You Choose the Wrong State: LLC Mistake Number Two

Asset Protection. Most people set up a limited liability company for asset protection, that is protection against the consequences of losing lawsuits. But, since LLCs have become so common and there are many non lawyers who are glad to put them together for you. Many people set them up without expert advice and make many mistakes.

Choice of Law. When you set up an LLC, you have to file “Articles of Organization” with a state government. The laws of the state in which your file the initial Articles then becomes the law that applies to the LLC. You do not have to choose the state in which you live or in which the property is located. Just as with Delaware Corporations, you can shop around and choose the best state in which to form your LLC. Many people who form their own LLCs incorrectly assume they have to set up the LLC in the state in which they live.

Enterprise Liability. LLC protections against lawsuits have two completely different aspects. These two are not usually understood by most people. The first one is protection against enterprise liability. That is, if you own a rental house in your own name, and the tenant has a big party and someone slips and falls on a broken beer bottle, the injured party goer may sue you for their damages. If the party person gets a judgment for $2,000,0000 against you and your insurance pays up to its top limit of $500,000, then the party person can come after your home, bank accounts, stocks, bonds, shares in your business corporation and maybe your IRA until they get the rest of $1,500,000.

Limited to the LLC Assets. If you own the house in an LLC, then in most states, the maximum that the party goer will get from their judgment is the liability insurance on the house and the equity in the house. Your liability is “limited” to what is owned by the LLC. The judgment creditor gets a judgment against the LLC and not you, unless they can prove you were at the party and threw the beer bottle at the injured party goer. LLCs and Corporations, if properly maintained, provide this “enterprise liability” protection.

Creditor Protection. There is a second type of liability protection that refers to “creditor protection”. In Virginia and Delaware, an LLC provides you greater protection than a Corporation formed in any state or LLCs formed in many other states.

Personal Judgment. You are in auto accident. At trial, the jury doesn’t like you, finds you at fault and renders a $2,000,000 judgment against you personally. You were driving so you are personally at fault and the judgment is against you and all of your assets. Your limit on your insurance pays $500,000 to the creditor and the creditor comes after you for the $1,500,000 balance. When entered in a court of record, that $1,500,000 judgment automatically becomes a lien against any real estate you own in your name in the county of that court and quickly goes on your credit report.

Personal Judgment Protection? You put your rental house into an LLC to protect against liabilities coming out of that enterprise. Will your LLC also protect you against the auto accident liability?

Collection Process. When a judgment is entered against you by a court, that is the beginning of the collection process. First, the judgment creditor can have the court issue a subpoena for you to appear in court to list all of your assets. Next, the creditor takes this information and starts to levy on your assets. For certain assets, the creditor may request that the judge order a court sale of the asset.

Sale on the Court House Steps. Prior to the change of the law in Virginia, a creditor could get a court order requiring the sale of your membership interests in your LLC to pay for a personal judgment. Today, this could happen still with an LLC formed in the District of Columbia, Maryland and many other states.

Charging Order Sole Remedy. When looking for a state in which to form an LLC, you look for the phrase in the state’s LLC law: “… the entry of a charging order is the exclusive remedy of the creditor” or similar language. This means that the creditor can only get a court order requiring you to pay over any money you take out of the LLC, but can not require a sale or seizure of your membership interest by court order as they are able to for your bank account or stock portfolio.

Encourages Favorable Settlements. Where state law of your LLC says that the charging order is the exclusive remedy, the creditor has to wait for distributions to come out of the LLC for the creditor to get paid. If the LLC distributes nothing, the creditor gets nothing. This is “creditor protection” and encourages settlements of the creditor’s claims and large reductions in the amount you will have to pay the creditor. Careful people will own most of their cash and brokerage accounts in an LLC for this reason.

Choose the Right State. If you choose the wrong state to form your LLC, you will not have this creditor protection. If you choose Virginia, Delaware and certain other states, you will. Can you live in Maryland and have the advantages of a Virginia LLC? Most state LLC statutes state that the law of the state in which you set up the LLC determines the rules applicable to that LLC. You should choose the state with the best law for what you are trying to do.

Counterattacks. It is possible that a local Judge may try to get around the state law and order a sale of the LLC interest. But, there appear to be very few cases on this issue at this time, probably because there is enough uncertainty to the creditor that these cases get settled. The results in a federal bankruptcy court may be different. There are additional costs for multistate registrations, but, with the right state, you have built a high hurdle for the aggressive creditor to jump over. We will cover how to keep the hurdles high in later blogs.

