Small businesses face many of the same legal issues as their larger counterparts, but often without the cost structure to support engaging legal counsel. If you own a small business, it’s important to understand when saving legal costs up-front can end up costing your business more in the long run.
All businesses – small, medium or large – make legal mistakes. However, a small business may not be as capable of weathering the storm. The effect of a legal mistake on a small business’s bottom line can be so disastrous that it may threaten its very survival. Accordingly, small businesses must pay extra attention to avoid certain legal mistakes up-front.
Below are the top five legal mistakes small businesses make and how to avoid them.
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Choose the right business structure
Many small businesses are sole proprietorships, which means there is no legal distinction between the business and the owner. The owner assumes all the liabilities of the business. Accordingly, the personal assets of the small business owner (e.g., house, car, investments etc.) may be seized to pay the debts of the business.
While there is a level of simplicity to operating a sole proprietorship, there are many advantages to incorporation that are worth considering. One of the main advantages is that the business becomes a separate entity under the law. This means that, if the business incurs a large debt or liability, the business’s assets may be seized to satisfy that debt or liability, but the owner’s personal assets are protected. However, this advantage may be impacted if the business owner has personally guaranteed any debt.
Another big advantage is the potential to minimize the owner’s overall tax liability. By incorporating, the owner has three opportunities to reduce the combined corporate and personal tax owed:
- Defer paying personal taxes on business earnings by leaving the earnings in the corporation and paying the lower corporate tax rate. While there is generally a small increase in the overall tax burden by earning income through a corporation and eventually paying it out to the shareholder as a dividend, the benefit of deferring when that tax is paid by leaving the income in the corporation and reinvesting it in the business may offset that increase.
- Pay the owner dividends instead of a salary and pay the lower dividend tax rate.
- Investigate whether you can split income with the spouse or adult children of the owner, though you should be aware of the Tax on Split Income (TOSI) rules which may apply when dividends are paid to family members who are not actively involved in the business. The TOSI rules were significantly expanded in 2018 and are very complex. To see how these rules affect your business you should consult with your CPA.
By minimizing and deferring tax liabilities, the owner of a small business may free up more capital to invest in the business’s future.
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Put key agreements in writing
All of the small business’s key agreements should be in writing. Verbal agreements are very difficult to enforce and often leave the business with no recourse for compensation or legal action.
Every small business should ensure that its key agreements are properly drafted. This means clearly spelling out each party’s roles and responsibilities, providing the business with the protections it needs against future liability and apportioning risk appropriately. This not only helps ensure everyone is on the same page going forward; if something does go wrong, having the agreement in writing will also help prove the other party’s fault.
In addition, given many small businesses may not have sufficient personnel and working capital to engage in traditional litigation, the parties can agree up-front on a different way to resolve any future disputes that may arise. For example, they could stipulate in the agreement that any disputes be submitted to binding arbitration, which results in a more timely and cost-effective dispute resolution mechanism than litigation.
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Make sure there are adequate employment agreements
Similarly, it is important for every small business to have properly-drafted employment agreements in place. These serve as the foundation of the business’s relationship with its employees. Common terms include whether the arrangement is permanent or temporary, whether the individual is an employee in the traditional sense or an independent contractor, an outline of the duties and responsibilities, and the rights and restrictions upon termination.
Not having a written employment agreement in place may expose the small business to unnecessary liability in future that could have easily been avoided. For example, if the relationship was not properly documented and managed, a small business that intends to hire an independent contractor may find itself liable for large common law termination and severance amounts once the relationship ends.
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Register intellectual property rights
Intellectual property is the legal right to ideas, inventions and creations in the industrial, scientific, literary and artistic fields. It also covers symbols, names, images, designs and models used in business.[1] In Canada, there are four types of intellectual property rights:
- copyrights
- trademarks
- patents
- industrial designs
Intellectual property is a valuable business asset and it comes with legal rights. Small businesses may be creating valuable intellectual property assets – sometimes without even realizing it – that should be legally protected. If properly protected, the small business has, among other benefits, the ability to prevent competitors from copying or closely imitating its products and services. Without adequate protection, a small business is vulnerable to being driven out of business by a more savvy competitor.
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Hire a good lawyer to help avoid mistakes
Every small business faces issues that require the expertise of good legal counsel. Unfortunately, in a misguided effort to minimize costs, many owners of small businesses ignore legal issues altogether or try to handle the issues themselves. This results in legal mistakes that may end up costing the business more in the long run and, in certain circumstances, threatening its very survival. Accordingly, it is important for small businesses to engage good legal counsel in key areas of the business to help avoid mistakes.
Like the other four tips provided here, if you own a small business, think of this not as an unnecessary expense, but as a necessary investment in the future of your business.
[1] “What is intellectual property?” Innovation, Science and Economic Development Canada. Available at : https://canadabusiness.ca/
government/copyright-and-intellectual-property/what-is-intellectual-property
Disclaimer:
BUSINESS MATTERS deals with a number of complex issues in a concise manner; it is recommended that accounting, legal or other appropriate professional advice should be sought before acting upon any of the information contained therein.
Although every reasonable effort has been made to ensure the accuracy of the information contained in this letter, no individual or organization involved in either the preparation or distribution of this letter accepts any contractual, tortious, or any other form of liability for its contents or for any consequences arising from its use.
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