While there are several factors to consider when choosing what type of entity to form, the primary function of an entity is asset protection. Business owners want to protect their personal assets from the liabilities of the business operations. But there is another form of liability that business owners should be aware of that could have an even more devastating effect if not protected against.
When discussing the use of entities for asset protection, most people focus on protecting owners’ personal assets from the liabilities of the business (what is called inside liability). Little attention is given, however, to protecting the business assets from the owners’ personal liabilities (outside liability).
An owner’s interest in an entity is non-exempt personal property subject to collection by his creditors. If a creditor obtains a judgment against the owner personally, they will try to collect from their interests in any entities, and the assets are owned by those entities.
While most entities offer the same level of protection against inside liability, certain entities offer superior protection against inside liability because of a powerful feature called charging order protection.
Under the Texas Business Organizations Code, a charging order is the exclusive remedy a creditor has for collecting against owner’s interest in certain entities (like LLCs and LPs). This is what we refer to as charging order protection. A charging order is a lien on the debtor’s economic interest in the entity. It is only a lien on distributions, so the creditor can only collect from distributions made to the debtor by the company. Most importantly, the creditor has cannot sell the debtor’s interest, vote the debtor’s interest, or exercise any of the debtor’s management rights.
Corporations, however, do not enjoy charging order protection, and shares may be collected by any lawful means, including foreclose on the debt’s shares. In this case the creditor could sell or vote the shares, and could affect the management of the company. This would be devastating where the debtor is the sole shareholder, because the creditor would take complete control of the business, and could even choose to liquidate all of its assets.
Charging order protection (1) deters potential creditors, (2) protects the business’s assets from existing creditors, (2) gives owner-debtors flexibility to operate while subject to the debt, and (3) puts debtors in a better position to settle the debt. It is one of the reasons that LLCs have become such a popular entity form to conduct business.
As stated at the beginning, assets protection is but one factor in deciding which entity to conduct business through. A business attorney can help you consider how all of these various factors apply to your specific business, and guide you towards the right decision.
If you want to form an entity, give us a call to set up a consultation to discuss which would be the best type for your business.