Mistakes to Avoid with Your LLC or FLP
How to Avoid Mistakes Creating an Asset Protection Plan
A recent case regarding Limited Liability Companies and Limited Partnerships in Texas will negatively affect some people. Some are saying the case, Heckert v. Heckert, decided in December 2017, is a drastic change in Texas law. Three critical issues in the case offer a roadmap for how to avoid mistakes in creating an asset protection plan.
Basic Facts of the Case: Mr. Heckert set up a single member LLC (SMLLC) called Averse 2 Risk, LLC. It was the general partner of a limited partnership, A2R, Ltd. He was the only limited partner. In his mind, he created a Family Limited Partnership (FLP). He transferred financial assets (brokerage accounts) into the FLP. He formed it after the divorce, and his ex-wife had a personal injury suit pending against him when the assets were transferred. The court forced the limited partnership to disgorge the account to her and awarded her $10,000 in attorney’s fees for her trouble.
1. Fraudulent Transfer, Fraudulent Conveyance, or Voidable Transfer
For asset protection purposes, there is no reason to transfer assets that can’t be taken away from you in a lawsuit. Those assets, known as exempt assets, are already safe from attack. Exempt means if you declare bankruptcy, those assets are exempt from the bankruptcy and creditors can’t take them.
Vulnerable assets are those assets that can be taken from you in a lawsuit. Those assets are called non-exempt assets. If you declare bankruptcy, non-exempt assets are turned over to the bankruptcy trustee. The trustee then can distribute those assets to your creditors who have pursued their claims. You may want to protect assets that can be taken away from you in a lawsuit. One asset protection strategy is to transfer vulnerable assets to some type of entity that a lawsuit predator can’t touch.
Not all planning will work, though. As Heckert shows, a plan that looks good can fail. This article is to show you how to avoid the mistakes made in the Heckert case.
When a lawsuit predator wins a lawsuit, he becomes a creditor. Creditors have rights. One creditor right is to make you play by the rules that were in place when the triggering event occurred.
A triggering event is an event that leads to a lawsuit. One key to good planning is to plan before a triggering event occurs. A second key is to transfer assets into the plan before a triggering event. The law presumes that the only reason to transfer after a triggering event is to defraud, hinder, or delay known or likely creditors. It should be obvious, but you can’t buy home insurance after your house burns down and expect the insurance company to pay. You can’t transfer non-exempt assets after a triggering event without raising suspicion.
Terminology has changed in recent years, but this concept is not new. If a transfer occurs after a triggering event occurs, it is a fraudulent transfer, a fraudulent conveyance, or the more modern term “voidable transfer.” A court can reverse those conveyances. There are several tests to determine if a transfer is voidable. Here are questions a court can look at:
- Was there a transfer of non-exempt assets?
- Did the transfer occur after the triggering event?
- If the transfer occurred after the triggering event, was it transferred for fair market value?
- Did the person who transferred the assets have enough assets after the transfer to satisfy any claims?
Applying those questions to the case,  the accounts he transferred to the FLP were non-exempt brokerage accounts. Heckert set up the FLP and  transferred the accounts to it while there was a pending personal injury claim. That personal injury was the triggering event.  He did not sell the assets for their full cash value, but instead contributed them to the FLP and took back partnership interest. The FLP interest was not the same value as the assets contributed. Any restrictions the FLP has on transfers would reduce the value of the partnership interest to less than the value of the assets inside it. Thus, the transfer was for less than fair market value.  Finally, the court found there were not enough non-exempt assets to pay the claim. Heckert lost on all four questions!
Since the claim was pending when the divorced occurred and the assets were divided in the divorce, Heckert never had any real opportunity to protect these assets from that claim. However, we can learn a lesson here. You must set up your asset protection plan before a triggering event occurs.
There is nothing inherently wrong with setting up an asset protection entity after a triggering event; however, don’t try to use that entity to protect the assets transferred to it after a triggering event. Even trying can result in the other side collecting attorney’s fees, which is what happened here. It is only safe to use that entity to protect assets transferred prior to a triggering event. Thus, transfers to an entity after a triggering event can only be protected against future triggering events.
