Volume 20, Number 3
April/May 2003

Danger Business Arrangements ahead 

By Darrell G. Stewart 

Darrell G. Stewart practices law in San Antonio, Texas.

It happens to many lawyers daily, or several times a week. A client makes an appointment to discuss a new business venture. “Attorney, how do you advise me?” says McNamara.1 Once you establish who your client is and settle the terms of your
attorney-client arrangements, you are left to answer the question and structure the new entity or entities for a business venture, be it startup or acquisition. First and foremost, everyone needs to understand that protection in business is not a game of absolutes. In the game of business, some fail and others succeed. Full protection or safety is available only if one does not play, leaving one’s money in well-capitalized bank deposits or U.S. government obligations. No assurances exist for a business, and planning needs to account equally for the possibility of success and the possibility of failure. Planning increases the likelihood of success, but safe investments are not to be found in starting businesses. People are typically motivated by a desire to be their own boss or expectations of great success, neither of which may be experienced as expected.Who Is the Client?

If McNamara shows up with Abraham, you start off with a problem about whom you will represent, with disclosure and consent for any joint representation or alternatively with disclosure and consent for the level of information that will be shared with McNamara or Abraham, whichever is not the client. Although it is not particularly important to McNamara or Abraham at the time, clarifying this up front and treating the individuals according to that decision will forestall later confusion. Written fee agreements excel at specifying the services offered. The fee agreement is also a good place to disclaim tax advice, if that is not part of the service the attorney provides.

Answering the Question

No one size will fit all, nor should it. As an attorney, one asks the questions, explains the options, and then helps narrow down these options for selection. I have always taken issue with those who believe that one solution is overwhelmingly the best option in most or all circumstances, as this tendency can lead to oversights. Patterns may emerge, but never lose sight of the options. Commonly, business is conducted in one of several formats.

What Are the Options?

Sole proprietorships. Many small businesses commence by an individual’s filing an assumed name. The “doing business as” designation (DBA) is an apparent default for those without partners who seek no advice from attorneys. In my experience, many people file DBAs because the bank wants them to open a business checking account, or because a friend or city agency told them it was required.

If McNamara is alone and already conducting business, this sole proprietor designation may apply (with or without the DBA). McNamara’s risk under such an arrangement is that all of the personal assets of a business owner are at risk for business activities, and all of the business assets of the business are at risk for personal activities. The hazard may be someone slipping and falling in the business, a divorce, or a serious auto accident caused by a spouse, a child, or an employee conducting business. Additionally, an unpaid vendor of the business and an unpaid credit card bill pose the same risk to the assets of the business and personal assets. The pools of assets that are reachable for tort or contract claims remain unchanged, with personal and business assets equally available. Adequate insurance may help, but not in a contract or intentional tort claim.

McNamara’s prior business activities as a sole proprietor are filed for tax purposes with McNamara’s personal IRS tax return on Schedule C. As the owner, McNamara pays self-employment taxes on all net income, whether the income is distributed or not. Attorneys rarely, if ever, find sole proprietorships a recommended option. Prudence dictates segmentation of the risks. Not all clients are receptive; I had one client with multiple business locations who refused to consider alternatives to a sole proprietorship despite multimillion-dollar revenues, numerous employees, and other risk factors. If McNamara and Abraham are like that client, it will make for a short meeting.

General partnerships. If McNamara and Abraham showed up together and had an existing business the goal of which was to make money, they are partners in a general partnership. No formalities are required in terms of registration with the state. No written agreement is required for a partnership to be created. In most situations, McNamara and Abraham will already have filed an assumed name with the state or county if their business is already in operation, for the same reason as a sole proprietor.

The general partnership places McNamara’s and Abraham’s personal and business assets on the line for every contract or negligent act of the business. The partners are liable personally for the business debts, and any partner can bind all. Creditors may sue any partner, or all partners and the partnership, at the creditor’s discretion.

Rarely is the general partnership a
preferred structure after the risks are
discussed. With or without a written agreement, it can be one of the most vicious cases to litigate after a bad occurrence. A partnership dispute is often described as a bad custody case, in which the partners never loved each other and there are no reasons (such as the impact on a child) to hold back. If the partners had been longtime friends before things went bad, there are frequently issues of hurt feelings and loss of trust. Add no written agreement to the mix, and it makes for expensive litigation.

On occasion, two existing entities (limited liability companies, corporations, or limited partnerships) will follow the path of a general partnership, although these are sometimes called joint ventures (not a separately recognized status). Until recently, I had no simple partnership agreement available because I steered all clients away from this option. Recently it was a solution to segmented operations involving other entities, and so I developed a form. Special circumstances may on occasion surface that cause a client to choose general partnership status, but it is not usually at the top of the attorney’s list of recommendations.

