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Your Entity Menu
Limited Liability Company (LLC)
Limited Partnership (LP)
As legal business systems and traditions have developed over the last five hundred years, several structures for running a business have evolved. Each structure (or entity) has its own advantages and drawbacks, which we will explore.
As a frame of reference for making your selection, it is important for you to clarify your strategy in this planning. The purpose of this chapter is foryou to clearly understand and choose the best entity for your unique and specific purpose. To that end, the following checklist should be considered:
1. Protection of family assets and investments
2. Management control
3. Avoiding family disputes
4. Flexibility of decision making
5. Succession of children and other family members to management
6. The nature of the business to be operated
7. The nature of the asset to be held
8. The number of owners involved
9. Estate planning and gifting of assets
10. Who may legally obligate the business
11. Effect upon an owner's death or departure
12. The need for start-up funding
14. Privacy of ownership
15. Consolidation of assets and investments
These and other issues will become apparent as we review your choices. And please note, your decision does not have to be made alone. It is recommended that these issues be discussed with your attorney, accountant, or other professional advisor. An individual well versed in these areas will provide excellent insight into which entity is right for you. It is important to know that in entity selection one size does not fit all.
If your attorney or accountant suggests only one entity, a general partnership for example, for each and every business venture you have him or her review,you will want to question why they believe one entity fits all situations. Or you may want to seek out a new professional advisor.
We will discuss which entities work well in various business and asset-holding scenarios. But before doing so, we must point out which entities do not work well in any situation. For as important as knowing which entity to use for running your business, protecting your assets, and limiting your liability is knowing which entity NOT to use.
In my legal practice I represent various businesses, from small and basic to large and complicated. I enjoy helping entrepreneurs and business owners make money, provide for their families and employees, and secure a stable future.
I cannot do my job if a client insists on using a bad entity. Sole proprietorships and general partnerships provide no asset protection. One lawsuit against your business, and your house, savings, and personal assets can all be lost. Our first case is illustrative.
Case No. 1-Johnny
Johnny was a plumber. He had been at it for five years and was starting to succeed. His customers were satisfied with his work and the word of mouth for Johnny's Ace Plumbing was good.
While Johnny was a good plumber, he felt intimidated by legal matters. Lawyers and accountants were supposed to be smart, so the work they did must be difficult. When Johnny was a young boy his father had been unfairly treated by a lawyer. He remembered it to this day, and wanted nothing to do with them.
So instead of consulting with a professional on how best to conduct his business, Johnny let his part-time bookkeeper select an entity off the menu. The results were disastrous.
Johnny's part-time bookkeeper knew only that forming a corporation required filing special documents with the state but did not know how to file them. He knew that a corporation needed to file a separate tax return but was not sure of the ins and outs of preparing one. As so he suggested Johnny use a sole proprietorship because he knew how to handle one and always suggested one for his clients. One size fits all.
The problem was that a sole proprietorship provides absolutely no asset protection. By operating as a sole proprietorship Johnny has unlimited liability for the debts, claims, and obligations of the business. This unlimited liability meant that his house and savings and personal assets were exposed to the claims of others.
Of course, as in all horror stories, a demon entered Johnny's business. He had hired Damien as an employee to assist with his growing workload. Damien seemed like a decent guy and appeared to know the plumbing business. Johnny did not bother to do a background check on Damien. Johnny was new to the business world and not aware of the need to do so.
After one week on the job, Damien assaulted one of Johnny's customers while they were alone in her house. Without going into the sordid details, this woman was so severely traumatized by what Damien did to her in her own home that she and her family had to move away.
Within three weeks of the incident Johnny's business was sued. Because Johnny was a sole proprietor, this meant that he, and not the business itself, as with a corporation, was sued and had to defend himself.
The lawyers suing for the woman did the background check of Damien that Johnny did not do. Damien was a recently released ex-convict with a history of sexual assaults. Johnny did not have the insurance to cover such a claim. The case went forward. The lawyers argued to a jury that Johnny's business was irresponsible for failing to check up on Damien and was responsible for the consequences. They presented to the jury what was truea business is vicariously liable, or responsible, for the acts of its employees. The jury was horrified by the whole case and awarded damages of $10 million.
Johnny was wiped out. As a sole proprietor he was completely and personally responsible for every claim the business incurred. And he had attorneys with a one-third contingent interest in the collection of $10 million after him.
Johnny lost his house, his savings, and his family. The stress of it all resulted in his wife divorcing him, obtaining custody of the children, and moving away. Johnny declared bankruptcy. He ended up a broken man despising lawyers and our legal system all the more.
The irony, of course, is that by consulting with a lawyer and using the legal system to his advantage, Johnny could have prevented the disastrous consequences that resulted from relying on a part-time bookkeeper with a one-size-fits-all mentality for entity selection.
A competent lawyer would have told Johnny that there were risks known and unknownin running any business. To protect yourself from such risks you need to limit your liability by establishing a corporation or other good entity.
A good entity is one that shields and protects your personal assets from business risk. A bad entity is one that provides you no protection whatsoever. By using a good entity Johnny could have used the legal systemwhich has evolved to encourage business activity and limit the liability of risk takersto his advantage.
A general partnership is also a bad entity. In fact it is twice as bad as a sole proprietorship because you have twice the personal exposure: personal liability for your acts and your partners' acts. This will be illustrated in Case No. 2 ahead.
Whenever two or more persons agree to share profits and losses a partnership has been formed. Even if you never sign a partnership agreement, state law provides that under such circumstances you have formed a general partnership.
