One-Entity Approach

April 13, 2006

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A simpler and less expensive (but sometimes less effective) alternative exists to using a holding entity and an operating entity, where leases, loans and liens can be used, but with only one entity. The small business owner, himself, may act as the "holding entity," personally owing the assets that otherwise would be placed within the holding entity.

However, while this simpler approach is less expensive, in that a second entity needn't be created and operated, it has its drawbacks. This strategy offers no protection to the business owner from his personal creditors. By contrast, assets within the holding entity are protected, to some extent, from the claims of the owner's personal creditors.

The business owner can implement all of the funding strategies outlined in this section, with the owner personally acting in place of the holding entity. Thus, the owner can personally own and lease exempt assets to the operating entity, strategically invest a combination of equity and debt, encumber the operating entity's assets with liens that run in favor of the owner, and regularly withdraw vulnerable funds, as they are generated.

However, caution should be exercised with leasing. Some assets by their nature carry an inherent risk that they might cause injury. Examples include buildings, land, machinery and equipment used in a factory, etc. In a case where an asset carries a high potential of liability, it may be unwise to hold ownership in the owners' personal capacity. Liability may run to the owner, in addition to the lessee.

This may expose the owner to unlimited, personal liability. It may be better to place this type of asset within a business form, in exchange for an equity interest, and expose the asset to potential loss, rather than run the risk of unlimited, personal liability. Even here, however, the asset can be protected by, for example, encumbering it with liens in favor of the owner. Of course, with only one entity, the option of placing this asset in the holding entity so that any liability would run there, rather than to the owner personally, is lost.

Joe Smith forms one limited liability company (LLC) to operate his business. He purchases a building in his own name, which he leases to the LLC. His theory in owning the building personally is that the greatest risk applies to assets in the business form, which is true.

What he doesn't realize is that liability for any injuries attributed to improper maintenance of the building may run back to him, because he is the owner of the building. Thus, all of his personal assets outside the business may be exposed to liability. These assets, almost assuredly, are more significant than the building itself. If the building is contributed to the LLC, only this one asset is exposed to liability.

A clause in the lease contract should impose the duty to maintain the building on the lessee (i.e., the LLC). However, courts usually will not allow a party to delegate certain duties, such as the duty to reasonably maintain his or her property.

Because the building is a high risk when it comes to injuries, Smith should consider contributing the building to the LLC, in exchange for his equity interest. The building could then be protected by liens that run to the owner.

Alternatively, Smith could own the building personally, and lease it to the LLC, if he is sure that his insurance liability coverage is more than adequate to cover all potential claims.

Where an asset, such as office equipment, has a low potential for liability, personally owning and leasing may be a suitable alternative. In short, this alternative may not be suitable for a small business owner who operates a machine shop with dangerous equipment, but it may be suitable for a professional, such as an accountant.

Of course, the machine shop owner could employ this strategy with respect to some of the assets used in the business, such as the office equipment. In addition, the owner could consider personally owning and leasing to the entity high-risk assets, if he is sure that he has adequate insurance liability coverage. In this type of business, however, the risk of loss is probably high enough to warrant the creation of a second entity.

Work Smart

A one-entity strategy is more appropriate for a smaller business operated by an owner with a modest net worth. In that case, the owner can initially limit his equity investment in the business to contributions of high-risk assets and cash, which can be quickly withdrawn in the payment of operating expenses, including salary to the owner.

In addition, the owner can personally purchase and then lease low-risk assets (e.g., furniture or office equipment) to the entity, and then withdraw funds from the entity as lease payments, in addition to salary. This also allows the owner to claim an asset exemption in the personally owned "tools of the trade."

As the business grows, the high-risk assets can then be encumbered with liens in favor of the owner, that result from loans and other extensions of credit from the owner to the entity.

As the business continues to grow, the owner can create and fund a holding entity, which then takes over the funding of the operating entity. In this case, the owner will directly own the equity interest in the holding entity.

He also can continue to directly own the equity interest in the operating entity or fund the holding entity with this interest in exchange for the equity interest in the holding entity. In the latter case, the operating entity would become a subsidiary of the holding entity.

Obviously, in situations where the business owner concludes the risk is high enough to contribute the asset, then the asset will not generate lease payments to the owner. Alternatively, the owner could then withdraw vulnerable funds as lease payments attributable to other assets, loan payments and salary. The effect on withdrawals when contributing an asset should be weighed when making a decision as to whether to contribute or lease the asset.