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Insulating Business Risk

Insulating Business Risk with LLC
The major criteria in selecting the entity within which to conduct a business is the degree of insulation offered from the liabilities of the business. If you already own a business or are planning to start one, do you want to place everything you own at the risk of the business?

Any business venture is a Dangerous Asset. There are leases to sign, bank loans, customers, employees, competitors, and government agencies-all with the potential to blow you sky high. You don’t want the liabilities from this business to threaten your other assets. The proper strategy is to contain the liabilities within the shield of the LLC. If something happens inside the company, make sure that it doesn’t contaminate your savings and other assets.

The purpose of asset protection planning is to allow you to engage in a business activity while protecting your other assets from the risks associated with the business. The proper plan enables you to pursue attractive investments and business opportunities without jeopardizing everything you own. Do you want to buy real estate or start a business? Understand your level of risk and then protect what you have. That’s the sensible approach.

Case Example #1
Mrs. Drake was a seventy-five-year-old widow. She sold a duplex she had owned in California for many years for $200,000 and used the money-her life savings-to move to Arizona and buy a condominium. Her only income was Social Security payments of $1,200 per month, which she used to pay her living expenses.

Three years after the sale, the real estate market in California collapsed and the value of the duplex dropped by half. That shouldn’t have mattered to Mrs. Drake since she had sold the property three years earlier. The new buyer was just unlucky when he lost his equity in the property.

But that’s not how it works anymore. The buyer sued Mrs. Drake in California claiming that she had failed to disclose defects in the property. None of these allegations were true. The reality was that the buyer had lost money when the market declined and he wanted it back. So he asked the court to rescind the sale contract-meaning that he wanted his $200,000 back plus interest.

The lawsuit placed Mrs. Drake in a terrible position. To defend the case she would have to hire an attorney-and these types of cases are very expensive. She was told that legal fees to defend her would run from $25,000-$50,000-money she clearly could not afford. The buyer’s attorney, on the other hand, was handling the case on a contingency-so the buyer really had no cost and nothing to lose by pursuing the lawsuit.

Rather than risk losing her home and the rest of her savings and knowing that the litigation costs alone could wipe her out, Mrs. Drake settled the case for $70,000. She borrowed the money against the equity in her condominium and she now uses most of her Social Security check to make the monthly mortgage payment. Instead of a comfortable retirement enjoying her life, she lives a spartan existence, barely surviving each month.

What did she do wrong? She sold her property at the top of the market. She should be rewarded for her good business sense. Instead, because she was an easy and a vulnerable target, the buyer and his lawyer managed to extort most of her life savings.

What should she have done? The outcome of the case would likely have been different if she had used an LLC to hold her Arizona condominium. The lawyer for the buyer would have determined that her assets (the condominium) were unreachable and without funds to pay a judgment she would not have been an attractive defendant. Additionally, the arrangement works so well from an asset protection standpoint, that even if Mrs. Drake had been sued by the buyer-and if she had lost-her home would have been shielded from the judgment. Legal protection for assets is a plan that usually defeats these types of extortion attempts
Case Example #2
The next illustration involves a client, Dr. Bell, who owned a valuable medical office building for many years. He had paid about $100,000 for it in 1970 and because of depreciation deductions it had a zero basis for tax purposes. In 1993, when he came to see us, the property had a value of $1 million. He had two principle objectives. First, he wanted to protect this asset from any claims which might arise from his medical practice or personal activities. Second, he wanted to protect himself from any liability associated with the property. He didn’t want to get sued because of some problem with the property and risk losing the other assets he had accumulated. He had no pending or threatened lawsuits or other immediate concerns. He was simply interested in developing a prudent business plan.

We felt that these objectives could be accomplished and as a part of his overall plan we put the office building into an LLC. His other assets including his savings were transferred into the Family Limited Partnership. We did not put the office building into the FLP because it is a Dangerous Asset and should not be mixed with Safe Assets.

In 1995, Dr. Bell got involved in some serious business problems because of a partner in a real estate venture. The partner refused to pay his share of the expenses and Dr. Bell was stuck with judgments and bills totaling more than $1 million. The creditor with the judgment attempted to collect from him. Because the office building was in the LLC, the judgment lien did not apply to that property. He was free to sell, refinance, or deal with the property as he decided. His bank accounts and brokerage accounts were safely protected in the FLP. The judgment had virtually no effect on Dr. Bell’s accumulated assets because he had engaged in the proper planning.

