— Disputes Among Partners —
Getting sued, with the risks of being buried in costs of litigation as well as being liable for any judgment that may be entered against you or the business.
Possible criminal liability exposure for violating the laws regulating your business.
When you are going into business, you usually don’t think about the risks of going out of business if the enterprise fails. Once a business is in trouble, though, many of these risks come back to the forefront in terms of whether you will ultimately be able to avoid bankruptcy. The risks include the possibility of personal liability exposure for the following:
- Whether the worker is operating a business independent of the hiring business.
- Where the work is actually performed (onsite at the hiring business or elsewhere).
- What control the hiring business has over the worker while the job is being performed.
- When You Want to Hire an Independent Contractor
All of these risks only underscore the need for proper planning before you go into business. This planning should include using the right business entity to shield you from the potential liabilities of operating a business.
What are some of the most common mistakes that people make when they go into business for themselves?
The enthusiasm of going into business for yourself must be tempered with being realistic about the risks involved. Statistics show, for example, that most small businesses do not succeed in the long run. Some of the reasons for failure include:
- Lack of a business plan that thoroughly addresses all of the “what if’s”
- Taking on partners when you don’t really need to do so
- Not understanding the business or the business marketplace
- Lack of capitalization and underestimating the costs of doing business
- Failing to take into account tax liabilities
- Trying to cut corners by trying to do everything yourself
- Not relying on or taking advantage of professional advice
- Underestimating the competition
- Inability to effectively manage the business
- Not thinking through your long term goals and an exit strategy
What are the pros and cons of a corporation?
A corporation can serve as an excellent investment vehicle. At the same time, though, there are complex bodies of securities law at both state and federal levels that govern the offering and issuance of shares of stock in corporations. Extreme care must be taken before taking on investors. This should never be done without the advice of an attorney.
It’s not always an easy process to form and maintain a corporation, as there are many formalities that must be followed. There are also costs in forming and maintaining a corporation that can be avoided if you choose to operate as a different type of business entity. For example, most states charge a “franchise” tax every year for the benefit of operating and maintaining a corporation in the state, regardless of whether the corporation has taxable income. And state laws generally require that a corporation maintain an organizational structure that includes directors, officers and shareholders.
The biggest benefit of incorporating is that it provides the owners (the stockholders) with a shield against potential liability exposure. The protection isn’t absolute, but it may be the best protection against personal liability exposure you can get in today’s business world. And a business owner can take advantage of certain tax laws by operating through a corporation. It may also be possible to provide better employee benefits through a corporation. In addition, it may be possible to deduct certain business expenses when operating through a corporation that might not be as easy to justify or to validate if operating as one of the other types of business entities.
What are the pros and cons of a partnership?
A partnership is an arrangement involving two or more people undertaking a business venture as co-owners, with the intent to make a profit. The simplest type of partnership entity is known as a “general” partnership.
While it is almost always preferable to put things in writing, the law doesn’t require that there be a written agreement in order to find that there is a legally binding partnership. Indeed, many people find themselves on the wrong end of a legal dispute because they went into a partnership without clearly defining their business relationship. Partnerships, like marriages, are easy to get into but hard to get out of.
Partnerships are perhaps the easiest and simplest way to go into business with another person. But the simplicity of a partnership can be its downfall, so careful planning is important. Partners should have a clear understanding as to why they’re entering into a partnership instead of some other business entity.
One particular benefit to a partnership is that it’s not a tax-paying entity. While a partnership must file its own tax returns, the profits and losses from the partnership are passed through to the partners. At the same time, however, the tax and accounting rules that deal with partnerships can be exceedingly complicated.
One of the principal drawbacks of a partnership is that it doesn’t protect against potential liability exposure any more than a sole proprietorship. A general partner, for example, can be held 100% responsible for the debts and liabilities of the partnership. This is usually true with a general partnership even though a given partner may have only a minority interest therein. So a general partner with only a one percent interest in a business could still be held liable for 100 percent of the debts and liabilities of that partnership.
What are the pros and cons of a sole proprietorship?
As the simplest way to do business, a sole proprietorship is operating a business in his or her individual capacity rather than through a formal business entity. Sometimes, a person will run a business as a sole proprietorship in his or her own name. However, it’s a common practice to operate under a fictitious name (which is sometimes called a “dba”). It’s important to understand, though, that a sole proprietorship doing business under a fictitious name is still just a sole proprietorship.
The biggest benefit to operating as a sole proprietorship is its simplicity. You’re your own boss and don’t have to worry about many of the rules and regulation that apply to corporations and other types of business entities. You don’t have to worry about filing separate tax returns. In theory, you don’t even need to keep separate books and records for your business.
