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Sole Proprietorships and General Partnerships Are Risky Business Forms

Filed under Asset Protection Strategies. Fact checked on May 24, 2012.

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You need to consider many factors when deciding how to structure your business. One of the angles that you must consider is asset protection. From this vantage point, operating as a sole proprietorship or as a general partnership is risky because your business creditors can get to your personal assets, as well as your business assets. However, limited partnerships (LP), limited liability partnerships (LLP) and limited liability limited partnerships (LLLP) provide some measure of protection .

If you are the sole owner of a business, and you have not formally created either a corporation or a limited liability company (LLC), you are operating a sole proprietorship. Sole proprietorships cannot themselves own any assets; therefore, all of the business assets will be considered your personal property. All of your assets--business and personal--are subject to the claims of all of your creditors--business and personal.

Asset protection strategies may provide limited protection for a sole proprietorship. What can you do to protect assets if you decide that you still want to operate as a sole proprietorship? You must rely on other asset protection strategies, including post-judgment and bankruptcy asset exemptions, asset protection trusts, use of independent contractors, insurance, etc.

Partnership Liability Is Major Risk

If you are a co-owner of a business, and you have not formally created a corporation, LLC, limited liability partnership, limited partnership, or a limited liability limited partnership, you are operating a general partnership. This means that you have unlimited, personal liability for all of the businesses debts, including the acts of employees. In addition, in a general partnership, you also have unlimited, personal liability for the acts of all of the other owners.

If after reading the above paragraph and you still want to operate in the form of a general partnership, here is some general advice: Don't do it. The general partner experiences all of the same exposures to liability as the sole proprietor, plus unlimited, personal liability for the acts of all of his co-owners. This should make even the biggest risk-taker reconsider that decision.

It has been said that when the biggest accounting firms were operating as general partnerships, they relied on one asset protection strategy in particular: a whole lot of insurance. In fact, some commentators attribute the rapid, spectacular collapse of the major accounting firm Arthur Andersen to the fact it was operating as a partnership. Today, all of the (remaining) major accounting firms are organized as LLPs, LLCs or corporations. Small business partnerships should follow the lead of these firms.

Limited Partnerships Take Many Forms Serve Many Ends

In a general partnership, all partners have unlimited personal liability for their own actions (or inactions) and those of each partner. In contrast, a limited partnership (LP) has two types of partners: general and limited. In an LP, there is at least one general partner who has unlimited personal liability, and at least one limited partner whose liability is limited to the investment he or she has made in the business.

Work Smart

To achieve limited liability for the owner who is assuming the general partnership interest, it was once common strategy for the general partner be a corporation owned by the individual who otherwise would have directly owned the general partnership interest. Today, this once common strategy, which requires the creation of two entities, is obsolete. The same objective, limited liability for all of the owners, can be accomplished through the use of one entity--the LLC.

Limited Partners are "Silent" Investors

Limited partners are "silent partners" who make an investment of capital, just as a shareholder does in a large, publicly traded corporation. Along with the positive aspect of limited liability, there is a negative aspect as well: limited partners are prohibited from making day-to-day management decisions. Because all of the owners usually want to participate in the management of the business, an LP is not a suitable form for operating many small businesses.

On the other hand, the fact that limited partners cannot participate in management means that this form can be useful for estate planning and succession planning. Parent/owners who don't want to lose control of the business, but who want to reduce the size of their taxable estate, can transfer ownership shares to children in the form of limited partnership interests. (Note that the same objectives also can be accomplished with an LLC.)

Because the LP is not a taxpaying entity, losses from the business are passed through to the owners and reported on the owners' personal tax returns. These losses can "shelter" or offset other passive income that the limited partners might have. The general partner's losses are not usually considered passive, so they can be used to shelter other income up to the value of the partner's investment in the partnership.

The LP can represent an effective shield for the owners' business interests against the claims of the owners' personal creditors. In many states, this can also be achieved in the LLC (but not in the corporation or LLP). In states where this is not possible in the LLC, the LP may represent a viable alternative to the LLC under the right conditions.

Tip

A recent Tax Court decision added to the growing line of cases that delivered both good news and bad news if you use an LP as a family wealth transfer device. The good news is the court found that the partnership was bona fide, that the liquidation restrictions were valid and that some substantial discounts for lack of marketability and lack of control could be applied in valuing the partnership interests that a father later transferred to his children. The bad news? The Court would not recognize extreme discounts that could never reasonably take place even for the most carefully constructed LPs.

This line of decisions just proves further that, while LPs can be used for asset protection and estate planning, they do have their limitations no matter how carefully constructed.

Limited Partnerships Differ from Limited Liability Partnerships

When choosing a business form, you may want to consider the limited liability partnership (LLP), one of the newest entity options. Do not confuse a limited partnership (LP) with a limited liability partnership (LLP). In many states, a general partnership has the option of registering as a Limited Liability Partnership, which confers some degree of liability protection on all the partners.

