Merely using an LLC or a corporation is not sufficient asset protection strategy. You must also structure and funded to minimize your liability exposure. You must operate your business in a way that maintains your limited liability.
Unfortunately, the mere formation of an LLC or a corporation is not, in itself, a sufficient asset protection strategy. Asset protection planning requires that the business be structured and funded to eliminate personal and business liability.
However, even forming an LLC or a corporation and structuring and funding it to avoid personal and business liability is not a sufficient asset protection strategy. The entity must also be operated in ways that preserve the owner's limited liability and, thus, protect the owner's personal assets outside of the entity as well as the business's assets (the owner's investment in the business).
Withdrawing funds from the business is, in essence, a complement to the structuring and funding strategies presented when using operating and holding companies. The business entity must be structured and funded strategically, to minimize the amount of vulnerable capital invested within the business form. In this way, the business's assets, which face the highest risk of loss, are protected, along with the owner's personal assets outside of the business form.
These withdrawal strategies ensure that vulnerable funds are withdrawn from the business entity as they are generated. Without withdrawal strategies, vulnerable funds would accumulate in the business entity, defeating the very purpose of the structuring and funding strategies previously implemented.
This discussion presents the advantages and disadvantages of alternative withdrawal strategies, including distributions of earnings and payments to the owners for salary, loans and leases, with a special emphasis on the effect that fraudulent transfer restrictions and the self-employment tax have on these withdrawal methods.
The discussion also examines the interrelationship between the fraudulent transfer restrictions imposed by state LLC and corporation statutes, and the restrictions imposed under the Uniform Fraudulent Transfers Act. Finally, this underscores the importance of authorizations and documentation when withdrawing funds from the business entity.
The articles Take Steps to Limit Liability for Contracts and Beware of Tort Exceptions to Limited Liability explain the significant exceptions to the limited liability for owners of an LLC or a corporation, with respect to the business entity's debts. If an exception applies, unlimited personal liability for the business entity's debts is imposed on the owners. When this occurs, the very purpose for which an LLC or a corporation is created--limited liability--is lost.
Because business owners, typically, are unaware of these exceptions, the objective of this section is identification of the specific exceptions, both in terms of the entity's contracts and any torts (e.g., negligence) committed by the entity's employees. With this knowledge, and the strategies presented in our discussion, business owners can avoid these exceptions and, thus, preserve their limited liability for the business's debts.
The discussion Piercing Veil of Limited Liability Results in Personal Exposure examines another important exception to limited liability--the concept of creditors "piercing the veil of limited liability" through what are termed the alter ego theory or the undercapitalization theory. Clearly, if either theory is applicable, the owners of the business will suffer unlimited personal liability for the business's debts, and the very essence of the LLC or corporation (limited liability) will be destroyed.
This article examines the nature of these two theories and the strategies that can ensure neither theory will be applied to the business.
Ideally, the small business owner will structure his financial affairs so that claims will not be made or, if claims occur, the claimants will be unable to satisfy their claims from the business owner's personal or business assets. The asset protection strategies advocated throughout this entire module are based on these principles. Occasionally, however, claims will be made. Some of these claims may penetrate the layers of protection set up by the business owner. If this occurs, one last layer of protection still should be ready to defend the business owner--insurance.