Funding entities to maximize asset protection

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.

Think ahead

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 under-capitalization 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.

Work smart

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 liability and 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.