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Chapter One

Entity Selection

This book is designed to explain how and when to use two of the most popular and powerful business entities available today. As you go through the book you will learn that both Limited Partnerships (LPs) and Limited Liability Companies (LLCs) offer the advantages of:

• Limited liability

• Protection from creditors

• Retained management control

• Family wealth transfers

• Transfer restrictions

• Flow Through Taxation

• Flexibility

The question of when to use either an LP or an LLC will be discussed first in this chapter where we will review scenarios for each entity. Later chapters employ a question and answer approach as well as scenarios to deal with such issues as management, taxation and specialized uses for each entity.

It is important to note that there are two separate and distinct uses of the LP and LLC. One use is for the operation of a business and the other is for the holding of assets. In some cases the two uses are accomplished by one entity. LPs and LLCs, as well as General Partnerships, Corporations and Sole Proprietorships, have been used for either purpose. Throughout this book, by distinguishing between the two uses – business operations and asset holdings – the intent is to arrive at the best possible entity selection for your particular purpose.

Using Advisors

As we go through the chapters there will be instances where I suggest you consult with your professional advisor – be it a lawyer, accountant or other professional. In other books I have written, some readers have been upset by these references, their concern being why pay for a book that directs them to a high-priced professional.

My answer to this is three-fold. First, by reading this book you will become well educated in the field. You will either know with certainty – or have a very good idea – on how to start. By not requiring your professional to educate you on basic business concepts (i.e., types of entities, flow-through taxation issues, preliminary estate planning concepts and basic business skills), you have already saved hundreds, if not thousands, of dollars in consultation fees. By being able to walk into a professional’s office with a strategy and a set of specific questions to which you couldn’t find an answer or didn’t quite understand, you will be able to get right to the heart of the matter, saving time and money. Your professional can play devil’s advocate with your strategy or suggest certain fine-tuning elements to enhance it, meaning that the consulting fee you wind up paying has a far greater value than if you walked in off the street cold, with little or no idea on how to begin capturing your dream. In other words, use your professional to maximize your strategy.

Secondly, the laws in the areas we are covering can be broad and sometimes complex. One book cannot cover every nuance. By giving you a heads-up on the fundamentals of a certain topic, your advisor can instead concentrate their time on the technical details and most tax-beneficial strategy for you. By focusing their effort on the technicalities, they may be able to refine your strategy in a manner that will save you several thousand dollars in your business. And that’s how you should look at your accountant or lawyer – from a cost benefit analysis approach. Should you spend $750 on an accountant to save $5,000? It’s your choice. Because certain laws and tax regulations are downright and annoyingly complex, it is really not worth your time to deal with them. You likely have a business to run and a family to raise. You don’t need to be spending your weekends learning the arcania of the recapture rules for depreciable assets. Pay someone who does it for a living to do it for you. And remember, while our laws can be complex, in complexity comes advantage. Working with a professional to take advantage of complexity can be very worthwhile. The rich have done so for a very long time.

The third part of my answer is that by reading this book you will be better able to judge your advisor’s capabilities. You don’t want to retain or continue with just any professional. You have the right to deal with the professional with whom you are most comfortable and in whom you have the most confidence. If the lawyer or accountant you are interviewing tells you to put rental property into a C Corporation, you will know to get up and walk out. That knowledge alone can also save you thousands of dollars in the long run.

Types of Entities

The best way to select the entity most suited to your use is to compare it to other available entities. In addition to LPs and LLCs, the traditional means of doing business or holding assets have been Sole Proprietorships, General Partnerships, C Corporations and S Corporations. We shall compare the advantages and disadvantages of each.

As a frame of reference for making your selection, it is important to clarify your strategy during the planning process. To that end, the following checklist should be considered:

1. The nature of the business to be operated.

2. The nature of the asset to be held.

3. Protection of family assets and investments.

4. Management control.

5. The number of owners involved.

6. Estate planning and gifting of assets.

7. Succession of children and other family members to management.

8. Avoiding family disputes.

9. Who may legally obligate the business.

10. Flexibility of decisions making.

11. The need for start-up funding.

12. Taxation.

13. Effect upon an owner’s death or departure.

14. Segregation of assets and investments.

15. Privacy of ownership.

These and other issues will become apparent as we review your choices. And, if after reading this book you still aren’t sure which entity is best for your business plan, then ask your advisor to clarify what you don’t understand. An attorney, accountant or other professional advisor well versed in this area should be able to answer your remaining questions so you can arrive at the best entity selection for you. If need be, you can call our office for a consultation.

