With a sole proprietorship, there are no barriers between the business done and the individual running/owning the business. Why is this bad? If a sole proprietor, acting on behalf of his business, commits negligence in his duties for the business that causes injury to a third person, the sole proprietor is personally liable for any and all injuries to that third person.
If the business puts out a product and the product malfunctions, thereby causing injury to some third party, the sole proprietor is personally liable for that injury. If an employee of the business harms a third person when acting within the scope of his/her employment, the sole proprietor is personally liable for the injury. If someone is harmed on the business premises (say for a slip and fall injury), the sole proprietor is personally liable for the injury.
When a sole proprietor is personally liable for any of the above examples, all of the sole proprietor’s personal and business assets are subject to claims by the creditors (the people who sue the sole proprietor’s business).
Conclusion. Don’t ever be a sole proprietor.
Partnership. A partnership is the absolute worst entity you could possibly be involved with from an asset protection standpoint. With a partnership, you get all the headaches and personal liability of a sole proprietorship with the additional twist of having a partner who can cause you even more liability.
Definition: A partnership exists when two or more people run a business together that is not a “corporation” (like S- or C-Corp or LLC or P.C.).
Consequences of being a Partnership—Every partner is liable for all the actions and debts of the other partners (as it relates to the business).
A few examples are the best way to illustrate the problem.
1) If one partner signs for a loan on behalf of the business and takes the money and blows it on a trip or drugs or whatever, the debt becomes the debt of the partnership (and, therefore, ALL the partners are personally liable for the debt).
2) If one partner sexually harasses an employee and the business gets sued for sexual harassment, the suit is against the partnership in which both partners have personal liability.
Conclusion. Never be a partnership.
Corporations
(not Limited Liability Companies or Professional Companies)
General information about formation and structure. Corporations are a legal entity formed under state laws. Corporations are owned by shareholders.
Shareholders elect a board of directors, which is responsible for overall management, and hires corporate officers to run daily operations of the corporation. A corporation can have as few as one shareholder who can elect himself to the board and can run the daily operations of the corporation.
A corporation can be either an S- or C-Corp.
Limited liability. The main reason businesses are corporations, not partnerships or sole proprietorships, is to avoid personal liability for negligent actions of the corporations. This includes limited liability of the corporate shareholders as well as individual liability of the employees of the company who are acting within the scope of employment.
Example:
Assume you own a company that manufactures widgets. Assume the company put out defective widgets into the stream of commerce that caused millions of dollars in damages and ultimately many lawsuits with verdicts against the company.
What is the liability of the shareholders, officers, and employees of the company in the above example? None. This is why corporations are used, i.e., to limit liability.
Types of Creditors. There are two main types of creditors: “Inside” and “Outside.”
Inside creditor. This is a creditor who has its exclusive remedy as one against the assets of the corporation.
Example:
Let’s use the widget example. Assume you own 100% of the stock of the company that puts defective widgets into the stream of commerce. Assume the company is sued and loses a $10,000,000 jury verdict because of these widgets.
In this example, the creditor is stuck going after only after assets inside or owned by the company and cannot go after your personal assets and are considered an “inside” creditor (this is the very reason corporations are used for asset protection purposes).
Outside creditor. This is a creditor who can go not only after a corporation’s assets, but your individual personal assets as well.
Example:
Assume you had a summer party at your lake house that has a 20 step staircase going down to a beach. Assume the hand rail used on the staircase to get down to the beach was not in working order. Assume that when someone used the handrail to go down to the beach it broke and that your friend tumbled down the stairs and sustained significant injuries (including a head injury).
The injured friend could sue you personally and go after “all” of your personal assets and therefore is considered an “inside” creditor.
Limited Liability Companies (LLCs),
Family Limited Liability Companies (FLLCs) and
Family Limited Partnerships (FLPs)
LLCs, FLLCs and FLPs are “the” tools to use when it comes to asset protection. The following material will give you the reasons from A-Z as to why an LLC, FLLC, or FLP is used by most of the asset protection gurus around the country when advising clients.
For future use in this section of the book, we will use LLC interchangeably as a term that stands for all three entities (LLC, FLLC, and FLP). For asset protection purposes, each entity works the same.
What is an LLC and How Does it Function? LLCs were first introduced in 1976 and have increased steadily with their popularity each year since their introduction. FLPs had been around for years prior to the LLC and were the traditional workhorse of asset protection and estate planning experts. But the FLP had limited applicability to a traditional business, which most of the time did not involve family members or friends, and left the general partner of the FLP liable for all debts and liabilities of the partnership.
LLCs were designed to bring together a single business organization with the best features of the pass-through income tax treatment of a partnership and the limited liability of owners in a corporation.
From a corporate operations standpoint, an LLC functions similarly to an S- or C-Corp in many ways.
Differences between LLCs and S- or C- Corporations:
1) Unlike an S- or C-Corp, instead of issuing “stock” (and stock certificates) to the owners, each owner simply owns a percent (%) interest in the LLC.
2) For tax purposes, an LLC can be treated like a sole proprietorship, partnership, S-, or C-Corp. The creator(s) of an LLC make an election of how they would like the LLC treated from a tax standpoint. If an election is not made, a default tax status will be taken by the state, which differs from state to state. For a more detailed discussion on formimg the proper entity to minimize income taxes, please see the Business Management section of this book.
3) Non-uniform income distributions. In an LLC, the members can vote to divide up the income differently than by member interest. In an S- or C-Corp, the income “distributed”