Legal myths about small business law abound, ready to confuse, mislead, and even damage you if you rely on them. Like many myths, there is often a grain (or more) of truth to the common bits of not-quite-correct small business law wisdom you encounter. However, being able to differentiate between the falsehoods and the good advice these myths convey isn’t always easy, and may require you to seek advice from an expert.
There are some commonly repeated myths you can use to better understand the legal environment surrounding small businesses today. Here are 10 of them.
1. You Get Tax Breaks as Soon as You Call Yourself a Business
If you have a small business, you can deduct business travel-related expenses, home office expenses, the costs of any goods sold, and much more. Though these tax breaks can be great, they don’t come without strings. You must jump through some specific hoops in order to show you have a legitimate business to receive the tax benefits.
In general, the IRS considers you in business if you engage in any activity with the reasonable expectation of earning a profit. To be able to prove or determine that you are in business and not just pursuing a hobby, there are a handful of factors you must consider.
- Effort: Are you putting a lot of time, effort, and thought into making your business profitable?
- Experience: Do you have a background in, or experience with, the kind of work or products your business focuses on?
- History: Have you made a profit in similar areas or pursuits before?
- Research and Advice: If you don’t know something or need help, do you seek out the advice of those who have experience or expertise?
- Asset Appreciation: Does your business acquire assets that will appreciate in value?
- Income Dependence: If your efforts produce income, are you relying on that income to pay for housing, food, utilities, or similar expenses?
- Startup or Unexpected Losses: If your business is losing money, is it because of the expenses associated with a start-up or economic factors outside of your control?
- Profitable Years: If you’ve been pursuing your business for several years and are not currently profitable, have you been able to show a profit in the past? In general , you’re in business if you can show a profit for three out of the last five tax years, or two of the last seven if you’re involved in breeding, training, or showing race horses.
- Progress: Have you adopted new strategies or business methods to improve your profits or give your pursuit a better chance at making a profit?
You don’t have to meet all these factors in order to qualify as a business, but can use them as a guide. If you cannot show you are operating a business, you won’t be able to use the tax benefits afforded to them by the IRS.
2. You’re Not in Business Until You File Official Documents
The idea of starting a business can bring to mind images of having to file any manner of documentation with official government offices. While local, state, or federal laws may require you to file a variety of documentation, failing to do so doesn’t stop you from going into business or becoming responsible for the actions your business takes.
It’s incredibly simple to start a business. In fact, it’s even possible to do so without realizing it.
Business by Default
You can start a business without filing or registering any documentation with a government agency. While you may need to file a range of documents to comply with any federal, state, or local business or tax laws, you are effectively in business as soon as you conduct business, or take any action you would only take in pursuit of starting a business.
For example, let’s say you make handcrafted greeting cards. You occasionally sell these cards to friends or family members, donate them to local charities, or give them away as holiday gifts. The little money you make is a pleasant bonus, but you don’t rely on it and don’t intend to pursue your hobby as a business.
But let’s say you decide that you want to take your hobby and turn it into something bigger: You want to start your own business selling your cards. You have some basic business cards printed, register a domain name, and set up a business checking account through your bank. Congratulations – even though you’ve not filed a single piece of paper with a government agency, you have now created a business.
Specifically, what you have created is a sole proprietorship. Sole proprietorships are the most common form of business entity. As the name implies, it is a business owned and operated by a single person. A college student who starts a summer business walking dogs or a mom who starts selling handmade goods on Etsy both create sole proprietorships.
Similarly, if you and someone else start your business together, you form a partnership. Again, you don’t have to file any documents, receive any approval, or do anything else other than agree with someone else to go into business for a profit.
Default businesses (sole proprietorships and partnerships) are the easiest to establish but offer the fewest benefits. You are personally responsible for everything. For example, you must keep track of income and pay all appropriate federal and state taxes. If you borrow money for your business, you are personally liable for paying it back. Your creditors can sue you if you default on your business debts, and can take your personal property to satisfy a judgment. If you have employees, you have an obligation to not engage in discriminatory practices, provide safe working environments, and provide appropriate payments.