Before we begin comparing LLCs, LPs and Corporations, it is important to know the language of each. While their basic structure is similar, the terms for each structural facet are different.

The Language of Corporations, Limited Liability Companies, and Limited Partnerships

Also, because we will be primarily discussing LLCs and LPs, and there are similarities to both, we shall use the following common terms for the review of both:

We shall also use the term “better practice” to indicate a situation which may not be legally required by statute but is proper for the efficient, ethical and stress-free operation of the entity.

Before engaging in our discussion of the relevant entities it is important to see how they can relate to real-life situations; the scenarios that you and your family face right now, as you are reading this book. For that reason, we shall look at our first two case studies as a starting point for understanding.

Case Examples:

Case Number 1 – John and Liz

John and Liz have been friends since their college days together. They have both worked for large companies over the years and have grown weary of the nonsensical corporate politics and less than rapid response to marketplace changes. They want to be part of a nimble, focused and responsive organization that can take advantage of market opportunities as they present themselves. They want to maximize their prior experiences and consult with other businesses in their area of expertise.

After initially talking about starting their own business, John and Liz begin to focus on what it would really take. They consider all aspects of the issue. On the business side they read a number of business startup guides and talk to local entrepreneurs for advice. On the emotional and psychological side they consider what effect a start-up might have on their families.

Once they feel they are mentally and financially prepared, John and Liz decide to move forward with their consulting business. They know from their readings and discussions with other business people that they need a limited liability entity, be it a Corporation or an LLC. They have raised $100,000 between them for their initial round of financing, which they believe will get them through the first year of business. It is projected that they will lose at least $70,000 in the first year of business. With the help of their accountant, they decide they should utilize a flow-through entity for tax purposes.

In terms of taxation, Sole Proprietorships, General Partnerships, S Corporations, LLCs and LPs are all flow-through tax entities. This means that, unlike C Corporations, there is no tax at the entity level. Instead, all tax obligations “flow through” the entity to the individual’s personal tax return. While a greater discussion of entity taxes will be had in Chapter Four, the following chart illustrates the concept:

As the chart illustrates, the C corporation pays a tax at the corporate level and another tax, if profits are distributed, at the shareholder level. Accordingly, we have double taxation. Conversely, on the right taxes are just paid once, at the member level. The tax obligation ‘flows through’ the LLC, LP or S corporation to the member owners.

John and Liz take the advice of their accountant on the use of a flow-through entity. To be able to deduct $70,000 in losses and offset income from other sources is good tax planning for them.

Another issue arises in that John and Liz have decided that they will issue founder’s equity not only to themselves but to their respective spouses as well. Liz’s husband is a Canadian citizen and because he works most of the year in Vancouver, British Columbia, he is classified as a nonresident alien. This precludes them from using an S Corporation, since foreign nationals that are non-residents and not a part of the United States tax system cannot own stock in such an entity. (Foreign nationals can, however, own stock in a C Corporation, LP or LLC.)

Thus, with the desire to utilize a tax flow-through entity and the need to issue shares to a non-United States citizen, John and Liz are required to form a Limited Liability Company.

Both the accountant and lawyer advise John and Liz that an LLC is their best choice anyway, irrespective of the Canadian citizenship issue. Their professional advisors indicate that an LLC offers the beneficial features of limited liability, management control and flexible operations. Some advisors prefer to use an S corporation for business operations, on the grounds that all profits flowing through an LLC may be subject to payroll taxes. Other advisors prefer to pay the owners of the business a salary (on which payroll taxes apply) and then flow profits (without payroll taxes) through an S corporation. Other practitioners, who like certain LLC benefits, will have the membership interests owned by an S corporation, thus negating the payroll tax issue an individual owner would have. As is evident, there are a number of choices here.