A written partnership agreement is not required by law. A handshake is acceptable for formation. In the event you do not sign a formal document, you will be subject to your state's applicable partnership law. This may not be to your advantage, since such general rules rarely satisfy specific situations. As an example, most states provide that profits and losses are to be divided equally among the partners. If your oral understanding is that you are to receive 75 percent of the profits, state law and your handshake will not help you. You are better advised to prepare a written agreement addressing your rights and rewards.
Unlike a sole proprietorship, in which only one individual may participate, by definition, a general partnership must consist of two or more people. You cannot have a one-person partnership. On the other hand, you may have as many partners as you want in a general partnership. This may sound like a blessing but it is actually a curse.
The greatest drawback of a general partnership is that each partner is liable for the debts and obligations incurred by all the other general partners. While you may trust the one general partner you have not to improperly obligate the partnership, the more general partners you bring aboard the greater risk you run that someone will create serious problems.
And remember, just as with a sole proprietorship, your personal assets are at risk in a general partnership. Your house and your life savings can be lost through the actions of your partner. While you may have had nothing to do with the decision that was made and you may have been five thousand miles away when it was made and you may have voiced your opposition to it when you found out it was made, you are still personally responsible for it as a general partner.
As such, a general partnership is much riskier than a sole proprietorship. In a sole proprietorship, only the proprietor can bind the business. In a general partnership, any general partner-no matter how wise or, unfortunately, how ignorantmay obligate the business. By contrast, limited liability companies, limited partnerships, and corporations offer much greater protection. All of them offer owners limited personal liability for business debts and the acts of others.
It should be noted that because of these unlimited risks the last thing you want to do is become a general partner of an enterprise in which you do not have day-to-day management control. If you do not thoroughly know what is going on in the company you should not put your future on the line as a general partner.
Case No. 2-Louise
Louise had worked for someone else all her life. For the last ten years she had worked in the gift section of a large department store. She did not like the floor manager insisting she do things a certain way when she knew her way would generate more sales for the company. It was all petty politics. She looked forward to the day when she could open her own business and make her own decisions.
Then one day, Maxine came to work at the department store. The two of them hit it off immediately. Maxine had a certain style and attitude that appealed to Louise. They had similar interests, the same feel for what the customers wanted, and the same desire to escape working for a faceless corporation filled with narrow-minded managers who stifled their every idea for improvement. Soon they were talking about opening their own gift boutique.
Louise had managed to save $10,000 to pursue her dream. Maxine did not have any money to contribute, but convinced Louise that she would contribute her first $5,000 in profits back into the business.
Louise was not aware that by agreeing to form a partnership with Maxine without getting a written agreement as to distributions meant that they were automatically 50-50 partners. While Louise put up all the money and Maxine orally agreed to put her profits back later, the law treated them as each owning 50 percent of their new business, L & M Gifts.
In nine businesses out of ten there are problems when only one partner puts up all the money. L & M Gifts was no exception.
Maxine wanted the store to have the right atmosphere. She decided on leasing a storefront in a nice area and obligated the partnership to a three-year lease at an above-market rate. She decided on stylish tenant improvements to achieve the right look for her dream store. She then obligated the partnership to buy a large quantity of gifts in order to stock the store.
Before L & M Gifts opened its doors the partnership had obligated itself to spend $12,000 on improvements. They were also obligated to pay $1,500 per month in rent for the next three years. Louise was not aware of these transactions. However, as general partner, Maxine could obligate the partnership without informing or getting the approval of her other partner.
Louise wanted to announce their grand opening by placing an ad in the newspaper. Because they were a new business, the paper wanted a check up front. When Louise went to write a check it hit her. They were out of money. Maxine had spent Louise's entire $10,000, and then some, to open the store.
When Louise confronted Maxine with this Maxine was unconcerned. She asked Louise if she could put up any more cash. But Louise did not have any more money. Her life savings, her dream of her own business and control of her future, was the $10,000 that Maxine had already spent.
Maxine said she did not have a credit card but asked if Louise had or could get a credit card to help them get over this hump. Maxine said that if they could just get the doors open together they would be rolling in profits. It was with this comment that Louise realized that she was putting up all the money and taking all the risk so that Maxine could share in all the profits.
Louise was shaken by this realization but remained composed. She said she did not have a credit card nor did she have good enough credit to get one.
At this, Maxine flew off the handle. She said that she had invested all her ideas of style and atmosphere into the business. All Louise had to do was put up the money. She was furious that her creative vision for L & M Gifts was to be dimmed by Louise's refusal to put in more money.
Louise was stunned by her partner's reaction. She had put her life savings into the business. Maxine, without telling her, had squandered it. And now Maxine was angry that she could not put in more.
As one would expect, things soured very quickly between the two. As soon as Maxine learned that no more money was forthcoming, she reignited a relationship with an old boyfriend who lived two thousand miles away. She picked up and left town within forty-eight hours. No one heard from her again.
Louise was left with all the bills. Because Maxine had obligated the partnership, even though Louise had no knowledge of such obligations, Louise as the remaining general partner was personally responsible.
The landlord, the contractor who did the tenant improvements, and the suppliers of the inventory all sued Louise. While Maxine was equally responsible (if not more so) for these debts, the creditors did not even bother to pursue her. She had no money and she was on the other side of the country. Why would someone spend the time and money to chase her? The sole burden of the partnership's debts fell upon Louise.
With her life savings gone and her vision of her own business dashed, Louise unhappily went back to work at the department store.
As Case No. 2 illustrates, with a general partnership you have double the exposure of a sole proprietorship. Not only youbut your partnercan put your personal assets at risk. All of the risk and double (or triple or more depending on the number of general partners you have) the exposure is not a good way to do business.
As our first two cases point out, it is important to select the correct entity at the start. (And, please note, not all of our stories will be so dire. It is just that right now we are dealing with bad entities.)
