Introduction:
About three hundred years ago, the world changed for those willing to take financial risks but did not want to face total economic ruin if the venture failed. Up to that time if a business or trade failed it meant the total collapse of a family’s finances and in most countries, debtor’s prison for the businessman or tradesman who could not pay his bills. Until the family or friends of the debtor could pay the bills or work out a resolution, the debtor remained in prison.
Recall that the United States bankruptcy laws were created precisely to avoid that inevitable result of failure and that the United States Constitution specifically provided that in the United States, there would be no imprisonment for debt.
But even without debtor’s prison, the result of the failure of a business was catastrophic for the debtor. All personal assets were seized, and the failed businessman became a pauper, lucky to find any employment to put food on the table. The risk was so great that the choice to venture into business was a risk only taken by a very few brave individuals and capital investment was nearly impossible to get given the downside risks of failure. This, in turn, greatly limited the creation of new businesses and innovation. It was a stranglehold on investment.
It was during the age of exploration when massive sums were needed to pay for large fleets of ships to go to the New World that the Crown, tired of footing most of the bill, was encouraging a new concept: limited stock companies. These allowed people to invest a specified amount of money into a business venture and to risk what was invested, but no more.
This concept was eventually extended to other ventures aside from trade. It was a slow process. In the United States of the eighteenth century, such limited liability entities were considered somehow unethical, as if a person risking all of his or her wealth in a venture was a requirement for proof of commitment. It is noteworthy that the age of the first millionaires in the United States, after the Civil War, saw the extension of limited liability entities to almost all aspects of business without any loss of credibility. It is not a coincidence that the explosion of the United States into an industrial powerhouse coincided with this new tool of limited liability. The concept of limited liability, begun in England, eventually spread throughout the world.
Such limited liability has also been extended into other fields of endeavor, from protection of assets from existing creditors to protection of family fortune from hostile governments. The types of limited liability structures and their potential uses are the topics of this article.
The Basic Entities:
Corporations
The earliest of the limited liability entities was the limited stock company which eventually became known as the corporation. Essentially, this is a structure similar to a small republic in which the owners (shareholders) elect a board of directors who in turn select the officers of the entity that operate the company. While the officers engage in the day-to-day operations of the company, they are normally replaced at will by the directors who, in turn, are normally elected annually by the shareholders.
The company is a separate legal entity in that it can hire, fire, contract, engage in business, and pays its own taxes. Most importantly, any third party seeking to impose liability upon the entity cannot normally extend the claim to the shareholders, directors, or officers, only to the company itself and what it owns.
This enables investors to limit their own liability for the debts, and failures, of the entity. It opens the door to many more investors and opens up the channel for massive investment from many investors.
A majority of stock ownership normally effectively controls the corporation, and a corporation can be owned by tens of thousands of shareholders, or one.
The owners do stand to lose the value they have invested in the company. But that is all.
There are variations of corporations which are of limited size called Closed Corporations which do not require much of the structure of a typical corporation, but they have largely been replaced by limited liability companies, described below.
One variation of the corporation allows it to pass its taxes directly through to the shareholders, just as a partnership does, but maintain limited liability. Those are called Subchapter S corporations, after the section of the Internal Revenue Code that provides for this tax treatment.
Limited Liability Companies
In the last fifty years, another limited liability entity has developed in most states and that is the Limited Liability Company. Unlike corporations which have a hundred and fifty years of precedent and statutes that require certain structures, the limited liability company allows the owners, within certain broad guidelines, to structure the ownership and control of the entity in ways that corporations do not, including doing without annual shareholder and director meetings and having greater freedom of action. The same limited liability applies, and this structure has been very popular with small businesses and real estate companies.
The entity creates an operating agreement that provides for rights, powers, and division of proceeds and normally appoints a manager who will run the day-to-day operations.
Limited Partnerships
Though without the tax benefit of a separate tax structure, a special type of partnership was developed over the past fifty years that eliminates, in part, the unlimited liability of the traditional partnership and allows a class of partners to be owners who do not engage in management but still own a portion of the business, called “limited partners.” While the general or managing partners of the entity face unlimited liability, the limited partners do not, and often the managing partners are limited liability companies or corporations, providing yet more limited liability.
These entities do not have the usual set of directors or multiple officers seen in most corporations and are a favorite entity for real estate companies that do not require day-to-day operations. Again, there is an agreement between the owners providing for methods of ownership and division of proceeds. But the key element is that the limited partners cannot control the day-to-day operations of the entity without losing limited liability status.
Irrevocable Trusts
While a revocable trust normally has tax and personal liability imposed upon the person creating a trust (“trustor,”) a trust that cannot be revoked by the trustor is considered a separate tax and legal entity and can enter into contracts and obligations just as a corporation can, without liability transferring to the trustor or beneficiary of the trust. This is often done for estate planning, tax planning, and long-term family asset planning but not for the typical business since the trust structure is difficult to use in operating an ongoing business.
Piercing the Entity Protection:
It is possible for third parties, including taxing authorities, to seek to have the court ignore the usual limited liability of an entity and impose the obligation upon the owners or beneficiaries and fiduciaries of the entity. Such legal actions are called “piercing the corporate veil” though they also apply to the other types of limited liability entities that exist.
There are two basic ways limited liability may be eliminated. First, by contract. Second, by wrongful actions.
Guaranties:
One can contractually agree to be liable for a third party’s obligations if that party does not pay and that includes the liabilities of corporations and other limited liability entities. It is not uncommon for creditors who are selling products or services to a limited liability entity to insist that the owners guarantee the debts. This is particularly true in high-risk or recently created entities. It is vital to note that these guaranty agreements are fully enforceable and essentially eliminate one of the key advantages of setting up the entity in the first place. If one is required to execute a guaranty, be sure to limit the length of time it will remain in effect.
Wrongful Actions:
If the owners ignore the corporate formalities and, more importantly, if they do not keep the corporate assets segregated from their own, then the court can determine that the corporation is a sham and impose personal liability on the owners. A typical situation would be a corporation’s bank account being used regularly to pay personal expenses of the owners or the entity not clearly indicating to third parties that the entity exists and has limited liability, thus misleading creditors into extending credit.
Piercing the corporate veil is a difficult task for the plaintiff or taxing authority. Courts understand the importance of allowing limited liability. Nevertheless, it is vital for the finances of the entity to be carefully restricted to benefiting the entity, not the owners. The owners receive dividends or a portion of the profits but are not allowed to invade the bank accounts or assets at will if they wish to maintain limited liability. The name “corporation” or “limited liability company” should be on letterhead and business cards to ensure that no confusion exists as to the nature of the company.
Conclusion:
One wag commented that the only first-class citizens in the United States are corporations. These powerful entities, whether publicly traded or privately owned, operate the overwhelming majority of business in the United States and wield tremendous political influence. They are one of the most effective tools of capitalism.
They are legally as real as any human and often far more powerful. Indeed, the Supreme Court recently indicated that they have many of the same rights as other “citizens.” They are a method of doing business that most people should seriously consider using, but such use entails understanding the mechanics of setting them up and maintaining them, including the payment of appropriate taxes and filing the requisite tax returns. It is essential to have both accounting and legal advice both in the creation and operation of the business.
But once mastered, the entity will become an essential part of your business life and well worth the trouble.