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Hiring Employees
10. interview and hire employees, and complete the necessary IRS paperwork.
There are some great self-help resources that can get you started on all of these tasks that can save save you hundreds, if
not thousands, of dollars in legal fees. You can find a book or software product that will walk you through each of these
transactions on the Nolo website at www.nolo.com.
Once your business is up and running, there are even more legal tasks you can take care of yourself. For instance, you
can:
1. hire independent contractors and consultants, and prepare written agreements for them
2. create written contracts with customers and clients for the sale or rental of goods
3. document LLC meetings and actions
4. call and hold corporate meetings and prepare corporate minutes
5. create a buy-sell agreement with your business partners
6. update your partnership agreement, operating agreement or shareholder’s agreement as your business
circumstances change, and
With the right self-help resource, you can accomplish all kinds of legal tasks at a fraction of the cost of hiring a lawyer.
When You and Your Lawyer Can Work as a Team
One of the nice things about taking care of your own legal tasks is that if you educate yourself about basic legal issues,
you can take care of a lot of the legal legwork yourself and just involve your attorney when you have a specific question.
Lots of businesspeople like to create their own business contracts and then ask their lawyer to look them over to make
sure there aren’t any gaping holes or major legal issues. This “legal coach” arrangement can be one of the most cost-
effective ways to use legal services.
No matter how you decide to approach business legal issues, make sure you find an attorney with whom you have a good
rapport, who is responsive and willing to let you handle some of your own legal issues.
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Copyright 2006 Nolo
No job security.
Although it can be great to work for yourself, it can also be a burden.
When you're an employee, you must be paid as long as you have your job, even if your employer's business is slow. This is
not the case when you're an IC. If you don't have business, you don't make any money. As one IC says, "If I fail, I don't
eat. I don't have the comfort of punching a time clock and knowing the check will be there on payday."
No employer-provided benefits.
Many employers provide their employees with health insurance, paid vacations, and paid sick leave. More generous
employers may also provide retirement benefits, bonuses, and even employee profit sharing.
When you're an IC, you get no such benefits. You must pay for your own health insurance, often at higher rates than
employers have to pay. Time lost due to vacations and illness comes directly out of your bottom line. And you must fund
your own retirement. If you don't earn enough money as an IC to purchase these items yourself, you will have to do
without.
For more information on deducting health insurance, vehicles, travel, and home office expenses, see
Tax Deductions for Professionals, by attorney Stephen Fishman (Nolo). This book can also help you:
1. choose the best legal structure for your practice
2. decide whether to buy or lease the building you work in, and
Example
Reza earns a salary as a chef in a local restaurant, and his wife Kay has no outside income. They file
a joint tax return. Kay has a passion for plants, and decides to try making a business of selling some
of the hundreds of plants she grows and propagates in her backyard greenhouse. After she spends
thousands of dollars on exotic plants, better lighting equipment, and permits, the greenhouse heater
goes on the fritz and many of her plants die. Her expenses for the year total $10,000, and she has
sold only $200 worth of plants.
The silver lining for Kay and Reza comes at tax time, when they deduct the $9,800 loss from their
joint taxable income of $65,000. By reducing their joint taxable income to $55,200, they not only are
taxed on less income, but their tax bracket is reduced from 25% to 15%.
Here's the catch: If Kay had not intended to make a profit -- that is, if she wasn't trying to run a
business -- the IRS would not have allowed Kay to use the loss to offset any income, except
against the $200 revenue she received from plant sales.
Of course, most entrepreneurs would much rather make money by earning a healthy profit rather than by taking tax
deductions because their business is losing money. And the savings made possible by a tax shelter do not always justify
continuing a marginal or losing business. But they definitely can make a difference when you're deciding whether or not it's
worth it to keep spending money on your hobby.
Proving That Your Hobby Is a Business
If you consistently use your business as a tax shelter, deducting your losses from your other income year after year,
you'll probably attract the attention of the IRS. Make sure that the IRS will consider you a real business in case you're ever
audited, before you start claiming deductions for the costs of your art projects or toy car collection.
The deciding factor in determining whether a business is legitimate is whether the activity is engaged in "for profit." In
other words, you must prove to the IRS that you're trying -- not necessarily succeeding -- to make a profit with your
venture. The IRS uses several different criteria for deciding whether or not your business truly has a profit motive.
One popular test for determining profit motive is called the "3-of-5" test. If your business makes a profit in any three out
of the past five consecutive years, it is presumed to have a profit motive. This means that if you claim a loss for the third
straight year after starting your business, you may be inviting an audit.
While the IRS gives a lot of weight to the 3-of-5 test, it is not conclusive. In other words, if you flunk the 3-of-5 test, you
still may be able to prove that your business is motivated by profit. You can use virtually any kind of evidence to show that
you're trying to make money.
Business cards, a well-maintained set of books, a separate business bank account, current business licenses and permits,
and advertising or other marketing efforts will all help to persuade an IRS auditor that your activity really is a business.
Complying With Local Business Rules
Many cities require every local business to obtain a business license, or tax registration certificate. Technically, this rule
applies to any money-making activity -- even if you don't intend to claim any federal or state tax deductions for your
hobby business. Also, if you sell goods (such as homemade jewelry), your sales will be subject to state sales taxes, which
means you'll have to apply for a "seller's permit."
In practice, many microbusinesses -- so tiny that the word "business" seems excessive -- might be able to fly under these
agencies' radar. But be aware that, depending on your local rules, you could be penalized if you're caught doing business
without the licenses or permits required by your state or local government. These penalties may include fines and any back
taxes that apply.
In addition, getting the necessary licenses and permits will help show the IRS that you really are running a business. For
more information, see Obtaining Licenses and Permits.
Click here for related information and products from Nolo
Copyright 2006 Nolo
Paying Estimated Taxes
by Attorney Stephen Fishman
From the Nolo Business & Human Resources Center
Contractors and consultants don't have taxes withheld from their paychecks, but they have to pay estimated
taxes every quarter.
Now that you're an independent contractor, you won't have any taxes withheld from your pay -- and your take-home pay
will be substantially higher than that of an employee who earns a similar amount.
However, self-employed workers still have to pay taxes, just like everyone else. And they don't have the luxury of waiting
until April 15 to pay all of their taxes for the previous year -- the IRS wants its money faster than that. Independent
contractors have to pay tax on their estimated annual incomes in four payments, spread out over each year. These
payments are called estimated taxes and are used to pay income taxes and self-employment taxes (Social Security and
Medicare taxes).
Because of this estimated tax requirement, self-employed people need to budget their money carefully. If you don't set
aside enough of your earnings to pay your estimated taxes, you could face a huge tax bill on April 15 -- and possibly
penalties for not paying estimated taxes -- and have a tough time coming up with the money to cover it.
Who Must Pay Estimated Taxes?
If, like the vast majority of self-employed people, you are a sole proprietor (that is, you own your own business), you have
to pay estimated taxes if you expect to owe at least $1,000 in federal tax for the year.
However, if you didn't have to pay any taxes last year -- for example, because your business didn't make a profit or
because you weren't working -- you don't have to pay any estimated tax this year, no matter what you earn. This rule
applies only if you were a U.S. citizen or resident for the year and your tax return for the previous year covered the whole
12 months.
How Much Estimated Tax You Must Pay
You should figure out how much estimated tax to pay after completing your tax return for the previous year. Most people
want to pay as little estimated tax as possible, so they can earn interest on their money instead of handing it over to the
IRS. However, the IRS imposes penalties if you don't pay enough estimated tax. You can avoid these penalties by paying
the lesser of:
1. 90% of your total tax due for the current year, or
2. 100% of the tax you paid the previous year (or possibly more, if you're a high-income taxpayer).
When to Pay Estimated Tax
You usually have to pay estimated tax in four installments, starting on April 15. However, you don't have to start making
payments until you actually earn income. If you don't receive any income by March 31, you can skip the April 15 payment
and make only three payments for the year, starting on June 15. If you don't receive any income by May 31, you can skip
the June 15 payment as well, and so on.
Here are the due dates and periods covered for each installment payment:
Income Received for the Period Estimated Tax Due
Get Personal
If letters don't work, it's time to get personal. It's a lot harder to withhold payment from someone you know than from a
stranger. For this reason, you shouldn't rely solely on successive collection letters. Instead, telephone the client. If you're
dealing with a large company, you may have to first contact someone in the accounts payable or purchasing department.
But if they don't prove helpful, don't hesitate to call higher-ups, including the president of the company.
Explain that cash flow is important to your business and that you can't afford to carry this unpaid receivable any longer. If
phone calls don't work, make an appointment to personally visit whoever is in charge of paying you.
Be Persistent
When it comes to collecting debts, the squeaky wheel usually gets paid first. A client who is struggling financially and has
only enough money to pay one creditor will likely pay the one who has made the most fuss. However, don't lose your
temper, make threats, or otherwise harass the client. This kind of behavior can get you into legal trouble.
If letters, phone calls, and personal meetings don't get you what you're owed, you have a few options.
Formal Methods of Getting Money From Your Client
If you know the client has the money to pay you, or you think that he or she will have the money some time in the future,
don't give up. There are a number of legal means available to collect debts.
12. advertising and marketing costs -- for example, the cost of a yellow pages ad or brochure.
Overhead also includes the cost of your fringe benefits, such as medical insurance, disability insurance, and retirement
benefits, as well as your income taxes and self-employment taxes.
If you're just starting out, you'll have to estimate these expenses or ask other ICs in the same field what they pay in
overhead, then use that amount in your calculations.
You're also entitled to earn a profit over and above your salary and overhead expenses. Your salary does not count
as profit; it's one of the costs of doing business. Profit is the reward you get for taking the risks of being in business for
yourself. It also provides money to expand and develop your business. Profit is usually expressed as a percentage of total
costs. There is no standard profit percentage, but a 10% to 20% profit is common.
Finally, you need to determine how many hours you'll work and get paid for during the year. Assume you'll work a 40-hour
week for purposes of this calculation, although you may end up working more than this. If you want to take a two-week
vacation each year, you'll have a maximum of 2,000 billable hours per year (50 weeks x 40 hours). If you want to
take more vacation, you'll have fewer billable hours.
However, you'll probably spend at least 25% to 35% of your time on tasks that you can't bill to clients, such as
bookkeeping and billing, drumming up business, and upgrading your skills. This means you'll probably have only 1,300 to
1,500 hours for which you can get paid each year, if you still want that two-week vacation.
Example
Sam, a self-employed website designer, earned $50,000 per year as an employee and feels that he
should receive at least the same annual salary as an IC. He estimates that his annual overhead will
be about $20,000 per year. He wants to earn a 10% profit and estimates that he'll work about 1,500
billable hours each year. Sam determines his hourly rate as follows:
1. He adds his salary and overhead together: $50,000 + $20,000 = $70,000.
2. He then multiplies this total by his 10% profit margin and adds this amount to his salary
and overhead: 10% of $70,000 = $7,000; $70,000 + $7,000 = $77,000.
3. Finally, he divides the total by his annual billable hours to arrive at his hourly rate:
$77,000 ÷ 1,500 = $51.33.
Sam rounds his hourly rate off to $50. However, depending on market conditions, Sam might be able
to charge more -- or have to accept less.
3. Talk to potential clients and customers -- for example, attend trade shows and business conventions.
You may discover that your ideal hourly rate is higher than what other ICs are charging in your area. However, if you're
highly skilled and performing work of unusually high quality, don't be afraid to ask for more than other ICs with lesser
skills charge. Lowballing your fees won't necessarily get you business. Many potential clients believe that they get what
they pay for -- and are willing to pay more for quality.
One approach is to start out charging a fee that is at the lower end of the spectrum for ICs performing similar services,
then gradually increase it until you start meeting price resistance. Over time, you should be able to find a payment method
and fee structure that enable you to get enough work while adequately compensating you for your services.
Make a Written Fee Agreement
Once you decide what you will charge, make sure you enter into a written fee agreement with every client. (If you choose
to charge a fixed fee for a project, multiply your estimated hours for a job by your chosen hourly rate.)
.
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Copyright 2006 Nolo
Insuring Your Home Business
From the Nolo Business & Human Resources Center
If you use your home for business, you may need additional insurance coverage.
If you operate a business from your home, it's important that you obtain adequate insurance coverage for your business
equipment and transactions, just as if you had a separate office. Even a small home enterprise needs full protection
against the risks of doing business.
Homeowners' or Renters' Insurance Policies
Do not rely exclusively on your regular homeowners' or renters' policy to protect your home business, at least without
checking first with the insurance company. Many of these policies do not cover business use of a home, which means that
you probably won't be protected against losses relating to your business. For example:
1. After your computer is stolen, you may find out that it's not covered by your homeowner's policy because
business property is excluded.
2. After your house burns down, you may find that your fire coverage is void because you didn't tell the insurance
company that you were using your home for business.
3. After a delivery person slips on your front porch and breaks his back, you may find that you're not covered for
injuries associated with business deliveries.
It's easy to avoid these nasty surprises. Sit down with your insurance agent and fully disclose your planned business
operations. It's relatively inexpensive to add riders to your homeowner's policy to cover normal business risks.
Replacement Cost
When you talk to your insurance agent and/or review policy provisions, make sure that the policy will pay you the full
replacement cost for your business equipment and furnishings -- not the (much lower) value of your used office property.
Figure out how much it would cost to replace your business property after a fire, theft, or other disaster. Don't overlook
things such as the specialized business software you run on your computer. Depending on the nature of your home
business, replacing equipment and furniture could run into the many thousands of dollars.
Ask your insurance agent what it will cost to insure this valuable property, allowing for a good-sized deductible to keep
costs down.
Liability Insurance
Your homeowners' or renters' insurance may not adequately protect you from liability to business visitors. Accidents --
such as people getting hurt when they trip and fall -- are more likely to happen at home than in a well-planned office
building. Your homeowners' policy probably protects you if you're sued by a social guest or someone at your home for a
nonbusiness purpose -- a florist's truck driver delivering flowers or the meter reader who's checking on gas usage.
Most homeowners' policies, however, do not cover injuries to a business associate, employee, customer, or delivery person
who is hurt on your property. To cover these risks, you may need a rider to your homeowners' policy or a commercial
general liability policy.
Also, think about the extent of your general liability coverage, should you accidentally injure someone or damage their
property while away from home on business. You may need a rider or special policy to cover this risk.
Certain types of businesses, home-based or not, need special kinds of insurance. If you render professional services, look
into professional liability insurance. If you manufacture, distribute, or sell products that may hurt someone, you might
consider products liability insurance. And if you have employees, you'll need to provide workers' compensation coverage.
Automobile Insurance
Of course, you'll need automobile liability insurance for cars or trucks that you use only for business. But if you do business
in your personal vehicle, make sure that your car insurance covers injuries that occur while you're on business errands.
You may have to switch companies to find insurance that will cover business-related driving.
If you have employees who use their own cars for work errands or deliveries, you'll want to consider getting special
insurance (called employers' non-owned automobile liability insurance).
Policies for Both Home and Business
Several insurance companies have developed special policies that cover both your home and a business run from your
home. Typically, these policies cover your computer equipment and other business property -- whether used in your house
or elsewhere -- and protect you from business liability lawsuits and loss of income.
These home/business policies can be less expensive than either adding riders to your home insurance or buying separate
policies for home and business. But check the coverage carefully, as these policies tend to primarily address home offices
and may not adequately insure you if, for example, you're a small manufacturer or a wholesaler who stores inventory in
your home.
.
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Copyright 2006 Nolo
Example
Reza earns a salary as a chef in a local restaurant, and his wife Kay has no outside income. They file
a joint tax return. Kay has a passion for plants, and decides to try making a business of selling some
of the hundreds of plants she grows and propagates in her backyard greenhouse. After she spends
thousands of dollars on exotic plants, better lighting equipment, and permits, the greenhouse heater
goes on the fritz and many of her plants die. Her expenses for the year total $10,000, and she has
sold only $200 worth of plants.
The silver lining for Kay and Reza comes at tax time, when they deduct the $9,800 loss from their
joint taxable income of $65,000. By reducing their joint taxable income to $55,200, they not only are
taxed on less income, but their tax bracket is reduced from 25% to 15%.
Here's the catch: If Kay had not intended to make a profit -- that is, if she wasn't trying to run a
business -- the IRS would not have allowed Kay to use the loss to offset any income, except
against the $200 revenue she received from plant sales.
Of course, most entrepreneurs would much rather make money by earning a healthy profit rather than by taking tax
deductions because their business is losing money. And the savings made possible by a tax shelter do not always justify
continuing a marginal or losing business. But they definitely can make a difference when you're deciding whether or not it's
worth it to keep spending money on your hobby.
Proving That Your Hobby Is a Business
If you consistently use your business as a tax shelter, deducting your losses from your other income year after year,
you'll probably attract the attention of the IRS. Make sure that the IRS will consider you a real business in case you're ever
audited, before you start claiming deductions for the costs of your art projects or toy car collection.
The deciding factor in determining whether a business is legitimate is whether the activity is engaged in "for profit." In
other words, you must prove to the IRS that you're trying -- not necessarily succeeding -- to make a profit with your
venture. The IRS uses several different criteria for deciding whether or not your business truly has a profit motive.
One popular test for determining profit motive is called the "3-of-5" test. If your business makes a profit in any three out
of the past five consecutive years, it is presumed to have a profit motive. This means that if you claim a loss for the third
straight year after starting your business, you may be inviting an audit.
While the IRS gives a lot of weight to the 3-of-5 test, it is not conclusive. In other words, if you flunk the 3-of-5 test, you
still may be able to prove that your business is motivated by profit. You can use virtually any kind of evidence to show that
you're trying to make money.
Business cards, a well-maintained set of books, a separate business bank account, current business licenses and permits,
and advertising or other marketing efforts will all help to persuade an IRS auditor that your activity really is a business.
Complying With Local Business Rules
Many cities require every local business to obtain a business license, or tax registration certificate. Technically, this rule
applies to any money-making activity -- even if you don't intend to claim any federal or state tax deductions for your
hobby business. Also, if you sell goods (such as homemade jewelry), your sales will be subject to state sales taxes, which
means you'll have to apply for a "seller's permit."
In practice, many microbusinesses -- so tiny that the word "business" seems excessive -- might be able to fly under these
agencies' radar. But be aware that, depending on your local rules, you could be penalized if you're caught doing business
without the licenses or permits required by your state or local government. These penalties may include fines and any back
taxes that apply.
In addition, getting the necessary licenses and permits will help show the IRS that you really are running a business. For
more information, see Obtaining Licenses and Permits.
Click here for related information and products from Nolo
Copyright 2006 Nolo
In an effort to protect residential property values, most subdivisions, condos, and planned unit
developments create special rules -- called Covenants, Conditions, and Restrictions (CC&Rs) -- that
govern many aspects of property use.
CC&Rs pertaining to home-based businesses are often significantly stricter than those found in city
ordinances. As long as the rules of your planned development are reasonably clear and consistently
enforced, you must follow them. Because many planned developments enforce their rules more
zealously than municipalities do, it's essential that you make sure your home-based business is in full
compliance.
1. Get up to speed on business basics. If you’re taking money for your art, you’re in business. Make the most of
what you earn by operating your business like... a business. Nolo's book, Whoops! I’m in Business, will get you going.
2. Write a business plan. It doesn’t have to be complex or formal, but putting your ideas on paper can help you
test their viability and improve your chances for success. It can also give you a clear idea of how you want to work with
sales channels and if you need professional advisors or potential helpers such as contractors or employees. Nolo’s How to
Write a Business Plan will give you coaching and templates. If you’re already in business, a plan can still help you fine tune
your business and improve your results.
1. Have a clear plan for funding. Whether you’re financing your efforts out of pocket or require investment to
expand, you need to know where your start-up capital will come from (if you need it), whether you will be servicing a debt,
and what resources you can call upon in the future. If you’re seeking funding, start with friends, family and the people in
your community. If you must tap into retirement accounts, read Nolo's IRAs, 401(k) & Other Retirement Plans: Taking
Your Money Out to find out how to minimize penalties.
2. Know how you’re going to bring in revenue. How will you sell your work? Will certain services (like credit
card processing) enhance your ability to sell? Is there a distribution network available to you? Will being online, attending
events like trade or craft shows, licensing your work, or other opportunities boost your revenue? Are their industry norms
for selling that affect your business (such as returns policies or payment schedules)? Nolo's Your Crafts Business will help
you plan and prepare and coaches you on distribution alternatives.
3. Keep your money. The fastest way to boost your profits is to keep what you earn. Deductions can help you
reduce your taxable income to a very low number, even to below zero in your first year or two of operation. Instant help is
available from Deduct It! and Tax Savvy for Small Businesses.
1. Get the right setup for your business. If you’re not sure what business structure will give you the most
advantages, check out LLC or Corporation? How to Choose the Right Form for Your Business. If you want to form a
partnership, you need The Partnership Book to make sure your business is protected in the future.
2. Make sure you have the right workspace. What are the space needs of your hobby/business? Do you require
storage space? Industrial strength refrigeration? Extra power? Two sewing machines? A quiet place to make uninterrupted
phone calls? Can you effectively work from your home or do you need to get studio or office space? If you’re renting space,
be sure to read Negotiate the Best Lease for Your Business. If you’re working from home, you can save a lot of money with
Home Business Tax Deductions: Keep What You Earn.
3. Get the proper licenses and permits. Depending on the type of business you start, you may need to get a
permits and occupational license from your city or state. Many cities and counties require every business -- even single-
owner, home-based operations -- to get a business license (a.k.a. tax registration). You may also have to get a sales tax
permit (often called a seller's permit) from your state.
1. Protect your intellectual property assets. When you name a product, or your business, you’re often taking
the first step to building a brand. Even though you may not care too much about the names you choose, protecting your
brand will be important later. Your brand can become one of your most important assets in building, and even selling, your
business. And if you’re a creative artist, your work product itself -- designs, writings, you name it -- need protection. Start
with Trademark: Legal Care for Your Product or Business Name and The Copyright Handbook.
While this list may seem intimidating, don’t let it scare you. These are common needs for any business and there’s plenty
of help to be found to deal with them.
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Copyright 2006 Nolo
Ordinary business expenses are deductible even if you don't qualify for the home office deduction. If you
don't meet the rules above, you can still deduct ordinary and necessary business expenses that arise at your home --for
instance, long-distance phone calls, a separate business telephone line, and the cost of office supplies and equipment. The
above IRS rules apply only to home-connected expenses such as utilities, rent, depreciation, home insurance, mortgage
interest, real estate taxes, and repairs.
Regular and Exclusive Use
To take deductions for home-related expenses, you must regularly use part of your home exclusively for your trade or
business.
Regular use. The IRS doesn't offer a clear definition of regular use -- only that you must use a part of your home for
business on a continuing basis, not just for occasional or incidental business. You can probably meet this test by working a
couple of days a week from home, or a few hours each day.
Exclusive use. Exclusive use means that you use a portion of your home only for business. If you use a room of your
home for your business and also for personal purposes, you don't meet the exclusive use test. However, you can set aside
a portion of a larger room to be used only for business, as long as your personal activities don't stray into it.
Example
Brook, a lawyer, uses a den in his home to write legal briefs and prepare contracts. He also uses the
den for poker games and hosting a book club. Because he uses the den for both business and
pleasure, Brook can't claim business deductions for using the den.
Marvin has a den he uses only for business. He also puts a business calendar, desk, and computer in
his kitchen, but continues to cook and eat there as well. Marvin can claim business deductions for the
den, but not the kitchen.
There are two exceptions to the exclusive use rule: You don't have to meet the exclusive use test if you use part of your
home to store inventory or product samples, or if you run a qualified day care facility at your home. (The storage
exception is discussed just below. For the day care rules, check IRS Publication 587, Business Use of Your Home, at
www.irs.gov.)
Storing inventory or product samples at home. If you store inventory or samples at home, you can deduct expenses
for the business use of your home, whether or not you use the storage space exclusively for business.
There are two limitations, however: First, you won't qualify for the deduction if you have an office or other business
location outside of your home. Second, you have to store the products in a particular place -- your garage, for example, or
a closet or bedroom. It's okay to use the storage space for other purposes as well, as long as you regularly use it for
storing inventory or samples.
Example
Jim sells heating and air conditioning filters to small businesses. His home is the only fixed location of
his business. Jim regularly stores his inventory of filters in half of his basement. He sometimes uses
the same area for working on his racing bikes. Jim can deduct the expenses for the storage space,
even though he doesn't use that part of his basement exclusively for business.
Finally, the home office deduction is available only if you are running a bona fide business. If the IRS decides that you are
indulging a hobby rather than trying to earn a profit, it won't let you take the home office deduction.
Principal Place of Business
In addition to using part of your home regularly and exclusively for a business, your home must be your "principal place of
business." If you conduct your business only from home, then you meet this requirement. But if you have more than one
business location (including your home) for a single trade or business, you must determine whether your home is your
principal place of business for that enterprise.
Your home automatically qualifies as your principal place of business if both of the following are true:
1. You conduct the administrative or management activities of your business from home.
2. You have no other fixed location where you conduct those activities.
Example
Ellen, a wallpaper installer, performs services for clients in their homes and offices. She also has a
home office that she uses regularly and exclusively to keep her books, arrange appointments, and
order supplies. Ellen is entitled to deduct home office expenses for that part of her home (assuming
she also satisfies the "regular and exclusive use" rule, above).
In other words, your home doesn't have to be the place where you generate most of your business income. It's enough
that you regularly use it for tasks such as keeping your books, scheduling appointments, doing research, and ordering
supplies. As long as you have no other fixed location where you do these things -- for example, an outside office -- you
should be able to take the deduction.
Even if your home is not your principal place of business or you have another location, there are two other ways to fulfill
the principal place of business requirement:
You meet clients or customers at home. If you regularly use part of your home to meet with clients, customers, or
patients, you may qualify for the deduction. Doing so even one or two days a week is probably sufficient. You can use the
business space for other business purposes, too -- doing bookkeeping, for example, or other business paperwork -- but
you'll lose the deduction if you use the space for personal purposes, such as watching videos.
Maintain an appointment book in which you carefully note the name of the client or customer and the date and time of
each meeting at your home. Save these books for at least three years. These logs will document your business use of your
home if your tax return is audited by the IRS.
You use a separate building for your business. You can deduct expenses for a separate, freestanding structure that
you use regularly and exclusively for your business. This might be a studio or a converted garage or barn, for example.
The structure doesn't have to be your principal place of business or a place where you meet patients, clients or customers.
But be sure you use the structure only for your business: You can't store garden supplies there or use it for the monthly
meeting of a club.
How to Claim the Home Office Deduction
If you qualify for the home office deduction, you must figure the amount of your deduction on IRS Form 8829, Expenses
for Business Use of Your Home. (You can find this and other tax forms at the IRS website, www.irs.gov.) Then you enter
the total amount of the deduction on Schedule C, Profit or Loss from Business. Attach both Form 8829 and Schedule C to
your Form 1040 tax return.
Be ready to prove to the IRS that you are entitled to take the home office deduction. Here are some steps you can take to
help establish your legal right to deduct home office expenses:
1. Photograph your home office and draw a diagram showing the location of the office in your home. Keep this
information in your tax folder.
2. Have your business mail sent to your home.
3. Use your home address on your business cards and stationery and in all business ads.
4. Get a separate phone line for the business.
5. Have clients or customers visit your home office -- and keep a log of those visits.
6. Keep track of the time you spend working at home.
For more information on the home office deduction as well as many other deductions for small business owners should
take, see Home Business Tax Deductions: Keep What You Earn, by Stephen Fishman (Nolo).
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For ten years Steve worked for several different construction companies -- first as a journeyman
carpenter and then as a project manager. When he got the itch to start his own business, it made
perfect sense for him to start a small contracting business specializing in home-improvement. He
knew the industry well, including the best places to buy supplies and what he could charge for
services, and he had the required skills, such as how to estimate and bid jobs -- and it didn't hurt
that he knew how to pound nails as well. The contacts he had developed over the years were glad to
talk to him about running a small contracting business, and many customers he had worked with in
the past told him they'd be willing to hire him if he were working on his own.
If you're interested in turning something you know and love into a business, talk to people you've worked with about what
it takes to run that kind of business. Learn all you can about start-up costs, overhead and expenses, and how much
revenue you can expect to make. If you have several interests, but aren't sure which would make the best business,
consider how you can translate your strengths, education, and skills into business opportunities, and research the
marketplace to see which types of business are presently needed in your area.
Example
Leo opened an upscale nursery and garden supply outfit at a time when, seemingly, such a business
"couldn't miss." Leo knew a good deal about running a small business, had a personality well suited
for it, and could borrow enough money to begin. However, the business never took off, and it cost
him two years and $30,000 to get rid of it.
Why? In his hurry to make a profit, Leo overlooked several crucial facts. The most important was
that Leo, a self-described "brown thumb," knew virtually nothing about plants and didn't really want
to learn. Not only was Leo unable to chat with customers about what types of flowers grow well in
partial shade or how to get rid of various garden pests, but he didn't even know enough about
nurseries to properly hire and supervise the right salespeople. In short, Leo made a classic mistake --
he started a business in a "hot" field because someone was foolish enough to lend him the money.
If you don't know much about the business you want to start, but are set on it, be prepared to spend enough time learning
it before you begin.
Research and Evaluate Your Business Idea
Here's a step-by-step guide to evaluating whether you and your chosen business are a good fit.
1. Try it out. Before you start a business of your own, get some experience in the industry or profession that
interests you -- even if you work for free. Learn everything you can about every aspect of the business. For
example, if you want to start a pasta shop, but don't know ravioli from cannelloni, go out and get a job with a
pasta maker.
If you're not familiar with the business you want to start and you're unable to find work in the
field, talk with others who provide the product or service that interests you. To increase your chances
of getting interviews and reliable answers to your questions, it's best to do this in a different locale
from the one in which you plan to locate. Small business owners are often quite willing to share their
knowledge once they are sure you will not compete with them.
2.
3. Evaluate whether you enjoy the work and excel at it. If not, find a new venture. It's a lot harder to make a
success of a business you don't like, and it's unlikely you'll like something you're not good at. If you enjoyed the
work and determined you were skilled enough to base your own business on it, go on to the next step.
3. Judge your ability and desire to handle every aspect of the business. If you don't want to or can't pitch in
wherever and whenever something needs to be done -- whether it involves manufacturing a product, dealing with
customers, or keeping the books -- you should think twice about starting that kind of business.
4. Determine whether the business has a solid chance of turning a profit. After working in the field for a few
months, you should have a good idea of whether the business is a potential moneymaker. To be sure, you should
analyze your market and conduct a break-even analysis, a preliminary financial projection that shows you the
amount of revenue you'll need to bring in to cover your expenses (this amount is called your break-even point).
If you're able to bring in more revenues than your break-even point, you'll be in the black (that is, you'll make a
profit).
5. Evaluate the risk this particular business requires. Even the best-laid plans can sour if you pick a business
that is unusually risky, vulnerable to competition, or subject to financial failure. For instance, the following
businesses have higher than average failure rates:
○ trucking firms
○ computer stores
○ restaurants
○ laundries and dry
cleaners ○ infant clothing
stores
○ florists
○ bakeries, and
○ used car dealerships
○ gas stations
○ grocery and meat
stores.
If your business idea is on this list, don't despair -- it doesn't mean you should automatically abandon it. However, you'll
need to be more critical and careful with the numbers when preparing your business plan.
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2. Sales revenue. This is the total dollars from sales activity that you bring into your business each month or year.
To perform a valid break-even analysis, you must base your forecast on the volume of business you really expect -- not on
how much you need to make a good profit.
3. Average gross profit for each sale. Average gross profit is the money left from each sales dollar after paying
the direct costs of a sale. (Direct costs are what you pay to provide your product or service.) For example, if Antoinette
pays an average of $100 for goods to make dresses that she sells for an average of $300, her average gross profit is $200.
4. Average gross profit percentage. This percentage tells you how much of each dollar of sales income is gross
profit. To calculate your average gross profit percentage, divide your average gross profit figure by the average selling
price. For example, if Antoinette makes an average gross profit of $200 on dresses that she sells for an average of $300,
her gross profit percentage is 66.7% ($200 divided by $300).
If you tinker with the numbers and your break-even sales revenue still seems like an unattainable number, you may need
to scrap your business idea. If that's the case, take heart in the fact that you found out before you invested your (or
someone else's) money in the idea.
Further Financial Analysis
If your break-even forecast shows you'll make more revenue than you need to break even, you can consider yourself
fortunate. But you still need to figure out how much profit your business will generate, and whether you'll have enough
cash available to pay your bills when they are due. In short, a break-even forecast is a great screening tool, but you need
a more complete analysis before you start investing real money in your venture.
The following are additional financial projections that should also be part of your business plan, to round out your
business's financial picture.
1. A profit-and-loss forecast. This is a month-by-month projection of your business's net profit from operations.
2. A cash flow projection. This shows you how much actual cash you'll have, month by month, to meet your
expenses.
3. A start-up cost estimate. This is the total of all the expenses you'll incur before your business opens.
For instructions on how to create a profit-and-loss forecast and a cash flow projection, see How to Write a Business Plan,
by Mike McKeever (Nolo).
Although creating a break-even forecast might sound complicated, you owe it to yourself to
prepare one as one of the first steps in your business planning process. Now is the time to get used
to using cost estimates and profit margins, if you're going to succeed in business. And as you can
see, a realistically prepared break-even forecast will tell you whether your idea is a sure winner, a
sure loser or, like most ideas, needs modifications to make it work. Plus, you'll have a big headstart
on your business plan!
Start on a shoestring. It can be a mistake to pour too much money into your business at the beginning. A fair
number of small businesses fail in the first year, so raising and spending a pile of money for an untested business idea can
lead to much grief -- especially if you’re personally on the hook for borrowed funds. Consider starting as small and cheaply
as possible.
Types of Lenders
You have many options when looking a loan for your business. For small ventures, friends and family members are
sometimes willing to help. For sophisticated or mid-sized businesses, banks, credit unions, and savings and loans may be
willing to lend you money. The U.S. Small Business Administration (SBA) and many state and local governments have loan
programs to encourage the growth of small businesses. For an excellent primer on loans and lenders, see
www.sba.gov/financing.
The Promissory Note
A lender will almost always want you to sign a written promissory note -- a paper that says, in effect, "I promise to pay
you $XXX plus interest of XX%."
While a friend or relative may be willing to lend you money on a handshake, this is a bad idea for both of you. It's always a
better business practice to put the loan in writing, and to state a specific interest rate and repayment plan. Otherwise, you
open the door to unfortunate misunderstandings that can chill your relationship. Also, you want to have documentation of
the loan's terms in case the IRS decides to audit your business.
Interest
State usury laws prevent lenders from charging illegally high interest on loans. As a general rule, a lender can safely
charge you interest of up to 10% per year and not have to worry about violating this usury law. However, there's a lot of
variation in usury laws from state to state, and different rules apply to commercial lenders and private lenders, so you
should check your state's law if you're concerned. Look under interest or usury in your state's statutes.
If your corporation is taking a loan from a shareholder (including yourself), make sure the interest rate is not too low --
the IRS likes to see loans that are commercially reasonable. Otherwise, the IRS might consider the loan as a capital
investment by the shareholder and treat the loan repayments as dividend payments to the shareholder.
Security Interests
Many lenders will require you to put up valuable property (called "security" or "collateral") that they can sell to collect their
money if you don't make your loan payments. For example, a lender may take a second mortgage or deed of trust on your
house, or ask for a security interest or lien on your business's equipment, inventory, or accounts receivable.
Personal Liability
Depending on how your business is organized, if you don't make good on your repayment commitment, a lender has the
right to sue you individually (if your business is a sole proprietorship or general partnership) or sue your business entity (if
your business is organized as a corporation or a limited liability company). If the lender sues you individually, it can take
your personal assets to satisfy the loan. If the lender sues your business entity, it can take the business’s assets.
Cosigners, Guarantors, and Personal Guarantees
A lender may also require that someone cosign or guarantee the loan. That means the lender will have two people rather
than one to collect from if you don't make your payments. When asking friends or relatives to cosign or guarantee a
promissory note, be sure they understand that they're risking their personal assets if you don't repay the loan.
If you’ve organized your business as a limited liability entity, such as a corporation or an LLC, the lender will probably ask
you -- the business owner -- to personally guarantee the loan and/or pledge your personal assets to guarantee repayment.
(Because small businesses have high failure rates, lenders feel more comfortable if business owners have a personal stake
in repaying the money.) Be aware that guaranteeing or personally cosigning your business’s loan circumvents your limited
liability status. All of your separate property, and either half or all of any property you jointly own with a spouse
(depending on which state you live in), could eventually be seized if you default on the loan.
Finally, if you're married, the lender may insist that your spouse cosign the promissory note. If your spouse cosigns the
loan, not only is your jointly owned property completely at risk for this joint debt, but also any assets that your spouse
owns separately -- a house, for example, or a bank account. What's more, if your spouse has a job, his or her earnings will
be subject to garnishment if the lender sues and gets a judgment against the two of you.
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Nolo's Quicken Legal Business Pro software and Legal Forms for
Starting & Running a Small Business, by Fred Steingold, provide
promissory notes with the following four repayment plans. In
addition, both the software and book offer a security agreement
to go with the promissory notes, in case collateral will be
required.
1. Amortized Payments
You've probably dealt with an amortized repayment schedule before, when paying off a car loan or a mortgage. You pay
the same amount each month (or year) for a specified number of months (or years). Part of each payment goes toward
interest, and the rest goes toward principal. When you make the last payment, the loan and interest are fully paid. In legal
and accounting jargon, this type of loan is "fully amortized" over the period that you make payments.
Once you know the terms of the loan (the amount you want to borrow, the interest rate, and the time over which you'll
make payments), you can figure out the amount of the payments using software such as Intuit's Quicken or Quickbooks or
an online calculator. Or you can use a printed amortization schedule, which are widely available from commercial lenders,
business publishers, and local libraries.
3. Apply for the right type of loan. For example, a line of credit is often used to cover seasonal ups and downs,
while a loan is better used for one-time equipment purchases.
4. State the specific purposes for which you will use the money. Your bank or lender will definitely want to
know what you plan to use the money for.
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Raising Money for Your Small Business: Loans vs. Equity Investments
From the Nolo Business & Human Resources Center
Here’s the lowdown on whether to borrow money or sell part of your business to an equity investor.
To raise money for your new business, you must decide whether you want to borrow money or sell ownership interests to
equity investors. Often, you may not have many options -- the person with money to lend or invest will obviously have a
lot to say about it. But you should understand the pros and cons of choosing one over the other.
Taking Out Business Loans
Borrowing money to fund your business has many advantages. Often, you'll borrow this money from a friend or family
member, but if you're lucky, you may be able to borrow from a commercial lender too.
3. intrastate offerings.
For a quick summary of these exemptions, see the SEC website at www.sec.gov.
Your only obligation to the lender is to repay the You can be flexible about repayment
loan on time. Loans from close relatives can have requirements.
flexible repayments terms.
Interest payments (but not principal payments) are If your business loses money or goes broke,
a deductible business expense. you probably won't have to repay your
investors.
Disadvantages:
You may have to make loan repayments when your Equity investors require a greater share of your
need for cash is greatest, such as during your profits than interest on a loan.
business's start-up or expansion.
You may have to assign a security interest in your Your investors have a legal right to be informed
property to obtain a loan, which may place your about all significant business events and a right
personal assets at risk. to ethical management.
Under most circumstances, you can be sued Your investors can sue you if they feel their
personally for any unpaid balance of the loan, even rights are being compromised.
if it's unsecured.
Corporation
Because corporations offer shareholders protection against personal liability for business debts (called limited liability), a
shareholder of a corporation who doesn't participate in corporate activities and decision making is virtually free from
liability for corporate debt or activity. A shareholder who helps run the company can be liable to outsiders for his or her
own actions -- for example, making slanderous statements or negligently operating a piece of equipment -- but isn't
personally liable for corporate debts or the actions of corporate employees. Not everyone chooses a corporation as their
business entity because organizing and running a corporation involves some initial and ongoing paperwork, as well as
some fairly substantial start-up costs.
Limited Partnership
If you form a limited partnership and your investors become limited partners, they will have limited personal liability for
business debts. A limited partner's freedom from personal liability is similar to that of a corporate shareholder, as long as
the limited partner doesn't become actively involved in running the business. However, every limited partnership must
have a general partner who is personally liable for the debts of the business. That will probably be you, so you should
evaluate your exposure to risk before you decide to form a limited partnership.
Advantages
1. The lender has no profit participation or management say in your business.
2. Your only obligation is to repay the loan on time.
3. Interest payments (not principal payments) are a deductible business expense.
4. Loans from close relatives can have flexible repayments terms.
Disadvantages
1. You may have to make loan repayments when your need for cash is greatest, such as during your business's
start-up or expansion.
2. You may have to assign a security interest in your property to obtain a loan, which may place personal assets at
risk.
3. Under most circumstances, you can be sued personally for any unpaid balance of the loan, even if it's unsecured.
Equity Investments
Equity investments are often the best way to finance start-up ventures because of the flexible repayment schedules.
Advantages
1. You can be flexible about repayment requirements.
2. Investors are sometimes partners or board members and often offer valuable advice and assistance.
3. If your business loses money or goes broke, you probably won't have to repay your investors.
Disadvantages
1. Equity investors require a larger share of the profits.
2. Your shareholders or partners have a legal right to be informed about all significant business events and a right
to ethical management. They can sue you if they feel their rights are being compromised.
If you don't already know an accountant specializing in small business affairs, you may want to find one to help you make
the decision. Your personal tax situation, the tax situation of the people who may invest, and the tax status of the type of
business you plan to open are all likely to influence your choice.
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7. anticipating potential problems so you can solve them before they become disasters.
Some people are intimidated by financial calculations and want to skip this process, hoping
they'll be one of the lucky few who "make it." And some people are so enamored with their business
concept and desperately eager to begin that they have no patience with the economic realities
involved in their business. If you recognize either of these tendencies in yourself, it's even more
important that you prepare financial forecasts carefully -- and pay attention to what they tell
you. Don't try to get out of it by telling yourself that your financial estimates will be wildly off base
and yield useless results. If you do your best to make realistic predictions of expenses and revenues
and accept that your guestimates will not be absolutely correct, you can learn a great deal about
what the financial side of your business will look like in its early months and even years of operation.
Even a somewhat inaccurate picture of your business's likely finances will be much more helpful than
having no picture at all.
Attracting Investors
If you will use your business plan to borrow money or interest investors, you should carefully design your plan so that it
sells your vision to skeptical people. Normally this means your business plan should include:
1. a persuasive introduction and request for funds
2. a statement of the purpose of your business
3. a detailed description of how the business will work (including what your product or service will be, whether you'll
have employees, who will supply your goods, and where you will be located)
4. an analysis of your market (who your customers are)
5. an evaluation of your main competitors
6. a description of your marketing strategy (how your business will reach plenty of customers and fend off your
competitors)
7. a résumé setting forth your business accomplishments, and
8. detailed financial information, including your best estimates of start-up costs, revenues and expenses, and your
ability to make a profit.
Together, all the parts of your plan should reveal the beauty of your business idea. You want to show potential lenders,
investors, or people you want to work with that you've hit upon a product or service that customers really want. In
addition, you should prove that you are exactly the right person to make your fine idea a roaring success.
Because your business plan will be submitted to people you don't know well, the writing should
be polished and the format clean and professional. Your numbers must also be accurate and clearly
presented. But not all business people are great writers or mathematicians. Consider paying a
freelance writer with small business savvy to help you polish your plan. Similarly, if you are
challenged by numbers, find a bookkeeper or accountant to provide needed help.
1. A break-even analysis. Here you'll use income and expense estimates to determine whether, in theory at least,
your business will bring in enough money to meet its costs.
2. A profit-and-loss forecast. Next you'll refine the sales and expense estimates that you used for your break-
even analysis into a formal, month-by-month projection of your business's profit for the first year of operations.
3. A cash flow projection. Even if your profit-and-loss forecast tells you that your business will have higher
revenues than expenses -- in other words, that it will be profitable -- those numbers won't tell you if you'll have enough
cash on hand from month to month to pay your rent or buy more inventory. A cash-flow projection shows how much
money you'll have -- or how much you'll be short -- each month. This lets you know if you'll need a credit line or other
arrangement to cover periodic shortfalls.
4. A start-up cost estimate. This is simply the total of all the expenses you'll incur before your business opens. If
you need to pay off these costs during the first year or two of business, they should be included in your month-to-month
cash-flow projection.
Again, no matter who your audience is, you should be as thorough as possible when calculating your break-even analysis
and profit-and-loss forecast. The last thing you want is to experience the very real misery of starting a business that never
had a chance to make a solid profit.
Getting Started on Your Business Plan
Your best bet is to follow a self-help business plan book that shows you how to conduct the financial forecasts described
above. Two good bets are Business Plan Pro, by Palo Alto Software, and How to Write a Business Plan, by Mike McKeever
(Nolo).
If you use business plan or accounting software, don't rely on the numbers it spits out unless
you fully understand them. To become a truly successful business owner, you should take the time to
learn the concepts behind financial projections.
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Cybersquatting Today
The practice that's come to be known as cybersquatting originated at a time when most businesses were not savvy
about the commercial opportunities on the Internet. Some entrepreneurial souls registered the names of well-known
companies as domain names, with the intent of selling the names back to the companies when they finally woke up.
Panasonic, Fry's Electronics, Hertz and Avon were among the "victims" of cybersquatters. Opportunities for
cybersquatters are rapidly diminishing, because most businesses now know that nailing down domain names is a high
priority.
Recognizing Cybersquatting
How do you know if the domain name you want is being used by a cybersquatter? As a general rule, first check to see if
the domain name takes you to a legitimate website. If the domain name takes you to a website that appears to be
functional and reasonably related in its subject matter to the domain name, you probably aren't facing a case of
cybersquatting. However, you may have a case of trademark infringement. (For more information, see What to Do If the
Domain Name You Want Is Taken.)
But if your browser produces any of the following results, you may have a case of cybersquatting on your hands:
1. you get a "can't find server" message
2. you get an "under construction" page, or
3. you get a page that appears to have no relationship to the meaning of the domain name.
Although each of these results suggests the possibility of cybersquatting, there may also be an innocent explanation,
especially if the website is still under construction. You can reserve a domain name for two years, so the fact that a
website is not up and running, even months after the name was reserved or registered, does not necessarily mean that the
registrant doesn't have perfectly legitimate plans to have a website in the future.
Before jumping to any conclusions, contact the domain name registrant. To find the name and address of a domain name
owner, you can use the "WHOIS Lookup" at whois.net. Find out whether there is a reasonable explanation for the use of
the domain name, or if the registrant is willing to sell you the name at a price you are willing to pay.
Sometimes, you may find that paying the cybersquatter is the easiest choice. It may be a lot cheaper and quicker for you
to come to terms with a squatter than to file a lawsuit or initiate an arbitration hearing: these processes cost money, and
although you may be able to recover your costs and attorney fees if you win, there is no guarantee; it's completely up to
the judge.
What You Can Do to Fight a Cybersquatter
A victim of cybersquatting in the United States can now sue under the provisions of the Anticybersquatting Consumer
Protection Act (ACPA) or can fight the cybersquatter using an international arbitration system created by the Internet
Corporation of Assigned Names and Numbers (ICANN). The ACPA defines cybersquatting as registering, trafficking in or
using a domain name with the intent to profit in bad faith from the goodwill of a trademark belonging to someone else. The
ICANN arbitration system is considered by trademark experts to be faster and less expensive than suing under the ACPA,
and the procedure does not require an attorney.
4. the trademark qualifies for protection under federal trademark laws -- that is, the trademark is distinctive and its
owner was the first to use the trademark in commerce.
If the person or company who registered the domain name had reasonable grounds to believe that the use of the domain
name was fair and lawful, they can avoid a court decision that they acted in bad faith. In other words, if the accused
cybersquatter can show a judge that he had a reason to register the domain name other than to sell it back to the
trademark owner for a profit, then a court will probably allow him to keep the domain name.
3. the domain name has been registered and is being used in bad faith.
All of these elements must be established in order for the complainant to prevail. If the complainant prevails, the domain
name will be canceled or transferred to the complainant, but financial remedies are not available under the UDNDRP.
Information about initiating a complaint is provided at the ICANN website.
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Any business name used to market and identify products or services is a trademark. For example, McDonald's uses its
business name to market its hamburgers. But to qualify for trademark protection under the trademark laws, your business
name should be what trademark law considers "distinctive."
1. Make your name memorable. A creative, distinctive name will not only be entitled to a high level of trademark
protection, but it will also stick in the minds of your customers. Forgettable names are those of people (like O'Brien Web
Design), those that include geographic terms (like Westside Health Foods), and names that literally describe a product or
service (like Appliance Sales and Repair, Inc.). Remember, you want to distinguish yourself from your competitors.
2. Your name should be appealing and easy to use. Choose a name that's easy to spell and pronounce, and
that is appealing to both eye and ear. Try to pick a catchy name that people will like to repeat. Make sure that any images
or associations it evokes will suit your customer base.
3. Avoid geographical names. Besides being easy to forget, and difficult to protect under trademark law, a
geographical name may no longer fit if your business expands its sales or service area. If you open Berkeley Aquariums &
Fish, for instance, will it be a problem if you want to open a second store in San Francisco? Especially if you plan to sell
products on the Internet, you should think twice about giving your business a geographic identifier.
4. Don't limit expanded product lines. Similarly, don't choose a name that might not be representative of future
product or service lines. For instance, if you start a business selling and installing canvas awnings using the name Sturdy
Canvas Awnings, your name might be a burden if you decide to also start making other products such as canvas signs or
vinyl awnings.
5. Get feedback. Before you settle on a name, get some feedback from potential customers, suppliers and others
in your support network. They may come up with a downside to a potential name or suggest an improvement you haven't
thought of.
Is Your Proposed Business Name Available?
Once you've come up with some ideas for distinctive names, you'll need to be sure you're not stepping on an existing
name or trademark.
As a first rule, don't use part of a famous name and hope you'll get away with it because you plan to use it in a different
way, as in Microsoft Cushions, or M & M Marketing. If you attract the attention of the big guys, you'll be threatened with a
lawsuit and will most likely have to change your business name on all of your marketing material.
For not so famous names, you'll have to do a name search to find out if the same name, or similar names, are already in
use, and how they're being used. If another company is using the same or a similar name to market different products and
services, it may be fine for you to use the name for your business.
Finally, if your business is a corporation, LLC, or limited partnership, in addition to checking for existing trademarks, you
must be sure your business name isn't the same as that of an existing corporation, LLC, or limited partnership in your
state. You'll have to contact your state filing office to find out how to search their name databases.
Is a Domain Name Available That's Similar to Your Business Name?
If your business will have a website, you must decide what your domain name (the address used to identify your website)
will be. Using all or part of your business name in your domain name will make your website easier for potential customers
to find. Since many domain names are already taken, check what's available before you settle on your business name. You
can search for available domain names by visiting a domain name registrar such as register.com.
Think of several business names that might suit your company and its products or services.
If you will do business online, check if your proposed business names are available as domain
names.
Check with your county clerk's office to see whether your proposed names are on the list of
fictitious or assumed business names in your county.
For corporations and LLCs: check the availability of your proposed names with the Secretary of
State or other corporate filing office.
Do a federal or state trademark search of the proposed names still on your list. If a proposed name
is being used as a trademark, eliminate it if your use of the name would confuse customers or if the
name is already famous.
Choose between the proposed names that are still on your list.
as a federal or state trademark (if you'll do business regionally or nationally and will use your
business name to identify a product or service), and
as a domain name (if you'll use the name as a Web address too).
Once you've chosen an available business name, you may have to -- or want to -- register it with the
local, state, or federal government, depending on your circumstances. If your business is organized
as a corporation, LLC, or limited partnership, your official business name should be automatically
registered with the state when you file your articles of incorporation, articles of organization, or
statement of limited partnership. But no matter what type of business you have, you may also need
to file a fictitious or assumed business name statement and register your name for trademark
protection at the state or federal level.
The fact that a slightly different name is available, or that a name is not available as .com, but is
available as .net, .biz, .info or .org, doesn't necessarily mean that you can or should use it. Using a
domain name very similar to an existing one may result in trademark infringement -- the violation of
someone's trademark rights. If you infringe someone's trademark, a court might order you to stop
using the name and pay money damages to the other domain name owner.
To find the name and address of a domain name owner, you can use the "WHOIS Lookup" service
at www.whois.net. Your search results will include a contact name, phone number, address and email
address for the domain name's owner.
While we've offered some suggestions here, your greatest resource will be your own imagination. For instance, perhaps a
simple letter demonstrating your ownership over the trademark, with an offer for small compensation or some other
arrangement, is all that is needed to resolve the conflict. Or, you might reach an unconventional agreement with the
holder of a desirable domain name, rather than meeting the stated purchase price. And of course, in the end, you might
just throw up your hands and decide to go back to the drawing board and make another list of names. That's fine too. Be
creative and the right solution will follow.
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Sometimes a powerful company tries to force a smaller one to give up a domain name that was
legally acquired in good faith by the smaller company. Because trademark conflicts are ultimately
resolved in court, a business that can easily afford to pay lawyers is in a powerful position to sue the
smaller company for trademark infringement (assuming there is any basis for doing so, which there
usually is). When the smaller company realizes that it will cost tens of thousands of dollars to defend
the suit, the big guy proposes a settlement under which the small company parts with the name for a
relatively meager sum. In other words, the powerful company ends up getting what it wants simply
because the court system is manifestly unfair to those who can't afford attorneys.
There are strategies to fight this sort of bullying. If the small company has the resources, of course,
it can mount a defense and actually win. In addition, the Internet community has been extremely
hostile to online bullies, and out-of-court campaigns sometimes make them back down. For more on
this issue, visit the Domain Name Rights Coalition at www.domainnamerights.org
.
Before you invest too much time and money in a formal name search, take a few minutes to
quickly screen out some of the names on your list. Type a name you're thinking of using into your
favorite search engine, such as Google or Altavista. You can quickly see whether someone else on the
Web is using a similar name to market similar products or services.
Registered Trademarks
Finally, everyone starting a business, no matter how small, should search the federal trademark database to determine
whether the name they want to use has already been registered with the U.S. Patent and Trademark Office (USPTO). If
you don't, and you use a trademark that's on the federal register and the trademark owner sues you, you can be liable for
what's called "willful infringement" -- that is, knowingly violating someone else's trademark, even though you didn't
actually check the federal database. Willful infringement carries more costly penalties than other types of trademark
violations. Plus, it's easy to search for federally registered trademarks.
You can search for federally registered trademarks by using the free trademark database on the USPTO's website. To start,
go to the USPTO's Trademark Electronic Business Center at http://www.uspto.gov/main/trademarks.htm and choose
"Search." Then follow the instructions you see on the screen.
In addition to checking the federal trademark register, it's a good idea to check your state's trademark database. The state
register is often part of the Secretary of State's office, though in some states it has a department of its own. You can also
check one of several sites that search for trademarks registered in all 50 states, such as trademark.com or
nameprotect.com. This is an especially good idea if you'll be doing business in more than one state.
Analyzing Your Search Results
If, after your search, you determine that the name you've chosen (or a similar name) does not already belong to someone
else, you can go ahead and use it.
On the other hand, if your search turns up an identical or similar name to the one you want to use, you may or may not be
able to use it, depending on the circumstances.
As a first rule, if your desired name uses part of a well-known or heavily marketed trademark, pick a new one right away.
Don't risk the expense of a possible fight with a big corporation, not to mention the costs of changing the name on all of
your business materials.
Also, if your desired name uses part of a name that's already registered for official trademark protection, especially at the
federal level, you should take that as a "No Trespassing" sign and pick another name -- even if the name isn't very well
known. Owners of federally registered trademarks have the right to use their trademarks anywhere in the country, and it is
easy for them to bring and win lawsuits against trademark violators.
That said, there are a few instances when taking a name that's already in use is okay (as long as the name isn't famous).
If the name is being used by a company that provides a very different product or service than the one you plan to sell,
then you can probably move forward with your plans to use the name. This is especially true if the two businesses serve
only local markets and are hundreds of miles apart.
