company. Unfortunately, in the heady, frantic days of business startup, many owners may be too focused on success to think about protecting themselves and their assets from the possibility of failure.
Asset sheltering strategies are designed to insulate entrepreneurs from the worst impacts of a business failure. Those strategies have the best effect if implemented at the start of the business venture as opposed to when a company is teetering on the brink of failure. In some cases, attempting to shelter or protect assets when the business is insolvent or near insolvency may be legally prohibited. Accordingly, early planning may make the difference in protecting the entrepreneur’s investment from some creditors.
The business owner has some basic decisions to make when starting the business. While businesses may be operated as a sole proprietorship, often the first step to protect the owner is to incorporate the business and operate it through a company. Many benefits can flow from this simple step. There can be tax advantages due to lower tax rates for some companies and through strategic remuneration of shareholders by a combination of income and dividends. The advice of business and tax specialists at the time of the formation of the company will be important.
Once incorporated, the company will be the primary obligant in respect of any claims arising from the operation of the business. The owner will not be liable for most obligations of the company, except for example, claims that arise due to the owner’s personal negligence or wrongdoing, or specific claims that might be made against the owner as a director of the company for collected taxes such as GST and for employee source deductions (for example, Canada Pension, employment insurance and the employee’s income taxes).
Depending on the nature of the business, additional creditor protection options can be considered. If there are distinct divisions or business operations, having separate companies for each division may be appropriate. In such case, the failure of one division might not affect other divisions.
If there is land and, or, significant equipment that is to be used in the business, those valuable assets can be acquired by a holding company which can then lease the assets to the operating company. If there is a failure of the operating business, the valuable assets in the holding company can be protected from unsecured creditors of the failed company, although lenders to the business may require security from both companies.
It is important to properly document both the arrangements and the accounting between the various companies and maintain the inter-company payments. Failure to do so may result in a successful company having financial obligations to a company that failed, defeating the asset protection strategies that were originally implemented.
Security to the Owner
A second initial step is for the business owner to take security over the assets of the company or companies for the owner’s loans. Care must be taken to document each loan and its terms before it is made; but when properly done, the business owner who has advanced funds and taken security for such advances will generally have priority over the claims of unsecured creditors. It is important that the advances be characterized as loans and not equity or capital investments so as to minimize the possibility of the application of certain subordination principles in the event of a bankruptcy.
While initially the owner may have priority in respect of his or her security, it should be recognized that other lenders, such as financial institutions, may also want security from the company. If so, these other lenders will usually demand that the owner give priority to the lender’s security. In addition, certain types of government claims may take priority over the owner’s security (as well as the security of other secured creditors of the company). Accordingly, while having security is not a guarantee that the owner will recover on his or her loans; it can give the owner the opportunity to recover ahead of unsecured creditors.
Supporting company debt
Business owners should avoid becoming an obligant in respect of the company’s debts. This may mean refusing to co-signing on leases with the company, refusing to give personal guarantees, and making sure that the company complies with obligations where the director/owner may become personally liable. That is often easier said than done. Financial institutions will generally want personal guarantees as may other creditors of the company. The owner should carefully weigh the effect of becoming personally liable for any company debt.
If the owner cannot avoid becoming personally liable for some of the company debts, he or she should take care to not personally accumulate assets from which those debts might be recovered. While that may be easy going forward, the assets in the hands of the owner at the commencement of the business may be available to satisfy such debts. Even though the business owner may be tempted to transfer property to a spouse, children or even a trust to put current held assets outside the reach of creditors, such transfer may be subject to reversal by the court if that is the sole reason for the transfer. However, transfers done for reasonable value or to achieve other legitimate goals, such as estate planning, may successfully survive a court challenge. Legal advice prior to making a transfer may avoid or limit problems in the future should creditors of the owner come to collect.
An experienced insolvency lawyer, together with tax and other advisors, can provide options and direction for business owners who seek techniques to shelter assets from creditors.