Risky Business: Start-ups and the Law

Many self-started businesses are built with a personal touch.  Each grows as the person who founded the business grows alongside it.  Often the two identities can merge.  This is why the

end of a business can be so difficult and emotionally charged for some.  Imperatively, however, neatly wrapping up this process requires level decision-making.  The last stages of a business’s life cycle can carry different legal implications; generally, these stages can be subdivided into 4 main categories: 1) Closing your business; 2) Selling your business; 3) Transferring ownership; and 4) Filing for bankruptcy or liquidation.

Closing your Business

            Depending on what type of business entity you have established, your requirements for closing that particular entity may differ.  Sole proprietorships may be closed by the lone decision of the owner.  Conversely, partnerships require an agreement of co-owners to close (forced dissolution is a separate partnership consideration that will not be discussed in the scope of this post).  Next comes a bevy of administrative, reputational, employment, and financial considerations.  This is generally applicable advice for successful businesses at any stage of its life cycle but be sure to scrupulously maintain records – documentation is always key!  More or less, you should follow these steps:

1. Decide to close your business and evidence it with a written document that adheres to your company’s articles of organization (if applicable).
2. File dissolution documents with any state your company is registered in. If not, be prepared for future unwanted taxes and filing requirements.
3. Cancel any unnecessary registrations, permits, licenses, and business names.
4. Make sure to comply with all federal and state labor and employment laws. The Worker Adjustment and Retraining Notification Act (WARN)[1] provides some invaluable insight.
5. Cancel your Employer Identification Number (EIN), notify federal and state tax agencies, and prepare final returns. This IRS checklist[2] for closing a business is handy![3]

Selling your Business

Best practices for selling your business dictate completing a valuation prior to marketing to prospective buyers.  There are several common valuation methods to choose from, including the income approach, market approach, and assets approach.[4]  The income approach individually considers the business you are selling.  It looks at your projected revenue while contrasting potential risks.  This method is best for capturing the unique value of your company.  The market approach, however, looks to similarly situated businesses that were recently sold.  This history can provide an easy benchmark to base your company’s valuation on.  Finally, there is the asset method.  This method is the most classic “accounting style valuation.”  It simply subtracts total business liabilities from the total value of assets.  For larger companies, some variation of all three methods should likely be used.  For small companies, however, it is important to pick the right valuation method that accurately reflects your business’s value.

Although not the cheapest, the safest way to accurately value your business is by bringing in a qualified business appraiser.  Additionally, having a third party come in will help remove inherent biases.  Valuing a business this way may be more expensive but it is the most likely to accurate assess the value of hard to calculate assets, including brand value, intellectual property, customer lists, and future projected revenue to name a few.  Finally, do not forget about the sales agreement!  This document is vital to legally transition to the next owner.  Make sure not to leave out any assets or liabilities as this can create lingering problems.  If there is a single step in this process not to overlook or spare expenses, it would be this one.  An attorney should look over the sales agreement prior to execution.

Transferring Ownership

Perhaps you do not wish to outright sell your business because it has been in the family for quite sometime and you merely wish to pass it on to the next generation.  Or perhaps you simply want an extended break and wish to travel for a year without the day to day restrictions of operating your business.  Or perhaps you are thinking of planning ahead for arrangements to be made in the event of an unexpected passing.  The wide umbrella of “transferring ownership” provides flexibility and contemplates both these scenarios.

This solution to ending (or momentary ending) of your business responsibilities seems like the most worry free, no strings attached approach.  Be careful! Transferring ownership may trigger estate and gift tax considerations.[5]  Checking with your corresponding state tax laws up front can save massive headaches later on down the road.  To that end, Pennsylvania’s Department of Revenue provides an incredibly helpful page that explains inheritance tax and its ramifications.  That page can be found here.

Filing for Bankruptcy/Liquidation

            This course of action should be pursued as somewhat of a last resort.  For the most part, it requires a team of professionals.  Bankruptcy and liquidation are best accomplished through solid planning.  Lawyers, accountants, and creditors should all be informed and involved.  Once again, taxes are a critical consideration here.  The IRS Bankruptcy Tax Guide[6] helps to make this complicated information as straight forward as possible.

