Updated December 8, 2020
I received an email from a client recently who was concerned about some information she received from a promoter of Wyoming and Nevada LLCs. She was told that a Wyoming LLC registered to conduct business in California will provide greater protection from charging orders than a California LLC. I hear this same argument from time to time and thought that I should share my response:
Dear Jane Doe,
In my opinion, a WY LLC or an NV LLC registered to do business in California would not prevent the creditor of a member from enforcing a charging order against the LLC. Why?
When it comes to asset protection and LLCs we are concerned with two forms of liability — inside liability and outside liability. With inside liability, the primary concern is protecting ourselves as members from liabilities associated with the activities taking place in the LLC e.g., rental real estate. The protection for inside liability claims is derived from two places: state law and the LLC operating agreement that governs how the LLC is run and the protection it offers to its members. Most states are fairly uniform in their approach to inside protection. Liabilities that occur inside an LLC remain inside and will not attach to the owners of the LLC. Of course, this is contingent upon having a solid LLC operating agreement that has adequate protection and indemnification provisions for the member and managers. Unfortunately, when I review a client’s operating agreement it is not uncommon to find two or three critical defects that, if exposed in a lawsuit, could spell disaster. Nevertheless, with the protection provided by state law and a good operating agreement, the LLC offers excellent protection from the liabilities associated with owning real estate. Thus, if you created a California LLC or a Wyoming LLC registered in California to hold your rental real estate, both entities will protect you from claims arising out of liabilities associated with the LLC’s assets. If, on the other hand, you simply set up a Wyoming LLC to hold the property without registering it California, it would provide you no protection whatsoever.
Outside liability protection is just the opposite. Rather than looking to the assets of the LLC for recovery, a creditor is seeking a judgment against an LLC member because it is the member that caused the harm and not the LLC. Most people I meet completely miss this point because so much attention is given to protecting you from your real estate that very little thought is given to your personal actions or, for that matter, those of your children who could also jeopardize your investments. You, by your everyday actions, are probably the greatest threat to your assets.
Nilse, an avid real estate investor, is traveling in his new BMW 7-series sedan on Interstate 5. Confused by the electronics, his focus is on the stereo and not the road! Because his attention is diverted, Nilse does not see the car in front of him suddenly brake. Nilse plows into the car, causing substantial damage to both vehicles and injuries to the occupants of the other vehicle. If Nilse owns his real estate investments in his personal name, he is at serious risk. Fortunately for Nilse, his attorney recommended he place his investments in LLCs. How does the LLC help Nilse? It has to do with state law and what the creditor of an LLC member can reach when he collects on his judgment.
Every state has, to some extent, given LLC members what the law refers to as “charging order” protections. Unlike the situation with “Inside Liability” where the creditor can only look to the assets of the LLC and not the members individually for recovery, with outside liability the creditor is looking to recover against the member’s assets. Your LLC membership interest, like the stock you own in a publicly traded company, is an asset that is considered personal property. One important feature of this asset is its unique characteristics that prevent creditors from levying on it if they have obtained a judgment against you personally. Approximately 23 states, Nevada and Wyoming included in this number, limit the judgment creditor to a charging order.
The benefit of the charging order is it limits your judgment creditor to a lien on any distributions you decide to make from your LLC. If you do not make distributions, then your creditor does not collect on the judgment. It sounds great and it is, but unfortunately, all states do not adhere to the charging order as the sole remedy. Some states, like California, go so far as to allow a judgment creditor to foreclose on the member’s interest if the LLC is not making distributions. For many investors, this is disconcerting given that the state requires the investor to have an LLC registered in the state if it is to hold real estate (the statute actually refers to conducting business and renting property falls within this definition). To trump a state like California and its creditor-friendly approach to asset protection, many investors will establish an LLC in a state like Nevada or Wyoming then register their LLC to conduct business in California as a foreign LLC. These investors believe that California must apply the law of the entity’s home jurisdiction when it comes to matters of charging order protections. For example, if I created a Nevada LLC (remember Nevada does not allow any remedy other than a charging order) then register it in California as a foreign LLC, I will be immune from California’s approach to the charging order should someone attempt to collect on my LLC interest. Unfortunately, California and every other state that I have researched does not take this approach.
Under California Corporation Code 17450 the laws of the state … under which a foreign limited liability company is organized shall govern its organization and internal affairs and the liability and authority of its managers and members. In other words, the laws of the state of an organization will govern any claims arising between the members or managers with respect to the inner workings of the company or between the company and its members or managers. The enforcement of a charging order on a member’s LLC interest does not fall within the statute’s definition. A charging order is the application of a judgment against personal property held by a California resident. Thus, if I am a creditor and I obtain a charging order against a California’s resident’s interest in their Nevada LLC registered to conduct business in California, I can, under California Corporation Code 17402, foreclose on the member’s interest. This is not considered part of the affairs or internal workings of the company.
In layman’s terms, this means I can foreclose on your out-of-state LLC because it has availed itself of California’s laws when it registered to conduct business in California. To obtain the protections offered by Wyoming or the other strong asset protection states you can create an LLC in one of these states and have it own your California LLCs. In this way the out of state LLC does not fall within the jurisdiction of California, nor is it subject to its enforcement actions.