How to Use Limited Liability Companies & Limited Partnerships. Garrett Sutton
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In lectures given to aspiring entrepreneurs, I am always asked the question: “If I’m just starting out, why not be a Sole Proprietorship?” The answer is that you are never just starting out. You have accumulated assets throughout your life, and by using a Sole Proprietorship you are putting them at risk. As well, you are putting your future at risk if you are sued as a sole proprietor. The cost to form and maintain an LLC or Corporation is minimal compared to the risks involved in operating any form of business.
There are two statistics that support this position:
1. There are over 1,310,000 lawyers in America today.
2. One-third of all Americans will be sued at least once during their lifetime.
If you have ever been sued, you well know that it can be an extremely stressful and costly proposition. As an attorney I find many of my colleagues are honorable, but the sad truth is that the elements of justice, civility and fair play are often lost when certain lawyers are involved. In addition, as many of you know, there are economic incentives in the system for lawyers to bring frivolous lawsuits. Until the courts start punishing improper lawyering, the only way to protect yourself is to remove all the assets you can from risk. Using a Sole Proprietorship or a General Partnership is not the way to do this.
If you have never been sued, please attempt to keep it that way. And as protection against it ever happening, take the legal and reasonable steps to put all of your personal assets out of the reach of potential business creditors and predators.
The extra step needed to protect your personal assets from business risk is to setup an LLC, LP, or Corporation. Our firm provides this service for a very reasonable fee. There is even a discount for the readers of this book in the back pages. By taking this step, and by following the minimal record keeping requirements associated with each entity, you can easily avoid the problems you may encounter with a Sole Proprietorship.
Another downside is that Sole Proprietorships are audited by the IRS at a much higher rate than more protective entities. The latest IRS statistics reveal that Sole Proprietorships are audited five times more often than LLCs and S corporations. The IRS has found it very easy to collect extra monies from entrepreneurs operating as sole proprietors. Why put yourself at such a risk?
Another feature of the Sole Proprietorship to be considered is the fact that it may only have one owner. If your business grows and you bring in another owner, you are no longer a Sole Proprietorship. Once you start splitting the profits with another individual, your business becomes a General Partnership. And with that you are using an even less desirable entity for doing business than a Sole Proprietorship.
General Partnership
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 laws. This may not be to your advantage in that 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 can actually be 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 mess up.
And remember, just as with Sole Proprietorships, 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, as a general partner you are still personally responsible for that decision.
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 ignorant – may obligate the business. By contrast, LLCs and LPs 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.
This issue occasionally arises when investment scam artists are trying to raise money through the sale of General Partnership interests. Because the sales of securities are so heavily regulated, and therefore costly to promote, certain unscrupulous types have promoted General Partnerships as an exception to the securities laws. Their slick rationale is that a General Partnership interest is not defined as a security since all general partners are manager/participants and thus not the type of passive investors for which the securities laws apply. Federal and state securities regulators do not agree with this definition. The interest you purchase allows you and several hundred other people to become general partners in, for example, “the most significant silver mining property in Bolivian history.” The promoters raise the money and obligate the partnership to purchase several million dollars worth of mining equipment. Of course, the promoters then retire to Bolivia, leaving the remaining general partners liable for the partnership’s debts.
In oil and gas investment scenarios, the only way to receive the very favorable tax incentives is to be a general partner in the limited partnership syndication. You must be a general partner as an individual (not through an entity) to get the tax breaks. In that event be certain the syndicator has plenty of insurance (which never completely reduces risk) and once all the tax benefits are received that you are converted to a limited partner, a position of much greater protection.
Certain advisors will, as with Sole Proprietorships, suggest that a General Partnership be used because it is easy to set up. Most states do not require organizational paperwork for a General Partnership to be filed with the secretary of state. Some advisors will comment that there is no requirement for a General Partnership to hold regular meetings or keep records of meetings, despite the fact that the better practice is to do so, and thus argue that General Partnerships are, again, easy.
As discussed with Sole Proprietorships, when it comes to General Partnerships, easier is not better. The specter of unlimited personal liability in this day and age is too overwhelming even for the lowliest aspiring start-up to take on. Furthermore, nothing about operating a business successfully is easy. Why then should one of the most important legal decisions you make about your business be “easy”?
There are two further arguments that certain advisors will make as to the easiness of General Partnerships. Both are fallacious and wrong.