Worst Case Scenarios

Asset Protection Scenarios (please change from “Worst Case” and add the “s” to make it plural; also, please add bold font as indicated below). Here are some different types of scenarios to consider. Each illustrates one or more concepts related to asset protect, estate planning, probate, and/or how the use of one or more legal entities (LLC, corporation, partnership, etc.) can help minimize the damage that might occur in a “worst-case scenario.”

Real estate investment scenarios:

The Story of Alex. Alex owned three residential rental properties in his own name, personally, along with his personal residence (he could have used a revocable living trust to own everything, but the result would have been the same since most trusts offer no asset protection). One day, a hot water pipe in one of his rental properties burst over a child’s bed while she was having a sleepover, severely scalding several children and even blinding one–the proverbial “worst-case scenario.” The tenant and other parents all collectively sued and obtained a judgment against the property owner-Alex. The judgment exceeded the insurance coverage (or, perhaps the insurance company got out of paying all or part of the claim on a technicality), and Alex, now the “judgment-debtor” in this scenario, was personally liable for a very, very large debt. The plaintiffs, now the “judgment-creditors,” went after ALL of Alex’s assets–virtually everything he owned–the house in which the tenant lived, the other two rental properties, Alex’s personal residence, Alex’s bank accounts…they were even able to garnish Alex’s “day job” wages until they were paid in full.

The Story of Bob. Bob owned three residential rental properties, and he did a good job of treating them as a business. All three properties were owned by one LLC, which was then owned by Bob. Rent was paid to the LLC, which had its own bank account. But, you knew Bob owned the LLC because it was easy to pull up the LLC records online (or it was relatively easy and inexpensive to order copies) and those records readily disclosed that, in fact, Bob was the sole owner of the LLC that owned the three rental properties. A “worst-case scenario” occurred, but, in this scenario, the property-owning LLC was the defendant, not Bob. Ultimately, the plaintiffs obtained a judgment against the LLC and were able to force a liquidation of all three properties in order to satisfy the judgment, but they were unable to go after Bob’s personal residence, bank accounts, etc.

The Story of Carol. Carol owned three residential rental properties, and she did a good job of treating them each as its own separate business. She had a consolidated management structure whereby one parent “holding” LLC owned 100% of each property-owning subsidiary LLC. It also acted as the property manager, collecting rents, screening tenants, etc., and offering a “lease-option” program to attract a higher-quality of tenant. To keep track of her finances, Carol used QuickBooks® to manage everything at the parent/holding LLC level. Each property-owning LLC was simply a different “class” in the accounting system, treated as a division of the same company for tax purposes, and to track income and expenses by property. To own the parent/holding/property manager LLC, Carol formed another LLC in a state that offers anonymous ownership. So, a search of the readily-available-online state business entity records for Carol’s state, which requires the disclosure of all LLC owners (or those owning 20% or more), resulted in a dead-end of anonymity. And, because she used different subsidiary LLCs to own each property, the online search did not reveal the common ownership of the other two properties. A “worst-case scenario” occurred, the LLC owning the one property was the defendant, and…instead of going to trial, the case settled for the amount of equity in the one rental property where the accident occurred, plus whatever insurance proceeds were available. Carol had to liquidate the one property in order to pay the settlement but still owns two rental properties, plus her personal assets were never at risk.

NOTE: In Bob and Carol’s scenarios, they could have still been held personally liable IF: (1) they were not experienced plumbers and they themselves, personally, installed or repaired the hot water pipe that burst; or (2) they failed to adequately screen potential plumbers and hired someone other than an experienced, licensed, bonded, professional plumber (you are always at risk of being held personally liable for anything you personally do yourself, whether it is making a repair or negligently hiring someone else to do so); or (3) they treated the LLC(s) as an “alternate persona,” commingling funds and otherwise not treating the rental properties as a separate business. Each LLC you own is a separate, legal “person,” much like having an adult child–it can have its own tax ID and credit history, open its own bank accounts, own its own real and personal property, and sue or be sued. Whether or not a plaintiff is successful in “piercing the corporate veil” of limited personal liability that using an LLC or corporation provides may well depend on how well you treat that entity as a separate person. Attorney Ely W. Sluder, your “virtual in-house counsel,” will help you and your business get set up properly. Remember: “An ounce of prevention can be worth a TON of cure™.”

