In a criminal case opinion called U.S. vs. Wilhite issued by a Colorado federal District Court on November 17, 2017, the court ruled that a federal law called the Fair Debt Collection Practice Act (FDCPA) preempted Colorado’s limited liability company charging order statute
Michael David Wilhite owed the U.S. money. He owned a membership interest in a Colorado LLC that transferred $200,000 that could have been distributed to Wilhite to Yahab Foundation. Wilhite argued that there was a six year statute of limitations on collection of the debt and the Colorado LLC charging order statute prohibited the federal government from garnishing the $200,000 paid to the Yahab Foundation.
The court ruled that: (i) the twenty year federal statute of limitations on collecting a criminal restitution obligation overruled the six year state statute of limitations of the FDCPA and (ii) the FDCPA overruled Colorado’s LLC charging order statute Colorado Revised Statutes Title 7 Corporations and Associations § 7-80-703.
The Court said:
“the Court likewise rejects Mr. Wilhite’s argument that Colorado law requiring the issuance of a charging order before levying interest in an LLC limits the Government’s ability to collect Mr. Wilhite’s restitution here.”
The Court ruled that the federal government could levy on the $200,000 distribution made to Yahab Foundation by an LLC in which the debtor owned a membership interest.
You want your LLC to be formed in a state like Arizona that has the charging order as the sole remedy of a creditor who gets a judgment against a member of the LLC, but if the creditor is the federal government collecting taxes, the state’s LLC charging order law will probably be overruled to allow the U.S. to collect money or property.
Arizona’s charging order statute is ARS Section 29-3503.
The 9th Circuit Court of Appeals issued an unpublished opinion dated September 8, 2017, in a case called In re Ellison in which the Court issued a warning that consulting with an asset protection attorney can be evidence that a debtor’s actions were taken to hinder or delay creditors. The case involves a man named Joseph Ellison who while facing the possibility of a large award for damages against him made several transfers of assets that the court found to be done to hinder or delay his creditors.
Ellison was terminated by JP Morgan. The parties became involved in an arbitration in which JP Morgan asked the arbitration panel to award it $750,000 for a loan made to Ellison that he had not repaid. In January of 2014 Ellison met with an asset protection attorney, but terminated the representation after the first meeting.
On June 3, 2014, the arbitration panel found that Joseph Ellison owed JP Morgan $790,000. Ellison took the following actions:
- In May of 2014 he transferred $18,000 to his wife’s law firm bank account.
- Shortly after June 3, 2014, he transferred $51,000 to his wife’s law firm account and $121,000 to a corporation owned 100% by Ellison. He later shot himself in the foot by testifying that he transferred the money to protect his family and prevent his creditors from getting it.
- Less than a week after the negative arbitration award Ellison paid his lenders that held first and second liens on his home $41,000 and $11,000, respectively. Again he shot himself in the other foot by testifying that he made the prepayments to protect his family and prevent his creditors from getting the money.
- Shortly thereafter Ellison made four transfers of money to his wife’s law firm bank account. The largest transfer was $17,000.
On July 29, 2014, Joseph Ellison did something attorney Jay Adkisson describes as follows:
“Ellison did one of the worst things that a debtor who has made transfers in defeat of his creditors can do: He filed for bankruptcy”
The reason it was a big mistake for Ellison to file for bankruptcy is because Bankruptcy Code § 727(a)(2)(A) says that a debtor cannot be discharged from debts if:
“the debtor, with intent to hinder, delay, or defraud a creditor . . . has transferred, removed, destroyed, mutilated, or concealed, or has permitted to be transferred, removed, destroyed, mutilated, or concealed . . . property of the debtor, within one year before the date of the filing of the petition”
The bankruptcy court refused to discharge Ellison’s debts and he appealed to the 9th Circuit Court of Appeals. The 9th Circuit found that Ellison’s transfers listed above violated Bankruptcy Code § 727(a)(2)(A) and it affirmed the bankruptcy court’s decision.
The 9th Circuit’s non-published opinion contains some troubling language about the significance of a debtor in bankruptcy who consulted with an asset protection attorney before transferring assets. The court said:
“Debtor argues that the bankruptcy court erred by relying on his meeting with attorney Woods as evidence of his intent, because the meeting preceded any of the critical transfers, and any intent he had at the time of that meeting was vitiated before he made those transfers.
But recall, bankruptcy courts may rely on a debtor’s course of conduct, or other circumstantial evidence, to infer intent to hinder or delay a creditor. * * * Here, the bankruptcy court was not relying on Debtor’s intent in meeting with Woods alone as sufficient to support a finding of his intent to hinder or delay a creditor. Rather, it found that the timing of Debtor’s meeting with Woods, together with Debtor’s knowledge and planning in doing so, was ‘additional evidence’ that supported a finding of Debtor’s intent to hinder or delay a creditor, particularly in prepaying his home loan lenders. In sum, the bankruptcy court appropriately relied on Debtor’s intent in meeting with Woods as circumstantial evidence to supports its finding of Debtor’s intent at the time he made the transfers to his creditors.” Emphasis added.
In his article on this case attorney Jay Adkisson states the following lesson about filing for bankruptcy:
“Another lesson here is . . . that voluntarily diving into bankruptcy is usually the single-worst decision that a person who has engaged in questionable transfers can do. Yes, post-judgment proceedings in state court can be quite painful and ultimately successful for creditors. But declaring bankruptcy is not just going from the frying pan into the fryer, but if somebody has made questionable transfers . . . it is like dousing oneself with gasoline and then jumping into the fire. The difference is one between the possibility of being seriously burned to the probability of being fried to a crisp. No court has the powers of a bankruptcy court to squeeze the last drop of blood from a recalcitrant debtor . . . .
Bottom line is that if you want to protect assets, you must take appropriate action such as forming an LLC and transferring assets to the LLC or to third party BEFORE a claim arises. Actions taken after a claim arises frequently are found to be fraudulent transfers done to hinder, delay, or defraud a creditor.
P.S. A claim does not arise when a lawsuit is filed. Here are some common examples of when a claim arises against you.
- The moment you cause a traffic accident that harms people or property.
- When you sign promissory note, contract or personal guaranty.
Arizona Revised Statutes Sections 33-1101 – 33-1105 contain Arizona’s homestead exemption that protects up to $150,00 of equity in a person’s Arizona home. Section 33-1101 provides:
“A. Any person the age of eighteen or over, married or single, who resides within the state may hold as a homestead exempt from attachment, execution and forced sale, not exceeding one hundred fifty thousand dollars in value, any one of the following:
1. The person’s interest in real property in one compact body upon which exists a dwelling house in which the person resides.
2. The person’s interest in one condominium or cooperative in which the person resides.
3. A mobile home in which the person resides.
4. A mobile home in which the person resides plus the land upon which that mobile home is located.
B. Only one homestead exemption may be held by a married couple or a single person under this section. The value as specified in this section refers to the equity of a single person or married couple. If a married couple lived together in a dwelling house, a condominium or cooperative, a mobile home or a mobile home plus land on which the mobile home is located and are then divorced, the total exemption allowed for that residence to either or both persons shall not exceed one hundred fifty thousand dollars in value.
C. The homestead exemption, not exceeding the value provided for in subsection A, automatically attaches to the person’s interest in identifiable cash proceeds from the voluntary or involuntary sale of the property. The homestead exemption in identifiable cash proceeds continues for eighteen months after the date of the sale of the property or until the person establishes a new homestead with the proceeds, whichever period is shorter. Only one homestead exemption at a time may be held by a person under this section.”
