Deciding how to structure your business is a basic and important decision. In a previous column, I mentioned the possibility of forming a corporation to save on your taxes, but there's another vital reason for doing so: shielding your assets from any accidental harm your business does to others. Here, I’ll explain the pitfalls of forming a sole proprietorship or partnership. Later columns will look at retirement planning and other special considerations that differ between various business structures.
Insuring your personal assets against claims
Remember Y2K? It wasn’t just an issue with servers, software, phone lines, and such. Every time I applied for a new insurance policy in 1998 and 1999, I was warned in no uncertain terms that I would not be covered for any Y2K liability.
Since I was getting insurance for my new ranch, some farm vehicles, and cattle, this seemed more than a bit silly, but it definitely showed just how interested insurance companies were in insuring companies against real-world risks. My consulting business was already covered by insurance, but I doubt I could have obtained new insurance for it in 1999 because insurance companies are much more interested in collecting payments than in covering your losses.
A recent television exposé demonstrated how dangerous it could be to rely on insurance. The piece showed how your friendly "neighbor" insurance company might have used totally unqualified third parties to write medical opinions in order to allegedly avoid paying potentially legitimate claims.
But even in a perfect world where people only sue when they’ve really been wronged and every insurance company pays every legitimate claim, you still need to look at a way to protect your assets. Forming a corporation is the absolute best way to do this because, unless you do intentional harm or violate the law, your home and other personal assets will probably be shielded from claims made against your business. I’ll address that issue in future columns, but first let's look over the other possibilities.
The sole proprietor, a person who starts a business entirely on his or her own and merely files a Schedule C on his or her personal tax return to cover business income and loss, is totally, 100 percent, exposed.
If sole proprietors are sued for something they do in business and lose a major judgment, they can lose everything they have and possibly everything they’ll ever earn in the future after the bare necessities are deducted.
If your part-time employee goes nuts and whacks somebody on company time, you're liable. If your truck's emergency brake cable snaps and the vehicle rolls downhill and hits someone, you’re liable. And those are just "legitimate" claims you could probably foresee and guard yourself against.
In many areas, you can start and operate a sole proprietorship with no paperwork. If you decide you want a business name, a paragraph or two in the local newspaper of record stating that you are the person operating the DBA (Doing Business As) "Business Name" will suffice. The newspaper should be one featuring classified advertisements that begin, “To whom it may concern.” Be sure to keep several copies for your records. The method for establishing a sole proprietorship varies with local and state laws, so don't assume that's all you need to do where you are. Check it out with your attorney.
All in all, only a fool would operate a sole proprietorship if he or she has assets to protect. A real businessperson wouldn't touch one, and that's one reason the IRS looks at them so closely when trying to decide if your Schedule C expenses are from a real business or just a hobby.
The next step up in legal status is a partnership, specifically what is known as a general partnership. Here, two or more people run what is essentially a sole proprietorship with several people.
Again, you could run into trouble under this scenario. In exchange for starting a business that can be formed on nothing more than a handshake, you get to put everything you own and will ever earn on the line just like with a sole proprietorship. You’re also responsible for everything all the other general partners may decide to do, whether they defraud someone, make some mistake, or even obligate the business to purchase or lease something you don't want. That means that each general partner not only gets to be responsible for overt criminal acts and civil torts committed by all the partnership's employees, but they also become jointly and severally liable (responsible) for actions by other general partners.
As far as liability is concerned, a general partnership is virtually identical to a marriage. The divorce rate is now hovering around 50 percent, and if you think watching Divorce Court is painful, you should remember that those people once loved each other—and general partners only wanted to make money together, not babies.
Of course, there are always exceptions, and among those are states where certain businesses (usually groups of professionals) can't incorporate and, therefore, must form partnerships. This is specifically so they can't hide behind the corporate structure.
If you have a question or suggestion for John McCormick, e-mail him at email@example.com. If you have a general comment, e-mail TechRepublic.