So you’re ready to open a business. You have 15 solid years of experience. Your first customer is waiting. A contract manufacturer is ready to start production. You’ve decided on an L.L.C. for your business structure and you’re ready to conquer the world …
The best advice for someone in the above scenario is to slow down. Choosing the right entity for a business is important, but it’s just one consideration in the larger context of an overall organizational structure. In the frenzy of start-up mode, few entrepreneurs realize that how they structure their business can make them vulnerable to losing everything or it can ensure their assets and future earning potential are protected if they lose big in a lawsuit.
The Terrible 2
Here’s how strategic structuring works using a real but anonymous client of ours. Let’s call him “Jack Martin” — a creative soul with annual sales in the tens of millions. When we first met Jack, his business was comprised of two entities: him (as an individual) and a single corporation that contained all of his businesses. If he were an artist who simply sold his unique works to a distributor, this structure would have been just fine.
But Jack’s business involved much more: thousands of creative works, leased retail locations in several states, media projects and online sales. Here he was — smart, talented and wealthy — but structured to lose everything. If he or the entity were sued and insurance couldn’t cover the judgment, his entire empire could potentially crumble. His current and future earning power was at risk.
From Two to Multiple Entities
Together, we re-structured his business to isolate him from personal liability and to isolate certain parts of his overall business from potential liabilities arising in other parts. We focused on three areas: intellectual property, real estate and business operations.
Intellectual Property. Jack’s cache of creative works — his IP — represents both current and future income. We separated this completely from the rest of his operations. Regardless of what a person does for a living, a lawsuit can decimate his or her company. Strategic structuring can safeguard the unique works, products and services that enabled the success in the first place. If the worst happens, he or she can start over in the same line of business with future earnings from the protected IP still intact and away from the reach of creditors.
Real Estate. We put each of Jack’s retail locations into a separate entity to minimize risk per location. If an incident at one location results in a huge loss, the others are insulated and protected from that loss. Likewise, our client is insulated from personal liability. Each retail location is covered by its own insurance policy as well.
Business Operations. Jack’s business operations were restructured into several corporations. The media portion is separate and distinct from the retail, design and creative works portions, and so on. Structure also impacts taxes. Careful analysis of business lines and locations can yield ideas for optimum income preservation. A consultation with an experienced tax attorney can help in structuring a business for the best tax-advantaged economic results.
In the “pre-revenue” stage, many entrepreneurs hesitate to consult with an attorney on the details. But the up-front cost is worth it. Fiercely protecting a business’s IP is smart. Tax-efficient structuring saves money. The longer the company operates under a protective structure, the more credibility it has if legal or tax questions arise.
“Better late than never” applies here. If the business is paying taxes twice because the company pays on earnings and pays again after taking a distribution, restructuring may make sense. Similarly, analyzing the business’s property holdings and how its IP is protected or exposed is worthwhile — the sooner the better.
Multiple corporate entities does create more administrative work. Accurate records and appropriate business practices are essential. Co-mingling funds, insurance policies or bank accounts can jeopardize the purpose of protective structuring.
Strategic business structuring can shield and strengthen a business. It’s the cheapest insurance a business owner can buy for safeguarding his or her future. As Jack’s experience exemplifies, it’s important to “slow down to go fast” when building that very important foundation for a business.
Thomas Morgan, a partner in Lewis and Roca’s Phoenix office, practices corporate, securities and tax law.
