It is no secret that many clients are in financial difficulty. The best time to address creditor protection issues for either a business or an individual is as far in advance of an actual problem as is conceivably possible. Here are a few brief thoughts on some actions to consider. NOTE: All of these must be analyzed and implemented by CPAs and attorneys. This is an overview of options sometimes overlooked and NOT a do it yourself guide. The penalties involved in doing incorrect creditor protection can be significant, so competent counsel is crucial.
Here are a few suggestions that may go a long way toward protecting the client in financial difficulty:
Pay Any Outstanding Taxes
In a bankruptcy, tax liability for the most recent few years is virtually impossible to discharge, but many other debts will be dischargeable. If a debt is discharged in the bankruptcy, the client will not have to pay it. If it is not discharged, it remains a debt of the client despite the bankruptcy. Clearly then it is best to get rid of any non-dischargeable debt as much as possible before dealing with dischargeable debt. Since tax liabilities will usually be non-dischargeable, paying all tax liabilities immediately for any and all outstanding years as well as the current year can be a good plan. Make pre-payments if necessary. If handled correctly, you will often be able to avoid having such payments deemed as fraudulent or preferential transfers (other bankruptcy traps for the unwary!).
Pay Down Debt on Exempt or Protected Assets
Some assets will likely be exempt to some extent in a bankruptcy. Others will be better creditor protected than others. Pay down debt on these assets instead of paying off other creditors. NOTE: Do not use retirement funds for this purpose without careful consideration as retirement accounts are often exempt assets.
Restructure Business/Asset Ownership
Entities like LLCs and corporations protect an owner's personal assets from claims on the entity itself. Here, I am addressing another type of creditor protection; namely where the owner is the one with the creditor problem. An LLC (but not an S or C Corporation) can provide special creditor protection for the owner's liabilities. This is because creditors of an LLC owner are usually limited to a charging order against the membership interest (i.e., can reach any distributions actually made from the LLC to the owner) but cannot reach or own the membership interest itself or the underlying assets of the LLC.
We often add one or more members to all family or single-member LLCs so long as the new member can buy the interest for a fair value. Also, if it otherwise makes sense as part of an estate plan and the clients are married, making real estate or businesses owned by husband and wife, tenants by the entireties, can be very protective if only one of the spouses has the creditor problems. This is because Michigan and most other states protect certain assets titled as entireties property from creditors of only one spouse.
Finally, if you have an S Corporation, you could convert it to an LLC which then elects S Corporation status. This allows the income tax situation to remain the same, while granting the owner(s) the extra creditor protection an LLC provides.
To provide the maximum creditor protection and also minimize tax issues, it is critical that a business' minute books and other corporate books and records are brought up to date, made accurate and to accord with reality.
Consider Working Outside of Bankruptcy
We work with clients and their other advisors to perform an orderly liquidation and negotiation of debt payoff with a client's creditors outside of a bankruptcy setting. When handled properly and done early enough, the results we have been able to achieve have allowed the clients to keep far more of the proceeds of sale than they would have received in a bankruptcy. Also, the client avoids the often very negative feelings or "stigma" about having to file for bankruptcy.
Consider The Parents
Is the client anticipating an inheritance? If so, check out whether the proposed benefactor would leave the inheritance in a creditor protected trust instead of outright to the client (where it may simply be taken by creditors). This is simple, but is often overlooked and can go a long way toward providing back up money for a finically troubled client. Actually, creditor protection trusts for all beneficiaries can be a wise tool, but that is a different topic!
For further information regarding these matters, please contact Ms. Umphrey at 248.619.2591 or [email protected]
Cynthia Umphrey helps families and business owners make significant personal and professional life decisions. Ms. Umphrey calls upon over 10 years of experience in estate planning, probate administration, business structuring and business exit planning to guide you though life's most important choices.