People facing potential litigation should be careful when they start a new business venture with a partner. The interest acquired in the business may be vulnerable to future judgment creditors, and the non-debtor partner may be embroiled in the judgment collection. There are alternatives to taking ownership of a business interest in your individual name(s) that provide better asset protection.
Consider, for example, one of my clients who is working with a long-time business associate to advance a start-up internet business. The business currently has no equity or value during the start-up phase, but based upon the partners’ joint business history it is possible the business could be worth a substantial amount of money in the future. The new business has few assets: a bank account, a web domain, and some computer coding. Being aware of my client’s potential legal problems, the partner started the business through an LLC owned 100% by the partner. The partner contributed the small amount of start-up funds required to launch the business.
The business venture anticipates expanding and raising capital in the next year. My client wants to secure his share in the LLC and the business, but does not want to expose the business, his partner, or his LLC interest to his creditors. If he owns part of the LLC his creditors could get a charging lien against distributions. His partner is not willing to restrict profit distributions just to circumvent the charging lien.
I suggested an alternative arrangement using the estate planning tool of an irrevocable trust. The partner, who now owns 100% of the LLC, would create an irrevocable trust for the benefit of my client. The partner would fund the trust with 50% of the LLC interest. My client could contribute money to the trust which in turn could make contributions, through the trustee, to the LLC. My client’s cash contributions would not make the trust “self-settled” because the trust would be established and seeded by the partner. There may be an independent trustee to administer the trust’s participation in the LLC and distributions to my client.
I think the client’s interest in the trust could not be subject to execution by a judgement creditor, and would not be part of my client’s bankruptcy estate, if the trust contained a spendthrift provision and discretionary distributions of income and principal.
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