Funding Entities to Maximize Asset Protection
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.
Retaining an Equity Interest in the Operating Entity
In terms of maximizing your asset protection planning, there are a number of funding strategies available when structuring a business using holding/operating companies. But you must be careful to balance the combination of equity and debt funding.
Funding the operating entity with debt (i.e., leases and loans) will mean those assets used by the business will not be vulnerable to loss. Further, exempt assets personally owned and leased to the operating entity will be doubly protected--they will not be exposed to liability with respect to the business's creditors, and the owner can still claim his exemption in the assets with respect to his personal creditors.
However, the owner will have to contribute some assets to the operating entity in exchange for his equity interest. Unless additional steps are taken, these assets will be vulnerable to the business's creditors after all.
Optimal Funding Balances Debt/Equity
Ultimately, you should always try to minimize the actual amount contributed for the equity interest. This can be done by funding the balance of the investment with debt (leases and loans).
There is, in practice, no one ideal formula for determining the ratio of equity and debt. Traditionally, in large, publicly held corporations, analysts have used a ratio of 30 percent debt and 70 percent equity as a benchmark. (These are the relative percentages of the business's assets funded through debt and equity contributions).
In small businesses, the ratio of debt to equity is often much higher. The limit to debt funding, in practice, is usually dictated by the business entity's ability to pay back the debt.
The small business owner should experiment, on paper, with various funding schemes for the operating entity, including different ratios of debt and equity, before starting or expanding his business. The ideal structure will depend on unique factors, including the amount and type of capital available.
In many cases, it may not be necessary to go beyond a 30 to 70 percent debt-to-equity ratio. The assets contributed for the equity interest can be protected through the use of liens, and you also can invest cash and services. However, remember that debt provides the legal basis for the creation of liens and, in part, for the withdrawal of vulnerable funds by the owner.
Make Sure to Adequately Capitalize Operating Company
Since the purpose of debt funding, from an asset protection viewpoint, is to give the owner a priority claim on the assets and to saddle the entity's assets with liens in favor of the owner, monthly repayments of the debt should not necessarily be the main focus of your actions. After all, a demand note can be issued to the owner or the holding entity, depending on the source of the loan. As the operating entity generates funds, the owner or holding entity can demand payment.
However, it would be a mistake to fund the equity interest with nothing, or only a minuscule or token amount of assets. This kind of undercapitalization could trigger an exception to limited liability.
A reversal of the traditional ratios, with 70 percent of the funding coming from debt, generally would still be reasonable, provided the entity's ability to service its debt were not impaired. A decision to use debt beyond this ratio should probably be made with the advice of an attorney.
Further, using debt beyond this amount may be unnecessary, for three reasons:
- First, the use of debt (leases, loans and other extensions of credit from the owner) provides the basis for another asset protection strategy (i.e., encumbering the operating entity's asset with liens in favor of the owner or the holding entity). These liens protect assets contributed though both debt and equity funding. Thus, assets that otherwise would be vulnerable (i.e., assets contributed for the equity interest) are protected.
- Second, cash can be contributed in return for the equity interest. This contribution then can be quickly withdrawn from the operating entity in the form of payments for the entity's expenses, including payments to the owner for leases, loans and other extensions of credit, as well as salary. Thus, debt provides yet another basis for protecting assets contributed for the equity interest.
- Third, future services can be contributed in return for the equity interest in the operating entity. When services are performed for the equity interest, no specific assets are contributed to the operating entity. With no assets in the business form, protection is not even an issue. Yet, the owner will have established, on paper, a significant equity interest in the business. An entrepreneur can usually justify a substantial salary as being "reasonable" in the eyes of the law.
In addition, when an asset contributed for an equity interest carries an especially high risk of injury, the asset should normally 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 should own these assets.
Another way to look at the relative amount of equity and debt funding is the debt-to-equity ratio. This is the amount of debt divided by the amount of equity.
A debt ratio (debt/assets) of 50 percent is the same as a debt-to-equity ratio of 1. Similarly, a debt ratio (debt/assets) of 60 percent is the same as a debt-to-equity ratio of 1.5 (60/40).
Most large businesses have a debt-to-equity ratio between .5 and 2, with most of these companies averaging less than 1. As discussed above, small businesses will typically have higher ratios.
Retaining an Equity Interest in the Holding Entity
The holding entity's assets will not be vulnerable because the holding entity will not engage in any operating activities. Thus, the holding entity may hold the assets loaned or leased to the operating entity, as well as the liens placed on the operating entity's assets. These assets may be contributed to the holding entity in exchange for the equity interest.
Still, the owner would be wise to personally own exempt assets and lease to the holding entity. This would include assets such as office equipment and furniture, automobiles, and other "tools of the trade," provided these assets do not carry a high degree of risk of causing personal injuries. In short, the rationale for doing this in the operating company--preserving valuable asset exemptions--also applies to the holding entity.
Moreover, the owner should remember to purchase liability insurance that will cover assets, especially high-risk assets, owned by the holding entity and leased to the operating entity, because of the possibility that liability for injuries caused by the assets could run to the owner.
For this reason, too, consideration should be given to withdrawing funds from the holding entity on a regular basis. Usually this is done in the holding entity in the form of payments of salary to the owner. While the assets within the holding entity are protected to some degree from the owner's personal creditors, there is some small degree of risk to these assets because of the operating entity's activities. Although the latter risk is usually not significant, by withdrawing funds, the overall risk of loss is reduced. In short, diversification reduces risk.
