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Limited Partnerships – Advantages and Case Study

by | Dec 27, 2021 | , ,

Advantages of Limited Partnerships

  • LPs allow for pass-through taxation for both the limited partner and the general partner.
  • Limited partners are not held personally responsible for the debts and liabilities of the business, although the GP, if an individual, may be personally responsible.
  • The general partner(s) have full control over all business decisions, which can be useful in family situations where ownership – but not control – has been gifted to children.
  • Estate planning strategies can be achieved with LPs.
  • Limited partners are not responsible for the partnership’s debts beyond the amount of their capital contribution or contribution obligation. So, unless they become actively involved, the limited partners are protected.
  • As a general rule, general partners are personally liable for all partnership debts. But as was mentioned above, there is a way to protect the general partner of a limited partnership. To reduce liability exposure, corporations or LLCs are formed to serve as general partners of the limited partnership. In this way, the liability of the general partner is encapsulated in a limited liability entity.
  • Because by definition limited partners may not participate in management, the general partner maintains complete control. In many cases, the general partner will hold only 2% of the partnership interest but will be able to assert 100% control over the partnership. This feature is valuable in estate planning situations where a parent is gifting or has gifted limited partnership interests to his children. Until such family members are old enough or trusted enough to act responsibly, the senior family members may continue to manage the LP even though only a very small general partnership interest is retained.
  • The ability to restrict the transfer of limited or general partnership interests to outside persons is a valuable feature of the limited partnership. Through a written limited partnership agreement, rights of first refusal, prohibited transfers, and conditions to permitted transfers are instituted to restrict the free transferability of partnership interests. It should be noted that LLCs can also afford beneficial restrictions on transfer. These restrictions are crucial for achieving the creditor protection and estate and gift tax advantages afforded by limited partnerships.
  • Creditors of a partnership can only reach the partnership assets and the assets of the general partner, which is limited by using a corporate general partner which does not hold a lot of assets.
  • The limited partnership provides a great deal of flexibility. A written partnership agreement can be drafted to tailor the business and family planning requirements of any situation. And there are very few statutory requirements that cannot be changed or eliminated through a well-drafted partnership agreement.
  • Limited partnerships, like general partnerships, are flow-through tax entities.

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Case Study:

When a Limited Partnership is Best

Jim is the proud father of three boys. Aaron, Bob, and Chris are active, athletic, and creative boys almost ready to embark upon their own careers. The problem was that they were sometimes too active, too athletic, and too creative.

At the time Jim came to see me, Aaron was seventeen years old and every one of the seemingly unlimited hormones he had was shouting for attention. He loved the girls, the girls loved him, and his social life was frenetic and chaotic.

Bob was sixteen years old and sports were all that mattered. He played sports, watched sports, and lived and breathed sports.

Chris was fifteen years old and the lead guitarist in a heavy metal band. When they practiced in Jim’s garage the neighbors did not confuse them with the Beatles.

Jim has five valuable real estate holdings that he wants to go to the boys. His wife had passed on several years before and he needed to make some estate planning decisions. But given the boys’ energy level and lack of direction he did not want them controlling or managing the real estate.

Jim knew that if he left the assets in his own name, when he died the IRS would take 55% of his estate, which was valued at over $10 million. And while estate taxes were supposed to be gradually eliminated, Jim knew that Congress played politics in this arena and no certainty was guaranteed. Jim had worked too hard, and had paid income taxes once already before buying the properties, to let the IRS’s estate taxes take away half his assets. But again, he could not let his boys have any sort of control over the assets. While the government could squander 55% of his assets, he knew that his boys could easily top that with a 100% effort.

I suggested that Jim place the five real estate holdings into five separate limited partnerships.

I further explained to Jim that the beauty of a limited partnership was that all management control was in the hands of the general partner. The limited partners were not allowed to get involved in the business. Their activity was “limited” to being passive owners.

It was explained that the general partner can own as little as 2% of the limited partnership, with the limited partners owning the other 98% of it, and yet the general partner can have 100% control in how the entity was managed. The limited partners, even though they own 98%, cannot be involved. This was a major and unique difference between the limited partnership and the limited liability company or a corporation. If the boys owned 98% of an LLC or a corporation they could vote out their dad, sell the assets, and have a party for the ages. Not so with a limited partnership.

The limited partnership was perfect for Jim. He could not imagine his boys performing any sort of responsible management. At least not then. And at the same time he wanted to get the assets out of his name so he would not pay a huge estate tax. The limited partnership was the best entity for this. The IRS allows discounts when you use a limited partnership for gifting. So instead of annually gifting $14,000 tax free to each boy he could gift $16,000 or more to each boy. Over a period of years, his limited partnership interest in each of the limited partnerships would be reduced and the boys’ interest would be increased. When Jim passes on, his estate tax will be based only on the amount of interest he had left in each limited partnership. If he lives long enough he can gift away his entire interest in all five limited partnerships.

Except for his general partnership interest. By retaining his 2% general partnership interest, Jim can control the entities until the day he dies. While he is hopeful his boys will straighten out, the limited partnership format allows him total control in the event that does not happen.

Jim also liked my advice that each of the five properties be put into five separate limited partnerships. I explained to him that the strategy today is to segregate assets. If someone gets injured at one property and sues, it is better to only have one property exposed. If all five properties were in the same limited partnership, the person suing could go after all five properties to satisfy his claim. By segregating assets into separate entities the person suing can only go after the one property where they were injured.

Jim liked the control and protections afforded by the limited partnership entity and proceeded to form five of them.

Is a Limited Partnership right for you? Get your free 15-minute consultation today!

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How to Set Up Single Member LLCs

by | Dec 26, 2021 | , , , ,

You must be very careful when you are the only owner of your LLC. Single member LLCs require extra planning and special language in the operating agreement.

One example: What happens when the single owner/member passes? Who takes over? It may be months before that is sorted out, and your business will falter without a clear leader.

Difficulties of Owning a Single Member LLC

You want the asset protection benefits of a limited liability company. But what if you don’t want any partners? What if you want to be the sole owner of your own LLC?

You can do that with a single owner LLC (sometimes known as a single member LLC).

But you have to be careful.

Before we discuss how to properly set up and use a single owner LLC we must acknowledge a nationwide trend. Courts are starting to deny sole owner LLCs the same protection as multiple member LLCs. The reason has to do with the charging order.

The charging order is a court order providing a judgment creditor (someone who has already won in court and is now trying to collect) a lien on distributions. A chart helps to illustrate:

Illustration showing typical multi-member LLC structure

John was in a car wreck. Moe does not have a claim against XYZ, LLC itself. The wreck had nothing to do with the duplex. Instead, Moe wants to collect against John’s assets, which is a 50% interest in XYZ, LLC. Courts have said it is not fair to Mary, the other 50% owner of XYZ, to let Moe come crashing into the LLC as a new partner. Instead, the courts give Moe a charging order, meaning that if any distributions (think profits) flow from XYZ, LLC to John then Moe is charged with receiving them.

