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LAW OFFICES
THOMAS D. SOLOMON
ATTORNEY AND COUNSELOR AT LAW
THE BUNKER HILL BUILDING
9525 KATY FREEWAY
SUITE 300
HOUSTON, TEXAS 77024
_______
Telephone (713) 984-9400
Facsimile (713) 465-2224
www.tomsolomon.com
tom@tomsolomon.com
TIPS AND PITFALLS FOR STARTING A BUSINESS IN TODAY'S ECONOMY
There are several components to starting and operating a business in today’s economy:
! Choice of Entity
! Formation and Operation
! Structure -- Reduce Liability and Increase Efficiency
! Owner’s Financial Situation
! Employee Issues
! Protecting Intellectual Capital
! Starting a Business by Buying a Business
This article will address choice of entity. Future articles will talk about the other components.
CHOICE OF ENTITY
The kind of business structure one chooses will carry consequences affecting several key
business areas:
Taxes – What amounts and types of taxes are owed and by whom
Liabilities – Who is ultimately liable for actions of the business
- Exposure to creditors of the individual owners
The type of business organization should be chosen carefully and thoughtfully. Although
revocable, the ability to switch between different types of organization as the business changes
may be limited.
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SOLE PROPRIETORSHIPS are businesses owned and operated by a single person. This is
the simplest form of organization. The proprietor is responsible for all business debts and
liable for any actions by the company or its employees. Profits pass directly to the owner
without any business income taxes.
GENERAL PARTNERSHIPS AND JOINT VENTURES involve two or more partners who
agree to share equally in all profits and losses. All partners are personally liable for everything
done by any partner, the partnership, or its employees. Many partnerships fail when a partner
dies or becomes disabled. A partnership agreement should therefore contain provisions for how
the partnership will be terminated. All profits pass directly to the partners without any business
income taxes.
CORPORATIONS – one form of asset ownership and business operation is the corporation.
" One of the benefits of a corporation is limited liability, but what does that really
mean?
- If an officer or director takes some action in that capacity, it is possible
to have limited liability to a creditor of the entity, that is, an inside
creditor, so long as the officer of director takes care to act solely in a
corporate, not individual capacity.
- Plus, the liability of shareholders is typically limited to the amount of
investment made in the corporation.
- All of the foregoing can be avoided by a creditor who pierces the
corporate veil or is successful in suing an officer or director as an
individual, in either of which cases, the corporate shield is no longer
available.
" All of the foregoing applies to a creditor of the corporation, but the corporate
shield does not protect an owner’s stock from a claim from a creditor unrelated
to the corporation, that is, an outside creditor. In that situation, a creditor can
obtain a turn over order and obtain ownership of the stock certificates to satisfy
a judgment. This means the creditor is now the owner of the corporation.
LIMITED LIABILITY COMPANY -- another business entity alternative
" In 1992, Texas passed a statute allowing an entity to be formed as a limited
liability company ("LLC").
" An LLC can look like a corporation for liability limitation purposes but can be
taxed as a partnership using the applicable "check the box" regulations.
" One advantage of an LLC is the fact that for an LLC formed on or after
September 1, 2007, the entry of a charging order is the exclusive remedy by
which a judgment creditor of an LLC member may satisfy a judgment out of the
judgment debtor’s membership interest. In that event, the judgment creditor has
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only the right to receive any distribution to which the LLC member would have
been entitled. Further, a creditor of an LLC member does not have the right to
obtain possession of or otherwise exercise legal or equitable remedies with
respect to the property of the LLC.
LIMITED PARTNERSHIPS
" Limited Partnerships (“LP”) provide a method to own property and control the
management, supervision and transferability of the ownership of the property
interests.
" One advantage of an LP as an asset protection tool is found in the fact that for an
LP formed on or after September 1, 2007, the entry of a charging order is the
exclusive remedy by which a judgment creditor of an LP member may satisfy a
judgment out of the judgment debtor’s membership interest. In that event, the
judgment creditor has only the right to receive any distribution to which the LP
member would have been entitled. Further, a creditor of an LP partner does not
have the right to obtain possession of or otherwise exercise legal or equitable
remedies with respect to the property of the LP.
