Domestic Strategies: Limited Liability Companies (LLCs)

When it comes to asset protection, you will find that corporations are not as helpful to you as a physician as they might be to some other businesses. This is because certain professionals, doctors included, are personally liable for all professional actions whether they are performed within a corporate structure or not. Corporations are still helpful, however, in limiting your personal liability for certain corporate responsibilities, such as employment issues, fiduciary responsibilities, etc.

Another way to use corporate entities to protect your assets is to use them for your assets themselves. For this purpose, you should consider Limited Liability Companies (LLCs), Family Limited Liability Companies (FLLCs) or Family Limited Partnerships (FLPs). In fact, LLCs (which I will use to represent all three types) are “the” tools of choice when it comes to asset protection.

LLCs were designed to bring together a single business organization with the best features of the pass through income tax treatment of a partnership and the limited liability of owners in a corporation.

If used for the medical practice itself, from a corporate liability standpoint, LLCs are similar to S- or C-Corps in that physicians still have personal liability when they see and screw up on patients, thereby causing a medical malpractice claim. LLCs also provide the standard corporate protection to shareholders and directors for negligence actions against the LLC itself.

For use in protecting assets, however, there is a major difference between LLCs and S- or C-Corps; and the key to that is something called a “charging order.” A charging order is the ONLY remedy a court of law can give a creditor who is trying to get (obtain) the assets of a debtor when the assets are in an LLC (or limited partnership).

A charging order DOES NOT allow creditors to sell assets of the LLC or to force distributions of income. The best way to illustrate what a charging order does is to use an example. Please note that the law affecting LLCs can vary from state to state, so please check your state statute to make sure there haven’t been any changes.

Example:

Patient Lucky sues and obtains a judgment against Dr. Smith for $3,000,000. Dr. Smith has $1,000,000 worth of medical malpractice coverage and has all the rest of his major personal assets owned by an LLC of which he owns 100%.

Lucky asks the court for satisfaction and asks the court to have Dr. Smith turn over the assets in his LLC to him. The court tells Lucky that the only remedy the court can give to him is a “charging order.”

What does the charging order get Lucky in the above example? Only the right to pay the taxes on income generated in the LLC.

What a creditor cannot get with a charging order

1) A charging order does not transfer the interest in the LLC to the creditor or force the debtor to sell his/her interest and turn over the sale proceeds to the creditor.

2) A creditor cannot force the LLC to sell assets.

3) A creditor cannot force an LLC to distribute income

So the only thing the creditor gets through a charging order is the right to pay income taxes on income generated in the LLC but NOT distributed. If you find this confusing, you’re not alone. Here’s how this works:

When Lucky obtains his charging order, Dr. Smith as the managing member of the LLC decides not to take any of the $45,000 out as income and instead leaves the income in the LLC.

Normally, when a corporation does not distribute all the income out of the corporation, there will be corporate taxes levied on that income. If the LLC is treated as an S-Corp or partnership (which is the case 95% of the time), the income is passed through to the shareholder (or member) and taxed at his/her individual tax bracket (as if he/she took the money out of the LLC).

Now that Lucky has a charging order against Dr. Smith’s LLC, Lucky, not Dr. Smith, will receive the income from the LLC. However, in our example, Dr. Smith as the managing member did not distribute the income from the LLC.

 

So now Lucky gets a K-1 for the taxes on what would have been distributed from the LLC to Dr. Smith. If Dr. Smith were a 100% owner of the LLC interest, Lucky would get a K-1 for all $45,000 that he NEVER received. I call this phantom income (which is income you do not receive but have to pay taxes on anyway).

 

The power of an LLC is derived from the fact that a creditor can only obtain a charging order against the LLC (vs. forced distribution of assets or income or, in the alternative, the sale of a debtor’s interest in the LLC) where, if the LLC creates income and does not distribute it, the creditor will get a K-1 for income they never did and never will receive.

There are a few potential problems with LLCs. Not all 50 states yet allow for single member LLCs, although all 50 states now recognize LLCs as legal business entities. As the years pass, though, eventually all 50 states will likely have single member LLCs.

And although single member LLCs have been used for some time now, you still may want to have another person as at least a 5% owner of an LLC. This will prevent a creditor from arguing that an LLC without more than one owner should not be able to hide behind a Charging Order as the sole remedy.

The particular types of assets you should hold in LLCs include especially the following:

1) Real Estate (mainly rental or vacation properties)

2) Brokerage Accounts (you will still have full authority to buy and sell stocks etc., but the assets in the account will be protected)

3) Boats, Planes, Snowmobiles, Waverunners (these should be placed in their own separate LLC to protect them, but more importantly, to protect the rest of your estate from the liability issues that might come up with these recreational vehicles).

4) Any other personal assets of value.

Physician Example:

If the previous material confused you a bit, I want to give you a real world example of how to protect your assets.

Example:

Assume Dr. Smith is 45 years old, married with two children, lives in Michigan, and has the following assets:

Value

Personal residence $1,000,000 (with $400,000 mortgage)
Vacation Home $ 450,000 (with a $200,000 mortgage)
Brokerage Account $ 500,000
401(k)/Profit Sharing $ 400,000
Airplane $ 125,000

The following is the recommended asset protection plan using LLCs.

Title

Personal residence Tenants by the Entireties

(Not typically in an LLC due to the fact that the client will eventually sell the house and will want to take advantage of the $500,000 joint capital gains tax credit.)

Vacation Home LLC #1

If the clients choose to rent the vacation home, I would suggest transferring the vacation home to its own individual LLC to protect it from a suit by a tenant for negligence.

Brokerage Account LLC #1

Again, if the vacation home were ever rented, the brokerage account would get its own LLC.

401(k)/Profit Sharing Qualified retirement money is federally protected

Airplane LLC #2

Because the airplane itself is a source of liability, I would suggest that it be owned in its own LLC so, if there is a crash (and it is always pilot error), the passenger who sues the physician’s estate will have to settle instead for whatever is in the LLC (nothing after the crash) and the insurance payments from the company insuring the plane.