SECURITIZATION AND CREDITOR PROOFING – USE IT OR LOSE IT

Think back 4 years ago. Before 9/11, SARS, Mad Cow Disease, Avian Flu, Enron, Worldcom, Pine Beetles, Softwood Lumber Duties ….. The world has forever changed. Risk is now a way of life. The impact on our personal lives and businesses has been immense. Given the unprecedented level of uncertainty we all live with, we still find that most small business owners have taken little if any action to protect themselves.

This article will look at the issue of protecting business and personal assets from the unforeseen claims of creditors. We will begin by examining the sources of the risk and then look at strategies, including life insurance programs, which can be undertaken to reduce the exposure.

A. The Sources of Risk

Generally speaking, risk comes from two sources: Business and financial.

Business risk includes the normal liability exposure of running a business. This can vary widely depending on the nature of the business. For example, a doctor may have a much higher degree of business risk than someone who runs a shoe repair business. One thing is certain, wherever the business falls within the risk spectrum, the potential for a liability claim has increased dramatically in the last several years. This by virtue of an increasingly litigious society and judges who are much more inclined to award large settlements based on the motivation of compensating the victim as opposed any one being at fault. A second aspect of business risk relates to items such as business interruption and loss of profits because of unforeseen events. Examples include items such as fire, natural disasters and items mentioned previously (softwood lumber duties, SARS, pine beetles and Mad Cow disease).

Financial risk would encompass all forms of indebtedness to third parties. This includes loans, secured charges, personal guarantees, trade payables and of course amounts owing to the Canada Revenue Agency (“the CRA”).

If someone is operating as a sole proprietor or through a partnership, the liability is unlimited for both business and financial risk. Everything is on the line. However, many people are of the view that operating through a limited liability company shields them from risk. Although at one time there may have been some validity to this, the reality is that in the modern business environment running a business through a limited liability company offers minimal protection. There are several reasons for this:

1. Most entrepreneurs are not only the shareholders of the their companies but are also a director and officer. Under modern corporate legislation modeled after the Canada Business Corporations Act (in effect in most provinces in Canada), there is very significant liability exposure for directors and officers and our courts have become increasingly inclined to hold directors and officers responsible for negligent business behavior. In addition, numerous other Federal and Provincial statutes hold directors and officers personally liable for corporate debts or misfeasance (examples include the Income Tax Act; Goods and Services Tax Act; Environmental Protection Legislation and Workers Compensation Legislation only to mention a few).
2. Apart and separate from the statutory recourse, the courts have become increasingly willing to “pierce the corporate veil” and ascribe personal liability to those who are responsible for operating an incorporated business in a negligent manner.
3. In order for a company to obtain any type of loan, it is normally a condition that the main shareholders are required to guarantee the indebtedness. This, in addition to any other security the lender may be able to extract.

As a final matter it should be mentioned that while most business owners have liability and hazard insurance protection, the value of this has diminished considerably in recent years. Coverages have become increasingly restrictive, exclusions broader and deductibles (and premiums) have become much higher.

B. Planning Options

These generally fall into two categories: 1. Transferring assets out of the company; and 2. Securitizing the position of the business owner.

Transferring assets out of the company – A creditor can only attach what you own. To the extent an operating company does not own anything, there is nothing to go after. Here are some strategies for transferring assets out of a company (we will assume throughout this article that any transfers will be done in such a manner so as to avoid application of provincial Fraudulent Conveyance legislation).

1. Placing Capital Assets in a Separate Holding Company (“HOLDCO) – We see many businesses with millions of dollars of capital assets (land, buildings, equipment) owned at the operating company level. To the extent there is a claim, it will arise first against the operating company. By owning assets in a HOLDCO and leasing them back to the operating company this protects those assets from the first level of attack by any business creditor. Ownership of capital assets at the “HOLDCO” level may also make it easier to sell the business later on. Finally, the operating company can ongoingly strip all cash and any other investment assets into HOLDCO thereby protecting them from future claims at the operating company level.
2. Retirement Compensation Arrangements (“RCA”) – Structured properly, an RCA can be a very effective method of removing cash from the operating business on a tax deductible basis and placing the funds into a creditor protected vehicle for the benefit of the business owner. To the extent funds within the RCA are loaned back to the company, the loan can be secured.

