We’re still in a recession. And although signs abound of emerging from the bad times, there’s still a lot of financial weakness around. Business owners never know when creditors might want to seize possession of their assets to satisfy debts, with cash on hand the first and easiest target. How do protect that cash, which you will need once things are really back to normal? And can you do so in a tax-smart way? For advice, we asked Bruce Bell, an attorney at the Chicago office of Schoenberg Finkel Beederman Bell Glazer.
Larry Light: How can you, as a business owner, protect your cash without exposing the money to creditors?
Bruce Bell: One common strategy is to distribute excess cash to the business owner, who in turn loans the funds back to the company. The loans should be structured as arms-length transactions requiring a market rate of interest and a fixed repayment schedule. At some point, the loans must be repaid.
Creditors with claims against a business have priority over business owners seeking to withdraw their share of profits from the business. So now you are a creditor, too.
Light: Even then, you need a leg up on the other creditors, right?
Bell: Being a creditor will not necessarily provide you with the protection you desire. Your business can grant security interests in its assets to you, the owner, who loaned the money. So now you are a secured creditor of the business. Secured creditors hold a preference over unsecured general creditors.
Light: What if these unsecured creditors file a lawsuit and get a judgment to force the business to return their money?
Bell: They would likely only be able to recover on their judgment once the owner loans are paid or, if sooner, when the collateral securing the owner loans is exhausted.
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Light: What could mess up this lending-to-your-own business strategy?
Bell: That would be if banks’ or other lenders’ loan agreements to your business prohibit it, the business, from further borrowing, or bar the business’ assets from being pledged to secure new loans, like the one you make to your business. Of course, owners of a cash-rich company who wish to protect liquid and other business assets seldom have significant bank or other debt.
Light: I suspect you have to be careful when lending to your own business, to avoid legal snares that lurk in such a maneuver.
Bell: Make sure your loan does not run afoul of fraudulent conveyance laws. These are meant to punish people whose aim is strictly to thwart claims of existing creditors.
Light: How do you know when you’ve crossed the line into 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, by taking the distribution and lending it back to your company, before any claims against the business arise. Regretfully, too many people do not think about asset protection planning until it is too late.
Light: What’s the tax situation with this strategy?
Bell: You may be taxed on the cash distribution. But if your business has been formed as a limited liability company, or a similar set-up, you may avoid income tax on the cash you receive.