Your Likely Options

April 13, 2006

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When choosing an organizational form for your business, most small business owners will usually want to form the business as an limited liability company (LLC) or a corporation.

The LLC will usually be a better choice when it comes to protecting the owner's business assets from the claims of personal creditors. Note that care must be taken to form the LLC in a state that follows the Revised Uniform Limited Partnership Act (RULPA) view in its LLC statutes.

However, if the business is to be formed in a state that allows foreclosure and liquidation in an LLC, the owner may want to consider a limited partnership (LP) as an alternative to the LLC, at least where the owner is especially concerned about protecting assets from the claims of personal creditors and the business will be family-owned, so that all of the owners will not necessarily be interested in managing the business.

If this is done, care must be taken to insulate the general partner from personal liability (by making the general partner a corporation or LLC owned by you). Of course, this will undermine the very purpose of the strategy--preventing foreclosure and liquidation by a personal creditor, because the strategy will have been undertaken in a state that allows foreclosure and liquidation in both the corporation and the LLC. Nevertheless, the limited partnership interests will still be protected from foreclosure and liquidation.

As more states begin to recognize the limited liability limited partnership (LLLP), this strategy will be an even more effective alternative to the LLC.

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Even when state law reflects the RULPA view prohibiting foreclosure and liquidation, is the result really satisfactory to a business owner? Assume the personal creditor does not give up or accept a reduced settlement. Under the modern view, the personal creditor of the owner attaches the owner's interest in the business and, thus, becomes entitled to all of the distributions of assets and income to which the owner would have been entitled.

The owner works in the business, but derives no benefits whatsoever. Any distributed income goes to the creditor, and when the business is finally voluntarily liquidated, all of the assets go to the creditor. How many small business owners would find this outcome satisfactory?

Nevertheless, the personal creditor, in many or even most cases, will give up or accept a reduced settlement. In particular, the fact the creditor will be taxed on the LLC's earnings, even though he or she receives nothing, usually will persuade the creditor to drop collection efforts, to cut his or her losses. Be sure to take care when drafting the entity's documents to avoid making any distributions to the owner mandatory (see our discussion of withdrawal strategies).

Since you can obtain protection from your personal creditors for assets owned by your LLC, some business owners think that they should convert as many assets as possible into business assets. Placing assets within a single LLC (in contrast to a single corporation), can offer significant protection from the claims of the owner's personal creditors, because, in many states, these creditors will not be able to foreclose on the interest and force a liquidation of the business.

However, the benefits of this strategy, within a single LLC, are very small, because most business owners are more likely to face a business debt liability or judgment than a personal one. The business's assets, as opposed to the owner's personal assets outside of the business, are usually at the greatest risk of loss, which means this strategy actually increases the risk of loss.

A better approach would be to use two entities, an operating entity and a holding entity. In this way, you can protect your assets against the claims of both your business and your personal creditors.