I recently had a client come in and discuss how he should protect himself from liability on his closely-held business (he and his brother-in-law were the sole owners). This got me thinking that the information would probably be of a benefit to others who follow this blog.
When you look at limiting liability that may stem from a business (called inside liability protection), one must look to the state corporations law as well as the federal tax laws, and how the best options will work for all of the owners. That being said, there are still a few options out there and I will try to do a short overview of the options.
Incorporation: One of the oldest ways to leagally protect from liability, every state has laws to allow incorporation of a business. By incorporating, the business will file with the State and the owners will receive stock back to signify their ownership of the company. Incorporating has been around for a long time, so there are many positives with established law that come from this type of choice of entity, however, there are many downsides, too. One of the main downsides is that corporations are generally taxed at the corporate level, and then again at the owner level (dividends). This can be avoided for most small businesses via an “S” election, that only causes taxation at the shareholder level, but the “S” election comes with its own restrictions. Another downside of the corporate choice of entity is that it does not come with a standard “outside liability protection”. Outside liability protection means that if an owner is sued, his shares of stock are not protected from the creditor; e.g., the creditor can become the new owner of the stock. When you are dealing with a closely-held business, the other owners will not want to deal with another owner’s creditor, and by choosing corporate form, it may result in the end of the business. Another downside is the imposition of franchise taxes at the state level, which are usually avoided with the other entities.
Limited Partnership: The Limited Partnership (LP) was one of the fist attempts to allow limitation on inside and outside liability as well as a way to avoid the double taxation associated with corporations. The LP must have a general partner (GP) who is subject to full liability, but all limited partners only risk losing what they have invested in the business. This option was greatly used 50 years ago, but with the advent of the LLC, there are not used as often now. LPs must be taxed as partnerships and there must always be a General Partner and at least one Limited Partner.
Limited Liability Company: The Limited Liability Company (LLC) is the most recent development in the options to limit liability of owners. The LLC (in most states) offers both inside and outside liability protection, meaning neither a creditor of the business nor a creditor of the owner will affect the other owners beyond initial investments. In addition, the LLC has the most flexibility with taxation due to the IRS “check the box” regulations. This means that an LLC can be taxed as a disregarded entity (if only one owner), as a partnership, as a corporation, or an “S” corporation. In addition, the LLC has flexibility for future planning because different classes of ownership can be created.
If you have a small business or farm then you should really look at ways to protect your assets and your family from liability. Consulting with a qualified estate and tax planning attorney is one of the best ways to rest assured you get the best protection.