Sole Proprietorship vs. Corporation?
Many advisors recommend their clients operate as a sole proprietorship because of the simplicity—you simply have to report the business on Schedule C of your tax return. There are two major problems with operating as a sole proprietorship. First, while a sole proprietorship allows a person to deduct most business expenses, there are tax deductions and tax reduction strategies that apply to S corporations and C corporations that can’t be used by a sole proprietor. The second major problem is liability. A sole proprietorship provides zero protection against lawsuits. If your business as a sole proprietorship is sued, all of your business and personal assets can be taken. If you are sued personally as a result of a car accident or injury at your home, all your personal and business assets can be taken. A sole proprietorship puts all of your professional assets (real estate, equipment, cash, etc.) and personal assets (cash, stocks, home, furniture, cars, etc.) at risk of being seized to satisfy a judgment.
Because of the problems associated with sole proprietorships, many choose instead to incorporate their businesses. While the corporation is a good management and tax-reduction tool, it is a poor lawsuit-protection tool, in most cases. If your corporation is sued, all of the assets owned by your corporation can be taken to satisfy the judgment. The corporation does provide some protection of personal assets with what is called the corporate veil. The corporate veil is supposed to prevent a creditor from going after personal assets to satisfy a business debt. However, the corporate veil can be pierced, enabling your personal assets to be seized to satisfy a judgment against your business.
Understanding FLP & LLC
If you own assets in your personal name, as a sole proprietor or in a corporation, the assets can be taken to satisfy a judgment. The good news is that there are legal entities you can use to protect 100% of your professional and personal assets from be taken to satisfy a judgment. Those tools are the carefully-constructed and properly-worded family limited partnership (FLP) and/or limited liability company (LLC). The FLP and LLC can also prevent lawsuits by making you so unattractive to a plaintiff’s attorney that they will never pursue a lawsuit against you. Specialized attorneys have retooled the FLP and LLC to include lawsuit protection principles. With almost ninety years of case law surrounding it, the FLP has emerged as a tremendously-powerful tool to hold assets to protect them against lawsuits; and the LLC is an ideal tool to protect real estate and other high-risk assets. Once your assets are properly structured, you will have the financial peace of mind that comes from knowing you are protecting the assets you have worked a lifetime to secure.
One of the key principles of lawsuit protection is to place your assets into separate legal entities. When doing so, it is important to understand the distinction between safe assets and unsafe assets. A safe asset is an asset that will not trigger a lawsuit, such as artwork, gold, stocks, jewelry, and savings accounts. An unsafe asset is an asset that can cause a lawsuit, such as a business, real estate, or car.
It is important to keep your unsafe assets in entities isolated from your other assets so that if an unsafe asset creates a lawsuit, it will be limited to that asset and not affect your other assets. For example, rental property is considered an unsafe asset: it could be sued for premise liability should someone get injured on the property. If you owned multiple rental properties in your name, held your assets in your name, and someone were to slip and fall at one of the rental properties, all of the rental properties and all your personal assets could be taken to satisfy a judgment against one property. Likewise, if you were to own multiple properties in one LLC, the lawsuit at one property also effects the other properties in the LLC.
The best approach for an unsafe asset, such as a rental property, is to own each property in its own entity. Generally, the LLC is the proper way to hold unsafe assets, since no individual member or manager of an LLC can be sued for an LLC-related obligation. This limits the liability and risk of an unsafe asset to the one property. If you own a number of unsafe assets, each should be placed in a separate entity. If you own ten rental properties, for instance, you would want to consider owning each property with a separate LLC. If someone were to slip and fall at one property and sue, your other properties and assets would be unreachable because they are in separate legal entities. Only the LLC that owns the property involved in the lawsuit would be affected. There would be no spillover effect to your other assets. The other properties and family assets would be safely insulated and shielded from liability under this arrangement.
Your business real estate (office building, hotel, restaurant, medical office, etc.) is another example of a dangerous asset, one which should be separate from your others assets. For example, a physician that owns his medical building should not own the building within his professional corporation. A physician’s practice and the building are both unsafe assets, and you do not want a suit against the building to have claim on the practice, nor a suit against the practice to have claim on the building. The medical building should be separated from the medical practice, in a separate LLC.
To protect your business assets, you need to have a corporation or LLC to operate your business, but your corporation or LLC should not own assets. You should have limited partnerships or LLCs own the business assets (real estate, equipment, etc.) and then have the limited partnerships or LLCs lease the assets to your business. Trademarks, patents, and copyrights are also valuable assets, which should not be owned directly by the operating entity. A separate company can own these assets and make them available through a licensing agreement. The objective is to protect these assets in the event of a judgment against the corporation. If your business is sued, there will be no assets for them to take, since the corporation or LLC owns nothing. This is also a deterrent from lawsuits being filed against the business because there are no assets to seize from the business. Should a suit still be filed against your company and a large judgment awarded, you would be able to have the corporation declare bankruptcy and eliminate the pending judgment without losing any assets, since the corporation owns nothing. You could then form a new company, which could operate under the same name by licensing the trade name and other trademarks that were safely protected in other entities; and the new company could then also lease the building, equipment, and other assets and continue business as usual.
If you have multiple locations or product lines, you may want to set up each in a separate entity. For example, if you owned three restaurants or retail stores and each were held separately and one were to falter financially, that one location could be closed without being a financial drain on the other two, profitable stores. Another example of this approach would be a taxi cab company that holds each taxi cab in a separate legal entity so that an accident by one cab driver is limited to that cab and does not expose the other taxi cabs to the risk of being lost.
All of your safe assets (cash, gold, art, etc.) can be put into one uniquely-drafted family limited partnership (FLP), and they are one hundred percent protected. Since safe assets do not trigger lawsuits, you can put millions, or even billions, of safe assets into the same limited partnership. If a lawsuit is filed against your business or against you as a result of a car accident, your safe assets are unreachable because they are in a separate legal entity.
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