OCJamaat-Biz Legal Issues

Legal Aspects of Starting &
Running a Small Business
A. Arastu
PRICE LAW GROUP, APC
Manager – Consumer Protection Department

TOPICS
• Choosing a Legal Entity
• Governmental Regulation, Licenses & Permits
• Tax Matters
• Financing the Business
• Employment Law
• Real Estate
• Developing Contracts and Forms

CHOOSING A LEGAL ENTITY THROUGH
WHICH YOU WILL DO BUSINESS

▫ THE 4 MAIN ALTERNATIVES:
 The Sole Proprietorship
 Partnership
 Corporation
 Limited Liability Company

SOLE PROPRIETORSHIP

▫ Definition: Business for profit owned by one
person who takes no steps to create a separate
legal entity

SOLE PROPRIETORSHIP
▫ Advantages:
 The most simple form, especially if owner performs
most job functions
 Freedom from legal formalities
 Usually, others can't create obligations which bind
you
 Since a sole proprietor is not considered an
"employee" of a business, you will not have to pay
unemployment taxes on your income from the
business
 You can move monies out of your business
account, and withdraw assets from the business with
very few legal limitations and without paying taxes

SOLE PROPRIETORSHIP
▫ Disadvantages:
 No insulation from personal liability for
obligations of the business
 No avoidance of trade name filing if business
done under another name
 Sole proprietorship does not qualify for tax
breaks accorded corporations for group-term life
insurance, long-term disability insurance, and
medical insurance

THE PARTNERSHIP
▫ Definition: The association of two or more persons
to carry on a business for profit as co-owners
▫ Partnership agreement not required, but desirable
▫ Each partner liable for all the obligations of the
partnership
▫ Partners share equally in profits and losses, unless
otherwise agreed
▫ Partnership is a tax-reporting entity. Must prepare
and file informational returns, even though
income and losses are flowed through to the
individual partners

THE PARTNERSHIP
▫ Advantages:
 Expanded sharing of management
responsibility, i.e., "two heads are better than
one"
 Minimal legal formalities. NOTE: Trade name
certificate must be filed if you do business under
any name other than names of all partners
 Limited duration: No formal action required in
order to "kill it off"

THE PARTNERSHIP
▫ Disadvantages:
 Potential for deadlock if partners don't agree on
management of business
 Each partner is personally liable for partnership
obligations incurred by other partners
 Partnership interests are not freely transferable by a
partner
 Unless the partnership agreement otherwise
provides, the death or bankruptcy of a partner, or
the unilateral decision of a partner to withdraw from
the partnership, will result in the dissolution of the
partnership

THE CORPORATION
▫ The Corporation is a separate legal person, a
separate legal entity, that comes into existence
when a Certificate of incorporation is filed with
the Division of Commercial Recording.

THE CORPORATION
▫ Advantages:
 Limited liability of shareholders. This is one of the most important "gifts"
in our common law. Especially important in view of our society's
litigiousness
 Centralized management in the corporation's board of directors
 Continuous existence. The corporation does not cease to exist upon the
death or bankruptcy of a shareholder, or the decision of a shareholder to
withdraw from the business
 Acceptability of business format makes it easier to raise equity financing
(eg. sale of shares to investors), and debt financing (eg. bank loans or
other loans)
 Use of corporate stock to "incentivize" key employees
 Unless restricted by corporate documents, shares of stock are freely
transferable
 As noted above, corporations receive favorable tax treatment for certain
fringe benefit plans, including medical insurance, disability insurance, and
group-term life insurance

THE CORPORATION
▫ Disadvantages:
 Expense of incorporation and recurring expense of annual
franchise or corporate income taxes
 Need to observe corporate formalities, including annual
meetings of shareholders, regular meetings of
directors, maintenance of corporate minutes and other
corporate records, and filing of annual reports with New Jersey
Secretary of State
 Consideration of federal and state securities law questions in
issuance of capital stock
 If business conducted in other states, corporation may need to
apply for a certificate of authority in such other states
 Duplication in licensing, i.e., both individual and corporation
may be required to obtain licenses

