Susan L. Beecher, Attorney for Families and Small Business in Kent, Washington
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General legal help for smaller enterprises

This week's tip:

When Owners Can’t Be There

 

No one likes to think about the worst “what if?” possibilities. This is especially true of the question, “What if the president/managing member/managing partner is incapacitated?” However, the time to address this problem is not after a tragedy has happened.

 

Corporations and limited liability companies are persons in their own right under law. However, if they are without a chief officer, they become incapacitated themselves. Important decisions cannot legally be made. Important documents cannot legally be signed. Opportunities may be lost, and critical activities may grind to a halt.

 

Therefore, it is important for all key people to have durable powers of attorney in place that will allow trusted personnel, family members, or a combination of both (depending on the type of business) to act on their behalf. By-Laws, operating agreements, and partnership agreements should also provide for immediate succession, whether permanent or temporary, so that someone can act with authority on behalf of the company.

 

Many companies also cover their chief officers with key person insurance. Sometimes, there simply isn’t another person at the company who could step in and do all that the president or manager does over the long term. If the company is to survive, someone with the required qualifications will need to be hired to step in.

 

If you are a business owner, you know that no one can run the company quite as well as you do. However, you probably also have employees, and perhaps a family, who rely on the company running as well as possible for their continued livelihood. You owe it to them to make plans so that, if you can’t be there (whether temporarily or permanently), their losses are minimized as much as possible.

Previous tips:

Why Do I Need An Attorney To Help Me Form A Business?

 

Many new business owners learn that one does not need an attorney to file articles of incorporation (for a corporation) or a certificate of formation (for an LLC) with the Secretary of State. In fact, on-line fill-in-the-blank forms make the process easier than ever. Many wonder why they need an attorney at all. You, too, may not need an attorney to form a business, IF you know how to address the following issues.

 

1) Which entity is right for my business? – Most small businesses, though not all, should be either limited liability companies or S-corporations. In many cases, choice of the wrong entity form (between these two) can have serious tax consequences. In a small percentage of cases, the best choice is neither of these.

 

2) What answers do I want to give on the form? – All of the fields look deceptively easy, but some are not. Should your LLC be member managed or manager managed? What kind of stock is your corporation going to issue? Who will you list as the registered agent? (Caution: Whatever name and address you list as registered agent will be readily available on the Secretary of State website.)

 

3) Once I form my entity, what do I need to do next besides start making money? – Once you form the entity, the work has only begun. You must also apply for a master business license with the state, a local business license, and any state or local licenses that may be particular to your line of work. You need to obtain an EIN number from the IRS, and if you intend that your corporation will be an S Corp, you will need to file a 2553 with the IRS promptly. Otherwise, your entity will be a C Corporation, and your dollars will be taxed twice. For many businesses, other steps, such as obtaining insurance or filing a bond, are required as well.

 

4) Once I obtain my licenses and take care of the various government agencies, is there anything else I need to do? – You also need to complete your company’s internal formation documents. These documents may strike you as the product of some hidden vendetta that lawyers have against trees, but they actually serve several important purposes.

 

a) These documents provide your business with the opportunity to opt out of some of the state’s laws. (For example, under Washington State laws, shareholders all have certain rights, and do not have other rights. Perhaps you would like shareholders in your corporation to have additional rights, or perhaps in your corporation’s case, it is appropriate that they relinquish some of those rights.) These variations from the “default setting” may be spelled out in the company’s shareholder’s agreement and bylaws (in the case of a corporation) or operating agreement (in the case of an LLC).

 

b) These documents allow your business to fill in the blanks where the law is silent. This is particularly important if there is more than one owner involved. How will you share the profits? Who will be responsible for what tasks? What is each contributing to the business? What happens if one owner is leaving the business? Who buys out whom, for how much, and under what terms? This can be an issue when two owners learn that they may be friends, but they can’t work together. However, it can also become important when one owner dies, becomes disabled, or decides to follow a better opportunity. Be aware, too, that in this state, the owner’s interest in the business may be considered community property in the event of dissolution of his or her marriage. Also, if one owner personally goes bankrupt, his or her interest becomes part of the bankruptcy estate. Properly prepared shareholders’ agreements and operating agreements can provide a significant amount of protection from this parade of horrible what-ifs.

 

c) Documentary formalities help strengthen the corporate veil. One of the reasons people choose to form entities is because they want the personal protection from liability for much of what happens in the company. Having proper documents in place helps to document the entrepreneur’s compliance with the formalities that are necessary to keep the business entity separate from his or her personal finances.

 

5) What about employees? – I have actually heard of business owners (including some attorneys!) who decide not to allow their businesses to grow beyond a certain point, because they do not want the hassle of complying with all the tax and other laws related to having employees. There are many reasons not to grow a business beyond a certain point, but this is an unfortunate one. Complying with the necessary laws is not difficult, and most business owners can do it with assistance at startup, and the occasional brief consultation.

