Various asset protection strategies exist for those individuals that may need additional protection beyond that provided by the Texas Constitution, Texas Property Code, and Texas Business Organizations Code. A previous article discussed the general protections from creditors that we as Texans enjoy. This article discusses the different methods of asset protection available and various levels of protection given by utilizing each strategy.
As a brief description of this article, you will learn how to effectively deter potential lawsuits and how to structure your affairs in a way that provide you with as much protection as possible. Strategies include:
Good Asset Protection
- Creation of a series (or traditional) limited liability company to separate business affairs from personal ones
Better Asset Protection
- Creation of a series limited liability company (holding company) to own all of the business assets; and
- Creation of a traditional limited liability company (management company) to deal with the public, vendors, investors, tenants, etc., to contract on behalf of the company, and to provide a public face for the business
Best Asset Protection
- Creation of a series limited liability company (holding company) to own all of the business assets;
- Creation of a traditional limited liability company (management company) to deal with the public, vendors, investors, tenants, etc., to contract on behalf of the company, and to provide a public face for the business;
- Use of Assumed Name Certificates for each LLC; and
- Creation of a trust to act as manager of the LLCs to provide anonymity to the investor
Asset Protection Generally
I would venture to guess that everyone would agree that his or her stuff should be protected from creditors. Unfortunately, only a small amount of our things are protected. In a previous Article, I discussed what assets are exempt from collection by creditors under Texas law.
In the asset protection arena, the name of the game is deterrence. No plan is bulletproof regardless of what some people will try to tell you. Your goal should be to frustrate anyone attempting to sue you to the point that he or she simply walks away. So how do we go about making this happen? How can you protect all of your hard earned assets from the prying hands of creditors, predators, and other bottom-feeders?
Asset Protection Methods
For purposes of this article, an example will be helpful in order to show you the different structures and the protection provided by each.
Let’s assume that John is a real estate investor. As part of his investment portfolio, he owns 3 rental properties: Property 1, Property 2, and Property 3. Further, let’s assume that John owns the properties outright in his individual name and operates his business as a sole proprietor. John does not have a liability policy or an umbrella insurance policy to cover catastrophic events at any of the rental properties.
A tenant at Property 1 is injured when a tree-limb falls onto his head in the backyard. He is severely injured and will need medical treatment for the remainder of his life. The injured tenant has filed a lawsuit against John and won a judgment for $1 million. This example will be used throughout to illustrate the level of protection that John could have enjoyed with proper planning.
Since John owns the rental properties in his individual name and because he has not formed a legal entity under Texas law, he is considered by default to be a sole proprietor. In a sole proprietorship, ALL of John’s personal assets are at risk, subject to those things that the State of Texas exempts from lawsuits like these (i.e., your house, vehicles, retirement plans, etc.).
John does not have $1 million to pay the judgment. However, he does have Property 2 and Property 3 that are not his personal residence and are not protected by any laws. In this scenario, a judge will order that Property 2 and Property 3 be sold in order to provide some of the funds necessary to satisfy the judgment. Also, any unprotected assets that John owns will be ordered paid to the injured tenant until $1 million is paid.
This is most assuredly not what John wants. Why should he have to sell two completely unrelated properties to pay a legal judgment for a horrific accident? Why should his personal investments be subject to turnover to the injured tenant?
Lucky for John there are ways to avoid this misfortune.
Good Asset Protection (Limited Liability Company)
The first method that John could utilize involves creating a limited liability company (LLC) to own the rental properties. In forming his LLC, John must decide between using a traditional LLC or a series LLC. Both structures are created for the same purpose, to limit John’s liability and protect his personal assets, savings, and investments from lawsuits waged against the business. However, a series LLC provides key protections that a traditional LLC does not.
A traditional LLC separates John’s business activities from his personal activities, effectively creating a shield that keeps his personal assets safe from the injured tenant. Each of the three rental properties would be retitled in the traditional LLCs name. All business would be conducted under the name of the newly formed LLC. This would afford John the protection that his personal investments, savings, and bank accounts could not be reached by the injured tenant.
What about Property 2 and Property 3? Can they still be ordered sold to pay the judgment? YES! Since the traditional LLC owns Property 1, 2, and 3 in a collective pool, a lawsuit involving any one of the three can bring the other two properties into litigation.