Other General Partnership Disadvantages
As if all of the risk and double the exposure were not bad enough, there are other disadvantages to operating as a general partnership:
Termination. A partnership terminates when one partner dies, leaves, or goes bankrupt. You may be surprised by some unexpected event.
Sale. Most sophisticated buyers do not want the risk of being in a general partnership. This will hinder the ability to sell your interest in a general partnership.
Rich Dad Tip
The longer you operate as a sole proprietorship or general partnership the longer you are going to be personally responsible for every bad thing that can happen in your business.
If you are currently operating as a sole proprietorship or general partnership, see a professional immediately about switching to a good entity.
If you are considering getting into a business, do not start out on the wrong foot by using a bad entity.
Limited liability companies (LLCs)
Limited partnerships (LPs)
To succeed in business, to protect your assets, and to limit your liability, you will want to select from one of the good entities listed above. Each one has its own advantages and specific uses. Each one is utilized by the rich and the knowledgeable in their business and personal financial affairs. And, depending on your state's fees, each one can be formed for $900 or less so that you can achieve the same benefits and protections that sophisticated business people have enjoyed for centuries.
Before we discuss the relative strengths of corporations, LLCs, and LPs, it is important to know the language of each. While their basic structure is similar, the terms for each structural facet are different. Here then is the language for the good entities.
The best place to start the discussion of good entities is with corporations. They have evolved over the last five hundred years to become the most commonly used entity for conducting business.
As Robert Kiyosaki learned during his study of admiralty law, corporations came into common usage in the 1500s to protect investors in maritime ventures. Prior to the popular use of corporations, investors would come together as a partnership, outfit a ship, and send it out for trading purposes. If the ship was lost at sea, the investors could not only lose everything but also be personally sued by various creditors. Of course, this exposure deterred people from risk taking and discouraged economic activity. Seeing this, the English Crown and courts allowed for the charter of corporations whereby risks and liabilities could be limited to the corporation itself.
The shareholders, the investors in the corporation, were liable only to the extent of their contribution to the business. This was a significant development in world economic history.
Case No. 3-The English Rose/Sir Richard Starkey
In the late 1500s maritime activity was increasing. The New World beckoned with the promise of riches and opportunity. The then small segment of Europeans with money were investing in sailing ships to pursue trading opportunities. If your ship could make it across the Atlantic with supplies, sell them or trade them for commodities, and return with a valuable cargo, you could make a fortune. This scenario was the origin of the phrase: "When my ship comes in."
During this time, two groups of London promoters were soliciting investors to outfit a ship and send it to the Caribbean in search of trading opportunities. A ship known as the Royale Returne had just recently arrived at the London docks and its investors had reaped profits of 1,000 percent. Investors were excited by these opportunities. The first group was outfitting a ship known as the English Flyer. The promoters brought investors in as general partners, offering 10 percent of the profits in exchange for £250. In Elizabethan England, as today, there was no special requirement to get permission to operate as a general partnership.
Two British gentlemen, Sir Richard Starkey and Master John Fowles, were potential investors. Master John Fowles was astounded by the profits the Royale Returne had generated for its investors. He wanted to invest in the very next ship set to sail. It didn't matter that the English Flyer was a partnership. The personal liability of a general partnership did not trouble himnot when huge profits were in sight. Master John Fowles invested £250 in the English Flyer as soon as he could.
The second group of promoters was outfitting the English Rose. They wanted the limited liability of a new entity called a corporation. The problem was that, like today, it cost extra money to form and you had to wait for the Crown to give you a charter. But the second group of promoters was more careful than the first. They did not want to put themselves or their investors at risk in case the ship never returned. Sir Richard Starkey, being prudent and cautious, chose to invest in the English Rose. He knew there was risk in venturing across the Atlantic. He wanted to limit his exposure to just £250.
As luck would have it, the English Flyer was lost near the Bermuda Triangle. The promoters had leased the boat, provided their own captain, and were now responsible to the owners for its loss. The promoters and 90 percent of the general partners did not have as much money as Master John Fowles did. As we learned in Louise's case, and as has been the case for centuries, creditors will go after the easiest target with the deepest pockets. As so Master John Fowles, only a 10 percent general partner, was sued and held responsible for the entire loss of the English Flyer. He learned the hard way what happens when your ship does not come in, and you are responsible for it.
As Sir Richard Starkey's luck would have it, the English Rose did well on each side of the Atlantic and provided a huge return to its investors. Unlike Master John Fowles, Sir Richard Starkey was willing to lose £250 and no more. By using a corporation instead of a partnership he was able to establish his downside risk, while allowing for his upside advantage to be unlimited.
Sir Richard Starkey and other knowledgeable and sophisticated investors have used corporations, and other good entities, to limit their liability for centuries.
Forming a corporation is simple. Essentially, you file a document that creates an independent legal entity with a life of its own. It has its own name, business purpose, and tax identity with the IRS. As such, itthe corporationis responsible for the activities of the business. In this way, the owners, or shareholders, are protected. The owners' liability is limited to the monies they used to start the corporation, not all of their other personal assets. If an entity is to be sued it is the corporation, not the individuals behind this legal entity.
A corporation is organized by one or more shareholders. Depending upon each state's law, it may allow one person to serve as all officers and directors. In certain states, to protect the owners' privacy, nominee officers and directors may be utilized. A corporation's first filing, the articles of incorporation, is signed by the incorporator. The incorporator may be any individual involved in the company, including, frequently, the company's attorney.
The articles of incorporation set out the company's name, the initial board of directors, the authorized number of shares, and other major items. Because it is a matter of public record, specific, detailed, or confidential information about the corporation should not be included in the articles of incorporation. The corporation is governed by rules found in its bylaws. Its decisions are recorded in meeting minutes, which are kept in the corporate minute book.