 

Okay, but why can’t I have an attorney help me with the parts I don’t understand, and do the rest myself. There is no good reason why not. New business owners don’t have unlimited cash flow, even in the best of times. Many attorneys are willing to work with entrepreneurs to do for them what they cannot do, but to give them direction and guidance in the things they can do for themselves.

 

 

Buying a Business

 

For many, buying a going concern is an appealing way to become a business owner. It is a little like adopting an adult dog from a rescue shelter rather than taking in a puppy. Just as the new guardian of an adult dog can often avoid the trials of housebreaking, endless chewing, obedience training and “energy outbursts” at inappropriate times, the purchaser of an established business can avoid the long, slow, hungry days of getting established and getting name recognition. But, just as someone seeking to take in an adult dog must be careful not to adopt someone else’s incontinent, chronic biter, the purchaser of an existing business must shop carefully to avoid taking on someone else’s sinking ship. However, with attentive research and the patience to wait for the right opportunity, it is possible to find an adult dog or an existing business that one would be delighted to call one’s own. Here are some points to think about when considering purchase of a business:

 

What are you buying? – Are you buying the business, or are you buying “substantially all of the assets”? If you buy the business, you are taking on the liabilities as well as the assets. Liabilities can include unpaid taxes, lawsuits based on conduct of the business under the previous owner (filed or not), unpaid debts, contract commitments and warranties. In theory, if you buy “substantially all of the assets”, you purchase the company’s goodwill, workforce in place, right to use the company name, customer base, plant and equipment and so forth, but the liabilities remain with the actual company, which remains with the old owners. When you purchase the company, also be very clear about what you are purchasing? Does it include outstanding receivables? Does it include contracts with existing customers? Does it include the right to use the name? Does it include the previous owner’s availability for consulting for a period of time?

 

If you buying the business – Be sure to do your homework, or due diligence, to find out what debts the company has outstanding and whether the business’ taxes are paid up to date. Find out what sort of risk history the company has with regard to commercial and liability insurance, workman’s compensation, unemployment compensation and any other coverage it may have, whether private or statutorily mandated. Find out if any lawsuits are pending and what credit rating the company has. Find out whether the employees are organized, or whether a union has taken an interest in the company.

 

Get commitments from the previous owners – Whether you are buying the business itself or “substantially all of the assets”, get commitments from the sellers to indemnify you against their problems. If you find yourself dealing with an undisclosed debt or with a lawsuit that springs from the actions of the previous owners, you may be liable as to the third party (in other words, you may have to deal with the problem as if it were yours all along) but you will want to be able to come back to the sellers and have them cover any losses you suffer, including attorney’s fees. In addition, you will want an agreement from the previous owners not to compete for a reasonable period of time.

 

Make sure financial terms are clear – Make sure the selling price is clear, and that the agreement spells out any payment terms. Is any part of the price contingent upon certain events (such as the business producing a certain amount of revenue in its first year)? If so, make sure the agreement is clear about what the contingent events are, the effects upon the price, and the responsibilities of the buyer and the seller. Take time to reach agreement between buyer and seller as to allocation of values for income tax purposes.

 

Mind the details – Make sure the purchase agreement covers the details and provides remedies if one party or the other does not follow through on its obligations. Get separate bills of sale to cover any motor vehicles. Make sure the correct parties are reflected in the paperwork. This last may seem obvious and silly, but buyers and sellers do sometimes become muddled about whether the seller (or the buyer) is the corporation (or LLC) in question, or the individual shareholders (or members). This question matters to the IRS, and so it must be properly addressed.

 

Get help if you need it – When one is buying or selling a business, significant amounts of money are necessarily at risk. Even if the business is a very small one, the purchase price usually is enough to be a matter of great concern to both buyer and seller. If you have any doubt about whether you have taken all the right steps and properly prepared your paperwork, get professional help. Many attorneys understand that buyers and sellers of a $20,000 micro-business do not want to spend $5000 in legal fees.

 

If you are shopping for a business, I wish you good hunting, and may you find the perfect opportunity at the right price.

What is a registered agent?

 

Any corporation or limited liability company that is formed in the State of Washington is required to list a registered agent with the Secretary of State. Any foreign entity (those based out of state as well as those based out of the country) must also have the name and street address of a registered agent on file with the Secretary of State. Many business owners who form their entities without assistance do not give much thought to this requirement.

 

The purpose of the registered agent is to provide a public face, legally speaking. Anyway wishing to file suit against an entity may serve papers upon the registered agent and as long as service upon the agent was proper, there can be no argument as to whether the corporation or LLC was properly served.

 

Many business owners list themselves as the registered agent, often listing their home address, if they do not yet have a business location at the time of filing the formation documents. This means that the owner’s home address will be on the Secretary of State’s website, available to anyone who may look for information about the company. Of course, papers for any lawsuits filed against the corporation or LLC will also be served at the owner’s home.

