ASSet PROTECTION

This article explains why I am not a big fan of asset protection.  However, I am NOT an expert in this and know very little beyond what is here.  If you want asset protection trusts or other devices, see an expert; not me. 

Many people want to invest in real estate, but worry about liability; either to a tenant, a passerby, or anyone looking to sue and make a buck.  There are several ways to limit liability.  The best for you depends on your personal situation. 

1)   Forming an Entity
If I form a corporation, LLC, or Partnership, I MAY achieve some asset protection.  Here's how it works.

Shareholders have NO Liability for Corporate Debts
I own stock in Enron.  I bought it at $100 and now they are in bankruptcy.  My investment is worthless, but the creditors of Enron cannot come after stockholders for more money.  I risked my $100, but that's my entire risk.  If there is no money to pay creditors, they cannot come after me or my other assets. 

I want to buy the building at 101 California Street.  It will cost 10% down and a mortgage for the rest.  I form 101 Corp, and put my money in.  I am the only stockholder, President, and Manager.  My new corporation then buys the building.  Life is good.  Until there is a shooting.  A crazy person shoots innocent people. 

The families of the dead victims sue everybody.  I know it's a tragedy, but it wasn't my fault!  But they sue everybody, including the owner of the building for not providing proper security for the building. 

Let's assume that the families get a major judgment against 101 Corp.  That is a real bummer, but they cannot take away my other assets, right?  Just like in the Enron example above, right?  I am just a stockholder.

Maybe.

Unlike Enron, I am the only owner of 101 Corp.  Also the President and Manager.  If they successfully blame ME personally for doing an inadequate job as Manager / President, they can go after my personal assets. 

Here is a simple illustration:

Assume I am a Doctor.  Incorporated. 

• Working alone, except for my staff.  I amputate the wrong leg.  Having a corporation does not insulate me.  I personally screwed up; I personally am responsible and they can go after my home.

• My receptionist gives an injection.  I am supposed to be supervising all medical procedures; I am liable for any injury.  Having a corporation does not insulate me.  I personally failed; I personally am responsible and they can go after my home.
  
  [This is not "piercing the corporate veil" because I am personally at fault.  "Piercing the corporate veil" means that the formalities of the entity are not honored by the owners; therefore no one else must honor the separateness of the owner from the entity.]

 

Assume I am Doctor 1.  Incorporated.  Working with well-qualified Doctor 2.  Doctor 2 amputates the wrong leg.  The corporation insulates me but not him; he personally screwed up; he is personally responsible; my home is safe, but his is lost.

It does not matter who owns the corporation: all by Doctor 1, or by both.

As you remain responsible for your personal actions, in the rental area, forming an entity is not going to provide perfect protection.

Back to 101 Corp.  The victims have huge judgments against the corporation.  Assuming they cannot prove I personally was at fault they cannot take away my other assets.  But they CAN take away assets owned by the 101 Corp: the whole building.

Although the corporation can protect personal assets, it does not save the corporate asset.

  

Entity Choices

Although I discuss corporations above, NEVER PUT REAL ESTATE IN A CORPORATION unless your CPA tells you about General Utilities (a really unpleasant tax case about corporations owning real estate).

 Limited Liability Company (LLC)

• Good protection for Owners ("Members")

• Minimum Cal Tax: $800 / year + Gross Receipts Tax

• Flow-Thru: Annual Income Tax Return (Issues K-1 to Owners)

 

Limited Partnership; No Corporate General Partner (GP)

• Good protection for Limited Partners: NO PROTECTION for GP

• Minimum Cal Tax: $800 / year

• Flow-Thru: Annual Income Tax Return (Issues K-1 to Owners)

           

Limited Partnership; Corporate General Partner

• Good protection

• Minimum Cal Tax: $1,600 / year + 2 Tax Returns (LP + corporation)

• Flow-Thru: Annual Income Tax Return (Issues K-1 to Owners)

  

General Partnership

• No protection

• No Tax

• Flow-Thru: Annual Income Tax Return (Issues K-1 to Owners)

• Privacy benefit

 

If we are seeking liability protection, the LLC is often the best choice.     

Since our objective is to isolate liability, we need a separate entity for each separate property.  That way a problem with Property #1 might cause the collapse of LLC#1, but not affect the other LLCs.

Can the Minimum California Tax be eliminated by use of Nevada entity to own California real estate?   NO. NO. NO.

If I owned a property in a State without a minimum annual tax, I would form an LLC to own it. 

Other entity uses:

• Estate Planning:

• Gifting shares of real estate without giving up control

• Discounts of Gifted Shares

• Discounts on Shares still held at death.

• Property Tax Drawback

 

2)  Insurance

My personal decision was to protect against liability by having $3,000,000 liability insurance.  If a problem arises, the first $3,000,000 is covered; if a bigger problem hits me, I have a BIG problem.

My umbrella policy bringing my coverage up to $3 million costs less than $700 per year.  (This is on top of a good auto and home policy.)

To compare the effectiveness of an entity to an umbrella, let's forget the downtown high-rise and look at a residential duplex.  Assume my tenant trips and falls and sues me for $2 million.   

My LLC has 1 asset: a property worth $600,000 with a mortgage of $350,000.  My LLC declares bankruptcy and I walk away from the debt and property.  The tenant gets the property but is still not going to collect the extra $1.75 million.  My home was not at risk; my other assets were not threatened.  But I lost $250,000 of property.

Alternatively, with no LLC but a good umbrella policy.  The insurance company pays the tenant $2,000,000.  I keep the building (or sell it to the tenant who is now rich).

Of the 2 choices, I am better off with the insurance (IF it's enough) and the tenant is fully compensated. 

 

How much insurance is enough? 

Many people look at their assets and erroneously conclude that they need as much insurance as they have in net worth.  This is the wrong approach.

If I am worth $400,000 and have $500,000 insurance, but get hit with a $1 million problem, I did not have enough insurance.

The correct approach is how much risk do you want to accept?  I figure my $3 million umbrella is enough to cover almost anything which might reasonably happen.

But, let's make it worse.  I get hit with a $4 million judgment and have only $3 million of coverage.  I am totally screwed.  The victim attaches my home, my other real estate, everything I own.  I thought I had enough insurance, but I was wrong.

 

Conclusion:
Dangerous assets should be insured and placed in separate LLCs. 

In addition to the obviously high risk businesses (construction company, bar, trucking company) which should be in an entity, dangerous assets to be isolated in separate entities include:

• Businesses dealing with the public in high volume

• Retail store

• Selling food related products

• Restaurant or food product

• Real Estate Used by many people (store / office) / high risk tenants

 

As I started,  I am not a big fan of asset protection.  However, I am NOT an expert in this and know very little beyond what is here.  If you want asset protection trusts or other devices, see an expert; not me. 

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Copyright 2002, Marc S. Weissman
Certified Specialist: Estate Planning, Trust and Probate Law
Certified by the California Board of Legal Specialization of The State Bar of California
Weiss & Weissman, Foster City, California
(650) 574-0362
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