When the corporation is formed, the shareholders take over the company from the incorporator. The shareholders elect the directors to oversee the company. The directors in turn appoint the officers to carry out day-to-day management.
The shareholders, directors, and officers of the company must remember to follow corporate formalities. They must treat the corporation as a separate and independent legal entity, which includes holding regularly scheduled meetings, conducting banking through a separate corporate bank account, filing a separate corporate tax return, and filing corporate papers with the state on a timely basis.
Failure to follow such formalities may allow a creditor to disregard the corporate veil and seek personal liability against the corporate officers, directors, and shareholders. This is known as "piercing the corporate veil"a legal maneuver in which the creditor tries to establish that the corporation failed to operate as a separate and distinct entity; if this is the case, then the veil of corporate protection is pierced and the individuals involved are held personally liable. Adhering to corporate formalities is not at all difficult or particularly time-consuming. In fact, if you have your attorney handle the corporate filings and preparation of annual minutes and direct your accountant to prepare the corporate tax return, you should spend no extra time at it with only a very slight increase in cost. The point is that if you spend the extra money to form a corporation in order to gain limited liability it makes sense to spend the extra, and minimal, time and money to ensure that protection is achieved.
One disadvantage of utilizing a regular, (or C) corporation to do business is that its earnings may be taxed twice. This generally happens at the end of the corporation's fiscal year. If the corporation earns a profit it pays a tax on the gain. If it then decides to pay a dividend to its shareholders, the shareholders are taxed once again. To avoid the double tax of a C corporation, most C corporation owners make sure there are no profits at the end of the year. Instead, they use all the write-offs allowed to reduce their net income.
The potential for double taxation does not occur with the other good entities, a limited liability company or a limited partnership. In those entities profits and losses flow through the entity directly to the owner. Thus, there is no entity tax but instead there is a tax obligation on your individual return. Depending on your situation, an LLC or LP with flow-through taxation may be to your advantage or disadvantage. Again, one size does not fit all.
It should be noted here that a corporation with flow-through taxation features does exist. The Subchapter S corporation (S corporation), named after the IRS code section allowing it, is a flow-through corporate entity. By filing Form 2553, "Election by a Small Business Corporation," the corporation is not treated as a distinct entity for tax purposes. As a result, profits and losses flow through to the shareholders as in a partnership.
While a Subchapter S corporation is the entity of choice for certain small businesses, it does have some limits. It can only have seventy-five or fewer shareholders. All shareholders must be American citizens. Corporations, limited partnerships, limited liability companies, and other entities, including certain trusts, may not be shareholders. A Subchapter S corporation may have only one class of stock.
In fact, it was the above-named limitations that led to the creation of the limited liability company. Because many shareholders wanted the protection of a corporation with flow-through taxation but could not live within the shareholder limitations of a Subchapter S corporation, the limited liability company was born.
The Subchapter S corporation requires the filing of Form 2553 by the 15th day or the third month of its tax year for the flow-through tax election to become effective. A limited liability company or limited partnership receives this treatment without the necessity of such a filing.
Another issue with the Subchapter S corporation is that flow-through taxation can be lost when one shareholder sells his stock to a nonpermitted owner, such as a foreign individual or trust. By so terminating the Subchapter S election, the business is then taxed as a C corporation and the company cannot reelect S status for a period of five years. The potential for this problem is eliminated by using a limited liability company.
Both C and S corporations require that stock be issued to their shareholders. While limited liability companies may issue membership interests and limited partnerships may issue partnership interests, they do not feature the same ease of transferability and liquidity (or salability) of corporate shares. Neither limited liability companies nor limited partnerships have the ability to offer an ownership incentive akin to stock options. Neither entity should be considered a viable candidate for a public offering. If stock incentives and public tradeability of shares are your objective, you must eventually become a C corporation.
Rich Dad Tips
If you think you may want to go public at some point in the future but want initial losses to flow through, consider starting with an S corporation or a limited liability company.
You can always convert to a C corporation at a later date, after you have taken advantage of flowing through losses.
Limited Liability Companies
The limited liability company is a good entity to use in certain situations. Because it provides the limited liability protection of a corporation and the flow-through taxation of a partnership, some have referred to the LLC as an incorporated partnership.
There are two more features that make the LLC unique:
Flexible management structure
Flexible allocation of profit and loss
These features will be illustrated in our next case.
Case No. 4-Thelma/Millennium Salsa
Thelma was looking to start a salsa business with two partners, Pepe and Hans. They had taken the beneficial step of preparing a business plan. They analyzed the market and their competition. They calculated their expenses, projected conservative revenues, and figured that Millennium Salsa could break even in two years.
The problem was that each partner had his or her own agenda that was difficult to reconcile. They had agreed that for their efforts each was to receive a one-third interest in Millennium Salsa. But beyond that it was looking doubtful that they could structure the business in such a way that it would work. Pepe was putting in $200,000 of start-up money to get the business going. He wanted no part of managing the business but wanted, first, to use any losses to offset other business/personal income; and, second, that all of the first profits be paid directly to him until he was paid back $300,000, or one and one half times what he had invested. Hans, on the other hand, was putting his salsa recipe into the company. It was a well-known and world-famous recipe renowned for its freshness and long shelf life, but beyond that Hans's contribution to the company would be limited. He had offered to work for the company, but for Thelma and Pepe, who both knew of Hans's odd work habits and culinary eccentricities, that was more of a threat than a promise.