Moe is not a partner, can’t make decisions or demands, and has to wait until John gets paid. If John never gets paid, neither does Moe. The charging order not only protects Mary but is a useful deterrent to frivolous litigation brought against John. Attorneys don’t like to wait around to get paid.

But what if there is only a single owner?

Illustration that shows a single member LLC structure

In this illustration there is no Mary to protect. It’s just John. Is it fair to Moe to only offer the charging order remedy? Or should other remedies be allowed?

How the Court Has Ruled Against LLCs With One Member

In June of 2010, the Florida Supreme Court decided the Olmstead vs. FTC case on these grounds. In a single owner LLC there are no other members to protect. The court allowed the FTC to seize Mr. Olmstead’s membership interests in order to collect. Other states have followed the trend.

Interestingly, even two of the strongest LLC states have denied charging order protection to single owner LLCs in limited circumstances.

In September of 2014, the US District Court in Nevada decided the bankruptcy case of In re: Cleveland.

The court held that the charging order did not protect a single member LLC owner in bankruptcy. Instead, the bankruptcy trustee could step into the shoes of the single owner and manage the LLC. This is not surprising since bankruptcy trustees have unique and far reaching powers, which are routinely upheld by the courts. (But know that, incredibly enough, a bankruptcy trustee can’t get control of the shares of a Nevada corporation. This is a special planning opportunity available to Nevada residents – or those who may become Nevada residents.)

In November of 2014, the Wyoming Supreme Court rendered a surprising verdict in the Greenhunter case.

The court held that the veil of a single owner LLC could be pierced. The issue centered on a Texas company’s use of a Wyoming LLC it solely owned. The LLC was undercapitalized (meaning not enough money was put into it) and it incurred all sorts of obligations. It wasn’t fair for the Texas company for the single owner to hide behind the LLC. The fact that a single owner LLC was involved was a material issue. The court pierced through the LLC and held the Texas company liable for the LLC’s debts.

Even though these are fairly narrow cases, both Nevada and Wyoming have held against single member LLCs. Again, this is the trend.

Luckily there are some things you can do to protect your assets as a single member LLC…

Strategies for Protecting Your Assets

One strategy is to set up a multi-member LLC structured in a way that gives the intended single member all of the decision making power. For example, parents can have adult children over 18 become member(s) or for those under 18 you can use a Uniform Gift to Minors Act designation. You may want to use an irrevocable spendthrift trust for children or others. A local estate planning attorney can help you set these up correctly.

But what is the smallest percentage you have to give up for the second member? Could you give up just 1/100th of 1 percent? Most practitioners feel that the percentage should not be inordinately low and that 5% is a suitable second member holding. So the ideal structure would be that John owns 95% of the LLC and the other 5% is owned by a child (or other family member) and/or an irrevocable trust.

Accordingly, in a state that doesn’t protect single owner LLCs, you have an excellent argument for charging order protection. There is a legitimate second member to protect. To further that legitimacy it is useful to have the second member participate in the affairs of the LLC. Attending meetings and making suggestions recorded into the meeting minutes is a good way to show such involvement.

But what if you don’t want to bring in a second member?

There are plenty of good reasons to set up a sole owner LLC. Other owners can bring a loss of privacy and protection. And if you paid 100% for the whole asset, why should you bring in another member anyway? Or, what if you don’t have any children or other family members that you want to bring in?

If a single member LLC is truly the best fit for you, there are three key factors to know and deal with.

1. The Corporate Veil

Many states’ LLC laws do not require annual meetings or written documents. Some see this as a benefit but it is actually a curse.

If you don’t follow the corporate formalities (which now apply to LLCs) a creditor can pierce the veil of protection and reach your personal assts. With a single owner LLC this is especially problematic. Because you are in complete management control it may appear that you aren’t respecting the entity’s separate existence or that you are comingling the LLC’s assets with your own personal assets. Without a clear distinction of the LLC’s separate identity, a creditor could successfully hold you personally responsible for the debts of the LLC (as they did in Wyoming’s Greenhunter case above.) Maintaining proper financial books and records and keeping LLC minutes can help demonstrate a definitive and separate identity for your single owner LLC. You must work with a company which appreciates the importance of this for single owner LLCs.

2. Different State Laws

LLC laws vary from state to state. Some states offer single owner LLCs very little protection. The states of California, Georgia, Florida, Utah, New York, Oregon, Colorado and Kansas, among others, deny the charging order protection to single owner LLCs.

Other states offer single owner LLCs a very high level of protection in traditional circumstances. So we have to pick our state of formation very carefully. In order to deal with this trend against protection, we use the states that do protect single member LLCs.

Wyoming, Nevada, Delaware, South Dakota and Alaska (collectively “the strong states”), have amended their LLC laws to state that the charging order in standard collection matters is the exclusive remedy for judgment creditors – even against single owner LLCs.

So how do we use these state laws to our advantage? Let’s consider an example:

A chart showing a properly structured single member LLC

In this example, John owns a fourplex in Georgia and a duplex in Utah. Each property is held in an in-state LLC (as required to operate in the state). The Georgia and Utah LLCs are in turn held by one Wyoming LLC. (This structure works in every state except California, which requires extra planning. Be sure to take advantage of our free 15-minute consultation if you are operating or residing in California).

I break down potential lawsuits into two different types of attacks: Attack #1, the inside attack and Attack #2, the outside attack.

In Attack #1, the inside attack, a tenant sues over a problem at the fourplex owned by GEORGIA, LLC. They have a claim against the equity inside that LLC. Whether GEORGIA, LLC is a single owner or multi-owner LLC doesn’t matter. The tenant’s claim is against GEORGIA, LLC itself. Importantly, the tenant can’t get at the assets inside UTAH, LLC or WYOMING, LLC. They are shielded since the tenants only claim is against GEORGIA, LLC.

The benefit of this structure comes in Attack #2, the outside attack. If John gets in a car wreck, it has nothing to do with GEORGIA, LLC or UTAH, LLC. But, the car wreck victim would like to get at those properties to collect on the judgment. If John held GEORGIA, LLC and UTAH, LLC directly in his name, the judgment creditor could force a sale of the fourplex and duplex since neither state protects single owner LLCs.

However, since John is the sole owner of WYOMING, LLC he is protected by Wyoming’s strong laws. The attacker can only get at WYOMING, LLC and gets a charging order, which means they have to wait until John gets a distribution and therefore could possibly never get paid. If John doesn’t take any distributions, there’s no way for the attacker (or his attorney) to collect. A strong state LLC offers a real deterrent to litigation, even for single owner LLCs.

3. Operating Agreement

Like bylaws for a corporation, the Operating Agreement is the road map for the LLC. While some states don’t require them, they are an absolute must for proper governance and protection. A single owner LLC operating agreement is very different than a multi-member operating agreement. 

