Which is Better Asset Protection?

The lawyers, financial planners and other doctor sycophants all cry malpractice and run around flailing their arms in the air saying you’re going to lose everything. The facts are doctors do go bankrupt or at least suffer major financial setbacks, and they lose valuable assets, but it’s not because of a malpractice lawsuit.

Your assets are exposed to a lot of hideous threats. Those threats don’t come from your practice or even malpractice. The IRS is one of your major asset protection threats. Divorce is right in there as a major threat to your assets. Over 50% of all bankruptcies in the U.S. stem from someone in the family getting sick.

What happens to your practice, real estate investments, brokerage accounts and other “personal” assets if you get sick and can’t practice anymore? What happens to your brokerage accounts if your real estate investments collapse? Remember, you’ve signed on the loans personally.

If all of your assets are held in your name, they are all subject to any attack that comes along. How do you protect personal assets along with the assets of your business/practice?

I had a man come to me and claim that he had solved all of his asset protection problems. He stated that he had put everything he owned into a corporation. All of his assets were securely behind the “corporate shield.” What protection did this give him?

The corporate shield

The corporate shield was designed by Congress to protect the personal assets of the business owner, officers and directors from the liabilities that arise in the business. If you practice as a professional corporation, the corporate shield will protect you from the liabilities that arise in your practice. With the exception that you can’t hide behind the corporate shield and be protected from your own malpractice.

Note that the corporate shield will only protect you from what happens in the “business.” If you get in trouble “outside” of the corporation, then the corporate shied won’t help you. Your creditors can take your personal assets, including your stock in your little company (practice).

If a creditor gets your stock in IBM, that’s not a big deal for IBM. However, in a small company when the creditor gets the stock, they “own” the company and all of its assets. The man who had put all of his assets into the corporation had simply tied them into a neat bundle, so that when he was sued for a “nonbusiness” purpose (sick, accident on the way to church, divorce, IRS problems, etc.) all his creditors would have to do is get the stock in his corporation, and they would have all of his assets.

The question always has to be “where is the attack coming from?” If it comes from inside the corporation, the assets of the business are at risk, but the corporate shield can protect the personal assets of the business owners and officers. If the attack comes from the personal side (not from inside the business) the corporate shield offers no protection to you or the corporation.

Charging order protection

Let’s double your asset protection. Don’t use a corporation, use a limited liability company (LLC). It has the exact same corporate shield a corporation has. It also has a second aspect to its asset protection. It has “charging order” protection. To understand charging order protection, you need to understand the history of charging orders.

Centuries ago in England the only form of business entity was a partnership. Assume that three partners spent 30 years putting together a company. After 30 years of hard work, assume one partner got into “trouble,” personally. Maybe he didn’t pay his taxes, made the king mad, got divorced, got sick, etc. His creditors came after him, and they got his partnership interest.

The law of partnerships says that any partner can do anything in the partnership. Any partner can bind the other partners, sell the partnership or do whatever he wants without the other partners’ approval. When partner 1 loses his partnership interest, the other two partners lose their business — everything they have worked 30 years to build. That’s not fair.

England decided that wasn’t fair, so a law was passed that forced partner 1’s creditors to get a judgment against him. Rather than just giving his creditors his partnership interest, his creditors had to take the judgment, go back to court, and get an order “charging” partner 1’s interest in the partnership. The charging order gave the creditors the “economic benefit” of partner 1’s interest in the partnership, but by law the creditors couldn’t just grab his partnership interest.

The creditors couldn’t control the partnership, have any say in the partnership, or bother the other two partners in any way. When the partnership had a profit or loss the creditors got whatever partner 1 would have gotten. Partner 1 could still work for the partnership and get a wage, but his creditors got the economic benefit he would have received as a result of the partnership interest.

The charging order protected the other two partners and gave partner 1’s creditors the benefits partner 1 would have gotten from the partnership.

(I’ve prepared an eBook, How to Double Your Asset Protection.)

Limited liability companies

LLCs were first created in 1977 by the Wyoming legislature. They started with a corporation and said that they would only use two of its four basic elements. That means they didn’t have a corporation anymore, because a corporation is a business entity that has four specific elements:

1. Limited liability

2. Continuity of life

3. Centralized management

4. Transferability

Then the Wyoming legislature combined the flawed corporation with a partnership. They kept the corporate shield element of the corporation and combined it with the charging order element of the partnership. They basically took the best of both entities.

The LLC’s operating agreement has to define which two of the four corporate elements you choose. You’ll always choose limited liability (the corporate shield), and then you have to choose another one of the three.

Lots of people don’t realize that by law they only get two of the four elements, and they choose three by writing them into the operating agreement. If you have three elements, by law you don’t have a corporation and you also don’t have an LLC. You inadvertently have a partnership — along with all of its liability exposure.

Your LLC’s operating agreement isn’t a casual document. The internet sites don’t explain what is going on, and, frankly, many lawyers just use a boiler plate form. When they alter the form, they are getting in over their head. Just as an example. When you set up your LLC, one of the issues was, “Is this a member-managed or manager-managed LLC?” Chances are high the internet site and your lawyer both said, “Just pick one. It really doesn’t matter.”

It certainly does matter what you picked. The problem is you didn’t realize that you had to make choices when you set up your LLC. It was certainly never explained that picking limited liability is one of your four choices. You assumed limited liability was automatically written into your operating agreement, and you picked manager-managed. You’ve got your two elements. You’re through picking. If you keep picking, you’re in trouble. What does your operating agreement say? The words mean something. In fact, in many cases they prove to be fatal.

In the next article, I will discuss the design of an operating agreement and finish the story of the man who put all of his assets into the corporation. How can you protect all of your assets? It’s a trick question.