In today’s uncertain economic environment, small business owners must protect themselves from liabilities arising, not only from disgruntled customers, but also from their creditors. This country’s recent economic problems have caused strains on most business owner’s cash flows, making it harder than ever to cover one’s overhead. The unfortunate result is that many self employed people are facing lawsuits from creditors, vendors, and suppliers, more so than from unhappy customers.

When establishing any new business, or when an existing business changes from one business form to another, it is always important to remember the mantra of business planning attorneys, “plan to succeed, but also plan to fail.” This means that whatever business format is chosen, it must accommodate both the good times while it protects the owners, and more importantly the owner’s assets, in the bad times.

TYPES OF BUSINESS

Historically speaking, only three types of business forms existed - the sole proprietorship, a traditional partnership, and a corporation. Of the three, the corporation is the only form that offered limited liability. The first two types exposed the principals to personal liability, which placed their personal assets at risk. Limited liability offered by a corporation shielded the owner’s personally and protected their personal assets, leaving only the assets of the corporation subject to any potential levy action.

Today, another entity, known as limited liability companies, has been added to the milieu. These are essentially a hybrid between a partnership and a corporation - taking the best of both and rolling them into one package.

Many self-employed people originally begin a business as a sole proprietorship out of simplicity. A sole proprietorship only requires that a Schedule C be filed with a person’s normal income tax return and does not necessitate an entire separate tax return, as does a corporation. Also, the owner does not have to worry about what name that he purchases assets in unlike a corporation or a limited liability company. Also, many states require that limited liability entities, such as corporations and LLCs, pay a business privilege tax in exchange for the limited liability.

However, simplicity has its own costs, and those can be severe. A successful litigant can levy on any asset, whether business related or not, to satisfy an outstanding judgment. Once a judgment is obtained there is no protection other than that offered under the bankruptcy laws, which is often an unattractive option in itself.

Old-fashioned general partnerships are rarely, if ever, used today. Limited Liability Companies (LLC) have taken the place of partnerships because they offer limited liability protection. Many states allow single member LLCs which have made them an attractive alternative for the sole proprietor.

The two best choices for most small business owners, whether solely or with partners, is either a corporation or an LLC. Corporations tend to be more “cookie-cutter” in fashion while LLCs offer a little more flexibility in the day-to-day operations of the business. Unlike corporations that require a Form 1120S to be filed with the IRS and any corresponding state taxing authority by March 15 of each year, single member LLCs information can be piggy-backed on the owner’s personal tax return.

The additional bureaucratic burden required by these two business forms is more than outweighed by the advantages that they offer. Both of these structures provide for limited liability protection, but they also offer perpetual existence so that the business can continue unabated even upon the death of one of the owners, or even all of the present owners.

In order to take advantage of the limited liability protection of these entities, it is imperative that the business be operated and advertised as that type of entity. All invoices, licenses, business cards, bank accounts, signs, and advertising must use either the initials LLC or Inc. At least one annual meeting must be held each year and minutes kept for each of these meetings. Also, upon the formation of a new entity, a new federal tax payer identification number must be issued for the business. No longer can the owner’s social security number be used for tax reporting purposes, which is probably smart given the prevalence of identify theft.

An additional technique to further protect your business and assets is to have your spouse hold legal title to the business assets and then lease the majority of those assets to the business under a written lease. Your limited liability entity should not be completely devoid of all assets, but it should only hold legal title to one or two with the understanding that these will be used as “sacrificial lambs” should a lawsuit ever occur. Usually a worn out truck or van is a good asset to have the business own. The idea behind this is to let the limited liability entity take the hit from any lawsuit while you, your money, and assets are protected.

As a final word of caution, beware of personal guarantees. They will completely undermine the limited liability offered by your LLC or corporation. But fret not, these too can be avoided by you owning the LLC or corporation and signing the personal guaranty, while your spouse owns all of the assets and leases them back to your company. In other words, one person owns the assets and the other person has no assets and takes on all of the liabilities.

Publication date: 02/14/2011