As I wrote in my August/September column, the best way to keep what you have is not to have anything in your name. To implement that strategy, you must choose the right business entity (or entities) to limit exposure of your assets to (successful) lawsuits and separate your asset ownership. This month, I’ll explain Sole Proprietorship, General Partnership and Corporation.

Sole Proprietorship

A sole proprietorship is simply “you doing business.” There is no filing requirement and no formal paperwork, except if you do business under a fictitious or trade name. In that case, you must usually file a “d/b/a” (doing business as) with the secretary of state of the state where you do business.As a sole proprietor, you report your income on schedule “C” of your federal income tax return. Your liability is unlimited because you and your business are one and the same. If your business is sued, then all of your personal assets, including your home, are at risk. If your business is bankrupt, then you must file personal bankruptcy to avoid the business debts.

General Partnership

A general partnership is formed when two or more individuals or entities agree to do business together, for a profit. No written partnership agreement is required, although one can be created. A general partnership can be created, even if you did not intend it (i.e., a judge will let you know when you are sued for something someone else did on your behalf - this is sometimes known as “partnership by estoppel”).

The partnership itself does not pay taxes; it files an informational tax return with the IRS. This return (IRS form 1065) simply summarizes the income, expenses, profits and losses of the partnership. The bottom-line profit or loss “flows through” to the partners who report their share of income or loss on schedule “E” of their personal income tax returns (the partnership will send each of the partners an IRS form K-1, which states the partner’s share of profit or loss).

A general partnership does not protect its partners from liability protection. Partners are jointly and severally liable for each other’s tortuous (wrongful) acts. “Jointly” means that if one partner causes the partnership to be sued, all partners are liable; “severally” means that all partners are liable for 100% of the judgment. If you are the “silent” partner who invests the most money and has more assets than your partner, then you have the most to lose.

Corporation

A corporation is an entity that exists separate and apart from its shareholders. It requires the filing of a certificate with your secretary of state, called an “articles of incorporation.” The corporation issues stock to its owners, called the “shareholders.” The shareholders elect a board of directors. The board of directors in turn appoints officers, such as president, secretary and treasurer.

The major policy decisions of a corporation are made by the board of directors in the form of a “resolution.” The officers of the company perform the day-to-day functions of the corporation. The shareholders own the corporation, but cannot directly run the corporation’s business.

In most states, one individual can be the shareholder, director and serve as all of the officers (in a few states, the offices of president and secretary cannot be held by the same person - check your state law). A “one-man” corporation is perfectly legal, but the individual must be careful to disclose the capacity in which he is acting (president, chairman of the board, etc.).

“S” versus “C” Corporation

There are two basic types of corporations for tax purposes, “C” corporations and “S” corporations. A corporation is a “C” corporation by default; the “S” status must be elected. All large, publicly traded corporations (e.g., IBM) are “C” corporations. A “C” corporation files its own tax return (IRS form 1120) and pays taxes on its income. The good news is that the tax rates for regular corporations are usually lower than personal tax rates to approximately $100,000. The bad news is that when profits are distributed, they are taxed again on the shareholders’ personal income tax return. This is what we commonly call “double taxation.” “C” corporations can permit employees, however, to take certain “fringe benefits,” such as health plans, medical reimbursements and life insurance. None of these benefits is taxable to employees, and the expense is deductible to the corporation. A “C” corporation can be a great tax savings vehicle for small, family businesses.

An “S” corporation is a “flow-through” entity. It files an informational return (IRS form 1120-S) and the profits and losses flow through to the shareholders. An “S” corporation, like a partnership, sends each of its shareholders an IRS form K-1, which states the shareholder’s share of profit or loss. This profit is not normally subject to self-employment tax. Unlike a “C” corporation, the “S” corporation does not have the same “fringe benefits,” but it still has tax advantages over a sole proprietorship.

When I served my three tours of military duty in Southeast Asia, we used multiple layers of defensive methods, or multiple redundancy defenses, to protect an installation.

For example, my job as a dog handler was to be the first level of defense, encountering the enemy outside the perimeter of the installation. We were also an early-warning system for those at the installation. The next levels of defense, in this order, were a listening post, with a rifleman behind sandbags; towers, M-60 machine guns and night surveillance devices guarding the perimeter fence; and then bunkers and roving patrols inside the perimeter. This same strategy of multiple levels of defense is equally important and effective to protect your martial arts school and wealth.

Protection of Your Real Estate

Ray Kroc, the founder of McDonalds, once said he was not in the hamburger business, but in the real estate business; the hamburgers simply paid the mortgages. I would encourage you to follow Mr. Kroc’s example and consider yourself in the real estate business. You can maximize the value of the tuition your students pay by using it to pay the mortgage on a facility you own, instead of just rent. That can be an excellent wealth-building asset for any small business owner.

When you decide to buy a building for your school or any commercial real estate, you should implement multiple layers of defense through the use of legal and/or corporate entities to protect those assets.

