From an asset protection standpoint, there are a number of funding strategies available when structuring a business using holding/operating companies. But you must be careful to balance the combination of equity and debt funding.
The holding entity's assets will not be vulnerable because the holding entity will not engage in any operating activities. Thus, the holding entity may hold the assets loaned or leased to the operating entity, as well as the liens placed on the operating entity's assets. These assets may be contributed to the holding entity in exchange for the equity interest.
Still, the owner would be wise to personally own and lease to the holding entity exempt assets such as office equipment and furniture, automobiles, and other "tools of the trade," at least where these assets are not at a high degree of risk of causing personal injuries. In short, the rationale for doing this in the operating company--preserving valuable asset exemptions--also applies to the holding entity.
Moreover, the owner should remember to purchase liability insurance that will cover assets, especially high-risk assets, owned by the holding entity and leased to the operating entity, because of the possibility that liability for injuries caused by the assets could run to the owner.
For this reason, too, consideration should be given to withdrawing funds from the holding entity on a regular basis. Usually this is done in the holding entity in the form of payments of salary to the owner. While the assets within the holding entity are protected to some degree from the owner's personal creditors, there is some small degree of risk to these assets because of the operating entity's activities. Although the latter risk is usually not significant, by withdrawing funds, the overall risk of loss is reduced. In short, diversification reduces risk.
Formal contribution of assets. A common mistake made by small business owners, which can have devastating consequences, is the failure to actually transfer assets into the business form in exchange for the equity interest. This mistake will almost always mean that co-mingling of assets will occur (i.e., the owner will use personal assets for business purposes and business assets for personal purposes).
When a business owner co-mingles business and personal assets, this may form the basis for the courts to pierce the veil of limited liability and impose unlimited, personal liability on the owner. Thus, the business owner must ensure that assets are actually titled to the operating entity when they are contributed in return for the equity interest.
Ownership of certain property is represented by a formal document of title. Examples include real property (land and buildings) and motor vehicles.
Title to real property must be transferred through the execution of a deed that takes a particular form. A quitclaim deed can be used where real property is transferred to a one-owner limited liability company (LLC) or corporation. This type of deed contains no warranties as to the validity of the transferor's title. In a two-or-more-owner business, a warranty deed, guaranteeing the validity the title, and a title search should be considered.
Note that a new deed is prepared for each transfer, with the legal description being copied from the transferor's old deed. The deed should be recorded as soon as possible on the land records, at the county courthouse or local town clerk's office, depending on the state. This ensures that the deed is valid against any subsequent transfers of the property by the original transferor.
By contrast, a motor vehicle title is usually transferred by executing the reverse side of the transferor's title. This title is then filed with the motor vehicle department, and a new title is issued in the transferee's name.
Other property, such as equipment and furniture, is not represented by a formal document of title. Here, it is still essential that the owner formally transfer ownership to the entity. The transfer document here, however, may take different forms. But essentially, a document transferring ownership must be executed.
Finally, in all of these cases, care must be taken that the entity formally approves of the receipt of the asset, and then formally authorizes the issuance of the member interests or common stock, as the case may be.
The holding entity (or owner) as a creditor. The holding entity (or the business owner) may serve in two roles with respect to the operating entity: the role of owner established through the equity interest and the role of a creditor established by financing the operating entity with debt.
A creditor has a priority claim on the entity's assets, in comparison to the owner's claim. On liquidation, creditors receive their share of assets before holders of the equity interest. Further, secured creditors have priority over general or unsecured creditors. Secured creditors hold a security interest in assets of the entity that have been put up as collateral for the extension of credit.
If the entity defaults on a secured loan, the secured creditor can, in effect, remove the collateral from the entity, and use it satisfy the debt. If the debt is over-secured (i.e., the value of the assets exceeds the amount owed), the difference is returned to the pool of assets available to unsecured creditors and the owners of the business. If the loan is under-secured (the balance owed exceeds the value of the collateral), the creditor is an unsecured creditor with respect to that excess.
The owner can protect his interests in the business's assets against the claims of the business's creditors by investing in the entity as a creditor and, in particular, as a secured creditor. This can be accomplished through the use of leases, loans and other extensions of credit.
Specifically, the holding entity (or owner) can lease assets to the operating entity. Because the holding entity retains ownership of the assets, but conducts no business activities, the assets are not exposed to liability at the holding entity level.
Further, because the operating entity does not own the leased assets, they are not exposed to liability at the operating entity level. In short, the assets are shielded from liability from the claims of the business's creditors. Further, if the assets are within the protective form of an LLC (i.e., the holding entity), they are protected from the claims of the owner's personal creditors.
The lease also can be secured by perfecting liens against the operating entity's assets.