With great risk comes great reward…or great loss IF you do not set your business up properly. While many of us realize that going into business for yourself is a risky endeavor, most business owners are so busy managing day-to-day operations, generating sales and revenue, and handling whatever is thrown in front of them, that many lack the time or energy to make sure that the business’s basic structure has been properly organized. Unfortunately, this can be an expensive mistake for many business owners, who do not face the reality of their failure to properly structure the business and insulate and protect their personal assets until they face a lawsuit. There may be nothing more gut wrenching for our business clients than sitting with a summons and complaint on their desk and realizing that they should have been more careful as they were building the business.
The reality is that lawsuits are a common - dare I say a “rite of passage” -for most California business owners. But oh what a costly endeavor they are. And even if you are a business owner lucky enough to say you have not been sued…yet, the reality is that California is an especially litigious jurisdiction. With this in mind, if you are not yet employing asset protection strategies as an entrepreneur, it is time to do so.
Asset protection is a form of strategic planning designed to minimize risk and protect and insulate assets from creditors’ claims and litigation. Careful asset protection can help you retain and sustain the value of the property and accounts you own.
As a business owner, there are numerous strategies you can employ to engage in even the most basic asset protection. Some of these strategies include:
- SEPARATE YOUR PERSONAL ASSETS FROM YOUR BUSINESS ASSETS BY ESTABLISHING A LIMITED LIABILITY BUSINESS ENTITY. When an individual starts a business for the first time, it is common to use a sole proprietorship. If you have two or more people forming a business, they may opt for a general partnership. The benefit of the sole proprietorship or partnership is that neither is complicated to form, usually commencing with the filing of a simple fictitious business name statement in the county or counties in which the business will operate and the opening of a bank account and the business is ready to go. Neither the sole proprietorship nor the general partnership is registered with the California Secretary of State, enabling the owner(s) of such businesses to get operating in no time at all.
These entities, though simple to create, do not legally protect the business owners’ personal assets whatsoever. This is unlike the registered business structures such as a limited partnership, limited liability company, and the corporation, all of which provide limited liability to the owners. This means that the owners of the business are not personally liable for the company’s debts or other liabilities—for example, if a judgment is obtained in a lawsuit against the business, the creditor cannot look to the owner’s personal assets to satisfy the judgment. A properly established and maintained limited liability business structure restricts liability to assets belonging only to the business. Creating a separate legal entity is one of the first steps every entrepreneur should take to protect personal assets. Subsequent practices like opening a separate business account, complying with legal requirements such as paying state filing fees, and not commingling personal funds with business funds further establish the legal separation between personal assets and business assets.
- KEEP MULTIPLE BUSINESS VENTURES SEPARATE. Both the blessing and the curse of the entrepreneur is the drive to always create, diversify, take risks and try new things. I am always amazed by how many of my business clients manage and operate multiple business owners, sometimes not even in related fields. Unfortunately, sometimes in the hustle and bustle of business management, the business owner may commingle assets amongst their multiple ventures. The problem with this approach, even if the company(ies) are registered limited liability entities, is that commingling is a surefire way to expose the business assets of one entity to the creditors of another.
In these cases, it is critical for the business owner to ensure that he or she keeps the assets of each business completely separate. This requires not only setting up different legal entities for each of the businesses, but also ensuring that each entity incurs separate debts and liabilities and maintains assets in each business’s proper name and endeavor not to ever commingle them. Failure to legally separate your diverse businesses may expose all of your businesses to each business’s creditors if litigation arises and one of your businesses is found liable. As a result, it is important to separate these business interests as soon as possible and to ensure that the documentation, accounting, banking, and record-keeping for each of your businesses reflect the distinction amongst the entities.
- OBTAIN SUFFICIENT BUSINESS AND PERSONAL INSURANCE. This may be one of the easiest, yet often overlooked, ways of protecting assets for a business owner. Accidents are inevitable when you own a business – whether it be a car accident, slip and fall incident, or negligence in how something was managed by your team. But having insurance available to cover you, both for damages from liability and even attorneys’ fees, can greatly insulate both you and the business from paying for losses that do occur, which obviously protects cash flow by avoiding the need for the business to pay these losses directly.
Various types of insurance are available to you as an entrepreneur; the types you should obtain depend on the type of business you conduct and your unique preferences. Commercial general liability insurance, employment practices liability insurance, and business interruption insurance are just a few of the many options that you should consider. But that is not all, you also need to review the insurance policies diligently each year to ensure that the coverage is adequate to cover the value of your assets and your potential for liability. Remember, if you doubled your revenue in one year to the next, you probably also greatly increased your exposure to liability.
- AVOID PERSONAL GUARANTEES. While easier said than done as an entrepreneur, to the extent you can avoid a personal guarantee you should. A personal guarantee is an agreement in which the business owner agrees to be personally liable for the debts of a business in the event that the business is unable to pay. These are, however, completely counterproductive to the limited liability protection you sought when you registered with the Secretary of State. Unfortunately, it is not uncommon, especially for startup entities, to be asked to sign these personal guarantees (especially when entering into a lease agreement). If you are asked to sign a personal guarantee, and to the extent this is feasible for you, consider negotiating a higher payment to the vendor to eliminate the need for the guarantee, or asking for a finite duration of the guarantee, even if the business relationship is expected to go far beyond the guarantee period. In my practice, it is not uncommon to request that a personal guarantee end at the termination of the first lease term. While it may seem daunting to request accommodations, especially as a startup hungry to get things moving with the new business, most things in life are negotiable and the long-term benefits of limitations to personal guarantees can provide invaluable asset protection.
- TRANSFER SOME OF YOUR ASSETS TO A TRUST. A trust is a legal tool that allows a third party, the trustee, to hold assets for the benefit of another, the beneficiary. There are various types of trusts available to individuals – the most common of which is a revocable living trust which provides no meaningful asset protection.
For business owners, one of the most common types of trust we use for asset protection purposes is an irrevocable trust because the business owner, by virtue of gifting the assets to the trustee of the irrevocable trust, relinquishes his or her ownership and control of the business assets, thereby removing the assets from the business owner’s personal name and eliminating the asset as a potential source of funds to satisfy a creditor or judgment. The irrevocable trust functions differently than the more common revocable living trust, because the business owner, who is typically also the trustee of the revocable living trust, may easily change the terms of the revocable trust at any time prior to his or her death and is still treated as the owner of the property held in the trust. This is dissimilar to an irrevocable trust where the owner no longer exercises control of the assets. Entrepreneurs interested in asset protection should strongly consider setting up an irrevocable trust early in their business development. If a trust is created after litigation arises, the trust may be viewed with suspicion by a court as a tool of liability avoidance and can actually be set aside in certain circumstances.
The moral of the story is that we are here for you and it is NEVER too late to make sure your business is structured properly. Protecting and preserving your wealth as an entrepreneur will not happen on its own - it requires involved strategic planning and executing on the plan with intention. Contact us so we can help protect you today.