Business Structures: How to Choose the Best Legal Structure for your Business.
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Business Structures: How to Choose the best legal Structure for your business
The Business Fashion Tips Podcast
We are making our way through the 10 steps in starting a business. In episode 1 you learned how to find the perfect business for you to succeed. In episode 2 we talked about how to write a business plan and in episode 4 we talked about how to fund your idea or your project or your business was using vendors or manufacturers that you use to make your product. I was just thinking about Christian Dior. When he came out with his very first collection in 1947, it was an instant sensation. The world decided to call it the “New Look.” What most people do not realize is that it was backed by a wealthy textile financier named, Marcel Broussard. This was a great investment on Broussard’s part. He was smart to realize that Dior might have something, and he would be using his textiles in Dior’s collection. So he was not only making money on the financing of Dior, but he was also making money on the textiles Dior was using in his collection. This just goes to show you that you have to be creative when trying to come up with funding for your business. The answer may be right at your fingertips as it was literally with Dior as he was draping his fabric across a mannequin.This fabric was owned by his financier.
The 4th step in starting a business has to do with the legalities of running a business. You may think this sounds boring, and I would have to agree, it is! But, listen up because the consequences of setting up these legalities wrong can have crucial financial consequences. So you want to make sure you do it right.
Business owners need to determine the structure their business will take. This is a crucial step because it determines how much you will be paying in taxes and how liable you will be personally should something go wrong and if you set this up wrong you may loose a lot of money.
The 3 most common forms a business can be organized in are are that of a:
- sole proprietor
A sole proprietor is when a single person owns the company. I could have been a sole proprietor because I owned 100% of my own company. It’s probably the easiest to set up and when you decide to dissolve a sole proprietorship, you can basically just walk away. It’s perfect for those that want no partners because you will alway have 100% control over how the company operates. When you fill out your taxes, everything just goes right onto your own personal income tax. However, the reason why I didn’t choose this type of legal form for my company was for one very important reason. In a sole proprietor, the owner is 100% liable or responsible for anything that happens within your company and if somebody decides to sue you, they can come after everything you own. For instance, if I had an employee that was being sexually harassed by another employee, that employee could come after everything owned not only in the company but everything I owned personally.
Now I’m not pretending to be a lawyer, so for the most accurate facts on this I suggest you contact a lawyer, I’m just giving you my personal opinion.
If your company sold a product (whether it was something you invented or something you purchased from another company and resold it), and someone hurt themselves with that product. They can go after not only anything your company owns but anything you own personally.
In a sole proprietor, you also have no partners to rely on in other areas of expertise. This can be overwhelming for some people whereas, people like me thrive on having total control. Another disadvantage is that raising capital is harder with a sole proprietorship and expansion can be difficult. For some people, a sole proprietorship is a good way to start a business. You can always change to another business structure such as a partnership or corporation in the future.
This brings us to the second form of a business structure which is that of a partnership. Partnerships are owned by two or more individuals and each is equally responsible or liable for what happens within the corporation and how it is run on a day-to-day basis. However, sometimes this is not good either because if you had a partner and they didn’t own anything personally, but you had many investments in your portfolio, someone who sues you for something your partner may have done can go after everything you both own (you and your partner). So if your partner has nothing, they can go after your portfolio. Both of you are also responsible for any debt you may incur. So if your partner overspends within your company, that is on both of you as well. Like a sole proprietor, any profit is again recorded on your personal income taxes of both partners. One of the downfalls of a partnership is, disagreements often take place in partnerships so this can cause unwanted stress within the company.
To set up a partnership up you need a written contract called the “articles of a partnership.” This states who the partners are, the length of the partnership, how profit and losses are divided among the partners – and it determines who will be taxed for what, the intentions or purchase of the partnership, who is contributing what (someone may be the worker and the other person just gives money as a financier). It would talk about what the degree of management authority is for each partner, what their salaries are, how future affairs will be handled should one or more of the partners die or become disabled, or how you will add or eliminate partners in the future.
There is also a business structure called a limited partnership. If someone doesn’t want to have unlimited liability as in a regular partnership, they can choose only to be liable for what they invested in the corporation. Most of the time a limited partner doesn’t play an active role in the company, they leave that up to the general partners.
Some of the advantages of a partnership over a sole proprietor are that you have more resources or capital that can be combined. And also, partners may specialize in different areas. Each may off their own area of expertise.
The third type is to incorporate. Corporations are owned by stockholders. So like limited partnerships stockholders are only liable for the amount they paid for their shares of stock. And this is the reason why I incorporated my business. When you set up the corporation you issue stock.
