A subspecialization for many business lawyers, including me, is a field of law and tax called asset protection. This field involves the creating of entities and other arrangements for clients that will protect them from claims by their creditors.
I sometimes feel slightly guilty in providing asset protection services to my clients, since, if claims against them are legitimate, the clients won’t deserve asset protection. But my clients usually pay their legitimate bills; so my goal is to protect them against claims that lack merit, whether in the form of meritless invoices or meritless lawsuits. In this country, anybody can sue anybody about anything, so providing legal protection against meritless lawsuits can be a major service for one’s clients.
The most basic asset protection for business owners is to form entities for them that will provide them with statutory liability shields against claims. Businesspeople who do business as state-law sole proprietors – i.e., through single-owner businesses not conducted as entities – don’t have these shields. This means they will be personally liable for claims by third parties against them for business actions or omissions not only by themselves but also by their employees, if they have any, and sometimes even by independent contractors who do work for them. And their homes, any securities they own and all of their other personal assets will be at risk in these claims except, normally, for cash they hold in qualified retirement plans.
The same goes for people who do business in state-law partnerships. People who conduct a business in cooperation with other people and who share the profits and losses of these businesses with them, even if they never think of themselves as state-law partners and never describe themselves as partners to other people, are partners nevertheless as a matter of New Hampshire law. Partners have the same personal liability as state-law sole proprietors.
And the same is also true for married couples who hold rental property as joint tenants. In the eyes of the law, they, too, are conducting their businesses as partners, and they have partnership liability.
All of the above businesspeople should conduct their businesses not as sole proprietors, partners or joint tenants, but rather, in state-law business corporations or LLCs, since these entities will give them the liability shields from third-party claims they need (except, of course, liability for claims arising from their own personal misconduct).
However, even if businesspeople do conduct their businesses through business corporations or LLCs, they should also give serious consideration to doing so through holding company/operating company structures if their businesses have valuable business property. This property may consist of cash, valuable real estate, valuable personal property such as machines, tools or vehicles, or valuable intellectual property, such as patents, trademarks or trade secrets.
Through proper title arrangements, valid property assignments or otherwise, their holding companies should hold all of these assets in their own names; they should lend, lease or license them to entirely separate entities, called operating companies; and these activities of lending, leasing and licensing their assets to their operating companies should be their holding companies’ only activities. The holding company of a business engage in no activities whatsoever with customers or other third parties. Instead, all activities with third parties should be conducted solely by operating companies. Under this structure, a business’s assets are likely to be entirely safe from third-party claims, and while their operating companies will be at risk for these claims, they will have no assets that successful claimants can seize.
Who should own a holding company’s operating company? Operating companies can be held either as wholly-owned subsidiaries of holding companies, or they can be held by entities often identified as “sister companies”—i.e., companies that have either some or all of the same owners as those of their holding companies. Choosing between ownership of operating companies as subsidiaries or as sister companies can be difficult. In general, however, holding company/subsidiary structures are likely to be simpler than sister-company structures; but in lawsuits, third-party plaintiffs are likely to argue that holding company subsidiaries are merely the “alter egos” of their parents. Thus, business owners concerned about the possibility of alter ego claims may prefer sister-company arrangements.
The key point is that business entities that have valuable assets should rarely operate through a single-entity structure; rather, they should use a holding company/operating company structure. Indeed, if corporations have boards of directors or if multi-member LLCs are governed by managers, the failure of these boards and managers to organize their companies in holding company/operating company structures may constitute serious breaches of their duties of care.
In other words, corporate directors and LLC managers may also need asset protection.
John Cunningham is a Concord tax and business lawyer. He has published “Limited Liability Company Operating Agreements” and “Maximizing Pass-Through Deductions under Internal Revenue Code Section 199A”. Both are the leading books in their fields.