 

The business owner wanting to avoid this invasion of privacy has several options. If it is possible to acquire the business space prior to forming the corporation or LLC, the owner should use that address when listing herself as the registered agent. This presumes that the owner has signed for the lease personally, since that would be the only way to acquire the space prior to filing the formation documents. This involves some financial risk to the signer, but most landlords will not lease to new businesses without the owner’s personal guarantee, so not much is lost. The shareholders (for corporations) or members (for LLCs) should still ratify the rental agreement once the entity is formed, and thereby enable the entity to assume the liability.

 

Another option is to allow an attorney to act as the registered agent. Some attorneys (including this one) do this for a nominal fee for their clients and waive the fee in any year that the attorney does billable work for the entity.

 

Yet another option is to turn to a professional registered agent. These are companies that provide a variety of services to businesses, including acting as registered agent for a fee.

 

There is no legal impediment to a business owner listing himself, at his home address, as registered agent. However, in this era of fragile privacy, a business owner should only elect to do this after informed consideration.

 

Default Judgments – The Hole in Your Pocket

 

You’ve been served with papers. Maybe you’ve never heard of the plaintiff, or maybe you know who they are, but you feel their claim is completely unjustified. Maybe you’ve already lost a lot of money in your dealings with the other party. In any case, you’re not going to throw good money after bad hiring an attorney to deal with that mess. You call up the other party’s attorney and explain why the suit is wrong, then you hang up when the attorney won’t drop it. You ignore it until the court date, then you show up in court to state your mind.

 

But your matter is never called.

 

And then you learn that you have a default judgment against your company. You’ve already lost, and the plaintiff’s attorney can now take steps to remove money from your company bank account, and seize your company’s assets.

 

In Washington State, if the defendant does not make an appropriate legal response (an “appearance”), the plaintiff can request and be granted a default judgment without having to argue the matter before a judge. (There are a few exceptions, in family law and in a few other areas.)

 

For this reason, once you are served with papers indicating there is a lawsuit against you or your company, it is NEVER a good idea to try to handle it yourself. Even if you have been wrongly named in the suit and cannot possibly be a party to the case, even if the suit is frivolous and based on the hallucinations of the complaining party, get an attorney.

 

Can default judgments be unwound? Sometimes, they can. If there was a procedural error, especially if you were not properly served with the papers, it may be possible to reverse the judgment. Otherwise, to unwind a default judgment, your attorney must be able to show the court:

 

1)     Evidence to support a defense – If the case had properly gone to trial, there is a reasonable likelihood that you would have prevailed.

2)     That your failure to “appear” (properly follow through) was due to “mistake, inadvertence, surprise, or excusable neglect.” – This element is not quite as forgiving as it sounds. You must show that there was good reason why you didn’t follow through.

3)     That you acted with due diligence after notice of entry of the default – as soon as you became aware of what happened, you acted.

4)     Vacating the judgment would not cause substantial hardship to the plaintiff – Generally, the fact that the plaintiff must give you your money back if you win is not in itself substantial hardship.

 

 

Perhaps you’re thinking that if you just invested enough time, you could defend against the lawsuit yourself. For business owners, this thinking not only exposes the business to less than completely competent representation, but it also may have a second pitfall. Unless you are a sole proprietor, a lawsuit against your business is not brought against you personally (although you may also be named personally) but against your S Corporation, or your LLC, or your partnership. If you try to represent that entity, the courts view that as unlicensed practice of law.

 

This does not mean that every attorney is unerringly competent. (If only that were true!) But most attorneys carry malpractice insurance, and you have recourse against an attorney who inexcusably bungles the job. You do not have such recourse against yourself.

 

Being served with papers for a lawsuit is always upsetting, whether the plaintiff has reasonable grounds or not. However, your response must always be the same. Get legal help. To do otherwise is the same as putting a spigot in your bank account and turning the tap

Is This Check Any Good?

 

In films, Harpo Marx would screen checks presented to him by dropping them to the floor. If the document jumped back up to his hand, he looked sternly at the presenter and shook his head “no”.

 

In the real world, we take risks when we accept checks, and we cannot rely on gravity to assure us the check will clear. However, looking for a few danger signals will greatly reduce our risk.

 

Cashier’s checks – At one time, I thought that nothing could be safer than a cashier’s check from a bank. There was no risk of insufficient funds, and no risk of an unauthorized signer. However, I learned that is not always the case.

 

Be wary of those who want to present a cashier’s check for a larger amount than what is called for, particularly if you are not dealing with your customer face-to-face. In a scam that has become widespread with almost infinite variations, the con artist will present a cashier’s check for a large amount from a bank in a distant state (or even a foreign country) and request that you remit the difference. If course, the check turns out to be counterfeit. Federal law requires that the bank credit the funds to your account after a certain number of days, even if the funds are not actually collected yet, so the fact that the money has been credited as available provides no reassurance. Once the check is found to be counterfeit, the bank is within its rights under law to collect the amount of the check from you, even if the bank previously showed the funds as available. Further, discovering the counterfeit may take weeks. To confirm that a cashier’s check is good, contact the financial institution yourself at the number you find by using a search engine or a directory. Do not use a phone number printed on the check or provided by the presenter.