[1] https://www.doleta.gov/programs/factsht/WARN_Fact_Sheet_updated_03.06.2019.pdf

[2] https://www.irs.gov/businesses/small-businesses-self-employed/closing-a-business-checklist

[3] https://www.sba.gov/business-guide/manage-your-business/close-or-sell-your-business

[4] https://www.thebalance.com/business-valuation-methods-2948478

[5] https://www.irs.gov/businesses/small-businesses-self-employed/estate-and-gift-taxes

[6] https://www.irs.gov/publications/p908

Starting a business can be born from a lifelong dream or a spur of the moment idea.  There’s a beauty with that contrast.  Regardless of what idea drives that business’s creation, statistics show that it’s hard to maintain financial solvency in the first couple years.   [1]  Not much has remained a constant since 1994 other than survival rates of new businesses.  It is not all hopeless though!  There is a significant tool that entrepreneurs can use to help mitigate some financial load in a business’s early years and beyond.  Ironically, this tool is under the radar and most people only think of it one day a year, usually when it’s too late to adequately prepare.  (Hint: April 15^th is on a Wednesday this year).

Under federal law, all businesses must file an annual tax return.  Partnerships file an “informational return,” but the annual filing principle remains.  Generally, these returns are filed so that businesses pay a tax to the government on income earned or received during the year.  Think of income as all the money that comes into a business – not the profit a business may or may not make in a given year.  The Internal Revenue Service (“IRS”), however, allows businesses to deduct expenses from its taxable income.  Deductions are a powerful asset for a business in reducing its tax liability.

**Of note, states are free to pass their own unique tax statutes.  For purposes of this post, I will be examining the basic federal tax system while providing state-specific examples for Pennsylvania.  Be sure to check the tax statutes in your own state first!**

As alluded to earlier, new businesses rarely turn a profit in the first couple years of operation.  This lack of profit, however, does not have to be all negative.  Tax considerations can help offset some of this financial burden.  If your business structure allows for pass-through taxation, these initial losses for your business can be used to offset personal income.  By doing so, you can pay less in annual income taxes than you would have otherwise.  Some common pass-through entities include sole proprietorships, partnerships, LLC’s, and “S” corporations to name a few.

Alternatively, if your business has turned a profit, or even if you simply wish to increase the amount of losses being passed through, all businesses should consider what it can and cannot “write-off.”  The term “write-off” can be used loosely to explain something that reduces taxable income.  Accordingly, deductions, credits, and expenses overall may be referred to as “write-offs.”

Because a business can deduct its expenses from taxable income, the next logical question should be “well, are there restrictions on what I can deduct?”  The bad news is absolutely!  Remember, the government is not going to let you off the hook completely for your tax bill – it still wants its share of the pie.  The good news is deductible expenses are fairly straight forward.  “To be deductible, a business expense must be both ordinary and necessary.  An ordinary expense is one that is common and accepted in your trade or business.  A necessary expense is one that is helpful and appropriate for your trade or business.” [2] (emphasis added)

Because these deductible expenses are highly contingent on the operative trade or business, it would be silly to attempt to compile a finite list of what is and is not deductible for businesses across the board.  There are, however, two relatively universal available deductions for early stage entrepreneurs.

Common Early-Stage Deductibles

First, if you use part of your home for business purposes, you may be able to deduct expenses for the business use of your home.  This may include a mortgage interest, insurance, utilities, repairs, and depreciation.  For more information, check out the IRS’s reference page for home office deductions here.

Second, if you partially use your car for business purposes, you can deduct those expenses.  Any deducted expenses must be in relation to a business purpose; however, you do not need to own separate personal and business vehicles to make this distinction.  If you use your car for both business and personal purposes, you can divide your expenses based on actual business mileage.  For more information, check out the IRS’s reference page for travel, entertainment, gift, and car expenses here.

“Recent” updates in the law

Any tax related article cannot be complete without mentioning the Tax Cuts and Jobs Act of 2017, the most sweeping tax legislation since the Tax Reform Act of 1986.[3]  The new Act does many things, but mainly it makes small reductions to income tax rates for most individual tax brackets and significantly reduces the income tax rate for corporations.[4]  The Pennsylvania Department of Revenue publishes a fantastic break down of both business-related and individual provisions of the Act as well as the details of federal and Pennsylvania treatments.  The detailed break down can be found here.

Tax resources, even those outside of a traditional accountant, are abundant if you give enough consideration to looking for them.  A small amount of research can end up saving you and your company a potentially large amount of money down the road.  Remember, it is never too early to start planning in general, especially for taxes.

[1] https://www.bls.gov/bdm/entrepreneurship/entrepreneurship.htm

[2] https://www.irs.gov/businesses/small-businesses-self-employed/deducting-business-expenses (emphasis added).

