The Transcript

from the interviews with attorney John Dolan
in Newport Beach, California

Table of Contents:

1. Tax law???
2. Home-office Deduction?
3. Sole proprietorship, Partnership or Corporation?
4. Contractors or Employees?
5. Deductions (and Tax Law)?
6. Hiring and Firing?
7. Collections?
8. Alternative Dispute Resolution?
9. Small claims court?
10. Non-compete clauses?
11. Legal templates? But be sure to follow the Letter of the Law
12. 30 days from when?

HOST: We've heard a lot about changes in the tax law. Well, how do these changes affect us small-business people? We go to legal expert John Patrick Dolan for answers in this week's Law Talk.

JOHN DOLAN: One change in particular is virtually devastating for small-business people. You remember the discussion in the media back and forth about how we're gonna add this extra 10 percent surcharge to the fat cats the people that make more than $250,000. And they're gonna pay. And, of course, a lot of Americans don't make anywhere near $250,000 and so people are saying, `Well, that sounds OK. They can afford it.'

Here's the problem.

Most of the people that are making $250,000 are not fat cats. They are small-business owners. They are people that are organized in a sole proprietorship or in a sub-chapter S corporation. And while it sounds like a lot of money, if you consider taking your own personal living expenses out of your $250,000 that you earn in your small business, and then intending to invest in some equipment, some inventory, etc., small-business owners need to understand that they're gonna be taxed at that 39 percent upper rate, plus 10 percent more as a surtax. The intent was to have people who make a lot of money pay more taxes. The effect is going to be that small-business owners, who've created most of the new employment in this country in the last 10 years, are going to be taxed to the point where they're not gonna be able to invest or add another employee. And that's really devastating. ..

HOST: Well, what do we do about this?

JOHN: Depends on how you're organized. If you are a sole proprietor or a sub-S corporation, both of which are taxed as though it was personal income, you have to do an evaluation with your tax adviser and you have to ask, `Would we be better off incorporating? Would we be better off deferring some income? Perhaps we don't want to employ a new person because we might not have the revenues, after we've paid this extra surtax, to pay these people over the long haul.'

HOST: But I understood, on a sub-chapter S corp., you're only taxed on the money that you take out.

JOHN: No. See, that's something that's misunderstood by a lot of people. In a sub-chapter S corporation, you are taxed on all the income. Whether you take it out of the corporation and use it for your personal expenses or you leave it in to, perhaps, invest in inventory or some other equipment purchases, all of the income, after your expenses, is taxed. And this is the very problem we're talking about here. You are prevented now, with this surtax--or at least it impacts the ability to add more to your inventory, to add other employers because that surtax, while it sounds like it's a good idea--rich people are having to pay it--ends up coming to bear on the small-business people, who are in a position where they're gonna take some of the money they've earned and reinvest it in their business. There's a penalty for having more money to reinvest in your business.

JOHN DOLAN: (Voiceover) Well, I think you need to understand this with a little historical perspective. Originally, people, if they had an office in their home, would take a home-office deduction; pretty understandable. In the late '70s, the Congress did a tax reform act, one of the many they do from time to time. And in this tax reform act, they said, `You can still take the home-office deduction, but only if this home office is your principal place of business.'

Your principal place of business is evaluated based on a couple criteria that are given in the case. First of all, what's the relative importance of what you do at home in this home office compared to what you do outside the home office? And if you think about what an anesthesiologist does, this is a problematic situation for taking the deduction, because even though he reads medical journals and talks to other doctors, and does a little bit of paperwork and all of his billing from this home office, his real work, administering anesthesia, is done in a hospital.

HOST: What about other small-business owners, like what about salespeople? Should they be nervous about this?

JOHN: I think salespeople should be awfully concerned about this. Most salespeople that would have a home office would actually do their real work face-to-face.

HOST: What if I'm in this position: What if I'm not sure whether I qualify or not? Now give me your best advice. Should I risk the deduction or should I not take the deduction?

JOHN: If I had to give you a one-word answer, it would be no. Don't take the deduction.