Thus, an LLP is similar to an LLC, in that all of the owners have limited liability (though the quality of this limited liability in the LLP varies from state to state). In contrast, in an LP, at least one owner must be a general partner, who has unlimited personal liability. Further, in an LLP, all of the owners can participate in management. In contrast, in an LP, limited partners are prohibited from participating in management.

Comparing LLP and LLC

Although there are similarities between an LLC and an LLP, an LLP is not the same form as an LLC. LLPs may offer less protection from business and personal creditors. This generally makes the LLC a better choice for the small business owner.

LLPs may offer less protection from business creditors. Most importantly, although all of the owners of both an LLC and an LLP have limited liability from the claims of the business's creditors, in many states the quality of the limited liability is not the same.

Many jurisdictions only offer what is termed a "limited shield" in an LLP. In these states, limited liability protection is significantly reduced. These jurisdictions include:

States Offering Limited-Shield Liability Protection for LLPs
Alaska Louisiana Ohio
Arkansas Maine Pennsylvania
District of Columbia Michigan South Carolina
Hawaii Nevada Tennessee
Illinois New Hampshire Texas
Kansas New Jersey Utah
Kentucky North Carolina West Virginia

Other states afford the LLP the same "full shield" protection as that enjoyed in the LLC and corporation. Since your business entity does not have to be created in the same state in which you reside or do business, it's best to avoid creating an LLP in one of these states.

LLPs offer less protection from personal creditors. In many states, the business interests of the owners of an LLP are afforded less protection from the claims of the owners' personal creditors, as compared to the LLC. Specifically, an LLC can be formed in a state that protects the owner's business interest against the claims of his personal creditors. This is not possible with the LLP, as no state affords this protection to LLP owners.

An LLP must have multiple "owners." Because the LLP is a partnership, it must have two or more owners. While states formerly required two or more owners to form an LLC, today one owner is sufficient.

Professionals may have limited entity choices. California and New York limit the use of LLPs to professionals, thus eliminating the LLP as a choice for other business owners. (In California, the term "professionals" is defined narrowly to include only lawyers and accountants, further restricting the availability of the LLP there).

Where professionals operate in the LLP form, many states impose mandatory insurance requirements on the owners. These requirements are not usually imposed on the owners of an LLC, although this may be an oversight that will be changed in the future.

When Does an LLP Make Sense?

There is still one instance when an LLP makes sense: When the business owner is operating a very large, complex general partnership, conversion to an LLP rather than an LLC will be less expensive and less burdensome. Even here, however, it makes sense to form the LLP in a "full shield" state, even if that is not where the business's operations are conducted.

Converting a General Partnership to an LLP

The conversion process from a general partnership to an LLP is unique in the law. The general partnership simply registers as an LLP. Technically, the old entity does not dissolve, and a new entity is not created. The old entity continues to exist, but is now subject to a new set of laws (i.e., those governing the LLP). The conversion does not trigger a taxable event because there is no change in the entity. Moreover, because of this registration process, none of the assets needs to be re-titled, making the conversion especially simple and inexpensive.

Limited Liability Limited Partnerships Can Protect Assets

As if business owners did not have enough "initials" to contend with (LLC, LLP, PLLC, LP, PC), a new business form--the LLLP--is beginning to emerge.

What is an LLLP? It is a limited liability limited partnership or, more specifically, a limited partnership (LP) that registers under state law so the general partner will have limited liability, similar to the limited partners. This is similar to the process of a general partnership registering to be recognized as a limited liability partnership (LLP), so that all of the owners have limited liability.

The LLLP form primarily is used to convert an existing limited partnership previously created under state law. However, it also will probably prove popular as an alternative to forming an LLC in those states that allow foreclosure of an owner's business interest, and forced liquidation of the business, by the owner's personal creditors.

States Allowing Limited Liability Limited Partnerships
Alabama Arizona Arkansas
Colorado Delaware District of Columbia
Florida Georgia Hawaii
Idaho Illinois Iowa
Kansas Kentucky Maine
Maryland Minnesota Missouri
Nevada New Mexico North Carolina
North Dakota Ohio Oklahoma
Pennsylvania Rhode Island South Dakota
Tennessee Texas Virginia
Wyoming    

LLCs and Corporations Provide Most Protection

If you are already operating a business as a sole proprietorship or general partnership, you should seriously consider converting the business to an LLC or corporation. This simple change converts your liability from unlimited, personal liability for the business's debts to limited liability, and the conversion may be accomplished tax-free.

Warning

In some cases, there may be a tax bill due upon the conversion of a general partnership to a corporation, so consult a tax professional first if you are considering this step.

The IRS will automatically treat a single-owner LLC as a sole proprietorship for tax purposes, so you would retain all the simplicity and tax savings of the simpler business form. Similarly, a multiple-owner LLC will be treated as if it were a partnership for tax purposes, so after a conversion you would continue to file a partnership tax return and retain the favorable pass-through tax treatment that goes along with partnership status. You can elect to forego the more favorable treatment and have your LLC taxed as a corporation, though this is rarely done.

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