THE CORPORATION
▫ Tax Considerations:
 For tax purposes, corporations are either regular corporations, referred to as "C" corporations, or
"S" corporations. In order to qualify for "S" corporation treatment, you must meet strict
requirements and file an "S" election on Form 2553
 "C" corporations are subject to two levels of taxes: once at the corporate level, and again when the
corporation makes distributions to its shareholders
 "S" corporations escape double taxation since they operate as pass-through entities. The
corporation generally pays no tax on its income; the shareholders are taxed at their individual
rates on the corporation's income. The "S" corporation combines the best features of the
corporation (limited liability) and the partnership (one level of taxation)
 Until 1993, "S" corporations were a very popular choice for the new business entity. However, the
Clinton Deficit Reduction tax package passed in 1993 has made the "S" corporation less attractive,
since the top individual tax rate was raised to 39.6%, up from the previous high of 31%. The top
tax rate for most corporations stayed at 34%. This leads to a situation where "S" corporation
shareholders may pay individual income tax at a higher rate than the "C" corporation would pay.
"S" corporations no longer have a distinct advantage over "C" corporations
 However, the "S" election still deserves careful consideration and consultation with the business
owner's accountant. "S" corporation status may be very beneficial if it's expected that the business
will incur losses in the early years or if the owner is expected to be in the lower individual tax
brackets for a while

THE LIMITED LIABILITY COMPANY

▫ Definition: A limited liability company ("LLC") is
a relatively new type of business entity that
combines features of a corporation and a
partnership


 Comparison of the LLC with the Partnership.
 LLCs and partnerships are both taxed in the same
way -- as pass-through entities
 Partners in a general partnership are personally
liable for the debts and obligations of the
partnership. Members of an LLC are not
personally liable for debts and obligations of the
LLC. The most they can lose is their investment in
the LLC

▫ Comparison of the LLC with a C corporation.
 C corporation shareholders are taxed twice -- once at the corporate level and a second time at the individual level as
shareholders
 Shareholders in a corporation and members in an LLC both enjoy insulation from personal liability for debts of the entity
 In addition to limited liability of shareholders, corporations have 3 other attributes:
 "Continuity of life", i.e., corporations live forever and don't terminate if a shareholder sells out or dies, etc
 "Free transferability of shares", i.e., shareholders are free to transfer their shares to others, unless there is an agreement to the contrary;
an
 "Centralized management", i.e., as a technical matter, the business of the corporation is managed, not by the shareholders, but by a
board of directors.
NOTE: Before January 1, 1997 there was a risk that an LLC that had these corporation attributes (continuity of life, free transferability of
shares and centralized management) would be taxed as a corporation and not as a partnership. Since most small business owners form
the LLC with the expectation that it will be taxed as a partnership, and not as a corporation, this was an undesirable situation requiring a
great deal of care in the formation of the LLC.
Now, with the IRS adoption of the so-called "check-the-box" regulations, this risk has been removed from the LLC. Effective January 1,
1997, LLCs will automatically be given pass-through tax treatment, unless they elect to be taxed as corporations
 Corporations generally are required to be managed by a board of directors which, in turn, appoints officers to run the day-to-
day affairs of the business. These rules do not apply to LLCs. LLCs are not required to have directors or officers. The
management of the business can be done by the LLC members, or the members may appoint managers
 A corporation must observe certain formalities in terms of shareholder and director meetings, maintenance of corporate
minutes, and filing of annual reports. Failure to observe these formalities can lead to "piercing of the corporate veil". The LLC
has no such corporate formalities
 In the C corporation, there is often a genuine concern about the ability of the IRS to claim that shareholder-officers of the
corporation have received "unreasonable compensation". The consequence of such a determination by the IRS is that the
"unreasonable" portion would not be deductible by the corporation, and would, therefore be subject to double taxation. Since
the LLC is not subject to two levels of tax, unreasonable compensation concerns are eliminated

