Asset Protection in Texas

Topics Covered

Texas Homestead Law
Forming Traditional and Series LLCs
LLC Documentation and Structuring
Asset Protection Strategies Before and After Suit
The Two-Company Structure
The Hub-Sub Structure
Avoid Personal Guarantees
Information Needed from an Asset Protection Client

Texas History

Texas has an established history of being a haven for debtors. For over a hundred years there has been a saying “So-and-so has gone to Texas.” Sometimes this meant the person had physically relocated to Texas; just as often it implied that he had left town to beat his creditors. This grand if ethically sketchy tradition continues. The Texas Constitution, the Business Organizations Code, and the Property Code make it possible for individuals and businesses to establish fortress-like operating structures and shield substantial income and assets from execution upon a judgment. Together, these laws make the Lone Star State an advantageous venue for asset protection.

TEXAS HOMESTEAD LAW

Homestead Protections are for Individuals

Texas offers unique protections for its residents that should be integrated into any asset protection plan. These are contained principally in the Texas Constitution Article XVI, Section 50 and in Texas Property Code Chapters 41 and 42. They apply to both income and assets.

In other states, execution on a judgment can strip you of your possessions and put you on the street, but that is usually not true in Texas. If a lawsuit is anticipated, or if a judgment creditor is expected to attempt collection, then it is wise to review and maximize these protections well in advance of litigation. It is even wiser to formulate an asset protection strategy long before adverse events occur.

The Homestead Residence

The homestead is the crown jewel of exemptions. It is protected from forced sale for purposes of paying debts and judgments except in cases of purchase money, taxes (both ad valorem and federal tax liens against both spouses), owelty of partition (divorce), home improvement loans, home equity loans, reverse mortgages, liens pre-dating the establishment of homestead, refinance loans, or the conversion or refinance of a lien on a mobile home that is attached to the homestead. Other liens are void.

No matter how much one’s home is worth, an ordinary judgment creditor cannot force its sale in the absence of fraud. In re. McCombs, 659 F.3d 503, 507 (5th Cir. 2011). Texas homestead laws are liberally construed by the courts. London v. London, 342 S.W.3d 768, 776 (Tex.App.—Houston [14th Dist.] 2011, no pet.). Other than the types of encumbrances listed in [Property Code Section] 41.001(b), “judgment liens that have been properly abstracted nevertheless cannot attach to a homestead while that property remains homestead.” Fairfield Fin. Grp. v. Synnott, 300 S.W.3d 316, 320 (Tex.App.—Austin, 2009, no pet.).

The homestead must be rooted in real estate. As much as one might enjoy living on the water, a yacht is not homestead but moveable chattel, i.e., not realty but personal property. Norris v. Thompson, 215 S.W.3d 851 (Tex. 2007).

Moving the Homestead

It is possible to move one’s equity from one homestead to another. Property Code Section 41.001(c) states: “The homestead claimant’s proceeds of a sale of a homestead are not subject to seizure for a creditor’s claim for six months after the date of sale.” This expressly permits homestead equity to be rolled over. Taylor v. Mosty Bros. Nursery, Inc., 777 S.W.2d 568, 570 (Tex.App.—San Antonio 1989, no writ).

However, beware of the propensity of title companies to collect for payment of judgments upon sale of the homestead in disregard of Section 41.001(c). Some title companies have a self-serving reflex requiring that all judgments on the title commitment should be paid and released. If that occurs, and if the property is homestead, then the seller should aggressively assert Section 41.001(c). If the title company continues to insist that the judgment be paid then the remedy may be to change title companies.

Wages and Personal Property

The Texas Constitution prohibits garnishment of wages, protecting the income of a person who receives a salary or wages. Tex. Const. Article 1, Section 28. A creditor cannot touch either one, at least not while the funds are on their way to the debtor.

Considerable personal property is also exempt from execution. Property Code Sections 42.001 et seq. specifically list the amount and types of exempt personal property, including a vehicle for each licensed driver in the household; home furnishings; and the debtor’s IRA or 401(k). In keeping with Texas’ frontier spirit, you can even keep two horses if you wish.

Other Exempted Personal Assets

Also exempted are certain savings plans “to the extent that the plan, contract, annuity, or account is exempt from federal income tax, or to the extent federal income on the person’s interest deferred until actual payment of benefits to the person” under the Internal Revenue Code (Prop. Code Sec. 42.0021); college tuition funds (including IRS Section 529 funds and accounts established under Subchapter F (Education Code Ch. 54,) which are exempted under Section 42.0022; and the cash value of annuities and life insurance policies exempted under Section 1108.001 of the Insurance Code—at least to the extent those items are exempt from garnishment, attachment, execution, or other seizure under Chapter 42 generally.

