We’re discussing reliance and restitution in my Contracts class this week and almost all of the cases are between family members. This is something that I see a lot in the tax preparation space, particularly when it comes to business formations. Family or really close friends will form a business together without any contract or an operating agreement in place because they think their relationship will stand the test of time. But what I always warn them is that getting out of a business partnership is more difficult than getting out of a marriage, so you need to be practical.
In general, when you start a company, you need to plan with the end in mind. This includes planning for if a partner decides they want to leave the company or a partnership doesn’t work out. Any business with more than one owner should have an operating agreement in place and should address this specific issue. Just in the time that I’ve been working with small business owners, I have seen several partnerships sour, but the partners weren’t prepared for this. Usually the partner trying to leave or who is being pushed out is aware that the company is worth something and they want a portion of that before they leave. Many times they will ask for a business valuation which is a service very few CPAs offer because there is a lot of risk involved and that means it can be quite expensive. This has put several business owners in the position of working with partners they no longer want to work with because it’s too much trouble to buy their partner’s share of the business.
The horror story that I share with clients is about a woman who started a salon with a very good friend of hers. Every business has to have a designated tax matters person, this is the person who is ultimately responsible in the eyes of the IRS for making sure the taxes get paid. This friend convinced the woman to be the tax matters person, but the friend would make sure the taxes were filed and paid correctly. This included the federal taxes, sales tax, and, since they had employees, the payroll taxes as well. As you can probably guess, the friend didn’t file the taxes and didn’t pay them and instead was transferring the money that was “for the taxes” into her personal account. When the woman started getting tax notices demanding payment from the IRS, the friend disappeared. The worst part is, the IRS doesn’t care that it was her friend who misappropriated the tax dollars or that she trusted this friend enough to agree to this arrangement. In the eyes of the IRS, she is still responsible for the tax payments because she is the tax matters person on file and she made the choice to be a business owner.
These stories are not just limited to friends that have had a falling out. One of the biggest struggles married couples face if they decide to get divorced is trying to split up a business. Especially if both spouses work for the business and that is their only source of income, divorce proceedings trying to determine who takes over the company can get messy. Maybe it’s because I’m not married or because I’ve just seen too many real life examples, but I have always been of the mindset that having an exit strategy is important in business and in your personal relationships and that is especially true if both of those things are intermingled. The truth is that 50% of marriages end in divorce and that percentage increases with second and third marriages. Going through a divorce is awful, but worrying about losing your business during that process can make it much worse.
And the cautionary tales go beyond husband and wife and includes children and extended family members. I’ve seen several family run businesses experience severe losses because a brother, child, or in-law misappropriated assets. As a business owner, you should have contracts that explicitly state your expectations of the family and friends you employ and what is not allowed. More importantly, you should have an independent third party preparing and reviewing your books. It may sound harsh, but the biggest mistakes I’ve seen in bookkeeping have been done by family members that were hired to do the bookkeeping.
No matter what when it comes to business dealings, you want to be logical and level headed. This is probably more true when working with family and friends because you will be more inclined to trust them with the more intimate details of your business. Having an operating agreement in place and contracts with those that work with you can prevent costly mistakes later on. And there is always the chance that if two friends or family members don’t work well together, a contract can salvage the relationship. If there’s a legal roadmap of how someone should exit a business relationship, that can save hurt feelings. As the saying goes: “An ounce of prevention is worth a pound of cure.”
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