Effective creditor proofing isolates the business and its assets from future claims of future creditors. Any asset transfer made to a related corporation with the intent to hinder or defeat creditors, may be overturned.
Generally, the best time to implement a creditor proofing strategy is when the business is either starting-up or is healthy and not facing creditor claims. The following are a few creditor proofing strategies we recommend to our clients.
Before implementing a creditor proofing plan, be sure to consult your tax advisers to avoid undesirable tax consequences.
Use of multiple corporations
Don’t put all your “eggs in one basket”. If you have multiple businesses, use multiple corporations.
Hold real estate, equipment, vehicles, fixtures and intellectual property (trade-marks, copyrights, patents, etc…) and other material assets in separate corporations, thereby isolating valuable assets from creditors. The asset holding company can license or lease the assets to the operating company and, if the operating company run into trouble, the licenses and leases terminate and the assets are preserved. The operating company’s assets should usually be restricted to its contracts, accounts receivable and inventory.
Fund the Business by Secured Loan
Rather than making equity or unsecured investments in your business, use a secured loan to give you priority over the assets of the business. If you obtain bank financing, likely you will be asked to postpone or subordinate your security interest to give the bank priority of the assets of the business. However, you will continue to be next in line should the business fail.
A secured loan is a loan (i.e. use a loan agreement or promissory note) secured against the assets of the corporation by way of a general security agreement registered under the Personal Property Security Act (Ontario).
Providing Services to the Operating Business through Another Company
An affiliated company may provide consulting, information processing, administrative or other services to the company operating the business, and the amounts which the affiliated company is owed for such services can be secured by the assets of the operating company.
Hold a Valuable Lease Separate from the Operating Business
This is a strategy sometimes used by restaurants, retail businesses and other businesses where the business location is valuable. The lease is held by one corporation and that corporation enters into a sub-lease with the operating corporation. This way, if the operating corporation fails, the sub-lease is terminated, as long as the head-lease is kept in good standing, the leased premises are preserved.
Another strategy is to use a separate or “shell” company with few assets other than the lease to execute the lease on behalf of the operating company. If the business fails, the landlord has recourse only to the “shell” company and not against the operating company.
If the lease is held by the operating corporation, a related corporation may enter into an option with the landlord to lease the premises should the operating business fail. In this way, the valuable asset – the location – is preserved.
Keep Deposits and Loans at Different Banks
If the business borrows from a bank and also keeps its operating deposit accounts at the same bank, if the business defaults on its loan the bank will set off the debt against deposits. Keeping deposits and loans at separate banking institutions prevents this risk of set off.
This strategy involves continually reducing the amount of assets vulnerable to potential creditor claims by converting such assets to cash and distributing the cash to shareholders i.e. a related corporation.
Selling or factoring accounts receivable, keeping inventory at lowest levels possible, selling and then leasing back equipment or selling intellectual property and licensing it back, are all strategies to generate cash to be dividended out and to thereby reduce the assets vulnerable to future creditor attack.
Dividing Ownership amongst Family Members
Creditors may be deterred from attempting to go after shares in any of the related companies if such shares don’t represent a controlling interest. By selling additional shares to other family members, or other family controlled corporations, or family trusts or limited partnerships, ownership may become diluted enough to avoid creditor efforts to seize the shares. Spreading ownership of a corporation amongst family members so that no one family member owns more than 49 percent may achieve the desired result.
However, just as with any transfers of personal assets by a business owner to members of his immediate family, transferring shares to family members still requires an owner to consider the stability of his marriage and his relationship with his children prior to the transfer. While transferring assets to family members may provide creditor protection, the owner may lose control of the assets as a result. Use of a family trust to hold the assets may be a preferred alternative.
Furthermore, bankruptcy and insolvency, fraudulent conveyance, and assignment and preference legislation makes transfers to family members particularly suspect. While putting assets in a spouse’s or adult child’s name may be a popular form of creditor proofing, such transfers may be void if the transferor becomes insolvent within one year of the transfer, and creditors may be able to reach back five years after the transfer and have it unwound with proper grounds. Also, transfers to children may have adverse tax consequences for the owner, given the capital gains and income attribution rules which may apply.