The key here is whether your use of the name, or something similar, would confuse customers about the origin of the
product or service. For example, just because a plumbing business in Coos, Oregon, calls itself Z-Pop doesn't mean you, in
Arizona, can't use Z-Pop as the brand name for your soda pop. That plumbing business in Oregon is not your competitor
and your use of Z-Pop for soda pop will not likely confuse customers into thinking that your soda pop is related to the
plumbing business. On the other hand, if Z-Pop is being used to market another soda pop product, you should choose a
different name.
Once you've found an available name, you may want to take advantage of the extra protection
that registering your name as a trademark can give you. While it's not required, registering your
name as a trademark can help prevent a competing business from using a name that's likely to be
confused with your business name.
Jason Desmond names his sole proprietorship "Perini Mountain Appellations." He must register the
name "Perini Mountain Appellations" as a fictitious business name because it doesn't contain his last
name, "Desmond."
Three partners named Gibbons, Armstrong, and Anderson are trying to decide whether to call their
partnership "South Bay Accounting" or "Gibbons & Armstrong." Either way, they will have to file a
fictitious name statement because the name won't contain the last names of all three owners.
The owners of Northern Colusa County Auto Mechanics' Ltd. Liability Co. decide to operate a repair
shop under the name "Grease Monkeys." The name "Grease Monkeys" is a fictitious business name,
and the LLC must register it.
Five states do not impose general sales taxes. In Alaska, Delaware, Montana, New Hampshire, and Oregon, you
may not be required to get a state sales permit. However, cities and counties in those states may issue sellers' permits and
charge sales taxes. Further, some transactions may be subject to something similar to a sales tax, although it has a
different name. Your state tax agency can tell you the specifics.
You’ll probably have to register with your state’s treasury department or department of revenue, except in the few states
that still assess no taxes on income. You may also have to register for other business taxes.
Business Entity Filings
If you’ve chosen to start out your business as a corporation , limited liability company (LLC), or limited partnership, you’ll
need to file organizational documents with your state’s Secretary of State, Department of Corporations, or similar office.
Most states have sample or form documents online.
If you share ownership of your business with investors or other owners who do not help you run the business, you
may need to comply with state (and federal) securities laws.
If you’re starting off with a partner (a partnership) or by yourself (a sole proprietorship), you may not have any state filing
to do. An ordinary partnership is created automatically when you agree to go into business with someone, so you don’t
legally have to write anything down. However, a written partnership agreement is generally a good idea, as a record of the
terms of your agreement.
Sometimes your business name doesn’t contain your legal name as the owner (for a
sole proprietorship or general partnership) or doesn’t match the company name
that’s on file with the state (for a corporation, limited partnership, or LLC). That’s
variously called a fictitious business name (FBN), assumed name, DBA (“doing
business as”), or trade name, and you must register it.
Depending on your state, sometimes you register directly with the state, although
you usually register with the county clerk in the county where your business is
located. (This registration may also be called a certification or filing.) The name will
go on a state FBN list.
Employer Responsibilities
If you have employees, you may have to register with your state department of labor or with the agencies that administer
the laws on unemployment compensation and workers’ compensation. In addition, if your state has a version of the federal
Occupational Safety and Health Act (OSHA), your business may need to meet certain mandated health and safety
requirements.
A business with employees or independent contractors has a number of tax requirements. To start with, you will need an
employer ID from state (and federal) tax authorities. After you get started, you’ll have to withhold income taxes and
employment taxes (Social Security/Medicare or "FICA") from the paychecks of employees. You may also need to withhold
other items, such as payments for disability insurance. You report these figures (to the employee, the state, and the IRS)
and pay the withheld taxes to the tax authorities. If you hire independent contractors, you need to report contract
payments annually on a Form 1099, which goes to the contractor and to the government.
Don’t forget to pay the taxes you withhold. Many small businesses get into big trouble by failing to pay the
employment taxes after their cash flow hits a dry spell.
Environmental Regulations
Many small businesses need to think about what they must do to avoid contaminating the environment. You may need a
special permit (and do more record keeping) if any of the following apply to your business:
1. Your equipment vents emissions into the air.
2. You need to discharge or store waste water.
3. Your business involves or produces hazardous wastes.
Environmental regulation isn’t limited to manufacturers. Small businesses, such as stained glass makers, dry cleaners, and
photo processors, need to know how to dispose of the dangerous metals or chemicals used in their work.
Your state's Small Business Development Center (SBDC) or other agency may offer a "one-stop
shopping" website that advises you on the licenses and permits you need for your particular type of
business. For instance, California offers a website (www.calgold.ca.gov) that will provide you with a
list of all federal, state, and local permits you need for your particular business. The Small Business
Administration maintains a list of SBDCs at www.sba.gov/sbdc.
The assessor or treasurer can tell you about local taxes on property, fixtures, equipment, inventory, and income or gross
receipts. The health department can advise you about permits and regulations if your business involves food preparation.
It also needs to test your water if you work in an area where water comes from wells or goes into septic systems.
The police, fire or building and safety departments can help you with issues of crowd control and safe exit from your
premises. The fire department will also be concerned about combustible materials used or stored on your business
premises.
Unofficial but often extremely helpful sources of information include: the local chamber of commerce, trade
associations, contractors who remodel commercial space, other people with businesses like yours, and lawyers who advise
small businesses.
Business Licenses, a.k.a. Tax Registration Certificates
In most locations, every business needs a basic business license, sometimes called a tax registration certificate. You
usually get the business license from your city or county. However, you may need other permits and licenses as well. No
single business license ensures compliance with the numerous licenses, permits and regulatory requirements that apply to
small businesses.
Fictitious Business Names
You may have to register a fictitious business name (the name you do business under, if it does not include your name as
the owner) with the county clerk in the county where your business is located. Picking a fictitious business name that no
one else is using may involve some research.
Zoning Ordinances
Before you sign a lease, you absolutely need to know that the space is properly zoned for your usage. If it’s not, you’d
better make the lease contingent on your getting the property rezoned or on your getting a variance or conditional use
permit from the planning department. In some communities, you must have a zoning compliance permit before you start
your business in a given location. Zoning laws may also regulate:
1. off-street parking
2. water and air quality
3. waste disposal, and
Consider your position. Keep in mind that you may trigger an investigation of zoning compliance when you apply
for a construction permit for remodeling or when you file tax information with the municipality.
Building Codes
For anything but the most minor renovation, you’re likely to need at least one permit from the department that enforces
building ordinances and codes. (This is usually called the building and safety department, but sometimes another
department, or more than one department, enforces the state building code and the local ordinances.) You may need
separate permits for electrical, plumbing, heating, and ventilating work.
Building codes are amended frequently, and each revision seems to put more requirements on the building owner.
Municipalities often exempt existing businesses from having to bring their premises “up to code” at each revision. This is
sometimes called “grandfathering,” which is slang for not applying new rules retroactively.
Grandfathering can create surprises. You may look at space in an older building and figure that you’ll have no
problems doing business there because the current or most recent tenant didn’t. But the prior occupant may have been
“grandfathered in.” A change in occupancy or ownership may end the benefits of grandfathering, and a new occupant or
owner may be required to make extensive improvements. Don't get caught in this trap! An experienced contractor can help
you determine the building and safety requirements that apply to a particular space, and the probable costs of compliance.
Environmental Issues
Increasingly, environmental concerns are being addressed by regional (multi-county) agencies rather than by (or
sometimes in addition to) the state or local government. This is particularly true in the following areas:
1. air pollution
2. waste water discharge or storage, and
Your business may need a permit or license from the regional authority that governs water quality, allocation, or
treatment.
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The various permit and license requirements for new businesses have three main
purposes:
1. to identify your business and make sure you're accountable for your actions
2. to protect the public health and safety, and
Tax Registrations
You should know about two kinds of federal tax registrations. The first is the Application for an Employer Identification
Number (EIN), Form SS-4, which is available free at www.irs.gov. All corporations, limited liability companies (LLCs), and
partnerships, as well as sole proprietors who will hire employees, need to apply for EINs.
Although using an EIN is a good way to keep your business and personal affairs separate, the IRS doesn't like to give an
EIN to a sole proprietor without employees. In that case, you will probably use your own Social Security number rather
than a separate EIN.
Second, if your business is a corporation and you want to elect status as an S corporation (for special tax treatment), you
need to file Form 2553, Election by a Small Business Corporation, also available at www.irs.gov.
Licenses for Regulated Businesses
You’re not likely to need a federal license or permit unless your business activity or product is supervised by a federal
agency, such as:
1. public transportation and trucking (the Motor Carrier Safety Administration)
2. investment advice (the Securities and Exchange Commission)
3. preparation of meat products or production of drugs (the Food and Drug Administration), or
4. tobacco products, alcohol and firearms (the Bureau of Alcohol, Tobacco and Firearms in the U.S. Treasury
Department).
Environmental Regulations
It’s possible that you’ll become involved with environmental regulations at the federal level (overseen by the
Environmental Protection Agency, or EPA). For example, you may buy a piece of contaminated industrial property that
needs cleaning up, or you may need a license to dispose of toxic by-products from your manufacturing process. For more
information, go to the EPA's Small Business Gateway at www.epa.gov/smallbusiness.
Securities Registration
If you're starting out your business as a corporation, a limited liability company or a limited partnership, and you'll be
sharing ownership with people who will not be actively working in the business, you may need to comply with federal (as
well as state) securities laws.
Securities laws are meant to protect investors from unscrupulous business owners. They require businesses to register the
sale of certain kinds of ownership interests with the federal Securities and Exchange Commission (SEC). This registration
takes time. It typically involves extra legal and accounting fees.
Fortunately, many small corporations get to skip the registration process because of securities "exemptions." For example,
SEC rules don't require a corporation to register a "private offering," which is a nonadvertised sale of stock to either:
1. a limited number of people (generally 35 or fewer), or
2. those who, because of their net worth or income earning capacity, can reasonably be expected to take care of
themselves in the investment process.
If you and a few associates are setting up a business that you'll actively manage, you will no doubt qualify for an
exemption, and you will not have to file any paperwork. For more information about federal exemptions, visit the
SEC's website and read their small business Q & A at www.sec.gov/info/smallbus/qasbsec.htm.
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Local zoning laws commonly require a business to provide parking. They also may regulate the size
and type of business signs. Be prepared for your city or county to look into both these issues. If
there's already a parking problem in your proposed area, you may have to come up with a plan for
how to deal with the increased traffic your business will attract. Also be ready for zoning officials to
get really nitpicky about your business sign. Many local laws limit the size of business signs (no signs
over 5 feet by 3 feet, for instance), their appearance (such as whether they're illuminated, flashing,
colorful, or made of neon), and their placement (flat against the building, hanging over the sidewalk,
or mounted on a pole). There are even some regulations attempting to limit the use of foreign
language on signs. Be sure to find out what your local regulations are before spending money on
having signs made.
One of the key things to understand about zoning laws is that more often than not, they're enforced for the sake of the
other people and companies in the neighborhood (this is particularly true of home-based businesses). While some areas
are strict about their zoning laws, most of the time you won't have a zoning official knocking unannounced on your door
unless neighbors have complained or you're in flagrant violation of the laws. Since enforcement is often triggered by
complaints, it's a good idea to get to know your neighbors and develop good relationships with them.
In most areas, zoning laws are created and monitored by city and county planning departments. Look under "planning" or
"zoning" in the government section of your phone book.
For answers to zoning questions, never rely on what the previous occupants of the space did. Don't assume
that you'll be allowed to do a certain activity simply because the previous tenants did it. For all kinds of reasons, some
businesses get away with zoning violations, even for long periods of time. Typically, however, new occupants are
scrutinized more carefully than existing businesses. It may not be fair, but it's common for a new business to be told it
can't do what an old one had long been doing.
It's also possible that the previous tenants, without violating the zoning rules, were doing something that is no longer
allowed in the area. For example, the previous occupants could have had a zoning variance (an exception to zoning laws)
for their particular business -- one that won't apply to you. And lots of times zoning laws change, but businesses that are
already in a space are allowed to keep doing what they were doing, even if the activity violates that new zoning law (a
system referred to as "grandfathering"). When a tenant with a grandfathered exception leaves and new occupants come
in, the new business will normally have to abide by the new law.
Shelby, owner of Small World Books, is delighted to learn that the drugstore next door is going out of
business. He immediately seeks to buy or sign a long-term lease for the building so he can expand
his profitable business. The future looks rosy.
Not so fast. Shelby learns that for his new business use of the building, he'll have to supply eight
parking spaces to get a permit. Doing this in his desperately crowded neighborhood is totally
impossible at anything approaching an affordable price.
Instead of giving up, Shelby asks the city planning commission for a variance to waive the parking
spaces rule. A public hearing is scheduled. Shelby knows he has to put on a persuasive case, so he:
1. Calls hundreds of local writers, publishers, critics, educators and book lovers to pack the
hearing and testify that an expanded bookstore will be a great community resource.
2. Documents the prohibitive cost of buying or leasing the required parking spaces.
3. Offers to validate at a parking at a lot four blocks away, just outside the worst of the
congested area.
4. Hires an architect who determines that a heavily used, nearly public garage can
accommodate 20 more cars if the parking spaces are striped differently.
5. Offers to pay for the re-striping.
Shelby gets the variance.
Strange as it may seem, many landlords -- especially in office buildings -- take their measurements from the middle or
even the outside of exterior walls. It’s a bit like the butcher who charges you for the bone and fat as well as the edible
portion of the steak. Obviously, if a landlord uses this method of measurement, you’ll wind up paying not only for usable
space but also for some or all of the thickness of the walls.
2. Determine whether and how much you’ll be paying for common areas. In many buildings, there are parts of the
structure or grounds that you’ll share with other tenants. For example, you and other tenants may share lobbies, hallways,
elevator shafts, bathrooms, and parking lots. When you add these spaces up, they can amount to a hefty chunk of the
property. Don’t assume that the landlord is going to let you use these shared facilities for free.
3. Don’t discount the importance of the layout. The way that a space is laid out -- not just its size -- will have a lot to
do with whether you’re getting your money’s worth. For example, awkward angles, interrupted workspaces, or narrow
corridors will be less useful than wide-open areas and passageways that can accommodate bookshelves, office equipment,
dividers, and well-designed work areas. Your rental cost may be less for a $20-per-square-foot space that’s efficiently laid
out than for an $18-per-square-foot space with an awkward configuration, simply because you’ll need less of the $20-per-
square-foot space.
4. Ask whether you will be required to pay for extras. If this is your first foray into the world of commercial leasing,
you may be surprised to learn that the rent doesn’t necessarily mean what it does when you rent an apartment or house.
In a residential situation, rent is normally one fixed amount. You’re rarely asked to pay additional rent -- sums to cover
operating expenses such as building insurance, maintenance, or real estate taxes. These costs are, of course, taken into
consideration when the landlord sets the rent for an apartment, but they’re not added on as separate charges. In a
commercial situation, however, you may be asked to pay for some or all of these additional sums.
5. Ask if the landlord will want a percentage of your profits. Shopping center landlords often demand a share of a
retail tenant’s profits in addition to the monthly rent. If you have a retail business and are headed for the mall, you may be
asked to pay what’s known as "percentage rent."
Want to Learn More?
For help negotiating rent, see Negotiate the Best Lease for Your Business, by attorneys Janet
Portman and Fred S. Steingold.
Parties or Lessor and Lessee The names of the landlord and tenant
Term When the lease begins and how long it will run
Hold Over What happens if you don’t move out as planned at the
end of your lease
Use Restrictions and requirements on how you use your
rented space
Utilities Explains how utilities are metered and how costs are
apportioned
Taxes Describes which taxes you will have to pay for, and how
much
Insurance & Indemnity Covers which insurance policies you must take out or pay
for
Alterations & Repairs Explains which alterations you may make and whether
you need permission, plus delegates repair duties
Assignment & Subletting Describes the conditions under which you can turn space
over to another tenant
Defaults & Remedies Explains what happens if you or the landlord fails to live
up to the lease
Subordination, Nondisturbance, & Attornment Financing clauses covering what happens if your
landlord’s lender forecloses on a loan that’s secured by
the building
Attorney Fees Your agreement as to who pays the winner’s fees and
costs if a disagreement ends in litigation
Guaranty Your promise that you will provide someone who will
guarantee your financial duties under the lease. (This
guarantor must also sign the lease.)
To learn about the ins and outs of negotiating each of the above lease clauses, see Negotiate the
Best Lease for Your Business, by attorneys Janet Portman and Fred S. Steingold.
Brokers and agents are great sources of information on rental costs in various neighborhoods.
They'll generally give you an average figure for the cost of commercial space per square foot per year
in a given area. Once you have this figure, you can compare it to the costs of other spaces you're
considering.
If you haven't done so already, research the average rental costs in your area to make sure the amount you budgeted for
rent makes sense, given the cost of commercial space in your area and how important location is for your business. For
example, if you determined that location is very important to your business, make sure your budget will allow you to rent
good space given the average cost of space in your area. If not, you may have to rework your business plan.
Is Your Proposed Location Appropriate for What You Plan to Do There?
When choosing business space, the biggest consideration is sometimes not where it is but what it is. The building facilities
need to be appropriate for (or adaptable to) your business. For example, if you're planning to open a coffeehouse, you
need a place with at least minimal kitchen facilities. Unless you can convince the landlord to put in the needed equipment
-- plumbing, electrical work, and the rest -- it's highly unlikely that laying out the cash to do it yourself will be worth it. In
short, if a building lacks something major that is essential to your business operation, you should probably look for
something else.
Communications Wiring
Another consideration that's important for many businesses these days is having modern phone and other data lines
available to the business. When you're considering a specific space, ask the agent or the landlord for information about
communications wiring, such as whether the space is connected to a fiber optic network or is wired for DSL or a T1 line
(high-volume Internet connections). Also, find out to whom the landlord has sold the rights to the risers (wire conduits) in
the building. A commercial landlord cannot enter into exclusive contracts with a single telecommunications provider such
as MCI or AT&T. However, to bring in another provider of your choosing could be expensive.
Parking
Adequate parking is another common need for many businesses. If a significant percentage of your customers will come by
car and there isn't enough parking at your chosen spot, it's probably best to look elsewhere. In fact, the city planning or
zoning board might not allow you to operate in a space that doesn't have adequate parking.
Zoning Rules
Finally, the location that you choose needs to be legally acceptable for whatever you plan to do there. A certain spot may
be good for business, but if it's not zoned for what you plan to do, you're asking for trouble.
You should never sign a lease without being sure you'll be permitted to operate your business in that space. Your city
planning or zoning board determines what activities are permissible in a given location. If your zoning board has a problem
with any of your business activities, and it's not willing to work out a way to accommodate your business, you may have to
find another space.
Working from home can be much simpler than renting a separate office space, but it might put you in
violation of zoning and other laws that regulate residential and business spaces. Be sure you're
familiar with the laws that affect home businesses, as well as other legal issues such as the home-
office tax deduction.
An exclusive clause is a promise by the landlord that only you and no one else in the mall or building may engage in a
particular type of business or carry a certain type of merchandise. (Naturally, other tenants will have use clauses that
prevent them from conducting business activities that would violate your “exclusive.”) Typically, only powerful “anchor”
tenants get exclusives.
Term Clause
Near the beginning of the lease, you’ll see a clause entitled “Term.” This clause describes the length of your lease and
specifies the starting and ending dates. You may be tempted to cruise right through it -- after all, if you want a five-year
lease and the Term clause gives you five years, where’s the complication? Alas, there’s more than one tricky wrinkle and
they’re apt to be hidden and dangerous. For example, some leases start as of the date the lease is signed, even though
you haven’t conducted business for even a day. Though you might not be responsible for rent right away, you will be
responsible for other obligations in the lease, such as the requirement that you carry insurance. Done properly, leases
should have many “start” dates, corresponding to when you can enter to set up, when your rent is due, when you become
responsible for securing insurance, when you can open for business, and so on.
Rent
For most small businesses, the amount of the monthly rent obligation is a very important issue. It’s important to look
carefully at the landlord’s lease clauses to see whether your rent estimates will pan out and to determine any new costs or
savings, such as:
1. expenses that you didn’t anticipate -- make sure you understand which parts of the landlord’s operating costs will
be passed-on to you
2. savings that may make it possible to shoulder other expenses -- for example, the landlord may offer a “tenant
improvement allowance,” which you will use to get the space ready for your operations, or
3. issues that you want to renegotiate, such as the landlord’s expectation that the rent will increase by a certain
amount on a stated date.
Security Deposits
Your landlord may ask for a security deposit to assure that cash will be available if you fail to pay the rent or don’t make
other payments required under the lease. Unlike residential landlords, who in many states may not ask for more than two
months’ rent as a deposit, commercial landlords may demand whatever amount they think they need as a cushion to cover
rent and other tenant financial obligations.
Or, instead of a security deposit, your landlord may ask for a “Letter of Credit” from your bank, in which the bank puts
aside an agreed-upon amount of your funds for use by the landlord should you not carry-out your financial obligations.
Other Clauses
Other common and important clauses in business leases include Option to Renew or Sublet (and
other Flexibility Clauses), Breaking the Lease, Disputes, Attorney Fees, Foreclosures, Condemnations,
and Guarantors. Nolo’s Negotiate the Best Lease for Your Business, by attorneys Janet Portman and
Fred S. Steingold, explains these clauses in detail.
1. Rule 1: Understand that the terms almost always favor the landlord.
2. Rule 2: Know that with a little effort you can almost always negotiate significant improvements to the terms.
In theory, all terms of a lease are negotiable. But your negotiating power depends on whether your local rental market is
hot or cold. If plenty of commercial space is available, you can probably win many landlord concessions. If your area's
rental market is tight or you are chasing a unique space, you'll have considerably less leverage.
Length of the Lease
One area of the lease you should always focus on is its length -- also called its "term." A short-term lease is almost always
to your benefit. Shorter leases give you more flexibility if the needs of your business change -- for example, you want
more space or decide that a different location would be better. There is a trade-off here, of course. A long-term lease
ensures that you'll have an affordable business space for a predictable period of time. And landlords are often willing to
make more concessions on longer-term leases.
If your business isn't particularly location-sensitive (a mail-order business or software testing lab, for example) and plenty
of commercial space is available in your area, then a short-term lease makes sense. Even if the landlord doesn't renew
your lease, finding comparable space won't be a problem.
On the other hand, if you have found an especially favorable location for a retail shop, restaurant or other business where
location is key, deciding on the best lease term is more problematic. If your business does well, you'll want the right to
stay on for an extended period. On the other hand, you'll probably be nervous about signing a four-year lease in case your
business goes kaput.
A good solution is to bargain for a short initial lease with one or more options to renew -- perhaps a one- or two-year lease
with an option to renew for two or three more years. Typically, an option to renew gives you the right to exercise your
option to stay by notifying your landlord in writing a certain number of days or months before the initial lease period
expires.
If you ask for an option, expect the landlord to want a higher rent for the renewal period. If the property is particularly
desirable, the owner may also want an extra fee in exchange for giving you the option of staying or leaving after your
initial term is up. This is a common arrangement, and if the space is important to the success of your business, seriously
consider paying it.
Rent and Rent Increases
Another primary issue to consider when leasing space is how much rent you'll pay. It's sensible to check out rates for
comparable spaces. If the rent seems unjustifiably high, try asking for a reduction. Many landlords, however, usually won't
consider lowering the rent (except in poor economic times or areas), but you may be able to get a few months of reduced
rent to compensate for moving costs.
Landlords will usually include an annual increase to your rent in your lease terms. If the landlord insists on keeping the
clause, try to get a cap on the amount of each year's increase, and try to exclude a rent increase for the first year.
When you're shopping around, look carefully at whether the landlord will pay utilities, repairs, taxes and insurance. With a
"gross lease," your rent includes these costs. By contrast, with a " net lease" you pay for them separately -- potentially a
large sum. In fact, the best approach may be to offer to pay a higher amount for rent in exchange for eliminating these
extras.
Tenant Improvements
If you'll need lots of improvements to the space, you may want to use the lion's share of your bargaining power to have
the landlord provide them at no cost to you. If you're willing to sign a long-term lease, the landlord will be more willing to
pay for improvements to the property.
Subleases and Assignments
Ask for the right to sublease or assign your space. That way, if you need to move out, you'll be able to have another
tenant take your space and pay the rent, without having to break the lease. Or, if you rent enough space to grow into, you
can sublease some of the space until you're ready to use it.
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1. Fewer consumer protection laws. Commercial leases are not subject to most consumer protection laws that
govern residential leases -- for example, there are no caps on security deposits or rules protecting a tenant's privacy.
2. No standard forms. Many commercial leases are not based on a standard form or agreement; each commercial
lease is customized to the landlord's needs. As a result, you need to carefully examine every commercial lease agreement
offered to you.
3. Long-term and binding. You cannot easily break or change a commercial lease. It is a legally binding contract,
and a good deal of money is usually at stake.
4. Negotiability and flexibility. Commercial leases are generally subject to much more negotiation between the
business owners and the landlord, since businesses often need special features in their spaces, and landlords are often
eager for tenants and willing to extend special offers.
Making Sure the Lease Will Fit Your Business
Before you sign a lease agreement, you should carefully investigate its terms to make sure the lease meets your
business's needs.
First, consider the amount of rent -- make sure you can afford it -- and the length of the lease. You probably don't want to
tie yourself to a five- or ten-year lease if you can help it; your business may grow faster than you expect or the location
might not work out for you. A short-term lease with renewal options is usually safer.
Also think about the physical space. If your business requires modifications to the existing space -- for example, adding
cubicles, raising a loading dock, or rewiring for better communications -- make sure that you (or the landlord) will be able
to make the necessary changes.
Other, less conspicuous items spelled out in the lease may be just as crucial to your business's success. For instance, if
you expect your camera repair business to depend largely on walk-in customers, be sure that your lease gives you the
right to put up a sign that's visible from the street. Or, if you are counting on being the only sandwich shop inside a new
commercial complex, make sure your lease prevents the landlord from leasing space to a competitor.
The following list includes many items that are often addressed in commercial leases. Pay attention
to terms regarding:
1. the length of lease (also called the lease term), when it begins and whether there are
renewal options
2. rent, including allowable increases (also called escalations) and how they will be computed
3. whether the rent you pay includes insurance, property taxes, and maintenance costs (called
a gross lease); or whether you will be charged for these items separately (called a net lease)
4. the security deposit and conditions for its return
5. exactly what space you are renting (including common areas such as hallways, rest rooms,
and elevators) and how the landlord measures the space (some measurement practices include the
thickness of the walls)
6. whether there will be improvements, modifications (called build outs when new space is
being finished to your specifications), or fixtures added to the space; who will pay for them, and who
will own them after the lease ends (generally, the landlord does)
7. specifications for signs, including where you may put them
8. who will maintain and repair the premises, including the heating and air conditioning
systems
9. whether the lease may be assigned or subleased to another tenant
10. whether there's an option to renew the lease or expand the space you are renting
11. if and how the lease may be terminated, including notice requirements, and whether there
are penalties for early termination, and
The Americans with Disabilities Act. The Americans with Disabilities Act (ADA) requires all
businesses that are open to the public or that employ more than 15 people to have premises that are
accessible to disabled people. Make sure that you and your landlord are in agreement about who will
pay for any needed modifications, such as adding a ramp or widening doorways to accommodate
wheelchairs.
Nolo’s Negotiate the Best Lease for Your Business, by attorneys Janet Portman and Fred S. Steingold,
has more information about every item listed above.
Ten Steps to Determining the Space You Need for Your Business
From the Nolo Business & Human Resources Center
Prioritize your needs before you look for commercial space to rent.
Whether you’re a small start-up or an established business, you should begin each search by carefully thinking through
your needs. A clear understanding of what you do (and don’t) want for your business will save precious time and money,
commodities that you undoubtedly want to plow into the business itself. So before you hit the pavement or engage a
broker to help you find the right spot, go through the points below and analyze what’s most important to you in a business
rental.
First, before you plunge headlong into the search for suitable commercial space, think carefully about whether you really
need to find space now. It may make more sense to run your business from your home. If you’re just starting out in a
business that doesn’t require significant space or ready access to the public, maybe you can keep expenses low by working
out of your house or apartment.
Or, if you’re already renting space but looking to move, you might consider ways to improve your current lease situation
and avoid the expense and inconvenience of relocating. Take another look at your lease -- does it have an option clause,
enabling you to expand into available space?
1. Priorities. If you’re convinced that now is the time to move, think carefully about what you need, would like, and won’t
abide. Take out a sheet of paper and list items in three columns: "Must Have," "Nice to Have," and "Won’t Have." Your goal
is to end up with a concise statement expressed in words (“downtown area”) or numbers (“maximum $3,000 rent”). When
you begin to consider available space, you can use this list to quickly and concisely evaluate its suitability.
2. Rent. The first issues to consider are the most obvious and, for many, the most important. Figure out the maximum
rent your business can afford to pay per month. And if the landlord asks you to put down a security deposit before you
move in, think about whether your reserves can handle a particularly big hit in the first month. Finally, consider how much
money you can afford to spend to alter the space to fit your needs and tastes.
3. Location. The physical location of your business is likely to be important to you, your employees, your customers or
clients, and/or your suppliers. The more people and groups you need to please, the smaller the number of possible rentals
that will fit the bill. Consider the neighborhood, commuting time, and access to public transportation.
4. Length of the lease. It may be important for you to secure a space that will be yours for a long time to come -- or you
might want the flexibility of a shorter lease. Do you need to find a place right away? Or do you have the luxury of shopping
around until you see the perfect spot? You need to assign a value -- a priority -- to the length of the lease and when it’s
available.
5. Size and physical features. Almost every tenant is concerned about the size of the rental. You’ll want enough space,
but to keep the rent down, limit the size to what you really need. You’ll want the space to be well laid-out, comfortable,
and welcoming to employees, clients, and customers.
6. Parking. For many businesses, it’s essential to have ample parking -- whether in a designated lot on the building site,
on the street, or in a nearby parking garage. Parking may be a high priority for several reasons. If public transit is
inadequate, people will need to drive to your business. If your business involves selling or servicing large items such as
stereo equipment, customers will need nearby parking.
7. Building security. If crime is a known problem in the neighborhood and customers or employees are assaulted or
robbed, you may be found partially responsible if you have not taken reasonable steps to prevent criminal incidents, or at
least warn of them. Your landlord, too, may ultimately bear some responsibility, but the portion of a jury award or
settlement figure that you end up paying is hardly the point. You never want to be in a position of worrying about
customers’ and employees’ safety. So think carefully about the security of the neighborhood, and if you conclude that the
risk is too high, look elsewhere.
8. Image and maintenance. The way a building looks -- and how it’s maintained -- will be important to some and
practically irrelevant to others. In general, the more your business serves the public, the more important is the building’s
appearance. If no one ever sees or visits your business, it may not matter much, except to you and your employees.
9. Expansion or purchase potential. If you plan on growing your business or would like to own your building in the
future, you may want to rent space that has the potential for expansion or purchase. You’ll save yourself the hassle and
expense of another search and move to new space, and you may be able to lock in favorable expansion or purchase terms
now, in your lease. Look for a a lease with an option to renew or an option to buy.
10. Neighboring tenants. It may be important to be in a building with certain types of tenants -- for example,
businesses that complement yours or provide a needed service. Lawyers, for example, may want to locate in a building
where there are accountants or title insurance providers. Healthcare professionals may want to be near a hospital,
pharmacy, or lab. Whatever your business, you may want to find a building that houses a health club, coffee shop, or a
fast copy service that you, your employees, or customers will find handy.
Nolo’s Negotiate the Best Lease for Your Business, by attorneys Janet Portman and Fred Steingold,
contains in-depth information about determining what space is best for your business, evaluating
vacancies, and negotiating the best price.
Nolo's book LLC or Corporation? How to Choose the Right Form for Your Business, by attorney
Anthony Mancuso, provides lots of real-world scenarios that demonstrate how these options work for
different types of companies.
After learning the basics of each business structure and considering the factors discussed above,
you may still find that you need help deciding which structure is best for your business. A good small
business or tax lawyer can help you choose the right one, given your tax picture and the possible
risks of your particular situation.
7. cooperative.
Sole Proprietorships
A sole proprietorship is a one-person business that is not registered with the state like a limited liability company (LLC) or
corporation. You don't have to do anything special or file any papers to set up a sole proprietorship -- you create one just
by going into business for yourself.
Legally, a sole proprietorship is inseparable from its owner -- the business and the owner are one and the same. This
means the owner of the business reports business income and losses on his or her personal tax return and is personally
liable for any business-related obligations, such as debts or court judgments.
Partnerships
Similarly, a partnership is simply a business owned by two or more people that hasn't filed papers to become a corporation
or a limited liability company (LLC). You don't have to file any paperwork to form a partnership -- the arrangement begins
as soon as you start a business with another person. As in a sole proprietorship, the partnership's owners pay taxes on
their shares of the business income on their personal tax returns and they are each personally liable for the entire amount
of any business debts and claims.
Sole proprietorships and partnerships make sense in a business where personal liability isn't a big worry -- for example, a
small service business in which you are unlikely to be sued and for which you won't be borrowing much money for
inventory or other costs.
Limited Partnerships
Limited partnerships are costly and complicated to set up and run, and are not recommended for the average small
business owner. Limited partnerships are usually created by one person or company (the "general partner"), who will
solicit investments from others (the "limited partners").
The general partner controls the limited partnership's day-to-day operations and is personally liable for business debts
(unless the general partner is a corporation or an LLC). Limited partners have minimal control over daily business decisions
or operations and, in return, they are not personally liable for business debts or claims. Consult a limited partnership
expert if you're interested in creating this type of business.
Corporations and LLCs
Forming and operating an LLC or a corporation is a bit more complicated and costly, but well worth the trouble for some
small businesses. The main benefit of an LLC or a corporation is that these structures limit the owners' personal liability for
business debts and court judgments against the business.
What sets the corporation apart from all other types of businesses is that a corporation is an independent legal and tax
entity, separate from the people who own, control and manage it. Because of this separate status, the owners of a
corporation don't use their personal tax returns to pay tax on corporate profits -- the corporation itself pays these taxes.
Owners pay personal income tax only on money they draw from the corporation in the form of salaries, bonuses, and the
like.
Like corporations, LLCs provide limited personal liability for business debts and claims. But when it comes to taxes, LLCs
are more like partnerships: the owners of an LLC pay taxes on their shares of the business income on their personal tax
returns.
Corporations and LLCs make sense for business owners who either 1) run a risk of being sued by customers or of piling up
a lot of business debts, or 2) have substantial personal assets they want to protect from business creditors.
Nonprofit Corporations
A nonprofit corporation is a corporation formed to carry out a charitable, educational, religious, literary ,or scientific
purpose. A nonprofit can raise much-needed funds by soliciting public and private grant money and donations from
individuals and companies. The federal and state governments do not generally tax nonprofit corporations on money
they take in that is related to their nonprofit purpose, because of the benefits they contribute to society.
Cooperatives
Some people dream of forming a business of true equals -- an organization owned and operated democratically by its
members. These grassroots business organizers often refer to their businesses as a "group," "collective," or "co-op" -- but
these are often informal rather than legal labels. For example, a consumer co-op could be formed to run a food store, a
bookstore, or any other retail business. Or a workers' co-op could be created to manufacture and sell arts and crafts. Most
states do have specific laws dealing with the set-up of cooperatives, and in some states you can file paperwork with the
secretary of state's office to have your cooperative formally recognized by the state. Check with your secretary of state's
office for more information.
Next Steps
You may want to also read LLC or Corporation? How to Choose the Right Form for Your Business, by
Anthony Mancuso (Nolo).
Risky Businesses
From the Nolo Business & Human Resources Center
Businesses that take chances start out with a strike against them.
Starting a business is always risky. In some businesses, however, the risks are particularly extreme. If you're planning to
launch an investment firm or start a hazardous waste management company, there's little doubt that you'll need all the
protection you can get, including limited personal liability as well as adequate insurance. Other businesses are not so
obviously risk-laden, but could still land you in trouble if fate strikes you a blow.
Here are a few red flags to watch for when analyzing the risks involved in your business:
1. using hazardous materials, such as dry cleaning solvents or photographic chemicals, or hazardous processes,
such as welding or operating heavy machinery
2. manufacturing or selling edible goods
3. building or repairing structures or vehicles
4. caring for children or animals
5. providing or allowing access to alcohol
6. driving as the main part of the job
7. allowing activities that may result in injury, such as weightlifting or skateboarding, and
If your business will face one or more risks like those listed here, consider whether business insurance will provide
adequate protection. Some risky activities, such as job-related driving, are good candidates for insurance and don't
necessarily warrant incorporating. But if insurance can't cover all of the risks involved in your business, you should
consider forming an LLC or a corporation, which will protect your personal asserts from claims and judgments against your
business.
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Copyright 2006 Nolo
1. You expect to have multiple investors in your business or to raise money from the public. While an LLC
works fine when you have just a few investors -- especially those who will be active in the day-to-day operations of the
business -- it may get more awkward when the number of investors increases. For example, you'll likely run into resistance
from potential investors if you can't offer them the corporate stock certificates that they consider tangible evidence of their
partial ownership of the business. Rather than wasting your time trying to overcome this resistance, it's probably better to
structure your business as a corporation.
2. You'd like to provide extensive fringe benefits to owners. Often, when you form a corporation, you expect
to be both a shareholder (owner) and an employee. The corporation can, for example, hire you to serve as its chief
executive officer, pay you a tax-deductible salary, and provide fringe benefits as well. These benefits can include the
payment of health insurance premiums and direct reimbursement of medical expenses.
The corporation can deduct the cost of these benefits and they are not treated as taxable income to the employees, which
can be an attractive feature of doing business through a regular corporation. With an LLC, you can only deduct a portion of
medical insurance premium payments, and other fringe benefits provided to members do not receive as favorable tax
treatment.
1. You want to entice or keep key employees by offering stock options and stock bonus incentives.
Simply put, LLCs don't have stock; corporations do. While it's possible to reward an employee by offering a membership
interest in an LLC, the process is awkward and likely to be less attractive to employees. Therefore, if you plan to offer
ownership in your business as an employee incentive, it makes sense to incorporate rather than form an LLC.
When an S Corporation May Make Sense
Self-employment taxes can tip the balance toward S corporations, since LLC owners may pay more. What are self-
employment taxes? Well, you know that taxes are withheld from employees' paychecks. In 2006, employers must withhold
7.65% of the first $94,200 of an employee's pay for Social Security and Medicare taxes, and 1.45% of earnings above that
amount for Medicare taxes alone. The employer adds an equal amount and sends these funds to the IRS. (The total sent to
the IRS is 15.3% on the first $94,200 of wages and 2.9% on anything above that.) You may not be aware that the IRS
collects a similar 15.3% tax on the first $94,200 earned by a self-employed person and a 2.9% tax on earnings above that
amount. This is the self-employment tax.
For an S corporation, the rules on the self-employment tax are well established: as an S corporation shareholder, you pay
the self-employment tax on money you receive as compensation for services, but not on profits that automatically pass
through to you as a shareholder. For example, if your share of S corporation income is $100,000 in 2005 and you perform
services for the corporation reasonably worth $65,000, you will owe the 15.3% self-employment tax on the $65,000 but
not on the remaining $35,000.
By contrast, the self-employment tax may be imposed on an LLC owner's entire share of LLC profits. However, the rules
for members of an LLC are murky.
Proposed IRS regulations (which Congress has placed on indefinite hold) would impose the self-employment tax on an LLC
owner's entire share of LLC profits in any of the following situations:
1. The LLC owner participates in the business for more than 500 hours during the LLC's tax year.
2. The LLC provides professional services in the fields of health, law, engineering, architecture, accounting, actuarial
science or consulting (no matter how many hours the owner works).
3. The LLC owner is empowered to sign contracts on behalf of the LLC.
Until the IRS clarifies the rules on self-employment tax for members of an LLC, you should assume that 100% of an LLC
member's earnings will be subject to the tax.
Therefore, an S corporation shareholder may pay less self-employment tax than an LLC member with similar income. You'll
need to decide if this potential tax saving is enough to offset such LLC advantages as less formal record keeping and
flexibility in management structure and in the method of distributing profits and losses.
You will probably find that you need more help deciding which structure is best for your business. A
good small business or tax lawyer can help you choose the right one, given your tax picture and the
possible risks of your particular situation. You might also benefit from reading Nolo's new book, LLC
or Corporation? How to Choose the Right Form for Your Business, by attorney Anthony Mancuso.
General Partnership Simple and inexpensive to create and Owners (partners) personally liable for business debts
operate
Owners (partners) report their share
of profit or loss on their personal tax
returns
Limited Partnership Limited partners have limited personal General partners personally liable for business debts
liability for business debts as long as
More expensive to create than general partnership
they don't participate in management
Suitable mainly for companies that invest in real estate
General partners can raise cash
without involving outside investors in
management of business
Regular Corporation Owners have limited personal liability More expensive to create than partnership or sole
for business debts proprietorship
Fringe benefits can be deducted as Paperwork can seem burdensome to some owners
business expense
Separate taxable entity
Owners can split corporate profit
among owners and corporation,
paying lower overall tax rate
S Corporation Owners have limited personal liability More expensive to create than partnership or sole
for business debts proprietorship
Owners report their share of corporate More paperwork than for a limited liability company which
profit or loss on their personal tax offers similar advantages
returns
Income must be allocated to owners according to their
Owners can use corporate loss to ownership interests
offset income from other sources
Fringe benefits limited for owners who own more than 2% of
shares
Professional Owners have no personal liability for More expensive to create than partnership or sole
Corporation malpractice of other owners proprietorship
Paperwork can seem burdensome to some owners
All owners must belong to the same profession
Nonprofit Corporation doesn't pay income taxes Full tax advantages available only to groups organized for
Corporation charitable, scientific, educational, literary or religious
Contributions to charitable corporation
purposes
are tax-deductible
Property transferred to corporation stays there; if
Fringe benefits can be deducted as
corporation ends, property must go to another nonprofit
business expense
Limited Liability Owners have limited personal liability More expensive to create than partnership or sole
Company for business debts even if they proprietorship
participate in management
State laws for creating LLCs may not reflect latest federal
Profit and loss can be allocated tax changes
differently than ownership interests
IRS rules now allow LLCs to choose
between being taxed as partnership or
corporation
Professional Limited Same advantages as a regular limited Same as for a regular limited liability company
Liability Company liability company
Members must all belong to the same profession
Gives state licensed professionals a
way to enjoy those advantages
Limited Liability Mostly of interest to partners in old Unlike a limited liability company or a professional limited
Partnership line professions such as law, medicine liability company, owners (partners) remain personally liable
and accounting for many types of obligations owed to business creditors,
lenders and landlords
Owners (partners) aren't personally
liable for the malpractice of other Not available in all states
partners
Often limited to a short list of professions
Owners report their share of profit or
loss on their personal tax returns
In addition to establishing what property is covered under a property insurance policy, you'll need to understand which
types of losses are covered. Most commercial property insurance policies provide either "basic," "broad" or "special" form
coverage, with special form policies offering the broadest coverage and basic the narrowest.
A basic form policy commonly covers fire, explosions, storms, smoke, riots, vandalism and sprinkler leaks. A broad form
policy typically adds damage from broken windows and other structural glass, falling objects and water damage to the list
of covered items. (Note that theft isn't typically covered under either a basic or broad form policy, a fact that surprises
many business owners.)
Special form coverage offers the widest range of protection, as it typically covers all risks (including theft), unless
specifically excluded from the policy. While premiums for special form policies are more expensive, it may be worth the
expense if your business faces multiple or unusual risks. Before purchasing any insurance policy, read it carefully to
determine what types of damage are covered.
Also, make sure you understand the coverage limits on various policies, any deductibles or co-payments required, and how
the insurance company pays claims. "Guaranteed replacement cost" insurance will reimburse you what it costs you to
replace the property, not merely its current (depreciated) value. If your computer equipment is destroyed, for instance,
this type of coverage will pay you as much as you'll need to replace it -- at today's cost.
Liability Insurance
Liability coverage protects your business against situations like the notorious slip-and-fall accident: someone injures
himself on your premises and sues you. A general liability policy (versus a product liability or vehicle liability policy) covers
damages that your business is ordered to pay to an individual (customer, supplier, business associate) who is injured on
your property.
A related, though technically different, type of insurance is product liability insurance, which protects you from lawsuits by
customers who claim to be hurt by a product you provided. If your business offers a product to the public, you might
consider this type of insurance. It can be expensive, but much less so than a multi-million dollar award to a victorious
plaintiff.
Finally, auto liability insurance covers damage that you or an employee cause in a business-related accident. Auto liability
coverage is not included in general liability policies, and is legally required for drivers in all but four states (Mississippi,
New Hampshire, Tennessee and Wisconsin). Even if this type of insurance is not required in your state, it's foolish not to
protect yourself against the potentially devastating risk of an auto accident. Make sure you insure any vehicles used in
your business, including employees' personal cars that are used for business purposes.
Liability insurance will never insulate you from regular business debts. If you think there's a
chance that your business will fall into serious debt, an LLC or corporation is probably the best
business structure for you.
If you are an employer, you will be subject to a number of additional insurance requirements --
you must typically pay for workers' compensation insurance, unemployment insurance and state
disability insurance. These insurance programs are specifically for employers and are largely
regulated at the state level. To find out more, contact your state employment department.
Examples
Example 1: Lester is the owner of a small manufacturing business. When business prospects look
good, he orders $50,000 worth of supplies and uses them in creating merchandise. Unfortunately,
there's a sudden drop in demand for his products, and Lester can't sell the items he has produced.
When the company that sold Lester the supplies demands payment, he can't pay the bill. As sole
proprietor, Lester is personally liable for this business obligation. This means that the creditor can
sue him and go after not only Lester's business assets, but his personal property as well. This can
include his house, his car, and his personal bank account.
Example 2: Shirley is the owner of a flower shop. One day Roger, one of Shirley's employees, is
delivering flowers using a truck owned by the business. Roger strikes and seriously injures a
pedestrian. The injured pedestrian sues Roger, claiming that he drove carelessly and caused the
accident. The lawsuit names Shirley as a co-defendant. After a trial, the jury returns a large verdict
against Shirley as owner of the business. Shirley is personally liable to the injured pedestrian. This
means the pedestrian can go after all of Shirley's assets, business and personal.
By contrast, the law provides owners of corporations and limited liability companies (LLCs) with what's called "limited
personal liability" for business obligations. This means that, unlike sole proprietors and general partners, owners of
corporations and LLCs can normally keep their house, investments, and other personal property even if their business fails.
If you will be engaged in a risky business, you may want to consider forming a corporation or an LLC.
Paying Taxes on Business Income
In the eyes of the law, a sole proprietorship is not legally separate from the person who owns it. The fact that a sole
proprietorship and its owner are one and the same means that a sole proprietor simply reports all business income or
losses on his or her individual income tax return -- IRS Form 1040, with Schedule C attached.
As a sole proprietor, you'll have to take responsibility for withholding and paying all income taxes -- something an
employer would normally do for you. This means you'll have to pay a "self-employment" tax, which consists of
contributions to Social Security and Medicare, and pay estimated taxes throughout the year.
Registering Your Sole Proprietorship
Unlike an LLC or a corporation, you generally don't have to file any special forms or pay any fees to start working as a sole
proprietor. All you have to do is state that your business is a sole proprietorship when you complete the general
registration requirements that apply to all new businesses.
Most cities and many counties do require businesses -- even tiny home-based sole proprietorships -- to register with them
and pay at least a minimum tax. In return, your business will receive a business license or tax registration certificate. You
may also have to obtain an employer identification number from the IRS (if you have employees), a seller's license from
your state, and a zoning permit from your local planning board.
If you do business under a name different from your own (such as "Custom Coding" instead of "Jim Smith Graphics"), you
usually must register that name -- known as a fictitious, or assumed, business name -- with your county.
In practice, lots of businesses are small enough to get away with ignoring these requirements. But if you are caught, you
may be subject to back taxes and other penalties.
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If you're confused by partnership taxes, you're not alone. A good way to learn the basics is to
read Tax Savvy for Small Business, by tax attorney Fred Daily (Nolo). Then, plan to get the help you
need from a tax advisor who specializes in partnership taxation, to make sure you comply with the
complex tax rules that apply to your business and stay on the good side of the IRS.
Each state (with the exception of Louisiana) has its own laws governing partnerships, contained in what's usually called
"The Uniform Partnership Act" or "The Revised Uniform Partnership Act" (or the "UPA" or "Revised UPA"). These
statutes establish the basic legal rules that apply to partnerships and will control many aspects of your partnership's life
unless you set out different rules in a written partnership agreement.
Don't be tempted to leave the terms of your partnership up to these state laws. Because they were designed as one-
size-fits-all fallback rules, they may not be helpful in your particular situation. It's much better to have an agreement in
which you and your partners state the rules that will apply to your business.
1. Name of the partnership. One of the first things you must do is agree on a name for your partnership. You can
use your own last names, such as Smith & Wesson, or you can adopt and register a fictitious business name, such as
Westside Home Repairs. If you choose a fictitious name, you must make sure that the name isn't already in use and then
file a fictitious business name statement with your county clerk.
2. Contributions to the partnership. It's critical that you and your partners work out and record who's going to
contribute cash, property, or services to the business before it opens -- and what ownership percentage each partner will
have. Disagreements over contributions have doomed many promising businesses.
3. Allocation of profits, losses, and draws. Will profits and losses be allocated in proportion to a partner's
percentage interest in the business? Will each partner be entitled to a regular draw (a withdrawal of allocated profits from
the business) or will all profits be distributed at the end of each year? You and your partners may have different financial
needs and different ideas about how the money should be divided up and distributed, so this is an area to which you
should pay particular attention.
4. Partners' authority. Without an agreement to the contrary, any partner can bind the partnership (to a contract
or debt, for example) without the consent of the other partners. If you want one or all of the partners to obtain the others'
consent before obligating the partnership, you must make this clear in your partnership agreement.
5. Partnership decision making. Although there's no magic formula or language for making decisions among
partners, you'll head off a lot of trouble if you try to work it out beforehand. You may, for example, want to require a
unanimous vote of all the partners for every business decision. Or if that leaves you feeling fettered, you can require a
unanimous vote for major decisions and allow individual partners to make minor decisions on their own. In that case, your
partnership agreement will have to describe what constitutes a major or minor decision. You should carefully think through
issues like these before you and your partners have to make important decisions
1. Management duties. You might not want to make ironclad rules about every management detail, but you'd be
wise to work out some guidelines in advance. For example, who will keep the books? Who will deal with customers?
Supervise employees? Negotiate with suppliers? Think through the management needs of your partnership and be sure
you've got everything covered.
2. Admitting new partners. Eventually, you may want to expand the business and bring in new partners.
Agreeing on a procedure for admitting new partners will make your lives a lot easier when this issue comes up.
3. Withdrawal or death of a partner. At least as important as the rules for admitting new partners to the
business are the rules for handling the departure of an owner. You should set up a reasonable buyout scheme in your
partnership agreement.
4. Resolving disputes. If you and your partners become deadlocked on an issue, do you want to go straight to
court? It might benefit everyone involved if your partnership agreement provides for alternative dispute resolution, such as
mediation or arbitration.
As you can see, there are many issues to consider before you and your partners open for business -- and you shouldn't
wait for a conflict to arise before hammering out some sound rules and procedures. A good self-help book, such as The
Partnership Book: How to Write a Partnership Agreement, by attorneys Denis Clifford and Ralph Warner (Nolo), can help
you think through the details and put them in writing.
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Making Special Allocations
From the Nolo Business & Human Resources Center
You must carefully follow IRS rules if you want to divide profits and losses in a way that's disproportionate to
the owners' interests in the business. If a business splits up profits and losses in a way that does not correspond to
the owners' percentage interests in the business, it's called a "special allocation." The IRS pays careful attention to special
allocations to be sure business owners aren't playing hide and seek with potential tax dollars -- for example, by allocating
all business losses to the owner in the highest income tax bracket.
If the IRS rejects your special allocation, it will tax you and your co-owners as if you had divided profits and losses in
proportion to your ownership interests, regardless of what your partnership agreement or operating agreement says.
Substantial Economic Effect
To be certain that a special allocation is legitimate, the IRS checks to see whether the allocation has what it calls
"substantial economic effect." This jargon means that a special allocation must reflect the owners' actual economic
circumstances, not an effort to shift income around to reduce taxes.
Example
John and Anna set up an LLC to operate their consulting business. John puts up all the cash, while
Anna signs a promissory note to contribute her share in installments over the first two years of the
business. Their operating agreement says that John and Anna each have a 50% ownership interest in
the LLC, but it also says that John will be allocated 75% of the LLC's profits (and losses) for the first
two years, and Anna will be allocated 25% of the LLC's profits (and losses) during this initial period.
After the first two years, the agreement says that both members will split LLC allocations of profits
and losses 50-50 -- that is, in proportion to their ownership interests. Because there are legitimate
financial reasons for the uneven split, the IRS should respect this special allocation.
Partnership Basics
From the Nolo Business & Human Resources Center
Learn more about the simplest business structure for companies with more than one owner.
By definition, a partnership is a business with more than one owner that has not filed papers with the state to become a
corporation or LLC (limited liability company). There are two basic types of partnerships: general partnerships and limited
partnerships. This article discusses general partnerships, the more common structure in which every partner has a hand in
managing the business.
The partnership is the simplest and least expensive co-owned business structure to create and maintain. However, there
are a few important facts you should know before you begin.
Personal Liability for All Owners
First, partners are personally liable for all business debts and obligations, including court judgments. This means that if the
business itself can't pay a creditor, such as a supplier, lender, or landlord, the creditor can legally come after any partner's
house, car, or other possessions.
There are a few exceptions to this personal liability. Some of the partners can have limited personal liability if the
partnership is set up as a limited partnership. This is a partnership in which only the general partner, who runs the
business, has personal liability, while the limited partners, who are basically passive investors, can lose no more than their
stake in the partnership. Also, some states allow special limited liability partnerships (LLPs). More commonly, though,
businesspeople who are particularly concerned about personal liability choose to incorporate their business or operate as a
limited liability company (LLC).
Joint Authority
In addition, any individual partner can usually bind the whole business to a contract or other business deal. For instance, if
your partner signs a year-long contract with a supplier to buy inventory at a price your business can't afford, you can be
held personally responsible for the money owed under the contract.
There are just a few limits on a partner's ability to commit the partnership to a deal -- for instance, one partner can't bind
the partnership to a sale of all of the partnership's assets. But generally, unless an outsider has reason to know of any
limits the partners have placed on each other's authority in their partnership agreement, any partner can bind the others
to a deal.
Joint Liability
Each individual partner can be sued for -- and required to pay -- the full amount of any business debt. If this happens, an
individual partner's only recourse may be to sue the other partners for their shares of the debt.
Because of this combination of personal liability for all partnership debt and the authority of each partner to bind the
partnership, it's critical that you trust the people with whom you start your business.
Partnership Taxes
A partnership is not a separate tax entity from its owners; instead, it's what the IRS calls a "pass-through entity." This
means the partnership itself does not pay any income taxes on profits. Business income simply "passes through" the
business to the partners, who report their share of profits (or losses) on their individual income tax returns. In addition,
each partner must make quarterly estimated tax payments to the IRS each year.
While the partnership itself doesn't pay taxes, it must file IRS Form 1065, an informational return, each year. This form
sets out each partner's share of the partnership profits (or losses), which the IRS reviews to make sure the partners are
reporting their income correctly.
Creating a Partnership
You don't have to file any paperwork to establish an ordinary partnership -- just agreeing to go into business with another
person will get you started.
Of course, partnerships must meet the same local registration requirements as any new business. Most cities and counties
require businesses to register with them and pay at least a minimum tax. You may also have to obtain an employer
identification number from the IRS, a seller's license from your state, and a zoning permit from your local planning board.
In addition, your partnership may have to register a fictitious or assumed business name. If your business name doesn't
contain all of the partners' last names (for instance, you want to use "London Landscapes" instead of "Harper & Reed
Landscapes"), you usually must register that name -- known as a fictitious or assumed business name -- with your county
clerk.
While the owners of a partnership are not legally required to have a written partnership agreement, it makes good sense
to put the details of ownership, including the partners' rights and responsibilities and their share of profits, into a written
agreement.
Ending a Partnership
One disadvantage of partnerships is that when one partner wants to leave the company, the partnership generally
dissolves. In that case, the partners must fulfill any remaining business obligations, pay off all debts, and divide any assets
and profits among themselves.
