Transcription
Hey, a judge signs a charging order. Now, the question is, do the creditors now own your limited liability company? Well, hey, not so fast. And the next 6 to 7 minutes, I'm going to show you exactly what a charging order is. A creditor sees what it blocks and the three moves that you need to be using to keep cash control and everything else untouchable. All right, let's get started.
So here's the setup. A creditor wins a $400,000 judgment against a member of, let's say, Mountain Peaks Limited Liability Company. And then he goes to court, and the court grants the creditor a charging order against the member's interest in this limited liability company. And of course, the creditor is now expecting big fat rent checks that'll be flowing out of the LLC because that LLC owns rental real estate. However, bad news for the creditor because the operating agreement lets the manager of the LLC decide when distributions are going to be paid out. So the creditor ends up getting nothing. And unfortunately, also, or fortunately from my standpoint, receives a tax bill.
Now, how does all this play out? I'm going to show you exactly what I'm referring to here. Why do you need this type of protection for your limited liability company? And it doesn't matter if you have rental real estate or you're running a business, the protection is the same because we want to make sure is if we get sued individually, that someone cannot swoop in and take our limited liability company.
So what is the charging order? Well, a charging order is essentially a lien on distributions. It's not on the assets of the limited liability company. And this is a big mistake that people make when they're thinking of charging orders and LLCs.
So what am I referring to? Let's say that I have a limited liability company here and this LLC owns, I don't know, let's just say has a brokerage account inside of it, has my trading account inside of here. And my savings. There's a total assets of $375,000 sitting in that LLC. And I am the member with my wife of this limited liability company. We're both members and we're also up here, we're serving as managers. Okay.
Now, when a charging order or this court-ordered lien is placed on my interest, what it's placing it on is my ownership interest in the LLC. You see, it doesn't attach any of the assets held inside of the limited liability company. Now, think about this. If those assets were in my name, and this is a mistake a lot of people make when it comes to holding their trading account, savings account, or any assets for that matter. When you keep those assets in your own name, you're opening them up to creditor attachment because if they were a trading account or a savings account, all the creditor would need to do is record a writ of garnishment or send a writ of garnishment to the financial institution, and that financial institution would then hold those assets for that creditor, meaning I would no longer have access to it. They'd all be paid out to the creditor.
So when you set up an LLC, you're turning the tables on people. You see, they get the charging order, but they don't get the underlying assets of the LLC. So what does this mean when you take out distributions? Well, who decides if distributions are going to be paid out? Well, you do as the manager of your LLC. So as long as you're deciding, I don't want to pay out distributions and wait, I'm going to talk about this as well a little bit later in this video. This is really important. You have to have a specific clause in there to protect this. If you don't, and this is where I've seen a lot of operating agreements fail, that they don't have the right language in there, and what I just described does not work. So you have to have the right language in your operating agreement to make this work. But as long as you're not taking distributions, there's nothing that's being paid to your creditor.
That's why with the charging order and the proper operating agreement, you ensure that anybody who gets a charging order against your LLC does not have any voting rights. They don't have any management rights. All they have is this lien.
Now, what did I say when I said tax it? Well, there is a certain revenue ruling 77-137, which holds that if a creditor places a lien on the interest of a member in a partnership, and this LLC is set up as a partnership, then that creditor becomes liable for the taxes associated with that lien interest. So in other words, if I go crazy with my trading account and I generate $100,000 in profit and a charging order was placed on my interest and assume I own 50% of this LLC, then 50% of the profits would not be taxed to me. I'm going to send that fat tax bill to this creditor over here, and they're going to be none too happy for it because I'm going to report them to the IRS for putting that on my interest. But hey, that's an aside. That's really not what I'm going after here. What I want you to understand is that a creditor does not get paid and how important it is. You use this type of structure to protect weak LLCs, as we're going to talk about, and your other assets.
Now, what does this mean overall? Well, they can't take your interest. But as I stated, you have to have the right LLC set up. So they're only going to receive distributions when you decide to issue them. Now, if you decide you never want to take distributions, then they're never going to get paid.
Now, unfortunately, this is not uniform. And this is a mistake that a lot of people make. They watch a video like mine and they only see it to this point here and they think, hey, I'm going to go out, I'm going to create an LLC or I'm feeling pretty good about the LLC I set up in California, not understanding they're at serious risk if they don't have the LLC that they're owning set up in the right state, because in some states, a creditor can place a charging order on your LLC, as I just described. But if you're not paying out because we wouldn't in that situation, then they can foreclose on your LLC.