Thelma was going to work in the business. Her contribution was to spend the next two years-or however long it tookworking for a very low wage to make a go of it. She had learned from her cousin Louise that a general partnership was a bad entity to use. The last thing Thelma wanted was for Hans to be out obligating their business to another bizarre food project like the banana-shaped onion fiasco.
The management of the business, and keeping Hans out of it, was one issue. But an even bigger issue was how to satisfy Pepe's demands for all the losses to flow through to him and the first $300,000 in profits to go to him.
Thelma knew that in a Subchapter S corporation when profits and losses flowed through the entity, they flowed rigidly according to the shareholder's ownership percentage. If you owned 50 percent, then 50 percent flowed through to you. In the case of Millennium Salsa, each person would have a one-third interest in whatever entity was to be used. But they needed to initially distribute more than one third to Pepe.
How could they satisfy Pepe's demands? Thelma knew she had to figure out some way to get it done or Pepe would not agree to the project. Thelma went to her part-time bookkeeper, who told her she had to use an S corporation. Thelma was told that Pepe's demands could not be met and that the only way to handle the corporate structure was to allocate profits and losses on a one-third basis to each Millennium Salsa shareholder. The bookkeeper said she used an S corporation for every such situation and that most of her clients were satisfied.
Thelma then sought the advice of a local attorney who specialized in business formation and structure. It was during her initial consultation that Thelma learned of the limited liability company for the first time. She learned that special allocations according to partnership formulas could be made to accommodate Pepe's conditions. She learned that a flexible LLC management structure could be implemented so that neither Pepe nor Hans would be involved as decision makers.
The attorney charted for her the difference between the rigidity of an S corporation and the flexibility of an LLC when it came to distributions.
In Millennium Salsa, Inc. the flow-through distributions have to be made according to each shareholder's percentage ownership. Because Pepe owns one third there is no way to allocate him 100 percent of either profits or losses. He is stuck with what flows through to him strictly according to his ownership interest. However, Thelma liked what could be accomplished with an LLC.
In the LLC scenario, Pepe's goals are achieved. He is able to take the first losses and receive the first $300,000 in profits. It should be noted that special allocations such as this must be based on legitimate economic circumstances as opposed to simply shifting tax obligations from one taxpayer to another. For an excellent discussion on these rules see Chapters 11-15 of Diane Kennedy's Loopholes of the Rich. The attorney informed Thelma she needed to work with a tax professional so that Millennium Salsa's objectives were properly documented and carried out.
The attorney also noted that money flowing through the LLC to Thelma, as an employee, was subject to self-employment taxes of 15.3 percent to the statutory maximum of $80,400 for 2001 and 2.9 percent over that for the Medicare portion. Because Pepe and Hans were not employees but rather investors, their flow through of monies was not subject to self-employment tax. It was noted that an S corporation, where self-employment taxes were only paid on monies deemed to be salaries and profits above that were not taxed as self-employment income, may be an option for Thelma's distributions. But again, the attorney noted the flexible distributions Pepe wanted could not be achieved in an S corporation. One entity did not fit all situations.
Thelma also learned that the management structure was different, and much more flexible, than that of a corporation. A corporation had directors elected by shareholders, officers elected by directors, and employees hired by officers. By contrast, an LLC could be managed by all its members, which are akin to shareholders in a corporation, or be managed by just some of its members or by a nonmember. The first was called a member-managed LLC, the second a manager-managed LLC. Because Pepe wanted no management responsibility and neither Thelma nor Pepe wanted Hans anywhere near management authority, it was decided that Thelma would be the sole manager of a manager-managed LLC. As manager she had complete authority for the company's affairs. In corporate terms, she was the board of directors, the president, secretary, treasurer, and all vice presidents of Millennium Salsa. And all her business card had to say was "Manager, Millennium Salsa, LLC."
Pepe liked the plan that Thelma brought back from the attorney's office. He funded the project and they were in business.
The LLC was designed to overcome the problems corporations faced in attempting to avoid double taxation. In the process, as we have seen, some unique and useful features were created as additional benefits to the entity.
The main features are as follows:
LIMITED LIABILITY PROTECTION
In an LLC, like a corporation, the owners do not face personal liability for business debts or for legal claims made against the company. In this day and age when litigation can unexpectedly wipe out a lifetime of savings, limited liability protection is of paramount importance.
It is important to note that in an LLC, as with a corporation, you may become personally liable for certain debts of the company if you sign a personal guarantee. As an example, most landlords will require the owners or officers of a new business to personally guarantee that the lease payments will be made. If the business goes under, the landlord has the right to seek monthly payments against the individual guarantors until the premises are leased to a new tenant. Likewise, loans backed by the Small Business Administration will require a personal guarantee. The SBA's representative will state that they will only loan to those persons committed enough to put their own assets at risk. In truth, as with any bank, they want as much security as they can get. Such personal guarantees are standard business requirements that will not change.
The important point to remember is that you are not going to sign a personal guarantee for each and every vendor agreement and customer transaction you enter. And in these matters, you will be protected through the proper use of an LLC. To obtain such protection it is important to sign any agreement as an officer of the LLC. By signing an agreement "Joe Doe" without adding "Manager, XYZ, LLC" you can become personally liable. The world must be put on notice that you are operating as an independent entity. To that end, it is important to include LLCor Inc. if you use a corporation, or LP for a limited partnership-on all your stationery, checks, invoices, promotional literature, and especially written agreements.
One of the reasons people have a problem utilizing the S corporation is the limits on owners. An S corporation can only have seventy-five or fewer shareholders. As well, some foreign citizens and certain entities are prohibited from becoming shareholders of an S corporation.
