Limited liability companies (“LLCs”) are a common asset protection tool for business owners. Although a relatively new type of business entity, LLCs have proven to be much simpler to own and operate than other entities, such as corporations. By conducting your business through an LLC rather than in your personal name, you may be personally protected from business debts and liabilities. In other words, if your LLC is the defendant in a lawsuit, the LLC provides protection to the assets of the owners (or “members”) of the LLC. The LLC’s assets may be vulnerable, but your personal assets will likely be protected. This liability protection may become unavailable if a member offers a personal guarantee on LLC debt, or, as described below, a court chooses to pierce the corporate veil.
LLCs can be taxed as a “pass through entity,” which means that LLCs might not pay federal (and sometimes state) income tax. Instead, an LLC passes its net income (or net loss) to its members as a “distribution.” The members then include this income on their personal income tax returns. By default LLCs are considered pass through entities, and are taxed as a sole proprietorship (for single-member LLCs) or partnerships (for multi-member LLCs). If you want to change the tax classification for your LLC, you must file IRS Form 8832. Veil recommends you work closely with a competent tax professional to make decisions related to the taxation of your entities.
Every state has enacted its own set of laws governing LLCs. These laws provide the default rules that LLCs and their members must abide by. However, there are instances in which an LLC’s management needs to clarify the rights and responsibilities of the parties associated with the entity. In these situations the LLC will need to adopt an operating agreement. The operating agreement can cover many different legal and business topics; the most basic function it serves is to clarify the roles of the members and managers, and establish who has the authority to act on behalf of the entity when dealing with third parties (e.g., lenders).
Keeping Your LLC Safe
Each LLC member and manager should conduct their business in a way that would prevent a court from “piercing the corporate veil.” LLCs generally provide excellent asset protection for members, but occasionally courts will disregard an LLC’s protections and allow creditors to access the personal assets of members. To prevent this, LLC members and managers should avoid certain practices, including but not limited to: fraudulent activity, commingling of funds, operating the LLC as the “alter ego” of the members, undercapitalization, or underinsurance. Courts rarely pierce the corporate veil, but members and managers should nevertheless operate their company in a way that reduces this risk.
As with LLCs, Corporations are considered limited liability entities, meaning that a corporation’s owners (or “shareholders”) are generally not personally liable for the debts and liabilities of the corporation. Assuming the shareholder is not personally liable for a judgment, the shareholder is only liable up to the amount of his or her personal investment in the company. Although corporations effectively protect owners’ assets, investors should have a good understanding of corporate governance before choosing this type of entity for their asset protection structure.
A key difference between LLCs and corporations is the amount of formalities that corporations must adhere to. While LLCs are simple to organize and operate, corporations require organized governance to prevent courts from “piercing the corporate veil.” As with LLCs (see previous section), corporate officers and directors should be mindful of the practices that can draw negative attention from judges and creditors. To summarize, corporate officers can reduce this risk by operating their business in a legal and organized manner, maintaining accurate corporate records (e.g., corporate resolutions, corporate minutes, financial records), and using the entity as a legitimate business rather than as the “alter ego” of the owners.
Corporate Taxation: S-Corps and C-Corps
There are two types of corporations, S-Corps and C-Corps. A corporation’s tax treatment depends on which type of corporation it is classified as. C-Corps must pay taxes on net income. Generally speaking, this tax is levied as a percentage of the C-Corp’s profits. Once the tax is paid the corporation can then make distributions to its shareholders, who then are responsible for including the distributions on their income tax returns. This process is known as double taxation.
Some investors wish to avoid double taxation so they file IRS Form 2553 to make an S-Corp election. If you decide to make the S-Corp election you must file IRS Form 2553 within 70 days of incorporation. Once the corporation makes an S-Corp election it no longer needs to pay taxes on net income. Instead, the S-Corp is free to make distributions to its shareholders, who will then claim the distribution as income on their individual income tax returns. A tax professional can help you operate your asset protection structure in a way that improves your ability to “deduct” eligible business expenses. Always consult with a competent tax professional as you confront these complicated and important tax issues!
