What type of business format should you choose?
The Answer to Legal Mystery Monday, September 21, 2015:
Over the years, Bob owned several businesses. Only the last one was a true success, probably because he actually consulted a lawyer before forming it. Before that, he was in a partnership with his golfing buddy, Tom. They didn’t bother documenting the relationship, certain that their diligent internet research and the advice onbusinessadviceforschumcks.com was sufficient. Besides, they were buddies, right? Things ended badly when, at the company Christmas party, Bob couldn’t keep his hands off Tom’s wife. A lawsuit to divide up the company lasted for a few years, and the legal fees nearly bankrupted Bob and Judy. What could Bob and Tom have done differently to make their break-up smoother and less expensive for all?
First thing’s first, Bob and Tom should have registered their venture as a business entity with the Secretary of State. These days, there are several business entity formats from which to choose. Registration is not required, but the risks of operating a business without proper formation can be disastrous, especially to relationships.
Without registering a business entity, Bob and Tom would be considered partners. Literally, everything is 50/50 – debts and liabilities. They would be taxed as if they were self-employed, counting their respective half interests as profit and loss. Self-employment taxes can be daunting for a small business owner, and a tax burden can be eased by consulting with an attorney AND an accountant before choosing the type of business entity. Perhaps a more important consideration is liability risk. Without a business entity to separate Bob and Tom personally from the business transactions, an injured party could go after their personal assets, assuming the shared business assets were not sufficient to cover the damages. It would take a few hours to discuss just the basics of the various business formats available, but taxation and liability are the primary issues to consider.
Back to the specifics of the hypothetical, the issue is how could they have made the breakup easier? What could they have done before trouble began? State statutes set the default rules for winding up and dissolving a business. However, those basics aren’t always compatible with the realities of the relationships. A solid operating agreement or partnership agreement (or for a corporation, a shareholder agreement), can allow the parties to stray from the default statutory rules, to some extent. Those documents lay the map for how the business runs and how disputes are resolved.
Another option for either Bob or Tom is a holding company. A holding company is sort of a third-party business entity. Rather than Bob and Tom owning their interests in the partnership directly, they each could’ve formed their own respective company, and those companies would be the owners of the joint venture. That would pit the lawsuit between their separate holding companies, rather than each other personally, saving their personal assets. Along the same lines, entrepreneurs often own more than one business. If they’re all operating as one entity or as a sole proprietorship, disaster in one venture could bring down the others. For example, if Bob sales razor blades under one name and barbed wire under another and if his razor blades caused someone injury, both business lines would be at risk. However, if Bob had a holding company, say Bob Is An Idiot, LLC, and his holding company owned a business called Bob’s Razors Will Cut You, LLC and another called Bob’s Barbed Wire, LLC, a razor victim’s lawsuit would be against Bob’s Razors Will Cut You, LLC. And if that lawsuit bankrupted Bob’s Razors Will Cut You, LLC, the other company and the holding company would survive. That’s assuming Bob was diligent about running each of the company’s completely separately. There are a number of such nifty bells and whistles to a holding company.
I reiterate that this is the short story of a very long novel. Deciding what type of business entity format to choose requires a detailed look at a person’s entire financial picture, business and personal goals, and the various lines of liability that could result from the existing and proposed business activities. Assuming that your neighbor’s business format is right for you, without consulting an attorney and an accountant, could cut your personal pockets deeply.
Call me so I can learn about your business and help you reach your goals with peace of mind.