For example, if a single owner transfers their interest in the LLC, inadvertent dissolution of the entire LLC can occur. This is not good. Or, again, what if the sole owner passes? Who takes over? Our Single Member Operating Agreement provides for a Successor Manager (a person you pick ahead of time) to step in.

The best way to deal with these issues, as well as others, is to have a specially drafted operating agreement to properly govern your Single Member LLC. Corporate Direct provides such a tailored document for our clients. When it comes to business and investments, you must do it the right way.

Incorporate First – Deduct Second

by | Mar 27, 2021 | , ,

Should you set up a corporation or LLC before you start trying to deduct expenses? A recent case suggests you should.

Many think that they can deduct all of their start up expenses before formally incorporating a business. But in Carrick v. Commissioner of Internal Revenue (T.C. Summ. Op. 2017-56, July 20, 2017) the Tax Court ruled otherwise.

The Facts of Carrick

The taxpayer had a bachelor’s degree in electrical engineering. For approximately 15 years, he was employed in the oceanographic industry. Before the years in issue, and during 2013 and 2014, he was employed by Remote Ocean Systems (ROS), building underwater equipment such as cameras, lights, thrusters, control devices, and integrative sonar.

During the years in issue, ROS was experiencing financial difficulty. The taxpayer was provided some flexibility in his work schedule, and he began exploring business ventures with other individuals, using the name Trifecta United as an umbrella name for the activities, which he named Local Bidz and Stingray Away.

The Local Bidz activity involved creating a website with features similar to those of the websites of Angie’s List, Yelp, and eBay, which would permit people to bid on hiring contractors for products and repairs. The taxpayer first had the idea for Local Bidz in 2012, and he went “full force in the beginning of 2013,” spending time accumulating data and developing software and the website.

At some point in 2013 the web developer moved to Los Angeles and other individuals left the project. For some unspecified period in 2013, the taxpayer traveled weekly from his home in San Diego to Los Angeles to consult with the web developer. The taxpayer abandoned the Local Bidz activity before the end of 2013. Sometime in 2014, the taxpayer began the Stingray Away activity, which involved researching and developing a device to prevent surfers and swimmers from being injured by stingrays.

The taxpayer initially noticed that sonar devices might affect the behavior of sharks and other species, so he conducted research at beaches in La Jolla, where swimmers and surfers often were stung and bitten by stingrays. The taxpayer did not fully develop any devices nor list any devices for sale in 2014. He had had no gross receipts during 2013 or 2014 from either the Local Bidz activity or the Stingray Away activity.

The Decision in Carrick

In Carrick, the taxpayer asserted that his reported expenses were deductible as ordinary and necessary business expenses relating to the activities of Local Bidz and Stingray Away. The Tax Court noted that 26 U.S.C. § 162(a) provides the general rule that a deduction is allowed for “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” The Tax Court stated that it was clear that the taxpayer was not “carrying on” a trade or business in 2013 or 2014 when the expenditures for the Local Bidz and Stingray Away activities were made.

Carrying on a trade or business requires more than preparatory work such as initial research or solicitation of potential customers; a business must have actually commenced. Expenses paid after a decision has been made to start a business, but before the business commences, are generally not deductible as ordinary and necessary business expenses. These preparatory expenses are capital expenditures.

The Tax Court pointed out that, while the taxpayer may have been conducting research in 2013 with respect to Local Bidz, or in 2014 with respect to Stingray Away, neither activity reached the point of actually commencing. There was neither sales activity nor evidence of the offering of products or services to the public. The taxpayer was still in the very early stages of research and development in each of these activities.

The Tax Court observed that there was nothing in the record indicating that the taxpayer had commenced any business activity as a sole proprietor. The taxpayer had not set up a formal business entity. Therefore, the Tax Court concluded that the taxpayer was not “carrying on” a trade or business in 2013 or 2014. See, 26 U.S.C. § 162(a); Frank, supra, 20 T.C. at 513-14 (1953); Shea, supra, T.C. Memo. 2000-179, 2000 WL 688593, at *5n. 10; Christian, supra, T.C. Memo. 1995-12, 1995 WL 9151, at *5.

Brief Discussion

If you’re preparing to open a new business, then you need to make certain that you understand the tax rules. It is crucial that you offer the product or service to the public and that you begin sales activity, because start-up expenditures, i.e., expenditures paid before a business begins, are not deductible in the years they are actually incurred. Instead, they are capital expenditures, which generally must be amortized over a 15-year period, once business begins, meaning gradually write off the cost over 15 years. See, 26 U.S.C. § 195. Thus, in order for an expenditure to be an ordinary and necessary trade or business expense, it must be related to more than a preparatory expenditure.

So, if the taxpayer in Carrick had opened his business first, then he might have been able to deduct his expenditures in the years they were actually incurred, instead of amortizing them over a 15-period.

Conclusion

The moral of the story is: Open your business first, and deduct later.

ADA Compliance and SEO

by | Feb 1, 2021 |

By: Melissa Matheson
Corporate Direct Webmaster

Back in 2017, we published an article regarding ADA compliance on websites. The Winn-Dixie case was the case that defined websites as “public spaces,” thereby requiring that they be accessible to those with disabilities. This in itself is not an issue, I think we can all agree that we want all people to be able to freely access information and services. And in brick and mortar business, these requirements are clearly outlined in the Americans With Disabilities Act Standards for Accessible Design (ADASAD). These standards are now embedded in building codes and permit requirements so there is no confusion as to how to make your brick and mortar business ADA compliant.

Website accessibility, however, has proven to be a more difficult issue. There are no strict guidelines for websites set by the ADA or in the ADASAD. You will however, be strictly liable for following these guidelines that do not exist. Strict Liability means that even with the absence of intent to harm and/or absence of negligence, you can be held liable for violating any provision of the law. There will be no leniency granted if you aren’t aware of the law, or if you are “working on it.” You are either in compliance, or you are not.

But there has to be some sort of guidelines, right? Well…yes, and no. The Web Content Accessibility Guidelines (WCAG 2.0 and WCAG 2.1) have been established. (WCAG 2.1 are appended guidelines to WCAG 2.0). The WCAG are extremely technical and reading them is akin to learning another language if you aren’t a complete tech nerd. As well, you can make your site accessible without meeting all of the WCAG. There is information contained in WCAG for all possible scenarios, so there is a ton of information making it nearly impossible to digest. So if you can make your site accessible without implementing all the WCAG, but there are no other clear guidelines, how exactly do you go about becoming compliant?

Good question. I have found that a common sense approach is much more beneficial than trying to read all of the WCAG. As stated in the beginning of the article, we want everybody to have access to our services, right? So this is just a matter of making sure that is possible. And it turns out, if you have built your website with SEO in mind (which I hope you have) you probably have the bulk of the work already done.

