Saturday, August 1, 2009

The Myth of Corporate Asset Protection

Most small to medium sized businesses are established as corporations. Many if not most of these businesses have just a few shareholders. For the principal owners of many closely held businesses, the corporate stock is far and away their largest single asset.

The corporate structure is touted to business clients by CPA's and attorneys to satisfy a number of objectives, but particularly as a means to protect the shareholders' assets. On a prior blog post, I recently discussed hearing a radio advertisement directed to the general public encouraging the use of corporations for asset protection purposes.

Unfortunately, the business owner who relies upon his or her corporation to protect their assets from creditors may be in for a rude surprise. While a corporation will shield the individual shareholder from liability against the corporation's creditors, the corporation will not protect the shareholder's stock -- which in almost every instance is considered personal property of the shareholder -- against claims from the shareholder's own personal creditors. We refer to this scenario as reverse veil piercing. Let's look at an example of the danger this type of exposure may pose:

Lou owns 100% of the stock in a plumbing supply company located in Orange County. Through hard work, integrity and good business practices, the value of Lou's company -- and the value of his stock -- has grown to $7 million. Lou is 63, and he is looking forward to being able to sell his business to a larger regional competitor and finally enjoy the fruits of his labor.

One day Lou and his wife, Monica, are babysitting for their 7-year-old grandson, Dylan. Having the attention span of a typical 7-year-old, Dylan leaves his skateboard by the front steps. Minutes later Lou's neighbor, Frank, comes by to drop off a flyer about the upcoming neighborhood block party. Frank is an orthopedic surgeon just entering the prime of his earning years. As he makes his way to the stairs of Lou's house, Frank trips over the skateboard and suffers a fractured vertebrae, leaving him paralyzed from the neck down.

After a trial, a jury awards Frank a $10 million judgment against Lou and Monica. Even with their $2 million umbrella insurance policy on top of their $1 million homeowner's liability insurance, Lou and Monica will still owe Frank $7 million to satisfy the judgment.

Well, at least Lou's corporation will protect his $7 million worth of assets in that business, right? Not so fast. All of Lou's personal property -- including his stock in his company -- can be seized by Frank to satisfy the legal judgment. Once Frank takes ownership of Lou's stock, Frank can appoint himself to the Board of Directors, fire Lou as President, and sell the company or its assets. Lou would end up seeing his entire life's work dismantled in a flash.

So, what could Lou have done differently to truly protect his business assets from his personal judgment creditors? Lou could have established his business as a limited liability company, or "LLC." LLC's were first created in Wyoming in 1987, and have since been statutorily approved in every state. Under the laws of many states, a judgment creditor cannot seize a membership interest in a limited liability company to satisfy a judgment. Instead, the judgment creditor is limited to what is known as a "charging order" that only permits the judgment creditor to distributions made to the judgment debtor from the LLC. If in our example Lou had established his business as an LLC, he would retain control over his company and can restrict distributions made to members from the business. Frank would not be able to require Lou to make distributions, and would be frustrated in his efforts to collect on the judgment. Frank (and his lawyers, who would only get paid by collecting on the judgment) would be more inclined to negotiate a settlement on terms favorable to Lou.

But what if Lou's business were already established as a corporation? Fortunately, Section 1003 of the New York limited liability law permits another "business entity" to be merged into an LLC, with the LLC to be left as the "surviving entity." Upon following the procedures outlined in the statute, Lou could have converted his corporation into an LLC formed under either New York law, or the law of another state if preferred.

In addition to the asset protection benefits inherent in the LLC structure, an LLC can be taxed as a corporation. In Lou's case, he would certainly elect to continue to be taxed as a corporation after the merger. There would be no difference if Lou's company were a "C" or an "S" corporation, as an LLC can elect to be taxed under either form. However, it is imperative to consult a tax professional before embarking upon a merger to avoid negative income tax consequences.

Given the LLC's many benefits, why would anyone consider establishing a corporation for their business? The only true advantage is that a corporate form is suited for entrepreneurs who intend to "go public" and sell shares in the company to a wide range of investors. LLC's are not structured to be publicly traded entities. However, for the remaining 99%+ of business owners who will always remain closely held, the LLC is the only way to go.

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