by Richard Keyt, Phoenix & Scottsdale limited liability company attorney
The primary reason people form a limited liability company is to protect their assets and life savings from claims and liabilities that can arise from owning a business or investment real estate. Yes, you can buy insurance (maybe), but judgments can exceed the policy limits or coverage can be denied. Insurance is your first line of defense, but the LLC is the backup plan. It’s the second line of defense against things that go wrong with a business or investment property.
Fact of Life #1: If you own it and something goes wrong that causes somebody to be killed or injured (including economic harm), you will be liable and your life savings may be lost.
Bad Example 1 (aka I’ll put my head in the sand and hope nothing goes wrong approach to asset protection):
Homer and Marge Simpson own a rental home with equity of $100,000 that they lease to Ned Flanders. The Simpsons purchase a $500,000 liability insurance policy that covers the rental of their investment property. The Simpson’s net worth is $500,000, consisting of: (a) the rental home with a $100,000 value free and clear liens, (b) their home with a fair market value of $400,000, but it is subject to a $100,000 deed of trust, and (c) $100,000 of stocks and bonds held in a Schwab investment account.
One of Ned’s kids trips over carpeting on the stairs of the rental home and dies from his injuries. Ned sues Homer and Marge and wins a judgment of $3,000,000. The insurance company pays $500,000 to Ned who is still owed $2.5 million. Ned begins the legal collection process that will eventually take everything from Homer and Marge that they have saved during their lives except assets that are exempt.
Ned records the $3 million judgment in Maricopa County, Arizona, where the rental property and the Simpson’s home are located. The rental home is worth $100,000 and is free and clear. Ned causes Maricopa County Sheriff Joe Arpio to seize both homes and sell them at a public auction to the highest bidder. The buyers at the two auctions purchase the rental home for $75,000 and the Simpson’s home for $200,000, respectively. The net proceeds of the home sales are allocated as follows:
$150,000 to the Simpson’s under Arizona’s homestead exemption
$ 50,000 to Ned to pay down the amount owed on the $2,500,000 unpaid judgment
$75,000 to Ned to pay down the amount owed on the $2,500,000 unpaid judgment.
Ned also uses the Arizona judgment collection process to realize $100,000 from the Schwab account. Of their $500,000 life savings, the Simpsons could save only the $150,000 of equity in their home. They lost $350,000, but only received credit for paying Ned $125,000. They still owe Ned $2,375.000.
Bad Example 2:
Same facts as Bad Example 1 except instead of owning an investment property, Homer operates a sole proprietorship consulting business out of his home. Normally Homer is the only person who provides any services for the business, but he hires a temporary assistant to help him prepare and mail 1,000 flyers to potential customers. Homer’s laser printer is running low on black toner so Homer sends the temp to the office supply store to buy more toner. While on the way back from the office supply store, the temporary worker runs over a man riding a bicycle. The victim suffers permanent brain injuries.
The victim sues Homer and the temporary worker for damages and wins a jury verdict of $3,000,000. The end result is the same as in Bad Example 1.
Lesson 1: It does not matter if your activity involves owning a business (with or without employees) or if it owns investment real estate. In either case, things can go wrong and people and/or property can be damaged and people can be killed. You must protect your life savings from the ultimate disaster by putting the business or the real estate in an LLC.
If you think accidents and lawsuits like the two described above don’t happen, you are wrong. Ignorance may be bliss, but it could cost you and your family your life savings. The 2010 Arizona case of Kerege v. Viscount Hotel Suite resulted in the family of a woman winning a $3,000,000 judgment against a company that owned a hotel in which a woman fell on the stairs and died.
Henry Esparza Jr. v. BCI Coca-Cola Bottling Company of Los Angeles and Kenneth Davis is a 2010 Maricopa County Superior Court case in which the jury rendered a verdict for $3,000,000 against the employer and employee because the employee struck and badly injured a bicyclist while driving the employer’s truck on company business.
Moral of the story: Plan now for the worst and hope it never happens. It something does go wrong and it results in a lawsuit and a judgment, you want the LLC to provide a shield between your life savings and the plaintiff/victim.
Good Example #3 (aka Homer cares about asset protection and does what he has to do to protect himself and his family from liabilities arising from the rental property that generates $700 a month):
Same facts as Example 1 except Homer purchased an umbrella insurance policy for $2 million and transfer title the the rental home to an Arizona LLC owned equally by Homer and Marge as community property with right of survivorship.
Ned sues the LLC and gets a $3,000,000 judgment. The umbrella insurance policy pays $2,000,000 leaving an unpaid balance owed to Ned of $1,000,000. Ned has the sheriff sell the rental home at an auction and collects the $75,000. Ned has no claim against Homer and Marge because they did not own the rental home. Homer and Marge lose their entire $100,000 investment in the rental home, but their other $400,000 in life savings are safe.
Fact of Life #2 – Get as Much Insurance as You Can Afford
One thing simple and relatively inexpensive thing that all real property owners and business owners can do is purchase umbrella insurance. In general, you can purchase millions of dollars of umbrella insurance coverage for a relatively small annual premium. If Homer had purchased a $3 million umbrella policy that would probably have only cost him several hundreds of dollars a year, he would not have lost the $100,000 he invested in the rental home.
Which type of person will you be? Will you put your head in the sand and leave you and your family’s life savings at risk. Will you do what you have to do and form an LLC to hold “hot” assets so your life savings are asset protected from things that might go wrong with the “hot” assets?
For a graphical picture of Example 1 (the bad scenario) and Example 2 (the good scenario) see my illustration of what I call the “Bottom Up Creditor Problem.” Page two of this graphic shows two pictures of when an LLC will not protect your live savings.
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