HOST: Really? Why so?

JOHN: Well, because you're not saving that much.

HOST: Really?

JOHN: I mean, if you have a huge home and a huge mortgage and you're real worried that you're gonna be paying a lot more taxes, go to a tax attorney, go to an accountant and get an opinion that would make you feel more comfortable. But the average person is not deducting that much and the tax savings is not that much so that it really is a pretty big risk for the reward that you get.

HOST: If you're just starting your own business, should you organize it as a sole proprietorship, a partnership or a corporation? John Patrick Dolan explains the benefits and drawbacks of each in today's LawTalk.

JOHN PATRICK DOLAN: A sole proprietorship is a business entity, organization, where essentially it's an individual who owns a business as an individual. The individual is taxed on profits of the business, after the expenses are paid, and so it's very similar in a sense to having a job. That is, whatever income you get in minus your expenses is what you pay taxes on.

A partnership is an interesting arrangement. It's like a marriage, in a sense. You go into the business, you're individuals, you have a contract with each other, hopefully, that describes the pluses and minuses of your relationship. I always advise my clients, first question you want to answer is, what do you do when the partnership is ended, when you dissolve it?

And the reason is, almost all partnerships end. And usually the litigation and the loss of money and time and emotional output comes from when a partnership ends. If you don't plan up front what you're going to do if that eventuality takes place, you can dissipate all the partnership's assets and maybe a lot of assets that aren't partnership assets just trying to unwind the problem.

HOST: OK, so we don't want to do a partnership. What are the other options?

JOHN: Well, of course, you can incorporate. An incorporation usually happens in two ways. You can have a regular C corporation, which would be a corporation that has an unlimited lifetime and has certain advantages to it, or you could be a subchapter S corporation.

HOST: OK. What are the differences?

JOHN: Well, a C corporation essentially is an entity in and of itself. It's a tax-paying entity. It takes in income, it pays expenses, it pays salaries to its owners, and so the owners would be able to take a salary out and still pay their own tax, and then they would have money accumulating within the corporation. And, of course, the corporation would pay tax on the money accumulating in the corporation.

HOST: So you do have to file two tax returns. OK. Do you have to do that with sub S?

JOHN: You do have to do it with sub S, but the tax return for the sub S corporation is what they call an information return, and the real taxes, of course, are paid by the individuals. So the information return doesn't require you to send in any money. So as a small-business owner, if you're an individual, probably it doesn't pay to spend the money to incorporate, although I would definitely talk to a tax adviser to get another opinion.

HOST: As your small business grows, you'll probably need to hire some help. Are these people independent contractors or employees of your company? Well, according to our legal expert, John Patrick Dolan, that depends.

JOHN DOLAN (Legal Expert): If you have an employee, you must pay them wages, you must deduct from their wages employee taxes, you must meet or match some of the tax liability and send this in to the taxing authority, the federal government and your state government. If you're hiring an independent contractor, you pay them once and that's it.

HOST: Well, I've got the answer. All of my employees are independent contractors.

JOHN: Well, a lot of small-business people like to say that, and a lot of small-business people want to believe that because their liability is usually less. The actual number of dollars outlaid for job performed is less. Here's the problem: The government looks at situations where there's a dispute, whether or not you have an employee or an independent contractor, and they look at things like this: Do you tell this person when to come to work? Do you provide the tools of work--business cards, PCs, desks, etc.? Do you tell them the kind of work they need to do and give them rules for doing the work? Do they work for anybody else? And if you don't pass these tests, if it looks like they're only working for you, even though you're calling them an independent contractor, and you tell them where to work and when to work and you provide the tools, you have an employee. And many small businesses have--have been hit rather hard by taxing authorities that come in and establish, `For the last 10 years, you've been saying you have independent contractors, but you really have employees. You owe us $10 gazillion in taxes.'

HOST: So your advice is, don't fudge on this one.