People sometimes ask me if they should transfer title to the home in which they live to an LLC for asset protection. My answer is no because:
- There is no business purpose so a court would probably disregard the LLC.
- It could cause a loss of the Arizona homestead exemption that protects $150,000 of equity in a personal residence.
An August 3, 2017, decision of the Court of Appeals of Utah called “Dean White vs. Julie Dawn White” ruled that the transfer of a home into a limited liability company caused the owner of the home to lose the Utah homestead exemption. Although the case is not an Arizona case it causes me to believe more strongly that a person who transfers his or her Arizona home into an LLC will lose the Arizona homestead exemption.
I am very proud of my son Richard C. Keyt for speaking on four topics at a two day seminar called “Estate Planning and Administration: the Complete Guide” offered by the National Business Institute (NBI). Ricky, who is licensed to practice law in Arizona and California and who was a CPA in a national accounting firm before he went to ASU’s law school, spoke on the following subjects on June 26 & 27, 2017:
- Common trust structures and when they are used
- Tax consequences of trusts
- Post-mortem tax planning options
- Marshaling assets and dealing with creditors
Ricky and I work together to prepare wills, trusts and estate plans for people. We are co-authors of a book called “Family Asset Protection.” The purpose of our book is to answer common questions people have about estate planning and explain what you need to do to protect your most valuable assets, your loved ones. Get free access to Family Asset Protection.
Question: I own Arizona real estate that I rent to tenants. I don’t want to be sued personally if somebody gets hurt on the property so I formed an Arizona limited liability company to own my investment real estate. If a tenant or guest is injured on the property and he or she wants to sue the owner the defendant will be the LLC not me because the LLC will own the land. What do I have to do to transfer the land to the Arizona LLC?
Answer: Forming an LLC to own the real estate and to shield you from liability if something goes wrong with the real estate is definitely a good idea. The plan, however, will not work unless you actually transfer ownership of the land from the current owner(s) to the LLC. To transfer the land to the LLC the owner(s) must sign a deed and the deed must be recorded with the county recorder of the county in which the real estate is located.
1. Title Insurance Issue #1. Example: After the LLC acquired title it discovers that the property is encumbered by a $25,000 lien. The title insurance policy acquired by the prior owner(s) did not list the lien as an exception from title insurance coverage.
Quit Claim Deed Bad Example. Because the LLC acquired title by a Quit Claim Deed the title insurance policy will not pay the $25,000 lien. A Quit Claim Deed does not contain any title warranties. This means that if a title defect is discovered while the LLC owns the land the LLC does not have a claim against the prior owner for breach of a title warranty. Because the LLC does not have a claim against the prior owner for breach of a title warranty the prior owner’s title insurance policy does not cover the $25,000 lien. The LLC must pay the lien or risk losing the property in a foreclosure.
Warranty Deed or Special Warranty Deed Good Example. A Warranty Deed and a Special Warranty Deed both contain title warranties that if breached give the new owner a claim against the prior owner(s). If a properly drafted Warranty Deed or Special Warranty Deed had been used to transfer title to the LLC the deed would contain a warranty that the land was not subject to the $25,000 lien. The breach of this title warranty gives the LLC a claim against the prior owner(s). Because the LLC has a claim against the prior owner(s) for breach of the title warranty the prior owner(s) could then make a claim under the prior owner(s) title insurance policy and the title insurance company would pay off the $25,000 lien.
2. Title Insurance Issue #2. The LLC should contact the title insurance company that issued the prior owner(s) title insurance and purchase an endorsement to the title insurance policy that names the LLC as an additional insured under the original title insurance policy issued to the prior owner(s) as of the date the prior owner(s) acquired the title insurance. With the endorsement the LLC can make a claim on the title insurance policy directly to the title insurer rather than against the prior owner(s) for breach of a title warranty. This type of endorsement typically costs $75 – $125.
3. Insurance Issue. When the LLC acquires title to the land be sure to contact your insurance company and notify it that the LLC owns the property and arrange for the LLC to be the named insured under the policy or added to the policy as an additional insured. If the property burns to the ground you don’t want the insurance company to deny coverage because it insured the prior owner(s) not the LLC. Make sure the LLC acquires all types of insurance that is appropriate for the property and its use.
4. Due on Sale Clause Issue. If the property is encumbered by a lien, the lender may have an option to call the loan if the borrower(s) transfers title to the LLC. This type of option is called a “due on sale clause.” If you ask the lender for permission to transfer the land to your LLC the lender will always say no. I’ve formed thousands of LLCs that acquired real estate subject to due on sale clauses. I’ve never had a client tell me that their lender called their loan when they transferred their land to their LLC. If you transfer your land to an LLC and your lender calls your loan, please let me know. The good news with respect to Arizona real estate encumbered by a Deed of Trust is that Arizona Revised Statutes Section 33-813.A allows the prior owner(s) to cure the default and stop a trustee’s sale under a Deed of Trust by deeding the property from the LLC back to the prior owner(s) who must also pay the lender its foreclosure costs.
Purchase a Do-It-Yourself Special Warranty Deed
If you need to transfer Arizona real estate to a limited liability company, purchase one of my editable do-it-yourself Word documents for $47. Each deed comes with instructions on how to complete the deed and record it with the appropriate Arizona county recorder. Purchase a deed in my legal forms web form store.
Question: I have heard the term “piercing the veil” of a corporation or a limited liability company. What does the term mean and why do owners of LLCs need to understand it?
Answer: “Piercing the veil” means that a court disregards the shield or veil created by state law that says the owners of a corporation or an LLC are not liable for the debts of the entity.
Example 1: Homer Simpson’s LLC called World Wide Widgets, LLC, borrowed $25,000 from Ned Flanders. The LLC signed the promissory note, but Homer didn’t. The LLC does not pay. World Wide Widgets, LLC, doesn’t have any assets so Ned knows if he gets a judgment against the LLC he can’t collect it. Ned never gets his money.
Example 2: Same facts as Example 1, but in operating the LLC Homer did not follow Arizona LLC law and did not follow proper procedures. Ned sues the LLC and Homer and asks the court to pierce the veil and hold Homer liable for the LLC’s debt. The court finds there are grounds to pierce the company veil and holds Homer personally liable for the LLC’s $25,000 debt. This is the bad result for the LLC member and frustrates the reason people form an LLC, i.e., to protect themselves from liability for the debts of the LLC.
Jay Adkisson, a nationally known asset protection lawyer, said the following in response to a recent court ruling in a case called Shermane Hector v. Mo–Dad Environmental Serv., LLC:
The veil-piercing/alter ego challenges to LLCs are going to be interesting because they start out with the intended lack of formality of corporations, and then their owners often get loosey-goosey about how the company is operated, how it is capitalized (and continues to be capitalized), etc. IMHO, the real challenge for planners is not so much in the meticulous drafting of LLC management agreements and the like, but in the education of owners as to how the entity needs to be run after all the ink dries.
How true. The vast majority of people think that if they file the Arizona Corporation Commission’s fill in the blanks form Articles of Organization they are home free and their life savings are protected from the LLC’s debts. Ignorance may be bliss, but ignorance of the legal concept called “piercing the company veil” can cost LLC members big bucks.
Most people who form an LLC don’t know that they must comply with Arizona’s LLC law or risk a court piercing the veil and holding them liable for the LLCs debts. For example, Arizona LLC law requires that every Arizona LLC maintain certain records. If you own an Arizona LLC don’t you think it would be a good idea to comply not only with that statute, but other Arizona LLC laws too?
