Legal Status, Tax Status, & Contracts 101

Legal Status, Tax Status, & Contracts 101

This year we’ve been talking about business entities. So far we’ve covered sole proprietorships, and registered entities like limited liability companies, limited partnerships, and corporations. 

A question that pops up frequently in our small business practice is the distinction between tax status and legal status. Let’s dive in.

What’s a Legal Status?

When we’re referring to legal status we mean that sole proprietorship and general partnership are both situations where the individual and the business are regarded as one and the same. 

The legal status essentially is that of the individual. That’s what it means when you have unlimited personal risk of liability exposure. So the legal status that we’re referring to in this context is really with respect to business entities and to registered entities.

If you missed our LinkedIn live about Business Registrations: Partnerships, Corporations, & LLCs, watch the replay here.

Legal status essentially is in relation to the form that business entities take, and in specific registered entities such as the three basic formations: the corporation, the limited liability company (or LLC,) and the limited partnership. Limited partnerships are comprised of at least one general partner (which may be another entity) and a series of limited partners. 

The formation of the registered entity is a way of stating who the managers are, how the company operates, and who the owners are, or who is in control of the company. Those are two distinct roles and they’re often expressed in different ways within the structure of the corporation, the limited liability company, and the limited partnership. 

In short, the legal status is the ownership structure and how company operations execute. 

What’s a Tax Status? Tax Status

In contrast, the tax status of a company is just one small aspect of the company, whereas the legal status provides the foundation. Tax status is just how one administrative agency regards business entities. We’re talking about the IRS and various state tax entities in each respective state like in Georgia, it is the Department of Revenue. 

Your business entity’s tax status is how your business income will be regarded when you’re filing tax returns. There are a few ways that you might elect to be regarded. There’s obviously default elections that are automatically selected when you file your returns versus when you are filling out a form to affirmatively elect a new tax status, which is another option that you have. 

The default election is to be disregarded for the sole proprietorship and the partnerships, which disregarded means that for tax purposes, your business status is disregarded. So the income, profit or losses are regarded as against your individual and not a business tax return. That’s the default tax status as a sole proprietorship or as a partner in a general partnership. 

Another way that the IRS regards you is pass-through, which means that the income passes through to the individual or the partner, schedule. Instead of paying corporate tax, you are paying at the individual rate on wages, or the dividend rate as a business owner on profit distributions. The most popular example is the S-corp election. Again, this is a tax status, not a legal status. So what’s interesting about that is since they work in tandem, you can have for example, an LLC (which can be one or more persons) that is taxed as an S corporation.

That reduces the individual income tax to only what your reasonable salary might be. Certainly, there are regulations about that which you can discuss with an attorney about changing your tax status. If you haven’t done that yet and you’re interested in talking about switching to an S-corp tax status then that’s a discussion and decision that we can help you with at Morin Legal.

The last tax status everyone’s familiar with is the corporate tax. That’s infamous because nobody likes to pay more tax than they have to, but corporations are double-taxed! This is because you pay the corporate tax, then your individual income tax on your paycheck, and finally, any dividend tax on profit distributions for shareholders is accounted for. 

It appears with its double-taxation to be an onerous tax structure, but why use corporations? Most of the time it’s to raise capital. Fundraising in S corporations is tricky because there’s only one form of stock, common stock. When you’re raising funds, you don’t always want to share your management and control with your fundraising partners. You might want to make all the creative and business decisions, but that stock structure would not permit that. Furthermore you might want to invite investors that are not U.S. citizens or natural persons and who might be foreign investors, business entities or institutions, which cannot invest in an S-corp.

So there are reasons people pay the double tax with a corporation (or individual income tax under an LLC), but certainly whatever tax status is right for you is a personal and professional decision that you want to make with the advice of a small business counselor and your CPA. 

Contracts are extensive, but we’ve outlined the basics for you to better understand them.

Contracts MasterclassContracts Masterclass

To better understand the tenets about contracts, we’re breaking down the nature of the practice, which for us is mostly transactional and involves either some type of intellectual property rights based in copyright law, trademark law, or some type of personal rights. 

Top 10 Aspects of a Basic Transactional Contract

1. Key Terms

Key terms to any contract include the identity of the parties to the contract, and that can be really important depending on how you want to be taxed for the income you receive or expenses you pay in the contract. 

The subject of the contract, the consideration to be paid in the contract (which can include compensation but doesn’t have to), the term or period during which the contract should apply, and the territory in which the contract applies are also key terms. Contracts are guidelines to behavior in which parties agree to a certain course of conduct of doing business. 

If you verbally agree to the key terms and depending on the nature of the agreement, you may have a binding agreement just verbally on reaching those key terms. Consult an attorney if you’re not really sure if you’ve reached a binding agreement. 