 

Be wary of those who present a cashier’s check without an apparent reason to do so. The customer in these cases may by trying to remain anonymous while purchasing your legitimate goods or services for an illegal purpose. If you have not requested a cashier’s check, and if use of cashier’s checks is not customary in your industry (particularly if you are dealing with another business), be a little skeptical. The check may clear, but you may be the unwitting participant in something undesirable.

 

Third party checks – It can be tough to check the ID of someone cashing a third party check, because they are not claiming to be the person whose name is preprinted on the check. Checks can be washed (cleared) and new payee names and amounts entered. When this happens and is discovered, the check is not properly payable, and the bank has no obligation to cover your loss.

 

In addition, when you present any check to your bank, you are warranting to the bank that there has been no material alteration to the check, regardless of what may have happened upstream.

 

Watch out, also, for the check endorsed, “without recourse”. This means that signer refuses liability if the check is not good.

 

Most businesses resolve the problem by refusing third party checks altogether.

 

No ID – Unless you know who you are dealing with (either because the check writer has been in your business before, or because the check writer is responding to your mailed invoice, to give two examples) be sure to check identification. If an imposter presents a check to you, written on the account of a third party, and the imposter claims to be that third party, the loss will be allocated to you, not to the bank or the third party. (Of course, if the miscreant is caught, the loss will be allocated to him or her, but often these individuals make themselves scarce and have no assets when caught.)

 

Credit cards and electronic payment systems such as PayPal™ are gaining currency (so to speak), but checks still remain an important payment system in business. A little wariness, knowledge, and common sense are still important tools for the small business owner when dealing with them.

Financing your business

 

Small businesses vary widely as to how much capital is needed at startup. Some businesses can begin operating with almost no capital while others require a staggering amount of investment for even the most modest operation. When you open your small business, your choice of financing will be determined by the requirements of your business, but also by your ability to handle the disadvantages that come with each mode of financing. Although many variations exist, capital can come from four basic sources.

 

Self financing

 

The disadvantage of this choice is obvious. If your business does not thrive, you lose your investment as well as your sweat equity in the business. The advantages to this method are also easy to spot. First, you do not have the disadvantages that accompany the other options. Second, you can control the rate of repayment, in the case of that portion of the financing that is a loan. Third, when the business begins producing profits, none of that need go to debt service or distributions to other investors.

 

One method of self financing that may not immediately occur to a new entrepreneur is the use or retirement funds. Simply liquidating your IRA is NOT recommended, as taxes and penalties make this an economically bad choice. However, a financial planner or a tax attorney can help you roll your investment into a type of 401k plan called an employee stock ownership plan, through a qualifying employer securities transaction. Put another way, you set up a type of 401k for yourself through your company, and that 401k reinvests your money in your company. The requirements for this transaction are somewhat baroque. If the transaction is not properly done, you will not avoid the tax consequence, so professional assistance is a good idea.

 

Bank financing

 

Lending institutions can be a good option if the financial requirements of your business exceed what you have on hand. The disadvantages are that such institutions are often uninterested in financing new businesses, and will generally require that you offer personal property (generally, your home) as collateral. Interest rates for new businesses are also often not particularly favorable. The advantage of an institutional lender is that it will expect repayment at a certain rate, but other than that, will not become particularly involved with your business.

 

Additional active owners

 

Your business plan may draw the attention of someone who is willing to buy in to become a shareholder (or member, or partner, depending on what type of entity you have). This new owner will become a source of a cash transfusion for your company. Many new business owners blind themselves to the obvious truth involved with this plan. Your new co-owner will have a say in how the business is run.

 

If you decide to bring in an additional owner, be sure to choose someone with whom you work comfortably, and who shares your particular vision for how the company should be run. Then, be sure to have drawn up an operating agreement (for an LLC), and shareholders agreement (for a corporation) or a partnership agreement (for a partnership) spelling out who owns what percentage, what buy/sell provisions apply, how major decisions will be made, and so forth. If you pull a “prefab” agreement off the internet, buy an hour or so of an attorney’s time so that you are sure the agreement meets your particular needs. Often, what will be right for the average business will not be right for you in at least one or two details.

 

Additional inactive owners

 

Finally, you may decide to finance your business through the use of funds from friends or relatives who believe you have a good business plan, but who do not want to become involved in the running of the company. The funds may be in the form of a loan or the sale of an interest in the business.

 

One clear disadvantage of this plan is that if your company does not succeed, you will have to explain to these erstwhile friends and unhappy relatives that their investments are gone. However, it is also important to understand that where the investor is not actively involved in the business, securities laws may be implicated. Even though your company is not publicly traded, there are still legal requirements that you must meet if you accept investment from individuals who are not actively involved in the business. Requirements are complex, and vary depending on the amount invested, the number of investors, and the sophistication of the investors. If you plan to finance your business in this way, it is a good idea to review your plan with an attorney who understands securities laws.