Now, what does that mean? Well, just like it sounds, they can actually take your interest from you and they step into your shoes as a member of that limited liability company. They force it to be sold to them. Or they can petition to appoint themselves up here as a manager or a receiver or some sort that's placed in control of that company to then issue out distributions to themselves, or make sure that you're using the money in an appropriate manner that does not hurt their interest. And so essentially, then you're in a co-management situation with someone else.
Now, if you've set up the LLC in a creditor or owner or debtor friendly state, not a creditor friendly state, a debtor friendly state such as Wyoming, and we'll talk about some of the other ones. Then you're in a really strong position because in those situations, here's what a creditor cannot do. They can't force you to take distributions. All right. So you're in control. Strong protector states. This is what we're going for. They cannot vote. They cannot expect your books and your records. They can't go anything beyond just a charging order. So everything that takes place up here is private.
Now, why is privacy important? Well, if I can't take money out personally as a distribution, then if I need access to that cash, another option that I may have here is to take out a loan. And a creditor would never know about that, because a creditor only gets notification if you're taking out distributions. But if you're taking out loans, that's private. That is different than a distribution. If a creditor knew what was going on with your LLC and could be involved in decision making, I guarantee you they would object to that. But if you set it up in the right state and you have strong protections, they can't interfere with your business and you can take out loans, you can take out management fees, you can loan money to another entity to put other investments together. So the creditor is outside and they're just waiting to get paid, which will never happen.
The other thing they can't do is they can't seize the underlying property or bank accounts titled in the LLC. So they can't, you know, work around you and get after the LLC's assets, and they can't replace you as a manager of that limited liability company. Again, when you set up the LLC in a strong state.
So what are the strong states? Well, there's three states primarily that we work with here at Anderson. They're Wyoming, Nevada, and Delaware. Now, the reason why I like those three states, and we use those pretty much exclusively at Anderson when we're looking for this type of protection for our clients, it's because the charging order is the exclusive remedy, and no other remedy, including foreclosure, is referenced in the statute. So that keeps creditors at bay. And it really prevents a court from fashioning some other type of remedy because they don't like the outcome. They feel that, hey, this person's been able to walk away from this potential obligation and the creditor is not getting paid immediately. So I'm going to work around the statute. Well, some states, when they have loose language in their statutes and they're not really tight, like Wyoming, Nevada, or Delaware, then the courts will fashion remedies that when you look at me, think, how do they reach that conclusion? Well, it's because the legislature didn't put the right language in their statute to really lock it down. That's what these three states have done. And that's why we use those in our asset protection planning to build out this type of protection for our clients' assets.
Now, there's other states out there that we refer to as moderate states. Texas, Arizona would be a few of those. And what do I mean by moderate state? Well, in those situations, you know, either they can potentially foreclose in a limited situation or they can have a receiver appointed that would then oversee how you're running your business. And I personally, I don't want to see that take place in my business, because if it's my business, it's my business and I don't want anybody up in it.
And then you have this other category, and there's a lot of these states that we're going to call the weak states, and a weak state is somewhere like California, for instance, where in California you can just move right to a foreclosure and you can take their limited liability company. So we have to be aware of the states where we're setting up the LLCs, and that means an LLC that we're a member in.
So you want to make sure when you're setting this up, step one is choose a strong protection state for the formation of what we refer to typically as a holding company. So you may have heard of this term before. I know I use it a lot on my channel where I talk about creating a holding LLC right here in Wyoming. So we set up a Wyoming LLC, and we loosely refer to this as a holding limited liability company. Now, it's not a legal entity per se. It's just a term of art that we use to reference the type of LLC, its purpose. It means that it's going to hold assets or it's going to hold other limited liability companies.
Now, a lot of times we'll create this one as a multi-member LLC. So we'll put the husband and wife on there or the two business partners or maybe an individual and a friend or another entity to make this a partnership. We do this for a couple different reasons why. Number one is to use it for financing purposes. The way the income hits your return, your 1040, we find that it looks better, reduces your risk of audit when you're using a K-1 to take that income out of your LLC on your 1040. And there's also that situation where you've probably read about this. There are certain states where if it's a single-member LLC, courts will not look at it or provide it the same protection as a multi-member LLC. Now, that's not the problem with Wyoming, because Wyoming actually carved out of their statute where they state that a single-member LLC has just as much protection as a multi-member LLC when it comes to the charging order. But we still like to do it as, you know, think of it as an ounce of caution.
So you set up this LLC in Wyoming like I just described. And then you want to make sure that you have proper clauses inside of your operating agreement that states that the charging order, okay, is the exclusive remedy. Okay. You got to make sure you get that. Put that in there. Okay. You want to make sure that you're building all this stuff in your operating agreement. What we refer to these as creditor-to-be-gone clauses to really make someone, whoever looked at that was coming after you or thinking, oh, there's no way I'm going to recover here. I'm going to go look somewhere else and I'm going to leave you alone, or else I'm going to settle.
