In order to protect both your business and personal assets, it is necessary to make sure that they are kept beyond the reach of creditors. Funding your business by a combination of equity and secured debt is one strategy that can protect your assets. In addition, keeping the title of assets divorced from the entity that runs the business day-to-day also can defeat creditor's claims.
When using holding and operating companies in a multiple-entity approach, there are ways to strategically invest in the business that minimize the risk of loss.
To be effective, any asset protection plan must include a strategy of minimizing the amount of vulnerable capital invested within the operating entity. Specifically, the operating entity's business assets can be protected through:
- the owner personally owning and leasing exempt assets to the operating entity
- a strategic combination of equity and debt funding
- encumbering the operating entity's assets with liens that run in favor of the holding entity or owner
- a practice of regular withdrawals of vulnerable funds as they are generated.
Continuously withdraw unneeded assets
A funding strategy that uses an operating/holding company structure and that also minimizes the amount of vulnerable assets invested in a business will not work unless a plan exists to withdraw, on a regular basis, the assets generated by the operating entity. Otherwise, vulnerable assets will stay within the operating entity, and the owner's liability, while limited, will still be significant, as these assets remain unprotected.
A number of withdrawal strategies exist to accomplish this objective, including salary, lease/loan payments, and sale of accounts receivable to the owner or the holding entity.
Creditors can attack the initial capitalization of an entity as fraudulent under a doctrine termed "piercing of the veil" of limited liability.
Creditors also can attack withdrawals, as well as the creation of liens, as fraudulent conveyances (see our discussion, "How to Avoid Asset Transfer Challenges").
Be especially cognizant of the entity's financial position (assets minus liabilities) when creating liens because insolvency can be a basis for creditors to attack these transfers.
A good practice is to leave a portion of the assets contributed for the equity interest unencumbered. This practice is insurance that the entity will not be insolvent, from a balance sheet analysis, when liens and other transfers take place.
Fund operations by personally owning and leasing exempt assets
When executing funding strategies for your operating and holding companies, one approach can be for you to personally own and lease to the operating entity assets that you can shield as exempt assets under you state's asset protection statutes. These can include assets such as office equipment, furniture, automobiles and other "tools of the trade."
This is most effective for assets that do not have a high risk of causing personal injuries. This strategy adds an extra layer of protection for business assets. If you contribute exempt assets to the business, instead of owning and leasing, you lose this extra layer of protection because the business can not claim any protection under asset exemption laws.
Asset exemptions are available only to natural persons, and not to business entities such as limited liability companies (LLCs) or corporations. Thus, a contribution of an exempt asset to the business entity will mean a loss of the exemption. As a rule, then, exempt assets should not be contributed into the business entity, and certain exempt assets, including a home, should never be contributed to a business entity.
Holding these assets outside the entity allows the owner to continue to claim his asset exemptions under bankruptcy and state court proceedings. Moreover, leases allow the owner to withdraw vulnerable funds from the entity. Clearly, the strategy of personally owning business assets can form the basis for multiple strategies.
Beware of personally owning high-risk assets
Exempt assets generally should not be contributed to the business entity. However, this is not the case with assets that pose a high risk of causing personal injuries. For example, high-risk assets, such as factory machinery or heavy equipment, generally should be contributed to the entity, because liability may run to the owner of the asset. Though the asset exemption is lost, the overall risks are reduced.
However, you can protect these assets in many cases by utilizing a multiple-entity organizational structure. Note that these assets can be contributed to the holding entity or to the operating entity. The following rules of thumb should be applied
- Where there is an especially high risk of injury, the assets should be contributed to the operating entity, and then encumbered with liens in favor of the holding entity or owner.
- Where the assets are especially valuable, and of only moderate risk, the holding entity may be a more appropriate reservoir for these assets.
Alternatively, the owner may personally own, and lease to the operating entity, certain high-risk assets, if he is sure he carries more than an adequate amount of liability coverage. This alternative is somewhat risky, as tort judgments can sometimes be extreme. This alternative becomes more attractive in a state with no cap on its exemption for tools of the trade.
Funding options can increase asset protection
Some assets will be inherently low risk, such as office equipment and furniture. These assets are ideal candidates for the contribution strategy. Moreover, these types of assets usually will be exempt as "tools of the trade". The actual exemption available in the particular state in question also should be determined as well, as states differ significantly in the amounts, and types, of tools of the trade they protect. This strategy will be most effective in states that have no cap on the tools of the trade exemption.
Other assets can have a high or low risk, depending on the circumstances. For example, an automobile driven only by the owner may be low risk, while automobiles or trucks driven by other employees generally will be high risk. Thus, in the former case, it may be possible to personally own and lease the assets to the operating entity, while in the latter case, it may make more sense to contribute the assets.
Combining equity and debt funding maximizes asset protection
When executing funding strategies for your operating/holding company business structure, it is important to balance your equity contributions and debt load, to ensure your asset protection plans reach their full potential.
When the owner forms his limited liability company (LLC) or corporation, he will take back an ownership or equity interest, signifying that he is as an owner, as opposed to a creditor, of the entity. After all, in a properly structured multiple-entity business operation you will serve in both roles.
In the LLC, the owner takes back a membership interest as a "member." In the corporation, the owner tales back an ownership interest in the form of common stock as a "shareholder." Certificates, evidencing the ownership interest, should always be used, in both the LLC and the corporation, even though by law they are not always required. (See our discussion on the formation and management of the LLC and corporation).
In return for this ownership or equity interest, you must contribute some assets to the business entity. As noted earlier, the general rule is that exempt assets should not be contributed to the business entity. The discussion here is assumed to apply to nonexempt assets, such as an office building, cash, etc., or to high-risk exempt assets, that might be contributed as an exception to this general rule.
Note that when high-risk assets are contributed in return for an equity interest, they may be contributed to the holding entity or the operating entity. Where there is an especially high risk of injury, the assets should be contributed to the operating entity, and then encumbered with liens in favor of the holding entity or owner. Any liability would then run only to the operating entity, while the asset would still be protected.
Where the assets are especially valuable, and of only moderate risk, the holding entity may be a more appropriate owner for these assets. The assets can then be leased to the operating entity. Here, the risk of loss associated with the operating entity owning these assets would probably outweigh the risk of any liability running back to the holding entity.
Funding the equity interest in the holding and operating entities normally can be accomplished tax-free, as can funding the entities with debt (leases and loans).
However, a contribution in return for the equity interest can sometimes be a taxable event or have other unanticipated tax consequences.
Moreover, if you do not follow some specific guidelines for establishing both the equity interest in the operating entity and the equity interest in the holding company, you run the risk of losing the limited liability and asset protections you've worked so hard to put in place.