John thinks that there must be a better way to structure things to avoid this negative result. Fortunately for him, he is once again correct.
If John instead uses a series LLC, he gains an added layer of protection that a traditional LLC does not afford him. The series LLC is designed to create individual units that can be insulated and protected from each other. In other words, the liabilities associated with one series are not imputed to any other series or the company at large. Each unit is “walled off” from the others. Once again, the properties are retitled in the series’ name and business is conducted under the individual series’ name. Series LLCs provide simplicity and economy and prevent the need for multiple entities to be created to safely do business.
Under the series LLC, John would have avoided having to sell Property 2 and Property 3. The judgment against Property 1 cannot be enforced against the other properties. Similarly, a judgment against Property 3 could not be satisfied from the assets of Property 1 or Property 2.
The series LLC has insulated John’s rental properties from each other in a way that a traditional LLC cannot. Since each property is owned by a separate unit, the units cannot be used against each other. While John would be forced to sell to Property 1 to pay towards the judgment, he would not have to sell Property 2 or Property 3.
This sounds much more appealing to John and something that sounds both practical and economical. However, John still wonders if there is anything more that can be done to protect the rental properties from judgments.
Better Asset Protection (Two Company Structure)
A higher level of protection is added when John creates a two company structure. John creates two separate LLCs, one a series LLC to hold title to assets (holding company) and the other a traditional LLC to manage the properties and engage in business. For simplicity, I will refer to these two LLCs as “Holding” and “Management.” The key concept to forming Holding and Management is the separation of assets from activities. By separating assets from activities, individuals can effectively keep the assets of the business shielded from lawsuits.
So how exactly does this work and how are the rental properties protected? John creates Holding and transfers each property to an individual series or unit of Holding. John then creates Management, which owns NO assets but is the public face of the rental properties.
There is no reason that anyone, especially tenants, should even know of the existence of Holding. This LLC should remain in the shadows in the background and should, under absolutely no circumstances, do anything business related. It is designed simply to hold title to the properties.
Management, on the other hand, does not own anything. Instead, the function of Management is to deal with tenants, sign leases and contracts, deal with vendors, work with realtors or property management companies, and generally to engage in business. Everyone, including John’s tenants, should know about the existence of Management. Rent checks should be made payable to Management, leases should be between Management and tenant, and bank accounts should be held in the name of Management to deposit John’s rent checks and pay expenses incurred in managing the properties.
What are the benefits of this structure for John? For starters, John can avoid having to sell Property 1, 2, or 3! This is due to a legal theory called privity of contract. Since tenants dealt with Management and not Holding, wrote rent checks to Management, and signed a lease with Management, Holding has absolutely no basis for being sued. Aside from the fact that John’s tenant should not even know about Holding, it has not contracted with the tenant and is thus untouchable. Properties 1, 2, and 3 are safe under this scenario and cannot be ordered sold to satisfy the judgment!!!
The second benefit to John is that the $1 million dollar judgment is only enforced against Management. Because Management was a shell company and owned nothing of value, the tenant’s judgment is virtually worthless. John can simply wind up and terminate Management and leave tenant holding a worthless piece of paper that cannot be collected on. John’s attorney may even provide more protection for Management by ensuring that any judgment creditor (like injured tenant) automatically becomes a Class B member which has no power to force the distributions of money. Again, the tenant has virtually no recourse against John.
Best Asset Protection (Trust & Two Company Structure)
The ultimate protection for John is the creation of a trust that will serve as manager of the LLCs. This is important in the realm of asset protection because it provides anonymity. More anonymity can be achieved if John utilizes an Assumed Name Certificate (also known as a d/b/a certificate) for each LLC. If John really wants to use the name Holding and Management, then that is perfectly fine. However, when the LLCs are formed John could use another name like Red, LLC and Green, LLC. In turn, Red, LLC would file an Assumed Name Certificate to operate and do business as Holdings. Green, LLC would file an Assumed Name Certificate to operate and do business as Management.
