Two Business Structures That Don't Work
Do you know what the number one question is that we are asked as tax strategists? Well, on the chance that you haven't guessed already, we'll tell you. The number one question we get is always: What's the best entity structure for my business? The answer is: It depends.
Business structuring is done to accomplish two very important goals: Asset Protection and Tax Savings. Asset protection is really a type of insurance. You get it in the good times to ward off the consequences of bad times. If you've ever tried to get health or life insurance after you've been diagnosed with a medical condition, you know that it's very difficult -- often impossible -- depending on the nature of your medical condition.
Asset protection operates on the same principle. By establishing asset protection as you build your wealth and your business, you're protected down the road in the event of a lawsuit or other attacks by a creditor, angry or injured customers, or anyone who has heard you have a lot of wealth and is trying to manufacture a lawsuit against you to share in that wealth. And, before you dismiss this as unlikely, consider this: America is the most litigious country in the world, and some statistics indicate that the average American has a one-in-ten chance of being sued during his or her lifetime.
No discussion of business structures is complete without a warning against business structures that don't work, or don't offer the same level of asset protection. There are several types of business structures that you can choose from. From a liability standpoint, using the wrong business structure can be detrimental. Being educated and understanding the difference between all of the various types of business structures will help you choose the right business entity for your business and give you peace of mind.
There are two structures that should generally not be used as business structures due to the risk of full liability. They are Sole Proprietorships and General Partnerships. That's because neither of these structures is a legal structure in the eyes of the law. A Sole Proprietorship is viewed as being an extension of you personally. A General Partnership is even worse, because that's viewed as being an extension of you personally and your partner. This means you are responsible for your partner's acts, and vice-versa. Most important, these two structures put your business and all of your personal belongings entirely at risk.
A Tale of Two Partners
Dr. Morgan and Dr. Welsh had a successful dental practice that they operated as a partnership. They decided to invest some of the profits from their practice into an office building that they would also own, allowing them to save money on rent. They wanted to keep things simple and safe, so they used a separate partnership to hold title to the building from the one they operated their practice through. They used a general partnership because they were easy to form and didn't need the assistance of an attorney or incorporation service.
All went well until Dr. Welsh's car accident, where the other driver was badly injured, and Dr. Welsh was found both at fault and personally liable (he was found to be legally over the blood-alcohol limit and his insurer denied his claim). The other driver sued, and that's when Dr. Morgan found out that a general partnership wasn't a good idea.
Because Dr. Welsh was being sued personally and had no insurance coverage, all of his unprotected assets were at risk. The accident wasn't work-related, so their malpractice insurance didn't cover the situation. And, as general partnerships are not legal entities in the eyes of the law, Dr. Welsh's half of both the dental practice partnership and the office building partnership were both fair game for his creditors. Before he knew it, Dr. Morgan had to find a new business partner (as Dr. Welsh had sold his practice) and a new landlord (as the plaintiff had successfully seized Dr. Welsh's half of the office building and obtained a court order to sell the building). Without doing anything wrong, Dr. Morgan was severely impacted by the actions of his partner.
Even though Dr. Morgan had the right idea, his execution of that asset-protection plan was flawed. Separating assets by using business structures only works if you use a properly protected business structure to begin with. Again, business structures work because they are full legal entities in the eyes of the law and that means they have a separate life and are distinct from you. If Dr. Morgan and Dr. Welsh had chosen the right business structure, their businesses would have been protected against their individual acts. In Dr. Welsh's case, his car accident cost him everything. And as for Dr. Morgan, he lost half of his business.
Had Drs. Morgan and Welsh come to us instead, we would have suggested a different plan. We would have suggested that their dental practice be operated through a professional limited liability entity, to provide each doctor with some protection from each other. Had they done that, Dr. Morgan may have received some financial compensation when Dr. Welsh sold his half of the practice.
We would also have suggested that they use a different business structure, ideally a limited liability company or a limited partnership to hold their office building. In most states, creditors may not take control of your ownership interests in an LLC or LP. The most that the creditor may be able to do is place a lien or garnishment against the profits of the entity. In this instance, the profits from the entity will be paid to the creditor until the judgment amount is paid off. If they had formed an LLC or LP from the beginning, Dr. Welsh's half of the dental practice and half of the office building wouldn't have been available to his creditors to seize.
Getting asset protection into place before any issues arise is essential because once someone has threatened you with a lawsuit, you're in trouble. Transferring assets once a lawsuit has started is illegal under most state and federal laws. Same goes for tax savings: if you decide to get your entities set up after you have made your profits for the year, it is often too late to protect that income from heavy taxes.
The asset protection and tax savings that you receive from this entity, if set up properly, should save you double or triple that amount in the first year you set it up. If you have any assets that you want to protect from creditors or income that you want to protect from the IRS, make sure you get your business entities in place before this year is over.