▫ Comparison of LLC with S corporation.
 Both LLCs and S corporations offer pass-through taxation at the federal level
 Both LLC and S corporations afford members/ shareholders insulation against
liability for the debts and obligations of the entity
 However, S corporations are subject to a number of tax rules that do not apply
to LLCs:
 S corporations may issue only one class of common stock, and no preferred stock. LLCs
can have flexible capital structures
 S corporations can not have more than 75 shareholders. LLCs may have an unlimited
number of members
 Before January 1, 1997, S Corporations could have corporations, partnerships or non-
U.S. persons as shareholders. Effective January 1, 1997, S Corporations are permitted to
be 100% shareholders of other S corporations. However, a Corporation cannot own
stock in an S corporation, In contrast, LLCs may have U.S. citizens or foreign
persons, and U.S. corporations and foreign corporations as members
 iv. S corporations are permitted to own 80% or more of the stock of a Corporation, and
100% of the stocks of an S Corporation. LLCs can have unlimited numbers of
subsidiaries
 S corporations must properly complete and timely file various tax forms. LLCs have no
such filing requirements

▫ How do you know if an LLC is right for your business?
 The LLC provides the same limitation on personal liability and pass-through tax treatment
as an S corporation, without the need for various S corporation tax filings
 Avoidance of the need for a board of directors. All members of an LLC can participate
directly in the management of the company, without the need for a board of directors
 Avoidance of the need for a shareholders agreement. In order to prevent free
transferability of shares of stock of a corporation, you need a shareholders agreement. By
law, however, the interest of a member in an LLC cannot be transferred without the
consent of all the other members. This alleviates the need for a shareholders agreement.
However, every LLC requires an "Operating Agreement". The Operating Agreement takes
the place of corporate by-laws and organizational resolutions, and, in most cases, will
cover many of the same subjects as a shareholder agreement
 The combination of limited liability, pass-through taxation, relaxed rules for non-U.S.
investors, and flexibility in capital structures will make the LLC the vehicle of choice for
situations involving:
 joint ventures
 non-U.S. investors; an
 passive investors

THE LEGAL ENTITY YOU CHOSE TO DO
BUSINESS AS MATTERS
▫ THE 4 MAIN ALTERNATIVES:
 The sole proprietorship
 Partnership
 Corporation
 S Corporation
 C Corporation
 Limited Liability Company
▫ OTHER ALTERNATIVES
 Limited Liability Partnership

STATE & LOCAL REGULATIONS
▫ There are multiple layers of state and local regulations that the small business person must
contend with:
 State licensing of certain businesses, such as warehouses, nursing homes, secondary
mortgage lenders, pharmacies and employment agencies.
 State licensing of an individual's practice of certain trades and professions, including
architects, professional engineers, pharmacists, plumbers, morticians, real estate
brokers, psychologists and nurses.
 Municipal licensing of certain businesses, such as automobile garages, movie theaters and
other places of public entertainment, lumber yards, hotels and motels.
 Local board of health permits for certain businesses, such as hotels and restaurants.
 If the business will be involved in retail sales or in furnishing certain services, then you will
be required to collect and remit sales taxes. An application for registration on Form REG-1
must be prepared and filed with the N.J. Division of Taxation.
▫ The N.J. Department of Commerce and Economic Development is a valuable resource to the
small business person. The license and certification hotline (800-533-0186) maintains a
computer database on New Jersey's licensing requirements for businesses and
professions, and can steer the business person to the appropriate state agency.

FEDERAL REGULATION
▫ In addition to state and local licenses and permits,
some small businesses also require federal
licenses or permits, including the following:
 Radio or television broadcasting (Federal
Communications Commission);
 Investment Advisory Services (Securities and
Exchange Commission);
 Preparation of meats (Food and Drug
Administration);
 Providing common carrier services (Interstate
Commerce Commission);

FEDERAL REGULATIONS
▫ In addition to state and local regulations, and federal
license requirements, there are numerous federal
regulations affecting the operation of small businesses.
(The following is a list of some of the federal
regulations, and is not intended to be comprehensive):
 Employment regulations, including equal opportunity
and antidiscrimination.
 Consumer credit regulations.
 Occupational Safety and Health Administration (OSHA)
regulations.
 Federal Trade Commission regulations concerning false
advertising.
 Antitrust regulations.
 Immigration regulations.

