10 Legal Mistakes New Businesses Make (That Are Easy To Avoid)

Written by Wesley Henderson

September 14, 2020

guy upset at computer

Everybody makes mistakes. It’s part of life. And part of your business journey. Read through the 10 legal mistakes new businesses make to cut down on your unforced errors. The fewer mistakes you make the better your chances that your product or service will take off!

1) Choosing the Wrong Form of Business (Or Not Choosing At All)

Will you be a corporation? A limited liability company? A partnership? A sole proprietor? The type of entity you choose for your business will have a big impact on you and the future of your company, so choose wisely.

The main issues to consider when choosing an entity are liability protection, taxes, paperwork, fees, and how you’ll raise money. Each entity has its own pros and cons with regard to these criteria. Select the business entity that makes the most sense for where your business is right now and where you see it growing in the future.

Also, don’t assume that you don’t have a business entity just because you haven’t filed any papers. You’re a sole proprietor if you’re conducting business by yourself, or you’re in a partnership if you’re conducting business with others. That’s true even if you’re not making much money. The IRS wants to know about all the money you make from your side business, and it wants you to start paying self-employment taxes if you make a net profit of at least $400, too.

This potential legal mistake is a topic deserves much more space than we have here to get into it, so go ahead and read our posts for more about each entity type, the pros and cons of each, how they compare, how to choose what’s best for you, and how to get started in business. You main take away is to get into an entity of some sort and do not operate as a Sole Proprietorship.

Action Steps    

  • Research Entity Types and Decide the Best One for You

 

2) Poorly Drafted (Or Non-Existent) Partnership Agreements, Operating Agreements, and Bylaws

Do partnership agreements, operating agreements, and bylaws sound boring to you? Of course! They’re boring to everyone. Maybe that’s why so many businesses skip out on creating these vital documents when they’re first starting out.

But I can’t tell you what a huge mistake that is. If you’re in business with other people, you must, I repeat must, clearly define the terms of your partnership agreement from the start, whether your company is a partnership, an LLC, or a corporation.

These documents help you figure out what to do when a dispute arises among members, which it inevitably will at some point. Don’t wait until a disagreement arises to address the issue. You’ve got to do it beforehand when everyone is rational and has the best interest of the business in mind.

These documents will also help the business weather life’s storms, like disability, death, or departure of one of the partners. Something like that can destroy a business that doesn’t have a clear plan in place. 

Here’s what you and your partners need to discuss before formally going into business together:

  •     Who owns what percentage of the company?
  •     What are the duties of each partner?
  •     How will the company raise new capital? 
  •     What happens if the company wants to add partners? 
  •     How does a partner cash out and what happens to their shares? 
  •     How will the company be managed? 
  •     How will the company be taxed?  

While many problems arise from lack of these documents, others arise when these documents are poorly written or not thought through. Remember that your business is unique to you and the life situations of the partners involved. 

Action Steps     

 

3) Relying on Handshake Deals

Even though we all know how important contracts are, many people avoid using them, perhaps because they believe it slows down the pace of business, or it’s unnecessary, or it’s insulting to imply the other party may not do what they say. Whatever the reason is, this is another easy to avoid legal mistake. You not only need the clarity that an agreement like this provides but you also need recourse if someone doesn’t deliver what they promise.

But that’s the wrong way to think about it. Yes, a contract does protect you and your business, and it gives you legal recourse if necessary. The best thing it does, though, is spell out the terms of the agreement between you and the other party, so that there’s no confusion around the issue. If a disagreement arises, either one of you can refer back to the contract and say “See? This is what we agreed on.” Without a contract, a simple disagreement becomes a mega battle of “he said/she said.”

Look, sometimes people make mistakes. They misunderstood something. Or they forgot. They thought they communicated well when they hadn’t. Maybe sometimes that person is you. It’s okay. A simple contract can clear up all these issues and helps manage expectations.

 Action Steps

  • Make it easy on yourself. Get used to using contracts in every aspect of your business. Have some drawn up and ready to give to new contractors, employees, vendors, and partners. At a minimum, summarize any agreements in an email (that’s better than nothing). 
  • Download Drafted Legal’s Templates

 

4) Not Respecting Intellectual Property

Copyrights, trademarks, trade secrets, and patents are vital to the long-term success of many companies. Just imagine where Coca-Cola would be if its formula were public knowledge. Maybe you’re not the next Coca-Cola, but you still need to respect intellectual property (IP).

First, don’t infringe on someone else’s IP. Before choosing a name for your business and getting 10,000 bumper stickers printed, check to make sure that name is not being used or claimed by someone else. If you don’t stop to check, you might get a cease-and-desist letter in the mail, and then what will you do with all those bumper stickers? Seriously, it’s happened that people have branded, built their businesses, and developed goodwill among customers, only to have it all go away when they find out that they’re violating someone else’s trademark. 

Second, actively protect your own IP. Trademark and copyright what you can. Use nondisclosure agreements (NDAs) when necessary. Don’t underestimate how important these intangible assets are to the success of your business.

Action Steps

  • Before choosing a name for your business, do your research and see if it’s already in use.
  • Seek available trademark and copyright protections for your company’s intellectual property.   
  • Draft up nondisclosure agreements for contractors and employees to sign if they’ll be given access to sensitive information.

 

5) Doing Your Business Taxes Yourself

Ben Franklin was spot-on when he observed that “Nothing is certain except death and taxes.”

Most business owners don’t make the mistake of failing to pay taxes for their business, since they know it’s a necessary evil. The mistake they make is trying to do it themselves and not doing a very good job.

Unless you are a tax professional, or spend your weekends pouring over the IRS’s delightfully endless tax code, I guarantee you that you don’t know as much about business taxes as you need to in order to handle them yourself. This is especially true if you have employees or if your business is a corporation, which has more exacting requirements for paperwork and filing.