[3] https://www.congress.gov/115/bills/hr1/BILLS-115hr1enr.pdf

[4] https://www.smith-howard.com/2018-tax-cuts-jobs-act-overview/

So, you’ve found the idea that you wish to build your business around.  What’s the next step?  There are a variety of answers to that question depending on who you ask, but chiefly among them should be solving the riddle of, “How am I going to profit off of this idea?”  Traditionally, when people wanted to buy a product, they all went through the same general routine: 1) figure out what they want to buy 2) find where the product was sold 3) go to where the product was sold 4) buy the product 5) rinse and repeat.  To facilitate this transaction of products, business owners would open up brick and mortar store locations locally to make this consumer cycle accessible to potential customers.  And then, the internet.

With the foundation-shattering internet revolution over the last 20 years, business owners have had to fundamentally rethink this customer-facing, physical storefront business model.  This revolution has been so game-changing that it has essentially required business owners to have at least some kind of online shop if not operate entirely online.  How transformative has selling goods online become?  Roughly 80% of the world’s internet users have bought goods and services online.  When people first began Amazon shopping and eBay bidding in 1995, the entire online shopping market was valued at just $131 million and the likes of Paypal had not even been invented yet. In 2015 when almost all major retailers are now online and customers are increasingly shopping on their phones with multiple payment options, e-commerce is valued at a staggering $1.55 trillion![1]

So, what are the positives and negatives to selling goods and services online?  One of the most obvious answers is that business owners would not have to shoulder the initial cost to construct a physical storefront or rent a commercial space.  Although entrepreneurs may not be burdened with the financial cost of opening up a brick and mortar storefront, selling goods and services through an online platform comes bundled with its own set of legal concerns: Taxes, payment gateways, trademarks, copyrights, patents, shipping restrictions, inventory, age restrictions, business insurance, licenses, permits, and payment card industry compliance to name a few.[2]

As the method of selling goods to consumers has evolved, so have the rules and regulations facilitating such an exchange.  In a recent Supreme Court ruling[3], the Court tackled the question of whether states should expect retailers with no physical state presence to collect a tax that residents of those states are obligated to pay.  The court held that the previous rule requiring a physical presence to collect sales tax was no longer valid.  The court referred to the proper relationship to collect sales tax as a substantial nexus.  This language leaves room for interpretation, but definitively makes it known that the standard for collecting state sales taxes has changed.[4]

Becoming an online retailer, however, is not the only way to establish an internet sales presence.  One of the ways small business owners and entrepreneurs can break into the online storefront market is by utilizing the services of a marketplace facilitator (e.g. Etsy, or eBay).  As defined by the Pennsylvania Department of Revenue, a marketplace facilitator is one who facilitates the sale of goods and services by: 1) Advertising goods and services for sale in a physical or electronic forum; 2) Collecting payment from the purchaser on behalf of the seller either directly or indirectly; and 3) Remitting payment back to the seller.[5]  By choosing the services of a marketplace facilitator, budding small businesses can alleviate some of the daunting legal considerations mentioned above.

In addition to the recent Supreme Court ruling, potential online platforms dedicated to facilitating transactions for aspiring business owners, including Etsy and eBay, have revamped their policies regarding sales tax as well.  Based on applicable tax laws, eBay will calculate, collect, and remit sales tax on behalf of sellers for items shipped to customers.  The collection process will apply to all sales, whether the seller is located in or outside of the United States.  As of 2019, eBay has begun to collect sales tax in four states.  eBay has also announced plans to scale this practice out to multiple other states, including Pennsylvania around July of 2019.  The good news for business owners is that once eBay starts to collect tax, no action is required on their part, and there will be no charges or fees for eBay automatically calculating, collecting and remitting sales tax.[6]

The rules and regulations governing the online sale of goods vary from state to state as well as from good to good.  Before diving head first into deciding whether to open up a candle store at the mall or to create a website to sell screen-printed t-shirts, make sure to check any and all relevant federal, state, and local laws.

[1] https://www.altushost.com/the-history-of-e-commerce-online-shopping-evolution-and-buyers-behaviour/

[2] https://www.bigcommerce.com/blog/online-business-laws/

[3] South Dakota v. Wayfair, Inc., 138 S.Ct. 2080 (2018).

[4] https://www.ecommercebytes.com/C/abblog/blog.pl?/pl/2018/6/1529591988.html

[5] https://www.revenue.pa.gov/GeneralTaxInformation/Tax%20Types%20and%20Information/SUT/MarketPlaceSales/Pages/Marketplace-Facilitators.aspx

[6] https://www.ecommercebytes.com/2019/01/04/ebay-starts-collecting-sales-tax-with-more-states-to-come/

“I really want to own my own business one day.”  Seemingly, everyone has at least one person in their life that has had this sentence as their go to ice-breaker for some poor soul at their office cocktail party for the better part of 5 years now.  Just do it already Chad so we can both move on with our lives.