TAX MATTERS

 Every business in New Jersey is required to register
with the New Jersey Division of Taxation. You can
obtain the New Jersey Tax Registration Packet
(Form REG-P) by contacting the Division's Taxpayer
Information Services at (609) 292-6400 or (800)
323-4400.

TAX MATTERS
▫ Although not complete, a small business should be
generally aware its obligation to pay the following
taxes:
 Federal Income Tax;
 State Gross Income Tax or corporation business tax
(also known as "franchise" tax);
 Federal Unemployment Tax;
 State Unemployment Compensation Contributions;
 State Disability Benefits Contributions;
 State Sales and Use Taxes;
 Real Property Tax; and
 Miscellaneous Other Taxes (eg. Litter Taxes)

THE IMPORTANCE OF AN ACCOUNTANT
▫ The small business needs to retain the services of a
qualified accountant who, in addition to preparing and
filing tax returns on behalf of the business, can also
help the small business owner in a number of other
ways, including the following:
 Establishing bookkeeping records and procedures
 Preparation of annual or more frequent financial
statements, including balance sheets, statements of
income, and statements of changes in financial
position; an
 General business consultation and advice.

FINANCING THE BUSINESS
▫ 1. CAPITAL CONTRIBUTIONS BY OWNERS
 By far and away, the most frequent method of financing the
start-up of a new business is by the capital contributions of its
owners. The seed capital for most new businesses is provided
by the life savings of the owners and funds provided by
relatives and friends.
 The assets contributed include cash, tangible assets such as
furniture, fixtures, machinery and equipment, and intangible
assets such as patents, trademarks and inventions.
 If the business is structured as a corporation, some of the
contributions will have to be classified as equity investment
(i.e., payment for stock) and the balance may be classified as
debt (i.e., loans that may be repaid to the owner). The
allocation or split between debt and equity should be worked
out in consultation with the accountant and attorney so that
applicable tax and legal rules are complied with.

▫ 2. FINANCING BY THIRD PARTIES
 "Sweat Equity“: Occasionally, the owners are able to step outside their circle of family and
friends to tap the resources of outside investors, who may be individuals or institutions.
 "VCs and Angels“: Historically, venture capitalists (affectionately referred to as "VCs")
provided healthy amounts of funding to start-ups and small businesses. This has changed
in the last 5 years or so, as the VCs invest in larger deals and more mature companies.
However, to a certain extent, the vacuum has been filled by smaller investors, sometimes
called "angels" who like to invest in these small risky deals.
 Corporate Partners: Some of the slack in availability of investment capital has been taken
up by so-called "corporate partners", which are established companies (usually, but not
always, larger companies) that are interested in making investments in start-up and small
ventures. The "corporate partner" is often driven by a different motivation than the
venture capitalist, who is usually motivated strictly by return on investment. The corporate
partner usually seeks benefits in other ways such as by assignment of inventions, licensing
rights, manufacturing rights or marketing rights.
 Customers and Suppliers: A little-used but often successful financing source for the small
business owner is a major customer or major supplier. The financing might consist of cash
for debt or equity, but more often will take the form of extended terms (in the case of the
supplier) or prepayments (in the case of the customer) or some combination of the
foregoing.

▫ 3. COMMERCIAL LOANS
 Bank Loans.
Generally, banks are poor sources of funds for start-up
companies. Banks like to make commercial loans on a
"secured" basis, taking liens in real estate, machinery and
equipment, inventory, accounts receivable and other assets of
the borrower. The problem is that most start-up companies
don't have the asset base to support a commercial loan.
 Alternatives.
If the business owner has equity in a residence or other real
estate, then the real estate might be sufficient collateral to
support a loan to the individual or to the company with the
personal guarantee of the owner. Explore all avenues. In one
case handled by speaker, the business owner's lottery prize was
utilized as a major component of the collateral package.

