You have dabbled in painting, pottery, woodworking or crafting most of your life. It has been your primary hobby. You are getting pretty good at it. You have done a few craft shows and art hops. You have made a little money. Your sales are starting to cover your expenses. You have decided to stop dabbling and turn your hobby into a full-fledged business. But you have never run your own business.
The setting up of your new business can be very complicated because there are things that you will not know what or how to do. For those things that you do not know how to accomplish, surround yourself with people who can assist you. Your professional team should be chosen at the outset. This team should include a tax advisor/accountant, attorney, insurance agent, business mentor and banker.
One of the first choices that you have to make is what form of entity to use for your business. When setting up your business, you have several options. Your business can generally be a sole proprietorship, a general or limited partnership, a C or S corporation or a limited liability company. Working with your attorney and tax advisor/accountant will aid you in determining which form to choose.
Will your new business have a high exposure to business liabilities? For example, if you are selling unframed watercolors online or at other third-party venues, you would have less of a liability exposure than if you have a high traffic retail store or are selling pottery designed to hold food or beverages. If you have a need to limit your liability exposure, you may want to choose a C or S corporation or a limited liability company.
With a C or S corporation or a limited liability company, your personal assets are generally protected from business creditors. A business creditor would only be able to access the business assets to satisfy the debt. With a limited partnership, the limited partners not active in the business would have their liability generally limited to their investment in the business. As a general partner in a partnership or as a sole proprietor, your personal assets are at risk for all business debts, even if you did not cause them. For example, if you had an employee or a partner cause a car accident while making a delivery and injured someone, your home and personal assets could be at risk to satisfy the personal injury judgment.
To save on your income taxes, you may want to organize your business as a partnership, an S corporation, or as a limited liability company taxed as one of them. Under the new Trump tax act, if your income is within certain limits, you can take a deduction of up to 20% of your business income. This special business deduction was added to encourage business formation and job growth. Your income taxes would be higher as a sole proprietor or as a C corporation. You should review your business and tax situation with your attorney and tax advisor to determine the best form of entity that should be utilized for your business.
And do not think that just filing your articles with the state is enough start up a corporation or limited liability company. There are provisions for your corporation or limited liability that are not in the state printed forms. You also need to have corporate bylaws or a limited liability company operating agreement, along with issuing stock or membership interests. And you have to have all of your organizational meetings. If you do not properly organize your corporation or limited liability company and/or do not act like a corporation or limited liability company, the protections that you thought were there, may not be.
On many occasions, I have even seen company organizational documents attempted to be prepared by non-attorney professional advisors such as tax preparers or accountants. In more than 30 years of practicing law, I have never seen non-attorney prepared business organizational documents completed properly.
Once you have setup as a corporation or a limited liability company, act like one. Keep up with annual filings and formalities of the organization. Whenever you are acting on behalf of the organization, make sure that the persons with whom you are dealing do not think they are dealing with a sole proprietor or partner. Use inc., corp., ltd., LLC or similar designations whenever you are dealing on behalf of the business. Put it on business cards, stationary, advertising, promotional pieces, websites, invoices, checks and any other written business materials.
If you do not follow all the rules and the laws, the risk you run is unlimited personal liability for business debts and lawsuits. If you get sued, it could be determined that you are operating the business as a sole proprietor or general partnership and have unlimited personal liability for all business debts and lawsuits. You could lose your house, savings accounts and other assets in the event of a catastrophic business creditor. This is called piercing the company veil. When this occurs, the company provides no creditor protection to the owners.
If you have a co-owner, you may be tempted to just set up your business 50/50, so each owner has an equal say in the business. This is all well and good. But what if you cannot agree on a decision with your co-owner? In that instance, you may be stuck with inaction and deadlock all decisions of the company. Your only recourse may be court proceedings.
When setting up a company with an even number of owners, I recommend that you put some sort of deadlock protection in your bylaws or operating agreement. You could add a minority owner who owns 5% or 10% of the company who would be the swing vote to create a majority. You could also set it up with one owner having 49% and the other with 51%, so that if there is a disagreement, the 51% owner rules. Another alternative is for the owners to appoint an independent third party to be the tie-breaker in the event of an owner deadlock.
One of the most important items that is often overlooked when setting up a business is getting out of the business. This is called an exit strategy. If you have family in the business, do not wait until you are in your seventies and your kids are in their fifties to sell them the business. At that stage in their lives, the kids may not want to go into debt for ten or more years to buy the business and when it’s finally paid off, they then have to find a buyer for the company before they can retire.
If there is more than one business owner, you should have a comprehensive buy-sell agreement for when one owner leaves the company through death, disability, divorce, bankruptcy, catastrophic creditor, retirement or any other reason such as the owners just cannot get along. It should be clear in your buy-sell agreement at which price the selling owner will sell the ownership interest in the business. It is important that the buyer be able to fund the purchase. This is frequently accomplished with seller financing.
You may be tempted to just put a few pages of buy-sell provisions into your corporate bylaws or limited liability company operating agreement thinking you have adequate buy-sell protection. Inevitably, you end up in a situation not contemplated in those few pages. Without a comprehensive buy-sell agreement, you may end up in court when a co-owner leaves. This could result in tens of thousands of dollars in legal fees. It’s like the old Fram oil filter commercial, “Pay me now, or pay me a lot more later.”
I have heard people say they can’t afford to pay an attorney to properly set up their business. One of the most common reasons that small businesses fail is because they are under-capitalized. If you cannot afford to pay an attorney to properly set up your business, you might want to rethink starting your business right now. You probably are under-capitalized and would be unable to fund a start-up business. You may want to wait until you have sufficient funds to start the business.
An experienced business attorney should be used to prepare your organizational documents. And surround yourself with qualified people to assist you in doing the things you do not know how to do or have the time to do. Protect yourself, protect your family, protect your assets by properly organizing your business.
By Matthew M. Wallace, CPA, JD
Published edited May 20, 2018 in The Times Herald newspaper Port Huron, Michigan as: Turning your hobby into a business