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Choice of Entity – Part 1: Asset Protection
When someone is starting a new business (or reviewing the structure of their ongoing business), they often ask a lawyer for advice on what type of business entity they should form. The most common entity types are sole proprietorships, partnerships, corporations, and limited liability companies (LLCs), and they each have their own advantages and disadvantages. In order to select the optimal entity, business owners must look at the options through three different lenses: Asset Protection, Taxation, and (let’s call it) Intangible Qualities. This post will explore the asset protection aspects of business entities.
Before lunging into each entity type, it is important to highlight the distinction between inside and outside liability. If a business creditor has a claim against a business, it is an inside creditor, and depending on the business entity involved, the creditor may be able to reach the assets of the business, and the personal assets of the business owner. Conversely, if a creditor has a claim against a business owner that is outside the scope of the business, then that creditor is an outside creditor. Depending on the business entity involved, outside creditors may be able to reach the personal assets of the business owner, and the business assets as well. The examples below will illustrate these differences.
A sole proprietor is an individual who does business on his own, without establishing any formal entity. So what asset protection does a sole proprietor receive? None. If a sole proprietor is sued, whether in contract or tort, all of his personal assets and business assets are reachable by his personal or business creditors. Except in rare circumstances, doing business as a sole proprietor is not recommended.
A partnership is two or more individuals carrying on business together for a profit. Given this broad definition, forming a partnership does not require registering with the state or filing any paperwork. Unfortunately, partners are not protected from the liability of the partnership. If a partnership is sued, its inside creditors may reach the business assets of the partnership, as well as the personal assets of any of the partners. Thus, a partnership affords no protection from inside creditors.
However, partnerships do offer protection from outside creditors. The courts have long held that the relationship between business partners is so intimate that they will not force anyone to become a business partner against their will. Therefore, if the outside creditor of a business partner sues that partner, the creditor will not be able to acquire the partner’s interest in the partnership. Instead, the creditor’s liability is limited to a “charging order,” which is essentially the right to receive distributions from the partnership to the debtor-partner. In such a case, the partnership would typically vote against capital distributions to the partners, and use other mechanisms for transferring money out of the partnership.
Corporations (Please note, the distinction between C-Corps and S-Corps relates to their tax treatment. Their treatment in the asset protection realm is identical)
A corporation is an official form of business entity, regulated and overseen by the government of the state in which it is formed. Creating a corporation requires filing Articles of Incorporation with the state, and payment of a fee. In exchange for fulfilling these requirements, state law provides that the owners of a corporations (shareholders) are protected from inside creditors. Therefore, a business creditor may not reach the personal assets of a shareholder.
Unfortunately, the same limitation of liability does not extend to outside creditors. For example, if I own 100 shares of stock in a company, and I hit someone with my car, they may be able to recover my shares of stock in that company.
Limited Liability Company (LLC)
A limited liability company is a creature of state law, and regulated much like a corporation. Accordingly, it is afforded the same liability protection against inside creditors as a corporation. Additionally, because an LLC is somewhat of a hybrid of a partnership and a corporation, it is also protected from outside creditors. Therefore, if an owner (member) of an LLC fails to pay his mortgage, the bank cannot take his interest in the LLC, but is instead limited to a charging order, as mentioned above.
In addition to the entities above, there are also Limited Partnerships (LPs), Limited Liability Partnerships (LLPs), and in some states, Limited Liability Limited Partnerships (LLLPs). These are mostly hybrids of the more basic entity types, and have specific estate planning and business purposes, which are beyond the scope of this post.
Of course this comparison of business entities is greatly simplified, and there is a lot more to entity selection than just asset protection. If you are considering establishing a new business, or are reconsidering the entity of your current business, you’ll want to ask a Massachusetts business attorney to carefully weigh your options, and explain them to you.