I recently received an email from a client who was concerned about some information she received from a promoter of Wyoming LLCs. She was told a Wyoming LLC registered to conduct business in California will provide greater asset protection (charging order protection to be specific) than a California LLC. This misconception is fostered by internet pitchmen and one trick pony attorneys whose only concern is selling you an entity (typically Wyoming, Nevada, or Delaware) and not properly structuring your affairs. The information they provide is full of half-truths and misleading statements designed to obtain your hard earned money under the false premise of superior protection. Do not misinterpret my statement to detract from the beneficial use of entities structured in these states for I use Nevada quite extensively to protect my clients affairs. The key to any strategy is knowing when such an entity makes sense versus when it only increases costs with minimal benefits. The following is my response:
Dear Jane Doe,
In my opinion, a WY LLC or a NV LLC registered to do business in California would not prevent the creditor of a member from enforcing a charging order against the LLC. Why? When it comes to asset protection and LLCs, we are concerned with two forms of liability: inside liability and outside liability. With inside liability, the primary concern is protecting ourselves as members from liabilities associated with the activities taking place in the LLC e.g., rental real estate. The protection for inside liability claims is derived from two places: state law and the LLC operating agreement, which is the document that governs how the LLC is operated and the protection it offers to its members. Most states are fairly uniform in their approach to inside protection although some, like Wyoming, have adopted the Revised Uniform Limited Liability Company Act and gone of the reservation making LLCs in these states less than desirable (here is a link to a prior post on this subject). Liabilities that occur inside a LLC remain inside and will not attach to the owners of the LLC. Of course, this is contingent upon having a solid LLC operating agreement that has adequate protection and indemnification provisions for the member and managers. Unfortunately, when I review a client’s operating agreement it is not uncommon to find two or three critical defects that, if exposed in a lawsuit, could spell disaster. Nevertheless, with the protection provided by state law and a good operating agreement, the LLC offers excellent protection from the liabilities associated with owning real estate. Thus, if you created a California LLC or a Wyoming LLC registered in California to hold your rental real estate, both entities will protect you from claims arising out of liabilities associated with the LLC’s assets. If, on the other hand, you simply set up a Wyoming LLC to hold the property without registering it California, the outcome may be less clear.
Outside liability protection is just the opposite. Rather than looking to the assets of the LLC for recovery, a creditor is seeking a judgment against a member of the LLC because it is the member that caused the harm and not the LLC. Most people I meet completely miss this point because so much attention is given to protecting you from your real estate that very little thought is given to your personal actions or, for that matter, those of your children who could also jeopardize your investments. You, by your everyday actions, are probably the greatest threat to your assets.
Every state has, to some extent, given LLC members what the law refers to as “charging order” protections. Unlike the situation with “Inside Liability” where the creditor can only look to the assets of the LLC and not the members individually for recovery, with outside liability the creditor is looking to recover against the member’s assets. Your LLC membership interest, like the stock you own in a publicly traded company, is an asset that is considered personal property. One important feature of this asset is its unique characteristics that prevent creditors from levying on it if they have a judgment against you personally. Approximately 23 states, Nevada and Wyoming included in this number, limit the judgment creditor to a charging order.
The benefit of the charging order is that it limits your judgment creditor to a lien on any distributions you decide to make from your LLC. If you do not take distributions, then your creditor does not collect on the judgment. It sounds great and it is, but unfortunately all states do not adhere to the charging order as the sole remedy. Some states, like California, go so far as to allow a judgment creditor to foreclose on the member’s interest if the LLC is not making distributions. For many investors this is disconcerting given all state’s requires the real estate investor to register his LLC with the state if it directly holds rental real estate (the statute actually refers to conducting business and renting property falls within this definition). To trump a state like California and its creditor-friendly approach to asset protection, many investors will establish a LLC in a state like Nevada or Wyoming then register the LLC to conduct business in California as a foreign LLC. These investors believe that California must apply the laws of the entity’s home jurisdiction when it comes to matters of charging order protections. For example, if I created a Nevada LLC (remember Nevada does not allow any remedy other than a charging order) then register it in California as a foreign LLC, I will be immune from California’s approach to the charging order should someone attempt to collect on my LLC interest. Unfortunately, California and every other state that I have researched does not take this approach.
Under California Corporation Code 17450 the laws of the state … under which a foreign limited liability company is organized shall govern its organization and internal affairs and the liability and authority of its managers and members. In other words, the laws of the state of organization will govern any claims arising between the members or managers with respect to the inner workings of the company or between the company and its members or managers. The enforcement of a charging order on a member’s LLC interest does not fall within the statute’s definition. A charging order is the application of a judgment against personal property held by a California resident. Thus, if I am a creditor and I obtain a charging order against a California resident’s interest in a Nevada LLC registered to conduct business in California, I can, under California Corporation Code 17402, foreclose on the member’s interest. This is not considered part of the affairs or internal workings of the company.
In layman’s terms this means I can foreclose on your out-of-state LLC because it has availed itself of California’s laws when it registered to conduct business in California. (see my prior post regarding the failure of a Delaware LLC conducting business in Utah) To obtain the protections offered by Nevada or the other strong asset protection states, you can create a LLC in one of these states and have it own your California LLC(s). Structuring you affairs in this manner, your out of state holding LLC does not fall within California’s jurisdiction and is immune from its enforcement actions.