When John forms his two LLCs, he is required to list the manager or member that is the decision-maker for the LLCs. This is done via the Certificate of Formation which becomes public record once it has been filed with the Secretary of State’s Office. Remember, the goal of asset protection is deterrence. The harder John can it for the tenant to sue him or any of his companies, the better.
How does this example work in reality? John creates a trust under a fictitious name, let’s say The Asset Protection Trust. John serves as the trustee of The Asset Protection Trust, retaining all of the rights and powers he enjoys in his own personal capacity. In all public filings, the manager of the two LLCs is listed as The Asset Protection Trust. There is no requirement that John list his name in the Certificate of Formation.
This added layer of protection (and frustration for tenant) makes it virtually impossible to ascertain the identity of John himself. If a future tenant files a lawsuit, it will likely cost him too much money to pursue any legal action. Let me explain why…
A tenant wants to file a lawsuit against John. The tenant speaks with a couple of attorney’s who decline to take the case on a contingency basis. In the attorneys’ opinions, there likely is not any money available in the event the tenant wins a judgment. This means that the attorneys do not get paid for their time and work. No attorney will accept this arrangement.
Instead, the attorneys all quote the tenant an hourly fee. After the lawyer has spent some time reviewing the d/b/a records at the county and state levels, he or she determines figures out the true identity of the parties. The attorney finds out that John’s business name is a d/b/a for the real legal name of the entity. The attorney then searches the Secretary of State’s records to see who the manager/member of the LLC is. The attorney finds that The Asset Protection Trust is listed as the manager of both LLCs. Incredibly, the attorney still does not know John’s name.
The attorney does recognize that one of the LLCs is set up as a series LLC, likely as a holding company, and the other is set up as a management company. This triggers the thought in the attorney’s head that only the holding company has anything of value. Moreover, the only assets that can be used to satisfy a judgment are contained in a separate, individual unit . . . the house where the tenant was injured.
As you might imagine, figuring out this much is quite costly for the tenant. Now the attorney tells the tenant of his or her findings and tells the tenant that it is going to cost several thousand more dollars to actually file suit and litigate the issue.
Let’s suppose the tenant agrees to pay additional money to proceed. During the discovery phase of the lawsuit, where each side can request documents and ask questions of the other party, the attorney requests copies of the Operating Agreements and Certificates of Formation for the LLCs. John cannot refuse to supply these documents or risk being held in contempt of court.
After looking through the Operating Agreements, the attorney figures out that the Holding did absolutely no business with tenant and is not in privity of contract with tenant. This takes Holdings out of the picture, the only LLC with actual hard assets with value.
When reviewing the Operating Agreement of Management, the attorney determines that it is a shell management company. The attorney further realizes that any judgment creditor (i.e., tenant) is automatically a Class B Member, which cannot participate in the decisions of Management nor force Management to distribute money. The tenant has no way of actually collecting on the judgment, since John can simply fold up Management and open another shell management company.
Attorney then informs tenant that a lawsuit is not viable since, even if tenant can win the case, there is nothing to collect on. If tenant wants to continue spending money fighting a losing battle, then so be it. John’s structure has already cost tenant a great deal of time, money, and headaches with only more to come. This will typically deter any potential lawsuit because who wants to throw good money away chasing bad money?
Asset protection is about anonymity, deterrence, and proper planning. Despite what you may hear from seminar gurus, friends, and even some attorneys, there is NO WAY TO COMPLETELY BULLETPROOF YOUR ASSETS. However, the structures discussed above can provide a big disincentive to any potential plaintiff that thinks about suing John. There are a number of other designs that can protect assets, but the methods discussed here will work for most everyone.
Also, these structures will work for individuals that have other investments besides rental properties. Just a quick FYI… Bank of America does absolutely no business with its customers. It is designed as a holding company and it owns the controlling interest in its banking, mortgage, lending, and investment institutions. If these strategies are big enough and good enough for one of the world’s largest banks, it only makes sense that it is sufficient for the “little” guy.
Call Green Law, PLLC at (806) 548-2953 or email us at firstname.lastname@example.org today for a free consultation. Let’s explore together the different methods available to you and how you can protect not only your personal assets from judgments, liens, levies, and executions, but also protect your individual investments from creditors and predators. A little bit of advanced planning can save you thousands of times over in the long run. We look forward to speaking with you today!