Asset protection is a growing concern for the small business owner, especially where the legal climate seems to charge the deeper pocket, not the most culpable.41 In the past, business owners increased insurance coverage in an attempt to hedge liability exposure. With the advent of outrageous jury verdicts and the resulting increase in the price of insurance coverage, business owners are looking for other methods to protect assets.42 Three themes dominate asset protection planning: 1) invest in assets that are exempt from creditors; 2) isolate assets to insulate them from the liability exposure of other assets; 3) structure business entities to make them unattractive to creditors.
Investing in Exempt Assets
The small business owner’s first line of defense against potential liability exposure involves his investment decisions. Specifically, the small business owner wishing to protect himself and his family from liability exposure should maximize his investment in exempt assets. In Texas, exempt assets include, among other things, the homestead, qualified retirement plans, cash surrender values of life insurance policies, and annuities.
In urban areas, the homestead of a family or single adult may not exceed one acre. In rural areas, the homestead of a single adult may not exceed 100 acres, but the homestead of a family may include up to 200 acres. In addition to the homestead, an individual’s rights under any stock bonus, pension, profit sharing, or similar plan, including retirement plans for the self employed, any annuity purchased using proceeds from a plan described above, and any retirement or annuity account described under IRC Section 403(b) is exempt from attachment, execution, and seizure for the satisfaction of debts. Finally, Article 21.22 of the Texas Insurance Code provides that benefits from insurance policies, such as policy proceeds and cash values payable to an insured or beneficiary, and benefits under an annuity contract shall be fully exempt from execution, attachment, garnishment, or other process, including any bankruptcy proceeding of the insured or beneficiary. The protections afforded to exempt assets will be frustrated, however, if a person uses nonexempt property to obtain an interest in, make improvements to, or pay an indebtedness on exempt property with the intent to defraud, delay, or hinder the acquisition of such non-exempt asset by an interested person entitled to such non-exempt property.
Isolate Assets to Insulate Them from the Liability Exposure of Other Assets
In addition to boosting investments in exempt assets, the business owner must isolate, to the extent economically efficient, the activities and/or assets of the business. For example, a construction company would probably create at least three different business entities. The land on which the business operates would be owned one business entity, the construction services would be managed under another business entity, and the equipment would be owned by yet another separate business entity. The business entity providing the construction services might then lease the building and equipment from the respective business entities owning such building or equipment.
Structuring Business Entities to Make Them less Attractive to Judgment Creditors
Limited partnerships and limited liability companies offer an added layer of asset protection not available to the shareholders of a corporation. A properly run corporation will protect the shareholders from being exposed to personal liability by the judgment creditors of a corporation. However, the stock of the corporation is not protected from the individual liabilities of its shareholders. The creditors of a shareholder may attach the corporate stock of the shareholder; and if the shareholder has a controlling interest in the corporation, the creditor may gain control of the corporation. Even if a creditor is unable to gain control of the corporation, the acquisition of corporate stock by a judgment creditor of a shareholder could pose a meaningful threat to other shareholders in the corporation, especially in the context of a small business. For example, an S corporation could lose its S corporation tax status if a creditor, who was not a permitted shareholder of an S corporation, were to attach the stock of the S corporation. The added measure of protection afforded to limited partners of a partnership and members of a limited liability company stem from statutory and non-statutory sources.
In contrast, and with respect to a limited partnership, on application to a court of competent jurisdiction by a judgment creditor of a partner or of any other owner of a partnership interest, the court may charge the partnership interest of the partner or other owner with payment of the unsatisfied amount of the judgment, with interest, may then or later appoint a receiver of the debtor partner’s share of the partnership’s profits and of any other money payable or that becomes payable to the debtor partner with respect to the partnership, and may make all other orders, directions, and inquiries that the circumstances of the case require. To the extent that the partnership interest is charged in this manner, the judgment creditor has only the rights of an assignee of the partnership interest.
Similarly, with respect to a limited liability company, on application to a court of competent jurisdiction by a judgment creditor of a member or any other owner of a membership interest, the court may charge the membership interest of the member or other owner with payment of the unsatisfied amount of the judgment. Except as otherwise provided in the regulations to the extent that the membership interest is charged in this manner, the judgment creditor has only the rights of an assignee of the interest. The member is not deprived of the benefit of any exemption laws applicable to that member’s membership interest.
