Case Study: Funding Multiple Entities

April 13, 2006

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John, a Connecticut resident, wants to start a business in Connecticut by investing $100,000 of cash.

If John forms a single entity, and invests the $100,000, this $100,000 will be exposed to the claims of the business's creditors.

Instead, John forms two limited liability companies (LLCs) in Connecticut, a holding LLC and an operating LLC. He first forms the holding entity. The holding entity then forms the operating entity, as its only owner.

John contributes $100,000 to the holding LLC in return for an equity interest in the holding company. The holding LLC uses the $100,000 to purchase the assets necessary to run the operating LLC. The holding LLC then leases these assets (through an approved written lease agreement) to the operating LLC, which then takes possession of the assets. Ownership of the assets, however, remains in the holding LLC.

As a result of this structure, and funding arrangement, John's $100,000 investment is now protected against the claims of both the business's creditors and John's personal creditors.

The operating LLC does not own the assets. Accordingly, the assets are not exposed to the claims of the business creditors at that level. The holding LLC conducts no operating activities. Thus, the assets are not exposed to the claims of the business's creditors at that level either. In short, the assets are protected against the claims of the business creditors.

At the same time, the assets are protected against the claims of John's personal creditors, because Connecticut follows the Revised Uniform Limited Partnership Act rule that prevents personal creditors from foreclosing on an owner's LLC interest or forcing a liquidation of the business to satisfy a personal debt.

Note that John's holding LLC would have established its equity interest in the operating LLC though a separate investment, apart from the lease. However, this equity investment would also be fully protected through liens on the operating entity's assets that would run to the holding entity, or to John personally.

For example, the lease would be used to withdraw funds from the operating entity, and also to encumber its assets with liens. These liens could be established by the lease against the operating entity's assets (the leased assets and other assets contributed for the equity interest) as security for the lease obligations. Liens could also be established as a result of other extensions of credit to the operating entity. Thus, the holding entity would have priority claims on these assets, in the event that the operating entity defaulted on the lease payments, which is a likely scenario if the business runs into financial difficulties.

In a different scenario, now let's say John contributes $100,000 to the holding entity, which lends the $100,000 to the operating entity, so that the operating entity can purchase a building for the business. The operating entity puts up the building as collateral for the loan, giving the holding entity a mortgage on the building.

Now the operating entity owns the building, but John enjoys the same protections he did before when the holding entity owned the assets.

However, John never records the mortgage. Subsequently, a creditor sues the operating entity, obtains a judgment of $100,000, and records a lien against the building for this amount on the land records.

The judgment creditor's lien takes precedence over the holding entity's lien. As a result, the judgment creditor may be able to foreclose on the building.

Had John recorded the holding entity's lien immediately after it was created, the holding entity's lien would have taken precedence. In this case, the judgment creditor would have been unlikely to foreclose on its lien, because doing so would require that it pay off the holding entity's lien. Either way, John would protect his $100,000 investment--he would keep the building or be paid the $100,000 lien in cash.