Isolating Business and Personal Assets - Protecting Business and Owner
An important choice small business owners must make is the legal form of their business organization. Choosing amongst a corporation (s-corp or c), LLC, partnership, or sole proprietorship can have lasting economic consequences. Today, I will discuss how a business entity isolates the assets of the owner and the business. Owner liability protection, i.e. protecting the owner's assets from business debts, is widely appreciated as a reason to form a LLC or to incorporate. Less appreciated is the fact that some business structures can isolate the business's assets from the owner's debts. Of course, asset isolation is only one consideration when choosing a legal form; others, such as taxation impacts, are very consequential to a business's bottom line.
Isolating the owner's assets from the business's debts is often an important consideration when organizing a business. If a business faces potential future tort liability exposure, such as lawsuits arising out of accidents or personal injuries, the limited liability characteristic of a corporation or limited liability company is very valuable. On the other hand, if most of the business debts are contractual, such as bank loans, the limited liability may be weakened by requirements for personal guarantees.
Isolation of the business's assets from the owner's debts is more complex and more limited in scope. This isolation is best understood from the standpoint of collections. If a business owner is sued on a personal matter, and the plaintiff successfully obtains a judgment, that judgment entitles the plaintiff to attempt to execute against the business owner's assets. Some of these assets may be protected by the property allowances provided by North Carolina exemptions, while others might not be and may be sold to satisfy the judgment. If the business has valuable property--say a $25,000 truck--that property would be appealing to the judgment creditor to execute against and have sold. Assuming no exemptions apply, if the business is a sole proprietorship, the creditor could sell the truck, despite the fact it is used in business.
If instead the business was organized as a corporation, the creditor could not execute directly against the truck. However, the creditor generally could execute against the stock of the corporation and sell it (see NCGS 1-324.3). The added complexity might slow some creditors, but the business owner still faces loss of control of the business. It should be noted that selling the shares does not inherently create a right to sell the assets of the business. The rights under state law of the corporation's other shareholders and creditors remain. Furthermore, if the corporation has its own debts, it is possible that the value of its shares (the total value of the business) may be less than the value of its assets, and the business owner may potentially be able to use his or her personal exemptions to protect some or all shares in the business.
In the case of partnership, shares do not exist to execute against and sell. However, a creditor can obtain a charging order by which the creditor can intercept partnership disbursements, as if the partner had assigned his or her interest (see NCGS 59-58 for general partnerships and NCGS 59-703 for limited partnerships). Such a charging order is not an exclusive remedy, and a creditor may also seek to appoint a receiver or attempt to foreclose upon the partnership interest. The ability to collect against a general partnership in such manner is statutorily recognized.
For an LLC, the protection of the business's assets is stronger. North Carolina case law (Herring v. Keasler, 563 S.E.2d 614 (NC App. 2002)) interpreting NCGS 57C-5-03 has held that a charging order is an exclusive remedy for the creditor. Under this case, a creditor has no ability to have the LLC interest sold, only to receive profits from the LLC towards satisfaction of the judgment. Such a protection allows a business owner to protect the going-concern value of the business in face of personal judgments.
Developing a strategy for asset isolation and protection can be important part of organizing a business entity. However, as with many protections from liability, these protections are only effective used in advance of incurring liability. Transferring assets after a judgment is fraught with problems, and can potentially be reversed by a creditor.