Why Your LLC Doesn’t Provide the Asset Protection You Expect
There are two types of asset protection provided by an LLC. First, an LLC can protect the members from the creditors of the company. Second, an LLC can protect the assets of the LLC from the creditors of the members.
The legal tests that determine whether a creditor can get through the LLC are different for each of these types of asset protection. The test used to determine if a company creditor can get through the LLC and go after the members is called “piercing the corporate veil.” The test used to determine if the creditor of a member can attach the assets or ownership interest in the company is often referred to as “charging order protection.”
The law that is applied to determine either of these two issues is the law of the state where the LLC is filed, not the law of the state where American Samoa LLC the company or the members are located. This principle is called the “internal affairs doctrine,” because it says that the internal affairs of a company are governed by the laws of the state where the LLC is filed. The internal affairs doctrine provides clarity in a situation where the company and the members are located in multiple states.
In most states, it is very difficult to pierce the corporate veil of a corporation or LLC unless you can show that the corporation or LLC is acting as the alter ego of the owner because the two have commingled funds or otherwise acted as if they are not separate entities. The test for piercing the corporate veil is similar in most states, except for California and Nevada. California courts are more likely to allow a piercing of the corporate veil than other states, and Nevada courts are much less likely to allow a piercing of the corporate veil. If your primary concern is to create an entity that will protect the members from the liabilities of the company, you should create your corporation or LLC in Nevada.
Protecting assets from the liabilities of the members is a different story. In most states, including California, a creditor is allowed to foreclose on a member’s LLC interest. In other states, a creditor is limited to a charging order (requiring distributions to be paid to the creditor instead of the member) as the exclusive remedy. Some people think these LLCs still provide excellent asset protection because what creditor would want an LLC interest that requires them to pay their share of the companies income taxes, when they have no vote and no ability to require distributions to be paid out of the company? Or what creditor would want a charging order if they can’t force distributions to ever be paid? It is true that this may provide some deterrent effect on creditors, but it may not be good enough.
Imagine that you own 10% of an LLC worth $1,000,000. A creditor gets a judgment against you for $100,000 and forecloses on your LLC interest. You have permanently lost your ownership in the LLC and the creditor could potentially receive much more than $100,000 if the assets in the LLC appreciate in the future. Do you really feel that your assets were protected?
Imagine that you and your wife each own 50% of a family LLC worth $1,000,000. A creditor gets a charging order providing that (1) all distributions relating to your interest must be paid to the creditor, (2) the creditor must be given copies of all partnership documents, agreements, tax returns, financial statements, and monthly bank statements, (3) the LLC may not make any loans to any person, (4) the LLC may not purchase any assets without the approval of the creditor or the court, (5) the LLC and its members may not sell or transfer any interest without the approval of the creditor or the court, and (6) the managers must report to the court and show that they are managing the LLC for the benefit of all members. All of these terms have been included in charging orders and they have set a precedent that could be used again in the future. I admit that the asset protection described above is better than nothing, but does this really feel like a victory?
An Alaska LLC is a much better solution for protecting assets from the creditors of a member. Alaska law provides that the exclusive remedy of the creditor of a member is a charging order, and that a court cannot issue an order for inquiries, accounting or directions from the LLC. In other words, a creditor of a member of an Alaska LLC cannot take away your ownership or get involved in the LLC, but rather must simply wait and hope that a distribution is made. There is more to designing an effective asset protection plan than choosing the best state in which to file, but choosing to file your LLC in Alaska is clearly a huge advantage compared to filing in any other state.