Interesting article on Asset/Liability Protection - Posted by Jacques
Posted by Jacques on September 27, 2004 at 03:55:20:
I found this article at investinginland.com. His reasoning seems to make a lot of sense.
So, does an LLC or Trust really protect investors? In what situations will it, and won’t it?
Below is part of the text of the article from that website.
Liability Protection.
Incorporating your business or transferring your real estate assets into a corporation or LLC makes no sense legally and offers you virtually no protection against lawsuits, creditors, or legal liability. This is just another of the many myths some real estate authors and gurus promote to sell courses and books on the subject. People who put their real estate into corporations or LLCs (“limited liability companies”) actually are doing themselves more legal harm than good, in fact, they are making it easier for creditors to attach their assets in the event of a lawsuit. They are also wasting a whole lot of money.
I recently received an advertisement from a well-known real estate guru and author the other day that claimed I could “shelter my real estate from liability and creditors by using a land trust, an LLC, or a Delaware or Nevada corporation.” Of course this person was selling not one but THREE $250 courses on the subject! This is also a common question I get from visitors to this website and readers of my Investing in Land Home Study Course which is usually phrased like “I’m about to buy some land and how should I take title, in my own name or should I form a corporation to hold it?”
I’ve been a lawyer for almost twenty years now and while I primarily practice real estate law, I started my career as a litigator (many lawyers do) and I’ve sued plenty of defendants on behalf of my clients over the years. I still do. So I know what I’m talking about when it comes to not only getting judgments but collecting the money owed (common called “executing”) under them.
The simple truth of the matter is that legal liability attaches not just to the legal owner of an asset but pretty much everyone who has a “nexus” or relationship to that asset or the event which gave rise to the liability. You simply cannot avoid legal liability by changing the way you legally own an asset. The only way to avoid legal liability and the financial consequences of being negligent or committing a tortious act is by not being negligent or reckless in the first place.
The reason behind this statement is also very simple. While many court cases and statutes have concluded that corporations, partnerships, LLCs, and other types of business entities are legal “persons” under law, common sense tells you that they aren’t really people. While corporations do have First Amendment rights exactly like every other American citizen, corporations are just legal creations that exist only on paper. A corporation cannot do anything from pay taxes or build a factory that the owners, directors, officers, shareholders, and employees of that corporation do not do for it. While Microsoft or Joe Smith Ice Cream, Inc. may both own assets, neither exists beyond paperwork filings at the local Secretary of State’s office. You cannot talk to or touch a corporation. But you can talk to, touch, and sue the owners, directors, officers, shareholders, and employees of a corporation, precisely those people that do the corporations bidding in the real world.
Again, you cannot escape legal liability by incorporating except by not being liable in the first place. Here are some examples explaining why.
Let’s assume Joe Smith owns some rental property and he’s concerned about liability so he creates Property Shelter, Inc. (“PS”) as a corporation to legally own his real estate assets. He transfers legal title to all his properties to PS. His lenders will allow the transfer, assuming they are paid a small fee to handle the paperwork. Such transfers are routine and banks are accustomed to doing such things. So far, Joe Smith has probably spent about $500-$1,000 to incorporate and arrange the transfers of title, maybe more if he hired a lawyer to do the incorporating and transfers for him.
So PS legally owns all the real estate. But who owns PS? Who are its officers and directors? Who manages the real estate PS owns? Who are the shareholders of PS, the real beneficial owners of the real estate it owns? It is likely that Joe Smith is one or all of the above. When Joe Smith incorporated PS and annually through his required corporate filings, who does he report as the officers and directors of the corporation? When new tenants need to be found for any of the properties PS owns, who finds them? Who makes repairs to PS properties? Who do the tenants call when something is broken or needs fixing? When the corporation shows a profit, who gets the cash money? If the answer to any of these questions is “Joe Smith” he’s liable in the event of a lawsuit.
Take this simple example based on the above facts. Let’s assume that Joe Smith manages the properties PS owns. He does the repairs, painting, finds tenants, and otherwise maintains the properties for PS. Maybe he even collects a salary from PS for doing so. One day a tenant is injured at the property because it is poorly maintained. Who is the tenant going to sue?