2. Rights (Property/Personal)

In the rights section of each Contract, there’s a provision discussing the rights to be transacted. The rights might either be based in intellectual property law, in some aspect of copyright law, trademark law, trade secrets, or personal rights, including commercialization of the person’s identity, including the name, image and likeness, and so forth. Celebrity endorsements fall under this category, as well as other types of merchandising or otherwise licensing agreements. 

3. Confidentiality/NDA

In doing business with another party, you might get access to information that might not otherwise be publicly available, but be necessary for performing the agreement. The parties agree that sharing such information will be done under certain conditions outlined usually in some section related to confidentiality. Those provisions are normally in the chief agreement. 

Another way of looking at these sections is in the context of non-disclosure agreements or NDAs. Usually you’ll enter into something like this prior to entering into a longer form or even a short-form agreement. The functionality of these agreements is to maintain disclosures to a minimum in order to perform the agreement and protect against any future disclosures.

4. Representations, Warranties, & Indemnities

I like to tell my clients that representations, warranties, and indemnities go together like carrots and peas because they function as symbiotic ingredients.

  • Representations are alleged facts, or material representations that you make in order to enter into an agreement that other persons are depending upon.
  • Warranties are promises of a certain quality or level of conduct that you will perform.
  • Indemnities are there in the event you have misrepresented a fact or acted to deviate from your conduct, and serve to protect the non-breaching party from any legal action. 

You’ll see reps, warranties, and indemnities usually go in that order in an agreement, sometimes mutually by both parties. Depending on the type of agreement, there might be more reps on one side than the other. Again, consulting a lawyer on this is essential if you’re going to understand what you’re actually agreeing to. 

5. Remedies (Notice/Cure)

What happens if somebody doesn’t perform and suddenly they’re in what we call breach? A notice and cure provision is extremely helpful because it keeps you from having to go to court right away to enforce an agreement. It essentially means you’re letting the person know they’re not performing up to what they agreed to, and they have maybe 2 weeks to cure the conduct. 

Certainly that is one tool in the toolbox that is great to exercise. Maybe it was an innocent or accidental breach, like for mispayment or misfiring of a check. Needless to say, it’s one step before having to go into the next bit, which is considering the effect of breach or termination. 

6. Termination

I always tell clients to never get into an agreement you cannot get out of. Look for the termination conditions and what the effects of termination are. 

  • Do you have to give back documents? 
  • Are the materials you create frozen in the process? 
  • What type of agreement really determines what the effect of termination is? 

It’s always good to see that you have a paragraph related to termination or otherwise an exit from the contract. If you do not understand the steps of exiting the agreement, then please consult with a lawyer to make sure you understand how to navigate the process.

7. Alternative Dispute Resolution (ADR)

Alternative Dispute Resolution (ADR) is an inexpensive and effective way of resolving business disputes. If the person doesn’t cure their conduct, you may then start with basic negotiation on the side of either party through their authorized representatives. 

If that doesn’t work out, you may proceed into mediation, and after that, arbitration. Litigation, depending on where the forum is, can be expensive and time consuming. Our firm does not litigate disputes (yet). We would send clients externally to a litigation and trial practice. ADR is great in trying to take baby steps to prevent more expensive “dispute resolution.”

8. Choice of Law/Forum

Choice of Law/Forum is important if you are going to have to settle your problems under the contract. 

Some contracts say, “Listen, we know that you’re in Georgia, but the choice of law in this contract is gonna be California or New York.” 

And guess what? 

That’s where the forum will be. So that’s where you’ll have to travel if you have to enter any mediation or arbitration.

That’s something just to be aware of when you’re making those tiny selections. If the worst should happen, what are the consequences and what are the costs involved? Keep some type of business reserves on hand for that. 

9. Boilerplate

Boilerplate is on every contract. We like to think of it as one giant paragraph. You see it very often where people just smash together a bunch of what seem like sentence fragments, but really they boil down to a science that probably only lawyers speak. 

It’s a paragraph talking about how this is the entire agreement. There’s no other agreement that applies. All of your intentions are reflected in this one single document. That’s something we call a merger agreement. It also provides a mechanism for if the parties want to amend or change their terms, or if somebody waives their rights to enforcement or to something else that they’re not agreeing to a future waiver. It further says if terms are illegal or impossible to perform, we can sever them from the agreement and not destroy the contract. 

There are other sections in the boilerplate on headings and counterparts if you’re signing two different originals in different areas, which brings us to our last point…

10. Signatures

You can electronically sign documents in the transactional space, with the exception solely of affidavits, which need to be notarized. Otherwise, electronic signatures have served us well in the contract world for transactional agreements.

Have questions about a legal status, tax status, or contracts? Reach out to Morin Legal at +1 (404) 800-5568 if you’re looking for an attorney’s assistance.

Selling the American dream of freedom and independence to small business owners since 2013. ™

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