Alana had left the beauty business to work in a title company. While she had never been detail oriented in school or as a beautician, her new job as a closing assistant for all types of real estate transactions got her head into the minutia, the small details that mattered. Her closing documents had to be letter perfect, and they were.
But her boss had over expanded during the real estate boom. With so much real estate being sold, there was a lot of money to be made providing title insurance and closing documents. When the crash came, he had four offices and enough work for just one. As he retrenched to survive he demanded more and more work out of the remaining few employees. As well, several payroll checks had bounced, which had created a cascade of bounced checks for all of the employees. Their complaints to the boss only made him more defensively intolerant. Alana had stopped enjoying going to work.
Alana and Sherri discussed their situation and decided it was time to get back into the beauty business. On their own. The competition had subsided, and they knew many people around town from their current careers who could become customers.
A significant impediment for Alana and Sherri moving forward was their husbands. Neither Will nor Clint wanted their wives to leave a steady paycheck behind. Starting a business involved huge risks, they argued. Who was going to sign a personal guarantee on a commercial lease?
The discussions lasted for weeks. There were raised voices and tears. Sherri and Clint had a young daughter, Ellie, who was scared by all the commotion. The arguments nearly tore the family apart. Finally, Alana and Sherri’s father, Big Jim, stepped forward. He could not allow this controversy to continue. For the sake of his family, Big Jim agreed to be the personal guarantor on the lease of a commercial space in a shopping center yet to be located. If his daughters didn’t make it in business he would be the one personally responsible for any lease payments until the end of the term. But he wanted to negotiate the lease. His daughters were ecstatic and grateful.
With the personal guarantee issue out of the way, Will and Clint grudgingly assented to their wives’ plans. They also knew not to mess with Big Jim. But if they were going to do it, they were going to do it right. Both husbands knew their personal assets would still be exposed if their wives did it the wrong way.
Alana knew from her real estate title company days that choice of entity was important. She scheduled an appointment with an attorney she knew so they could review their options.
What entity will they choose?...
Choice of Entity
Choosing the correct entity is one of the most important decisions you can make. This one decision will dictate how you prepare your taxes, how you keep your books, how much of your business’ income you keep and how much you don’t. It will dictate your profits and losses, the financial security (and safety) of your family, maybe even your health and happiness.
Do not take the decision of which corporate entity you choose lightly. There is no part of your business that will not be affected by it. Let’s review some of your choices:
Sole Proprietorship
Each entity choice has its pros and cons. There is no one-size-fits-all corporate entity that will be the best for every situation. (And beware of the advisor who tells you there is.) However, there is one entity that we call the bad entity. It is the Sole Proprietorship. One lawsuit and (as in the case of Righteous Rock) you can lose all of your assets, meaning both your business and personal assets. The sole proprietorship offers no asset protection. It is not an entity in the true sense of the word because there is no separateness. You don’t file for a charter with your state, and thus there is no separate corporate legal identity. It is just you, doing business without any protection.
Why anyone would use it is simple: Because they do not bother to make a true decision about corporate structure. If you never choose a corporate entity but start up a business anyway, you are a sole proprietor. You are your business and your business is you. Making a bad decision or, in some cases, no decision can end up costing you not only your business assets but your personal assets as well.
There is no entity easier to set up than a sole proprietorship. You can easily set it up on your own because there is not that much to do. Once you start operating you will mostly forget about it. (Until you get sued and realize they can get everything you own.) You can run the business under your own name, if you choose, or apply for a fictitious name or a DBA (Doing Business As) at your county clerk’s office. With a sole proprietorship, there are really no prerequisites for starting up, no amount of startup cash to be accumulated, no filings with the state, no bylaws or articles of incorporation. However, again, it is also the entity that exposes you and your business to the most risk.
The only official steps you have to take to start a sole proprietorship is obtain a business license with your municipal and state agencies, obtain an occupancy permit for your place of business (if you’re not running e-commerce or working out of your home), and/or apply for a franchise certificate if you’re opening a franchise. And that’s it. You’re not even required to open a separate bank account for the business.
At the end of the year, your business activities are included on your personal tax return. There can only be one owner in a sole proprietorship. If you are going to have partners you can’t operate as a sole proprietorship (which removed it from Alana and Sherri’s list of choices).
A sole proprietorship can be set up almost instantly. It can also get you into trouble almost instantly. With a sole proprietorship, you are your business, which means that if a creditor sues your business, that creditor sues you, and you’re liable. When you set up your business as a sole proprietor, you put your house, your bank account, your car and all your assets on the line.
Quick and easy isn’t always the best way.
General Partnership
A general partnership is the ugly entity. Unlike a sole proprietorship, a general partnership requires two or more owners, or partners, which means it could work for Sherri and Alana. Unfortunately, like a sole proprietorship, a general partnership, as Tom and Nancy learned, offers no asset protection. Again, there is no charter from the state, no legal separateness and, accordingly, no protection.
In a general partnership not only are you personally responsible for your own mistakes as in a sole proprietorship, but you are also personally responsible for your partner’s mistakes. It is liability times two.
A partnership can be formed with a simple handshake between two or more people who agree to work together. You don’t need a partnership agreement or any sort of written document. Such a loose agreement also leaves no paper trail for the partners to go back to when things go south. When partners become adversaries and there’s no written partnership agreement in place, the laws of the state in which the partnership was formed take precedence, and the partners are left without any choice in the matter. Similarly, if one partner leaves, dies or goes bankrupt, the partnership is terminated and the partners are liable for the company’s debts and obligations.
I will not set up a general partnership, ever. Not only is there too much liability but it requires a great deal of document drafting. A general partnership agreement includes, at a minimum:
• Type of business.
• Finance requirements (the amount each partner is expected to contribute to finance the company up front).
• Rights and duties (what is expected of each partner).
• Dispute resolution procedures.
• Compensation (the method of sharing profits and losses).
• System authorizing cash withdrawals and salaries.
• Termination procedures