What is Charging Order Protection - Video Transcript
Today we're going to talk about charging order protection. Charging order protection is a certain characteristic that partnerships and limited liability companies have. It's very important for asset protection because a lot of times you put your assets into an limited liability company (LLC) or a limited partnership and the charging order protection keeps your creditors from getting assets inside the LLC or partnership.
So, charging order protection – basically if a creditor tries to get your assets inside your limited liability company (LLC) or partnership, he is usually statutorily forbidden from doing so. Instead a creditor may only get a charging order which entitles him or her to only distributions made from the LLC to you, the debtor and that’s only if and when distributions are made.
Most often what happens is if someone gets a charging order against the LLC you have an ownership interest in because you owe that creditor a debt, the manager just doesn’t make any distributions and the creditor ends up with nothing and it's just a stalemate.
You can't get assets out because it could go the creditor, but the creditor is not going to get anything and the creditor may not become a member of the LLC, may not get assets inside the limited liability company (LLC), may not control the LLC and may not force assets out of the LLC. So, they're really left high and dry until you decide well okay, we'll make a distribution and give it to you which maybe never.
So, for that reason, most creditors- and I've actually read court cases where you know the prosecutor or the – I’m sorry, plaintiff’s attorney after the case said this just isn't fair. He started, you know, whining; but the law is the law and we're going to use it to our advantage.
A lot of times creditors don’t even try and get a charging order against your limited liability company (LLC) because they know in most circumstances it's not going to do them any good. In fact, I used to work with the late great Dr. Arnold Goldstein he did asset protection for 45 years.
He’s an emeritus professor at Northeastern University, two law degrees, a Ph.D. He had almost 20,000 clients or rather his law firm did most of which he handled at least in some capacity on a personal level over his 45-year career, and he set up well over 10,000 LLCs.
He had several hundreds of clients with LLCs. He gets sued or you know at some point have some type of creditor problem and they had LLCs. Well, only three or four of those LLCs out of those 10,000 or out of those several hundred that got sued, only three or four ever got a charging order against him.
So, most of the time, the LLC works. They won't even try for charging order and your assets just stay safe, but the creditor does get a charging order although they will most likely not get your assets. If you need to get assets out of that entity, it may be difficult for you. So if you're relying on an income stream for that LLC or whatnot, there are ways that we can make it so they cannot even get a charging order against your limited liability company (LLC).
But you do want to understand for your LLC or partnership to benefit from this charging order protection, your LLC or other entity needs to be set up and operated in a careful and correct manner.
It's not rocket science, but it needs to be done right. A lot of asset protection planners don’t know all the ways that a creditor can circumvent your charging order protection. That’s why I often not only have I read tons of court cases to see ways creditors might try and pierce through an limited liability company (LLC) and the flaws those LLCs have, but I often work with attorneys with many many years of litigation experience; and for that reason, we always reinforce our LLCs so that creditors won't have a way to convince a judge to say hey, just disregard that charging order protection, let me get the assets in that LLC.
So, when may a creditor circumvent charging order protection?
Well, if you have an LLC with only one owner, we call that single member LLC, it may not have charging order protection. Now, this is not settled in every State, but there's at least three or four States I can think of: California, Colorado, Florida among others, that there's court cases that have shown single member limited liability company (LLC), no asset protection in those States and quite possibly in other States, no asset protection, no charging order protection for single member LLCs. There's two cases there, Ashley Albright, Olmstead versus FTC. I always recommend you always have a second member added even if that person only owns 1 to 5% of the company. Best case is 5% or more. You don’t really need to go more than 5%, but 1% is still pretty good. I try to get as close to 5% or more if possible.
Now, if all members are creditors of the same debtor, in other words, let's say you have three members and they all have a judgment against them by the same creditor, then that creditor can argue well, listen it's not – since everyone owes me money, let's just get the assets inside that limited liability company (LLC) because the reason for charging order protection is when these laws were being made. It came out of the United Kingdom actually and the legislature reasoned that well if creditor or person A gets assets inside of that partnership or LLC, that’s going to hurt these other two partners or members of the limited liability company (LLC).
They have nothing to do with this lawsuit because it's going to interrupt the business of this company, and that’s going to hurt profitability and hurt these other people. So, we're not going to let that happen. Well, if everyone is a debtor of the same creditor, there's no one innocent that’s not a party to the suit that will be heard.
So, you’ve got to make sure that you run your business so you'll never have it so that all of the owners of the limited liability company (LLC) are debtors to the same creditor. Now with husband and wife sometimes, you know, I have a husband and wife come to me and they say, "Can we just make it a multimember LLC and make the husband and wife the members or those two members"?
