13 Costly Misconceptions That Could Destroy Your Business

13 Costly Misconceptions That Could Destroy Your Business

by Richard Fonfrias,

J.D. Chicago’s Financial Rescue &

Bankruptcy Lawyer

Fonfrias Law Group, LLC

MISCONCEPTION #1:  I don’t need to be a corporation or an LLC.  They are too expensive.

 Wrong!  Business owners often feel that the formal structure of an LLC or a corporation is only for large businesses.  But, to the contrary, one of an LLC’s or a corporation’s most important benefits is the way it protects its owner from personal liability.

 Let’s say, for example, that your delivery man has a wreck and kills someone.  Unless you have an LLC or a corporation to protect you from liability, you and your family are personally responsible to pay damages to that man’s surviving spouse and/or relatives.  That could amount to hundreds of thousands of dollars — perhaps, even millions.  Scary, isn’t it!

 I call a corporation or an LLC “very cheap insurance” with a single premium.  Why?  Because either insulates you from personal liability for the debts, liabilities and obligations of the business.  Your single premium is the one-time investment in legal fees needed to organize the corporation.

 After you set it up, so long as you use your corporation properly, you enjoy limited liability.  This means that, beyond your investment in the corporation, your personal assets are not exposed to the liabilities that will arise in the business.

 RECOMMENDATION:  Talk with an experienced business lawyer about the importance of using a corporation or an LLC to protect yourself and your family from liability.

MISCONCEPTION #2:  If I set up a corporation, my taxes will increase.

 Not necessarily.  A corporation is a separate legal entity that is subject to federal and state taxes on its net income.  The tax rates on corporate income are higher than the rates paid by individuals.  However, conducting your business as a corporation does not necessarily mean that your company will pay higher income taxes.

 Often, careful tax planning from year to year can dramatically reduce or eliminate net income.  Many small businesses pay bonuses to their owners so the corporation has no income.  These bonuses must be reasonable compensation to the owners for their services.  And, it is important to be sure that the bonus is not veiled dividends since dividends are not deductible from the corporate income.

 A technique used by smaller corporations is to choose a Subchapter S election under the tax code.  When implemented properly, the Subchapter S status allows all corporate income and losses to pass through to the shareholders.  They, in turn, report the income or loss on their personal tax returns.

 Since many small businesses operate at a loss for tax purposes, especially in the early years, the Subchapter S election can actually save taxes for the owners.  These tax considerations present other planning opportunities to the business owner, as well.

 RECOMMENDATION:  Talk with an experienced business lawyer who can help you with tax planning so you use a corporation to your advantage and minimize your tax liability.

 MISCONCEPTION #3:  I own 50% of my company’s stock so I am protected because I’m in control.

 Wrong!  When two people decide to organize a business — whether as a corporation, LLC or partnership — they often share ownership equally.  But, that 50% ownership is not control.  Fifth percent is not a majority and, as a business owner, you can come face to face with many problems that confront a business and its owners when no one has clear control.  50/50 ownership is nothing more than a built-in deadlock.  Ultimately, a deadlock can result in the forced sale of your business under court order.

 You can avoid this business stalemate in many ways.  The simplest method is to reserve to one owner more than 50% of the ownership or voting power in business decisions.  Other methods include giving a third party a small vote to break any deadlocks, agreeing that a greater than majority vote, such as two-thirds or three-fourths, is necessary for certain decisions and special buy-sell provisions.

 RECOMMENDATION:  Talk with an experienced business lawyer about voting rights and potential deadlocks.  This will help assure the long-term success of your business.

 MISCONCEPTION #4:  If I treat my employees as independent contractors, I can avoid the hassles of payroll taxes.

 Not a chance!  One common cause of business failure is the failure to pay federal withholding taxes.  No question, payroll tax reporting is a major headache.  And, the hassles associated with the paperwork are made worse by the added expense associated with the employer’s contribution for FICA (social security) and Medicare, on top of the actual compensation paid to employees.

 Many employers believe they can simply treat employees as independent contractors and avoid the requirements of withholding and the employer’s payroll tax.  Some employers even require employees to sign an independent contractor agreement.

 These misconceptions have led to many business failures.  What’s more, even if the business is incorporated, business owners are slapped with the personal liability of paying the payroll taxes that should have been withheld.  Plus, the Internal Revenue Service assesses the added employer’s share of taxes, interest and penalties.

 The crux of the matter is this:  The employer/employee relationship is controlled by its substance, not its form.  You cannot change an employer/employee relationship to an independent contractor relationship merely by calling the employee an independent contractor.

