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.
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.