Statutory Protections Afforded to Limited Partners of Partnership
While the judgment creditors of a shareholder may attach, via judgment, the corporate stock of such shareholder, the partners of a limited partnership and the members of a limited liability company are protected from such attachment, as the only remedy under statute that a judgment creditor may receive against the interest of a partner in a limited partnership or a member of a limited liability company is a charging order against such interest. Rooted in English law, the charging order developed as a way to prevent the creditor of one partner from holding up the business of the entire partnership and causing injustice to the other partners. To prevent the clumsy method of proceeding, the English rule forbidding execution sale of a partner’s interest in the partnership to satisfy a non-partnership debt was codified in the Uniform Partnership Act and English Partnership Act of 1890. Under the revised English rule, the creditor’s remedy against a partner was limited to receiving the partner’s share of the partnership’s profits and
When a creditor of a limited partner receives a charging order against such limited partner’s partnership interest, the creditor’s interest in the partner’s share of the partnership is limited to that of an assignee. While the creditor may enjoy the partnership distributions that would have been distributed to the debtor partner in the absence of such creditor, the creditor does not receive the rights of such partner. As an assignee of a partnership interest, the creditor may not become a limited partner unless all other partners consent, something unlikely to occur. The creditor cannot vote on partnership matters, inspect or copy partnership records, or even obtain from the general partner business and tax information regarding the affairs of the limited partnership that are usually available to limited partners as a matter of law. Moreover, in a family limited partnership, the general partner will likely be a family member sympathetic to the plight of the partner who has been subject to the creditor’s charging order. Thus, it is unlikely that the general partner would elect to make a cash distribution to partners which would entitle the creditor/assignee to a distribution.
Even though the judgment creditor of a limited partner has no rights with regard to the partnership, other than receiving an income distribution, the IRS has long taken the position that an assignee acquiring substantially all of the dominion and control over the interest of a limited partner is treated as a substituted limited partner for federal income tax purposes.56 Since the income of a partnership flows through to the partners, the partners are taxed on the income whether or not they actually received it. Further, only the general partner of the partnership may make distributions to the limited partners. As a consequence, well advised creditors of limited partners will not seek satisfaction of judgments through charging a limited partnership interest for fear that they will be required to pay income taxes on partnership income not distributed to them.
The limited liability company offers its members a similar level of protection from creditors as the limited partnership. Practitioners have been slow to replace the limited partnership with the limited liability company as the centerpiece of an estate plan, perhaps because the limited liability company is relatively new in the United States and, as a consequence, does not have a depth of case law supporting its use as an asset protection tool. The limited liability company has replaced the corporation as the entity of choice for serving as a general partner of a limited partnership. In the past, corporations typically served as the general partner of limited partnerships, as the shareholders of a corporation were protected from the liabilities of the corporation. However, this arrangement failed to protect the limited partners from the creditors of the shareholders of the corporate general partner because the creditors could attach the stock of the corporation and gain control of the partnership. The limited liability company offers the benefit of protecting the members from the liabilities of the company. Moreover, the limited liability company is protected from the judgment creditors of its members in much the same way as a limited partnership. Consequently, because control of the limited liability company cannot be transferred to the judgment creditors of a member, the limited liability company is preferred over the corporation as the entity of choice to serve as general partner of a limited partnership.
Non-statutory Protections Afforded to Limited Partners
In light of the limited and disagreeable options available to the creditor seeking to satisfy a judgment by charging a limited partner’s interest in a limited partnership, the creditor will likely be more amenable to settlement. Moreover, the partnership should anticipate the possibility of partnership interests being charged by the judgment creditor of a limited partner and draft the partnership agreement to protect the limited partners. Mario A. Mata, an attorney in Austin, Texas, suggests that a well drafted partnership will
have protective language granting to the limited partners, who are not affected by the creditor, the option to purchase the creditor’s interest in the partnership. In addition, the partnership agreement should provide for a quick, simplified, and favorable method of valuing the interest of the charged partner.