Choice of Entities - Protecting Yourself from Personal Liability for Business Actions

Introduction: Many people ask us about shielding themselves from liability because of a lawsuit. In California there are six main forms of entities that one can have in business. The following will discuss them all.

Question: Dear Attorney Cheng – Last year I lost a lawsuit and had to pay $200,000.00. I don’t know why but I was also personally liable. Now, I will be doing a totally different business but want to do it right. Can you help? Mr. Banta – Los Angeles

Answer: Mr. Banta, I do not have your incorporation documents in front me so I do not know why you were personally liable. However, what I will do is break down the different types of entities you can have for businesses. I am sure that your question will be answered. In California, there are six main types of business entities. They are sole proprietorship, corporations, general partnerships, limited liability partnerships (LLP), limited partnerships (LP), and limited liability corporations (LLC).

For most businesses, failure of formalities usually results in what is called in law as “piercing the veil.” One of the main the purposes of creating an alternate entity are to shield any person from personal liability. However, to create a shield one must do it correctly. It’s almost like saying a car is not a car without four wheels. Let’s go over each type of entity to help you pick what is best.

Sole Proprietorship: A sole proprietorship is set up to allow an individual to own and operate a business by him/herself. A sole proprietor has total control, receives all profits from and is responsible for taxes and liabilities of the business. Essentially, if you have not filed any documentation you pretty much are in a sole proprietorship business. The bad thing about this type of formation is that there is no protection if you lose in a lawsuit. You get all the flexibility but you also get all the liability too.

Corporations: One major historical advantage of doing business in the corporate form was the ability of shareholders to limit their personal liability for the business’s debts and obligations to the amount of their contributions. Done right, corporations are extremely helpful in shielding you from personal liability.

Background of LLP and LLC: The LLP and the LLC are the newest and most popular types of business entities, although in California the LLP is of more limited use since it is only available to accountants, lawyers and architects, and LLC’s are not available to businesses regulated under the California Business and Professions Code. The primary problems of LLP or LLC status is that case law pertaining to these entities is not very well developed because of their relatively short periods of legal existence. Corporate law and partnership law, on the other hand, have existed for a long period of time and are surrounded by well-developed and accepted case law.

LLC: A LLC is an unincorporated entity created by statute that provides presumptive limited liability for all of its owners (called “members”). An LLC can be created with flow-through tax treatment, limited liability for its owners, perpetual existence, free transferability of interest, and either centralized management or some other management structure. This makes the LLC the most appealing non-corporate entity for business organization purposes. The LLC is fast becoming the entity of choice for closely held businesses in the US.

LLP: LLP status is particularly appealing to members of professional partnerships because they can continue to function as general partnerships while limiting partners’ vicarious liability for any malpractice committed by other partners.

Limited Partnerships: A limited partnerships is a partnership formed by two or more persons having one or more general partners and one or more limited partners. In a limited partnership, the general partners are synonymous with the entity. The limited partners, on the other hand, are viewed as a distinct from the partnership and are liable only to the extent of their capital contributions. Limited partners cannot participate in the management of the limited partnership without risking their limited liability status and becoming personally liable. Management rights rests solely with the general partners.

General Partnerships: A partnership is an association of two or more persons to carry on as co-owners of a business. Partnerships can be formed through an oral or written agreement and the terms of the agreement can be extremely flexible. Unlike other entities, partners in a general partnership have a duty of loyal and care to the partnership and can get sued when they do not comply. Although a partnership is an entity separate and distinct from its partners, all partners in a general partnership are jointly liable for all the debts of the partnership.

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