Asset Protection and Limited Liability Companies in Texas
by HMB Law|
Real Estate investors and small business owners should be aware of asset protection strategies and the role they can play in protecting wealth. Whether you're a seasoned business owner or investor or just setting up your first venture, understanding and utilizing robust asset protection strategies can be the key to safeguarding and enhancing your business's financial health. Regardless of your business's size, asset protection is not just a luxury for the rich - it's a fundamental strategy that can protect your hard-earned wealth and help your business thrive in today's competitive marketplace.
Asset Protection Explained.
So, what is asset protection? Simply put, it is the process of safeguarding one's wealth from potential future creditors. It involves arranging your assets—such as property, cash, investments, and other valuables—in a way that limits creditors' access to them while staying within the bounds of debtor-creditor law.
An essential point to remember is that asset protection planning must be done in advance. If you start transferring assets and restructuring your ownership once a creditor claim or a lawsuit arises, it could be seen as fraudulent transfer— an attempt to evade a legitimate debt— and may result in severe penalties.
The Role of Limited Liability Companies.
In Texas, one commonly used tool for asset protection is the formation of a Limited Liability Company, or LLC. LLCs are popular because they can provide a shield for your assets and protect you from the liabilities of the LLC. The owners of the LLC, known as members, separate their personal assets from those owned by the LLC. In addition, liabilities of the LLC are kept separate from personal liabilities.
LLCs can be either single-member (owned by one person) or multi-member (owned by multiple people). In either case, if a member is sued over something unrelated to the LLC's operations, a creditor cannot seize the member's ownership interest in the LLC to pay off the debt. Instead, the most a creditor can do is obtain a "charging order."
A charging order is a legal tool that gives the creditor the right to any future distributions from the LLC that the debtor member would have received. However, it's a limited tool—it doesn't let the creditor interfere with the LLC's operations or force it to make a distribution or to be sold to satisfy the debt. This limitation effectively prevents a creditor from converting the charging order into immediate cash to pay off the debtor's obligation. Unless the LLC elects to make distributions, the charging order is of no value to the creditor.
Let's imagine a situation where an investor, John, holds several real estate investments through his single-member LLC. Suppose a creditor successfully sues John for a personal matter unrelated to his LLC, obtaining a charging order against John's interest in the LLC. This would usually entitle the creditor to John's share of the LLC's profits. But the catch here is that the creditor cannot force the LLC to distribute those profits.
In our example, John, being the sole member, has control over the LLC's distributions. He may choose not to make any distributions while the charging order is in effect, effectively limiting the creditor's ability to collect on the debt. The creditor cannot compel the sale of the LLC's real estate investments, nor can they take over John's management role within the LLC to make the LLC sell assets or distribute profits.
Now, consider the tax implications. Traditionally, an LLC is a pass-through entity for tax purposes, meaning that the income of the LLC is reported on the member's personal income tax return, and not at the LLC level. With a charging order in place, the IRS considers the creditor as the assignee of the member's profit interest. As such, the creditor becomes responsible for paying taxes on their share of the LLC's income, even if the LLC makes no distributions. This could result in a situation often referred to as "phantom income," where the creditor is liable for taxes on income they have never actually received, exacerbating the frustrations for the creditor trying to collect on the debt. This can result in a horrible situation for a creditor. Not only can he not force distributions of cash, but he is taxed on John’s share of the LLCs income.
Recent Challenges to Single-Member LLCs.
Recent court rulings have put the asset protection capabilities of single-member LLCs under scrutiny. Some courts have equated single-member LLCs to sole proprietorships, suggesting that the LLC's assets may not be fully protected from creditors, casting a cloud of uncertainty over the future of single-member LLCs.
However, a significant development in Texas law, known as Senate Bill 2314 (SB 2314), has sought to rectify this. It amends the Business Organizations Code to make sure a charging order is the sole and exclusive remedy against a person who is the sole member of a single-member LLC. This change provides the same level of protection for single-member LLCs that multimember LLCs have enjoyed.
This law, which will be effective on September 1, 2023, effectively clears away the ambiguity surrounding the asset protection capabilities of single-member LLCs. It reaffirms the LLC as a valuable tool for asset protection, shielding the financial future of investors, small businesses and entrepreneurs.
Asset protection is not just for the wealthy. It's a fundamental financial strategy that everyone, from individuals to small businesses and real estate investors, should consider. With the recent developments in Texas law, the use of LLCs, particularly single-member LLCs, has become an even more effective method for asset protection. However, it's always advisable to seek professional advice when embarking on asset protection planning to ensure all legal requirements are met and your assets are securely protected.