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Chapter Seventeen
Legal Issues: Recognizing
Your Small Business Needs
Copyright 2021 © McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.

2. © McGraw-Hill Education 2
You and the Law
It is important for a small business owner to understand the legal system
as the U.S. is a litigious society.
It is easy to underestimate the number of laws
that apply to your small business.
• There are federal, state, and even county and
city laws that may apply.
• There are several business and taxation, as
well as environmental/health and safety laws.
• This may seem overwhelming but not all laws
will apply when you start your company.
State laws are
extraordinarily
varied.
One state’s laws
are unlikely to be of
much use
anywhere else.
There are sources
for finding state law.

3. © McGraw-Hill Education 3
You Need a Good Attorney
Think of legal knowledge as insurance – the key is the right lawyer.
• Look for an attorney experienced with small businesses.
• Ask fellow business owners and bankers for recommendations.
• A less certain way of finding a good lawyer is online, but there are
some reputable sites.
• You may need more than one attorney, and their specialty.
• Ongoing relationships allow them to provide immediate advice.
Attorneys typically charge in one of four ways.
• An hourly fee.
• A flat fee.
• Available on a retainer.
• Contingency fees are typical in personal injury situations.

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Can I Do This for Free?
There are three elements to most aspects of business law – finding the
right information, negotiating the outcome you want, and filing the
associated paperwork – things you pay an attorney to do.
There are two basic categories of legal
information available to owners – free or paid.
• If paying, just hire an attorney.
• Falling between free and paid are the do-it-
yourself products.
• Of the free information, some is more reliable
than others.
• Government sites are reliable.
• Trade associations are another source.
Be wary of legal
information offered
by individuals who
seek to profit from
doing business
with you.
When in doubt, call
your lawyer.

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Small-Claims Court
This is a legal option that does not involve an attorney.
• Evidence helps.
• Have everything ready and with you when you go to court.
• Practice your explanation and be on time.
• Stay calm, and above all, stay respectful to the judge and court.
This works only when you are owed money, can prove it, and have
exhausted other procedures.
• Next, you have to find the right court, contact them for costs and fees.
When in court, be confident and answer directly, briefly, and politely.
• If you win, the court gives you official support to get your money.

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Choosing a Business Name
The legal issue is protecting your business name or idea from copycats.
An intellectual property issue – there are ways to protect your business.
• The name of your business is its trade name, assumed name, or a
doing business as (dba) name.
• Your trade name must be registered in the states you do business
using an assumed name filing or a fictitious name filing.
• There may be more than one business using the same name within a
state – Courtesy Cleaners, Courtesy Pharmacy, etc.
• Choose a name that is memorable and descriptive and meets your
goals as a business owner.

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Choosing a Business Form
Except for sole proprietorships, business forms are a legal entity.
• Originated from English law which holds an individual may own
property and be a plaintiff or a defendant in a lawsuit.
Today, there are seven general types of business form.
• Sole proprietorships, general partnerships and limited partnerships.
• C corporations, S corporations and professional corporations.
• Limited liability companies, or LLCs.
Each has its own advantages and disadvantages.
• If you have partners, in any form, create articles of organization.
• For all forms, other than sole proprietorship, beware of piercing the
veil and remember no form of business ownership protects you fully.

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Sole Proprietorship
• Unlimited personal liability.
• Single taxation of income.
• Proprietor has control.
• The company ends with the
death of the proprietor.
• Raising capital is dependent on
assets and credit of owner.
• No government permission is
required.
• Few, if any, legal costs.
• A major advantage is ease of set
up.
• The major disadvantage is the
owner’s personally responsibility.
• The owner’s home, stocks,
savings, and personal property
could be used to pay damages.

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Partnerships
In a general partnership, partners
are equally responsible.
• A limited partnership means
partners are liable only for the
amount they invested.
• Every limited partnership has at
least one general partner.
Both forms offer single taxation.
• Authority is shared equally in a
general partnership.
• Authority is set forth in the
articles for a limited partnership.
For both, if partners change, the
partnership is dissolved.
Raising capital is dependent on
partner contributions, and credit of
the partnership and partners.
• General partnerships form with
no government permission.
• Limited partnerships have to
meet state requirements.
Partnerships vary dramatically.
• They can be set up quickly.
• A formal legal agreement,
called articles of partnership
is recommended.

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Corporation, S Corporation, Professional Corporation
Shareholders are not responsible
for debts of any corporation.
• Double taxation of earnings is
generated in a corporation.
• An S corporation’s earnings are
passed through to owners.
• In a PC, earnings are taxed at
an individual rate.
• The board of directors has
control in all corporations.
• The corporation as an entity in
any form can exist indefinitely.
• Raising capital includes issuing
stocks and bonds, or loans for
corporations and S corporations.
• A PC may issue stock though
ownership may be limited.
• All forms of corporations are
created by the state.