The LLC offers the flexibility of allowing for one member to an unlimited number of members, each of whom may be a foreign citizen, spendthrift trust, or corporate entity. And unlike an S corporation, you won't have to worry about losing your flow-through taxation in the event one shareholder sells their shares to a prohibited shareholder.
LLCs offer two very flexible and workable means of management. First, they can be managed by all of their members, which is known as member-managed. Or they can be managed by just one or some of their members or by an outside nonmember, which is called manager-managed.
It is very easy to designate whether the LLC is to be member-or-manager-managed. In some states, the articles of organization filed with the state must set out how the LLC is to be managed. In other jurisdictions, management is detailed in the operating agreement. If the members of an LLC want to change from manager-managed to member-managed, or vice versa, it can be accomplished by a vote of the members.
In most cases, the LLC will be managed by the members. In a small, growing company, each owner will want to have an active say in how the business is operated. Member management is a direct and simple way to accomplish this.
It should be noted that in a corporation there are several layers of man-agement supervision. The officerspresident, secretary, treasurer, and vice presidentshandle the day-to-day affairs. They are appointed by the board of directors, which oversees the larger, strategic issues of the corporation. The directors are elected by the shareholders. By contrast, in a member-managed LLC, the members are the shareholders, directors, and officers all at once.
In some cases, manager management is appropriate for conducting the business of the LLC. The following situations may call for manager man-agement:
1. One or several LLC members are only interested in investing in the business and want no part of management decision making.
2. A family member has gifted membership interests to his children but does not want them or consider them ready to take part in management decisions.
3. A nonmember has lent money to the LLC and wants a say in how the funds are spent. The solution is to adopt manager management and make him a manager.
4. A group of members come together and invest in a business. They feel it is prudent to hire a professional outside manager to run the business and give him management authority.
As with a corporation, it is advisable to keep minutes of the meetings held by those making management decisions. While some states do not require annual or other meetings of an LLC, the better practice is to document such meetings on a consistent basis in order to avoid miscommunication, claims of mismanagement, or attempts to assert personal liability.
DISTRIBUTION OF LLC PROFITS AND LOSSES/SPECIAL ALLOCATIONS
One of the remarkable features of an LLC is that partnership rules provide that members may divide the profits and losses in a flexible manner. This is a significant departure from the corporate regime whereby dividends are allocated according to percentage ownership.
For example, an LLC can provide 40 percent of the profits to a member who only contributed 20 percent of the initial capital. This is achieved by making what is called a special allocation.
To be accepted by the IRS, special allocations must have a "substantial economic effect." In IRS lingo this means that the allocation must be based upon legitimate economic circumstances. An allocation cannot be used to simply reduce one owner's tax obligations.
By including special language in your LLC's operating agreement you may be able to create a safe harbor to insure that future special allocations will have a substantial economic effect. (As with ships at sea, a safe harbor for IRS purposes is a place of comfort and certainty.) The required language deals with the following:
1. Capital accounts, which represent the investment of the owner plus accumulated undistributed earnings, less accumulated losses less any distribution of capital back to the owners. Each member's capital account must be carried on the books under special rules set forth in the IRS regulations. Consult with your tax advisor on these rules. They are not unusual or out of the ordinary.
2. Liquidation based upon capital accounts. Upon dissolution of the LLC, distributions are to be made according to positive capital account balances.
3. Negative capital account paybacks. Any members with a negative capital account balance must return their account to a zero balance upon the sale or liquidation of the LLC, or when the owner sells his interest. It should be noted that complying with the special allocation rules and qualifying under the safe harbor provisions is a complicated area of the law. Be sure to consult with an advisor who is qualified to assist you in this arena.
As has been mentioned throughout, one of the most significant benefits of the LLC, and a key reason for its existence, is the fact that the IRS recognizes it as a pass-through tax entity. All of the profits and losses of the business flow through the LLC without tax. They flow through to the business owner's tax return and are dealt with at the individual level.
Again, a C corporation does not offer such a feature. In a C corporation, the profits are taxed at the corporate level and then taxed again when a dividend is paid to the shareholder. Thus, the issue of double taxation. Still, with proper planning, the specter of C corporation double taxation can be minimized.
In an S corporation, profits and losses flow through the corporation, thereby avoiding double taxation, but may only be allocated to the shareholders according to their percentage ownership interest. As described above, LLC profits and losses flow through the entity and may be freely allocated without regard to ownership percentages. As such, the LLC offers the combination of two significant financial benefits that other entities do not.
LACK OF PRECEDENT
One of the drawbacks to the LLC is the fact that it is a new entity. As such, there are not many court decisions defining the various aspects of its use. With corporations and partnerships, on the other hand, you have several hundred years of court cases creating a precedent for their operation.
Most legal commentators anticipate that the courts will look to corporate law to define the limited liability and corporate features of the LLC and to partnership law to define the partnership aspects of the entity. In time, a cohesive body of LLC law will emerge.
Until that day arrives, owners of an LLC must be cognizant that the courts may interpret a feature, a benefit, or even a wrinkle of LLC law in a way that does not suit them. If you are on the fence between selecting a limited partnership, a corporation, or an LLC and do not like the uncertainty associated with a lack of legal precedent, you may want to consider utilizing an entity other than an LLC.
Rich Dad Tips
California residents must be cautious when considering the use of an LLC. The fees are onerous.
In addition to the annual LLC tax of $800 the state of California hits LLCs with a fee based on their gross income. This fee has nothing to do with whether your company is profitable or not. It is only based on revenue generated, so you can lose money and still owe the fee.
On gross income of $250,000 to $499,999 the fee is $1,042. The fee gradually rises to $9,377 on gross income of over $5 million. Be sure to consider this fee when analyzing which entity to use in California.
