There is currently an asset protection structure that is making its way around social media that is aimed for smallish real estate investors. These are investors who buy residential properties and then rent them out. Some of these investors might just have one property, some might have twenty, and of course everything in between. This structure is being billed as a cheap and effective way of protecting these residences. But the truth might be something different.
The structure involves three layers. The top layer is created by the investor creating a revocable trust, usually a “living trust” where the investor is all of the settlor, trustee and lifetime beneficiary. Acting as the trustee of the revocable trust, the second layer is then created.
This second layer consists of an LLC owned by the revocable trust and is called the “holding company”. The holding then forms yet another LLC, called the “real property company” which will actually own the real estate.
To recap all this, the investor’s revocable trust owns 100% of the management company, which itself owns 100% of the real property company, and the real property company owns whatever parcel is being purchased. There are, thus, said to be three layers of “asset protection” between the investor and the real estate. In fact, three times zero still equaling zero, there really isn’t much asset protection provided by this structure at all.
To really analyze this structure, it must be understood that in asset protection liability may be parsed into two broad categories. The first category is inside liability which refers to the liabilities which are generated by the assets themselves. For example, if a water heater explodes in a house and the plaintiff tries to go up the ownership chain to reach the ultimate beneficial owners, that will be an inside liability.
While this structure might facially provide some protection against inside liabilities, that protection might be defeated in various ways. One way is direct liability to whoever is managing the property. If the investor is also the property manager, as so often is the case, then the manager has direct personal liability for the consequences of his own actions. In other words, if that water heater explodes, then the investor will be personally sued for negligence in not replacing it, and the liability shield of the real property company is thus circumvented. This is why I frequently tell these investors to hire a property management company and not do the property management themselves.
Another means of circumventing the protection of the real property company is through veil piercing using an alter ego theory. These theories are complicated well beyond the scope of this article, but they often boil down to whether there are the so-called “unities” of ultimate ownership and control and also the entity was used to create an injustice, which is broadly defined. Where there are several layers of entities, but all are owned 100%, a court may properly collapse all these entities together as one for alter ego purposes.
The second broad category of liabilities is outside liability which refers to the liabilities of the owner behind applied against the assets of the entities which he owns and controls. These theories are another form of alter ego theory known as “reverse veil piercing”, which operates like regular veil piercing but in the other direction. A creditor of the investor could use reverse veil piercing to collapse this structure and apply any judgment against the assets of the real property company.
But in many jurisdictions, a creditor does not even need to do that. Each layer can be peeled away like the skins of an onion until the middle is reached. The top layer — the revocable trust — is a big nothingburger because the assets of a revocable trust are available to creditors of the person who created it, known as the settlor or sometimes trustor. Next, a creditor in many jurisdictions can take a charging order against the holding company, foreclose on that company and take its interests in the real property company, then repeat the process with the real property company and take its assets as well.
But even if the laws of the applicable jurisdiction did not allow for foreclosure and the court did not allow for reverse piercing, a creditor merely taking a charging order against the holding company could cause great financial distress to the investor. Usually, investors buy properties with leverage and the loans of course require repayment. Investors will usually use some or all of the rentals of one property to pay the loans of another property. If the properties are in separate LLCs, and the creditor can get a charging order against the LLCs, then the investor will be cut off from the revenue stream and become unable to repay the loans.
The fundamental flaw with this structure is the revocable trust. A revocable trust is counted as simply a zero for asset protection purposes; it does not protect assets until the settlor dies and then the residual beneficiaries will presumably be protected from their creditors if there is a spendthrift clause. Thus, effective asset protection generally involves only irrevocable trusts, but these can be complicated (and thus relatively expensive) from tax and administration standpoints so smallish investors are loathe to create them. But, an irrevocable trust can do what revocable trusts cannot do, which is to contain inside liabilities away from the settlor and his other assets, as well as distance the assets from the investor’s outside liabilities.
In the end, this revocable trust plus two single-member LLCs structure probably accomplishes no more than to provide a temporary speed bump for creditors. But it can also complicate investor’s lives. Attempts to put single properties into separate LLCs sounds good on paper, but may cause problems in acquiring insurance on the properties at the best rates. Since insurance is the best form of asset protection found anywhere, this can be a downer.
Real asset protection is not easy, and requires some working knowledge of a lot of areas of law. Basic knowledge of all of creditor-debtor law, trust law, LLC law, bankruptcy law, tax law, etc. & etc., are necessary to create a workable asset protection plan. A person who is not at least somewhat knowledgeable in these areas has as much chance of creating a quality asset protection plan than they do of creating a flying 747 in their garage. For instance, having a decent knowledge of bankruptcy law would tell one that in the event the investor had to file for personal bankruptcy for whatever reason, this entire structure and all the properties in the structure would become property of the bankruptcy estate and then liquidated by the bankruptcy trustee.
These days some Youtube guru can present what she thinks is a good asset protection plan and then everybody swallows it has gospel. That the plan has very serious flaws is not known until individual investors experience a bad event and then the flaws become clear. I learned decades ago a good general rule to be applied in the area of asset protection planning: If everybody is doing it, it is probably wrong. At the very least, get a second opinion by somebody who is knowledgeable in this area.
I suspect that folks will now also start using AI to structure their asset protection plans. That will be a real mess. It will be like asking AI for instructions on how to replace your own knee. Yeah, you’ll get some instructions.
Good for creditors. Not so good for debtors.
Read the full article here