Business owners are often told to operate their enterprises through a ‘proprietary limited company’ to cap their liability if something goes wrong. This is good advice, but it is nowhere near the end of the story. You also need to protect your assets.
How a proprietary limited company works
A proprietary limited company (identified by the term ‘Pty Ltd’ in the company name) is one where the ownership of the company is private, and the liability of the owners is capped to the amount paid for their shares. Shares are usually issued fully-paid, so in most cases, the shareholder’s liability will be limited to what they have already put in as capital, often as little as $2. This means if the business fails, and the company can’t pay all its debts, the shareholders will not be personally liable for those debts.
However, ordinarily, the owners of the shares in the company are also directors. In certain situations, for example, if you knowingly allow your company to trade while insolvent, the directors will be personally liable. For this reason, before you get appointed as a director, get prepared by minimising the extent of assets in your own personal name.
But what about the assets used in your business? One of the main reasons people start a business is to grow value within the business itself. If all goes well, this value can soon become your family’s biggest asset. What happens to that business value if your business fails?
During the administration of an insolvent business, the assets of the business are sold to repay creditors. If you own stock, equipment, commercial property, intellectual property, cash and any other any assets in your company, the value will be available to your creditors. For that reason, you need a business structure that not only limits your personal liability but also protects the value you are building within the business itself.
Limit the value of the assets owned by your company
After setting up a company, the next step in establishing a successful business structure is separating ‘business risks’ from ‘business wealth’. ‘Risk’ here is represented by the business’ operations, and ‘business wealth’ by the assets used by the business.
This can be achieved by having a dual-entity structure, where one entity, say your proprietary limited company operates the business (the Operating Entity), and another entity, perhaps a trust, self-managed super fund or another company, owns the business assets (the Asset Owning Entity). The Asset Owning Entity then makes the assets available to the Operating Entity under a ‘lease’, ‘licence’ and/or ‘loan’.
This structure allows your Operating Entity to use the assets in your business, but if the business fails with debts owing to creditors, the assets used in the business will not be available to satisfy those debts, since they are owned by another legal entity (i.e. the Asset Owning Entity).
The following two important steps must be implemented for this strategy to work:
1. Have formal lease/licence/loan agreements between your entities
For this ‘business asset protection’ strategy to work, you need a formal agreement between your two entities, whereby the Asset Owning Entity provides the Operating Entity with the use of the business assets. These agreements record the fact that the assets remain owned by the Asset Owning Entity and are only available to be ‘used‘ by the Operating Entity. These agreements must clearly record the assets involved and any fees payable by the Operating Entity back to the Asset Owning Entity for use of the assets.
2. Registering the security interest
The Asset Owning Entity must also register its security interest in the business assets it is providing to the Operating Entity on the Personal Property Securities Registry (PPSR). The PPSR is a public notice system for interests in personal property (such as the assets used in the business).
Failure to register the fact that the Asset Owning Entity owns the business assets means people dealing with the Operating Entity are not aware of the fact that it does not own the assets it is using. People trading with the Operating Entity could reasonably be mistaken for thinking the Operating Entity owns the assets. For this reason, under our insolvency laws, if there is no registration and the Operating Entity fails, the assets are then available to meet the debts owed by the Operating Entity – even though the Operating Entity did not own the assets.
For the Asset Owning Entity to be able to take back its assets if the Operating Entity fails, the Asset Owning Entity needs to have registered its interest in the business assets on the public PPS Register. If this has not been done, the assets will be lost, and the ‘structural asset protection’ strategy of having business assets owned in a separate legal entity fails.
Note that real estate should also be owned in an entity separate from the Operating Entity, but it is not possible (or necessary) to register the ownership of the real estate on the PPSR. Real estate has its own registration system, bring the lands title system.
Paying out profits from your business
Don’t forget about cash. If the Operating Entity is sued and becomes insolvent, all assets owned by the business will be available to repay creditors, including any cash held in the business as retained earnings. Business owners should regularly pay out profits from the Operating Entity to a holding entity (which can be the same Asset Owning Entity), so the business will not have large amounts of cash lying around if someone makes a claim. If the Operating Entity needs cash for working capital purposes, then the Asset Owning Entity can lend this cash back to the Operating Entity under a secured loan agreement which needs to be recorded on the PPSR.
Key takeaways
When putting in place a business structure that limits your liability, remember:
- A company on its own is not an ‘asset protection’ structure – it is a ‘liability limitation structure’;
- To protect your business assets, you must separate ‘business risks’ and ‘business wealth’;
- To protect your business assets, use a dual-entity structurewhere business risk is assumed by an operating entity and the assets used in the business are owned by a second legal entity;
- To make sure you have formal agreements in place between your entities to record how your asset entity is allowing your operating entity to use its assets;
- The asset owning entity must register its ‘security interest’ over the business assets on the PPSR; and
- The operating entity should distribute its accumulated profits on a regular basis so that there is no spare cash lying around your operating entity if something goes wrong.
