A Primer on Legal Issues Small Businesses Face

If you are a small business owner, an entrepreneur, or about to start-up a business, a basic understanding of the legal issues small businesses typically face is essential to avoid economic failure or unforeseen litigation.

A simple Google© search on “legal issues for small companies” results in thousands of website hits discussing “top five”, “top three” or the “top ten” legal mistakes, hurdles and issues facing an entrepreneur or a small business owner. No doubt these mistakes occur in large measure because business start-ups usually do not have the capital and cannot fund a team of lawyers to follow them around advising them on every decision. Over my thirty plus years of legal practice, I have witnessed, prosecuted and defended small business owners’ and entrepreneurs’ decisions which made or broke their businesses. This article attempts to share with you some of the more common legal issues the resolution of which I have found to be crucial to the success of business start-ups, entrepreneurs as well as established small businesses.

Choosing a Business Legal Structure

   Selecting the appropriate legal structure for your business may be the most important decision you make. It can affect how much you pay in taxes, whether you may be held personally liable in the event of a lawsuit, and what your ownership/shareholder rights are with respect to the people with whom you are conducting business. Here are some of the most common legal structures:

   Sole proprietorship: You own and run an unincorporated business by yourself and do not set up any legal entity. You have total control of the business, receive all of its profits, and are responsible for all of its taxes and liabilities. Your personal assets and investments will be exposed to any claims made against your business.

   Partnership: A partnership is a verbal or written agreement by two or more persons to work together. It is similar to a sole proprietorship in that the owners are personally liable for the company’s obligations and debts. In addition, partnerships must file annual reports of income and deductions, plus gains and losses from operations. Unlike C corporations, however, partnerships do not separately pay income taxes; rather, the firm’s profits (or losses) are “passed through” to the individual partners and reported on each partner’s individual tax return.

   C corporation: This is an independent legal entity separate from its shareholder owners. Consequently an owner’s personal exposure to company liability is limited and, generally, a judgment creditor cannot get to an owner’s personal assets. C corporations must elect a board of directors to make business decisions. They are subject to “double taxation” inasmuch as income is taxed first at the corporate level and then again at the shareholder level through distributions. C corporations can also raise money by issuing shares of stock to new investors.

   S corporation: Enjoying the same protection from personal liability that a C corp. offers, a so-called “S” corporation has the additional advantage of avoiding “double taxation” by passing through profits and losses to the shareholder owners. To qualify as an S corporation, the entity may have no more than 100 shareholders and have only one class of stock. Further, the S corp. must be a domestic corporation. A shareholder who works for his S corporation must pay himself “reasonable compensation,” or the IRS may reclassify additional corporate earnings as wages.

   Limited liability Company (LLC): Like an S Corp, an LLC is not subject to “double taxation”; profits and losses of the business are passed through to each owner (“member”) of the LLC. Members also enjoy limited liability for business debts and obligations. Each state varies on how LLCs are treated and what is required to set up and operate an LLC.

   For any business entity beyond a sole proprietorship, the owners should execute a written agreement setting out their respective rights and duties as well as providing for transfers of their ownership interests. I can assure you that tens of thousands of dollars in litigation costs and fees can be avoided with well drafted business formation and ownership provisions at the outset of your venture. And review these documents with your lawyer before you sign them!

Employees/Independent Contractors

    You may have only a small number of employees, but you must treat employee relations with the same discipline as a large corporation. Having no formal employee handbook which outlines company policies and procedures, is a common error. Failing to perform annual reviews and maintaining detailed employee records of job duties and performance is another.

   Misclassifying employees is also a major mistake. Wrongly characterizing employees may be a violation of the Fair Labor Standards Act (FLSA) and employment laws in most states, resulting in potential liability for owing back pay, penalties, employee withholding taxes, unpaid overtime, and reimbursing the misclassified employee’s attorneys’ fees if you lose.

   Many companies prefer hiring “independent contractors” rather than “employees.” Hiring independent contractors may reduce overhead because you do not have to satisfy wage and hour requirements and FUTA and FICA tax matches. However, many small businesses incorrectly attempt to classify their workers as independent contractors which puts their companies at risk for costly employment litigation and tax liabilities and penalties.

   Classifying workers as either employees or independent contractor sometimes requires a complex evaluation but considering the following factors is a good starting point:

   Independent contractors. The person performing services is engaged in an occupation/business separate and distinct from that of your company. The person supplies and uses their own tools and equipment to complete the work. The person performs the work on their schedule and how they want. The skills required by the work are specialized.

   Employees: Your company supervises, directs and retains control over how the person works and when the work is performed. The person uses the employer’s tools and equipment. The person is paid by time (by the hour, daily rate, etc.) rather than by the project. The employer has the authority to terminate the person.