First, PS. The legal owner of the property. Property owners have a legal duty to maintain their properties in safe condition and this property owner was negligent.
Second, Joe Smith. He is the property manger. He has a legal duty to examine and expect the properties and make sure they are safe.
Third, the officers and directors of PS. They have a legal duty to make sure that PS complies with all required state laws.
Fourth, the shareholders of PS. Despite what you have read, shareholders of small closely-held corporations like PS get sued all the time. They can be sued under any number of theories, a common one being called “piercing the corporate veil” and it applies to corporations that are undercapitalized or really those just formed as anti-liability devices, in other words, they serve no real business purpose other than to shield owners from liability.
Joe Smith is getting sued under a variety of theories. And let’s face it. If he loses at just the corporate level, his properties are gone. If PS has to give up its real estate to settle a judgment, who cares if Joe Smith isn’t liable further down the chain?
This time, Joe gets smart!
Joe Smith gets nervous about liability after reading the above and gets himself a guru course on the subject and gets wises up really fast.
First, PS still owns his properties.
Second, he no longer manages his properties. He hires a management company to do it for him.
Third, he does not serve as the officer or director of PS. He hires other people to do it for him.
Is he safe, yet?
No, not even close.
If PS gets sued and loses, he still loses his properties. He then owns a corporation that has no assets. He can still be sued as a shareholder under various theories. He may have legal claims against the manager or the officers and directors, but he’s also been paying them to do their jobs too. At best here, Joe Smith loses his property and that’s all.
What if Joe Smith is very rich?
What if Joe Smith is a millionaire and wants to shelter all his other assets from liability in case something happens at his real estate rentals? Can he do it by using PS as a shield?
No, again. He still would be liable as a shareholder. In fact, the situation is even worse for him in many ways. Assume the reason for a lawsuit is that the property wasn’t maintained and a tenant was injured. This might suggest that PS was undercapitalized and could not make repairs and the very rich Joe Smith wouldn’t give PS the money it needed to operate and maintain its properties. I would find it very easy to pierce the corporate veil in this situation. Juries are often suspicious of rich people and especially rich people and corporations at the same time. Can you imagine how a jury would react when it learned that Joe Smith the Millionaire formed a corporation with no other purpose other than to shield him from liability but didn’t give the entity enough money to do routine maintenance and repairs on its own properties? Ever hear the expression “punitive damages”?
It really doesn’t matter what you do if you want to behave badly.
I’ve seen all sorts of devices over the years used to shield people from liability. They almost all fail. They can slow creditors down but determination beats them every time and I can honestly say the more roadblocks you throw at a creditor and their lawyer, the more relentless they become to get your money. It becomes a matter of pride after a while, a game where time is on the side of the creditor.
You can have a corporation owned by a foreign trust which holds its beneficial interest for an LLC formed in another state that is owned by another trust and so on forever. It really doesn’t matter. Ultimately there is a human being at the end of the chain and the whole charade is created to benefit that person.
Always remember that in the end…
Someone receives the profits and cash the corporation, LLC, or other entity receives.
Someone is responsible for managing the properties or assets.
Someone is responsible for operating the corporation.
Someone always is the actual owner of the entity.
And all these “someones” are flesh-and-blood people, not paper entities, and all are liable in the event of a lawsuit.
What about protecting yourself when your assets aren’t involved in a tort or negligence action?
Say, for example, Joe Smith has PS owning his properties, all of which are well-maintained and in perfect shape. His tenants love and adore him and the ground he walks on. But one night Joe Smith gets drunk with his friends and seriously injures a woman in a drunk driving accident. She sues him, claiming negligence and other tortious conduct.
Here the corporation or the management of its real estate is not the agent of the liability. Joe Smith caused the liability by his reckless conduct. The issue is whether Joe Smith can be sued but his real estate in the perfectly innocent corporation is safe from a judgment creditor.