A sole proprietorship exists when an individual operates a business for a profit without making formal arrangements to operate as a different type of entity. Sole proprietorships are owned, operated, and controlled by a single individual. Sole proprietorships are generally treated as flow-through entities for federal taxation purposes, so the entity’s profits, losses, and gains are passed on to the owner. One of the most important characteristics of a sole proprietorship is the owner’s liability for the debts of the business. Unlike owners of an LLC, sole proprietors are personally responsible for the business’s debts and obligations.
Formation, Termination, and Conversion
A sole proprietorship has an informal formation and termination process: no paperwork or filings need to be used in order to create a sole proprietorship. Likewise, a sole proprietorship can be terminated simply by the intent of the owner, or by the death or withdrawal of the owner. Traditionally sole proprietorships have been a very common business entity. Recently, however, business owners are recognizing the benefits of alternative business entities, such as LLCs. The exact process for convertinga sole proprietorship to an LLC depends on the rules of the state where the business is located, and whether the business has acquired property, licenses, bank accounts, etc.
To formally convert a business from a sole proprietorship to an LLC, the owner generally should create an LLC by filing Articles of Organization with the Secretary of State’s Office. The business will then need an Employer Identification Number (“EIN”) from the IRS. Once the LLC has been established the owner can transfer the business’s assets to the LLC. Although the new LLC will give the business owner liability protection for business debts and obligations, former sole proprietors should be aware that they are likely personally liable for business debts and obligations incurred before the business was converted to the LLC.
Advantages of a Sole Proprietorship
There are a few advantages to using a sole proprietorship. Most importantly, sole proprietorships are informal and generally easier to organize and operate than other business entities. In spite of the advantages, investors should be aware of the main drawback of using this entity: sole proprietorships do not offer owners liability protection from the debts and obligations of the company. To improve liability protection investors can look to other types of business entity – for instance, LLCs and corporations.
Partnerships come in various forms – general partnerships, limited partnerships, limited liability partnerships, and family limited partnerships. Continue reading to learn about each of these partnerships.
General partnerships are the most fundamental type of partnership. In a general partnership a group of partners (either individuals or entities) operate a business jointly pursuant to the terms of an agreement. By default, partnerships are governed by the laws of the state where the partnership is located. Partners should adopt a partnership agreement if they need to clarify or change the rules of the partnership. General partnerships are comparable to LLCs because both entities are flexible and can be structured and operated according to the needs of the owners. Control and management of a general partnership is typically vested in its owners equally unless a partnership agreement states otherwise.
As with most other types of business entity (including limited partnerships and limited liability partnerships), general partnerships are considered a pass-through entity for federal taxation purposes, so the partnership’s profits, losses, and gains are passed on to its owners. Unlike some business entities (e.g., LLCs, corporations), general partnerships do not require a formal filing with the Secretary of State in order to officially organize the entity. Instead, a general partnership is brought into existence simply by agreement of the partners. Similarly, a general partnership is dissolved by the express intent of the partners, or by the death, expulsion, or withdrawal of a partner.
For investors deciding between a general partnership and a limited liability entity (e.g., LLC, corporation, limited liability partnership), the most important factor to keep in mind is the lack of liability protection for partners in a general partnership. Specifically, in a general partnership, all of the partners are liable for the debts and obligations incurred by the partnership. Conversely, owners of limited liability entities typically avoid this level of personal liability. If a partnership needs to convert to a different type of entity (e.g., LLC), the conversion process is fairly straightforward and can be accomplished by one of several methods, depending on the state where the business is located.
As mentioned above, general partnerships hold a few advantages over other entities. For example, general partnerships are quick and easy to organize, and are flexible in their organizational and operational structure. However, investors should be cautious of using general partnerships mainly because of the lack of liability protection from business debts and obligations.
