went forward. The lawyers argued to a jury that Johnny’s business was irresponsible for failing to check up on Damien and was responsible for the consequences. They presented to the jury what was true—a business is vicariously liable, or responsible, for the acts of its employees. The jury was horrified by the whole case and awarded damages of $10 million.
Johnny was wiped out. As a sole proprietor he was completely and personally responsible for every claim the business incurred. And he had attorneys with a one-third contingent interest in the collection of $10 million after him.
Johnny lost his house, his savings, and his family. The stress of it all resulted in his wife divorcing him, obtaining custody of the children, and moving away. Johnny declared bankruptcy. He ended up a broken man despising lawyers and our legal system all the more.
The irony, of course, is that by consulting with a lawyer and using the legal system to his advantage, Johnny could have prevented the disastrous consequences that resulted from relying on a part-time bookkeeper with a one-size-fits-all mentality for entity selection.
A competent lawyer would have told Johnny that there were risks-known and unknown—in running any business. To protect yourself from such risks you need to limit your liability by establishing a corporation or other good entity.
A good entity is one that shields and protects your personal assets from business risk. A bad entity is one that provides you no protection whatsoever. By using a good entity Johnny could have used the legal system—which has evolved to encourage business activity and limit the liability of risk takers—to his advantage.
Other Sole Proprietorship Disadvantages
As if personal liability was not bad enough, there are several other disadvantages to using a sole proprietorship:
• Owners. There can only be one owner of a sole proprietorship. If you later want to bring on owners you will have to switch to another business entity.
• Sale. It is hard to sell a sole proprietorship since its value is based on the owner and not the business.
• Death. When a sole proprietor dies, the sole proprietorship terminates. The sole proprietor’s successors can only sell assets, not the business as a going concern.
• Audit Risk. Because sole proprietors report their business profits and losses to the IRS on Schedule C, there is a much higher risk of IRS audit. Schedule C returns are audited at a five times greater rate than corporate tax returns.
A general partnership is also a bad entity. In fact it is twice as bad as a sole proprietorship because you have twice the personal exposure: personal liability for your acts and your partners’ acts. This will be illustrated in Case No. 2 ahead.
Whenever two or more persons agree to share profits and losses a partnership has been formed. Even if you never sign a partnership agreement, state law provides that under such circumstances you have formed a general partnership.
A written partnership agreement is not required by law. A handshake is acceptable for formation. In the event you do not sign a formal document, you will be subject to your state’s applicable partnership law. This may not be to your advantage, since such general rules rarely satisfy specific situations. As an example, most states provide that profits and losses are to be divided equally among the partners. If your oral understanding is that you are to receive 75 percent of the profits, state law and your handshake will not help you. Instead, against your wishes, state law may have you sharing 50-50. You are better advised to prepare a written agreement addressing your rights and rewards. But again, you are better off not using a general partnership in the first place.
Unlike a sole proprietorship, in which only one individual may participate, by definition, a general partnership must consist of two or more people. You cannot have a one-person partnership. On the other hand, you may have as many partners as you want in a general partnership. This may sound like a blessing but it is actually a curse.
The greatest drawback of a general partnership is that each partner is liable for the debts and obligations incurred by all the other general partners. While you may trust the one general partner you have not to improperly obligate the partnership, the more general partners you bring aboard the greater risk you run that someone will create serious problems.
And remember, just as with a sole proprietorship, your personal assets are at risk in a general partnership. Your house and your life savings can be lost through the actions of your partner. While you may have had nothing to do with the decision that was made and you may have been five thousand miles away when it was made and you may have voiced your opposition to it when you found out it was made, you are still personally responsible for it as a general partner.
As such, a general partnership is much riskier than a sole proprietorship. In a sole proprietorship, only the proprietor can bind the business. In a general partnership, any general partner—no matter how wise or, unfortunately, how ignorant—may obligate the business. By contrast, limited liability companies, limited partnerships, and corporations offer much greater protection. All of them offer owners limited personal liability for business debts and the acts of others.
It should be noted that because of these unlimited risks the last thing you want to do is become a general partner of an enterprise in which you do not have day-to-day management control. If you do not thoroughly know what is going on in the company you should not put your future on the line as a general partner.
Case No. 2: Louise
Louise had worked for someone else all her life. For the last ten years she had worked in the gift section of a large department store. She did not like the floor manager insisting she do things a certain way when she knew her way would generate more sales for the company. It was all petty politics. She looked forward to the day when she could open her own business and make her own decisions.
Then one day, Maxine came to work at the department store. The two of them hit it off immediately. Maxine had a certain style and attitude that appealed to Louise. They had similar interests, the same feel for what the customers wanted, and the same desire to escape working for a faceless corporation filled with narrow-minded managers who stifled their every idea for improvement. Soon they were talking about opening their own gift boutique.
Louise had managed to save $10,000 to pursue her dream. Maxine did not have any money to contribute, but convinced Louise that she would contribute her first $5,000 in profits back into the business.
Louise was not aware that agreeing to form a partnership with Maxine without getting a written agreement as to distributions meant that they were automatically 50-50 partners. While Louise put up all the money and Maxine orally agreed to put her profits back later, the law treated them as each owning 50 percent of their new business, L&M Gifts.
In nine businesses out of ten there are problems when only one partner puts up all the money. L&M Gifts was no exception.
Maxine wanted the store to have the right atmosphere. She decided on leasing a storefront in a nice area and obligated the partnership to a three-year lease at an above-market rate. She decided on stylish tenant improvements to achieve the right look for her dream store. She then obligated the partnership to buy a large quantity of gifts in order to stock the store.
Before L&M Gifts opened its doors the partnership had obligated itself to spend $12,000 on improvements. They were also obligated to pay $1,500 per month in rent for the next three years. Louise was not aware of these transactions. However, as general
