Protecting Your Personal Holdings From Your Small Business or Investment Property Through Limited Liability Entities

Kern County is filled with hardworking entrepreneurs. In my practice, helping people build businesses and providing tax and asset protection advice, one of the most re-occurring issues that arises is asset protection, specifically, protecting the property and monies you have acquired over a lifetime of hard work from your investment and business activities.

 There are two primary ways this issue arises.

 1.      Operating a small business as a sole proprietorship 

or

 2.      Holding real property for investment purposes, whether commercial, residential, or agricultural as an individual.

A sole proprietorship means a business that is owned and operated by an individual, either under their own name, or under a fictitious business name. 

When I reference real property for investment purposes, I mean any real property that is held, not for personal use, but primarily to generate income; this usually means commercial property or property that you rent or lease to other individuals. Whether you consider such or not, this is business activity.

What most people do not realize, is that when you own or operate a sole proprietorship or hold real property for investment purposes, and you don't do this through some form of entity that limits your liability, all of your assets are potentially at risk from any liability resulting from those activities.

The best way to protect against this personal liability is to hold your property through some sort of entity. The primary choices available to most people are corporations, partnerships, and limited liability companies. Generally, if you operate your business through one of these entities, in accordance with the law and treat the entity as a separate business entity; your other property will not be subject to claims of liability resulting from those businesses.

Clients are often concerned about the tax result of forming and operating an entity.

First, the most important matter for most to note is that there is generally no tax result from forming an entity; even when you contribute your business assets to that entity. This is because there is a general rule of non-recognition of the formation of entities, provided in the tax code.

Further, while there are formalities that should be adhered to while operating these entities, in almost every situation, the protections afforded by limited liability is well worth theses costs. Of course, any person considering the formation of these entities should consult with a professional to determine what is most appropriate for their business or investment property, the following is intended to be a brief overview of how these entities operate, and generally how they are taxed.

 

Corporations

Corporations are the most commonly known form of entity. Corporations are owned by their shareholders; who select a board of directors, who choose officers to operate the company, commonly known by titles such as chief executive officer, chief operating officer, etc. These officers are responsible for managing the day to day business and employees. Typically, you, the business or property owner forming an entity is the shareholder, director, and officer. 

Generally, for a number of reasons, corporations are more suited to service organizations with multiple employees working for the business owner. They are also advantageous to situations where a business owner may need to acquire significant outside capital investors. Investors typically prefer to own stock instead of some other interest for various tax reasons, and due to statutory grace provided to small business stock presently - taxpayers can exclude up to fifty percent of the gain on the sale of such stock.

There are generally two types of corporations, "C" Corporations, and "S" Corporations. These are tax designations that bear on how the entities are taxed. Put simply in a C-Corporation, the profits of the enterprise are taxed twice before they are distributed to the owner as a shareholder, once when they are earned by the corporation, and then again when they are distributed from the corporation to the shareholder. C corporations that make over $100,000.00 are generally going to pay a tax rate of approximately 35%; the dividend passed to the shareholders may receive qualified dividend treatment and be taxed at a capital gain rate; otherwise it will be taxed as income at the individuals normal tax rate. Thus, there is significant taxation of income through a C-Corporation. 

Since the double-taxation is not desirable for most small business owner, there exist "S' corporations, which provide the same limited liability of a C-corporation, but there is only one level of tax; the tax attributes of the corporation are passed on to the individual shareholders, similar to a partnership. For this reason, many small business owners choose S-Corporations as the entity for their small business.

Due to their structure, and the formalities of operating them, corporations can be somewhat complex, and generally require more effort to operate in accordance with the law on an annual basis. That being said, if operated in accordance with the law they offer immediate limited liability protection of your other personal assets from the operation of the incorporated business.

 

Partnerships

For most people, the partnership form that is appropriate is a limited partnership; though there are several available types for specific purposes. A limited partnership consists of at least one general partner, and one limited partner. The general partner is typically responsible for operating, managing and controlling the business of the partnership, while the limited partner or partners do not typically have management authority, but have contributed money or property to the adventure. This is what is typically considered the "silent" partner. 

