In the current economic environment, a business’s worst-case scenario might include the bankruptcy of a major customer or supplier; a banker’s decision to trim your credit line; the cancellation or postponement of plans for an initial public offering; or a sharp decline in your business’s value.
Planning for such contingencies can take a number forms. But whatever approaches taken, focus on two very important issues: asset diversification and protection from creditors.
Strategies to helpAccording to Dennis Filangeri, a certified financial planner based in San Diego, concentration of assets is a very shaky proposition for business owners.
“You are in a financially precarious position when a substantial portion of your assets are tied up in a single entity, be it your own company or someone else’s,” he says.
Filangeri urges business owners to accumulate personal assets outside their companies as soon as corporate cash flow can support decent compensation for the business owner.
“You should place your personal funds in well diversified and fairly liquid investments,” he says. “By doing so, should your business lose value or even go under, you will still have sheltered a portion of your household’s assets.”
Predictably, it’s difficult for a business owner to diversify his/her personal assets when their business is encountering difficulty. If one is forced to cut back on personal compensation or are compelled to cash in some family investments to raise capital for his business, he will of course have to forgo diversification until conditions stabilize.
Filangeri suggests that owners concentrate their energies on protecting your personal assets from business creditors. Business creditors can range from a lender to someone who wins a judgment against your company. Unfortunately lawsuits are likely to increase during an economic downturn. Filangeri says, “Make sure your personal assets are segregated from you business assets to avoid potentially catastrophic personal exposure.”
Filangeri recommends that owners incorporate their businesses to protect themselves from personal liability for business debts.
In addition, he says, “Don’t use a personal credit card for business purchases unless you file an expense report and formally request reimbursement.”
Similarly, he counsels against using a corporate card for personal transactions.
“Keep separate bank accounts for your company and your family,” he says. The idea is to avoid doing anything that might “pierce the corporate veil.” That’s the term used by attorneys to describe a situation where a business owner mixes his personal and business transactions to such an extent that a judge might rule that there is no distinction between his personal and business transactions. If a judge were to make such a ruling, you would lose the protection that incorporating your business affords would otherwise convey.
Filangeri urges business owners to conform to the formal requirements that go with incorporating a business.
“Make sure to have an annual meeting of the board even if by telephone,” he says. “Keep minutes of board meetings to document what was discussed and what decisions were reached. If there are transfers of funds between you and your company, keep meticulous records that explain the transactions, whether it’s a loan by you to the company or the other way around, or a bonus that was voted upon by the board.”
To really plan for the worst, one could transfer ownership of certain personal assets away from you. For example, one could transfer a home or other holdings to a spouse, but only if the spouse is not involved in the business and the marriage is secure.
Cautions Filangeri, “Make sure you don’t execute any documents that inadvertently expose your spouse to your business’s obligations that could eventually allow creditors access to such assets.”
Protect yourself at all timesCommon mistakes business owners make: One spouse owns the home while the other owns the business but both sign personal guarantees to support a business loan. Even worse is to keep a business loan and your home mortgage at the same bank. It’s possible for a bank to consider both loans in default if you get into trouble with either one of them. Should you be forced to request bankruptcy protection for your business, most states have a “Homestead” exemption that allows you to retain ownership of your home within certain limits. The amount of the homestead exemption differs significantly by state but in some, like Florida, it’s unlimited, notes Filangeri.
There’s a proposal afoot in Washington to set a national limit of $125,000 on the homestead exemption in bankruptcy, but so far, it’s going nowhere. In addition, many states protect life-insurance policies and annuities from creditors. While a creditor cannot get at your money while it is in the annuity, the creditor can garnish, attach, or have a constructive trust imposed on your annuity payments from the insurance company. In practical terms, your creditor can get at the money in your annuity, but he/she must wait until payments start. Moreover, because you have tied your money up in the annuity contract, there is no way for you to move it out of harm’s way—it is only a matter of time before the creditor gets it. Offshore annuities, on the other hand, do offer real asset protection, for a variety of reasons.
First, offshore annuities are not subject to U.S. jurisdiction, which means that a creditor who seeks to challenge the legality of an annuity contract must go to the country where the insurance company is located and litigate the claim there. Most creditors are not prepared to invest substantial amounts of money in legal fees when the outcome is uncertain.
Second, offshore annuities can be purchased through an offshore grantor trust that one can have set up by the insurance company, naming the offshore trust as the beneficiary, so that when the contract “Annuitizes” and monthly payments begin, they are paid to the offshore trust and not you (and offshore trusts are almost impossible for creditors to penetrate). Third, offshore annuities can sometimes be “customized” to provide asset protection features within the annuity contract itself, i.e., that in the event that a creditor is attempting to garnish annuity payments, the insurance company has the right to suspend payments, make a lump sum payoff to an offshore trust or other third party, etc.
If you purchase an annuity, and want the money you pay into the annuity to be protected from creditors, consider purchasing an offshore annuity. Although most of us cannot foresee a situation where we might need asset protection, it is not at all uncommon for individuals to suddenly find themselves under siege from unwanted creditors/litigants. If however, you have no asset protection concerns, and cannot imagine ever being in a position where you would want to protect your assets, you may still want to purchase an offshore annuity to provide income for your retirement. U.S. annuity companies typically offer investment alternatives under a variable annuity in the form of mutual funds offered by the insurance company issuing the annuity contract. Substantially greater investment flexibility is available under a carefully chosen offshore annuity. For example, your investment advisor (chosen for you by the insurance company) can direct the annuity investments in any type of security (subject to reasonable diversification requirements): IBM, Intel, General Motors, etc.—not restricted to “in-house” mutual funds of the issuer. The investment advisor can also be your current U.S. investment advisor or any other unrelated person chosen by you.
Although the IRS requires U.S. citizens and residents to report foreign financial and bank accounts, annuity contracts do not fall within either classification, and are not subject to the foreign account reporting requirements. Although annuity payments received by an offshore trust during the life of the U.S. “Grantor” of the trust, i.e., the person who establishes the trust, are taxable to the U.S. grantor, payments from an offshore annuity made to an foreign trust after the death of the grantor/annuitant are only taxable to the U.S. beneficiaries of the trust when the money is actually distributed to them by the trust. This provides an additional tax deferral benefit for surviving beneficiaries and can be effectively used as an estate planning strategy.
The IRS has never been too keen on U.S. citizens investing their moneys abroad, so it is recommended that you consult a U.S. tax practitioner who is knowledgeable in this field.
The bottom line: Planning for the worst should be approached carefully and involve your corporate attorney and accountant. Don’t try to be your own attorney. It can really backfire!