Types of Liability

There are basically two types of liability when it comes to business: Inside Liability and Outside Liability.

Inside Liability is one that arises from the operation of a business.

Examples include:

A person slips and falls in a restaurant.

An auto repair mechanic forgets to put oil back in the car during an oil change.

A manufacturing plant causes a product defect.

An employee commits identity theft of customers.

These incidents are examples of a liability that arises from the conduct of a business, and from the point of view of the business owner, these are types of liability they would like to limit if possible.

Outside Liability has to do with liabilities that arise unconnected to the operation of the business.

Examples include:

Car accidents, where the accident occurred on personal time.

Personal loan guarantees.

Debts from other businesses with respect any particular business. (For example, business #1 causes the owner liability. That liability is “Outside Liability” for owner’s business #2.)

Community Property Law

Another area of concern, though not properly termed as a “liability” is property division at divorce. Specifically we are talking about Community Property law which applies in 9 states: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin.

The basics rule of Community Property law is that assets acquired during marriage are characterized as Community Property and each of the couple has a ½ interest in all property characterized as Community Property. Property acquired before or after marriage, or received as a gift or inheritance is presumed to be Separate Property.

Now the complication in the how this law is applied is in the Tracing Rule. When a court tries to determine the character of a property (that is whether it’s Community or Separate), the court traces the funds used to acquire the property. If a person takes $5,000 of separate property and purchases a motorcycle, the motorcycle isn’t really a new asset—the $5,000 just changed form and a change of form doesn’t change its character.

What does change the character of property is “commingling.” This basically means a mixing between separate property and community property and when that happens, the property is presumed to be community property.

The best way to illustrate this issue is by example:

Let’s say a client by the name of Harry works as a poker dealer for a casino (we are after all based in Las Vegas, Nevada). Harry’s on day 1 is unmarried and has his paycheck is directly deposited to his personal checking account. From this account, he has an automatic bill pay that pays the mortgage on his home. On that day 1, all of the funds in his checking account and the entire home is separate property. Harry gets married to Wilma on day 1. If they were to be divorced day 2, all of that separate property would remain his.

Now let’s say that instead of getting divorced on day 2, they remain happily married. His paycheck from his job as a poker dealer is now community property because it is earned while he is married. Remember his paycheck is direct deposited into his checking account so on payday, his community property paycheck is direct deposited into his separate property checking account. That is commingling. Notice that there hasn’t been any change on Harry’s part—it’s the same paycheck and the same account which now become community property because community property funds were transferred into a separate property account. Recall also that he uses automatic bill pay to pay his mortgage. Immediately after marriage, Harry’s home is separate property, but once the automatic bill pay makes a payment from the commingled community property checking account, now the home has been subject to commingling.

This is just one of many circumstances in which commingling occur and proper asset protection structuring can prevent this accidental commingling.

Inside Liability Protection

Up until this point, we have been discussing potential problems that arise. We now turn to concepts revolving around safeguards against these issues.

Inside Liability Protection is provided by establishing a business entity. Corporations, Limited Liability Companies, and Limited Partnerships (for the Limited Partner, but not the General Partner) protect the owners from the liabilities of the business with a few caveats.

If an owner is an employee of any of the business entities listed above, and commits an act resulting in liability, the owner/employee will not be protected by the business entity. For example, Tucker the Trucker, owns Trucking Corporation. He is the sole owner and sole employee. During a delivery run, he negligently causes an accident. Since he was driver of the vehicle, the Corporation doesn’t protect Tucker the Trucker from liability from the accident and Tucker’s personal assets like his home may be taken.

Compare this to a second example with a different outcome. Let’s say Tucker the Trucker owns Trucking Corporation, but now instead of being the driver, he has an employee, Drake the Driver. Drake the Driver on a delivery run has a disastrous accident. Drake would be liable for the accident, but now, Tucker the Trucker is merely an owner and not an employee. As a result, the Corporation protects Tucker’s personal assets such as his home.

The business liability shield is not bullet proof, however. When a plaintiff is able to defeat the liability protection offered by the corporation or the LLC, it is know as “Piercing the Corporate Veil” or “Disregarding Corporate Existence.” This is one area where the laws of one state may be stronger or weaker than its sister states.

Factors that a court looks at in determining whether or not it should disregard a corporation’s existence focuses on whether or not the corporation or LLC was treated as a legitimate business. For example:

Were corporate formalities such as meeting minutes kept?

Did the LLC have its own separate accounting books?

Were business and personal expenses commingled in the company?

Were ownership certificates issued?