Heckert would not have gotten a second look from asset protection planners if the court had stopped there, but it went further.
2. Charging Orders and Single Person Asset Protection Plans
A little history is in order. When Texas first created LLCs, it followed its limited partnership statutes. The two statutes are almost identical. There are differences between the two entity types for which the law doesn’t account. By state law definition, a partnership is two or more people entering into business to make a profit. There is no such thing as a single person partnership. There is such a thing as a single member limited liability company (SMLLC). That raises the question of whether all parts of the limited partnership statute can apply to a SMLLC.
What does a creditor do when he has a claim against a member of an LLC or a partner in a limited partnership? When assets are in an LLC or FLP, under Texas law, the only remedy available to a creditor is a charging order. A charging order entitles the creditor to receive whatever the debtor would receive out of the entity. It doesn’t allow the creditor to reach into the entity to take assets.
Heckert argued that his creditor’s only remedy was a charging order. The court found that Heckert should not get charging order protection.
The Texas statutes do not say what the result is with a charging order when the entity only involves one person. That has led some to believe charging order protection is available in single member entities because the statute doesn’t say otherwise. That is probably the majority opinion among asset protection planners. The problem is the statutes don’t specifically cover such entities with charging order protection.
The court identified a problem though. The Heckert court said, “The charging order was developed to prevent a judgment creditor’s disruption of an entity’s business by forcing an execution sale of the partner’s or member’s entity interest to satisfy a debt of the individual partner or member.”
The purpose of the charging order is to protect other partners from business being disrupted by the sale of business assets to satisfy the judgment. That is unfair to other partners because the withdrawal of assets could disrupt the business of the partnership. That would destroy the business of innocent partners.
Foreclosure of the partnership or membership interest is not available, either. If the law allowed foreclosure of the partnership interest under attack, other partners could have a new partner forced upon them that they never agreed to have. It is unfair to other partners since a state law partnership is a voluntary entity.
In this case, there was no other partner’s interest to protect. Here, turning over the brokerage accounts doesn’t disrupt any other party. Nor would a turnover order disrupt any business interest.
Charging orders have always been about protecting other partners. For them to apply, I don’t think a single person, or even just a married couple involved, truly gets charging order protection.
While this was a divorce case, the same rule can be applied to married couples. For litigation purposes, a married couple is treated as one person. Even if they contribute separate property to the entity, for litigation I think they are still one person.
The lesson to apply here is don’t expect an entity with a single person, or just a married couple, to obtain charging order protection in Texas. For many years, I’ve been a proponent of getting at least one other partner involved, even if that partner owns only a very small interest.
3. Are Financial Assets Only in an LLC or LP a Risky Plan in Texas?
The Heckert court went even further. It pointed out that the assets were only financial assets. Turning those assets over would not disrupt any operating business. The court mentioned the problem of a lack of a true operating business, but the court didn’t say financial only partnerships or LLCs would necessarily fail. However, the court’s comments at least raise the question of how financial only entities will fare in future cases.
Let us assume that an objective is to protect non-exempt assets that are attractive to creditors. They are attractive because creditors can quickly turn readily accessible cash or “cash equivalents” to cash. Creditors love those types of assets because if they collect the full amount of their claims, they can spend it immediately. Is using an LLC or limited partnership in Texas doomed to fail if the only assets in it are non-business type assets? The court doesn’t say that, but it does hint at that.
The Heckert case is plagued with several problems.
- It involved an asset transfer for less than fair market value after a triggering event occurred. That is always deadly to planning. Planning and transfers must complete prior to the triggering event. The further prior to the triggering event, the safer the planning is.
- It involved a single-person structure. Without another person’s interest to protect, charging order protection likely does not exist.
- Financial assets might have survived attack had the first two problems not existed.
Have your asset protection plan reviewed by someone who understands the significance of the Heckert case. Don’t depend on your own analysis. If your plan doesn’t involve others besides either yourself or you and your spouse, know that charging order protection is not likely to help you. If your plan involves only financial assets, have your plan reviewed for potential issues.
Author: Rex Hogue