The Cash Problem

Cash not associated with a retirement plan is the most vulnerable of all assets, even in Texas. What should a debtor do with it when pursued by creditors? Options are to carefully and incrementally convert it to homestead-exempt assets such as the home or vehicles; use it for reasonable expenses (e.g., retaining an attorney, paying the IRS, paying a child’s tuition, etc.); and progressively withdraw it from the bank over time for legitimate purposes. The conversion process can be tricky, particularly if a lawsuit is already pending. If challenged, a debtor must be able to credibly assert the ordinary-course-of business defense in Property Code Section 42.004.

Conversion of cash into exempt assets should be accomplished in the orderly course of business or personal life for purposes that can be reasonably justified independent of any threatened or pending litigation.

Stocks and Bonds

Two points: first, stocks and bonds are just as vulnerable to a judgment as cash unless they are held in an exempt retirement or tuition savings plan; and second, if one wishes to move such assets out of a personal name, the best alternative is usually a stand-alone traditional LLC that is dedicated to the purpose.

Clients frequently request that stocks and bonds be placed in the same entity as rental properties—perhaps in a different series of the investor’s series holding company. This is a bad idea and not only because it violates the core asset protection principle of keeping like with like. Investment properties (whether residential or commercial) are prolific generators of liability and lawsuits, so it makes little sense to put stocks and bonds into the same entity. Doing so only makes matters easier for a creditor executing on a judgment.

Homestead Exemptions and Registered Entities

Homestead exemptions benefit only individuals, not registered entities like corporations, LLCs, or limited partnerships. This is the reason that a red line should be drawn between investments assets and the homestead. It is not prudent to mix non-exempt investments and the homestead in the same entity.

In Texas, stock in a corporation is non-exempt personal property (BOC Sec. 21.801) that can be subject to levy (Tex. R. Civ. P. 641; Bus. & Com. Code Sec. 8.112), garnishment (Tex. R. Civ. P. 669), or turnover (Civ. Prac. & Rem. Code Sec. 31.002).

However, partnership and LLC interests are subject only to a charging order, which means that if distributions occur, and only if they occur, then the creditor may attach them (see BOC Sec. 101.112 re. LLCs and Sec. 152.308 re. partnerships).

BEYOND HOMESTEAD PROTECTIONS:
FORMING AN LLC FOR INVESTMENTS

Transferring Investment Assets to the LLC

For those who seeking to defend assets beyond the homestead, the next level of asset protection is achieved by (1) forming an LLC to own non-homestead investment properties, and (2) transferring these properties into the LLC using a general or special warranty deed. If the asset is a business or other non-realty item, then a bill of sale or assignment of interest is used.

The due-on-sale clause (contained in nearly all residential deeds of trust) is seldom an issue in this context. Lenders are highly unlikely to accelerate a performing loan when an investors transfers a property into the investor’s personal LLC for asset protection purposes.

LLC Documents as Deterrence

All LLC documents should be drafted with a view toward (1) asset protection generally and (2) with the expectation they will survive court scrutiny if the company is sued. In this sense, deterrence becomes part of the purpose of LLC documentation. Example: the company agreement may provide for two classes of membership interest: Class A for regular members and Class B for creditors who acquire an interest or influence (directly or indirectly) in the company.

In this setup, owners of Class B are second-class citizens. Class B is unable to vote, may not serve as manager, may not direct that assets be encumbered or sold, and may not alter or impair the company’s ability to do business. What sensible plaintiffs’ attorney would want to spend time and money suing a company when a victory would consist of acquiring influence over Class B? Reluctance would increase if the attorney is being paid by means of a contingent fee. This is part of a core strategy of putting up obstacle after obstacle in order to exhaust an opponent’s resolve and resources.

LLC Documentary Maintenance

Minimum company actions and formalities should be prudently observed—not because they are legally required (strictly speaking, they are not in Texas) but because they enhance the appearance of legitimacy and propriety if the LLC is ever challenged in court. Any experienced litigator will tell you that such things matter in the outcome of a court case.

LLC documentation should include well-drafted organizational minutes and a company agreement; issuance of membership certificates; minutes of annual meetings; obtaining an EIN and filing tax returns; having a separate company bank account; and other actions to validate the independent nature of the entity.

