There is an old expression, “those who fail to plan, plan to fail”. Sage advice. From a legal point of view, however, proper planning should include planning for failure. In a business context this simply translates to planning and structuring your business affairs so that certain assets are not available to satisfy the claims of the creditors of the business.
While there are numerous legal devices to shelter assets, the most frequently employed are described below:
The fundamental principle in corporate law is that a corporation is a distinct entity from its shareholders. Therefore, if persons starting a business have assets, it is always prudent to incorporate a company to shield their personal assets from the claims of business creditors. Likewise, if a person owns shares in a successful business and wishes to acquire new assets or another business, the acquisition ought to be completed by a separate corporation. These newly acquired assets are then not available in the future to the creditors of that other business.
The most common example of this type of strategy occurs when an operating company wants to acquire real estate to house its business activities. The transaction should be structured so that a new corporation, owned by the principals of the operating company, acquires the real estate. This ensures that the creditors of the operating corporation never have available to them the real estate to satisfy any claims.
2. Holding Corporations
A “holding corporation” can be described as a corporation that does not engage in active business but merely holds shares in an operating company or holds real estate from which the operating company carries on its business.
Where a holding corporation owns shares in an operating corporation, dividends (distributing earnings or retained earnings) can generally be declared and paid to the holding corporation without any resulting tax liability to the holding corporation. Tax liability results only when those dividends are ultimately distributed to an individual tax payer either by way of dividend, bonus or salary. Once the dividend (usually in the form of cash) is received by the holding corporation then that property becomes property of the holding corporation and no longer the property of the operating corporation subject to claim by the operating corporation’s creditors.
If the operating corporation subsequently requires that cash for working capital purposes, the monies can be advanced to the operating company by way of loan and secured by way of a general security agreement in favour of the holding corporation. The holding corporation then becomes a secured creditor of the operating company, with priority over unsecured or subsequent secured creditors of the business.
At some point in the gradual process of accumulating wealth, a person may reach a point where their assets exceed the level reasonably required to finance their lifestyle. At such point, it is wise to consider whether surplus assets should be transferred, or a corporation owned by such person be restructured so that beneficial ownership of those assets, together with the future growth of those assets, reside with others, typically one’s spouse and children. The vehicle most commonly used for such a transfer is the family trust. Family trusts are usually set up so that persons with wealth divest themselves of certain property but act as the trustee with full, unfettered discretion respecting the administration of the trust and the determination of who receives the direct benefits thereunder.
If the trustee encounters financial misfortune after establishing the trust, the assets in the trust are not available to satisfy the claims of his or her creditors as the trust property does not belong to the trustee. In addition, as long as the property remains in the trust, it is free from the claims of the beneficiaries’ creditors.
The use of family trusts can form part of an estate freeze, the purpose of which is to avoid or reduce capital gains on the increased value of equity shares over time in the succession of businesses from one generation to the next.
Failing to properly plan your affairs can result in expensive and unanticipated consequences. Proper planning should be done in consultation with your professional advisors.