Some clients believe that the general partnership status is cheaper because no filing fees go to the state. The savings in filing are offset by the degree of customization that is required. Drafting a comprehensive partnership agreement can make this an expensive engagement for McNamara and Abraham, if they pick this option.

Tax returns for a partnership are filed under an information return (Form 1065), and the partners are issued K-1s for their respective interests. Partners pay self-employment taxes on any guaranteed payments and their share of net income. No protection exists for personal assets in this form of business.

Limited partnerships. Limited partnerships require formal structure and registration. Documents must be prepared, and are commonly done by attorneys. The limited partnership requires a general partner to manage it and may contain any number of limited partners. Limited partners are not directly responsible for the debts of the limited partnership, capping their liability at their contribution to the limited partnership. The liability cap is removable if the limited partner acts to manage the limited partnership or if the limited partner commits an intentional tort.

McNamara and Abraham may be attracted to this choice of business entity. However, before deciding one must determine who will be the general partner(s); at least one is required. The general partner might be McNamara or Abraham, or both, but in that case the downsides of a general partnership apply, as the general partner is liable for all partnership obligations. In my practice, individual general partners have been limited to estate planning using family limited partnerships, and even in these cases they are not always the best choice.

A general partner must own 1 percent or more. The limited partnership takes action by authority of the general partner. Commonly, a limited liability company (LLC) or a corporation is formed to act as the general partner of the limited partnership. Assuming common ownership,
McNamara and Abraham can act as officers or authorized representatives of the LLC or corporation without jeopardizing their limited partnership status. This may also be helpful if a third person, Rodriquez, is introduced to operate the business and McNamara and Abraham were investors. The general partner may be paid a management fee for actions taken on behalf of the partnership, to fund the operations or as part of the overall compensation scheme.

Limited partners are unrestricted in the sense that they can be any other entity or trust without jeopardizing the taxable status of the limited partnership (unlike S Corporations, discussed below). Limited partnerships file the same tax return as a general partnership, Form 1065, allowing the income to pass through the entity to the owners. Unlike a general partnership, the limited partners do not pay self-employment taxes on distributions of income, but only on any guaranteed payments. Income distributions can be different from ownership percentages, allowing the creation of different classes of limited partners. Voting rights and repayment schemes are subject to variance, allowing some classes to have preferences in payments and others in control issues.

Texas has been a state where the limited partnership has flourished, in part because a limited partnership has not paid franchise taxes, Texas’s version of an income tax by another name. As this article is written, the state legislature will shortly convene facing an estimated $5 billion to $10 billion deficit, so this historical advantage may disappear shortly.

Downsides to the limited partnership structure are the additional record keeping and tax returns required when another entity is created as a general partner. Keeping two sets of books correctly and mastering the procedures to operate an active business have been known to cause difficulty for some clients. If mastered, the limited partnership structure provides numerous planning opportunities for McNamara and Abraham and can be designed to accommodate most business concerns.

Drafting a limited partnership agreement can be complex, and filing fees may be high, so this form of a business entity can be the most expensive to set up and operate. McNamara and Abraham must be convinced that the added complexity is worthwhile to be pleased with this choice of an entity.

One benefit to McNamara and Abraham would be limited protection of their personal interest in the limited partnership. In the event that a limited partner has a judgment later issued against it, a postjudgment collection is generally limited to a charging order. In this instance, a judgment creditor cannot attack the assets owned by the limited partnership, nor force dissolution, but must look to income distributions for funds. Extensive provisions in the area of a limited partnership’s rights and ability to assign interests are common in limited partnership agreements. On occasion, the attacking judgment creditor must pay taxes on income that is not distributed, without a say in the management.

Limited liability companies. The limited liability company (LLC) is available by statute in all 50 states, with some significant state-to-state variances. McNamara and Abraham may consider this entity a viable structure for their business. The owner of an LLC is called a member. An LLC must be created and filed with the state to have effect, and documents are generally drafted by an attorney.

An LLC can be crafted to almost any business arrangement. Some LLCs have managers (similar to a board of directors); others do not. Some LLCs have officers; others do not. Texas allows one-member LLCs, but not all states do. If the LLC has members, managers, and officers, it may function similarly enough to the long-
established corporations for many business people (and banks and title companies) to understand it. Many of the LLCs that attorneys form in this area have all three, but one can create many different variants with this free-form hybrid.