Getting Friendly with the Competition

 

When we hear the words “anti-trust” and “restraint of trade”, we tend to think of Microsoft, A T & T and the like, getting their comeuppances under the watchful eye of the Department of Justice and the popular press. However, smaller entrepreneurs need to remember that these laws apply to them, too. Interpreting the Sherman Act, and its Washington State equivalent, included in RCW chapter 19.86, as well as other related statutes, is a complex area of law. However, this tip will alert owners of small business to issues of which they should be aware, and to warning signs that they may be straying into forbidden territory. Managers and owners who are unsure should review the particulars of their individual situations with their business attorneys.

 

Not all collaboration between competitors is necessarily forbidden. Software developers may share information with each other as necessary to enable their products to work harmoniously on the user’s computer. Dairy farmers may join together to advertise their commodity. (“Got milk?”) Members of an industry may form trade associations to lobby for laws that benefit their industry, and to provide training opportunities and other benefits to their members.

 

Yet, other types of cooperation, such as agreeing not to flood the market or sharing price information, are strictly forbidden, and carry the risk of severe financial sanctions and imprisonment. What’s okay and what’s not?

 

One important key is to consider what effect the cooperation or collaboration has. It will probably pass muster if it:

 

1)     Lowers prices of the end products

2)     Improves quality

3)     Brings products to market more quickly

4)     Increases quantity and variety of available product

 

Thus, collaboration on research and development is often smiled upon, particularly if three or more other players in the market (in addition to those working together) are also conducting research in the field in question.

 

On the other hand, agreements that are certain to be found wanting, or in some cases likely to be found wanting, include those that:

 

1)     Fix or increase prices

2)     Reduce available product on the market

3)     Limit independent decision making by the parties

4)     Combine control of or financial interest in production or key assets

5)     Implement agreements regarding price, output, or other competitively sensitive variables

6)     Reduce the parties’ incentive or ability to compete independently

7)     Results in exclusivity

8)     Results in consolidation of control over assets

9)     Have a longer duration than is reasonably necessary to accomplish a legitimate goal.

10) Block new participants from entering the field

 

As is true with most business law issues, each situation is a little different. Also, in the case of a few industries, the laws may be applied in unique ways. (For example, steamship lines are permitted to set prices among themselves under certain conditions.) If you are unsure about a collaborative effort that you and a friendly competitor are contemplating, check with your attorney.

 

Copyright violations - Is your sales and marketing department putting your company at risk?

 

Most business owners are aware of the need to make sure the company sales people do not put the company at risk by promising a product or service that the company cannot deliver, or offering a price the company cannot honor. Most managers are aware that overly enthusiastic sales people will sometimes edge into consumer fraud, often unintentionally, in order to get the sales figures up. This can be controlled with properly structured incentives and disincentives, education, clearly defined policies, and where possible, thoughtfully prepared sales materials.

 

However, there are other areas where the well intentioned but over zealous sales person or marketing department member can lead the company into trouble.

 

One pitfall that well meaning sales people may stumble into is copyright violation. Information based marketing is a recognized strategy in some fields (law practice is a good example) and is widely used. Many companies write newsletters for their clients or customers. Blogging is another expression of this marketing technique.

 

The problem arises when copyrighted content is forwarded without permission of the copyright holder. In the past, this often took the form of photocopying a magazine article. Now, many businesses receive industry periodicals in electronic form, and some sales people have been tempted to simply forward these industry journals to interested customers by email.

 

In the past, few publishers went to the expense or trouble to try to catch copyright violators who photocopied the odd magazine article, and this lack of enforcement has left many with the impression that duplication of published material in this situation is acceptable. However, with the transition to electronic media, it is becoming easier to detect violators. At the same time, it is becoming easier for violators to distribute protected material more broadly, also increasing the chance of detection. Publishers and other owners of copyrighted content are now taking steps to enforce their rights, to the dismay of some business owners.

 

The penalty for those caught infringing can be substantial. Under Federal law, 17 USC 504, penalties may be based on actual damages, but may also be based on statutory damages of between $750 and $30,000 per copyrighted work. In the case of willful infringement, the damages may be as high as $150,000 per work infringed. (“Willful” means voluntarily and intentionally, not necessarily maliciously; if I know the work was copyrighted, but duplicated and forwarded it anyway, that’s willful.)

 

Unfortunately, it is no defense that infringement might have been the work of an employee without the knowledge (and certainly without the blessing) of management. Employers are vicariously liable for the acts of employees committed while furthering the employer’s business.

 

“Fair use”, the battle cry of many infringing educators, is a limited defense that applies only to use of copyrighted material for educational purposes on short notice, and to use of short quotations in reviews and critical writing. It would almost never apply in the business context.

 

Employers can take several steps to protect themselves:

 

1)     Educate employees as to the law regarding copyright protection. Make sure they understand that while the customers may indeed find the protected information helpful, if it’s copyrighted, it can’t be forwarded without the copyright holder’s permission.

2)     Employees should also understand that employers are liable as to the copyright owners, but can attempt to recover from their employees, and therefore employees should be aware that they will also be held liable for these stiff penalties.

