April 25, 2023
Are you comfortably doing business in a partnership? Maybe father and son, siblings, or just good friends, you started out this way years ago. It is a simple way to do business. All the income and expenses go through one bank account; help is hired through the business; one tax return is completed; and the partners each report and pay tax on their share of the profit.
You’ve got good, trustworthy people, each putting in their share of the work, and life is good. When one of you is ready to retire, the other will buy out their half of the equipment. Maybe you will both retire together, sell out and split the money. If one dies, the survivor will buy out the heirs.
Everything will be fine. Said the ostrich.
It is easy in Illinois to convert a general partnership to a limited liability company, or LLC. In recent years, more partners are reluctantly asking, “Should we convert the partnership to an LLC?” The answer is, absolutely.
First, an LLC brings order to chaos. In a general partnership, any business act of any partner binds the business and every other partner. Some actions are appropriate: sell grain at the right time, buy a tractor, lease more land, hire tiling, pay for seed and fertilizer. It works fine while it is brothers Alvin and Bob, each a 50% partner. But when Bob dies or retires, and his children Ellen and Dan each inherit 25%, is Alvin comfortable with his new partners making business decisions? No vote is needed: Even a minority partner can act.
An LLC offers management structure. First, the acts of LLC partners — properly called “members” — cannot bind the other members personally. So even if a member foolishly incurs some ill-advised business debt, only the assets of the LLC would be at risk. Other members are not personally on the hook.
But an LLC can be even more orderly. Instead of each member having power to act for the business, the LLC operating agreement can say that only elected managers can bind the business. Assuming Alvin and Bob were managers, then Bob’s shares pass to Ellen and Dan — 25% each. They will have no power to act for the LLC unless elected by a majority of the membership interests. Because Alvin is 50% owner, unless he agrees to elect Ellen or Dan, neither will have management authority. They cannot act for the business. Taking it a step further, the operating agreement could limit authority of a manager. For example, it might say a manager can only purchase new equipment if a majority of the members approve.
A step further
Let’s expand on this personal liability issue. In a general partnership, every partner is personally liable for all liabilities of the partnership. If Dan goes out and finances the purchase of a $600,000 tractor for the partnership, Alvin and Ellen are each responsible for 100% of the cost. Not 50%, not 25%, but 100%.
If the partnership business goes well, each will end up paying their proportion of the cost. But if business turns sour, Alvin is still personally liable for the entire $600,000. Personal liability means his home, land, savings and other non-business assets are all at risk.
But tiling, seed and fertilizer bills, even tractor payments are modest risks. In a general partnership, all partners are also personally liable for the tragic accident with terrible injuries. Brakes fail on the semi, the minivan in your blind spot or the hired hand falls asleep. Doesn’t matter who — if anyone in the business caused the accident, each partner is personally liable for 100% of the injuries.
Not so in the LLC. Recall that no member, manager or employee can bind the other members to a tractor loan. Similarly, the accidental liability of one person does not cause the other LLC members to be personally liable. The LLC itself can be sued, just as the LLC can be sued to pay for the tractor Dan bought. But members’ assets outside of the business are generally safe.
As I have written before, protection doesn’t come from just converting to an LLC. The LLC must be operated with genuine business formalities in order to do what you expect in the long run.
It’s time to make the conversion. Stop exposing your entire estate to all the business risks.
Ferguson is an attorney who owns The Estate Planning Center in Salem, Ill. Learn more at thefarmersestateplanningattorneys.com.
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