Question:  Our business holds a large amount of cash which needs to be retained for various purposes.  Is there a way to protect our cash without exposing these funds to our creditors?

Answer:  While there are various techniques which are available, one common strategy is to distribute excess cash to the business owners who in turn loan 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 will need to be repaid. Since creditors with claims against a business have priority over business owners seeking to withdraw their share of profits from the business, the effect of the transaction is to place business owners on par with prospective business creditors.

More of course can be done to protect the rights of business owners to cash and other assets accumulated in a business. That is, merely being in the same position as potential creditors will not necessarily provide business owners with the protection they desire.  As a further means of protecting company assets from creditors, the borrowing entity can grant security interests in its assets to the lending owners, thereby permitting the owners to become secured creditors of the business.  Secured creditors of a borrower hold a preference over the borrower’s unsecured general creditors to the extent of the collateral securing the loans. In the event of a judgment against the business, the general unsecured creditors 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.   

Bear in mind that many businesses have existing loans and other indebtedness, whether from banks or other lenders. Often times lenders have imposed restrictions in their loan agreements prohibiting a business from further borrowing and/or permitting business assets from being pledged to secure other loans. Loan agreements from conventional lenders will need to be carefully reviewed to ensure that owner loans and or asset pledges will not violate restrictions in existing loan agreements lest the senior loan fall into default. In circumstances where these restrictions do exist, lenders can be asked to and may consent to business owner loans. At the same time, owners of a cash rich company desiring to protect liquid and other business assets are in many cases not the ones with significant bank or other debt.

As with all asset protection strategies, the transaction must be structured carefully so that it does not run afoul of fraudulent conveyance laws.  While these laws vary from state to state, the general thrust of these rules is to impose personal liability on persons who engage in transactions strictly for the purpose of defeating claims of existing creditors.  Some state fraudulent conveyance laws also impose liability on attorneys and other persons who advise prospective debtors on asset protection strategies in an attempt to defeat existing creditor claims. If third party creditors are already threating the business with litigation or lawsuits, distributing funds to the owners may give rise to a claim by business creditors that their rights have been improperly jeopardized or defeated. For those undergoing asset protection planning, the best time for implementing the strategy is before any claims against the business arise. Regretfully, too many people do not think about asset protection planning until it is too late.

As with all business transactions, tax considerations must be taken into account. Distributions of cash to company owners may or may not have tax consequences to the recipients. With limited liability companies and certain types of corporations, cash distributions can be made to owners without owners being subject to income tax on the funds received. A distribution of cash, therefore, followed by a loan back to the business may accomplish the asset protection sought without a corresponding tax cost.  

The Tax Corner addresses various tax, estate, asset protection and other business matters. Should you have any questions regarding the subject matter or if you have questions you want answered, you may contact Bruce at (312) 648-2300 or send an e-mail to [email protected].