Business Entities (Part III)

In the last two posts, we described the various types of entities available to conduct a business and examined the taxation issues in detail. We concluded that in most cases, a pass through entity such as a Sole Proprietorship, Partnership or Limited Liability Company (LLC) is more advantageous than a Corporation for tax purposes and an S Corp is generally more advantageous than a C Corp. Besides keeping taxes to a minimum, business owners also want to keep their personal liability for the businesses debts to a minimum. This post will examine the personal liability issue in detail

There are four potential situations in which owners can be personally liable for their business’s debts. We will compare Corporations and LLCs (C Corp and S Corp shareholders and LLC members generally have the same potential liability) with Partnerships and Sole Proprietorships. General Partners have joint and several liability which means that regardless of a General Partner’s percentage of ownership of the Partnership, he or she is personally liable to a creditor for the full amount of the debt just like a Sole Proprietor who is of course personally liable for all of the business’s debts. Limited Partners that do not participate in the management and control of their business are treated more like shareholders than General Partners.

1. Personal liability for entity level debt. Corporate shareholders, LLC owners (members) and Limited Partners are not personally liable for debts incurred by the Corporation, LLC or Partnership unless they personally guarantee the debt. General partners and Proprietors are each liable for the full amount of entity debt whether or not such owners personally guaranteed the debt.

2. Personal liability for co-workers torts. The second area in which an owner can be personally liable is for the torts (wrongs such as negligence) caused by a co owner or employee. Shareholders, Members and Limited Partners are not liable unless they supervised or controlled the co worker committing the tort. General Partners and Proprietors are liable for all torts created by anyone in the organization. In some states though there is an exception for Partners in a “Limited Liability Partnership” or “LLP”, which is a type of partnership favored by professional practices before LLCs became operative.

3. Piercing the veil. In limited circumstances, creditors can ignore the corporate or company “veil” of protection. This happens only when the owners misuse their entity to deceive creditors. In such a case, shareholders and LLC members can be held personally liable for their business’s debts. Similarly, a Limited Partner who manages and/or controls the Partnership can be treated like a General Partner and be held personally liable. This common law doctrine has no relevance to true General Partners and Proprietors since they are personally liable anyway.

4. Responsible Party. Federal and state statutes can hold owners deemed the “responsible party” personally liable for certain business debts. For example if employment taxes are not remitted by the entity, the person responsible to remit these taxes can be personally liable even if they are a shareholder or member. There can be similar personal liability for owners responsible for paying sales tax and wages.

In BUSINESS ENTITIES (PART II) we concluded that for tax purposes a pass through entity such as a Partnership or LLC is the most advantageous choice. Here we conclude that for liability purposes, a Corporation (C or S) or LLC is the most advantageous choice. It should be obvious that at least when starting a business, an LLC would generally be the preferred entity. The next question for some business owners is should they change from a Corporation or Partnership to an LLC. This issue will be addressed in the next post (BUSINESS ENTITIES PART IV).