Transcription
A recent court case just blew apart someone's asset protection with their limited liability company. In this video, what I'm going to do is I'm going to break down for you what they did wrong and what you need to do to make sure your limited liability company's asset protection remains rock solid. All right. Let's get started.
Okay, so what am I referring to here when I see a recent court case? Well, I'm referring to the case of Orix Re versus Collier out of California. And what happened in that case is that an individual was sued individually and a judgment was entered against them. Now, this individual had a limited liability company, and the plaintiff took their judgment, and they wanted to proceed with a charging order against this individual's interest. Now, what the individual argued is that, hey, I don't hold an interest in an LLC, so you cannot come after an interest that I do not own.
Well, the plaintiff here in this case decided to get creative. What they wanted to do was to make the individual defendant prove that they're not an owner in the limited liability company. I mean, you just can't say I'm not an owner in an LLC. You have to actually show them the court that you don't own an interest. Well, what they're able to discover through the discovery process was that even though this individual purported to transfer their ownership interest several years before this judgment was entered against him, the facts or the material in the case, the documents proved otherwise. For example, there wasn't anything updated with the Secretary of State to show that he was no longer an owner. Further, he continued to sign on behalf of the limited liability company as its member manager.
You see, the reason why he was doing this and argument he wasn't a member is because he realized that if they put a charging order on his interest, then that would allow the the plaintiff then to move to a foreclosure action, which means they could take his LLC from them and from him. And that's exactly what they did. So this individual lost his LLC through this action, which was a charging order. Then it flipped over to a foreclosure. Now, this is the worst case scenario, and it's what we all want to avoid when we have limited liability companies. That's why we have to be extra judicious in how we operate our LLCs.
So let me break this down for you and show you what I'm talking about here. So for those of you that are watching this video, you're thinking, well, what is a charging order and why is this so important to me if I have a limited liability company? Well, this is the way it works. Let's say you set up a limited liability company, as this individual did in his case. And so you're down here as the member of this LLC. Now, if a lawsuit happens inside of the LLC, that's called inside liability protection, meaning that the LLC itself is where the lawsuit is being directed. So say we have somebody over here and they're suing the LLC. Well, you're going to be protected from any claims brought against this limited liability company. Great. That applies in all 50 states. That's why we set up LLCs as business owners or people who own residential real estate. And we want asset protection.
Now, the opposite side of the coin is what happens on the outside. That is what happens if the member is being sued individually. And that is exactly the crux of that particular case. So now this plaintiff here was suing, not the LLC. Instead they were suing this owner and they got a judgment against the owner. Now, when you have a judgment against an owner and a limited liability company, state statutes. And this is uniform what they state in their state statute, lot of states there. Is that the creditor of a member in an LLC is entitled to what is referred to as a charging order. And so what that's saying is that if this individual here, okay, is that who is running this LLC and let's say he had $300,000 inside of it and the creditor is owed half a mill. In this judgment, if the individual down here, who's also the manager of his LLC, decides to take out a distribution, that is, take 100,000 of that and pay it out to himself as a member. If he takes 100,000 out of his LLC, then per the terms of the charging order, he has to then pay that money over to the creditor. And that would knock down this judgment from 500,000 to $400,000.
Okay, so ask yourself this. Right. If you're in this position and you were being sued and the court told you if you take any money out of the LLC, you have to pay to your creditor. You're thinking, I'm not going to take any money out of my LLC if I have to pay the creditor, because the purpose in having the LLC is to protect my assets from creditors. Well, that's not the main purpose. That's just a benefit of having an LLC. So in this particular case, what happened once they proved he was in fact the member in the of that LLC because he held himself out as being that despite whatever document he could show that he transferred the interest to someone else, he still acted in his membership capacity. Then they're allowed to go after a secondary remedy, meaning the charging order was the first remedy. And because we know this person isn't going to pay anything out, then the court or the state statute allows for the creditor to foreclose. And so in a foreclosure action, what they're doing is they're actually taking your membership interest. They assume control of the LLC, and then they get access to the funds. So that is what happened here. And this is what's so important when we're setting up our limited liability companies in our overall asset protection plan, we want to ensure that this does not happen to us. Okay, that you're not going to be in that situation.
So what can you do then to ensure that if you've got a limited liability company right now, how do you protect it? Okay. So the first thing you need to do is set up the right entity stack. Now this gentleman, his LLC, he was in California. And the problem with California limited liability companies is that their state law allows for foreclosure to do exactly what I just described. And there's a lot of states that permit this. So the first thing we want to do is we want to take that LLC right here. And you'll see me in a lot of my videos talk about this. We want to create a Wyoming LLC down here in the state specific in this case it's California LLC is owned 100% by your Wyoming Limited liability company. Okay. So we want to stack it into a LLC here in Wyoming because this Wyoming LLC under Wyoming law, the charging order is the only remedy available to a creditor. All that foreclosure stuff that happened in California that doesn't apply under Wyoming law. So we want to lock it down. We want to make sure that, hey, yeah, the only thing you can get is a charging order.