If you have not focused on using the best SEO practices, you’ve probably got a lot of work to do. And if that is the case, please remember that there is no quick and easy miracle solution. There are many out there who have capitalized on the fact that people need to make these changes to their sites. But unfortunately, there are no miracle cures for this. Please do not spend your money on WordPress plugins or fancy scans. They won’t help. There are many WordPress Plugins out there (premade snippets of code that can be easily imported into your site) that are available both for free, and for sale. Be careful with these. If they are free, secure, and you like what they do, that’s great. Use them. But don’t be fooled into thinking that any of these plugins (even if they cost a fortune) are going to make your website ADA compliant. They will not. Regardless of how fancy they are, there are no tools available in them that make it easier for say, a screen reader, to access your content. They also usually provide functionality that can be achieved by just using the web browser functions (i.e., enlarging text).

As well, there are free scans that are great and can give you a very good idea of where you are in regards to compliance. A company called aCe for example, will scan your site and give you scores on different categories of your site for free. It will also show you code snippets of where the issues are along with any successful examples (if you have any) so that you can easily find where errors are and understand how to apply the fixes. Again, there are tools to help, but the solutions are largely manual and will take some time to complete.

Back to SEO. If you have built your site with SEO in mind, you have probably made sure to add alternative text to your images, captioned your videos and have a site map. You probably have a content rich site and have focused on presenting the content in a logical manner. You know that you will be punished by the SEO masters for any deceptive anchor text or other such tricks from the early days of the internet, so no worries there. You regularly speed check your site and apply fixes to anything slowing you down.

It turns out that by following SEO best practices, you are also in line with the four principles of the WCAG. The WCAG says (broadly) that your site should be: Perceivable, Operable, Understandable, and Robust. While there will still be some technical issues for you to bring your site into full compliance, if you have paid attention to SEO, you’ve also knocked out some of the biggest reasons that people get sued for not complying with ADA.

ADA website compliance lawsuits often begin because a company has failed to provide alternative text on their images. Again, using common sense, you can see how this can be a problem. If you have 25 products listed as images with no text, a visually impaired person would not be able to use your website with their screen reader as there would be nothing to read. Also, crawlers can’t read images so you have to add text if you want your site to be indexed properly. So adding that alternative text to help you climb higher in search results actually serves two purposes now.

The second biggest issue is not providing alternative multimedia support. The type of media will dictate your approach to making it fully accessible. Captioning videos may not be a huge SEO issue directly, but we all know how much it helps to have a video captioned when we put it out on social media. The click through rates, exposure and added interest in your company all indirectly affect SEO so if you’re not currently captioning videos that you put on social media you should start anyway. If it is audio only, like a podcast, you need to include a complete transcript. You can either have a link to it, or display the full text near the podcast. (Bonus: If you are lacking text content on your site, displaying the entire text will help to easily add some good text content).

Last but not least, the structure of sites often get people in trouble. Just like with SEO, your site must flow easily and not contain deceptive or unclear link structures. Anchor text to your links should clearly show the purpose. For example, your link should not be anchored with only “click here,” it should show as “click here to see an article about anchor text.” Get rid of any redundant links or any information that clutters your site and make sure that all of your menu items are available through keyboard navigation.

Although ADA compliance seems daunting and confusing at first, you may have more of it done than you realize. This is by no means an exhaustive list of requirements but if you don’t have much done, then taking compliance measures will not only keep you on the right side of the law, it will help you on the SEO side.

Through our research, we found Kris Rivenburgh, who does an outstanding job of breaking the WCAG down into terms that normal people can understand. He offers a WCAG guide at no charge (at the time of this writing) which can be found on the website he founded: accessible.org. If you have questions on ADA compliance, definitely check him out at accessible.org and KrisRivenburgh.com.

Can Emails Create a Binding Contract?

by | Jul 15, 2020 | ,

Joe exchanged emails with Mary. They were investigating whether Joe wanted a consignment of Mary’s embroidered toilet seat covers for Joe’s hardware store. The email conversation trailed off and Joe went on to other things.

Two days later, to Joe’s surprise, the toilet seat covers arrived.

Instead of emailing, Joe immediately called Mary.

“Why did you send these over?”

“Because we have a contract” said Mary.

“No we don’t,” said Joe. “We only have a string of emails”

“Which created a contract,” said Mary. “Aren’t you up on the new laws?”

Joe ended his conversation with Mary and called Hank, his attorney. After laying out the scenario, Hank told Joe what was happening in the world of emails.

“To create a contract,” said Hank, “you need to meet four elements. You must have offer, acceptance, mutual obligation or valuable consideration and capacity to contract. While I haven’t read the emails, courts are now saying that you can piece together the strings of an email conversation to find all of those elements.”

“But,” said Joe, “I didn’t sign a contract.”

“You don’t need ink anymore,” said Hank. “There’s a recent Texas case saying that the name or email address in the ‘from’ field satisfies federal law for a signature under the Uniform Electronic Transactions Act.”

Joe was exasperated. “That’s enough to create a contract?”

“In that case it was. Do you put your stylized signature at the end of your emails?”

“Yes. My web guy says it makes the emails look more personal.”

“And more binding. Some cases have looked to that as a binding signature, even for real estate contracts.”

“What do I do?”

Hank laughed. “I’m not going to charge you $5,000 to settle a $1,500 dispute. Just sell the merchandise and never do business with Mary again.”

“But for the future?” asked Joe.

“Today,” said Hank, “talk to your web guy. Tell them to change your name to block letters, so that it looks less similar to a real signature.”

“Anything else?”

“Yes,” said Hank. “Tell them to add this disclaimer to the language at the end of your emails:

The content of any and all communications from this email address shall not be interpreted as an enforceable offer or acceptance and shall not form the basis for a binding contract.

“Okay,” said Joe. “Thanks. Seems like this has become an issue.”

“Exactly,” said Hank. “Especially for my real estate clients. In real estate transactions the Statute of Frauds requires a signature for an enforceable contract. Some courts are holding that a purposely typed email signature now satisfies that requirement.”

“It’s a brave new world.”

Hank agreed. “Everyone needs to be careful.”

The Lesson: Beware of email conversations that create a contract and use disclaimer language to prevent contract formation. When negotiating terms via email, make it clear in the beginning that the email exchange is for discussion purposes only and that all communications are non-binding until the parties fully execute a formal contract.

Beyond including disclaimers, there are a few other things that you should keep in mind when communicating by email. Along with piecing together emails and ruling that emails can constitute a contract, some courts have also deemed certain emails as amendments or waivers to an existing contract. It should be expressly stated in your contracts that emails are not qualified to amend or waive any terms of the contract. Also, be sure to stay away from contractual language in your email conversations. Avoid using words like “agree,” “accept” and/or “offer”.

