An important part of operating a financially successful business is income protection. Most business owners recognize the need to protect business and personal assets from those who could bring legal claims against the business. This is called creditor proofing.
A common way for a business owner to creditor proof is through incorporation. A sole proprietor or a partner in a general partnership is personally liable for the debts of their business. The business and the owner are considered one and the same. Incorporation allows a business owner to escape personal liability for the debts of the incorporated business. The corporation and the owner are considered two separate persons at law. The business debt belongs to the corporation operating the business, not the owner.
Typically, a business protection plan involves the incorporation of a single company along with a general liability insurance policy, but planning can go much further. For example, a “holding company” is part of a more comprehensive creditor proofing plan that can be implemented by a business owner, but there are a few options involving corporations and holding companies.
Diversification is an important part of minimizing risk. If you own more than one business (for example, you operate a fencing business, run your own vineyard and offer winemaking consulting services), you should consider having more than one corporation to run each businesses.
This strategy allows an owner to protect the assets of the other businesses if one business fails. In our example, if your fencing business runs into financial trouble and cannot make it’s payments, that business can be liquidated or sold off without sacrificing your strong vineyard operation and profitable consulting services. The need to protect one business from another is especially important if one of the businesses is new and vulnerable to failure.
Going one step further, a single holding company can own the multiple corporations used to operate your businesses. Your businesses would be subsidiaries of the holding company. This is another extension of a creditor proofing plan as the profit of each subsidiary could be passed to the holding company and protected from possible legal claims against the subsidiary.
In our example, the profit from your consulting business can pass to the holding company using inter-corporate dividends and be protected if one of your clients starts a claim against your business for damages resulting from allegedly improper advice. The use of a holding company in this way creditor proofs the profits of an operating business, but the other assets of the business, like land, machinery and equipment, trademarks, etc., are not protected.
A complex creditor proofing plan can go even further so other valuable assets of the business are owned by yet another corporation. This corporation would, for example, own the land the operating company uses to run its day to day business. The operating company would simply lease the land and building from the real estate corporation that owns it.
If any claims are made against the operating company, the assets of the real estate corporation will not be available to satisfy those claims. If necessary, the lease can be terminated. If this strategy is implemented, there is asset protection along with profit protection.
It can be argued an operating company should not own more assets than those necessary to run the business activities. This is true creditor protection in that there is not much in the business for a creditor to target. In this case, assets could be limited to contracts, accounts receivable and inventory.
There are many factors to consider when determining the best corporate structure. Asset protection is one factor, but it is a very important factor, especially when a business in new and vulnerable; however, tax, financing and operational factors are also important considerations.
It is important to meet with your legal and tax professionals when determining the best foundation for your business whether you are starting out or have been operating for many years.
Remember, creditor proofing should be done when your business is able to meet its debt as it becomes due. Do not wait until your business is being chased by creditors or on the verge of insolvency. Your creditor proofing plan must be done for valid business reasons. Oppressive conduct designed to defeat creditors will likely be considered contrary to law and overturned. Effective creditor proofing protects against claims of future creditors, not existing claims of existing creditors. Proceed with caution and protect your income.