Medical (or other Professional) Practice Scenarios:

The Story of Dr. Adam. Dr. Adam had a long, successful medical (or dental, or accounting, or other professional) career. He teamed up with one other doctor and they practiced as a general partnership. After working hard for a few years, the partnership was able to buy a building for the practice. The partnership was eventually able to purchase and open multiple locations, hiring or partnering with other doctors to run them. Everything was treated as one, big, general partnership practice. Then, someone sued the partnership for medical malpractice based on the alleged neglect of one of the other partners. Not only were all of the assets of the partnership at risk, including all of the real property it owned, each and every doctor who was a partner in the general partnership was at risk of being help personally liable for the actions of the one partner. This is because general partnerships offer no liability protection. There are limited partnerships, limited liability partnerships, and limited liability limited partnerships, some of which require that there is at least one general partner who is personally liable for the debts and other liabilities of the partnership. Bottom line–partnerships are complicated, risky, and outdated due to the relatively recent emergence of LLCs as the legal entity of choice for partnership-type ventures.

Because they had very little leverage, Dr. Adam and the other partners ended up having to agree to a very expensive settlement to resolve the medical malpractice claim. Thereafter, they converted the partnership into a professional limited liability company (a “PLC” or “PLLC”) and entered into an Operating Agreement that included comprehensive buy/sell provisions. Basically, when a member of the PLC dies, the PLC is required to buy out the doctor’s ownership interest, which can be done over a period of several years, with regular payments made to the doctor’s estate until the promissory note evidencing the carried purchase price is paid in full. The Story of Dr. Bill. Dr. Bill had a long, successful solo practice, which he ran through a PLC. When he bought a building for his practice, he did so using his PLC. He went on to buy two other locations, all owned by the same PLC. He employed doctors and nurses to run everything. Then, someone slipped and fell in one of the properties, was seriously injured, and sued the PLC. The plaintiff wound up with a large settlement, one so large that one of the properties had to be sold and the location closed in order to raise the funds needed to satisfy the judgment.

When Dr. Bill and his wife were killed unexpectedly, he was still the sole owner of the practice. He had no children, no estate plan, and no business succession plan in place to ensure that the practice would continue to run smoothly while being transitioned to new ownership. Patient care was disrupted, with doctors taking what patients would follow them to their new practice, eventually leaving the estate owning real property that was no longer producing income, which greatly devalued its worth. Eventually, after probating the estate pursuant to the intestate laws of their state, Dr. Bill’s nephew received a much smaller inheritance than he might have otherwise if Dr. Bill had a comprehensive estate and succession plan in place.

The Story of Dr. Chad. Dr. Chad had a successful practice, one he ran through a PLC. When he expanded beyond one location, he set up a new PLC and established each as its own, stand-alone practice. For each location, Dr. Chad hired one or more doctors who were eventually allowed to buy into that specific practice’s PLC and become full members. Dr. Chad would maintain majority control, and each PLC had a comprehensive Operating Agreement with good buy-sell provisions. So, if something dire happened to Dr. Chad, the patients would still be well cared for by the other doctor(s) who are invested in the practice. And, because each practice PLC maintained a life insurance policy on its members to fund the buy-sell provisions, Dr. Chad knew that his family would be well-compensated for the value of each practice in the event he was to die or become disabled.

Unlike Dr. Bill, Dr. Chad used a separate, single-asset LLC to purchase each location, which then leased the commercial property to the medical practice PLC at that location. Each property-owning LLC was a subsidiary, owned by a parent/holding LLC that provided property management services to all of them. This allowed Dr. Chad to consolidate banking and accounting at the parent/holding LLC level rather than having to maintain separate systems for each property-owning LLC.

When someone slipped and fell in one of the offices, only the equity in that one property was at risk as only that one single-asset LLC was at risk of being sued. When someone filed a medical malpractice lawsuit against one of the doctors with whom he had teamed up with using one of the medical practice PLCs, only that practice was at risk. And, because the practice didn’t own any substantial assets, the lawsuit was settled for the full amount of the insurance proceeds only.

Equipment Rental Scenarios:

The Story of Ayden. Ayden lived near a large lake that was a popular tourist destination for people who enjoyed boating and 4×4-ing. Ayden had a lot of toys–one dirt bike, two jeeps, three four-wheeler ATVs, a houseboat, a patio boat, a speedboat, and a couple waverunners. Ayden and his buddies can’t play with everything all the time, so he decides to rent his toys when he’s not using them. So, he posts listings online and eventually makes some pretty good money on the side--cash only, of course. Ayden is able to really put away some money, investing in gold and silver, and paying off his house. Then, a “worst-case scenario” occurred--someone got seriously injured while using one of his rented toys, got a personal injury attorney, and sued Ayden. Ayden failed to obtain any sort of liability insurance coverage beyond his basic homeowner’s policy, which, luckily for him, kicked in. But, it wasn’t enough, and the person ended up with a lawsuit against Ayden personally, who eventually had to seek bankruptcy protection to avoid losing his home, and who had to sell all his toys, and his gold and silver, to help satisfy the judgment against him.