Failure to perform routine documentary maintenance when accompanied by allegations of actual fraud can make a company vulnerable to piercing-the-veil allegations. Although they do not often succeed, piercing allegations are common in business lawsuits.

Even if attempts at veil piercing fail (as they should in Texas in the absence of actual fraud), it is time-consuming and expensive to dispose of them. Why offer the opposition an opening on these issues? It is a given that a creditor-plaintiff will ask to see the contents of the company book during the discovery process. When produced, the documentation should be flawless.

LLC STRUCTURING

The Classic Two-Company Structure

A sound asset protection structure for real estate investors involves two LLCs, one to hold title to assets (a holding company) and the other to manage them and engage with third parties (a management company). The holding company is usually a series LLC while the management company is a traditional LLC.

The management company is visible and active. It collects rents, signs leases, deals with contractors and vendors, employs personnel, leases office furniture and vehicles, and is otherwise the public face of the business. It is a separate, stand-alone entity with no serious assets. It is, in fact, an intentional target for litigation. If sued, one remedy is to walk away, form a new management company, and continue business as usual with minimal loss.

Separation of assets (held in the holding company) from activities (conducted by the management company) must be rigorously maintained if the effectiveness of the structure is to be preserved. Few people, especially tenants in rental properties, should even know that the holding company even exists.

The holding company does no business with anyone, has no privity with anyone, and therefore there is no legitimate basis for a cause of action against it.

Identity of the Investor

The investor should instruct tenants, creditors, vendors, and the public generally that they are doing business with the management LLC’s chosen DBA, and checks should be written accordingly. Invoices, payments, and the like should all be sent to the management company DBA rather than to the investor individually.

The investor’s personal name should not appear in any public-facing business transactions except perhaps in the capacity of an authorized representative signing on behalf of an entity. Caveat: if a tenant requests the proper legal name of the landlord’s business (management or ownership) then the landlord must provide it. Prop. Code Sec. 92.201.

The Hub-Sub Anonymity Structure

The hub-sub structure integrates various assets and enterprises into a double-layered two-company structure with multiple firewalls. The heart of the structure is the hub company—a series LLC which is in turn owned by an anonymity trust. The attorney acts as organizer and, for Texas LLCs, as registered agent.

Series A of the hub company owns another series company (usually a Texas series LLC). This second series entity is thus a wholly-owned subsidiary of (and managed by) series A of the hub company. Again, the attorney acts as organizer to maximize anonymity.

The subsidiary series LLC is the actual holding company where individual rental properties are held. Series A of the sub company may own 123 Oak Street; series B 458 Elm Street; and so on.

The unique value of the hub-sub structure lies in entity layering that (1) uses two series LLCs that are (2) structured so as to maximize available anonymity.

What about the other series of the hub company? These other series are open and available for the investor’s other business interests. The result is a compact, efficient, and largely anonymous structure which provides a diversified investor with everything he needs and nothing he does not.

ASSET PROTECTION STRATEGIES
BEFORE AND AFTER SUIT

Pre-Suit Asset Protection Strategies

Asset protection strategies fall into two groups: (1) strategies implemented in advance of suit by a plaintiff or judgment creditor and (2) strategies that are feasible afterward. It is preferable to plan ahead and be prepared, since the range of pre-suit alternatives is far greater before suit is filed.

After suit is filed, depending on the circumstances, options are reduced by laws relating to fraudulent transfers—moving assets around to defeat legitimate claims of creditors. Creditors and courts are on the lookout for these.

For details, look at the Uniform Fraudulent Transfer Act found in Chapter 24 of the Business Organizations Code. The purpose of UFTA is to prevent debtors from placing assets beyond the reach of creditors. See also Mladenka v. Mladenka, 130 S.W.3d 397 (Tex.App.—Houston [14th Dist.] 2004, no pet.).

Post-Suit Strategies

Once litigation begins, the court may be asked to set aside or unwind obvious attempts by the defendant to manipulate and maneuver assets beyond the reach of the plaintiff. Even exempt assets can be at risk. Property Code Section 42.004 states that an exemption is lost if non-exempt assets are used to buy or pay down indebtedness on exempt assets “with the intent to defraud, delay, or hinder” a creditor. The defense? The transfer was made in the ordinary course of business as permitted by Property Code Section 42.004(c).

The Property Code protects actions and transfers undertaken in the ordinary course of business and daily life. Competent planning should include preparation to make effective and legitimate use of this defense.