The Shermane Hector v. Mo–Dad Environmental Serv., LLC court said this about veil piercing:
Some of the relevant factors considered in determining whether to apply the alter ego doctrine include: commingling of corporate and shareholder funds; failing to follow statutory formalities for incorporating and transacting corporate affairs; undercapitalization; failing to maintain separate bank accounts and bookkeeping records; and failing to hold regular shareholder and director meetings”
In forming 8,900+ Arizona LLCs I learned a long time ago that I must educate my LLC clients about Arizona LLC law. I accomplish this two ways:
- The LLC Operations Manual: This is a 170 page book I wrote that explains Arizona’s LLC law in great detail. For example, chapter 3 of the Operations Manual contains a list of 34 tasks that every LLC should complete in its first 75 days. Learn more about the LLC Operations Manual.
- Informative Email Messages: Everybody who hires me to form an Arizona LLC will be sent 50 email messages during the first year informing them about Arizona LLC law and reminding them to do things like sign the Operating Agreement, open a bank account, set up the LLC’s bookkeeping system, consult with a CPA and document loans by members to the LLC.
To learn more about this very important topic read my article called “Two Phases in the Life of an LLC.”
University of California, Los Angeles (UCLA) – School of Law Proffessor Stephen M. Bainbridge wrote a great article called “Abolishing LLC Veil Piercing.” The abstract says:
“Courts are now routinely applying the corporate law doctrine of veil piercing to limited liability companies. This extension of a seriously flawed doctrine into a new arena is not required by statute and is unsupportable as a matter of policy. The standards by which veil piercing is effected are vague, leaving judges great discretion. The result has been uncertainty and lack of predictability, increasing transaction costs for small businesses. At the same time, however, there is no evidence that veil piercing has been rigorously applied to affect socially beneficial policy outcomes. Judges typically seem to be concerned more with the facts and equities of the specific case at bar than with the implications of personal shareholder liability for society at large.
A standard academic move treats veil piercing as a safety valve allowing courts to address cases in which the externalities associated with limited liability seem excessive. In doing so, veil piercing is called upon to achieve such lofty goals as leading LLC members to optimally internalize risk, while not deterring capital formation and economic growth, while promoting populist notions of economic democracy. The task is untenable. Veil piercing is rare, unprincipled, and arbitrary. Abolishing veil piercing would refocus judicial analysis on the appropriate question – did the defendant – LLC member do anything for which he or she should be held directly liable.
Attorney Tanya Simpson’s article in the Florida State University Law Review is subtitled “How Restrictions on Dissolution have Crippled the LLC as a Viable Small Business Entity.” Here is her introduction to her article:
“When blushing couples walk down the aisle, they hope to live happily ever after, promising ‘ ’til death do us part.’ Even with such high hopes, many savvy couples sign prenuptial agreements in anticipation of the possibility that the marriage might not turn out as they had planned. Indeed, many individuals will not enter into a marriage without having such an agreement in place. How many would enter into a marriage today if it were possible that their state might not permit them to divorce at all?
When a marriage isn’t going well, all states have a judicial mechanism whereby the unhappy couple can divorce without either spouse having to prove fault, and many states provide the option of proving fault as well.1 However, when the “marriage” is one of members in a Limited Liability Company (LLC), the availability and mechanisms of dissolution vary from state to state. Some states have default rules whereby one member can force a dissolution,2 while other states require the consent of at least a majority of members.3 In states requiring majority consent, a minority member may still be able to obtain judicial dissolution, but to do so, the minority member must not only state that the “marriage” is irretrievably broken but must also prove this assertion to the satisfaction of the court by meeting standards that range from relatively easy to nearly impossible to achieve.4 Furthermore, with the paucity of case law on the subject and the lack of judicial consistency as to which body of law the courts will apply, determining which standards the court will likely apply is a gamble at best–making it difficult for the member to prepare its case appropriately. If the member is unsuccessful in predicting the court’s standards and proving that its case has met them, the member will find itself stuck in the marriage indefinitely, with its capital tied up and no say as to the decisions that affect its investment. This has not always been the case.”
When On February 2, 2012, the Colorado Court of Appeals issued its opinion in the case of Martin vs. Freeman, a case that is important for all limited liability company owners who want to avoid becoming liable for the debts of their LLC.
Dean C.B. Freeman was the sole member and manager of Tradewinds Group, LLC, a Colorado limited liability company. Tradewinds only asset was an airplane that it owed free and clear with a value of approximately $300,000. Tradewinds hired Robert L. Martin to build an airplane hangar for its airplane. Tradewinds sued Martin in 2006 for breach of the construction contract. In 2007 Tradewinds sold the airplane for $300,000. After making sure that all creditors were paid Freeman caused the LLC to pay him all funds that remained in the LLC’s bank account. Thereafter Freeman paid all of Tradewinds’ litigation expenses from his funds.
In 2008, the trial court entered a judgment in favor of Tradewinds. Martin appealed and won the appeal. The Colorado Court of Appeals found that Tradewinds’ damages were speculative and sent the case back to the trial court with directions to enter judgment in favor of Martin. The trial court ruled in 2010 that Martin was the prevailing party and awarded him $36,645.40 in costs.
When Martin won the $36,645 judgment against Tradewinds Group, LLC, it did not have any because it had sold its only asset and paid all of the company’s funds to its sole member, Dean Freeman. Martin then sued to pierce the LLC veil and collect Tradewinds’ debt from Freeman, the sole member of the LLC.
The primary issue before the Colorado Court of Appeals was should the court allow Martin to pierce the LLC’s veil and hold its sole member liable for Martin’s judgment against Tradewinds Group, LLC? The appellate court stated:
“To pierce the LLC veil, the court must conclude
- the corporate entity is an alter ego or mere instrumentality;
- the corporate form was used to perpetrate a fraud or defeat a rightful claim; and
- an equitable result would be achieved by disregarding the corporate form.”
The Colorado Court of Appeals in a two to one decision ruled that all three criteria existed and that Dean C.B. Freeman was personally obligated to pay the judgment owed to Robert L. Martin.
1st Factor: Alter Ego
The majority’s opinion says that courts consider a variety of factors in determining alter ego status, including whether:
- “the entity is operated as a distinct business entity;
- funds and assets are commingled;
- adequate corporate records are maintained;
- the nature and form of the entity’s ownership and control facilitate insider misuse;
- the business is thinly capitalized;
- the entity is used as a mere shell;
- legal formalities are disregarded; and
- entity funds or assets are used for non-entity purposes.”
The Court does not, however, tell us if alter ego status exists if a majority of the factors exist or if all all of the factors must exist or it is is merely a gut feeling determined by the court that sufficient factors exist to justify a finding that the company was the alter ego of the member. The Court found the following facts that justified its conclusion Tradewinds was Freeman’s alter ego:
- “Tradewinds’ assets were commingled with Freeman’s personal assets and the assets of one of his other entities, Aircraft Storage LLC;
- Tradewinds maintained negligible corporate records;
- the records concerning Tradewinds’ substantive transactions were inadequate;
- the fact that a single individual served as the entity’s sole member and manager facilitated misuse;
- the entity was thinly capitalized;
- undocumented infusions of cash were required to pay all of Tradewinds’ operating expenses, including its litigation expenses;
- Tradewinds was never operated as an active business; legal formalities were disregarded;
- Freeman paid Tradewinds’ debts without characterizing the transactions;
- Tradewinds’ assets, including the airplane, were used for nonentity purposes in that the plane was used by Aircraft Storage LLC, without agreement or compensation;
- Tradewinds was operated as a mere assetless shell, and the proceeds of the sale of its only significant asset, the airplane, were diverted from the entity to Freeman’s personal account.”
