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Business Law

Choice of Entity for Owning and Operating a Business

Why is the type of legal entity you choose for your business important? Because owners can be held accountable for tax liabilities, tortious injuries/damages and breaches of contract caused by their business. Whether the owner is then held personally responsible for such business liabilities often hinges on the type of legal entity under which you operate your business. Depending on the type of entity you choose, you, as an owner, could be personally sued by the government, tenants or private parties in the event something goes wrong. With the proper choice of legal entity, you can limit your exposure and worry less about liability.

What Factors Go into the Choice of Entity?

Every single fact concerning your business is relevant to your decision about the type of entity you wish to use. Not all of these facts are of equal importance, but they all matter to some degree. For almost all businesses, the considerations that should be in the forefront are:

  • Tax, tort and contractual liability issues;

  • The annual cost of maintaining the entity;

  • Protection of intellectual property;

  • Size and complexity of the entity (now and in the future); and

  • Regulatory requirements that local, state or federal governments place on the prospective business activity

Sole Proprietorship

A sole proprietorship is a business owned by an individual which is not otherwise incorporated or organized as a separate legal entity (i.e., there is no partnership, limited liability company or corporation). A sole proprietorship is a business where an individual conducts business and holds title in his or her name and is directly and personally liable for the obligations of the business. There is no corporate entity or legal device to own the business assets or limit the liability of the owner for any debts, liabilities or obligations of the business. This type of business operation generally exposes the owner to the most potential personal liability. The tax code treats the sole proprietorship and the owner as one and the same. Income and expenses are reported on Schedule C of the Owner's Form 1040. Sole proprietorships are taxed on all net income; there is no way for your business to retain earnings without you being taxed on that money.

Despite the personal liability that comes with the sole proprietorship, this is still the most prevalent type of business structure. Approximately 80% of the small businesses in the United States are sole proprietorships. The primary reason is the simplicity in establishing a sole proprietorship. Unlike other forms of business entities, there are typically no specific laws governing the creation and existence of sole proprietorships. Instead, basic rules of contract law, tort law, and property law apply. The existence of the sole proprietorship ends upon the death of the owner and the property of the business will be disposed of according to the terms of the owner's Last Will and Testament.

From a liability standpoint, Proprietorships are the riskiest form of business organization. I remain amazed at how many manufactured home and RV Communities are owned as proprietorships, unnecessarily exposing the owners and their assets to potential personal risk. In my opinion, a business should virtually never be operated as a proprietorship.

Corporations

Corporations are entities that are created under various state laws. Many corporations can be operated quite simply, with as little as one shareholder. Generally, there are two (2) types of corporations that are most frequently formed. The first is the C-corporation; the second is the S-corporation. Both are typically formed and treated the same under state law. However, they differ significantly in tax treatment.

The laws governing the formation of a corporation must be strictly followed, otherwise the attempt at incorporation may fail and a partnership may result by default. Although the laws governing the formation of a corporation vary from state to state, in general, the necessary actions to incorporate are fairly standard: prepare and execute a pre-organization subscription agreement for the stock that the corporation will issue; prepare the By-laws and Articles of Incorporation; prepare and file the corporate charter with the appropriate state agency; hold an organizational meeting of the board of directors; establish the books, records, home office, etc. of the corporation; and file any reports required by the state. Mistakes in the formation documents can cause problems ranging from minor annoyances to business-killing litigation. Do not try to create a corporation yourself. Always use an experienced attorney. However, once the corporation is formed, it can often be run very simply, with many corporations merely being operated from a desktop at the owner's home.

A corporation is an autonomous legal entity, existing apart from its shareholders, officers and directors. Neither a sole proprietorship nor a partnership can truly be considered distinct from the persons creating it. Corporations have a kind of legal immortality. The corporation can exist for as long as the shareholders desire. A corporation even continues on regardless of the circumstances surrounding the owners.

According to law, day-to-day management of a corporation rests with the officers appointed by the board of directors, who are ultimately responsible for the management of the corporation. The board of directors is elected by the vote of the shareholders. The exact duties of the board and the officers are usually spelled out in the by-laws or, less frequently the articles of incorporation. A corporation can even be set up with a single person serving as the sole shareholder, board member and officer.

Unlike partnerships and sole proprietorships, corporate shareholders are generally not liable for a corporation's debts. This means that the risk to the owners/shareholders is typically limited to the corporation's assets. This is true regardless of how much a shareholder participates in management. Even a shareholder who owns 100% of a business and makes every decision cannot typically be held liable for the debts of the corporation, unless he personally causes certain torts or runs afoul of a legal theory known as "piercing the corporate veil." Even though the corporation may be liable for the acts of its employees and agents who commit tortious acts (i.e. civil wrongs), the shareholders will generally not be liable. However, a corporation will not protect you against lawsuits alleging personal tortious conduct or fraudulent or criminal actions by you during the course of corporate business, but that is just common sense.