Each stockholder has a vote based on the % of stock they own. And the company must have a board of directors. If you own 100% stock in the corporation, you can be the sole person on the board of directors or hire people to be on your board of directors. The board also hires the management in the corporation. Profit is paid to the stockholders as a dividend or more stock in the company which are then taxed as personal income. Corporations can be privately held (like my company is 100% privately held as I own 100% of my company). Or they can be publicly held on the open market where stocks can be sold or purchased in an exchange (like the NY stock exchange or NASDAQ) and here at least some of the shares are owned by the general public who are not involved in the day-to-day operations of the company.
So let me give you an example of a fashion partnership that turned into a corporation. You may have heard of Esprit de Corp? They were very popular in the 1980’s. Here is how it started… In the 1960’s, A designer named Jane Tise proposed a business venture to her friend Susie Tompkins. Together they formed a partnership and named their company, Plain Jane Dress company. Tise designed clothes while Tompkins sold them. After it was successful locally in California, a man named Allan Schwartz became a 3rd partner in the company who marketed the brand to NY department stores. Then later in the 1960’s Susie’s husband, Doug Tompkins joined Plain Jane as a 4th partner. At that time the Tompkins owned roughly 45% and Tise and Schwartz’s held 55%.
While Tise and Susie Tompkins designed the product and added new designs and labels to their popular line, Doug and Schwartz handled the marketing and sales responsibilities. In the 1970’s their sales exceeded $1m a year. They then incorporated the company and became Esprit de Corp in 1971.
Doug Tompkins decided he wanted to take over major decisions in the business and in 1976 Schwartz and Tise sold their shares to the Tompkins. It was an amicable buyout and Schwartz decided to leave. Tise remained as chief fashion designer for 3 more years. Because she no longer owned a stake in the company, she became distraught feeling the Tompkins were no longer listening to her ideas so she up and left and Susie was put in charge of the designs. At this time, the corporation was still privately held.
During the early 1980s Esprit swiftly expanded, distinguishing itself not only through its sales but the way in which it reflected tit’s fashions through the eclectic taste of Susie and Doug Tompkins.
From 1979 to 1985 the company’s sales grew from $120 million to over $700 million. As design director, Susie approved all drawings and fabrics, while Doug held the titles of President and “image director.” . then they borrowed nearly $75 million to open several retail stores and their core retail customers started to complain. The retail customer felt that they were partners with Esprit de Corp and by them opening up their own stores, they were in direct competition with their current store wholesale customers. This was the start of their demise.
In 1986 and 1987, Esprit experienced losses for the first time and earnings fell from $62 million to $10 million, representing an 83 percent downturn. The Tompkins started disagreeing on things and Susie insisted they hire outside help to run the company. In 1988, Esprit was looking for an equity partner to add cash back into the organization. The new board that they hired recommended that Susie and Doug each remain 50-percent owners of Esprit but that they give up their operating control of the company. Doug’s duties at Esprit remained the same, Susie’s role at the company changed dramatically. No longer the chief fashion designer, she was effectively out of the business.. ON top of all of this early in 1989, Susie and Doug Tompkins filed for divorce in their personal life. In July of 1989, Esprit de Corp announced a new plan to refocus Esprit under one Tompkins. Doug was given the option to buy out Susie’s 50 percent within 120 days of the agreement. If he did not, both halves of the company would go up for sale at auction. It was rumored, that giant manufacturing companies such as Benetton and Reebok became interested in acquiring Esprit. When Doug never exercised his option to buy out Susie, only one day before the bidding on Esprit was to close, Doug and Susie worked out a deal, Esprit never went to auction.
Susie Tompkins returned to head Esprit. She had found a partner to help fund the buyout and he took a 25% stake in the company. His name was Bruce Katz. Doug retained ownership of Esprit’s southern European operations and some of its other international affiliates but otherwise, he was out. Under Susie’s ownership, she brought back her design team with which she had worked before leaving Esprit in 1988.
Soon thereafter, however, 1992 Susie Tompkins again stepped down, or perhaps she was forced out, as creative director of Esprit.
Forced to restructure its loans. Esprit saw a succession of CEOs moving in and out of the company and fashion failures. In 1993, Espirt was taken public. Susie Tompkins and Bruce Katz had disagreements and Susie agreed to buy out his minority stake in the company. That’s when Katz resigned from Esprit’s board of directors. Finally, in 1996, a former vice-chairman at both Tommy Hilfiger and Liz Claiborne, came to the helm. His name was Jay Margolis and he was backed by Oaktree Capital of Los Angeles and Cerberus Partners of New York. He bought Esprit’s defaulted loans for $80 million dollars, severing ties with Susie Tomkins. For years after that, there were legal issues tied to tax indemnifications between Susie Tompkins and Esprit de Corp. Throughout all of this, Women’s Wear Daily took a poll and ranked Esprit as 28th in a list of 100 most recognized fashion brands,
Esprit de Corp is a great example to show a company that moved from a partnership to a private corporation, to a public corporation. And it also shows some of the downfalls and achievements a company has during its growth or demise.