▫ 4. U. S. SMALL BUSINESS ADMINISTRATION
(SBA) LOANS
 Due to funding cutbacks the SBA will consider
applications for direct lending only to Vietnam era
veterans; disabled veterans with a rated disability of at
least 30%; handicapped individuals who qualify under
the SBA's handicapped loan program; business located in
high - unemployment areas, or owned by low income
individuals.
 Most SBA lending is now provided under the SBA's Loan
Guaranty program, whereby the SBA guarantees up to
$750,000 of a loan made by a lending institution.

▫ 5. N. J. ECONOMIC DEVELOPMENT
AUTHORITY (EDA) LOANS
 The N.J. Economic Development Authority (EDA)
helps businesses in New Jersey by providing
loans, loan guarantees, and both taxable and tax-free
bonds.
 For more information about the EDA's "Statewide
Loan Pool for Businesses", you may call or write:
New Jersey Economic Development
Authority, Capital Place One, 200 South Warren
Street, CN 990, Trenton, New Jersey 08625-
0990, (609) 292-1800.

HIRING EMPLOYEES
-- THE EMPLOYMENT APPLICATION
• The small business owner should have an employment application that has been reviewed by counsel.
▫ Be on the look-out for illegal questions. By regulation in California, employers may not ask any
questions regarding the job candidate's race, creed, color, national origin, ancestry, age, marital
status, sex or liability for service in the U.S. Armed Forces unless the requested information
legitimately relates to the fulfillment of a "bona fide occupational qualification".
▫ There are many questions that should not be asked, in conversation or on the application
form, eg., what is the applicant's native language. Watch out for use of photo before hiring.
▫ The use of an employment-at-will disclaimer on the application is recommended such as the
following:
"In consideration of my employment, I agree to conform to the rules and regulations of XYZ
Company, and my employment and compensation can be terminated, with or without cause and with
or without notice, at any time, at the option of either the Company or myself. I understand that no
manager or representative of the Company, other than the President or Vice-President of XYZ
Company, has any authority to enter into any agreement for employment for any specified period of
time, or to make any agreement contrary to the foregoing."
▫ Include on the application an agreement not to reveal trade secrets or confidential information;
also, a statement about false or fraudulent information.
▫ If any pre-employment investigation of an applicant is made, the Federal Fair Credit and Reporting
Act requires a disclosure statement such as the following: "We intend to request a background
investigation regarding your general reputation, education, work experience, finances and
community standing. In accordance with the Fair Credit and Reporting Act, you have a right to
request in writing a disclosure of the nature and scope of the information requested. Please sign and
indicate your acceptance of these terms."

HIRING EMPLOYEES
-- INTERVIEWING DOS & DON’TS
▫ The interview process can be a legal minefield for your company.
▫ Some of the things an interviewer may properly do include:
 Telling prospective employees that the company is a nice place
to work, treats employees well, is forward-thinking, and is
concerned about employees.
 Engaging in fair commentary about the company's treatment of
employees.
 Giving information about performance appraisals and salary
reviews.
 Giving information about the company's fringe benefits.
▫ Some of the statements that the interviewer should avoid include:
 Inducing individuals away from other employment with assurances or
promises such as: "you'll have a permanent job here," or "you'll be able
to work here the rest of your life," etc.
 Promising or implying that employment will not be terminated except
for "good cause" or words of similar effect.

HIRING EMPLOYEES
-- EMPLOYMENT AGREEMENTS
▫ The employment agreement has undergone major change in the last 10 to 15 years. Whereas
historically it was used primarily with top executive officers, now it is used with employees all
up and down the line.
▫ Employees became accustomed to thinking of the employment agreement as a pro-employee
document. Although the employment agreement does offer significant benefits to the
employee, it also carries with it major drawbacks.
▫ The advantages of the employment agreement to the employee can include:
 job security, guaranteed compensation, and fringe benefits.
▫ The employer, however, can load the agreement with provisions that benefit the company, at
the expense of the employee, including:
 acknowledgement of the employee's employment-at-will status;
 restrictive covenants, including noncompetition, nonsolicitation and nondisclosure
agreements; and
 assignment of inventions provisions.
▫ Even in a situation where the owners are the sole employees, an employment agreement
makes sense for tax reasons:
 the agreement validates the company's payments of profits to the owners, and blunts the
ability of the IRS to claim that the owners' compensation is really disguised dividends
which should be subject to double tax.
 Another benefit of the employment agreement in the small company setting is to avoid
disputes between the owners as to sharing of profits.