Was property titled into the name of the business entity?

Because these factors are important corporate formalities, merely going on a Secretary of State Website and filing Articles of Incorporation or Organization is insufficient for creating limited liability.

Lastly, a very important factor in piercing a corporation is the level of culpability of the owners of a corporation or LLC. In other words, if the owners of a corporation or LLC follow all of the formalities and treat the corporation or LLC as a legitimate business, yet use the business entity to commit intentional fraud or other bad acts, the corporation or LLC won’t protect them.

Outside Liability Protection / Charging Order Protection

One area where corporations and limited liability companies differ is outside liability protection. For the purposes of this part of the discussion, what is said about limited liability companies applies to limited partnerships and general partnerships as well.

As a reminder, outside liability is a liability that arises outside the business, like a car accident while on a personal vacation.

Owners of a corporation are called Shareholders (or “Stockholders’). The units of ownership in a corporation are called Shares of Stock (or simply “Shares” or “Stock”). Shares of stock are considered “personal property” meaning that in a lawsuit, these shares of stock may be taken by a plaintiff. Once shares of stock are seized, the plaintiff has ownership of the corporation and can elect himself Director and Officer. The plaintiff can then dissolve the corporation and take any assets inside. For this reason, if the purpose of a plan is to protect certain assets like rental properties from personal liability, a corporation is a bad choice—it offers no outside liability protection.

Limited Liability Companies (and any of the partnership entities) are quite different and much better. Ownership in an LLC is referred to as Membership Interest and is expressed in terms of percentage, such a “100% Membership Interest.” Membership interest is not personal property and cannot be seized by a plaintiff. A plaintiff can only obtain a “Charging Order.”

This Charging Order is best understood by illustration of its rationale. Let’s take partners Careless Carla and Prudent Paula. They own an LLC, each as 50% members. Careless Carla is on vacation and gets into a bad accident with Larry the Lawyer. If the law were to allow Larry the Lawyer to seize Careless Carla’s ownership in the LLC, Prudent Paula would be stuck with a new partner, Larry the Lawyer. Basically, Prudent Paula, who was a completely innocent person, would be penalized by being stuck with a stranger for a partner. For this reason, the law protects the innocent Prudent Paula. Instead of taking away Careless Carla’s ownership and giving it to Larry the Lawyer, Larry only receives a lien against Careless Carla’s 50% of the profits. This lien is called a “Charging Order.” Basically this order states that before Careless Carla can receive any profits, Larry the Lawyer’s charging order must first be paid off. Larry the Lawyer will hate to have a Charging Order because the LLC can choose to not distribute any profit for as long as it likes, stalling Larry as long as necessary. This gives Larry the Lawyer powerful motivation to negotiate some type of settlement. In the meantime, the assets inside the LLC remain intact–Larry has been unable to seize the revenue generating assets of the business.

Notice that the rationale for a Charging Order is to protect the innocent party. However, in an LLC where one person owns 100% of the membership interest (i.e. a Single Member LLC), who would be the innocent party? If the single member of the LLC were to cause liability, who would be hurt by seizing his ownership and giving it to the plaintiff? There are no innocent parties in that case, and under that reasoning, Charging Order protection should not apply to a single member LLC. In fact, that is the case in several states, such as Colorado and California, and courts outside Colorado or California can always borrow this reasoning in order to break a Single Member LLC. Again, this is one area where state laws differ. In Nevada, the state statutes specifically provide that a Charging Order is the sole remedy for the plaintiff. In other words, a single member LLC formed and operated solely in Nevada should provide charging order protection in Nevada (and Nevada only).

Spendthrift Trust Concept

Perhaps the strongest tool in asset protection is the trust. While business entities provide liability protection for business assets, various Trusts are the only means of protecting personal assets.

Before addressing how a trust works, we need to first define several terms. The person who sets up a trust is called a “Grantor” (or in older terminology, “Settlor,” or “Trustor”). The person who manages or runs the trust is called the “Trustee.” The persons for whom the trust is managed are called “Beneficiaries.” A trust which can be completely changed or undone is said to be “revocable” while one that has limitations on being changed is called “irrevocable.”

A trust is a legal entity, much like a corporation or an LLC. One difference from a trust to a corporation or LLC is that unlike a business entity, a trust is not filed with the Secretary of State or any government agency in order to be formed. A trust is formed through a private written agreement called a Trust Agreement that is signed by the Grantor and the Trustee. Unlike a corporation or LLC which is intended to produce a profit, the purpose of a trust is simply to own and manage property.

