In order to protect assets from creditors, a small business owner can fund the business by encumbering the assets of the business with liens that run in favor of a holding company or the owner himself or herself.
When executing funding strategies for an operating/holding company business structure, small business owners should strategically combine debt and equity funding to maximize asset protection planning. To secure the debt funding, the owner (now acting as a creditor to the operating company) can use liens that run in favor of the holding entity or owner.
These liens must be perfected in order for them to be valid. Mortgages on real property, must be recorded to protect the owner's priority claim, while liens against personal property (i.e., property used inside or outside of a business other than real property) are perfected by filing the Uniform Commercial Code Form 1 (UCC1). This form can be used to perfect a lien when acquiring assets, as well as on existing or future assets.
There is a less complicated alternative to using a holding entity and an operating entity to protect the operating entity's assets: the one-entity approach. Leases, liens and loans are still used, but the business owner personally acts as the holding entity. This method is simpler than using holding and operating entities, but is not always as effective.
Use liens when acquiring assets
In this strategy, when a business acquires assets, the operating company owns the assets, such as a building, but in a way so they are not vulnerable to loss: The operating entity obtains ownership of an asset through a loan of cash from the holding entity (or owner) in exchange for a mortgage or other lien taken back by the holding entity (or owner).
This type of lien is called a “purchase money security interest" because the cash was loaned specifically to purchase the asset, which is then put up as collateral for the loan. The asset is owned by the operating entity, but it is not vulnerable, as the liability represented by the lien, in effect, cancels the value that the asset otherwise would have to an outside creditor of the operating entity.
Upon liquidation, the holding entity (or owner) takes the asset because it is a secured creditor. This leaves the other creditors with little or nothing. The outcome is the same as if the holding company owned the asset and the operating company owned nothing.
Example: An example of this strategy took place in 1994, when Rockefeller Center went bankrupt, apparently jeopardizing $1.3 billion worth of real estate. However, asset protection strategies ensured that none of this real estate was lost to creditors. Rockefeller Properties, two partnerships that acted as operating companies, owned the real estate. However, the real estate was encumbered by a lien, of approximately $1.3 billion, in favor of a corporation, Rockefeller Center Properties, which acted as the holding company.
This structure employed the use of two asset protection strategies: separate operating and holding entities, and ownership of the assets being vested in the operating entity, but with a lien of approximately equal value in favor of the holding entity, which meant the assets were not vulnerable to creditors.
Using liens on existing or future assets
Not only can liens be used when acquiring assets, they can be used when the holding entity (or the owner) makes loans of cash to the operating entity to cover the entity's operating expenses, (i.e., when assets are not being purchased with the proceeds). Liens are then placed on existing assets, and even assets acquired in the future.
Similarly, liens can be created when compensation (salary, bonus, retirement and health plan contributions, etc.) or reimbursement of expenses is owed by the operating entity to the owner, but unpaid. Here, both existing and future-acquired assets once again can be put up as collateral.
Real property liens must be recorded
A lien on real property must be created by a mortgage deed. The promissory note is a separate document detailing the nature of the loan, the repayment terms, etc. The mortgage is the lien, securing the promises made in the promissory note. The exact legal nature of the mortgage varies from state to state.
In some states, the mortgage actually transfers legal title to the creditor, to secure the note. In most states, the mortgage simply creates a security interest in the property, without an actual transfer of title, similar to the way personal property is secured.
The mortgage and the related promissory note must be recorded on the land records in order to make sure that the mortgagor's claim is valid against third parties, including subsequent creditors. The land records are located at the county court house in many states or in the local town clerk's office.
The lien must be recorded to give the owner a priority claim. If the mortgage is not recorded, the claims of other creditors on the real property may take precedence.
States have different rules when it comes to priorities for recorded liens on real property. However, many states follow the general rule that the first to record takes priority. Thus, if the owner fails to record, the holding entity's lien may be ineffective.
Have attorney review documents
It is wise to have an attorney review any document before it is executed. Laws vary from state to state. For example, while states usually require certain exact language be used in an acknowledgment for a mortgage deed, this language differs by state. Moreover, documents should be adapted to the particular needs of the business and the owner.
In addition, to having an attorney review the paperwork, you should consider the impact encumbering assets will have on the business entity's ability to borrow through "asset-backed" loans. These are loans secured by the business's equipment and inventory.
In order to loan necessary capital, a lender may require that the entity give the lender a priority position. This would enable the entity to secure funds through asset-backed loans and still protect the assets from other creditors.