Badges of Fraud

Fraudulent transfers are generally indicated by badges of fraud including transfers to a family member; whether or not suit was threatened before it was filed; whether the transfer was of substantially all of the person’s assets; whether assets have been removed, undisclosed, or concealed; whether there was equivalent consideration for the transfer (as opposed to a gift or a transfer for $10 and other valuable consideration); and whether or not, after the transfer, the transferor became essentially insolvent as a result (made his cash or other non-exempt assets disappear all at once).

Look-Back Period

Waiting until one has no recourse remaining other than to engage in questionable or fraudulent transfers is poor asset protection planning. Courts may to reach back up to two years in cases of fraudulent transfers.

In a post-suit strategy, it is important to move assets so as to be able to convincingly claim that a certain action would have been taken anyway, for good reasons that have nothing to do with avoiding a creditor’s claims.

After all, life does not end merely because a lawsuit has been threatened or filed, so this should not be a difficult argument to make. People continue to engage in commerce, buy and sell houses and vehicles, make new investments, and otherwise go about the business of living and supporting themselves and their dependents.

Post-Judgment Discovery

How do creditor-plaintiffs find out when one moves around? Principally by using the discovery process—interrogatories, requests for production of documents, and depositions, all required to be answered under oath.

The scope of post-judgment discovery can reach back several years. The plaintiff (now a judgment creditor) can go beyond the facts of the case and compel disclosure of unrelated sources of income as well as the location and value of all assets—even assets that are legally exempt and which (supposedly) cannot be touched.

Anonymity Strategies

An LLC can provide a measure of anonymity depending on the amount of information that is disclosed in the certificate of formation. The certificate of formation requires three names and addresses: the registered agent (physical address only), the initial manager (a post office box is acceptable), and the organizer (often the attorney).

Anonymity (to the extent that it can be achieved) begins at LLC formation. It cannot be added on later.

Avoid using the home as the registered address. Disclosing it hardly enhances anonymity, nor does it prevent a constable from banging on your door at 5:30 a.m. to serve a lawsuit. The world is both a legally and physically dangerous place. We have a client whose home was bombed by an angry tenant. Tenants, vendors, contractors, and the public at large should never have an investor’s homestead address.

The COF requires a physical address, not a box, for the registered agent since the constable cannot serve a mailbox. Recently, the Secretary of State has become more aggressive in checking whether or not registered addresses are really mailbox stores. They occasionally even google a proposed registered agent address. If they think it is a postal box, the COF will likely be rejected.

The COF also requires the designation of an initial manager. This is usually where the owner’s name goes. A creative approach is to name an anonymity trust in this capacity, but this is an advanced technique to be used only with guidance from an attorney.

Multiple Properties in Multiple Jurisdictions

It is common for real estate investors to have properties in different states. One must be mindful, however, that the U.S. is a federalized republic with 51 principal sets of laws and rules of procedure (50 states plus the federal system). This adds both complexity and the need to have legal advisors in each of the jurisdictions where one owns property. Newer investors may be unprepared for this, hoping that their Texas or California lawyer can also handle their Florida duplex. Unfortunately, that is not the case. Choosing multiple properties in multiple jurisdictions has practical consequences.

The Strategic Role of Insurance

Is liability insurance alone sufficient for asset protection? No. Insurance is a passive measure that has its place in the mix; however, asset protection experts recommend a blend of insurance and active asset protection measures such as forming a two-company structure.

Insurance can never be truly relied upon since insurers are openly engaged in the business model of collecting premiums and denying claims. Expect that every effort will be made by an insurer to exclude or avoid coverage in case of loss. Also, there may also be special issues if a creditor-plaintiff alleges fraud since fraud is never covered.

Even if an insurer concedes coverage, extravagant claims made plaintiffs may (and often do) exceed available limits. Moreover, the existence of a sizable policy and umbrella may actually encourage a lawsuit because it will be perceived as a tempting target. Even so, having adequate insurance is a necessary precaution.

Bankruptcy

Bankruptcy is the nuclear option in asset protection. Rules against fraudulent transfers (preferences in Bankruptcy Code) apply in this area as well, and more strictly. The bankruptcy court can reach back a year or more. Also, suspicious or false information in a bankruptcy petition may be investigated by the FBI. And of course bankruptcy does not discharge income taxes (although the IRS may be more likely to work with you on a payment plan), child support obligations, student loans, and any items that a debtor fails to list on the petition.

The Bankruptcy Code allows a debtor to choose between the federal exemptions (i.e., list of exempt assets) or the state ones. In Texas it is more common to choose the state exemptions since they are more favorable.