Getting back to the example of Esprit de Corp, sets for business structure and how important it is… Once you loose control of your ownership your partners no longer have to listen to you. This is exactly what happened to Tise once she sold her shares in the company to the Tompkins. And remember this whole ideal of a fashion company was Tise’s idea in the first place. You saw how the Tompkins partnership broke up and how the company was threatened and almost broke down from their personal divorce. We also saw what happens when a company is taken public and gains new stakeholders and a new board of directors.
The corporations I’ve been talking about thus far are C-corporations. There is also an
S corporation and the S stands for Subchapter. My company, DeBora Rachelle Inc., an S-corporation and I did this for two reasons. The first reason I talked about before. I wanted to incorporate so I’m not personally liable. People cannot come after my personal assets, they can only come after the stock or what the company has/owns.The second reason has to do with taxes. So let’s talk about taxes.
When you are a sole proprietor, everything you make (all the profit or losses you take) is brought right to your personal income tax form. The same is true for partnerships. It goes right to your personal income tax form depending on how your partnership is structured and who gets what – as far as having to claim the profits. With a corporation, the corporation itself is charged tax on its profits and then that income is distributed as dividends to its shareholders. The shareholders then take the dividends and then they report it again as income on their personal income tax form. So, basically as a corporation, the income is double taxed. Once as a corporation, and once in the dividend to the stockholder on their tax form. An S-corporation is a little different. It still retains the fact that the legal obligations of the corporation cannot become the debt of the individual(s) associated with the business. Another advantage is you are not double taxed like a c-corporation. All the profits or losses are turned right over to the shareholders for their personal income tax return. I’ll be going into greater detail about this in the book that I have coming out in the near future. So let’s go over some of the advantages and disadvantages to each business structure.
Advantages and disadvantages of a sole proprietor include:
- It doesn’t require a lot of paperwork. So it’s the easiest to form of all of the business structures.
- The owner has total control over the company and how it is run on a day-to-day basis.
- It is easier to file taxes.
- If you want to close the business, you just cease operations.
- The owner accepts all of the responsibility of the business losses and all of its liabilities.
- The owner is responsible for raising all the capital for the start-up costs.
- It’s harder to sell a sole proprietor business because the business is completely tied to the sole owner.
Advantages and disadvantages of a partnership include:
- Each partner may bring their own areas of expertise.
- Raising capital is easier because you have two or more partners with different connections and resources.
- If you are in need of capital, you can bring in another partner to share the expenses.
- Having a partner creates a better balance between work and life experiences.
- There will be times when you disagree with your partner(s) which can lead to major disagreements between the partners. (Listen to podcast for and example pertaining to Taco Bell).
- Both partners carry all the liabilities regardless of who incurred the debt. Unless you form a limited liability structure. Limited liability partnerships can also get tax deductions for business losses.
Advantages and disadvantages of a private corporation include:
- You are not obligated to reveal financial results to the public.
- You are not prone to shareholder pressure for stock results.
- There is limited liability exposure for owners.
- There are more stringent regulations than a partnership or sole proprietorship.
- There is less control of the business with more shareholders.
Here are some advantages and disadvantages of C- corporations:
- The legal obligations/liabilities of the corporation cannot become the debt of any individual associated with the business.
- They can raise money by selling stock.
- You can transfer ownership easily. Shares are simply transferred to heirs or sold.
- If you want to go public this can cost anywhere from $250,000 to $500,000.
- More extensive reporting, record-keeping and operational processes are required.
- Corporations are also taxed at a higher tax rates. They are double taxed.
- Still have to hold annual stockholders meeting even if you only have one stockholder – takes notes.
- The board can fire the founder of the business at any time.
Here are some advantages and disadvantages of S corporations:
- Less liabilties.
- They get the benefits of incorporation while enjoying the tax-exempt privileges of a partnership.
- Some corporate penalties do not apply.
- Transferring ownership is simple.
- There is no double taxation.
- They must meet certain requirements. Such as having few than 100 shareholders.
- They must allow all shareholders to vote on major decisions.
- They can only issue common stock, which could impact their ability to raise capital.
- Still have to hold annual stockholders meeting even if you only have one stockholder – takes notes.
If you want more information on business structures you can read my book (coming soon), it talks about how I lost thousands of dollars be structuring as the wrong type of company. Learn from my mistakes so you don’t have to make the same ones!
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