A trust’s ability to protect assets comes from the Spendthrift Trust concept. The dictionary definition of “Spendthrift” is a person who spends money recklessly or wastefully and the Spendthrift Trust concept was developed in order to address the needs of protecting a spendthrift from themselves.

A good example of a spendthrift is a young child who cannot manage money and most likely will not be mature enough to manage money for a long time to come. Let’s say the child’s only parent is dying and wants a way for a parent to provide for this child upon the parent’s death. One way is to set up a trust agreement between the parent and the parent’s best friend, who now becomes the Trustee. The Trustee promises the parent, in the agreement, he will use the Trust’s money solely to protect and benefit the child. Now let’s say the child reaches the age he can have credit cards. He irresponsibly maxes out his credit cards and goes to the Trustee to ask for money. The Trustee can choose not give money to the child, and in fact, even a court can’t compel the Trustee to make a distribution of the trust property, to the child, or to the credit card companies. The rational for this is that the child does not own the trust, and does not own the property in the trust. In fact, the child has no power to remove property from the trust in any way. This trust is the essence of the Spendthrift Trust—it protects the beneficiary, in this case the child, from his own recklessness or wastefulness because it is a separate entity that the beneficiary has no legal control over.

The concept of a Spendthrift Trust is particularly important because such a trust can be set up for anyone—even an adult. A Spendthrift Trust, properly designed can own property and protect that property from the beneficiary’s irresponsibility. When people talk about using a trust for liability protection, it is essentially this type feature of a trust that is being discussed.

However, not all trusts provide asset protection. Up until this point we have been discussing Spendthrift Trusts established by one person for another (we refer to this type of trust as a “Non Self Settled Spendthrift Trust” or “Third Party Spendthrift Trust”). A Non Self Settled Spendthrift Trust is respected in all 50 states. However, most states will not respect a Spendthrift Trust a person creates for themselves (called a “Self Settled Spendthrift Trust”).

Let’s examine this more closely. A person, the Grantor, sets up a Spendthrift Trust for themselves as the sole Beneficiary, in order to protect the assets from the Beneficiary’s own irresponsibility. In all but 5 states in the U.S., such a trust would not be upheld in court primarily because it is viewed as unfair. Essentially a person could establish a Spendthrift Trust and then run away from any liability.

However, 5 states, Nevada, Utah, Arizona, Alaska, and Rhode Island allow these “Self Settled Spendthrift Trusts.” In order to address the danger that a person might establish one of these Self-Settled Spendthrift Trusts to escape immediate liability, these states each have a statute of limitations in which the Trust assets can be attacked. Each state varies, with Nevada having the shortest time frame of 2 years. In other words, after a Self-Settled Trust is established and an asset has been transferred to that Trust, that asset is not protected by the trust until 2 more years pass. This type of trust is also called the “Nevada Asset Protection Trust” or the “Nevada On-Shore Trust” (or Alaska Asset Protection Trust if you set one up in Alaska and so on…)

In this entire discussion, we have been addressing only an irrevocable type of trust. If the spendthrift trust (no matter who set it up) was revocable, it would provide no protection at all. A court can simply order the revocation of a revocable trust. The trust’s asset would revert back to the grantor and be subject to judgment. This is a very important factor to consider since some asset protection planners advocate using a revocable living trust as an asset protection structure. While a revocable living trust is an excellent tool for estate planning, it provides nothing in the way of asset protection, and any such planner recommending that use should be viewed with some suspicion. Any revocable trust provides zero liability protection—that includes most revocable living trusts and family trusts.

Fraudulent Transfers

In asset protection planning, an important rule that must be respected is in regards to fraudulent transfer. A fraudulent transfer is basically a gift or transfer of an asset in anticipation of a judgment with the intent to hide or protect the transferred asset.

For example, a person is sued after a car accident. He decides to give his house to a trust for his son so the plaintiff can’t seize the house. This would be construed as a fraudulent transfer and the remedy is for the court to disregard the transfer.

This relates to a very important point in asset protection planning. Planning must be done beforehand, while the “seas are calm” and there are no problems on the horizon. Once there is a controversy or potential liability, it is essentially too late.

Creditor Identity

Throughout our discussion, we have made an assumption (for the sake of simplicity) that all creditors are alike. That is not quite accurate. Asset Protection works in the context of a civil lawsuit. However, nothing will stop the IRS or a State Franchise Tax Board from piercing through any type of structuring. Also child support matters are unaffected by any asset protection structuring. Strategies discussed on this site, unless otherwise specified, apply only to the context of a civil lawsuit.