2nd Factor: Defeat of a Rightful Claim
The Court stated:
“The second prong of the veil-piercing test is whether justice requires recognizing the substance of the relationship between the corporation and the person or entity sought to be held liable over the form because the corporate fiction was ‘used to perpetrate a fraud or defeat a rightful claim.”
The Court went on to make the unfortunate statement that there is no Colorado case that ruled “that a party seeking to pierce the corporate veil must show wrongful intent.” The Court found:
“We conclude that defeating a potential creditor’s claim is sufficient to support the second prong. We further conclude, as a matter of first impression, that wrongful intent or bad faith need not be shown to pierce the LLC veil.”
The Court’s ruling effectively throws out the second prong of the three prong alter ego test and ignores 100+ years of corporate law. If a company has assets sufficient to pay its debt, the creditor does not need to sue the owner and try to pierce the corporate/company veil. It is only when the company cannot pay its debt that a creditor will sue the owner in an attempt to collect the company’s debt from the owner.
The corporate and LLC law of most if not all states provides that a fundamental asset protection concept is that the owners of the entity are not liable for the entity’s debts or obligations. It may be appropriate in some cases to find that a rightful claim of a creditor should be paid by an owner of the company after a court finding that the company was the owner’s alter ego and used to perpetrate a fraud, but the mere fact that the creditor was not paid should never be considered and used to find the owner liable. If people will be held liable for the debts of a company simply because the company has unpaid debts it will have a chilling affect on business and prevent many people from investing in businesses that would hire employees.
3rd Factor: Equitable Result
The Court did not discuss the facts that support a finding that an equitable result would be achieved by disregarding the corporate form, nor did it rule on the issue. Apparently Colorado now has a two prong test to determine if the when a Colorado court will pierce the company veil and hold the owner of an LLC liable for its debts.
Let’s hope this case is appealed because it is bad law for the owners of LLCs, corporations, limited partnerships, limited liability partnerships and limited liability limited partnerships.
What Martin v. Freeman Means for LLC Members
Some commentators have written that this case is another reason people should shy away from the single member limited liability company. I disagree. The court did not discuss that the fact the LLC had only one member was significant. What was significant to the court was the historical facts as to how the LLC operated and conducted its affairs. The case stands for the proposition that LLC owners, both single and multiple members) must follow the formalities of operating the company or risk having the veil pierced and the owners becoming liable for the LLC’s debts.
Consider the facts that the Court found that cased it to conclude that the company was Freeman’s alter ego:
1. Tradewinds’ assets were commingled with Freeman’s personal assets and the assets of one of his other entities, Aircraft Storage LLC: This is a fundamental no no. Never allow assets of a member to be commingled with the company’s assets.
2. Tradewinds maintained negligible corporate records: Again this is a no brainer.
Your LLC must maintain a good set of financial books. Use Quickbooks. Have an experienced Quickbooks expert set it up. It’s not too expensive. Make sure all income and expenses are entered and properly annotated.
If you loan money to your LLC, the books must show the date and amount of the loan and the loan should be documented by a promissory note signed by the LLC and a resolution signed by all of the members that authorizes the loan.
If you transfer assets to the company, prepare a Bill of Sale signed by the transferor that lists the assets transferred as of the stated date. If you are an employee of the company, sign an employment agreement with the company and have the members sign a resolution authorizing the LLC to enter into the employment agreement.
If the company enters into a contract with a third party have the members sign a resolution authorizing the LLC to enter into the contract.
3. The records concerning Tradewinds’ substantive transactions were inadequate: The tasks listed in the prior paragraph apply here too. In addition, one of the best things every LLC should do is routinely document all significant major actions taken by the company with minutes or resolutions signed by the members. Here is a partial list of company actions that EVERY LLC should document with minutes or resolutions:
Contributions of money or property by a member to the LLC.
Loans of money by a member to the LLC.
Adding or removing a member.
Changing the percentage ownership of a member.
Employing a member or key employee.
Hiring an independent contractor.
Buying, selling or leasing real property or personal property with significant value.
Entering into contracts with third parties.
Applying for licenses such as a real estate broker’s license or a contractor’s license.
Doing business in another state.
Entering into an Operating Agreement with the members.
Entering into a Buy Sell Agreement with the members.
An annual meeting of members and managers (if manager managed).
It is imperative that the members of the company document all significant actions taken by the company with minutes or resolutions. I know from being a business lawyer since 1980 that very few companies have the self discipline to document their actions. Routinely documenting transactions is one of the most important things the members of an LLC should do to prevent a court from finding that the company was the alter ego of the members.
3. Solution to the Lack of Records Problem: Prepare minutes and resolutions and have them signed by the members and managers.
4. The fact that a single individual served as the entity’s sole member and manager facilitated misuse: Note the Court said that having a single member “facilitated” misuse. It did not say that having a single member LLC is always a negative factor. The Court recognized that doting the eyes and crossing the tees is less likely to occur with a single member LLC because it takes more self discipline to have meetings with yourself and document those meetings. This fact of life is another reason why it is particularly important for single member LLCs to follow all of the formalities of operating the LLC and using a minutes service like Just a Minute.
5. The entity was thinly capitalized: The law requires that every LLC to be adequately capitalized, but it does not give LLC owners a clue as to what that term means. Adequate capitalization for an LLC means the company must always have sufficient assets for its needs, but the law doesn’t tell LLC owners exactly what constitutes adequate capitalization. LLC owners only know if their company is adequately capitalized years later if they are sued and a judge or jury rules one way or the other on the issue. Another problem is that adequate capitalization is a moving target because the number changes as the LLCs business facts and circumstances change. If the LLC does not have sufficient assets to meet its capital needs then it is not adequately capitalized. However, if the LLC does have sufficient assets to meet its capital needs a court could still find the company was not adequately capitalized. Remedy: Make sure the company has sufficient capital to pay its expenses plus a reserve of as much as you can afford and hope that if your LLC is ever challenged the judge or the jury will rule in your favor.
6. Undocumented infusions of cash were required to pay all of Tradewinds’ operating expenses, including its litigation expenses: This is a common problem that is easily avoided. If your LLC needs money there are two ways to get the money: (a) one or more members make a capital contribution to the company, or (b) the company borrows money from one or more members or a third party lender.
Capital Contributions: A capital contribution is a gift of money or property by a member of an LLC to the company. The company is not obligated to repay the contribution at any time except on liquidation if the contribution was not previously repaid. The company should document all capital contributions by: (a) making a proper entry in the company’s books that the member made a contribution of $x on a specified date, and (b) having the members sign minutes or a resolution that authorizes and approves the contribution.
Loans: Regardless of who loans money to the LLC, the loan must always properly documented by: (a) having the LLC sign a promissory note that states the loan amount, interest rate and repayment terms, and (b) having the members sign minutes or a resolution that authorizes and approves the loan. For more on this topic see my article called “How Do I Loan Money to My LLC?“
Undocumented infusions of cash are a routine event in most LLCs, but that does not make it right. Protect yourself by always documenting cash infusions. It’s easy to do and could make the difference between whether a court will one day allow or refuse to allow a creditor of the company to get a judgment against you. Undocumented cash infusions should never happen if you use a minutes service like Just a Minute, LLC, to automate the preparation of minutes on a monthly basis.