If you want to prevent this kind of ending for your business, you should create a buy-sell agreement, or buyout
agreement, which can be included as part of your partnership agreement. A buy-sell/buyout agreement helps partners
decide and plan for what will happen when one partner retires, dies, becomes disabled, or leaves the partnership to pursue
other interests. For example, such an agreement might allow the partners to buy out a departing partner's interest, so
business can continue as usual.
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Owner Buyout Agreements: Plan Ahead for Changes in Partnership Ownership
by Attorney Bethany K. Laurence
From the Nolo Business & Human Resources Center
Your partnership agreement isn't complete without a buyout agreement stating what will happen when a
partner leaves the business.
Many new partners neglect to make a buyout, or buy-sell, agreement, but they are critical to protect your investment in a
partnership. When you create buyout provisions for your partnership agreement, you and your partners will be prepared if
one partner wants to leave the business, or worse, dies, goes bankrupt, or gets divorced.
What Is a Buyout, or Buy-Sell, Agreement?
Contrary to popular belief, a buy-sell agreement is not about buying and selling companies. It is a binding contract
between business partners about the future ownership of the business. Because of this confusion in terminology, we will
use the term buyout agreement from now on.
A buyout agreement can stand on its own or can be several provisions in your written partnership agreement that control
the following business decisions:
1. whether a departing partner must be bought out
2. what price will be paid for the departing partner's interest in the partnership
3. who can buy the departing partner's share of the business (this may include outsiders or be limited to other
partners), and
It may help to think of a buyout agreement as a sort of "premarital agreement" between you and your partners: Although
you might think that your partnership will last as long as you all shall live, the buyout determines what will happen if
things don't go exactly as you planned.
Events Covered Under a Buyout Agreement
Typically, the events that trigger a buy out of a partner's interest under a buyout agreement are:
1. the retirement or resignation of a partner
2. an attractive offer from an outsider to purchase a partner's interest in the company
3. a divorce settlement in which a partner's ex-spouse stands to receive a partnership interest in the company
4. the foreclosure of a debt secured by a partnership interest
5. the personal bankruptcy of a partner, or
Shareholders
Shareholders own stock (called shares or ownership interests) in the corporation. Shareholders have the exclusive right to:
1. elect and remove directors
2. amend the articles of incorporation and bylaws
3. approve the sale of all or substantially all of the corporate assets
4. approve mergers and reorganizations, and
State laws typically require the shareholders to hold an annual meeting. However, many states allow shareholders to do
this through a "written consent" or "consent resolution" -- a document signed by all of the shareholders -- instead of a
face-to-face meeting.
Directors
The board of directors sets policy for the corporation and makes major financial decisions. Among other things, the
directors:
1. authorize the issuance of stock
2. elect the corporate officers
3. set officer and key employee salary amounts
4. decide whether to mortgage, sell, or lease real estate, and
While many states require directors to hold regular meetings, it's often simpler and just as effective for the directors to
take actions by signing a consent resolution or written consent. Alternatively, most states allow directors' meetings to be
held by telephone.
While the organizational structure of corporations separates the rights and duties of shareholders and directors, this
separation isn't much of an issue for small corporations because most shareholders are also directors and officers.
However, even if you are both a shareholder and director of your corporation, you must still observe the formalities
required by law, which means wearing different hats at different times. For instance, sometimes you'll have to sign a
document in your capacity as director; at other times, you'll sign as a shareholder.
Officers
Officers are responsible for the day-to-day operation and management of the corporation. State laws usually require the
corporation to have at least a president, a secretary, and a treasurer (sometimes called a chief financial officer). But in
most states, the same person can hold all of the required offices.
The president is usually the chief operating officer (COO) of the corporation. The secretary is responsible for the corporate
records. The treasurer, or chief financial officer (CFO), of course, is responsible for the corporate finances, although it's
common to delegate everyday fiscal duties to a bookkeeper.
Employees
In small corporations, the owners are usually also employees of the corporation. Owners of small corporations receive
most of their financial benefits through the salary and other compensation they receive as corporate employees.
Documenting Corporate Decisions
While you don't need to document routine business decisions, you should prepare written minutes or consent resolutions
for events or decisions that require formal board of director or shareholder participation. These include:
1. the proceedings of annual meetings of directors and shareholders
2. the issuance of stock to new or existing shareholders
3. the purchase of real property
4. the approval of a long-term lease
5. the authorization of a substantial loan or line of credit
6. the adoption of a stock option or retirement plan, and
If you document important corporate decisions, whether through formal written minutes or less formal consent resolutions,
you'll protect your limited liability status -- and you'll have solid documentation if key decisions are later questioned by
creditors, the courts, or the IRS. In addition, keeping good corporate records allows you to note the reasons for making
critical decisions; this can head off controversy and dissension in your ranks in the future.
To learn more about corporate decision making and record keeping, and to obtain blank minutes, written consents, and
resolutions forms, use The Corporate Minutes Book, by Anthony Mancuso (Nolo).
In addition to keeping records of important business decisions, your corporation must record financial transactions in a
double-entry bookkeeping system and keep other necessary financial records, so it can file an annual corporate tax return.
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It may help to think of a buyout agreement as a sort of "premarital agreement" between co-owners: It determines what
will happen if your corporation's owners decide not to stay together 'til death do they part.
What Events Should Be Covered in a Buyout Agreement?
Typically, the events that trigger the buyout of a shareholder's interest are:
1. the retirement or resignation of a shareholder
2. an attractive offer from an outsider to purchase a shareholder's interest in the corporation
3. a divorce settlement in which a shareholder's ex-spouse stands to receive all or part of a shareholder's stock of
the corporation
4. the foreclosure of a debt secured by a shareholder's stock
5. the personal bankruptcy of a shareholder, or
Corporation Basics
From the Nolo Business & Human Resources Center
Forming a corporation limits your personal liability for business debts, but running one takes work.
Most people have heard that forming a corporation provides "limited liability" -- that is, it limits your personal liability for
business debts. What you may not know is that there's more to creating and running a corporation than filing a few
papers. You'll need to keep good records to handle the more complicated corporate tax return and, in order to retain your
limited liability, you must follow corporate formalities involving decision making and record keeping. In short, you've got to
be organized.
Limited Personal Liability
One of the main advantages of incorporating is that the owners' personal assets are protected from creditors of the
corporation. For instance, if a court judgment is entered against your corporation saying that it owes a creditor $100,000,
you can't be forced to use personal assets, such as your house, to pay the debt. Because only corporate assets need be
used to pay business debts, you stand to lose only the money that you've invested in the corporation.
5. treats the corporation as an extension of his or her personal affairs, rather than as a separate legal entity.
This last exception is the most important. In some circumstances, courts can rule that a corporation doesn't really exist
and that its owners should not be shielded from personal liability for their acts. This might happen if you fail to follow
routine corporate formalities such as:
1. adequately investing money in ("capitalizing") the corporation
2. formally issuing stock to the initial shareholders
3. regularly holding meetings of directors and shareholders, or
4. keeping business records and transactions separate from those of the owners.
Liability Insurance
Incorporating should never take the place of good business insurance. Even though forming a corporation protects your
personal assets, you should use insurance to guard your corporate assets from lawsuits and claims.
A solid liability insurance policy can protect you against many of the risks of doing business. For instance, if you operate a
clothing store, good business insurance should adequately cover the bill if someone slips and falls in your store.
Also, insurance can protect you where the limited liability feature will not. For example, if you personally injure someone
while doing business for the corporation, say by causing a car accident, liability insurance will usually cover the accident so
that you won't have to use either corporate or personal assets to pay the bill. However, insurance won't help if
your corporation doesn't pay the bills: commercial insurance usually does not protect personal or corporate assets from
unpaid business debts, whether or not they're personally guaranteed.
Paying Corporate Income Tax
If an owner of a corporation works for the corporation, that owner is paid a salary, and possibly bonuses, like any other
employee. The owner pays taxes on this income just like regular employees, reporting and paying the tax on his or her
personal tax return.
The corporation pays taxes on whatever profits are left in the businesses after paying out all salaries, bonuses, overhead,
and other expenses. To do this, the corporation files its own tax return, Form 1120, with the IRS and pays taxes at a
special corporate tax rate.
Alternatively, corporate shareholders can elect what's called "S corporation" status by filing Form 2553 with the IRS. This
means that the corporation will be treated like a partnership (or LLC) for tax purposes, with business profits and losses
"passing through" the corporation to be reported on the owners' individual tax returns.
Forming a Corporation
To form a corporation, you must file "articles of incorporation" with the corporations division (usually part of the secretary
of state's office) of your state government. Filing fees are typically $100 or so.
For most small corporations, articles of incorporation are relatively short and easy to prepare. Most states provide a
simple form for you to fill out, which usually asks for little more than the name of your corporation, its address, and the
contact information for one person involved with the corporation (often called a "registered agent"). Some states also
require you to list the names of the directors of your corporation.
In addition to filing articles of incorporation, you must create "corporate bylaws." While bylaws do not have to be filed with
the state, they are important because they set out the basic rules that govern the ongoing formalities and decisions of
corporate life, such as how and when to hold regular and special meetings of directors and shareholders and the number of
votes that are necessary to approve corporate decisions.
Finally, you must issue stock certificates to the initial owners (shareholders) of the corporation and record who owns the
ownership interests (shares or stock) in the business.
Retaining Corporate Status
Corporations and their owners must observe certain formalities to retain the corporation's status as a separate entity.
Specifically, corporations must:
1. hold annual shareholders' and directors' meetings
2. keep minutes of shareholders' and directors' major decisions
3. make sure that corporate officers and directors sign documents in the name of the corporation
4. maintain separate bank accounts from their owners
5. keep detailed financial records, and
6. file a separate corporate income tax return.
Professional Corporations
From the Nolo Business & Human Resources Center
In many states, professionals who want to incorporate their practices must create what's called a professional
corporation.
In many states, people in certain occupations (for example, doctors, lawyers or accountants) who want to incorporate their
practice can do so only through a "professional corporations" or "professional service corporations." In other states, some
professionals have a choice of incorporating as either a professional corporation or a regular corporation. And in all states,
certain professionals are allowed to form professional corporations or professional service corporations.
The list of professionals required to incorporate as a professional corporation is different in each state. Usually, though,
mandatory professional incorporation requirements apply to these professionals:
1. accountants
2. engineers
3. health care professionals such as audiologists, dentists, nurses, opticians, optometrists, pharmacists, physical
therapists, physicians and speech pathologists
4. lawyers
5. psychologists
6. social workers
7. veterinarians.
You'll need to call your state's corporate filing office (usually the Secretary of State or Corporation Commissioner) to see
which professions are required to form professional corporations in your own state.
Professional corporations aren't as popular as they used to be. The main reason for professionals to incorporate --
favorable corporate taxation rules -- has disappeared. Before 1986, professionals who incorporated could shelter more
money from taxes than sole proprietors or partners could. This has all changed. Most professional corporations are
classified as "personal service corporations" by the IRS, which means that their corporate income is taxed at a flat 35%.
So there's no longer any advantage to be gained by the two-tiered tax structure that allows ordinary corporations to save
taxes on some retained earnings.
Are there any reasons left for professionals to form professional corporations? Perhaps. Professional corporations provide a
limit on the owners' personal liability for business debts and claims. Incorporating can't protect a professional against
liability for his or her negligence or malpractice, but it can protect against liability for the negligence or malpractice of an
associate.
Example 1
Dr. Anton and Dr. Bartolo are surgeons who practice as partners. Dr. Bartolo leaves an instrument
inside a patient, who bleeds to death. The jury returns a $2 million verdict against Dr. Bartolo and
the partnership. There is only $1 million in malpractice insurance to cover the judgment. Dr. Anton
(along with Dr. Bartolo) would be personally liable for the $1 million not covered by insurance.
Example 2
Drs. Anton and Bartolo create a professional corporation. Dr. Bartolo commits the malpractice
described in Example 1. Dr. Anton, a corporate employee, would not be personally liable for the
portion of the verdict not covered by insurance. Dr. Bartolo, however, would still be personally
responsible for the $1 million excess, because he was the one guilty of malpractice. (In some states,
Dr. Anton would be free from personal liability only if the professional corporation carried at least the
minimum amount of insurance mandated by state law.)
As an alternative to incorporating, professionals wishing to limit their personal liability should consider forming a limited
liability company (LLC).
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S Corporation Facts
From the Nolo Business & Human Resources Center
S corporations are similar to LLCs in that they provide owners with limited liability protection while offering
the tax structure of a partnership.
Many entrepreneurs have two goals when choosing a structure for their business: Protecting their personal assets from
business claims (limited liability) and having business profits taxed on their individual tax returns. Not long ago, an S
corporation was the only choice for these business owners. In recent years, however, S corporations have been largely
replaced by limited liability companies (LLCs). Still, some businesses can benefit by organizing as S corporations.
What Is an S Corporation?
An S corporation is a regular corporation that has elected "S corporation" tax status. Forming an S corporation lets you
enjoy the limited liability of a corporate shareholder but pay income taxes as if you were a sole proprietor or a partner.
In a regular corporation (also known as a C corporation), the company itself is taxed on business profits. The owners pay
individual income tax only on money they receive from the corporation as salary, bonuses, or dividends.
By contrast, in an S corporation, all business profits "pass through" to the owners, who report them on their personal tax
returns (as in sole proprietorships, partnerships, and LLCs). The S corporation itself does not pay any income tax, although
an S corporation with more than one owner must file an informational tax return like a partnership or LLC, to report each
shareholder's portion of the corporate income.
Most states follow the federal pattern when taxing S corporations: They don't impose a corporate tax, choosing instead to
tax the business's profits on the shareholders' personal tax returns. About half a dozen states, however, tax an S
corporation like a regular corporation. The tax division of your state treasury department can tell you how S corporations
are taxed in your state.
Should You Elect S Corporation Status?
Operating as an S corporation may be wise for several reasons:
1. Forming an S corporation generally allows you to pass business losses through to your personal income tax
return, where you can use it to offset any income that you (and your spouse, if you're married) have from other sources.
2. When you sell your S corporation, your taxable gain on the sale of the business can be less than it would have
been had you operated the business as a regular corporation.
3. S corporation shareholders are not subject to self-employment taxes (active LLC owners are). These taxes, which
add up to more than 15% of your income, are used to pay your Social Security and Medicare taxes.
Aside from the benefits, S corporations impose strict requirements. Here are the main rules:
1. Each S corporation shareholder must be a U.S. citizen or resident.
2. S corporations may not have more than 100 shareholders.
3. S corporation profits and losses may be allocated only in proportion to each shareholder's interest in the
business.
4. An S corporation shareholder may not deduct corporate losses that exceed his or her "basis" in corporate stock --
which equals the amount of the shareholder's investment in the company plus or minus a few adjustments.
5. S corporations may not deduct the cost of fringe benefits provided to employee-shareholders who own more than
2% of the corporation.
Fortunately, a decision to elect to be an S corporation isn't permanent. If your business later becomes more profitable and
you find there are tax advantages to being a regular corporation, you can drop your S corporation status after a certain
amount of time.
How to Elect S Corporation Status
To create an S corporation, you must first create a regular corporation by filing articles of incorporation with your secretary
of state's office or your state's corporations division. Then, to be treated as an S corporation, all shareholders must sign
and file IRS Form 2553.
If you're ready to incorporate, Nolo offers the following helpful guides, which come with forms on CD-
ROM:
1. Incorporate Your Business: A Legal Guide to Forming a Corporation in Your State, by
attorney Anthony Mancuso, or
2. How to Form Your Own California Corporation, by attorney Anthony Mancuso.
Nolo also publishes Incorporator Pro, software that will create articles of incorporation and bylaws for
you.
S Corporation Alternatives
You can get the benefits of limited liability and pass-through taxation by creating a limited liability company (LLC).
Because an LLC offers its owners the significant advantage of greater flexibility in allocating profits and losses, and
because LLCs aren't subject to the many restrictions of S corporations, forming an LLC is often the better choice.
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1. The name cannot be the same as the name of another corporation on file with the corporations office.
2. The name must end with a corporate designator, such as "Corporation," "Incorporated," "Limited," or an
abbreviation of one of these words (Corp., Inc., or Ltd.).
3. The name cannot contain certain words that suggest an association with the federal government or restricted
type of business, such as Bank, Cooperative, Federal, National, United States, or Reserve.
Your state's corporations office can tell you how to find out whether your proposed name is available for your use. Often,
for a small fee, you can reserve your corporate name for a short period of time until you file your articles of incorporation.
Besides following your state's corporate naming rules, you must make sure your name won't violate another company's
trademark.
Once you've found a legal and available name, you usually don't need to file the name of your business with your state.
When you file your articles of incorporation, your business name will be automatically registered.
However, if you will sell your products or services under a different name, you must file a "fictitious" or "assumed" name
statement with the state or county where your business is headquartered.
Appointing Directors
Directors make major policy and financial decisions for the corporation. For example, the directors authorize the issuance
of stock, appoint the corporate officers and set their salaries, and approve loans to and from the corporation. Directors are
typically appointed by the initial owners (shareholders) of the corporation before the business opens. Often, the owners
simply appoint themselves to be the directors, but directors do not have to be owners.
Most states permit a corporation to have just one director, regardless of the number of owners. In other states, a
corporation may have one director only if it has one owner; a corporation with two owners must have at least two
directors, and a corporation with three or more owners must have three or more directors.
Filing Articles of Incorporation
After you've chosen a name for your business and appointed your directors, you must prepare and file "articles of
incorporation" with your state's corporate filing office. Typically, this is the department or secretary of state's office,
located in your state's capital city. While most states use the term "articles of incorporation" to refer to the basic document
creating the corporation, some states use other terms, such as "certificate of incorporation" or "charter."
No state requires a corporation to have more than one owner. For single-owner corporations, the sole owner simply
prepares, signs, and files the articles of incorporation himself. For co-owned corporations, the owners may either all sign
the articles or appoint just one person to sign them. Whoever signs the articles is called the "incorporator" or "promoter."
Articles of incorporation don't have to be lengthy or complex. In fact, you can usually prepare articles of incorporation in
just a few minutes by filling out a form provided by your state's corporate filing office. Typically, the articles of
incorporation must specify just a few basic details about your corporation, such as its name, principal office address, and
sometimes the names of its directors.
You will probably also have to list the name and address of one person -- usually one of your directors -- who will act as
your corporation's "registered agent" or "agent for service of process." This person is on file so that members of the public
know how to contact the corporation -- for example, if they want to sue or otherwise involve the corporation in a lawsuit.
Drafting Corporate Bylaws
Bylaws are the internal rules that govern the day-to-day operations of a corporation, such as when and where the
corporation will hold directors' and shareholders' meetings and what the shareholders' and directors' voting requirements
are. To create bylaws, you can either follow the instructions in a self-help resource or hire a lawyer in your state to draft
them for you. Typically, the bylaws are adopted by the corporation's directors at their first board meeting.
A shareholders' agreement helps owners of a small corporation decide and plan for what will happen
when one owner retires, dies, becomes disabled, or leaves the corporation to pursue other interests.
Additionally, if the corporation will be an S corporation, the directors should approve the election of S corporation status.
Issuing Stock
You should not do business as a corporation until you have issued shares of stock. Issuing shares formally divides up
ownership interests in the business. It is also a requirement of doing business as a corporation -- and you must act like a
corporation at all times to qualify for the legal protections offered by corporate status.
Securities Registration
Issuing stock can be complicated; it must be accomplished in accordance with securities laws. This means that large
corporations must register their stock offerings with the federal Securities and Exchange Commission (SEC) and the state
securities agency. Registration takes time and typically involves extra legal and accounting fees.
Exemptions to Securities Registration
Fortunately, most small corporations qualify for exemptions from securities registration. For example, SEC rules do not
require a corporation to register a "private offering" -- that is, a non-advertised sale to a limited number of people
(generally 35 or fewer) or to those who can reasonably be expected to take care of themselves because of their net worth
or income earning capacity. And most states have enacted their own versions of this SEC exemption. In short, if your
corporation will issue shares to a small number of people (generally ten or less) who will actively participate in running the
business, it will certainly qualify for exemptions to securities registration.
If you're selling shares of stock to passive investors (people who won't be involved in running
the company), complying with state and federal securities laws gets complicated. Get help from a
good small business lawyer.
For more information about federal securities laws and exemptions, visit the SEC website at www.sec.gov. For more
information on your state's exemption rules, go to your secretary of state's website. (You can find links to every state's
site at the website of the National Association of Secretaries of State, www.nass.org.)
Finally, you'll prepare and issue the stock certificates. In some states you may also have to file a "notice of stock
transaction" or similar form with your state corporations office.
Obtaining Licenses and Permits
After you've filed your articles, created your bylaws, held your first directors' meeting, and issued stock, you're almost
ready to go. But you still need to obtain the required licenses and permits that anyone needs to start a new business, such
as a business license (also known as a tax registration certificate). You may also have to obtain an employer identification
number from the IRS, a seller's permit from your state, or a zoning permit from your local planning board.
Next Steps
If you're ready to incorporate your business, Nolo offers the following helpful guides, which come
with a CD-ROM of the forms you need:
Nolo also publishes Incorporator Pro, software that will create articles of incorporation and bylaws for
you.
1
$0 to $50,000 5
%
2
$50,001 to $75,000 5
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3
$75,001 to $100,000 4
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$0 to $7,550 0
%
1
$7,551 to $30,650 5
%
2
$30,651 to $74,200 5
%
2
$74,201 to $154,800 8
%
3
$154,801 to $336,550 3
%
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$0 to $15,100 0
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$15,101 to $61,300 1
5
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2
$61,301 to $123,700 5
%
2
$123,701 to $188,450 8
%
3
$188,451 to $336,550 3
%
Example
Ken owns and operates Balanced Interiors, Inc., a newly incorporated interior decorating business.
Ken keeps the first year’s net income of $75,000 in the business, living on savings that he
accumulated (on which he has already paid taxes) prior to incorporating. Balanced Interiors pays
$13,750 in corporate income taxes on this retained corporate income. This is almost $1,600 less than
the $15,331.50 individual income taxes Ken would have paid on the same net income if he took all of
the income out of the business as salary.
Start-Up Costs
Especially in the early days of a business, owners typically find that they must retain some profits in the corporation to buy
inventory and equipment, meet payroll costs, develop new products, and cover other expenses of a growing business.
Fortunately, up to $75,000 of these profits will be taxed at the lower corporate tax rates.
Increased Profitability
As a business matures and begins earning more than it needs to fund growth, the owners will no doubt want to pay out
more corporate profits to themselves in the form of salaries and bonuses. Regardless of the possible continued savings
from income splitting, owners are likely to increase their salaries or declare bonuses if the corporation's cash reserves are
adequate to meet foreseeable needs. Plus, the possibility of savings from income splitting decreases as more profits are
kept in the corporation -- rarely will a corporation save money by retaining more than $100,000 of profits in the
corporation each year.
Tax-Deductible Expenses
To reduce taxable profits, a corporation can deduct many of its business expenses -- money the corporation spends in the
legitimate pursuit of profit. In addition to start-up costs, operating expenses, and product and advertising outlays, a
corporation can deduct the salaries and bonuses it pays and all of the costs associated with medical and retirement plans
for employees.
Tax on Dividends
If a corporation distributes dividends to the owners, they must report and pay personal income tax on these amounts. And
because dividends, unlike salaries and bonuses, are not tax-deductible, the corporation must also pay taxes on them. This
means that dividends are taxed twice -- once to the corporation and again to the shareholders. Smaller corporations rarely
face this problem: Because their owners typically work for the corporation as employees, the corporation can pay them in
the form of tax-deductible salaries and bonuses, rather than taxable dividends.
S Corporation Taxes
The scheme of taxation described in this article applies only to regular corporations, called "C
corporations." By contrast, a corporation that has elected "S corporation" status pays taxes like a
partnership or limited liability company (LLC): All corporate profits or losses "pass through" the
business and are reported on the owners' personal income tax returns.
Retained Earnings
Many corporations will want or need to retain some profits in the business at the end of the year -- for instance, to fund
expansion and future growth. If it does, that money will be taxed to the corporation at corporate income tax rates.
Because initial corporate income tax rates (15% - 25% on profits up to the first $75,000) are lower than most owners'
marginal income tax rates for the same amount of income, a corporation's owners can save money by keeping some
profits in the company. (This does not apply to professional corporations, however, as they are taxed at a flat rate of
35%.) In contrast, owners of sole proprietorships, partnerships, and LLCs must pay taxes on all business profits at their
individual income tax rates, whether they take the profits out of the business or not.
The IRS will allow you to leave profits in your corporation, up to a limit: Most corporations can safely keep a total of
$250,000 (at any one time) in the corporation without facing tax penalties (some professional corporations may not retain
more than $150,000).
Fringe Benefits
Another tax benefit of forming a corporation is that the company can deduct the full cost of fringe benefits provided to
employees -- almost always including the business's owners -- and the owner-employees are not taxed on these benefits.
Other types of business entities can also deduct the cost of many fringe benefits as a business expense, but owners who
receive these benefits will ordinarily be taxed on their value.
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Copyright 2006 Nolo
1. Agent. Your spouse could be viewed as an agent of the LLC. The LLC is typically responsible for authorized
actions by its agent. However, the LLC structure usually protects the owners' personal property from claims related to an
agent's acts. The agent (your spouse) also would not be personally liable for his or her actions, as long as they fell within
the scope of his or her authority to act for the LLC.
2. Employee. Your spouse could be viewed as an employee of the LLC. An employee is personally liable only for
certain extreme and unauthorized acts, such as assault or other criminal behavior. The LLC structure should protect your
personal property from liability for the acts of an employee. (But the IRS could come after you for back payroll taxes,
withholding, and penalties -- see below.)
3. An independent contractor. Your spouse could be viewed as acting as an independent contractor. An
independent contractor could be held personally liable for just about anything he or she does. That means that although
the LLC protects your own personal property, your personal marital property and your spouse’s personal property could be
at risk.
4. A general partner. Your spouse could be treated as an individual who has gone into a general partnership with
the LLC. As a general partner, your spouse would have personal liability for business debts.
Any scenario in which your spouse has personal liability is a bad one, because a successful claimant might try to collect a
judgment from your spouse’s personal property -- which will usually include your jointly owned personal property, such as
bank accounts and your house.
One way to avoid these possibly negative characterizations is to make your spouse an LLC member (co-owner). An LLC
member can pitch in as much or as little as the members agree, and the LLC protects each member’s personal property
from business liability. See "How a Spouse Becomes an LLC Member," below.
A Participating Spouse Could Create Tax Liability
The degree to which your spouse participates in the business could also affect your tax obligations. If your spouse chips in
very occasionally and isn't paid, you probably won't have any tax issues to worry about.
However, if your spouse works regularly for the business and receives compensation, the IRS could decide that your
spouse is an employee. If you haven't been following the rules that apply to businesses with employees, the IRS could
come after you for back payroll taxes, withholding, and penalties.
How Your Spouse Can Avoid Liability
There are a couple of ways to avoid these problems: the simplest is just to make your spouse a member of the LLC (see
below). Or, if your spouse is not worried about personal liability, you could hire your spouse as an independent contractor,
who is responsible for paying his or her own income and self-employment taxes.
You can make your spouse an official employee from the get-go, but it may not be worth the paperwork and record-
keeping hassles unless your LLC already has other employees. For any employee, the LLC must withhold taxes, report
state and federal income tax, report and pay employment taxes, pay workers’ compensation insurance, comply with
workplace-safety reports, and (in some states) pay unemployment insurance.
Your spouse cannot become an LLC member automatically, even though the LLC might qualify
as marital property that belongs jointly to you and your spouse, and even though you and your
spouse report LLC income on your joint tax return.
LLCs have formal operating requirements, which govern how new members can be admitted (among
other things). This is true whether the LLC has drafted its own operating agreement or is subject to
state default rules that apply in the absence of an operating agreement. When your spouse becomes
a new member, you'll need to follow the rules that apply to your LLC.
At the very least, you'll have to make a written record of the decision to admit your spouse as a
member. In addition, if your LLC operates under an operating agreement, you will probably need to
amend the operating agreement to reflect the capital, profits, and voting interests of the new
member and the changes in the existing members’ interest.
Don't set your spouse's capital rights and voting rights at zero. If you do, a court or the
IRS might call the membership a sham.
Once your spouse is a member, you will both report LLC income on your personal tax return. Both of
you will pay quarterly estimated income taxes and self-employment taxes. Plus, you have to carry
out the LLC formalities for member voting according to your operating agreement (if you have one)
or under state law.
Single-Owner LLCs
The IRS treats one-member LLCs as sole proprietorships for tax purposes. This means that the LLC itself does not pay
taxes and does not have to file a return with the IRS.
As the sole owner of your LLC, you must report all profits (or losses) of the LLC on Schedule C and submit it with your
1040 tax return. Even if you leave profits in the company's bank account at the end of the year -- for instance, to cover
future expenses or expand the business -- you must pay income tax on that money.
Multi-Owner LLCs
The IRS treats co-owned LLCs as partnerships for tax purposes. Like one-member LLCs, co-owned LLCs do not pay taxes
on business income; instead, the LLC owners each pay taxes on their lawful share of the profits on their personal income
tax returns (with Schedule E attached). Each LLC member's share of profits and losses, called a distributive share, should
be set out in the LLC operating agreement.
Most operating agreements provide that a member's distributive share is in proportion to his or her percentage interest in
the business. For instance, if Jimmy owns 60% of the LLC, and Luana owns the other 40%, Jimmy will be entitled to 60%
of the LLC's profits and losses, and Luana will be entitled to 40%. If you'd like to split up profits and losses in a way that is
not proportionate to the members' percentage interests in the business, it's called a "special allocation," and you must
carefully follow IRS rules.
However members' distributive shares are divvied up, the IRS treats each LLC member as though the member receives his
or her entire distributive share each year. This means that each LLC member must pay taxes on his or her whole
distributive share, whether or not the LLC actually distributes all (or any of) the money to the members. The practical
significance of this IRS rule is that, even if LLC members need to leave profits in the LLC -- for instance, to buy inventory
or expand the business -- each LLC member is liable for income tax on the member's rightful share of that money.
Even though a co-owned LLC itself does not pay income taxes, it must file Form 1065 with the IRS. This form, the same
one that a partnership files, is an informational return that the IRS reviews to make sure that LLC members are reporting
their income correctly. The LLC must also provide each LLC member with a Schedule K-1, which breaks down each
member's share of the LLC's profits and losses. In turn, each LLC member reports this profit and loss information on his or
her individual Form 1040, with Schedule E attached.
If your LLC will regularly need to retain a significant amount of profits in the company, you (and
your co-owners, if you have any) may be able to save money by electing to have your LLC taxed as a
corporation. For details, see "Can Corporate Taxation Cut Your LLC Tax Bill?" at the end of this
article.
As you no doubt already know, you don't have to pay taxes -- income taxes or self-employment
taxes -- on most of the money that your business spends in pursuit of profit. You can deduct ("write
off") your legitimate business expenses from your business income, which can greatly lower the
profits you must report to the IRS. Deductible expenses include start-up costs, automobile and travel
expenses, equipment costs, and advertising and promotion costs.
If you will regularly need to keep a substantial amount of profits in your LLC (called "retained
earnings"), you might benefit from electing corporate taxation (which you can do as an LLC). Any LLC
can choose to be treated like a corporation for tax purposes by filing IRS Form 8832 and checking the
corporate tax treatment box on the form.
Because the corporate income tax rates for the first $75,000 of corporate taxable income are lower
than the individual income tax rates that apply to most LLC owners, this can save you and your co-
owners money in overall taxes.
1
$0 to $50,000 5
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$50,001 to $75,000 5
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$15,101 to $61,300 5
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%
3
$188,451 to $336,550 3
%
Example
Ken owns and operates Balanced Interiors, Inc., a newly incorporated interior decorating business.
Ken keeps the first year’s net income of $75,000 in the business, living on savings that he
accumulated (on which he has already paid taxes) prior to incorporating. Balanced Interiors pays
$13,750 in corporate income taxes on this retained corporate income. This is almost $1,600 less than
the $15,331.50 individual income taxes Ken would have paid on the same net income if he took all of
the income out of the business as salary.
Start-Up Costs
Especially in the early days of a business, owners typically find that they must retain some profits in the corporation to buy
inventory and equipment, meet payroll costs, develop new products, and cover other expenses of a growing business.
Fortunately, up to $75,000 of these profits will be taxed at the lower corporate tax rates.
Increased Profitability
As a business matures and begins earning more than it needs to fund growth, the owners will no doubt want to pay out
more corporate profits to themselves in the form of salaries and bonuses. Regardless of the possible continued savings
from income splitting, owners are likely to increase their salaries or declare bonuses if the corporation's cash reserves are
adequate to meet foreseeable needs. Plus, the possibility of savings from income splitting decreases as more profits are
kept in the corporation -- rarely will a corporation save money by retaining more than $100,000 of profits in the
corporation each year.
To learn more about saving taxes by splitting income between you and your corporation, including
examples of how you can accomplish tax savings, see Save Taxes With Corporate Income Splitting,
by attorney Anthony Mancuso (Nolo).
LLC Basics
From the Nolo Business & Human Resources Center
Limited liability companies combine the best aspects of partnerships and corporations.
A limited liability company (LLC) combines the corporation's protection from personal liability for business debts and the
pass-through tax structure of a partnership or sole proprietorship. And, while setting up an LLC is more difficult than
creating a partnership or sole proprietorship, running one is significantly easier than running a corporation.
Here are the main features of an LLC:
Limited Personal Liability
Like shareholders of a corporation, all LLC owners are protected from personal liability for business debts and claims. This
means that if the business itself can't pay a creditor -- such as a supplier, a lender, or a landlord -- the creditor cannot
legally come after any LLC member's house, car, or other personal possessions. Because only LLC assets are used to pay
off business debts, LLC owners stand to lose only the money that they've invested in the LLC. This feature is often called
"limited liability."
5. treats the LLC as an extension of his or her personal affairs, rather than as a separate legal entity.
This last exception is the most important. If owners don't treat the LLC as a separate business, a court might say that the
LLC doesn't really exist and find that its owners are really doing business as individuals, who are personally liable for their
acts. To keep this from happening, make sure you and your co-owners:
1. Act fairly and legally. Do not conceal or misrepresent material facts or the state of your finances to vendors,
creditors, or other outsiders.
2. Fund your LLC adequately. Invest enough cash into the business so that your LLC can meet foreseeable
expenses and liabilities.
3. Keep LLC and personal business separate. Get a federal employer identification number, open up a business-
only checking account, and keep your personal finances out of your LLC accounting books.
4. Create an operating agreement. Having a formal written operating agreement lends credibility to your LLC's
separate existence.
Business Insurance
A good liability insurance policy can shield your personal assets when limited liability protection does not. For instance, if
you are a massage therapist and you accidentally injure a client's back, your liability insurance policy should cover you.
Insurance can also protect your personal assets in the event that your limited liability status is ignored by a court.
In addition to protecting your personal assets in such situations, insurance can protect your corporate assets from lawsuits
and claims. But your LLC won't be protected if it doesn't pay its bills: commercial insurance usually does not protect
personal or corporate assets from unpaid business debts, whether or not they're personally guaranteed.
LLC Taxes
Unlike a corporation, an LLC is not considered separate from its owners for tax purposes. Instead, it is what the IRS calls a
"pass-through entity," like a partnership or sole proprietorship. This means that business income passes through the
business to the LLC members, who report their share of profits -- or losses -- on their individual income tax returns. Each
LLC member must make quarterly estimated tax payments to the IRS.
While an LLC itself doesn't pay taxes, co-owned LLCs must file Form 1065, an informational return, with the IRS each year.
This form, the same one that a partnership files, sets out each LLC member's share of the LLC's profits (or losses), which
the IRS reviews to make sure LLC members are correctly reporting their income.
LLC Management
The owners of most small LLCs participate equally in the management of their business. This arrangement is called
"member management."
There is an alternative management structure -- somewhat awkwardly called "manager management" -- in which you
designate one or more owners (or even an outsider) to take responsibility for managing the LLC. The nonmanaging owners
(sometimes family members who have invested in the company) simply sit back and share in LLC profits. In a manager-
managed LLC, only the named managers get to vote on management decisions and act as agents of the LLC. Choosing
manager management sometimes makes sense, but it might require you to deal with state and federal laws regulating the
sale of securities.
Forming an LLC
To create an LLC, you file "articles of organization" (in some states called a "certificate of organization" or "certificate of
formation") with the LLC division of your state government. This office is often in the same department as the corporations
division, which is usually part of the secretary of state's office. Filing fees range from about $100 to $800. You can now
form an LLC with just one person in every state.
Many states supply a blank one-page form for the articles of organization, on which you need only specify a few basic
details about your LLC, such as its name and address, and contact information for a person involved with the LLC (usually
called a "registered agent") who will receive legal papers on its behalf. Some states also require you to list the names and
addresses of the LLC members.
In addition to filing articles of organization, you must create a written LLC operating agreement. While you don't have to
file your operating agreement with the state, it's a crucial document because it sets out the LLC members' rights and
responsibilities, their percentage interests in the business, and their share of the profits.
Ending an LLC
Under the laws of many states, unless your operating agreement says otherwise, when one member wants to leave the
LLC, the company dissolves. In that case, the LLC members must fulfill any remaining business obligations, pay off all
debts, divide any assets and profits among themselves, and then decide whether they want to start a new LLC to continue
the business with the remaining members.
Your LLC operating agreement can prevent this kind of abrupt ending to your business by including "buy-sell," or
buyout, provisions, which set up guidelines for what will happen when one member retires, dies, becomes disabled, or
leaves the LLC to pursue other interests.
Next Steps
If you're ready to create an LLC for your business, Form Your Own Limited Liability Company, by
attorney Anthony Mancuso (Nolo), provides you with guidance and forms on disc. Nolo also publishes
LLC Maker, software that will create articles of organization and an LLC operating agreement for you.
7. buyout, or buy-sell, provisions, which establish a framework for what happens when a member wants to sell
his or her interest, dies, or becomes disabled.
While these items may seem fairly straightforward, each requires important details. Make sure you fill out the particulars in
the following key areas.
Percentages of Ownership
The owners of an LLC ordinarily make financial contributions of cash, property, or services to the business to get it started.
In return, each LLC member gets a percentage of ownership in the assets of the LLC. Members usually receive ownership
percentages in proportion to their contributions of capital, but LLC members are free to divide up ownership in any way
they wish. These contributions and percentage interests are an important part of your operating agreement.
Distributive Shares
In addition to receiving ownership interests in exchange for their contributions of capital, LLC owners also receive shares of
the LLC's profits and losses, called "distributive shares." Most often, operating agreements provide that each owner's
distributive share corresponds to his or her percentage of ownership in the LLC. For example, because Tony owns only
35% of his LLC, he receives just 35% of its profits and losses. Najate, on the other hand, is entitled to 65% of the LLC's
profits and losses because she owns 65% of the business. (If your LLC wants to assign distributive shares that aren't in
proportion to the owners' percentage interests in the LLC, you'll have to follow rules for "special allocations." For more
information, see Making Special Allocations.)
Voting Rights
While most LLC management decisions are made informally, sometimes a decision is so important or controversial that a
formal vote is necessary. There are two ways to split voting power among LLC members: Either each member's voting
power corresponds to his or her percentage interest in the business, or each member gets one vote -- called "per capita"
voting. Most LLCs mete out votes in proportion to the members' ownership interests. Whichever method you choose, make
sure your operating agreement specifies how much voting power each member has, as well as whether a majority of the
votes or a unanimous decision will be required to resolve an issue.
Ownership Transitions
Many new business owners neglect to think about what will happen if one owner retires, dies, or decides to sell the owner's
interest in the company. These concerns may not be on your mind now, but such situations crop up frequently for small
business owners, and it pays to be prepared. Operating agreements should include a buyout scheme -- rules for what will
happen when a member leaves the LLC for any reason.
How to Create an Operating Agreement
Obviously, you'll need help beyond this article to make your own operating agreement. There are many sources for blank
or sample LLC operating agreements, but you must be sure that your operating agreement is drafted to suit the needs of
your business and the laws of your state.
Software that helps you create your own LLC may be your best alternative. For example, LLC Maker (from Nolo) will use
your input to customize an operating agreement that suits the needs of you and your co-owners and meets the
requirements of your state's laws.
You can also pay a business lawyer for assistance -- in fact, we recommend this for LLCs with more than five owners, and
also for those that opt to have a special manager or management group run the LLC. Lawyers typically have several types
of standard agreements on hand that can be customized for your LLC. Although using a lawyer can get pricey, the peace of
mind you'll gain from knowing that your LLC is protected -- and has adopted operating rules that will best serve its
interests -- may well be worth the cost.
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Copyright 2006 Nolo
How to Form an LLC
From the Nolo Business & Human Resources Center
Limited liability companies (LLCs) are easier to create than corporations -- and forming one may be the best
thing you can do for your business.
Forming an LLC (limited liability company) is not as hard as most people think. Here are the steps you need to take to
make your LLC a legal reality.
1. Choose an available business name that complies with your state's LLC rules.
2. File formal paperwork, usually called articles of organization, and pay the filing fee (ranging from about $100 to
$800, depending on your state's rules).
3. Create an LLC operating agreement, which sets out the rights and responsibilities of the LLC members.
4. Publish a notice of your intent to form an LLC (required in only a few states).
5. Obtain licenses and permits that may be required for your business.
Choosing a Name for Your LLC
The name of your LLC must comply with the rules of your state's LLC division. (Typically, this office is combined with the
corporations division, and is part of the secretary of state's office.) While requirements differ from state to state, generally:
1. the name cannot be the same as the name of another LLC on file with the LLC office
2. the name must end with an LLC designator, such as "Limited Liability Company" or "Limited Company," or an
abbreviation of one of these phrases (such as "LLC," "L.L.C.," or "Ltd. Liability Co."), and
3. the name cannot include certain words prohibited by the state, such as Bank, Insurance, Corporation or City
(state rules differ on which words are prohibited).
Your state's LLC office can tell you how to find out whether your proposed name is available for your use. Often, for a small
fee, you can reserve your LLC name for a short period of time until you file your articles of organization.
Besides following your state's LLC naming rules, you must make sure your name won't violate another company's
trademark.
Once you've found a legal and available name, you don't usually need to register it with your state. When you file your
articles of organization, your business name will be automatically registered.
Filing Articles of Organization
After settling on a name, you must prepare and file "articles of organization" with your state's LLC filing office. While most
states use the term "articles of organization" to refer to the basic document required to create an LLC, some states use the
term "certificate of formation" or "certificate of organization."
Filing Fees
One disadvantage of forming an LLC instead of a partnership or a sole proprietorship is that you'll have to pay a filing fee
when you submit your articles of organization. In most states, the fees are modest -- typically around $100. In a few
others, they take a bigger bite: this includes California, which charges an $800 annual tax on top of its filing fee.
Required Information
Articles of organization are short, simple documents. In fact, you can usually prepare your own in just a few minutes by
filling in the blanks and checking the boxes on a form provided by your state's filing office. Typically, you must provide
only your LLC's name, its address, and sometimes the names of all of the owners -- called members. Generally, all of the
LLC owners may prepare and sign the articles, or they can appoint just one person to do so.
Registered Agent
You will probably also be required to list the name and address of a person -- usually one of the LLC members -- who will
act as your LLC's "registered agent," or "agent for service of process." Your agent is the person who will receive legal
papers in any future lawsuit involving your LLC.
Creating an LLC Operating Agreement
Even though operating agreements need not be filed with the LLC filing office and are rarely required by state law, it is
essential that you create one. In an LLC operating agreement, you set out rules for the ownership and operation of the
business (much like a partnership agreement or corporate bylaws). A typical operating agreement includes:
1. the members' percentage interests in the business
2. the members' rights and responsibilities
3. the members' voting power
4. how profits and losses will be allocated
5. how the LLC will be managed
6. rules for holding meetings and taking votes, and
7. "buy-sell" provisions, which establish rules for what happens if a member wants to sell his or her interest, dies,
or becomes disabled.
Publication Requirements
In a few states, you must take an additional step to make your company official: You must
publish in a local newspaper a simple notice stating that you intend to form an LLC. You are required
to publish the notice several times over a period of weeks and then submit an "affidavit of
publication" to the LLC filing office. Your local newspaper should be able to help you with this filing.
Do It Yourself Materials
You can use LLC Maker software (from Nolo) to create articles of organization and a customized
operating agreement that suits the needs of you and your co-owners and meets the requirements of
your state's laws. If you'd rather use a book (with forms on CD), take a look at Form Your Own
Limited Liability Company, by Tony Mancuso (Nolo).
Resources
For guidance in taking legitimate deductions, more information on how to avoid audit triggers, and
how to keep proper records for the IRS, see the following Nolo products:
2. Working for Yourself: Law & Taxes for Independent Contractors, Freelancers, & Consultants,
by attorney Stephen Fishman
3. Deduct It! Lower Your Small Business Taxes, by attorney Stephen Fishman.
Example
Toni invests $1,000 in the stock of Ronaldo's Rubber Fashions, a small business corporation, and
later sells her stock for $1,500. Only $500 is considered income for tax purposes; the other $1,000 is
a return of capital to Toni.
Tax-free withdrawals. If you borrow against an asset, whether it belongs to your business or to you personally, the loan
proceeds are not income. Borrowing is a valuable tool for taking money tax-free out of an unincorporated business that
holds an appreciated asset, such as real estate.
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For more information on deducting health insurance, vehicles, travel, and home office expenses, see
Tax Deductions for Professionals, by attorney Stephen Fishman (Nolo). This book can also help you:
1. choose the best legal structure for your practice
2. decide whether to buy or lease the building you work in, and
1. Does your lifestyle square with your reported income? An auditor sizes you up for dress style, jewelry, car,
and furnishings in your home or office, if given a chance to make these observations. Someone who looks like a Vegas
high roller, with the tax return of a missionary, will cause any auditor to dig deeper.
2. Does your business handle a lot of cash? If your business handles a lot of cash, expect the auditor to suspect
skimming, or diverting income into your own pocket without declaring it.
3. Did you write off auto expenses for your only car? Personal use of your business-deducted set of wheels is
so common that auditors expect to find it. That doesn't mean they will accept it, however. Auditors don't believe you use
your one-and-only auto 100% for business and never to run to the grocery store or the dentist. If you operate your car for
both business and pleasure and claim a high percentage of business usage, keep good records (preferably a mileage log).
4. Did you claim personal entertainment, meals, or vacation costs as business expenses? Travel and
entertainment business expenses are another area where the IRS knows it can strike gold. Document all travel and
entertainment deductions. Taking buddies to the ball game and calling it business won't fly if you can't explain the
business relationship in a credible fashion.
1. Did you "forget" to report all of your business sales or receipts? If you failed to report significant business
income -- $10,000 or more -- strongly consider hiring a tax pro to handle the audit. Remove yourself from the process
altogether. If the auditor finds evidence of large amounts of unreported income, and it looks intentional, he may call in the
IRS criminal investigation team. However, if there is any kind of halfway plausible explanation ("Someone must have
forgotten to record September's sales"), then don't worry about jail. The auditor will probably just assess the additional tax
you should have paid in the first place, plus interest and a 20% penalty.
2. Did you write off personal living costs as business expenses? Let's face it, every small-time operator has
claimed a personal expense as a business one. For little things, such as a few personal long-distance calls on the business
telephone line, the IRS won't get too excited. But if you deducted $2,000 in repairs on your motor home during a trip to
Yellowstone, an auditor may figure this out by looking at your receipts and disallow it, with penalty added.
3. If you have employees, are you filing payroll tax returns and making tax payments? Employment taxes
are a routine part of every audit of a small enterprise.
4. And last but not least, if you hire people you call "independent contractors," are they really
employees? The IRS routinely conducts audits of businesses that hire independent contractors, because of the tax
savings associated with hiring contractors instead of employees.
This list is by no means complete. These are just the most likely things an IRS auditor will look for. For more information
on business taxes and audits, see Tax Savvy for Small Business, by attorney Frederick W. Daily (Nolo).
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Example
Mr. Henry, an accountant, deducted his yacht expenses, contending that because the boat flew a
pennant with the numbers "1040," it brought him professional recognition and clients. The matter
ended up before the tax court. The court ruled that the yacht wasn't a normal business expense for a
tax professional, and so it wasn't "ordinary" or "necessary." In short, the yacht expense was personal
and thus nondeductible. (Henry v. CIR, 36 TC 879 (1961).)
The laugh test. Tax professionals frequently rely on the "laugh test": Can you put down an expense for business without
laughing about putting one over on the IRS? In the example above, the tax court laughed the accountant and his yacht out
of court.
Large Expenses
Because the IRS knows that people don't intentionally overpay for anything, amounts paid aren't usually questioned.
However, IRS auditors sometimes object to expenditures deemed unreasonably large under the circumstances.
While the tax code itself contains no "too big" limitation, courts have ruled that it is inherent in Section 162. For example,
it might be reasonable for a multi-state apparel company to lease a jet for travel between manufacturing plants, but not
for a corner deli owner to fly to New York to meet with her pickle supplier.
Personal Expenses
The number one concern of the IRS when auditing business deductions is whether purely personal expenditures are being
claimed as business expenses. For instance, you can't deduct the cost of commuting to work, because the tax code
specifically says this is a personal, not a business, expense. Ditto with using the business credit card for a vacation or
cruising the beach in the company car. Because such shenanigans are common, IRS auditors are ever watchful.
Fortunately, you can often arrange your affairs -- legally -- in a way that lets you derive considerable personal benefit and
enjoyment from business expenditures.
Be careful if you deal with relatives. An IRS auditor will look askance at payments to a family member or to
another business in which your relatives have an ownership interest (in tax code parlance, these are termed "related
parties"). An auditor may suspect that taxable profits are being taken out of your business for direct or indirect personal
benefit in the guise of deductible expenses. For example, paying your spouse's father, who is in prison, $5,000 as a
consultant's fee for your restaurant business would smell bad to an auditor.
1. Bank Statements, canceled checks, and receipts. The auditor will want to see bank records from all of your
accounts, both personal and business. As a rule, don't discard any business-related canceled checks, invoices, or sales
slips. If you paid some expenses with cash, keep the paperwork (handwritten notes, notebooks, receipts, or petty cash
vouchers) showing the payments.
2. Electronic records. Most banks don't return canceled checks anymore, and many business expenses are
charged on credit or debit cards. Bank and charge card (Visa, MasterCard, American Express) statements are now
accepted by the IRS as proof of payment. They must show the name, the date, the amount, and the address of the payee.
Since charges and statements don't always show the business nature of the expense, you can't rely on them as
your only records.
3. Books and records. The auditor will ask to see your "books." The tax code doesn't require small businesses to
keep a formal set of books; don't let an auditor tell you otherwise. If you keep records with only a checkbook and cash
register tapes, so be it. If you maintain more formal records such as ledgers and journals, the auditor is entitled to see
them. If your data is on a computer, the auditor will want to see a printout.
Don't make the IRS guess. If you don't produce adequate records, the auditor is legally permitted to estimate your
income and/or expenses and to impose a separate penalty for your failure to keep records.
1. Appointment books, logs, and diaries. Businesses that offer services typically track activities and expenses
using calendars, business diaries, appointment books, and logs. An entry in a business diary helps justify an expense to an
auditor as long as it appears to be reasonable.
Additionally, you must keep special records for certain equipment, called "listed property," that is often used for
both business and personal purposes. (IRC § 280F.) Cell phones, computers kept at home but used for business,
and vehicles used for both business and pleasure are designated as listed property.
Purely business equipment is not in this category. For example, mechanic's tools, a lathe, or a carpet loom are
purely business tools, and no records of usage are required. But when assets are put to both business and
personal use, the auditor can demand records of usage. For example, if you use a computer for business email
and to play solitaire, keep track of the business portion. One way is to make notes in a note pad next to the
computer.
If you haven't kept usage records of listed property, reconstruct them by memory or reference to projects that
you worked on during the year.
2. Auto records. A vehicle can be "listed property" if it's used for personal purposes as well as business. So
business use of your personal auto requires detailed records showing the work use portion. A log is the best way to keep
track (and it's easy to keep a little notebook in the glove compartment), although it's not required by the tax code.
Alternatively, you can keep all gas and repair receipts in an orderly fashion, with notations of trips showing how the car
was used for business. A less accurate way to keep records is to add up the gas bills and divide by the number of miles per
gallon that your car averages. Show the auditor your auto trip receipts and explain how they link up to sales trips by your
business diary or calendar notations.
1. Travel and entertainment records. By law, out-of-town business travel and entertainment expenses (T & E, in
auditor lingo) require greater recordkeeping than most other expenses. You must have a written record of the specific
business purpose of the travel or entertainment expense, as well as a receipt for it. (IRC § 267.)
A good way to document T & E expenses is with an appointment book or log, noting each time you incur a
business expense, and the reason. Most folks aren't disciplined enough to write down every expense as it is
incurred. It is okay to put together a log or diary after you have received an audit notice. But be up-front about it
-- don't insult the auditor's intelligence by trying to pass off wet-inked paper as an old record. Remember, it's key
to develop and maintain credibility with the auditor.
Example 1:
Bianca, a self-employed designer, reconstructs a calendar book with a notation for June 18, 2006, as
follows: "Round-trip cab fare to office of John Johnson, prospective client, $14 (no receipt). Lunch at
Circle Restaurant: Discuss proposal to decorate new offices at 333 Pine Street, $32 (Visa charge)
plus cash tip of $6 (no receipt)." Bianca can also give the auditor details, if asked. The auditor will
probably be satisfied if it appears reasonable.
Example 2:
Sam, the owner of a computer store went to an out-of-town computer retailers' convention. He spent
$1,800 and claimed it as business travel expenses on his tax return. On audit, Sam produces charge
card statements to prove the $1,800 was spent for hotels, meals, and convention registration. The
auditor wants more and asks Sam to justify the business purpose of this trip. Sam produces an ad for
the convention, an agenda of events, and notes he took at programs. If it looks legitimate, and
Sam's explanation of why it was important for him to be there is convincing, the auditor should allow
the deduction in full.
1. Expenses for renting or buying property. To prove business rental expenses, bring in a copy of your lease. If
you purchased the property or equipment, have the purchase contract. This establishes grounds for claiming these
expenses as well as a beginning tax basis of the property, if you claim depreciation expenses.
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If you expect your business to make a profit immediately, you may be able to work around this rule by a delay
in paying some bills until after you're in business, or by doing a small amount of business just to officially start. But if, like
many businesses, you will suffer losses during the first few years of operation, you might be better off taking the deduction
over five years, so you'll have some profits to offset.
3. Education Expenses
You can deduct education expenses if they are related to your current business, trade, or occupation. The expense must be
to maintain or improve skills required in your present employment, or be required by your employer or as a legal
requirement of your job. The cost of education that qualifies you for a new job isn't deductible.
4. Legal and Professional Fees
Fees that you pay lawyers, tax professionals, or consultants generally can be deducted in the year incurred. But if the work
clearly relates to future years, they must be deducted over the life of the benefit you get from the lawyer or other
professional.
Business books, including those that help you do without legal and tax professionals, are fully deductible as a cost of doing
business.
5. Bad Debts
If someone stiffs your business, the bad debt may or may not be deductible -- it depends on the kind of product your
business sells.
If your business sells goods, you can deduct the cost of goods that you sell but aren't paid for. If, however, your business
provides services, no deduction is allowed for time you devoted to a client or customer who doesn't pay. The rationale
behind this rule is that it would be too easy for businesses to inflate bills and claim large deductions for bad debts.
6. Business Entertaining
If you pick up the tab for entertaining present or prospective customers, you may deduct 50% of the cost if it is either:
1. "directly related" to the business and business is discussed at the event -- for example, a catered meeting at
your office, or
2. "associated with" the business, and the entertainment takes place immediately before or after a business
discussion.
Make notes. On the receipt or bill, always make a note of the specific business purpose -- for example, "Lunch with
Joyce Slater of Ace Manufacturing Co. to discuss widget contract."
7. Travel
When you travel for business, you can deduct many expenses, including the cost of plane fare, costs of operating your car,
taxis, lodging, meals, shipping business materials, clothes cleaning, telephone calls, faxes, and tips.
