ComplianceLegalFinanceJune 24, 2020

Withdraw funds from business to limit amount at risk

To limit the amount of vulnerable assets within a business that could be exposed to a creditor's claims, you should have a plan to continuously and regularly withdraw funds from the entity. However, that strategy must not run afoul of the restrictions imposed by state law, especially the fraud provisions.

As we've discussed elsewhere, an owner of a limited liability company (LLC) or a corporation enjoys limited liability for the business's debts. In other words, the owner's liability is limited to the amount he invested (or promised to invest) in the business entity.

In contrast, the entity itself has unlimited liability for all of its debts. Because of the inherent risks associated with the operation of a business entity, generally the assets invested within the business form are more vulnerable than the owner's personal assets outside of the business form.

You should strive to minimize the amount of vulnerable capital invested within your business. You can accomplish this goal when starting your business in several different ways, including the following:

  • initially investing a minimum amount in the entity;
  • capitalizing the entity with debt (i.e., loans and leases); and
  • using equity to encumber the entity's assets with liens that run in favor of the owner (or a separate entity controlled by the owner), and which result from extensions of credit (e.g., loans, unpaid salary, etc.) from the owner to the entity (see our discussion of protecting capital through separate holding and operating companies.)

However, to be effective long-term, your initial strategy of minimizing the amount of capital invested within the business form must be combined with a strategy calling for regular withdrawals of money from the business as income is generated. Funds generated by the business entity, but left within it, are in essence invested in the entity, as if they were invested from an outside source, but in a way that leaves them vulnerable to the claims of the business's creditors. A continual withdrawal of funds, as they are generated, guarantees that vulnerable funds will not accumulate within the business entity.

To efficiently accomplish this goal, you'll need an understanding of the restrictions on withdrawals, before you review the withdrawal methods available to you. Once your plan to minimize vulnerable capital is in place, you'll need proper authorization and documentation to secure the withdrawals from a creditor's challenge.

Think ahead

Clearly, a business planning a major expansion, requiring a significant amount of capital, may want to accumulate assets within the business form.

Assets can be safely accumulated, provided that the owners employ other asset protection strategies in lieu of continuous withdrawals, in particular the use of liens that run in favor of the owners. The best strategy in this case, of course, would be to accumulate the funds in the holding entity.

Alternatively, these funds may be withdrawn, in accordance with a regular withdrawal policy, and then reinvested when necessary.

Know what restrictions limit withdrawals

Before deciding on the best withdrawal strategies, you must be aware of the different restrictions on withdrawals in every state's statutes governing LLCs and corporations, as well as the general restrictions imposed by the Uniform Fraudulent Transfers Act (UFTA).

The UFTA outlaws two different types of fraudulent transfers: constructive fraud and actual fraud. The UFTA's actual fraud provisions will apply to withdrawals from a business entity. Further, the separate provisions imposed by the LLC and corporation statutes are based on the UFTA's constructive fraud provisions, although, the corporation statutes, in particular, usually impose more significant restrictions than the UFTA.

UFTA actual fraud provisions may limit ability to withdraw funds

You must be careful not to run afoul of the restrictions on withdrawals imposed by the Uniform Fraudulent Transfers Act (UFTA). The UFTA actual fraud restrictions will apply to all transfers from a business entity to the owners, including distributions to owners on account of their ownership interest (i.e., dividends and ownership reductions), as well as payments for salary, loans and leases.

Actual fraud exists only when it can be proven that the transferor intended to defraud creditors through the transfer. Under this test, a transfer is not automatically deemed fraudulent simply because certain conditions are met. Instead, courts use a number of criteria to determine the transferor's intent, including:

  • an assessment of the transferor's motive
  • the timing of the transfer
  • the solvency of the transferor at the time of the transfer
  • whether the transfer was concealed from the creditor
  • whether the business received adequate consideration in return for the transfer
  • whether at the time the transfer occurred the debtor had incurred a substantial debt
  • whether the transfer was made up of all or substantially all of the debtor's assets
  • whether the transfer was to an insider (i.e., family member or controlled entity)
  • whether the debtor absconded or tried to hide assets
  • whether the debtor transferred assets to a lien holder, who then transferred the assets to an insider of the debtor

As noted, actual fraud requires that a creditor prove that the transferor's actual intent in making the transfer was to defraud creditors. This can be a very difficult burden, absent specific circumstances from which this intent can be clearly inferred.

However, a finding of constructive fraud under the UFTA is not as difficult to reach if certain conditions are met.

UFTA and state law restrict transfers

Under the UFTA, constructive fraud arises when both:

  • the transferor receives nothing (or less than full value) in return for a transfer
  • the transferor is insolvent at the time of, or because of, the transfer, under either a cash flow test (unable to pay debts as they come due) or a balance sheet test (liabilities exceed assets)

When both of these two conditions apply, the transfer is automatically deemed to be fraudulent. For a finding of constructive fraud, your intent is completely irrelevant.

Fortunately, with respect to transfers from a business entity to its owners, constructive fraud is easy to avoid because transfers to the owners for return value from the transfer take the transfers out of the reach of the definition of constructive fraud. Thus, payments to the owners for salary, loans and leases do not come within the purview of the constructive fraud restrictions.

State laws limit withdrawals

In developing a strategy to withdraw funds from you business, you need to be aware of state laws , as well as the Uniform Fraudulent Transfer Act provisions. Different laws will apply to an LLC that will to a corporation, so you need to be aware of the laws that govern your entity type.