7. Tradewinds was never operated as an active business: Tradewinds only purpose was to own and operate Freeman’s airplane. It did not have any customers or generate any revenue. This factor is what other courts call the business purpose doctrine. A concept in asset protection law is that a court may disregard the formation of an entity like an LLC or a corporation if it has no business purpose. For example there is no business purpose to transfer title to your home to your solely owned LLC while you continue to live in the home. If the only reason you put property into an LLC is to protect it from the claims of your creditors, then the plan probably will not work. Imagine what would happen if you take the witness stand and the plaintiff’s attorney asks why did you put your home in the LLC and you answer to prevent my creditors from getting it. You lose. Because Tradewinds did not have a business, customers or revenue, it failed the business purpose test.
8. Legal formalities were disregarded: Yes the are legal formalities that apply to operating LLCs and your LLC must comply with all of them. One of the reasons I wrote my 170 page book called the Arizona LLC Operations Manual is so I could notify my LLC clients and purchasers of the book about the legal formalities applicable to Arizona LLCs. Every LLC must comply with the legal formalities of its formation state.
9. Freeman paid Tradewinds’ debts without characterizing the transactions: This is a no brainer. Members should never pay the LLCs debt. The LLC should never pay a member’s debt. DO NOT DO THIS. If your LLC needs money, write a check payable to the LLC and deposit the funds in the LLC’s bank account then pay the debt with the LLC’s money. Don’t forget to properly document the transaction as a capital contribution or a loan. If you need LLC money to pay your debt, have the LLC write a check to you so you can deposit the funds in your account and pay from your account. Don’t forget to properly document the distribution of money as a loan, compensation or a return of capital (if you have a positive capital account balance). Document the distribution with a promissory note (if a loan) and minutes or resolutions signed by the members.
10. Tradewinds’ assets, including the airplane, were used for nonentity purposes in that the plane was used by Aircraft Storage LLC, without agreement or compensation: The LLC allowed another entity to use its $300,000 airplane without paying any compensation and without a written agreement. Why? This type of transaction is a red flag asking for trouble in more ways than one. No person or entity should ever use LLC assets for non-LLC purposes unless the LLC enters into a written agreement with the user and the user compensates the LLC for the reasonable value of the use.
11. Tradewinds was operated as a mere assetless shell, and the proceeds of the sale of its only significant asset, the airplane, were diverted from the entity to Freeman’s personal account: The Court is wrong on this factor. The LLC was not assetless. It owned a $300,000 asset free and clear. It sold its assets and distributed the proceeds to its only member. The Court calls this “diversion” of assets, but this is the common and accepted method of liquidating an LLC or a corporation. The law does not require companies to retain cash in the company in perpetuity after the company liquidates its assets. It is not right that the Court found this fact to be a negative factor.
This case is a wake up call to all LLCs that do not dot the eyes and cross the tees. If your LLC is not religiously following the legal formalities of your state’s LLC law and properly documenting LLC transactions, especially transactions with members, then the company is setting the groundwork for a court ruling that the company veil should be pierced and the member(s) should be liable for the debts of the company.
Does your LLC properly document all significant transactions? If not, then I have two statements for you:
- If your LLC has not been documenting LLC transactions with minutes and resolutions, you won’t be doing it in the future.
Here are some other articles on this important topic:
“With the stripping of the requirement to prove wrongful conduct and expansion of liability for contingent claims, the ruling diminishes the limited liability protection afforded to all corporations and LLCs operating in Colorado. Incorporation in a jurisdiction with more robust liability protections seemingly provides no remedy – the Martin Court applied Colorado LLC statutes and case law without discussion of why Colorado law should apply to Tradewinds, a Delaware LLC. The ruling also highlights the renewed importance of maintaining adequate corporate records and practices as a means of avoiding ensnarement under the first prong of the veil-piercing test.”
“Update Corporate Records and Follow Required Formalities. Many closely held businesses do not keep their corporate record books up to date. In the event of a lawsuit against the company, a plaintiff’s attorney can attempt to “pierce to corporate veil”. This means the corporation will essentially be ignored and the owners (shareholders) will be personally liable for the corporate debts. Following basic corporate formalities, including
- Holding an annual shareholders meeting;
- Holding regular meetings of the Board of Directors;
- Avoiding any mixing of personal and corporate assets; and
- Keeping corporate records up to date.
will all help to insure that the assets of the owner(s) of the business are insulated from any judgment against the business.”
For People Who Want to Form an LLC Themselves
If you think you might want to create a do-it-yourself Arizona LLC you must read Arizona LLC attorney Richard Keyt’s article called “Step by Step Guide: How to Form Arizona LLC 2019 in (6 Easy Steps).”
Forbes: “If you’re aiming to stiff creditors, litigants or an ex-spouse, should you hide your money in Nevis or Nevada? Forget about hiding money offshore from the Internal Revenue Service–unless you want to risk the penalties, back tax bills and threat of prosecution that thousands of American clients of ubs now face. But what about protecting your cash from vexatious litigants, a grasping ex-spouse or pesky creditors? Then offshore trusts are still an option, but a far less attractive one now that legal reporting requirements for offshore holdings have become more onerous and some U.S. judges have taken to jailing folks who won’t (or can’t) turn over offshore assets. That’s good news for the lawyers and bankers promoting domestic asset protection trusts instead.
Question: What are the reasons why I should have my revocable living trust own my membership interests in a limited liability company?
Answer: The following is a list of the benefits of having a revocable living trust own all of your LLC membership interests:
- Incapacity: The co-trustee or successor trustee can administer assets held in trust if the owner / current beneficiary becomes incapacitated.
- Avoid Probate: Assets held in trust avoid probate when a current beneficiary dies.
- Asset Management: You can name a trusted person or a trust company to be the trustee to manage and invest the assets held in trust after your death if your beneficiaries are too young, cannot be trusted with the money, have creditor problems or a money-grabbing spouse.
- Payment of Funds After Death: The trust contains your estate distribution plan, i.e., who will inherit your assets after your death. It states how much and when beneficiares will be paid distributions from the trust.
- Asset Protection: If the trust is drafted properly, it will be an excellent asset protected device for your beneficiaries. A properly worded trust will prevent your beneficiaries’ creditors, ex-spouses and bankruptcy court from getting any of their inheritance.
Hire Arizona Wills & Trusts Attorney Richard Keyt to Prepare Your Trust
To learn more about my wills, trusts and estate planning services, go to my website called “Arizona Wills & Trusts.”
Arizona Attorney General Sues Spouse Because She Owned a Community Property Interest in Husband’s LLC
Arizona Attorney General Tom Horne sued a Phoenix-area firearms dealer for consumer fraud in a lawsuit filed in Maricopa County Superior Court. The defendants in the lawsuit are Lancaster Arms, LLC, owned by co-defendants Chester Durda and his wife Marsha. The AG alleges that the LLC and its member Chester Durda defrauded consumers by failing to provide promised merchandise and services to dozens of customers between February of 2009 and September of 2011.
The Attorney General’s press release states:
“Protecting consumers is one of the most important jobs of this office,” Horne said. “Businesses such as the one named in this lawsuit cannot be allowed to make promises to customers and not deliver on those promises. The problem is made even worse when, as in this case, some customers made advance payments with the expectation that they would get either merchandise or services in return, and instead they got nothing. The legal action requests that the court order the business to make restitution, pay penalties, and prevent it from defrauding additional consumers.”
