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Suppose you are the sole proprietor of a retail firm, and a customer falls and gets hurt in your store. Your personal assets, such as your home, could be used to satisfy business litigation awards. When you have a general partnership (two or more people conduct a business), partners are not only liable for themselves but also for the actions of other partners. Insurance policies can protect you up to a certain point, but you might still be open to risks without a formal way to conduct business. Below are a few different routes you could take to protect yourself against personal liability.
|LP/LLP||Corp and S- Corp||LLC|
|Liability Protection||To limited partners only||Yes||Yes|
|Created at state level||Yes||Yes with S-Corp requiring IRS approval||Yes|
|Tax status, IRS||Partnership||Corporation taxes, except for S-Corp||Flexible. Could be taxed as corporation or sole proprietor or partnership.|
|Advantages||Can complement an existing general partnership|
Recognized way to conduct business
Possibility of endless life to the firm.
Simple to setup and maintain
Flexible options on taxation
No annual meetings or keeping minutes
Unlimited liability of general partners
Death of partners dissolves the LLP
Complex to set up and maintain
Except for S-Corp, double taxation
Relatively new form of business that may not be fully understood by banks and investors
Possibility of being dissolved upon death of member
Limited Liability Partnership (LP or LLP)
This type of entity is a more formal way of doing business than a general partnership. Limited partnerships include both general and limited partners. Limited partners are usually investors with not much say in the business. An LLP can be formed after a general partnership has been set up and is working well. For example, a father and son own a business using an informal general partnership setup. However, now they need funds to make improvements and to open a new branch. While other family members and friends might be willing to help out, they’re not interested in the risks involved – so they choose to be limited partners.
The LLP is not a separate entity as far as taxes are concerned. This means that the LLP doesn’t pay separate income taxes, and profits/losses flow directly into the partner’s tax returns. Note that an LLP is required to file an annual information return using Form 1065 and K-1s to all partners.
The rules about opening an LLP and documentation vary by state. Check out with the Secretary of State or another department for registration and compliance requirements. In California, the LLP structure is used primarily by certain professional services, and firms must pay an annual fee of $800.
One of the main advantages of an LLP is that it’s easy to attract investors, who might become silent partners without dissolving the original general partnership. On the other hand, the chief disadvantage of this type of structure is that you still have general partners who have liability over the business. The death of any partner dissolves the partnership.
A corporation is a separate entity created at the state level. A corporation has rights and liabilities that are separate from the owners, shielding them from personal liability for business activities – a major advantage of a corporation. If a product hurts a customer and he sues, corporate owners are not at risk of losing their assets. A corporation has stockholders as owners and distributes profits and losses through dividends. Income doesn’t automatically flow through the owners.
It’s easy to transfer ownership through the transference of stocks, allowing for more flexibility and the possibility of endless life. When a stockholder dies, the effect on the business is not as high as in the case of a sole proprietorship or a partnership. A corporation is an older, more traditional entity conducting business in the United States. Banks and investors tend to be more comfortable with a corporation rather than a Limited Partnership or Limited Liability Company.
Corporations file separate tax returns and pay taxes at their own rate. This often causes the problem of double-taxation of owners, who are taxed on dividends, while corporations are taxed on earnings. Certain corporations do qualify with the IRS to be S-Corporations and are able to avoid corporate taxation.
Professionals, such as doctors and attorneys, form professional corporations that offer lower liability protection for negligence or malpractice. This sub-type of corporation is preferred when compared to a general partnership, where professionals are liable for the malpractice of other owners.
A disadvantage of corporations is the work involved in dealing with specific legal and financial requirements at both state and federal levels, such as holding annual members’ meetings. Also, some states charge corporations fees. For example, corporations operating in California pay $800 a year in fees even if they have losses or are based in other states.
Limited Liability Company (LLC)
LLCs are a very popular structure for a firm because it’s simple and easy to set up, providing business owners with flexibility not available with the other types of entities. It allows the benefits of liability protection similar to a corporation and offers the option of a “pass-through” taxation, like a partnership.
An LLC with only one owner can be considered to be a “disregarded entity,” with profits and losses flowing directly into the personal tax return of the owner. The LLC can also choose to be treated as a corporation for income tax purposes – this level of flexibility can be very appealing to many business owners. There is no need to hold annual meetings or submit minutes with this entity. However, it does need to have bylaws or an operating agreement to avoid losing liability protection.
An LLC is not a corporation, and its creation is a bit different than a corporation. Some states, such as California, don’t allow for licensed professionals to form professional limited liability companies (PLLC). Certain circumstances, such as making the company insolvent because of excessive partners’ distributions, can make owners personally liable for the debts of the LLC.
Note that when a member of the LLC dies, the LLC may dissolve, depending on the state the company resides in and its operating agreement. Also, note that an LLC is a relatively new form of business, and state laws continue to change regarding this type of entity. Banks and investors may prefer to invest in a corporation that they are more familiar with than an LLC entity.
Considering the types of entities available for business owners who want to formalize their operations and protect themselves from liability, it’s always a good idea to talk to professionals familiar with the various options. Don’t wait until your assets are at risk to take care of the liabilities of owning a business – be proactive and start to consider your options now.