Drafting the articles of organization (analogous to articles of incorporation for a corporation) and regulations (analogous to corporate bylaws) allow one to provide for the formality of operation necessary to
McNamara and Abraham. One advantage is the ability to dispense with some of the formalities of operating a corporation. Some LLCs are crafted to remove the need for formal documentation of meetings once the entity is formed successfully, or at least to excuse the absence of annual meetings. Ownership interests may be reflected on a membership certificate, which in Texas is optional.

An LLC is a separate entity, stand-
ing alone for contract and tort claims.
McNamara’s and Abraham’s personal assets would not be attached for an LLC debt, whether in tort or contract. The separation of personal assets would not apply if McNamara and Abraham guaranteed a debt personally, nor would it protect either from an intentional tort where one was the actor.

The free-form and hybrid nature of the LLC carries over into the federal tax arena. By default, an LLC with two or more members is taxed as a partnership, files a 1065, and passes its income through to the members. A one-member LLC is disregarded by default, and the owner files on the owner’s personal tax return as if it were a sole proprietorship (Schedule C). In both of these instances, self-employment taxes are typically paid on the income that passes through to the member. If a member in an LLC with two or more members is solely an investor, a case can also be made for taxing the member as if the member were a limited partner in a limited partnership, omitting the payment of self-employment taxes for distributions.

Federal income tax in an LLC creates a lack of clear rules that some see as opportunity for tax planning. For instance, some tax advisers select corporate status and then file a subchapter S election when the member owners qualify. One may also elect corporate status for tax purposes similar to a subchapter C corporation. (The distinction between the S corporation and the C corporation is discussed below.)

One tax-related approach is to have an individual form an LLC as part of a deferred real estate exchange (called a Starker or 1031 exchange). The individual sells the first parcel of real estate but takes title to the exchanged real property purchased as a replacement in the name of an LLC. This is possible because a one-member LLC is disregarded for tax purposes.

In visiting with McNamara and Abraham, an attorney should inquire about the accountant that they will use. Some accountants strongly disfavor the LLC, perhaps owing to their lack of familiarity with the format or because of its lack of clarity in the tax arena. Tax adviser opposition can lead to choosing another accountant or an alternate choice. Pushing too hard on the perceived benefits of an LLC can lead that alternate choice to be another lawyer, or worse yet, result in the accountant or tax adviser filing their own solution. Despite the multidisciplinary practice movement, in Texas an unauthorized practice of law issue is presented when an accountant or adviser forms an entity.

One benefit to McNamara and Abraham in Texas and many states is that their personal membership interest in the LLC would be somewhat protected from their respective personal creditors. A future judgment creditor of McNamara or Abraham would be limited to a charging order, just as in a limited partnership. (Not all states follow this approach of making the membership interest subject to a charging order.)

Overall, many business clients choose the limited liability company for its flexibility and benefits. An equal number of my clients choose the next alternative as well, for differing but valid reasons.

Corporations. A corporation as a separate entity has been a popular choice for many years, offering its owners protection from personal liability. The corporation is the most widely recognized creature of statute creating a separate entity. Business people, bankers, accountants, lawyers, and title companies understand the general operation of these entities.

Some accountants continue to favor the corporate structure, and alternatives can create issues if McNamara and Abraham are unwilling to change accountants. Some business people are themselves comfortable in the corporate structure and resist alternatives. If McNamara were alone in the business venture, a solely owned corporation is subject to wider state acceptance than a one-member LLC.

Two variants, based on federal tax status, exist of the corporation formed for general business purposes. To form either, one files articles of incorporation, drafts bylaws, and has an organizational meeting. Further documentation of annual meetings and significant events are commonly required as well.

S corporations, or subchapter S corporations, are pass-through entities for federal tax purposes. Shareholders file a subchapter S election to allow the income to be taxed directly to them and remove double-taxation issues associated with a C corporation. The corporation cannot have more than 75 shareholders (owners). Only one class of stock is allowed, with some latitude for differing voting interests (commonly used in some estate plans for individuals). All shares must confer identical rights to distribution and liquidation proceeds. Shareholders generally must be individuals (not nonresident aliens), with certain trusts and estates allowed under special conditions. In conjunction with an allowed charitable organization, advanced estate planning techniques may be available regarding the ownership of an S corporation.

Disadvantages to an S corporation compared to a C corporation, other than ownership restrictions, relate to reduced deductions to owners who work in the business. Deductions for health insurance and retirement benefits are more fully available to owners who work in a C corporation. If an owner’s spouse works in the S corporation business, however, then full health insurance deductions may be available by allowing family coverage for the non-owning spouse’s employment.

