When analyzing a business transaction the analysis tends to break down into two major categories: Tax and Non-Tax concerns. Yup, it's that easy. I am of the view that there is really no such thing as a "sole-proprietorship." This is because every business shares the same "silent partner:" Uncle Sam. That said, this article will not focus on Tax Concerns. Rather, this article shall focus on a particular "Non-Tax" concern, namely "limited liability."

In my experience, among the most popular Non-Tax objectives when building a business is for the owners to limit their liability for the debts of the business. When a creditor seeks to hold a business owner personally liable for the debts of the business the creditor seeks to "pierce the corporate veil." Broadly speaking, the business owner defends against such an attack by establishing that the business has "observed corporate formalities" by "dotting the I's and crossing the T's" which (painting with a broad brush) breaks down to observing and respecting the "separate-ness" of the business from the owner. This means the business owner shows that the business has its own books and records, own bank accounts, own assets and liabilities, and does not "commingle" money and assets with the business owner's personal money and assets. This can be a very detailed and fact intensive analysis.

That said, the focus of this article is on one very specific "corporate formality" ... the corporate signature. Ah, yes, "the pen is mightier than the sword." The sentence was coined by English author Edward Bulwer-Lytton in 1839 for his play Richelieu. The play was about Cardinal Richelieu. The Cardinal's line in Act II, scene II, was more fully:

"True, This! -

Beneath the rule of men entirely great

The pen is mightier than the sword. Behold

The arch-enchanters wand! - itself is nothing! -

But taking sorcery from the master-hand

To paralyse the Cęsars, and to strike

The loud earth breathless! - Take away the sword -

States can be saved without it!"

So let's take a hypothetical business owner who we shall call "John Doe." Let's say that John Doe started a new business that manufactures and sells hats online and in retail outlets. To "limit" his potential liability for the debts of his new business Mr. Doe organized a limited liability company (LLC) in the State of California as the vehicle through which the new business will operate. Mr. Doe named his new business (the LLC) "JD's Groovy Hats, LLC." Mr. Doe is the sole member (i. e., the only owner) of JD's Groovy Hats, LLC. So the question becomes, when executing contracts OR WHENEVER SIGNING ON BEHALF OF THE BUSINESS, how should Mr. Doe sign his name?

Should he sign:

"__/John Doe/____________

John Doe"?

Answer: No! Why? Because there is no indication that John Doe is signing on behalf of JD's Groovy Hats, LLC. What will a creditor argue? That Mr. Doe signed the contract in his INDIVIDUAL capacity and therefore should be held PERSONALLY liable for the obligations of JD's Groovy Hats, LLC under that particular contract. Limited liability may be defeated in such a case.

So how should Mr. Doe sign on behalf of JD's Groovy Hats, LLC?

"JD's Groovy Hats, LLC,

a California limited liability company

By: ____/John Doe/________________

       John Doe, Member"

The above signature "block" indicates that Mr. Doe is signing on behalf of JD's Groovy Hats, LLC. Mr. Doe will argue that he signed the contract on behalf of JD's Groovy Hats, LLC, and NOT in his INDIVIDUAL capacity and therefore he should NOT be PERSONALLY liable for the obligations of JD's Groovy Hats, LLC under that particular contract. As a general rule, limited liability will be respected in such a case (absent fraud or other bad acts by Mr. Doe).

So, just as the pen is mightier than the sword, a proper signature "block" may assist a business owner defend against personal liability for the debts of his business entity. Yes, I admit, it is a bit of a tortured metaphor, but I think you get the point.

Every three years we California lawyers need to complete 25 hours of continuing education. As my group needs to complete the requirement by the end of January 2014, I have been listening to my legal education programs online. One of my favorite lecturers is Dr. Bart A. Basi (I will call him Bart). He is a really smart guy and I enjoy listening to him. He has taught me a lot. Recently, I was listening to one of his courses when he made in effect the following comment: "C Corporations" provide better asset protection to their owners than "S Corporations." The comment hit me like a thunderbolt. Why is that I wondered? I eagerly awaited the explanation. Alas, Bart did not explain why and just moved to the next topic on his syllabus.

You see, the "C Corporation" and "S Corporation" is primarily a tax distinction. I tell clients that all corporations are "born" as "C Corporations." What this means is that they will be taxed under Subchapter C - Corporate Distributions and Adjustments (Sections 301 to 395) of the Internal Revenue Code (IRC). At the risk of gross oversimplification, this means that your C corporation will be subject to the dreaded "double taxation" in that the entity will be taxed once at the corporate level on its corporate income, and AGAIN, at the individual shareholder level, on dividends and other similar distributions to the shareholders.

After a "C Corp" is born, if eligible, its shareholders can ELECT to be taxed under Subchapter S - Tax Treatment of S Corporations and Their Shareholders (Sections 1361-1379) of the IRC. This means the corporation will not be subject to "double taxation." Yes, the "S Corp" must FILE a corporate tax return, but with very limited exceptions beyond the scope of this article, the "S Corp" does NOT pay any tax. Rather, all of the income, gain, loss, deduction and credit of the S Corp "flows or passes through" to its shareholders in proportion to their ownership of the S Corp. So, for example, if an S Corp with four (4) equal shareholders has $100 of taxable income, each shareholder will report $25 of this taxable income on their individual Form 1040 tax returns. The mechanism by which this information is reported by the S Corp to the shareholders and ultimately to the IRS is the Schedule K-1 issued to each shareholder by the S Corp.

