Before you launch that business …
by Thomas M. Mullinix
Many entrepreneurs start new ventures without considering the ramifications of their choice of business entity and the potential personal liability they may incur. But legal entity is just the first consideration. Other choices, such as personal guarantees of a business loan, or credit card use for business needs, raise additional issues of protection.
So before you set up shop, a few things to consider, starting with the business legal entity:
Proprietorship: The simplest business form, this involves a single owner who does not need to follow special formalities of law or have written agreements on profits, losses or sharing of responsibilities with others. A proprietor obtains necessary licenses in his name, has a separate tax identification number and is personally liable for all debts of the enterprise. But there are pitfalls to this, the biggest being that the proprietor is also personally liable for all business debts, as well as liabilities arising from injuries caused by business operations.
General partnership: Often very simple to set up, partnerships historically have been the entity choice of small to mid-sized businesses with more than one owner that wish to avoid the double taxation consequences of C-corporations. Two or more parties enter a partnership agreement, and liabilities pass through to the general partners on a jointly and severally liable basis, regardless of the right of contribution that one partner may hold against the other. The inherent disadvantage: All partners are liable for the partnership’s obligations. Generally, it has the same total liability disadvantages as the proprietorship.
Limited partnership: This has all the advantages of a general partnership, but does not have the same disadvantages. Only the general partner is liable for the partnership obligations. Limited partners are not normally liable for the debts of the partnership, unless they specifically otherwise agree. The liability shield can be lost for limited partners who participate in management. Generally, that exposure is not triggered if the limited partner is acting in his capacity as an officer, director, or employee of the corporate general partner.
C-corporations and S-corporations: The advantage of a C-corporation is that the shareholders are not liable for the debts of the corporation. In general, the only liability that a shareholder faces in a properly run C-corporation is the loss of his investment. The S-corporation has many of the same advantages, but for all practical purposes, does not pay federal income tax. Instead, profits (or losses) are divided among and “passed through” to the shareholders to report on individual tax returns.
Limited liability companies: These are hybrid entities that have the corporate attributes of limited liability for all owners, like a corporation, but are often classified as partnerships for federal tax purposes. In general, the LLC has the same advantages of a general partnership. Members, however, are normally not liable for the obligations of the LLC, except to the extent that they personally guaranteed the debts. The LLC has an important advantage over a limited partnership in that all members may enjoy limited liability and still participate in the management of the entity.
Two other areas that are worth caution involve loan guarantees and use of credit cards.
Guarantees: With a guarantee, a lending institution generally will require the owner of a corporate entity (whatever form) to guarantee the obligations of that entity. For example, if Newco LLC borrows $350,000 from the bank for its operating line of credit, the owner or significant shareholders would have to provide an unconditional guarantee of the obligation. This permits the bank to proceed against the guarantor if the corporate entity is unable to service the obligation, which essentially thwarts the reason for doing business as a corporate entity—the avoidance of liability. Thus, an owner or shareholder should do everything possible to avoid providing a guarantee. But if obtaining a loan is impossible without one, the guarantee could be limited by amount, by duration, or by requiring the lender to pursue the debtor or the secured asset before pursuing the guarantor.
Spousal guarantees should not be required by the lender, and should be discouraged, as should spousal ownership or senior management role. Finally, the guarantee can be stepped down upon debt repayment: If the principal of the loan obligation is repaid by 20 percent, for example, then the guarantee should be stepped down by 20 percent.
Credit Cards: Many small business entities use them when unable to obtain bank financing. Credit cards do have some advantages, but they also carry significant disadvantage: The primary shareholder is generally required to provide a personal guarantee for the obligation, the interest rate can rise dramatically after missed payments, and many credit cards require a more aggressive reduction of the principal than required by a bank line of credit.
Thomas M. Mullinix Partner in the firm of Evans & Mullinix.
P | 913.962.8700
E | tmm@Evans-Mullinix.com
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