S corporation shareholders who work in the business take out money in two ways. First, one takes salary for the value of the work performed, with the normal deductions and contributions for Social Security and Medicare (one-half employer, one-half employee). As a second manner of taking out money, dividends paid to a shareholder are not subject to self-employment taxes, which may reduce the overall tax burden.

C corporations, or subchapter C corporations, are effectively the only choice if the business is one that is expected to go public. Depending on the economy, that may not be an issue this year, but it would have been a couple of years ago. No restrictions on ownership (beyond security regulation issues) exist for a C corporation, so shareholders can be corporate, LLC, individual, trust, charity, or other lesser known variants.

The largest downside to a C corporation is one of double taxation: The net income of a corporation is subject to federal income tax, but distributions by a C corporation to a shareholder are also taxable. The double-taxation issue can be avoided by moving expenses into the corporation that are still deductible business expenses. One advantage to a shareholder that works in a C corporation is that health insurance and other fringe benefits, including retirement plans, are not taxed to the shareholder as they are in an S corporation. A second advantage to a shareholder of a C corporation is in the area of retained earnings: C corporations are allowed to retain earnings for an amount that meets the reasonable needs of the business.

Frequently the shareholder borrows money, signing a promissory note following the rules to prevent it from being a disguised distribution. The risk is that borrowed funds may be considered not necessary for reasonable needs of the business because they are no longer present in the business. A second risk is that borrowings must be paid back in the instance of sale or business failure, which catches some business owners off guard when a bankruptcy trustee or stock purchaser later makes demand for the loan repayment.

If McNamara and Abraham intend to sell the business within a few years, the C corporation will bear further scrutiny. If the C corporation is sold, effectively the retained earnings are converted to capital gains realized in the sale of the corporation. In this instance, the gains may have a lower tax burden than if the money was taxable income.

Liquidations and conversions of corporations can be problematic. The solo or small firm practitioner is well advised to consult with tax advisers in this instance.

For the non-tax specialist, the documents created for the establishment of the corporation remain largely unchanged regardless of whether an S corporation or C corporation is chosen. The choice may be reflected in the formative documents but should be left to the client to decide after consultation with a tax adviser.

Shares of corporate stock are not protected from the owner’s creditors. A future judgment creditor will be able to attach shares of stock without difficulty. The judgment creditor may then act rather freely. If a corporation is selected by
McNamara and Abraham, share restrictions should be written into a separate shareholder agreement to address future creditors, marital dissolution issues, and similar concerns.

Securities issues. State and federal securities laws apply to purchases of shares of stocks, membership interests, or limited partnership interests. In-state exemptions (valuable in Texas, less so in Maryland) and other common exemptions apply to many business formations where two or three people have gotten together to form a business. In instances where initial capital is to be raised from someone else, refer the client or bring in a securities law specialist to assist in determining whether registration is required. Unless one’s practice is structured to accommodate it, securities registration requirements are formidable, with many traps, high liability potential for the attorney, and high malpractice premiums. Referring those clients out is the best solution for many practitioners.

Owner agreements. As shareholders, members, or limited partners, McNamara and Abraham should have agreements in place that cover common disputes and allow for transition issues in the event of death, divorce, or future personal judgment creditors.

Such planning sometimes involves a two-step process, where the entity decision is made in one meeting and a second meeting is scheduled later to deal with dissolution issues or conflicts between owners. A formal buy-sell agreement can be signed or incorporated into the documents and is advisable. Funding sources for the buy-sell provisions (including life insurance) must be evaluated. Also, techniques to resolve logjams in opposing points of view must be discussed and considered.

The overall structure of McNamara’s and Abraham’s respective estate planning may also create issues for discussion and resolution. Solving all of it at once may require several attorneys and try everyone’s patience. Finding a manner of segmenting and limiting the areas covered can be essential to allowing the client to make informed decisions versus getting lost in the details. Hopefully, McNamara or Abraham or both are going to be better informed after the meeting.

So, What Is the Answer?

If McNamara or Abraham were a typical client in my practice, there would be an equal likelihood from anecdotal occurrences of choosing a limited liability company or an S corporation, with a larger business or more sophisticated client choosing a limited partnership. However, I have clients operating in all of these forms of business, some of which are operating contrary to attorney recommendations. Typical clients in my practice range from new business startups to asset purchases of ongoing businesses for $1.5 million to $5 million. Some are in retail, manufacturing, or real estate, but the majority is in service-related industries such as the hospitality industry, logistics, or medical or other professions. 

Notes

1.   While some aspects of this article may be combined from actual occurrences, the names and storylines of attorney-client activities are fiction. The names were chosen because the author has no clients by those names.

 

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