However, because a general partner is subject to personal liability for his or her actions in the partnership, the asset protection does not exist; unless the general partner is itself another entity with limited liability. Therefore, this type of entities typically require the form of another entity to act as the general partner, to ensure limited liability for the general partner. That being said, limited partnerships are easy to operate administratively as compared to a corporation.

Similar to the S-Corporation described above, in a partnership, the income (or other tax attributes) flowing from the partnership activity flows through to the individual partners and is taxed at the applicable rate for that individual; ordinary income is taxed at the shareholder’s income tax rate; capital gain is taxed at the appropriate capital gain rate for that individual – based on their income tax rate.

Partnerships also allow the partners to agree to allocate the tax attributes of the operations of the partnership, to certain partners – though, subject to strict rules, which can provide tax planning opportunities to meet real business needs.

Due to the simplicity of formation and management, and the tax treatment of partnership operations, are generally suitable to the management of land resources such as owning, farming, leasing real property.

 

Limited Liability Companies

Limited liability companies are a relatively new form of entity that seek to combine the easily achieved limited liability of a corporation, with the flexibility of partnership taxation. Similar to a partnership, they have “members” who own the entity. They can either operate the entity by vote similar to a general partnership, or appoint a “manager” or “managers” who need not be members, to manage the activities of the company. However, unlike a general partner, the manager is generally not going to be personally liable for his acts as a manager in the ordinary course of business; similar to the officer of a corporation. Limited liability companies are also very easy to form and manage, similar to a partnership.

Further, limited liability companies can elect to be taxed like a partnership or a corporation; offering significant flexibility as to how they are taxed. However, as entities, they are a relatively new form, and they are not always suitable in business where you envision attracting outside investors.

Due to the ease of formation and management, they are suitable for persons who simply want to protect assets they hold for lease or rent from liability; however, holding assets for lease or rent; they are also suitable for enterprises involving employees and services.

Of course, this is just an overview of these entities. Your decision of which entity to choose should be guided by the nature of the business, and trying to minimize your tax liability. This decision should always be made on the advice of qualified and competent counsel. 

If you have questions about entities and your tax liability, contact Chris Hamilton at The Law Offices of Young Wooldridge, LLP

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Kern County is filled with hardworking entrepreneurs. In my practice, helping people build businesses and providing tax and asset protection advice, one of the most re-occurring issues that arises is asset protection, specifically, protecting the property and monies you have acquired over a lifetime of hard work from your investment and business activities.

 There are two primary ways this issue arises.

 1.      Operating a small business as a sole proprietorship 

or

 2.      Holding real property for investment purposes, whether commercial, residential, or agricultural as an individual.

A sole proprietorship means a business that is owned and operated by an individual, either under their own name, or under a fictitious business name. 

When I reference real property for investment purposes, I mean any real property that is held, not for personal use, but primarily to generate income; this usually means commercial property or property that you rent or lease to other individuals. Whether you consider such or not, this is business activity.

What most people do not realize, is that when you own or operate a sole proprietorship or hold real property for investment purposes, and you don't do this through some form of entity that limits your liability, all of your assets are potentially at risk from any liability resulting from those activities.

The best way to protect against this personal liability is to hold your property through some sort of entity. The primary choices available to most people are corporations, partnerships, and limited liability companies. Generally, if you operate your business through one of these entities, in accordance with the law and treat the entity as a separate business entity; your other property will not be subject to claims of liability resulting from those businesses.

Clients are often concerned about the tax result of forming and operating an entity.

First, the most important matter for most to note is that there is generally no tax result from forming an entity; even when you contribute your business assets to that entity. This is because there is a general rule of non-recognition of the formation of entities, provided in the tax code.

Further, while there are formalities that should be adhered to while operating these entities, in almost every situation, the protections afforded by limited liability is well worth theses costs. Of course, any person considering the formation of these entities should consult with a professional to determine what is most appropriate for their business or investment property, the following is intended to be a brief overview of how these entities operate, and generally how they are taxed. 

