Tax & Business Insights


Liabilities and the Form of Business

Volume 7 Issue 4 -- July/August 1995

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 owner's 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 business's debts and liabilities. In other words, a sole proprietorship affords no limitation on liability at all. Instead, the owner's 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 business's 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 1960's, professional corporations and professional associations appeared. More recently, limited liability companies (LLC's) and limited liability partnerships (LLP's) 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 (LLC's) 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 (PC's) and limited liability partnerships (LLP's), 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 supervise.

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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