Worst Case Scenario FAQS

When a charging order is obtained against you and is legally in place, no distribution is allowed/made to the creditor/litigant based on the Operating Agreement. The advantage of this structure with the proper Operating Agreement is that the creditor/litigant ends up getting stuck legally with a tax bill based on the amount of the charging order. This is despite the fact that no money was paid out/distributed to the Creditor/Plaintiff. It is called phantom income and under IRC section 37-177 that litigant could owe taxes as if he/she received the amount of funds awarded by the court. The fact that they would have to pay taxes against monies they have not received is extremely discouraging to litigants and is a powerful incentive for them to either not pursue the lawsuit, drop it after starting it or settle as soon as they win for anything you offer.
We will answer this from the technical not legal standpoint. Please check with your state law and see how much disclosure you must give your bank. But here it is: The WY LLC could be formed now ASAP while you are still making the payments and are in good standing. You will capitalize it by creating a Promissory Note in the aggregate value of your equity in your other holdings. You will then record liens against those other properties (that have equity) and then continue making your payments on time for at least the next 12 months. After which point you should contact the bank on the upside down property and discuss the short sale option. I realize that making 12 more monthly payments is painful, but if you want to keep all your other equity in the other properties then you need to do it. The bank will first verify if the property is really under water (meaning loan is higher than value), then if they decide to go after your other assets, they will quickly realize there is no equity there and liens have been recorded over 12 months prior, so they will work out a good modification of payments, a short share or a settlement of some sort for the specific property in question. Please check with an attorney to make sure you would not run afoul with the law in your state regarding this strategy.
When it comes to Bankruptcy laws, things have been modified as of a couple of years ago and all the courts require is that you had been set up with this asset protection structure for at least 2 years prior to filing the bankruptcy. While there is no 100% certainty what a bankruptcy Judge will decide, this structure has past muster in the past based on a few conditions. It is advisable to have made at least one payment per year and not taken the money out for personal purpose. Keep it in the LLC’s bank account or use it as an expense for the LLC business operation or marketing etc. Disclose all your assets in full and show on all court documents that the liens are to your WY LLC. Timing is one of the most crucial elements here as if the structure had been in place for at least 2 years prior to your filing of bankruptcy there is a higher likelihood that the Judge would accept the structure as is.
  • If you set up the structure AFTER a lawsuit had been initiated against you, then a Judge may unravel the structure.
  • If you have an incomplete Operating Agreement with clear business purpose and separate reason for the capitalization and several other requirements than the Judge may very well refute the structure.
  • If you’ve filed a lien that is incorrectly worded and/or is not in full compliance with your specific state lending laws, a judge could dismantle the structure
  • If you do not make the payments to your LLC, as structured in the promissory note, then a judge could consider the structure false and a mere front to transfer assets.
Yes, you can attempt to protect the rest of your assets but there are no guarantees how the Judge would look at it. For instance, if someone fell in one of your investment properties and is now suing you. We can file liens against all your other assets and businesses with one LLC in WY. If the plaintiff wins the case against you and the insurance coverage is not enough or the insurance denies the claim for whatever reason and the plaintiff wants to collect on his/her awarded lawsuit, they may try to force you to sell that investment property. If the net they receive is not enough, they may try to go after your other assets. Once they see that they are all stripped of any equity they may want to go through another lawsuit based on a Fraudulent Transfer Act, which basically means that you did what is called a “last minute transfer” and that give the court an opportunity to exercise its power to set aside such transfers of assets and put them aside or revert them back within reach of the plaintiff, who now became a creditor, so funds could be made available to satisfy the judgment they obtained. Although we are not transferring any of the assets per se, we are still bound by the same act because placing a lien for the benefit of another entity (the WY LLC) could be considered a transfer of equity especially that it was done after the lawsuit was filed. So, we have to assume the worst.

It is important to know that the plaintiff, now creditor cannot just take away any of your assets that have been stripped or transferred. The best he/she can do is tie them up until he/she can prove to the court that you placed these assets out of their reach AFTER the lawsuit was filed for the sole purpose of not paying the judgment.

The judge will have to see your conduct in real life such as:

  1. When, how and with what motivation these liens were recorded.
  2. If you had an intent to defraud the plaintiff/creditor by such transfer (very hard to prove especially if you were trying to reason with the plaintiff and settle amicably)
  3. If there are business reasons for such transfers (creation of liens to the LLC are made for over a dozen business reasons spelled out in the Operating Agreement)
  4. Whether you have been negligible in your affairs or not (most likely you can easily show that you are a professional and conduct your business prudently)
  5. If you have obtained and maintained enough insurance. (easy to prove especially for real estate holdings since each property requires a liability insurance)
  6. In fraudulent transfer cases, the court has especially broad discretion to do the “right thing” so despite the clear statute its practical application is not always predictable.

There are mainly three types of remedies when a plaintiff gets a judgment order to his/her favor against an owner/member of an LLC: A Charging order and/or a foreclosure. This is in only a handful of states like California. (Washington, South Carolina, etc.
Look here: http://www.nolo.com/legal-encyclopedia/limited- liability-protection-llcs-a-50-state-guide.html

  • A Charging order only (as the sole remedy) in all the other states. And the best according to legislature is Wyoming.

  • Order the LLC to be dissolved (Very rare)

To see how each state deals with the issue of personal creditors’ rights and LLCs, follow the link below: http://www.nolo.com/legal-encyclopedia/limited-liability-protection-llcs-a-50-state-guide.html

When it comes to LLCs, a foreclosure is a bad thing and a charging order is a good thing. In a state where the “foreclosure” of an LLC member’s interest is allowed, if a plaintiff gets a judgment against you (the owner/ member) for $50,000 and you do not pay it, the plaintiff can attack the LLC and foreclose on your financial interest portion in it. So, if your interest is valued at $200,000 and you owe the plaintiff $50,000, he/ she can foreclose and keep the entire $200,000. But if your interest is valued at only $25,000, then the plaintiff will foreclose and get that amount but you will still owe him/her the difference.

In a “charging order” state, the sole remedy is the charging order and there is no foreclosure. That means if your financial interest in the LLC is valued at $200,000, the plaintiff cannot get to keep it all.

If and when you make a distribution however, then the plaintiff can get some money. We write the Operating Agreement in a way that makes it legal for you NOT to make any distribution, (only salaries and other expenses etc.), hence you the plaintiff gets nothing except a tax bill for phantom income as explained in our videos and presentations. In conclusion in a Foreclosure LLC state, the plaintiff can get financial rights over your interest in the LLC. In a charging order LLC state the plaintiff could end up with nothing if the LLCF is drafted properly especially if it is set up in Wyoming.

Please send us any questions you may have regarding Asset Protection and we will do our best to answer them in this section as we update it as often as we can. Email us at Info@kmagb.com or call us at (407) 608-5448.