Is Your Small Business Placing Your Personal Assets At Risk?
Owning a small business entails both risks and rewards. On the upside, a small business owner can achieve financial and managerial independence, as well as an unlimited earning capacity. As with any business, however, there is no guarantee of success. Moreover, much of what can go right and wrong in establishing and running a business is beyond a business owner's control. One thing you can and should control, however, is the extent of your personal financial liability. Because without question, a business owner who operates his business as a sole proprietorship or a general partnership may unwittingly be placing all of his personal assets at risk.
Many businesses choose to operate as sole proprietorships because these structures are easy and inexpensive to establish. A sole proprietorship is a one-person business that is not registered with the state. No filings are required and the business can be established by default when you start operating. Legally speaking, a sole proprietorship is inseparable from its owner; the business and its owner are treated as one person. The implication of this is that the business owner reports any income or losses from the business on his/her individual tax return. On the flip side, however, it also means that the business owner is personally liable for any business obligations such as debts or judgments. Accordingly, any trade or judgment creditors can look not only to the business' assets, but also the personal assets of the owner to satisfy its debts.
Like a sole proprietorship, a general partnership is fairly easy and inexpensive to establish. A general partnership is simply a business owned by two or more individuals. There are no filings with the state and the general partnership's existence begins as soon as the owners start doing business. In addition, the partners report any income or losses from the business on their individual tax returns. However, the ease in creating a general partnership also carries the risk of personal liability for the owners. Each of the partners is personally liable for the entire amount of any debts or judgments of the general partnership.
Limited Liability Entities
In order to avoid personal liability, a business owner needs to create a separate legal entity to operate his business. Here, the most popular choices are a corporation, a limited liability company or a limited partnership. Each of these separate legal entities still has all of the same powers that a sole proprietorship and general partnership has. For example, the entity can make contracts, own and dispose of assets, borrow money, hire employees and anything else that a sole proprietorship and general partnership can do. The key difference, however, is that with a separate legal entity, only the entity's assets are at risk. Unlike in the case of a sole proprietorship or a general partnership, a trade or judgment creditor cannot look to the personal assets of the members or shareholders of the entity to satisfy its debts.
Keep in mind, however, that merely forming a separate legal entity is not enough to avoid personal liability. The owners must actually treat the business as a separate legal entity and not merely as the alter ego of its owners. For example, the owners cannot simply siphon money out of the business. Moreover, they should keep separate accounts in the name of the business, hold regular meetings, keep accurate records, keep the business adequately capitalized and observe all corporate formalities such as obtaining the necessary votes for major decisions. The owners' failure to treat the business as a separate legal entity can allow a court to "pierce the corporate veil," and expose the owners to personal liability. While the formalities associated with these separate legal entities are slightly more cumbersome than operating as a sole proprietorship or general partnership, owners who take these precautions can rest assured that their personal assets will not be at risk.
In addition to offering personal liability protection, forming a separate legal entity has certain tax advantages. The owners can take what would otherwise be non-deductible personal expenses and treat them as deductible business expenses. For example, the expenses associated with the business' annual and weekly meetings can be deducted. Similarly, if the business requires the use of an automobile, the owners can set up a vehicle lease and deduct the cost as a business expense. Likewise, if a business is operated out of a portion of an owner's home, the business can pay rent for the use of that portion of the home and deduct the amount paid as a business expense. Sole proprietorships and general partnerships may also take advantage of various business expenses on IRS Form 1040 Schedule C (Profit or Loss From Business). However, the audit rate for individuals who take business deductions on Schedule C is much higher than that for businesses that have incorporated or organized a limited liability company and taken similar deductions on the business' tax return.
Taking the time to consider the legal structure of a small business is a simple and often overlooked aspect of business planning. Business owners should carefully consider forming a separate legal entity to operate their business in order to protect their personal assets. Experienced counsel can help you select and create the ownership structure that is the best fit for your company.
David Morosan is a member of the Corporate and Business group at Cohen and Wolf, P.C. Attorney Morosan helps clients achieve their business goals by providing strategic and timely advice on legal matters related to their growing business. He can be reached at email@example.com or (203) 368-0211.