Safer Structures

April 1, 2006

Nothing can put a successful business in jeopardy faster than a lawsuit. Whether you own a real estate brokerage, work for a broker as an independent contractor, or invest in or manage real estate for yourself or others, you need to protect yourself from lawsuits, unforeseen debts, unintended commingling of funds, and other potential financial disasters. One of the best safeguards is to form a business entity such as a partnership, limited liability company, or subchapter S or subchapter C corporation.

Unlike a sole proprietorship — the easiest type of business entity to create — these forms of business ownership provide a separate identity for your business and, in many cases, personal liability protection for the business owner. This means that if your business should lose a lawsuit and have a judgment filed against it or incur a debt that it can’t repay, your personal assets may be shielded. (Your state’s license law may impose certain liabilities.) Under a sole proprietorship, all your business and personal assets are at risk.

Entity options

The challenge is to determine which entity structure best fits your business needs. In making your decision, keep in mind that each state has statutes that establish specific rules for the various structures. IRS regulations will also affect your choice.

Partnerships. A general partnership, limited partnership, limited liability partnership, and limited liability limited partnership are business entities that allow two or more individuals to operate a business together. Partners may share equally in control (a general partnership) or have one managing partner and several less-involved investor-partners (a limited partnership).

Partnership agreements govern the relationship and roles of the partners and outline how profits, losses, and distributions are allocated. The tax consequences of partnerships are generally straightforward since a partnership isn’t a separate entity subject to taxes as is the case with a C corporation. All partners receive a share of income according to their proportionate ownership interests and pay taxes on that income as individuals. The partnership doesn’t separately pay taxes on profits.

In a GP, LP, or LLP, general partners (who act as managers) remain individually liable for acts or obligations of the partnership. An LLLP allows for limited liability of all partners, so that none would be held personally responsible for acts or obligations of the partnership (except in the cases of fraud, misrepresentation, or other illegal conduct). Historically, partnerships have been used as a flexible alternative to a corporation structure. However, because of the difficulties in dissolving a partnership on the death or removal of a general partner, LLCs are often a better choice than partnerships for a small business. It’s easier to transfer ownership interests in an LLC and keep the company operating.

LLCs. Like corporations, LLCs offer limited personal liability for debts or judgments against the company. Like partnerships, LLCs offer pass-through tax treatment of profits and losses. If the entity is a single-member LLC, the IRS disregards the entity for tax purposes and lets all income and losses for the LLC flow through to your personal income taxes, just like a sole proprietorship. If the LLC has two or more members, you can elect to have the LLC treated like a partnership for tax purposes. The LLC is also more flexible than an S corporation because it can have any number of owners, who could be individuals or entities.

LLC owners are also shielded from personal liability so long as they avoid wrongdoing, such as commingling funds, fraud, or negligent acts. Note that while all states permit LLCs, some state statutes are more comprehensive than others. Consult with your attorney to evaluate your best option.

Corporations. Both traditional corporations (sometimes referred to as “C corporations” or “C corps”) and small business corporations (“S corps”) have a significant and established history as reliable, consistent business structures. Like other limited liability models, corporations provide liability and debt protection to owners’ personal assets. For the most part, C corps are best for larger businesses (generally those with 75 or more owners or that are publicly traded) as profits are taxed at both the corporate and individual levels.

An S corp operates much like a C corp but without the double taxation. S corps or LLCs taxed as S corps also offer a benefit to practitioners: You can pay yourself a salary in addition to getting dividends. Unlike an LLC, S corp distributions, but not wages, are exempt from self-employment tax. Discuss this potential tax advantage with your tax adviser because there can be Social Security implications.

However, you lose some flexibility in an S corp structure. An S corporation is limited in both the number and type of shareholders it can have. For example, an LLC can’t be a stockholder in an S corp. This limitation may make it more difficult to attract other businesses as potential investors or shared owners.

Creating the entity

Typically, once you choose an entity type, ask your attorney to assist in creating written documentation of the entity’s structure and organization, such as agreements between the parties and bylaws. It’s far easier and much less expensive to have an attorney, accountant, CPA, or other trusted professional advise you about the legal or tax consequences of your decision initially than to face a big judgment later.

Learn More

IRS guidance on structuring your company.

Brad J. Boyd, an attorney with Thomsen & Nybeck, P.A., in Edina, Minn., has a background in both law and real estate brokerage. He and his firm represent various REALTOR® associations and real estate companies. Contact him at bboyd@tn-law.com.

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