technology, information product, or speaking business…., you may need three separate entities to protect all three individual businesses. That way, if one comes under attack, it won’t bring down the other two.
Are your domain names worth protecting? Remember, when you register a domain name, it is free and clear. You put “cash” upfront for the name. Many of you may have thousands of visitors coming to your domain every day, and it may be a very valuable asset for your business. Is your “virtual real estate,” your domain name, worth $100,000 + collectively? If it is, should it be owned by either you or your main operating company? Probably not. You may want to consider a separate legal entity to hold your domain names, and then lease them back to your operating entity. Typically, an LLC taxed as a partnership or single-member LLC will work for that situation. If you are new to your business and your domains have very little traffic or value, it may not be necessary to form a separate legal entity, at this point.
Did you remember to connect your DBA names to your new entity? If you had a DBA (doing business as) with you as a sole proprietorship applicant, which means unlimited liability. You must refile the DBA name with your new entity as the applicant, not you personally!
Do You have “Safe Assets” Unrelated to Your at-Risk Assets? Is so, are They Protected?
Make sure you separate your safe from at-risk assets. A safe asset will not directly cause someone liability, like investments outside your retirement account, cryptocurrency, cash in your personal check account (above $50K); an at-risk asset, like real estate or an operating business, can cause direct liability. Do not, out of convenience, but those two items in the same entity bucket. If you have valuable safe assets, typically an LLC taxed as a partnership or single-member LLC disregarded will make sense. Some states like Florida and Colorado do not recognize the charging order protection from a single-member LLC so proper planning is required.
What would happen if you were Sued at the Personal Level, Unrelated to Your Operating Business? Would you Lose Control of Your Company?
If your operating entity is an S or C corporation, this may be a big concern for you that you were not aware of until now. This means if you get sued for something unrelated to your operating business, like a car accident, a contract now in your own name, another entity where the entity veil was pierced, and your insurance company does not pick up the entire tab, you may lose your most valuable personal asset, the stock of your S or C Corporation. Even if it is owned by your living trust, you may lose 100% control of the ownership of your company!
Now, if the S or C corporation has no value (meaning the day you stop working there is no value), then it may not be that big of a concern if you lose control of your company. This is not a concern with consultants because the day they stop working, no more revenue comes in so there is very little value of the stock of your S corp to someone else. Many entrepreneurs and business owners are aware of the dangers they face with these entities.
The solution, if you have a valuable C Corporation, is that the stock can be held by an LLC, either taxed as a partnership or a single-member LLC disregarded for tax purposes. Remember, with an S corporation there are restrictions on who can be the shareholder, so only a single-member LLC disregarded can own the stock of an S corporation. It cannot be an LLC taxed as a partnership. Why the LLC? Now instead of owning the stock of the S or C Corporation, you will own the membership interest in the LLC, which means if you get sued personally, the plaintiff may get a “charging order” against you, which means they get access to distributions of profits vs. a controlling interest in the stock of the S or C Corporation.
There is some discussion as to the value of the single-member LLC vs. multimember LLC when it comes to the charging order protection. Basically, some argue that there is not as much protection with a single-member LLC, because the charging order protection originally came from partnership law, which means at least two partners. Well, a single-member LLC only has one partner. Although most state statutes do not distinguish between how many members, it has come up as maybe a reason to have a multimember LLC vs. single member.
Would Your Partner being Sued Disrupt the Operating Company?
The charging order is very powerful and will help protect the ownership of the operating LLC, but it can still be disruptive. If your partner in the LLC is personally sued for something unrelated to the operating company, before one gets a charging order, they may subpoena the operating agreement, bank accounts of the LLC and account records. This can all be very disruptive to the operating business. If you have an LLC with an outside partner (not your spouse or significant other), you may want to strongly consider EACH member have their own separate LLC to ONLY hold safe assets, which then become the owners of the operating business. Now, if you or your partner are sued personally, it will only affect the membership interest to your PERSONAL LLC, not the OPERATING LLC! This avoids any disruption to the operating business!
Does your Living Trust Holding Valuable Assets Protect You if You Were Sued Personally?
The living trust is very important for probate and estate planning, to help you pass on your asset to your appropriate heirs. A living trust is revocable (99% of the time), which means you can move assets in and out of the trust, which also means a creditor can get access to the assets inside your living trust (there are some exceptions, like retirement plan money, which depends on the type of plan and which state you live in as to whether that may be protected). The reason so many falsely believe that living trusts protect assets is because they hear from their estate planners that a living trust protects your assets, but they do not hear “FROM WHAT” – not from liability; only from probate and estate taxes. That means that your assets titled to your living trust may be at great risk in a lawsuit. If your LLC membership interest is titled to your living trust, that is a good move!
Do you have Adequate insurance?