According to the complaint, Lancaster Arms claimed to consumers, some of whom worked in law enforcement and the military, and to some weapons dealers, on the internet and through personal contact by Chester Durda, that the company sold weapons, parts and accessories and that it provided weapon kit assembly services to consumers who sent their kits to the company. Additionally, Lancaster Arms represented that some of its weapons were subject to its “Limited Life Time Warranty”. The lawsuit alleges that Lancaster Arms failed to ship merchandise that consumers had paid for, failed to repair weapons under warranty, and failed to provide refunds. The lawsuit also alleges that Lancaster Arms failed to assemble weapons kits sent to it by consumers and failed to return the un-assembled kits to the consumers or to provide them with refunds. The complaint asks the court to enter an injunction prohibiting the defendants from engaging in any further unlawful acts, require the defendants to restore money and property to consumers, order the payment of civil penalties of up to $10,000 per violation, and to reimburse the State’s court costs and other related expenses.
The lesson to be learned from this lawsuit is that assuming that Mrs. Durda did not have any involvement with the LLC or the alleged unlawful activities she was named as a defendant because the plaintiff wants to be able to collect damages from her community property. When spouses own an interest in an LLC as community property there always the risk that the non-active spouse could be named as a defendant in a lawsuit for this reason. If this is a concern and the non-involved spouse wants to protect his or her assets from liabilities arising from the active spouse’s involvement with the LLC, then the active spouse should own all of the LLC as separate property and the non-active spouse would not own any of the LLC.
See my article called “How Do I Acquire an Ownership Interest in an Arizona LLC as Separate Property?“
Read the Complaint.
Carter G. Bishop, Professor of Law at Suffolk University Law School compiled a summary of the status of limited liability company charging order protection or lack thereof in all fifty states. His work entitled “Fifty State Series: LLC Charging Order Statutes” is dated October 6, 2011. The table reflects the statutory charging order language of all fifty states. It also classifies each state’s charging order statutes in one of four classes. All links in the table are live to Westlaw and the table is updated a new legislative activity occurs.
Arizona’s LLC charging order statute is Arizona Revised Statute Section 29-3503.E, which states in part:
“This Section provides the exclusive remedy by which a person seeking in the capacity of judgment creditor to enforce a judgment against a member or transferee may satisfy the judgment from the judgment debtor’s transferable interest.”
Nevada asset protection trust guru and attorney Steve Oshins published an update to his ranking of the best states to form a domestic asset protection trust. He ranks the 13 states that have DAPTs in the following order:
- South Dakota
- Rhode Island
- New Hampshire
If you are the manager of an Arizona manager managed LLC or a member of an Arizona member managed LLC, do you know how to sign contracts on behalf of the LLC? If not, your ignorance could cost you big bucks. The recent Pennsylvania case of Hazer v. Zabala, 26 A.3d 1166, 2011 Pa. Super., found that the member of a PA LLC was liable for amounts owed on a lease because the member did not properly sign the lease on behalf of the LLC. This case is an important lesson for every LLC member and manager.
I have said many times that people who form Arizona limited liability companies mistakenly believe that once they file the LLC’s Articles of Organization they are automatically protected from the debts and obligations of the LLC. The primary reason people form an LLC is to shield themselves from the LLC’s activities and liabilities. Unfortunately, owner protection is not automatic. There are any number of ways that a member or manager of an LLC can become liable for the LLC’s debts. For members and managers of an Arizona LLC to obtain the protection from liabilities offered by Arizona’s LLC laws, they must operate the LLC in compliance with applicable LLC law. Most people who form an Arizona LLC do not know what Arizona LLC law is and therefore frequently cause the LLC to engage in activity that violates Arizona LLC and creates a risk that the members and managers could be found liable for the LLC’s debts.
It goes without saying that it is not likely your LLC will comply with Arizona LLC law if you do not know what the law is. The primary reason I wrote my 170 page book called the “Arizona LLC Operations Manual” is I want to inform Arizona LLC members and managers about Arizona LLC law so they can cause their LLC to comply with the law. One important and fundamental aspect of Arizona law is exactly how should a contract be worded so that the LLC rather than a member or manager is liable under the contract? My Quick Start Guide has sample signature blocks that illustrate exactly how the signature of the LLC should appear in a contract.
Facts in Hazer v. Zabala
The case involved a lease that was signed by a member of Zabala Broker, LLC. The member, Juan Zabala, signed his name on the lease and underneath is signature he printed “DBA/ZABALA BROKER, LLC.” The court ruled that Mr. Zabala was personally liable on the lease because he signed it in his name, not as the member or manager of his LLC.
For the signer to avoid personal liability and for the LLC to be the party liable on the lease the contract should have designated the LLC as follows:
The first paragraph of the lease (or any contract) should have read:
Zabala, Broker, LLC, a Pennsylvania limited liability company
The signature block as the end of the lease (or any contract) should have read:
Example 1: For a member managed LLC:
Zabala, Broker, LLC, a Pennsylvania limited liability company
Juan Zabala, member
Example 2: For a manager managed LLC:
Zabala, Broker, LLC, a Pennsylvania limited liability company
Juan Zabala, manager
Members and managers must know how to designate their LLC properly in contracts because they may become personally liable on the contract if it is not worded correctly.
How to Purchase the Ebook Version of the Arizona LLC Operations Manual
Click here to purchase the eBook version of our Arizona LLC Operations Manual from our internet store for the incredibly low price of $97.
Alaska Asset Protection Trust Funded By Solvent Settlor Completely Fails To Protect Assets In Bankruptcy Against Future Creditors
Forbes: “In 2005, an Alaska resident, Mortensen, who was solvent and liquid at the time, settled a self-settled Alaska Domestic Asset Protection Trust (“DAPT” or “APT”) for his own benefit and the benefit of his heirs, and contributed a $60,000 piece of property to the trust, along with $80,000 in cash that was a gift from his mother. . . . the Mortensen opinion basically says that under Bankruptcy Code section 548(e), Asset Protection Trusts do not provide protection in bankruptcy for a period of at least 10 years from the date the Trust was settled, where a purpose of the trust was to protect the trust assets from creditors of the settlor/beneficiary.”
Nationally recognized Nevada domestic asset protection trust lawyer Steve Oshins says this about the Mortenson case:
” I have looked through the facts of the case carefully and there is absolutely no doubt in my mind that the judge would have been crazy to have ruled differently than he did. Other than some subtle inner-issues regarding how the judge looked at the 10-year bankruptcy clawback, this case was really a non-issue for DAPTs. We all knew since 2005 that there’s a bankruptcy clawback. One of the reasons Bob and I are doing the teleseminar is to make sure the public doesn’t misinterpret the case as being meaningful. With the viral effect of the Internet, those who don’t do DAPTs could easily misinterpret this case. I think it is important for people to take note of what was done wrong in the case which is helpful because “what not to do” is a good training tool. “
Read “Trust Experts Say Judge Made “Bad Law” in Landmark Asset Protection Case,” which states:
“But trust companies that rely on asset protection as a selling point say the ruling is a fluke that won’t affect truly well-constructed vehicles of this type — and the estate planners who know most about the field agree. . . .’If there was ever an illustration of how extreme facts contradict the law, this might be it,’ says Wisconsin estate planner Bob Keebler. ‘The sky is not falling on domestic asset protection trusts,’ he says. ‘This is really not a surprise to anyone’.”
The case is Battley v. Mortensen, Adv. D.Alaska, No. A09-90036-DMD, May 26, 2011.