It's important to understand that neither the recording of a mortgage nor the filing of a UCC1 statement actually creates the lien. The promissory note or agreement between the holding entity (or owner) and the operating entity creates the lien. (This underscores the importance of properly executing the underlying agreements. Of course, execution of all agreements must be formally authorized by the management of the entities.) However, perfecting the lien by complying with the UCC provisions is essential if you want to take priority against the claims of other creditors.
Filing form UCC1 perfects personal property liens
Liens against personal property are perfected differently than liens on real property. Here, "personal property" does not mean property owned personally by the owner of the business. Instead, the term refers to all property that is not real property (buildings and land) that used in a business, including equipment, furniture, inventory, etc.
To perfect a lien against personal property used in a business, you must execute a Uniform Commercial Code Form 1 (UCC1) and file it in either the secretary of state's office or the county courthouse, depending on the laws of the state. Each state uses it own version of this form.Although states usually accept a generic version, they will likely charge an additional processing fee if their form is not used.
Once recorded (filed), the UCC1 makes the lien valid and serves as notice that the lien exists. Existing property subject to the lien is specifically listed on the UCC1. The UCC1 also describes the nature of the indebtedness and the lien that has been established.
A UCC1 filing is effective for five years. It can be renewed through the filing of a Continuation Statement, provided this is done at least six months before the five-year period expires. It is important that the owner have the filing officer record the file number, date and hour of filing on his copy of the document.
Priority of liens on personal property varies
Article 9 of the Uniform Commercial Code contains rules on types of liens and their priority. Usually, the first lien recorded will take priority. However, there are exceptions. The most important are inventory purchased from an outside creditor and non-inventory property purchased from an outside creditor.
When the operating entity purchases inventory from an outside creditor and puts up the inventory as collateral for the purchase (a purchase money security interest), the holding entity that has a perfected non-purchase money security interest in the inventory must give notice of the lien before the purchase, or otherwise the outside creditor's lien will have priority, even though it was not recorded first.
However, if the property is not inventory, the outside creditor will take priority only if he records the lien within ten days after the operating entity takes possession of the purchased property.
Liens on after-acquired property and open accounts. The UCC1 not only can be used to perfect a lien when acquiring assets, but also can be used for liens against existing property, future-acquired property and open accounts (i.e., future debt).
So-called "floating liens" apply to future-acquired property or future credit. The agreement, which created the lien, between the holding entity (or owner) and the operating entity may state that all future-acquired property of the same class is subject to the same lien.
Similarly, the operating entity can establish an "open account" with the holding entity (or owner), whereby any future credit extended by the holding entity (or owner), perhaps with credit exceptions, is subject to the open account agreement, and the lien that it established.
The UCC1 can specifically state that the lien applies to future-acquired property of the same class, future credit extended under an open account agreement, or both. In this way, only one UCC1 statement needs to be filed to cover many different extensions of credit from the holding entity (or owner) to the operating entity.
Purchase money interests in consumer goods. Business owners should remember that they also will be creditors with respect to their customers when selling them goods on credit provided by the business. A purchase-money security interest in consumer goods (goods purchased primarily for home or personal use) does not have to be recorded to be perfected. The UCC1 financing statement must be perfected by filing only if the goods involved are used in a business (this is why liens on the operating entity's business assets need to be recorded).
However, sometimes an asset has a mixed use, part personal and part business. This is common today with many people starting small businesses and using home offices, and purchasing mixed-use equipment such as a home computer. The primary use (e.g., business versus personal miles driven for a vehicle, or business versus personal hours of computer usage) will determine whether the lien must be recorded to be perfected.
Example: A consumer purchased a $3,000 computer, telling the merchant that it would be used for personal use and also in her home business. The buyer financed the purchase in an agreement giving the merchant a lien on the computer. The merchant did not record the lien. In a Chapter 7 bankruptcy proceeding, the court held that the lien was not perfected, because the goods were purchased primarily for business use. Accordingly, the merchant lost the $3,000.
Small business owners who provide credit for goods they sell should have the buyer specify, in the credit agreement, that the purchase is primarily for personal or household use, or file the lien in a UCC1 financing statement.
Liens on motor vehicles. Note that motor vehicles are treated differently than other types of personal property. A lien on a motor vehicle usually must be perfected by placing the lien on the actual motor vehicle title, and then submitting the title to the moto