How to Protect Your Assets as a Business Owner
Many business owners spend much of their time working on their business to improve efficiency and increase profits. While being consumed with the day-to-day activities, many business owners neglect certain asset protection issues. Business owners who own their business in the corporate form need to understand how to own corporate stock that will minimize exposure to creditors. Also, business owners can create agreements that will enhance the value of the business from the inside.
When a creditor seizes a shareholder’s stock, they also obtain the same rights that the debtor had such as management and liquidation rights. Also. A charging order protection, which protects your interest in a company from creditors, does not apply to C and S corporations. Additionally, an S corporation owner may have a concern if their creditor is an ineligible S corporation creditor, potentially threatening the company’s status as an S corporation. If this is the case, the corporation will be treated as a C corporation and make itself subject to double taxation.
An owner of S or C corporation stock should consider the asset protection benefits of converting that corporation into an LLC. There are a few different options when it comes to limited liability organizations that can protect business assets from the personal creditors of the owner. Entities such as partnerships, limited partnerships, and limited liability limited partnerships are treated as partnerships for federal tax purposes. Unfortunately, partnerships are not allowed to own S corporation stock. If you want to hold ownership through a company, an LLC may be your best option because an LLC can elect to be taxed as a corporation and would be able to own S corporation stock.
The asset protection benefit of an LLC is called a “charging order” and is a judicial remedy. A charging order protects the owner’s interest in a LLC from their personal liabilities. If a creditor receives a charging order, the creditor’s interest in the LLC is limited. The creditor will have the right to any distribution that is made from the LLC. However, the creditor is not entitled to any voting rights, thus will have no say in any management or liquidation decisions.
With the right methods, owners of C or S corporations will be able to benefit from the LLC asset protection if they decide to convert their corporation into an LLC that will be taxed as a corporation. When doing so, the conversion is treat as a nontaxable “F” reorganization under IRC Section 368(a)(1)(F). During this process, it is important to consider and evaluate the individual state law consequences. For example, C corporations considering conversion should look for the “built-in-gains tax” under IRC Section 1374. Also, the level of protection that a charging order provides varies state by state.
There are various types of business agreements that can protect your business. Among them include a Non-Compete and Confidentiality Agreement, Buy-Sell Agreement, and a Deferred Compensation or Bonus Plan for certain employees.
Few events can be as detrimental to a business as a key employee leaving and starting a similar business that serves as direct competition. The more important that employee is to your business, the more detrimental it can be. That is why it is important to have your employee sign a Non-Compete, starting with your most important employees and working your way down. As long as the agreement is considered reasonable under the law, the agreement will be enforceable.
A Buy-Sell Agreement can be one of the most important business agreements a company can make. A Buy-Sell agreement that is properly drafted will allow he owner to protect their interest as well as the remaining business owner’s interest. A good Buy-Sell agreement will provide the selling owner a fair value for his or her interest while allowing the new owner the proper means to buy the remaining interests of the corporation without depleting the value of the company. The purpose of the Buy-Sell Agreement is to provide a predetermined business value (or method of arriving at a business value) at the occurrence of an event such as death, disability, or retirement of an owner’s interest in the business to ensure a smooth transition of ownership.
It is important to plan ahead to make sure there are sufficient funds available to implement the buy-sell provisions without taking too much money out of the cash flow of the business. Funding the agreement at the owner’s death will be easier since you can use the proceeds from the life insurance fund to enact the agreement. It will be more difficult to buy-out an owner’s interest in the event of a disability, retirement, or involuntary or voluntary termination. Once the agreement is in place, it is important to continually update the agreement as the value of the business or the owner’s objectives change with time.
Business owners should also consider a deferred compensation plan or bonus agreement to incentivize employees to reach certain performance goals as a way to protect their business assets. In doing so, the employee’s will be rewarded for certain objectives that increase the value of the business. This often results in increasing the value of the business in a shorter window because employees are appropriately incentivized. Also, such agreements, place what many people call “golden handcuffs” on your best employees that make it difficult for them to leave the company when they are being offered such benefits and rewards. Not only do these agreements enable the business to grow, but also makes the company more attractive to potential investors when they know that the key employees are secured in the business.
This article only scratches the surface of asset protection strategies for business owners. If you are looking for more information on the topic, check out our blog or schedule a consultation with an attorney for advice on the appropriate methods and plans. That being said, there are many small things a business owner can do to protect the value of the business that are often overlooked. The agreements discussed in this article can save a business owner a lot of money and headaches if they are put in place early on. Not only does it make owning a business easier, but it also makes the business more attractive to potential buyers when the owner decides to sell.