What about combining business and pleasure? It's okay, as long as business is the primary purpose of the trip. But if you
take your family along, you can deduct only your own expenses, just as if you had traveled alone.
8. New Equipment
Some small businesses can write off the full cost of some assets in the year they buy them, rather than "capitalizing" them
-- deducting their cost over a number of years. Section 179 of the Internal Revenue Code allows you to deduct up to
$105,000 form the cost of new equipment or other assets in 2005 through 2007 (subject to a phase-out if you placed more
than $420,000 of equipment in service in any one year). Some assets don't qualify for this Section 179 deduction,
including real estate, inventory bought for resale, and property bought from a close relative.
9. Interest
If, like many folks, you use credit to finance business purchases, the interest and carrying charges are fully tax-deductible.
The same is true if you take out a personal loan and use the proceeds for your business. But be sure to keep good records
showing that the money was really put into your business. Otherwise, if you're audited later, the interest expense
deduction could be disallowed because it's considered a personal expense.
10. Moving Expenses
If you move because of your business or job, you may be able to deduct certain moving costs that would otherwise be
nondeductible personal living expenses. To qualify, you must have moved in connection with your business (or job, if
you're an employee of your own corporation or someone else's business). The new workplace must be at least 50 miles
farther from your old home than your old workplace was. (Technically, moving expenses aren't business expenses; there's
a special place to list them on your Form 1040 tax return.)
11. Software
As a general rule, software bought for business use must be depreciated over a 36-month period. But there are some
important exceptions:
1. Computer software placed in service from 1/1/2003 to 12/31/2007 is eligible for a Section 179 deduction, which
means that 100% of the cost of software can be deducted in the year purchased. Starting in 2008, you will no longer be
able to use Section 179 to deduct off-the-shelf software.
2. When software comes with a computer, and its cost is not separately stated, it's treated as part of the hardware
and is depreciated over five years. However, you can write off a whole computer system, including bundled software, in
the first year (under Section 179) if the total cost is less than a certain amount ($105,000 in 2005 through 2007). See IRS
Publication 946, How to Depreciate Property.
12. Charitable Contributions
If your business is a partnership, a limited liability company, or an S corporation (a corporation that has chosen to be
taxed like a partnership), your business can make a charitable contribution and pass the deduction through to you, to
claim on your individual tax return. If you own a regular (C) corporation, the corporation can deduct the charitable
contributions.
If you've got some old computers or office furniture, giving it to a school or nonprofit organization can yield
goodwill plus a tax benefit. But if the equipment has been fully depreciated (written off), you can't claim a deduction.
13. Taxes
Taxes incurred in operating your business are generally deductible. How and when they are deducted depends on the type
of tax.
1. Sales tax on items you buy for your business's day-to-day operations is deductible as part of the cost of the
items; it's not deducted separately. But tax on a big business asset, such as a car, must be added to the car's cost basis; it
isn't deductible entirely in the year the car was bought.
2. Excise and fuel taxes are separately deductible expenses.
3. If your business pays employment taxes, the employer's share is deductible as a business expense. Self-
employment tax is paid by individuals, not their businesses, and so isn't a business expense.
4. Federal income tax paid on business income is never deductible. State income tax can be deducted on your
federal return as an itemized deduction, not as a business expense.
5. Real estate tax on property used for business is deductible, along with any special local assessments for repairs
or maintenance. If the assessment is for an improvement -- for example, to build a sidewalk -- it isn't immediately
deductible; instead, it is deducted over a period of years.
14. Advertising and Promotion
The cost of ordinary advertising of your goods or services -- business cards, yellow page ads, and so on -- is deductible as
a current expense. Promotional costs that create business goodwill -- for example, sponsoring a peewee football team --
are also deductible as long as there is a clear connection between the sponsorship and your business. For example, naming
the team the "Southwest Auto Parts Blues" or listing the business name in the program is evidence of the promotion effort.
Here are some additional routine deductions that many business owners miss. Keep your eye out for
them.
1. audiotapes and videotapes related to 1. credit bureau fees
business skills
2. office supplies
2. bank service charges
3. online computer services related to
3. business association dues business
4. business gifts 4. parking and meters
5. business-related magazines and books 5. petty cash funds
6. casual labor and tips 6. postage
7. casualty and theft losses 7. promotion and publicity
8. coffee and beverage service 8. seminars and trade shows
9. commissions 9. taxi and bus fare
10. consultant fees 10. telephone calls away from the
business
Note: Just because you didn't get a receipt doesn't mean you can't deduct the expense, so keep
track of those small items and get big tax savings.
A valuable tax break creating an exception to the long-term write-off rules is found in IRC Section
179. A small business can write off in one year most types of its capital expenditures, up to a grand
total of $105,000 in 2005 through 2007. The annual deduction limit is scheduled to go down to
$25,000 in 2008. Some assets don't qualify for this deduction: real estate, inventory bought for
resale, and property bought from a close relative.
All small businesses should take full advantage of this provision, unless they don't have enough
business income to offset the Section 179 deduction (the Section 179 deduction can't exceed your
total taxable earnings).
"Improvements" usually refers to real estate -- for example, putting in new electrical wiring, plumbing, and lighting -- but
the rule also applies to rebuilding business equipment.
Example:
Gunther uses a specialized die-stamping machine in his metal fabrication shop. After 15 years of
constant use, the machine is on its last legs. His average yearly maintenance expenses on the
machine have been $10,000, which Gunther has properly deducted as a repair expense. In 2006,
Gunther is faced with either thoroughly rehabilitating the machine at a cost of $80,000, or buying a
new one for $175,000. He goes for the rebuilding. The $80,000 expense must be capitalized -- that
is, it can't be deducted using Section 179 because it is an improvement -- not a normal repair. Under
the tax code, metal-fabricating machinery must be deducted over five years.
Example
Your computer installation business finishes a job in November, and doesn't get paid until three
months later in January. Under the cash method, you would record the payment in January. Under
the accrual method, you would record the income in your books in November.
Example
You purchase a new laser printer on credit in May and pay $1,000 for it in July, two months later.
Using the cash method accounting, you would record a $1,000 payment for the month of July, the
month when the money is actually paid. Under the accrual method, you would record the $1,000
payment in May, when you take the laser printer and become obligated to pay for it.
Example
Zara runs a small flower shop called ZuZu's Petals. On December 22, 2006, Zara buys a set of new
lighting equipment for her shop, for which she will be billed $400. She installs the lighting equipment
that day but, according to the terms of the purchase, doesn't pay for it for 30 days. Under her
accrual system of accounting, she counts the $400 expense in the December 2006 accounting period,
even though she didn't actually write the check until January of the next year. This means that Zara
can deduct the $400 as a business expense from her taxable income of 2006.
Example
Scott and Lisa operate A Stitch in Hide, a leather repair shop. They're hired to repair an antique
leather couch, and they finish their job on December 15, 2006. They bill the customer for $750,
which they receive on January 20, 2007. Because they use the accrual method of accounting, Scott
and Lisa count the $750 income in December 2006, the date they earned the money by finishing the
job. This income must be reported in their 2006 tax return even though they don't receive the
money.
Again, you can usually choose the method of accounting that is most advantageous for your business, unless your business
stocks an inventory of items that you will sell to the public, or your business has sales of more than $5 million per year.
Tax Years and Accounting Periods
Income and expenses must be reported to the IRS for a specific period of time, called your tax year, your accounting
period, or your fiscal year.
Unless there is a valid business reason to use a different period, or your business is a corporation, you'll have to use the
calendar year, beginning on January 1 and ending on December 31. Most business owners use the calendar year for their
tax year, simply because they find it easy and natural to use. If you want to use a different period, you must request
permission from the IRS by filing Form 8716, Election to Have a Tax Year Other Than a Required Tax Year.
Also, your fiscal year can't begin and end on just any day of the month: It must begin on the first day of a month and end
on the last day of the previous month one year later.
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If your customer is applying to you to establish a new credit account or increase an existing credit
line to pay for the merchandise being ordered and if you don’t give a shipment date, you are allowed
50 (instead of 30) days to ship. The extra 20 days is to give you time to process the credit
application. Of course, if you want to use this provision of the FTC rule, you must have a reasonable
basis to believe you can ship in 50 days. For more information about these rules, check out the FTC's
website at www.ftc.gov.
Drop Shipping
Drop shipping is a process in which you sell items you don’t keep in stock. Instead, you collect the money and forward the
order to a distributor, who ships to the customer using your packaging. Amazon and other online stores perfected this art,
and it has since been adopted by thousands of online retailers. The advantage of drop-shipping is that you can offer a wide
variety of merchandise without maintaining an inventory. The disadvantage is that you may have to pay setup fees, make
a minimum number of orders each month, and deal with refunds if the drop shipper screws up.
In cases of drop-shipped orders, you (the person taking the order), not the shipper, are responsible for complying with the
30-day rule. Find out the distributor’s return policy and post it at your point of sale or in your catalog, or if that’s not
possible, include it with the order.
If the customer complains about the merchandise -- for example, it arrives damaged or has a factory defect -- the
distributor will have to correct the error. But because the customer purchased the product from you, not the distributor,
you’ll have to stay on top of the transaction -- for example, get the RMA (return merchandise authorization) number from
the distributor and email it to the customer. The RMA allows you and the distributor to accurately track and process the
returned merchandise.
To learn about starting and running your own business, see Whoops! I'm in Business: A Crash Course in Business Basics,
by attorneys Richard Stim & Lisa Guerin (Nolo).
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To learn about starting and running your own business, see Whoops! I'm in Business: A Crash
Course in Business Basics, by attorneys Richard Stim & Lisa Guerin (Nolo).
1. To keep track of your income and expenses, which improves your chances of making a profit.
2. To collect the financial information necessary for filing your various tax returns.
Sounds pretty simple, doesn't it? It can be, especially if you remind yourself of these two goals whenever you feel
overwhelmed by the details of keeping your financial records.
There is no requirement that your records be kept in any particular way. As long as your records accurately reflect your
business's income and expenses, the IRS will find them acceptable. (There is a requirement, however, that some
businesses use a certain method of crediting their accounts: the cash method or accrual method. )
Three Steps to Keeping Your Books
The actual process of keeping your books is easy to understand when broken down into three steps.
1. Keep receipts or other acceptable records of every payment to and every expenditure by your business.
2. Summarize your income and expenditure records on some periodic basis (daily, weekly, or monthly).
3. Use your summaries to create financial reports that will tell you specific information about your business, such as
how much monthly profit you're making or how much your business is worth at a specific point in time.
Whether you do your accounting by hand on ledger sheets or use accounting software, these principles are exactly the
same.
Step One: Keeping Your Receipts
Each of your business's sales and purchases must be backed by some type of record containing the amount, the date, and
other relevant information about that sale. You'll use these to create summaries of your transactions.
From a legal point of view, your method of keeping receipts can range from slips kept in a cigar box to a sophisticated cash
register hooked into a computer system. Practically, you'll want to choose a system that fits your business needs. For
example, a small service business that handles only relatively few jobs may get by with a bare-bones approach. But the
more sales and expenditures your business makes, the better your receipt filing system needs to be.
Step Two: Setting Up and Posting to Ledgers
A completed ledger is really nothing more than a summary of revenues, expenditures, and whatever else you're keeping
track of (entered from your receipts according to category and date). Later, you'll use these summaries to answer specific
financial questions about your business, such as whether you're making a profit and, if so, how much.
On some regular basis -- like every day, once a week, or at least once a month -- you should transfer the amounts from
your receipts for sales and purchases into your ledger. This is called "posting;" how often you do this depends on how
many sales and expenditures your business makes, and how detailed you want your books to be.
Generally speaking, the more sales you do, the more often you should post to your ledger. A retail store, for instance, that
does hundreds of sales amounting to thousands or tens of thousands of dollars every day should post daily. With that
volume of sales, it's important to see what's happening every day and not to fall behind with the paperwork. To do this,
the busy retailer should use a cash register that totals and posts the day's sales to a computerized bookkeeping system at
the push of a button. A slower business, however, or one with just a few large transactions per month, such as a small
website design shop, dog-sitting service, or swimming-pool repair company, would probably be fine if it posted weekly or
even monthly.
You can purchase an accounting software program that will generate its own ledgers as you enter your information (and
then automatically generate the necessary financial reports from the same information). All but the tiniest new business
are well advised to use an accounting software package to help keep their books (and micro-businesses can get by with
personal finance software such as Quicken).
Step Three: Creating Basic Financial Reports
Financial reports are important because they bring together several key pieces of financial information about your business
in one place. Think of it this way: while your income ledger may tell you that your business brought in a lot of money
during the year, you may have no way of knowing whether you turned a profit without measuring your income against
your total expenses. And even comparing your monthly totals of income and expenses won't tell you whether your credit
customers are paying fast enough to keep adequate cash flowing through your business to pay your bills on time.
That's why you need financial reports: to combine data from your ledgers and sculpt it into a shape that shows you the big
picture of your business. The key reports you need to create regularly are a cash flow analysis, a profit and loss forecast,
and a balance sheet. (Both QuickBooks and Quicken Home and Business, as well as other accounting software, can provide
these regular reports.)
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If your customer is applying to you to establish a new credit account or increase an existing credit
line to pay for the merchandise being ordered and if you don’t give a shipment date, you are allowed
50 (instead of 30) days to ship. The extra 20 days is to give you time to process the credit
application. Of course, if you want to use this provision of the FTC rule, you must have a reasonable
basis to believe you can ship in 50 days. For more information about these rules, check out the FTC's
website at www.ftc.gov.
Drop Shipping
Drop shipping is a process in which you sell items you don’t keep in stock. Instead, you collect the money and forward the
order to a distributor, who ships to the customer using your packaging. Amazon and other online stores perfected this art,
and it has since been adopted by thousands of online retailers. The advantage of drop-shipping is that you can offer a wide
variety of merchandise without maintaining an inventory. The disadvantage is that you may have to pay setup fees, make
a minimum number of orders each month, and deal with refunds if the drop shipper screws up.
In cases of drop-shipped orders, you (the person taking the order), not the shipper, are responsible for complying with the
30-day rule. Find out the distributor’s return policy and post it at your point of sale or in your catalog, or if that’s not
possible, include it with the order.
If the customer complains about the merchandise -- for example, it arrives damaged or has a factory defect -- the
distributor will have to correct the error. But because the customer purchased the product from you, not the distributor,
you’ll have to stay on top of the transaction -- for example, get the RMA (return merchandise authorization) number from
the distributor and email it to the customer. The RMA allows you and the distributor to accurately track and process the
returned merchandise.
To learn about starting and running your own business, see Whoops! I'm in Business: A Crash Course in Business Basics,
by attorneys Richard Stim & Lisa Guerin (Nolo).
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Copyright 2006 Nolo
Consignment Sales
A consignment occurs when you provide work to a reseller (the “consignee”), who agrees to pay you proceeds from the
sales minus a commission. If your product doesn’t sell, the consignee can return it. Under this arrangement, the consignee
takes very little risk since it does not have to purchase goods. The advantage to you can be that it gives you access to
sales outlets that might not otherwise be open to you.
Consignment sales can be big business. In craft sales alone, consignments account for more than $3 billion annually in
the United States. These numbers can be exciting, but before you jump into consignment sales, you should consider:
1. the credit or references of your consignee
2. having a written consignment agreement that spells out the inventory being consigned and other details
3. the retail price the goods will be sold for
4. the consignee’s fees
5. who pays for shipping and other matters that will affect your ability to realize a profit on your goods
6. insurance that the consignee will carry to protect your goods
7. when the deal will terminate, and
Collecting Payment
No matter what you sell, you may have problems collecting what you are owed. The best way to avoid problems is to
minimize them up front with good policies and by carefully offering credit on larger orders. If you have a client who does
not pay and you can’t work out a plan, you have several collections options:
1. Turn the account over to a collection agency.
2. Sue in small claims court.
3. Hire a lawyer.
To set the right procedures in plans in place, get help from Your Crafts Business: A Legal Guide, by attorney Richard Stim
(Nolo).
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To learn about starting and running your own business, see Whoops! I'm in Business: A Crash
Course in Business Basics, by attorneys Richard Stim & Lisa Guerin (Nolo).
Price Reductions
Offering a reduction from your usual selling price is a common sales technique. But the price is misleading unless the
former price is the actual, bona fide price at which you offered the article. For example, if you announce a new product for
$129, but sell it to wholesalers as if it were a $79 product, and similarly discount it to direct customers, the $129 price
never really existed -- and you have broken the law. It misleads customers into thinking they are receiving a discount.
It's even more blatant to buy a special batch of merchandise especially for a sale and create a fictional "regular" price or
one you adhered to for only a day or two. Some merchants are tempted to do this when they buy seconds or discontinued
product lines at a deep discount and want to pretend customers are getting a bargain.
If your ad compares your price with what other merchants are charging for the same product, be sure of two things:
1. the other merchants are selling the identical product, and
2. the other merchants had enough sales at the higher price in your area so that you're offering a legitimate
bargain.
In other words, make sure that the higher comparison price isn't an isolated or unrepresentative price.
2. usually provide a service (such as free delivery) with a paint purchase, but don't when the customer gets a "free"
brush.
You can find out more about consumer protection laws by contacting the Federal Trade Commission
(www.ftc.gov), 600 Pennsylvania Avenue NW, Washington, DC 20850, 877-FTC-HELP (382-4357),
and by contacting your state's consumer protection agency.
5. the amount of any late payment charges and when they'll be imposed.
Example:
Ron notifies CompuCo that he wasn't properly credited for a payment he sent in on his computer
purchase. Under the Fair Credit Billing Act, CompuCo must acknowledge Ron's notice within 30 days.
And within 90 days, CompuCo must either agree with Ron and correct his account or, after
conducting a reasonable investigation, send Ron a letter explaining why the company feels his bill
was correct. While this is happening, Ron doesn't have to pay the disputed amount. And he can't be
penalized for withholding payment. During this period, CompuCo can't tell a credit reporting agency
that this is a delinquent bill. CompuCo can charge interest on the disputed amount, but if Ron turns
out to be right, the interest must be dropped.
State laws may also deal with billing disputes. Generally, if a state law on this subject conflicts with the federal statute, the
federal statute will control -- but there's one exception: a state law will prevail if it gives a consumer more time to notify a
creditor about a billing error. For example, as explained above, the federal law gives a consumer 60 days after receiving a
bill to notify you of a billing error. If a state law gives a consumer 90 days to notify you, the consumer will be entitled to
the extra 30 days.
In addition to telling you how to handle billing disputes, the Fair Credit Billing Act requires you, in periodic mailings, to tell
consumers what their rights are.
3. The Equal Credit Opportunity Act
You may not discriminate against a credit applicant on the basis of race, color, religion, national origin, age, sex or marital
status. The Act does leave you free to consider legitimate factors in granting credit, such as the applicant's financial status
(earnings and savings) and credit record. Despite the prohibition on age discrimination, you can reject a consumer who
hasn't reached the legal age for entering into contracts.
4. The Fair Credit Reporting Act
This federal law deals primarily with credit reports issued by credit reporting agencies. It's intended to protect consumers
from having their eligibility for credit thwarted by incomplete or misleading credit report information. The law gives
consumers the right to a copy of their credit reports. If they see an inaccurate item, they can ask that it be corrected or
removed. If the business reporting the credit problem doesn't agree to a change or deletion or if the credit bureau refuses
to make it, the consumer can add a 100-word statement to the file explaining his or her side of the story. This becomes a
part of any future credit report.
5. The Fair Debt Collection Practices Act
This federal law addresses abusive methods used by third-party collectors -- bill collectors you hire to collect overdue bills.
Small businesses are more directly affected by state laws that apply directly to collection methods used by a creditor.
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Revoking an Offer
Whoever makes an offer can revoke it as long as it hasn't yet been accepted. This means if you make an offer and the
other party wants some time to think it through, or makes a counteroffer with changed terms, you can revoke your original
offer. Once the other party accepts, however, you'll have a binding agreement. Revocation must happen before
acceptance.
An exception to this rule occurs if the parties agree that the offer will remain open for a stated period of time.
Counteroffers
Often, when an offer is made, the response will be to start bargaining. Of course, haggling over price is the most common
type of negotiating that occurs in business situations. When one party responds to an offer by proposing something
different, this proposal is called a "counteroffer." When a counteroffer is made, the legal responsibility to accept, decline or
make another counteroffer shifts to the original offeror.
For instance, suppose your printer (here, the original offeror) offers to print 5,000 brochures for $300, and you respond by
saying you'll pay $250 for the job. You have not accepted his offer (no contract has been formed) but instead have made a
counteroffer. If your printer then agrees to do the job exactly as you have specified, for $250, he's accepted your
counteroffer, and a legal agreement has been reached.
While it's true that a contract is formed only if the accepting party agrees to all substantial terms of an offer, this doesn't
mean you can rely on inconsequential differences to void a contract later. For example, if you offer to buy 100 chicken
sandwiches on one-inch-thick sourdough bread, there is no contract if the other party replies she will provide 100 emu
filets on rye bread. But if she agrees to provide the chicken sandwiches on one-inch-thick sourdough bread, a valid
contract exists, and you can't later refuse to pay if the bread turns out to be a hair thicker or thinner than one inch.
2. Exchange of Things of Value
In addition to both parties' agreement to the terms, a contract isn't valid unless both parties exchange something of value,
in anticipation of the completion of the contract. The "thing of value" being exchanged -- which every law student who ever
lived has been taught to call "consideration" -- is most often a promise to do something in the future, such as a promise to
perform a certain job or a promise to pay a fee for a job. For instance, let's return to the example of the print job. Once
you and the printer agree on terms, there is an exchange of things of value (consideration): the printer has promised to
print the 5,000 brochures and you have promised to pay $250 for them.
The main importance of requiring things of value to be exchanged is to differentiate a contract from a generous statement
or a one-sided promise, neither of which are enforceable by law. If a friend offers you a gift without asking anything in
return -- for instance, such as offering to stop by and help you move a pile of rocks -- the arrangement wouldn't count as
a contract because you didn't give or promise your friend anything of value. If your friend never followed through with her
gift, you would not be able to enforce her promise. However, if you promise your friend you'll help her weed her vegetable
garden on Sunday, in exchange for her helping you move rocks on Saturday, a contract exists.
Although the exchange-of-value requirement is met in most business transactions by an exchange of promises ("I'll
promise to pay money if you promise to paint my building next month"), actually doing the work can also satisfy the rule.
If, for instance, you leave your printer a voice-mail message that you'll pay an extra $100 if your brochures are cut and
stapled when you pick them up, the printer can create a binding contract by actually doing the cutting and stapling. And
once he does so, you can't weasel out of the deal by claiming you changed your mind.
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What Is Bankruptcy?
Here's a quick review of what bankruptcy means for the debtor and for you. Individual and business
debtors file for bankruptcy because their debts have become overwhelming, and the debtors want
the court to relieve them of their obligation for some of the debts and to help them arrange (delay)
the orderly repayment of the others. The three types of bankruptcy you're most likely to encounter
include:
2. Chapter 13 bankruptcy. Consumer debtors whose income is regular and who owe less
than $307,675 in unsecured debts and less than $922,975 in secured debts can make use of Chapter
13 bankruptcy. The court and a trustee allow the debtor to keep his or her property so long as the
debtor pays all or part of creditors' claims according to a plan and repayment schedule.
3. Chapter 11 bankruptcy. Chapter 11 is like Chapter 13, but is mainly for corporations. The
debtor acts as his or her own trustee and gets creditors to vote in favor of a reorganization plan, then
continues to run the business while paying a portion or all of creditors' claims according to the plan.
As soon as a debtor files for bankruptcy, something called the "automatic stay" kicks in, which stops
you and all other creditors from attempting to collect your debts. That means your only choice (with
rare exceptions) is either to learn about and participate in the bankruptcy, or to cut your losses.
First, stop all collection activities. Whether or not you get involved with the bankruptcy case, as soon as you find
out that a debtor has filed for bankruptcy, you should mark the account as being in bankruptcy and advise your collection
personnel to stop their activities (in compliance with the "automatic stay"). Then decide whether it's worth going to court
to request lifting of the automatic stay (sometimes appropriate if you're a secured creditor who wants to foreclose on your
collateral).
Examine the debtor’s bankruptcy papers. If you spend an hour or two looking over the paperwork that the debtor filed
with the court, you'll gain information that will help you decide whether to proceed, and investigate whether there's more
money to be had than the creditor is confessing to. The papers will tell you what property the debtor claims to own, which
items the debtor thinks are safe from being sold in bankruptcy, and the identity of other creditors (both secured creditors,
who were given collateral, and unsecured creditors). With a little detective work, you may be the one to uncover mistakes
or omissions. For example, you may know about property that the debtor didn't mention. Or, you may figure out that
certain property must exist; for example, if the debtor lists a debt to a tire company but fails to mention owning a car, the
debtor may be concealing ownership of an automobile.
Attend a meeting of creditors. All debtors must submit to a public examination by their creditors. It's a great
opportunity for you to question the debtor about details relevant to your claim, such as what the debtor plans to do with
your collateral (if any), or your suspicions that the debtor hid assets, underreported income, or overreported expenses.
You'll probably wait 30 minutes to attend a meeting that lasts only a few minutes -- especially because so few creditors
ordinarily show up.
File a proof of claim. The proof of claim is a one-page form that essentially says "I want in on the bankruptcy
proceedings." You'll need to attach any documents proving your claim, such as contracts, notes, mortgages, and security
agreements. If you don't file a proof of claim with the court, you normally lose your opportunity to have a voice in the
proceedings and to be paid your debt from the bankruptcy proceeds. (Even if you're a secured creditor, you can't
necessarily count on collecting on your claim through your lien unless you file a proof of claim form.) The proof of claim
should take you about fifteen minutes to fill out, assemble, and mail to the court. If the debtor objects to any portion of
your claim, you’ll need to attend a court hearing, unless you and the debtor reach an agreement resolving the debtor’s
objection.
Attend a hearing regarding the debtor’s reorganization/repayment plan (Chapters 11 and 13 only). If the
debtor filed for a Chapter 11 reorganization, you may choose to propose a reorganization (and repayment) plan and will be
given an opportunity to vote on which proposed plan gets adopted. Voting is handled by mail. Consideration of any plan
you submit is done at a hearing.
If the debtor filed for a Chapter 13 reorganization, you’ll want to attend the hearing at which the court decides whether the
debtor's proposed repayment plan should be confirmed. Sometimes these confirmation hearings are held at the same time
as the meeting of creditors. At the hearing, you can object to defects in the debtor's plan.
Follow through to the extent necessary. With any luck, your participation in the previous steps will be enough, and the
bankruptcy trustee will see to administering a repayment plan (in a Chapter 11 or 13 case) or handling the sale of the
debtor's available property and repaying the creditors (in a Chapter 7 case). If, however, disputes or other unusual
circumstances arise, more court proceedings may be required. You would want to reassess the amount of money at stake
and decide whether it's worth hiring an attorney to continue.
Your Chances of Success
Is it realistic to hope that any money can be wrung from this debtor? You may be in a better position to answer that than
anyone. Based on your past knowledge of the debtor or on your alert perusal of the debtor's bankruptcy paperwork, you
may have formed an opinion about the debtor's financial prospects and level of honesty. Is the debtor the type likely to
have an overseas bank account and a hidden boat, or is the debtor someone who's truly down on his or her luck with
nothing left?
If you don't have a good sense of the debtor, consider the following:
1. Your active participation in developing a reorganization plan (in a Chapter 11 or 13 case) may lead to a better
deal for you and other creditors.
2. In most cases, the bankruptcy trustee will be looking for hidden assets and income, and if you've maintained
your role in the case, you will be among those who ultimately benefit.
3. Reorganization cases take many months to complete, during which time the debtor may get a pay raise, collect
an inheritance, or win a lawsuit, all of which will increase the amount of money available to you and other creditors.
If you decide to stake your claim against a bankrupt debtor, you'll want to obtain a copy of Nolo's Getting Paid: How to
Collect From Bankrupt Debtors, by Stephen Elias.
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Copyright 2006 Nolo
1. Diversify Your Customer Base. You know the old saying: Don’t put all your eggs in one basket. If you’re
supplying goods and services to larger businesses, this can be all too easy to forget. By diversifying your
customer base, you can help ensure that you won’t be forced to file for bankruptcy because one of your
customers does.
2. Get Credit Applications from New Customers. Lending money or extending credit to customers without
checking their creditworthiness is asking for trouble, as you run the risk of not getting paid if the customer files
for bankruptcy. You can protect yourself from the risk of nonpayment and preserve your ability to challenge
fraudulently incurred charges by having a customer give you a detailed, written, and signed credit application.
For a sample credit application form, see Legal Guide for Starting & Running a Small Business, by Fred S. Steingold
(Nolo).
3. Verify the Customer’s Credit History. After the customer has completed the credit application, verify the
information -- or find out the truth -- by obtaining a credit report from one of the three major credit-reporting
agencies. You'll need to subscribe to one of their services. The big three are:
• Equifax, at 888-202-4025 or www.equifax.com
• Experian, at 888-217-6064 or www.experian.com
• TransUnion, at 312-466-7363 or www.transunion.com.
If your customer is a business, credit reports can be obtained from Dun & Bradstreet (888-814-1435). By reviewing the
credit reports you receive, you'll be better able to predict how likely the customer is to default on a loan. If the customer
ultimately does go bankrupt, you'll be better protected by showing you reasonably relied on a positive credit report.
4. Require a Cosigner or Guarantor. You need not rely on just one person to pay a debt. If the credit application
is from an individual, you can ask that someone else cosign for the debt. If the credit application is from a
business, see if one of the principals will guarantee the debt. By requiring a cosigner or guarantor, you will be
more likely to receive the money you are owed if the person you provided credit to files for bankruptcy.
5. Obtain Collateral. You can look to the debtor’s property for payment, by asking the customer to give you a
security interest. A security interest allows you to sell the property that is collateral for the loan in order to collect
your claim if the debtor doesn’t fully repay you. Although the customer's bankruptcy will hamper your ability to
sell the collateral, you'll be in a much better position than the "unsecured" creditors (who have no collateral).
6. Cash All Checks Promptly. Don’t let checks sit around your office. You may think you’ve been paid as soon as
the check arrives, but the law says the money isn’t yours until the debtor’s bank honors the check. If the debtor
is sliding toward bankruptcy -- a fact you may not know until it’s too late -- you’re better off getting that check
through the system as soon as possible.
7. Ask Customers to Pay by Cashier’s Check or Money Order. If you’ve got reason to worry about a particular
customer's financial situation, don't accept a personal check. Cashier's checks and money orders are legally
considered equal to cash, so the transfer occurs as soon as they're given to you.
8. Periodically Review Long-Term Customers' Creditworthiness. A customer who three years ago passed
your credit application with flying colors may be in very different straits today. Depending on how well you know
your customers, ask for updated credit information before extending new credit.
9. Look for Telltale Signs by Business Customers. A business customer who is at risk of filing for bankruptcy
may exhibit warning signs, which you can catch if your radar is up. Start asking questions if you notice your
customer’s:
• pattern of late payments
• selling off of assets
• changes in company personnel
• changes in payment practices
• changes in buying patterns, or
10. Know When to Sue. If a customer has a delinquent account, don’t let a mere threat of bankruptcy stop you
from suing. The worst that’s going to happen is that the customer will file for bankruptcy before you receive a
judgment, in which case the automatic stay will simply stop matters in their tracks. The best that could happen is
that you’ll get a judgment and get paid by enforcing it against the debtor’s income or property. The upside clearly
outweighs the downside.
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1. Don’t harass. Don't harass people who owe you money, but let them know that you follow these matters
closely. Don’t leave more than one phone message per day for a debtor, and never leave messages that threaten the
debtor or contain statements that put the debtor in a bad light.
2. Be direct, listen, and don’t get personal. Keep your calls short and be specific. Your goal, according to
collections expert Carol Frischer, should be to prevent the debtor from taking the call personally -- that is, from associating
the failure to pay as meaning a failure in life. Always stay calm but always maintain a sense of urgency about getting paid.
1. Get creative. If the customer has genuine financial problems, ask what amount they can realistically afford to
pay. Consider extending the time for payment if the customer agrees in writing to a new payment schedule. Call the day
before the next scheduled payment is due to be sure the customer plans to respect the agreement.
2. Write demand letters. Along with phone calls, send a series of letters that escalate in intensity. Save copies of
all correspondence with the customer and keep notes of all telephone conversations. You may need these if you hand the
matter over to a collections agency or take the customer to court.
3. Use a collections agency to send letters. You can pay a collection agency a fixed fee to write a series of
letters on your behalf. This is different than turning over the debt to an agency. For example, Dun & Bradstreet Small
Business Solutions (http://smallbusiness.dnb.com) will write a series of three letters for under $30. They will also make
telephone collection calls on your behalf. Other companies such as Transworld Systems (www.transworldsystems.com) and
I.C. System (www.icsystem.com) offer similar services.
4. Offer a one-time deep discount. If an account is fairly large and remains unpaid for an extended period (say
six months) and you're doubtful about ever collecting on the debt, consider offering in writing a time-limited, deep
discount to resolve the matter. You can finalize this with a mutual release and settlement, a legal document that
terminates the debt.
5. Learn from the pros. Debt collectors can offer helpful tips. You can learn some by reading either Collections
Made Easy, by Carol Frischer (Career Press), or Paid in Full, by Timothy R. Paulsen (Ragnar), both of which are friendly,
succinct, and helpful.
6. Turn the account over to a collection agency. Turning a debt over to collections is your last resort. A
collection agency will usually pay you 50% of what it recovers. Of course, in some cases, half is better than nothing. Dun
and Bradstreet Small Business Solutions, and the similar business services Transworld Systems and I.C. System, all offer
debt collection services. The Commercial Collection Agency Association (www.ccascollect.com) provides more information
on debt collection agencies.
For more information on collecting debts for your small business, see Whoops! I'm in Business: A Crash Course in Business
Basics, by attorneys Richard Stim & Lisa Guerin (Nolo).
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1. Web Marketing Today (http://www.wilsonWeb.com) is a free weekly email from Ralph Wilson, who sells design
and marketing services to people who own and operate websites. This newsletter combines Ralph's gentle self-promotion
with useful information about developing and promoting websites. And the newsletter always includes links to free, in-
depth articles posted at Ralph's site.
2. Web Reference Update (http://webreference.com/new) is a free email newsletter from Andy King who offers
technical services to website developers. It offers short, newsletter-style articles and each one is hyperlinked to more
detailed information posted at websites including Andy's and others. You could spend 20 seconds or 20 minutes reading
Andy's emails, depending on how much of the linked information you want to explore.
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For more help marketing your business, see Marketing Without Advertising: Inspire Customers to
Rave About Your Business to Create Lasting Success, by Michael Phillips and Salli Rasberry (Nolo).
XML-Based Signatures
Other e-signature systems have been developed, including a method for digitally recording a fingerprint, and hardware
that electronically records your signature. In addition, the organization that sets Web standards for the Internet, the
Worldwide Web Consortium (W3C), developed XML-compliant guidelines for digital signatures. The results of their working
group are discussed at the W3C website at www.w3.org/Signature.
Opting Out of Electronic Contracts
While the federal e-signature law makes paper unnecessary in many situations, it also gives consumers and businesses the
right to continue to use paper where desired. The law provides a means for consumers who prefer paper to opt out of
using electronic contracts.
Prior to obtaining a consumer's consent for electronic contracts, a business must provide a notice indicating whether paper
contracts are available and informing consumers that if they give their consent to use electronic documents, they can later
change their mind and request a paper agreement instead. The notice must also explain what fees or penalties might apply
if the company must use paper agreements for the transaction. The notice must also indicate whether the consumer's
consent applies only to the particular transaction at hand, or to a larger category of transactions between the business and
the consumer -- in other words, whether the business has to get consent to use e-contracts/signatures for each
transaction.
A business must also provide a statement outlining the hardware and software requirements to read and save the
business's electronic documents. If the hardware or software requirements change, the business must notify consumers of
the change and give consumers the option (penalty-free) to revoke their consent to using electronic documents.
Although the e-signature law doesn't force consumers to accept electronic documents from businesses, it poses a potential
disadvantage for low-tech citizens by allowing businesses to collect additional fees from those who opt for paper.
Contracts That Must Be on Paper
To protect consumers from potential abuses, electronic versions of the following documents are invalid and unenforceable:
1. wills, codicils, and testamentary trusts
2. documents relating to adoption, divorce, and other family law matters
3. court orders, notices, and other court documents such as pleadings or motions
4. notices of cancellation or termination of utility services
5. notices of default, repossession, foreclosure, or eviction
6. notices of cancellation or termination of health or life insurance benefits
7. product recall notices affecting health or safety, and
Government Filings
As for the government, transactions between citizens and the federal government were addressed in 1998's Government
Paperwork Elimination Act (GPEA), which created requirements and incentives for the federal government to make
electronic versions of their forms available online. A good deal of progress has been made, as many online consumer
transactions -- such as paying taxes and registering trademarks -- are now available from the feds. State governments are
slowly catching up, as some states now allow you to register your business online.
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1. Monitor postings. Regularly review all postings and promptly take down those you think are offensive or
libelous.
1. Remove suspect postings. If asked to remove a posting by a third party, remove it while you investigate. If
you determine -- after speaking with an attorney -- that you are entitled to keep the post, then you can put it back up.
2. Include a disclaimer. Your disclaimer should explain you don’t endorse and aren’t responsible for the accuracy
or reliability of statements made by third parties. This won’t shield you from claims, but it may minimize your financial
damages if you’re involved in a lawsuit over the posting.
Copyright Notices
Regardless of what your site does, you should include notices regarding copyright and trademark -- for example “Copyright
© 2006 RichandAndrea.com” or “Cyzuki is a trademark of Cynthia Lloyd.”
If you want to use someone else's work on your website, read the following article: Getting Permission to Publish: Ten Tips
for Webmasters.
Protecting Minors
If you are catering to an audience under 13 years old, special rules apply. You should learn more about dealing with
children at the Federal Trade Commission’s website, www.ftc.gov/kidzprivacy.
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EXAMPLE
Margo is passionate about rare orchids but can't find them in Indiana, so she orders her supplies online from an orchid
supplier with headquarters in Vermont. The supplier has all of its facilities in Vermont and collects payment in Vermont.
Margo does not have to pay Indiana sales tax (or Vermont sales tax) on her orchids.
A few months later, the supplier opens a warehouse in Indiana to handle its online orders for the entire country. Margo
continues to order her orchids from the headquarters in Vermont but she must now pay Indiana sales tax. Her ride on
the tax-free train is over.
Company A and Company B both sell concert tickets online, including services for exchanging
unwanted tickets and earning rewards for frequent purchases. Company A holds a patent on a
method of exchanging concert tickets. Company B has a patent on a method of offering rewards to
concert promoters for group ticket purchases. Although each company believes the other is infringing
its patent, neither seeks to enforce its rights in court, fearing that the other is almost sure to file a
lawsuit in response. Instead, after a few months of legal posturing, Company A and B agree to share,
or "cross-license," their technology.
Example:
Company A has been using a business accounting method for years, but never publicly disclosed it.
Company B independently develops the method and obtains a patent on it. Company B sues
Company A. Under the amendment to the patent law, Company A has not infringed the patent.
If Company A had been using the method publicly for more than year before the patent application was filed, Company B's
patent would be invalidated or, more likely, never would have been granted in the first place.
Legal Requirements for Getting a Business Method Patent
In order to qualify for patent protection, a business method or software must meet four requirements:
1. The method or software must fall within the classes of patentable subject matter. Anything that is created by
humans falls within these classes; laws of nature, natural phenomena and abstract ideas do not.
2. The method or software must be useful. This requirement is fairly easy to satisfy because any functional purpose
will suffice. A business need only demonstrate that its method or software provides some concrete tangible result. For
example, the Amazon 1-Click patent provides a tangible result -- an expedited purchase.
3. The method or software must be novel. This requirement means the method must have an aspect that is
different in some way from all previous knowledge and inventions. This requirement is discussed in more detail below.
4. The method or software must be nonobvious, meaning that someone who has ordinary skill in the specific
technology could not easily think of it. This, too, is discussed just below.
The cost of obtaining a business method patent depends on several factors, including the subject
matter of the patent, the complexity of the examination process and whether a lawyer's fees are
involved. You can expect to pay between $3,000 and $15,000 to acquire a business method patent
unless you do it yourself, in which case the costs are much reduced. After a patent is issued, the
owner must pay maintenance fees to the USPTO after 3.5, 7.5 and 11.5 years. Of course, if the
patent is challenged -- and many are -- the costs can skyrocket.
Novelty
An Internet method will flunk the novelty test if it was put to public use -- or described in a published document -- more
than one year before the patent application for the business method was filed. (If the method is exposed to the public in
one of these ways, it loses its novelty.) For this reason, a business that is seeking to acquire a patent must research the
prior art and promptly file its patent application or it risks losing valuable patent rights.
A business method is considered novel when it is different in at least one element from all previous methods -- known in
patentspeak as the "prior art." Prior art consists of:
1. any published writing (including any patent) that was made publicly available either: (1) before the date of
invention of the business method or (2) more than one year before the patent application for the business method is filed
2. any U.S. patent that has a filing date earlier than the date of invention of the business method
3. any relevant method or process (whether described in writing or not) existing publicly before the business
method was conceived, or
4. any public or commercial use, sale, or knowledge of the business method more than one year before the patent
application for the business method is filed.
For purposes of prior art, the date of invention of the business method is the date that the business can demonstrate that
the method works. The USPTO will consider all prior art, whether Internet-related or not.
Nonobviousness
Meeting the nonobviousness test turns on whether or not the method provides a result that would be new or unexpected to
someone with ordinary skill in the field of the business. Or put another way, if the differences between the business
method and the prior art would not have been an obvious development to someone in the field, it is probably nonobvious.
Example:
An economist devised a method of avoiding taxes by using a credit card to borrow money from a
40l(k) fund. The method did not exist previously and differed substantially from previous methods of
avoiding taxes. Since the method was new and was not obvious to accountants or tax experts, the
economist acquired a patent (U.S. Pat. No. 5,206,803).
Business methods and software can also be protected under trade secret laws. A trade secret is any
confidential business information developed by a company that gives it an advantage over
competitors. As long as it's kept secret, this protection does not expire.
Patent protection, however, although more expensive and shorter in duration, is often preferable to
trade secret protection because a patent owner can stop others from using the patented method
even if the new user developed the method on its own, without stealing or copying directly from the
patent owner.
In addition, a patent owner can use the business method publicly or license it to others without losing
its rights in the method.
If you know that your business method infringes an existing patent and you continue to use it,
particularly after being warned by the patent owner, you may be found liable for willful infringement.
If this occurs, you might be required to pay up to three times the actual damages. In other words,
the court will determine the patent owner's lost profits and then multiply them by three. In addition,
you may be responsible for paying the patent owner's attorney fees (as well as your own lawyer's
charges).
If you are accused of violating another company's patent, you'll no dount need the help of a patent attorney to defend
yourself and prove that the other company's patent is invalid.
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1. A domain name. You can get your domain name (your address on the Web -- for example, www.nolo.com) at a
domain name registrar or through a hosting company. Expect to pay between $10 and $35 a year.
2. Website development software. You create your website on your own computer using development software
and then transfer it to your hosting company. There is a learning curve for website software, and of the three leading
products -- Macromedia Dreamweaver, Adobe Go Live and Microsoft FrontPage -- FrontPage is considered the easiest to learn.
3. A hosting company. A hosting company, sometimes referred to as an Internet Service Provider or ISP, rents
out space on its equipment. You give the host your domain name information (or they’ll get the domain name for you) and
your website design, and they broadcast your website for the world to see. Expect to pay $5 to $50 a month for Web
hosting, depending on the bells and whistles.
Selling Products Online
If you’re interested in selling products online, you’ll need to do more than if you’re setting up an information-only site.
There are two ways to do this: set up a community business on someone else's site, or create your your store from
scratch.
Quick and easy: Set up a community store. A community store on a site such as an eBay or Yahoo offers a complete
turnkey solution. eBay or Yahoo will help you quickly set up your site and make it possible for you to accept credit card
payments. All you’ll need to do is pay the fees and provide photos and copy for your products. For a good example of a
successful community store, check out the Yahoo! Store for Vermont Teddy Bear Company at
http://store.yahoo.com/vtbear.
More time-consuming: Build a store from scratch. Building a store from scratch is not as simple as creating an
information site from scratch, as described above. You have to go through the same basic steps -- get a domain name,
design your site, and locate an ISP -- with one added twist: You need to incorporate a shopping cart and credit card
payment system. And when you do business online, the mechanics of accepting credit cards is different than in person or
over the phone -- and avoiding fraud is more difficult. You have two options for collecting payments:
1. Shopping cart and gateway. To collect money from a customer, you deal with an intermediary known as a
transaction processor, or transaction clearinghouse, that handles credit card transactions for your merchant bank. The
transaction clearinghouse checks the validity of the customer's card and okays (or rejects) the purchase. For online
purchases, the gateway is the method of connecting your online business to the transaction clearinghouse. You can have a
company (a gateway service) provide this connection service, or you can purchase gateway software on disk or in
hardware that acts as the digital equivalent of the card-swipe machine used in a store.
2. PayPal. PayPal (www.paypal.com), an online payment system owned by eBay, is an intermediary for credit card
payments as well as for bank transfers. If you’re selling only a few items, you may be able to avoid the shopping cart
system with a simple order form and a link to PayPal. You can start accepting credit card payments instantly by signing up
for a free PayPal account. (With PayPal, you don't need a gateway or merchant account.)
Few business owners can handle setting up a shopping cart and gateway themselves, and the great majority outsource
these tasks to companies that provide shopping cart solutions. These companies will handle all of your back end details
and deposit payments into your account.
Hiring a Website Developer
If you can’t or don’t want to deal with website creation, get a developer to do it for you. Expect to pay between $500 to
$2,000 for a basic site (five to ten pages). You can find developers online or in your local Yellow Pages.
Keep in mind that websites are not static; they need to change as your business changes. So unless you set up a system
to update the site yourself, you’ll have to keep returning to a developer for every fix. The best solution: Have the
developer set up the site and then teach you how to update it.
Once you've got a website, you'll need get some user traffic coming to it and connect it to other
sites. Here are some other questions to consider:
1. How will you encourage visitors to your site?
2. Will you submit your site to search engines?
3. Will you provide links to other sites?
For help answering these questions and step-by-step coaching on taking your business online, see
Whoops! I'm in Business, by attorney Richard Stim (Nolo).
1. Questionable profitability. Most franchisors do not provide much information to potential franchisees regarding
earnings possibilities, making it difficult to assess how lucrative investment in the company could be. Even the
franchisors who do supply this information usually only give average sales figures and profits before expenses are
deducted, numbers that aren’t very helpful when trying to determine if your individual franchise will be
successful.
2. High start-up costs. Before opening your franchise, you may be required to pay a non-refundable initial
franchise fee, which can cost from several thousand to several hundred thousand dollars. In addition to the initial
fee, there are also usually high start-up costs associated with furnishing your franchise with the necessary
inventory and equipment. It can easily take several years to recoup the expenses connected with getting your
franchise off the ground.
3. Encroachment. Imagine the following scenario: You have just spent thousands of dollars opening your own
GasMart station, when another GasMart station opens across the street, essentially cutting your customer base in
half. This type of thing happens to franchisees all the time, as nearly every franchisor reserves the right to
operate anywhere they want.
4. Lack of legal recourse. As a franchisee, there is little legal recourse that you can take if you are wronged by
the franchisor. Most franchisors make franchisees sign agreements waiving his or her rights under applicable
federal and state law, and some agreements contain provisions allowing the franchisor to choose the venue and
the law under which any dispute would be litigated. Shamefully, the Federal Trade Commission (FTC), which is
supposed to regulate fairness in franchising, investigates less than 6% of the franchise-related complaints it
receives.
5. Limited independence. When you buy a franchise, you are not just buying the right to use the franchisor’s
name, but you are buying its business plan as well. As a result, most franchisors impose price, appearance, and
design standards on franchisees, limiting the ways you can operate the franchise. While these regulations can
help promote uniformity, they can also be stifling to franchisees who feel they could run the business more
effectively their own way.
6. Royalty payments. Franchisees are generally required to make continuing royalty payments to the franchisor
each month based on a percentage of his or her franchise’s sales, eating into the franchisee’s net profits.
7. Inflated pricing on supplies. In many cases, the franchisor can designate your franchise’s supplier of goods
and services. Franchisors argue that this is done to maintain quality control, but almost all franchisors receive
kickbacks from the vendors. By not allowing you to shop around and subsequently limiting competition, you are
forced to pay higher prices on supplies.
8. Restrictions on post-term competition. Let’s say that you decide to purchase a McDonald’s, but after a
couple of years you determine that you could run a higher-quality, more profitable burger joint on your own.
Unfortunately, due to noncompetition clauses built into almost every franchise agreement, franchisees are not
allowed to become independent business owners in a similar business after termination of the franchise
agreement. By purchasing a franchise, you may be unwittingly limiting your business opportunities for years after
the expiration of your contract.
9. Advertising fees. Many franchisees are obligated to make regular contributions to the franchisor’s advertising
fund. Franchisors maintain broad discretion over how to administer the advertising fund, and the money you
contribute does not necessarily need to be used to target your specific franchise. In a case against Meineke
Discount Muffler Shops, for example, it was discovered that Meineke was using the advertising fund for costs
wholly separate from advertising, yet the case was ruled in Meineke’s favor under a verdict that stated that the
franchisor has no fiduciary duty to its franchisees!
10. Unfair termination. Even the slightest impropriety on your part, such as being late on a royalty payment or
violating the franchise’s standard operating procedure, can be cause for the franchisor to terminate your
agreement. While most franchisors are not this strict, the possibility of losing your entire investment for being
late on a payment is a scary thought.
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When You Can't Pay Your Business Debts: Personal Liability and Bankruptcy Options
by Attorney Shannon Miehe
From the Nolo Business & Human Resources Center
If your business is in the red, take steps to protect your personal assets.
If your business is in distress -- you owe a lot of money but you can't pay -- your creditors will probably threaten legal
action against you personally. How much they can collect, and how they can go about collecting it, will depend on how
your business is organized, whether you personally guaranteed repayment of these amounts, and whether you decide to
file for bankruptcy.
Personal Liability for Business Debts
If your business's survival is threatened due to serious financial problems, you need to determine your potential personal
liability. The extent of your personal liability depends on two things: how your business is structured and whether you
personally guaranteed or secured any debts.
The IRS holds all business owners personally liable for unpaid payroll taxes, regardless of your business's structure. If
your only debt is unpaid payroll taxes, skip ahead to "Payroll Tax Debt," below.
Unpaid Rent
If your business owes your landlord back rent, you are probably personally liable for the debt. (Sole proprietors and
partners are automatically personally liable for rent payments, and most small business corporations and LLCs also get
stuck personally guaranteeing the lease payments -- check your lease. If you didn't, give yourself a pat on the back for
being a savvy negotiator.)
Filing for bankruptcy might keep the landlord from taking your personal property to pay the debt, especially if you file
under Chapter 13 and come up with a payment plan.
Further Information
When your business has real debt problems, there are some steps you should take -- and some you
should avoid -- to stay out of trouble with the IRS and even the courts. For more information, see
Ten Tips for Financially Troubled Businesses.
If you're considering selling most or all of your business assets, see Eight Key Steps to Selling Your
Business.
When you've trying everything and nothing has worked, it may be time to close your doors. For
information on what you need to do to protect yourself and your business reputation, see Closing
Your Business: What You Need to Do.
5. if the business is a franchise, what it will take to get the necessary franchisor approval.
This isn't an exhaustive list; you should also review any business records that will provide you with information to help you
decide whether the business is a smart purchase. If the seller refuses to supply any of this information, or if you find any
misinformation, this may be a sign that you should look elsewhere for the right business to buy.
Closing the Deal
If you've thoroughly investigated a company and wish to go ahead with a purchase, there are a few more steps you'll have
to take. First, you and the owner will have to agree on a fair purchase price. A good way to do this is to hire an
experienced appraiser who can estimate the company's fair market value. Next, you and the business owner will agree on
which assets you will buy and the terms of payment -- most often, businesses are purchased on an installment plan with a
sizable down payment.
After you have outlined the terms on which you and the seller agree, you'll need to create a written sales agreement and
possibly have a lawyer review it before you sign on the dotted line. One good resource is Buying a Business: Legal &
Practical Steps, by Attorney Fred S. Steingold (Nolo), which contains a fill-in-the-blank sales agreement.
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1. Income valuation approach. Analyzing the business's revenue is one way to come up with a fair price for the
business. This assumes that the buyer is looking at a business as just one more type of investment competing with stocks,
bonds, real estate, and so on. The question then becomes “What kind of return can the buyer expect from an investment
in this business?”
2. Asset-based approach. This approach puts a price on the business by totaling up the value of all of the assets,
starting with tangible ones such a furniture and including intangible ones, such as trademarks or copyrights. This approach
is usually based on your assets' resale value, not how much it would cost to replace them.
3. Industry formulas and rules of thumb. There are formulas that may be used in your industry, such as three
times your earnings averaged over a three-year period, or two times the book value of your company. These rough guides
can give you an idea of the current market, but they may be too simplistic to do more than that.
But the closest to an ideal way to set a value on your business is to see what other enterprises like yours have sold for. In
the real estate business, this is called looking at comparables. But unlike house sales, where it's usually not too difficult to
find recent sales of homes more or less like yours, in the business world there may have been few, if any, recent sales of
businesses similar to yours. What's more, because small businesses tend to be unique, even if you are able to find a
somewhat similar sale in your field or area, the business won't be the same as yours in terms of location, sales volume,
number of employees, and a host of other important factors.
Professional resources you can use in pricing your business include accountants, brokers, appraisers, and seminars on
valuing a business. Accountants will help you organize and evaluate your financial data. Brokers, besides knowing about
potential buyers, may also be able to track down elusive information about sales of comparable businesses in your
industry. Appraisers can help you set a price for the business or just value your business's assets.
Depending on your business, the low end of your price range will probably be little more than the liquidation value of the
assets. The high end is likely to be based on income projections and what an enthusiastic buyer might pay for the right to
receive (and hopefully increase) those earnings in the future. If you have a healthy business -- especially one with a well-
established customer base and positive reputation -- you'll probably pick an initial asking price towards the top of your
range and then, if necessary, be prepared to back off a bit in negotiating the final price.
Several factors that don't involve the business's income, assets, or comparables also go into pricing a business. These
include:
1. terms of payment
2. type of buyer
3. market demand, and
You'll need to take into account the general economic climate as well as trends in your industry -- positive or negative.
And, of course, if you have to sell quickly, you may be required to settle for less than you'd receive if you could take your
time.
And while of course you'd like the sale price to be as high as possible, you need to be sure that the overall deal -- price
and payment terms -- is realistic. You also need to feel reasonably certain that the buyer is unlikely to falter in making
payments over time, as installment arrangements are extremely common in business sales.
3. Do I want to maintain a relationship with the business? Explore ways to stay attached to your business if you so
choose -- at least for the short term.
4. What will I do next? Think about how you’ll earn a living after the sale so that a noncompete agreement with the
buyer of your business won’t sideline you.
In addition, understanding the steps involved in selling your business can help you make a better decision about whether
the time is right to sell your business and how to best go about it. For more information, see The Complete Guide to
Selling a Business, by attorney Fred S. Steingold (Nolo). It will walk you through the entire process step-by-step.
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8. accounts receivable (With accounts receivable, a list may not be good enough. You need to know more about the
individual accounts, as some of them may not be collectable.)
You also need a list of business debts -- and information on whether the creditors have a security interest (lien) on any
business assets. To double check on liens, you or your lawyer can do a lien check at the public office where liens are filed.
This is often called a UCC-1 search. UCC stands for Uniform Commercial Code -- the basic business law that’s in effect in
virtually every state.
Banks, suppliers, and other creditors typically file a UCC-1 form to protect their interests when they extend credit to a
business. If a secured debt isn’t paid, the creditor can seize and sell the secured assets.
Inspect the Physical Assets
Your purchase may include physical assets such as equipment and inventory. Make sure the equipment is in good working
order. Consider hiring an expert to check it for you. Also, find out if the business owns the equipment or is just leasing it.
If the equipment is being leased, look at the terms of the equipment lease and make sure you have the right to take over
the lease.