 Some state laws and tax laws are involved in determining the nature of the relationship.  But the primary test involves determining whether the employer has the right to control the time, method and manner of the employee’s performance of his or her duties.  If so, the employer has the obligation to withhold income taxes and pay them to the I.R.S.

 Since most employers want to control the people employed in their business, the vast majority of working relationships are, in fact, employer/employee relationships.  Unfortunately, in many cases, the determination of the relationship is delayed and the business or its owners are slapped with taxes, interest and penalties in future years.

 RECOMMENDATION:  Don’t try to handle this matter on your own.  The consequences can be serious, to the point of shutting down your business.  Make sure you get help from a qualified business lawyer so you protect yourself from this delayed — and severe — tax liability.

 MISCONCEPTION #5:  If my partner or employee quits, he can’t take my business with him.

 Wrong again!  Your business depends upon its relationships with your customers or clients.  Except in the case of a sole proprietorship, these relationships are nurtured by each person associated with the business.  And the people serving the client are working on behalf of the business. 

 Even though these contacts, contracts and relationships are the property of the business, a departing employee or partner is free to compete with you.

 We work in a free enterprise economy that encourages competition.  This allows some of your employees to start working for your competitors — or begin a new business of their own — expecting to solicit business from your clients and customers.

 Here’s something many business owners don’t know:  The law permits you to place reasonable limitations on partners and employees in their contracts so they cannot unfairly compete against you if they leave your company. 

 RECOMMENDATION:  Talk with an experienced business lawyer so you can protect yourself from ex-employees and ex-partners who can leave your company and take your customers with them.

 MISCONCEPTION #6:  I don’t have to keep records because I’m just a small business.

 Wrong!  Few things are more important to a small business — whether an LLC, a sole proprietorship, partnership or corporation — than keeping proper records.  All of the ideas in this Survival Guide will, at one time or another, require business records for substantiation and proof.  In the case of a corporation, if you hope to preserve your limited liability, you must keep proper records that prove that you conducted business as a corporation.

 Many business agreements are based only on a phone call or handshake.  Unfortunately, because memories are not perfect, in the event of a dispute, the parties’ recollections of the terms is always different.  That’s why putting all agreements in writing is vital to your success.

 Another reason for accurate record keeping arises from the unpleasant prospect of a tax audit.  When the IRS comes knocking, one of the first things the agent asks for is a copy of your business and, if you are a corporation, your corporate records, including a corporate minute book.  In most cases, records of corporate meetings are required to assure that the corporate form will be recognized for business and tax purposes.

 RECOMMENDATION:  Talk with an experienced business lawyer so you don’t risk losing the liability protection afforded by your corporation.

 MISCONCEPTION #7:  I’m the business owner so I can pay my business and personal bills from the same checking account.

 You’d better not!  Business owners often treat their corporate bank account as their personal checking account.  But if you hope to prevent problems, don’t fall into this trap. 

 First, you face the basic tax problems.  Every time you pay a personal expense from your corporate account the payment is considered either your salary or dividend.  Rest assured, the IRS will treat the payment as a nondeductible dividend, thus increasing the taxes your corporation must pay.  On the other hand, if the payment is treated as compensation, the corporation is liable for withholding and payroll taxes.

 Next, you may lose your personal liability protection.  If claims are made against the business, your commingling of personal and business funds often results in losing the liability protection afforded by the corporation.  In other words, when you commingle personal and business assets, creditors may be able to ignore the corporate structure and assess liability claims directly against you and your spouse.

 RECOMMENDATION:  Talk with an experienced business lawyer so you handle your personal and business assets properly and don’t risk losing your corporate protection.

 MISCONCEPTION #8:  I can do anything I want with my business and the minority shareholders or partners (those who own less than 50%) can’t do anything about it.

 No way!  The fact that you own over 50% of the stock in your company does not give you the right to run roughshod or take unfair advantage of the minority owners.

 You must understand that minority partners or shareholders are entitled to information about the business’s operation, finances and taxes.  Minority owners are entitled to attend and vote their shares at shareholders meetings, which must be held at least annually.  Then, if a shareholder disagrees with major business decisions, such as the sale of substantially all of the corporation’s assets, minority shareholders have the right to dissent.  They can then demand payment for the fair value of their shares.  And, this may all apply to LLCs, too.

 RECOMMENDATION:  Talk with an experienced business lawyer so you keep minority partners informed about the business and avoid unpleasant legal consequences.

 MISCONCEPTION #9:  I don’t need employment contracts for my people.

