Reducing Liability by Segregating Assets

To help hold onto what you’ve worked hard to accumulate and to manage risk (especially for business owners) it’s important to segregate assets and activities into separate legal buckets. The separate buckets should be put into place BEFORE the threat of legal action or the court may rule that a fraudulent conveyance occurred.

The number of buckets needed will depend on the type of activities and the amount of assets you own. For example, if you operate a business AND own investment real estate, the two activities should be held in two separate limited liability buckets. This would help protect the assets in one bucket from liability coming from the other.

Also, an estate plan should be setup to govern your personal affairs. This would create (in a sense) a third bucket, which would be the minimum number needed in this example. Going forward as more assets are acquired, more buckets may be necessary to effectively manage your risks and provide maximum protections.

Many of the most important asset buckets and the actions needed to keep the buckets separate are addressed below:

Operate your business through an entity that limits liability. If you operate your business as a sole-proprietor or general partnership, you have absolutely zero asset protection. That means your business, home and personal assets are all in one bucket and available to creditors. General partnerships are even worse, because you could be personally liable for the decisions of the other partners as well. In contrast, when you operate your business through a corporation or an LLC, you have taken a huge step in managing risk by creating a separate bucket of assets and activities.

Setup an estate plan with certain durable powers. One of the most important documents in an estate plan is the durable power of attorney for financial matters (DPOA). A DPOA comes into action when you are unable to handle your financial affairs (perhaps due to a lack of legal capacity).  A DPOA names an agent to act on your behalf and outlines the powers in which the agent can act, such as making decisions in your business. Having a DPOA could be what saves your business from financial ruin, until you are able to take the reins again. Without this document, a court-ordered conservatorship would be required, which could be very costly.

Manage rentals and investment real estate through an LLC to create a separate bucket of protection. This will help insulate your real estate from both personal liability and legal issues coming from your business. Rental properties have their own set of good business practices that must be followed in order to protect the properties and to successfully manage your risk. Good practices include (among others) complying with the tenant-landlord laws and not committing any alter ego blunders.

Title ownership properly. Property must be correctly titled in order to maximize segregation. If it’s supposed to be owned by a corporation, LLC or trust, then it should be titled in that manner. If it’s supposed to be personally owned the title should be clear as to whether it’s separate property, community property, tenants in common or held in a trust with you as trustee. Beware of holding title jointly (especially with someone you’re not married to) or your property could be subject to a divorce or judgment of the joint owner. If the asset is improperly titled, it may not be legally protected.

Establish your company’s legal standing. Many small corporations and LLCs in California have absolutely no legal standing, because they were not formed properly. Corporations MUST adopt bylaws and LLCs MUST have an operating agreement to have legal protections. If the documents don’t exist, then no legal separation exists between owner and company. The owner’s home, personal assets and business would ALL be in one legal bucket subject to creditors. In addition (without legal standing) the company’s contracts could be deemed invalid and it could be barred from defending itself in court or from bringing suit for damages against another.

Establish your company’s rules of operation. Corporations and LLCs are required to layout their rules of operation and governance. For LLCs this is done in its operating agreement (OA); for corporations, in the shareholder agreement (SA). OAs and SAs should explain how conflicts are resolved; how owners are added or removed; a pre-determined formula for valuing an owner’s interest and other important issues. OAs and SAs have legal binding authority in settling issues and may eliminate the need to go to court should a dispute occur, thereby saving the company thousands in legal fees.

Protect business in case of divorce.  For marriages that occur after your business is up and going, a prenuptial or postnuptial can help protect your business interests. Nuptials can be helpful to each spouse by documenting in writing which part of the business (if any) will be marital property and what will be separate. This is especially important in community property states like California, where a business could be legally ripped in half upon divorce.

To effectively manage risk, business owners need to segregate assets and activities into separate buckets followed by good business practices. To be effective the two parts must work together. Segregating assets alone WON’T provide ANY protection without good business practices. When the two parts work in tandem, litigation becomes more difficult and expensive for would-be-creditors.

(See our article: “Reducing Liability with Good Business Practices” for details).

Categories: ASSET PROTECTION and SMALL BUSINESS ADVISORY.