Again, the answer is no. Joe Smith may not own the real estate but Joe Smith owns the corporation which owns the real estate. Those shares in PS are his assets that can be attached to satisfy a judgment against him. What if Joe Smith doesn’t own the shares in PS in his own name but transfers them to a trust? Then he can legally say he doesn’t own PS or any real estate, right? Wrong again. Creditor counsel will ask him if he holds any beneficial interest in any trust or real estate, it is a standard interrogatory question when attempting to collect on a judgment. What if Joe Smith does not retain any beneficial interest in the trust but passes the interest on to his wife and kids? Is he safe yet? No, once again. Because another standard interrogatory question is whether he retains any legal rights under any trust, such as to replace a trustee or direct a beneficial interest, or has recently relinquished or transferred such an interest.
This game can go on forever but ask yourself one question. If Joe Smith so divorces himself from his properties that he does not collect any income from them, has no stake in their future appreciation, and has absolutely no ownership interest in them at all, why does he want to own them anyway? Put another way, why own real estate when you legally preclude yourself from making any money in it, now and forever?
Who is concerned about legal liability? Not me.
There are two classes of people who buy into all these “corporations as liability shield” asset protection schemes.
The first class are people who do not know any better. This is the group that thinks millionaires shield their assets this way and they want to act like millionaires. The average person who owns three rental properties who fancies himself the next Donald Trump goes out and forms a variety of corporations and trusts, thinking that’s what rich people do. They don’t. This group of well-intentioned but misguided individuals are the people who buy the books and courses on land trusts and Nevada corporations. In real life most if not nearly all of these people don’t commit intentional torts and actually maintain their properties very well but they have been so scared into believing there is a hungry lawyer and plaintiff behind every tree waiting to pounce on their equity for no reason they spend thousands of dollars on meaningless “insurance” that only complicates their financial lives.
The other class of people who buy this asset protection nonsense are those who actually do behave recklessly and are worried about being sued one day. These are the men who hide assets from their wives (or vice versa) so in the event of divorce she won’t get the half she’s entitled to under the law. These are the slumlords who milk their properties and exploit tenants, promising repairs and improvements but rarely delivering on either. And these are the people who live shameful lives, they drive drunk, have promiscuous sex, gamble to excess, cheat on partners, and otherwise take inordinate risks with their lives and future. They know it is likely they will be sued so they plan ahead, not knowing what they do really has very little liability protection after all.
I know many very rich people. I mean VERY rich people. These are not the real estate investors and business owners who are obsessed with land trusts, Delaware corporations, LLCs, numbered foreign bank accounts, trusts in the Caymen Islands, and all the other silly asset protection measures you can buy books about. These people actually got to be rich by being financially responsible and ethically prudent. Many people would say they are boring because they go to church on Sunday, pay their taxes, don’t drink alcohol or have extramarital affairs, and treat their employees and tenants very well. There is a famous book called THE MILLIONAIRE NEXT DOOR by Thomas J. Stanley and William D. Danko that explains who the rich really are in America. They aren’t these flashy corporate pirates who take advantage of the weak and live in mansions and cheat the government and their business associates every chance they get. That’s the Hollywood myth from television shows like DYNASTY and DALLAS. The average millionaire is a typical run-of-the-mill person who owns and operates their own family business and has made some real money by living below their means, saving constantly, and working hard. Most millionaires in America made their own fortunes and did not inherit their money from Daddy. These people are rich precisely because they run honest businesses and live honorable and ethical lives, not because they are dishonest and have asset liability protection schemes in place that shield them from their corporate treachery and personal debauchery.
These devices actually make it easier to seize your money!
Not only don’t these land trusts and corporations protect your assets, they can actually make it easier for creditors to seize your assets.
First, there is the “all your eggs in one basket” problem. It is much easier for a creditor’s attorney to identify and attach your assets when they are all in one place, like owned by one corporation or trust.
Second, is that individuals have creditor protections that trusts, corporations, and LLCs do not have. For example, individuals have generous bankruptcy exemptions while corporations do not. Corporations and trusts are relatively defenseless in creditor proceedings while individuals can raise all sorts of claims.