So what does all this "tax stuff" have to do with asset protection? What was Bart referring to? Since he did not say I was left to figure it out myself. I don't know why Bart made the comment. But the more I thought about, the more I think Bart is on to something. A distinctive feature of the S Corp is the above discussed "pass-through" of the S Corporation's income, gain, loss, deduction and credit to its shareholders. Now compare this with asset protection. A distinctive feature of a good asset protection plan is the SEPARATION of the person seeking asset protection with the asset sought to be protected. So, if your S Corporation owns an asset that you want protected from your creditors, there is an affinity between you and your S Corporation that does not exist when using a C Corporation. Now, on the one hand, both the S Corporation and the C Corporation are corporations under state law both seemingly entitled to provide their respective shareholders with the same limited liability from the entity creditors. So I admit, in the first instance, it does not appear that the C Corporation should provide its shareholders greater protection from its creditors than an S Corporation.

But that said, a clever, aggressive and well healed creditor will no doubt press for every advantage. Why give them the benefit of this "affinity" in the first place. If the only reason is that the shareholders want to avoid "double taxation," is that not just as easily accomplished by simply issuing the shareholders a year-end bonus, or otherwise expensing out any excess income at the end of the tax year so that there is NO corporate level income? Voila, "de facto" S Corporation tax treatment of your C Corporation. Now I know this is a big subject. For example, one good reason to elect S Corporation treatment, is if the shareholders expect losses in the beginning and want those losses to "pass-through" to their respective individual tax returns to offset other income.

Still, if and to the extent that asset protection is important to the shareholders, I think some consideration should be given to Bart's comments.

As for me, I will continue to ponder Bart's comments ... and listen to his courses.

Elizabeth Barrett Browning wrote the poem "How Do I Love Thee? (Sonnet 43)." It begins, "How do I love thee? Let me count the ways." While I am rather sure she was not writing about the limited liability company (LLC) form of business entity, she might as well have. Why? Let's face it; we have fallen in love with them. We are smitten. They are irresistible. They seem to have become the entity of choice for just about any kind of business you can imagine. Why? Well, to use the words of Ms. Browning, let us count the ways ...

Reason No 1: They are easy, fast and quick to form. Just download, fill out, and file the one page form from the Secretary of State's website along with the requisite minimal filing fee and voila, your LLC is formed.

Reason No 2: You do not need to hold meetings (unless you elect to) in order to "observe corporate formalities." As a general rule, corporations require more in the way of holding and documenting meetings, at least annually, than LLC's do, in order to "observe corporate formalities." This means it may be harder to "pierce the corporate veil" of an LLC, and just generally allows more "informality" in terms of management.

Reason No 3: Like people who do a lot of yoga, LLC's are oh so flexible. Flexible how you ask? Well, first, unlike "S" Corporations, you can have different "classes" of equity holders (i. e., owners) so that you are virtually only limited by your imagination when it comes to how you (the owners) want to carve up the ownership pie. Furthermore, when it comes to how you want to divide up items of income, gain, loss, deduction and credit, you once again can get very creative. That said, you must be mindful of the impact of the Internal Revenue Laws of the United States. Notwithstanding how you have "structured" your LLC under "State Law," remember that the Internal Revenue Laws are federal laws and must be complied with as well. So, if your LLC is taxed as a partnership, then you must comply with federal tax laws concerning partnerships which can be very complex. Oh well, nothing is perfect.

Now, like any love object, if we are not careful, we can be hurt by our lover. Having fallen in love with our LLC, how might our LLC hurt us?

Hurtful possibility No 1: In California, you still need to pay the $800 minimum franchise tax each year if you want to keep your LLC in good standing. It does not matter whether your LLC does business, does no business, made money or lost money ... you still have to pay the $800 to the state.

Hurtful possibility No 2: An owner's creditor can still try to "pierce the corporate veil" of the LLC in an attempt to hold the individual owner liable for the debts of the LLC, or to otherwise reach the assets of the LLC to satisfy alleged debts of the owner. Television commercials seem to suggest that all you have to do is form your LLC and presto - all of the assets of the LLC are absolutely unreachable by any of your creditors. They seem to imply that the LLC will be "bullet proof" from your creditors. You might want to familiarize yourself with your jurisdiction's "Fraudulent Conveyance" laws. There is an awful lot that goes into a successful asset protection plan and you don't know how strong your plan is until it is tested by an aggressive, clever and well paid creditor's attorney.

Hurtful possibility No 3: For those of you who have partners in your LLC (called "Members"), the role of the Operating Agreement is very important. The Operating Agreement is the agreement between the owners as to their respective rights, duties and obligations. Please, please, please show it to your attorney before you sign. It is worth an hour or two of the attorney's time to make sure you know what the Operating Agreement says. If you do not, you may have a very mistaken impression of how your LLC is going to work and what your rights are.

So feel free to fall in love, but make sure to read the prenup (spelled Operating Agreement). If you are setting up your LLC as an asset protection plan, make sure you know what a fraudulent conveyance is. And don't forget to pay the state to keep your LLC in good standing.

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