The Story of Ben. Ben also lived near a large, recreational lake. He didn’t have a lot of toys, but he was a good businessman, and he was the favorite nephew of a wealthy uncle. Uncle agreed to finance a venture whereby Ben and Uncle would all be equal members in an LLC, which would buy toys to rent out to tourists. Ben would receive 50% of “sweat equity” for managing the venture, with Uncle receiving the other half as the “silent partner” for contributing the necessary capital. Uncle puts $250,000 into the LLC, which is then used to buy several boats, jeeps, and ATVs, all for cash, no financing. The LLC obtains an umbrella liability policy with $1 million of coverage. Business is good, and, eventually, they are able to buy a property location with a large, fenced-in yard, where they can park the boats and other toys when not being used. A worst-case scenario happens, someone dies and sues, seeking $5 million in damages. The lawsuit includes Ben and Uncle, personally, as defendants in the lawsuit. Uncle, as the silent partner who is not involved in the management of the LLC, was able to get himself dismissed from the lawsuit. But, because the claim related to a repair on a vehicle that was done by Ben, personally, instead of by a qualified mechanic hired by the LLC, Ben was unable to get himself removed as a defendant. They lost the lawsuit, with a judgment of $5 million, plus plaintiff’s attorneys’ fees, awarded against them. The insurance policy paid the full $1 million, then the LLC had to liquidate everything–the toys and the real estate–but it wasn’t enough. Ben eventually was forced to file bankruptcy and, needless to say, was no longer Uncle’s favorite nephew.

The Story of Cassie. Cassie was the favorite niece of her wealthy aunt. Cassie wanted to start a similar, toy-renting business, and Aunt was willing to fund it. But, instead of forming one LLC with them both as members, Cassie set up one single-member LLC, the “Service LLC,” to provide the service of renting toys to tourists, while Aunt set up another LLC, owned solely by Aunt, the “Equipment LLC.” Aunt funded (or perhaps she loaned) her single-member Equipment LLC $250,000, which it used to purchase a large fleet of boats, jeeps, ATVs, mountain bikes, camp gear, and other equipment, using low-interest financing to leverage her purchasing power. The Equipment LLC then entered into a master “triple-net”-type lease whereby everything was leased to the Service LLC, which was responsible for maintaining and insuring everything. The lease rental rate was adjusted annually to provide for a generally-equal split of the profits generated by the Service LLC, and the rental income earned by Aunt was considered unearned, “passive” income (generally speaking, rent, stock dividends, royalties/license fees for intellectual property, interest, income from online advertisements on your websites, and profits from a business that does not require your direct involvement).

Business was doing great, thanks to the LLC’s large fleet of rental toys. Eventually, Cassie and her Aunt decided to purchase a commercial property. Cassie and her Aunt formed a new LLC, the “Property LLC,” which they owned equally. The Property LLC obtained a bank loan (guaranteed by Aunt and Cassie) to purchase the property, which it then leased to the Service LLC. Each month, the Service LLC was usually able to pay more than the minimum monthly loan payment, and soon the bank loan was paid off. Aunt and Cassie added an irrevocable living trust as a 10% member of the Property LLC, with Cassie’s two children as the beneficiaries. That way, a portion of the proceeds paid as rent by the Service LLC could flow to the children’s trust; the children were taxed at a much lower rate than Cassie and the Aunt (who loved the children and was happy to help provide for them in this manner), and the trust funds could then be used to buy clothes and school supplies, pay tuition, or provide medical coverage/care for the children. And, because it was set up as an irrevocable “spendthrift” trust, creditors of the children were unable to reach the trust assets.

Then, a worst-case scenario happened--a houseboat caught fire and an entire family was killed. The Service LLC was slapped with a multi-million dollar lawsuit and its $3 million liability insurance policy, which seemed like a lot of coverage at the time, seemed insignificant when compared to the claimed damages. But, the Service LLC had minimal assets (office equipment, furniture, and an old truck), and the plaintiffs had no legal claim against the Equipment LLC or the Property LLC. One of the Service LLC’s mechanics was shown to have been inadvertently negligent in some way, but Cassie hired highly-trained, qualified mechanics, so the plaintiffs did not have a valid claim against her, personally. The plaintiffs ended up settling for the full amount of the insurance coverage–$3 million. The Service LLC stayed in business, the Equipment LLC retained ownership of all of the toys, and the Property LLC did not have to liquidate the property to satisfy a judgment.

Conclusion:

These scenarios are but a few examples of how “an ounce of legal prevention is worth a TON of cure™,” and the overall structure of your business venture can be very, very important. Attorney Ely W. Sluder is ready to help you structure your empire in order to avoid having the “worst-case scenario” take it down. Call 609-208-0999 or contact us online to set up an appointment to discuss how best to protect your assets.