When agricultural producers are considering the various business structures available, they should first consider what they are seeking to gain. Often, the motivating factors are to limit personal liability, limit tax liability, to bring additional owners into the operation, and to plan for generational transitions in the business. While all of these considerations are important, this article will focus on the liability protection available in each of the following entities: Sole Proprietorships, Partnerships, Corporations, and Limited Liability Companies.
If you are the sole owner of your business and have not yet taken steps to formally organize your business into the other entities discussed below, you are likely, by default, operating a sole proprietorship. The advantage of a sole proprietorship is the simplicity that it provides. As the sole owner, you are free to easily make all decisions for the business. Also, sole proprietorships require no additional steps at tax time, since all of the business’s income and losses are reported directly on the individual owner’s tax return.
While the simplicity of a sole proprietorship is attractive, the lack of protection from personal liability makes it undesirable for most agricultural producers. The business owner is personally liable for all of the business’s obligations, including all loans and lawsuits. Obviously, many producers insure their operations to protect themselves, but it is important to remember that any liabilities that exceed or fall outside the scope of an insurance policy could attach to the business owner personally. As discussed below, a business owner can work to prevent this from occurring by setting up separate entities for businesses, and essentially preventing liability from attaching to the owner personally.
Partnerships are businesses with more than one owner, and if no other formalities have been taken, are by default being operated as General Partnerships (“GP”). In a GP, each owner is liable for all of the partnership’s obligations. This is referred to as “joint and several liability” and is unattractive because each partner can be held personally liable for all of the business’s obligations. By doing some planning,, partners can prevent this liability by creating a Limited Partnership (“LP”), or a Limited Liability Partnership (“LLP”). LPs work well in situations in which one partner (the general partner) is doing most of the day-to-day operation of the business, while the other owners (the limited partners) have no authority to make management decisions, but can still have an interest in the business while avoiding personal liability for the business’s debts. However, general partners in a LP can still be subject to personal liability. LLPs work well in situations where all of the partners have an active role in the business, but all want to limit their liability to only their contribution and equity in the business.
Forming a corporation is another option to limit personal liability. A corporation’s owners, referred to as shareholders, are protected from being personally liable for the debts and liabilities of the corporation. Therefore, a shareholder is only at risk for what he or she has invested in the corporation. In practice, however, it is common for financial institutions to require shareholders of a corporation to sign personal guarantees on promissory notes. It is important that shareholders understand that by so doing they have taken on risk of personal liability.
To ensure that personal assets remain protected from liability, shareholders of a corporation must ensure that all of the necessary formalities are being followed. For example, personal liability protection can be lost if a shareholder does not operate the corporation as a separate legal entity, and for example, intermingles corporate funds with their personal assets. When this occurs, a creditor may be able to convince a court to “pierce the corporate veil” and reach the personal assets of the shareholder.
Limited Liability Companies
Limited Liability Companies (“LLCs”) have become an increasingly popular planning tool in all different types of businesses. LLCs function as a hybrid of limited partnerships and corporations, in that they offer the liability protection of a corporation while retaining the ease of operation of a limited partnership.
In South Dakota, LLCs are a particularly attractive business entity, and limit liability better than LLCs in many other states. This is because the only legal remedy available to creditors of a member of a South Dakota LLC is a “charging order.” A charging order is a court order that directs the LLC to pay the creditor any distributions that would otherwise be payable to the individual LLC member. This means that creditors cannot force the sale of the business’s assets to pay debts, and if there are no distributions to be made to the individual, the creditor will receive no payments.
None of the strategies discussed in this article should be implemented without a conversation with both your attorney and your accountant. Each business is unique, and there are many variables that can determine which entity is right for you and your business.
This article is intended as an overview of business structures often considered by agricultural producers, and is not intended as legal advice and does not create an attorney/client relationship.
This article was originally published at Tri-State Livestock News as the first in a monthly column written by Lynn Jackson Spearfish attorney, Drew Skjoldal. Contact Drew at email@example.com or 605-722-9000.