While accumulating assets may be the most obvious focus of financial planning, protecting those assets is equally important. Most investors are aware of common risks that can erode savings — market declines, longevity, taxes, and inflation, for example — which are addressed with planning strategies such as diversification and insurance products.
One risk that is often overlooked is creditor risk.
Several strategies can be employed to help protect assets from creditors in the event of a bankruptcy or civil litigation. They include purchasing an umbrella liability insurance policy, securing homestead protection for a house, and various types of trusts and retirement accounts that can offer safeguards from lawsuits or bankruptcy.
Another strategy that can be effective, particularly for real assets, is establishing a Limited Liability Company (LLC).
The following examples illustrate how an LLC can be used in asset protection.
1. Owning rental property exposes owners to risk. Consider successful retirees Mary and John, who own several properties in addition to their primary residence, including a condominium and vacation home that they occasionally offer as rentals to defray expenses.
Given the risks associated with real property, particularly when it involves renters, Mary and John might consider an option other than outright ownership. If someone is injured on the property, there is a risk to the owners’ personal assets and savings. By establishing a LLC for the rental condo and a separate LLC for the vacation home, Mary and John can contain the risk in the event of a lawsuit.
2. Physicians are at risk for medical-related litigation. George, a physician, and his partners own a private medical practice. This includes the small office building where they work as well as expensive medical equipment. Because medical professionals face a high risk of litigation from patients, it may be appropriate to remove as much equity from the practice as possible in the event of a lawsuit.
Instead of the practice itself owning the building and equipment, they may consider establishing separate LLCs for each, and having the practice enter into an leasing arrangement with those LLCs. This removes equity from the practice while also containing other risk, such as property risk, outside of the practice.
LLCs can be complicated
Another potential advantage to an LLC is that in many states, resolving a case against an LLC may result in a “charging order” for the plaintiff. The charging order doesn’t typically allow the plaintiff to access membership (i.e., ownership) shares of the LLC, but instead may provide them with access to a portion of distributions from the LLC. If the LLC does not make distributions, plaintiffs may be in a situation where they are waiting to collect on the judgement, which often results in a settlement that could be more favorable to the LLC owner.
Laws governing LLCs are complex. It is important to work with a qualified attorney with expertise in establishing LLCs and knowledge of the specific state laws that govern them. For more details about asset protection strategies, read Putnam’s investor education piece, “Asset protection: Basic principles and strategies for safeguarding your wealth.”