How Trusts Can Be Used to Protect LLCs From Creditors

Combining limited liability companies with domestic asset protection trusts can achieve maximum asset protection.

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Three stacked wooden blocks spell out the initials LLC.
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Editor’s note: This is part 14 of an ongoing series about using trusts and LLCs in estate planning, asset protection and tax planning. The effectiveness of these powerful tools — especially for asset protection and tax planning — depends very much on how they are configured to work together and whether certain types of control over assets and property are surrendered by the property owner. See below for links to the other articles in the series.

Even though the owner of a limited liability company (LLC) is generally protected from a lawsuit originating from inside of an LLC — the legal disaster cannot usually harm the LLC owner, as I wrote about in my previous article, Limited Liability Companies (LLCs): How Assets Are Protected — the LLC itself is not protected from a lawsuit originating from outside of the LLC, or against the LLC owner personally.

Put differently, a personal lawsuit can come downstream from the LLC owner or their family (sometimes called “reverse veil piercing”), permitting the judgment creditor who wins the litigation to recover any property that the losing side owns, and the winner of a lawsuit can even recover against the assets of an LLC that is owned by the loser of a lawsuit.

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Example. A landlord owns five rental properties in LLCs and wants to protect the rental properties owned by the LLCs from lawsuits. So the landlord decides to transfer the LLCs into a holding company, believing that the holding company will provide additional asset protection. Later, the landlord loses a personal lawsuit not related to the rental properties in the LLC, and the judgment creditor forecloses on the landlord’s holding company, making it even easier for the judgment creditor to gain possession of all five LLCs by simply taking over the holding company.

Why using a trust is essential

Many of the clients I counsel initially believe that they can form an LLC holding company to protect multiple LLCs from a personal creditor, but because a person owns the holding company, that company is considered a personal asset. So if the person is sued by a creditor, then the company can be used to satisfy a personal judgment. Using a trust is essential to remove the ownership of LLCs from humans who have a hand to shake — or throat to choke.

Because of the asset protection limitations with LLCs, from 2014 to 2015, I worked on a committee to survey asset protection trust statutes around the country and help to draft and enact an asset protection trust statute in Utah. By placing an LLC into a domestic asset protection trust, a person can both protect themselves from judgements and liabilities originating inside of the LLC, and also protect the LLC from personal liabilities originating outside of the LLC.

The domestic asset protection trust is an irrevocable trust that usually works best when paired together with a revocable trust to hold LLCs until the transferor has enough liquidity to still meet their obligations before transferring the LLC from the revocable trust and into the irrevocable asset protection trust. This way, a person can ensure that when an LLC is transferred into the irrevocable asset protection trust, the transfer of the LLC is not defective for transfer law purposes.

To give this perspective, a common family trust (revocable trust) can hold the LLCs for a time, with the LLC providing half the protection and estate planning most people are seeking (protection from the LLC customers or renters of LLC property), and after the owner of the LLC has enough liquidity to comply with transfer laws, the LLCs can be transferred into an irrevocable domestic asset protection trust to provide the other half of the protection people want by protecting the LLC itself from their personal creditors.

Order of creation can matter

LLCs must be used together with irrevocable trusts to fortify against both inside and outside liabilities. However, LLCs used together with irrevocable asset protection trusts are best formed by the irrevocable trustee acting as the organizer of the LLC from inception. That way, the irrevocable trust is both the forming party, as well as the original owner of the LLC, and no transfer of the LLC from a person to the irrevocable asset protection trust is needed. Not only does this potentially make the LLC more private, but it avoids an additional vulnerability by avoiding the transfer to the irrevocable trust.

Put differently, if an LLC is going to be formed to be fully owned by an asset protection trust, it is a best practice to form the asset protection trust first and then form the LLC after the asset protection trust is running. Otherwise, the LLC will need to be revised and transferred into the trust later, requiring additional paperwork and transfers.

Once again, surrendering control over the LLC to an irrevocable asset protection trust, so that control over the LLC is vested in the irrevocable trust rather than the property owner forming the LLC, is the way to achieve maximum asset protection against inside and outside liabilities.

An LLC owned by an asset protection trust is an effective technique to guard against both upstream and downstream legal attacks.

Paired with irrevocable trusts, LLCs are powerful tools for asset protection, though as with all power tools, LLCs and irrevocable trusts must be formed and operated with caution and with compliance to transfer laws and tax laws.

My next article will explore common mistakes that are made with LLCs.

Other Articles in This Series

Disclaimer

This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.

Rustin Diehl, JD, LLM
Rustin Diehl, JD, LLM
Attorney and Counselor at Law, Allegis Law

Rustin Diehl advises clients on tax, business and estate planning matters. Rustin serves as an adjunct professor, frequent speaker and is current or former chair of professional associations. Rustin is a prolific author and has published many technical and popular articles on estate and business issues, as well as drafting and advising legislators in developing numerous statutes pertaining to trust and estate and business planning, creditor exemption planning and digital asset (blockchain) trusts and blockchain entities known as decentralized autonomous organizations.

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