 Not true!  Even if you have nothing formal in writing, you already have an employment contract with each employee.  This is because verbal agreements of employment create an employment “at will”, which can be terminated by either party with or without good cause.  Without a written contract, you have none of the protections from unfair competition discussed in this guide.  You have nothing to rely on in a dispute over compensation or bonus or vacation time.

 Don’t you think you would be wise to enter into a written employment contract, rather than leaving your business unprotected?

 Certainly, this is true with any contract or business relationship, but even more so when it involves employment.

 Your written contract should include the basics of compensation, duties and service hours.  In addition, a properly drawn agreement can go beyond these basics to include protections for business trade secrets and prohibitions against unfair competition.  I cannot overstate the importance of these agreements in resolving future misunderstandings and disputes.

 RECOMMENDATION:  Talk with an experienced business lawyer who can discuss how you can protect yourself from liability exposure by having contracts with your employees.

 MISCONCEPTION #10:  My partner and I don’t need a written partnership agreement.

 Wrong!  My comments about employment contracts are even more important to people in business together no matter what the business form.  The basic agreement should address the issues of compensation, division of profits, allocation of duties and responsibilities, and control.

In addition, the agreement should also deal with sensitive issues, such as an owner’s withdrawal from the business and what happens in the event of an owner’s death.  Not many owners want to be forced to continue the business with the spouse of a deceased owner.  Nor would they want to be forced to dissolve the business.

 A properly written ownership agreement should deal with all of these issues, and more.  And, you need one whether you are an LLC, a corporation or a partnership.

 IMPORTANT NOTE:  If you do not have a written agreement, the law will apply certain rules to your relationship.  Unfortunately, in most cases, these rules do not reflect the true understanding between the owners.  It’s better to have the agreement you want than to have your business run by the laws of the state.

 RECOMMENDATION:  Talk with an experienced business lawyer and learn how a comprehensive agreement can protect you and your family from unforeseen consequences in your business.

 MISCONCEPTION #11:  Non-compete clauses in contracts are not worth the paper they are written on.

 Not true.  Earlier I discussed the fundamental concept of our free enterprise economy.  But free enterprise and competition are not the same as unfair competition.

 When you share with an employee your trade secrets, business processes, or customer lists, you have the right to protect yourself.  Further, under current law, you are allowed to limit an employee’s future use of this information, as long as your limitations are reasonable.

 You can use a written agreement to limit an employee’s ability to solicit a customer’s business for himself or future employers.  These agreements can limit solicitation only within a specific territory for a certain period of time. 

 When the agreements are carefully drawn, the courts will enforce them.

 RECOMMENDATION:  Talk with an experienced business lawyer and discover how you can use non-compete clauses so you don’t lose your customers, customer lists and trade secrets.

 MISCONCEPTION #12:  If my business is a corporation or an LLC, I won’t ever have personal liability.

 Wrong!  You can never get rid of your personal liability.  If you perform a service and things aren’t right, you’re still liable.  If you hire an employee to be your delivery person and they have a serious accident and you knew he/she has a drinking problem, you can be held liable.

 RECOMMENDATION:  Talk with an experienced business lawyer and discover what you can do to protect yourself in such a situation.

 MISCONCEPTION #13:  I don’t need a lawyer.  I can get my legal forms at an office supply store.

 You probably suspect this already.  The basic forms you get at office supply stores — such as contracts, leases and deeds — are generic.  They are not geared to your specific needs.  When you go to the office supply store, you find that the legal documents are worth exactly what you pay for them — almost nothing.  Sadly, you often get much more than you pay for in the way of problems, headaches and hassles because generic forms often cause more trouble than they prevent.

 Business owners often ask me when they should seek the help of a lawyer.  My answer is, “Whenever you cannot afford to lose the amount of money at risk — and whenever you are absolutely sure you are not exposing yourself to additional legal liability.”

 If you can afford to lose the money — and if you don’t accept any added risk — then you probably don’t need to see a lawyer.  But if you’re concerned about the legal consequences of a contract or another legal document, calling an experienced business lawyer could be the best investment you’ll ever make.

 If you make a bad decision that allows an ex-employee to steal your customers —

 If you make a bad decision that allows IRS to slap you with tens of thousands of dollars in additional taxes —

 If you make a bad decision that allows creditors to invalidate your corporation and hold your personally liable —

 …you’ll wish you had called your lawyer BEFORE making that decision.

 RECOMMENDATION:  Do yourself and your family a favor.  Whenever you have a question or concern about your liability, don’t hesitate to call your lawyer.  Without exaggeration, it could be the best business decision you’ll ever make.