Permits, Licenses, and Registration
While starting a default business type is simple, there may be steps you have to take to make sure your business complies with any local, state, or federal laws or regulations. You also must file documentation or registration if you want to take advantage of business forms beyond sole proprietorships and partnerships.
For example, you don’t usually have to register your business name with a state entity if your business name includes your personal name (for example, “Marcy Smith Auto Detailing”). On the other hand, if you want to start a business and use a business name that doesn’t include your personal name (for example, “ABC Auto Detailing”), you likely must register your business name with a state government office.
Registering or filing documents is necessary if you want to create a more advanced business structure, such as an LLC or corporation. Also, specific types of businesses may need specific permits or licenses. For example, you’ll need a liquor license if you want to sell alcohol, a local business license if you want to start a brick-and-mortar shop in your town, and a permit from the U.S. Fish and Wildlife Service if you want to import or export animals or animal products.
Failing to file or register your business as the law requires doesn’t mean you’re not in business. Rather, it means you may face negative consequences. At the minimum, failing to register or file does not free you from any tax obligations you have, nor does it free you from potential liability for business debts. For example, you cannot claim that you don’t owe the IRS or your state income taxes on your business because you never registered, not can you avoid being sued for business debts.
What failing to register or file does do is expose you to complications, or prevent you from taking advantage of some benefits. For example, if your city requires businesses to file for a business license every year and you never do, you may not face any negative consequences unless city officials discover you’ve been operating without a license. If the city does find out, you may have to pay a fine for all the years you failed to register. Similarly, if you want to start an LLC and fail to file the appropriate documents, you will not receive the protections an LLC affords, such as not being held personally liable for business debts.
Other issues, such as owning a restaurant that sells alcohol and failing to get a liquor license, could result in significant fines, and even jail time – not to mention, having your business shut down. Determining what, if any, permits and documentation you need isn’t always easy, and may require that you talk to an attorney or accountant in your area.
3. You Must Make Contracts in Writing
A contract is a legally enforceable agreement between two or more people or groups (parties). This means that, if called to, a court can enforce the terms of the agreement should any party fail to live up to its obligations. And contrary to what you may believe, as a general rule, oral contracts are just as legal as written contracts.
If you want to enter into a contractual relationship, several elements, must be present in your agreement:
- Offer. The process of creating a contract begins when one party makes an offer to another. An offer can be almost anything, from buying or selling something, such as fishing equipment, or taking some kind of action, such as taking a customer on a guided fishing trip.
- Acceptance. After one party makes an offer, the other party can either accept it or reject it. Acceptance can take place in a variety of ways. Verbally agreeing to the terms, signing a document that lists the terms, or taking actions that unambiguously imply that you accept the terms are all ways this element can be satisfied. For example, when you go to a grocery store, take an item off the shelves, and place the item on the checkout conveyor, you are explicitly accepting the terms of a contract: The store is offering the item by keeping it on the shelves and listing the sale price, and your actions implicitly show that you agree to the terms (the sale price).
- Consideration. In contract terms, consideration is a thing of value that one party agrees to provide the other. Typically, consideration consists of property, services, or promises to act or refrain from acting. (Money is the most commonly used type of consideration.) For example, let’s say you list some furniture for sale online and include the price. While you may later alter the price, the money the buyer must pay serves as the buyer’s consideration, while your transferring of ownership of the furniture to the buyer is your consideration.
- Capacity. Every party to a contract has to have capacity. In general, everyone is capable of entering into a contract unless the person is a minor or is mentally incapacitated.
In general, contract law does not require that any of these elements be met in writing. Both oral and written contracts are permitted and enforceable.
Written Contracts Sometimes Required
In some situations, you may be legally required a have a written contract if you want your agreement to be enforceable. The requirement that certain kinds of contracts must be in writing does not mean that entering into such an agreement without a written document is illegal or criminal. It can be easy to misunderstand the requirement that some contracts must be made in writing to mean that not making a written contract is an illegal or criminal act, but this isn’t true.
Rather, when the law requires you to make a written contract, it means that if you ask a court to enforce the terms of such a contact, the court will not do so unless you have made it in writing. (Like all legal issues, the kinds of contracts that must be made in writing can differ from state to state.)