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Limited Liability Company, LLC.
LLC members are not responsible
for debts.
• There is check the box
taxation.
• Members enter into an
operating agreement to
determine control.
• Depending on the state, an
LLC may exist indefinitely.
• Raising capital comes from the
members, or a loan.
• Some states allow a single
person to form an LLC.
There are six major factors at play
in the decision to form any type of
business organization.
• Personal liability of the owner.
• Taxation.
• Complexity and costs.
• Control of the business.
• Continuity of the business.
• Ability to raise capital.

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Taxation Issues
The legal form of organization you choose can impact the taxes you pay.
• For every legal form except the C corporation and the LLC, the taxes
are paid by the owner on the basis of income received.
• For C corporations and PCs, you are taxed on shareholder income.
• Though individual tax rates are lower, this is double taxation.
• For other forms, except the LLC, money you take out is taxed at your
individual rate.
• In a C corporation and S corporation, the IRS expects you to pay
yourself a salary at market rates.
• An LLC can choose to tax as a corporation, a sole proprietorship, or a
partnership.
You also must pay self-employment tax, estimated tax, Social Security
tax, Medicare tax, and federal unemployment tax.

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Nonprofits and Social Benefit Organizations
Nonprofits that see themselves as charities that raise money and secure
grants to fund themselves, may choose a nonprofit corporation.
• Some states allow nonprofit LLCs.
• File for incorporation in your state, then file federally for 501(c)(3) tax
exemption.
For social ventures – the firm is for-profit but uses some/all profits to fund
social benefits, the legal forms of organization are problematic.
• New legal forms have emerged including low-profit limited liability
companies (L3Cs) and benefit corporations.
• You can also make your intent known through a certification process
available nationwide to become a certified B corp.
These strike a balance between profit and benefit in a transparent way for
investors.

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Everything Is Negotiable, and Negotiation Is Everything
The ideal goal in negotiation is for each side to feel it got what it wanted.
Prepare – what you want to achieve and learn as much as you can about
the other side’s position.
Position – show confidence in yourself and do not lie or mislead.
Propose – solutions that provide value for both sides.
• Seek to create value.
• Seek long-term solutions.
• Seek balance.
• Seek mutual safety.
• Seek outcomes commensurate with investment.
Pounce – when agreement appears at hand, move to close the deal.
Optimal strategy: tit-tit-tat.

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Legal Liabilities
Torts: Your Actions and the Actions of Employees
Torts are civil (not criminal) wrongs that arise when a person’s legal rights
are violated in ways other than a breach of contract.
• An employer can be sued by an injured employee for what is called
vicarious (indirect) liability.
• Possible if the employee was an agent of the business and at the time
of injury doing work for the employer.
Two typical arguments can deflect the liability.
• The actor is not an employee, but an independent contractor.
• The actions were outside the scope of agency/employment.
If you can prove either one, your firm is not likely to be held accountable.

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The Independent Contractor Argument
Sidestepping the problem of agency is one reason businesses use
independent contractors.
• You do not have to pay benefits, another attraction for owners.
According to the IRS, to be an independent contractor the person has to
display three characteristics.
• Behavioral – the contractor decides how the work is to be done.
• Financial – the contractor pays their own expenses.
• Relational – the contractor is employed for a project or a term.
If the IRS classifies the contractor as an employee, the firm becomes
responsible for damages.
• Also for benefits not paid, and for taxes and workers’ compensation.
Training your employees is one way to protect against liability exposure.

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The Scope of Authority Argument
Employees differ in the amount of authority they have to do their jobs.
• If employees make a decision requiring more authority than they
possess, the business can argue it was not liable for the problem.
For this to work, the firm must show it trains or informs employees of the
exact authority they possess.
• It helps to inform employees they may face personal liability for
problems that arise from their exceeding their authority.
• Employee authority level should be conveyed to customers as well.
Management must listen to employees because one rule of agency law is
that notice to an agent can serve as notice to the business itself.
• A customer comes inside a store and informs a clerk that sleet is
making the entry slippery – the store has now been notified.

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SOX and Dealing with Big Businesses
The Sarbanes-Oxley Act (SOX) resulted from Enron and other scandals.
• Its purpose is to make a company’s financial activities more visible to
shareholders, government, and the public.
• SOX requires data preservation and tracking, as well as extensive
financial reporting requirements and external checks on all of these.
• Small business that are not publicly traded are not covered by SOX.
Many large businesses are requiring subcontractors meet SOX standards.
• Big businesses thinking about buying smaller firms look at the SOX
liabilities, so compliance makes a firm more saleable.
• If asked to follow SOX rules, get legal and accounting advice on how to
do it correctly – this is not a do-it-yourself project.

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What Is the Right Level of Paranoia?
Is there any way to avoid being sued or taken to court?
Plan to do good.
• Be honest and open from the start, this means
you have less to hide.
Check with a lawyer early on.
• To lean what issues you have and when you
need to deal with them.
Recognize the predictable surprises of business
and life.
• Thinking ahead gives you a chance to figure a
response and prepare.
Your goal is to think
about liability
ahead of time, take
steps to manage or
prepare for it, and
then stop worrying.