This protection against liability for corporate debt may be somewhat deceptive to the uninitiated. Most banks or investors who loan money to small corporations, as well as businesses who extend credit to small corporations, also require one or more of the shareholders to personally guarantee the obligation. The limited liability of this structure (and all other structures) is therefore somewhat misleading and the shareholders are likely to take on some of the risks of the corporation. The benefit to incorporating still exists however, because you usually take on only those liabilities to which you voluntarily agree.

The theory of "piercing the corporate veil" is important for corporate shareholders to understand in order to minimize their personal liability. In general, if the shareholders commingle assets or do not follow rudimentary corporate formalities, a court can pierce the corporate veil (i.e. the protection for the shareholders) and hold the shareholders personally liable for corporate obligations. For example, when a smaller corporation has financial trouble and one or more creditors are not going to get repaid what they are owed, the creditors may ask a court to issue a judicial order stating the corporate owners are personally liable for the corporation' s unpaid debts. Courts will only do so under very limited circumstances. If a court agrees to issue such an order it is known as "piercing the corporate veil." Before issuing such an order, courts look at certain actions by the owners and management of the business to determine if the order is warranted. Generally, the court looks at any combination of three factors:

  • Did the owners fail to observe corporate formalities such as keeping minute books, passing resolutions, and holding board meetings?

  • Did the shareholders really treat the corporation as a separate entity or merely as a simple artifice?

  • Did the corporation have sufficient money when it began (i.e., adequate capitalization) or was it merely an undercapitalized shell?

To avoid having a court pierce the corporate veil, shareholders and directors of smaller corporations should follow a few basic rules:

  • Treat all corporate money as just that: corporate money. Do not commingle personal funds and corporate funds.

  • Deal with third parties as an officer or representative of the corporation, not as a person making a business decision on his or her own.

  • Start the corporation with enough money or assets to make it legitimate.

  • Treat the corporation like it is a separate entity.

Take care to create the minute books, save all documents, make sure the small stuff is taken care of and observe all formalities. A little time spent this way can save a lot of money later.

The above points are common to all corporations, whether they be formed as a C-corporation or as an S-corporation. The main difference between a C-corporation and an S-corporation is the tax treatment. Below is a very general overview of just some of the tax differences between a C and an S Corporation.

With a C-corporation, you do not get the "flow-through" tax benefits that the other small business entities enjoy. What this means is that the profits and losses of the company are the company's profits and losses, not yours as a shareholder. The C-corporation must file a tax return and pay taxes on the income it receives. Then, if there are any dividends to be paid to the shareholders, the shareholders will have to pay taxes again on the money received as dividends. This is the double taxation on C-corporations that so many shareholders grumble about.

With an S-corporation, the income and losses of the Corporation are attributed pro rata to the owners (shareholders). This means that there is no "double taxation" of corporate income like the C-corporation and items of income and expense "pass through" to individual shareholders. In order to qualify as an S-corporation, you must meet certain requirements (such as 75 or fewer shareholders and using only one class of stock) and file a form with the IRS stating your intention to be treated as an S-corporation. Once filed, the S-corporation election will remain in force until you notify the IRS that you revoke the S-corporation election or your business no longer qualifies as an S-corporation.

Partnerships

There are two types of partnerships, general and limited. Like other business entities, partnerships are a creation of state law. The money and property contributed to the partnership by the partners are called "contributions". The value of each partner's contribution forms the partner's "capital account". A capital account is more a financial record of your investment in the partnership than an actual "account" in the way a bank savings account is an account. The capital account helps determine the tax you owe on distributions paid to you by the partnership. A partner's capital account is increased by the value of the property he or she contributes to the partnership and decreased for the partnership's distributions. Contributions of property rather than money bring other tax rules into effect. Generally, the value of property you contribute to the partnership will determine your capital account. Capital accounts are adjusted upward during the life of the partnership as well as whenever a partner contributes additional money or property and decreases whenever there is a distribution of money (or recognition of losses).

If you or another partner is a "skills" person who contributes no money or other property but is instead receiving a partnership interest for bringing unique (or not so unique) skills to the partnership, you should be aware that the IRS does not recognize this as a contribution. As far as the IRS is concerned, a person who receives a partnership interest without making a capital contribution of money or property is getting a valuable asset for nothing. This is a taxable event and the person receiving the partnership interest will have to pay income taxes on the value of the ownership interest received. Keep this in mind if, for example, one person is putting in $100,000 for a 50% interest and another is putting in nothing for her 50% interest. The person who put in nothing just received ½ of the $100,000 contributed by the other partner, creating a taxable event.

A. General Partnerships. General partnerships consist of two or more partners. Each one of those partners carries unlimited personal liability for the obligations of the partnership. Each partner has complete and equal management control over partnership affairs unless there is a partnership agreement stating otherwise.

Although a partnership can be formed very informally, it is preferable to have an attorney draw up an agreement reflecting your particular needs, if only to prevent future disagreements over the present intentions of the parties. A partnership has some characteristics of a separate legal entity. Often, a partnership can sue other parties in courts and convey or buy property. But partnerships retain one very large disadvantage similar to a sole proprietorship: partners are held personally liable for the obligations of the partnership. Under the Uniform Partnership Act, general partners are jointly liable for partnership obligations. Moreover, general partners are jointly and severally liable for the tortious acts of co-partners who are acting within the scope of the partnership business. Unpaid debts and tax bills of the partnership can result in the partners' personal assets being subject to seizure. Thus, each general partner has personal liability for all of the partnership debts.

