Start Your Own Corporation. Garrett Sutton
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it is important for you to clarify your strategy in this planning. The purpose of this chapter is for you to clearly understand and choose the best entity for your unique and specific purpose. To that end, the following checklist should be considered:
1. Protection of family assets and investments
2. Management control
3. Avoiding family disputes
4. Flexibility of decision making
5. Succession of children and other family members to management
6. The nature of the business to be operated
7. The nature of the asset to be held
8. The number of owners involved
9. Estate planning and gifting of assets
10. Who may legally obligate the business
11. Effect upon an owner’s death or departure
12. The need for start-up funding and raising of capital
13. Taxation
14. Privacy of ownership
15. Consolidation of assets and investments
These and other issues will become apparent as we review your choices. And please note, your decision does not have to be made alone. It is recommended that these issues be discussed with your attorney, accountant, or other professional advisor. An individual well versed in these areas will provide excellent insight into which entity is right for you.
By reading this book you will be better able to work with your professional advisors. They won’t have to spend time explaining all of the tax issues and limitations of liability strategies to you. By reading this book you will have a leg up. When you meet with your advisors you won’t be stepping up to the plate for the first time. Instead, you’ll be at second base, ready to score. (Fear not, our first sports analogy is also our last one.)
It is important to know that in entity selection one size does not fit all. If your attorney or accountant suggests only one entity, a general partnership for example, for each and every business venture you have him or her review, you will want to question why they believe one entity fits all situations. Or you may want to seek out a new professional advisor.
We will discuss which entities work well in various business and asset holding scenarios. But before doing so, we must point out which entities do not work well in any situation. For as important as knowing which entity to use for running your business, protecting your assets, and limiting your liability is knowing which entity NOT to use.
• Sole proprietorships
• General partnerships
In my legal practice I represent various businesses, from small and basic to large and complicated. I enjoy helping entrepreneurs and business owners make money, provide for their families and employees, and secure a stable future.
I cannot do my job if a client insists on using a bad entity. Sole proprietorships and general partnerships provide no asset protection. Remember the Latin word ‘ens’? It means an existing or real thing. These bad entities are not separate legal ‘things.’ You haven’t registered them with your state. Instead, they are just you, doing business without any protection. One lawsuit against your business, and your house, savings, and personal assets can all be lost. Our first case is illustrative.
Case No. 1: Johnny
Johnny was a plumber. He had been at it for five years and was starting to succeed. His customers were satisfied with his work and the word of mouth for Johnny’s Ace Plumbing was good.
While Johnny was a good plumber, he felt intimidated by legal matters. Lawyers and accountants were supposed to be smart, so the work they did must be difficult. When Johnny was a young boy his father had been unfairly treated by a lawyer. He remembered it to this day, and wanted nothing to do with them.
So instead of consulting with a professional on how best to conduct his business, Johnny let his part-time bookkeeper select an entity off the menu. The results were disastrous.
Johnny’s part-time bookkeeper knew only that forming a corporation required filing special documents with the state but did not know how to file them. He knew that a corporation needed to file a separate tax return but was not sure of the ins and outs of preparing one. And so he suggested Johnny use a sole proprietorship because he knew how to handle one and always suggested one for his clients. One size fits all.
The problem was that a sole proprietorship provides absolutely no asset protection. By operating as a sole proprietorship Johnny has unlimited liability for the debts, claims, and obligations of the business. This unlimited liability meant that his house and savings and personal assets were exposed to the claims of others.
Of course, as in all horror stories, a demon entered Johnny’s business. He had hired Damien as an employee to assist with his growing workload. Damien seemed like a decent guy and appeared to know the plumbing business. Johnny did not bother to do a background check on Damien. Johnny was new to the business world and not aware of the need to do so.
After one week on the job, Damien assaulted one of Johnny’s customers while they were alone in her house. Without going into the sordid details, this woman was so severely traumatized by what Damien did to her in her own home that she and her family had to move away.
Within three weeks of the incident Johnny’s business was sued. Because Johnny was a sole proprietor, this meant that he, and not the business itself, as with a corporation, was sued and had to defend himself.
The lawyers suing for the woman did the background check of Damien that Johnny did not do. Damien was a recently released ex-convict with a history of sexual assaults. Johnny did not have the insurance to cover such a claim. The case went forward. The lawyers argued to a jury that Johnny’s business was irresponsible for failing to check up on Damien and was responsible for the consequences. They presented to the jury what was true—a business is vicariously liable, or responsible, for the acts of its employees. The jury was horrified by the whole case and awarded damages of $10 million.
Johnny was wiped out. As a sole proprietor he was completely and personally responsible for every claim the business incurred. And he had attorneys with a one-third contingent interest in the collection of $10 million after him.
Johnny lost his house, his savings, and his family. The stress of it all resulted in his wife divorcing him, obtaining custody of the children, and moving away. Johnny declared bankruptcy. He ended up a broken man despising lawyers and our legal system all the more.
The irony, of course, is that by consulting with a lawyer and using the legal system to his advantage, Johnny could have prevented the disastrous consequences that resulted from relying on a part-time bookkeeper with a one-size-fits-all mentality for entity selection.
A competent lawyer would have told Johnny that there were risks-known and unknown—in running any business. To protect yourself from such risks you need to limit your liability by establishing a corporation or other good entity.
A good entity is one that shields and protects your personal assets from business risk. A bad entity is one that provides you no protection whatsoever. By using a good entity Johnny could have used the legal system—which has evolved to encourage business activity and limit the liability of risk takers—to his advantage.
Other Sole Proprietorship Disadvantages
As if personal liability was not bad enough, there are several other disadvantages to using a sole proprietorship:
• Owners. There can only be one owner of a sole proprietorship. If you later want to bring on owners you will have to switch to another business entity.
• Sale. It is hard to sell a sole proprietorship since its value is based on the owner and not the business.