JOHN: If you have an independent contractor, someone chosen for a short period of time to do a particular task, of course, treat them like an independent contractor and save whatever expenses you might otherwise expend if they were an employee. But if they're an employee--I mean, if they're with you longer than about 90 days, they're pretty much an employee. Start withholding and paying your matching, and don't think you're fooling anybody.

HOST: As the owner of your small business, it's your job to hire and possibly fire the people who work for you. Well, according to legal expert John Patrick Dolan, the laws regulating both of these tasks are specific and must be followed closely.

JOHN PATRICK DOLAN (Legal Expert): In this country, in the last few years, there have been lots of laws and much legislation regarding hiring and firing. And there's a real sensitivity in the marketplace, although there needs to be even a higher sensitivity to discrimination as it relates to hiring, promoting, training, firing people; sensitivity regarding race, sensitivity regarding sexual orientation, sensitivity regarding national origin, sensitivity regarding age. And all of these things come to bear on small businesses, depending upon how many employees. Now if there's only one employee, you're probably not going to have the EEOC breathing down your neck because they're too busy. Originally it started out about 50 employees is when the federal government statutes started kicking in. Lately the trend has been around 20 employees, and I would say even if you only have one or two employees, you would not want to be a person who is overtly discriminating on one basis or another because you could get yourself in trouble. Hiring people is a very interesting area of putting together a business and a neglected area.

HOST: Well, talk to me now about firing.

JOHN: Well, that's a hard one, isn't it? Most small businesses don't have a policy manual or procedure manual or a grievance system. They simply are operating as best they can, and so maybe they decide, `I'm gonna fire this person.' A couple of things that apply to any business, including small businesses, and that is if you fire someone, you owe them what they've earned up until that date within about 24 hours, if you want to keep yourself safe from getting sued, so you need to know that. You need to know that if someone calls and asks for a reference, you would be well-advised not to do anything more than confirm they worked for you for whatever period of time they worked, because anything you say that impacts their employment at the--or failure to be employed--at the other employer could cause you some liability as well, even as a small-businessperson because they could be damaged by some comment about their reputation, their honesty, etc.

HOST: So really, the less said, the better.

JOHN: The less said, the better. Essentially, you got to try and find the best people you can, and then you got to take care of them the best way you can so that they'll stay with you and be productive. And, of course, with a small business, we're always competing for dollars. I mean, how do you spend the money for training? Where do you get the money to give a person a couple of days off if they need a couple of days off? And all this impacts on how people relate to the work, and whether or not they do the work properly, or if they're trying to sabotage the organization so that you eventually have to fire them.

HOST: Small-business owners had better watch the law pretty carefully because it's always changing, especially in the area of employment, as John Patrick Dolan tells us in this week's LawTalk.

JOHN PATRICK DOLAN: Teresa worked in a deli in Iowa. She got fired, her boss said, because of inadequate performance; she said because she kept inquiring about insurance coverage that was supposed to be part of her employment and couldn't get a straight answer. He got annoyed. She even threatened legal action; he fired her. Well, the district court in Iowa concluded--Iowa has a statute that allows an employee to ask for an accounting of benefits and income from the employer, and if she was fired because of retaliation, that is for threatening to bring a lawyer into the situation, that she would have a cause of action for wrongful termination. So it's very important for small-business owners to recognize we need to follow the letter of the law, too.

Recent changes in the tax law affect small-business owners. In this week's Law Talk, attorney John Patrick Dolan looks at some of the changes in deductions we can take on our tax returns.

JOHN PATRICK DOLAN (Legal Consultant): There's a couple of things that actually represent good news for small-business people. One of them is there was an increase in the amount of money you can spend on equipment in any one year, capital investment. The amount has been increased to $17,500, so any small-business owner probably ought to be looking toward the end of the year at where they need to invest in maybe a new PC or maybe add something to their network, or a new printer, because up to $17,500 can be deducted immediately, rather than depreciated, as in the past it had to be, over time.

HOST: Well, so that is good news.