3)     Copyrights protect “any tangible medium of expression” or “original work of authorship”. They do not protect ideas or facts. If the information is particularly helpful in a given article, the company might be wise to write its own article on the topic, using the protected article as a research source. These articles authored by or for the business can then be freely distributed by the sales staff, through newsletters, or on company websites.

4)     In some cases, the copyright owner may be willing to permit distribution of the article, particularly if there is a commercial benefit, such as increased exposure in a new market, available to the copyright owner. If that might be the case, it never hurts to ask permission.

 

No business is too small to produce its own information based sales material (this website is produced by a law firm with one practitioner), and such material is a good hedge against the temptation to forward protected material.

Recycling contracts

 

Okay, we know most business people do it. I did it all the time when I was in business. We attorneys recommend against it, but we know that the advice is not heard. We know that many entrepreneurs take a contract written for one purpose, and amend it for use in a related purpose. A contract for leasing commercial space is amended to accommodate a sublet. A sales rep agreement for one product becomes the sales rep agreement for another product in a different area.

 

No two situations are exactly the same, and so, in theory, each situation requires a new contract. However, the more closely two situations resemble each other, the less likely there will be a problem from a borrowed contract. Car rental agencies would go out of business if a new contract had to be drafted for each customer. Employers might be flirting with employment discrimination laws if similarly situated employees do not sign identical or nearly identical employment agreements.

 

The purpose of this week’s tip, therefore, is to encourage business owners to think of contracts as being something like computer software. Certain fields (names of parties or agreed price, for example), are meant to be changed. Other fields may not look like they are contributing anything to the application, but should not be deleted! Non-techies who play with computer code get programs that crash. The following are some clauses that should not be deleted, no matter how earnest one’s desire to save trees.

 

Acceleration clause – “If you breach this contract, you owe me everything right now.” If there is no acceleration clause, the breaching party may try to wait until the other party files suit, then bring the contract current. As the breaching party has cured the default, the suit must be dropped. If an agreement requires regular, periodic payments, the acceleration clause is a must.

 

Severability – “If one part of this contract is found to be illegal, the rest is still good.” Attorneys make mistakes (oh, yes!) as do non-attorneys who tinker with contracts. Laws also get changed. A severability clause will keep the whole contract from being void if one part must be voided.

 

Integration clause – “Everything we have agreed to is right here.” This prevents parties from bringing evidence of other (conflicting) agreements.

 

Merger clause – “This agreement overrides anything we agreed to before.” This is closely related to the integration clause, and prevents parties from introducing prior communications or agreements to trump this agreement. Something offered in negotiations may be off the table by the time the final agreement is signed.

 

Force majeure – “Here are the special arrangements that will apply when the sky falls.” In the event of war, riots, natural disasters and other calamities, the parties may not be able to perform what was agreed to in the contract. This clause outlines special arrangements that apply when these woes, severe and beyond the control of either party, befall one or both of them.

 

Venue and choice of law – “If we cannot agree, we settle it in [jurisdiction] under [jurisdiction’s] laws.” This is particularly important for those who do business across state lines, such as vendors who sell on the internet. If the seller’s contract with her customers does not contain a venue and choice of law clause, the seller can possibly be haled into court in any state where she ships her goods.

 

Time is of the essence – “The time requirements stated here prevail, not the statutory ones.” Statutory deadlines are often quite relaxed, allowing “reasonable time”. Courts might interpret this as (for example) a month or two for a party to perform an obligation (such as making a down payment) that the other party might desire to be done within a day or two.

 

Attorney’s fees – Many contracts include provisions that if one party breaches and is found to be in breach by the court, that party must pay the non-breaching party’s court costs and attorneys’ fees. Enforcing a contract in court is not cheap. If the loss to the non-breaching party is “only” $5000, the breaching party may calculate that her opponent will not spend $8,000 or more in legal expense to extract $5000. The worst that can happen is that the party holding the bag will take the matter to small claims court for the maximum $4000, and the chiseling party will still get a $1000 discount. In contract disputes, if this clause is not there, each party pays his own way, no matter who is at fault.

Do I Need a Partnership Agreement?

 

The first question to ask is whether you in fact already have a partnership, and whether that is the right entity for your company.

 

If two or more are working together for profit as co-owners of an enterprise, and if there is no formal entity in place (such as a corporation or an LLC), these owners have a partnership. In deciding whether a partnership is in place, courts will consider whether both profits and losses will be shared, whether there is a shared right to control the business, and whether there is co-ownership of property. Additionally, if the owners attempt to create a formal entity but fail (for example, articles of incorporation are prepared but not properly filed with the Secretary of State), a partnership is created by default. Finally, even if a more structured entity is successfully created, the company will be deemed a partnership during the period prior to date of formation.

 

Partnerships have disadvantages not shared by corporations and LLCs. The most well known drawback is that liability for the partnership’s activities passes through to the owners. This means that if the partnership cannot pay its debts and meet its contractual obligations, the partners will be personally liable. It also means that each partner is personally liable for any harm done to third parties (tort liability), which can include, for example, injury from defective products, unauthorized use of intellectual property, defamation (as with thoughtlessly written advertising copy) or a traffic accident that an employee or another partner may have while on company business. Additionally, choosing partnership as your company’s entity also has tax implications beyond the scope of this article. If you decide to form a partnership, consult your CPA about what these implications might be in your case.

