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Compartmentalizing Risk with Entity Planning

Often clients are overly preoccupied about taxes they will save or incur as a result of a certain business structure, without giving thought as to how to allocate their operating liabilities. This is particularly true where a business operation consists of multiple locations and/or revenue streams.

Consider a real estate development company that establishes an investment vehicle to develop several separate but closely situated properties. One property is a rental apartment building to be converted into condominiums. The other property is a commercial building that will lease ground level retail operations such as Laundromats and 99 cent stores. Both have significantly different revenue streams and both have high levels of liability. As a result, the success of one operation can be significantly impacted by the failures of another.

Although the investment vehicle will be funding both ventures, the investors should only be exposed to the potential upside of the properties not the operations? liabilities. Hence structural planning should attempt to contain liability. One simple approach would be the establishment of separate business entities for each component of the total operation. Hence there will likely be at least three business entities (for example an S-Corp for the investment vehicle, an LLC for the first property, and one LLC for the second property.)

Separating each major component will create liability barriers to each other. Barring any special guarantees and the absence of activity that could lead to piercing the corporate veil, a personal injury suit based on a slip and fall on property 1 will likely not jeopardize the revenues from property two. This is due to each entity being considered a separate "person" for liability purposes. Although both properties and their corresponding entities are owned by the same financing vehicle, that vehicle is technically not involved in the activities of property 1. And although a plaintiff might sue the investment vehicle as a separately named party, it will be harder for it to prevail.

These types of considerations are least as important as the tax man, especially if the chance of lawsuits are high. Adding to the example above, questions should be asked about the type of each entity (LLC vs. S-Corp.) and their relative tax/liability advantages given the operation ad its goals. At the very least, many operations should be thought of logical components that sometimes and sometimes do not benefit from using entities to compartmentalize risk.

Full post as published by BizMediaLaw Blog from Wahab, Riveles & Medenica LLC on October 17, 2006 (boomark / email).