Exempt/Non-exempt Employees

A second way in which companies frequently misclassify their employees is on the issue of whether the employee is “exempt” or “non-exempt” from the FSLA’s overtime provisions. “Exempt” employees are not entitled to overtime pay while “non-exempt” employees are. Many small-business owners wrongly assume that a salaried employee is automatically exempt from federal and state overtime pay rules. The Fair Labor Standards Act contains dozens of exemptions under which specific categories of employers and employees are exempted from overtime requirements. The most common exemptions are the white-collar exemptions for administrative, executive, and professional employees, computer professionals, and outside sales employees.

The primary advantages of classifying employees as exempt are that you do not have to track their hours or pay them overtime, no matter how many hours they work. An employee who meets the salary level tests and also the salary basis tests is exempt only if she also performs exempt job duties. Whether the duties of a particular job qualify as exempt depends on what they are. For example, an employee may fall under the exemption for “executives” if the employee regularly supervises two or more other employees, has management as the primary duty of the position, and has some genuine input into the job status of other employees. The supervision must be a regular part of the employee's job, and must be of other employees. Again, the analysis can become rather complex.

Intellectual Property Issues, Trade Secrets

   The next legal issue to consider is your intellectual property, such as trademarks and copyright. Your ideas, products, logistics, branding themes, client lists are essential to your business. Knowing what constitutes intellectual property helps, but sometimes, it is not enough. “Patent trolls,” people who register as many patents as they can and file frivolous lawsuits, are everywhere. Retaining a lawyer can be costly but a good one will save your company thousands in the long run by defending you against baseless litigation, researching and filing patents and trademarks and warning you about potential infringement issues.

   Intellectual property law covers patents (which protect inventions); copyrights (which protect artistic creations); and trademarks (which protect brands). Punishments for infringing intellectual property rights range from crippling monetary penalties to injunctions, both of which can be fatal to a young business. You might have the perfect product, logo, website photo and company name, but if any of those constitute someone else’s intellectual property, you will have to pay for using them without permission. Registering a trademark gives you the exclusive right to use a specific word or words, name, design, or logo in connection with specific goods or services. It is valid for 10 years and is renewable if certain requirements are met.

   Trade Secrets is another area of company property which needs to be protected. In North Carolina, a trade secret is defined as information, including a formula, pattern, compilation, program, device, method, technique or process, that derives its economic value from not being generally known to the public and is protected by reasonable efforts to maintain its secrecy.   If you have information such as customer lists, process methods, recipes or other formulas that you or your company’s employees have developed, this information can and should be protected as trade secrets. This could include storing the information in a password protected place, only disclosing the information on a need-to-know basis and making sure the information is not posted in a public place (like the Internet).

   You need to remember that when a person is not an employee of the business, the rights to the intellectual property created vest in the creator, not the company, unless appropriate written agreements are in place. It is highly recommended that all independent contractors and company employees sign confidentiality agreements outlining what the company believes are its trade secrets, who will own the creative product and what are the non-disclosure rules for employees and contractors regarding company’s secrets, clients and property.

Vicarious Liability

Most owners understand that they are directly responsible for their employees when an employee is hurt while on company property or while using company equipment. But an owner’s liability is much greater. Injury or harm to third parties, caused by a company’s employee while that employee is acting within the course and scope of his or her job duties, exposes the company to vicarious liability for that harm. For example, an employee may be dropping the company’s mail off at the post office on the way home from work. If that employee causes an accident en route, even if he or she is driving a personal vehicle, your business could be liable for damages sustained by the other party in the accident. This is not a common situation, but it is one that could have major consequences for your business.

To avoid finding yourself on the wrong end of a vicarious liability summons, define your employees’ job descriptions clearly and purchase a commercial general liability insurance policy that covers employees at work and in personal vehicles (also known as non-owned auto coverage).

DIY Dispute Resolution

   Trying to resolve legal issues by yourself may prove penny wise and pound foolish. If you are contacted by an attorney on behalf of another individual or company, you should hire your own attorney to respond. What you say or how you respond can and will be used against you or your company and may be used as evidence in a legal dispute. Your attorney’s communication or response is not evidence or testimony,

   If there is more than one owner in the company, or if your business or its future profits are to be divided, you should hire competent counsel to document the company’s ownership and draft the shareholder agreements. Failure to address ownership issues at the outset is a recipe for protracted and unnecessary litigation.

    Establish a working relationship with counsel of your own choosing who can gain familiarity with your business and be available for counsel as you may need it. Those few dollars spent on legal prevention may save you and your company significant money when legal issues do arise.