It may be helpful to remember that a signature is not needed to create a valid contract – there need only be offer, acceptance, consideration and capacity. Although a signature is the most common form of acceptance, that element can be proven in other ways. If all of the four elements can be proven, the lack of a signature alone may not be a sufficient argument of non-acceptance.

On the other hand, emails can be a quicker and more efficient way to create and/or amend contract terms. If you are comfortable doing business in that manner, it is acceptable to do so. The most important thing either way is that you know from the outset how you would like to conduct business and immediately make that clear to all parties involved.

Ultimate Guide to Vetting a Business Partner

by | Apr 1, 2019 | , ,

By Gerri Detweiler

After surviving several tumultuous business partnerships, Susan Nilon has learned to be more skeptical and cautious. In the past, she admits she was so excited about business possibilities that she “didn’t pay attention to red flags.”

She and her current business partner in a legal research firm, De Novo Law Services, not only have a formal partnership agreement, they’ve taken it one step further. She created an addendum to the agreement “writing out 10 steps on how to survive our partnership,” she says. This document spells out the things that are not normally called out in a contract, like how to handle disputes and what to do when the other partner is not pulling their weight.

Business partnerships can bring together individuals whose complementary skills and experience can help the venture succeed. And sometimes a partner can contribute valuable resources — including money — to help fund the business. But these arrangements can also result in headaches or heartache.

Here are nine ways to vet a potential business partner and (hopefully) avoid those headaches:

Do Your Own Recon

Spend some time researching your prospective partner online. Review their social media accounts. Do their tweets or Facebook posts jive with the person you think you’ll be working with? Do you want to be professionally associated with them? Be sure to go back a while in their timeline: there may be older information they forgot about that provides valuable insight into their thinking and character. And don’t overlook a social media platform just because you don’t use it yourself.

Similarly, when you conduct your online search into their background, don’t stick to one search engine. Dig a little deeper. “Different articles will be highlighted on different search engines,” says Nilon.

Have ‘The Talk’

“What do you really want out of this relationship?” It’s that awkward question that often comes up when dating. That question, along with “What do you really want out of this business?” can be just as awkward. But it’s essential you have that conversation.

It’s “truly like a marriage,” Nilon points out. Avoiding these difficult conversations can have long-term consequences. She compares it to a relationship where “you don’t talk about wanting children before you get married. If you find out your partner doesn’t want kids and you do, the relationship might not survive.” She adds: “Knowing how you see the future and communicating that to the other is a key step to avoiding disappointments.”

With more than twenty years of experience in human resources, Ben Martinez knows as well as anyone how crucial it is to find the right people to work with. But even he learned the hard way how challenging that can be. He runs two very different businesses — STS Talent (an HR and recruiting firm for high tech businesses) and Sumato Coffee Company.

When he founded Sumato Coffee, he brought in a business partner he had worked with in the past. She was smart and capable, but he discovered she was in a different phase of her life than he. It was soon apparent that she wanted to devote more time to building her corporate career. “We had to part ways,” he says. In hindsight, he wishes he had asked more questions about what she wanted out of the business and her life.

Another partner he brought in later loved the product but he discovered she wasn’t as excited about all the work that goes into building a business. “She was mainly in it for the money,” he observed. “She was passionate about coffee and ecommerce but the work ethic wasn’t there.” He parted ways with her, too.

Have a Money Talk

Figure out how to handle money up front. What do each of you bring the the table and how do you value that? How much do each of you get paid, and how long can each of you go without receiving a steady paycheck?

“In an LLC you can provide profits based not on the percentage of ownership but on the amount of time spent in the business,” explains Sutton. “And even with an S corp you could have a salary or bonus based on the amount of hours put in. The person that doesn’t contribute wouldn’t receive as much compensation. Then buy sell agreement could allow a partner to buy back the shares at low value” if one partner wants to get out.

Check Credit

You can check business credit on any business, so if your future partner is an entrepreneur, consider at least running a commercial credit check on their businesses. (This guide explains how to check business credit on another business.)

While there are dozens of places you can check your own credit for free, it’s not as easy to check someone else’s personal credit, and you’ll first need to get permission from your future business partner. In fact, unless your run a business that already obtains credit reports on job applicants, they will likely have to get their own report and share it with you.

Run a Background Check

Your local courthouse can be a source of information about lawsuits or other public record information. However, keep in mind this information will be limited to actions taken in that jurisdiction. And it may even be inaccurate. It’s not unusual for people with similar names to be mistaken for one another for example. (Millions of court judgments have been removed from credit reports recently because they couldn’t be thoroughly matched to the right person.) “Courts do not conduct criminal background checks,” warns the National Center for State Courts on its website.

For those reasons, purchasing a full background check that you both agree to review together may be a better bet. A background check that includes credit, criminal proceedings and other details will likely require the permission of the person on whom you request the report so be upfront with your request.

Every business owner interviewed for this article agreed that background checks can be useful. “Certain crimes could prevent you from raising money or obtaining government licenses,” points out Caton Hanson, cofounder and chief legal officer of Nav. And “IRS or states taxing authority problems could get you entangled with their problems,” he warns.

If you’re serious about the business and willing to spend the money, you may even want to hire a private investigator who can dig up more than you can likely find out on your own.

Do a Compatibility Check

Even if your partner is squeaky clean that doesn’t mean the two of you will work well together. Different personal and working styles can quickly drive a wedge in the relationship.

One big wedge driver: a partner who feels entitled because they came up with the idea for the business. “People put too much value on whose idea it was,” says Hanson. “Ideas are a dime a dozen. There are two things that matter: money and work. You can’t have a successful business without them.”

Hanson’s business partner Levi King and he have developed something they call the “St. George test.” It basically means asking themselves to imagine a 3-4 hour drive from Salt Lake City, where Nav’s primary office is based, to St. George, Utah with that person. “Could you do it and not go crazy?” Hanson laughs. “You need to really like your business partner.”

You can also use more formal assessments such as personality or work style tests. Consider springing to get them professionally administered and reviewed by an HR professional or someone trained to analyze and help interpret the results.

Hanson says King had him take a sales aptitude test and a personality quiz to “make sure we didn’t clash.” Martinez says these types of tools can be helpful to raise awareness of your partner’s styles or to find complementary work styles but it’s important to “get clear on what you are using it for.”

Try a Practice Run

If one of you has an existing business, consider hiring the other person for a project or limited period of time to see whether you work well together. It’s not foolproof, though, as Martinez learned. It’s probably more like dating than marriage — with both partners trying to make a good impression — but you will be able to get a better sense of how you might work together.

That’s what Hanson and King did. King hired him to work for him in a different company before they founded Nav together. “The work we did was almost like working together like business partners,” Hanson says. It gave them confidence that they could indeed succeed as partners.

Get it in Writing

If you’ve decided to proceed with a partnership, spring for a formal partnership agreement written by an attorney. Hanson shared the story of a business he knows that won an award that earned them a lot of attention, and eventually they were able to raise venture capital. The partners had no written partnership agreement, however.

