By the end of this section, you will be able to:
- Recognize other business forms: sub-S corporations, limited liability partnerships, and limited liability limited partnerships.
The sub-S corporation or the S corporation gets its name from the IRS Code, Chapter 1, Subchapter S. It was authorized by Congress in 1958 to help small corporations and to stem the economic and cultural influence of the relatively few, but increasingly powerful, huge multinational corporations. According to the website of an S corporation champion, “a half century later, S corporations are the most popular corporate structure in America. The IRS estimates that there were 4.5 million S corporation owners in the United States in 2007—about twice the number of C [standard] corporations.”
Creation and Capitalization
The S corporation is a regular corporation created upon application to the appropriate secretary of state’s office and operated according to its bylaws and shareholders’ agreements. There are, however, some limits on how the business is set up, among them the following:
- It must be incorporated in the United States.
- It cannot have more than one hundred shareholders (a married couple counts as one shareholder).
- The only shareholders are individuals, estates, certain exempt organizations, or certain trusts.
- Only US citizens and resident aliens may be shareholders.
- The corporation has only one class of stock.
- With some exceptions, it cannot be a bank, thrift institution, or insurance company.
- All shareholders must consent to the S corporation election.
- It is capitalized as is a regular corporation.
The owners of the S corporation have limited liability.
Taxation is the crux of the matter. The S corporation pays no corporate income tax (unless it has a lot of passive income). The S corporation’s shareholders include on their personal income statements, and pay tax on, their share of the corporation’s separately stated items of income, deduction, and loss. That is, the S corporation avoids the dreaded double taxation of corporate income.
Transferability of Ownership
S corporations’ shares can be bought or sold via share purchase agreements, and all changes in the ownership are reflected in the share ledger in the corporate minute book.
Limited Liability Partnerships
In 1991, Texas enacted the first limited liability partnership (LLP) statute, largely in response to the liability that had been imposed on partners in partnerships sued by government agencies in relation to massive savings and loan failures in the 1980s. (Here we see an example of the legislature allowing business owners to externalize the risks of business operation.) More broadly, the success of the limited liability company attracted the attention of professionals like accountants, lawyers, and doctors who sought insulation from personal liability for the mistakes or malpractice of their partners. Their wish was granted with the adoption in all states of statutes authorizing the creation of the limited liability partnership in the early 1990s. Most partnership law under the Revised Uniform Partnership Act applies to LLPs.
Members of a partnership (only a majority is required) who want to form an LLP must file with the secretary of state; the name of the firm must include “limited liability partnership” or “LLP” to notify the public that its members will not stand personally for the firm’s liabilities.
As noted, the purpose of the LLP form of business is to afford insulation from liability for its members. A typical statute provides as follows: “Any obligation of a partnership incurred while the partnership is a limited liability partnership, whether arising in contract, tort or otherwise, is solely the obligation of the partnership. A partner is not personally liable, directly or indirectly, by way of indemnification, contribution, assessment or otherwise, for such an obligation solely by reason of being or so acting as a partner.”
However, the statutes vary. The early ones only allowed limited liability for negligent acts and retained unlimited liability for other acts, such as malpractice, misconduct, or wrongful acts by partners, employees, or agents. The second wave eliminated all these as grounds for unlimited liability, leaving only breaches of ordinary contract obligation. These two types of legislation are called partial shield statutes. The third wave of LLP legislation offered full shield protection—no unlimited liability at all. Needless to say, the full-shield type has been most popular and most widely adopted. Still, however, many statutes require specified amounts of professional malpractice insurance, and partners remain fully liable for their own negligence or for wrongful acts of those in the LLP whom they supervise.
In other respects, the LLP is like a partnership.
Limited Liability Limited Partnerships
The progress toward achieving limited liability continues. A limited liability limited partnership (LLLP, or triple LP) is the latest invention. It is a limited partnership that has invoked the LLLP provisions of its state partnership law by filing with a specified public official the appropriate documentation to become an LLLP. This form completely eliminates the automatic personal liability of the general partner for partnership obligations and, under most statutes, also eliminates the “control rule” liability exposure for all limited partners. It is noteworthy that California law does not allow for an LLLP to be formed in California; however, it does recognize LLLPs formed in other states. A “foreign” LLLP doing business in California must register with the secretary of state. As of February 2011, twenty-one states allow the formation of LLLPs.
The 2001 revision of the Uniform Limited Partnership Act (ULPA) provides this definition of an LLLP: “‘Limited liability limited partnership’…means a limited partnership whose certificate of limited partnership states that the limited partnership is a limited liability limited partnership.” Section 404(c) gets to the point: “An obligation of a limited partnership incurred while the limited partnership is a limited liability limited partnership, whether arising in contract, tort, or otherwise, is solely the obligation of the limited partnership. A general partner is not personally liable, directly or indirectly, by way of contribution or otherwise, for such an obligation solely by reason of being or acting as a general partner. This subsection applies despite anything inconsistent in the partnership agreement that existed immediately before the consent required to become a limited liability limited partnership[.]”
In the discussion of limited partnerships, we noted that ULPA-2001 eliminates the “control rule” so that limited partners who exercise day-to-day control are not thereby liable as general partners. Now, in the section quoted in the previous paragraph, the general partner’s liability for partnership obligations is vaporized too. (Of course, the general partner is liable for its, his, or her own torts.) The preface to ULPA-2001 explains, “In a limited liability limited partnership (‘LLLP’), no partner—whether general or limited—is liable on account of partner status for the limited partnership’s obligations. Both general and limited partners benefit from a full, status-based liability shield that is equivalent to the shield enjoyed by corporate shareholders, LLC members, and partners in an LLP.”
Presumably, most existing limited partnerships will switch over to LLLPs. The ULPA-2001 provides that “the Act makes LLLP status available through a simple statement in the certificate of limited partnership.”
There was a reason that partnership law imposed personal liability on the partners: people tend to be more careful when they are personally liable for their own mistakes and bad judgment. Many government programs reflect peoples’ interest in adverting risk: federal deposit insurance, Social Security, and bankruptcy, to name three. And of course corporate limited liability has existed for two hundred years. Whether the movement to allow almost anybody the right to a business organization that affords limited liability will encourage entrepreneurship and business activity or whether it will usher in a new era of moral hazard—people being allowed to escape the consequences of their own irresponsibility—is yet to be seen.
Businesspeople always prefer to reduce their risks. The partnership form imposes serious potential risk: unlimited personal liability. The corporate form eliminates that risk but imposes some onerous formalities and double taxation. Early on, then, the limited partnership form was born, but it still imposed unlimited liability on the general partner and on the limited partner if she became too actively involved. Congress was induced in the mid-1950s to allow certain small US corporations the right to single taxation, but the sub-S corporation still suffered from various limitations on its structure. In the 1980s, the limited liability company was invented; it has become the entity of choice for many businesspeople, but its availability for professionals was limited. In the late 1980s, the limited liability partnership form gained favor, and in the early 2000s, the limited liability limited partnership finished off unlimited liability for limited partnerships.
- The principal disadvantage of the general partnership is that it imposes unlimited personal liability on the partners. What is the disadvantage of the corporate form?
- Why isn’t the limited partnership an entirely satisfactory solution to the liability problem of the partnership?
- Explain the issue of “moral hazard” and the business organization form.