Limited Liability Partnerships
Limited liability partnerships (“LLPs”) are similar to general partnerships and LLCs, but there are a few noteworthy differences. Unlike general partnerships, in order to organize an LLP the owners must file formal paperwork with the appropriate state agency – generally the Secretary of State in the state in which the partnership is located. An LLP is typically controlled by its partners equally unless otherwise indicated in its partnership agreement. Since state statutes provide the default rules of LLP governance, LLP partners often adopt a partnership agreement in order to clarify the rights and responsibilities of those associated with the entity.
Limited liability partnership and limited liability companies have similar names; however, there is a significant difference between the liability protection that the two entities offer. Owners of LLCs are generally not liable for any debts or obligations of the company. Owners of LLPs, however, are personally liable for some the debts and obligations of the company as set forth in the statutes of the state where the LLP is organized. In addition, LLP partners must act as fiduciaries to one another and should always provide full disclosure. Investors should therefore consider state-specific restrictions on LLP partners before choosing this entity.
In addition, termination of limited liability partnerships is unique in a few ways. An LLP can be terminated either by inference or by a documented intent of its partners. An LLP may also dissolve when a partner withdraws, dies, or is expelled. Once the LLP dissolves the remaining owners must decide whether to continue operating as a business, and, if so, organize a replacement entity.
Limited liability partnerships may sometimes be the best choice for investors. However, before choosing an LLP, investors should bear in mind that LLPs offer partial – not absolute – protection from liability for the debts and obligations of the business. Other entity types – for example, LLCs – may be a better option for investors that need stronger protection from the company’s liabilities.
Limited partnerships (“LPs”) share several similarities with other types of partnerships. For example, LPs are formed by filing paperwork with the Secretary of State office in the state in which the business is located. As with other business entities, state law provides the default rules that govern the protections and duties of persons associated with a limited partnership. Owners of a limited partnership may draft a partnership agreement if state law does not provide favorable default rules for the partnership.
The most unique attribute of a limited partnership is the distinction between general partners and limited partners. The LP must have at least one person listed as a general partner and at least one person listed as a limited partner. General partners have the right to participate in the management and control of the partnership, but general partners are personally liable for the debts and obligations of the partnership. Limited partners, on the other hand, do not have the right to manage and control the partnership, but they enjoy protection from liability to third parties for partnership debts and obligations.
Another important aspect of LPs is the taxation – both federal and state taxation – of limited partnership income. It is vital for investors to consult with a competent tax professional in order to evaluate the tax advantages and disadvantages associated with owning and operating a limited partnership and other business entities.
Limited partnerships are appropriate in some circumstances. However, investors must remember that liability protection in limited partnerships has its limits. Specifically, limited partners are generally only liable for partnership debts and obligations up to the amount of their personal investment in the partnership. General partners, on the other hand, are exposed to unlimited personal liability for business debts and obligations. Other business entities – for example, LLCs and corporations – often provide stronger liability protection and may therefore be a more appropriate choice.
Business entities are an important part of an individual’s business holdings, but they are not the only tool available for asset protection. Many of Veil’s clients choose to adopt a living trust in addition to their business entities. Trusts are effective tools that help investors’ assets avoid the long and costly process of probate. When properly drafted, trusts ensure that assets are distributed efficiently according to the terms of the trust. Many of Veil’s clients mistakenly believe that trusts are an adequate substitution for other asset protection strategies. It is important to remember that trusts should be used as a complement to – rather than a substitute for –other asset protection techniques.
In addition to trusts and estate planning, a vital piece of every strong asset protection structure is a general liability insurance policy. A robust insurance policy acts as the “front line” protection against potential creditors. Ideally, your insurance policy will cover your liabilities and you will not need to rely on the protections offered by limited liability entities. However, in the event that your liability exceeds your policy, you will be glad you included limited liability entities as part of your structure. Speak with a trustworthy insurance representative as you choose a policy that works with your structure.