Asset Protection for Business Entities – What If My Business Is Sued?

Why Asset Protection Matters for Businesses

Lawsuits can be devastating, and this is as true for business owners as for anyone else. With a single case, your business which you may have spent years or decades building from nothing could be utterly decimated.

Not only that, but as a business owner, the judicial environment is hostile to you. All too many plaintiffs and judges view corporations as faceless, soulless entities, fair game to sue and bleed dry. Of course, most businesses are smaller operations owned by an individual or family who are struggling to stay afloat just like anyone else, but when people see you as Goliath, there is no convincing them that you are actually David.

This is why asset protection is so important for businesses. Although every business should plan for how to protect their assets, it is particularly crucial for smaller companies, which often do not have the resources that large companies have to invest in legal and financial planning, and are thus less well-prepared to navigate the regulatory and judicial maze.

We made a thorough Asset Protection Guide to go over other elements of asset protection as a whole.

The good news is that if you are planning to create a business, or have already created one, there are a number of straightforward and proactive steps you can take to protect your assets. One of the most important involves creating the right kind of business structure, and in this article we will explain how to do that, as well as a number of other steps that you as a business owner can and should take.

Types of Business Structures

Graphic of different businesses

As someone looking to form a business, you have several options for how to structure your business. The type of structure you choose will have a significant impact on how well your assets are protected.

Sole Proprietorships

The first option for structuring your business, and the simplest, is the sole proprietorship. A sole proprietorship is so simple, in fact, that you have to do very little to set it up aside from obtaining a local license and filing the right tax forms along with your 1040.

As a sole proprietor, you have few up-front costs and a lot of control over your business, but there is one major disadvantage related to asset protection: you will be personally responsible for all debts incurred by the proprietorship. The law recognizes no difference between personal and business property for sole proprietors.

If someone sues your proprietorship, they will be suing you, with all that entails. If they win, they will be able to dip into your personal finances to recover damages. In the event of a severe injury or loss, this may be enough to financially ruin you.

Partnerships

A general partnership is a business structure in which multiple people share the management of a business. Partnerships, like sole proprietorships, offer no liability protection for partners: if someone sues the partnership, they will be suing you. In fact, partnerships are actually a lot worse than sole proprietorships, because if one partner is sued or falls into debt, all of the partners will be held equally liable!

A limited partnership is somewhat like a general partnership, except that the partnership includes both general and limited partners. If you are a limited partner, then your assets will be much better protected than those of the general partners, but as a limited partner you will have much less say over the affairs of the partnership.

Corporations and LLCs

Fortunately, if you are looking to protect your assets, there are a few other options which work better than sole proprietorships and partnerships. These include corporations and limited liability companies (LLCs).

A corporation is a type of business entity that exists separately from its owners. Corporations are considered to be legal persons, in the sense that they can hold assets, sue, and be sued in their own name.

Under United States law, you may create one of two types of corporation: a C corporation or an S corporation. The primary difference between C and S corporations has to do with how they are taxed: the profits of C corporations are taxed at the corporate level as well as the individual level for their shareholders (leading, in practice, to “double taxation”), while S corporations are able to avoid corporate taxation in exchange for abiding by certain restrictions.

A limited liability company is similar to a corporation, although there are some important structural differences: LLCs allow for more flexibility in terms of both management structure and taxation, and the relationship between the business and its owners is somewhat different.

However, C corporations, S corporations, and LLCs all have one major asset protection advantage that sole proprietorships and partnerships do not: limited liability.

Limited Liability

The Corporate Veil

Limited liability is a rock-solid legal principle, and its history dates back several centuries.

In England, corporations during the sixteenth and seventeenth centuries, such as the British East India Company, were typically created by a charter from the government. However, these corporations were a risky investment, because if they went bankrupt (which, as you can imagine, happened fairly often in the era of high-risk shipping ventures), then their shareholders could lose all of their assets to debt collectors.

Limited liability was the answer to this: under this legal theory, a shareholder in a business would only stand to lose what they had invested in the business. By the middle of the nineteenth century, this principle was enshrined in both English and American law, and it is safe to say that without limited liability, the modern corporate world would not exist, because it would simply be too dangerous for most people to invest in corporate stock.

Because of limited liability, if a corporation or LLC is sued or incurs a debt, then the plaintiff or debt collector may only recover assets from the business itself. They may not recover the personal property of the owners or shareholders.

If you are a business owner, the asset protection benefits of this setup are obvious. Even if a plaintiff or debt collector manages to bankrupt a business, they will not be able to take any of the assets that you have retained in your own name. Your business may be destroyed (and this is often bad enough), but you personally will be safe.

Exceptions to Limited Liability

Limited liability is not all-inclusive. There are a few ways in which it can be breached. This is known as “piercing the corporate veil,” and if it occurs, then your own personal finances will be placed at risk. Needless to say, this is an outcome best avoided!

If you run a corporation or an LLC, you should be aware of the ways in which the corporate veil can be pierced:

  • If an agent of the business, including the owner or any employee, personally commits a tort, then they may be held personally liable for that tort. Every individual is responsible for their own actions, and this applies to you as a business owner as much as to anyone else.
  • Similarly, if you as the owner of the business harm another party by acting in a manner that is fraudulent, reckless, or illegal, then you may be held personally liable. Being a business owner does not absolve you of your legal duties.
  • If you comingle your personal assets with those of the business, then courts will likely take this as an excuse to pierce the corporate veil. You must be very careful to preserve the integrity of this barrier on both sides: do not use your personal funds for company expenses, and do not use company funds for your personal expenses. A corporate veil is like a balloon: pierce it anywhere and it will pop completely. To this end, you should be as transparent as possible with regard to your finances, both business and personal.
  • If you fail to follow appropriate legal standards and practices for a business owner, then this may open you up to personal liability. Businesses must regularly hold (and keep minutes of) shareholder meetings and ensure that their business’ formal operating agreement and corporate bylaws are adhered to. You must pay all of the taxes that you withhold from your employees and ensure that the business has enough capital to operate on its own.