Securitizing the position of the business owner – The remainder of this article will look at various strategies for securing the position of the business owner (by transferring assets to other parties or placing assets into creditor protected vehicles) while still allowing the business owner to enjoy some degree of control and benefit.

1. Securing Shareholder Loans – We have seen countless successful incorporated businesses with multi million dollar unsecured shareholder loans owing to principal shareholders. The loans typically arise through tax planning to pay bonuses down to the small business tax rate and then the shareholder loans the money back the company to support business activities. Although this is a loan to the company like any other loan, most shareholders do not look at it that way and the only recognition is a note to the financial statements indicating “This loan is a demand, non-interest bearing loan to ______ shareholder”. In reality, it is very easy for the shareholder to put in place a general security arrangement so as to give the shareholder priority over all other unsecured creditors (including the CRA). This a relatively inexpensive, simple and effective method which provides a significant degree of protection.
2. Transferring Assets to a Spouse – Often the business owner is married and the spouse is not involved in the business or, if involved, the spouse does not have to be a director, officer or guarantor of the business. Transferring personally owned assets into the hands of the spouse can be a very effective securitization technique. Any newly acquired assets should also be placed in the hands of the lower risk spouse. Transferring assets to a spouse will not create any tax consequences (there is a “rollover” between spouses) and in the event of a subsequent matrimonial dispute there would be no downside given that property of this nature would normally be divided equally irrespective of who holds title.
3. Estate Freeze – If it is anticipated that the business will experience significant growth and the business owner is otherwise a proper candidate for an estate freeze, transferring future growth to other family members (either directly or through a trust) can be a very viable securitization technique. Not only is the growth in value protected from personal claims against the business owner but also favorable tax planning can result.
4. Family Trust – Either done separately or as part of an estate freeze, transferring assets into a discretionary family trust can not only protect those assets from the claims of creditors but also allow the transferor to retain control and benefit of those assets.
5. Private Foundation – Similar to a family trust, where a significant charitable giving intention is present, use of a private family foundation achieves the charitable giving objective and also protects assets from the claims of creditors while still allowing for retention of control.
6. Life Insurance – All of our provincial Insurance Acts provide that in the event the beneficiary of a personally owned insurance policy is within a prescribed (related) class, death benefits and accumulating cash values are protected from the claims of creditors. This position has been repeatedly supported by our courts (see the Supreme Court of Canada decision in Ramgotra). When combined with the ability to realize tax free compounding within the policy and access to the investment value at any time (through a complimentary leveraging strategy), use of life insurance can be a powerful estate planning strategy. It combines the ability to protect the assets while still retain control and benefit.

The risks of carrying on business in the 21st century are substantial and expanding. The thinking of most advisors and wealthy families has not caught up with this reality. Numerous strategies and planning opportunities are available to protect the family wealth. It is a case of use it or risk losing it.

Footnotes:

1. RSC 1985 c. C – 44
2. Examples include the Income Tax Act: Goods and Services Tax Act; Environmental Protection legislations and Workers Compensation legislation.
3. We will assume throughout this article that any transfers will be done in such a manner so as to avoid application of provincial Fraudulent Conveyance legislation.
4. Section 186 of the Income Tax Act Canada R.S.C 1985, c. 1.
5. Defined in Section 248(1) of the Act (Kevin: you may wish to include references to previous Articles in Insurance Planning – I do not have a comprehensive index).
6. Not specifically dealt with in the Act. However, see Interpretation Bulletin IT 85 R2.
7. Section 125 of the Act.
8. Section 73(1) of the Act.
9. Kevin – please include reference to earlier articles in Insurance Planning which deal generally with estate freezing.
10. The definition of “disposition” in Section 54 of the Act includes a transfer of property to a trust. Section 73 (1) of the Act deals with “alter-ego” and “joint partner” trusts. (Kevin, please also include reference to the previous article which I published in Insurance Planning on Joint Partner and Alter Ego trusts.).
11. See for example Insurance Act of British Columbia RSBC 1996 Chapter 227.
12. Kevin – I couldn’t lay my hands on the Ramgotra citation. If you have it handy, please insert. Otherwise, let me know and I will dig further. Thanks.
13. Kevin – again, I think we can refer to previous articles in Insurance Planning.