 

Assuming you have formed a partnership, whether intentionally, or inadvertently, the State of Washington has default rules under RCW 25.05 which will apply to your partnership if there is no agreement. Some of the rules which apply are as follows:

 

1)     All partners have equal rights to share profit and to make decisions for the partnership, regardless of percentage of capital contributed.

2)     Matters of ordinary business are decided by a majority of the partners

3)     Partners do not have any right to be compensated for time spent at the business, except in the course of dissolution.

4)     If one partner decides to leave the partnership, the partnership must dissolve (subject to certain exceptions). RCW 25.05.300

 

All partners owe one another and the partnership a fiduciary duty of loyalty and care. (A duty of loyalty means that the partner cannot self deal and cannot personally take advantage of opportunities that would be suitable for the company. A duty of care means that the partner is obligated to work diligently and use her best judgment in pursuit of partnership interests.) These duties may not be contracted away.

 

All other default terms of partnership may be changed in the partnership agreement. One size very seldom fits all, and most business partners have their own preferences about how profits should be split, who should make what decisions, and under what terms a partner may leave the organization. If you have a partnership, and you are not willing to accept the short sleeves and baggy waist of the state’s off-the-rack partnership agreement, your partnership should arrange to have a professionally prepared agreement tailored to the needs of your firm’s partners.

Who Needs a Buy-Sell Agreement?

 

Unless your business is a sole proprietorship (a flawed entity choice 99.9% of the time, but that’s for another article), an LLC with one member or a corporation with one stockholder, a buy-sell agreement is strongly recommended. (This is sometimes also included in the shareholders’ agreement, in the case of a corporation, or the operating agreement, in the case of an LLC). The agreement defines the value of the owners’ equity interests and spells out the triggers and the mechanisms for an owner to sell his interest. The best time to draw up the buy-sell agreement is at the time the company is formed or when the second owner acquires an interest. Too often, at times like these, owners are too giddy with the prospects of the successful business they plan to run together to think about the day when one of them will leave.

 

Yet, buy sell agreements are critical. First, they provide for what happens if the collaboration between the owners fails. Partnerships, whether true partnerships or shared ownership of a closely held corporation or an LLC, are often harder to keep running smoothly than marriages. When both owners are risking their livelihoods on the business, and find they cannot agree on decisions as to when to take risks or how to handle other financial decisions, it is often best that one owner leave. A buy-sell agreement provides a mechanism for that event with a minimum of damage to the business and help limit antagonism between the owners.

 

However, the prospect of a breakup is only a small part of why a buy-sell is needed. Planning should also take into account the “three big ‘D’s”; death, disability and divorce. If one owner dies, her interest passes with her estate. Owners should decide in advance whether the business will be best served if one of the owner’s heirs steps into her shoes and if not, how the other owner(s) will buy out her interest. If one of the owners becomes disabled and can no longer participate in the business, it is reasonable that he (or his guardian or the holder of his durable power of attorney) will want to sell his interest. If an owner divorces, in Washington (a community property state), it is possible that the owner’s spouse will own an interest in the business after the divorce. This is not desirable when the divorce has been less than amicable. If one of the owners files bankruptcy personally, her interest in the company will become part of the bankruptcy estate, and subject to decisions of the trustee. Finally, life is about change, and one of the owners may simply want to move on.

 

“Canned” buy-sell agreements are not likely to be a good fit. Each company is a little different. A company owned 60% by one owner and 20% each by two others will need a different agreement from one owned equally by three owners. A professional corporation of doctors in practice together should not try to work with an agreement drawn up for a company that manufactures high tech machinery. Different mechanisms will also be appropriate depending upon the reason for leaving. The heirs of an owner who has died may need to be able to receive the value of his interest quickly. An owner who leaves to move on to other endeavors might reasonably be asked to wait a little longer for payment.

 

A good buy-sell agreement should address:

 

1)     What triggers a buy-out?

2)     Who is allowed to purchase the interest?

3)     How is the purchaser to be found? (It is often not a wise idea to leave responsibility for this to the departing owner.)

4)     How is value to be determined?

5)     Where will money come from to accomplish the buy-out?

6)     What are the tax implications of the choices?

7)     Under what schedule must payment be made?

 

It is a good idea to have an attorney draw up, or at least review, your buy-sell agreement. Ideas that sound clever may have hidden pitfalls. An example is the “showdown clause”, a business variation of the method many mothers use to encourage fair sharing (“you cut the cake and let your brother choose a piece first”).  One owner names the price and the other owner decides whether to buy or sell. In practice, unless all owners are similarly situated in ownership and in life, this is a mechanism to allow the financially stronger owner to oust the weaker one.

 

 

Is it a business or is it a hobby?