A limited partnership is similar to a general partnership with the exception that it has two types of partners. The first type is a general partner who is responsible for managing the partnership. As with a general partnership, the general partner of a limited partnership has broad powers to obligate the partnership and is also personally liable for the business's debts and claims. If there is more than one general partner involved they are all jointly and severally liable, meaning that a creditor can go after just one partner for the entire debt. However, a corporation or an LLC can be formed to serve as a general partner of a limited partnership, thus isolating unlimited liability in a good entity.
The second type of limited partnership partner is a limited partner. By definition, a limited partner is "limited" to his contribution of capital to the partnership and may not become actively involved in the business of the partnership. A limited partner may then be owner but have absolutely no say in how the entity operates. This was exactly what Jim wanted.
Case No. 5-Jim
Jim was the proud father of three boys in high school. Aaron, Bob, and Chris were coming of age. They were active, athletic, and creative boys almost ready to embark upon their own careers. The problem was that they were sometimes too active, too athletic, and too creative.
Aaron was seventeen years old and every one of the seemingly unlimited hormones he had was shouting for attention. He loved the girls, the girls loved him, and his social life was frenetic and chaotic. Jim knew his son was smart but worried whether he would ever settle down enough to complete one homework assignment, much less go to college.
Bob was sixteen years old and sports was all that mattered. He played sports, watched sports, and lived and breathed sports. Bob was hoping to get a college scholarship to play football and/or baseball. But Jim worried that if a scholarship wasn't offered whether Bob would ever get into or be interested in going to college.
Chris was fifteen years old and the lead guitarist in a heavy metal band known as Shrike. When Shrike practiced in Jim's garage the neighbors did not confuse them with the Beatles. The members of Shrike had pierced appendages, graphic tattoos, and girlfriends who looked like wild animals. Jim worried about the company that Chris kept. When you could hear the lyrics, Shrike's songs made frequent reference to school as a brainwashing tool of the elite. And while Jim may have also believed that to be true when he was fifteen, he worried that Chris would still embrace the idea at age twenty-one.
Compounding Jim's concerns was that he had five valuable real estate holdings that he wanted to go to the boys. His wife had passed on several years before and he needed to make some estate planning decisions. But given the boys' energy level and lack of direction he did not want them controlling or managing the real estate.
Jim knew that if he left the assets in his own name, when he died the IRS would take 55 percent of his estate, which was valued at over $2 million. And while estate taxes were to be gradually eliminated, Jim knew that Congress could always reinstate them. Jim had worked too hard, and had paid income taxes once already before buying the properties, to let the IRS's estate taxes take away half his assets. But again, he could not let his boys have any sort of control over the assets. While the government could squander 55 percent of his assets, he knew that his boys could easily top that with a 100 percent effort.
Jim asked his friends to refer him to a good attorney who could put together a plan to assist him. The attorney he met with suggested that Jim place the five real estate holdings into five separate limited partnerships.
It was explained to Jim that the beauty of a limited partnership was that all management control was in the hands of the general partner. The limiteds were not allowed to get involved in the business. Their activity was "limited" to being passive owners.
It was explained that the general partner can own as little as 1 percent of the limited partnership, with the limited partners owning the other 99 percent of it, and yet the general partner can have 100 percent control in how the entity was managed. The limited partners, even though they own 99 percent, cannot be involved. This was a major and unique difference between the limited partnership and the limited liability company or a corporation. If the boys owned 99 percent of an LLC or a corporation they could vote out their dad, sell the assets, and have a party for the ages. Not so with a limited partnership.
The limited partnership was perfect for Jim. He could not imagine his boys performing any sort of responsible management. At least not now. And at the same time he wanted to get the assets out of his name so he would not pay a huge estate tax. The limited partnership was the best entity for this. The IRS allowed discounts when you used a limited partnership for gifting. So instead of gifting $10,000 tax free to each boy he could gift $12,500 or more to each boy. Over a period of years, his limited partnership interest in each of the limited partnerships would be reduced and the boys' interest would be increased. When Jim passed on, his estate tax would be based only on the amount of interest he had left in each limited partnership. If he lived long enough he could gift away his entire interest in all five limited partnerships.
Except for his general partnership interest. By retaining his 1 percent general partnership interest, Jim could control the entities until the day he died. While he was hopeful his boys would straighten out, the limited partnership format allowed him total control in the event that did not happen. Jim also liked the attorney's advice that each of the five properties be put into five separate limited partnerships. It was explained to him that the strategy today is to segregate assets. If someone gets injured at one property and sues, it is better to only have one property exposed. If all five properties were in the same limited partnership, the person suing could go after all five properties to satisfy his claim. By segregating assets into separate entities the person suing can only go after the one property where they were injured.
An added benefit to segregating assets in Jim's case was the boys were interested in different activities. One of the properties housed a batting cage business and another a laundromat. He could see Bob being interested in the batting cage business and Aaron meeting girls while owning the laundromat. (Jim owned nothing that would currently appeal to Chris.) As the boys got older he could gift more of one limited partnership to one boy and more of another to another.
Jim liked the control and protections afforded by the limited partnership entity and proceeded to immediately form five of them. To organize a limited partnership you must file a certificate of limited partnership, otherwise known as an LP-1, with your state secretary of state's office. This document contains certain information about the general partner and, depending on the state, limited partners and is akin to the filing of articles of incorporation for a corporation or articles of organization for a LLC. As with the LLC, the LP offers certain unique advantages not found in other entities. These features include:
Limited partners are not responsible for the partnership's debts beyond the amount of their capital contribution or contribution obligation. So, as discussed, unless they become actively involved, the limited partners are protected. As a general rule, general partners are personally liable for all partnership debts. But as was mentioned above, there is a way to protect the general partner of a limited partnership. To reduce liability exposure, corporations or LLCs are formed to serve as general partners of the limited partnership. In this way, the liability of the general partner is encapsulated in a limited liability entity. Assume a creditor sues a limited partnership over a business debt and seeks to hold the general partner liable. If the general partner is a corporation or LLC, that is where the liability ends. No one's personal assets are at risk.