Third, each time a corporation, trust, or some such entity is created it leaves a paper trail for creditors to follow. Each year documents need to be filed with public authorities like the local Secretary of State’s office, additional tax returns need to be prepared and sent to the IRS and state tax agencies, and otherwise many trees need to be felled to create all the paper these entities require. New bank accounts need to be opened and managed, new statements mailed and received, and more people keep records and become aware of these entities and their activities. Paper trails are easy to follow. If I learn that Joe Smith cashed a check from the “Acme Trust” in his personal checking account, it won’t take me long to find out who signed the check, where the money in the account came from, and who owns the trust and its assets.
There are many more reasons why creating these entities to own your assets makes it easier for creditors to seize them. My favorite reason is that when people fail to maintain these entities they are automatically dissolved by state action and many do not maintain them by paying the proper fees, filing the correct paperwork, completing the proper resolutions, and otherwise complying with the cumbersome requirements the law imposes on these entities. I know of many occasions where corporations that own valuable assets have been dissolved under state law only to have other creditors seize these assets merely by filing the appropriate paperwork with the Secretary of State’s office. So if Joe Smith owns Acme Corporation and allows its corporate status to lapse, all I have to do to own Acme’s assets is incorporate my own Acme Corporation!
How to REALLY avoid legal liability and lawsuits
Here’s some real advice on avoiding getting sued and losing your assets. Most are common sense but I’ll repeat them anyway.
First, don’t commit intentional torts. Do not drive drunk, beat up people for no reason, engage in vandalism, steal, or otherwise hurt people or their property. Be a responsible adult and don’t act like a college student on Spring Break. Don’t take on more debt than you can afford to cover. Pay your bills on time. Be a nice person and a model for your community.
Second, maintain your rental properties very well. Listen to your tenants. It pays to live in your own properties during a vacancy for a few days and learn what tenants do while living there. The major tenant concerns are repairs not being made and security issues. Address them both in advance. Most tenant based lawsuits center around very small problems that are allowed to fester into major issues, such as a broken lock on an alleyway door or a buzzer that doesn’t work that leads to a rape or other act of violence. Your tenants are your eyes and ears for your rental properties. Just don’t treat them as walking wallets that make your mortgage payments for you. Most just want a clean and safe place to live and will help you if you just ask.
Third, always maintain adequate insurance on your properties and your assets. Liability insurance can sometimes get expensive but you can get deals by shopping around and getting umbrella policies. In addition, there is much you can do to lower your premiums and insurance companies are willing to help. They don’t want to pay out awards any more than you do.
Fourth, do not maintain lots of equity in your properties. Why give a creditor’s attorney a nice fat target to shoot at? It makes no sense to have “dead equity” in properties you own from a financial planning standpoint anyway. You lower your return-on-equity by having lots of equity, you tie up valuable capital in a stale asset you already own, and invite lawsuits by flaunting your equity. Either refinance it out, create a note against it and sell it to an investor, or better still sell your property quickly and pyramid your equity elsewhere.
Fifth, do not flaunt your wealth. I like nice things too but when I deal with my tenants I wear jeans and drive my pickup truck to my rentals. If you collect your rents in a suit and tie and drive over to your building to discuss your tenant’s rent delinquency in your brand new Lexus, you are inviting trouble. Try to keep a low profile. One of the richest men in the county I live in (he owns nearly sixty rental properties in this one county alone) is only seen in public in a suit and tie once a week, and that’s on Sunday when he’s at church. Otherwise, he’s in overalls and work boots and looks like the country farmer he really is at heart.
Most importantly, be an ethical and honest person. Don’t give people reasons to sue you. Give people a dollar’s value for a dollar paid. Don’t badmouth people behind their back. Most lawsuits aren’t really about money but are about “principle” or settling scores. Sure there are greedy lawyers in this world with hungry plaintiffs who treat the courts like a lottery and an instant way to wealth. But bad lawsuits get dismissed when there are no facts underlying them and most bad ones do not get very far. You don’t hear how many lawsuits are dismissed in the press but most never make it past the preliminary stages, costing defendants little or nothing to defend against them.
You don’t need to worry about asset protection strategies and lawsuits if you give no person a reason to sue you.