As a business owner, you probably realize that operating and owning a business can be fraught with pitfalls and risks. Turning a profit isn't enough; you must also protect your business from claims and lawsuits. Debts and mortgage obligations to third parties and vendors, claims for damages caused by your employees, product or professional liability, and consumer-protection issues are just some of the risks you must deal with. If handled improperly, these risks could result in the loss of both business and personal assets. Knowing what risks you face and how to minimize or avoid them gives you the chance to run your business successfully.
Why Is Asset Protection Important?
The goal of a comprehensive asset-protection plan is to prevent or significantly reduce risk by insulating your business and personal assets from the claims of creditors. Unfortunately, most small-business owners are unaware of all the potential risks that can harm their business and the options available to protect themselves. An asset-protection plan employs legal strategies, put in place before a lawsuit or claim arises, that can deter a potential claimant or help prevent the seizure of your assets after a judgment. If you haven't already put your asset-protection plan in place, don't wait. The longer the plan has been in existence, the stronger it likely will be. (Read "Will Insurance Keep Your Business Safe?" to learn how to guard against the loss of skilled workers.)
Strategies used in asset-protection planning include separate legal structures or arrangements, such as corporations, partnerships and trusts. The structures that will work best for you depend, in large part, on the kinds of assets you own and the types of creditors most likely to pursue claims against you.
The following are two general types of claims that can be made against you. For asset protection, it's important to know the difference.
- Internal claims arise from creditors whose remedy is limited to assets of a particular entity, such as a corporation. For example, if you have a corporation that owns a piece of real estate and someone slips and falls on the property owned by the corporation, the injured party is limited to pursuing the corporation's assets (i.e., the real estate). This assumes you did not cause the injury.
- External claims are not limited to the assets of the entity and can extend to your personal assets. For instance, if the same corporation owned a truck that you negligently drove into a crowd of pedestrians, the injured could not only sue the corporation but also you, and satisfy any judgment from corporate assets as well as your personal assets.
Knowing the type of claims that can be made will allow you to better plan and protect your property from seizure and your wages from garnishment. It is also important to understand which types of assets are more susceptible to claims.
So-called dangerous asset, by their very nature, create a substantial risk of liability. Examples of dangerous assets include rental real estate, commercial property, business assets, such as tools and equipment, and motor vehicles. Safe assets, on the other hand, do not promote a high degree of inherent liability. Ownership of stocks, bonds and individually owned bank accounts do not incorporate risk by their very existence.
Safe assets can generally be owned by you individually or by the same entity since they carry with them a low probability of risk. However, you do not want to commingle dangerous assets either with other dangerous assets or with safe assets. Keeping ownership of dangerous assets separate limits exposure of loss to the individual asset.
For example, a medical practice has obvious, inherent risk of liability. But did you know that if you own the building in which the practice is operated, that property may also be considered a dangerous asset? If both the practice and building are owned by you or by the same entity, liability arising from either asset could stretch to and include the other, exposing both your livelihood and property to risk of loss. (For further reading, check out "Don't Get Sued: 5 Tips to Protect Your Small Business" and "Protect Your Company From Employee Lawsuits.")
Types of Asset-Protection Vehicles
Many different strategies have been developed over the years claiming to protect assets. Some of these plans use long-standing legal entities to carry out their intent, while others are nefarious or even illegal, and promote a money-making scam on the innocent and uneducated. Some of the more common legal vehicles used for asset protection include corporations, partnerships and trusts. (Read "The Biggest Stock Scams of All Time" to learn from others' mistakes.)
Corporations are a form of business organization created in accordance with state law. Legal ownership of the corporation vests in its shareholders, as evidenced by shares of stock. Generally, each shareholder is entitled to elect a board of directors charged with the overall management of the corporation. The board of directors elects the officers (the president, secretary and treasurer), who are authorized to conduct the day-to-day business of the corporation. Many states permit a single individual to serve as sole director and to hold all of the corporate offices.
There are several types of corporations that are used to protect assets: business or C corporation, S corporations and limited liability companies (LLCs). The appeal of corporations as an asset-protection tool lies in the limited liability provided to its officers, directors and shareholders (principals). Corporate principals have no personal liability for corporate debts, breaches of contract or personal injuries to third parties caused by the corporation, employees or agents. While the corporation may be liable or responsible, a creditor is limited to pursuing only corporate assets to satisfy a claim. The assets of the corporate principals are not susceptible to claim or seizure for corporate debts. This protection from personal liability distinguishes the corporation from other entities, such as partnerships or trusts.
One prominent exception to limited liability of corporate principals relates to providers of personal services. Personal service liability includes work done for or on behalf of another by doctors, attorneys, accountants and financial professionals. For example, a doctor who forms a corporation and works for it as an employee may still be liable for damages attributable to treatment of a patient even though he was working for the corporation. (For related reading, see "Cover Your Company With Liability Insurance.")
In addition, liability protection offered by a corporation will be available only if the corporation carries itself as a separate and distinct entity, apart from the individual shareholders or officers. If a corporation has no significant assets, a creditor can attempt to prove that the corporation is not acting as a separate and distinct business entity but is the alter ego of its officers or shareholders. This strategy is called piercing the corporate veil, and if successfully proven, it allows the creditor to reach beyond the corporation to the assets of its shareholders. (For more, read "Should You Incorporate Your Business?")
