Starting up a Limited Liability Company (LLC) can provide important business protection and potentially reduce to your tax liability. However, not all state LLC statutes are the same. And the protection afforded an LLC largely depends on how a person sets it up and uses it.
What is a limited liability company?
A limited liability company, or LLC, is a type of business entity that combines the advantages of both a corporation and a partnership. It provides the owners with protection from personal liability for debts or liabilities incurred by the business. This in turn makes it an attractive option for many entrepreneurs. An LLC also has fewer formalities and more flexibility than corporations, allowing owners to manage the business as they see fit. However, forming an LLC does require certain steps to ensure compliance with state laws.
The Benefit of Charging Order Protection.
One of the biggest advantages of setting up a Limited Liability Company (LLC) is that it provides you with “charging order protection” in some states. (Arizona is one of the states that gives this benefit.)
What is a charging order?
A charging order places a lien on the LLC’s income stream. This can prevent you from accessing certain funds typically used to cover business expenses. This protection ensures that creditors cannot attach any liens or judgments to the LLC and thus prevents them from seizing any assets or personal property. Additionally, in some states, it also provides liability protection for individual members of the LLC should a creditor attempt to collect against them.
The benefit of having a creditor’s remedy limited to a charging order.
Some states (like Arizona) limit a creditor’s remedy against an LLC member to a charging order. That means that if someone gets a judgment against you personally, your creditor cannot get your interest in an LLC that you own. The most they can get is a charging order.
Here’s how that’s a powerful protection. Whoever manages the LLC (and it could be you) can choose not to distribute income out of the company. Instead, the LLC manager can choose to let the income accumulate inside the company. That creates “phantom income.” Phantom income is income that someone needs to pay tax on, even though the tax payer doesn’t receive money.
Then if you creditor can get a charging order, and you decide not to distribute out the LLC’s income, your creditor needs to pay tax on the phantom income.
Here’s a quick story about phantom income.
When I was in junior high school, my parents brought in some investors to help expand a nursing home business that they owned. Together they formed a limited partnership. My mom was a limited partner. The general partners decided to squeeze my mom out of the business. They did this by refusing to distribute money to her to pay for her share of the partnership’s income. In other words, my mom had phantom income. This was very difficult for my parents. I still believe it was one of the reasons my dad died of a heart attack within a few years after this happened. My mom eventually settled with the other partners by simply agreeing to walk away from the business. To her it was a good deal because she avoided having to pay any more income on the business’s phantom income.
Quick Recap About Charging Orders.
In the event of someone suing you, they will only be able to obtain a charging order against your LLC instead of seizing the assets in the LLC. This type of protection ensures that assets inside the LLC are completely shielded from your personal creditors and lawsuits. This means that you can rest easy knowing your hard earned profits are protected from unexpected circumstances.
Do You Need a Separate Limited Liability Company For Each Rental Property?
Many real estate investors wonder if they need to set up a separate LLC for each rental property they own. Generally speaking, it is not necessary to have a separate LLC for every rental property you own. However, it is important to evaluate your particular situation and ensure that having multiple LLCs makes sense from a legal and tax standpoint before forming them.
Single-Member LLCs Do Not Have Charging Order Protection.
Single-member LLCs have no charging order protection. What this means is that if you are the 100% owner of an LLC, and you have a personal creditor, that creditor can go after your company’s assets as well as your personal assets.
Here are two ways to avoid this problem:
- You can have your LLC owned by a Family Limited Partnership. A partnership DOES have charging order protection (at least in Arizona and some other states).
- Have the LLC owned by at least two members.
Register Your Foreign Limited Liability Company In Your State.
Some popular asset protection planners on the internet tout the benefits of LLCs formed in certain states. Here in late 2022, Wyoming is a popular state for forming LLCs. A main benefit of a Wyoming LLC is that it protects the owner’s privacy.
But here’s the rub. If you get sued, and the plaintiff gets a judgment against you, the next step is to bring you into court for a debtor’s exam. That’s where a judge puts you under oath, and then you and the plaintiff’s attorney go out into the lobby. The plaintiff’s attorney then asks you all about your assets. They will ask you if you own any business. At that point you can lie and say “no.” But that’s perjury. And perjury could end you up in jail. Or you disclose that you own a Wyoming LLC.
Now, if your Wyoming LLC is a single-member LLC, the local court in your home state can simply disregard it and order you to turn over the assets of that LLC. Your local court isn’t going to care whether Wyoming says your assets are protected. A local state court will apply its own laws and get you to cough up assets to pay your creditor.
And even if you insist on having a foreign LLC, you still need to register it in your home state in order to be able to conduct business. If you want to evict a tenant out of a house that your Wyoming LLC owns, you need to register the LLC in your home state.
To conclude, creating a limited liability company that will protect you from lawsuits and creditors requires more than just filing Articles of Organization with the Corporation Commission. There are other details that can come back to bite you in the ****.
Also, don’t believe everything you read on the internet. Wyoming LLCs are not as wonderful as they are promoted to be.
If you want help forming an LLC properly, give us a call at 602-443-4888. We’re here to help.