I am not a big fan of just relying upon insurance to protect you, but it is an important tool to reduce risk. Keep in mind that insurance companies can go out of business, just like any other business. Plus, you need to be aware of the loopholes in your insurance policy that may cause you to be unprotected.
The rubber meets the road question for your insurance provider on your new million dollar policy is… “Tell me, over the last three years, how many times any of your clients who have this policy were sued for anywhere between $800,000 and $1,000,000? And, of those times, how many times did you not pay out the claim? And when you did not pay out the claim, can you tell me the loopholes that caused your clients NOT to be covered, so I can anticipate similar areas where I would also NOT be covered by your policy you are attempting to sell me?” That is an important question!
You may need an umbrella insurance policy personally, that maybe $3- to $4-million of coverage, plus other business liability insurance for proper protection.
Is real estate (not your residence) out of your name personally?
Owning real estate in your own name is like having your financial statement taped to your forehead, saying loudly, “I have assets, so sue me!” Even if the real estate you own has no equity, it makes sense not to own it in your own name. It shouts to the world that you must have money to be in the position to own a home and other real estate as well. The big question that comes up is how much protection is necessary?
If you have three rental properties, do you need three separate LLCs? That depends on the amount of equity in each property and the overall percentage of your net worth it represents. For example, if you have three rentals each with $300,000 of equity and that $900,000 of equity represents 90% of your net worth, then three separate LLCs (one for each rental) would make sense. Now, if you get sued at the property level (entity level), you would only lose 33% of your equity, vs. 100% if it was owned by one entity. Issues that come up with real estate are transfer tax, due-on-sale clauses, and insurance issues.
Typically, if you own the real estate before and after you transfer it to an LLC, there is no transfer tax. You will need to ask your local county clerk’s office for the rules and exceptions on the transfer tax. A due-on-sale clause means if you have a mortgage on the property and you transfer it to a separate legal owner, like an LLC, which may trigger a due-on-sale, which means when you record the new title in the name of the LLC, it appears there has been a sale. The banks may be in a position to call the note and say, “Since you sold it, you have to pay off the mortgage.” The fact is you did not sell it; you simply transferred title. In reality, no bank will really tell you they will waive the due-on-sale clause.
From the bank’s perspective, the key is whether or not they will get a monthly check to pay down the mortgage; 95% of the time, a due-on-sale does not come into play. The strategy is to form an LLC, either taxed as a partnership or single-member LLC, and quitclaim or warranty deed the property in the name of the LLC. Now, if you are sued personally, you do not personally own the real estate. You own a membership interest in the LLC that controls the real estate. That is a huge difference!
Does Your Residence have a lot of Equity? If so, is Your Equity Protected?
Your residence, on the other hand, is handled very differently. You do not want to transfer your principal residence into an LLC. Why? Several reasons. First, you would lose your $250,000 capital gain exclusion when you sell it. Second, your insurance company would have an issue when you transferred the title to an LLC. This is when safe and at-risk assets need to be separated. The next step is to file for homestead protection to protect the equity in your house. Each state has different levels of protection, ranging from unlimited in Texas and Florida to only $5,000 of equity in some states. The first step is to file for that protection.
If you have a lot of equity in your home, you may want to consider a personal residence trust for protection. This does not have the downside that a separate legal entity would have. We would recommend you speak to an attorney in your area to explain the options that the personal resident trust may provide!
If You Have a Partner, Do You Have a Buy/Sell Agreement?
Do you have an outside partner as an owner in one of your entities? If so, it is very important that you have a buy/sell agreement with each other. The buy/sell agreement will provide for a smooth transition if one of the partners can no longer continue with the business. The common events that may arise are death, divorce or desire to sell to a third party. Not having this agreement in place typically results in unexpected situations and, many times, lawsuits (especially over the value of the company as one partner wants to sell out) or the destruction of the actual business.
Typically, life insurance is purchased on each owner, in case of death, to pay off the estate. One important clause that will come into play is an agreement on the accounting formula to determine the value of your company, so there are no arguments when it comes to determining the value. It is very important to have an attorney draft your buy/sell agreement, which is separate from the operating agreement in an LLC.
Do you have Legal Agreements with your Independent Contractors, Employees, or Joint Venture Partners?
One of the fastest ways to go out of business and get stuck in many lawsuits is not having agreements in place for several situations. If you use independent contractors to do work for you, make sure they sign an independent contractor agreement that tells the independent contractor that the work they do on your behalf is owned 100% by you, that they are responsible for their own taxes, and other key provisions to establish the nature of the relationship. Keep in mind just because they sign an independent contractor agreement, it does NOT mean they qualify as an independent contractor according to the IRS. Make sure they are not an employee! Nothing is worse than to fire an independent contractor and they file for unemployment, thinking that they were really an employee, and now you have the labor division after you!
Make it a priority to plug up any asset protection holes you have in your plan in 2020. Don’t wait until you are sued, because it may be too late to protect yourself. You will sleep a lot better at night when everything is in order!