State fraud laws and LLCs. Restrictions on withdrawals imposed by state LLC statutes are usually identical to the Uniform Fraudulent Transfers Act's (UFTA) constructive fraud restrictions with one significant exception.

The constructive fraud restrictions imposed by the LLC statutes are limited to distributions of LLC income or redemptions of an owner's interest. Thus, these restrictions do not apply to payments by the LLC to the owners for salary, loans and leases. In this way, they differ from the UFTA's constructive fraud provisions.

Thus, in an LLC, distributions to owners on account of their ownership interests (i.e., distributions of LLC income or redemption of an owner's interest) will automatically be deemed fraudulent if both the following conditions are met:

  1. The LLC receives nothing (or less than full value) in return for a transfer
  2. the LLC is insolvent at the time of, or because of, the transfer under either a cash flow test (unable to pay debts as they come due) or a balance sheet test (liabilities exceed assets).

Note that, by definition, a distribution of LLC income or the redemption of an owner's interest will be for no return consideration. Thus, the first criterion under the constructive fraud test is really irrelevant, and the only issue involves the solvency of the LLC under the cash flow test and the balance sheet test.

State fraud laws and corporations. For corporations, state laws' restrictions on withdrawals usually impose the same types of constructive fraud provisions on transfers as they do when restricting limited liability companies (LLC).

First, a transfer is fraudulent if the corporation receives nothing (or less than full value) in return.

Second, solvency is determined by imposing a cash flow test and a balance sheet test to prove the legality of distributions to owners on the basis of their ownership interests (i.e., distributions of earnings or dividends and stock redemptions).

However, while these statutes impose the standard cash flow test (inability to pay debts as they come due), they usually apply a more restrictive balance sheet test than that used by the Uniform Fraudulent Transfers Act (UFTA).

Authorization and documentation is critical

You should develop and implement an on-going strategy that reduces the amount of funds within a business that could be seized by creditors. However, you must withdraw funds properly, steering clear of fraud under the UFTA and under state statutes.

One of the best ways to establish a non-fraudulent purpose is through good recordkeeping.

All arrangements for salary should be based on a written salary arrangement, which is authorized and signed by the entity's management. Similarly, loan arrangements should be based on written promissory notes and security agreements, and lease arrangements should be based on written lease contracts. In the case of loans and leases, once again the agreements should be authorized and signed by the entity's management. Courts will look at the regularity of the withdrawals and the amount of the withdrawals.

Regular withdrawals help show non-fraudulent purpose

One of the factors that can indicate actual fraud involves the timing of the transfers. Transfers (even if they are allegedly salary, loans and leases, or distributions of earnings) that occur suddenly, when the business entity experiences financial difficulty, indicate that the motive for the transfers was avoidance of creditor's claims. Thus, fraudulent intent may be inferred from this type of conduct.

Accordingly, withdrawals should be made on a regular basis, and authorized in uniform amounts. If the business entity subsequently experiences financial difficulties and withdrawals continue, in accordance with a long established pattern, a court is much less likely to infer fraudulent intent. Thus, a pattern of regular withdrawals can work to defeat a finding of actual fraud, even as the withdrawals continue.

If the withdrawals are for return value and not on account of the owner's interests, constructive fraud provisions under the Uniform Fraudulent Transfers Act as well as under the state corporation statutes and limited liability company (LLC) statutes, will not apply to the withdrawals. Thus, a regular pattern of withdrawals in the form of payments for salary, loans and leases usually will be the most effective strategy.

Amount of withdrawals can point to fraud

Creditors may sometimes argue that withdrawals (e.g., for salary) indicate fraudulent intent However, when these withdrawals are authorized, documented and occur on a regular basis, creditors will have a difficult burden in establishing intent, based solely on the size of withdrawals.

In addition to fraud determinations, tax cases frequently involve the issue as to whether salary is reasonable, because a corporation can deduct only "reasonable" salaries. Due to the time and effort an entrepreneur devotes to his business, courts in these cases deem as "reasonable" extremely large salaries taken by owners.

In one case, the tax court found "reasonable" compensation of almost $900,000 for one year paid by a corporation to its only owner. This compensation consisted of a $200,000 salary, a $400,000 bonus, and a $296,000 lump sum retirement benefit.

The Tax Court generally relies on five factors in deciding the compensation was reasonable:

  • the employee's role in the business;
  • a comparison of the compensation with what is paid to similar employees by other companies;
  • the character and condition of the business;
  • whether, in a regular C corporation, the compensation is really a "disguised dividend" intended to avoid the double tax on dividends; and
  • whether the compensation was consistently paid under a structured and formal arrangement.

The fourth factor underscores why these tax cases often arise. A regular or C corporation is a separate tax-paying entity. Dividends paid by a C corporation are subject to a double tax, because they are not deductible by the corporation and thus are taxed at the corporate level. Dividends also are taxed a second time, at the individual tax rates when they are received by the owner.

C corporations sometimes attempt to disguise a dividend as salary, in an attempt at avoiding the tax at the corporate level, as the salary is deductible by the corporation. The salary is considered to be a disguised dividend, only to the extent the salary is deemed to be unreasonable.

While the same tax issue does not arise in the case of a subchapter S corporation or a limited liability company (LLC), the reasoning can extend to actual fraud cases. Payment of a reasonable salary is not indicative of fraudulent intent.

Note, too, that the fifth factor formally recognizes authorization and documentation as important factors in determining the reasonableness of the salary.

Between payments for salary, loans and leases, and other withdrawal strategies, it will seldom be a problem for small business owners to withdraw all of the vulnerable funds from the business in a manner that is "reasonable," and thus not found to be fraudulent.

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