The Asset Protection Need with LLCs
We as a society have determined two things that tend to contract each other.
- Someone who has wronged another in some way should pay for the wrong caused. (That is an ideal in the civil justice system, even if reality may differ for many).
- There need to be limits on that liability for sound policy reasons legislatures get to decide on.
LLCs are one way to come to a compromise on these two things.
So say Elyas owns shares in Apple, a massive publicly traded company. He does not work for Apple in any capacity; he owns shares he purchased in a brokerage account. Someone sues Apple for employment discrimination.
Can Elyas be sued for something Apple did? Yes, of course, he can be sued. You can sue anyone for anything, never mind how ridiculous. However, Elyas would likely win such a lawsuit very quickly, as quickly as we would if he owned no Apple shares (though I am sure such a case would be frustrating and expensive for the person to suffer it).
This principle also works for non-publicly traded companies: Say Elyas owns a hardware store, and an employee sues for employment discrimination. Same thing, though, with a couple of significant differences. Elyas is always liable for stuff he does and says. So his liability is different if he did something that caused an employee to sue. If he owns Apple stock, he will usually have no opportunity to engage in personal conduct with Apple employees that would get him sued for employment discrimination.
There is another exception that applies the same way to Elyas’s Apple stock AND hardware store. If he is sued for something unrelated to those two things and loses, he can lose his shares in both the hardware store and the Apple stock, just like cash.
General Partnerships
Say Elyas and Bilal buy an investment property together. They own 50% each. Elyas has some other savings and owns a house. Bilal only possesses his interest in the investment property. A tenant’s customer suffers an injury after a roof collapses on him. He sues and wins the lawsuit.
Because Elyas and Bilal do not own their property in a business entity, say a corporation, a limited partnership, or an LLC, they are liable for each other’s obligations. Elyas can lose substantial assets, and a judgment against them could haunt them for years.
This kind of liability can strike Elyas for things he has nothing to do with and is unrelated to the building he owns with Bilal.
People often create general partnerships by accident. There are no legal formalities required, only a business relationship. This fact can sometimes hit people hard.
What is a Limited Liability Company (LLC)
A limited liability company (LLC) is a creation of state law and a hybrid of a limited partnership and a corporation. There is a remarkable level of organizational flexibility in an LLC. Like a corporation, an LLC can be publicly traded or privately held. Owners are not called shareholders but “members.” There can be one owner or many (most states require two). Business owners can chose to have them taxed in a variety of ways.
Those who care about asset protection often find an LLC far superior to owning a corporation. Still, in some cases, it may be the same as a corporation, or in other situations, no different from doing nothing. LLCs can be different from one another based on the following:
- Ownership and Management Structure
- The operating agreement features (and the reasons they may exist)
- Tax treatment
- The LLC Law
When we create LLCs for Islamic Estate Planning, we rely on the flexibility for gifts, income distribution, wealth transfer, structuring valuation, and teaching future generations about business and real estate, among other reasons. Every client and circumstance is different in some way.
Members and Managers
Organizers of Limited Liability companies can make them “member-managed” or “manager-managed.” Members can determine how to manage the LLC together in a member-managed structure. In a manager-managed LLC, one or more people act in a CEO-like arrangement.
Example:
Sohaib wants to gift a building to his daughter, Asia. Asia is young and is yet unmarried. He does not know who she will marry and if there may be problems in the future. He would also like to protect the gift so that it is for her benefit, notwithstanding any bad decisions she may make in the future. Sohaib would also like to draw income from the building for now.
This solution is to create an LLC where he is the manager to draw a salary for his work managing the business. He can also gift a portion of the LLC over time to his daughter or the whole thing. More than likely, Sohaib would want to place his daughter’s interest in a gifting trust so the shares can pass to Asia’s heirs per the Islamic Rules of Inheritance and increase the asset protection benefits.
Formalities in management
Corporations must have a board of directors, which needs meetings and a minute book. Failure of the owner to follow these formalities could mean failure of the corporation itself.
One of the often-cited benefits of an LLC is that you don’t need to do the same formalities; there is no requirement for minutes. While this is true, it’s possible to overstate this as a benefit, as discussed below.
Alter Ego Doctrine
In the words of former Presidential Candidate Mitt Romney, “Corporations are people, my friend.” A business entity has “corporate personhood.” That means it can sue people and others can sue it; it has rights like freedom of expression.
If someone is suing your LLC, often, that means you are not, and if somehow you are, the LLC is protecting you because you maintained appropriate formalities.
Example:
Hamid has an LLC that owns a rental property. He uses the rent for his daily living expenses. The renters pay his LLC rent, which goes to a separate LLC bank account. Hamid draws from this account to pay for personal expenses, including vacations, gifts for his children, and his bills. He also maintained no minutes for his corporation.
A renter’s guest, Earl, sues Hamid. Earl was seriously injured when the railing from a stairway failed. The plaintiff claims Hamid should be personally liable because Hamid made no distinction between himself and his LLC; why should anyone else?