JOHN: That is a good one, and that's nice, especially for those of us that have to keep adding to our PCs and our networks. A couple of other things have been affected, too. Charitable donations. Many small-business people get involved in providing goods and money to charities in their neighborhood, and the law has been changed now to where any donation, especially of items--goods over $250, you must have actually written information from the charity that says they received it and places a value on it. So this is just an extra hoop we have to jump through, it's nothing terribly hard, but it is something new.

Moving expenses have been affected. That is, if you're going to move from one residence to another because of your work, the law now requires that you move at least 50 miles. If you don't move over 50 miles, you're gonna have difficulty deducting the expenses, and that's significant for small-business people, because many times, we have a company, and we do well, and so we decide we're going to move into a nicer neighborhood, and if we don't move over 50 miles, or if we employ someone and they don't move over 50 miles into their new residence, they're not gonna be able to deduct the expenses.

And the other one that's really important for small-business people is the entertainment and meal expense deduction.

HOST: Ah, right.

JOHN: I guess people got to be known for having the three-martini lunch and the backlash is still going on, because originally, you could deduct all those expenses.

HOST: Yeah, all of it.

JOHN: The law was changed down to 80 percent, and in this new Revenue Reconciliation Act now, it's 50 percent of the meal expense or the entertainment expense that you expend to promote your business can be deducted. But the other 50 percent, you need to pay taxes on, so you've got to be very careful when you go out to lunch, why you go out to lunch and why you make the entertainment expenditures.

HOST: If someone owes you money, how do you go about collecting? Well, there are some right ways and some wrong ways, as John Patrick Dolan tells us in this week's LawTalk.

JOHN DOLAN (Legal Consultant): Well, you need to collect the debt. And so the question is how do you collect the debt and what's appropriate? The federal government passed a law called the Fair Debt Collection Practices Act, and what it basically says is you need to collect your debts in an appropriate fashion. So you don't want to call people at 3 AM, and you don't want to send Vito the leg-breaker to beat down their front door, and you don't want to call and abuse people at their workplace. And if you do, you could be in trouble.

Let's say you have somebody that owes you $500, and so you decide that you're going to figure out a way to get them to pay, because maybe, as a small-business person, this is the profit that you make in this transaction. You're allowed to contact them and see if you can get them to pay, under reasonable circumstances, during regular business hours at work--unless they say, `Please don't contact me at work anymore'--at home, through correspondence, etc. The federal Fair Debt Collection Practices Act, however, says if you abuse your ability to collect your debts--that is, if you do things that are really rude, abusive, inappropriate--you can be liable up to $1,000 for any particular debt. And recently a case came down that said this: It's not just $1,000 on your hypothetical $500 debt, but it's $1,000 every time you do something rude and abusive, like three phone calls at 3 AM, four knocks on the door from bad guys, and three other abusive acts adds up to 10 acts, you could be liable for $10,000 to this person.

HOST: OK. I don't want to abuse them, but how do I get my money?

JOHN DOLAN: Well, I would say the simple thing to do, first of all, is to correspond in the beginning. After you correspond, there are a number of reputable collection agencies where you could send out a bad debt--and, of course, when you engage an agency like this, make sure that they're familiar with the Fair Debt Collection Practices Act--and you might even, by the way, put together in your relationship--contractual relationship with this debt collection agency an agreement that if they act beyond the scope of your engaging them--that is, if they do some things that are inappropriate--that you are going to be held harmless, and that they will take full liability for this.

And then after this, you end up in litigation. We try and avoid litigation wherever possible, but sometimes it's the only alternative.

HOST: But then we've got to get lawyers involved, and we definitely don't want to do that, right, John?

JOHN DOLAN: Lawyers are expensive. Sometimes you need us.

Legal expert John Dolan has given us some of the dos and don'ts about debt collection. Here is another step we can take if someone owes us money and doesn't pay.

JOHN DOLAN: There's a big trend in America--and I think small-business people can take advantage of this trend--it's called alternative dispute resolution. And how it works is, you put together in your contract or agreement with yourself and your customer of client a clause that says, `If we have a disagreement, if we have a dispute over payment, we both agree that we would use an alternative dispute resolution mechanism rather than going directly to court. It might be a neighborhood justice center, it could be an arbitrator agreed upon by both of us.'