For example, you can combine a land trust with a limited partnership and a corporation to insure lawsuit protection of your real estate. The limited partner’s interest in a limited partnership is virtually “untouchable.” A general partner, while in control of the partnership, is subjected to personal liability; therefore, you need a general partner under your control to “stand in” and take the hit. The solution is to create a corporation to be the general partner of a limited partnership. The corporation must only have a small interest for the purpose of control.

If the limited partnership were sued, then the general partner, not the limited partners, would be liable. If the corporation had little or no assets, the limited partners could “cut it loose” by buying its entire shares for a token amount. The limited partners would then create a new corporation to be the general partner.

Now, let’s add one more layer of protection. The real estate will be titled in a land trust. The beneficiary of the land trust would be the limited partnership, with a corporation as 2% general partner. The corporation, of course, should be under ownership or control of the limited partners (i.e., the limited partners could also be the stockholders of the corporation).

Variation: The Limited Liability Company (LLC)

In the above scenario, you may consider an LLC instead of a corporation/limited-partnership combination. It involves less paperwork than using two entities. Some states, such as California and Texas, impose a high annual franchise tax on the use of LLCs, which makes using multiple limited partnerships more cost effective. In these high franchise tax states, it is cheaper to use multiple limited partnerships than multiple LLCs.

Here Comes the Lawsuit

Let’s suppose a student or vendor decides to sue the owner of the property. The first layer of protection is the land trust. Even if the property owner or his attorney were familiar with a land trust, he would have to designate the beneficiary. The student or vendor’s attorney would then have to ask a court to set aside the land trust.

Even then, the attorney would be confronted by a limited partnership (or LLC). He could try to sue the general partner, only to find that it was a corporation. He might obtain a judgment against the corporation, but its only asset is a 2% share of the limited partnership. The limited partners then decide to cut the general partner loose by buying its 2% share. The student or vendor’s attorney could then try to attach the limited partner’s interest, but that attempt would be futile. In his last desperate attempt, he tries to persuade the court that the corporate general partner is a sham and should be pierced. The court agrees and a judgment is entered against the property owner. By the time this whole process is completed, however, his cash is safe in other LLCs and trusts.

The more roadblocks you put in front of your potential creditors, the less likely they will sue you. If they insist on suing you anyway, then you can stall their collection efforts for years and force them to settle their claims for a fraction of their value. The sophisticated wealth warrior starts the process of asset protection before the assets start building and your martial arts school is making big money and owns multiple of real estate.

Most of them tend to spend all their time learning self-defense techniques to teach their students, instead of studying business, marketing, sales and wealth “self-defense”. This can result in them being vulnerable to lose it all with one lawsuit, if they don’t understand entity structuring and asset protection.

With eighty million lawsuits being filed every year, an instructor is more likely to be sued than being assaulted on the street. Seventy percent of the world’s lawyers are in the U. S., and almost 50,000 new law school graduates enter the profession each year! More lawyers mean more competition for clients and that leads to new and creative theories of liability and methods to extract profits from profitable school owners.

Here are some more interesting lawsuit facts:

• Contingency fees by trial lawyers exceed $10 billion annually.
• For personal injury litigation, more than $96 billion is spent or lost each year in America to pay $41 billion in compensation to injured parties and their attorneys.
• Lawsuits are a real threat to a martial arts school owners and their financial wellbeing. Imagine a punk sticking a .357 magnum at your throat and demanding your wallet, credit cards, jewelry and keys to your luxury car. You would recognize that your wealth and personal wellbeing is being attacked and maybe you’d even feel vulnerable and violated.
• You will experience the same feelings if you are sued, but that will be legal. As a Black Belt businessperson, you must learn skills to help you avoid ambulance-chasing attorneys who might target you and your hard-earned assets.
• Do you own the building that houses your school or do you plan to own it someday? This is one of the key elements to build wealth. If you are ever sued, then the jury (who are more likely to consist of people who pay rents as tenants and are usually jealous of those that have a little wealth and own real estate) may consider your trial as a “pay back” opportunity to even the score with any hard-nosed landlords.
• Consider this: most judges may earn less than you. How sympathetic could they possibly be? Do you think it’s likely you’ll receive a fair trial? You might as well just hand the court your checkbook and the title to your house or commercial building, unless you have studied asset protection self-defense strategies!

Lawsuit versus Asset Protection

You can’t prevent all lawsuits, but you can design a wealth self-defense plan to protect yourself from personal liability. If there is a lawsuit, are you or a corporate entity currently liable? If you lose a lawsuit, then what assets could be seized? Asset protection is the last line of defense against those that will try to take what you have worked so hard to earn.

Be A Proactive Wealth Warrior

Do not rely on counterattack strategies; instead, be proactive and put your action plans to work in advance, before trouble happens. Once a lawsuit starts, it is too late to move or hide assets. It must be done in advance. Now is the best time to start to learn wealth self-defense. You must incorporate specialized knowledge and plan, on paper, exactly how you have designed you entity self-defense plan to protect you and your family.