An S corporation is similar to a C corporation except that it qualifies for a special IRS tax election to have corporate profits pass through the business and be taxed only at the shareholder level. While the liability protection afforded to C corporations generally applies to S corporations as well, there are additional qualifications the S corporation must meet as to the number and type of shareholders, how profits and losses may be allocated among shareholders, and the kinds of stock the company can issue to investors.
Limited Liability Corporations
Due to the added formalities imposed on S corporations, this entity evolved. An LLC affords similar liability protection to corporate principals as a C corporation and the same "pass-through" tax treatment of S corporations, but without the formalities and restrictions associated with those corporation structures.
A general partnership is an association of two or more persons carrying on a business activity together. This agreement can be written or oral. As an asset-protection tool, a general partnership is one of the least-useful arrangements because each partner is personally liable for all of the debts of the partnership, including debts incurred by other partners on behalf of the partnership. Any one partner can act on behalf of the other partners with or without their knowledge and consent.
This feature of unlimited liability contrasts with the limited liability of the owners of a corporation. Not only is a partner liable for contracts entered into by other partners, but each partner is also liable for the other partners' negligence. In addition, each partner is personally liable for the entire amount of any partnership obligation.
A limited partnership (LP) is authorized by state law and consists of one or more general partners and one or more limited partners. The same person can be both a general partner and a limited partner, as long as there are at least two legal persons or entities, such as a corporation, who are partners in the partnership. The general partner is responsible for the management of the affairs of the partnership and has unlimited personal liability for all partnership debts and obligations.
Limited partners have no personal liability for the debts and obligations of the partnership beyond their contributions to the partnership. Because of this protection, limited partners also have little control over the day-to-day management of the partnership. If a limited partner assumes an active role in management, that partner may lose his or her limited liability protection and be treated as a general partner. This restricted control over the partnership business diminishes the value of limited-partnership shares.
A trust is an agreement between the person creating the trust (referred to as the settler, trustor or grantor) and the person responsible for managing the assets of the trust (the trustee). The trust provides that the grantor will transfer certain assets to the trustee, who will hold and manage the assets in trust for the benefit of another person, called the beneficiary. A trust created during the life of the grantor is called an inter-vivos trust or living trust, while a trust created at the death of the grantor through a will or living trust is referred to as a testamentary trust.
While trusts have been used in many different asset-protection strategies, there are two basic types of trusts: revocable and irrevocable. A revocable trust is one in which the grantor reserves the right to alter the trust by amendment, or to dissolve a part or all of the trust by revoking it. The grantor has no such rights with an irrevocable trust. It's this precise lack of control that makes the irrevocable trust a powerful asset-protection tool. You can't be sued for assets you no longer own or control. (For further reading, see "Pick the Perfect Trust" and "Establishing a Revocable Living Trust.")
Selecting the Right Asset-Protection Vehicle
Now that you're familiar with the most common asset-protection structures, let's consider which vehicles work best to protect particular types of assets.
If you own a professional practice or business, your risk of loss and liability for claims is particularly high, making this type of business a dangerous asset. Incorporating your business or practice was once considered the best way to insulate your personal assets from liability and seizure resulting from claims against your business. However, the limited liability company has quickly replaced the standard business or C corporation as the asset-protection entity of choice, as it offers a more convenient, flexible, efficient and less-expensive alternative to the C corporation, while providing the same level of protection.
Because LLCs are creatures of individual state law, the filing requirements and protections they offer may differ from state to state. But, for the most part, state law essentially separates the owners of the LLC and their personal assets for liability arising out of LLC activities.
Nevertheless, in many states, certain types of business professionals cannot afford themselves all of the protections offered by the LLC. Professionals, such as doctors, lawyers, dentists and psychiatrists, to name a few, can't shield themselves from liability with either an LLC or a corporation for claims directly arising from their actions or inaction.
If the business entity cannot protect you personally, consider sheltering your personal assets in other entities, such as a family limited partnership (FLP), a trust or an LLC. Then, even if you are sued personally, at least some of your personal assets are protected within one or a combination of these entities, discouraging creditors from pursuing them.
A final note for professional practice or business owners: It is still worth your while to incorporate either with a C corporation or an LLC. While these business entities may not protect you from malpractice claims, they will shelter you from financial obligations of the corporation, unless you personally guarantee the debt. You also may be protected from most other claims of the business not directly related to your actions as a professional, such as claims of employees, suppliers, landlords or tenants.
Should You Ever Participate in a General Partnership?
The answer is almost always an unequivocal "no." As a co-partner, you are responsible for all partnership debts and acts of the partners regardless of your participation or knowledge. Being part of a general partnership greatly expands the exposure of your personal assets to claims arising from your business relationship.
If you are part of a general partnership, strongly consider protecting your personal property as described above. Without some protection, you could lose everything because of your mere association with the partnership and other partners.
The Bottom Line
Creating and implementing a comprehensive asset-protection plan involves almost every aspect of your business. The goal of the plan is to protect your business assets within the framework of your business operations. Protecting your business is both allowed and encouraged, using honest, legal concepts and entities where appropriate. Extending these goals to intentionally deceive other businesses or individuals is not asset-protection planning - it's fraud.
Consider the services of an asset-protection professional, such as an attorney or financial advisor, in developing an asset-protection plan that works best for you.
For related reading, see "Build a Wall Around Your Assets."