A person’s livelihood is many times found in their business. They draw income from it to support themselves, family, and overall standard of living. This is why it is extremely important to make sure the business is protected against outside creditor attack. After all, an attack against the business is an attack against the individual.
Therefore, it is extremely important to (1) form the business with the appropriate entity; (2) manage the risks within the business itself; and (3) maintain a barrier between you and the business.
There are a number of entities that exist that provide for limited liability. Notably, the limited liability company (LLC), corporation, and limited partnership offer such limitation. This means that the owners are not liable, solely by virtue of being an owner, for the debts, obligations, or liability of the business.
In essence, the aforementioned entities, under the law, already have strong asset protection tenets built into them. This is because the law treats these entities as people, i.e. separate and distinct from its owners. Why would you have to respond to the debt of someone else? Put differently, the LLC, corporation, and limited partnership create a barrier between the debts of the owner and the debts of the business.
When a creditor comes calling, the assets of the business may be at risk. For example:
If Restaurant A takes out a loan, defaults on the loan, and cannot come up with the funds to pay it back, Creditor Bank will look to the assets of the business as recourse, i.e. payment. Thus, Creditor Bank could take the expensive kitchen equipment, sell it, and apply the proceeds to the loan. (Note: if you had personally guaranteed the loan to Restaurant A, Creditor Bank may be able to go after you personally to satisfy the debt.)
In this example, the kitchen equipment is just a spoke on a wheel full of assets. In reality, businesses have many moving parts, including accounts receivable, intellectual property, manufacturing equipment, the land itself, employees, investment property, and so on. Thus, it would not be wise to keep these assets all in one entity as a creditor, with certain exceptions, could levy, attach, and sell any one of them to satisfy a business debt.
Moreover, one asset (a risky asset) could put others in jeopardy and subject them all to the claims of a creditor. This is usually the case with employees and investment property. As an aside, note that the United States is an extremely litigious society with results-oriented judges and juries awarding astronomical sums of money to plaintiffs. Therefore, separating the risky and non-risky assets from the business, and each asset from each other (depending on its risk), is the type of preventative asset protection planning essential to survival.
One way (and there are many) to do this is through the creation of separate entities that act to isolate the liability-producing assets from the rest. In this scenario, an operating entity is formed, which runs the day-to-day affairs, and other holding companies are formed, which own and lease assets back to the operating company.
Evidently, liability for business operations falls squarely on the operating entity. The holding entity, in turn, is not liable for the debts, obligations, or liability of the operating entity. This is because it is both a separate and distinct company and, importantly, not involved with the business operations of the liability-prone operating entity.
In addition, the lease payments paid to the holding business act to drain away the cash from the liability-prone operating business. Thus, the profits would be funneled to the appropriate holding company and protected from the creditors of the operating entity.
Observing business formalities
The effectiveness of the asset protection plan for your business depends on you. As previously stated, it is imperative that you maintain a barrier between yourself and the company. In other words, you cannot treat the business like your own personal bank account nor commingle personal and business funds together. Doing this degrades the effectiveness of a separate legal entity and puts yourself personally at risk for the debts, obligations, or liabilities of the business.
A business debt that goes unpaid will certainly be answered by the creditor. If the business does not have the resources to pay the debt, the creditor will next look to see if the business was run as an actual business or just a mere facade of yourself. If so, the creditor would be able to pierce the veil (legal parlance for making you personally liable for the business debt) under a variety of theories.
One such theory is failure to observe corporate formalities, keep your books in order, and the like. Another theory, as mentioned above, is to prove that the business was operating as your own alter ego. In this instance, the creditor will show that the owner, yourself, was mixing both personal and business expenses together, such as using the business account to take your family out to dinner.
I repeat: there is no one-size-fits-all plan. What may work for one business may not be the best course of action for another. In fact, there are many other things that can be done, such as purchasing insurance and doing your due diligence. However, speaking with an attorney, going over your options, and getting informed should be what comes first.