Some common situations or transactions that generally require written contracts include the following:
- Mortgages and Real Estate: Contracts for real estate (real property) must be made in writing. This includes mortgages, modifications to a mortgage, agreements to buy or sell property, and agreements in property rights. For example, if you own a piece of real estate and want to lease the gas or mineral rights, you must make your agreement in writing in order for it to be enforceable.
- Some Rental Agreements: If you want to rent or lease a property for longer than a year, you must have a written agreement that includes specific information, such as the location of the property, the length of the rental, the rent amount, when rent is due, and the manner of payment. Contract for rentals of less than a year in length, such as month-to-month leases, can be made orally.
- Contract for Goods Over $500: In most states, any agreement to buy or sell goods of $500 or more must be made in writing. Note that this requirement only applies to goods, not services.
- Contracts in Consideration of Marriage: When you promise to do something in return for getting married, you have to make your agreement in writing. So, if you promise to buy your boyfriend a car when you get married, your boyfriend cannot ask a court to enforce the promise unless it was in writing.
- Contracts That Cannot Be Performed Within One Year: If a contract’s terms cannot be completed within one year, the contact has to be in writing. For example, let’s say you play music at a friend’s wedding. A couple at the wedding is impressed and wants to hire you to play for their 10th wedding anniversary, which is 14 months away. Because it is not possible for you to complete your obligation within a year, the contract must be made in writing to be enforceable.
- Agreements to Pay Someone Else’s Debt: If you agree to pay someone else’s debt, such as by becoming a cosigner on a loan, you and the creditor have to enter into a written contract for the agreement to be enforceable. However, this requirement generally only applies between the creditor and you. If you verbally agree with the debtor to pay his or her loan, you can create a contract, even if there is no written document.
4. You Have to Provide Your Employees With Health Insurance
The Patient Protection and Affordable Care Act (ACA), more commonly referred to as “Obamacare,” imposes an obligation on business owners to provide health insurance to its employees. However, that requirement only applies to business with 50 or more full-time employees (a full-time employee is one with an average of 30 work hours per week, or at least 130 work hours per month).
If you have a small business with fewer than 50 full-time employees, you are not obligated to providing them with health insurance – though you can choose to do so.
5. You Must Form an LLC or Corporation
Creating an LLC, corporation, limited partnership, or other advanced business structure is not a legal necessity to go into business. However, while you have no obligation to do so, choosing a business structure that fits your needs and the needs of your business is one of the best steps you can take, as these entities offer significant benefits and protections that you do not receive otherwise.
There are many different kinds of business structures available, each of which has its own specific sets of benefits, limitations, restrictions, and options. For example, both corporations and LLCs allow you liability protection, but LLCs have pass-through taxation while corporations do not. This means that a corporation must pay income taxes, as do the employees who receive income from the corporation. On the other hand, an LLC owner pays income taxes as a single entity, not two distinct entities. Depending on your circumstances and the kind of business you have, one structure may be better suited for your needs than another.
6. Creating an LLC, Corporation, or Other Business Structure Will Always Protect You
Limited liability companies (LLCs) and corporations are business entities that afford their owners protections that other entities, such as partnerships or sole proprietorships, do not. In particular, these types of business structures create distinct legal entities that can shield you from liability. Therefore, if the business is sued or incurs debts it cannot pay, only the assets the business owns will be in jeopardy, not the personal assets of the business owner.
But the liability protection benefits afforded by LLCs and corporations are not all-encompassing, and require you to take specific steps in order to be protected. For example, let’s say you start a small business and want to organize it as an LLC. To become an LLC, you have to comply with your state’s laws about LLC formation. These differ slightly, but typically require filing an application with a state agency and paying an application fee. Unless you meet the requirements imposed by your state, you don’t have an LLC, and are not afforded the protections and benefits they provide.
Even if you create an LLC or a corporation, your personal assets aren’t always protected from business liabilities. There are a number of ways you can become personally liable for business debts. For example, if you fail to comply with state business laws, act negligently or criminally, co-mingle business and personal assets, or personally serve as a guarantor for a business loan, your personal assets can still be at risk.
7. Copyrights Are Difficult to Attain, Especially Online
There are a host of myths about copyright law, especially when it comes to the Internet and your business. While copyright protections are a valuable form of intellectual property, and copyrighted works can be valuable assets, many myths regarding copyright law are dangerous if relied upon.
