The Basics of limiting liability in Business

Kevin Spence

Types of business entities

1. Using a Business Entity

   1. The formation of a business entity creates a distinct “legal person”from the business owners.

   2. A business entity separates the assets and liabilities of the business from those of the business owners

   3. The separation is not complete. Businesses that provide professional services are still personally liable for negligence.

2. Formation of business entities

   1. To form a LLC or a corporation you must file the minimum documents with the Oregon secretary of state

   2. These documents are either the articles of incorporation or the articles of organization

      1. You can file online at www.filinginoregon.com

   3. Drafting bylaws or operating agreement

   4. Transference of assets to the new limited liability entity, issuing stock, etc.

3. Benefits of Limiting Liability

   1. The major disadvantage of a sole proprietorship is that the business owner is personally liable for all debts and liabilities of the business.

   2. The formation of a LLC or other limited liability entity protects the owners from most of the liabilities and debts from the business.

   3. In Oregon, the costs of forming a limited liability entity are minimal and can be completed online.

   4. The IRS considers a single member LLC a “disregarded entity” for tax purposes. That is, a sole proprietor’s taxes will be almost exactly the same when the business is conducted as a single member LLC.

1. Maintaining a business entity

   1. Certain formalities must be followed in order to maintain the business entity as distinct.

   2. Minimum filing requirements with the Oregon Secretary of State

      1. Initial Filings

      2. Annual reports

      3. Maintaining a registered agent

   3. Separate banking accounts from business owners

   4. Corporate minutes and records

   5. Employment records

2. Limits on Limited Liability

   Certain exceptions exists to the protections provided by a LLC or Corporation.

   1. A member may be liable for the debts and liabilities of the company if the member/shareholder waived their right

      1. Personal guaranties on lines of credit

      2. Personal guaranties on lease agreements

      3. Waivers made in the operating agreement or the bylaws of a company

   2. Violating or exceeding statutory withholdings

      1. Tax withholding issues

      2. Incorrectly garnishing wages

   3. Torts committed by the owner during the course of business

   4. Piercing the corporate veil

      1. The idea that the business is effectively the alter ego of the business owner

      2. How to prevent “Piercing the corporate veil”.

         1. Make sure your business is adequately capitalized

         2. Observe business formalities

            1. Separate banking accounts for the business and the owners

            2. Maintaining business records

            3. Maintaining employee records

         3. Don’t use your business to commit fraud.

3. Using insurance to limit risk

   Specific types of insurance policies can protect businesses and business owners from certain types of risk

   1. General Liability insurance

      1. Typically, the generally liability insurer agrees to pay on behalf of the insured business those sums that the business becomes legally obligated to pay as damages because of bodily injury, property damage, personal injury

   2. Specific Types of insurance

      1. Malpractice

      2. Errors and commissions

   3. Fire and Casualty

   4. Disability insurance

      1. The primary source of income for most small business owners is their business. Because of this, the owner should consider purchasing disability insurance in order to replace the income while the owner is unable to operate the business

   5. Life Insurance

      1. Life insurance should be considered if the business owner has dependents

      2. Provides cash to pay off debts of the business if a sole proprietor or if the owner personally guaranteed the debts. Early stage businesses generally require personal guarantees on most debts so a business owner may need the life insurance when they are younger rather than older.

      3. Can provide cash to operate the business until it can be sold.

4. Using contracts to limit risk

   The requirements on what constitutes an adequate disclaimer need to be considered when the contracts are drafted. Types of contractual limitations:

   1. Exculpatory clauses

   2. Disclaimers

   3. Limitations on liability

   4. Limitations on remedies

5. Limiting Employment Liability

   1. Listen to Peter Stutheit later this morning

Not to insult our great County and City, but the MCBIT/PBL tax is kind of like that annoying, yipping terrier who thinks he is bigger than the other larger dogs at the park.  Nothing against terriers either, but the fact that the City of Portland will not accept the federal extension form like ODR, requires payment with extension, sends constant notices hounding taxpayers, and complicates our lives with more rules than some state taxing authorities makes the imagery all the more real.  We have enough to worry about in Oregon with our Federal and State business tax returns and estimated tax payments, so when you get to the local level you are simply exhausted and the extra complication and added paperwork has always made me apathetic to say the least.  However, at least some “simplification” has been made for 2008:

• The gross receipts exemption will now be $50k for both the MCBIT tax and the PBL “license”, unlike the 2007 tax year, which left most confused with the two sets of limits and figures.  However, this only really helps very small businesses and lets us finally increase rents paid to shareholders from the $24,999 annual figure we have had it at for years.
• The compensation allowance deduction will also be the same for both agencies at $80k plus the inflation adjustment.  It is also scheduled to head up to $125k over the next five years.
• Effective 9/19/08, the council voted to change the Portland “license” to an after-the-fact tax, which means no more confusion regarding initial and final year fees.  It also simplifies tax planning as we used to spend time trying to minimize net income in the first year and put off real estate sales until the final year to minimize the PBL fee.

Of course, anytime they simplify and/or reduce tax, they always raise tax in other places.  The bad news is that the MCBIT now has a minimum fee of $100 like with the PBL fee.  This means that many of you small S-Corporation owners taking minimum reasonable wages are actually going to pay more tax despite the supposed “tax relief”.

Kevin covered some of the other changes from the 9/19/08 council meeting in a related post, but overall even though some will pay more tax - the simplification is much appreciated.  City Council - if you simplified the extension process and held off on presumptive fees until after the extended deadlines pass like the bigger taxing agencies, then I might take back the yipping terrier bit.

Stay tuned for some City and County tax tips that I will feature in my next post - otherwise, enjoy the last of the summer weather while you can!   Brian Germer, CPA

The controlling document of a Limited Liability Company is call a Operating Agreement. Basically, an operating agreement sets out the rules by which the company will be run. Because of its importance, LLC members should put some time and thought into how they want their company governed. Issues that should be resolved by everyone regardless of the entity they chose are: management of the day to day operations and implementing strategy; allocating profits and losses; transferability of ownership; how they are going to resolve the inevitable member disputes; and, voting rights. In this post, I will cover some of the management issues that can arise. In later posts, I’ll talk about the other issues.

Management issues

It is important to decide how the day to day activities of a company are going to be handled. In the case of an LLC, the members can designate a manager to run the business. Certain limitations should be placed on the manager authority and should require the permission of the members. The manager should not have the authority to dissolve the company, amend the operating agreement or to sell the assets of the company outside of the ordinary course of business. Another limitation that should be placed on the manager is the amount of debt that the manager can accrue without the authorization of the members. If the company is to be managed by the members, similar limitations should be placed on the authority of the members.

Either a member or the manager should be designated to maintain of the bookkeeping and accounts for the company. Whether this is done by the member or by a third party accountant, someone should be responsible for the preparation and generation of tax returns and financial reports. These records should be made available to be inspected by the other members at reasonable times. Designating a member to prepare or to make sure they are prepared will help you make better decisions about the direction of your company and will help resolve member disputes. Beyond being a good business practice, certain sections of the Internal Revenue code and treasury regulations require that a partner be designated.

The operating agreement should also set out the duties and obligations that the members have to the company. Any exemption to any member’s duty of loyalty to the company or the other members must be expressed in the operating agreement. That is, if you want the members to be able to compete against the company, you need to write into the contract. Otherwise, the default provisions of the Oregon LLC Act prohibit such actions.

The company may need to raise more capital to finance an acquisition or an expansion. The operating agreement may obligate the members to make additional capital contributions to the company (“Capital Calls”). Provisions should be put to place to handle the capital calls and the potential failure of one of the members to make the necessary capital contribution. Another source of capital for the company may be from personal loans from the individual members. Some thought should be put into the terms and rates for such a loan.

Those are some of the major issues that anyone going into business should discuss with their potential partners. I’ve found that planning how the business will be run is much easier during the early stages. The longer the company runs, the harder and more expensive it will be to deal with the problems.

Also changed was requiring new businesses to pay a $100 registration fee.

I haven’t read the text of the new provisions so I’m not sure what to make of it yet.  Generally I’m in favor of harmonizing rules across industries.

The Portland Business Journal has an article about it here.

Yet another reason why you should be honest. Small understatements in revenue can have tremendous impacts on future valuations of your company.

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How difficult was it to comply with this clause? About a 15 minute phonecall and maybe $500.  That’s probably why he put it off for so long.  There is always the tendency to put off simple tasks and focus on the meatier projects.  The danger is that these simple tasks will be forgotten.  I’m not sure if his business could have survived a forced relocation and I doubt he wanted to find out.