Partnerships, unlike corporations, do not have perpetual existence. Partnerships generally end upon the occurrence of the following events: the death, retirement, withdrawal, expulsion, incapacity, or bankruptcy of a partner; court ordered dissolution of the partnership; or the expiration of any date as the termination date in the partnership agreement.

The good news is that partnerships are not subject to federal income tax on the income they earn. The bad news is that the partners are considered to have earned the income attributable to the partnership. At the end of the partnership's tax year, the books for the year are closed out, and all monies left over after paying bills, expenses, etc. are divided among the partners according to their ownership percentages. Regardless of whether the money actually gets paid out, the IRS treats it as though all profits of the partnership have been distributed to the partners according to their ownerships interests. The partners then pay tax on the income from the partnership as though that money was personal income. Alternatively, if the partnership lost money during the year, the partners get a deduction equal to the losses corresponding to their ownership percentages (limited to the basis of what the partner invested and/or the passive activity rules). It is also important to note that if a partnership retains money at the end of the year instead of paying it out, the partners must still pay income tax on their respective shares of the partnership income. If you think that you are going to run a business which will require a lot of retained capital, you may want to consider a C-corporation.

B. Limited Partnerships. A special type of partnership is the limited partnership. Although it is based on the structure of the general partnership, the limited partnership has some very significant differences. To form a limited partnership, there are strict and inflexible statutory rules which must be followed. Otherwise, the attempt to form the limited partnership fails and a general partnership usually results instead. A certificate must usually be filed with the State to provide a public record of the existence of the limited partnership.

Limited partnerships must have at least one general partner who is the person liable for the debts of the partnership debt. However, limited partnerships have one very large advantage over the general partnership: limited partners do not take on personal liability for the obligations of the partnership. Therefore, they are only liable to the extent of the money contributed to the partnership. The general partner in the limited partnership, however, retains all of the personal liability for partnership debts that one finds in the general partnership entity. But, since this general partner can be a corporation, the requirement does not mean that one of the members of the limited partnership needs to accept potentially ruinous liability. The general partner controls the limited partnership with the same scope of powers as a general partner would have in a standard general partnership. The general partner also owes the limited partnership at least the same level of fiduciary duty that a general partner in a general partnership owes, perhaps more.

Unlike general partnerships, the death, retirement, withdrawal, or bankruptcy of a limited partner does not end the existence of the limited partnership, but instead only requires an amendment to the limited partnership's certificate. The limited partnership interest may be transferred to another person without the consent of the other limited or general partners.

The limited liability partnership is often attractive to entrepreneurs because they can retain control over a business by acting as the general partner, while still being able to offer limited partner investors the tax benefits of a tax flow-through entity. But with Limited Liability Companies now offering the same benefits without requiring a general partner, limited partnerships are becoming old news. Part Four in this series will address Limited Liability Companies, which is the most popular type of entity being formed today.

Limited Liability Companies

Limited liability companies ("LLCs") have now become the most popular form of legal entity for owning mobile home, manufactured home and RV communities. LLCs afford their members protection from personal liability just like that of a Corporation. At the same time, LLCs provide pass-through taxation like that of a partnership, limited partnership or S-corporation. LLCs also require very few formalities in formation and operation. Consequently, LLC provide many of the benefits of a corporation and the desirable tax treatment afforded by a partnership without the complexity and expense of a setting up and maintaining those types of entities. Almost every new entity I have set up during the past ten years has been an LLC.

An LLC is formed by preparing and submitting Articles of Organization to the appropriate state agency. Typically, the owners of the LLC, called "members", enter into a written agreement outlining how the LLC will be managed and how profits will be divided between the members. This agreement is called the Operating Agreement and is similar to a limited partnership agreement. If the members fail to create an Operating Agreement, then the LLC statutes adopted by the State will apply and will govern the operation of the LLC.

The LLC form of organization has one very large advantage over the general partnership: members of an LLC do not assume personal liability for the obligations of the LLC and they are only liable for the debts of the LLC to the extent of their investment interest in the LLC. Additionally, unlike a limited partnership, the members of a LLC may participate in the business and not lose the liability protection of the LLC because of their participation.

In recent years, LLCs have become the choice of entity for most of my clients. To help minimize liabilities, I typically recommend that a separate entity be established to own each property. After all, if something catastrophic should happen to one property (a large claim, environmental problem, uninsured or underinsured casualty loss, etc.), why would you want to put your other assets or properties at risk?

Good business planning, including selecting the correct form of business entity, is an essential part of an overall business plan. A wise property owner would be well advised to consult with legal counsel regarding the type entity to own and operate an investment property, or whether it would make sense to switch to a different type of entity to own and operate your business.

This article was originally published in 2008.

 
          

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