Choose Wisely. Choose the right state law for your LLC.

Delaware: Still A Great State, Just Don't Live There

Taking More of Your Money. When you and I have less income coming in, we cut our expenses and maybe use some savings. But, when government has less income, they take more of our income by raising taxes.

Reinstated Estate Tax. The Delaware legislature effective July 1, 2009 raised taxes by reinstituting an estate tax on its residents. There was a trend of some states, such as Virginia, in eliminating state estate taxes. This means that Delaware may no longer be a safe haven for retirees fleeing high tax Maryland and the District of Columbia.

Have they lost their minds? Does this mean Delaware is no longer a good place to set up a corporation, limited liability company or a trust? Most know that Delaware is where many major US corporations are “Delaware Corporations” to take advantage of Delaware corporate laws and a specialty court system well trained in commercial law. Delaware is also a top state for forming limited liability companies; we will discuss the advantages of Delaware LLCs in future blogs. We rely on Delaware politicians to provide us better law than we can get from our own politicians where we live. Delaware government receives substantial revenue from out of state business registrations and the selling of Delaware law employs thousands of people in Delaware. There is hot competition between Delaware and Alaska, Nevada and South Dakota for this business. It does raise suspicions about the ability of politicians in Delaware to keep from ruining the status of Delaware as one of the top tier states for planning.

Advantages. Delaware has many advantages for setting up your trust in Delaware:

*Keep the Family Business. The ability to use an Administrative Trustee which enables family to retain control of a real estate portfolio or a family business after the death of founder of the business or of a mini real estate empire.

*Avoid State Taxes. In Virginia, New York and certain other states, with a properly structured Delaware non grantor trust, you are able to avoid state capital gain taxes on sales of stocks held in a Delaware Trust by non residents.

*No Frontier Justice. The Delaware Court of Chancery has judges that enforce the law (not make it up as they go), understand complex structures, do not pander to local prejudices, and do not have their own agenda to “share the wealth”.

*Protect Your Assets. The ability to set up a trust and obtain certain asset protection and a limited ability to benefit from the income from the trust, available in only a hand full of other states.

*Build Generations of Accomplishment. The ability to have a trust that will last for several generations, something that can be done in Virginia and Maryland, and a minority of other states.

*Stop the Greedy Son in Law. The ability to set up a trust for a child and to avoid claims of the spouse of the child against the Delaware trust assets.

*A Century of Performance. Delaware has been a leader in trust law for over a century, unlike its competitors in Alaska and Nevada.

*Protect Bank Accounts. Establishment of bank accounts that may not be subject to the claims of creditors.

*Motivate New Wife and Kids of Former Wife to Cooperate. The opportunity to use total return trusts to reconcile the interests of a spouse of a second marriage and children of a prior marriage.

Residents Pay an Estate Tax. Is this all ruined by the new Delaware tax on estates? The Delaware tax applies to residents of Delaware. As a resident, you will be exempt from estate taxes on the first $3.5 million of assets in 2009, certainly better than the $1,000,000 limits of DC and Maryland. But, if the federal government allows the federal tax exemption go to $1,000,000 in 2011, then residents of Delaware will pay taxes on their estates greater than $1,000,000. The tax will range from 9.6% to 16%, should be deductable from federal tax, and results in an effective rate of 8.8% for the estates paying at the 45% federal rate.

Beware of the Non Resident Tax. It only applies to a non resident to the extent that the non resident has real estate or “tangible” property in Delaware and the non resident has an estate greater than the federal exemption. Tangible property are things you can touch such as an antique pool table, a mint condition yellow Edsel, a record cover autographed by Elvis, a 3rd century hand decorated Turkish bible, 12th century Japanese Samurai armor, first addition movie posters, platinum necklaces and your gun collection. Because of this new Delaware estate tax, you may want to avoid having a beach house in Delaware and will want to keep your collectables in Florida, where there is no estate tax, if you are subject to a federal estate tax. As a non resident, your stocks, bonds, checking accounts, insurance policies inside your Delaware Trust are not subject to this new estate tax.

Delaware is still a great state for planning, just don’t live there.

