Volume 7 Issue 4
Liabilities and the Form of Business
© by Tax & Business Professionals
Many view the "I" word, "Incorporation,"
with misunderstanding or fear. Some new businesses believe, incorrectly, that they must be
incorporated in order to engage in commercial activities. Much of the current confusion
relates to the mixed evolution of liability concerns and federal tax law.
In recent years, the question of choosing the best form of
entity has grown even more difficult. One reason for this is the proliferation of options.
Years ago, the basic choices were essentially three: sole
proprietorship, partnership, or corporation. Now, however, there are a number of
additional alternatives, including limited partnerships, limited liability companies,
limited liability partnerships, and several species of corporations, including
professional corporations and S corporations.
While each of these different forms of entity may have varying
tax and other consequences, one of the most important differences among these choices
relates to the question of liabilities.
There has long been a need for business owners to insulate
personal assets, such as their homes, from exposure to business risks. If the worst
happens, the business may be lost, but can the business owners home and personal
wealth be preserved?
The ability to insulate personal assets from business risks is
known as "limited liability." What this means, in essence, is that in the case
of entities that provide limited liability, the liability of the owners is generally
limited to their investment in the business. The different choices of entity mentioned
above provide limited liability to varying degrees.
If a person operates a business and directly owns all of its
assets, this is usually known as a "sole proprietorship." The owner and the
business are essentially one and the same, and the owner is directly responsible for all
of the businesss debts and liabilities. In other words, a sole proprietorship
affords no limitation on liability at all. Instead, the owners liability for
uninsured business losses is essentially unlimited.
The same is true with a partnership. Unless special steps are
taken, partnerships are usually known as "general" partnerships, and each of the
owners or partners can be fully liable for all of the businesss debts or losses. In
other words, from a liability standpoint, a general partnership is essentially the same as
a sole proprietorship in that the business owners and their personal assets are fully
exposed to the risks of the business.
Traditionally, the only way to avoid unlimited liability was to
form either a limited partnership or a corporation. In a limited partnership, there are
two types of partners. The general partners must have unlimited liability, just as in a
general partnership. In addition, there are also limited partners, whose liability is
generally limited to the amount of their investment.
Until fairly recently, the only way to have limited liability
for all the owners of the business was to form a corporation. In a corporation, generally,
the stockholders, who are the owners of the business, are liable only to the extent of
their investment, assuming that all laws necessary for the creation and operation of the
corporation have been satisfied.
In recent years, there has been a proliferation of new types of
business entities. In the 1960s, professional corporations and professional
associations appeared. More recently, limited liability companies (LLCs) and limited
liability partnerships (LLPs) emerged. While some states may not recognize all of
these newer forms of business organization, most states recognize most of these basic
options. The consequences of each form, however, may vary from state to state.
To one degree or another, most of these newer forms of business
organization are driven by the desire to provide the benefits of limited liability without
all of the consequences of being a regular corporation.
It is useful to think of these newer forms of business
organization as falling into two main groups. The first includes limited liability
companies (LLCs) and represents a form of business organization that is potentially
applicable to almost any type of business. An LLC is much like a limited partnership
without a general partner. In other words, the members of an LLC have limited liability
(similar to corporate shareholders) without the requirement of a limited partnership that
there be at least one partner with unlimited liability.
The second category, including professional corporations
(PCs) and limited liability partnerships (LLPs), are intended primarily for
"professional" practices, such as accountants, architects, medical
professionals, and lawyers. These forms of organization generally provide a measure of
limited liability with respect to most types of liabilities other than professional-type
claims (i.e., malpractice) against the individual professional owners and those they
Over the next several issues, we will explore in
greater detail some of the consequences of each of these types of business organization,
and we will look at some of the planning opportunities and misconceptions that exist
regarding these options.
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