We are still in a recession. And while signs abound of bad times, there is still a lot of financial weakness around. Business owners never know when creditors might want to take possession of their assets to settle their debts, with cash being the first and easiest target. How do you protect that money you will need once things really get back to normal? And can you do it in a tax-smart way? For advice, we asked Bruce Bell, attorney in the Chicago office of Schoenberg Finkel Beederman Bell Glazer.
Larry Lumière: How can you, as a business owner, to protect your money without exposing the money to creditors?
Bruce Bell: A common strategy is to distribute excess cash to the business owner, who in turn lends the funds to the business. Loans should be structured as arm’s length transactions requiring a market rate of interest and a fixed repayment schedule. At some point, the loans have to be repaid.
Creditors with claims against a business take priority over business owners seeking to take their share of the company’s profits. So now you are a creditor too.
Light: Even then, you need a head start over other creditors, right?
Bell: Being a creditor will not necessarily give you the protection you want. Your business can give security over its assets to you, the owner, who loaned the money. So now you are a secured creditor of the business. Secured creditors have a preference over unsecured ordinary creditors.
Light: What if these unsecured creditors take legal action and obtain a judgment to force the company to return their money?
Bell: They would likely only be able to recoup their judgment after the homeowner’s loans are paid off or, if earlier, when the collateral securing the homeowner’s loans is exhausted.
Light: What could spoil this business strategy of lending to your own account?
Bell: This would be if the loan agreements of banks or other lenders to your business would prohibit the business from borrowing more, or prohibiting the assets of the business from being pledged to secure new loans, like the one you give to your business. Of course, owners of a cash-rich business who wish to protect their cash and other assets rarely have significant bank or other debts.
Light: I suspect you need to be careful when lending to your own business, to avoid the legal pitfalls that lurk in such a maneuver.
Bell: Make sure your loan doesn’t violate fraudulent transfer laws. These are meant to punish people whose purpose is strictly to thwart the claims of existing creditors.
Light: How do you know you crossed the line with a fraudulent conveyance?
Bell: If these creditors are already threatening the business with lawsuits, then distributing funds to you, the business owner, puts you in a perilous position. So you need to act first, taking the distribution and loaning it to your business, before any claims against the business arise. Unfortunately, too many people don’t think about planning for asset protection before it’s too late.
Light: What is the fiscal situation with this strategy?
Bell: You could be taxed on the cash distribution. But if your business has been incorporated as a limited liability company or similar organization, you can avoid income tax on the money you receive.