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Common Small Business Legal Issues and How to Avoid Them

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From getting a company started to hiring and paying taxes, there is some legal complexity to running a business. Here are four areas where small businesses commonly run into legal issues and how you can avoid them.


If you do not need to separate your business liabilities from your personal assets, you can do business as a sole proprietorship or a general partnership. However, to protect personal assets from business liability, you must select a corporation or limited liability company structure.

Other factors to consider include:

  • The type of business you own
  • Your personal financial situation
  • Your investment goals
  • The cost to establish the structure
  • The amount of documentation required

Running a sole proprietorship does not require you to set up a legal entity, so the cost barrier is low. You own and run an unincorporated business alone with no partners. You have complete control of the business, and you receive all the profits.

The downside it that you are also responsible for all taxes and liabilities. If your sole proprietorship goes into debt, your personal assets are at risk.


A partnership is rather like a sole proprietorship but with more people involved. All owners are responsible for financial obligations and debt as well as share profits and losses. In a partnership, all owners split responsibility for debt equally, but if one partner should renege, the remaining partners are required to pick up the debt. Personal assets are still vulnerable.

For tax purposes, a partnership must file annual reports for income, deductions, gains, and losses from operations. However, the company does not file or pay taxes. All profits and losses are passed through to the owners who must report them on their personal income tax returns.


The C-corporation is an independent legal entity, and the owners are called shareholders. If the company is sued, the shareholders are only liable for the investment they have in the business; personal assets are protected.

A C-corporation is required to elect a board of directors to make the business decisions, and the company executives can raise cash by issuing stock to new investors. Most C-corporations must issue regular financial statements.  Administration fees are higher and the tax and legal requirements more complicated.


An S-corporation is sort of a mash-up of a C-corporation and a partnership. Like a partnership, company profits and losses are passed through to the owners and reported on personal income tax returns.

An S-corporation must remain a domestic company and is limited to no more than 100 shareholders. Only one class of stock may be issued. Shareholder personal assets are separate from the business, but shareholders must pay themselves a reasonable compensation or the IRS could reclassify additional corporate earnings as wages.


Like corporations, profits and losses from a limited liability company are passed through to each member of the LLC. It is not taxed as a separate business entity, but the liability for owners is limited for business debts and obligations, protecting personal assets. 

Regulations for an LLC vary for each state; it would be wise to consult a knowledgeable attorney or CPA for guidance.


If you are going into business, you should have researched the market for your product and services first. You need to determine your costs and profit potential to see if the business will generate enough cash flow or if you will need outside investors.

Any and all important business must be in writing to be enforceable. Oral or handshake agreements are not. A well-written contract provides flexibility, protection, and the ability to take legal action if needed.

If you have shareholders, each one should sign an agreement as to how much time and effort is expected as well as how much capital each will contribute. Other rules, such as how to raise more capital, transfer shares, and succession plans should also be addressed.

Be diligent about all documentation and record keeping. Good practices will keep you out of trouble with the IRS and the courts.


Trade secrets are commercial information that is not disclosed to the public. If your company has trade secrets, every employee should sign a confidentiality agreement. If you use contractors, an invention assignment agreement or other non-disclosure agreement is necessary, even if your products or services are decidedly low tech. Trade secret law protects your proprietary business assets so you can keep your competitive edge.

Trademarks such as logos, designs, phrases, colors, and sounds that represent your brand should be registered, and any written information, images, or video should have a copyright notice. Protect patents as well by registering them with the United States Patent and Trademark Office.

Be sure to respect the intellectual property rights of others as well. Do not infringe on anyone else’s property including trademarks, patents, and copyrights.


If your business is large enough you need others to help, brush up on employee laws and regulations. Your first challenge is to classify your workers for tax purposes correctly.

Do you need help classifying employees?

Download the FLSA guide today!

If you classify workers as employees, you must withhold payroll taxes, social security, and Medicare. You must also pay unemployment insurance and comply with all state and federal employment law.

An employee is someone who has little control over what work is done, or how and when it is performed.

Contractors have a great deal of control over their work, and you do not need to do anything more than issue Form-1099 to them for taxes. If you classify workers as contractors, be very careful. Misclassification of employees as contractors can cost you penalties, back pay, and a host of other financial and legal trouble.

Develop an employee handbook outlining all company policies and procedures, including separation from the business. Written policies and procedures help ensure everyone is treated uniformly when issues, offenses, and rewards occur.

Done correctly, the handbook may be useful as a legal document if a dispute arises. It is also a good place to reinforce anti-discrimination and criminal behavior policies.


These are four of several areas where small businesses have a tendency to run into legal issues. Each one has a raft of rules and regulations to navigate. At the risk of sounding self-serving, we recommend getting experienced legal assistance to help you set up your business with the right structure, well-written contracts, and good employee policy.

A growing business needs an experienced attorney to help with stock option plans, intellectual property issues, and other aspects so you can be assured of protection from legal action and compliance with the law.

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