Compare the difference in this case that resulted from the strategy he used. If he had not put office building in the LLC, the judgment lien would have attached to the property. The creditor would have foreclosed on the property to collect the debt.

For income tax purposes, a foreclosure is treated like a sale for the amount of the debt. In other words, if the creditor had seized the office building, Dr. Bell would have been treated as if he had sold the property for $1 million. His tax basis was zero so the taxable gain would have been $1 million. Not only would he have lost the property with all that equity-he would have been stuck with a tax bill to the IRS of about $300,000.

Instead he managed to shield his valuable assets and continue to defer the taxes on the office building. This is a dramatic example of the advantages which can be obtained by using the correct legal structure to protect valuable assets.

Attachments and Liens
The most powerful weapon of a potential legal adversary is the ability to freeze your assets. When your bank account is frozen, it means nothing can be moved. You cannot pay your bills or run your business or withdraw your money. Your residence, rental property, or business can also be attached. You can’t collect rents or income, and your property cannot be sold or refinanced.

The plaintiff can attach your property during or after the lawsuit. An attachment during the case is known as a pre-judgment attachment. After the case is decided, it is called a judgment lien. A pre-judgment attachment is only granted in certain types of cases, generally those involving a contract dispute over a particular amount of money.

A judgment lien applies if the plaintiff receives an award in his favor. The judgment lien immediately attaches to all real estate in your name, all bank accounts, brokerage accounts, and other assets. A lien acts like a mortgage or trust deed. You cannot sell or refinance a property without paying off the creditor, and he can foreclose on the real estate and seize any accounts in your name. A creditor with a judgment lien clearly holds all of the cards. You have no leverage and no room to negotiate. At that point he has got you. You are trapped and there is no way out. Certainly that is not the position you want to be in when you deal with an adversary.

Case Example #1
One of our clients, Ed, was a wealthy real estate investor and owned five apartment buildings worth about $3 million. Although he was involved in a lawsuit concerning a property dispute at the time, he felt he had little exposure. We set up a plan for him using several LLCs to hold the properties. A year later we received a call from Ed telling us that he had lost the case and there was a judgment against him for $1.5 million. Had he not set up the plan he would have been in big trouble. The plaintiff would have had a lien on all of the client’s real estate, worth $3 million, as security for the judgment. The property would have been frozen and then seized. The plaintiff would not have taken a penny less than the full amount of the judgment. Nothing to talk about or discuss-just pay up. That’s a bad position to be in.

But because Ed was a smart guy, he was not in a bad position. Since all of his assets had been transferred into the plan, the judgment lien did not affect the properties. Ed was free to sell, refinance, collect rents, and deal with his property just like he had always done. Since the creditor had no security for his judgment and stood to collect nothing, Ed now had the leverage to negotiate a favorable settlement. He held all of the chips, and in fact, he settled the case for $75,000-clearly a better result than losing the $1.5 million. In this case the proper asset protection plan changed the relative bargaining power of each side. Ed could have been weak and vulnerable but instead was able to negotiate from a position of superior strength.

Case Example #2
Another client, an architect, had savings of about $75,000, which he had inherited from his mother. Architects have a high lawsuit risk, and our client needed to protect these funds for the care and special education of his eight-year-old child who had severe physical and learning disabilities. Sure enough, within two years after setting up the plan, my client was served with a lawsuit. The plaintiff attempted to get a pre-judgment attachment of the savings but the judge ruled that the assets were properly protected and could not be reached by a lien. Without any assurance of payment, the plaintiff’s attorney quickly lost interest and the case was settled for under $2,000.

These examples illustrate the importance of protecting valuable assets from pre-judgment attachments and judgment liens. Without access to your funds, you can’t pay your household expenses and you can’t operate a business. Worse, if you can’t pay your lawyer to defend the case, you will be forced into an immediate and unfavorable settlement. The proper strategy allows you to maintain access to your funds and your property during and after litigation and that is sound financial and business planning.

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