You cut costs and became leaner to face your competitors head-on in today’s challenging environment, but is that really all you can do?
Congratulations! You are a business owner—the king of your castle, master of your universe—and you have dominion over all you survey. Your guts, dedication and success, unfortunately, make you a prime target for those who want a piece of what you have managed to build.
In medieval times, the king protected the assets of the kingdom through his minions. The royal gold, the queen’s silverware and the crown jewels were all at risk for siege, thievery and every other kind of peril. So, the king built walls, fortresses and moats and posted armed men to keep the thieves at bay.
In jolly old England, a new way to protect assets did not evolve for centuries until an association of bold gentlemen we now refer to as “Lloyds of London” gathered in Mr. Lloyds’ coffeehouse to become among the first to take on the risks of others, trading contracts for silver and gold and then trading those contracts among themselves (what we now take for granted as “insurance policies”).
These days, things are entirely different, right? Surely, you need not worry about marauding Vikings breaching your fortress or savage vandals sacking your headquarters. Today, instead of armies, mounted horses and cannons, your adversary might wear a suit and tie, smiling while thrusting not a sword, but a subpoena into your belly.
Your assets still need protection today, just as in ages past, but moats, drawbridges, castles (the stuff of fairytales) and even insurance will not provide security against all threats spawned by an ever-litigious society. There are, nonetheless, simple steps to protect yourself, but beware: Even when everything is set up properly, the way you conduct business can still put your assets at risk.
The following vignettes are true, but the real names and places remain confidential, except in one infamous case. The misfortunes portrayed teach us how to more fully secure business and personal assets.
Bringing home the bacon “Jake” was a likable fellow with a thriving home improvement business. He did not take much in salary and, when asked about the topic, said, “There’s more than one way to skin a cat…I get my share in other ways.” When his tax consultant reviewed his financial statements and tax returns, Jake’s QuickBooks journal entries showed several pages of expenses paid to a well-known supermarket chain. Jake readily admitted he used his business as a sort of “piggybank,” funding many household expenses through the company. The technical term for Jake’s practice is “comingling.”
Jake’s comingling posed several problems. If audited by state or federal tax authorities, his expenses would be regarded as taxable compensation and not tax deductible expenses. Beyond that, comingling provides a perfect way for a crafty plaintiff ’s attorney to pierce Jake’s corporate veil (the feature of a corporation that is supposed to protect Jake and his family). If defeated, the loss of the corporate veil would mean that Jake could be declared a sole proprietor because he is the corporation’s sole shareholder, allowing even personal assets to be attached, aside from any business assets.
No meeting of the minds “Bill,” a successful manufacturer of precision parts for prime suppliers to the automotive industry, became so successful he had to add a second shift to keep up with demand. One of Bill’s newer customers fell behind paying invoices and refused to budge on payment terms, so Bill required cash on delivery (COD) payment going forward. Predictably, this mismanaged customer needed components to ship to the car companies and disputed Bill’s decision. Bill’s attorney filed a lawsuit to recover $185,000 in outstanding invoices because the customer’s future looked shaky.
During the discovery phase of the lawsuit, Bill’s opponent refused to supply a corporate minute book because the shareholders of that company failed to conduct a board meeting during their three-year history. Bill and his attorney scheduled a motion to have the judge declare the defendant a partnership because the law was quite clear: A board needs to meet at least annually to maintain good standing as a corporation in Bill’s state.
The judge heard arguments from both sides and immediately ruled in favor of Bill. Bill’s attorney then requested a fiveminute recess, went into the hallway, called his paralegal and had her file a lis pendens (a property lien filed in anticipation of a legal settlement) on the home of each “shareholder,” now all partners, per court order. As previously discussed, partners do not enjoy corporate veil protection. Happily, the case quickly settled for nearly the full amount in dispute without proceeding to a costly trial.
Even if Bill’s opponent did comply with state law and remained a corporation, Bill may have ultimately won at trial anyhow. But the owners made a serious mistake. They put their personal assets at risk and found themselves cornered with no escape.
Corporations from here, there and everywhere The residential and office cleaning business “Judy” created grew at a remarkable pace by the time she met her tax consultant. Proudly, Judy said she did not worry much about taxes thanks to an advertisement she heard on satellite radio. Intrigued, the tax consultant asked her to elaborate.
Judy explained that because her company was a Nevada corporation, although located in the Midwest, it did not have to pay taxes. What Judy did not know is her state, like most states, requires that outside “foreign” corporations, with any business activity in her state, file a certificate with the secretary of state authorizing the foreign entity to operate locally.
If Judy did file her certificate of authority, she would soon discover that she must pay her taxes like everyone else. In addition, her company, and possibly Judy personally, may be liable for any taxes due plus penalties and interest. Because taxing authorities can file liens and levies for statutory enforcement, Judy’s personal assets are also at risk. In any case, a Nevada corporation legally operating in Judy’s state has the same tax liabilities as a domestic entity.