In order to dissuade creditors from attempting to pursue your personal funds, it will be helpful to advertise, to the greatest degree possible, the fact that you are a corporation or LLC. Companies don’t just put “Inc.” and “LLC” abbreviations everywhere just to show off!

How to Further Protect Your Business

Turning your business into a corporation or LLC is not the only way to protect your business assets. There are many other steps you can and should take.

Step 1: Buy Insurance

One of the simplest and most effective steps that you can take to preserve your business assets is to purchase as much insurance as possible.

What types of insurance will you need? It will depend on the precise nature of your business. You can often purchase several necessary coverages at once in the form of a Business Owner’s Policy (BOP), which will typically include general liability insurance, property insurance, business interruption insurance, commercial automobile insurance for any vehicles owned by the company, and more.

You should also purchase worker’s compensation insurance, which is typically required by state law. If you are a professional such as a doctor or lawyer, you will likely need malpractice insurance, and as a last line of defense, you may find it advisable to purchase an umbrella policy.

The costs of buying the various kinds of insurance can be high. The cost of not insuring yourself as a business owner may be far higher. This is one of the single strongest asset protection steps you can take.

Step 2: Place Your Assets in a Trust

We’ve spoken previously about the myriad benefits of setting up an asset protection trust for high risk individuals. If you are a business owner, these benefits ring no less true.

Asset protection trusts are different from trusts created for the purpose of estate planning (i.e. to supplant a will). These trusts are self-settled, meaning that you are the beneficiary of the trust as well as the settlor. They may be created either in the United States, typically in a state such as Nevada which has passed legislation making itself a haven for such trusts, or in a foreign country.

There are many countries which have passed laws friendly to foreign investors (such as yourself) looking to protect their assets. The best nation for this purpose by far is the Cook Islands, a small chain of islands in the Pacific. The Cook Islands have strong legal institutions and have implemented a whole host of legal protections which make it nearly impossible for creditors in the United States to recover money from the Cooks.

Some of our clients have elected to set up LLCs that are owned by the trust. They remain as managers of the LLC and signatories on the bank account. This is what we refer to as the Modular Structure and it is proved very successful and popular in the past.

So long as you pay all of your taxes to Uncle Sam, asset protection trusts are perfectly legal. Moving your assets offshore for the purpose of asset protection is very different from doing so for the purpose of tax evasion.

Step 3: Transfer Assets out of the Business

This is one way to take advantage of the corporate veil. Since anyone who sues your corporation or LLC will usually only be able to collect business assets, then it makes sense to transfer as many assets as possible out of the business.

How much should you transfer? This can be a tricky question. As we mentioned above, if you transfer too many assets out of your business, this could lead to the piercing of the corporate veil, because the courts will recognize this as a form of fraud.

As a general rule, you should leave at least enough money in your business so that it can pay its expenses and remain solvent. You don’t want your business to look like a front or an “in name only” operation. If there are excess assets, however, you can and should remove them from the purview of the business.

Step 4: Protect Your Personal Assets by Placing Them in the Hands of Your Spouse

Protecting your business assets is not enough. The corporate veil may be pierced, and so you should take some preemptive steps to protect your personal assets in case this occurs.
One of the simplest but most effective ways to protect your own assets is to place them in the hands of your spouse.

How does this work? Well, in California and many other states, all property obtained by either partner in a marriage is, as a general rule, considered the “community property” of both partners. Both partners have equal right to this property and will split it equally in the event of a divorce. However, by the mutual consent of you and your spouse, you may gift your spouse certain assets, at which point they will become your spouse’s personal property.

If someone sues you and manages to breach the corporate veil, then any community property of you and your spouse will be vulnerable, but the personal assets of your spouse will be protected from any creditors! The asset protection benefits of this are obvious, but it does come with a risk: you will be entrusting these assets entirely to your spouse, and if you get divorced, your spouse will be able to keep all of the assets that are their personal property, rather than splitting them equally.

As a result, a lot depends on how much reason you have to trust your wife or husband. If there are any skeletons in the closet of your marriage, or any other reason to believe that you may divorce at any point in the future, this strategy might be a hidden monster.

Asset protection of this kind does not necessarily involve your spouse, either. You may also opt to give assets to your relatives or close friends. This strategy, of course, runs the same risks, and large gifts may be subject to the gift tax.

Addendum: Plan Ahead

The important thing with all of these asset protection techniques is to plan ahead. This is more than just common-sense proactivity, too. If you wait to protect your assets until you are in debt, then you will be found guilty of fraudulent transfer.

The logic behind fraudulent transfer is simple: you cannot transfer your assets to another party, or move them to the Cook Islands, to avoid a specific judgment that has already been levied against you or is imminent in your near future. If this were allowed, then no one would ever pay their debts. For asset protection to be legal and ethical, you must plan far in advance, and take these measures long before any debts or lawsuits are on the horizon.

Once you need to think about asset protection, it is generally too late to think about asset protection. That’s the central paradox of all this and is why you should begin making your asset protection plan for your business today. To this end, the best thing you can do is speak to an asset protection attorney and see what steps you can take to best safeguard your business.

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