Still, with the Canadian citizenship issue, John and Liz are pleased with their advice and decide to form J & L Consulting, LLC. We will come back to John and Liz’s consulting business to see how they benefit from operating as an LLC.

Case Number 2 – Mary and Gary

Mary and Gary have been married for over ten years, have three children, a dog and a mortgage. They have done well in their business careers and investments and have accumulated assets. Gary is involved in a business in which he deals with the public, which therefore means he can be sued by almost anyone for any reason. The two of them want to protect their assets. They know that if they try to shelter their assets once they have been sued, it will be considered a fraudulent conveyance and could be set aside by a court order. (We shall have a more comprehensive discussion of this concept in Chapter Seventeen.) They know that the time to protect their assets is when they are not being sued, and so they decide to move ahead with an asset protection plan. The sooner the better is their feeling.

After speaking with their accountant and lawyer they decide to form a Limited Partnership (LP). A key benefit of the LP is that it allows one party – the general partner – to maintain almost absolute control. By definition the other limited partners are limited in their management and control. They cannot tell the general partner how to run the business or to make distributions of monies received. It is an excellent vehicle for holding family assets whereby the children do, or eventually will, hold a majority interest but the parents still want to control the assets.

In Mary and Gary’s case, they want to start gifting interests to their children in order to reduce their estate tax obligations. But they also want to control the assets in order to avoid them being squandered while their children aren’t yet old enough to know money does not grow on trees.

There is one issue involving a Limited Partnership which they have to deal with: The general partner is personally liable for the debts of the LP. If you list your personal name as the general partner you are liable for everything that happens in the LP. This is easily overcome by creating a Corporation or LLC to serve as the corporate general partner, thus encapsulating the risk in a limited liability entity.

But to do it right we need to form two entities, the LP and a Corporation or LLC to be the general partner. With an LLC we only need to form one entity, the LLC itself. Advantage LLC.

Still, there are other advantages to the Limited Partnership that Mary and Gary like, including restrictions on transfers and limited liability. Mary and Gary decide to form M & G Holdings, LP to hold and protect their assets. As with John and Liz, we will come back to Mary and Gary’s holding entity to see how they benefit from holding assets in a Limited Partnership.

Comparison of Entities

Sole Proprietorship

The easiest means of getting into business is to become a Sole Proprietor. You obtain a business license and a sales tax permit, comply with regulations that any other business has to follow and you are in business.

However, easier is not always better. The major drawback of a Sole Proprietorship is that its sole owner is completely liable for all business debts and claims. If someone falls at your business location and your insurance does not cover it, your personal assets are at risk for the satisfaction of judgment. If you have a rough month and cannot pay the bills or the credit line to the bank, your personal bank account, and the equity in your house, your car and other personal assets can be attached for the repayment of judgments and debts.

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.

In 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 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 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. While the assets within the corporate or LLC entity may be exposed to a creditor’s claim, a useful and popular strategy is to hold few or no assets in the corporate general partner. In this way the personal assets of the owners of the corporate general partner are protected and not at risk.

As such, many, if not most, Limited Partnerships are organized using corporate or LLC general partners. In this way, both the limited and general partners achieve limited liability protection.

Restrictions on Transfer

By definition, limiteds may not participate in management, therefore the general partner maintains complete control. In many cases, the general partner will hold only two 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.

Retained Management

The ability to restrict the transfer of Limited or General Partnership interests to outside persons is a valuable feature of the Limited Partnership. Do you want to keep unknown parties or undesirable ex-spouses out of your company? 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 one separate corporate general partner. 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 Limited Partnership interest equal to 25 percent 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 money earned by your son’s 25 percent Limited Partnership interest, and then only, in many states, through the charging order procedure. Charging orders, which do not offer an easy path to payment, are discussed more fully in Chapter Seven, and are not favored by creditors.

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, at the time of this writing, allows one individual to give another individual a gift of $14,000 per year. Any gifts valued at over $14,000 are subject to a gift tax, but may also be counted as a lifetime gift, which allows $5.34 million in gifts during your life and at death. As such, you have two tracks of gifting: the annual (currently $14,000 per year) and the lifetime (currently $5.34 million per spouse). 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 40 percent are minimized. Please note that Congress is always prone to change these rules so stay current with your advisors.

