I’m starting a business....should I create a corporation or an LLC to protect my assets from liability arising out of my business?

A Corporation or an LLC often does not give small business owners as much limited liability protection as they would assume. To explain why, I commonly tell my clients a story about how limited liability evolved and give them an example involving a delivery truck driver.

But first, the History of Corporations and Limited Liability.

Before we dive into the story of the delivery truck driver, let’s review some history.

Hundreds of years ago in England, wealthy land owners were investing in shipping companies. Shipping was a risky business. Ships would often go down at sea with their expensive cargo. The owners of that cargo would then sue the shipping company, and its owners, and the captain, if he survived.

The concept of a corporation was created to encourage wealthy land owners to invest in trade. The creation of a Corporation protected the personal assets of the wealthy land owners.

The word corporation comes from the Latin word corpus which literally means body. And a corporation was deemed to be a separate legal person. The concept of a “corporate veil” was introduced to represent the barrier between landowners personal assets vs. those of the corporation. Creditors of that corporation could take any assets owned by the corporation, but could not pierce the corporate veil and take the personal assets of the investors (a.k.a. the shareholders).

Thus, the investors could lose any funds invested in the corporation, but no more. This is what is referred to as “limited liability.”

So, in summary, from its very inception, the concept of limited liability was meant to protect passive investors and NOT the active participants in a business. The shipping Corporation itself could be wiped out by creditors’ claims from the unlucky cargo owners. And if the captain or crew members survived the sinking of the ship and were later found by the court to be negligent and to have caused the loss, then their personal assets could be reached and taken by the unlucky cargo owners. But the investors who had nothing to do with the shipwreck could sleep well at night, knowing their personal assets were safe.

We will see that the situation today is much the same.

The example of the Delivery Truck Driver

Assume that Eddie the Entrepreneur approaches Issac the Investor and convinces him to invest $50,000 in a new delivery truck Corporation. Further assume that Eddie hires Dwayne the Drunkard to be the delivery truck driver. Dwayne has three prior convictions for DWI, but Eddie does not perform a background check and is unaware of the prior convictions. Dwayne gets drunk and gets into an accident and causes a million dollars worth of pain and suffering damage to another driver. Dwayne is guilty for his own negligent actions. Eddie is also liable for negligent hiring and thus, can be sued directly in his personal capacity by the victim. The Corporation is also liable under a legal doctrine called “Respondeat Superior” for the actions of its employees perform on behalf of the Corporation. So, the victim can wipe out any assets that Dwayne owns (except his exempt property) and any property that Eddie owns (except his exempt property) and any property that the Corporation owns. BUT, the victim CAN NOT reach Isaac’s personal assets.

Now let’s assume a different scenario. Eddie puts his own $50,000 into the business and does his own delivery truck driving. In this scenario, Eddie is wearing all three hats: investor, CEO and frontline worker. If Eddie gets drunk, causes an accident and causes a million dollars in pain and suffering to a victim. Eddie can not jump out of the truck and say, “You can’t sue me, you have to sue my corporation.” If that worked, everyone would create their own personal corporation and no one would be able to reach anyone’s property. On the contrary, the victim can sue Eddie directly because the victim interacted directly with Eddie.

Thus, in a one person startup business where the owner is also the investor, CEO, and frontline worker, running the business through an LLC may not protect the personal assets of the owner.

However, many lawyers still feel that there is some value in having even one person businesses operate through an LLC or a corporation. For one thing, an LLC or corporation may seem more professional or legitimate to potential customers. Also, some potential plaintiffs may be scared away by the prospect of limited liability. Also, as the business grows and brings in additional investors, it will be of great benefit to any passive investors to have an LLC in place.

Finally, as the business grows and employees are hired and the owner becomes less and less likely to directly interact with clients/customers, the value of having a limited liability entity increases.

Piercing the corporate veil

There are a few situations where an investor can have his assets reached by a creditor. This is called “piercing the corporate veil.” Some situations where courts have allowed piercing the corporate veil include serious wrongdoing (such as operating a criminal enterprise through a corporation), failure of corporation to pay annual franchise taxes to the state, fraud, under capitalization, and the situation where the investor completely disregards the corporation form and co-mingles corporate assets and generally treats the corporation as his alter ego. The trend in most states in recent years has been to make it more difficult for creditors to reach through the corporate veil.

