Choosing a Business Structure to Limit Liability

Robert A. Tufts

Ralph and Tom have formed a timber harvesting business where each contributed $10,000 in capital. Ralph is a large landowner and knows a lot of procurement foresters. Tom has experience managing logging operations, but owns very few assets. Last week, Tom went to town to pick up supplies for the business. On the return trip Tom was in a hurry and proceeded through an intersection without stopping as required. His vehicle struck another vehicle in the intersection killing one person and permanently disabling two others. Who has to pay and what is the extent of the liability? The answer is: It depends on the form of business.

As part of a literature review for an upcoming AAES project, researchers found six forms of business available to residents of Alabama--sole proprietorship (SP), general partnership (GP), limited partnership (LP), registered limited liability partnership (LLP), limited liability company (LLC), and corporation. The LLP has only been available since Jan. 1, 1997. The LLC has been available since October, 1993; however, a recent amendment became effective Jan. 1, 1998.

Prior to Jan. 1, 1998, the only forms of business available to an individual were the SP and a corporation. The recent amendments to the Limited Liability Company Act now permit a one-person LLC. If the business is owned by more than one person, all of the forms except the SP are available.

So, what is the answer to the question? If the business were an SP or GP, then all of the owners are jointly and severally liable for the debts of the business. The general partner in an LP is also jointly and severally liable. This means that not only business assets, but also personal assets are at stake. The court may force Ralph to sell his land to satisfy the judgement.

If the business were an LLP, LLC, or corporation, then business assets are at stake, but not the personal assets of non-liable owners. This is also true for limited partners in an LP. In this scenario, Ralph would lose the $10,000 he invested in the business, but none of his other assets would be at stake. (There is a concept called "piercing the corporate veil" where a shareholder can be made personally liable for the debts of a corporation. This happens when a shareholder disregards the corporate formalities, corporate governance structure, or corporate economic separateness, or the corporation is undercapitalized.)

What about Tom? There is no form of business that will protect an individual from his own negligent acts. That is because the business would be sued, and Tom would also be sued individually as the negligent driver of the vehicle.

Which form of business should you choose? There are advantages and disadvantages of each form and your choice should be determined by a discussion with your attorney and accountant. However, research indicates the LLC is a preferred form of business. Factors to consider include classification for tax purposes, transferability of interests, permissible participation in management, voting power of owners, allocation of profits and losses, effect of dissociation of an owner, and miscellaneous items such as employment taxes and fringe benefits.

All forms of business except the C-corporation provide pass-through tax treatment. This means that profits and losses are reported on the owners' individual tax returns and only taxed once. A C-corporation pays taxes on its income and shareholders pay tax again when that income is distributed to them, so there is double taxation. Also, C-corporations do not pass losses to the owners. S-corporations do pass through gains and losses like a partnership.

Ownership of a corporation is, generally, freely transferable. This means you may not be able to control who becomes an owner of the business. For the other forms of business, you can assign an income interest, but not a management interest. Tom could sell his interest in the business to Dick, but all Dick would receive is the income Tom would have received. Dick cannot participate in any management decisions of the business. These forms of business require unanimous consent before a new owner is admitted. This means that even a minority owner can prevent another person from joining the business.

Officers and directors conduct the day-to-day operations of a corporation, and shareholders who are not officers or directors have no management control. For the other forms of business, all owners participate equally in the management of the business and decisions are made on a majority basis. Management of the LLC can be limited to managers. The partnership agreement can be used to limit the management powers of some owners of a GP or LLP; however, this limitation is not effective against third parties.

There are no formalities for creating an SP or GP. The owners and the business are one and there is no limited liability.

To create an LP, LLP, LLC, or corporation, a document has to be filed with the Judge of Probate in the county where the business' office is located and the Secretary of State. This document constitutes notice to the public that you are limiting the liability of the owners of the business; so, if they deal with you as an owner, they are not dealing with you personally. One other way the public is put on notice is the name of your business. For example, if your business is an LLC, the last characters of your business name must include Limited Liability Company, L.L.C. or LLC.

The disadvantage of the corporate form is the higher cost of formation and record keeping and the formalities of governance. There is also an annual franchise tax. However, if most of the owners are employees and the business is consistently profitable, there are some tax advantages and fringe benefits available only to C-corporation.

The LLP is a partnership that has registered itself to limit liability. The biggest disadvantage is that the limited liability lasts for only one year from the filing. This means that the limited liability can lapse. So, to maintain the existence of the LLP an annual filing and fee is required.

The LLC has been described as an incorporated partnership. The LLC requires a single filing and no annual fee. The ability to limit management of the LLC is another advantage.

Research indicates if you are currently organized as a sole proprietorship or general partnership you should consider one of the other forms of business to limit your liability. You may want to divide your business into multiple organizations to further limit liability.