Estate planning will be discussed in greater depth in Chapter Nine.

Flexibility

The Limited Partnership provides a great deal of flexibility. A written Limited 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 Limited Partnership Agreement.

Taxation

Limited Partnerships, like General Partnerships, are flow-through tax entities. The Limited Partnership files an informational partnership tax return (IRS Form 1065, United States Partnership Return of Income, the same as a General Partnership) and each limited receives an IRS Schedule K-1 (1065), Partner’s Share of Income, Credits and Deductions, from the Limited Partnership. Each limited then files the K-1 with his or her individual IRS 1040 tax return. The issue of taxation will be discussed more fully in Chapter Four.

Limited Liability Company

A Limited Liability Company is a new form of entity introduced into the United States in 1977. The LLC combines certain advantages of partnerships and Corporations and has been called an “incorporated partnership.”

Genesis of the LLC

The Limited Liability Company can be traced to a German entity known as the Gesellschaft mit beschranker Haftung (GmbH). Created in 1892 and combining limited liability with flow-through taxation, this entity soon found converts in a number of Latin American and European countries, including Portugal (1901); Panama (1917); Brazil (1919); France (1925); Chile (1929); Argentina (1932); Uruguay (1933); Mexico (1934); Belgium (1935); Switzerland (1936); Italy (1936); Peru (1936); Columbia (1937); Costa Rica (1942) and Honduras (1950).

As United States businesses engaged in international commerce after World War II, many became exposed to the benefits of these foreign LLCs. Finally, Hamilton Brothers, an oil exploration firm that had used LLCs throughout Latin America, saw the benefits of the United States offering such an entity. They lobbied the Wyoming legislature to enact LLC legislation and effective June 30, 1977, Wyoming became the first state to offer LLCs. Florida followed in 1982, and by 1994 all 50 states had enacted permitting legislation.

One of the primary advantages of an LLC is that no one has personal liability, as in a Limited Partnership. As discussed, the general partner of a Limited Partnership is personally liable for the debts of the partnership. The way to minimize this is to form a separate Corporation or LLC to serve as the general partner, thus encapsulating personal liability within a protected entity.

However, with an LLC, both managers and members (akin to the directors and officers and shareholders of a Corporation) are free from personal liability. This LLC feature removes the need to form a separate Corporation or LLC manager.

LLCs also offer the previously mentioned Limited Partnership features of restrictions on transfers and protection from creditors. LLCs are also useful for family wealth transfers, although some CPAs and estate planning professionals are more comfortable using Limited Partnerships for this purpose.

Flow-Through Taxation

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, real estate, or asset-holding 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. In a Sub 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 below, LLC profits and losses flow through the entity and may be allocated in a flexible manner without regard to ownership percentages. As such, the LLC offers the combination of two significant financial benefits that other entities do not.

Flexible Ownership

In 1997, the IRS abandoned its creaky rules on tax classification, allowing for single-member LLCs. State legislatures immediately followed suit and amended their statutes to allow for single-member LLCs.

As a result, you can now form an LLC and be the sole member. You can enjoy the benefits of limited liability and flow-through taxation and not answer to anyone (except, of course, possibly your spouse and the IRS). And, because the IRS views a single-member LLC as a “disregarded entity” for tax purposes, you may not even need to file an LLC tax return. Instead, the LLC’s profits and losses can flow directly onto your personal tax return, be it Schedule C, E, or F (depending on the type of trade or business carried on by your single-member LLC). And, a single-member can also include a husband and wife as joint tenants, or a living trust. Better yet, while the IRS views a single-member LLC as a disregarded entity (thus obviating the need for an LLC tax return), the law still views a single-member LLC as being entitled to limited liability protection. Single member LLC’s are so popular that in Chile they have created the EIRL (Empresario Individual Responsabilidad Limitada), a nationally chartered single member limited liability entity.