The common trope of wanting to own your own business might be boring anecdotally, but studies have actually shown positive results for the bold coworkers that have finally taken the plunge into the independent world.  According to a study published on entrepreneur.com,

• About 68 percent of entrepreneurs reached profitability within the first year
• About 16 percent did so between years one and four
• Only 8 percent reached profitability after their fifth year in business, and
• Only 7 percent of respondents said they still were not profitable. [1]

The overwhelming indication is that the first four years are truly make-or-break years for any new company.  However, profitability is not synonymous with success.  Sadly, breaking even into the black is not the only consideration; entrepreneurship has major risks associated with the practice as well.  A bit more than 50 percent of small businesses fail or go out of business within the first four years.  In fact, of all small businesses started in 2011:

• 4 percent made it to the second year
• 3 percent made it to the third year
• 9 percent made it to the fourth year
• 3 percent made it to the fifth year.[2]

Given the inherent risk of failure associated with being an independent business owner, before you go head first and quit your office job to team up with Chad from accounting to start your revolutionary new idea for a two-sided stapler, you should make sure your “new” idea is actually original.  One potential obstacle for new entrepreneurs to hurdle comes in the mysterious package of trade secrets.  If you’re scratching your head skeptically trying to reassure yourself that you know what a trade secret is, you are not alone as it is a rather complicated topic.  Basically, a “Trade Secret” is an inherently non-descript label for any confidential business information which provides an enterprise a competitive edge.[3]  These secrets bring economic value due to the fact that they are not publicly known and come in a variety of shapes and sizes.  Some of the most common trade secrets come in the form of a company developed list/survey method, an algorithm/formula, or even a recipe/secret ingredient(s).  Examples include the New York Times Bestseller List, the Google search algorithm, and the Colonel’s delicious crispy fried chicken.[4]

Trade secrets have certain advantages to them that do not come with other well-known methods of protecting information like copyrights, patents, and trademarks.  These advantages include no requirements for publicizing your invention and, theoretically at least, indefinite protection.  Laws protecting trade secrets include the Uniform Trade Secrets Act (UTSA) and the Economic Espionage Act.  Violating these laws can also come with hefty penalties which could be devastating to small businesses, especially in their infancy.  Potential penalties include injunctions, damages (including both value lost due to misappropriation and unjust enrichment), and paying attorney’s fees.[5]

Trade Secret protections additionally exist at a state level.  Through most of Pennsylvania’s history, individual cases shaped trade secrets law.  These cases created a “common law” authority.  Common law, however, often leads to conflicting reasoning and is sometimes difficult for others to abide by.  For these reasons and others, the National Conference on Uniform State Laws drafted the Uniform Trade Secrets Act to codify and effectively replace the common law. Effective April 19, 2004, Pennsylvania joined the growing number of States which have adopted the Uniform Trade Secrets Act.

Armed with the knowledge of what a trade secret is and how they are protected, the next logical question of aspiring entrepreneurs logically has to be “How do I make sure to not violate protected trade secrets?”  Obviously, if you have stolen, extorted, or bribed someone for protected company information, you are in violation.  However, if you are currently working for a company and want to double check you aren’t utilizing or taking protected information, look to your employment agreement to see if you are bound by a duty of confidentiality not to disclose or use trade secret information, especially if you are in a leadership position.  Additionally, check any non-disclosure agreements you may have signed.

This all may seem daunting, but don’t worry!  There is one group of people that cannot be stopped from using information protected under trade secret law. People who discover the “secret” independently, that is, without using illegal means or violating agreements or state laws cannot be punished. For example, it is not a violation of trade secret law to analyze (or “reverse engineer”) any lawfully obtained product and determine its trade secret.[6]  The moral of the story is that authentic, independent creativity is ultimately not hindered by any legislation designed to protect trade secrets.  If you feel like owning your own business make sure to keep trade secrets in mind!

 

[1] https://www.entrepreneur.com/article/315718

[2] https://smallbiztrends.com/2016/11/startup-statistics-small-business.html

[3] https://www.wipo.int/sme/en/ip_business/trade_secrets/trade_secrets.htm

[4] https://info.vethanlaw.com/blog/trade-secrets-10-of-the-most-famous-examples

[5] https://www.rocketlawyer.com/article/uniform-trade-secrets-act-ps.rl

[6] https://www.nolo.com/legal-encyclopedia/trade-secret-basics-faq.html