Earl would likely win here. If you don’t respect your LLC, don’t expect anyone else will.
Operating Agreement Features
The LLC operating agreement is a critical component, even though the state may not require it.
For example, Rashida and her sisters Sara and Haritha own an office building together, a gift from their parents years ago. Haritha wants to sell to the highest bidder, an outside investor. Sara and Haritha want the building to stay in the family. The operating agreement can determine if Haritha would be able to do this.
LLC operating agreements can also include voting, non-voting, and equity and non-equity interests. These are often useful in estate planning.
Tax Treatment
What tax treatment to select often depends on advice from a CPA or tax professional. It’s an important decision and usually not an obvious choice. The government can tax an LLC like a “c-corp,” traditional corporate taxation where the corporation pays income taxes, and dividends paid to the owner are taxed again. Many people don’t like the government taxing them twice; however, it will pencil out just fine in many situations. While it’s beyond the scope of this article, in some cases, it may be silly not to get a c-corporation.
The other way is what is known as “s-corp” taxation. The corporation issues a K-1 to shareholders, but there is taxation only at the partner level, not the corporate level. This kind of treatment is not available to everyone and has many more restrictions.
An LLC can also be a “disregarded entity.” That means the IRS ignores the entity’s existence. This choice is common with investment properties.
The LLC Law
Most publicly traded companies are incorporated in Delaware, regardless of their headquarters’ location. The reasons concern corporate law that founders of publicly traded companies have found beneficial. They can do this without visiting the state.
This kind of analysis enters into many decisions people face in the law. Lawyers often look for other jurisdictions regarding trusts and limited liability companies. While, like publicly traded companies, Delaware makes itself competitive for other things, the state is not the best place for everything.
An LLC for Real Estate and Investment Properties
The most common use of LLCs is for real estate ownership. Different owners have varying reasons for this, but flexibility, informality, and often superior asset protection compared to the corporate form. Several tax benefits are associated with investment property ownership, and many investors want those benefits. However, owning property in an individual’s name subjects the owner to unlimited liability.
How a limited liability company works for Asset Protection- the charging order
The charging order is an essential concept in asset protection. You should think of it as being something like a “wage garnishment.” Say William does not pay his child support, a Judge orders that his employer pay his ex-wife a portion of the wage to cover child-related expenses.
A limited liability company may pay out income to an owner. Suppose a judge selects the “charging order” as the remedy to pay the judgement creditor (it is an “exclusive remedy” in some states). In that case, a creditor does not have other options readily available, such as forcing the sale of a property, replacing a partner in a business, etc. The charging order is not an exclusive remedy everywhere.
Property Taxes
Remember that property taxes are different in California from just about anywhere else. So if you are not in California, you can skip this part. In California, changes in ownership will often trigger a reassessment. Remember, under Prop 13, long-term ownership has an inherent advantage because as the property appreciates, property taxes do not increase at the same rate. A new owner often pays more in property taxes than the prior owner.
But what if the new owner is the old owner, and the only difference is that the property is in an LLC wrapper? So long as the owner proprtionately distributes ownership to that business entity, the property tax should be the same.
Example:
Hasan and Amal own a fourplex apartment building; they own 50% each, purchased for $700,000 in 2010. In 2023, Hasan and Amal transferred the property to a Limited Liability Company, BiHafa Holdings LLC, 40% to Hasan, 40% to Amal, and 10% to their daughters, Fatima and Bilquis. Hasan is the manager.
The county assessor will reassess the property. The county will reassess the fourplex as the property has appreciated to over $3,000,000. Hasan and Amal will get a higher property tax bill as a result.
If, however, Hasan and Amal had transferred ownership to an LLC where they did not give gifts to their daughters, the property taxes would have been the same.
This example is not to discourage giving gifts to daughters. However, Hasan and Amal can structure their gifts with property tax consequences in mind.
LLCs in family estate plans
LLCs are like Trusts because they do not die when the asset’s owner dies. They can have a perpetual existence. LLCs do not last forever since they cease to exist when the business entity stops paying fees and taxes. Perpetual does not mean forever.
People often create LLCs for asset protection, wealth distribution, and tax planning. In the gift and estate tax area, how much a family is taxed depends mainly on the value of things—many disputes between taxpayers and the government center around valuation. Property owners tend to undervalue their assets and governments (especially the federal government) are interested in overvaluing them. Valuation is vast area of law in itself.
So, for example, the property owned by Hasan and Amal in the example above was $3,000,000. What if Hasan and Amal wanted their LLC that owns the property to appraise at $2,000,000 and have that pass scrutiny? Yes, it’s possible with good LLC planning.
For families that want to give gifts
The gift and estate tax system in the United States is often subject to change in various ways. In 2023, parents can gift up to $17,000 a year free of any gift tax consequences or even the need to file a gift tax return. So, for a husband and wife, this is $34,000 per year. This ability can be helpful in many ways:
Example:
Abdullah and Salma have been married for 50 years. They have a diversified set of assets worth about 30,000,000. They are concerned about the federal estate tax. The exemption in 2023 is $12,920,000 per person, and for both of them, $25,840,000. They have many options to mitigate their estate tax liability while, at the same time, spreading wealth among family members.
