Upsides and Pitfalls of Lending to Borrowers with Multiple Entities
May 26, 2016
Borrowers that operate various lines of business under one “roof” may expose themselves and their bankers to high levels of financial and legal risks. But creating separate legal entities for different business lines or assets can reduce those risks.
That said, operating multiple entities can make it easier for a dishonest business owner or manager to hide evidence of fraud. And weak oversight may cause the IRS or a court to disregard the legal separation between entities. So, while there may be legitimate strategic reasons for a borrower to divvy up its operations, doing so may require the banker to conduct additional due diligence.
What are the legal benefits of separation?
Borrowers often create new legal entities to better departmentalize and contain their risks. Consider, for example, a retailer that owns its real estate as a supplement to its main line of business. If both the real estate and the operating business are owned by one legal entity, it could spell disaster if someone is injured on site or the local real estate market crumbles.
If, however, the retailer carves out its real estate into a separate entity, it might prevent tax and legal claims against the property from affecting its main line of business (and vice versa). This is an upside for bankers, too, because it safeguards collateral from outside claims and minimizes the risk of loan default, even when unexpected negative events occur.
Why else might a borrower split up its business?
There also may be other strategic advantages to setting up a separate legal entity. For example, when a company is owned by several individuals, they might have different investment preferences and priorities.
To illustrate, suppose a manufacturing business is owned equally by two people. One shareholder has extra cash on hand and wants to buy the plant the company has leased for years from a third party. He’s 70 years old and sees the rental income as a way to generate extra income during retirement. The other owner is paying for triplets in college and has limited cash for a down payment on the property. She doesn’t expect to retire for another 25 years.
Both shareholders’ needs can be met by setting up a separate entity for the real estate that’s owned 100% by the older shareholder. In this case, the real estate venture would have a different ownership structure than the operating business.
Alternatively, some borrowers separate business operations for estate planning purposes. A classic example is a family-owned business that’s transitioning to second-generation owners. Often nonoperating assets (such as real estate) are carved out of the main business and transferred to heirs who aren’t active in day-to-day business operations. Then the operating business is transferred to the heirs running that business. This setup gives all of the heirs a stake in the business without compromising daily business operations.
When separating business lines, borrowers often opt for pass-through entities, such as limited liability companies or S corporations. These structures generally offer the tax advantages of partnerships — that is, business income is taxed only once at the owners’ personal tax rates. They also can limit an owner’s personal liability, similar to the legal protections available to C corporations.
What are the potential pitfalls?
The more legal entities that a company operates, the greater its opportunities for incomplete recordkeeping and even fraud. When the numbers don’t add up or there are other suspicious circumstances, a forensic accountant can help analyze transactions between a borrower’s entities to ensure that everything is done by the books.
It’s also critical for borrowers to keep business operations truly separate and maintain arm’s length transactions between related entities. If not, the IRS or a court could challenge the legality of the separation between the entities, thereby exposing the parent entity to any outstanding legal and tax claims.
Balance the ups and downs
It’s often smart to divvy up business operations into separate legal entities, especially for borrowers with high-risk business segments or assets. But the upsides can quickly disappear without adequate attention to detail.
Looking for more information on this topic? Contact Mark Abrams at 404-874-6244 or fill out our form for more information.
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