For example, some people believe that unless an original work has a copyright notice attached to it – via the familiar © symbol, for example – it isn’t protected by copyright law and is fair game to use. This may have been true decades ago, but is no longer the case. Copyright protections attach automatically to any original work that is affixed in a medium. In other words, if it’s yours (you didn’t copy some else’s work) and its more than a thought (for example, you wrote it down, drew it, or wrote it on the Internet) you own its copyright. The same goes for everything else you come across, even if it’s on the Internet.
Complicating the automatic creation of copyright laws is the idea of “fair use.” Though it’s oft-cited and frequently discussed, few people know how it works. In general, fair use allows you to use someone else’s copyrighted work, but only under limited circumstances. Unfortunately, if you’re using a copyrighted work for business purposes, your chances of successfully invoking fair use as defense against a copyright infringement claim are slim.
For example, if you are a fan of a TV show or movie and want to create and sell some fan art, you are almost certainly violating copyright law, as copyrights protect “derivative” works. Fan art is typically considered derivative, even if created by someone other than the copyright holder.
As a general rule, unless you have permission or are the original creator of a work, you can’t use it for your business. If you do, the copyright owner can sue you. In some cases you might even face criminal charges.
8. If Your Business Goes Bad, You Can Always File for Bankruptcy
Bankruptcy is a legal process that protects you from creditors. If your business is unable to pay its bills, or if you are struggling with personal or business debts, filing for bankruptcy can protect you from repossessions, garnishments, and other remedies your creditors might otherwise take against you. While there are several types of bankruptcy available, they all offer the possibility of eliminating debts while protecting you from adverse creditor actions.
But bankruptcy is no panacea against all financial or debt issues. For example, if you have secured creditors, those creditors may be able to take possession of the secured property (collateral), even if you file for bankruptcy. Also, if you’ve fallen behind on your tax bill, it’s very hard to get those debts discharged through bankruptcy.
Beyond that, each type of bankruptcy offers specific protections and limitations, and with qualification standards you have to meet. For example, if you want to file for Chapter 7 (liquidation) bankruptcy, you have to pass the “means test,” a financial evaluation that looks at your income and your ability to pay outstanding debts. If you don’t pass the test, you can’t file for Chapter 7 bankruptcy, though other forms (such as Chapter 13) might still be available to you.
9. You Must Create a Business Plan
A business plan can be an invaluable tool for any small business owner. While having a business plan does not guarantee that you’ll succeed, it can provide a range of benefits: It can help convince creditors or investors of your business’s worth, give your business a growth plan, allow you to set quantifiable goals, and more.
But a business plan is not a legal requirement. You are under no legal obligation to have a business plan at any time. While unwise, you can start your business without making any plans, doing any research, or taking any preparatory steps at all.
10. You Don’t Need a Lawyer or CPA, or Any Professional Advice
This isn’t a legal myth so much as it is a misguided piece of wisdom. While it is true that you are not obligated to hire or consult an attorney, accountant, or anyone else when you start or run a small business, not doing so can be a big mistake.
Take, for example, a situation in which you run a business and want to create or use a contract, financial power of attorney, or nondisclosure agreement. Each of these documents must contain specific parts to be effective, do what you intend them to do, or grant you as many protections and abilities as possible. Though each may seem simple, the details of creating the right document that fits your needs and your particular circumstances can be crucial. If you use a generic document you find online, you have no way to be sure that the document is legally effective, nor can you be sure you’re using it correctly.
Similarly, a good accountant can be vital. An accountant can make sure you keep your financial information in order, and also help you shape your business and take advantage of opportunities you may not realize exist.
Starting a small side business for extra income or exploring your entrepreneurial dreams can be exciting, challenging, frustrating, and rewarding. You may succeed, or you may fail. There is no way to know what the future holds.
But before you start your journey, you should take the time to build a good foundation. Having a basic understanding of your legal abilities, obligations, and opportunities doesn’t guarantee success, but it can save you from some serious problems down the road. If you are starting a business (or are considering it), or are a business owner facing a legal problem, speaking to an attorney who specializes in small business legal issues is your best option.
What legal issues have you faced as a small business owner?