As for inventory, see that it’s up to date and marketable. You don’t want to pay good money for obsolete goods that you’ll
have to sell at distress prices or cart to the dump.
Get Consent to Take Over the Lease
Most businesses occupy leased space. You need to get a copy of the lease and review it carefully. How long will the lease
last? Will you have an option to renew it? Are the rent terms acceptable? Can you live with the lease's restrictions?
Make sure it’s okay for the business to continue to occupy the space under your ownership. The lease may require the
landlord’s consent for you to take over the lease -- especially if the current business is owned by a sole proprietorship or
partnership. Talk to the landlord directly about this.
While you’re at it, have the landlord confirm that the current business owner is up to date on rent payments. You’d hate to
take over the business, only to learn that the lease is in default and that you’re facing eviction.
In talking to the landlord, you may want to negotiate a new lease -- one with a longer term or lower rent, perhaps. Give it
a try. Be prepared to show why it’s in the landlord’s best interest to cut a deal with you.
Check the Business's Legal Status
If the business is owned by a corporation or LLC, there are two scenarios. One is that you’re buying the assets of the
business. The other is that you’re buying the business entity itself (which owns the assets). Buying the assets is usually
the better option for the buyer.
But if your plan is to buy the business entity -- the stock of the corporation or the membership interests of the LLC -- then
you need to see the documents that created the entity and also any related documents such as bylaws, resolutions, and
operating agreements.
Confirm that the business is in good standing with the state and that the owner has legal authority to sell it.
Finally, ask the owner of the business (no matter what its legal structure) to tell you of any pending or threatened lawsuits
or governmental proceedings. You and your lawyer can then evaluate your own exposure if you decide to buy the
business.
Get the Owner's Guarantee
Even after you’ve carefully investigated the business, other surprises may be lurking in the background. Have the current
owner personally guarantee that the information you have is complete and accurate. You can put this in the purchase
agreement under the heading, “Representations and Warranties.”
Hold Back Some of the Purchase Price
If you decide to buy the business, don’t pay the full purchase price at closing. Arrange for at least part of it to be paid six
months or a year down the road. That way, if you suffer a loss because the owner failed to disclose crucial information (a
debt, for example, or a tax liability), you can deduct the money from what you owe.
You can either withhold a set amount of money for a period of time or have the seller place some of your purchase money
in escrow. (Place money with a third party, called an escrow agent or escrow holder.) If you and the seller agree to place
money in escrow, write up a short escrow agreement (the escrow holder may have one for you).
Record the Terms of the Deal in a Contract
Be sure to record all the terms of the purchase in a written contract, including a list of all assets being purchased and their
value. Your contract should also mention your promissory note and security agreement, if you will sign these additional
documents. Nolo provides all of these documents in each of these products: Buying a Business: Legal and Practical Steps,
by Fred Steingold, and Quicken Legal Business Pro software.
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18. File your final income tax returns, checking the box stating that this is your final return.
19. If you sell business assets, file IRS Form 4797, Sales of Business Property or, if you sell the bulk of your business
assets to one buyer, file IRS Form 8594, Asset Acquisition Statement.
20. Leave contact information with former business contacts, colleagues, and employees.
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8. salaries and bonuses paid to family members who work in the business.
For instance, let's say you enjoy travel so you've been attending trade shows at attractive locations. You've deducted the
cost as legitimate business expenses -- lowering your tax bill, but also lowering the bottom line.
A buyer needs to understand that the travel is discretionary. If it's eliminated, the business will show more profit for its
new owner. In recasting your tax numbers, you're not deceiving either the IRS or prospective buyers. You're simply
pointing out that the buyer may prefer not to spend money on some of these items in the future, even though you've
taken perfectly proper tax deductions for them.
4. Seek Potential Buyers
If your business is well known, word that it's for sale may be enough to bring prospective buyers to your doorstep. Or,
possibly someone close to you -- an employee, a relative, a friend, a supplier, or a customer -- could be an interested and
logical prospect.
But finding buyers may not be easy. More likely, you'll need to reach out to a bigger pool of potential buyers. This often
includes putting ads in newspapers, in trade publications, and on business-sale websites.
You may want to engage a business broker to reach more buyers -- though you'll pay a substantial commission for the
broker's services. Sometimes, too, you need keep a low profile in your marketing efforts to avoid alarming customers and
suppliers. An intermediary such as a broker can help keep information from leaking out prematurely.
5. Negotiate Your Deal
Once you attract an interested buyer, you need to work out the terms of the sale. Here are some key issues:
1. Will you sell your business entity or just its assets?
2. Will you keep some of the assets (a car or truck, perhaps) that are currently being used in the business?
3. Will the buyer pay you in one lump sum or make installment payments?
4. In an installment sale, how large will the down payment be and how long will the buyer be given to pay off the
balance?
5. After the closing, will you work for the buyer, either as an employee or an independent contractor?
6. Will the buyer require you to sign a non-compete agreement that limits your right to work in your current
industry?
6. Sign a Sales Agreement
Once you've worked out the key terms with the buyer, you need to put the deal in writing. Among other things, you'll need
to list all of the assets the buyer is purchasing and the value you will assign to those assets for tax purposes and any
business contracts the buyer is assuming, including business leases. Your sales agreement should also include protections
that assure you'll get paid the full sale price.
In an installment sale, it makes sense to require the buyer to have a spouse or other cosigner guarantee payment of the
balance owed. And, for sure, you'll want to retain a security interest in the business until the sale price is fully paid. You
may even find it prudent to take a lien (a second mortgage) on the buyer's home or other real estate.
If you attempt the first draft of the sales agreement yourself, have it reviewed by a business lawyer to make sure you've
covered all the bases.
7. Plan for the Closing
The closing is the meeting at which you transfer the business to the buyer. To reduce the chance of last-minute hassles,
make a checklist of all the papers you'll be bringing and all that the buyer is expected to bring. While every sale is
different, here's a list of common documents and items that you may need to bring with you.
1. Alarm codes, computer access codes, and safe combinations
2. Asset allocation statement (IRS Form 8594)
3. Bill of sale or transfer documents for license, real estate, and vehicles
4. Cashier's check
5. Consent of entity owners to sale of assets
6. Consulting contract (independent contractor agreement)
7. Covenant not to compete (noncompete agreement)
1. Customer lists
2. Employment contract
3. Escrow agreement for post-closing adjustments
4. Insurance certificates for the policy covering secured assets
5. Keys to file cabinets, premises, and vehicles
6. Mortgage or deed of trust
7. Owners' manuals for business equipment
8. Promissory note
9. Security agreement
10. Statement regarding absence of creditors
11. Supplier lists
12. Title insurance commitment
13. UCC financing statement
8. File Paperwork With the IRS
After the sale, you and the buyer need to complete IRS Form 8594, Asset Acquisition Statement and file it with your tax
returns for the year in which the sale took place. You and the buyer should fill out the form together, allocating the
purchase price among the assets purchased and classifying the assets among the various IRS categories, and file duplicate
copies of the form.
Nolo's book, Sell Your Business: The Step-by-Step Legal Guide, by attorney Fred Steingold (Nolo),
guides you through the entire selling process, from deciding whether to sell to preparing a sales
agreement and going to the closing. It includes a sales agreement, promissory notes and security
agreements, and confidentiality, noncompete, and consulting agreements.
The IRS can hold you and any co-owners personally liable for payroll taxes, even if your business
operated as a corporation or LLC. This means the IRS could take your personal assets, such as a car
or a vacation house, to pay your business debts. Filing bankruptcy is of limited help in this area. Your
only options may be to negotiate a payment plan with the IRS or get the IRS to accept a settlement,
called an "offer in compromise."
If you will be selling off some business assets to recoup some of your investment, you'll need to file Form 4797, Sales of
Business Property. (See IRS Publication 544, Sales and Other Dispositions of Assets for more information.) If you're selling all of
your business assets as a group, you may need to file IRS Form 8594, Asset Acquisition Statement instead.
As for income taxes, during tax time you will need to file a final tax return with the IRS and probably with your state tax
agency as well. For partnerships, corporations, and LLCs, the federal return has a box you can check indicating that it's
your final return. Sole proprietors just stop filing Schedules C and SE with their Form 1040.
If your business collected sales taxes, be sure to submit the final forms and funds that are due up to the closeout date to
the state office that collects your sales tax.
Before your last day in business, if you have employees, make plans to pay them their last paychecks. Most states require
employers to give employees their final paychecks on their last day of work or within a few days. Also, some states require
businesses to pay out accrued, unused vacation days at the same time.
Apart from taxes, you may have run-of-the-mill business debts -- money owed to your landlord, bank, suppliers, utilities,
and service providers. Notify these creditors of your upcoming closure and make plans to pay in full, or settle, all of these
business debts. (See "Notify Your Creditors, Employees, and Customers," just below, for more information.) If you have
paid off a particular creditor, ask for a letter indicating that your bills are paid in full.
If you fear you won't be able to pay all of your debts, you need to understand what options you have
and how to minimize the risk to your personal assets.
If you can pay some but not all of your debts and you are considering bankruptcy for help with the
rest, be careful not to make preferential payments to creditors such as friends and relatives.
Invariably, after you close up shop, a creditor will come out of the woodwork. If you have assets left, or cash left from
selling the assets, you should set aside some money for potential claims and make sure that people who might need to get
in touch with you have your contact information, so issues can be resolved efficiently, without damaging your business
reputation.
Notify Your Creditors, Employees, and Customers
Generally, you will need to notify the following people of your impending closure.
• Suppliers. Suppliers will want to know when the last delivery should be made, what goods you're returning (if that's
part of your contract), and where and how they'll get paid for goods they've supplied. However, if you're not ready to stop
buying, you may want to keep your impending closure quiet for a while. Some suppliers, when they find out your business
is about to close its doors, may pull your credit line and require that all orders be paid for in cash.
• Service providers. These providers, such as utilities, business insurers, and payroll preparers, will want to know the
final day you'll require services and where to send the final bill. If you have any deposits down, find out how to get them
back. When you notify your business insurer that you are going out of business, the insurer will want to know about any
potential liabilities that might crop up after the business is shut down. Be honest; you risk losing coverage if you don't
disclose any pending legal threats or problems.
• Bank accounts and credit cards. Be sure to close out your business bank account and cancel your business credit
cards.
• Lenders. If you have outstanding business loans, your lender will want to know how you plan on paying them off. The
lender may want to take a look at any business collateral to make sure it's in saleable condition.
If you are plan on selling off the majority of your business's inventory and your business was retail,
wholesale, or manufacturing, you may need to comply with your state's "bulk sales law," if it exists
(only about ten states have these laws). These laws require you to notify your creditors a specific
number of days before you close your business, and in some states, to publish a notice of your
impending closure in a local newspaper. These laws can be tricky -- you may want to get help from a
small business lawyer.
• Landlords. Give your landlord the required amount of notice as stated in your lease -- at least 30 days. If you're closing
your business before the end of your lease term, you are liable for any remaining rent payments (although depending on
your state's law, your landlord might have what's called a "duty to mitigate” by looking for a new tenant). In any case,
your landlord will probably want to work with you rather than chase you down for the money in court, so you may be able
to negotiate something. If you're not breaking the lease early and the landlord is holding a deposit from you, be sure to
get it back.
• Employees. If you have employees, tell them what you expect from them until the last day. If you fear a premature
mass exodus of employees, tell only key employees of your plans to close -- but be sure to give the rest of your employees
at least two weeks' notice.
• Customers. Give your customers plenty of notice that you are going out of business, then fill any last orders, complete
any final projects, and fulfill any contractual obligations. If you can't, let the customer know immediately and return any
deposits or payments for goods not delivered or services not rendered. If you're sitting on saleable inventory, consider a
"going out of business" sale.
If you have outstanding accounts receivable, try to collect these bills before you close your doors --
they may be much harder to collect once you're out of business.
4. a strategic analysis.
Identify Strategies
With your goals, objectives, and activities identified and your current resources assessed, you're ready to do some true
strategic thinking. In the realm of strategic planning, "strategies" are practical ideas about how to make the best use of
your resources to achieve your goals.
A common approach to strategic thinking is called a "SWOT" analysis -- an acronym for strengths, weaknesses,
opportunities, and threats. Strengths and weaknesses are positive and negative elements within the organization;
opportunities and threats are positive and negative elements outside the organization. A SWOT analysis is sometimes
called a "situational assessment" or an "environmental analysis," but they all use the same basic approach.
1. Strengths are positive assets within your organization. Examples might include a highly
respected board member, a talented group of volunteers, or ownership of valuable intellectual
property, such as a book or software.
2. Weaknesses are negative aspects within your organization. Examples might include a
shortage of volunteers or outdated technology.
3. Opportunities are positive elements outside your organization. Examples might include a
high demand for your services or availability of a grant in your topic area.
4. Threats are negative elements outside your organization. Examples might include a
competing nonprofit or the demise of a major funder.
The key to doing a SWOT analysis is to think about ways to maximize the positive and minimize the negative elements.
Brainstorm about ways to use your strengths to take advantage of existing opportunities and to overcome threats you've
identified. Also focus on how you will minimize your weaknesses to make your group less vulnerable to threats.
Edit and Finalize Your Plan
Once you've completed all the essential elements of your initial strategic plan, let your plan sit for a day or two before
beginning a final review. This allows the planners to clear their brains and look at it with fresh perspectives. It's a good
idea to establish a firm deadline for incorporating any final edits, to keep everyone in "wrap-up" mode and prevent endless
rounds of tinkering with the work you've already done.
Once your final edits have been incorporated, you may be finished. Or, if you plan to submit the strategic plan to potential
funders, you may want to spiff it up and produce a professional document, perhaps using of desktop publishing software.
Package the information as necessary for your intended purposes -- an internal working document can be much less formal
than a package you send to potential major donors.
For more practical information on creating your strategic plan, as well as information on getting a
nonprofit off the ground, see Starting & Running A Nonprofit: A Practical Guide , by Peri H. Pakroo
J.D. (Nolo).
1. Nonprofit corporations cannot contribute money to political campaigns. Nonprofit corporations with a
501(c)(3) tax exemption (the most common) are not allowed to participate in political campaigns or contribute money to
them. If they do, the IRS can revoke their nonprofit status, and can assess a special excise tax against the organization
and its managers.
2. Nonprofit corporations can engage in only limited lobbying activities. Tax-exempt 501(c)(3) nonprofits
that influence legislation to any "substantial degree" face the loss of their nonprofit status. However, for tax-exempt
nonprofits that want to participate in lobbying, the IRS simply sets a limit on the money they can spend on political
activities.
1. Nonprofit corporations must not distribute profits to members, officers, or directors. A nonprofit
corporation cannot be organized to financially benefit its members, officers, or directors. However, reasonable salaries and
expense reimbursements are permitted.
2. Nonprofit corporations must pay taxes on income from "unrelated activities." Sometimes, a nonprofit
organization will earn income through activities that aren't directly related to its nonprofit purpose; for example, the
directors of an organization dedicated to preserving open space may collect a consulting fee for advising other nonprofits.
The IRS requires nonprofits to pay corporate income taxes on such unrelated income over $1,000, whether or not the
group uses that money to fund its tax-exempt activities.
3. Nonprofit corporations cannot make substantial profits from unrelated activities. If a nonprofit spends
too much time on unrelated activities, or if the unrelated activities generate "substantial" income, the group's nonprofit
status may be jeopardized. Nonprofit corporations that plan to engage in activities that aren't related to their tax-exempt
purpose should consult a lawyer or tax expert with experience in nonprofit law.
4. When a nonprofit corporation dissolves, its assets must be distributed to another tax-exempt group.
Since tax-exempt organizations and their assets cannot be owned, they can never be sold. If the directors of a nonprofit
decide to disband the organization, they must donate its assets to another nonprofit group. This also means that once
property goes into a nonprofit corporation, it cannot later be distributed to a member or director.
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Nonprofit Basics
From the Nolo Business & Human Resources Center
Becoming a nonprofit corporation requires some paperwork, but for many groups, the benefits are worth it.
Nonprofit (or not-for-profit) corporations work well for all sorts of groups, from artists and musicians to people active in
education, health, and community services. Often the reason for doing this is simple -- nonprofit status is usually a
requirement for obtaining funds from government agencies and private foundations. Obtaining grants, however, is not the
only reason to incorporate. Here, we discuss two additional important benefits of forming a nonprofit -- tax-exempt status
and personal liability protection. We then introduce you to some of the basic rules for setting up and running your
nonprofit corporation.
Tax-Exempt Status
In addition to qualifying for public and private grant money, most nonprofit groups seek nonprofit corporate status to
obtain exemptions from federal and state income taxes. The most common federal tax exemption for nonprofits comes
from Section 501(c)(3) of the Internal Revenue Code, which is why nonprofits are sometimes called 501(c)(3)
corporations.
If your group obtains tax-exempt status, not only is it free from paying taxes on all income from activities related to its
nonprofit purpose, but people and organizations that donate to the nonprofit can take a tax deduction for their
contributions.
Protection From Personal Liability
Forming a nonprofit corporation normally protects the directors, officers, and members of the nonprofit from personal
liability for the corporation's debts and other obligations. Called "limited liability," this shield ensures that anyone who
obtains a judgment against the nonprofit can reach only the assets of the corporation, not the bank accounts, houses, or
other property owned by the individuals who manage, work for, or participate in the business.
As an example, consider a nonprofit symphony that is sued by a visitor who falls through a poorly maintained railing on a
staircase. The court finds in favor of the visitor and issues a judgment against the nonprofit for an amount greater than the
nonprofit's insurance coverage. The amount of the judgment is a debt of the corporation, but the directors, officers, and
members are not personally responsible for paying it. By contrast, if an unincorporated association of musicians owned the
premises, the principals of the unincorporated group could be required to pay the judgment amount out of their own
pockets.
In a few situations, people involved with a nonprofit corporation can be held personally liable for
its debts. A director or officer of a nonprofit corporation can be held personally liable if she:
1. personally and directly injures someone
2. personally guarantees a bank loan or a business debt on which the corporation defaults
3. fails to deposit taxes or file any necessary tax returns
4. does something intentionally fraudulent, illegal, or clearly wrong-headed that causes harm,
or
To cover some of these exceptions, reasonably priced insurance is available to protect volunteer
directors, who may be reluctant to serve without it.
8. conservation groups.
If your group isn't on this list, it doesn't necessarily mean you won't qualify for tax-exempt status. As long as your group's
activity is charitable, educational, literary, religious, or scientific, you should be able to get a tax exemption.
Forming a Nonprofit Corporation
Forming a nonprofit corporation is very similar to forming a regular corporation: You must file "articles of incorporation"
with the corporations division (usually part of the secretary of state's office) of your state government. But unlike regular
corporations, you must also complete federal and state applications for tax exemptions.
After filing this initial paperwork, you will create "corporate bylaws," which lay out the operating rules for your nonprofit.
Finally, you elect the initial directors of your nonprofit and hold an organizational meeting of the board.
Running a Nonprofit Corporation
Most nonprofit corporations are run by a board of directors -- called "trustees" in some states. The directors set policy for
the nonprofit and are usually actively involved in the work of the corporation. Officers (who may also serve on the board)
carry out the day-to-day business of the corporation and sometimes receive salaries. Depending on its structure, a
nonprofit may or may not have formal members with voting rights. If the nonprofit does not create a formal membership
structure, the only people who participate in the management of the nonprofit are the directors and officers.
Nonprofit corporations must observe most of the same formalities as regular corporations. These include keeping good
corporate records, holding and preparing minutes of directors' (and possibly members') meetings, and maintaining a
separate bank account.
Unlike regular corporations, a nonprofit corporation cannot distribute any profits to its members, contribute money to
political campaigns, or engage in lobbying activity, except in very limited circumstances.
Ending a Nonprofit Corporation
Nonprofits are not actually owned by anyone and therefore cannot be sold. If the directors of a nonprofit corporation
decide to dissolve it, they must pay off all debts and obligations of the nonprofit and distribute all of its assets to another
tax-exempt nonprofit corporation.
Treat Web visitors in a manner true to your organization's mission and ideals. An organization that works
with the elderly, for example, shouldn't use a tiny text font. An organization working with the disabled should ensure that
its website is accessible to its clientele.
3. Content. The best websites contain substantive information, preferably information that the reader might not get
elsewhere. Readers might be interested in your nonprofit's current activities -- ongoing projects, follow-up information on
issues they've heard about before, or details and signup information for events and classes. If you're more ambitious, you
can collect and post information that doesn't derive directly from your nonprofit, such as articles about relevant national or
local news issues.
Yes, it's a lot of work -- but studies have shown that readers rate substantive content number one in importance when
evaluating a nonprofit’s website. If you're able to, go one step farther and offer readers regular email newsletters or news
alerts (a great way of collecting email addresses of potential future supporters).
4. Keep your Web content fresh -- or at least not obviously stale. Launching your website is a lot of work -- but too
many nonprofits make the initial push, then allow the site to go stale. Unless your website appears current and up to date,
you'll turn off the very people you were hoping to attract.
Ideally, interesting and timely content will make your website a regular stop for people tracking or researching the issue
you cover, thus turning anonymous Web visitors into eventual donors. If that's too much to hope for, given your staffing
and budget, at least don't bite off more than you can chew. Cull your annual reports, newsletters, and other materials, and
include stories or information that isn’t likely to become dated.
5. Donation information. Everything on your website should be easy to find, but links to information about donating or
otherwise getting involved must be prominently displayed. At the same time, you don't want to rush people to the
payment page without giving them some background information about why, how, and how much to give.
Your homepage should have a tab saying "Support Us," "Get Involved," "How You Can Help," or something similar. This
link should lead to an introductory page explaining how donations will be used, how different dollar amounts will help, and
any other relevant information about your projects and giving opportunities. Then offer a link to a payment page. If you
can offer online donation opportunities, great. If not, offer a printable page that contains all the information on your
regular reply card, along with information on where to fax or mail the completed form and check.
6. Information on where the money goes. Where and how supporters’ gifts will be spent is a topic worthy of a
separate page on your website -- and it's a page that should be easy to find, perhaps as a link from your introductory
giving page. Remember, supporters want to know that their money is funding worthwhile projects and programs. Studies
have found that users rank information about how donations are spent high in importance when visiting a charity's
website. This portion of your website should also include links to your annual report (if available online) and your Form
990.
7. Funder and donor information. If you've been scrambling to find ways to publicly thank your foundation funders and
major private donors, a website can really take the pressure off. Many organizations add a simple link to "Our Funders,"
whether on their homepage or a deeper page within the site.
Mentioning your funders and donors online is also a way to build trust in your organization. You want Web viewers to think,
"If the ABC Foundation and So-and-So support this group, they must be respectable." Some nonprofits also post profiles of
individual donors, complete with photos and personal accounts of why they give. (You would, of course, have to get
permission from the donors first.) Again, this is a way to inspire potential supporters.
8. Tracking users. It doesn't take particularly advanced technology for your Web designer to add a feature allowing you
to keep “site traffic statistics. This information will tell you not only how many people are visiting your site but also which
websites your visitors came from and where they go within your site -- which links are enticing them to click, which pages
they're leaving unviewed, what they're downloading, which page they most commonly exit your website from, and the like.
Once you make a habit of collecting and interpreting your traffic statistics, they can be invaluable for measuring and
enhancing your website's fundraising effectiveness. For example, over time you'll be able to evaluate the comparative
success of an email campaign, the drawing power of a press release, or your best referral sources.
Advertise your Web address in all of your printed materials. After you've created a website that meets as many
of the above criteria as are financially feasible, don't keep it a secret. Your website should become one of your principal
communication devices. Feature the address prominently on business cards, stationary, brochures, T-shirts, and every
printed document you produce. Encourage newsletter readers to check your website for further information or updates on
issues they're reading about. And include links to your website within emails sent to supporters, allowing them to click for
further information or to donate online.
Further Resources
For more information on ways to raise funds for your nonprofit, online and off, see Effective
Fundraising for Nonprofits: Real-World Strategies That Work, by attorney Ilona Bray (Nolo).
Your state's corporate filing division, usually part of the secretary or department of state's office, will
often send you a packet of nonprofit materials that will be immensely helpful to you in forming your
nonprofit. This packet may include sample or fill-in-the blank articles of incorporation, your state's
nonprofit corporation laws, a filing fee schedule, and forms and instructions for checking the
availability of your proposed business name. Contact your state's corporate filing office to obtain this
packet.
In addition to confirming that another corporation in your state isn't already using your proposed name, you must make
sure your name won't violate a trademark owned by another company (in your state or out of state). To do this, you'll
need to conduct a trademark search.
Once you've found a legal and available name, you aren't usually required to file or reserve the name with your state --
when you file your articles of incorporation, your nonprofit's name will be automatically registered.
Prepare and File Your Articles of Incorporation
After you've decided on your business name, you must prepare and file "articles of incorporation" with the corporate filing
office. This document goes by a different name in a handful of states; your state may instead use the term "articles of
organization," "certificate of incorporation," "certificate of formation," or "charter."
Your state's corporate filing office will usually provide you with nonprofit articles of incorporation -- either a fill-in-the-blank
form or a sample on which you can base your articles. Although preparing this document isn't difficult, you do need to
include specific language to ensure that you'll receive tax-exempt status. Your state's nonprofit formation packet, if
available, may include the required information. If not, or if you need help understanding the requirements, consult a good
legal self-help guide such as How to Form a Nonprofit Corporation, by Anthony Mancuso (Nolo), to make sure your articles
comply with your state's nonprofit law.
Apply for Your Federal 501(c)(3) Tax Exemption
After the corporate filing office returns a copy of your filed articles, you can submit your federal 501(c)(3) tax exemption
application to the IRS. (The IRS requires you to submit a copy of your filed articles with your application.) This is a critical
step in the formation of your nonprofit organization since most of the real benefits of being a nonprofit flow from 501(c)(3)
tax-exempt status.
To apply for your exemption, you must complete IRS Form 8718, User Fee for Exempt Organization Determination Letter Request,
and IRS Package 1023, Application for Recognition of Exemption. For instructions on filling out these forms, read IRS
Publication 557, Tax-Exempt Status for Your Organization. (You can obtain all of these items for free by calling 800-TAX-FORM,
or you can download them from the IRS website at www.irs.gov.) If you need a bit of help deciphering the IRS-speak,
consider downloading Nolo's plain-English eGuide, Nonprofit Corporations: Qualify for Federal Income Tax Exemption.
While you can't actually file your exemption application until the corporate filing office has approved
your articles of incorporation, before you file your articles, take a couple of hours to learn what it
takes to qualify for the tax exemption. If you file your articles and then discover a problem as you
begin working through the tax exemption application, you could be stuck paying taxes while you
work through these issues -- or even learn too late that your group isn't eligible for an exemption.
After the IRS reviews your application, it will send you a letter indicating that it has approved your nonprofit status, or it
might ask you for more information about your organization. The IRS can also deny your application outright. If this
happens, see a lawyer who specializes in nonprofits.
Apply for a State Tax Exemption (If Necessary)
In a few states (California, Montana, North Carolina, and Pennsylvania), you must complete a separate application to get a
state tax exemption. In other states, as long as you file nonprofit articles of incorporation and obtain your federal 501(c)
(3) tax-exempt status, your state tax exemption will be automatically granted. In still others, to get your state exemption
you must send in a copy of the IRS determination letter that granted your federal exemption. Contact your state tax
agency to find out what steps you must take.
Draft Corporate Bylaws
Next you must create bylaws, the internal rules that govern your nonprofit corporation. Bylaws contain rules and
procedures for holding meetings, voting on issues, and electing directors and officers. To create bylaws, you can either
follow the instructions in a self-help resource or hire a lawyer in your state to draft them for you. Typically, the bylaws are
adopted by the corporation's directors at their first board meeting.
Appoint Directors
Directors, who meet and make decisions collectively as the board of directors, have the authority (and responsibility) to
manage and run the nonprofit corporation. Many states allow nonprofits to have just one director, but other states require
at least three.
Hold a Directors' Meeting
The purpose of the first meeting of the board of directors is to conduct the initial business of the corporation and take care
of other formalities, such as recording the receipt of federal and state tax exemptions.
The directors should first adopt the bylaws and elect officers -- state law usually requires a president, secretary, and
treasurer, and sometimes a vice president as well. Then, the directors should authorize the newly elected officers to take
actions necessary to start the business of the nonprofit -- for example, setting up bank accounts and admitting members.
After the meeting is completed, minutes of the meeting should be created and filed in your corporate records book.
Obtain Licenses and Permits
Many businesses, whether operating as for-profit or nonprofit corporations, partnerships, or sole proprietorships, are
required to obtain state or local licenses and permits before commencing business. So, while you may not be subject to the
kind of red tape that entangles profit-making enterprises, you should check with your state department of consumer affairs
(or similar state licensing agency) for information concerning state licensing requirements for your type of organization.
For instance, a local business license (sometimes called your "tax registration certificate") may be required for your
activities, and if you sell anything to consumers, you'll need a sales tax permit.
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Example
Better Books and Learning begins as a part-time effort by a few dedicated individuals to hold book groups for
disadvantaged youth. The volunteers pay all of the expenses out of their own pockets, and the group never turns a
profit. Then a board member of a local junior college asks the group to administer and run book groups as part of the
college curriculum -- for a fee. Since the group will now show a profit from its educational activities, it decides to
incorporate as a nonprofit and seek tax-exempt status with the IRS.
Example
For Shore United wants to sponsor monthly cleanup drives to pick up and haul away trash left along
the local bay shore. They've enlisted a sufficient number of enthusiastic volunteers, but they need
funds to rent a truck, buy gas, and pay for volunteers' meals. They know that many people in the
community would chip in to help fund their effort if their group was a recognized public charity
eligible to receive tax-deductible contributions. Incorporating the group as a nonprofit corporation
and applying for tax-exempt status can help them raise these much-needed funds.
You Want Protection From Personal Liability for the Group's Activities
If your group finds itself the target of a lawsuit, incorporation can provide welcome peace of mind. Nonprofit corporations
can be sued -- but their members and directors are generally protected from personal liability, meaning that their own
money, houses, cars, or other property isn't at risk. That's not true of an unincorporated association.
Example
Engineers for the Environment is a nonprofit consulting firm that helps developers prepare
environmental impact reports for nonprofit housing developments. To avoid legal liability if
unforeseen federal and state guidelines cause costly delays, the firm decides to incorporate their
organization as a nonprofit.
Example
Citizens for a Smoke-Free America informs the public about the health hazards of secondary smoke
from cigarettes. The group decides to campaign for local legislation banning cigarette advertising on
billboards in the community. It expects an unfriendly response from cigarette advertisers in the form
of expensive and time-consuming lawsuits against the organization, and its directors and officers.
The group decides to incorporate before beginning the campaign, to allow the corporation to pay the
officers' and directors' legal expenses, and to insulate the directors and officers from personal
liability.
1. Special postage rates. Nonprofits can apply for and receive a mailing permit that gives them a special reduced
nonprofit rate for mailings. This is especially helpful for organizations that will do a lot of solicitation by mail.
2. Property tax exemptions. In addition to an exemption from income taxes, nonprofits are usually exempt from
paying property taxes on real estate and other property. Contact your county assessor's office for more information on this
property tax exemption, which is called a "welfare exemption."
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5. the distribution of items worth less than $5 as incentives for donating money (such as stamps or pre-printed
mailing labels).
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9. the employee has hired a lawyer to represent him or her in dealing with you.
You may also wish to have a lawyer review any employment decision that will affect a large number of employees. For
example, if you are planning to lay off some workers, change your pension plan, or discontinue an employee benefit, it
would be smart to run your plans by a lawyer before you take action. The lawyer can tell you about any potential legal
pitfalls you might be facing -- and give you advice on avoiding them.
Representation in Legal or Administrative Proceedings
If a current or former employee sues you, speak to a lawyer right away. Employment lawsuits can be very complex. You
have to take certain actions immediately to make sure that your rights are protected -- and to preserve evidence that
might be used in court. The time limits for taking action are very short -- many courts require you to file a formal, legal
response to a lawsuit within just a few weeks. As soon as your receive notice of a lawsuit against you, begin looking for a
lawyer.
Sometimes, a current or former employee initiates some kind of adversarial process short of a lawsuit. For example, an
employee might file an administrative charge of discrimination, retaliation, or harassment with the U.S. Equal Employment
Opportunity Commission or a similar state agency. Or, a former employee might appeal the denial of unemployment
benefits, which in many states allows the employee to request a hearing.
In these situations, you should at least consult a lawyer, if not hire one. Although some employers can and do handle
these administrative matters on their own, most could probably benefit from some legal advice on the strength of the
employee's claim, how to prepare a response to the charge, how to handle an agency investigation, and how to present
evidence at the hearing. It might be worth hiring a lawyer to represent you if:
1. the employee raises serious claims that could result in a large award of damages against you
2. other employees or former employees have made similar allegations, either to the agency or within the
workplace
3. the employee has indicated that he or she intends to file a lawsuit (in this situation, the employee may just be
using the administrative proceeding to gather evidence to use against you in court), or
Next Steps
If you have decided that it might be wise to speak to a lawyer, your next step is to find a good one. For tips and
information on finding an attorney, read How to Find an Excellent Lawyer. For detailed advice on every stage of a civil
lawsuit, from finding a lawyer to filing an appeal, see The Lawsuit Survival Guide, by Joseph L. Matthews (Nolo).
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Agricultural Jobs
If you own or operate a farm or other type of agricultural business, the following child labor rules apply to you.
1. You may hire a worker who is 16 years or older for any work, whether hazardous or not, for unlimited hours.
2. You may hire a worker who is 14 or 15 years old for any nonhazardous work outside of school hours.
3. You may hire a worker who is 12 or 13 years old for any nonhazardous work outside of school hours if the child's
parents work on the same farm or if you have their written consent.
4. You may hire a worker who is 10 or 11 years old if you've been granted a waiver by the U.S. Department of
Labor to employ the youngster as a hand harvest laborer for no more than eight weeks in any calendar year.
5. If you own or operate the farm, you can hire your own children to do any kind of work on the farm, regardless of
their ages.
Nonagricultural Jobs
If you seek to hire a youngster for work that is nonagricultural, the following rules apply:
1. You may hire a worker who is 18 years or older for any job, hazardous or not, for unlimited hours.
2. A worker who will do job-related driving on public roads must be at least 17 years old, must have a valid driver's
license, and must not have any moving violations.
3. You may hire a worker who is 16 or 17 years old for any nonhazardous job, for unlimited hours.
4. You may hire a worker who is 14 or 15 years old outside school hours in various nonmanufacturing, nonmining,
and nonhazardous jobs, but some restrictions apply. The teen cannot work more than three hours on a school day, 18
hours in a school week, eight hours on a nonschool day, or 40 hours in a nonschool week. Also, the work cannot begin
before 7 a.m. or end after 7 p.m., except from June 1 through Labor Day, when evening hours are extended to 9 p.m.
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1. Make sure your inquiries are related to the job. If you decide to do a background check, stick to information
that is relevant to the job for which you are considering the worker. For example, if you are hiring a security guard who
will carry a weapon and be responsible for large amounts of cash, you might reasonably check for past criminal
convictions. If you are hiring a seasonal farm worker, however, a criminal background check is probably unnecessary.
2. Ask for consent. You are on safest legal ground if you ask the applicant, in writing, to consent to your
background check. Explain clearly what you plan to check and how you will gather information. This gives applicants a
chance to take themselves out of the running if there are things they don't want you to know. It also prevents applicants
from later claiming that you unfairly invaded their privacy. If an applicant refuses to consent to a reasonable request for
information, you may legally decide not to hire the worker on that basis.
1. Be reasonable. Employers can get in legal trouble if they engage in overkill. You will not need to perform an
extensive background check on every applicant. Even if you decide to check, you probably won't need to get into excessive
detail for every position. If you find yourself questioning neighbors, ordering credit checks, and performing exhaustive
searches of public records every time you hire a clerk or counterperson, you need to scale it back.
In addition to these general considerations, specific rules apply to certain types of information:
1. School records. Under federal law and the law of some states, educational records -- including transcripts,
recommendations, and financial information -- are confidential. Because of these laws, most schools will not release
records without the consent of the student. And some schools will only release records directly to the student.
2. Credit reports. Under the Fair Credit Reporting Act, or FCRA (15 U.S.C. §1681), employers must get an
employee's written consent before seeking that employee's credit report. Many employers routinely include a request for
such consent in their employment applications. If you decide not to hire or promote someone based on information in the
credit report, you must provide a copy of the report and let the applicant know of his or her right to challenge the report
under the FCRA. Some states have more stringent rules limiting the use of credit reports.
3. Bankruptcies. Federal law prohibits employers from discriminating against applicants because they have filed
for bankruptcy. This means you cannot decide not to hire someone simply because he or she has declared bankruptcy in
the past.
1. Criminal records. The law varies from state to state on whether, and to what extent, a private employer may
consider an applicant's criminal history in making hiring decisions. Some states prohibit employers from asking about
arrests, convictions that occurred well in the past, juvenile crimes, or sealed records. Some states allow employers to
consider convictions only if the crimes are relevant to the job. And some states allow employers to consider criminal
history only for certain positions: nurses, childcare workers, private detectives, and other jobs requiring licenses, for
example. Because of this variation, you should consult with a lawyer or do further legal research on the law of your state
before digging into an applicant's criminal past.
2. Workers' compensation records. An employer may consider information contained in the public record from a
workers' compensation appeal in making a job decision only if the applicant's injury might interfere with his or her ability
to perform required duties.
3. Other medical records. Under the Americans with Disabilities Act, or ADA (42 U.S.C. §12101 and following),
employers may inquire only about an applicant's ability to perform specific job duties -- they may not request an
employee's medical records. An employer may not make a job decision (on hiring or promotion, for example) based on an
employee's disability, as long as the employee can do the job, with or without a reasonable accommodation. (For
compliance tips, see Avoid Disability Discrimination When Hiring New Employees.) Some states also have laws protecting
the confidentiality of medical records.
4. Records of military service. Members and former members of the armed forces have a right to privacy in their
service records. These records may be released only under limited circumstances, and consent is generally required.
However, the military may disclose name, rank, salary, duty assignments, awards, and duty status without the member's
consent.
5. Driving records. An employer should check the driving record of any employee whose job will require large
amounts of driving (delivery persons or bus drivers, for example). These records are available, sometimes for a small fee,
from the state's motor vehicles department.
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1. Don't ask about anything that the law prohibits you from considering in making your decision. For
example, don't ask about an applicant's race or religion, because you are not allowed to consider these factors in
making your decision. The chart below provides some ideas on how to get information while staying within the
bounds of the law. And don't panic if an applicant raises a delicate subject -- such as disability or national origin
-- without any prompting from you. You can't raise such subjects, but the applicant can.
2. Respect the applicant's privacy. Although federal law does not require you to do so, many state laws and
rules of etiquette do.
3. Don't make promises you can't keep. If you exaggerate your company's prospects in an effort to sell the
applicant on your business, and the applicant accepts the job because of those statements, you might face a
lawsuit for fraud. And, if you make promises about job security -- for example, that the company doesn't
fire employees who are performing well -- you will have to keep them, or risk a lawsuit for breach of contract.
Once you know about these pitfalls, it's not that difficult to stay on the right side of the law. As long you focus on the
applicant's ability to do the job (that is, don't ask about prohibited topics) and are truthful (that is, don't tell the
applicant anything false or misleading), you'll do just fine.
Don't Ask
The best way to avoid improper questions is to do some preparation. Before the interview, create two lists: one of all the
tasks that the applicant will have to perform as part of the job and the other of all the skills and experience that you
require for the position. This will help you focus on what you really need to find out: whether the applicant can do the job.
At the interview, you can use your list as a guide to come up with questions about the applicant's qualifications.
The lists will help you in a second way. If you use each list with each applicant, you can ensure that you are asking all
applicants essentially the same questions. This will help you avoid the appearance of treating some applicants differently
from others.
To avoid questions that violate an applicant's privacy, good taste is your best guide. Don't ask any applicant about his or
her sex life, beliefs about contraception and family planning, or opinions about same-sex relationships. Don't ask any
applicant about personal finances, religious beliefs, or political affiliations. You might also consider finding out what your
state legislature and courts have had to say on the subject. Contact your state labor department for details.
Here are some examples of ways that you can get the information that you need without running
afoul of anti-discrimination laws.
Age Are you 18 years of age or older? (to How old are you?
determine if the applicant is legally old
enough to perform the job)
Citizenship Are you legally authorized to work in Are you a native-born citizen
the United States on a full-time basis? of the United States? Where
are you from?
Disability These [provide applicant with list of job Do you have any physical
functions] are the essential functions of disabilities that would prevent
the job. How would you perform them? you from doing this job?
Drug and alcohol use Do you currently use illegal drugs? Have you ever been addicted
to drugs?
Don't Tell
To avoid making inflated promises, follow one simple rule: tell the truth. After all, job applicants are trying to figure out
whether the job will fit with their career goals, skills, and lives outside the workplace. They deserve to know the truth so
they can make the right decision.
This strategy will not only keep you out of legal trouble, but also increase your chances of finding an employee who is right
for the job and for your business. After all, no one wants a disgruntled employee on the payroll. If you're told the applicant
the truth and he or she wants the job, then you've probably found a good fit.
Here are a few rules that will help you avoid common promise pitfalls:
1. Don't make predictions about your company's financial future. Even if you honestly believe that you're
heading for the Fortune 500, keep your optimism to yourself. If the applicant asks about the company's prospects, stick to
the facts -- and if you make any statements about what the future might bring, clearly identify them as hopes, not
predictions. For example, you might say "our business has doubled in each of the last three years, and we're hoping that
growth trend will continue," but you shouldn't say "we'll be the industry leader by 2006."
2. Don't estimate the future value of stock options. Let's face it: You simply can't know what your stock
options will be worth in the future. It's fine to explain your stock option program to applicants and to tell them that you
hope the options will be valuable, but don't say things like "when these options vest, we'll all be millionaires!"
3. Don't say anything that might limit your right to make personnel decisions in the future. If you tell
an applicant that you only fire workers for poor performance, this will limit your ability to terminate that person for any
other reason -- such as personality conflicts or economic downturns -- if he or she accepts the job. Similarly, if you
promise pay increases at regular intervals, the employee could hold you to that promise, even if your company's financials
or the employee's performance doesn't warrant a raise.
4. If layoffs are likely, say so. If your company is considering staff reductions and there is even a remote change
that the applicant you are interviewing might lose that new job as a result, disclose this before the applicant accepts the
job. Otherwise, you may find yourself slapped with a lawsuit -- especially if the employee left a secure job elsewhere to
come work for you. Of course, this strategy might make it difficult to find new employees, but it really isn't fair (or legal)
to hire people on false pretenses.
5. Be accurate in describing the position. Don't exaggerate the job requirements to land an applicant -- and
don't play bait and switch by offering an applicant one job, then placing him or her in another. It may not matter to you
who does what, but it will matter to the employee. And an employee who accepts the position based on statements that
turn out to be false will have grounds for a lawsuit.
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Job Interview Questions That You Can and Can't Ask Under the ADA
The U.S. Equal Employment Opportunity Commission (EEOC) is the federal agency that enforces the
ADA.
According to the EEOC, you should never ask the following questions in a job interview:
1. Have you ever had or been treated for any of the following conditions or diseases?
(Followed by a checklist of various diseases or conditions.)
2. List any conditions or diseases for which you have been treated in the past three years.
3. Have you ever been hospitalized? If so, for what condition?
4. Have you ever been treated by a psychologist or psychiatrist? If so, for what?
5. Have you ever been treated for any mental condition?
6. Do you suffer from any health-related condition that might prevent you from performing
this job?
7. Have you had any major illnesses in the past five years?
8. How many days were you absent from work because of illness last year? (You may,
however, tell the applicant what your attendance requirements are and then ask whether he or
she will be able to meet those requirements.)
9. Do you have any physical defects that preclude you from doing certain types of things?
10. Do you have any disabilities or impairments that might affect your ability to do the job?
11. Are you taking any prescribed drugs?
12. Have you ever been treated for drug addiction or alcoholism?
13. Have you ever filed a worker's compensation claim?
According to the EEOC, you may ask the following questions in a job interview:
1. Can you perform all of the job functions?
2. How would you perform the job functions? (If you want to ask any applicant this question,
you should ask all applicants this question.)
3. Can you meet my attendance requirements?
4. What are your professional certifications and licenses?
5. Do you currently use illegal drugs?
2. A list of job functions -- a more detailed description of duties. While listing what people have to do to perform a
job might seem pretty straightforward, it can be a legal minefield for managers who aren't aware of federal and state
antidiscrimination laws, including the Americans With Disabilities Act (ADA).
3. A requirements section -- a list of the education, certifications, licenses, and experience necessary to do the job.
4. A section for other important information about the position, such as location, working hours, travel
requirements, reporting relationships, and so on.
Benefits of Using Job Descriptions
A well-crafted job description provides you and the employee who report to you with a blueprint for success. It's the basic
tool you use to hire, measure, and manage the performance of each employee, and of your team as a whole. Taking the
time to create an accurate description will help you in almost every role you play as a manager:
1. Hiring. The job description is the basis of your search for a new hire. It will help you weed out applicants who
don't have the necessary qualifications, and help you find a new employee who has what it takes to succeed.
2. Interviews. You can build your set of interview questions around the job's actual requirements, as set out in the
description. This will not only help you find a great hire, but also help you steer clear of topics that could lead to legal
trouble.
3. Orientation. New or recently promoted employees can use the job description to get an immediate
understanding of what you and the company expect, and hit the ground running on their very first day on the job.
4. Performance management. The job description explains what constitutes success in the job. You can measure
an employee's performance against those expectations. The description also gives you written proof that your employees
knew what the company expected of them, if you later have to discipline or fire someone who couldn't measure up.
5. Compensation. A job description gives you (or your human resources department) a solid way to measure the
value of a job and set the pay accordingly.
How to Get Started
The first step in writing a job description is to analyze and define the job. What are you expecting of the person in this
position? What do others in your company expect of this position? What would success look like for the person who holds
this job? And what big picture factors -- such as the current economy, what your competitors are doing, and your
company's plans for the future -- might influence what you want this position to accomplish? These questions will help you
start brainstorming about the requirements and functions of the job.
For detailed instructions on how to create and use job descriptions, including tips, exercises, and examples that will help
you through each step of the process, from brainstorming to final product, see The Job Description Handbook, by Margie
Mader-Clark (Nolo).
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3. In addition to issues of discrimination and privacy, psychological tests are treated like medical tests when they
elicit answers that suggest a mental disorder or impairment (see below). This fact puts the test clearly within the purview
of the Americans With Disabilities Act (ADA) and all of its restrictions.
If you do decide to use one of these types of tests, proceed with extreme caution. Make sure that the test has been
screened scientifically for validity and that it genuinely correlates to necessary job skills. Review the test carefully for any
questions that may intrude into an applicant's privacy.
Lie Detector and Honesty Tests
The federal Employee Polygraph Protection Act generally prohibits employers from requiring applicants to take a lie
detector test or asking applicants about previous lie detector tests. The law includes a narrow list of exceptions that apply
to, for example, businesses that provide armored car services, alarm or guard services, or manufacture, distribute, or
dispense pharmaceuticals.
Even though there is no federal law specifically prohibiting you from using a written honesty test on job applicants, these
tests frequently violate federal and state laws that protect against discrimination and violations of privacy. Plus, the tests
are rarely reliable. Prudent employers stay away from them.
Medical Tests
To avoid violating the Americans With Disabilities Act, don't ask an applicant about his or her medical history and don't
conduct any medical exam before you make a job offer.
Once you decide to offer the applicant a job, you can make the offer conditional on the applicant passing a medical exam.
Just be sure you require the exam for all entering employees who are doing the same job. If you only require people whom
you believe or know to have disabilities to take the exam, you will be violating the Americans With Disabilities Act.
Drug Tests
The laws on drug testing vary widely from state to state. Some states allow them only for jobs involving public safety;
some states allow them only for drivers; some states allow them for any occupation; some states don't allow them at all.
Before requiring an applicant to take a drug test, consult with your state department of labor to learn the rules in your
state.
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For a complete list of hazardous agricultural occupations, refer to the Department of Labor's website at
http://www.dol.gov.
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Have all potential workers fill out a questionnaire regarding their independent contractor status before you hire them,
and collect documents from them proving they are indeed independent contractors (for example,
advertisements, invoices from other companies, professional licenses, and tax returns).
The IRS
The IRS is probably the most important agency to satisfy when it comes to classifying a worker as an IC. Under the IRS's
test, workers are considered employees if the company they work for has the right to direct and control the way they work
-- including the details of when, where, and how the job is accomplished. In contrast, the IRS will consider workers
independent contractors if the company they work for does not manage how they work, except to accept or reject their
final results.
The IRS looks at a number of factors when determining whether a worker is an employee or an independent contractor.
The agency is more likely to classify as an independent contractor a worker who:
1. can earn a profit or suffer a loss from the activity
2. furnishes the tools and materials needed to do the work
3. is paid by the job
4. works for more than one firm at a time
5. invests in equipment and facilities
6. pays his or her own business and traveling expenses
7. hires and pays assistants, and
On the other hand, the IRS is more likely to classify as an employee a worker who:
1. can be fired at any time by the hiring firm
2. is paid by the hour
3. receives instructions from the hiring firm
4. receives training from the hiring firm
5. works full time for the hiring firm
6. receives employee benefits
7. has the right to quit without incurring liability, and
8. provides services that are an integral part of the hiring firm's day-to-day operations.
If you think the IRS would consider the worker an IC, you don't have to withhold federal payroll taxes for the worker,
including Social Security taxes, federal disability taxes and federal income taxes. If the IRS would not consider the worker
an IC, then you should withhold these taxes.
To find out more about the IRS test, go to the agency's website at www.irs.gov.
Microsoft Learns the Hard Way Not to Treat Contractors Like Employees
Even the largest corporations have to worry about how they classify their workers. A prime example
is Microsoft, which had a regular practice of hiring temporary workers -- whom it classifed as
independent contractors -- to edit, proofread, format, index, and test software products. Microsoft
required these workers to sign independent contractor agreements and didn't withhold or pay any
Social Security or Medicare taxes on their behalf, nor did it provide them with employee benefits.
However, Microsoft did not treat these temporary workers as self-employed businesspeople. Instead,
it integrated them into its workforce -- the temporary workers worked on teams along with regular
employees, sharing the same supervisors, performing identical jobs, and working the same hours.
When the IRS audited Microsoft's payroll accounts in 1989 and 1990, it determined that Microsoft
treated the workers as employees, and so should have paid and withheld payroll taxes on their
behalf. Microsoft had to pay back taxes and overtime for the workers. But that wasn't the end of the
story -- once the misclassified workers got wind of the IRS's decision, eight of them filed a lawsuit
demanding full employee benefits for the time they were misclassifed as independent contractors.
After a long struggle, a federal appeals court decided that the workers were improperly excluded
from Microsoft's benefits plans.
13. an explanation of how you and the independent contractor will resolve any disputes that arise between you.
Other terms you could include range from copyright ownership to naming who will be responsible for the independent
contractor’s employees.
Resources
Fortunately, an independent contractor agreement is something that you can create yourself. Two excellent sources for
such agreements are Hiring Independent Contractors and Consultant & Independent Contractor Agreements, both
by Stephen Fishman and both published by Nolo.
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9. an atlas.
All together, these payments can easily increase your payroll costs by 20% to 30% -- or more.
You have more flexibility in staffing projects. Working with ICs allows employers greater leeway in hiring and letting
go of workers, which can be especially advantageous for employers with fluctuating workloads. You can hire an IC for a
specific task or project, knowing that the worker will be gone when the job is finished. You won't have to face the trauma,
expense, and potential legal trouble that often accompany firings and layoffs.
You may also enjoy greater efficiency when you use ICs. Because most ICs bring specialized expertise to the job, they can
usually be productive immediately, which eliminates the time and cost of training. By using ICs, you can expand and
contract your workforce as needed, without taking on unnecessary expenses.
You reduce your exposure to lawsuits. Employees have a wide array of rights under state and federal laws -- and
therefore, a variety of legal claims they can potentially bring against their employers for violating those rights. Because ICs
are considered independent businesspeople, they are not protected by many of these laws. Among the rights that are
available to employees but not to ICs are:
1. the right to receive at least the minimum wage and, for employees who qualify, overtime compensation at the
rate of one-and-a-half times their regular hourly wage
2. protection from discrimination on the basis of race, national origin, color, religion, gender, and so on
3. the right to form a union, and
4. the right to take time off to care for a sick family member or bond with a new child.
Employees may also be able to sue their employers for wrongful termination, in circumstances that vary from state to
state. ICs cannot bring this type of lawsuit (although there may be restrictions on your right to terminate an IC
relationship, depending on what the written IC agreement says -- see Put Your Independent Contractor Agreement in
Writing for more information on IC contracts).
Disadvantages of Using Independent Contractors
After reading about the possible benefits of hiring ICs, you may be thinking that you'll never hire an employee again. But
there are also some important drawbacks to using ICs -- and the significant risk that your classification decision may be
questioned by government agencies.
You have less control over your workers. Unlike employees, whom you can closely supervise and micromanage to
your heart's content, independent contractors enjoy a certain autonomy to decide how best to do the job for which you
hired them. If you interfere too much in an IC's work, you risk making the IC look like an employee -- for whom you
should be paying payroll taxes, workers' compensation insurance premiums, and more. If you want to exercise ultimate
control over your workers, classify them as employees.
Your workers will come and go. Many employers use ICs only as needed for relatively short-term projects. This means
that workers will be constantly coming and going, which can be inconvenient and disruptive. And the quality of work you
get from various ICs may be uneven. Employers who want to be able to depend on having the same workers available day
after day would be better off hiring employees rather than ICs.
Your right to fire an IC depends on your written agreement. You do not have an unrestricted right to fire an IC, as
you might with your employees. Your right to terminate an IC's services is limited by the terms of your written IC
agreement. If you fire an IC in violation of the agreement, you could be liable for damages.
You may be liable for injuries an IC suffers on the job. Employees who are injured on the job are generally covered
by workers' compensation insurance. In exchange for the benefits they receive for their injuries, these employees give up
the right to sue their employer for damages. ICs are not covered by workers' compensation, which means that they can
sue you for damages if they are injured on the job because of your carelessness.
You may not own copyright in works created by an IC. If you hire an IC to create a work that can be copyrighted --
such as an article, book, or photograph -- you might not be considered the owner of the work unless you use a written
agreement transferring copyright ownership from the IC to you. In contrast, if an employee creates such a work, you will
automatically own copyright in the work, in most circumstances.
You face a risk of government audits. State and federal agencies -- particularly the IRS -- want to see as many
workers as possible classified as employees, not ICs. The reason for this preference is financial: The more workers are
classified as employees, the more tax and insurance money flows into government coffers, and the harder it is for workers
to underreport or hide their income from the tax man.
Any number of state and federal agencies might audit your business if it believes you have misclassified employees as ICs.
At the federal level, you might face an audit from the IRS; the Department of Labor, which enforces federal minimum
wage and hour laws; the National Labor Relations Board, which enforces employees' rights to form a union; or the
Occupational Safety and Health Administration, which enforces workplace safety laws.
At the state level, you could attract the attention of your state's unemployment compensation or workers' compensation
agency if a worker you classified as an IC applies for benefits. You could also face an audit from your state's tax agency.
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None of the answers to these questions will provide conclusive evidence that a worker is an employee or an IC. But taken
together, this information will help you decide whether the worker is an independent businessperson whom you can safely
treat as an IC.
Employment applications are for employees, not independent contractors. Don't ask an IC to complete one
of your standard employment applications. Government agencies could use the mere fact that the IC filled out an
"employment" application as evidence that the IC is actually your employee. Make sure the term "independent contractor"
appears prominently in the title of your questionnaire, to avoid any possible confusion.
Gather Documents
Ask the IC to provide documents that will enable you to establish that the IC is a separate business entity, should the
government ever decide to audit you. Make copies of all such documents and keep them in your files along with the
questionnaire described above.