What is exempt property?

Exempt property is property that can not be taken from you by your creditors. In other words, it is property that is exempt from levy by creditors. Even hundreds of years ago in England, where our legal system was developed, debtors were able to keep the shirts on their backs. Today the law is more generous. The idea behind exemptions is that debtors get to keep the minimal property necessary to sustain themselves and their livelihoods. So, in most states, the list of exempt property includes things like clothing and personal effects, tools of the trade, one vehicle per driver (up to a limited dollar amount of value), your home (up to a limited dollar amount of value in most states), retirement accounts, and life insurance policies.

After hearing that list, most people say, “That covers everything I own. What kinds of things are not exempt?” Common examples of non-exempt property which CAN be taken by creditors include boats, RV’s additional real estate (i.e. real estate other than your homestead), stocks/bonds, ownership of a business, expensive jewelry and cash in a checking or savings account.

Each state has its own list of which types of property are on the list and what is on the list can vary greatly from state to state. And there are several exceptional types of debts, such as child support and taxes, that can allow creditors to reach even otherwise exempt property.

Also, if a debtor voluntarily places himself into bankruptcy, additional federal laws come into play which can vary what is exempt and what is not.

QPRT’s – Estate Tax Planning

One estate tax avoidance strategy is to gift to your children a remainder interest in your home. As an example, let's say your home is currently valued at $1 million, and let's also say that you draw a gift deed so that your children's remainder interest vests after ten years. The value of the gift you are making today would be the present value of receiving the home ten years from now. Appraisals and estimates from qualified professionals would have to be made to support your estimation of the present value of the gifted remainder interest. Assume for the sake of this example that the present value of the gifted remainder is $600,000. Results of the gift would be (i) you pay gift tax now on $600,000, (ii) your kids get a remainder interest that will result in them owning the home outright in 10 years (when it's worth more than $1 million, and (iii) you get property worth $1 million out of your estate and avoid paying any estate tax on it at death.

CAVEAT: You must live longer than the ten year vesting period for this to work. If you are in poor health or of advanced age, pick a shorter vesting period. If you die before the remainder vesting period ends, the entire value of the home is subject to estate tax as though it's part of the estate at your death. In other words, if you don't live for the entire remainder vesting period (10 years in our example), the whole transaction is disregarded by the IRS for estate tax purposes.

Rather than deed a remainder interest in the home to your children today, an alternative is to use a Qualified Personal Residence Trust ("QPRT"). That is, rather than deeding the home to your children, you deed it to a QPRT and have 100% ownership interest in the property vest in the QPRT immediately. The QPRT trust instrument specifies that you can live in the house during some period of time, let’s say, 10 years. This is called your “enjoyment period.” After that, you lose the right to possess and use and enjoy the property, and your children obtain the right to possess and use and enjoy the property. Why choose this option? Because a QPRT allows you to deal with a variety of contingencies in the trust instrument. For example, what if your children die before you, before the vesting period is complete? Who should get the property? If you've deeded the property to your children and they predecease you, ownership would be tied up in their individual probate proceedings. But if you use a QPRT, the trust instrument can set forth what should happen in that and other possible scenarios.

CAVEAT: Just as you must live for the entire vesting period when using a gift deed, you must also live through your entire enjoyment period of the QPRT, or the IRS will disregard the transaction. In other words, if our example with the one million dollar home, you must lose the right to live there before you die, or the QPRT will be disregarded by the IRS for estate tax purposes.

QPRTs are similar to Charitable Lead Trusts in that both utilize the time value of money to minimize the present value of a gift given to the next generation. With Charitable Lead Trusts, you give property to a charity to use for 10-20 years, and then the ownership reverts back to your children. With QPRTs, you continue to enjoy your interest in the property (say for 10 years) before your children get use of the property. Either way, the delayed nature of the gift to your children makes it a less valuable gift. Thus, the property is out of your estate with a decreased gift/estate tax payment. The trade-off is that you have to pay gift tax now rather than waiting until you die and paying a larger amount of estate tax.