" Because of the broad equitable nature of the charging order remedy, the limited
partnership structure, like the LLC, is not an absolute creditor protection device.
- Nevertheless, if a creditor becomes an assignee, he cannot sell the interest
unless the limited partnership agreement so provides; he cannot replace
the limited partner in the partnership; he cannot cause a partition of the
partnership or require the limited partnership interest of the debtor or the
partnership to pay him the judgment. He can only wait for income to be
paid. If the limited partnership agreement so provides, the general partner
has the absolute discretion to not pay any income to the limited partner.
- Although it cannot be said that use of a limited partnership will absolutely
prevent a creditor from reaching the interest of a partner in a limited
partnership, as a practical matter, most commentators feel that creditors
are unlikely to be interested in becoming an assignee of a limited
partnership interest because that status
# does not give the creditor any role in management,
# may restrict the creditor solely to distributions of profits (if the
general partner decides to make distributions), and
# may require the creditor to pay tax on the income of the
partnership.
* The prospect of tax liability with no distributions can be a
large disincentive to a creditor of an individual limited
because the general partner has no obligation to make
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distributions of income under a well drafted Limited
Partnership Agreement.
* In such case, the judgment creditor may receive nothing for
the interest that the creditor has obtained, yet may have
responsibility for federal income tax liability, yet have
only very limited rights to receive distributions.
* Since the creditors may be responsible for paying taxes on
phantom income, and do not acquire partnership assets or
take part in partnership management, they may be
interested in settling the judgment for less than its face
value.
" This means that a creditor of a limited partner effectively is unable to do
anything with the assets of the limited partnership.
- The creditor may seek the appointment of a receiver to take the debtor's
share of the partnership's profits, but should not be able to reach the
partnership assets, nor force any distributions from the partnership.
- The general partner can
# restrict partnership distributions and
# make loans to the partners for cash flow purposes, create phantom
income, etc., thereby persuading the creditor to settle the claim or
sell the assignee interest to the partnership or another partner at a
substantial discount.
" In order for the foregoing to be effective, the limited partnership must have been
formed before the claim against the partner arose, otherwise the transfer of assets
is susceptible to being set aside under the Texas Uniform Fraudulent Transfer Act
USING AN LLC AS A LIMITED PARTNERSHIP'S GENERAL PARTNER.
" It is often useful to have an LLC serve as the general partner of a limited
partnership.
" An LLC makes an excellent general partner.
- An LLC's ownership is not limited to certain types of shareholders as in
an "S" corporation.
- An LLC may also assist in obtaining additional creditor protection and in
pass-through federal income-tax treatment as a partnership.
# The creditor protection is obtained by the fact that a judgement
creditor is limited to getting only a charging order on the
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judgement debtor's membership interest in the LLC without any
rights to manage the LLC.
# Usually the LLC's ownership is spread among members or their
trusts or other entities.
Additional Considerations in Using a Limited Partnership
" Besides offering some creditor protection, the limited partnership may
- facilitate annual gifting from one generation of partnership interest
owners to lower generation of partnership interest owners,
- help protect separate property assets in the event of a divorce,
- reduce potential transfer tax consequences due to possible discounts
because of the closely-held nature of the interest and lack of
marketability, and
- avoid double taxation that can be present in a corporation.
Separate Limited Partnerships and LLCs
" The use of separate limited partnerships or LLCs to own separate properties or
businesses can also be beneficial.
" For example, a business can reduce liability exposure by placing different
operations in separate LLC’s or limited partnerships.
Additional Considerations
" The primary purpose of the limited partnership should be to hold, manage and
administer assets.
" The arrangement must have a business function - not just creditor avoidance.
Naturally, this article cannot cover all the issues to be addressed when deciding on
the form of entity, so if anyone would like to discuss the matter further, give me a call.
THIS INFORMATIONAL MEMORANDA FROM THE LAW OFFICES OF THOMAS
D. SOLOMON is provided as a courtesy to our friends and clients to provide them with items of
interest in the corporate acquisition area. It is not and is not intended to be an exhaustive
treatment of its subject matter, but rather an overview of some of the elements of such subject. It
is not intended to be legal advice or a legal opinion and should not be relied on in making legal
or business decisions. If you have any questions, please call.
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