But for every benefit comes a drawback. Several U.S. states now deny asset protection to single member LLCs. (We shall explore the reasons for this in Chapter Eight.) In varying degrees, California, Colorado, Florida, Kansas and Montana, among other states, do not support single member LLCs. Additional states may follow suit. (Know that Nevada and Wyoming do protect the single member LLC.) But again, when weighing the advantage of no LLC tax return, you’ve got to weigh it against a possible loss of entity protection. Many people may choose to have a two or more member LLC just to be safe, and to file an LLC tax return as necessary.

Another flexibility benefit has to do with ownership. One of the reasons that people have a problem utilizing the Sub S corporation is the limit on owners. When LLCs were created, a Sub S corporation could only have 35 or fewer shareholders. The IRS has since raised that number to 100. Certain foreign citizens and domestic entities are still prohibited from becoming shareholders of a Sub S corporation.

The LLC offers the flexibility of allowing from one member to an unlimited number of members, each of whom may be a foreign citizen, trust or a 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 his or her shares to a prohibited shareholder.

Flexible Management

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 the 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, such a change 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 management supervision. The officers – president, secretary, treasurer and vice presidents – handle 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, such as the following, manager management is appropriate for conducting the business of the LLC:

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 or her children but does not want them (perhaps because they are not 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 or her 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 or her 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 for mismanagement or attempts to assert personal liability.

Distribution of LLC Profits and Losses

One of the remarkable features of an LLC is that members may divide the profits and losses in a flexible manner. This is a significant departure from the corporate regime whereby dividends and distributions, respectively, are allocated according to percentage ownership.

As an example, Red, Blue and Tiny each own one third of a business. Red puts in all of the money, Blue does all the work and Tiny doesn’t do much of anything. The business loses $90,000 the first year and makes $120,000 the second year. In an S corporation, the three would each be allocated a loss of $30,000 the first year and a gain of $40,000 in the second year. Red and Blue are understandably not too keen on this distribution scheme. Tiny did nothing.

However, with an LLC, Red could be allocated all of the losses in the first year and Blue could be allocated a large percentage of the gain in the second year. As long as certain special tax split rules are met and each individual pays the taxes on the gains he or she receives, the IRS is amenable to this flexible approach. And in terms of business world reality, where some people put up the money, some do most of the work and a few do absolutely nothing at all, the flexibility of LLC distributions can make all the difference between moving forward and getting bogged down in squabbling over who is doing what.

While you have flexibility you still must have agreement. If two out of three members disagree, absent a well drafted Operating Agreement at the start, a minority member may not achieve the split they want.

Lack of Precedent

One of the initial drawbacks to the LLC was that it was a new entity. There were 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 operation.

Early on, owners of an LLC had to be cognizant that the courts may interpret a feature, a benefit or even a wrinkle of LLC law in a way that did not suit them. And that is still true to a minor extent. If you do not like the uncertainty associated with a lack of legal precedent, you may want to consider utilizing an entity other than an LLC. Still, as the years pass and LLCs are formed in record numbers, this concern has diminished. In fact, in the intervening years between the first and fourth edition of this book, the issue of legal precedent has receded significantly.

The greatest concern I have with the absence of LLC legal precedence deals with how the courts will “pierce the LLC veil” and impose personal liability upon the members. Courts are starting to track the reasons and means for piercing the veil in line with a corporate situation. We shall discuss this issue in greater detail throughout the book.

In a corporate scenario one can easily avoid the imposition of personal liability by simply following certain corporate formalities. These include:

1. Annual meetings of directors and shareholders

2. Timely filings with the state.

3. Preparation of corporate tax returns.

4. Maintaining a separate bank account.

5. Separating personal and business matters.

6. Adequate capitalization of the company.

In the LLC scenario, the last five requirements apply anyway in order to maintain your status. As with a Corporation, you will need to prepare a tax return for each member to reflect the business results of the LLC (unless, as discussed, you are a single-member LLC). In addition, while not all states require annual meetings of the members, as mentioned above, the better practice is to hold such meetings. When some court someday holds that, despite no state requirement to do so, failure to hold member meetings is evidence of a lack of LLC formality you will want to have a minute book chock full of annual meeting minutes to overcome any such challenge.

By adhering to the formalities that a Corporation is required to follow to avoid piercing the corporate veil, it is anticipated that members of an LLC will avoid having their LLC veil pierced in the future.