The documents you should request include the following:
1. copies of the IC's business cards and stationery
2. copies of any advertising that the IC has done, including advertising in the Yellow Pages
3. a copy of the IC's White Pages business listing, if there is one
4. if the IC is operating under a fictitious or assumed business name, a copy of the fictitious or assumed business
name statement or application
5. copies of any business or professional licenses
6. certificates showing that the IC has insurance, including general liability insurance (and workers' compensation
insurance if the IC has employees)
1. a copy of the invoice form that the IC uses to bill for services
2. if the IC rents business space, a copy of the office lease
3. if the IC has employees, a document containing the IC's unemployment insurance number and Employer
Identification Number
4. copies of IRS Form 1099-MISC that other hiring firms have issued to the IC, and
5. if the IC is a sole proprietor and will agree to hand them over, copies of the IC's tax returns for the previous two
years showing that the IC has filed a Schedule C, Profit or Loss From a Business (which will show that the IC has been
operating as an independent business).
Next Steps
Once you have reviewed the IC's questionnaire and documents, you will have to decide whether you can safely treat him
or her as an IC -- or whether a government agency is likely to challenge that classification. For information on how
government agencies decide whether a worker should be classifed as an IC or an employee, see Independent Contractor or
Employee: How Government Agencies Make the Call.
If you are satisfied that the worker qualifies as an IC, your next step is to create a written agreement detailing the terms
of the project. For tips on drafting an agreement, see Put Your Independent Contractor Agreements in Writing.
If you have serious concerns that government agencies might classify the worker as an employee, you probably shouldn't
court trouble by hiring the worker as an IC. Instead, you might consider hiring the worker as an employee -- or, you can
thank the worker for his or her time and continue your search for a truly self-employed freelancer.
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Even if your business or your employees are exempt from the federal minimum wage law, they may still be covered under
your state or local law. To learn more about your state minimum wage law, contact your state labor department.
Paying Employees Who Receive Tips
If your employees earn tips from customers, you may be entitled to pay them less than the minimum wage, as long as
what you pay them plus the tips they actually earn add up to at least the minimum wage per hour worked. If you follow
this procedure (often referred to as a "tip credit"), you are legally required to adopt a policy explaining it to your
employees.
Not all states let employers take a tip credit. Among the states where a tip credit is allowed, the rules vary as to which
workers qualify and how much you must pay those workers before adding in their tips. To find out whether and how you
can take a tip credit, contact your state labor department.
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11. casual domestic baby sitters and people who provide companionship to those who are unable to care for
themselves (this exception does not apply to those who provide nursing care or to personal and home care aides who
perform a variety of domestic services).
Administrative, Executive, and Professional Employees
Probably the most common -- and confusing -- exceptions to the overtime laws are for so-called "white collar" workers.
Employees who the law defines as "administrative, executive, or professional" need not be paid overtime.
To be considered exempt, administrative, executive, or professional employees must be paid on a salary basis and must
spend most of their time performing job duties that require the use of discretion and independent judgment.
Salary Basis
An employee who is paid on a salary basis must earn at least $455 per week, and must receive the same salary every
week, regardless of how many hours the employee works or the quantity or quality of the work the employee does. There
are a few circumstances in which an employer may pay a salaried worker less than his or her full salary for a week -- for
example, if the employee takes a couple of days of paid sick or vacation leave, or takes time off under the Family and
Medical Leave Act. Generally, however, if an employer docks an employee’s pay (for taking a personal day or not meeting
a sales target, for example), then the employee is not paid on a salary basis and is entitled to overtime.
Job Duties
Not every employee who earns $455 or more per week is exempt from overtime. The employee must also be performing
certain types of work -- generally, work that requires an advanced degree, is managerial or supervisory in nature, or
requires the employee to make relatively high-level business decisions. Here are the basic requirements for the
administrative, executive, and professional exemptions.
1. An administrative employee must perform office or other non-manual work that is directly related to the
management or business operations of the employer or its customers, and must exercise discretion and independent
judgment regarding significant issues.
2. An executive employee’s primary duty must be managing the employer’s enterprise or a recognized division or
department of that enterprise; the employee must regularly supervise at least two full-time employees (or the equivalent),
and must have the authority to hire and fire or have significant input into hiring and firing decisions.
3. A professional employee’s primary duty must either be performing work that requires advanced knowledge in the
field of science or learning, of a type that is usually attained through an advanced course of study; or performing work that
requires invention, imagination, originality, or talent in a recognized creative or artistic field.
7. to serve an unpaid disciplinary suspension imposed in good faith for infractions of workplace conduct rules, but
only if the employer has a written policy regarding such suspensions that applies to all employees.
Penalties for Improper Deductions
An employer that makes improper deductions from a salaried employee’s pay can get into big trouble. However, the law
contains a “safe harbor” provision, which offers employers some protection if they made improper deductions
inadvertently.
5. whether the employer has a clearly communicated policy that either permits or prohibits improper deductions.
An employer who has an actual practice of making improper deductions will lose the overtime exemption for all employees
who work in the job classification(s) for which the deductions were made and who work for the same managers responsible
for making the deductions. In other words, the employer will have to pay overtime (if earned by the employees) to
everyone who holds the position from which improper deductions were taken.
One-Day Trips
If you send an employee on a one-day business trip, you must pay for the time the employee spends traveling. However,
you can subtract the time it takes the employee to get to the airport or public transportation hub as commuting time, even
if it takes the employee longer than his or her ordinary commute to the worksite.
Example
Tom lives in Greenbrae, California, and regularly commutes to his job in San Francisco. His commute
takes about 1/2 hour each way by bus. His employer sends him to Los Angeles for a business trip.
Tom leaves home at 6 a.m. to catch an 8 a.m. flight. He spends all day with a customer in Los
Angeles, then dashes off to the airport to catch his 6:30 p.m. flight, which lands at 8 p.m. Tom
arrives home by 9 p.m. He is entitled to be paid for 12 hours of work; the time he spends commuting
between his home and the airport is considered noncompensable commuting time, even though it's
quite a bit longer than his usual commute.
Overnight Trips
When an employee spends more than a day out of town, the rules are different. Of course, you must pay the employee for
all of the time he or she spends actually working. However, whether you have to pay the employee for time spent in transit
depends on when the travel takes place.
Employees are entitled to pay for time spent traveling during the hours when they regularly work (the period of the day
they regularly work), even if they ordinarily work Monday through Friday but travel on the weekend. For example, if Tom
usually works 9 to 5, and leaves the office at 3 p.m. to catch a flight for an overnight business trip, he should be paid for
the two remaining hours in his day, but not for the rest of the time he spends traveling that evening. But if Tom returns
home on a 10 a.m. Saturday flight that takes four hours, he is entitled to pay for all of that time. Even though he traveled
on the weekend, the flight took place during his ordinary hours of weekday work.
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When you have finished writing the appraisal, set up a meeting to discuss it with your worker. Remember, this is likely to
be one of the most important meetings you have with your worker all year, so be sure to schedule enough time to discuss
each issue thoroughly. At the meeting, let your worker know what you think he or she did well and which areas could use
some improvement. Using your evaluation as a guide, explain your conclusions about each standard and goal. Listen
carefully to your worker's comments -- and ask the worker to write them down on the evaluation form. Take notes on the
meeting and include those notes on the form.
Evaluation Tips
Giving evaluations can be difficult. Some workers react to criticism defensively. And, sometimes, no one understands what
merits a positive evaluation. If your workers feel that you take it easy on some of them while coming down hard on others,
resentment is inevitable. Avoid these problems by following these rules:
1. Be specific. When you set goals and standards for your workers, spell out exactly what they will have to do to
achieve them. For example, don't say "work harder" or "improve quality." Instead, say "increase sales by 20% over last
year" or "make no more than three errors per day in data input." Similarly, when you evaluate a worker, give specific
examples of what the employee did to achieve -- or fall short of -- the goal.
2. Give deadlines. If you want to see improvement, give the worker a timeline to turn things around. If you expect
something to be done by a certain date, say so.
3. Be realistic. If you set unrealistic or impossible goals and standards, everyone will be disheartened -- and will
have little incentive to do their best if they know they will still fall short. Don't make your standards too easy to achieve,
but do take into account the realities of your workplace.
1. Be honest. If you avoid telling a worker about performance problems, the worker won't know that he or she
needs to improve. Be sure to give the bad news, even if it is uncomfortable.
2. Be complete. Write your evaluation so that an outsider reading it would be able to understand exactly what
happened and why. Remember, that evaluation just might become evidence in a lawsuit. If it does, you will want the judge
and jury to see why you rated the employee as you did.
3. Evaluate performance, not personality. Focus on how well (or poorly) the worker does the job -- not on the
worker's personal characteristics or traits. For instance, don't say the employee is "angry and emotional." Instead, focus
on the workplace conduct that is the problem -- for example, you can say the employee "has been insubordinate to the
supervisor twice in the past six months. This behavior is unacceptable and must stop."
4. Listen to your employees. The evaluation process will seem fairer to your workers if they have an opportunity
to express their concerns, too. Ask employees what they enjoy about their jobs and about working at the company. Also
ask about any concerns or problems they might have. You'll gain valuable information, and your employees will feel
like real participants in the process. In some cases, you might even learn something that could change your evaluation.
For More Guidance
1. Personal use of the email system. Explain whether employees can use email for personal messages. If you
place any restrictions on personal messages (for example, that employees can send them only during nonwork hours,
must exercise discretion as to the number and type of messages sent, or may not send personal messages with large
attachments), describe those rules.
2. Monitoring. Reserve your right to monitor employee email messages at any time. Explain that any messages
employees send using company equipment are not private, even if the employee considers them to be personal. If you will
monitor regularly using a particular system -- for example, a system that flags key words or copies every draft of a
message -- explain it briefly. This will help deter employees from sending offensive messages in the first place.
3. Rules. Make clear that all of your workplace policies and rules -- such as rules against harassment,
discrimination, violence, solicitation, and theft of trade secrets -- apply to employee use of the email system. Remind
employees that all email messages sent on company equipment should be professional and appropriate. Some employers
also include so-called netiquette rules -- style guidelines for email writing.
4. Deleting email. Establish a regular schedule for purging email messages. If you don't, you will eventually run
into a storage problem. Let your employees know how they can save important messages from the purge.
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1. Clear guidelines for employee behavior. A straightforward, easy-to-understand disciplinary policy will tell
your employees what you expect of them and what conduct you will not tolerate. Enforcing the policy in a uniform manner
will show your employees that you take these rules seriously.
2. Good morale for other employees. It's true that the employee you discipline is not likely to enjoy a morale
boost, but the rest of your workforce will. Other employees do not like to see a coworker getting away with poor,
unproductive behavior while they work thanklessly at their jobs. And, if a problem employee is allowed to misbehave
without suffering any consequences, others in the workforce will soon realize that they can get away with slacking off, too.
3. Protection against employee lawsuits. If you clearly inform your employees of the consequences of poor
behavior and enforce your policy fairly, you will buy yourself some insurance in future disputes. It will be more difficult for
an employee to argue that his or her termination was unjustified if you can show that you told your employees what
conduct would result in discipline, and that this particular employee had been subject to prior disciplinary action.
Writing a Disciplinary Policy
The trick to writing an effective disciplinary policy is to give your employees clear notice of the consequences of poor
behavior without locking yourself into following the same course of action in every situation. For example, even though you
may generally follow a policy of progressive discipline (in which a first offense is met with a verbal warning, a second
offense with a written warning, and so on), you should always reserve the right to immediately fire an employee who really
acts badly. You will also want to avoid any hint of a promise that employees will not be fired unless they engage in
specified misconduct -- you may find that your employees dream up bad acts you never considered, or that you have to
fire employees for reasons entirely separate from their performance (an economic downturn or plant closing, for example).
How to Give the Bad News
Once you know that an employee has violated a company rule, you will have to dispense some of that discipline promised
in your policy. Here are some guidelines to follow:
1. Don't procrastinate. Once you have determined that discipline is in order, set up a meeting with the employee
right away. The sooner you place the employee on notice, the sooner he or she will know that it's time to try harder -- and
the sooner you will know whether the employee will actually improve or whether you'll have to start considering other
options.
2. Keep it private. Schedule a meeting with your employee to discuss the problem one on one. Make sure you can
meet in a private place, away from eavesdropping coworkers and office gossip.
3. Be honest. Your natural tendency may be to accentuate the positive, but now is not the time to indulge it. The
purpose of this meeting is to notice and improve poor behavior. You must tell the employee precisely what the problem is,
what steps he or she must take to correct it, and the consequences of failing to do so.
4. Be respectful. Even bad news is best delivered with respect. Let your employee know that you want him or her
to improve, and that you will help if you can. Set aside enough time for the meeting so that the employee will have an
opportunity to respond. Make sure to listen to your employee's concerns; it may be that a performance problem is the
result of a misunderstanding or could be easily corrected if you work together.
5. Write it down. Document every disciplinary meeting, action, or discussion with each of your employees, and
place that record in the employee's personnel file. In the case of a written warning, give the employee a copy of the
warning and ask him or her to sign it to acknowledge receipt. These records will help you later, if that employee decides to
file a lawsuit.
6. Follow up. If you tell your employee that you must see improvement by a certain date, make sure to follow up.
Check with your employee periodically to make sure everything is proceeding smoothly.
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Nolo's Create Your Own Employee Handbook: A Legal & Practical Guide, by attorneys Lisa Guerin and
Amy DelPo, supplies sample policies that you can use as-is or tailor to meet your needs (and a CD-
ROM allows you to cut and paste the policies into your own handbook).
15. documents relating to the worker's departure from the company (such as reasons why the worker left or was
fired, unemployment documents, insurance continuation forms, and so on).
What Not to Keep in a Personnel File
Do not put medical records into a personnel file. If your worker has a disability, you are legally required to keep all of the
worker's medical records in a separate file -- and limit access to only a few people. Even for workers who are not disabled,
you may have a legal obligation to keep medical records private (and it's a good idea to do so, in any case).
Do not put Form I-9 into an employee's personnel file. This is a form from an agency now known as USCIS (U.S.Citizenship
and Immigration Services, formerly the INS). You must complete an I-9 for all employees, verifying that you have checked
to be sure that the employees are legally authorized to work in the United States. You should put all Form I-9s into one
folder for USCIS. The government is entitled to inspect these forms. If it does, you don't want the agents viewing the rest
of the employee's personnel -- and personal -- information at the same time. Not only would this compromise your
workers' privacy, but it might also open your business up to additional questions and investigation.
Although an employee's personnel file should contain every other important job-related document, don't go overboard.
Remember that, in many states, employees have the right to view their personnel files. And, in the worst-case scenario,
that file may turn into evidence in a lawsuit brought by a disgruntled former employee. Indiscreet entries that do not
directly relate to an employee's job performance and qualifications -- like references to an employee's private life or
political beliefs, or unsubstantiated criticisms or comments about an employee's race, sex, or religion -- will come back to
haunt you. A good rule of thumb: Don't put anything in a personnel file that you would not want a jury to see.
How to Maintain a Personnel File
You should establish a time to periodically review each employee's personnel file, perhaps when you conduct the
employee's evaluation. During this review, consider whether the documents in the file are accurate, up to date, and
complete. Some questions to consider:
1. Does the file reflect all of the employee's raises, promotions, and commendations?
2. Does the file contain every written evaluation of the employee?
3. Does the file show every warning or other disciplinary action taken against the employee?
4. If your policies provide that written warnings or other records of discipline will be removed from an employee's
file after a certain period, have they been removed?
5. If the employee was on a performance improvement plan, a probationary or training period, or other temporary
status, has it ended? Has the file been updated to reflect the employee's current status?
6. If the employee handbook has been updated since the employee started working for you, does the file contain a
receipt or acknowledgment for the most recent version?
7. Does the file contain current versions of every contract or other agreement between you and the employee?
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1. Pregnancy leave. Pregnant employees are entitled to use FMLA leave if complications from their pregnancy
constitute a serious health condition. As a practical matter, if a woman's doctor determines that a period of leave is
medically necessary, she will be able to use FMLA leave for that purpose.
1. Parental leave. New parents may use FMLA leave as parental leave following the birth or adoption of a child, or
the placement of a foster child. This leave may be taken any time during the first year after the new child arrives.
2. Intermittent parental leave. Parental leave may be taken intermittently, but only with your permission. For
example, new parents may wish to work part-time for a period or take some leave immediately following the birth and
some leave later. As long as you agree, you and your employee can work out a flexible leave arrangement under the
FMLA.
3. Combining parental leave. If both parents work for you (and are married to each other), you may restrict
them to a combined total of 12 weeks of parental leave. (This rule does not apply to an employee who must take time off
for her own serious health condition, however. So if your employee had a difficult birth and is unable to work for 12 weeks,
you will also have to provide her husband with 12 weeks of parental leave, if requested.)
Some states require you to provide more than 12 weeks of leave, particularly if the leave is for "maternity disability" -- the
legal term for the period of time when women are actually unable to work because of pregnancy and childbirth.
Your Policies
Your own employment policies may obligate you to provide paid leave to pregnant employees and new parents. Generally,
if you make paid personal or medical leave available to other workers, you must make it available to pregnant employees
and new parents. For example, if you provide paid leave to employees who are temporarily disabled (unable to work) for
medical reasons, you must make this leave available to employees who are unable to work because of pregnancy.
Similarly, if you provide personal or vacation leave to your employees, you must allow new parents to use this time off as
parental leave, as long as they meet the other requirements of your policy (for example, providing adequate notice or
scheduling the leave with their supervisors).
For help drafting pregnancy or parental leave policies, including sample policies on CD-ROM, see Nolo's Create Your Own
Employee Handbook: A Legal & Practical Guide, by attorneys Lisa Guerin & Amy DelPo.
Avoid Discrimination Claims
Federal and state laws prohibit discrimination on the basis of gender, and this includes discrimination because
of pregnancy. This means that you may not fire, demote, or take any other negative employment action against a worker
because she is pregnant. Here are a few tips that will help you stay within the law when dealing with parental leave issues:
1. Never require an employee to take pregnancy or maternity leave. In times past, an employer could force
a pregnant worker to stop working when she reached a certain stage of her pregnancy or was "showing." This is no longer
legal. You must allow your pregnant employee to work for as long as she remains able to do her job -- even up to the date
she gives birth.
2. Treat a pregnant employee who needs time off like other temporarily disabled workers. Unless required
by state or federal law, you need not offer special benefits to pregnant workers, but you must treat them as well as you
treat other workers who are temporarily unable to do their jobs because of disability or illness.
3. Offer parental leave, not maternity leave. If you offer any time off for a parent to spend with a new child,
you must make it available to both fathers and mothers. If you offer a benefit that can be used solely by women -- like
maternity leave -- you can be sued for discrimination.
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Giving Employees Time Off for Voting and Jury Duty
From the Nolo Business & Human Resources Center
Most states require employers to let employees take time off work to vote or serve on a jury.
The laws of almost every state require employers to give employees time off to cast a ballot or show up for jury duty.
These laws vary widely in the details, however -- some require employers to provide paid leave, while others do not; some
allow employers to require employees to show some proof that they voted or were called for jury service; and some
actually impose criminal penalties on employers who fire or otherwise penalize an employee for taking time off work for
these civic obligations.
Voting
Almost every state prohibits employers from disciplining or firing an employee who takes time off work to vote. Some state
laws require employers to give their employees a specific amount of time off to cast their ballots; in most of these states,
the time an employee takes off must be paid.
Often, how much time off you have to provide depends on the employee's schedule -- for example, if an employee has two
or three consecutive hours off while the polls are open or otherwise has enough time to vote before or after work, you may
not have to let the employee take leave to vote during work hours.
The obligations of these laws do not fall entirely on employers, however. In some states, employees who want to take
advantage of these laws must meet certain requirements, like proving that they actually cast ballots or giving their
employers notice, in advance, that they intend to take time off work to vote. To find out the rules in your state, contact
your state labor department.
Even if your state doesn't require you to give time off for voting, you might still have to provide time off to vote if you
have promised to do so in your employee handbook or other personnel policies.
Jury Duty
Some employers doggedly resist giving employees time off for jury duty -- and apply subtle (and sometimes not-so-subtle)
pressure on them to avoid serving. This can be a big legal mistake, however. Most states prohibit employers from firing or
disciplining employees called for jury service. Some states go farther and prohibit employers from trying to discourage or
intimidate employees from serving on a jury.
Although you have to provide time off for jury duty, you probably don't have to pay for it. Unless your employee handbook
or other personnel policies state otherwise, employers in most states don't have to provide paid time off work to
employees responding to a summons or serving on a jury. However, a handful of states do require employers to provide at
least some pay for this time off.
In addition, some states allow employers to require employees to provide proof that they were called for jury duty before
they take any time off work. And some states give employees additional rights -- for example, to use accrued paid leave
for the time they spend on jury duty, or to take time off of night shift work, even though it doesn't directly conflict with
jury service. For information on your state's requirements, contact your state labor department.
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1. Apply the policy consistently to all employees. If you offer some employees a more attractive package than
others, you are opening yourself up to claims of unfair treatment -- and inviting morale problems.
2. Require employees to schedule leave in advance, if possible. Sometimes, an employee cannot know ahead
of time that he or she will need time off -- for a sudden illness or family emergency, for example. In all other
circumstances, however, you should ask your employees to schedule leaves -- particularly vacations -- at least a month in
advance. This will help you make sure your staffing needs are met, particularly during summers and holidays.
3. Adopt a sensible vacation accrual policy. Many of us enjoy taking a longer vacation from time to time, and a
policy that allows employees to save up a long stretch of vacation time -- four weeks, say -- for this purpose is reasonable.
You may want to put some cap on how much vacation time your employees can accrue or use at one time, however.
Otherwise, you may suddenly have several employees asking for months off at a time. And until those employees take
their long vacation, they may suffer from job burn-out from years of work without time off.
1. Discourage misuse of sick leave. Some employees treat sick leave as an extra allotment of vacation days.
Crack down by requiring employees to call in each day they are ill, requiring a doctor's note for serious illnesses, and
monitoring patterns of sick leave use. Do you have employees who only seem to call in sick on Mondays and Fridays? Do
some employees claim illness at the end of every year, in an effort to take advantage of unused sick time? Counsel these
employees about the proper use of sick leave and discipline those who abuse the system.
2. Consider what you will pay when an employee quits or is fired. If your policy allows paid leave to accrue,
you must decide whether to pay out unused leave to departing employees. Some states, including California and
Massachusetts, require payment of accrued vacation time when employment ends. Although you are generally not required
to pay out unused sick days, some employers do pay out unused sick days, perhaps believing that this encourages
employees not to misuse sick leave.
Nolo's Create Your Own Employee Handbook: A Legal & Practical Guide, by attorneys Lisa Guerin &
Amy DelPo, supplies sample vacation and sick leave policies that you can use as-is or tailor to meet
your needs (and a CD-ROM allows you to cut and paste the policies into your own handbook).
1. The employee must have given notice, before taking leave, that the leave was for military service.
2. The employee must have spent no more than five years on leave for military service (with some exceptions).
3. The employee must have been released from military service under honorable conditions.
4. The employee must report back or apply for reinstatement within specified time limits (these limits vary
depending on the length of the employee’s leave).
Reinstatement Benefits
USERRA requires employers to reinstate workers to the same position they would have held had they been continuously
employed throughout their leave, as long as they are otherwise qualified for that job. This means that you cannot simply
return the worker to his or her former position; instead, you must provide any promotions, increased pay, or additional job
responsibilities the worker would have received if he or she had never taken leave -- but only if the worker is qualified to
do that job. If the worker is not qualified, you must try to get him or her qualified.
You must also provide the benefits and seniority the worker would have earned had he or she been continuously
employed. For purposes of your benefits plans and leave policies, the time your worker spent on leave must be counted as
time worked.
Returning members of the military receive one additional benefit: You cannot fire them without cause for up to one year
after they are reinstated (the exact length of this protection depends on the length of the worker’s military service). Thus,
no matter what your employment policies say, these workers are no longer at-will employment employees for a limited
period after they return.
Protections for State Militia or National Guard
In addition to these federal protections, almost every state has a law prohibiting discrimination against those in the state’s
militia or National Guard. Most state laws also require employers to grant leave to employees for certain types of military
service. Some states require leave only for those employees called to active duty; other states require leave for those
called for training as well.
To find out more about USERRA, check out the website of the National Committee for Employer
Support of the Guard and Reserve, at www.esgr.org. To find out about your state's law, contact your
state department of labor.
1. Birth, adoption, or foster care. A new parent or foster parent may take FMLA leave within one year after the
child is born or placed in the parent's home. Leave may begin before the child arrives, if necessary for prenatal care or
preparations for the child. If both parents work for the same employer, they may be entitled to less leave.
2. The employee's serious health condition. Generally, an employee who requires inpatient treatment, has a
chronic health problem, or is unable to perform normal activities for at least three days while under the treatment of a
doctor has a serious health condition.
3. A family member's serious health condition. You must grant leave to an employee who needs to care for an
ill family member. Under the FMLA, only parents, spouses, and children are considered family members. Grandparents,
same-sex partners, in-laws, and siblings are not included.
What You Must Provide
Under the FMLA, an eligible employee is entitled to take 12 weeks of unpaid leave in any 12-month period for the reasons
listed above. When the employee's leave is over, you must reinstate the employee to the same position he or she held
prior to taking leave, subject to these conditions:
1. You do not have to reinstate an employee who would have been fired or laid off if not on leave. In
other words, if your employee works in the accounting department and you decide, while the employee is on leave, to cut
the entire department and outsource your bookkeeping needs, you are not required to reinstate the employee.
2. You may refuse to reinstate certain highly paid employees. The FMLA recognizes how difficult it would be
for many businesses to thrive without their top executives. The law allows you to refuse reinstatement if (1) the employee
is among the highest paid 10% of the salaried workers you employ within 75 miles of the employee's workplace, and (2)
taking back the employee would cause "substantial and grievous economic injury" to your business.
If you have a group health plan for your employees, you must also maintain insurance coverage for employees on FMLA
leave. However, you can require your employees to reimburse you for the premiums you paid if they choose not to return
to work when their leave ends.
Although FMLA leave is unpaid, you must allow your employees to substitute their accrued paid leave in certain
circumstances. An employee is always allowed to use accrued vacation or personal leave as FMLA leave. An employee may
substitute accrued paid sick or family leave for FMLA leave, but only if the reasons for the leave are covered by your sick
leave plan. For example, you need not allow an employee to use sick leave as FMLA leave to care for an ill family member
unless your sick leave plan allows employees to take paid time off for this purpose.
Scheduling and Notice Requirements
Having employees gone for 12 weeks at a time can be disruptive to your workplace. Recognizing this, the FMLA requires
employees to give you 30 days' notice of the need for leave if it is foreseeable. This is most often the case if leave will be
taken for the birth or adoption of a child or to care for a family member recovering from surgery or other planned medical
treatment.
If the need for leave is not foreseeable, the employee is required to give only such notice as is practical. If a medical
emergency arises, for example, it might be impossible for an employee to give you notice in advance.
Intermittent Leave
In some circumstances, an employee may want to take leave intermittently rather than all at once. If an employee
requires physical therapy for a serious injury, for example, or needs to care for a spouse receiving periodic medical
treatment, it might make more sense to take several hours off per week rather than 12 weeks at a clip. This may also
make more sense for your business, as you will continue to have the services of your employee most of the time.
If it is medically necessary for an employee to take intermittent leave to care for a family member or for his or her own
serious health condition, the employee has a right to do so. In other situations (for example, when an employee wants to
take time off to care for a new child), you may, but are not required to, allow the employee to take leave on an
intermittent schedule.
Certifications: Medical Proof of Illness
The law allows you to require proof that your employee or employee's family member really suffers from a serious health
condition. You may ask your employee to provide certification from the treating doctor, giving certain details about the
condition, including the duration of the condition, a diagnosis, and the treatment prescribed.
The law also allows you to ask for a second opinion from a doctor of your choosing, as long as you pay for it and the doctor
you choose is not regularly employed by your company. If the first and second certifications conflict, you can require a
third opinion from yet another doctor; this opinion will be binding on both you and your employee.
If your employee is out for an extended period of time, you may ask for a recertification of the employee's illness
periodically -- generally, not more often than every 30 days.
Resources
Nolo's Create Your Own Employee Handbook: A Legal & Practical Guide, by attorneys Lisa Guerin &
Amy DelPo, supplies sample leave policies that you can use as-is or tailor to meet your needs (and a
CD-ROM allows you to cut and paste the policies into your own handbook).
1. Keep an open mind. Many employers have a hard time believing that discrimination or harassment could be
happening right under their noses. As a result, they often fail to investigate complaints, assuming that they could not
possibly be true. Unfortunately, failing to investigate a complaint is a surefire way to land in court. Investigate every
complaint you receive. Don't come to any conclusions until your investigation is complete.
2. Treat the complainer with respect and compassion. Employees often find it extremely difficult to complain
about discrimination or harassment. They feel vulnerable and afraid. This can have an impact on the quality of their work,
and it can also lead them to seek outside assistance from lawyers. When an employee comes to you with concerns about
discrimination or harassment, be understanding. An employee who feels that you are taking the problem seriously is less
likely to escalate the issue to a government agency or to court.
3. Do not blame the complainer. You may be tempted to become angry at the complaining employee for the fact
that you must now deal with the specter of discrimination and harassment in your business. But don't forget that the
complaining employee is the victim and not the cause of the problem. If you allow yourself to become angry at the
employee, you open yourself up to claims of illegal retaliation (see next tip, below). You also run the risk of polarizing your
workplace, damaging morale, and lowering productivity.
1. Don't retaliate against the complainer. It is against the law to punish someone for complaining about
discrimination or harassment. The most obvious forms of retaliation are termination, discipline, demotion, pay cuts, or
threats to do any of these things. More subtle forms of retaliation may include changing the shift hours or work area of the
accuser, changing the accuser's job responsibilities, or isolating the accuser by leaving her out of meetings and other office
functions.
2. Follow established procedures. If you have an employee handbook or other documented policies relating to
discrimination and harassment, follow those policies. Don't open yourself up to claims of unfair treatment by bending the
rules.
3. Educate yourself. Do some research on the law of discrimination and harassment: what it is, how it is proven in
court, and what your responsibilities are as an employer.
4. Interview the people involved. Start by talking to the person who complained. Find out exactly what the
employee's concerns are. Get details: what was said or done, when, and where, and who else was there. Take notes of
your interviews. Then talk to any employees who are being accused of discrimination or harassment. Get details from them
as well. Be sure to interview any witnesses who may have seen or heard any problematic conduct. Gather any relevant
documents. For detailed information on conducting an investigation, see Workplace Investigations, by Lisa Guerin (Nolo) (it
includes separate chapters on investigating discrimination and harassment).
1. Look for corroboration or contradiction. Discrimination and harassment complaints often offer the classic
example of "he said/she said." Often, the accuser and accused offer different versions of incidents, leaving you with
conflicting stories. You may have to turn to other sources for clues. For example, schedules, time cards, and other
attendance records (for trainings, meetings, and so on) may help you determine if each party was where he or she claimed
to be. Witnesses -- including coworkers, vendors, customers, or friends -- may have seen part of an incident. And, in some
cases, documents will prove one side right. After all, it's hard to argue with an email that contains racial slurs or sexual
innuendo.
2. Keep it confidential. A discrimination complaint can polarize a workplace. Workers will likely side with either
the complaining employee or the accused employee, and the rumor mill will start working overtime. Worse, if too many
details about the complaint are leaked, you may be accused of damaging the reputation of the alleged victim or alleged
harasser -- and get slapped with a defamation lawsuit. Avoid these problems by insisting on confidentiality and practicing it
in your investigation.
3. Write it all down. Take notes during your interviews. Before the interview is over, go back through your notes
with the interviewee to make sure you got it right. Keep a journal of your investigation. Write down the steps you have
taken to get at the truth, including dates and places of interviews you have conducted. Write down the names of all
documents you have reviewed. Document any action taken against the accused or the reasons for deciding not to take
action. This written record will protect you later if your employee claims that you ignored a complaint or conducted a one-
sided investigation.
1. Cooperate with government agencies. If the employee makes a complaint with a government agency (either
the federal Equal Employment Opportunity Commission (EEOC) or an equivalent state agency), that agency may
investigate. It will probably ask you to provide certain documents, give your side of the story, and explain any efforts you
made to deal with the complaint yourself. Be cautious, but cooperative. Try to provide the agency with the materials it
requests, but remember that the agency is gathering evidence that could be used against you later. This is a good time to
consider hiring a lawyer to advise you.
2. Consider hiring an experienced investigator. Many law firms and private consulting agencies will investigate
workplace complaints for a fee. You might consider bringing in outside help if more than one employee complains of
harassment; the accused is a high-ranking official in your business (like the president or CEO); the accuser has publicized
the complaint, either in the workplace or in the media; the accusations are extreme (allegations of rape or assault, for
example); or, for any reason, you feel too personally involved to make a fair, objective decision.
3. Take appropriate action against the wrongdoer(s). Once you have gathered all the information available, sit
down and decide what you think really happened. If you conclude that some form of discrimination or harassment
occurred, figure out how to discipline the wrongdoer(s) appropriately. Termination may be warranted for more egregious
kinds of discrimination and harassment, such as threats, stalking, or repeated and unwanted physical contact. Lesser
discipline, such as a warning or counseling, might be in order if the harassment arises out of a misunderstanding (a
blundered attempt to ask a coworker on a date, for example). Once you have decided on an appropriate action, take it
quickly, document it, and notify the accuser.
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Negotiating an Accomodation
It is your employee's responsibility to inform you of the disability and request a reasonable accommodation -- you are not
legally required to guess at what might help the employee do his or her job. However, once an employee informs you of
his or her disability, you must engage in what the law calls a "flexible interactive process" -- essentially, a brainstorming
dialogue with your worker to figure out what kinds of accommodations might be effective and practical. You do not have to
give your worker the precise accommodation he or she requests, but you must work together to come up with a
reasonable solution.
You and the employee may have different opinions about what constitutes a reasonable accommodation and what would
be an undue hardship. If you’re unsure whether you must provide a disabled employee with a specific accommodation, you
might want to get some legal help.
Alcohol and Drugs
Alcohol and drug use pose special problems under the ADA. Employees who use (or have used) alcohol or drugs may be
disabled under the law. However, an employer can require these employees to meet the same work standards -- including
not drinking or using drugs on the job -- as nondisabled employees. Here are some guidelines to follow when dealing with
these tricky issues:
1. Alcoholism. Alcoholism is a disability covered by the ADA. This means that an employer cannot fire or discipline
a worker simply for being an alcoholic. However, an employer can fire or discipline an alcoholic worker for failing to meet
work-related performance and behavior standards imposed on all employees -- even if the worker fails to meet these
standards because of alcohol abuse.
2. Illegal drug use. The ADA does not protect employees who currently use or are addicted to illegal drugs. These
workers are not considered "disabled" within the meaning of the law and therefore don't have the right to be free from
discrimination or to receive a reasonable accommodation. However, the ADA does cover workers who are no longer using
drugs and have successfully completed (or are currently participating in) a supervised drug rehabilitation program.
3. Use of legal drugs. If an employee is taking prescription medication or over-the-counter drugs to treat a
disability, you may have to accommodate that employee’s use of drugs and the side effects that the drugs have on the
employee. However, you do not have to accommodate legal drug use if you cannot find a reasonable accommodation.
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Preventing Retaliation Claims by Employees
From the Nolo Business & Human Resources Center
It's against the law to punish your employees for complaining about harassment or discrimination.
When an employee complains about discrimination or harassment -- to you, to a government agency, or to someone
within your business -- you must treat that employee with care. If you take any action that the employee might view as
punishment or retaliation for the complaint, you might find yourself on the wrong end of a lawsuit. It is illegal to retaliate
against an employee for complaining about discrimination and harassment -- and retaliation is often in the eye of the
beholder.
All employers, managers, supervisors, and human resources representatives should become familiar with the law of
retaliation, because retaliation claims are becoming more and more common. And they are also becoming more costly.
Even if the original complaint of discrimination or harassment turns out to be unfounded, an employee who can prove that
something negative happened because of the complaint can still win a retaliation claim.
Retaliation Defined
Retaliation means any adverse action that you or someone who works for you takes against an employee because he or
she complained about harassment or discrimination. Employees who participate in an investigation of any of these
problems are also protected -- for example, you cannot punish an employee for giving a statement to a government
agency that is looking into a discrimination claim.
Adverse action includes demotion, discipline, firing, salary reduction, negative evaluation, change in job assignment, or
change in shift assignment. Retaliation can also include hostile behavior or attitudes -- by you or someone who works for
you -- toward an employee who complains.
Retaliation Need Not Be Intended
Although retaliation obviously includes any action that you take with the intent to harm or punish the employee for
complaining, it can also include actions that you take with the best of intentions -- if those actions have a negative impact
on the employee.
For example:
1. A female employee complains that her supervisor is sexually harassing her. In response, you change the
employee from the day shift to the night shift so that she doesn't have to work with the supervisor any more. Even though
you didn't intend to hurt the employee, this action could be retaliatory if the employee preferred the day shift.
2. An African-American employee complains to you that the store in which he works is racially hostile toward him
because his coworkers tell racial jokes and call him racially derogatory names. In response, you transfer the employee to
another store. This action could be retaliatory if the new store is farther from the employee's home or the position is less
desirable in some other way.
In both of the above examples, the employer made the mistake of focusing on the complaining employee rather than
focusing on the wrongdoer. When someone complains about something unlawful in the workplace, the employer's job is to
fix the problem -- not avoid it by removing the complaining employee from the situation. By focusing on the employee, the
employer took actions that could be viewed as retaliatory.
Strategies to Prevent Retaliation
As soon as someone complains about discrimination or harassment in the workplace, the groundwork is laid for a
retaliation claim -- unless you take some precautionary steps:
1. Establish a policy against retaliation. Even before an employee complains, you should have a clear policy
against retaliation. Your policy should spell out exactly what retaliation is, and it should make perfectly clear that you will
not tolerate retaliation from any of your managers or other employees. It should also tell employees what steps to take if
they feel they are being retaliated against.
1. Communicate with the complaining employee. Explain that you are taking the complaint seriously. Tell the
employee that you want to hear about anything that happens that the employee considers hostile or negative. Refer the
employee to your antiretaliation policy. Explain what retaliation is. Tell the employee flat out that you won't tolerate
retaliation from anyone in the company.
2. Keep confidential any complaints that you receive. The fewer people who know about a complaint, the
smaller the chances are that someone will retaliate against the complainer. Of course, when you investigate the
employee's complaint, you will have to tell some people about it. Make sure that you tell only the people who absolutely
need to know. And, when you tell them, explain what retaliation is and tell them that you won't tolerate it. (For more
investigation tips, see Investigate a Workplace Complaint.)
3. Document, document, document. Take notes of everything you do to prevent retaliation. Send the
complaining employee a letter confirming what you have told him or her about retaliation.
Handling Discipline Problems
An adverse action is retaliatory only if it is taken because the employee complained. You are free to take actions against
an employee for other reasons, even if that employee has complained about discrimination or harassment.
For example:
1. You can give a negative evaluation to an employee with performance problems.
2. You can discipline an employee who is always late to work for tardiness.
3. You can fire an employee who brings a gun to work.
The problem for employers is that some employees will claim that these adverse actions are retaliation -- even if they have
nothing to do with the employee's complaint.
If you must take adverse action against an employee who has complained, be prepared to show that you had valid reasons
for discipline, unrelated to the complaint. Those reasons should be supported, if possible, by prior documented warnings to
the employee.
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1. Adopt a clear sexual harassment policy. In your employee handbook, you should have a policy devoted to
sexual harassment. That policy should:
1. define sexual harassment
2. state in no uncertain terms that you will not tolerate sexual harassment
3. state that you will discipline or fire any wrongdoers
4. set out a clear procedure for filing sexual harassment complaints
5. state that you will investigate fully any complaint that you receive, and
6. state that you will not tolerate retaliation against anyone who complains about sexual harassment.
2. Train employees. At least once a year, conduct training sessions for employees. These sessions should teach
employees what sexual harassment is, explain that employees have a right to a workplace free of sexual harassment,
review your complaint procedure, and encourage employees to use it.
3. Train supervisors and managers. At least once a year, conduct training sessions for supervisors and
managers that are separate from the employee sessions. The sessions should educate the managers and supervisors about
sexual harassment and explain how to deal with complaints. .
Some states require certain employers to conduct sexual harassment training. Most recently,
California passed a law requiring employers that have at least 50 employees to provide supervisors
with two hours of interactive sexual harassment training every two years, starting in January 2006.
Connecticut and Maine also require sexual harassment training. And other states strongly encourage
employers to provide such training, even if it isn't legally required. Even if your state doesn't require
or suggest training, it's still a good idea -- your managers will know what the law is and what to do
when employees complain, and, if you find yourself in a lawsuit, you'll be able to show that you took
steps to try to prevent harassment.
1. Monitor your workplace. Get out among your employees periodically. Talk to them about the work
environment. Ask for their input. Look around the workplace itself. Do you see any offensive posters or notes? Talk to your
supervisors and managers about what is going on. Keep the lines of communication open.
2. Take all complaints seriously. If someone complains about sexual harassment, act immediately to investigate
the complaint. If the complaint turns out to be valid, your response should be swift and effective.
The U.S. Equal Employment Opportunity Commission is the federal agency that enforces sexual harassment laws. To learn
more about sexual harassment, refer to the agency's website at www.eeoc.gov.
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Language Rules
An employer may be able to prohibit on-duty employees from speaking any language other than English if it can show that
the rule is necessary for business reasons. If you impose an English-only rule, you must tell employees when they have to
speak English (for example, whenever customers are present) and the consequences of breaking the rule. And, if an
employee challenges your English-only rule, you will have to defend its scope: a rule that forbids workers from ever
speaking another language, even during breaks or when a customer who speaks that language is present, is probably too
broad.
Accent Rules
Because an employee's accent is often associated with his or her national origin, employers must tread carefully when
making employment decisions based on accent. An employer may decide not to hire or promote an employee to a position
that requires clear oral communication in English if the employee's accent substantially affects his or her ability to
communicate clearly. However, if the employee's accent does not impair his or her ability to be understood, you may not
make job decisions on that basis -- for example, you cannot simply adopt a blanket rule that employees who speak
accented English may not work in customer service positions.
Harassment Is Illegal, Too
Harassment on the basis of race and national origin is also prohibited. Harassment is any conduct based on a person's race
or national origin that creates an intimidating, hostile, or offensive work environment or interferes with the person's work
performance. Harassing conduct might include racial slurs, jokes about a particular ethnic group, comments or questions
about a person's cultural habits, or physical acts of particular significance to a certain racial or ethnic group -- for example,
hanging a noose in an African-American employee's locker.
Companies Are Paying the Price
In recent years, companies have been hit with huge verdicts -- or have agreed to pay massive settlements -- to employees
who have been discriminated against or harassed on the basis of race or national origin. For example:
1. In 2004, the EEOC announced a $50 million settlement of a race and sex discrimination lawsuit against the
clothing retail company Abercrombie & Fitch. Among the allegations were a claim that the clothier refused to hire female
and nonwhite applicants because they did not fit the image or "look" the company was trying to project in the
marketplace.
2. Consolidated Freightways Corporation of Delaware agreed to pay $2.75 million to settle a racial harassment
lawsuit filed by the Equal Employment Opportunity Commission (EEOC). Twelve African-American employees alleged that
they were subjected to racial intimidation, threats, assault, racist graffiti, and property damage, among other things.
3. Coca-Cola settled a class action race discrimination lawsuit for $192.5 million. African-American employees said
that Coke imposed a racial "glass ceiling" by discriminating against them in pay and promotions. Of the total settlement,
$36 million was earmarked for monitoring the company's employment practices to make sure that the discrimination
stopped.
4. In 2000, Commonwealth Edison Company agreed to pay $2.5 million to settle a lawsuit brought by a group of
Latino employees alleging discrimination based on national origin. The employees charged that the company failed to
promote them to middle management positions.
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1. Search only if necessary. In many companies, there will rarely be a need to search. Unless your employees
routinely handle large amounts of money or valuable and easily-hidden items (such as prescription drugs or jewelry), you
may not need to search at all. If you do want to conduct a search, make sure you have a legitimate business reason (theft,
for example).
2. Verify first, if possible. Before you conduct a search, check available sources of information (such as a security
camera or time cards) to rule out possibilities. If you search an employee whom you suspect of theft and you could easily
have discovered that the employee was not in the area where the theft occurred, for example, you might get into trouble.
1. If you plan to search, have a policy. If you warn your employees in advance that certain areas (like desks or
lockers) might be subject to search, employees will have lower expectations of privacy in those areas -- and less reason to
complain about a particular search.
2. Don't conduct random searches. Courts tend to frown on employers who conduct random searches of their
workers, even if the employer's policy puts employees on notice of this possibility. These searches, particularly if
conducted when the employer has no reason to suspect any wrongdoing, can get employers into trouble.
3. Never search an employee's body. Some employers become so zealous in their investigative efforts that they
want to conduct physical searches of their workers for contraband or stolen items. This is always a bad idea. Your worker
has a very strong privacy interest in his or her own body. If you have strong and legitimate concerns, consider calling the
police to take it to the next level.
4. Restrooms and changing rooms are generally off limits. Most workers legitimately expect that they will not
be filmed while using the toilet or changing their clothes. This expectation is highly reasonable. If you must monitor these
areas, warn your employees and monitor only to the extent necessary. And make sure your state's law doesn't prohibit
this type of surveillance.
5. Consider the worker's privacy expectations. Before you search, think about whether an average worker
would consider a particular space private in your workplace. Do your employees routinely lock their desk drawers? If so,
they might have higher privacy expectations. On the other hand, if no one has an assigned desk in your office, or if
workers routinely use each other's desks, an unlocked drawer is not as private.
1. Don't hold employees against their will. Some employers detain workers in connection with a search -- to
keep the worker out of the area being searched, for example, or to exert a little pressure on the worker to consent to a
search ("No one is leaving this room until you show me what's in your backpack!") This is a bad idea. Under a legal theory
called "false imprisonment," an employee can sue an employer who leads the employee to believe that he or she is not
free to leave.
Workplace Investigations: A Step-by-Step Guide, by attorney Lisa Guerin (Nolo), explains how to
conduct an investigation while avoiding privacy violations.
Phone Calls
Employers may monitor employee conversations with clients or customers for quality control. Some states require
employers to inform the parties to the call -- either by announcement or by signal (such as a beeping noise during the call)
-- that someone is listening in. However, federal law allows employers to monitor work calls unannounced.
An exception is made for personal calls. Under federal law, once an employer realizes that a call is personal, the employer
must immediately stop monitoring the call. However, if an employee has been warned not to make personal calls from
particular phones, an employer might have more monitoring leeway.
Voicemail Messages
Although this is not yet a settled question, employers probably have the right to peruse their employees' voicemail, at
least if the employer has a sound, work-related reason for monitoring. However, employees may have a legitimate gripe if
you led them to believe their voicemail boxes would be private by, for example, making a statement to that effect in your
policies, giving employees private voicemail box access codes, or allowing employees to make and receive personal calls at
work.
Email Messages
Employers generally have the right to read employee email messages, unless company policy assures workers that their
email messages will remain private. If the company takes steps to protect the privacy of email (by providing a system that
allows messages to be designated "confidential" or creating private passwords known only to the employee, for example),
a worker might have a stronger expectation of privacy in the messages covered by these rules. For the most part,
however, courts have upheld employers' rights to read employee email -- particularly if they have a compelling reason to
do so (to investigate a harassment claim or possible theft of trade secrets, for example).
Internet Use
Employers may keep track of the Internet sites visited by their workers. Some employers install devices that block access
to certain sites (sites with pornographic images, for example) or limit the time workers may spend on sites that are not
specified as work related.
Tips for Staying Within the Law
Employers currently have a lot of leeway in monitoring their employees' communications. However, the law in this field is
evolving rapidly, as technological change and increasing concerns about privacy pressure legislators and courts to take
action. If you decide to monitor your workers, consider following these tips:
1. Adopt a policy. Tell your workers that they will be monitored, and under what circumstances. If you indicate
that you will respect the privacy of personal phone calls or email messages, make sure that you live up to your promise.
The safest course is to ask employees to sign a consent form, as part of their first-day paperwork, acknowledging that they
understand and agree to the company's monitoring policies.
2. Monitor only for legitimate reasons. You will be on safest legal ground -- and waste less time and money -- if
you monitor only for sound, business-related reasons. If you have a reasonable suspicion that a particular employee is
engaging in unauthorized use of your equipment, that would certainly qualify as a legitimate cause for monitoring. Equally
sound reasons include keeping track of productivity or monitoring the quality of customer service.
3. Be reasonable. Employees will not perform their best work if they are in constant fear of eavesdropping.
Overreaching monitoring -- or unnecessarily draconian policies about personal use of communications equipment -- will
only result in employee resentment and attrition. It is reasonable to prohibit workers from spending hours on the phone
wooing a lover or catching up on gossip with an old friend. But it is unreasonable to prohibit brief personal calls of the "I'll
be home late" or "where shall we meet tonight" variety.
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Testing Employees
From the Nolo Business & Human Resources Center
Can you require your employees to submit to a medical exam, drug screen, psychological test, or lie detector
test? Find out the rules here.
Workplace testing has become increasingly popular, as employers screen their workers in an effort to figure out who would
be the best candidate for promotion or who is responsible for a workplace problem. As long as a test is designed to predict
a worker's actual ability to do the job (and is relatively non-invasive), it is probably legal. For example, an employer can
generally require typing tests for clerical jobs or agility/strength tests for positions requiring certain physical skills.
Privacy Violations
Employers who require their employees to take more comprehensive or intrusive tests can get into trouble for violating
their workers' privacy rights, particularly if the tests aren't closely related to the job in question. Generally, an employer
should have a sound, work-related reason to require a current employee to submit to testing. But that might not be
enough: if the test is too intrusive or delves too deeply into personal issues, it might invade the employee's right to privacy
(and result in a lawsuit).
For example, one California employer asked applicants to take a comprehensive psychological exam -- including agreeing
or disagreeing with such statements as "I am very strongly attracted by members of my own sex" or "I believe in the
second coming of Christ" -- before considering them for the position of store security guard. The company eventually paid
more than $2 million to settle the dispute.
There are few hard and fast rules about whether a particular test is legal -- courts generally decide these issues on a case-
by-case basis, looking at all the facts and circumstances. For the most part, employers can stay out of trouble by using
simple common sense. An employer who inquires into an employee's sex life or personal beliefs probably crosses the line,
while an employer who tests only for necessary job skills is probably on safe ground.
In addition to these general considerations, specific rules apply to particular types of tests.
Medical Examinations
The Americans With Disabilities Act (ADA) limits an employer's ability to administer medical tests that might unfairly
screen out workers with disabilities. Employers can require a medical examination only after a job offer has been made, for
example.
In addition, the ADA cloaks the results of a medical examination with certain privacy protections. Data gathered in medical
examinations must be kept in a separate file available only to those with a demonstrable "need to know."
Once an employee is already on the job, an employer's right to conduct a medical examination is usually limited to so-
called "fitness for duty" situations. Where an employee has exhibited objective indications that he or she is physically or
mentally unfit to perform the essential functions of the job, an employer may ask about the employee's condition or
request that the employee take a medical examination.
ADA Resource
You can find lots of information about the ADA's rules for medical examinations of current employees
in the Equal Employment Opportunity Commission's policy guidance on the subject, "Enforcement
Guidance: Disability-Related Inquiries and Medical Examination of Employees Under the Americans
With Disabilities Act (ADA)," available at www.eeoc.gov.
Drug Tests
Although an employer can generally require job applicants to submit to drug testing, state laws place more restrictions on
an employer's right to drug test current employees. For example, many states allow testing only for certain occupations or
in certain circumstances (for instance, if an employee has recently completed a rehabilitation program or has been
involved in a workplace accident). To find out more about your state's rules, contact your state labor department.
Psychological Screening
Some employers use pencil and paper psychological tests to attempt to predict whether an employee will steal, fight, or
engage in other misconduct in the workplace. There are two problems with using such tests. First, it is heavily disputed
whether these tests can accurately predict an employee's future conduct. Second, many of the test questions are highly
intrusive and invade the employee's privacy. For the most part, employers would be well-advised to steer clear of
psychological tests unless there is a compelling justification -- and a consultation with a lawyer.
Lie Detector Tests
The Federal Employee Polygraph Protection Act (29 U.S.C. § 2001) prohibits most private employers from requiring their
workers to submit to lie detector tests, with one exception: An employer may require a worker it reasonably suspects of
theft or embezzlement to take a polygraph test, if certain requirements are met. Aside from this limited exception,
however, an employer may not require a current employee to take a lie detector test, use the results of any such test, or
discipline or discharge any employee who refuses to take one. Many states ban polygraph testing outright, in any
circumstances.
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Many employers routinely give severance packages to long-term employees who are fired for reasons other than serious
misconduct, even if they are not legally required to do so. Why? To soften the blow of being fired and to buy a little
insurance against lawsuits. A severance package may help sweeten the sour grapes a worker feels about being fired. And a
happier former employee is a less litigious former employee.
If you decide to pay severance, the most important rule is to be consistent. The amount of severance can vary depending
on how long the employee has worked for you and the employee's job category. But be sure to treat your employees
equally. If you are evenhanded and uniform in paying severance, you are less likely to face claims of discrimination (for
example, that men received higher severance pay than women).
What to Include in a Severance Package
There are no hard-and-fast rules about what constitutes a severance package. The idea is to ease the burden on the fired
employee. To this end, you might want to consider including any or all of the following benefits:
1. Pay. Realistically, this is what is most important to your employees. Many employers pay a set amount -- a week
or two of salary -- for every year of employment.
2. Insurance benefits. Some employers offer to pay for continuation of health, life, or disability insurance
coverage for a period of time after an employee is fired. Although a federal law called the Consolidated Omnibus Budget
Reconciliation Act (COBRA) requires some employers who offer group health insurance to offer their employees the
opportunity to continue their coverage, it does not require employers to foot the bill. Many states also have health
insurance continuation laws, and a few of them require some employers to pay for a short period of continued coverage; to
find out about your state's rules, contact your state insurance department.
3. Uncontested unemployment compensation. Fired employees can claim unemployment benefits if they were
fired for reasons other than serious misconduct. After an employee applies for benefits, the employer has the opportunity
to contest the employee's claim. If you don't contest an employee's claim, it is much more likely that the employee will
receive benefits.
4. Outplacement services. An outplacement program is designed to help an employee find a new job. It may offer
counseling on career goals and job skills, tips on resume writing, leads for potential jobs, practice interview sessions, and
help in negotiating with potential employers.
1. References. You might agree to come up with a mutually agreeable letter of reference for an employee to use in
job hunting. But proceed with caution here. Providing references carries some possible risks.
2. Other benefits. Certain benefits or items may be particularly important to a departing employee. If possible,
have an honest discussion with your worker to find out what he or she would like in a severance package. You might want
to consider allowing the employee to keep advances or money paid for moving expenses, letting an employee keep
equipment (such as a cell phone or computer), or releasing an employee from contractual obligations, like a covenant not
to compete.
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Alabama No statute
Alaska
If employee is fired: within three days.
If employee quits: next regular payday at least three days after employee gives notice. (Alaska
Stat. § 23.05.140.)
Arizona
If employee is fired: within three days or next payday, whichever is sooner.
If employee quits: next payday. (Ariz. Rev. Stat. Ann. § 23-353.)
Colorado
If employee is fired: immediately.
If employee quits: next scheduled payday. (Colo. Rev. Stat. Ann. § 8-4-109.)
Connecticut
If employee is fired: next business day.
If employee quits: next scheduled payday. (Conn. Gen. Stat. Ann. § 31-71c.)
Delaware
If employee is fired: next scheduled payday.
If employee quits: next scheduled payday. (Del. Code Ann. tit. 19, § 1103.)
District of Columbi
If employee is fired: next business day.
a
If employee quits: next scheduled payday or within seven days, whichever is sooner. (D.C. Code
§ 32-1303.)
Florida No statute.
Georgia No statute.
Hawaii
If employee is fired: immediately or next day, if conditions prevent immediate payment.
If employee quits: next scheduled payday or immediately, if employee gives one pay period's
notice. (Haw. Rev. Stat. § 388-3.)
Idaho
If employee is fired: next payday or within 10 days, whichever is sooner. If employee makes a
written request for earlier payment, within 48 hours of receiving request.