The advantage to this is, you can continue to do business, especially with good customers, while you have a dispute resolved outside of your regular business channels. And that way, you don't ruin the relationship. When you're talking about a small business and you're talking about debts, you know, $500, $700, $1,000, lawyers' fees eat up so much that it almost becomes irrelevant to go to a lawyer. And so for everybody's protection, the trend is--and I encourage small-business people to include in their agreements--an alternative dispute resolution clause so they can go outside of the legal system but outside of their personal relationship to get a problem resolved. You don't have to lose your business relationship in order to resolve a dispute that you have.

HOST: Collecting payment can take up a lot of our time. We've talked with our legal expert, John Dolan, about some of the steps in debt collection, but what if you've decided you have to go to court. Here's John.

JOHN DOLAN (Legal Consultant): Small claims court is designed for small claims. And small-business people, many times, have claims. Small claims defined in today's marketplace are usually claims under about $5,000. Now that's a lot of money, any individual debt of $1,000 or $2,000 or $3,000 to a small-business person but when it comes to the court system, it is viewed as a smaller claim. The small claims court is interesting. You don't have to have a lawyer. In fact, many small claims courts prevent lawyers from appearing, so it ends up being sort of like Judge Wapner on television. You come and tell your story about the person who didn't pay your bill. They tell their story about why they didn't pay the bill. The judge listens and makes an evaluation, and makes a decision. In this way, you can get the bill paid by using the court system without having to resort to paying large amounts of money to lawyers.

HOST: OK, so I have a judgment against the guy, but he still won't pay. Do I have any recourse?

JOHN: Yes, you do. It takes a little more effort on your part. There's something called a judgment debtor hearing in almost every jurisdiction. So you get a judgment and someone doesn't pay up. You can subpoena them to court and they must, under oath, under the court's jurisdiction, tell you all about their assets. You can ask them, `Do you own property? Do you have bank accounts? Do you have other assets that could be attached?' Once you find out where their assets are, then you can send the marshal out to attach their assets and satisfy your debt.

HOST: Something that all small-businesspeople should be informed about is the subject of non-compete clauses. These contractual legal restrictions exist in many businesses, and they're the subject this week for legal expert John Dolan.

JOHN DOLAN (Legal Consultant): The covenant not to compete. This is something that comes up a lot of times in a small business situation. One way it can come up is you buy a business. You go to someone's business--let's say they have the greatest hamburger stand in town, and I buy your hamburger stand from you, and you agree with me that you won't open up another hamburger stand anywhere within 50 miles. If part of our agreement is you get certain compensation, specific compensation, so many dollars for this agreement not to compete, the courts will enforce those kinds of agreements, because it makes sense, doesn't it? If I'm buying your business, I want to know that you're not going to put me out of business by opening up next door. And so those kinds of non-compete clauses are routinely enforced.

But here's how it comes up, and it can be significant for a small-business owner. Let's say you work at Megacorporation, and you've decided to go out and open up your own company. And in your original employment contract with Megacorporation, it says you agree that you will never go out and compete with Megacorporation producing the products that they produce, or similar products, in the area. You go out and open up a company. Most of the time the courts will not enforce that kind of a non-compete clause, and the reason is pretty simple. If you're given specific compensation, and you voluntarily agree not to do something, not to compete, the courts will enforce that. But if it's just part of the contract, and there's no specific compensation, the courts have generally found that's an unfair clause to enforce, because it can prevent someone from earning a living, and the courts don't want to do that.

HOST: So if I, as a small-business owner, want to keep someone from competing against me, I need to offer compensation.

JOHN: Yes. Specifically within your contractual agreement to purchase the business, you want to identify a portion of the compensation for the purchase of the business that is allocated to the agreement not to compete. So it's $10,000 as part of the purchase of this business is allocated to your agreement that you will not compete with me within 50 miles for five years. Once there is an exchange of consideration, the courts are happy to enforce that kind of agreement.