Provident Trust: “Steve Oshins is a nationally acclaimed estate planning and asset protection attorney . . . renowned for his efforts at providing innovative solutions for the asset protection concerns of clients. He has played a unique role in designing legislation that has made Nevada a leading trust and asset protection jurisdiction. According to Forbes Magazine, Nevada has the most favorable asset protection trust laws of any state in the country. Recently, Mr. Oshins was instrumental in the drafting of the part of Senate Bill 405, signed into law on June 16, 2011, that specifies charging order protection as the exclusive remedy for creditors of a debtor who is the sole member of a single member limited liability company (SMLLC).”
Question: Some people, including some lawyers, say that a single member limited liability company does not give the member/owner any asset protection. Is that true?
Answer: No. People say this to me all the time. I also see a lot of articles on the internet that make the same erroneous statement. I even know of lawyers who spread this myth.
People who claim single member LLCs do not provide any asset protection are ignorant of both asset protection law and LLC law. If a person or entity forms a single member Arizona LLC to operate a business or to own investment real estate and if the LLC is operated in compliance with applicable laws, the LLC gives its owner the same protection from the LLC’s debts and obligations that Arizona law gives to multi-member LLCs and single shareholder corporations.
Example 1: Homer Simpson forms an Arizona LLC and owns it as his sole and separate property. He is the only member. Homer writes a check to the LLC for $50,000 that the LLC uses to buy a rental home. The tenant’s mother slips on stairs in the home and dies. Victim’s family sues the LLC and Homer and attempts to pierce the company veil and hold both the LLC and Homer liable for the family’s damages. If Homer’s LLC has complied with applicable laws and if Homer did not have anything to do with causing or knowing of the problem with the stairs, Arizona law should protect Homer from any judgment rendered against the LLC that owns the home. If you think this example is ridiculous, see Kerege v. Viscount Hotel Suite, one of the ten largest Arizona jury awards in 2010 that involved an elderly woman who fell down carpeted stairs in a hotel atrium and died. The jury awarded the plaintiff $3,000,000.
I am not aware of any Arizona court case that has found the owner of a single member Arizona LLC liable under the fact pattern described above. If you know of such a case, please send it to me.
I am not saying that the owner of a single member LLC cannot be liable for causing harm in connection with the LLC’s activities. Never forget this important fact of life:
A person is always liable for harm caused by the person’s acts or omissions even if the acts or omissions arise while acting on behalf of a limited liability company.
Example 2: Same facts as in Example 1 above except Homer installed the carpeting on the stairs and his installation made a bump on the stairs that caused the tenant’s mother to trip when her foot hit the bump. Homer’s botched installation job caused the accident so he will be liable for the harm he caused and so will the LLC because he was acting on behalf of the LLC when he installed the carpet.
The result in Example 2 does not mean that a single member LLC does not provide any asset protection. Homer would not have escaped liability for causing the accident if the LLC had been a multi-member LLC. The number of members of the LLC is irrelevant in this scenario because Homer’s liability arises because of his bad act.
What is the Source of this Myth?
The reason some people mistakenly claim the single member LLC does not offer any asset protection arises from a misunderstanding of the legal implications of a famous (in LLC lawyer circles) bankruptcy case called “In re Albright,” No. 01-11367 (Colo. Bkrpt. April 4, 2003). This case involved a woman who was the only member of an LLC that had assets. She argued that the bankruptcy court could not give the assets of the LLC to her creditors because Colorado LLC law provided that the creditors’ remedy for claims against its sole member was a charging order. The bankruptcy court rejected that argument and allowed the bankruptcy trustee to sell the LLC’s assets and give the proceeds to Albright’s creditors.
The court made some statements that it may not have liquidated the LLC if it had multiple members. It said:
“To the extent a debtor intends to hinder, delay or defraud creditors through a multi-member LLC with ‘peppercorn’ co-members, bankruptcy avoidance provisions and fraudulent transfer law would provide creditors or a bankruptcy trustee with recourse.”
This off the cuff statement (called “dictum”*) are the basis on which the nonbelievers claim that single member LLCs do not provide any asset protection.
*Latin for “remark,” a comment by a judge in a decision or ruling which is not required to reach the decision, but may state a related legal principle as the judge understands it. While it may be cited in legal argument, it does not have the full force of a precedent (previous court decisions or interpretations) since the comment was not part of the legal basis for judgment. The standard counter argument is: “it is only dictum (or dicta).”
The Albright case did not involve a claim made against the LLC that arose from the LLC’s activities. I call this type of claim a bottom up creditor claim. Instead, the Albright case involved claims MADE AGAINST THE SOLE MEMBER ARISING FROM THE MEMBER’S ACTS OR OMISSIONS. IT DID NOT INVOLVE A CLAIM THAT AROSE FROM THE ACTIVITIES OF THE LLC AND AN ATTEMPT BY THE CREDITOR TO PIERCE THE VEIL AND HOLD THE SOLE MEMBER LIABLE FOR THE DEBTS OF THE LLC. See my graphical depiction of bottom up and top down creditors.
It takes quite a leap of ignorant faith to conclude from In re Albright that it stands for the proposition that single member LLCs lack asset protection. Nationally known asset protection attorney Jay Adkinson says the following about single member LLCs, In re Albright and asset protection on his great website called “Asset Protection Book:”
“Based on Albright, sometimes I hear planners blurt out, “Single Member LLCs provide no asset protection!” This is wrong. The lack of charging order protection is a far cry from concluding that SMLLCs are “worthless” as asset protection vehicles. SMLLCs may still provide substantial protection for owners against the liabilities of the entity itself, which are so-called “internal liabilities”.
For example: SMLLC owns a strip mall and is successfully sued by one of the tenants. If the SMLLC is adequately capitalized, is not the alter ego of the sole member, and is not used to perpetuate a fraud, the tenant may not assert liability against the member.
There is no reason that a SMLLC should be treated much differently from a sole shareholder corporation. Historically, sole shareholder corporations have contained liability within the entity and shielded the liability away from its owners.
To summarize, even if SMLLCs do not offer the same charging order protection as multiple-member LLCs, they can still be very valuable business planning vehicles. Certainly, it is preferable from a liability standpoint to own one’s business in a SMLLC than to run it as a sole proprietorship. But of course, where external liability is a concern and it is feasible to add another member, that should be done so that charging order protection arises.”
To learn more about this topic and attacks by creditors on the charging order protection offered by LLC laws in states outside Arizona, read my article called “Beware of the Single Member LLC.”
For People Who Want to Form an LLC Themselves
If you think you might want to create a do-it-yourself Arizona LLC you must read Arizona LLC attorney Richard Keyt’s article called “Step by Step Guide: How to Form Arizona LLC 2019 in (6 Easy Steps).”
Maricopa County Sheriff Joe Arpaio and his wife formed an Arizona limited liability company in December of 2010 called “Ava Investments, LLC.” In June of 2011 they transferred eight parcels of land into Ava Investments, LLC.
Apparently Joe and Ava were not concerned about confidentiality because their home address is listed in the Articles of Organization and on the Arizona Corporation Commission’s website as well as their names. I can’t fault Sheriff Joe, however because he didn’t have a chance to read my article called “The Confidential LLC – How to Form an Arizona LLC without Disclosing Its Ultimate Owner(s)” because the article was written after the Arpaios formed Ava Investments, LLC.
Lesson 1: If you want to keep your ownership of an Arizona limited liability company confidential and not on public display, do not be a member or manager of an Arizona LLC or use your home address for any purpose in the LLC’s Articles of Organization.