If employee quits: next payday or within 10 days, whichever is sooner. If employee makes a
written request for earlier payment, within 48 hours of receiving request.(Idaho Code §§ 45-606,
45-617.)
Illinois
If employee is fired: next scheduled payday.
If employee quits: next scheduled payday. (820 Ill. Comp. Stat. 115/5.)
Indiana
If employee is fired: next scheduled payday.
If employee quits: next scheduled payday. If employee has not provided a forwarding address,
employer may wait until ten days after employee demands wages or provides an address where the
check may be mailed. (Ind. Code §§ 22-2-9-2 and 22-2-5-1.)
Iowa
If employee is fired: next scheduled payday.
If employee quits: next scheduled payday. (Iowa Code Ann. § 91A.4.)
Kansas
If employee is fired: next scheduled payday.
If employee quits: next scheduled payday. (Kan. Stat. Ann. § 44-315.)
Kentucky
If employee is fired: next scheduled payday or within 14 days, whichever is later.
If employee quits: next scheduled payday or within 14 days, whichever is later. (Ky. Rev. Stat.
Ann. § 337.055.)
Louisiana
If employee is fired: next payday or within 15 days, whichever is earlier.
If employee quits: next payday or within 15 days, whichever is earlier. (La. Rev. Stat. Ann. §
23:631.)
Maine
If employee is fired: next scheduled payday or within two weeks after demand, whichever is
earlier.
If employee quits: next scheduled payday or within two weeks after demand, whichever is earlier.
(Me. Rev. Stat. Ann. tit. 26, § 626.)
Maryland
If employee is fired: next scheduled payday.
If employee quits: next scheduled payday. (Md. Lab. & Emp. Code Ann. § 3-505.)
Massachusetts
If employee is fired: immediately.
If employee quits: next scheduled payday or the Saturday following the employee's resignation, if
there is no scheduled payday. (Mass. Ann. Laws ch. 149 § 148.)
Michigan
If employee is fired: next payday.
If employee quits: next payday. (Mich. Comp. Laws §§ 408.474, 408.475.)
Minnesota
If employee is fired: immediately.
If employee quits: next payday. If payday is less than five days after last day of work, employer
may pay on the following payday or 20 days after last day of work, whichever is earlier. (Minn. Stat.
§§ 181.13 and 181.14.)
Mississippi No statute
Montana
If employee is laid off or fired for cause: immediately. Employer may have a written policy
extending this time to the next payday or within 15 days, whichever is earlier.
If employee quits: next payday or within 15 days, whichever is earlier. (Mont. Code Ann. § 39-3-
205.)
Nebraska
If employee is fired: next scheduled payday or within two weeks, whichever is earlier. (Neb. Rev.
Stat. § 48-1230.)
Nevada
If employee is fired: immediately.
If employee quits: next scheduled payday or within seven days, whichever is earlier. (Nev. Rev.
Stat. §§ 608.020 to 608.030.)
New Hampshire
If employee is fired: within 72 hours. If employee is laid off, employer may wait until the next
payday.
If employee quits: next scheduled payday or within 72 hours, if employee gives one pay period's
notice. (N.H. Rev. Stat. Ann. § 275:44.)
New Jersey
If employee is fired: next scheduled payday.
If employee quits: next scheduled payday. (N.J. Stat. Ann. § 34:11-4.3.)
New Mexico
If employee is fired: within 5 days. If the employee is paid by task or commission, within 10 days.
If employee quits: next payday. (N.M. Stat. Ann. §§ 50-4-4 and 50-4-5.)
New York
If employee is fired: next scheduled payday.
If employee quits: next scheduled payday. (N.Y. Labor Laws § 191.)
North Carolina
If employee is fired: next scheduled payday. If the employee is paid by commission or bonus,
next payday after amount calculated.
If employee quits: next scheduled payday. If the employee is paid by commission or bonus, next
payday after amount calculated. (N.C. Gen. Stat. § 95.25.7.)
North Dakota
If employee is fired: next payday or within 15 days, whichever is earlier.
If employee quits: next payday. (N.D. Cent. Code § 34-14-03.)
Ohio If employee quits: first of the month for wages earned in the first half of prior month; fifteenth of
the month for wages earned in second half of prior month. (Ohio Rev. Code Ann. § 4113.15.)
Oklahoma
If employee is fired: next scheduled payday.
If employee quits: next scheduled payday. (Okla. Stat. Ann. tit. 40, § 165.3.)
Oregon
If employee is fired: end of next business day.
If employee quits: immediately if employee has given 48 hours' notice. Without notice, within five
days or the next payday, whichever occurs first. (Or. Rev. Stat. § 652.140.)
Pennsylvania
If employee is fired: next scheduled payday.
If employee quits: next scheduled payday. (43 Pa. Cons. Stat. Ann. § 260.5.)
Rhode Island
If employee is fired: next scheduled payday.
If employee quits: next scheduled payday. (R.I. Gen. Laws § 28-14-4.)
South Carolina If employee is fired: within 48 hours or next scheduled payday, but not more than 30 days. (S.C.
Codified Laws § 41-10-50.)
South Dakota
If employee is fired: next payday or when employee returns employer's property.
If employee quits: next payday or when employee returns employer's property. (S.D. Codified
Laws §§ 60-11-10 and 60-11-14.)
Tennessee
If employee is fired: next scheduled payday or within 21 days, whichever is later.
If employee quits: next scheduled payday or within 21 days, whichever is later. (Tenn. Code. Ann.
§ 50-2-103.)
Texas
If employee is fired: within six days.
If employee quits: next payday. (Texas Code Ann., Labor § 61.014)
Utah
If employee is fired: within 24 hours.
If employee quits: next regular payday. (Utah Code Ann. § 34-28-5.)
Vermont
If employee is fired: within 72 hours.
If employee quits: next scheduled payday or, if no scheduled payday exists, the next Friday. (Vt.
Stat. Ann. tit. 21, § 342.)
Virginia
If employee is fired: next scheduled payday.
If employee quits: next scheduled payday. (Va. Code § 40.1-29.)
Washington
If employee is fired: next pay period
If employee quits: next pay period. (Wash. Rev. Code § 49.48.010.)
West Virginia
If employee is fired: within 72 hours.
If employee quits: Immediately if employee has given one pay period's notice; otherwise, next
regular payday. (W. Va. Code § 21-5-4.)
Wisconsin
If employee is fired: next payday or within one month, whichever is earlier. If termination is due
to merger, relocation, or liquidation of business, within 24 hours.
If employee quits: next payday. (Wis. Stat. Ann. § 109.03.)
Wyoming
If employee is fired: five business days.
If employee quits: five business days. (Wyo. Stat. Ann. § 27-4-104.)
It can be challenging to figure out what to tell the rest of your workforce when an employee leaves
on less-than-positive terms.Our advice: Don't go into detail. Shortly after an employee is fired, make
a brief statement to your other workers, saying that the employee is no longer with the company.
Tell them who will handle the tasks that person was responsible for, and ask them to direct any
questions to you.
1. Warn a difficult employee that your reference won't be good. Yes, the employee should know this already.
But you can avoid problems at the outset by stating the obvious: "I cannot provide a positive reference for you."
2. Keep it brief. Some employers adopt a policy of only giving out dates of employment, job title, and final salary
to prospective employers. If you choose to tell more, keep it to a minimum.
3. Stick to the facts. Now is not the time to speculate about your former employee's bad qualities, or to opine on
the reasons for his or her failure to perform. Limit your comments to accurate, easily documented information.
4. Don't be spiteful. Many states offer some protection for former employers called upon to provide a reference.
These laws generally provide that you will be shielded from defamation lawsuits as long as you provide information in good
faith. This is a fairly nebulous legal standard, but it surely does not cover nasty or mean-spirited gripes.
5. Don't give false flattery. If you had to fire a real bad egg (for example, a worker who was violent in the
workplace or threatened coworkers), don't lie about it. You may choose to give only name, rank, and serial number, but, if
you give a more expansive reference, don't hide the bad news. You may find yourself in legal trouble for failing to warn the
new employer about these serious problems.
1. Designate one person to give references. Choose one trusted person in your company to be responsible for
all references, and tell all of your employees to direct inquiries to that person. Make sure that a record is kept of every
request for a reference and every response, in case of later trouble. And you may want to adopt a policy of providing
references only in writing, so you'll have proof of exactly what was said.
2. Insist on a written release. If you want to make absolutely sure that you're protected against lawsuits, require
former employees to sign a release -- an agreement that gives you permission to provide information to prospective
employers (and promises not to sue you for doing so).
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1. You must give the employee something in exchange for the release. You are asking the employee to
waive the right to sue you, and that right is worth something. This means that if you ordinarily offer a severance package
to those employees who are not asked to sign a release, you will have to give something extra to employees who do sign.
Specify what you will provide (typically, a sum of money) in the release.
1. Be clear about the rights the employee is waiving. You might state that the employee is waiving any right
to sue you for claims arising out of the employment relationship, including the termination of that relationship. In any
case, make sure the release is specific enough to forestall any later claim that the employee did not know what it covered
-- and comprehensive enough to cover every claim the employee might conceivably raise.
2. Give the employee plenty of time to decide whether to sign. It is reasonable for an employee to take a
week or two to decide whether to give up the right to sue you. You might even suggest that the employee consult with a
lawyer to review the agreement.
3. Avoid any hint of coercion. An employee's decision to sign a release must be voluntary, or courts will not
enforce the release. Don't threaten or talk tough with your employees to convince them to sign; you won't be gaining
anything if your release gets thrown out of court.
4. Special rules apply to older workers. If the employee is 40 years of age or older, a federal law -- the Older
Workers' Benefits Protection Act (OWBPA) -- dictates what must be included in a release. Among other things, you must
give these employees a longer period of time to review the release, allow them to revoke the agreement (in other words,
to change their minds) for a limited time after they sign, and advise them in writing to consult with an attorney. You can
find more information about the OWBPA at the website of the Equal Employment Opportunity Commission, www.eeoc.gov.
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1. A pizza company hired a delivery driver without looking into his criminal past -- which included a sexual assault
conviction and an arrest for stalking a women he met while delivering pizza for another company. After he raped a
customer, the pizza franchise was liable to his victim for negligent hiring.
2. A car rental company hired a man who later raped a coworker. Had the company verified his resume claims, it
would have discovered that he was in prison for robbery during the years he claimed to be in high school and college. The
company was liable to the coworker.
3. A furniture company hired a delivery man without requiring him to fill out an application or performing a
background check. The employee assaulted a female customer in her home with a knife. The company was liable to the
customer for negligent hiring.
Avoiding Claims of Negligent Hiring or Retention
Many states have allowed claims for negligent hiring and negligent retention. Although these lawsuits have not yet
appeared in every state, the clear legal trend is to allow injured third parties to sue employers for hiring or keeping on a
dangerous worker. What can you do to stay out of trouble? Here are a few tips:
1. Perform background checks. Make it your policy to run a routine background check before you hire an
applicant. Verify information on resumes, look for criminal convictions (to the extent allowed in your state), and check
driving records. These simple steps will weed out many dangerous workers -- and help you show that you were not
careless in your hiring practices.
1. Use special care in hiring workers who will have a lot of public contact. You are more likely to be held
responsible for a worker's actions if the job involves working with the public. These workers all require more careful
screening:
1. workers who go to a customer's home (to make deliveries, perform home repairs, or manage apartment
buildings, for example)
2. workers who deal with vulnerable people such as children, the elderly, or the disabled
2. Root out problem employees immediately. Under the theory of negligent retention, you can be responsible
for keeping a worker on your payroll after you learn (or should have been aware) that the worker poses a potential danger.
If an employee has made violent threats against customers, brings an unauthorized weapon to work, or racks up a few
moving violations, you have to take immediate action.
For more information on handling potentially dangerous workers, see Dealing With Problem Employees: A Legal Guide, by
attorneys Amy DelPo and Lisa Guerin (Nolo) and Workplace Investigations, by attorney Lisa Guerin (Nolo).
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Punishing Whistleblowers Can Lead to Trouble
From the Nolo Business & Human Resources Center
It’s never a good idea to kill the messenger.
State and federal laws -- including the Sarbanes-Oxley Act of 2002 -- protect whistleblowers from retaliation by their
employers. If you take disciplinary action against an employee who complains of fraud, illegalities, or other workplace
wrongdoing, you risk a lawsuit from the disciplined worker -- and possibly fines and even criminal charges brought by the
government.
What Is a Whistleblower?
A whistleblower is an employee who complains of company misconduct, such as health and safety violations, shareholder
fraud, or financial mismanagement. Usually, workers who don't make the initial complaint but participate in an
investigation of alleged wrongdoing are also considered protected whistleblowers. A number of federal and state laws
protect whistleblowers from being punished by their employers.
The Sarbanes-Oxley Act
In the wake of the Enron affair and other corporate mismanagement scandals, Congress enacted the Sarbanes-Oxley Act
(named after its Congressional sponsors) to force companies to straighten up. The Act is primarily aimed at preventing
shareholder fraud and financial shenanigans in publicly traded companies, but its provisions also create strong protections
for whistleblowers.
Under the Act, an employee who complains that his or her employer is breaking certain federal laws, including laws
relating to securities, shareholder fraud, or wire, mail, or bank fraud, is protected from retaliation. And the employee
doesn't have to be right to be protected: As long as the employee has a reasonable belief that a legal violation has taken
place, the employee is considered a whistleblower, even if that belief turns out to be mistaken.
An employee doesn't have to complain to a government agency to be protected. A complaint within the company -- to a
supervisor, for example -- triggers the Act's whistleblower protections.
Other Federal Laws Protecting Whistleblowers
A number of federal workplace laws also protect employees who complain of illegal activity. For example, an employee who
complains of discrimination or harassment is protected from retaliation by the employer. The same is true of an employee
who complains of unsafe or unhealthy workplace conditions, violations of the Family and Medical Leave Act, and violations
of wage and hour laws. These laws generally don't use the term "whistleblower," but they provide the same protection:
Employees cannot be fired or otherwise subjected to disciplinary action for making a complaint, whether within or outside
of the company.
Additional federal laws also protect those who complain of wrongdoing in specific industries or work relationships, such as
companies that have contracts to do work for the federal government or companies that deal in hazardous materials.
State Whistleblower Protections
Many state workplace laws also prohibit retaliation against those who complain that the law has been violated. These laws
include, for example, state laws regarding family and medical leave, state wage and hour laws, state laws requiring
employers to provide time off for jury duty and voting, and state antidiscrimination laws.
In addition, some states allow employees to bring lawsuits claiming that they were fired or disciplined "in violation of public
policy." Generally, these claims allege that the employee was fired or disciplined for exercising a legal right or complaining
about the company's illegal actions. The rules for bringing such claims vary widely from state to state. Some states allow
employees to bring a violation of public policy claim only if they complain to government officials, while others allow an
employee who makes an internal complaint to sue. Some states allow employees to sue only if the law that was allegedly
violated contains an explicit antiretaliation or whistleblower provision, while other states allow employees to bring a claim
based on any violation of laws or regulations -- or even based on actions that are unethical even if they are not explicitly
illegal. And some states don't recognize public policy claims at all.
Avoiding Whistleblower Claims
Whistleblower lawsuits can be very damaging to a company's reputation and pocketbook. Happily, you can go a long way
towards preventing whistleblower claims by following a few simple steps:
1. Don't blame the messenger. It's not always easy to treat complaining employees with respect, particularly if
they are alleging misconduct that is disturbing. You may not want to believe that illegal activity is going on in your
company. But taking your frustration out on the employee who raises the issue will lead to trouble. Instead, treat the
complaint as an opportunity to make any changes necessary to bring your workplace back in line.
2. Adopt a complaint policy. The Sarbanes-Oxley Act imposes specific complaint-handling requirements on
publicly traded companies. Even if you don't have to follow these rules, you should have a complaint policy -- and make
sure that your employees understand how to use it. Emphasize that you will not retaliate against those who make
complaints. (You can find a sample complaint policy -- as well as policies on dozens of other workplace issues -- in Create
Your Own Employee Handbook, by Lisa Guerin and Amy DelPo (Nolo).)
3. Investigate complaints. Once you receive a complaint of wrongdoing, investigate it thoroughly and take action
to correct misconduct. If you don't investigate complaints, your employees will be discouraged from making them in the
first place -- and may decide to take their concerns directly to government agencies or lawyers.
1. Think twice before disciplining a whistleblower for unrelated conduct. Sometimes, an employee who
blows the whistle is genuinely deserving of discipline on other grounds. For example, an employee who has performance
problems may merit a written warning, even if he or she has recently complained of illegal conduct. However, you should
be very careful before taking this type of action; consider consulting with a lawyer before deciding what to do, particularly
if you don't have documentation showing that the employee's problems predated the employee's complaint.
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3. terminating an employee for exercising a legal right (such as voting or taking family leave).
Good Cause
As explained above, most employment contracts require that employees be terminated only for good cause. The exact
meaning of good cause varies from state to state, but generally it means what it says: You must have a legitimate reason
for firing the employee. In general, the termination must be based on reasons related to business needs and goals. Firing
an employee because you don't like the fact that she has an illegitimate child, for example, isn't good cause. Firing an
employee because he harasses female coworkers is.
Other examples of good cause include the following:
1. poor job performance
2. low productivity
3. refusal to follow instructions
4. habitual tardiness
5. excessive absences from work
6. possession of a weapon at work
7. threats of violence
8. violating company rules
9. stealing or other criminal activity
10. dishonesty
11. endangering health and safety
12. revealing company trade secrets
13. harassing coworkers
14. disrupting the work environment
15. preventing coworkers from doing their jobs, and
16. insubordination.
What's Below:
What is an independent contractor?
What are the benefits and drawbacks of being self-employed?
Do I need to use written agreements when I do contract work for clients?
How do I decide how much to charge for my work?
Do I have to pay taxes on my freelance income?
How can I make sure that my clients pay me?
Who decides whether I'm an employee or an independent contractor?
What happens if a government agency decides that I am an employee?
What is an independent contractor?
An independent contractor (IC) is someone who runs his or her own business. Independent contractors earn their
livelihoods from their own independent businesses instead of depending upon an employer to earn a living. Independent
contractors are sometimes called consultants, freelancers, self-employed, and even entrepreneurs and business owners.
Unlike an employee who works for one employer, independent contractors typically work for a number of different clients,
tackling particular jobs or projects that require special expertise.
Back to top
What are the benefits and drawbacks of being self-employed?
There can be many advantages to being self-employed:
1. You are your own boss.
2. You may be paid more than employees.
3. No federal or state tax is withheld from your pay.
4. You can take increased business deductions.
Despite the advantages, however, being self-employed is no bed of roses. Here are some of the major drawbacks.
1. You have no job security.
2. You might not get paid.
3. You must pay self-employment taxes.
4. You may be personally liable for business debts.
5. You have no employer-provided benefits.
6. You have no unemployment insurance benefits.
7. You have no employer-provided workers' compensation.
8. You have few labor law protections.
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Do I need to use written agreements when I do contract work for clients?
You really should. Using a written agreement avoids disputes by providing a written description of the services you're
supposed to perform, when they are to be performed, and how much you will be paid.
A written independent contractor agreement can also help establish that you really are an independent contractor -- not
your client's employee. Although an agreement by itself doesn't definitively prove that a worker qualifies as an
independent contractor, it will help show the IRS and other agencies that both you and the hiring firm intended to create a
hiring firm-independent contractor relationship, not an employer-employee relationship.
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How do I decide how much to charge for my work?
When you're just starting out as an independent contractor, it can be tough to figure out what to charge your clients. You'll
want to come up with a figure that pays your expenses, adequately compensates you for your time, and allows you to earn
at least some profit. And, of course, you'll have to make sure not to charge more than the market will bear -- if freelancers
in your area are willing to perform the same work for a much lower fee, you probably won't drum up much business.
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Do I have to pay taxes on my freelance income?
When you work as an independent contractor, you have to pay income tax, just like an employee. Unlike an employee,
however, you won't have any taxes withheld from your paycheck to cover income tax, Social Security, and Medicare. And
also unlike an employee, you can't wait until April 15 to pay all of your taxes due for the previous year. Instead, you have
to pay estimated taxes four times a year.
Fortunately, contractors can take advantage of some great tax deductions; for instance, the home office deduction can
effectively take some money off your rent or mortgage.
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How can I make sure that my clients pay me?
Many consultants find that they spend way too much time acting as a collection agency, going after deadbeat clients who
refuse to pay their bills. The best way to avoid this problem is to use a written client agreement, clearly setting forth your
fees (including late charges) and a payment schedule.
If a client still won't pay, you should start turning up the heat by persistently demanding payment and pursuing your legal
options, if necessary.
Back to top
Who decides whether I'm an employee or an independent contractor?
Initially, it's up to you and each hiring firm you deal with to decide whether you should be classified as an independent
contractor or an employee. But this decision is subject to review by various government agencies, including the IRS and
state workers' compensation and unemployment compensation agencies.
The IRS looks at a number of factors when determining whether a worker is an employee or an independent contractor.
The agency is more likely to classify as an independent contractor a worker who:
1. can earn a profit or suffer a loss from the activity
2. furnishes the tools and materials needed to do the work
3. is paid by the job
4. works for more than one firm at a time
5. invests in equipment and facilities
6. pays his or her own business and traveling expenses
7. hires and pays assistants, and
For more information on the criteria used to determine whether a worker is an employee or an independent contractor,
see Preserving Your Status as an Independent Contractor.
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What happens if a government agency decides that I am an employee?
If a government agency determines that you should have been classified as an employee, you'll suffer some consequences.
For example, the hiring firm may decide not to use you any more because it doesn't want to pay the additional expenses of
treating you as an employee. Or, the hiring firm may insist on reducing your compensation to make up for the extra
employee expenses. And reclassification as an employee could create additional tax burdens for you, if you have to forego
some of the tax deductions to which you were entitled as a contractor.
In addition, the hiring firm can suffer severe consequences. The IRS may impose substantial assessments and penalties on
the firm. At the very least, the firm will have to pay 20% of the Social Security and Medicare taxes that should have been
withheld from your pay, 100% of the Social Security, Medicare, and federal unemployment taxes the employer should
have paid, a penalty equal to 1.5% of your compensation, interest and sometimes other hefty penalties as well.
Back to top
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Thinking about starting your own business? Here are some questions you should ask yourself before you get
started.
What's Below:
How do I evaluate and develop a business idea?
What type of business should I start?
Are there any types of businesses I should avoid?
What are the benefits of starting my own business?
What are the risks of starting my own business?
How can I tell if my business will make money?
How do I evaluate and develop a business idea?
1. Determine if it's the right type of business.
5. Write a business plan, including a profit/loss forecast and a cash flow analysis.
Back to top
What type of business should I start?
There are so many different kinds of businesses -- and so many different kinds of people -- that it's impossible to give
specific advice on the particular type of business you should start. Only you will be able to answer that question, but to
maximize your chances of success, you should:
1. Choose something you enjoy doing. It's much more difficult (and a lot less fun) to make a success of a small
business that doesn't interest you -- for instance, running an autoparts store when your heart is really in graphic design.
2. Choose a business you know intimately. Trying to learn a new industry or skill at the same time you're
getting your business up and running will add a lot of unnecessary stress to your new venture and lower your chances of
success. Sure, it might be fun to run a hair salon, but if you've spent the last ten years baking pastries and don't have any
experience cutting hair, you might be better off starting a catering business or opening your own bakery. That's not to say
that you can't learn a new business -- but you should learn how to run a pizza parlor before you blow Aunt Sadie's
retirement money on a wood-burning pizza oven.
3. Choose a business that has a good chance of turning a profit. The best way to determine your business's
potential profitability is to prepare a "break-even analysis," a financial projection that will estimate how easy or difficult it
will be to turn a profit.
Back to top
Are there any types of businesses I should avoid?
Businesses that use hazardous materials, make edible goods, care for children, sell alcohol, or build or repair structures,
vehicles, or other items of value come with inherent risks. Unless you are prepared to start a corporation or limited liability
company and can afford adequate liability insurance (which can be pricey), you may be better off working for one of these
businesses rather than starting your own. For more information,
In addition, there are some types of businesses that are partcularly vulnerable to competition, including restaurants,
bookstores, video rental stores, movie theaters, grocery stores, and Internet and computer service providers. But these
businesses sometimes do survive, especially if they can fill a niche market and develop a loyal following.
Back to top
What are the benefits of starting my own business?
Starting a business can be scary. But great rewards await entrepreneurs lucky enough to create successful small
businesses -- benefits you may miss out on if you remain a wage earner for the rest of your life. Although only you can
decide if you're ready to quit your job and plunge into running your own business, here are some of the rewards of going
out on your own:
1. Independence and flexibility. You'll have more freedom and independence working for yourself. And once your
business is firmly established, you'll probably have the flexibility to make sure you don't miss the moments and events
that matter most to you in life.
2. Personal fulfillment. Owning and running your own business can be more satisfying and fulfilling than working
for someone else. Many successful small business owners find they enjoy the respect they earn from their peers for having
the courage to go out on their own.
3. Power. Don't be surprised if power is one of your goals. When it's your business, you can have your employees
do it your way. If power is important to you, think about how to use it in a constructive way.
4. Money. The risks of forgoing a steady paycheck can pay off when you own your own business. You can get rich
in a small business, or at least do very well financially. Although most entrepreneurs don't get wealthy, some do.
Back to top
What are the risks of starting my own business?
Although you can reap many benefits by starting your own business, there are definitely some risks. The most common
include:
1. Losing money. You're going to need money to get your small business started. Whether you raid your savings
account, hit up friends and relatives, or borrow from a bank, there's a very real possibility that your business won't
succeed and that you, your friends, and/or the bank will never see that money again. If your business idea is risky, ask
yourself whether you're willing to gamble your retirement, your friendships, and even your good credit on your business
idea.
2. Personal sacrifice. Business success can come at a high personal cost. Getting your business up and running
may consume most of your time and energy, including your precious evenings and weekends. You may not have much
time for family or friends or the extra cash to take a second honeymoon with your spouse. Before you quit your job, decide
whether you (and your family) are ready to make some of the personal sacrifices necessary for you to create a successful
small business.
Back to top
How can I tell if my business will make money?
Even a good business idea might not be financially workable. To learn how your idea will fare, you should prepare what's
called a "break-even analysis." In a break-even analysis, you project income and expense estimates for a year to
determine whether, in theory at least, your business will make enough sales revenue to pay its expenses.
A break-even forecast includes the following:
1. how much your business will earn over a specified period of time (your projected sales revenue)
2. your fixed costs, such as rent and insurance
3. your profit after deducting the direct cost of the product or service you provide (your gross profit), and
4. the sales revenue you will need just to keep your business running (your "break-even point" or "break-even
revenue").
If you find your break-even revenue represents an amount of work your business can handle -- that is, if you can easily
bring in more than the amount of sales revenue you'll need to meet your expenses -- then your business stands a good
chance of making money.
Back to top
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Copyright 2006 Nolo
Here are answers to some of your most frequently asked questions about raising money for your small
business.
What's Below:
How can I raise money for my business?
What are the main differences between borrowing money and selling ownership interests in my business?
How do business loans work?
If I borrow money, what are my repayment options?
How do I sell ownership interests in my business?
How can I raise money for my business?
The main ways to raise money are borrowing it from a friend, family member, or a commercial lender, or selling ownership
interests (equity) in your business. There’s no hard and fast rule about the best way to raise money -- you’ll have to
evaluate your situation and decide what kind of loan or investment you're willing to take. (And, of course, whoever loans
or gives you money will have some input, too.)
If you'll be going beyond family and friends for loans or equity investments, you'll need a business plan.
Back to top
What are the main differences between borrowing money and selling ownership interests in my business?
If you take out a loan, you will repay the money over time (usually monthly), with interest. The lender won’t receive an
ownership interest in your business, and you won’t have to share any of your future profits with the lender.
By contrast, if you raise money by selling equity (ownership interests), you won’t have to make these monthly payments
or repay the investment at any particular date. Instead, if your business is profitable, you’ll have to share those profits
with your investors, generally in proportion to the percentage of the business they own.
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How do business loans work?
Business loans work just like any other loan -- you and the lender agree on an interest rate and a payment schedule, and
you sign a promissory note that sets out your agreement in writing. The lender may require you to provide security for the
loan, such as your home or other valuable personal property, that the lender can take if you fail to repay the money.
Back to top
If I borrow money, what are my repayment options?
If you decide to borrow money to raise start-up cash, there are a number of different ways you can repay it. The most
common repayment schedule involves making equal monthly payments that incorporate both loan principal and interest.
However, you can also make lower monthly payments for a short period of time, and pay off the remaining principal and
interest in one large balloon payment. Or, you can make monthly payments of interest, and then make one large balloon
payment of the principal and the remaining interest on a specified date.
Back to top
How do I sell ownership interests in my business?
If you're going to raise money by taking in co-owners, the first thing you'll need to decide is whether to structure your
business as a general partnership, a corporation, a limited liability company, or a limited partnership. There are
advantages and disadvantages to each of these types of business organizations, so be sure to research your choice
thoroughly.
In addition, depending on how many investors you take in and how much money you raise, you may need to comply with
federal and state securities laws.
Back to top
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What's Below:
What is a business plan?
Do I need to create a business plan even if I'm not going to borrow money?
How do I write a business plan?
What is a business plan?
A business plan is a written document that describes the business you want to start and how it will become profitable. A
business plan usually begins with a statement outlining the purpose and goals of the business and goes on to show how
the business owner will realize those goals, including a detailed marketing strategy. A complete business plan also contains
a formal break-even analysis, a profit-and-loss projection, and a cash-flow analysis designed to show that if the business
develops as expected, it will make money.
For more information, see The Essentials of a Business Plan.
Back to top
Do I need to create a business plan even if I'm not going to borrow money?
Absolutely. A business plan isn't just window dressing to attract potential investors or market your business to potential
lenders. A solid business plan should sell you, the potential owner, on the financial viability and soundness of your business
idea.
Creating a business plan will force you to think about key issues before you start your business -- such as how you'll raise
money and what your projected start-up costs and marketing strategies are -- and will help you figure out if your idea is a
winner.
If you write a business plan, complete with a break-even analysis, profit-and-loss forecast, and cash flow projection, you
can tinker with your idea and improve it before you start. On the other hand, you may take an honest look at the numbers
and find that hoped-for profits are unlikely to materialize. In this case, one of the most important purposes of writing a
good business plan is to talk yourself out of starting a bad business.
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How do I write a business plan?
The structure, content, and format of your business plan will depend on your business idea and your intended audience. If
you're trying to raise money from investors or borrow money from a bank, your business plan will have to present solid
financial data and market research in a professional, polished package. On the other hand, if you're funding your business
yourself, you can probably forgo the sales pitch (and the fancy paper), but the basic principle is the same: Do your
homework and create a business plan that gives you a realistic picture of your proposed business.
To learn more about creating a solid business plan, see The Essentials of a Business Plan.
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Copyright 2006 Nolo
Get answers to your questions about domain names and trademarks, and how the two can conflict.
What's Below:
When does an Internet domain name qualify as a trademark?
How can I find out whether a trademark I want to use as a domain name is already being used?
What happens if there is a conflict between an Internet domain name and an existing trademark?
Can a business trademark a domain name for future use?
When does an Internet domain name qualify as a trademark?
A domain name, such as nolo.com, can qualify as a trademark when it is used in connection with a website that offers
services to the public. This includes all sites conducting e-commerce and sites such as Yahoo.com that provide Web-related
services.
However, only some types of commercial domain names qualify for trademark protection. For instance, while domain
names that use common or descriptive terms, such as healthanswers.com or stampfinders.com, may work very well to
bring users to a website, they usually do not qualify for much trademark protection. This means that owners of such
domain names generally won't have much luck stopping the use of these words and phrases in other domain names. In
other words, by using common terms that are the generic name for the service (for example, "dictionary.com") or by using
words that merely describe the service or some aspect of it (for example, "returnbuy.com"), the owner of the name will
have less trademark rights against the users of similar domain names than she would if her domain name was distinctive.
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How can I find out whether a trademark I want to use as a domain name is already being used?
Because so much business is now being done online, most people will want to be able to use their proposed trademark as
a domain name so that their customers can easily locate them on the Web.
The easiest way is to check if a domain name is available is at one of the dozens of online companies that have been
approved to register domain names. A listing of these registrars can be accessed at either the InterNIC site or at the
ICANN site. ICANN is the organization that oversees the process of approving domain name registrars. Every registrar
provides a searching system to determine if a domain name is available. Type in the domain name choice and the registrar
will determine if it is available.
If you find that a domain name is already taken, it's possible to locate information about the
owner of the domain name. A simple way to check ownership is to use Whois.net. Type in the
domain name, and the website provides the contact information supplied by the domain name
registrant.
Beware that some registrants, especially those acting in bad faith, may supply false information
about domain name ownership and in these cases, there’s not much that can be done to track
down the domain name holder.
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What happens if there is a conflict between an Internet domain name and an existing trademark?
Even if a company owns a federally registered trademark, someone else may still have the right to the domain name. For
example, many different companies have federally registered the trademark Executive for different goods or services. All of
these companies may want www.executive.com but the first one to purchase it—in this case, Executive Software—is the
one that acquired the domain name and has the rights to it.
Sometimes a person (known as a “cybersquatter”) registers a trademark as a domain name hoping to later profit by
reselling the domain name back to the trademark owner. If you believe that someone has taken a domain in bad faith, you
can either sue under the provisions of the Anticybersquatting Consumer Protection Act (ACPA), or you can fight the
cybersquatter using an international arbitration system created by the Internet Corporation of Assigned Names and
Numbers (ICANN). The ACPA defines cybersquatting as registering, trafficking in, or using a domain name with the intent
to profit in bad faith from the goodwill of a trademark belonging to someone else. The ICANN arbitration system is
considered by trademark experts to be faster and less expensive than suing under the ACPA, and the procedure does not
require an attorney. For information on the ICANN policy, visit the ICANN site.
Courts and arbitrators generally side with trademark owners in these disputes and order the cybersquatter to stop using
the trademarked name.
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Can a business trademark a domain name for future use?
It is possible to acquire ownership of a trademark by filing an "intent-to-use" (ITU) trademark application with the U.S.
Patent and Trademark Office (PTO) before actually starting to use the domain name. The applicant must start using the
domain name within the required time limits -- six months to three years after the PTO approves the trademark,
depending on whether the applicant seeks and pays for extensions of time. The filing date of this application will be
considered the date of first use of the trademark as long as the applicant actually uses the trademark within the required
time limits.
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Copyright 2006 Nolo
Answers to commonly asked questions about choosing and registering a successful business name.
What's Below:
What's the best type of name for my business?
What issues should I keep in mind when picking a name for my business?
How do I find out if the business name I want is available?
What is a trademark?
What is the "legal name" of my business?
What is a fictitious business name?
Do I have to register my business name?
Can I change my business name to include "Inc." or "LLC"?
What's the best type of name for my business?
There's no one-size-fits-all formula for picking a great business name. The best name depends on a host of considerations
-- some as obvious as the kind of business you do, others as unique as your own tastes and style. There are, however, a
few guidelines that will steer you in the right direction. A good business name should:
1. be distinctive
2. be memorable
3. be easily spelled and pronounced
4. suggest the products or services you offer, and
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What issues should I keep in mind when picking a name for my business?
No doubt you'll spend hours brainstorming for a business name that represents your products or services -- a name that's
both marketable and infused with personality. To help the creative process along, you might surf the Web, browse the
dictionary, read trade magazines, and bounce ideas off of friends and colleagues. But as you hunt for the perfect name,
keep three main questions in mind:
1. Will your business name receive trademark protection?
2. Is your proposed business name available?
3. If your business will have a website, is a similar domain name available?
Plus, if you're starting a corporation, LLC, or limited partnership, you must comply with a few state rules for naming your
business.
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How do I find out if the business name I want is available?
You'll have to conduct a name and trademark search to make sure no one else is using the name you want to use (or a
very similar name) to market similar products or services. You should also check with your county clerk's office to see
whether your proposed name is already on the list of fictitious or assumed business names in your county. If you find that
your chosen name (or a very similar one) is registered as a trademark, or is listed on a fictitious or assumed name
register, you shouldn't use it.
If you're organizing your business as a corporation, LLC, or limited partnership, you must also make sure your business
name isn't the same as that of an existing corporation, LLC, or limited partnership in your state. If a name that is identical
or very similar to your proposed business name turns up in your state's database, you'll have to choose another.
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What is a trademark?
A trademark (sometimes called simply a "mark") is any word, phrase, design, or symbol used to market a product or
service. Technically, a mark used to market a service, rather than a product, is called a service mark, though the term
"trademark" is commonly used for both types of marks because they refer to the same group of legal protections. Owners
of trademarks have rights under both federal and state law that give them the power in many cases to prevent others from
using the same or confusingly similar trademarks.
To make sure your proposed business name won't step on someone else's rights to an existing trademark, you'll have to
do a trademark search. Also, when picking a business name, you should take care to choose a name that will be likely to
receive trademark protection and then take steps to protect your business name as a trademark.
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What is the "legal name" of my business?
The legal name of a business is the official name of the person or entity that owns a business. If you are the only owner of
your business, then its legal name is simply your full name.
If your business is a general partnership, and you have a written partnership agreement that gives a name to the
partnership, then that name is the legal name of the business. Otherwise, the legal name of a general partnership consists
of the last names of the owners.
For limited partnerships, LLCs, and corporations, the legal name of the business is the name registered with the state filing
office.
Your business's legal name will be required on all government forms and applications, and is particularly important to use
on your application for a federal employer identification number.
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What is a fictitious business name?
The term "fictitious business name" (or "assumed business name," "trade name," or "DBA" for "doing business as") is used
when a business uses a name that's different from its legal name. For instance, if John O'Toole names his sole
proprietorship Turtle's Classic Cars, the name "Turtle's Classic Cars" is a fictitious business name because it does not
contain John's last name, "O'Toole."
If your business uses a fictitious business name, you'll need to register it with a government agency -- in most states, your
local county clerk's office.
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Do I have to register my business name?
If you're starting a corporation, LLC, or limited partnership, your official business name will be automatically registered
when you file your articles of incorporation, articles of organization, or statement of limited partnership with your state
filing office. However, if you will sell products or services under a different name, you must also file a fictitious name
statement (sometimes called an "assumed" name statement) with the state or county where your business is
headquartered.
Other types of businesses may also have to comply with fictitious or assumed business name requirements. Generally, any
business that doesn't use its legal name as part of its business name must file a fictitious name statement with a
government agency, usually the county clerk's office.
You may also want to take advantage of the extra protection that registering your name as a trademark can give you.
While it's not required, registering your name as a trademark at the state and/or federal level can prevent other
businesses from using a name that's likely to be confused with your business name.
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Can I change my business name to include "Inc." or "LLC"?
Some people confuse choosing a business name with choosing a type of ownership structure, such as a corporation or
limited liability company (LLC). But you can't just tack "Inc." or "LLC" onto the end of your business name and start calling
yourself a corporation or LLC.
First you must form a corporation or LLC, and to do so you've got to follow certain filing procedures to register the new
type of company with your state.
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Copyright 2006 Nolo
Answers to commonly asked questions about choosing and registering a successful business name.
What's Below:
Should I rent or buy space for my business?
How do I pick a location for my business?
What is a commercial lease?
Are commercial lease terms negotiable?
How do I determine if the location I want is properly zoned for my business?
Should I rent or buy space for my business?
Almost all small businesses start out in leased (rented) premises, and most use leased space throughout the life of the
business. By leasing rather than buying, you avoid tying up valuable working capital, and it's easier to move to new
quarters if your space needs change.
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How do I pick a location for my business?
Commercial real estate brokers are fond of saying that the three most important factors in establishing a business are
location, location and location. While true for some businesses, for others, locating in a popular, high-cost area may be a
mistake. To make sure your space will suit the financial and physical needs of your business, ask yourself these questions:
1. Is location important for the success of your business?
2. What type of location is best for your business?
3. How much rent can you afford?
4. Is your proposed location appropriate for what you plan to do there?
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What is a commercial lease?
A commercial lease -- as opposed to a residential lease -- is a contract between a business and a landlord for the rental of
building space. A lease can be for a short term (as little as one month) or long term (up to ten or 15 years), and it can be
written or oral (spoken) -- although an oral lease for more than a year will generally not be enforced by a judge after the
first year.
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Are commercial lease terms negotiable?
Most landlords start out asking for lease terms that aren't in a business owner's best interest, but they are almost always
willing to make concessions. Of course, your bargaining power depends on your local rental market -- if the market is
tight, you won't have a lot of leverage.
Even when the rent isn't negotiable, your landlord may agree to limit annual rent increases and possibly pay for utilities,
repairs, taxes and insurance. You might also be able to negotiate a shorter lease term, perhaps with one or two options to
renew the lease, and the authority to sublease or assign the space. Finally, landlords are often willing to pay for necessary
improvements to the building before you move in, especially if you're agree to sign a long-term lease.
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How do I determine if the location I want is properly zoned for my business?
First, you'll need to check your local zoning ordinances. These laws allow certain types of businesses to occupy different
areas of a city or county -- most cities have residential, commercial, industrial and mixed-use neighborhoods.
Next you'll need to find out whether any other legal restrictions will affect your operations. For example, some cities limit
the number of certain types of business -- such as fast food restaurants or coffee bars -- in certain areas, and others
require that a business provide off-street parking, close early on weeknights, and keep advertising signs to a minimum.
Many cities have business development offices that help small business owners understand and cope with the various
restrictions.
To learn more about zoning laws and how to comply with them, read Pick a Legal Location and Avoid Zoning Trouble.
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Copyright 2006 Nolo
If you operate as a sole proprietorship, you and your business are legally inseparable.
What's Below:
What is a sole proprietorship and how do I create one?
How are sole proprietorships taxed?
Are sole proprietors personally liable for business debts?
What is a sole proprietorship and how do I create one?
A sole proprietorship is a company with one owner that is not registered with the state as a limited liability company (LLC)
or a corporation. In some states, a sole proprietorship is referred to as a DBA (doing business as), as in "José Smith, doing
business as Smith Heating and Air Conditioning."
Establishing a sole proprietorship is cheap and relatively uncomplicated. You don't have to file any papers to set it up --
you create a sole proprietorship just by going into business. In other words, if you'll be the only owner of the business
you're starting, your business will automatically be a sole proprietorship, unless you incorporate it or organize it as an LLC.
Of course, you do have to get the same business licenses and permits as any other company that goes into the same
business.
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How are sole proprietorships taxed?
Unlike a corporation, a sole proprietorship is not considered separate from its owner for tax purposes. This means the sole
proprietorship itself does not pay income tax; instead, the owner reports business income or losses on his or her individual
income tax return. Note that all business income is taxed to the owner in the year the business receives it, whether or not
the owner removes the money from the business.
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Are sole proprietors personally liable for business debts?
Legally, a sole proprietorship is inseparable from its owner -- the business and the owner are one and the same. As a
result, the owner of a sole proprietorship is personally liable for the entire amount of any business-related obligations, such
as debts or court judgments. This means that if you form a sole proprietorship, creditors of the business can come after
your personal assets -- your house or your car, for example -- to collect what the business owes them.
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Partnerships FAQ
From the Nolo Business & Human Resources Center
Before you start a business with others, get the answers to commonly asked questions about partnerships.
What's Below:
What is a partnership and how do I create one?
Are there special rules for running partnerships?
Is a written partnership agreement required for every partnership?
How are partnerships taxed?
Are owners of a partnership personally liable for business debts?
What happens if one partner wants to leave the partnership?
What are the differences between a partnership and a limited liability company?
What is the difference between a general partnership and a limited partnership?
What is a partnership and how do I create one?
A partnership is a business owned by two or more people that hasn't filed papers to become a corporation or a limited
liability company (LLC). You don't have to complete any paperwork to create your partnership -- the arrangement begins
as soon as you start a business with another person.
Although the law doesn't require it, many partners work out the details of how they will manage their business in a written
partnership agreement. If you don't create a written agreement, the partnership laws of your state will govern your
partnership.
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Are there special rules for running partnerships?
Unlike corporations, partnerships are relatively informal business structures. Partnerships aren't required to hold meetings,
prepare minutes, elect officers, or issue stock certificates. Generally, partners share equally in the management of the
partnership and its profits and losses, and assume equal responsibility for its debts and liabilities. These and other details
are typically described in a partnership agreement.
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Is a written partnership agreement required for every partnership?
No law requires partners to create a written partnership agreement, but it's smart to do so. If you don't make a
partnership agreement, you run the risk that the default rules in your state's partnership laws will govern your partnership
in ways you and your partners won't like.
Creating a written partnership agreement will also give you and your partners a chance to discuss your expectations of
each other, define how each of you will participate in the business, and help you work out any sticky issues before they
become major problems.
You don't have to spend a fortune on lawyer's fees to create a valid agreement -- you and your partners can easily put
together a simple, clear agreement yourselves.
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How are partnerships taxed?
A partnership is not considered separate from its partners for tax purposes. Generally, this means the partnership itself
does not pay any income taxes; instead, partnership income "passes through" the business to each partner, who then
reports his or her share of business profits or losses on an individual federal tax return. Each partner will need to estimate
the taxes he or she will owe at the end of the year and make four quarterly estimated tax payments to the IRS.
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Are owners of a partnership personally liable for business debts?
Legally, a partnership is inseparable from its owners. As a result, each partner (with the exception of the limited partners
in a limited partnership) is personally liable for the entire amount of any business-related obligations. This means that if
you form a partnership, creditors can come after your personal assets (such as your house or car) to make sure any
partnership debts get paid.
In addition, you are legally bound to any business transactions made by you or any of your partners, and you can be held
personally liable for those actions. For example, if your partner takes out an ill-advised high interest loan on behalf of the
partnership, you can be held personally responsible for the debt.
In contrast, owners of limited liability companies (LLCs) and corporations are not personally liable for business debts.
For more information about limited liability, see LLC Basics and Corporation Basics.
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What happens if one partner wants to leave the partnership?
Before you go into business together, you and your partners should decide what will happen to the partnership when one
partner retires, dies, or wants to leave the partnership for some other reason, such as a divorce or bankruptcy. You might
feel like you're being overly cautious or pessimistic, but it almost always makes sense to include "buy-sell" provisions in
your partnership agreement to deal with these issues. It's the best way to prevent resentments and serious problems
(including messy lawsuits) from cropping up later on.
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What are the differences between a partnership and a limited liability company?
When two or more people go into business together, they've automatically formed a partnership; they don't need to file
any formal paperwork. By contrast, to form a limited liability company (LLC), business owners must file formal articles of
organization (sometimes called a certificate of organization) with their state's LLC filing office (usually the secretary of
state or department of corporations) and comply with other state filing requirements.
Aside from formation requirements, the main difference between a partnership and an LLC is that partners are personally
liable for any business debts of the partnership -- meaning that creditors of the partnership can go after the partners'
personal assets -- while members (owners) of an LLC are not personally liable for the company's debts and liabilities.
There is one similarity between LLCs and partnerships, however. They both offer "pass-through" taxation, which means
that the owners report business income or losses on their individual tax returns; the partnership or LLC itself does not pay
taxes.
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What is the difference between a general partnership and a limited partnership?
Usually, when you hear the term "partnership," it refers to a general partnership -- that is, one where all partners
participate to some extent in the day-to-day management of the business. Limited partnerships are very different from
general partnerships, and are usually set up by companies that invest money in other businesses or real estate.
While limited partnerships have at least one general partner who controls the company's day-to-day operations and is
personally liable for business debts, they also have passive partners called limited partners. Limited partners contribute
capital to the business (investment money) but have minimal control over daily business decisions or operations.
In return for giving up management power, a limited partner's personal liability is capped at the amount of his or her
investment. In other words, the limited partner's investment can go toward paying off any partnership debts, but the
investor's personal assets cannot be touched -- this is called "limited liability." However, a limited partner who starts
tinkering with the management of the business can quickly lose limited liability status.
Doing business as a limited partnership can be at least as costly and complicated as doing business as a corporation. For
instance, complex securities laws often apply to the sale of limited partnership interests. Consult a lawyer with experience
in setting up limited partnerships if you're interested in creating this type of business.
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Copyright 2006 Nolo
Corporations FAQ
From the Nolo Business & Human Resources Center
Answers to the most frequently asked questions about corporations: what they are, how they work, and
whether or not you should incorporate your business.
What's Below:
What is a corporation?
What is "limited liability" and why is it important?
How are corporations different from partnerships, sole proprietorships, and LLCs?
Who should form a corporation?
How do I form a corporation?
Does running a corporation involve more paperwork than running other types of businesses?
How is corporate income taxed?
What is double taxation? Does it mean that corporate income is taxed twice?
What is a professional corporation?
Do I need to worry about securities laws when I issue stock in my corporation?
What is a corporation?
What sets the corporation apart from all other types of businesses is that a corporation is an independent legal entity,
separate from the people who own, control, and manage it. In other words, corporation and tax laws view the corporation
as a legal "person" that can enter into contracts, incur debts, and pay taxes apart from its owners. Other important
characteristics also result from the corporation's separate existence: A corporation does not dissolve when its owners
(shareholders) change or die, and the owners of a corporation have limited liability -- that is, they are not personally
responsible for the corporation's debts.
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What is "limited liability" and why is it important?
If a business owner has "limited liability," it means that he or she is not personally responsible for business debts and
obligations of the corporation. In other words, if the corporation is sued, only the assets of the business are at risk, not the
owners' (shareholders) personal assets, such as their houses or cars. The corporation's owners must comply with certain
corporate formalities, keep up with paperwork requirements, and adequately fund ("capitalize") their business to maintain
this limited liability privilege.
Limited liability, traditionally associated with corporations, is the main reason most people consider incorporating.
However, other business structures, such as limited liability companies (LLCs), now offer this limited personal liability to
business owners. Sole proprietorships and general partnerships do not.
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How are corporations different from partnerships, sole proprietorships, and LLCs?
Unlike corporations, partnerships and sole proprietorships do not provide limited personal liability for business debts. This
means that creditors of those businesses can go after the owners' personal assets to collect what's due. However,
organizing and operating a partnership or sole proprietorship is much easier than forming a corporation, because no formal
paperwork is required.
A limited liability company (LLC), on the other hand, does offer limited personal liability, like a corporation. And while
formal paperwork is required to form an LLC, running an LLC is less complicated than running a corporation. LLC owners do
not have to hold regular ownership and management meetings or follow other corporate formalities, for example.
Corporations also differ from other business structures in the way they are taxed. The corporation itself must pay
corporate income taxes on its profits -- whatever is left over after paying salaries, bonuses, and other deductible expenses.
In contrast, partnerships, sole proprietorships, and LLCs are not taxed on business profits; instead, the profits "pass
through" the business to the owners, who report business income or losses on their personal tax returns.
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Who should form a corporation?
Because of the expense and formalities involved in setting up a corporation and issuing stock (shares in the corporation),
you should form a corporation only if you have good reason to do so. If you merely want to limit your personal liability for
business debts, forming a limited liability company (LLC) is probably smarter, because LLCs cost less to form and are
easier to run. But here are some situations in which incorporating your business instead of forming an LLC may make
sense:
1. Your business needs the ability to issue stock or stock options to attract key employees or outside investment
capital.
2. Your business is so profitable that you can save significant income tax dollars by keeping some profits in the
corporation each year. This strategy, called "income splitting," takes advantage of the lower tax rates on corporate income
up to $75,000.
3. You own a family business and you want to begin making gifts of ownership to your family as part of your
financial or estate plan or to plan for the next generation of owners. You can easily make gifts of shares in your corporation
without necessarily giving up management control and, if it's done correctly, without paying gift tax.
4. Others insist that you incorporate your business. For example, if you are an independent contractor, companies
you want to work for may ask you to incorporate before they will sign contracts for your services. These companies don't
want the IRS or another government agency to reclassify you as an employee, which is very unlikely if you have
incorporated.
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How do I form a corporation?
There are several steps required to legally create a corporation. The first is filing a short document called "articles of
incorporation" with the corporations division of your state government. (Some states refer to this organizational document
as a "certificate of incorporation," a "certificate of formation," or a "charter.") You'll have to pay a filing fee that ranges
from about $100 to $800, depending on the rules of the state where you file. This document contains basic information
such as:
1. the name of your corporation
2. the corporation's address
3. the name and address of your "registered agent" (the person to be contacted by any member of the public who
needs to speak to someone about the corporation), and
When forming your corporation, you must also create "corporate bylaws," a longer document that sets out the rules that
govern your corporation, including decision-making procedures and voting rights.
Finally, before you start doing business, you must hold an initial meeting of your board of directors to take care of some
formalities, and you need to issue shares of stock to the initial owners (shareholders).
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Does running a corporation involve more paperwork than running other types of businesses?
Yes. Corporations must comply with statutory rules that unincorporated businesses, such as limited liability companies
(LLCs), partnerships, and sole proprietorships, do not. For instance, corporations must observe corporate formalities such
as holding and taking minutes of annual shareholder and director meetings and documenting important decisions. Also,
corporations must file and pay taxes on a separate corporate tax return and must set up a double-entry bookkeeping
system to record business transactions, complete with daily journals and a general ledger.
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How is corporate income taxed?
Unlike sole proprietors and owners of partnerships and LLCs, a corporation's owners do not pay individual taxes on all
business profits. The owners pay taxes only on profits paid out to them in the form of salaries, bonuses, and dividends.
(Dividends are portions of profits that large corporations sometimes pay out to shareholders in return for their investment
in the company.) The corporation pays taxes, at special corporate tax rates, on any profits that are left in the company
from year to year (called "retained earnings").
Note that this taxation scheme does not apply to S corporations, which are corporations that have elected partnership-
style taxation. (Regular corporations, discussed above, are called "C" corporations.) If your corporation elects to be taxed
as an S corporation, all of the corporation's profits and losses will "pass through" to the owners, who will report them on
their individual income tax returns.
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What is double taxation? Does it mean that corporate income is taxed twice?
Many people have heard that corporate income is taxed twice: once to the corporation itself and then again a second time
when earnings are paid out to the corporation's owners (shareholders). This is true only for earnings paid out to
shareholders in the form of dividends -- that is, profits paid by the corporation to its shareholders in return for their
investment in the company.
In practice, this sort of double taxation seldom occurs in a small corporation. The reason is simple: Shareholders rarely pay
themselves dividends. Instead, they work for the corporation and pay themselves salaries and bonuses. Because the
corporation can deduct salaries and bonuses as ordinary and necessary business expenses, it doesn't have to pay
corporate tax on them. (Dividends, on the other hand, are not a tax-deductible corporate expense, so both the corporation
and the shareholder must pay tax.) As long as you work for your corporation, even in a part-time or consulting capacity,
you can avoid double taxation by taking home profits in the form of a salary and bonuses rather than dividends.
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What is a professional corporation?
A professional corporation is a special kind of corporation that only members of certain professions, such as lawyers,
doctors, and healthcare workers, can create. By forming a professional corporation, professionals can limit their personal
liability for the malpractice of their associates.
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Do I need to worry about securities laws when I issue stock in my corporation?
Securities laws are meant to protect investors from unscrupulous business owners. These laws require corporations to
jump through some hoops before accepting investments in exchange for shares of stock (the "securities"). Technically, a
corporation is required to register the sale of shares with the federal Securities and Exchange Commission (SEC) and its
state securities agency before granting stock to the initial corporate owners (shareholders). Registration takes time and
typically involves extra legal and accounting fees.
Fortunately, many small corporations can skip the registration process because of exemptions provided by both federal and
state laws. For example, SEC rules don't require a corporation to register a "private offering," which is a non-advertised
sale of stock to either:
1. a limited number of people (generally 35 or fewer), or
2. those who, because of their net worth or income earning capacity, can reasonably be expected to take care of
themselves in the investment process.
Most states have enacted their own versions of this popular federal exemption.
If you and a few associates are setting up a corporation that you'll actively manage, you will no doubt qualify for an
exemption, and you will not have to file any paperwork. For more information about federal exemptions, visit the SEC
website at www.sec.gov. For more information on your state's exemption rules, go to your secretary of state's website;
you can find links to each state's site at the website of the National Association of Secretaries of State, www.nass.org.
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Copyright 2006 Nolo
Limited Liability Company FAQ
From the Nolo Business & Human Resources Center
What's Below:
What is a limited liability company?
How many people do I need to form an LLC?
Who should form an LLC?