“One of the partners was sitting at home playing video games,” he says. But because he owned shares in the company, the partners had to buy him out.

Even though you may still be in the starry-eyed stage, think through some worse case scenarios.

What happens if the partner dies, becomes incapacitated or needs to get a full-time job to support themselves or their family, for example. “You can create a buy sell agreement that says if one person abandons the projects they lose all their shares,” explains Sutton. “If they commit fraud they are out of the business. If they get divorced, only the person you entered the deal with can be an owner — the spouse can’t be granted those shares. A good attorney can prepare a buy sell agreement that can cover all these contingencies,” he advises.

About the Author — Gerri Detweiler serves as Head of Market Education for Nav, which provides business owners with simple tools to build business credit and access to lending options based on their credit scores and needs. She develops educational programs and content for small business owners, and works on advocacy initiatives. A prolific writer, her articles have been featured on popular websites such as Yahoo!, MSN Money, ABCNews.com, CBSNews.com, NBCNews.com, Forbes, The Today Show website and many others.

Protect What’s Yours: The Top 10 Benefits of Incorporating Your Business

by | Jan 1, 2019 | , , , ,

Starting your business from scratch is a big deal. There are a million details to take care of, and the list of demands can seem endless. Small business owners have to hire employees, worry about taxes, and find ways to maximize profits while keeping costs as low as possible.

Every smart business owner should consider the benefits of incorporating. This is an important decision that has a significant financial impact.

Let’s take a look at the reasons why this is a smart move by helping you understand a few of the benefits.

Protect What’s Yours: The Top 10 Benefits of Incorporating Your Business

Have you heard about business incorporation but aren’t sure why it’s worthwhile? Read on to learn the top 10 benefits of incorporating your business.

1. It Protects Your Personal Assets from Lawsuits

Incorporating creates a safety barrier between you and your business. This is important because believe it or not, if you don’t incorporate your business, you run the risk of losing your personal assets when sued. Incorporating protects your personal assets if a lawsuit is filed against you.

2. It Protects Personal Assets From Creditors

Incorporating also protects your personal assets from creditors wanting to collect on business debts. This is accomplished by forming an LLC, or a C or S Corporation that protects your personal property in the event that your business falls on hard times.

When not incorporated, your personal property will be automatically linked to your business, including your home, investment accounts, cars, as well as future assets.

3. It Makes It Easier to Transfer the Business

Someday you may wish to sell your business or pass it on to a member of your family. Or perhaps you will get sick and no longer have the energy to continue running things. This is something many people don’t think about until they are near retirement.

When you are running a sole proprietorship, all of your personal property is linked to your business, making it very difficult to value the business or transfer it to someone else. Incorporating makes this process much easier.

4. It Allows Your Business to Grow Long After You’re Gone

The reality is that you won’t be around forever. Despite this, you will likely wish for your business to flourish long after you’ve passed away. When you are incorporated, probate won’t touch the business directly. The business will simply go directly to the new owner assuming you have the proper documentation in place.

5. It Has Huge Tax Benefits

Incorporating also offers massive tax benefits, such as the ability to deduct travel expenses and Social Security taxes that you’re paying into the system, deduct business losses, and claim some daily expenses required to operate the business.

Keep in mind that when you make the transition from being a partnership or a sole proprietor to an LLC or similar business structure, there are a multitude of deductions available to you that weren’t at your disposal as an individual.

6. It Makes It Easier to Raise Investment Capital

Another significant advantage of incorporating your business is the access it gives you to raising vital capital. The ability to borrow money is very important to any business, and being incorporated adds a legitimacy that helps when applying for loans.

It also allows you to open bank accounts and establish lines of credit that will make it easier and more efficient to operate your business.

7. It Makes it Easier to Sell Your Business

Incorporating also adds legitimacy to your business in other ways. Sole proprietors simply aren’t as attractive to potential buyers.

This is due to the fact that corporations are easier to track and manage, and they tend to be more stable. These are things that are of the utmost importance from an investor’s perspective.

Being incorporated also gives you a leg up when there are competing businesses that a buyer might be interested in.

8. It Helps Protect Your Brand

When it comes to owning a business, branding is everything. Keep in mind that if you don’t take the necessary steps to protect your brand, it’s possible for someone to swoop in and steal it.

That’s why incorporating is also important for protecting your brand. This includes everything from your business name, slogans, logos, and colors that represent your brand, to trademarks and any designs that distinguish your business from everyone else. Not sure if you’ve got a brand worth protecting? There are some tweaks you can do immediately to improve your brand.

9. It Makes Establishing Retirement Accounts Easier

When you own a business, you want to make sure that you and your employees are taken care of beyond a basic paycheck. Many companies provide health savings accounts and retirement accounts to help employees plan for the future.

Incorporating makes this process less expensive due to tax-advantages, and there is far less red tape involved in setting these types of accounts as a corporation compared to a sole proprietorship.

And even if you don’t have employees, there are still plenty of advantages to setting up accounts for yourself by incorporating your business.

10. It Helps Protect Your Privacy

One of the biggest benefits of incorporating your small business is something you might not have considered.

When your business is incorporated, you’re better able to keep your personal information hidden. This is especially vital for companies who need to closely protect trade secrets. For many companies, this level of privacy is what helps them maintain an edge on the competition.

Incorporating allows you to keep all of your business affairs private, and they will be kept completely confidential unless you make the decision to disclose them.

Taking Your Business to the Next Level

When you take the time to consider the benefits of incorporating, it really doesn’t make sense not to. After all, the advantages of incorporation not only include ways to save money, they also provide brand protection and allow you to more effectively manage the long-term needs of your employees.

As you can see, there are plenty of good reasons to incorporate, and far fewer reasons not to. So take your business to the next level by incorporating!

State Franchise Fees: Beware of Delaware’s New Rules

by | Apr 1, 2018 | ,

Delaware’s New Rules Are a Cost To Consider When Forming Your Entity

Delaware recently increased the various fees assessed by their Secretary of State as Annual Franchise Tax Fees for Delaware corporations. While the changes do not apply to Limited Liability Companies (LLCs) or Limited Partnerships (LPs), and religious and charitable non-stock corporations remain exempt from the tax, the increased fees for corporations must be considered when forming an entity.

All corporations incorporated in the State of Delaware, irrespective of whether they actually do business in the State of Delaware, must file an Annual Franchise Tax Report and pay an Annual Franchise Tax. The Annual Franchise Tax is calculated on capital stock, and it is levied on corporations even if they are not producing any income.

The changes in the new law are fourfold: (1) the Franchise Tax Cap has been increased; (2) the Authorized Shares Method for calculating the Annual Franchise Tax has been modified; (3) the Assumed Par Value Capital Method for calculating the Annual Franchise Tax has been modified; and (4) the Late Penalty has been modified.

