By G. Timothy Leighton *
March 9, 2021 — As business owners create value and wealth for themselves as owners, they are often concerned about preserving that value in case things go wrong. For example, if someone sues the business, the owners don’t want to risk losing their assets, inside or out of the business. The most obvious way to prevent that loss is by not doing things that inspire lawsuits, but that is often easier said than done.
There are three fundamental rules as a starting point for risk management. First, do no harm. Second, shift some of the risk to a financial institution. And third, insulate your assets by use of appropriate legal structures.
Do No Harm. Doctors by tradition include this concept in their basic oath. The similar concept applies to all professionals and business operators. Don’t go out of your way to hurt somebody. Don’t kick dogs. Do treat people with care and respect. Consider the Golden Rule and treat people appropriately.
Liability Insurance. One easy step to avoid jeopardizing your business is to purchase various forms of liability insurance. Liability insurance is a topic that deserves at least one article all on its own. Today’s column focuses on the choice of entity and then touches on special assets that enjoy special protection under state law. Work with risk management professionals, such as quality insurance agents, to identify appropriate ways to shift some risk to one or more financial institutions. Put the law of large numbers to work for you. Be sure to disclose all of the potential risks you and your enterprise may generate so that your insurance professional can help tailor your coverage to your specific needs and exposures.
Structure the Appropriate Type of Entity. Business owners typically have multiple objectives when choosing how to structure their enterprise. Some things to consider include ease of operation and compliance, how the business will be taxed, how to transfer the business in the future and/or wrap up at the end of the business life, how to preserve privacy for the owners, and how to limit the liability of the owners along with minimizing exposure of assets. The most common forms of ownership structure are sole proprietorship, partnership, corporation and limited liability company. Similar to liability insurance, each of these entities could use at least one article to describe their important elements.
A key reason for choosing a corporation or limited liability company is to limit the exposure to loss of the owners and their assets. Another way of saying that is that business owners often seek to shelter their personal assets. Generally, the extent to which an owner faces a potential loss arising from claims against a business structured as a corporation or limited liability company is whatever investment the owner has made in the enterprise. It is critical that business owners comply with various rules set forth in state law and other requirements in order to limit that liability exposure. In other words, attend to the formalities such as creating relevant organizational documents and address annual renewal requirements, both public and private. Failure to maintain fidelity to those formalities exposes the enterprise to a claim of corporate shell as sham. Then a claimant may try to “pierce the corporate shield.” Additionally, the owner must be cautious not to deliberately or unintentionally hurt someone who is involved in their business or utilizes their services. Recklessness could mean that the owner might have personal liability for the action. The risk exposure of a corporation or limited liability entity is typically not greater than the value of the assets in that enterprise. Personal assets outside of the business are not usually subject to the claims of creditors of that business when the business maintains the necessary formalities.
Special Trusts and Family Limited Partnerships. One asset protection strategy to consider is setting up a special kind of trust to hold the ownership interest of the enterprise. As part of comprehensive estate and asset protection planning, business owners often turn to trusts as vehicles to accomplish various planning objectives. Under appropriate circumstances, an entrepreneur aiming to manage risk might strategically set up an irrevocable trust to be the actual owner of the stock or membership interest. The business owner would select a trusted individual or institution to serve as trustee of the irrevocable trust.
There are also other complex structures, such as family limited partnerships. These structures offer additional layers of asset protection. Keep in mind that there are tradeoffs. Among other things, someone other than the business owner becomes the legal titleholder of that asset, albeit for the benefit of the entrepreneur and/or other designated beneficiaries. There are costs involved in setting up and maintaining irrevocable trusts. But these instruments are powerful devices that can include so-called “spendthrift” clauses. These provisions can serve to reduce the potential access by creditors. Some entrepreneurs also explore jurisdictional protections. Some states have developed specialized statutes to provide creditor protections. There are also off-shore alternatives beyond the United States borders. Jurisdictional shopping is complex and entails additional costs.
Life Insurance and Annuities. The entrepreneur can also consider acquiring particular assets that have special protection under Illinois law and the laws of several other states. A business owner with flexible cash flow can consider devoting some of that cash to acquiring and growing special assets that enjoy significant protection from claims of creditors. Certain life insurance policies and annuities are exempt from creditor access. Unless the owner has set up these instruments with specific intent to defraud those to whom they owe money, they are generally not subject to claims of creditors. State laws limit creditor rights in this way as a matter of public policy. This policy reinforces responsible behavior. The idea is that people are encouraged to provide for the needs of dependents upon untimely death of their providers. These laws are designed to help assure that those for whom insurance benefits are intended will actually receive insurance proceeds, whether or not the insured remains solvent. There are special procedures required to achieve this result, so as with any complicated financial instrument, those who are interested should work closely with their professional advisors.
Business owners have many tools available to them to preserve enterprise value from the claims of those who seek to take something away from them. These tools range from basic decisions in organizing the enterprise to risk management tools along with complex legal and financial instruments. You as an entrepreneur should involve your professional advisors to determine and implement the appropriate combination of protection strategies. Click here for ways to contact us to schedule your appointment.
* Tim Leighton of Leighton Legal Group, LLC is an experienced lawyer based in Bloomington, Illinois who helps business Clients build their enterprises and plan for continuation after it is time to close the business or sell the business to someone else.
Important note: This information is designed to provide a general overview with regard to the subject matter covered. The author and publisher and host are not providing legal, accounting, or specific advice to your situation. You should consult with the professional advisors of your choice for specific advice.