However, the simplicity of a sole proprietorship can also be a business owner’s worst enemy. Why? Because a sole proprietorship doesn’t give any protection against the inherent risks and potential liability exposure of running a business. Creditors are free to go after not only the assets of the business but also all of your personal assets, such as bank and savings accounts, land holdings, investments, heirlooms and household furnishings. So if you operate as a sole proprietor, you’ll want to try to protect your assets through insurance, homesteading a residence, retirement accounts and perhaps eventually bankruptcy.
Many sole proprietors operate their businesses with a false sense of security that insurance provides them with adequate protection against the perils of personal liability exposure. To the contrary, there are many risks that are typically not covered by insurance, such as damages for breach of contract and claims arising out of an employment relationship (like sexual harassment or wrongful termination).
What do I need to know if I am going into business for myself?
You certainly need some business savvy in order to go into business for yourself. Assuming you have a good idea on how to make money, you should develop a detailed business plan before you do anything else. Going through this process will give you a much better idea of what you need to know about your business before you begin operations. Things to cover would include the following:
- capital requirements
- costs of operating
- ownership and control
- profits and losses
- labor and employment laws
- potential liability exposure
- insurance coverage
- tax consequences
- regulatory hurdles
- administrative issues
- marketing angles
Beyond all these issues, it is also extremely important for all business owners to know that they can’t know everything. By definition, business is always a risky venture. The best way to quantify the risk is, when appropriate, to rely on other people for advice and consultation. Every business, for example, should have a working relationship with a lawyer, an accountant, an insurance agent and a banker.
It likewise makes sense to delegate out certain job functions when it is either cost effective to do so (for example, payroll services) or when it helps to spread the risk of your business enterprise (for example, subcontracting out part of a project when someone else will assume the risk of doing a comparable job at a cheaper price).
What form of business entity should I use?
Although maybe not the best alternative in the long run, the simplest and cheapest way to start up a business is as a sole proprietorship. A sole proprietorship means you are doing business in your individual capacity and not through any type of business entity. You may operate the business in your own name (for example, John Doe’s Painting), or you may operate under a fictitious name (for example, John Doe, doing business as, or “dba” Acme Painting). Before legally doing business under a fictitious name, you are required to file a fictitious business name statement in the county or township where your business is located.
The time tested legal entity to use when forming a business enterprise is the corporation. A corporation is a legal entity that the law treats as a “person” in the sense that the organization has its own corporate identity and existence. As a separate legal entity, a corporation serves as a shield between the owners and third parties doing business with the organization. So long as corporate formalities are observed, the corporate shield makes it difficult for third parties to “pierce the corporate veil” to go after the owners. Instead, creditors and other third parties can be limited to going after the assets of the corporation. A corporation also has its’ own name and identity separate from the owners. It pays taxes and has the ability to contract. It can own property. A corporation can sue and be sued. In some instances, a corporation can be charged with and convicted of crimes.
Another alternative is a partnership. A partnership is an arrangement involving two or more people undertaking a business venture as co-owners, with the intent to make a profit. The simplest type of partnership entity is known as a general partnership. Forming a general partnership is the easiest way to go into business with another person. But the simplicity of a partnership can be a problem, so careful planning is important. One of the principal drawbacks of a general partnership is that a general partner can be held responsible for all debts and liabilities of the partnership. Thus, a general partner with only a one percent interest in a business could still be held liable for 100% of the debts and liabilities of the partnership. From a tax standpoint, it’s sometimes better to invest in a partnership rather than incorporating.
In order to address the issue of potentially unlimited personal liability, most states also recognize another type of business entity that is called a limited partnership. A limited partnership must have at least one general partner, but all of the other investors can be limited partners whose potential liability exposure can usually be limited to the extent of that partner’s investment. So, for example, if a limited partner invests $10,000 in a business venture organized as a limited partnership, his or her potential liability would be limited to the $10,000 invested rather than the rest of the limited partner’s personal assets. One of the resulting tradeoffs, though, is that an investor must take a passive role in the operation of the business in order to maintain the status of a limited partner. In many ways, a limited partner is comparable to a shareholder in a corporation.
Another business entity is the limited liability company. This type of business entity is perhaps best described as a hybrid of a corporation and a general partnership. It’s treated as a corporation for limited liability purposes but as a general partnership for tax purposes. The owners are called “members.” Unlike a shareholder or a limited partner, they don’t have to take a passive role in the business.
Yet another alternative for a business entity that is sometimes overlooked is a non-profit corporation. Just because a business is non-profit doesn’t mean that it can’t make money. If you think your business idea might be able to operate as a non-profit entity, this is something you would want to discuss with your attorney.