Now, if you're thinking, well, Clint, the charging order doesn't protect me. It does. Right? Because the charging order ensures that your assets stay inside of that LLC. They stay protected from your creditors, so you just can't take out distributions. But that's not a bad thing because there's other ways to access your funds. It's not a limitation. Let me put it that way. You can loan yourself money. You can help a management fee. You're still going to have access to the funds, but who's not going to have access to those funds, of course is your creditor. And isn't that the whole point in creating an asset protection plan, setting up an LLC to make sure you have your assets in the event of a disaster? This individual in this case didn't understand that. So rule number one, use an entity stack like I just drew up here.
Now if you want to further this protection, add a little more there. Maybe you bring on a second partner here. Maybe you bring on a spouse. It's not necessary to have a two partner LLC in Wyoming and still have strong charging order protections, but it might be a good idea to do it just to make sure you're covering all your bases and say, hey, there's other people here, other members we need to protect. Now, a third thing that you need to do with your structure is you want to make sure that your operating agreement is drafted in a way that ensures that the charging order is the only remedy available to a creditor, and that nothing else. And if somebody does get a charging order against your members interest. And now this is key, it's actually has to be written into your operating agreement. I've read a lot of operating agreements that do not contain this language. So with the language with state is that if somebody gets a charging order against my interest, that person, okay, the affected member automatically converts to a transfer fee only status, right? So you automatically remove the member from any voting rights and things like that. So so somebody can't say, hey, he's still controlling the LLC. If you do that, you're strengthening the protections. So in the case that we just dealt with in California, the plaintiff would have a hard time saying, well, even though he held himself out as a member in that LLC when he was signing documents reporting, but he really had no rights and he couldn't do anything. He couldn't vote on the LLC. So he was taken out of that, that that whole entire, ownership structure. He's just this transferee. So that's really important.
Other things you can do, you can allow for what we call a call, right? Meaning that if somebody did come after that interest, like what happened in California and this may have saved his LLC, give another member the right to buy your interest from you, okay? They can they can call out your interest and then they can take it so it does not go to a creditor. And you can put pre-agreed upon terms in your operating agreement to state that they can buy it for a set sum of money. And that could be far below what the exact value is at the time, because it was negotiated at the outset of the limited liability company. These are some of these. We are often referred to as creditor begone remedies, but they have to be baked into your LLC.
Now another thing I would do is I would make sure you have in there that, if somebody does put a charging order on your LLC interest that they have to pay your taxes, right? You want to make sure they have to cover your taxes. And what do I mean by that? Well, LLC is a pass through entity. So here's what we do. We've got a creditor over here that thinks, oh man, look what I did. I put a charging order for $500,000 on this guy's limited liability company. Well, if I'm that individual, I'm looking at that creditor. I'm saying, oh, thank you very much. I'm so glad you place that charging order on my LLC. Because now, per my operating agreement and actually per, pursuant to a revenue ruling, 77 137, I'm going to make you cover my tax liability. So if my LLC, let's say this had a rental property and it's generating for me 50 K a year, you're going to pay the taxes on that. And you know what? Inside my operating agreement, it states that anybody who places a charging order on my LLC is liable for my taxes. In addition to that, it also states, and this is another key clause, okay, that you have to have in there that the LLC is not required to distribute any money to the members to cover their tax liability. Essentially Glossier to hold onto the funds. Somebody has got to pay taxes on money they never receive. So this these are all important aspects of having a limited liability company set up the right way.
One other clause I would put into there is that distributions are at the discretion of the manager. So they're not mandatory. So many operating agreements that I've read over over the course of my career state that the LLC will make distributions of profit on an annual basis or on a quarterly basis. You see these little types of, mistakes that get drafted into operating agreements, create the situations like we saw in Orix, where a creditor is able to step in and take someone's assets. So all you got to do is this make sure you're drafting your operating agreement. You're setting up the operating agreement with the right provisions inside of there. So it's strong so it can withstand creditor attack. And also make sure that you have the right entity stack using an LLC, such as a Wyoming limited liability company, possibly a Delaware LLC, that offers these charging order only languages in their statute. That is what's going to save you in the event of a lawsuit. Don't make the same mistakes that I've seen other individuals make by setting up the LLCs with the wrong language in the wrong states, holding the wrong interest, and then wonder, why did this plan fail? It failed because you didn't set it up from the outset with the right provisions in it.
Hey, if you like this type of video on this type of content, be sure to hit the like button. And if you want to learn more about asset protection and how it would apply in a business context, or when it comes to real estate investing, I'd love to have you join me on my one day Tax and Asset protection workshop. We teach it on Saturdays. There is a link below in the show notes. All you got to do. It's completely free. Click on that link and you'll receive an invite to come to this one day free event. You'll learn so much when it comes to setting up your LLCs the right way. With the maximum amount of protection, teach you how to take your business interests and really harness the tax code to put more money back in your pocket. Hey, I love to see you on that event. Take the opportunity. Do it now and I wish you all the best with your investing.