Apparently the purpose of Ava Investments, LLC, is to hold the Arpaio’s investment real estate. I searched the Maricopa County Recorder’s website for Ava Investments, LLC, and found the following deeds:
- June 6, 2011, Special Warranty Deed recorded on June 14, 2011, was signed by Joe and Ava as grantors conveying two parcels of land to Ava Investments, LLC. The Affidavit of Value recorded with this deed says that: (i) the seller was Ava Investments Corporation, not Joe and Ava, (ii) the sales price was $75,000, (iii) the method of financing was “exchange or trade,” and (iv) the property is for commercial or industrial use.” The signature on the Affidavit appears to be that of Ava Arpaio who acknowledged that she was “duly sworn on oath . . . that the foregoing statement is a true and correct of the facts pertaining to the transfer of the above described property.” These two parcels are located at 10635 & 10637 North 71st Place, Scottsdale, Arizona. Problems: The price listed is $75,00, but the deed transferred two parcels. What is the price of each parcel? Is $75,000 the total price? Who was the seller? The deed was signed by the Arpaios, not Ava Investment Corporation. The Affidavit of Value states that the seller was the corporation. If the property is/was owned by the corporation then the deed signed by the Arpaios did not transfer the title to the LLC.
- June 6, 2011, Special Warranty Deed recorded on June 15, 2011, was signed by Joe and Ava as grantors conveying land to Ava Investments, LLC. The Affidavit of Value recorded with this deed says that: (i) the seller was Joe and Ava, (ii) the sales price was $60,000, (iii) the method of financing was “exchange or trade,” and (iv) the property is for commercial or industrial use.” The signature on the Affidavit appears to be that of Ava Arpaio. This property is located at 10614 North 71st Place, Scottsdale, Arizona.
- June 6, 2011, Special Warranty Deed recorded on June 15, 2011, was signed by Ava Investment Corporation as grantor conveying land to Ava Investments, LLC. The Affidavit of Value recorded with this deed says that: (i) the seller was Ava Investment Corporation, (ii) the sales price was $75,000, (iii) the method of financing was “exchange or trade,” and (iv) the property is for commercial or industrial use.” The signature on the Affidavit appears to be that of Ava Arpaio. This property is located at 10610 North 71st Place, Scottsdale, Arizona.
- June 6, 2011, Special Warranty Deed recorded on June 15, 2011, was signed by Ava Investment Corporation as grantor conveying land to Ava Investments, LLC. The Affidavit of Value recorded with this deed says that: (i) the seller was Ava Investment Corporation, (ii) the sales price was $325,000, (iii) the method of financing was “exchange or trade,” and (iv) the property is for commercial or industrial use.” The signature on the Affidavit appears to be that of Ava Arpaio. This property is located at 16733 East Palisades Blvd., Fountain Hills, Arizona.
- June 6, 2011, Special Warranty Deed recorded on June 15, 2011, was signed by Joe and Ava as grantors conveying land to Ava Investments, LLC. The Affidavit of Value recorded with this deed says that: (i) the seller was Joe and Ava, (ii) the sales price was $75,000, (iii) the method of financing was “exchange or trade,” and (iv) the property is for commercial or industrial use.” The signature on the Affidavit appears to be that of Ava Arpaio. This property is located at 10632 North 71st Place, Scottsdale, Arizona.
- June 6, 2011, Special Warranty Deed recorded on June 15, 2011, was signed by Ava Investment Corporation as grantor conveying land to Ava Investments, LLC. The Affidavit of Value recorded with this deed says that: (i) the seller was Ava Investment Corporation, (ii) the sales price was $325,000, (iii) the method of financing was “exchange or trade,” and (iv) the property is a single family residence and used for commercial or industrial use.” Note: The Affidavit says to check only one box to indicate the type of property, but two boxes were checked. The signature on the Affidavit appears to be that of Ava Arpaio. This property is located at 16743 East Palisades Blvd., Fountain Hills, Arizona.
- June 6, 2011, Special Warranty Deed recorded on June 15, 2011, was signed by Joe and Ava as grantors conveying land to Ava Investments, LLC. The Affidavit of Value recorded with this deed says that: (i) the seller was Joe and Ava, (ii) the sales price was $60,000, (iii) the method of financing was “exchange or trade,” and (iv) the property is for commercial or industrial use.” The signature on the Affidavit appears to be that of Ava Arpaio. This property is located at 10630 North 71st Place, Scottsdale, Arizona.
Lesson 2: Diversity – do not put all of your eggs or assets in one basket. We all know what happens when you drop your basket, you lose all of your eggs or real estate if you have all of your real estate eggs in one basket. The Arpaios have 8 parcels of real property in one LLC. If somebody gets killed or injured on one property and there is a large lawsuit against the LLC, all the properties could be lost. For maximum asset protection, put each parcel of real estate in a separate LLC so in the worst case scenario, you only lose the equity you have in that one LLC. Do not put multiple parcels of valuable real estate in the same limited liability company because you could lose everything if something goes wrong with one of the properties. For more on this topic see my article called “How Many LLCs Should I Form for My Properties?“
The paper trail raises some interesting issues that everybody who transfers land into an LLC should consider before making the transfer.
Lesson 3. Always Consider Income Tax Consequences When Transferring Property. The total purchase price of all the properties stated on the Affidavits of Value is $995,000. The Affidavits of Value indicate that all the transfers involved an exchange or trade to satisfy the purchase price. Therefore the newly formed Ava Investments, LLC, must have been funded with property valued at $995,000 that was used to exchange or trade with the sellers of the properties. Did the Arpaios fund their LLC with a loan of property or make capital contributions of property valued at $995,000. If the latter, the LLC’s basis in the property would be a carry over basis. Would the exchange / trade be a taxable transaction? Income tax law (Internal Revenue Code Section 1031) does provide for tax-free exchanges of real estate for real estate, but not real estate for personal property or money. It is possible that one or more of the transactions could have created taxable events for buyer and seller. Hopefully the Arpaio’s consulted with an experienced tax advisor before they consummated the transfers and taken steps to eliminate or mimimize any adverse income tax consequences.
Lesson 4. Document & Track the Tax Basis of the Property Going into the LLC. The LLC should document the income tax basis of property it acquires so it can deduct the basis from any amount realized on a later sale of the property. If the LLC buys the property from the seller for its fair market value then the tax basis of the purchased property is the amount paid to acquire the property. If the property is contributed to the LLC by a member, the LLC takes the same tax basis in the property that the member had in the property.
Lesson 5. Document the Affect the Contribution of the Property to an LLC Has with respect to the Contributing Member’s Capital Account. This is especially important when the LLC is a multi-member LLC other than a two member husband and wife LLC. If a member contributes money or property to a multi-member LLC, the member’s capital account should be increased by the amount of money contributed or the value of the property contributed. This is an important concept for multi-member LLCs. Documenting or failing to document the value of members’ contributions added or not added to a their capital account has real economic consequences to the all the members. All of the members should sign a document in which they agree to the value of contributed property and the amount that will be added to the contributing member’s capital account. Think of a member’s capital account as similar to a bank account. If you contribute real estate to a multi-member LLC that has $50,000 of equity, you want your capital account to increase by $50,000 because for every dollar that does not get credited to your capital account you will lose $1 or real money at some time in the future.
Lesson 6. How Do You Determine Property Values? It is unusual for two parcels of real estate to have the same value. The purchase price of two of the parcels was $60,000, three parcels were priced at $75,000 and two were $325,000. What a co-inky-dink! How did the Arpaios determine the values of the properties?