In a community property State, you have to be careful because community property state- that’s a lot of the States on the West Coast, you know, California, Nevada, Arizona, there's I think around 10 in all, and they'll treat the assets acquired during marriage as assets of the community meaning 50-50 owned by husband and wife. But there is a chance that a court may say, well the community that husband and wife marital State is the owner of the limited liability company (LLC) because the husband and wife were only members. We're going to treat the community as a single owner, therefore a single member LLC, let's get the assets inside.
So, community property states, I recommend you always add a third member, give him 1 to 5% interest other than the husband and wife. If it's not in a community property State, you're probably okay. You'll probably get the charging order protection that a multimember LLC gets unless both husband and wife are debtors to the same creditor which sometimes happens. So, you just have to be careful if you're saying well, can husband and wife be the only members? It's better than a single member limited liability company (LLC), but still be careful.
So, another thing is, there are court cases out. There is this case In re: Turner. It's a 2005 bankruptcy case in northern district of California, and if you use your LLC or other business entity just as a personal piggy bank to hold art and jewelry or things that have no business purpose whatsoever, this case In re: Turner specifically said if you do that, no asset protection for your business entity because you didn’t use it for a business purpose.
So, you need to put in investments that are at least being traded somewhat so you can say well, I’m doing some trades for profit. It's not just a personal piggy bank. I just didn’t take all my money, put it in the LLC in a money market fund and it really doesn’t do anything. I’m actually making trades trying to make a living even if it's only a few a year. You have to have some business context or a family business, rental, real estate, something else but if it's strictly a personal asset. Don’t put it in an LLC, because you’d run a high risk of that charging order protection being disregarded because the judge may reason you didn’t use the entity for a legitimate business purpose.
Also, if you use the entity as your alter ego or if you comingle funds; what alter ego means is you don’t create enough separation between the activities of your company and your personal activities.
So, comingling is an example. If you use your limited liability company (LLC) bank account to pay your personal groceries, to pay your car payment and your house payment – I had one client that did this when I told him not to. He came back and said Ryan I know you told me not to do this and guess what, a creditor got $350,000 out of his LLC trading account and he specifically argued that this was his alter ego. They were right because he’s paying his personal car and house payments out of his LLC account. You want to keep separate books and records for your limited liability company (LLC).
You want to have a separate mailing address if possible. I say just go to a UPS mail drop, UPS store mail drop. It's an actual street address instead of a P.O. Box and you want to keep the affairs separate.
Now, another way a creditor can circumvent this charging order protection is by committing a fraudulent transfer. You may ask what is a fraudulent transfer? Well, if a creditor can prove that you put assets into your LLC, limited partnership, etc, other charging order protected entity which is basically those; but if a creditor argues that you did this specifically so that to hinder that creditor from collecting on his debts because you're trying to get assets out of the way where he can't get them, they can undo that transfer and not all circumstances but most circumstances if they prove yeah, that’s specific intent when he put the assets in the LLC.
Now, if you have a valid tax savings you can realize through using the limited liability company (LLC), if you have a valid business purpose for those assets, if you – we're going to talk in another video about using the family LLC for estate planning, if you have these other valid reasons you did besides just well, you know, I want to get the limited liability, it makes your limited liability company (LLC) much stronger. It makes it harder to argue that a fraudulent transfer is committed.
The most important thing is that you put your assets into your LLC before a creditor comes along and gets a judgment against you or even threatens to sue you. If you know there's something brewing on the horizon and they can prove you know something, well that goes a long way to saying well you knew the creditor is going to come after your assets so – and then all of a sudden you did this planning, well that may give credence to them saying to you had fraudulent intent. Now fraudulent transfer is not a crime.
It's just really a remedy a court can use to undo the transfer into the limited liability company (LLC) so that the asset is back in your name, so that the creditor who has a judgment can grab that asset.
So, it's not fraud. There are times where we give it a shot because we have so many reasons for what we're doing besides just asset protection. Even though you have creditors on the horizon, and in most circumstances it can work; but just be aware if you already have creditor threats and you try and do put assets into an limited liability company (LLC) to protect them. There's always at least a little bit of a chance, and if you do a really poor transfer and it's really egregious that you're just to dodge your creditors, there may be a very good chance that the creditor can undo the transfer as a fraudulent transfer.
So, that concludes this video. I hope you found it useful and I wish you luck in your asset protection planning.