“Demetrius” heard something similar one day during a “wealth seminar” he attended last year at a local hotel ballroom. He formed his auto repair shop under Delaware law, even though he lives and works in the South.
According to Demetrius’ understanding, Delaware corporations cannot be touched in terms of liability, and they save big money on taxes. What Demetrius did not realize is that publicly traded companies like The Coca-Cola Company, although a Delaware corporation, pays plenty of taxes. The maker of Coke® and other products had a 2008 tax bill topping $1.6 billion per its 10-K filing with the U.S. Securities and Exchange Commission.
As for liabilities, Delaware corporations are sued just as often as corporations anywhere else, perhaps even more so because the state has so many public companies domiciled there often with high visibility like AIG, General Motors and others. Like Judy’s Nevada entity, Demetrius’ Delaware corporation must file a certificate with the secretary of state to operate in his state and yes, he would have to pay taxes like any other corporation as well.
On the road again During their married life, “Ben” and “Dora” built a mini-FedEx, but without the planes. Their company delivers small packages throughout their state, often with same-day service, which allows them to compete with the big guys. Truly a family business, Ben and Dora’s children, Arnie, Kristy and Ben Jr., also work in the company, gradually acquiring ownership thanks to their parents’ annual gifts of stock.
All was well until one day, a company driver making a rush delivery slammed into a church bus, flipping the bus on its side. Mercifully, no one was fatally hurt, but the cost of hospitalizing dozens of injured children and the driver stripped the company’s million-dollar insurance policy of its limits within days. With no further insurance coverage available, the family ultimately lost their business lock, stock and barrel, from the fleet of new trucks financed through a local bank down to the last paper clip. Sadly, they still owed the bank even after the company assets were auctioned off.
Utilizing the remainder of the family savings, Ben and Dora purchased several used trucks at another auction and formed a new delivery company, putting all the stock in the names of the three adult children. Inexplicably, they structured the new company identically to their defunct enterprise, never realizing a few subtle changes to their corporate structure and business operations could protect their fleet from the same calamity that created such havoc in their lives.
“Randy” found the perfect business to buy after his retirement from an aerospace giant in the Pacific Northwest: a florist shop with a fleet of four delivery vans. Business was brisk and Randy hired two new drivers and leased two additional vans.
One day, the police called Randy with some bad news. Long-time driver, “Ned,” who worked for years under the prior owner, was found unconscious in the company vehicle and was later pronounced dead at a nearby hospital. An autopsy revealed that Ned was a drug user. Ned’s widow had no idea her late husband was an addict and neither did Randy. While he still believes he hires great people, Randy now realizes he has no idea what kinds of things employees do on their own time.
When the tax consultant heard Randy describe the shock he felt, she asked to see Randy’s liability insurance policy. As suspected, she showed Randy a clause that disclaimed liability for vehicle accidents involving drugs or alcohol if Randy “knows or has reason to know” of a driver’s substance abuse, which is legalese for having a drug testing program in place. The tax consultant asked Randy, “What if Ned did not die, but survived and drove under the influence, then collided with another vehicle, pedestrian or cyclist?” Randy did not know what to say at first, but looked around his shop and quietly replied, “I guess this would all be gone.” Similar to Ben and Dora’s family operation, proper entity structuring and business procedures can protect what insurance alone cannot.
You dirty rat You have got to give Bernie Madoff credit for having the perfect name for someone who “made off ” with the investments of others! Though Madoff formed multiple corporations, they would protect neither his business nor his personal assets from acts of fraud. When U.S. Marshals took possession of Madoff ’s New York City penthouse, Mrs. Madoff was not even allowed to leave the premises wearing her favorite fur coat, so transferring assets to a spouse cannot provide asset protection as many commonly believe. The government took everything it could find and continues to track down cash, securities and other property and will likely do so for years to come. The moral of the story is that fraud destroys the protections a corporate structure should provide, placing both personal and business assets at risk.
Lessons learned Despite assurances from slick radio ads, mass market Web sites for legal-like services and other promoters, we can easily see from the misery of others that merely incorporating does not guarantee protection from that well-dressed lawyer advertising on the back of your telephone book or from the tax man—you must do more, even if just a little bit more.
Just one corporation standing alone is virtually never effective for minimizing taxes or protecting assets. Aside from tax and asset protection issues, state laws are intricate because there are 51 ways to form a business, each unique to the 50 states plus the District of Columbia, so what can you do?
An old saying points to danger when “you don’t know what you don’t know.” You have every reason to learn the right way to structure and conduct your business, so consulting a qualified tax strategist regarding the nuances of federal and state law makes terrific sense. An expert provides the knowledge for the “belt and suspenders” approach needed toward protecting your family and your business from the barbarians at the gate to your castle.