How to Use Limited Liability Companies & Limited Partnerships. Garrett Sutton

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 individual or trust. By so terminating the 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 its 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 of corporate shares. Neither Limited Liability Companies nor Limited Partnerships have the ability to offer an ownership incentive akin to stock options. Neither should either entity be considered a viable candidate for a public offering. If stock incentives and public tradability of shares is your objective, your first and only choice is to organize as a Corporation.

      For a more complete discussion of corporate benefits and strategies, see my books, Start Your Own Corporation and Run Your Own Corporation (RDA Press).

      Limited Partnership

      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 (or both partners) for the entire debt. (But as discussed below under Limited Liability, general partners can be protected in a Limited Partnership.) The second type of partner in a Limited Partnership is a limited partner. By definition, a limited partner is limited to his or her contribution of capital to the partnership and may not become actively involved in the business of the partnership. In the event a limited partner does become active in management, he or she may become personally responsible as a general partner.

      To understand the management structure of a Limited Partnership, as well as an LLC and a Corporation, the following chart may be useful:

      To organize a Limited Partnership you must file a Certificate of Limited Partnership, otherwise known as an LP-1, with the 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 an LLC.

      The Limited Partnership offers certain unique advantages not always found in other entities. These features include:

      Limited Liability

      Limited partners (limiteds) are not responsible for the partnership debts beyond the amount of their capital contribution or contribution obligation. So, as discussed, unless they become actively involved, the limiteds are protected.

      As a rule, general partners are personally liable for all partnership debts. However, as was alluded to 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