In order to protect your business assets from creditors, you should regularly and consistently withdraw excess funds from the business. Options for withdrawing funds include distributions of earnings, salary payments to yourself and family members, payments on loans or leases you have made with the business, guaranteed payments and sales of accounts receivable. Whatever combination of methods you chose, make sure you follow business formalities, including written documentation of a regular, consistent plan.
A small business owner should always seek to minimize the amount of assets within the business entity that can be seized by creditors by withdrawing funds from the business.
Funds can be withdrawn thorough:
- distributions of earnings to the owners (i.e., dividends);
- payments of salary to the owners for services rendered;
- payments to the owners for loans and leases that the owners have extended to the entity;
- the contractual obligation of guaranteed payments; and
- sales of accounts receivable.
Whatever method or combination of methods that you use, be sure to make formal and regular withdrawals, backed in writing.
In general, the Uniform Fraudulent Transfers Act's constructive fraud restrictions can cause significant problems for small business owners, because if certain conditions are met, transfers are automatically deemed to be fraudulent, regardless of the transferor's intent.
Similarly, the restrictions imposed by state limited liability company (LLC) statutes and corporation statutes on distributions to owners on account of their ownership interests can cause these same problems because these restrictions are based on the UFTA's constructive fraud concept. Further, when proving solvency, the balance sheet version of the constructive fraud test as applied by these statutes is even more severe than the UFTA's balance sheet test.
However, distributions to owners for salary, loans and leases avoid this problem, as the constructive fraud provisions under the UFTA or the state corporation and LLC statutes do not apply to these distributions. In particular, because these distributions are for return value, the UFTA's constructive fraud does not apply. Also, because the distributions are made to the owners, other than on account of their ownership interests, the restrictions imposed by state LLC and corporation statutes also do not apply.
In short, distributions for salary, loan and lease payments, as opposed to distributions of earnings, are much more likely to be found to be valid, especially when the entity is experiencing a financial crisis. Only the UFTA's actual fraud concept will apply as a restriction in making these distributions.
However, the impact of taxes may affect whether the withdrawals are structured as distributions of earnings, salary or as payments for loans and leases.
Withdraw cash using dividend distributions
One way to withdraw funds from the business is to distribute earnings among the owners based on their ownership interests. But there are some statutory restrictions on how this must be done.
By definition, a distribution of a corporation's income (i.e., a dividend) or in redemption of an owner's interest (i.e., a stock redemption) will be for no return consideration. This makes this type of withdrawal more vulnerable to charges of fraud than other methods. The first criterion under the constructive fraud test again really is irrelevant, and the only issue involves the solvency of the corporation, under the cash flow test and the balance sheet test.
The cash flow test under the corporation statutes is identical to the cash flow test under the Uniform Fraudulent Transfers Act (UFTA). Thus, if a distribution to an owner on account of his ownership interest is made when a corporation is unable to pay its debts as they come due, the distribution automatically is deemed to be fraudulent.
State corporation statutes also impose a balance sheet test. However, the balance sheet test under the corporation statutes, which is limited to distributions of earnings (i.e., dividends) and stock redemptions, is much more restrictive than the balance sheet test imposed by the UFTA. The actual balance sheet test applied to dividends and stock redemptions varies, to a certain degree, from state to state, and is based on the capital structure of the corporation.
Finally, distributions for dividends and stock redemptions by a corporation also will be restricted by the earned surplus test.