Combining Equity and Debt Funding

April 13, 2006

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When executing funding strategies for your operating/holding company business structure, it is important to balance your equity contributions and debt load, to ensure your asset protection plans reach their full potential.

When the owner forms his limited liability company (LLC) or corporation, he will take back an ownership or equity interest, signifying that he is as an owner, as opposed to a creditor, of the entity. After all, in a properly structured multiple-entity business operation you will serve in both roles.

In the LLC, the owner takes back a membership interest as a "member." In the corporation, the owner tales back an ownership interest in the form of common stock as a "shareholder." Certificates, evidencing the ownership interest, should always be used, in both the LLC and the corporation, even though by law they are not always required (see our discussion on the formation and management of the LLC and corporation).

In return for this ownership or equity interest, you must contribute some assets to the business entity. As a general rule, exempt assets should not be contributed to the business entity. The discussion here is assumed to apply to nonexempt assets, such as an office building, cash, etc., or to high-risk exempt assets, that might be contributed as an exception to this general rule.

Note that when high-risk assets are contributed in return for an equity interest, they may be contributed to the holding entity or the operating entity. Where there is an especially high risk of injury, the assets should be contributed to the operating entity, and then encumbered with liens in favor of the holding entity or owner. Any liability would then run only to the operating entity, while the asset would still be protected.

Where the assets are especially valuable, and of only moderate risk, the holding entity may be a more appropriate owner for these assets. The assets can then be leased to the operating entity. Here, the risk of loss associated with the operating entity owning these assets would probably outweigh the risk of any liability running back to the holding entity.

Warning

Funding the equity interest in the holding and operating entities normally can be accomplished tax-free, as can funding the entities with debt (leases and loans).

However, a contribution in return for the equity interest can sometimes be a taxable event or have other unanticipated tax consequences (see our discussion of the tax aspects related to funding the equity interest).

Moreover, if you do not follow some specific guidelines for establishing both the equity interest in the operating entity and the equity interest in the holding company, you run the risk of losing the limited liability and asset protections you've worked so hard to put in place.