1. Franchise Tax Cap

Effective for Fiscal Year 2018, the Franchise Tax Cap has been increased to from $180,000 to $200,000 per year ($250,000 per year for some large corporate filers). It should be noted that LLCs and partnerships only pay $300 per year. But corporations with a large number of shares must take note.

2. Authorized Shares Method

There are two ways to calculate what you owe Delaware each year. The first focuses on how many shares you have authorized.

Under this method, the rate presently is $175 for a corporation with 5,000 authorized shares or less; $250 for a corporation with 5,001 to 10,000 authorized shares; and $75 for each additional 10,000 shares or portion thereof. Effective for fiscal year 2018, HB 175 has increased this rate from $75 to $85 for each additional 10,000 shares of portion thereof. For example, a corporation with 1,000,000 authorized shares now will owe $250 for the first 10,000 shares, plus an additional $8,415 ($85 times 99), for a total due of $8,665, plus $50 for the Annual Report Fee. These thousands of dollars compare with Wyoming’s annual fee of just $50.

3. Assumed Par Value Capital Method

Delaware also employs an alternative method for calculating the Annual Franchise Tax. This method is denominated as the Assumed Par Value Capital Method, and a taxpayer is free to use either method, and use whichever amount is less. The Assumed Par Value Capital Method is difficult to compare to the Authorized Shares Method because it necessarily makes certain assumptions about total gross assets. It is also difficult to calculate, period. Here is an example of how it works:

To use this method, you must give figures for all issued shares (including treasury shares) and total gross assets in the space provided in your Annual Franchise Tax Report. Total Gross Assets shall be those “total assets” reported on the U.S. Form 1120, Schedule L (Federal Return) relative to the company’s fiscal year ending the calendar year of the report. The tax rate under this method is $400 per million or portion of a million. If the assumed par value capital is less than $1,000,000, the tax is calculated by dividing the assumed par value capital by $1,000,000 then multiplying that result by $400.

The example cited below is for a corporation having 1,000,000 shares of stock with a par value of $1.00 and 250,000 shares of stock with a par value of $5.00, gross assets of $1,000,000.00 and issued shares totaling 485,000.

  1.  Divide your total gross assets by your total issued shares carrying to 6 decimal places. The result is your “assumed par.” Example: $1,000,000 assets, 485,000 issued shares = $2.061856 assumed par.
  2.  Multiply the assumed par by the number of authorized shares having a par value of less than the assumed par. Example: $2.061856 assumed par, 1,000,000 shares = $2,061,856.
  3.  Multiply the number of authorized shares with a par value greater than the assumed par by their respective par value. Example: 250,000 shares $5.00 par value – $1,250,000.
  4.  Add the results of #2 and #3 above.  The result is your assumed par value capital.  Example: $2,061,856 plus $1,250,000 = $3,311,856 assumed par value capital.
  5.  Figure your tax by dividing the assumed par value capital, rounded up to the next million if it is over $1,000,000, by 1,000,000 and then multiply by $400.00. Example: 4 x $400.00 = $1,600.00.
  6.  The minimum tax for the Assumed Par Value Capital Method of calculation is $400.00.

As you can see, the calculation is pretty complicated. Be sure to work with your tax advisor to get it right. Or maybe incorporate in another state without such rules and fees.

The new law increased the minimum amount of Annual Franchise Tax that is due and payable by a Delaware corporation under this alternative method. The minimum amount of Annual Franchise Tax for a Delaware corporation now is $400 per year, effective for fiscal year 2018.

4. Late Penalty

The new law has increased the Late Penalty from $125 to $250.

A COMPARISON

As noted above, the minimum amount of Annual Franchise Tax now payable by a Delaware corporation is $450 per year, effective for fiscal year 2018. It is informative to compare this $450 per year minimum amount of Annual Franchise Tax to similar taxes and fees in the States of California, Nevada and Wyoming.

1. California

California has taxes: corporate and personal income tax, California Alternative Minimum Tax, and California Franchise Tax. California Franchise Tax applies to LPs, LLPs, S and C corporations, and LLCs. All pay a minimum amount of $800 per year. But then other taxes kick in depending upon entity type. For S corporations, the California Franchise Tax is 1.5% of the S corporation’s net income, along with the minimum tax of $800 per year. For California LLCs, California Tax is a flat fee, based upon California gross income, plus an Annual Franchise Tax of $800 per year, regardless of income, calculated, as follows:

  • Gross income less than $250,000 – $0 + $800 = $800
  • Gross income from $250,00 to $499,999 – $900 + $800 = $1,700
  • Gross income from $500,000 to $999,999 – $2,500 + $800 = $3,300
  • Gross income from $1,000,000 to $4,999,999 – $6,000 + $800 = $6,800
  • Gross income over $5,000,000 – $11,790 + 800 = $12,590

California C corporations and LLCs electing to be treated as C corporations are subject to the $800 minimum fee plus the California State Corporate Tax of 8.84%, based upon California net income. As well, they are subject to a 6.65% California Alternative Minimum Tax (AMT), based on the Federal AMT, with modifications. If you do business in California, expect to pay some of the highest taxes in the nation.

2. Nevada

Nevada no corporate or personal income tax, and there is no franchise tax for corporations or LLCs; however, there are initial filing fees, renewal filing fees, and a business license fee.

The initial filing fee for a Nevada for-profit corporation is based upon the value of the total number of authorized shares, as follows:

  • $75,000 or less – $75.00
  • Over $75,000 and not over $200,000 – $175.00
  • Over $200,000 and not over $500,000 – $275.00
  • Over $500,000 and not over $1,000,000 – $375.00
  • Over $1,000,000
    • For the first $1,000,000 – $375.00
    • For each additional $500,000, or fraction thereof – $275.00
    • Maximum fee – $35,000.00

To get around these fees you can establish a value of $.001 per share. With 20 million shares at $.001 per share the value of the shares is just $20,000, well under the $75,000 threshold for increased fees. In Delaware you would pay much more every year for that many shares.

The renewal filing fee for a Nevada for-profit corporation is $650, calculated, as follows: (1) Annual List of Officers and Directors – $150; and (2) Business License Fee – $500. Nevada how also has a gross receipts tax on monies generated within Nevada. The tax starts on monies earned at $4 million per year and is dependent on what industry or business you are involved with. Work with your tax advisor to see if this tax would apply to you.

The initial filing fee for a Nevada LLC is $425, calculated, as follows: (1) Articles of Organization – $75; (2) Initial List of Managers of Members – $150; and (3) Business License Fee – $200.

