Entity Basics

THE SOLE PROPRIETORSHIP Explained

  • The oldest, most basic business type.
  • 1 owner basically just starts a business.
  • He may register a “doing business as” name w/local courthouse or county recorder’s office.
  • Pros: No need to register anything, simplest set up and operation.
  • Cons: No limited liability, no special tax reduction benefits (self-employment tax savings, etc.). Personal creditors may reach biz assets, biz creditors may reach personal assets.

THE GENERAL PARTNERSHIP Explained

  • No special registration needed (but is optional in some states)
  • Multiple people just “get together” and form a partnership.
  • Everyone is a manager.
  • Each partner is liable for the other partners’ actions. This is BAD!
  • GPs do have charging order protection.

THE CORPORATION - Pro's and Con's

  • First statutory entity (artificial person allowed to be created by statute), and also first limited liability entity.
  • Stock may be freely alienated; no charging order protection.
  • Shareholders have no liability for business debts beyond their investment in the corporation.
  • Directors and officers are often still held liable for personal torts committed in connection with corporation’s business.
  • Shareholders may be held liable for business debts if a plaintiff convinces a judge that the corp is the ‘alter-ego’ of the shareholder(s).
  • Taxed under U.S. law as a subchapter C or S corporation.
  • C corporation = good if you have annual net profit of less than $100,000 and wish to reinvest profits into the company. May convert to an S corp later.
  • Has a 3-tiered management structure (shareholder, directors, corporate officers). Also must follow corporate formalities. LP, LLP, and LLC are generally easier to operate.
  • S corporation = ‘pass-through’ taxation and is often used to reduce self-employment taxes.
  • Usually only a good idea to form a corporation if you plan on going public. Otherwise consider an LLC (which may be taxed as a C or S corp, if it chooses) or sometimes an LP or LLP.
  • THE LIMITED PARTNERSHIP (LP) Pro's and Con's

    • Two classes of partners: general partners and limited partners.
    • General partners manage the partnership; no limited liability for business debts.
    • Limited partners may not manage (still sometimes work for partnership), but have limited liability. Generally, no self-employment tax on limited partner distributions.
    • Everyone gets charging order protection.
    • Sometimes uses the ‘valuation discount’ strategy although this strategy has been diminished somewhat since 2009.
    • Sometimes avoids entity level taxes that LLCs must pay (ex: pays less tax in CA than some LLCs.)
    • A few states (such as Florida, see Olmstead v. FTC (2010)) give better charging order protection for LPs over LLCs.
    • Otherwise, the LLC is a generally more flexible and preferable entity.

    THE LIMITED LIABILITY COMPANY (LLC) Pro's and Cons

    • In the U.S. since 1977. A ‘hybrid’ entity offering the best features of corporations and partnerships.
    • An unincorporated business entity. Limited liability for all members.
    • Some members may manage, or all, or none and hire a non-member manager. Management change is easier than with an LP.
    • Everyone gets charging order protection.
    • May be taxed as a ‘disregarded entity’, partnership, S corp, or C corp = pick your poison.
    • Two-tiered management: members and managers.
    • Following ‘formalities’ may be a good idea but not necessarily required. Less reasons to pierce an LLC than a corporation.
    • Usually the most flexible and best business entity to form, but not always.
    • Download example Nevis LLC offshore operating agreement as an example of a offshore LLC operating agreement.

    LIMITED LIABILITY PARTNERSHIPS (LLPS) AND LIMITED LIABILITY LIMITED PARTNERSHIPS (LLLP)

    • LLP = Everyone partner manages, and also has limited liability. A partner is not liable for the torts of other partners. Might be a good choice in Florida, since LPs are expensive to form there and LLC charging order protection is under fire right now (2010-2011). The LLP is sometimes used by licensed professionals, such as law firms.
    • LLLP = A limited partnership where the general partners have limited liability. Still less flexible than an LLC, so it is not used that often, but there are a few states where an LLLP makes sense. LLLPs are not available in many states.

    Remember: Business entities are for holding business assets i.e. assets that can be used to generate profit. A personal residence, personal yacht, or something else that has no chance of making you money should NOT be owned by a business entity so as to protect your assets.
    See for example In re Turner, 335 B.R. 140 (Bkrpt. N.D. Cal 2005).

    “‘Asset protection’ is not illegal and is honored by the law if done for a legitimate purpose. For example, an individual may do business through a corporation or limited liability company and will not be held personally liable for the debts of the entity. The assets of the corporation or limited liability company will not be considered the assets of the individual interest holder.

    However, an entity or series of entities may not be created with no business purpose and personal assets transferred to them with no relationship to any business purpose, simply as a means of shielding them from creditors. Under such circumstances, the law views the entity as the alter ego of the individual debtor and will disregard it to prevent injustice.”

    Personal assets are usually protected with some form of trust. Not any trust will do. You need a Non Qualified Personal Residence Trust (NQPRT) for a home, Defective Beneficiary Taxed Trust (DBETT) for other personal assets, or an offshore trust for assets that can be placed offshore. We discuss these types of trust in later lessons.

    Posted in ENTITIES (Trusts, FLP's, LLC's and Corporations) and tagged , , .