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Litigation versus Arbitration versus Mediation
Litigation uses small-claims court or the regular court to settle differences.
• The only guaranteed winners are the attorneys.
• Good attorneys keep their clients out of court.
• Large companies weather expensive litigation better than small firms.
• Beware any attorney guaranteeing a certain outcome.
Arbitration involves the two sides presenting their case to a private judge.
• Agreement to arbitrate should be written, often included in contracts.
• You may not sue if you agree to arbitration – the decision is binding.
Mediation puts the dispute to a neutral third party who is not a judge.
• This works only if both sides agree to the decision and settlement.
• If mediation fails, arbitration and litigation are still possible.

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Commonsense Ways to Avoid Torts
In addition to the obvious ways of avoiding being sued:
• Making sure your property is hazard-free, not infringing on another’s
trademark, and impressing upon employees the importance of safety.
There is another method that is rarely mentioned – conflict management.
Communication and negotiation are ways of
dealing with conflict rather than suing.
• Lawsuits are often filed out of frustration
and anger.
• They are less likely to sue if they perceive
you to be willing to work out the problem.
• A likeable and genuinely concerned person
can often diffuse an angry reaction.
Try to develop client
loyalty.
Give personal
service.
Listen to your
customers.
Developing such
relationships can
keep you out of court.

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Contracting
Oral agreements are legally binding, but difficult to enforce - put it in
writing.
Have your lawyer take charge in these
instances.
• Standard contracts.
• Specialty contracts.
• Interstate contracts.
• If including a noncompete clause.
• If using exculpatory clauses.
• If including a hold harmless
agreement, also called a waiver.
Three ways to take the fear
out of contracting:
• Include a binding
arbitration clause to
minimize court costs.
• If sued, your liability
insurance may cover
legal fees.
• Consider extra liability
insurance if facing risks.

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Subcontracting and Internet Issues in Contracting
A subcontract may be necessary to fulfill a “larger” contract.
• Small firms may subcontract HR or marketing.
• Generally the same principles apply to regular and subcontracts, but
saying a subcontractor did not perform does not get you off the hook.
In business-to-business (B2B) transactions, contracts may involve EDI.
• There is generally a master contract or umbrella contract stating the
terms, leaving the details to be determined in each transaction.
• These are known as trading partner agreements.
Another internet contract is the business-to-consumer (B2C) contract.
• When selling online, control the process by clearly stating that
information on the site is not an offer.
• E-signatures are more common.
Establish and enforce policies on employee internet and email usage.

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Intellectual Property
Intellectual property (IP) is a type of intangible property – what is being
protected is an idea or a form of expression.
This includes the law
of patents, trade
secrets, copyrights,
and trademarks and
touches on the
creation of a trade
name.
Intellectual property
laws are most active
at the federal level,
though trademarks
and service marks
can be registered with
any state.
State level laws vary
dramatically, so
check what laws
apply, and how they
apply, in your state.

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Patents
• A design patent covers product look and essential parts for 14 years.
• Utility patents cover processes and functions and last 20 years.
• Plant patents last 20 years covering new strains of living matter.
A lawyer (if you choose) does a patent search and renders an opinion of
patentability.
• If favorable, the next step is to quickly file a provisional patent.
Patents are monopolies granting the owners exclusive rights to make,
use, or sell an invention for a certain period of time.
• Once issued, infringers may be sued by the patent holder.
• The U.S. provides a grace period of one year to qualify for protection.
Patentable ideas may be kept as trade secrets if the useful life extends
the period of protection the patent extends.

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Trade Secrets
If not patentable, an invention’s only protection may be as a trade secret.
• A trade secret is information known to certain people in the company
that makes the company more competitive.
• If a competitor would pay for the information, it is a trade secret.
There are five steps in protecting trade secrets.
• Ensure that the trade secrets are really secrets.
• Use warning labels.
• Restrict physical access.
• Get signed confidentiality agreements.
• Keep doing steps 1 through 4.
Wrongful acquisition of a trade secret is a tort and may involve criminal
violations if trespassing or bribery is involved.

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Copyright
Copyright involves the expression of ideas, not the ideas themselves.
• Copyrights for new works last for the creator’s life plus 70 years.
• If a “work for hire,” the copyright lasts for 120 years or 95 years from
publication, whichever is less.
• The government does not create copyrights, but they can be
registered with the federal government.
An issue with self-employed professional web designers and artists is
who owns the work they do for others.
• Unless the contract states otherwise, the creator owns the material.

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Trademarks
A trademark can be of significance as they identify certain goods.
• Some words or groups of words, such as WW® can be both
trademarks and service marks.
• Once established, an owner of the mark can keep others from using a
similar or identical mark to identify similar or identical goods.
• Infringers can be pursued for 10 years and renewing the trademark
can extend it another 10 years.
Check to see what marks are already used before selecting your mark.
• Entrepreneurs do not realize the power of a trademark.
• Where a patent or copyright may not work, a trademark protects you.
• Consult an attorney before incurring the expense of printing labels,
signs, or any type of advertising.

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