By and large, filing bankruptcy is an admission that previous asset protection strategies have failed.

AVOID PERSONAL GUARANTEES

No Real Defense

Business lawyers who have practiced for any substantial period of time have many stories of clients ruined by personal guarantees. A typical case is a physician-oriented real estate investment that calls for personal guarantees of the entire seven-figure project (an apartment or strip center, for instance). This can end catastrophically for the individual investors.

There is no real defense against a valid personal guarantee in the absence of actual fraud by the lender—and a valid guarantee is absurdly easy to write. Large law firms are fond of writing guaranty agreements that go on for page after page, but the truth is that one sentence will usually do the job.

Many guarantees state that they are “unlimited, full, and unconditional.” If one is going to sign a guarantee at all, one should at least beware of guarantees that are not capped in terms of monetary amount or in duration of time. In such cases the guarantor winds up being liable for the entire underlying debt, and this liability goes on until the indebtedness is paid or the statute of limitations (four years from the date of default) expires. Thus the result of a casual signature on a personal guaranty can be a serious contingent liability that lasts for many years, even decades.

Guarantors Have Joint and Several Liability

When the lender sues, liability is joint and several with the primary borrower for the full amount of the debt. The judgment will be for all unpaid principal, interest, costs, and attorney’s fees. The judgment amount then accrues interest over time as well.

This firm has assisted many guarantors who have fled their state of origin in favor of Texas in order to sink their remaining assets into a protected homestead that cannot be taken by the lender under Texas law. This is a substantial life disruption—all for a one-page personal guaranty that was signed without a second thought.

When it comes to personal guarantees, the best policy is to just say no. If this is not practical under the circumstances (and it may not be), every effort should be made to limit the extent and scope of the guaranty. There are a number of ways to do this. For example, a monetary cap can be imposed on the guarantor’s liability; the guaranty can be limited to a certain period of time (say one year); and it can include so-called “bad-boy carveouts” that exclude liability in the event the borrower commits fraud or a material misrepresentation. Liability for exemplary damages can also be expressly excluded.

What the Attorney Needs from the Client

When designing a new asset protection plan, an attorney needs to consider a number of factors:

(1) What is the client’s existing structure if any? Can parts of it be salvaged or updated for ongoing use? If there are existing entities, are they in good standing? Obtain copies of the certificates of formation, certificates of filing, company agreements, any meetings of members, etc. in order to evaluate their usefulness (or lack thereof) going forward. Existing entities may have to be updated and extensively redocumented in order for them to be of use. Interests may have to be assigned and properties re-deeded.

(2) What is the present nature of the client’s business and where does he want to take it in five years? Can all goals be accommodated within the same proposed structure? If the client has diverse goals then some ventures may belong in their own single-purpose entities, unmixed with other businesses.

(3) Is litigation pending or threatened? At what stage is that litigation? Is the client competently represented in those matters?

(4) Are there unpaid judgments? Obtain copies of these to see exactly which persons or entities are liable.

(5) Are there partners or co-venturers involved? If so, and if their interests diverge, the lawyer may need to advise them to obtain their own counsel. It should not always be assumed (for instance) that different unrelated members of an LLC have identical goals or interests.

(6) In what capacity will various participants be involved? It may be best for the respective partners or members to each form a personal LLC and then create an asset protection super-structure that is built upon these individual LLCs. An example would be a joint venture which should almost always be set up as an association of LLCs rather than individuals.

(7) What is the client’s level of commitment to asset protection? This varies widely. Clients often arrive with either a minimalist or maximalist mindset. It is also important to ascertain whether or not the client is willing to engage in the layering of entities to enhance the sturdiness of the structure. In certain cases, a layered structure may be the only way to achieve an acceptable level of asset protection.

(8) Lastly, what is the client’s budget? If the client says that he wants an anonymous two-company structure combined with a trust but his budget is only $2,500, then the lawyer will need to tell him that his goal is unrealistic at that level of investment. One can buy a Ford or a Mercedes, but not usually at the same price.

Conclusion

Intelligent asset protection requires an awareness not only of the structures and transactions but also of potential outcomes and consequences. No contract or transaction should ever be entered into without consideration of the asset protection ramifications if the deal fails. It is often the attorney who must counsel a starry-eyed, in-a-rush client that a proposed transaction could fail as well as succeed. In the event of failure, what is the exit strategy? Which of the client’s assets will be exposed and how can that exposure be limited?