The chart on the following pages illustrates some of the differences and similarities between the various entities we have discussed.

With our overview and comparison completed, it is now time to consider the various specific issues associated with using and operating Limited Liability Companies and Limited Partnerships. But first, here are some commonly asked questions and their answers regarding LLCs and LPs.

Frequently Asked Questions

When should I use an LLC over an LP and vice-versa?

Since everyone’s situation is different there is no definitive and correct answer to this question. As a general rule, some planners will more frequently use LPs for estate planning and holding purposes and LLCs for operating businesses and real estate investments. However, there can be valid reasons to use LLCs and LPs for the other activities mentioned. If you have a question in your own mind, you and your professional advisor should arrive at the entity best suited for your specific needs.

Is there a difference in liability protection between an LLC and an LP?

The one major difference is that in an LP the general partner is personally liable for the debts and obligations of the Limited Partnership, which may be minimized by using an LLC or Corporation as the general partner. As well, the limited partners, by acting as generals, may become personally liable. In an LLC, managers and members are not personally exposed. Please note that in an LLC, LP or even a Corporation, individuals may be held personally responsible for fraudulent and willful misconduct as well as for the failure to pay payroll taxes to the IRS. Limited liability protection does not extend to intentional bad acts.

Can non-United States citizens be members of an LLC or partners in an LP?

Yes. While non-resident aliens (foreign individuals living outside the United States) may not be shareholders of S Corporations, they may own interests in and be involved in management of an LLC, LP or C corporation.

Can an LLC or LP own stock in a S corporation?

It depends. A single member LLC taxed as a disregarded entity may hold shares in an S corporation. Otherwise, multi-member LLCs, LPs as well as C corporations, irrevocable trusts or non-resident aliens cannot own stock in an S corporation.

If I use a C corporation as the manager of an LLC or the general partner of an LP, should I open a bank account in the name of the C corporation or the LLC/LP?

You may need to open two bank accounts. The business or holding entity will need a bank account for its purposes. The C corporation, if it receives a management fee from the LLC/LP, will need a bank account to receive and disburse the income it receives.

What is a “Partnership in Commendam”?

In Louisiana, a Limited Partnership is known as a “partnership in commendam.”

How many pieces of income-producing property should be held in one LP or LLC?

Again, there is no correct answer here. The overall strategy is to segregate assets. You don’t want a judgment creditor (one with a court-approved claim against you) to be able to reach ten properties in one entity. But does that mean that each entity holds one asset or four assets? That is a judgment call for you to decide. I have some clients who are not troubled by the annual fees and put only one asset into one entity in order to completely segregate assets. I have others who feel that three assets per entity is the right number. You must arrive at your own decision.

How many general partners and limited partners may an LP have?

There are no limits. Of course, you must follow the securities laws when bringing in large numbers of investors.

How many managers and members may an LLC have?

Again, there are no limits subject to application of the securities laws.

Would you suggest an LLC or an LP to hold a large securities portfolio?

I would suggest one or the other depending upon your circumstances. For estate planning and control purposes some planners would more often use an LP. In a situation where several persons were owners and all wanted a say in management, a member-managed LLC may be appropriate.

Can my wife and I own 100 percent of a corporate general partner that owns 2 percent of an LP and also individually own the remaining 98 percent of the LP as limited partners?

Yes. This scenario is frequently used in Limited Partnerships and is not considered to be too closely held.

Can the same 2 percent general partner corporation also own the 98 percent Limited Partnership interests?

No. In that case, there are not two partners as required for an LP.

What is a Family Limited Partnership?

It is important to know that there is no such thing as a family limited partnership or “FLP”. While there are promoters selling an expensive package of asset protection strategies known as the family limited partnership, there is no such entity authorized under any state law as the family limited partnership. Yes, there are limited partnerships which can hold family assets. But beware of promoters selling you expensive forms for illusory entities which do not exist.

What is a Family Limited Liability Company?

Once again, there is no such thing as a family limited liability company or “FLLC”. Yes, LLCs can hold family assets but beware of promoters trying to sell you an FLLC as something better or more protective than a regular LLC.