Avoid Mistakes in Capitalizing Holding Company
A common mistake made by small business owners, which can have devastating consequences, is the failure to actually transfer assets into the business form in exchange for the equity interest. This mistake will almost always mean that co-mingling of assets will occur (i.e., the owner will use personal assets for business purposes and business assets for personal purposes).
Co-mingling business and personal assets may form the basis for the courts to pierce the veil of limited liabilityand impose unlimited, personal liability on the owner. Thus, the business owner must ensure that assets are actually titled to the operating entity when they are contributed in return for the equity interest.
Title to real property must be transferred through the execution of a deed that takes a particular form. A quitclaim deed can be used where real property is transferred to a one-owner limited liability company (LLC) or corporation. This type of deed contains no warranties as to the validity of the transferor's title. In a two-or-more-owner business, a warranty deed, guaranteeing the validity the title, and a title search should be considered.
By contrast, a motor vehicle title is usually transferred by executing the reverse side of the transferor's title. This title is then filed with the motor vehicle department, and a new title is issued in the transferee's name. Title to other property, such as equipment and furniture, is not represented by a formal title document. However, it is still essential that the owner formally transfer ownership to the entity by executing a document that specifically transfers the ownership
In all of these cases, the entity must formally approve the receipt of the asset and then must formally authorize the issuance of the member interests or common stock, as the case may be.
Holding Company Can Function as Creditor
The holding entity (or the business owner) may serve in two roles with respect to the operating entity: the role of owner established through the equity interest and the role of a creditor established by financing the operating entity with debt.
A creditor has a priority claim on the entity's assets, in comparison to the owner's claim. Upon liquidation, creditors receive their share of assets before holders of the equity interest. Further, secured creditors have priority over general or unsecured creditors. Secured creditors hold a security interest in assets of the entity that have been put up as collateral for the extension of credit.
The owner can protect his interests in the business's assets against the claims of the business's creditors by investing in the entity as a creditor and, in particular, as a secured creditor. This can be accomplished through the use of leases, loans and other extensions of credit.
Further, because the operating entity does not own the leased assets, they are not exposed to liability at the operating entity level. In short, the assets are shielded from liability from the claims of the business's creditors. Further, if the assets are within the protective form of an LLC (i.e., the holding entity), they are protected from the claims of the owner's personal creditors.
Case Study: Funding Multiple Entities
John, a Connecticut resident, wants to start a business in Connecticut by investing $100,000 in cash.
If John forms a single entity and invests the $100,000, the money will be exposed to the claims of the business's creditors. In order to avoid this, John forms two LLCs in Connecticut: a holding LLC and an operating LLC. He first forms the holding entity. The holding entity then forms the operating entity, as its only owner.
John contributes $100,000 to the holding LLC in return for an equity interest in the holding company. The holding LLC uses the $100,000 to purchase the assets necessary to run the operating LLC. The holding LLC then leases these assets (through an approved written lease agreement) to the operating LLC, which then takes possession of the assets. Ownership of the assets remains in the holding LLC.
As a result of this structure, and funding arrangement, John's investment is now protected against the claims of both the business's creditors and John's personal creditors.
The operating LLC does not own the assets. Accordingly, the assets are not exposed to the claims of the business creditors at that level. The holding LLC conducts no operating activities. Thus, the assets are not exposed to the claims of the business's creditors at that level either. In short, the assets are protected against the claims of the business creditors.
At the same time, the assets are protected against the claims of John's personal creditors, because Connecticut follows the Revised Uniform Limited Partnership Act that prevents personal creditors from foreclosing on an owner's LLC interest or forcing a liquidation of the business to satisfy a personal debt.
Note that John's holding LLC would have established its equity interest in the operating LLC though a separate investment, apart from the lease. However, this equity investment would also be fully protected through liens on the operating entity's assets that would run to the holding entity, or to John personally.
In addition, lease payment withdraw funds from the operating entity, as well as encumber its assets with liens. These liens could be established by the lease against the operating entity's assets (the leased assets and other assets contributed for the equity interest) as security for the lease obligations. Liens could also be established as a result of other extensions of credit to the operating entity. Thus, the holding entity would have priority claims on these assets, in the event that the operating entity defaults.
John contributes an $100,000 to the holding entity, which lends the $100,000 to the operating entity, so that the operating entity can purchase a building for the business. The operating entity puts up the building as collateral for the loan, giving the holding entity a mortgage on the building. The operating entity owns the building, but because the holding company holds the mortgage, his assets are as safe as if the holding entity owned the assets.
However, John never records the mortgage. Subsequently, a creditor sues the operating entity, obtains a judgment of $100,000, and records a lien against the building on the land records. The judgment creditor's lien takes precedence over the holding entity's lien. As a result, the judgment creditor may be able to foreclose on the building.
Had John recorded the holding entity's lien immediately after it was created, the holding entity's lien would have taken precedence. In this case, the judgment creditor would have been unlikely to foreclose on its lien, because doing so would require that it pay off the holding entity's lien. Either way, John would protect his $100,000 investment--he would keep the building or be paid the $100,000 lien in cash.
Business Entity Compliance from CT Corporation — Partner with the Industry Leader
Contact your CT service representative now!