Who Will take Care of Your Children if You Can Not? The Michael Jackson Case

Choosing A Guardian. The hardest part of estate planning for parents with minor children is choosing who will take care of their children if both parents die before the children are adults. Because this is such a difficult decision, it often is never made, with tragic consequences. But, even where a parent has made a choice, the courts are not bound by the parent’s will, and may appoint an ill suited ex spouse, the worst nightmare of a caring parent. This is front page news in the Michael Jackson case.

Jackson’s Will. Michael Jackson’s will designates his mother, Katherine Jackson, as the person to receive custody and to be the guardian of his three children, 12-year old Prince Michael, 11-year old Paris Michael and 7-year old Prince “Blanket” Michael II. But, Jackson’s ex-wife, Debbie Rowe is negotiating over custody with Katherine Jackson. The Los Angeles Court had delayed until July 20 a ruling on who will receive permanent custody of the children by a joint request of Katherine Jackson and Debbie Rowe. See Michael Jackson's Will Here.

Is Debbie the Mother? Debbie Rowe claims to be the mother of Prince Michael and Paris Michael. The mother of Blanket was an unknown surrogate. Michael Jackson and Debbie Rowe were married in 1996 and divorced in 1999, with Rowe giving full custody rights to Jackson in the divorce. Reports are that Michael Jackson paid Rowe $8 million and gave her a house in Beverly Hills to get her out of

the life of his children. An agreement giving up her parental rights was later set aside by a court in 2004, but Rowe and Jackson entered into another agreement in 2006 for allegedly an additional large payment. TMZ reports that Rowe was not the biological mother, but actually a surrogate mother. This is denied by Rowe and is probably irrelevant because previous court decisions have treated her as their mother. Reports are that Jackson and Rowe reportedly had little of a real marriage, no contact since the divorce and that there is no relationship between Rowe and the children, Prince and Paris.

Primacy of a Parent. If there is a big court battle between Katherine Jackson and Rowe, many legal experts think Rowe would likely be given custody of the children even though Jackson’s will chooses Katherine, someone who has a strong relationship with the children. First and foremost, a sole surviving parent has often a decisive legal right to the custody of their children. Rowe’s attorney might make a case that Katherine, nearing 80, is too old, and that her husband, Joseph Jackson, was abusive to his children, making their home not a healthy and safe place for Michael’s children. Katherine’s advocates would fire back that Debbie has no regular contact with the children and gave up her custody rights for money.

What to Do. What does all of this tragic soap opera mean for us? In estate planning, one of the most wrenching problems is making sure that the children of a responsible parent do not end up with an ex spouse who is irresponsible. The basics are that your designation of a friend, new spouse, or your parent as the guardian for your children in your will is not legally binding on the court. What can you do?

1. Name the Guardian and Alternatives in your will. If you do not have a will, the court will appoint a guardian for you. Name a primary and at least one back up guardian.

2. Give the reasons for your choice. Put in your will, your cogent and persuasive reasons for your choice of guardians. I am not talking about: “my ex husband is a bum and a drunk”. But if the ex husband beat the children, is an alcoholic and you have proof, then include that.

3. Fund the Fight. In your living trust, emphasize the importance of your choice of guardians and require the trustee to spend funds from the trust assets to buy the best legal talent to fight for custody.

4. Reference any court orders, doctor’s findings or other evidence that shows the ex spouse would be a bad choice for guardianship. Even siblings and close friends will not be able to find old court cases or testimony determining custody in a divorce or even know that they exist. In one case, we put in the will the report of the examining psychologist that the mother was an alcoholic and suffered from acute mental disorders and was an unfit mother and should receive no custody of the children in the divorce proceeding. But, with this likely testimony, the ex wife gave up custody before the hearing so there were no formal court findings in the record. If we did not have the information in the will, no one may know about it. You might be concerned that the will is a public document and you might prefer a private statement. However, the will is likely to be admitted as evidence before a court and a separate statement may be excluded from consideration by the rules of evidence.

5. Have the Guardians involved with your children. When possible, have the prospective guardians be a part of family gatherings and even do some babysitting. An important factor is the relationship between the guardians and the children.

6. Choose Your Guardians Well. Choose responsible people who do not have a criminal record or a history of child abuse and who have experience as good parents.

You might say, well, I will just buy off the ex spouse in exchange for their parental rights. Michael Jackson appears to have tried that, but the Court set it aside. A contract to sell your children is probably not enforceable and in many cases is a crime in California and other states.