Asset Protection: The Corporate Veil and Charging Orders

What Is Asset Protection?

Many people assume that asset protection planning is just another term for “hiding” your assets from creditors, but that is not the case. Instead, asset protection operates well within the confines of the law. It is smart and completely legal.

Anyone can end up facing a lawsuit that can cost them thousands of dollars, regardless of whether or not you own your own business. Someone can easily get hurt on your property or you may cause a car accident, resulting in a costly legal battle. If your insurance company denies you coverage, you may be on the hook for the injured party’s medical bills, lost wages, pain and suffering, and a lot more. Proper asset protection planning helps you avoid losing some of the most important and valuable property that you own.

Starting the Asset Protection Process

While asset protection planning is completely legal, you must initiate the process long before you actually need it. If you start moving assets after litigation starts or on the eve of trial, you are going to have problems.

Transferring assets out of your name with the intent to hinder, defraud, or delay a particular creditor is illegal. These are called “fraudulent transfers.” While the term is often associated with bankruptcy, state laws have their own version of what constitutes a fraudulent transfer or fraudulent conveyance. The definitions are very similar.

Instead, you should begin planning for asset protection as soon as possible, just in case you need it. It is never too early to get the process started. Proper planning can help you keep some of your most valuable assets and protect your business as well.

The Corporate Veil: The Basics

Corporations and LLCs are separate legal entities. They can enter into contracts on their own, and they can incur debt by themselves. They also have their own legal responsibility for their actions. Due to this separate legal status, owners and shareholders are generally not liable for obligations of the corporation or LLC. Instead, their liability is limited to the investment that they have provided to the enterprise. This limited liability is often referred to as the “corporate veil.”

The corporate veil protects owners’ and shareholders’ assets from the obligations of the company, so they are not personally liable for contracts, debts, or even lawsuits against the business.

Piercing the Corporate Veil

The liability protection that corporations and LLCs provide is not absolute. Instead, a creditor can “pierce the corporate veil” and make owners or shareholders personally liable under certain circumstances. Essentially, the creditor attempting to pierce the corporate veil will have to prove that the company is really just a shell or a sham, or that the corporation’s actions were fraudulent or that particular owners acted irresponsibly.

Failing to follow corporate formalities is one of the most common reasons that creditors can pierce the corporate veil. For example, corporations have an obligation to conduct annual shareholders' and board of directors' meetings and keep minutes of these meetings. They must also issue stock and track the sale of stock. They also have reporting obligations to the state that must be met to keep their corporate status. Failing to fulfill any of these obligations may result in a claim that the corporation is not acting like a corporation and should be ignored to determine liability.

Another common pitfall is that the owners or shareholders of the company do not maintain the business separately from their own personal responsibilities. This is particularly prevalent with single-owner entities. Companies need to have a separate bank account and financial tracking system.

Failing to adhere to corporate requirements can ultimately undermine the asset protection that the corporation or LLC provides to its owners.

Charging Order Protection

While many people have heard of corporate veil protection, charging order protection is far less well-known. Charging order protection essentially offers asset protection in the opposite direction as corporate veil protection. It protects the business from legal obligations that may be created by the individual owners.

For example, imagine that your daughter has friends over to jump on the trampoline. One friend falls off and is seriously injured. Her parents sue you, and your homeowners insurance does not offer protection for trampoline accidents. That means that you must pay for the medical expenses associated with the fall on your own.

If the girl’s parents get a judgment against you, they can start trying to collect through putting a lien on your home or garnishing your wages. For business owners, this can be a problem because they may try to access some of the company’s assets as part of their collection efforts as well. Charging order protection cuts off the liability with the business; only you will be personally liable for the little girl’s injuries. That way, your company will continue to function and be completely unaffected by your personal obligations.

Charging order protection is particularly important for businesses that have many owners or in situations where the owners may be “litigation prone” or own other businesses. In those circumstances, charging order protection helps other owners protect their investment as well. It simply would not be fair that one owner’s personal liabilities would affect all of the owners..

If a creditor does get a judgment against you and tries to collect, the only thing that he or she will be able to obtain from your business is the income that you receive from it. That is, if the company gives you wages or dividends, then the creditor may be able to garnish that income. Nonetheless, the assets and income provided to other owners will remain protected thanks to charging order protection.

The Limits of Charging Order Protection

Just like corporate veil protection, charging order protection will only help you if your business is not a sham company or “alter ego” or “extension” of the owner. It may also be limited depending on the type of business entity you use. Generally, corporations offer strong charging order protection, but LLCs may not be as solid.

One of the reasons that charging order protection developed is because of the “fairness” of it. That is, other owners of a company should not be liable for your personal debt obligations merely because they own a business with you. By shielding the business, charging order protection also protects the other owners of the company. However, when there is only one owner or member of an LLC, this rationale simply does not apply.

Today, only five states provide charging order protection to single-member LLCs:

• Alaska
• South Dakota
• Nevada
• Delaware
• Wyoming

In fact, Delaware, Nevada, and Wyoming are often considered three of the friendliest states for business in the United States.

The remaining 45 states limit charging order protection to multi-member LLCs and corporations. This fact is extremely important to keep in mind if you are considering forming a new business.

Other Means of Asset Protection Planning

Developing a corporation or LLC is certainly not the only way that you can engage in asset protection planning. However, forming a business is the only means of obtaining corporate veil protection or charging order protection. Nonetheless, other asset protection tools may be used in combination with your company or separately.

Examples of other asset protection tools may include the following:

• Insurance – Many people overlook insurance as an asset protection tool, but it can be useful in protecting you from creditors. Insurance can cover both personal liabilities and business obligations, making it a reliable choice for asset protection. General liability insurance, homeowners insurance, and auto insurance are all good examples of insurance that provide a valuable asset protection service on your behalf.
• Trusts – Trusts are similar to corporations or LLCs because they are also considered separate legal entities. However, the trust must be “irrevocable” to obtain this status. Otherwise, revocable trusts are often just regarded as an extension of the trust owner. In an irrevocable trust, the assets are transferred to the trust. As the owner of the trust is no longer the owner of the property within the trust, creditors have a much harder time accessing anything in the trust. Like businesses, however, creditors can still often obtain any income derived from the trust, including most distributions.
• Exempt assets – Most states have a list of “exempt” assets. These assets are those that creditors cannot legally take. They often include things like your home, your retirement account, or your personal items (clothing, home furnishings, etc.). Putting money into these exempt assets allows you to keep the money safe from creditors. For example, some states completely exempt retirement accounts from creditor collection. By putting extra money in your retirement account, you are essentially keeping that money in a safe that creditors cannot touch. However, once you take the money out, a creditor may be able to reach it. The example also does not work if your state does not exempt retirement accounts. Many people also put additional money on their mortgage as an asset protection mechanism. This is because many states have a homestead exemption that protects your home from creditors.
• Gifts – If you no longer own the property, creditors generally have a hard time collecting it. That means that if you give gifts to others, creditors cannot go after that property either. However, it is important to note that gifting assets to others just before going to trial or filing for bankruptcy can be considered fraud—be careful!

Planning Properly for Asset Protection

Asset protection planning requires careful thought and deliberation. It may also require some creativity. Regardless of how you decide to protect your assets, you need to get the process started early for it to be most effective when you need it.

LegalNature’s legal documents can point you in the right direction. Our business formation documents are great resources that you can start using today.