JOHN DOLAN (Legal Consultant): Well, I don't want to talk myself out of any business, because lawyers always like to get hired to do things like this, but I can tell you, there's a real sensitivity in the legal profession to the fact that small-business people have to put together buy-sell agreements, materials purchase agreements, special kinds of things regarding their wills and trusts and things like this. And it can get very expensive.

For people who operate small businesses, there are software packages that are available by several different manufacturers: Software packages that include wills, trusts, partnership agreements, sole proprietor agreements, employment agreements, employment contracts, things like this.

Now it's really important that you don't just use some of these software packages willy-nilly. Now my suggestion would be to small-businesspeople, if you get a hold of one of these packages, which could include as many as 200 or 300 different kinds of contracts and documents, take the package down to your lawyer, and say, `Is there anything about this package of documents that would cause any difficulties in our particular jurisdiction?'

And a good lawyer would be able to look things over and say, `Well, this kind of document has to have this certain kind of addendum in this particular jurisdiction,' etc. And then you ought to be able to use them in your business, and really, really reduce the expenses attendant to putting together documents or contracts between yourself, your suppliers and your customers.

HOST: So in essence, we become our own lawyers. But not quite.

JOHN: Not every time.

"In the future, employers have an obligation to provide opportunity for self-improvement; employees have to take charge of their own careers." -Business Week

HOST: There are lots of ways to send information, but when it comes to legal matters, you have to be careful and pay attention to the fine print, as John Patrick Dolan tells us in this week's LawTalk.

JOHN PATRICK DOLAN (Legal Consultant): In South Carolina, their Supreme Court made an interesting decision. A franchisee put up some money, and was waiting for a geographical location to be assigned regarding the business that they were franchising. Well, the contract said, `If you don't like the geographical location, let us know by Registered Mail or return receipt requested.' Instead what happened, when the franchisee found out they didn't like the location, they sent a FedEx. All parties agree that the FedEx was received and the information was transmitted, but the court found if a contract calls for return receipt requested by the US mail, you are not allowed to liberally construe that and send it by some other means, like FedEx or the Internet or something else. Be very careful in business contracts to follow the letter of the law.

"The marketplace for virtually all industries has become global. Clearly, the the export markets for U.S. companies positioned to respond to opportunity have dramatically opened." -Price-Waterhouse

JOHN DOLAN (Legal Consultant): It's interesting, because, you know, technology sometimes advances beyond the law that is intended to govern certain conduct or certain kinds of transactions. March 1st, 1994, supposedly the FTC began to catch up with technology. Here is one of the things that comes up all the time, when you're selling products over the telephone, or in direct response marketing through television, or maybe some of these special PC software programs where they actually make telephone calls for you or fax on demand. When products are sold, there's a general rule that the FTC has applied for a long time. You need to either give a shipping time--that is, four to six weeks you'll see many times on an advertisement--if you don't, then 30 days is the amount of time imposed by law, within which you must ship, or else you can be liable for damages. Well, this applied essentially to things that were advertised, but they really hadn't extended it until March 1st, 1994 to things like electronic billboards, to receiving a fax. And here's the critical thing for small-business people to understand: the 30 days begins to run when you receive the order, not when you process the order, but when you receive it.

HOST: OK, John, but what if I'm a broker, and I'm getting my materials from a supplier, and that supplier doesn't get me the materials within 30 days. Am I liable?

JOHN: The answer is yes. If you don't advertise, either on the electronic billboard or over the telephone or in your space ad, four to six weeks, or eight weeks, and extend the 30-day period beyond what's required by statute, if you are silent as to your shipping time, then 30 days is the requirement. And if your supplier doesn't get to you within 30 days, you are liable. Now that's technical, because, obviously, if you found out your supplier couldn't produce a product, you'd get on the phone and call your customer, and you'd say, `We've got a problem. Is it all right if we take another two weeks?,' or, `Do you want to maintain the order or would you like to cancel the order?'

As long as you take remedial action, you're probably gonna be OK, but you are stuck with the 30 days no matter what happens with your supplier.

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