ISOLATING BUSINESS RISKS by Arthur H. Skola, Esq.

Builders and contractors do business in several forms: Sole proprietorships, partnerships, corporations and limited liability companies (unavailable to contractors in some states). There are pros and cons to each form. The main reason to choose a corporate form, LLC, or limited partnership is to protect against liability.

As we discussed in last month's article, there are some liabilities that cannot be effectively insured against. Construction defect claims are the major concern. However, even where the individual owners of a corporation are protected from personal liability, the company itself is vulnerable. A Company with substantial value can be wiped out by a civil judgment. The larger the company, the greater the vulnerability. One project gone badly can destroy the value of a company built up by a hundred successful ones.

One strategy that can be employed is to isolate risks by creating subsidiaries for each major project or a number of smaller projects. Subsidiaries may be corporations or limited liability companies. A subsidiary partnership would not work because the parent entity would have general partner liability.

An example may help illuminate the concept. Suppose you are a builder that constructs projects throughout Southern California. If you have one major project every tow years or so, say a high-rise office building, and several minor projects in one county, two subsidiaries might be formed. The main company may wholly own each subsidiary.

We will call the main company "Acme Construction, Inc." Acme plans to build a high-rise and creates Acme Highrise, Inc." to do so. It also creates Acme San Bernardino, Inc. to develop the several small projects in that county. If each is adequately capitalized and insured (and other formalities observed) each company may be isolated for liability purposes. Suppose the office high- rise is very successful but a couple of the minor projects develop major problems. In that case all of Acme San Bernardino, Inc.'s capital is at risk, but its losses and liabilities will not affect Acme High-rise, Inc. or Acme Construction's profits.

If Acme Construction had invested $100,000 in each subsidiary and High-Rise showed a $1,000,000 profits upon sale but San Bernardino was subject to a $1,000,000 uninsured judgment against it, Acme Construction would receive the $1,000,000 profit from High-Rise and recognize a $100,000 capital loss on San Bernardino. The judgment (except in unusual circumstances) would not reach the parent company and would go uncollected. On the other hand, if both projects had been built under the Acme Construction umbrella, the $1,000,000 profit would end up paying the $1,000,000 judgment, and the owners would see no profit.

Although such structures complicate accounting and management, they are often worth looking into as one's business grows.

Copyright © 1996 Chilstead Associates