 

The federal government has authority to tax income “from whatever source derived”. This means that if you earn money from your hobby, that income is taxable, though you may deduct your expenses related to that hobby, up to the amount of the income for the hobby. If you have income from your business, that is also taxable, but you can deduct all business expenses, even if in excess of your income from that business. (A discussion of what constitutes a business expense will be saved for a later time.) So, one important purpose of determining whether your activity is a business or a hobby is determining how much of your expenses are deductible, if you operated at a loss. If you paint portraits and sell them, is that a business or a hobby? If you design web pages in the evening, is that a business or a hobby?

 

In determining what kind of enterprise you are conducting, the IRS will decide whether you carried on your activity to make a profit. The IRS will consider the following factors as a whole. No one factor is decisive.

 

1)     Did you carry on the activity in a business-like manner?

2)     Does the time and effort you put into the activity indicate you intend to make it profitable?

3)     Do you depend on income from the activity for your livelihood?

4)     Are your losses due to circumstances beyond your control (or are they normal in the start-up phase of your type of business)?

5)     Have you changed your methods of operation in an attempt to improve profitability?

6)     Do you, or your advisors, have the knowledge needed to carry on the activity as a successful business?

7)     Were you successful in making a profit in similar activities in the past?

8)     Does the activity make a profit in some years, and if so, how much?

9)     Can you expect to make a future profit from the appreciation of the assets used in the activity?

 

In Commissioner v. Groetzinger (1987), the court ruled that because a professional (but inept) gambler had devoted his full time to his gambling, and intended to make a living thereby, his impressive losses were deductible. (Before anyone rushes to the closest casino, Congress has since passed a law specifically overruling this case as to gambling losses, which may no longer be deducted under the business expense rules.) The point, however, is that even if a business is losing money, it still may be found to be a business, and not a hobby.

 

If the company makes a profit for three out of five years (if the business is raising and training race horses, the guideline is two out of seven years), there is a presumption that the business is operated for profit, and the IRS will normally not go on to apply the questions listed above. If your business is operating at a loss, but you would like to preserve the presumption (have it considered later, within the five year period), consider filing a Form 5213.

 

The IRS code is complex, and tax law often forms a trap for the unwary. The guidance in this article will get you started, but it is a good idea always to review your particular situation with your CPA or other tax professional.

 

 

Running your business from home

 

Working from a home office, once the choice of freelance writers and startups in their first six months of life, has now become a widely accepted practice in a number of fields. Advances in technology make it possible for one person to do more, and for employees, if any are needed, to work off premises. Many successful and highly competent solo attorneys work from home offices, favoring the cost savings, greater flexibility in work hours, short commute, and ability to be accessible to their families.

 

Yet, the home office is not right for everyone, and even owners of startup businesses should consider carefully before opting for the home office. There are legal considerations as well as practice and financial ones.

 

Here are eight questions to ask yourself before choosing to locate your business in your home.

 

1)     How will customers perceive my home office arrangement? – For some businesses, customers will never know where your office is located and will not care. For some businesses, customers will not be troubled by a home office. In some industries, however, customers (rightly or wrongly) will interpret placement of your business at home as lack of commitment to professionalism.

2)     Assuming customers or clients are comfortable with my home office, will I be comfortable with customers coming to my home? – Feelings about this vary, but consider whether you would ever object to your customers knowing where you live.

3)     Will I be able to work effectively at home? – Sometimes family can be a big distraction, even if a pleasant one. Sometimes proximity to the refrigerator throughout the day can be troublesome, too.

4)     Are there zoning restrictions? – Many if not most residences are, predictably, in areas zoned for residences, not business. Check with your city government to see if restrictions apply, if they can be waived and if so, under what conditions. Often, businesses will be allowed in a residential area if customer traffic is below a certain level, signage is limited or not used, and the neighbors’ quiet enjoyment of their property is not disturbed in any other way.

5)     Will my home meet licensing requirements that apply to my line of work? – A caterer, to choose an obvious example, might be able to do paperwork and planning at home, but would probably need to rent commercial kitchen space elsewhere in order to meet food handling license requirements.

6)     Will this affect my homeowner’s insurance? – If customers are visiting your home, or if you are handling materials or machinery not normally found in a home, your insurance carrier may want to increase your premium or make other changes.

7)     If I am planning to take a tax deduction for the space used, do I have appropriate space? – Many feel that taking a deduction for a home office invites an audit. True or not, you must be scrupulous in observing the IRS rules. See the link at the end of this tip for more details.

8)     If my business grows as anticipated, will I be able to remain at home and if not, how costly will relocation be? – Costs to relocate a business vary, but relocation always places a time burden on the owner, and a successful business owner’s time is worth money.

 

If you choose to work from home, remember also that you will still generally need the same business licenses that would apply if you worked from a commercial location.

IRS guidelines for home offices

The business of the law is to make sense of the confusion of what we call human life - to reduce it to order but at the same time to give it possibility, scope, even dignity.
 
Archibald MacLeish

Serving the needs of families and small business