3. Wyoming

Likewise, Wyoming has no personal or corporate income tax. Unlike Nevada, the Equality State has no gross receipts tax. Wyoming does have an Initial Filing Fee of $100, and an Annual Report License Tax for Wyoming for-profit corporations and LLCs, which is either $50 or two-tenths of one mill per dollar of assets ($.0002), whichever is greater, based upon the company’s assets located and employed in the State of Wyoming. For example, a Wyoming for-profit corporation or LLC with $1,000,000 in assets in Wyoming would pay an Initial Filing Fee of $100, a Registered Agent Fee of $25 per year, and $200 per year in Annual Report License Tax ($1,000,000 x 0.0002). For most of our clients the annual Wyoming fee for corporations and LLC’s is just $50 per year.

CONCLUSION

As demonstrated, the number of authorized shares greatly impacts the amount of Annual Franchise Tax for Delaware corporations. Small- and medium-sized Delaware corporations may wish to consider either recapitalizing, and thereby reducing their number of authorized but unneeded shares, or else changing from a corporation to an LLC or an LP.

As well, Delaware corporations can be ‘continued’ into Wyoming. Your original incorporation date and EIN remain the same, as if you had set up in Wyoming in the first place. 

In terms of starting a new corporation, the states of Nevada and Wyoming will generally offer much lower annual franchise fees than will Delaware.

The Top 12 LLC Advantages and Disadvantages

by | Jul 1, 2015 | , , , , ,

When looking to start a business or protect investments you have several options in the type of entity you can form. As with anything, there are advantages and disadvantages to limited liability companies.

Advantages

  • It limits liability for managers and members.
  • Superior protection via the charging order.
  • Flexible management.
  • Flow-through taxation: profits are distributed to the members, who are taxed on profits at their personal tax level. This avoids double taxation.
  • Good privacy protection, especially in Wyoming.
  • This is a premier vehicle for holding appreciating assets, such as real estate, stock portfolios, and intellectual property.
  • Extraordinary flexibility in the ability to allocate profits and losses to members in varying amounts.

Disadvantages

LLCs and the Charging Order

One of the great asset protection advantages of the LLC is the charging order.

Charging order protection arises from each state’s law and is a key strategy for shielding your assets from attack. As with anything in the law, the charging order is subject to change and interpretation by the courts. Some states view the statute differently than others, which is why it is important to choose the right state when forming a limited partnership (LP) or limited liability company (LLC). It is also important to keep up on the new court cases and trends in this area to keep yourself better protected. Remember, the LLC has only been widely used in the USA in the last 25 years or so. We are just now starting to see court cases defining their scope and use.

Going back to the original statute (the rule passed by each state’s legislature) we consider section 703 of the Uniform Limited Partnership Act. It states that if a partner of an LP owes money to a judgement creditor (one who has gone to court and prevailed) the court may order a ‘charge’ against the partner’s interest to pay the judgement creditor. Thus the term ‘charging order’. This rule also applies to LLCs.

For example, if John owns a 50% membership interest in XYZ, LLC and John owes money to Mary after losing to her in court, Mary can seek a charging order to receive John’s 50% share in the distributions from XYZ, LLC. Of course, John’s other partner Carlos is not as keen to this, but any disruption is minimized with the charging order. Mary does not step into John’s shoes as a substituted partner. She can’t vote and tell Carlos how to run the business. Instead, she is only assigned the distributions that would have been made to John.

Again, the charging order is a court order providing a judgement creditor (someone who has already won in court and is now trying to collect) a lien on distributions. A chart helps to illustrate our example:

illustration of charging order

In our example, John was in a car wreck which injured Mary, the other driver. Mary does not have a claim against XYZ, LLC itself. The wreck had nothing to do with the duplex. Instead, Mary wants to collect against John’s main asset, which is a 50% interest in XYZ, LLC. Courts have said it is not fair to Carlos, the other 50% owner of XYZ, to let Mary come crashing into the LLC as a new partner. Instead, the courts give Mary a charging order, meaning if any distributions (think profits) flow from XYZ, LLC to John then Mary is charged with receiving them.

Mary is not a partner, can’t make decisions or demands and has to wait until John gets paid. If John never gets paid, neither does Mary. The charging order not only protects Mary, but it is a useful deterrent to frivolous litigation brought against John. Attorneys don’t like to wait around to get paid.

This short video also explains the charging order:

But what if there is only a single owner?

The Difficulties of Single Member LLCs

In a Single Member LLC, there is no Carlos to protect. It’s just John. Is it fair to Mary to only offer the charging order remedy? Or should other remedies be allowed?

llc advantages and disadvantages charging order single member llc

A key issue is whether the charging order applies to a single member (one owner) LLCs. There is a nationwide trend against protecting single member LLCs with the charging order. Courts are starting to deny single owner LLCs the same protection as multiple member LLCs. The reason has to do with the unique nature of the charging order.

In June of 2010, the Florida Supreme Court decided the Olmstead vs. FTC on these grounds. In a single owner LLC there are no other members to protect. The court allowed the FTC to seize Mr. Olmstead’s membership interests in order to collect. Other states have followed the trend.

How Corporate Structure Can Increase Protection

Say you have a property in Oregon. That property is entitled to an Oregon LLC, which is owned by a Wyoming LLC. You then invest in a property in North Carolina, so you set up a North Carolina LLC owned by the Wyoming LLC.

If a tenant of your Oregon property sues over something that happened on the property, they have a claim against the Oregon LLC, not against you personally. They can’t get at your North Carolina LLC, and they can’t get at equity held on your personal property.

As you can see it’s beneficial to spread your properties across multiple LLCs. If you have 10 properties all in one LLC, it becomes a target-rich LLC. Often, we recommend only having one property per LLC. You may wish to have two or three properties in an LLC, but it really depends on how much equity you have in each property. The structure of your business really comes in to play during an inside attack, which is where the lawsuit is against an LLC, not the owner.

In the case of an outside attack, where the owner of the LLC is the target of a lawsuit, the charging order comes into play. In our example above where Mary is trying to get at John’s property, let’s assume John is the owner of a Wyoming LLC, and he has LLCs in North Carolina and Oregon. The car wreck has nothing to do with John’s Wyoming LLC, the holding in Oregon or the holding in North Carolina, so Mary can only go after John. And since John has a Wyoming LLC, even if he is the sole owner of the Wyoming LLC, Mary’s only option is the charging order. If the Wyoming LLC makes no distributions, Mary gets nothing. If the Oregon LLC and the North Carolina LLC make no distributions to Wyoming, Mary gets nothing.

This is not a great situation for attorneys who are on a contingency fee. They get a percentage of what is collected and it’s not a really good way to operate if they have to sit around get a charging order against the Wyoming LLC and then sit around and wait to get paid. Attorneys, being rational, economic animals are going to take the next case that has insurance instead of waiting for John to pay Mary.

You want to use the strategic positioning of the Wyoming LLC, which will own all your other out-of-state LLCs. States like Oregon and North Carolina may not protect the single member LLC, so you really need a Wyoming entity for protection in a case like the car wreck example. The Wyoming LLC creates a firewall against attorneys and frivolous lawsuits.

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