Here, they decide to create a special kind of gifting trust that helps with their tax and estate planning.
How to pick a state for an LLC
For many people, it makes sense to get an LLC in the state they are in. As discussed above, the state matters. Your attorney should help you determine the best fit in terms of protection that you need. LLC laws are regularly changing, as are other things, like costs, privacy, and service.
How hard or easy is it to get an LLC
It’s not hard in and of itself. Many states make filling out a form easy and pay a small fee. There are other aspects to an LLC, however, that go beyond mere formation. As I mentioned above, many people create LLCs and place themselves in no better position than when they started the entity.
Owning your home in an LLC
Many people look at the “asset protection” benefit of an LLC and figure it may be nice to place their home in an LLC. Though there is no rule against this, courts have pierced the corporate veil when a business entity owned a personal residence. So, the gesture is pointless. People have options for protecting their home; this is not it.
What about liability insurance and an umbrella policy?
The nature of insurance is to compensate people for loss. So if a tree fell on your parked car, an insurance company would pay you for a new car. If sued you over something covered by the policy, an insurance company would pay a lawyer to defend you, and if there were damages, pay for those damages.
Say Amal and Hasan want to insure their fourplex. They would have liability insurance of $2,000,000 and an umbrella policy that covers liability from $2,000,000 to $5,000,000. This second policy tends to be cheaper than the first since the second insurance company pays only after the first insurance company pays.
There are some significant limitations with insurance. The biggest one is that they often don’t pay when you need them to. Insurance contracts are not one sentence long; there are exclusions- often many of them. Then there is always a limitation on what they pay even when they agree it’s covered, and they pay those liabilities after attorney fees and other costs that may eat up much of the coverage.
A limited liability company is often an excellent firewall against further liability.
A Negotiating Tool
A structure like a limited liability company is helpful when sued, as it discourages someone suing you from thinking the case can be worth more. If they know a defendant has taken steps to limit their liability, they won’t dream about going after personal assets. They may be more likely to settle for insurance money.
Maintaining formalities in an LLC
One ongoing issue with limited liability companies is that some claim, not incorrectly, that LLCs don’t have the same kind of formalities as a corporation and that board minutes are not required. But this only tells part of the story.
Anyone with an LLC should develop facts that would help them fight any claims that the business entity is an “alter ego” of the owner. This kind of finding will cause, in the language of lawyers, a piercing of the “corporate veil.” Maintaining a minute book, meetings, and other formalities, like a separate bank account and accounting, is vital when protecting your assets. Asset protection is a dynamic process.
Owning Multiple LLCs
The reasons to own multiple LLCs are obvious; how many eggs do you want in each basket? If it’s too many, you are vulnerable. Real estate investors generally prefer to own their properties in individual LLCs so long as this is economical.
Integrating the LLC with an Asset Protection Plan
Judgment creditors, who have won a judgment, have immense power even in a world where we have Limited Liability Companies. In some states, a charging order is the “exclusive remedy.” That means that if the manager declares income, the judgment creditor is entitled to some of it.
But judgments, and judgment creditors, tend to go nowhere. They can lurk around for years. They can sell their judgments to well-funded businesses that specialize in making life miserable for debtors. If you want to enjoy your wealth at some point, having a judgment hanging over your head is not a lifestyle anyone would want.
Some people create additional firewalls and techniques that include LLCs to protect their wealth over the long term. These firewalls can consist of asset protection trusts, private retirement plans, and other methods as part of an integrated asset protection strategy.
Integrating an LLC (indeed any business entity) with an Islamic Estate Plan
An LLC does not distribute your assets after death. An Islamic Living Trust does that, sometimes acting as the LLC membership interest owner. There is much more to business planning, however. Here is an example:
Salman owns Falafel Properties LLC, which owns several LLCs with different properties. Salman’s son Abdul Matin has been helping him with the investment property business. Other children, all adults, have developed other career paths. He has been gifting part of his company to his children and grandchildren in trusts for several years.
After he passes, Salman wants to keep Falafel Properties LLC as a functioning real estate business. He would like to have Salman and perhaps other family members manage the company over time. Maybe in the future nobody in the family would be able to act as manager, and the family would need to hire a professional manager.
An LLC operating agreement, trust planning, and other documents can address several important issues. For example:
- Distribution of interests per the Islamic Rules of Inheritance after death.
- How to select managers.
- If a family member wants to be bought out by the other owners, how does that work?
- Can outsiders buy into the business, or must it be sold to other family members or the company itself?
- How does the family decide to sell everything?
You should consider LLCs
If you own investment property or need to think about asset protection by building walls of protection around your business, or want to integrate business planning into your Islamic Estate Plan, schedule a 15-minute no-obligation mini-consultation with Attorney and Certified Specialist in Estate Planning, Trust, and Probate Law, Ahmed Shaikh, by clicking here.
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