EMPLOYMENT LAW
-- OTHER THINGS TO CONSIDER
▫ Employee Benefits
 Pension Plans, Profit-sharing, Deferred
Compensation, Vacation/Sick Pay, Severance
Pay, etc.
▫ The Occupational Safety And Health Act (OSHA)
 Requires every employer to provide a workplace free
of hazards that are likely to cause serious physical
injury or death to employees.
▫ State and Federal Child Labor Laws
▫ State and Federal Minimum Wage Laws

REAL ESTATE –
SELECTING A SITE FOR YOUR BUSINESS
▫ As a business person, you will be faced with a
number of different considerations in selecting
a physical location for your business, including
market considerations regarding the
company's goods or services; the local labor
pool; transportation; and local purchase or
rental costs.

REAL ESTATE –
ZONING AND OTHER RESTRICTIONS
▫ Check local zoning laws to make sure that you
may operate your business in the chosen
location. An attorney can also assist you in
investigating local ordinances that affect
signage, exterior lighting, permitted hours of
operation and other matters affecting your
business.

DEVELOPING CONTRACTS AND FORMS
FOR USE IN YOUR BUSINESS
▫ No Two Businesses Are Alike. Each business
has its own needs when it comes to contracts
and forms. Some businesses have extensive
needs for contracts and forms and others
require only one or two forms, but just about
every business has need for some contracts or
forms.

▫ Customer Contracts. It is a good idea to analyze
your method of dealing with customers in order to
determine if your business requires a contract or
form for use with customers. Whether you sell
goods or services it is advisable to have a customer
contract or form in place so that you can:
 clarify the important business terms, including
price, payment terms and other terms and conditions of
sale;
 have a basis to pursue collection if the customer does not
pay;
 avoid disputes; and
 put in terms and conditions that are favorable to you so
that, if you can't avoid a dispute, at least the contract
governing your dispute will be in your favor.

▫ Forms for Use With Suppliers. If you purchase
goods or services from a vendor or
supplier, then consideration should be given to
the development of a form setting forth the
terms and conditions under which you will
buy. If you are a purchaser of goods, you
should have a purchase order form. Many
small to mid-sized businesses overlook the
need for a purchase order form with terms and
conditions on the reverse side.

▫ Employment Contracts and Forms. In the
employment law section of the workshop, we
identified a number of employment-related
documents that every employer should have in
place:
 the employment application;
 performance appraisal form;
 employment agreements;
 a restrictive covenant agreement containing one or more
of the following: noncompetition agreement;
nonsolicitation agreement; and nondisclosure agreement
(also known as a "secrecy agreement" or "confidentiality
agreement").

▫ Independent Contractors and Consultants.
 Many businesses have agents or representatives who are not
employees, but independent contractors. An example: a real estate sales
person for a real estate brokerage business. Independent contractor status
offers advantages for the business, if you qualify. An independent
contractor agreement, by itself, will not suffice, but if you do qualify under
the complicated legal and tax rules, you should have a written
independent contractor agreement in place to support your claim of
independent contractor status.
 If you work with consultants, for example, a software programmer who is
hired to develop custom software, you should also have a written contract
in place. The U.S. Supreme Court decision in Community for Creative
Non-violence v. Reed highlights just one of the reasons why.
 If you have contractors who come onto your premises, eg. a building
contractor to handle a plant renovation, you should have forms in place
whereby the contractor waives all rights to sue you for personal injury to
his workers.

▫ Special Situations. The types of contracts and
forms listed above are by no means
comprehensive. There are numerous special
situations that come up in your day-to-day
business which also require contracts and
forms. Whenever you encounter such a special
situation, you should consult with an
experienced business lawyer to counsel and
assist you.

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