You want to make sure that you have clauses in there that give the manager, and I talked about this earlier, that the manager of the LLC has discretionary distribution powers. So what I'm referring to there is that the manager can decide whether or not distributions will be made on an annual, quarterly, whatever basis. See, the biggest mistake that we find when we review another operating agreement that somebody has prepared is oftentimes they have language in the operating agreement that requires the manager to make annual distributions of profits. You do not, do not want that in there. Or worse yet, that the distributions will be made on a pro-rata basis. You always want to make sure that distributions are on a non-pro-rata basis. And what that allows you to do then is to distribute assets, say to my wife, but none to me because my interest has a charging order on it. So we still have access to the cash without having to go to the management fee or a loan to gain access to those funds.
So setting this up is your base entity is how you build this protection, because you definitely want to have charging orders. So many people when it comes to asset protection planning and they, and I hear this all the time, they say, oh, I'm protected. I've set up a limited liability company. Look at me. I've got my California LLC right here, and my attorney or my CPA told me it gives me asset protection. Well, you're only getting one half of the asset protection that you could have. Meaning, going back to my California example. Yeah, you're protected if something goes wrong inside of the LLC, but your LLC isn't protected from what goes wrong in your personal life. And hey, if you're going to set up an LLC and you're going to go to the trouble of making sure that your assets are protected from creditors, why not get both forms of protection? So that California LLC should never be in your name. You want to make sure that it's owned by your Wyoming LLC. Therefore, if you get sued personally and somebody asks you, hey, do you have an interest in the California LLC? No, I do not. I only own an interest in a Wyoming LLC. And oh, by the way, Wyoming doesn't allow you access to my California LLC because it's an asset of that Wyoming company.
So this is what we can also refer to not only as a holding company, but as a block or entity. Okay. It blocks creditors from your upper-tier limited liability companies. So we like to stack them in this manner. So that anything that happens with you down here never hits up here.
Now, I get a lot of questions about this on my YouTube channel in the comments. People want to know, can a creditor garnish my salary from a limited liability company? Well, obviously, if your LLC is not set up as a holding company, let's say you set up an LLC in Wyoming and this is your Wyoming LLC, and it's an actual business. Maybe you're running your TikTok influencing business through this LLC in Wyoming. You have it treated as an S Corp for federal tax purposes. Great. Well, if somebody sued you and you're taking out a W-2 salary out of there, yes, they can garnish that. All right. They can go after your salary. But if you're taking out a distribution, all right. That's where the charging order will apply. So they can get to your salary with a garnishment. But they can't get to your assets of the LLC unless you actually take out a distribution. So in that case, you would want to maintain your and your assets up here in the LLC.
Now, the secondary question that always flows from this is, you know, does the S corporation tax status change anything? It does not change anything, right. Charging order remedies follow state law. They do not follow how you tax your entity for federal tax purposes. So that's irrelevant.
And then some people have asked me in the past, hey, if I want to get a loan and I have this type of structure set up right here, I want a lender to see that, not want to loan me money, because if I default on the note, they won't be able to get after my assets. No, that's incorrect as well. You see, when you set up the LLC and you get a loan and it's against this asset right here, for example, then if a creditor's foreclosing, they're foreclosing on the property. That's how they're getting paid. Right? So they still have a secured interest in the asset. Are they going to come after you and go after your LLC? No, it's not going to happen.
Now, there have been situations where we've had clients that were provided personal guarantees on commercial loans, and when they defaulted on those because the economy turned and they walked away. Yeah. The lenders were stuck in a situation where they could not get collect on the assets, and they ended up settling with our individual clients that I'm referring to. And they didn't get paid. They just let them leave and they just took the property back. So that's actually a favorable benefit for you and holding your assets in this way.
Now, if you've heard about the charging order and you want to know more, what you can do is you can download the charging order protection checklist that I've created for you. It's in the show notes below. Make sure you click on that. It's going to walk you through some of the important aspects of the charging order, and what you should be doing for your own structuring. And you've probably heard me say this a bazillion times, but if you're not yet a subscriber, why not be sure to hit the subscribe button and subscribe to my channel. So whenever I drop a video like this, which I tend to do a few videos a week, you're going to receive instant notification of my new video drop.
And if you'd like to have someone review your individualized situation, look at what you're doing from a tax and asset protection standpoint, just book a call. We make it really simple for you. There's a link in the show notes for a free 45-minute strategy session. We work with someone on my team will review your plan. Maybe it's a business that you're setting up, a current situation, you have a current business, you're real estate investing, maybe you're a stock trader. We'll show you how to structure that the right way to protect your assets and reduce your taxes.
All the best with your investing or your business.