The best-case scenario: You miss out on some deductions and ways of categorizing expenses that could reduce your tax bill and save you money. The worst case scenario: You screw up royally and find the IRS breathing down your neck. (Or worse.)

In short, work with an accountant or a CPA to help you prepare and file your year-end taxes. It’s not free, but the expense is worth every penny.  

Action Steps  

  • Find an accountant to prepare your taxes and to advise on money matters throughout the year.

 

6) Ignoring Threatening Letters

This is an easy mistake to avoid.

From time to time, you may find yourself on the receiving end of a love note from the IRS, the ICE (Immigration and Customs Enforcement), the City, or another company. Maybe you overlooked something or failed to pay something on time or made some other honest mistake. It happens. The worst thing you can do now is ignore the letter and hope the matter goes away. Instead, address the issue promptly.

For example, let’s say your company is served with a lawsuit. Contact an attorney immediately! You may only have 30 days to respond, so taking your time isn’t an option. Or say you get a letter from the City reminding you of some overdue fees. Just write the darn check, stick it in the mail, and move on.

This advice may sound ridiculously obvious, but you’d be surprised at how many people adopt an “if I don’t think about it, it’ll go away” approach. I can tell you that it doesn’t work.

Don’t let something manageable become a problem by ignoring the issue. If it was important enough for someone to send you a letter, it’s not going away. 

Action Steps

  • When your company receives threatening letters in the mail, do not ignore them. Take action! If you don’t know what steps to take next, consult with an attorney for advice.

 

7) Poorly Documented Employee Files

These last four mistakes have to do with employees, and this first one is about paperwork.

Most companies should keep at least three different files on employees. 

  1. A General Employee File. This includes work-related documentation for each employee, like a signed job description, signed employee manual compliant with state law, performance reviews, and any documentation of disciplinary action taken. 
  2. Health File. This separate file contains health insurance information, reports regarding a disability, and any other materials related to the health of the employee. These files are kept separately so that someone going through the General Employee Files won’t see sensitive health information.
  3. I-9s. An I-9 should be collected for each employee and kept all together in this last file. The form I-9 serves as identification verification and shows that the employee is eligible for employment in the United States. If a federal officer comes asking for I-9 forms, it’s best to have them all together in one place, separate from other sensitive information. 

Action Steps

  • Set up and maintain a comprehensive filing system for employee-related documents.

 

8) Drafting Bad Employee Handbooks

Did you know that employee handbooks very are important for the business owner? It’s true.

Did you also know that poorly written employee handbooks can do more harm than good? Also true.

Employee handbooks, when done correctly, protect the interests of you, the business owner, while also spelling out expectations and policies to your employees.

When worded incorrectly, an employee handbook can put you in a position you don’t want to be in. One of the most common examples of this is when an employee handbook includes a section on progressive discipline; for example, the handbook states that an employee breaking company policy will first receive a verbal warning, then a written warning, then will be terminated. This may limit your ability to fire the employee when you want, as the wording makes it sound like there’s a contracted relationship. Instead, you want to avoid mention of progressive discipline and make sure to include an “at-will” clause, if you’re in an at-will state. (Most states are “at-will” states, meaning that an employee can be fired for any reason as long as it’s not for an illegal reason like firing someone based on gender, race, or religion.) 

 

This is just one example of a snafu that can occur when you try to write an employee handbook yourself without understanding all the legal consequences. Make sure you do it the right way.

Action Steps

  • Create an employee handbook that follows all applicable state employment laws and protects the business. If you have an HR department or an employment attorney, they can draft it. If you choose to draft it yourself, have it reviewed by an attorney familiar with employment law in your state.

 

9) Confusing Independent Contractors and Employees

Employers have good reason to prefer independent contractors over employees: because they can save money. By hiring independent contractors, employees aren’t responsible for employment taxes, benefits, workers’ compensation insurance, vicarious liability, maintaining employee files, and a number of other personnel issues. 

But just because a company calls someone an “independent contractor” does not make it so. The IRS has guidelines for determining whether a worker is an independent contractor (1099) or a true employee (W-2) for issues of taxation, and your state has its own rules, too, for issues of workers’ compensation, unemployment benefits, and so on.

What can happen if you misclassify someone? If the IRS determines that you classified someone incorrectly, you might be on the hook for paying back taxes and other expenses, which could add up to a lot of money if it’s been going on for a long time.

In general, if you exercise control over where, when, and how someone works for you, they may be considered an employee in the eyes of the law, whether you call them an independent contractor or not. 

Action Steps

  • Read up on IRS and individual state guidelines for what constitutes an employee versus an independent contractor, and make sure you’re classifying your employees correctly.

 

10) Hiring and Firing Employees the Wrong Way

“Hire slow, fire fast” is a popular saying for a reason. Making good choices about who to employ from the beginning can save you a lot of headaches down the road.

It all begins with a good job description. If the job description is good, then the employee knows what’s expected and the employer has the ability to measure the employee’s performance. A poor job description that sets unrealistic goals or fails to define the job will create a problem if the company must dismiss an employee. 

Firing an employee is not fun, but sometimes it’s the only alternative left. Make sure you have a good job description, a fair employee review process, and a well-documented employee file, and be sure that the decision to let the employee go is based on the merits of the employee’s performance and your company’s needs. If you have to let an employee go, make sure you do it in a respectful way and don’t embarrass them. 

Action Steps

  •  Create a good job description for the position for which you’re hiring.
  • Be respectful when firing someone, and have the documentation to back the decisions up.

You May Also Like…

Drafted Legal Templates

Business
Law
101
Course

Start Your LLC