Corporate asset protection: Shielding your business from lawsuits, threats — Part II
Wednesday, January 22, 2014
As we discussed in Part I of this article, in attempting to protect an ongoing business against lawsuits and potential creditor threats, most businesses leave much to be desired. They may rely too heavily on insurance, have suboptimal corporate structures in place and even unknowingly miss out on significant tax advantages.
In the first part of this two-part article, we examined the proper use of insurance and discussed corporate structure options. Here, in Part II, we will examine techniques to protect the common assets of the business — from accounts receivable to equipment and real estate. Shielding the business's cash flow will be the subject of a future article.
Protecting a business's accounts receivable
Certainly, the accounts receivable (AR) of the practice are important to protect. The AR is what you, in fact, work for. This is cash flow for the next 30, 60 or 90 days.
What most business owners and executives don't realize is that a lawsuit against the business (created by a wrongful act of any of the partners) for product liability, malpractice, employee claims or any liability threatens all of the AR in a typical business setup.
Certainly, there have been cases where businesses had to work for free for a number of months because of the lawsuit judgment resulting from the claim created a loss of the AR for the entire business. Thus, owning the AR in the business entity is very risky. The options to shield the AR are three-fold:
In unrelated AR financing, a business can effectively give a top shield to its AR. This essentially involves getting a loan from a third party and using the AR balance as the collateral for that loan. So long as the security agreement for the loan is drafted correctly (not always so, in those that we have reviewed), the protection should hold.
However, the key to the economic transaction is what happens with the loan proceeds. How are they protected? How are they invested to offset the cost of the loan interest? What if the interest rate rises and the investment returns decrease? This can be extremely important if a $1 million-plus loan is involved and tens of thousands of dollars in annual interest needs be paid to the lender each year. Certainly, these are real economic concerns for a real economic transaction.
In related AR financing, an irrevocable trust or family limited partnership is set up for the family of the business owner. This trust or partnership then makes a bona fide market-comparable loan to the business, making the AR the loan collateral. In this way, the interest payments are made to the family trust or partnership rather than to a bank. The key, like most legal structures, is in the details and the compliance with formalities.
In AR segregation, there is no loan at all. Instead, the AR are provided a shield by having the business transfer the ownership of the AR to one or more limited liability companies (LLCs). While this may involve adjustments to employment agreements and a collection agreement involved, the day-to-day operations of the business stay the same, according to the attorneys who structure this arrangement. The structure here is analogous to what we will discuss below in terms of equipment, intellectual property and real estate — using what we call an "LLC-lease back" arrangement.
Shielding equipment, intellectual property and real estate
Like the AR, if the equipment, intellectual property or real estate are owned by the operating business entity, a lawsuit against that entity for any reason threatens the equity in such assets.
To shield assets such as these, many savvy businesses utilize an "LLC-lease back" arrangement. This requires establishing separate LLCs and leasing or licensing the assets back to the practice entity — typically a lease for equipment or real estate and a license arrangement for intellectual property.
The business would pay rent or license payments to the LLC, and the LLC would actually own the underlying assets. The LLC could then be owned and controlled by the same owners who own the operating entity.
This lease-back arrangement is popular for business real estate but is not as common for equipment and even less so for intellectual property. This is unfortunate, as often the equipment and intellectual assets can be quite valuable.
For all lease-back arrangements, compliance with formalities is paramount. There should be real fair market-value lease terms and documentation. All insurances and asset taxes (i.e., property taxes) and financing payments (i.e., mortgages) need to be paid by the LLC or as specified in any lease or license documents.
Also, for any new arrangement to be implemented, cost-benefit considerations should be considered (i.e., "Is it worth the trouble and expense?" "What is the equipment really worth to an outsider?") as well as any hidden tax traps (local lease taxes, depreciation recapture) before moving forward
Conclusion: Business protection is crucial
Given today's litigious society where successful businesses are lawsuit targets from the government, competitors, clients, customers and even employees, business protection planning is essential. As discussed in Part I of this article, property and casualty insurance and a superior corporate structure begins such planning. Beyond that, a focus on protecting specific assets of the business is always wise.
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