Corporations

Corporations are the most commonly known form of entity. Corporations are owned by their shareholders; who select a board of directors, who choose officers to operate the company, commonly known by titles such as chief executive officer, chief operating officer, etc. These officers are responsible for managing the day to day business and employees. Typically, you, the business or property owner forming an entity is the shareholder, director, and officer. 

Generally, for a number of reasons, corporations are more suited to service organizations with multiple employees working for the business owner. They are also advantageous to situations where a business owner may need to acquire significant outside capital investors. Investors typically prefer to own stock instead of some other interest for various tax reasons, and due to statutory grace provided to small business stock presently - taxpayers can exclude up to fifty percent of the gain on the sale of such stock.

There are generally two types of corporations, "C" Corporations, and "S" Corporations. These are tax designations that bear on how the entities are taxed. Put simply in a C-Corporation, the profits of the enterprise are taxed twice before they are distributed to the owner as a shareholder, once when they are earned by the corporation, and then again when they are distributed from the corporation to the shareholder. C corporations that make over $100,000.00 are generally going to pay a tax rate of approximately 35%; the dividend passed to the shareholders may receive qualified dividend treatment and be taxed at a capital gain rate; otherwise it will be taxed as income at the individuals normal tax rate. Thus, there is significant taxation of income through a C-Corporation. 

Since the double-taxation is not desirable for most small business owner, there exist "S' corporations, which provide the same limited liability of a C-corporation, but there is only one level of tax; the tax attributes of the corporation are passed on to the individual shareholders, similar to a partnership. For this reason, many small business owners choose S-Corporations as the entity for their small business.

Due to their structure, and the formalities of operating them, corporations can be somewhat complex, and generally require more effort to operate in accordance with the law on an annual basis. That being said, if operated in accordance with the law they offer immediate limited liability protection of your other personal assets from the operation of the incorporated business. 

Partnerships

For most people, the partnership form that is appropriate is a limited partnership; though there are several available types for specific purposes. A limited partnership consists of at least one general partner, and one limited partner. The general partner is typically responsible for operating, managing and controlling the business of the partnership, while the limited partner or partners do not typically have management authority, but have contributed money or property to the adventure. This is what is typically considered the "silent" partner. 

However, because a general partner is subject to personal liability for his or her actions in the partnership, the asset protection does not exist; unless the general partner is itself another entity with limited liability. Therefore, this type of entities typically require the form of another entity to act as the general partner, to ensure limited liability for the general partner. That being said, limited partnerships are easy to operate administratively as compared to a corporation.

Similar to the S-Corporation described above, in a partnership, the income (or other tax attributes) flowing from the partnership activity flows through to the individual partners and is taxed at the applicable rate for that individual; ordinary income is taxed at the shareholder’s income tax rate; capital gain is taxed at the appropriate capital gain rate for that individual – based on their income tax rate.

Partnerships also allow the partners to agree to allocate the tax attributes of the operations of the partnership, to certain partners – though, subject to strict rules, which can provide tax planning opportunities to meet real business needs.

Due to the simplicity of formation and management, and the tax treatment of partnership operations, are generally suitable to the management of land resources such as owning, farming, leasing real property. 

Limited Liability Companies

Limited liability companies are a relatively new form of entity that seek to combine the easily achieved limited liability of a corporation, with the flexibility of partnership taxation. Similar to a partnership, they have “members” who own the entity. They can either operate the entity by vote similar to a general partnership, or appoint a “manager” or “managers” who need not be members, to manage the activities of the company. However, unlike a general partner, the manager is generally not going to be personally liable for his acts as a manager in the ordinary course of business; similar to the officer of a corporation. Limited liability companies are also very easy to form and manage, similar to a partnership.

Further, limited liability companies can elect to be taxed like a partnership or a corporation; offering significant flexibility as to how they are taxed. However, as entities, they are a relatively new form, and they are not always suitable in business where you envision attracting outside investors.

Due to the ease of formation and management, they are suitable for persons who simply want to protect assets they hold for lease or rent from liability; however, holding assets for lease or rent; they are also suitable for enterprises involving employees and services.

Of course, this is just an overview of these entities. Your decision of which entity to choose should be guided by the nature of the business, and trying to minimize your tax liability. This decision should always be made on the advice of qualified and competent counsel.