Many people believe that when it comes to proactive legal planning – in estate planning, asset protection, or business formation – they have to create legal structures under the laws of their home state. They don’t realize that in many cases there are significant limitations or disadvantages to using their home law. They are often unaware of important characteristics of their home state law, and they don’t realize that in most cases, they can employ a more favorable state’s laws for their strategies.
Whose trust is it, anyway?
For example, there are fundamental differences in the quality of trust laws from one state to the next. States generally take one of two general approaches in forming their trust laws, resulting in a confusing patchwork of laws across the U.S.
A more traditional approach favors “settlor intent” – that is, it places a priority on what the settlor wanted to accomplish when he or she first created the trust. (The “settlor” is the person who establishes the trust and puts their property in it.) This first approach usually results in greater privacy for the settlor, greater asset protection for the beneficiaries, and fewer remedies for future creditors.
The second, more modern approach, tends to diminish the importance of the settlor’s intent and gives more rights to the beneficiaries. (The “beneficiaries” are the people who inherit property through a trust.) While that generally seems appealing from the beneficiary’s perspective, it also increases the rights of future creditors and diminishes the asset protection inside the trust. (This is the path Colorado is choosing to follow.)
We favor the more traditional approach that protects assets to the greatest extent allowed by law and creating as much privacy as possible for our clients. We typically employ the laws of more protective, private jurisdictions in our clients’ estate and asset protection plans. We include multi-state flexibility even in our most modest plans to provide that protection and privacy.
How good is that corporate veil?
Another example of the differences in state law: the level of protection for LLCs.
Limited liability companies (LLCs) have become the most common corporate form for small businesses. They’re flexible, easy to set up, and every state has default rules for operating an LLC. But the level of protection and privacy an LLC provides differs dramatically from state to state. (Please see the earlier discussion about corporate veils here.)
LLCs are generally simpler to operate than statutory corporations. Unlike corporations, LLCs are not required by law to keep detailed minute books, post meeting notices, or follow other strict corporate formalities. (Although it’s definitely a best practice to keep detailed records of company decisions.)
Also, LLCs are “tax chameleons.” They can be taxed as a sole proprietorship (in the case of a single-member LLC) or as a partnership (in the case of a multi-member LLC), or as an S Corporation or a C Corporation (whether single- or multi-member) if the company needs a different kind of tax status. Electing tax status is as simple as completing a quick form from the IRS.
The level of asset protection and privacy of company information differs dramatically from state to state. For example, Colorado law provides that a creditor may be given a “charging order” against an owner’s interest in the company in the event of a successful lawsuit. The essence of a charging order is to allow the creditor to receive the owner’s distributions of money from the company, but not to seize the owner’s equity in the company to force the company to liquidate assets.
BUT, Colorado law also provides that the creditor can petition the court to have a receiver appointed to foreclose on the charging order, or to force a company sale to satisfy the creditor’s claim. Colorado simply does not have very business friendly LLC laws.
What about the nosy neighbor?
Colorado has sought to make it extremely easy for individuals to form LLCs online. This has created the unintended consequence of making it very easy for curiosity seekers to find detailed information about a company, its owner, the company’s business address, and other important records. Someone with bad intent could even file other official company documents online or even dissolve the company without the business owner’s knowledge! These and other weaknesses in state law make Colorado an unattractive jurisdiction to form LLCs.
Other states expressly provide that a charging order is a creditor’s exclusive remedy and that the creditor cannot force a foreclosure or have a lien placed against the LLC owner’s interest. More protective, business friendly states also limit the amount of information available online, making it much more difficult for curiosity seekers or others to meddle in the company’s affairs.
Think outside your state’s borders.
Proper trust and business formation starts with understanding the nature of your own state’s laws, and knowing its limitations. Beyond that, it’s essential to understand that there are far more favorable options available under the laws of more protective states if you know what to look for and how to plan. Sometimes there’s no place like someone else’s home to set up your plan.