Sometimes Dividing the Pie Makes it Bigger: Why Use Multiple Business Entities.
I’ve been trying to find a catchy description for the legal implications of the too common practice of mixing different lines of business and types of risks in a single business entity. “Negative synergy," the whole being less than the sum of the parts, doesn’t quite get it. “Dumb" is unkind because the human-owned businesses that make this particular mistake almost certainly had a business advisor that didn’t stop them.
Mixtures of disparate assets and risks occur as successful businesses evolve. It’s easy to imagine the scenarios: “Instead of paying these rents, why not buy our own building?" “Let’s lease a few trucks; we can transport our widgets better and cheaper than our current hauler." “I really love ice cream. Why not make this a combination law firm/ice cream parlor?" (Ok, maybe “dumb" is sometimes appropriate.)
A business that evolves without attention to structure can create significant consequences in matters such as wealth preservation, taxes and financing/capitalization--critical concepts for any business owner. These consequences are almost always discovered when a fix is too late or very painful. To illustrate, consider the common situation of a building that is bought inside an operating business; that owner:
· could see a single mistake in the operating business wipe out the equity in the property, or vice versa,
· may end up paying significant sums in otherwise avoidable income and estate taxes, and
· might find plans to finance further growth, whether through selling stock or borrowing money, thwarted.
Asset protection is the most common reason for incorporating a business. Folks, this does not need to be a one-time phenomenon. As you create value in your business, it is just as important to insulate that value from unrelated liabilities as it is to protect your home and retirement plan from problems in the business.
Separate legal entities can be used to segregate various aspects of the business. In my example, the building could be bought in a newly formed LLC that then leases the building to the operating business. The problems of the building stay in the building, the problems of the business stay in the business. It will easier and cheaper to finance and insure the building. And two or more distinct entities open up a number business and estate planning opportunities not available in a single combined company.
This segregated approach is not without its own set of issues. It costs a bit more for starters, but the potential savings on legal and accounting fees is completely eclipsed by the benefits to you. Inside the company can be problematic too. You and your management team must work hard to avoid silo mentalities that could keep various entities, especially when there are multiple business units, from creating collaborative value.
And then there is “corporate veil." Whether you have one corporation or ten, if you don’t treat each as a distinct legal entity then why should a court? A family of related companies must be properly administered or else a creditor of one will get to the assets of another. Protecting the insulating veil is a bit of work, but the result is a more valuable and sustainable business.