As such, many, if not most, limited partnerships are organized using corporations or LLCs as general partners. In this way, both the limited and general partners achieve limited liability protection.
Because by definition limited partners may not participate in management, the general partner maintains complete control. In many cases, the general partner will hold only 1 percent or 2 percent of the partnership interest but will be able to assert 100 percent control over the partnership. This feature is valuable in estate planning situations where a parent is gifting or has gifted limited partnership interests to his children. Until such family members are old enough or trusted enough to act responsibly, the senior family members may continue to manage the LP even though only a very small general partnership interest is retained.
RESTRICTIONS ON TRANSFER
The ability to restrict the transfer of limited or general partnership interests to outside persons is a valuable feature of the limited partnership. Through a written limited partnership agreement, rights of first refusal, prohibited transfers, and conditions to permitted transfers are instituted to restrict the free transferability of partnership interests. It should be noted that LLCs can also afford beneficial restrictions on transfer. These restrictions are crucial for achieving the creditor protection and estate and gift tax advantages afforded by limited partnerships.
PROTECTION FROM CREDITORS
Creditors of a partnership can only reach the partnership assets and the assets of the general partner, which is limited by using a corporate general partner. Thus if, for example, you and your family owned three separate apartment buildings, it may be prudent to compartmentalize these assets into three separate limited partnerships, using three separate corporate general partners. If a litigious tenant sued over conditions at one of the properties, the other two buildings would not be exposed to satisfy any claims. Creditors of the individual partners can only reach that person's partnership interest and not the partnership assets themselves. Assume you've gifted a 25 percent limited partnership interest in one of the apartment building partnerships to your son. He is young and forgets to obtain automobile insurance. Of course, in this example, he gets in a car accident and has a judgment creditor looking for assets. This creditor cannot reach the apartment building asset itself because it is in the limited partnership. He can only reach the limited partnership interest, and then only through a charging order procedure; a charging order allows the creditor of a judgment debtor who is in a partnership with others to reach the debtor's partnership interest without dissolving the partnership. Charging orders, which can result in phantom income to the creditor, are not favored by creditors. This is because phantom income is the allocation of a tax obligation to the creditor without the receipt of money to pay the taxes on such income. Not many creditors enjoy paying taxes on an uncollectable debt.
FAMILY WEALTH TRANSFERS
With proper planning, transfers of family assets from one generation to the next can occur at discounted rates. As a general rule, the IRS allows one individual to give another individual a gift of $10,000 per year. Any gifts valued at over $10,000 are subject to a gift tax starting at 18 percent. In the estate planning arena, senior family members may be advised to give assets away during their lifetimes so that estate taxes of up to 55 percent are minimized.
By using a family limited partnership, a limited partnership used for the management, and gifting of family assets, gifting can be accelerated with an IRS-approved discount. As discussed, because limited partnership interests do not entitle the holder to take part in management affairs and are frequently restricted as to their transferability, discounts on their value are permissible. In other words, even if the book value of 10 percent of a certain limited partnership is $12,500, a normal investor wouldn't pay that much for it because, as a limited partner, they would have no say in the partnership's management and would be restricted in their ability to transfer their interest at a later date. So, instead of valuing that limited partnership interest at $12,500, the IRS recognizes that it may be worth more like $10,000.
The advantage of this recognition comes into play when parents are ready to gift to their children. Assume a husband and wife have four children. Each spouse can gift $10,000 per year to each child without paying a gift tax. As such, a total of $80,000 can be gifted each year (two parents times four children times $10,000). With the valuation discount reflecting that the $12,500 interest is really only worth $10,000 to a normal investor, each parent gifts a 10 percent limited partnership interest to each child. Their combined gifts total an $80,000 valuation, thus incurring no gift tax. However, of the partnership valued at $125,000 they have gifted away 80 percent of the limited partnership with a book value of $100,000. Had they not used a limited partnership they would have had to pay a gift tax on the $20,000 difference between the $80,000 discounted gifted value and the $100,000 undiscounted value of eight $12,500 10 percent partnership interests that were gifted.
As the example illustrates, transfers of family wealth can be accelerated through the use of limited partnership discounts. Once this technique is appreciated, the question always becomes: How much of a discount will the IRS allow? Is it 25 percent, 35 percent, or can you go as high as 65 percent? While there is no brightline test or number, the simple answer is found in this maxim: Pigs get fat, hogs get slaughtered. If you get greedy with your discounting, the IRS will call into question all of your planning. In my practice, I do not advise my clients to go over a 30 percent discount. That may be conservative. I have dealt with some professionals who with certainty assert higher discounts are easily justified. Again, there is no correct answer. You and your advisor should establish your own comfort level.
The limited partnership provides a great deal of flexibility. A written partnership agreement can be drafted to tailor the business and family planning requirements of any situation. And there are very few statutory requirements that cannot be changed or eliminated through a well-drafted partnership agreement.
Limited partnerships, like general partnerships, are flow-through tax entities. The limited partnership files an informational partnership tax return (IRS Form 1065, "U.S. Partnership Return of Income," the same as a general partnership), and each partner receives an IRS Schedule K-1 (1065), "Partner's Share of Income, Credits and Deductions," from the partnership. Each partner then files the K-1 with their individual IRS 1040 tax return.
Copyright (c) 2001 by Garrett Sutton, Esq.