How do I form an LLC?
Do I need a lawyer to form an LLC?
Does my LLC need an operating agreement?
How are LLCs taxed?
What are the differences between a limited liability company and a partnership?
Can I convert my existing business to an LLC?
Do I need to know about securities laws to set up an LLC?
What is a limited liability company?
A limited liability company, commonly called an "LLC," is a business structure that combines the pass-through taxation of a
partnership or sole proprietorship with the limited liability of a corporation.
Like owners of partnerships or sole proprietorships, LLC owners report business profits or losses on their personal income
tax returns; the LLC itself is not a separate taxable entity. Like owners of a corporation, however, all LLC owners are
protected from personal liability for business debts and claims -- a feature known as "limited liability." This means that if
the business owes money or faces a lawsuit for some other reason, only the assets of the business itself are at risk.
Creditors usually can't reach the personal assets of the LLC owners, such as a house or car. (Both LLC owners and
corporate shareholders can lose this protection by acting illegally, unethically, or irresponsibly.)
For these reasons, many people say the LLC combines the best features of the partnership and corporate business
structures.
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How many people do I need to form an LLC?
You can form an LLC in any state with just one owner.
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Who should form an LLC?
You should consider forming an LLC if you are concerned about personal exposure to lawsuits or debts arising from your
business. For example, if you decide to open a store-front business that deals directly with the public, you may worry that
your commercial liability insurance won't fully protect your personal assets from potential slip-and-fall lawsuits or claims by
your suppliers for unpaid bills. Running your business as an LLC may help you sleep better, because it instantly gives you
personal protection against these and other potential claims against your business.
Not all businesses can operate as LLCs, however. Businesses in the banking, trust, and insurance industry, for example,
are typically prohibited from forming LLCs. In addition, some states, including California, prohibit professionals such as
architects, accountants, doctors, and licensed healthcare workers from forming LLCs.
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How do I form an LLC?
In most states, you create an LLC simply by filing "articles of organization" with your state's LLC filing office (which is
usually part of the secretary of state's office) and paying a filing fee. A few states refer to this organizational document as
a "certificate of organization" or a "certificate of formation." Most states provide a fill-in-the-blank form that takes just a
few minutes to prepare. You can obtain the form by mail or download it from your state's website (check your state's
secretary of state or corporations division home page).
A few states impose an additional requirement: Prior to filing your articles of organization, you must publish your intention
to form an LLC in a local newspaper.
You'll also want to prepare an LLC operating agreement, though it isn't legally required in most states. Your operating
agreement explicitly states the rights and responsibilities of the LLC owners. The main reasons to do this are to clarify your
business arrangements, and to decide how your LLC will be run. If you don't create a written operating agreement, the LLC
laws of your state will govern the inner workings of your LLC.
You can use a self-help book or software program to guide you through the process of creating personalized articles of
organization and writing an LLC operating agreement.
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Do I need a lawyer to form an LLC?
No. All states allow business owners to form their own LLC by filing articles of organization. In most states, the information
required for the articles of organization is non-technical -- it typically includes the name of the LLC, the location of its
principal office, the names and addresses of the LLC's owners, and the name and address of the LLC's registered agent (a
person or company that agrees to accept legal papers on behalf of the LLC).
Now that most states provide downloadable fill-in-the-blank forms and instructions, the process is even easier. And LLC
filing offices are becoming more accustomed to dealing directly with business owners; they often allow business owners to
email questions to them directly.
Of course, if you're trying to decide whether the LLC is the right structure for your business, you may want to consult an
expert. You may also want an expert to review your operating agreement or set up your bookkeeping and accounting
systems.
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Does my LLC need an operating agreement?
Although most states' LLC laws don't require a written operating agreement, you shouldn't consider starting business
without one. Here's why an operating agreement is necessary:
1. It helps to ensure that courts will respect your personal liability protection by showing that you have been
conscientious about organizing your LLC.
2. It sets out rules that govern how profits will be split up, how major business decisions will be made, and the
procedures for handling the departure and addition of members.
3. It helps to avert misunderstandings among the owners over finances and management.
4. It allows you to create your own operating rules rather than being governed by the default rules in your state's
LLC laws, which might not be to your benefit.
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How are LLCs taxed?
Like sole proprietorships (one-owner businesses) and partnerships, an LLC is not considered a separate entity from its
owners for tax purposes. This means that the LLC does not generally pay any income taxes itself; instead, the LLC owners
pay taxes on their allocated share of profits (or deduct their share of business losses) on their personal tax returns.
LLC owners can elect to have their LLC taxed like a corporation. This may reduce taxes for LLC owners who need to retain
a significant amount of profits in the company.
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What are the differences between a limited liability company and a partnership?
The main difference between an LLC and a partnership is that LLC owners are not personally liable for the company's debts
and liabilities. This means that creditors of the LLC usually cannot go after the owners' personal assets to pay off LLC
debts. Partners, on the other hand, do not receive this limited liability protection unless they are designated "limited"
partners in their partnership agreement.
Also, owners of limited liability companies must file formal articles of organization with their state's LLC filing office, pay a
filing fee, and comply with certain other state filing requirements before they open for business. By contrast, people who
form a partnership don't need to file any formal paperwork or pay any special fees.
LLCs and partnerships are almost identical when it comes to taxation, however. In both types of businesses, the owners
report business income or losses on their personal tax returns; the business itself does not pay tax on this money. In fact,
LLC and partnerships file the same informational tax return with the IRS (Form 1065) and distribute the same schedules to
the business's owners (Schedule K-1, which lists each owner's share of income).
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Can I convert my existing business to an LLC?
Yes. Converting a sole proprietorship or a partnership to an LLC is an easy way for sole proprietors and partners to protect
their personal assets without changing the way their business income is taxed.
Some states provide a simple form for converting a partnership to an LLC (often called a "certificate of conversion"). Sole
proprietors and partners in states that don't provide a conversion form must file regular articles of organization to create
an LLC.
In some states, before a partnership can officially convert to an LLC, it must publish a notice in a local newspaper that the
partnership is being terminated. And in all states, you'll have to transfer all identification numbers, licenses, and permits to
the name of your new LLC, including:
1. your federal employer identification number
2. your state employer identification number
3. your sales tax permit
4. your business license (or tax registration), and
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Do I need to know about securities laws to set up an LLC?
If you'll be the sole owner of your LLC and you don't plan to take investments from outsiders, your ownership interest in
the LLC will not be considered a "security" and you don't have to concern yourself with these laws.
For co-owned LLCs, however, the answer to this question is not so clear. A security is an investment in a profit-making
enterprise that is not run by the investor. If a person invests in a business with the expectation of making money from the
efforts of others, that person's investment is generally considered a "security" under federal and state law. Conversely,
when a person will rely on his or her own efforts to make a profit (that is, he or she will be an active owner of an LLC),
that person's ownership interest in the company will not usually be treated as a security.
How does this apply to you? Generally, if all of the owners will actively manage the LLC -- which is typical in most small
start-up LLCs -- the LLC ownership interests will not be considered securities. But if one or more of your co-owners will not
work for the company or play an active role in managing the company -- as may be true for LLCs that accept investments
from friends and family or that are run by a special management group -- your LLC's ownership interests may be treated
as securities by your state and by the federal Securities and Exchange Commission (SEC).
If your ownership interests are considered securities, you must get an exemption from the state and federal securities laws
before the initial owners of your LLC invest their money. If you don't qualify for an exemption to the securities laws, you
must register the sale of your LLC's ownership interests with the SEC and your state.
Fortunately, smaller LLCs, even those that plan to sell memberships to passive investors, usually qualify for securities law
exemptions. For example, SEC rules exempt the private sale of securities if all owners reside in one state and all sales are
made within the state; this is called the "intrastate offering" exemption. Another federal exemption covers "private
offerings." A private offering is an unadvertised sale that is limited to a small number of people (35 or fewer) or to those
who, because of their net worth or income earning capacity, can reasonably be expected to be able to take care of
themselves in the investment process. Most states have enacted their own versions of these popular federal exemptions.
For more information about SEC exemptions, visit the SEC website at www.sec.gov. A quick way to research your state's
exemption rules is to go to the home page of your state's securities agency, which typically posts the state's exemptions
rules and procedures. To find your state securities agency, go to your secretary of state's website. You can find links to
every secretary of state's office at the National Association of Secretaries of State, www.nass.org.
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Copyright 2006 Nolo
What's Below:
What is -- and isn't -- a tax deductible business expense?
If I use my car for business, how much of that expense can I write off?
Can I claim a deduction for business-related entertainment?
What is the difference between current and capital expenses?
If I buy a new computer system this year, do I have to deduct the cost over a five-year period?
I am planning a trip to a trade show. Can I take my family along for a vacation and still deduct the expenses?
I work in my home part time. Can I take the home office tax deduction?
I want to start my own small business. What do I have to do to keep out of trouble with the IRS?
Does incorporating a small business start-up offer tax breaks?
Is it safe and sensible for me to keep my own books and file my own tax returns?
I am hiring people to help out with a big job coming up. Are they considered independent contractors or new employees?
What is -- and isn't -- a tax deductible business expense?
Just about any "ordinary, necessary, and reasonable" expense that helps you earn business income is deductible. What's
ordinary and necessary? The IRS has defined this as anything that's "helpful and appropriate" for your business. For
example, buying a computer, or even a sound system, for your office or store can be an "ordinary and necessary" business
expense. Buying the same items for your family room cannot be a business expense, however.
A few things are specifically prohibited by law from being deducted even if the expenses are for the purpose of conducting
business -- for instance, a bribe paid to a public official. Other deduction no-nos are traffic tickets, your home telephone
line, and clothing you wear on the job, unless it is a required uniform.
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If I use my car for business, how much of that expense can I write off?
You can calculate your vehicle deduction using the standard mileage method or the actual expense method. The standard
mileage method is more commonly used because the record-keeping requirements are much simpler. Under this method,
the IRS determines the amount you can deduct per mile. (For the tax year 2006, the rate is 44.5 cents per mile; from
1/1/05 to 8/31/05, the rate was 40.5 cents per mile; and from 9/1/05 to 12/31/05, the rate was 48.5 per mile.)
Under the actual expense method, you deduct the actual costs you incur each year to operate your car, plus depreciation
you pay for gas and repairs (according to a tax code schedule). Your deductible costs include gas and oil, repairs and
maintenance, license fees, insurance, tolls, and even car washing. If you use the car partly for personal use, you must
multiply your actual expenses by your percentage of business use.
Most people use the standard mileage rate because they don't want to bother with a lot of record keeping. But this ease
comes at a price -- you usually get a lower deduction using the standard mileage rate than you would with the actual
expense method. You must use the standard mileage rate, however, if you claimed certain related deductions (such as
under Section 179 of the IRC) in previous years. (For more information on Section 179 depreciation, see Understanding
Small Business Tax Deductions.)
To use either of these methods, you must keep track of how much you use your car for business. (And you'll need to
produce your records if you are audited.) Keep a log showing the miles for each business use, always noting the purpose of
trip.
You can also depreciate (write off) the cost of the vehicle over a number of years. For more information, see Deduct It!:
Lower Your Small Business Taxes, by Stephen Fishman (Nolo).
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Can I claim a deduction for business-related entertainment?
You may deduct only 50% of expenses for entertaining clients or customers for business purposes, no matter how many
martinis or Perriers you swigged. (Yes, this is a change. In the old days you could write off 100% of every entertainment
expense, and, until a few years ago, 80%.) Qualified business entertainment includes taking a client to a ball game, a
concert, or dinner at a fancy restaurant, or just inviting a few of your customers over for a Sunday barbecue at your home.
Keep in mind that if you are audited, you must be able to show some proof that the entertainment expense was either
directly related to, or associated with, business. So, keep a guest list and note the business (or potential) relationship of
each person entertained.
Parties, picnics, and other social events that you put on for your employees and their families are an exception to the 50%
rule -- such events are 100% deductible, and you need not prove it was directly related to a business goal.
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What is the difference between current and capital expenses?
Current expenses can be deducted from your business's total income in the year you incur them. They include the
everyday costs of keeping your business going, such as office supplies, rent, and electricity.
Expenditures for things that will help generate revenue in future years -- a desk, a copier, or a car, for example -- are
called capital expenses and must be written off over their useful life. Usually that period is three, five, or seven years,
according to IRS rules.
There is one important exception to this rule, called the Section 179 deduction, which may let you fully deduct capital
expenses in the year you incur them.
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If I buy a new computer system this year, do I have to deduct the cost over a five-year period?
Probably not. Under Section 179, you can deduct in one year the cost of tangible personal property that you buy for your
business (such as computers, office furniture, and equipment). This is a major exception to the general rule that the cost
of "capital equipment" -- equipment that has a useful life of more than one year, such as a computer system -- must be
deducted over a number of years.
There is a limit to the total amount of business property expenses that you can deduct each year under Section 179. For
2005 through 2007, the limit is $105,000. Many small businesses can fit all of their capital expenditures each year into this
allotted amount. But watch out -- the Section 179 limit is scheduled to go back down to $25,000 in 2008 (although
Congress could decide to make the higher limits permanent).
Section 179 doesn't apply to land, buildings, inventory, intangible assets, and air conditioning and heating units. It does
apply to vehicles, but special rules limit the portion of the cost of a car that you can depreciate each year. For more
information, see Deduct It!: Lower Your Small Business Taxes, by Stephen Fishman (Nolo).
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I am planning a trip to a trade show. Can I take my family along for a vacation and still deduct the expenses?
If you take others with you on a business trip, you can deduct business expenses for the trip, but no more than if you were
traveling alone. If, for example, your family rides in the back seat of the car and stays in one standard motel room, then
you can fully deduct your automobile and hotel expenses. But you can't claim a deduction for your family's meals or jaunts
to Disneyland or Universal Studios.
If you extend your stay and partake in some of the fun after the business is over, the expenses attributed to the
nonbusiness days aren't deductible, unless you extended your stay to get discounted airfare (the "Saturday overnight"
requirement). In this case, your hotel room and meals would be fully deductible.
Also, you can fully deduct the cost of your airline ticket even if it features a two-for-one or "companion" discount.
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I work in my home part time. Can I take the home office tax deduction?
If you run a business out of your home, you may be able to take the home office deduction. This allows you to deduct a
portion of your rent or mortgage costs, as well as some related costs -- such as utilities, insurance, and remodeling.
However, there are strict requirements you must meet. For instance, you will not qualify if you use your office partly for
work and partly for personal reasons or if you don't use the space regularly for business.
For more information, check with a tax professional.
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I want to start my own small business. What do I have to do to keep out of trouble with the IRS?
Start by learning a new set of "3 Rs": record keeping, record keeping, and (you guessed it) record keeping. IRS studies
show that poor records -- not dishonesty - - cause most small business people to fail to comply with their tax reporting
obligations and to lose at audits, with resulting fines and penalties.
Even if you hire someone to keep your records, you need to know how to supervise him or her -- because if your
bookkeeper goofs up, you are responsible. Consider using a computer to keep your records if you aren't already in the
electronic age.
Keep all receipts and canceled checks for business expenses, and keep them organized and in a safe place. Separate the
documents by category, such as:
1. auto expenses
2. rent
3. utilities
4. advertising
5. travel
6. entertainment, and
7. professional fees.
Put your documents into individual folders or envelopes. If you are ever audited (and small businesses are about three
times more likely to be audited than individuals), the IRS is most likely to zero in on business deductions for car expenses
and travel and entertainment expenses. Furthermore, the burden will be on you -- not the IRS -- to substantiate your
deductions. If you're unsure how to get started or what documents you need to keep, consult a tax professional who is
familiar with small business record keeping.
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Does incorporating a small business start-up offer tax breaks?
Keep in mind that most corporate tax benefits flow to profitable, established corporations, not to start-ups in their first few
years. For example, corporations can offer more tax-flexible pension plans than sole proprietors or partnerships, but few
start-ups have the cash flow needed to take advantage of these tax breaks.
Similarly, the ability to split income between a corporation and its owners -- thereby keeping some income in lower
corporate tax brackets -- is effective only if the business is solidly profitable.
In addition, incorporating adds state fees, as well as legal and accounting charges. So unless you are sure that substantial
profits will begin to roll in immediately, you may want to hold off incorporating your business.
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Is it safe and sensible for me to keep my own books and file my own tax returns?
To keep your own books, consider using a check-register type computer program such as Quicken Home & Business or
Quickbooks (by Intuit) to track your expenses. If you are doing your own tax return, use the companion program,
TurboTax.
To make sure you're on the right track, it's a good idea to run your bookkeeping system by a savvy, small business tax
pro. With just a few hours of work, he or she should help you avoid most common mistakes and show you how to dovetail
your bookkeeping system with tax filing requirements.
When your business is firmly in the black, consider hiring a bookkeeper to take care of your day-to-day payables and
receivables, and an outside tax pro to handle your heavier-duty tax work. Not only are a tax pro's fees a tax deductible
business expense, but chances are your business will benefit if you put more of your time into running it and less into
completing routine paperwork.
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I am hiring people to help out with a big job coming up. Are they considered independent contractors or new
employees?
If you will be telling your workers where, when, and how to do their jobs, you should treat them as employees, because
that is how the IRS will classify them. Generally, you can treat workers as independent contractors only if they have their
own businesses and offer their services to several clients -- for example, a specialty sign painter with his own shop or a
freelancer who works for many clients. If in doubt, err on the side of treating workers as employees.
While classifying your workers as contractors can save you money in the short run (you don't have to pay the employer's
share of payroll taxes or have an accountant keep records and file payroll tax forms), it may get you into big trouble if the
IRS later audits you. The IRS may reclassify your "independent contractors" as employees and assess hefty back taxes,
penalties, and interest against you.
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Copyright 2006 Nolo
Don't neglect to write a business prenup before putting money into a venture.
What's Below:
When does a business need a buy-sell agreement?
A buy-sell agreement is used for buying and selling businesses, right?
If a co-owner of a business gets divorced, can the former spouse ask the divorce court for part ownership in the business?
Can a co-owner’s personal bankruptcy affect the business?
What’s the best way to value a company when an owner is being bought out?
What happens if a company needs to, but can't afford to, buy out one of its owners?
Can a buy-sell agreement be used to avoid estate taxes?
When does a business need a buy-sell agreement?
Every co-owned business needs a buy-sell, or buyout, agreement the moment the business is formed or as soon after that
as possible. Every day that value is added to the business without a plan for future transition, it increases its financial risk.
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A buy-sell agreement is used for buying and selling businesses, right?
No. Despite the name, buy-sell agreements have little to do with buying and selling companies. Instead, they are binding
contracts between co-owners that control when owners can sell their interest, who can buy an owner’s interest, and what
price will be paid. These agreements come into play when an owner retires, goes bankrupt, becomes disabled, gets
divorced, or dies -- in other words, a buy-sell agreement is a sort of prenuptial agreement between business co-owners.
Mainly these agreements guide buyouts between the owners themselves; that's why we like to call them buyout
agreements.
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If a co-owner of a business gets divorced, can the former spouse ask the divorce court for part ownership in
the business?
In some states, yes, and the former spouse can succeed in getting it, too. In community property states (Arizona,
California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin), all earnings during marriage and all
property acquired with those earnings are considered community property, owned equally by husband and wife. When
property is divided during a divorce, each spouse can claim a right to all community property.
Even in non-community property states, a spouse could argue for a partial interest in the business, because marital
property laws require property to be divided equitably during divorce.
To avoid this prospect, a good buyout or buy-sell agreement requires the former spouse of a divorced owner to sell any
interest received in a divorce settlement back to the company or the other co-owners, according to a valuation method
provided in the agreement.
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Can a co-owner’s personal bankruptcy affect the business?
In the worst case scenario, a bankruptcy trustee could liquidate the business (sell all of its assets) and take half to pay the
bankrupt owner's debts. To prevent a business from getting tied up in bankruptcy court, the owners can sign a buy-sell or
buyout agreement that requires a co-owner who faces bankruptcy to notify other co-owners before filing. Under the terms
of this agreement, this becomes an automatic offer to sell the bankrupt owner’s interest back to the other owners. The
buyout money goes to the bankruptcy trustee and the business can proceed without difficulties.
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What’s the best way to value a company when an owner is being bought out?
You can hire a professional appraiser or use a valuation formula to come up with a price using financial statements from
one or more years. But the problem is that valuing a business at the time of sale usually results in co-owners seizing on
different valuation formulas, which can produce very different results. For that reason, it helps for the owners to agree on
a way to value the company in advance in a buy-sell or buyout agreement. This gives owners the chance to discuss and
vote on how a reasonable price for the company should be calculated. The fact that a sound method was agreed to
beforehand can go a long way to reducing conflict when the time for a buyout comes.
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What happens if a company needs to, but can't afford to, buy out one of its owners?
Requiring an immediate 100% lump-sum cash payout can prevent even the most successful company from buying back an
owner's interest. That's why having flexible payment terms built into a buy-sell or buyout agreement, signed in advance,
can help. For instance, a buyout agreement can provide for a down payment of 1/4 to 1/3 of the buyout price followed by
installment payments for three to five years at a reasonable rate of interest.
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Can a buy-sell agreement be used to avoid estate taxes?
Buy-sell, or buyout, agreements have been used successfully to lower estate taxes in intergenerational businesses --
businesses where at least one co-owner plans to leave the interest to heirs who will remain active in the business. This can
help a family business owner pass the business on to children or other relatives without burdening them with unnecessary
estate taxes caused by an aggressive value of the business. The key for estate planning is choosing a conservative price or
valuation formula for the business in the buy-sell or buyout agreement. The result can be to legally set the value of the
ownership interest at an amount considerably lower than its sales value at the time of death.
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Copyright 2006 Nolo
Nonprofits FAQ
From the Nolo Business & Human Resources Center
Answers to your questions about nonprofit organizations and 501(c(3) corporations.
What's Below:
What is a nonprofit corporation?
What are the benefits of forming a nonprofit corporation?
How do I form a nonprofit corporation?
Is it difficult to run a nonprofit corporation?
What is a nonprofit corporation?
A nonprofit corporation is a corporation formed to carry out a charitable, educational, religious, literary, or scientific
purpose. A nonprofit corporation doesn't pay federal or state income taxes on profits it makes from activities in which it
engages to carry out its objectives. This is because the IRS and state tax agencies believe that the benefits the public
derives from these organizations' activities entitle them to a special tax-exempt status.
The most common federal tax exemption for nonprofits comes from Section 501(c)(3) of the Internal Revenue Code, which
is why nonprofits are sometimes called 501(c)(3) corporations.
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What are the benefits of forming a nonprofit corporation?
Nonprofit corporations enjoy an exemption from corporate income taxes on profits from activities that are related to their
organizational purpose. Also, a nonprofit is permitted to raise funds by receiving public and private grant money and
donations from individuals and companies. (And the tax laws encourage people and businesses to donate money and
property by allowing donors to deduct their contributions on their own tax returns.) Finally, structuring an organization as
a nonprofit corporation protects its directors, officers, and members from personal liability for the corporation's debts and
liabilities.
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How do I form a nonprofit corporation?
There are several steps you must take to create a nonprofit corporation. The first is filing a short document, usually called
"articles of incorporation," with the corporations division of your state government. To do this, you'll have to pay a filing
fee of $30 or so. Articles of incorporation contain:
1. the name of your corporation
2. the corporation's address
3. the name and address of a "registered agent" (a person who agrees to receive legal papers on behalf of the
corporation), and sometimes
After you file your articles, you must apply for state and federal income tax exemptions (the most common federal tax
exemption comes from Section 501(c)(3) of the Internal Revenue Code), which require you to complete a fairly lengthy set
of forms. You must also write "corporate bylaws," a document that sets out the rules that govern your corporation,
including procedures for making major business decisions, voting rights, and other important guidelines. Finally, before
you start doing business, you must elect a board of directors and hold an initial meeting of the board.
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Is it difficult to run a nonprofit corporation?
Although operating a nonprofit corporation requires some attention to detail, as long as you understand and follow some
basic rules, you'll be fine. The first rule is to hold required meetings of directors and members and to keep minutes of
these meetings in a corporate records book.
The IRS also has a thing or two to say about what a nonprofit can and cannot do. For instance, a nonprofit cannot make
political lobbying (influencing legislation) a substantial part of its total activities, and a nonprofit must make sure that its
activities don't personally benefit its directors, officers, or members.
For more information about these and other rules, see Protecting Your Nonprofit Corporation's Tax-Exempt Status.
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Copyright 2006 Nolo
Hiring Employees FAQ
From the Nolo Business & Human Resources Center
Avoid problems when hiring employees; learn about discrimination, interviewing, contracts, and more.
What's Below:
What laws must I follow when hiring new employees?
When I hire someone, do I have to use a written employment contract?
Do any special rules apply if I'm hiring a teenager?
Can I take an applicant's disability into account when I'm hiring?
Can I ask where an applicant was born or whether he or she is a U.S. citizen?
I want to know whether applicants have ever been fired or stolen from a prior employer -- can I require them to take a lie
detector test?
Can I check an applicant's credit report?
What laws must I follow when hiring new employees?
A variety of state and federal laws govern what you can and cannot do during all phases of the hiring process, including
interviewing, investigating, testing, and selecting new employees.
Generally, you must:
1. avoid illegal discrimination
2. respect the applicant's privacy rights
3. refrain from making promises you can't keep
4. follow the legal rules for hiring immigrants, and
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When I hire someone, do I have to use a written employment contract?
No. The law does not require you to make written contracts with your employees. However, using a contract can be a good
idea, especially if you are hiring for a high-level position and want to make sure that the employee sticks around for a
while.
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Do any special rules apply if I'm hiring a teenager?
Yes. Because most teenagers are in school and many don't yet have the physical capabilities and stamina of adults, federal
and state laws restrict the types of jobs they can be hired to do and the hours they can be required to work. Most
hazardous jobs -- those using heavy machinery or potentially dangerous chemicals, for example -- are closed to teenagers,
as are jobs that would require younger teens to work more than three hours on a school day.
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Can I take an applicant's disability into account when I'm hiring?
Yes, but only if the applicant's disability makes him or her unable to perform an essential function of the job. For example,
you can refuse to hire someone who is unable to lift things if one of the essential functions of the job is heavy lifting.
However, the Americans With Disabilities Act (ADA) puts limits on what and how you can ask applicants about disabilities
before you make a job offer.
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Can I ask where an applicant was born or whether he or she is a U.S. citizen?
Not in so many words. Because it is illegal to discriminate against applicants and employees based on their national origin
or citizenship status, you shouldn't ask about these things during an interview. However, you can ask if the worker is
legally authorized to work in the United States on a full-time basis.
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I want to know whether applicants have ever been fired or stolen from a prior employer -- can I require them
to take a lie detector test?
No. A federal law called the Employee Polygraph Protection Act (and the laws of many states) prohibits almost all
employers from asking or requiring applicants to take a lie detector test. The only exception is for employers that deal in
controlled substances or provide certain types of security services, who are allowed to require certain applicants to take a
polygraph test (a particular kind of lie detector test).
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Can I check an applicant's credit report?
Yes, but only if the applicant consents. Many employers comply with this requirement by including a standard request for
consent in their employment applications. If you decide not to hire someone based on information in the credit report, you
have to let the applicant know and explain his or her right to challenge the contents of the report.
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Copyright 2006 Nolo
Plain-English answers to questions about hiring independent contractors -- and the differences between
contractors and employees.
What's Below:
What is an independent contractor?
What are the benefits of hiring independent contractors?
What are the risks of hiring independent contractors?
How do government agencies determine whether workers are ICs or employees?
Should I ask freelancers and consultants to sign written independent contractor agreements?
How can I prove that the worker I hired is really an independent contractor?
Who owns intellectual property created by independent contractors?
What is an independent contractor?
Independent contractors (ICs) are people who contract to perform services for others, but don't have the legal status of
employees. Because many employment laws and tax rules that cover employees don't apply to ICs, businesses can save
time, money, and headaches by hiring ICs instead of employees.
ICs may call themselves by a variety of names -- freelancers, consultants, the self-employed, entrepreneurs, or business
owners.
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What are the benefits of hiring independent contractors?
Businesses can usually save money by hiring ICs instead of employees. In addition to salaries or other compensation,
employers generally have to pay additional expenses for employees, including payroll taxes, insurance premiums,
employee benefits, and more.
When you hire ICs instead of employees, you also have reduced exposure to some types of lawsuits, such as those alleging
job discrimination or wrongful termination.
Most importantly for many firms, ICs provide a level of flexibility that can't be obtained with employees. You can pay an IC
to accomplish only a specific task, allowing your business to get specialized expertise for a short period -- without having
to pay for training.
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What are the risks of hiring independent contractors?
Despite the advantages, many businesses are wary of using ICs because they have heard about or experienced the
consequences of misclassifying as ICs workers who are, legally, employees. And it's true that the consequences can be
economically devastating. A business must pay the IRS all back taxes owed, with interest, plus a penalty of 12% to 35% of
the tax bill.
Audits by state agencies are even more common than IRS audits. State audits most frequently occur when workers
classified as ICs apply for unemployment compensation after their services are terminated.
Another major disadvantage of hiring ICs is that they can sue you for negligence if they are injured on the job. This is
something employees normally cannot do, because their work injuries are covered by workers' compensation insurance.
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How do government agencies determine whether workers are ICs or employees?
There is no single, clear-cut test for classification. Different legal tests for determining worker status are used by various
government agencies, including:
1. the Internal Revenue Service
2. state unemployment compensation insurance agencies
3. state workers' compensation insurance agencies
4. state tax departments
5. the United States Labor Department, and
Each of these agencies is concerned with worker classification for different reasons, and has different biases and practices.
Each agency normally makes classification decisions on its own and need not consider what other agencies have done,
which means that one agency can find that a worker is an IC while another decides that he or she is an employee. It's also
possible, though rare, for a worker to be deemed an IC in one state and an employee in another.
To find out the rules these agencies use, see Independent Contractor or Employee: How Government Agencies Make the
Call.
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Should I ask freelancers and consultants to sign written independent contractor agreements?
Absolutely. Using a written agreement avoids later disputes by providing a written description of the services the IC is to
perform, when they are to be performed, and how much the IC will be paid.
A written IC agreement can also help establish that a worker is an independent contractor. Although an agreement by itself
is never enough to make a worker an IC, it will help show the IRS and other agencies that both you and the worker
intended to create a hiring company-independent contractor relationship, not an employer-employee relationship. IRS
training materials state that where all the other factors are evenly balanced, a written IC agreement may tip the scale to
the IC side.
But remember, an IC agreement is only useful if you follow it. If you treat a worker like an employee, no contract will undo
the damage -- or protect you from government audits.
For help creating a contractor agreement, see Put Your Independent Contractor Agreements in Writing.
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How can I prove that the worker I hired is really an independent contractor?
The time to gather evidence of a worker's independent contractor status is before you make a hiring decision -- not after
you are audited by a government agency. Protect your company by following these two steps every time you hire an IC:
1. Ask the IC to fill out a questionnaire designed to elicit information showing that the IC is really running an
independent business.
2. Require the IC to give you documents that will help you prove that the IC is self-employed.
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Who owns intellectual property created by independent contractors?
When you hire an IC to create a work of authorship such as a computer program, written work, artwork, musical work,
photographs, or multimedia work, you need to be concerned about copyright ownership.
The copyright laws contain a major trap for unwary hiring companies. The hiring company will not own the copyright to the
IC's work unless it obtains a written assignment of copyright ownership. An assignment is simply a transfer of copyright
ownership. You should obtain an assignment before the IC starts work. This assignment should be included in the IC
agreement.
There are exceptions to this rule. Certain specially commissioned works by ICs are considered to be works for hire, to
which the hiring company owns the copyright. However, this rule is not automatic -- you still have to enter into a written
agreement explicitly stating that the work is for hire.
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Copyright 2006 Nolo
Answers to some common questions about paying workers, from the minimum wage to overtime
requirements.
What's Below:
Do the minimum wage laws apply to small businesses?
Do I have to pay minimum wage to employees who receive tips?
Do I have to pay my managers overtime?
Can I give my employees time off instead of paying them overtime?
Do I have to pay my employees for travel time?
Can I dock an employee's pay for failing to meet a production quota?
Do the minimum wage laws apply to small businesses?
Yes, for the most part. The Fair Labor Standards Act (FLSA), the federal law that requires payment of the minimum wage,
applies to all businesses that have $500,000 or more in annual sales. Even if your sales don't reach this threshold, your
employees may still be covered if they work in "interstate commerce" -- commerce between states. Although this term
might sound fairly restrictive, courts have interpreted it very broadly to include sending or receiving mail from out of state,
making interstate phone calls, or handling goods that have moved interstate.
Even if your business is so small and local that it doesn't fall within these parameters, you may be subject to your state's
minimum wage law. Some cities and counties also impose minimum wage requirements on businesses within their
borders.
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Do I have to pay minimum wage to employees who receive tips?
It depends on how generous your customers are. Under federal law, as long as an employee routinely earns at least $30
per month in tips, you can pay the employee as little as $2.13 an hour. However, the amount you pay plus the tips the
employee actually earns must bring the employee's earnings up to minimum wage level. If the employee's total earnings
fall short of the minimum wage, you must make up the difference.
Some states, including California, don't allow employers to pay tipped employees less than the minimum wage. And some
states require employers to pay a higher hourly amount to tipped employees (though still less than the state or federal
minimum wage).
For more information on minimum wage laws, see When Do I Have to Pay the Minimum Wage?
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Do I have to pay my managers overtime?
If they are truly management employees, probably not. Under federal law, executive employees are not entitled to
overtime pay. An executive employee is one who earns at least $455 a week, routinely supervises two or more employees,
has the right to hire, fire, or promote workers, and manages the business or one of its subdivisions. So, if your managers
supervise a department and manage at least two employees, they are not entitled to overtime. But if you have simply
tacked a glorified title onto an otherwise low-level job -- if you are in the habit of calling your janitorial staff Assistant
Managers of Sanitation, for example -- you are required to pay overtime.
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Can I give my employees time off instead of paying them overtime?
It depends on how much time off you give them, and when. Private employers are not allowed to give compensatory or
"comp" time -- one hour off for every hour worked -- because this type of arrangement cheats employees out of their
higher overtime pay. However, there are a couple of ways to rearrange an employee's work schedule during a pay period
to avoid paying out overtime.
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Do I have to pay my employees for travel time?
You have to pay them for travel time that is part of their job duties. The time employees spend commuting from their
homes to the workplace is not paid. However, if an employee is required to spend time traveling after the work day begins
-- to call on customers or to purchase goods and equipment, for example -- you must pay them for this time. If an
employee takes a business trip to another city, you may have to pay for time spent in transit; the rules depend on the
length of the trip and when the employee travels.
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Can I dock an employee's pay for failing to meet a production quota?
Yes, but you might pay a big price. If an employee is exempt from the overtime rules (that is, the employee fits into an
exception to the rules and is therefore not entitled to overtime pay for extra hours worked), pay docking is allowed only in
limited circumstances. Generally, if you subtract money from an exempt employee's pay check based on the quality or
quantity of work the employee does, the employee is no longer exempt and is entitled to earn overtime. And, if you make
a regular habit of improper pay docking, you might owe overtime to every other employee in that job classification. .
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Copyright 2006 Nolo
Answers to common questions about personnel policies, from creating and maintaining personnel files to
evaluating and disciplining employees.
What's Below:
What should I keep in personnel files?
Do I need to keep any forms proving that my employees are legally allowed to work in this country?
Who is allowed to see an employee's personnel file?
Are there special rules for keeping employee medical records?
Do I need an employee handbook?
How do I avoid legal problems when giving employee evaluations?
How can I discipline problem employees without getting into legal trouble?
Should we have a policy about employee use of email?
What should I keep in personnel files?
You should keep a personnel file for each of your employees, containing every important job-related document, including
job applications, offer letters, employment contracts, benefits and salary information, government forms, performance
evaluations, and disciplinary actions. For more on personnel files, including tips on keeping them up to date, see Creating
and Maintaining Personnel Files.
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Do I need to keep any forms proving that my employees are legally allowed to work in this country?
Yes. For each of your employees, you must complete and keep Form I-9, provided by the agency now known as U.S.
Citizenship and Immigration Services (USCIS, formerly called the INS). Within three days of starting employment, your
employees are required to show you documents proving their identity and their right to work in the United States. You
must verify, on the form, that you have reviewed these documents for each employee. You should not keep this form in
the employee's regular personnel file, however.
For information on storing I-9 forms, see Creating and Maintaining Personnel Files.
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Who is allowed to see an employee's personnel file?
In most states, employees -- or former employees -- have the right to inspect at least certain documents from their own
personnel files. Typically, if your state allows employees to see their files, you can be present for the inspection, to make
sure nothing is added, removed, or altered.
Generally, you should treat personnel files as you would any other private records. Limit access to those with a need -- or
a legal right -- to the information. A reasonable policy might allow access to you, the employee, and the employee's
supervisor or manager, as necessary, to make personnel decisions.
To learn more about keeping personnel files confidential while allowing access to those with a need or right to inspect
them, see Who Has a Right to View Personnel Files?.
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Are there special rules for keeping employee medical records?
Yes. The Americans With Disabilities Act (ADA) imposes strict rules on the use of information obtained through post-job
offer medical examinations and inquiries. In addition, the Health Insurance Portability and Accountability Act (HIPAA)
requires many employers who provide group health plans to follow special procedures to keep employee health information
private.
To learn more about maintaining medical records, see Who Has a Right to View Personnel Files?
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Do I need an employee handbook?
There is no law requiring employers to have an employee handbook, but it's a good idea. A handbook lets you inform your
employees about your workplace rules in an efficient, uniform way. Your employees will know what is expected of them
and what they can expect of you. And you will be able to prove that all employees were aware of the rules if an employee
later decides to challenge you in court.
For suggestions on what to include in an employee handbook, see Why You Should Create an Employee Handbook.
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How do I avoid legal problems when giving employee evaluations?
Create an evaluation form for each job category that focuses on the skills needed for successful job performance. Focus on
job duties, not personality traits. Some generally appropriate considerations are work quality, dependability, punctuality,
and communication skills. Allow your employees to see the form ahead of time, so they will know the basis for their
evaluations.
Be honest and consistent with your employees. Try to maintain an overall positive approach so your employees will be
motivated to improve, but don't sugarcoat the bad news. Give your employees a real opportunity to improve by giving
them constructive criticism and performance goals. And make sure to back up your evaluations with real consequences: If
an employee is far exceeding expectations, consider giving a raise or other recognition. If an employee is having serious
performance problems, discipline might be in order.
For more on employee evaluations, see How to Conduct Employee Evaluations.
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How can I discipline problem employees without getting into legal trouble?
First, you need a clear written disciplinary policy. This will let your employees know what to expect if they fail to meet your
performance standards. But be careful not to limit your ability to fire employees "at will" (that is, for any reason that is not
illegal).
Next, apply your policy fairly and consistently to all employees. Avoid claims of discrimination or favoritism by imposing
similar discipline for similar offenses. Make sure your employees get the message: Be honest and up front in your criticism,
listen to your employee's response, and try to work together to resolve the problem.
Finally, document everything. Whenever you have to discipline an employee, take notes and place them in the employee's
personnel file. If the employee later decides to file a lawsuit, you will have proof that the employee was warned about
performance problems and was unable to improve.
To learn more about writing a disciplinary policy and delivering the discipline, see Developing a Disciplinary Policy.
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Should we have a policy about employee use of email?
Absolutely. You can use a written email policy to reserve your right to read email messages, in case you're ever faced with
an employee who engages in misconduct in cyberspace (by sending harassing messages or revealing company trade
secrets through email, for example). Your policy can also explain the rules on using the email system to send personal
messages, how often you will purge email messages, and more.
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Copyright 2006 Nolo
Leave Policies in the Workplace FAQ
From the Nolo Business & Human Resources Center
Learn the basics about what paid and unpaid leave you must provide to your employees.
What's Below:
Am I legally required to offer paid vacation and sick leave to my employees?
I run a small business and cannot afford to have my employees on leave for months at a time. Do I have to provide family
and medical leave?
Am I legally required to give my employee leave to care for a sibling?
How can I find out if my employee really has a serious health condition?
Do I have to let my male employees take paternity leave?
Do I have to give my employees time off for National Guard training or other military service?
Do I have to pay my employees for time spent voting?
One of my employees just got called for jury duty. If she gets seated on a jury, can I replace her?
Am I legally required to offer paid vacation and sick leave to my employees?
No. Many employers are surprised to learn that they are not legally required to give their employees paid time off. Despite
this legal leeway, however, most employers do offer some variety of paid leave. A generous leave policy can help you
attract high-quality employees and improve office productivity and morale.
If you decide to adopt a policy that gives your employees paid vacation or sick time, be sure to apply the policy
consistently to all of your employees. If some employees receive a more attractive package than others, you might be
vulnerable to a discrimination claim.
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I run a small business and cannot afford to have my employees on leave for months at a time. Do I have to
provide family and medical leave?
It depends on how small your business is. The federal Family and Medical Leave Act (FMLA), which requires employers to
give 12 weeks of unpaid leave in certain circumstances, applies only to companies that employ more than 50 people within
a 75-mile radius. If your company doesn't meet these conditions, you do not have to provide leave under the FMLA.
However, many states also have family and medical leave laws, and these often apply to smaller business. So even if the
FMLA does not apply to you, your state's law might. To learn more about your state leave law, contact your state labor
department.
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Am I legally required to give my employee leave to care for a sibling?
Not by federal law. The federal Family and Medical Leave Act (FMLA) requires you to grant leave for your employees to
care for seriously ill family members, and it defines family members as parents, spouses, and children. (Parents include
those persons who took the place of a parent when the employee was a child; children include those children whom the
employee cares for and supports.) The definition, however, does not include many people that most of us consider family
members, including grandparents, aunts and uncles, in-laws, same-sex partners, or siblings.
If your state has a family and medical leave law, it might require leave to care for siblings. To find out about your state's
law, contact your state labor department.
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How can I find out if my employee really has a serious health condition?
The Family and Medical Leave Act (FMLA) allows you to ask your employee for a doctor's certification -- a written
statement from a doctor giving certain details of the employee's illness, including the expected duration, diagnosis, and
treatment plan. You also have the right to seek a second opinion and perhaps a third.
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Do I have to let my male employees take paternity leave?
It depends. If your business is covered by the Family and Medical Leave Act (FMLA) and the employee is eligible for leave,
you must allow the employee to take up to 12 weeks of leave to care for a new child. This leave is unpaid and must be
taken within a year of the child's arrival.
Generally, employers are not required to offer paid leave to either parent after a child's birth. However, if you do offer a
paid maternity leave benefit, you must offer this leave to new fathers as well as mothers or risk a lawsuit for sex
discrimination. In other words, if you offer paid leave, it must be parental leave, not maternal or paternal leave.
In addition, the state of California now provides six weeks of paid family leave to new mothers and fathers. This state
program is funded by employees, through payroll withholding. Many others states are considering paid family leave laws as
well.
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Do I have to give my employees time off for National Guard training or other military service?
Most likely. In almost every state, employers must allow their employees to take leave for certain types of military service.
In some states, only those called for active duty are entitled to take leave; other states require leave for training as well.
You are not required to pay your employees for this time off.
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Do I have to pay my employees for time spent voting?
This issue is governed by state law, so the answer depends on where your workplace is. Almost half of the states require
employers to provide a few hours of paid leave to allow their employees to vote. Generally, paid leave is required only if
the employee would have insufficient time to vote without taking time off.
Even if you live in a state that does not require paid leave for voting, you must not punish any employee for taking time off
to cast a ballot. Almost every state prohibits employers from firing or disciplining an employee for taking leave to vote.
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One of my employees just got called for jury duty. If she gets seated on a jury, can I replace her?
If you are asking whether it is legal to fire an employee for serving on a jury, the answer is no. Almost every state
prohibits employers from firing or disciplining an employee for being called to jury duty. In some states, an employee fired
in violation of these laws can sue you for lost wages. In addition, a handful of states impose criminal penalties against
employers who break this law.
However, most states do not require you to pay your employees for the time they spend on jury duty, unless your own
employment policies provide for such pay. Perhaps with the money you save on the employees' wages or salary, you can
afford to hire a temporary replacement worker to fill in until the jury reaches a verdict.
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Copyright 2006 Nolo
Answers to some common questions about workplace discrimination and harassment laws, including which
laws apply to you and what you should do if an employee complains.
What's Below:
What forms of discrimination are illegal in the workplace?
What is sexual harassment?
Do antidiscrimination laws apply to small businesses?
What should I do if an employee complains about discrimination?
Can I fire or discipline an employee for complaining about discrimination?
Are English-only rules legal?
What is age discrimination?
Are there laws that prohibit discrimination based on sexual orientation?
Do I have to provide the reasonable accommodation a disabled employee requests?
Do I have to give an employee time off for religious observances?
What forms of discrimination are illegal in the workplace?
If a characteristic is specifically listed in an antidiscrimination law, then it is illegal to discriminate against someone on the
basis of that characteristic.
Federal law prohibits discrimination on the basis of race, gender, pregnancy, national origin (including affiliation with a
Native American tribe), religion, disability, citizenship status, and age (if the person is at least 40 years old).
State and local laws often prohibit additional types of discrimination, including discrimination on the basis of marriage,
sexual orientation, and weight. To learn more about your state and local laws, contact your state fair employment office.
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What is sexual harassment?
Sexual harassment is a type of gender discrimination. It is any unwelcome sexual advance or conduct on the job that
creates an intimidating, hostile, or offensive working environment. It is any offensive conduct related to an employee's
gender that a reasonable woman or man should not have to endure.
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Do antidiscrimination laws apply to small businesses?
If you have a really small business -- with only one to three employees -- you do not have to worry about the vast
majority of antidiscrimination laws. The major exception to this general rule is the federal Equal Pay Act, which applies to
virtually all employers, regardless of size. For a description of the Equal Pay Act, see Federal Antidiscrimination Laws.
In addition, there might be a local ordinance or state law that does apply to you (although the majority of these laws
applies only to employers with five or more employees). To investigate your state laws, contact your state fair employment
practices agency; ask your local government for information on municipal or county ordinances.
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What should I do if an employee complains about discrimination?
The most important thing to do is to take the complaint seriously, no matter how angry it makes you or how fictional you
think the complaint is. Investigate the complaint thoroughly and, if you find any merit to the complaint, remedy the
situation as quickly as possible.
For more information about handling complaints of discrimination, see Guidelines for Handling Discrimination and
Harassment Complaints.
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Can I fire or discipline an employee for complaining about discrimination?
Absolutely not. Most antidiscrimination laws contain a provision that forbids employers to retaliate against employees who
assert their rights to a workplace free of discrimination. Both firing and discipline constitute retaliation. To learn more
about what constitutes retaliation and how to avoid it, see Preventing Retaliation Claims by Employees.
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Are English-only rules legal?
It depends on the purpose and scope of the rule. An employer may be able to prohibit on-duty employees from speaking
any language other than English if it can show that the rule is necessary for business reasons. If your company has an
English-only rule, you must tell employees when they have to speak English (for example, whenever customers are
present) and the consequences of breaking the rule.
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What is age discrimination?
Age discrimination is making employment decisions based on a person's age -- or on stereotypes about youth and age. For
example, if you tend to hire younger workers because you believe they are more energetic and better able to adapt to
changing circumstances, that is discriminatory. Only workers who are at least 40 years old are protected from age
discrimination; younger workers are not.
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Are there laws that prohibit discrimination based on sexual orientation?
Fifteen states prohibit private employers from making employment decisions based on sexual orientation, as do many
county and municipal governments. However, no federal law prohibits sexual orientation discrimination in private
employment.
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Do I have to provide the reasonable accommodation a disabled employee requests?
Not necessarily. If an employee asks for a reasonable accommodation, you are required to brainstorm with your employee
about what types of changes might help the employee do his or her job. You are not required to provide the precise
accommodation the employee requests, but you must work together to come up with a reasonable solution.
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Do I have to give an employee time off for religious observances?
It depends on how easy or difficult it would be for you to do so. You are legally required to work with your employees to
make it possible for them to practice their religion. This might include not scheduling an employee to work on an important
religious holiday. However, you are not required to offer this accommodation if it would cause a hardship on your business
or other workers -- for example, if it would upset your seniority system.
For information on religious discrimination and accommodations, see Religious Discrimination in the Workplace.
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Copyright 2006 Nolo
Can you run a background check, use an employment test, or check up on employees' activities on or off the
job?
What's Below:
Can I require all employees that I am considering for management positions to take a psychological test?
Can I fire a worker whose personal beliefs clash with mine?
Can I read my employees' email messages?
Can I monitor my workers' phone calls to make sure they are properly serving my customers?
Can I randomly search my employees as they leave the workplace to minimize theft?
Can I install cameras in the workplace to discourage employee misconduct?
Can I require all employees that I am considering for management positions to take a psychological test?
Although this is an unsettled area of law, it might depend on the test. Many widely used psychological tests ask questions
that invade the test-taker's privacy. And the jury is still out as to whether these tests have any ability to predict whether a
particular employee will lie, steal, manage poorly, or cause other workplace problems. Because of these limitations, it's a
good idea to talk to a lawyer before imposing a testing requirement.
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Can I fire a worker whose personal beliefs clash with mine?
You may not fire a worker because of his or her religious or political beliefs. Federal and state laws protect workers from
this type of discrimination. However, if a worker brings those beliefs into the workplace by, for example, attempting to
convert other workers or publicizing political beliefs during work time, you may put a stop to this.
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Can I read my employees' email messages?
Generally yes, depending on your policies. If you have a policy of email privacy (for example, if you tell your employees
that their email will be confidential or will not be read by the company), then you should abide by that policy. Also, if you
allow employees to designate certain messages as confidential or private, you probably shouldn't read the messages so
designated. Otherwise, however, you have the right to monitor employee email, as long as you have a legitimate business
purpose for doing so.
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Can I monitor my workers' phone calls to make sure they are properly serving my customers?
Yes, with a few limitations. You are legally allowed to monitor employee conversations with customers for quality control.
Federal law allows you to do so without warning or announcement, although some states require you to inform the parties
to the call in some way that you are listening. However, you may not monitor personal calls. You must stop monitoring
once you realize that a particular call is personal.
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Can I randomly search my employees as they leave the workplace to minimize theft?
This is usually a bad idea. Generally, you can perform a workplace search in order to serve important, work-related
interests -- as long as you don't unduly intrude on your workers' privacy rights. Random searches are less likely to pass
legal muster than a search of a particular employee whom you reasonably suspect of theft. And even if you have a
reasonable suspicion, you must not search too invasively: Although searching an employee's bag might be reasonable
under some circumstances, searching the employee's body crosses the line.
For more information, see Workplace Searches.
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Can I install cameras in the workplace to discourage employee misconduct?
It depends on where you want to put the cameras, and why. You must have a reasonable basis for monitoring in this
manner (to discourage theft from a cash register and enhance the security of customers, for example) and inform your
employees of the cameras. Certain areas of the workplace (the bathroom or changing areas, for example) are generally
off-limits to this type of monitoring.
For more information, see Workplace Searches.
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Copyright 2006 Nolo
What you need to know when an employee leaves -- from final paychecks to severance pay to providing
references.
What's Below:
Are there any rules about when I have to give workers their final paychecks?
I just had to fire an employee. What should I tell the rest of my workforce?
How do I give a reference for a worker I had to fire?
Am I legally required to pay severance to workers when they leave?
Are there situations when I should consider offering severance pay?
Is there anything I can do to protect myself from lawsuits by former employees?
Are there any rules about when I have to give workers their final paychecks?
Yes. Most states have laws requiring employers to give employees their final paychecks very soon after termination --
sometimes on their last day of work. This may mean that you cannot wait for your usual payroll process to issue the final
check. In some states, these deadlines depend on whether the employee was fired or quit.
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I just had to fire an employee. What should I tell the rest of my workforce?
This is a very tricky area. On the one hand, you want to acknowledge that their coworker is no longer around. On the other
hand, you don't want to fuel office gossip or worse, wind up on the receiving end of a lawsuit. The safest course of action is
to make a limited statement without going into detail. You might want to say something like, "Sarah is no longer with the
company. Sam and Martin will be sharing her job duties until we are able to replace her."
Avoid the temptation to explain why the employee is gone. If these statements put the employee in a bad light (as most
reasons for firing do), and the employee later hears of them, you might get sued for defamation.
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How do I give a reference for a worker I had to fire?
The course of action least likely to land you in legal hot water is to say as little as possible. Many employers adopt a policy
of giving out only dates of employment, job title, and final salary to prospective employers. As long as you stick to easily
documented facts and keep it brief, you will stay out of trouble.
If you decide to give more expansive references, use caution. If you make false statements about a former employee with
the intent to harm his or her reputation, you can be sued for defamation.
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Am I legally required to pay severance to workers when they leave?
Probably not. Unless you lead your employees to believe that they are entitled to severance (through language in an
employment contract, employee handbook, or oral promise, or by routinely paying severance to departing employees), you
are under no obligation.
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Are there situations when I should consider offering severance pay?
Yes. Many employers customarily offer severance pay to all long-term employees. A severance package helps ease the
burden of being fired and may help the employee transition to a new job. A severance package may also help soothe the
bad feelings of a fired employee. Not only will this ease your conscience when you have to fire employees, it will also make
lawsuits from former employees less likely. After all, a former employee who has been rewarded for prior service to the
company may not be particularly motivated to sue.
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Is there anything I can do to protect myself from lawsuits by former employees?
Yes. You can ask the employee to sign a release -- an agreement not to sue you for being fired -- in exchange for certain
benefits. Some employers routinely ask employees to sign a release as a condition of receiving a severance package.
If you decide to seek a release from a departing employee, you will probably need the help of a lawyer. In some states, a
release must contain specific language or a court will not honor it. And you will want to tailor the release to meet the needs
of your company and the particulars of the employment situation.
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Answers to some commonly asked questions about firing employees, from limits on when you can fire to
severance packages.
What's Below:
Can I fire an employee for any reason?
Do I have to give a fired employee a severance package?
What do I tell prospective employers who call me for a reference for an employee whom I fired?
Can my company be sued for hiring -- or keeping on -- a dangerous employee?
Can I fire an employee for making a false complaint about our company's billing practices to a government agency?
Can I fire an employee for any reason?
No. Although the law gives employers a great deal of leeway in deciding whether to fire an employee, there are limits.
State and federal laws prohibit employers from firing workers for certain reasons -- for example, because of the worker's
race or religion, because the worker took family leave, or because the worker complained of illegal company activity.
If the employee has an employment contract or you have made promises to the employee, then you must honor your
commitment. Typically, this means you cannot fire the employee without "good cause."
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Do I have to give a fired employee a severance package?
It depends. The law does not require you to give severance packages to employees whom you fire. However, if you ever
promised the employee a severance package, you should deliver on that promise. And if you ever signed a contract with
an employee in which you agreed to provide a severance package, then you must honor that contract.
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What do I tell prospective employers who call me for a reference for an employee whom I fired?
Sometimes, you might be willing to give a fired employee a positive reference. After all, an employee who wasn't a good fit
at your business might do well elsewhere. If you can say positive things about the employee, then say them.
If, however, you are not comfortable giving a positive reference, then you shouldn't. In such a situation, less is better than
more. When prospective employers call, tell them that you can only confirm dates of employment and job responsibilities
and no more. You must take care not to "trash" the employee to a prospective employer, because this will leave you
vulnerable to a defamation suit from the former employee.
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Can my company be sued for hiring -- or keeping on -- a dangerous employee?
In many states, yes. Failing to fire an employee who poses a danger to coworkers, customers, or others can lead to a
lawsuit for "negligent retention." For example, if you hire an employee to make deliveries to customers' homes, and that
employee has a serious criminal record that you failed to check, you might be liable to a customer whom the employee
robs or assaults.
For more on your responsibility for employees' conduct, including tips on avoiding claims of negligent hiring and retention,
see Employer Liability for an Employee's Bad Acts.
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Can I fire an employee for making a false complaint about our company's billing practices to a government
agency?
Under most "whistleblower" laws, it depends on the employee's intent. As long as the employee has a good faith belief that
something illegal is going on, you cannot fire the employee for complaining about it. If, however, the employee knows the
complaint is false and makes it simply to stir up trouble, the employee probably is not a protected whistleblower.
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Copyright 2006 Nolo