discussing the issue of unlimited personal liability for the acts of general partners, some will suggest that insurance can overcome such risks. This ignores the fact that many affordable commercial insurance policies contain:
• high deductibles for which the partners are responsible; and
• innumerable exclusions designed to limit coverage
Furthermore, most people involved in small businesses cannot foresee all the possible risks, and even if they could, would not be able to afford full coverage. No policy will cover the mismanagement of the partnership, much less the wrongful acts of one general partner. And no insurance is going to cover the inability of the partnership to pay its normal debts and obligations. Again, such acts become the personal responsibility of the general partners. On the other hand, LLCs and Corporations, as a matter of law, shield their owners from such liability.
A second argument made as to the easiness of the General Partnership is that all it takes is a simple General Partnership Agreement. As discussed, the need for a written document to reflect the partners’ intent is prudent. However, the problem arises in that no General Partnership Agreement is simple. Each one must be tailored to reflect the specifics of the understanding and the transaction. The cost to have an attorney draft a General Partnership Agreement will run between $1,500 and $5,000. And with that, you are paying a significant amount of money for a document and an entity that will not protect you.
In my practice, I will not prepare a General Partnership Agreement for a client. It is simply not the right entity for any of my clients. Our company, Corporate Direct, Inc., prepares a complete and fully ready LLC, LP or Corporation for $695 or less, plus state filing fees. In doing so, we can better protect our clients and save them money in the process. Why should our clients pay more money to be put at greater risk?
I trust this initial discussion of Sole Proprietorships and General Partnerships has dissuaded you from considering the use of such entities. They will be noted in the entity chart and in the section on taxation for purposes of comparison, but not seriously discussed hereafter.
Corporations
Forming a Corporation involves creating 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, it – the Corporation – is 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.
The history of Corporations can be traced to western civilization’s rise from the stagnation of the Dark Ages. In the early 1500s it became apparent that a new form of business was needed in order to advance economic activity. Previously, an investor/entrepreneur who engaged in a business that was not successful would not only lose all of his personal assets, he also could be thrown into debtor’s prison or hanged for his failings. How’s that for encouraging risk? It wasn’t really until the nation states of Europe needed their entrepreneurs to start competing for overseas opportunities that the limited liability corporate form of doing business was authorized and blossomed. And the result was one of the major catalysts for economic advancement out of the Dark Ages. When people are willing to take risks, and their personal assets can be protected in the process, societies will benefit.
A Corporation is organized by one or more shareholders. Depending upon each state’s laws, it may allow one person to serve as all officers and directors. In certain states, to protect the owner’s privacy, nominee officers and directors may be utilized. A Corporation’s first filings, the Articles of Incorporation, are 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 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 or corporate file.
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 pierce the corporate veil and seek personal liability against the officers, directors and shareholders. 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 expend no extra time 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 insure that protection.
For some, a disadvantage of utilizing a regular Corporation (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. As illustrated in the chart on page 17, if the Corporation earns a profit it pays a tax on the gain. If it then decides to pay a dividend from any after tax profits to its shareholders, the shareholders are taxed once again. However, through proper planning, the specter of double taxation can be minimized.
Nevertheless, this double taxation does not occur with a Limited Liability Company or a Limited Partnership. The flow-through taxation of Limited Liability Companies and Limited Partnerships represents, for many, a significant advantage over the corporate entity.
It should be noted here that a Corporation with flow-through taxation features does exist. The S corporation (named after an 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 an S corporation is the entity of choice for certain small businesses, it does have some limits, as we discussed earlier. These limitations include the number of persons who could be shareholders (100 or less), a prohibition against non-United States residents from being shareholders, and prohibitions against other corporate entities, such as C Corporations, Limited Partnerships, Limited Liability Companies and other entities, including certain trusts, from being shareholders. Finally, an S corporation may have only one class of stock.
In fact, it was the above-named limitations that, in part, lead to the adoption of the Limited Liability Company throughout the United States in the early 1990s. Because many shareholders wanted the protection of a Corporation with flow-through taxation but could not live within the shareholder limitations of an S corporation, the Limited Liability Company was legislatively authorized.
The S corporation requires the filing of IRS Form 2553 by the 15th day of 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 an S corporation is that flow-through taxation can be lost when one shareholder sells his stock to a non-permitted owner, such as a foreign
