Protecting Yourself from Creditors When You Own a Business
UPDATED: January 28, 2009
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How do you protect your assets from this potential liability? Since your business is likely to be your riskiest undertaking, youll need to consider carefully the organizational form in which your business is conducted. While you can choose to run your business as a sole proprietorship, partnership, limited partnership, corporation or limited liability company (LLC), in most cases the LLC will offer the most effective protection for both your personal assets outside the business and your investment in the business itself. Following is a discussion of each business form and the risks and protections each affords.
In a Sole Proprietorship, the simplest business form, there is one owner and there are no formal requirements to create or operate the business. The owner has unlimited personal liability for all of the business debts and the acts of employees. The income is reported on the owners personal tax return.
A General Partnership must have two or more owners. There are no formal requirements to create or operate this form of business either. All the owners have unlimited, personal liability for all of the business debts and for the acts of employees. In addition, each owner has unlimited, personal liability for the acts of all the other owners. Exposure to liability is so great with this form that, simply put, it should not be used. The income is reported on each owners personal income tax returns.
Like a General Partnership, a Limited Partnership (LP) must have two or more owners. It is formally created under state law. At least one owner must be a general partner who has unlimited, personal liability in all of the same ways as in a general partnership. At least one owner must be a limited partner who has limited liability, similar to owners of a corporation or limited liability company (see below). However, unlike those owners, limited partners are prohibited from participating in the management of the business. This business form is used mostly for tax planning purposes (tax shelters) and estate planning purposes (transfer of discounted ownership shares to children). In addition, an LP can register to become an LLLP (see below), which gives the general partner limited liability.
You usually think of only big companies like Chevron, Coca Cola, Nike, etc. as corporations, but a small business may be a Corporation, as well. A corporation may have one or more owners. It must be formally created under state law. All of the owners have limited liability for the business debts. It is usually more expensive to create and maintain than an LLC and it is subject to many formal statutory rules regarding officers and directors, and meeting and record keeping requirements. A regular corporation, called a C corporation is a separate taxpaying entity, which may result in higher taxes and requires the filing of a separate tax return. When you want your corporation to be treated as a conduit for tax purposes, so that its income and loss flow to the owners, it is called a subchapter S corporation or simply an S corporation. In a small group of states, the corporation may be formed as a statutory close corporation, which operates more like a partnership or LLC (see below).
A Limited Liability Company (LLC) is a newer form of business. Like an LP or a Corporation, it is formally created under state law. All of the owners have limited liability for the business debts. It is less costly than a corporation to create and maintain. The rules governing its operation are more relaxed and less burdensome than a corporation. Unlike a corporation, it is not a separate taxpaying entity. The income is reported on the owners personal tax returns. The LLC combines into one form the best elements from the corporation (limited liability for all the owners) and the general partnership (absence of formalities, low costs, tax benefits). In many states, the business interests of the owners of an LLC are protected from the claims of the owners personal creditors. This is not the case with corporations or LLPs.
A Limited Liability Partnership (LLP) requires two or more owners. It is similar to an LLC, but with some important differences. It is formally created under state law. All of the owners have limited liability for the business debts, but in many states, the limited liability offers less protection than what is afforded to the owners of an LLC or a corporation. Generally, anyone can form an LLP, however California and NY limit the use of the LLP to professionals, such as attorneys, physicians, accountants, etc. Some states use the term Registered LLP (RLLP) because it is really a general partnership that has registered in the LLP form to achieve some version of limited liability for all the owners of the business.
A Limited Liability Limited Partnership (LLLP) is a limited partnership (LP) that registers under state law so the general partner will have limited liability, similar to limited partners. This is similar to the process of a general partnership registering to be recognized as an LLP, so that all the owners have limited liability. It is primarily used to convert an existing LP previously created under state law. Colorado, Delaware, Florida, Georgia, Maryland and Texas recognize the LLLP. In the future, it is likely that other states will follow suit.
As you can see, only the LLC and the Corporation offer the protection of full limited liability to all of the owners of the business in every state. The owner's liability for the business's debts is limited to what he or she has invested in the business (i.e., the business' assets).
Suppose the owner of a sole proprietorship or a general partnership has a personal net worth of one million dollars outside of his business. His business suffers severe financial difficulties, resulting in a debt of $1.5 million, due to a loss of market share, default on loans, loss of a major lawsuit, etc. If the owner, at the time of the loss, has $2,000 invested in the business, what does the owner stand to lose? The answer is his entire personal net worth of $1 million, in addition to the $2,000 he invested in his business. If the owner had been operating his business as a corporation or LLC, however, due to limited liability, his loss now would be limited to his investment in the business of $2,000. His personal net worth of $1 million would be safe.