Use LLC or LP to Protect Real Estate from Plaintiffs and Creditors

By Jacob Stein, Esq.

With proper planning commercial property owners can protect their property as well as their personal assets from most lawsuits and creditor claims. While you can never completely insulate yourself from every liability that may cross your path or shield your assets from the claims of every creditor, you can make it a lot less attractive for plaintiffs and creditors to pursue your assets. That is the goal of the area of law known as asset protection.

If you can make it so expensive and so difficult for plaintiffs and creditors to get to your assets that they will simply give up the chase, or settle with you on terms that would be much less favorable to them, you have effectively shielded and protected your assets.

Commercial property owners should protect their real estate assets from being depleted by two types of legal claims: those that stem from their property ownership and those that stem from their personal or business actions.

Protection Against Property-Related Claims

Your property exposes you to risks of lawsuits. A tenant may slip and fall, the janitorial staff can be blamed for lost property, or you may simply default on a loan payment. The resulting lawsuit will then be filed against you as the owner of the property. Once the plaintiff obtains a judgment against you, the plaintiff would be able to use that judgment to seize your assets.

This is commonly prevented by owning commercial real estate through a limited liability company (LLC) or a limited partnership (LP). Because these entities have a legal existence separate from yours, a lawsuit directed against one of these entities will generally not put your personal assets at risk.

If the real estate is owned through a limited partnership, then it is important to use a limited liability company as the general partner. That effectively blocks the unlimited liability exposure to which general partners are exposed.

Once the ownership of real estate is transferred to an LLC or LP, any lawsuits directed against the owner of the real estate will name the LLC or the LP—not you—as the defendant. These entities will shield you from lawsuits as long as the courts respect them as separate legal entities. That should not be a problem if you do not pay your personal expenses from the bank account of the legal entity.

Example: My law firm recently represented a client who owned, among many other assets, a small office building through a limited liability company. A visitor to the building was verbally abused by a janitor, and filed a multimillion dollar lawsuit against the LLC, as the owner of the building. Although the lawsuit exceeded the insurance coverage on the building, the client never feared that the lawsuit put his personal assets at risk, because the suit was properly directed against the LLC, and not the client personally.

Protection Against Personal and Business Claims

The other risk of liability exposure has nothing to do with your commercial real estate, but has everything to do with the rest of your life. If, for example, you are involved in a car accident or are sued by a former business partner, and the plaintiff obtains a judgment against you, that judgment would allow the plaintiff to seize any and all of your assets, with a few exceptions.

One of the most important exceptions protects your interests in LLCs and LPs.

If you transfer assets to an LLC or an LP, in the eyes of the law you will no longer be considered the owner of those assets. The assets will now be owned by the legal entity. For example, if you transfer your ownership of a building into an LLC, you will now own the LLC, but—for all legal purposes—you will not own the building.

Because the plaintiff can no longer pursue your building, it is forced to pursue your LLC interest. Forcing the plaintiff to pursue an ownership interest in an LLC or LP is advantageous because interests in those entities cannot be taken from you by creditors or plaintiffs. This is known as the “charging order protection.” The charging order protection limits a plaintiff's ability to put a lien on the distributions from the legal entity, because it doesn't confer on the plaintiff any voting or management rights. Because you will always remain in control of the entity and can defer distributions, the plaintiff will have no way of enforcing the judgment against your LLC or LP interests or the assets owned by these entities.

Assets owned through a corporation are not as protected. There is no charging order protection for corporate stock. This means that the same building owned through a corporation can be seized by a creditor by first seizing the corporate stock and then liquidating the corporation.

For this reason, it is also not recommended to have a corporation act as a general partner in an LP. By seizing the stock of the corporation, the creditor would gain control of the LP. The creditor would then be able to make distributions from the LP and intercept them with a charging order against your LP interest.

Further Benefits of LLCs, LPs

Your interests in LLCs and LPs can be further protected in one of two ways.

The LLC or partnership agreement should provide that, in the event of a charging order, the manager or the general partner should be able to make distributions to every member/partner other than the debtor. These agreements, when entered into by family members, should also incorporate a provision that would allow the other members/partners to buy out the debtor's interest for a nominal sum in the event of a collection action.

The ownership of the interests in these entities may also be transferred into an irrevocable trust. With this structure, you will retain no legal ownership over these entities, and a creditor would not even be able to pursue a charging order. By carefully selecting the right trustee and drafting the trust so that it does not have income tax or estate tax implications, you can have a flexible, tax-neutral structure that you can control and that would provide you with the maximum possible protection from creditors.

As a practical matter, LLCs and LPs create a formidable obstacle to a plaintiff's collection efforts and usually force the plaintiff to drop his collection efforts or to settle. These entities should be considered by all real estate investors for all valuable assets.

Jacob Stein is a partner in the Los Angeles-based law firm of Boldra, Klueger & Stein, LLP, which has protected the assets of over 1,000 public and private companies and wealthy individuals. He can be reached at jacob@lataxlawyers.com.

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Using Equity Strips

It may also be possible to protect commercial real estate within an LLC or LP with an “equity strip.” Creditors do not pursue the real estate itself; they pursue the equity in the real estate. If the real estate has little or no equity, it is not an attractive asset to a creditor.

There are two commonly used equity-stripping techniques.

One technique involves obtaining a bank loan. The bank secures its loan with a deed of trust, reducing the equity. But there are two problems with bank loans: It is difficult to find a lender that would lend an amount sufficient to eliminate 100 percent of the equity, and it may be difficult to find an off-setting investment for the loan proceeds that will pay a higher interest rate than the interest rate you would have to pay on the loan.

Another option is to make it seem as if you are borrowing money from a friend and securing that loan with your property, thereby depleting the equity in your property. In these transactions no actual loan is made. But these transactions are nothing more than shams, and are illegal in some states. Any determined creditor would be able to prove this transaction is a sham, and there will be no protection.