Writing as a Business
One reason writers enjoy their craft is because they feel it provides an escape from the bureaucracy of the corporate world—but they have not escaped it entirely. The same legal system that governs billion-dollar industries governs the writer. This does not need to be a bad thing, since writers can learn to use some of these laws to their advantage. Few writers realize the importance of selecting the legal form their business should adopt, even though it affects their working relationships, taxes, ability to borrow, and exposure to liability. It only makes sense to structure the business to address these concerns.
Each business has an organizational form best suited to it, whether it be a sole proprietorship, partnership, corporation, limited liability company, or one of the hybrid business forms. When considering which form to use to conduct business, writers should go about it in two steps. First, there are the considerations of taxes and liability. Once the appropriate form is determined, the organizational details, such as partnership agreements and corporate documents, must be drafted. These documents define the structure of the business and the rules for day-to-day operations. Since each business is unique, these documents must be tailored to the individual business.
This chapter describes the features of the various kinds of business organizations, including their advantages and disadvantages. There are many intricacies involved in setting up a business. Writers are advised to consult a business attorney before deciding to adopt any particular structure. The information that follows is intended to increase your understanding of the choices and facilitate communication with your lawyer.
The term sole proprietorship may be unfamiliar to many writers, although it is the form of business by which most operate. It is an unincorporated business owned by one person. As a form of business, it is elegant in its simplicity. All it requires is a little money and a lot of work. The legal requirements associated with operating as a sole proprietor are few and simple. In some localities, you may be required to procure a business license, although professionals, such as writers, are often not required to have them. If you wish to operate using an assumed or fictitious business name (e.g., The Uncle Bob Writing Company), the name must be registered with the jurisdiction in which you are doing business. In most states, this will be through a state agency. However, in some states, registration is handled by the county. With these details taken care of, you are in business.
There are risks involved in operating your business as a sole proprietor. If you recognize any of these dangers as a real threat, you should give some consideration to doing business under another form of organization. Sole proprietors are personally liable for the debts and other liabilities that may be incurred by the business. In other words, their personal assets may be at stake should the liabilities of the business exceed its assets. For example, if someone prevails in a defamation case against a writer who is a sole proprietor, all the property owned by the writer would be at risk in order to satisfy the judgment, not just the writer’s business assets. An unexpected lawsuit, as well as economic difficulties, can drive a small business into bankruptcy. For sole proprietors, this will mean a personal bankruptcy.
Writers can obtain insurance that covers some risks, but insurance is not readily available for all the risks faced by writers. For example, it is difficult for writers to obtain insurance against defamation. In any case, insurance policies have policy limits, deductibles, and premiums, and are not a cure-all.
Sole proprietors are taxed on all profits of the business and may deduct the losses. The options for managing tax liabilities are more limited for sole proprietorships than for corporations. In some cases, a writer can reduce his or her tax burden by establishing a formal business entity.
PARTNERSHIPS AND OTHER COLLABORATIONS
When a writer agrees to work on a manuscript with another writer, or when a writer and an illustrator agree to produce an illustrated manuscript, a partnership is formed. A partnership is defined by most state laws as an association of two or more persons to conduct, as co-owners, a business for profit. No formalities are required. In fact, some people have been held to be partners even though they never intended to form a partnership. This is important because each partner is subject to unlimited personal liability for the debts incurred by the partnership. Also, each partner is liable for the negligence of the other partner and the partnership’s employees, when a negligent act occurs in the course of business. In effect, each partner is considered an employee of the partnership.
The economic advantages of doing business as a partnership are the pooling of capital, collaboration, easier access to credit because of the collective credit rating, and a potentially more efficient allocation of labor and resources. A major disadvantage is that each partner is fully and personally liable for all the debts of the partnership, even if not personally involved in incurring those debts.
A partnership does not possess any special tax advantages over a sole proprietorship. As a partner, you will pay tax on your share of the profits, whether they are distributed to you or not. You may also claim your share of deductions and credits. The partnership must file an annual information return known as a K-1 form with the IRS, against which the IRS can check the individual returns filed by the partners.
The most common situation in which writers do business as partnerships is when they collaborate to write a book, report, or article. As stated previously, no formalities are required to create a partnership. If the writers do not have a formal agreement defining the terms of the partnership, such as control or the distribution of profits, state law will determine the terms and legal obligations of each party. State laws are based on the fundamental characteristics of the typical partnership as it has existed throughout the ages, and therefore tend to express what most partners would reasonably expect. The most important aspects of state partnership laws are as follows.
• No one can actually become a member of a partnership without the unanimous consent of all partners.
• All members have an equal vote in the management of the partnership, regardless of the size of their interest in it.
• All partners share equally in the profits and losses of the partnership, no matter how much capital they have contributed.
• A simple majority vote is required for decisions in the ordinary course of business, and a unanimous vote is required to change the fundamental character of the business.
• A partnership is terminable at will by any partner. A partner can withdraw from the partnership at any time. This withdrawal will cause the dissolution of the partnership.
State laws also contain provisions that allow partners to make their own agreements regarding the management structure and division of profits that best suit the needs of the individual partners. It is recommended that writers working in partnership take the time to consider defining the structure of the partnership before it commences. When drafting a partnership agreement, the parties should consider the following aspects.
The Name of the Partnership
Many partnerships simply use the surnames of the major partners as the partnership name. The choice in that case is nothing more than the order of names, which depends on various factors, from prestige to the way the names sound. If a name other than the partners’ is used, it will be necessary to file the proposed business name with the appropriate governmental agency. Care should be taken to choose a name that is distinctive and not already in use. If the name is not distinctive, others can copy it; if the name is already in use, you could be liable for trade name infringement.
A Description of the Business
In describing the business, partners should agree on the basic scope of the project (e.g., the partnership shall be for one book or all written work), its requirements with regard to capital and labor, the parties’ individual contributions of capital and labor, and perhaps some plans regarding future growth.
Partnership Capital
After determining how much capital to contribute, the partners must decide when it will be contributed, how to value the property contributed, and whether there is to be a right to contribute more or to withdraw any at a later date.
Sometimes partnerships are organized for a fixed period of time or are automatically dissolved on certain conditions, such as the completion or publication of a book.
Distribution of Profits
Partners can make whatever arrangement they want for distribution. Although a partner does not ordinarily receive a salary, it is possible to give an active partner a guaranteed salary in addition to a share of the profits. Since the partnership’s profits can be determined only at the close of a business year, usually no distribution is made until that time. However, it is possible to allow the partners a monthly draw of money against their final share of profits. In some cases, it may be necessary to allow limited expense accounts for some partners.
Not all of the profits of the partnership need to be distributed at year’s end. Some can be retained for expansion, an arrangement that can be provided for in the partnership agreement. It is important to note that whether the profits are distributed or not, each partner must pay tax on his or her share of the distributable profit. The federal tax code refers directly to the partnership agreement to determine what that share is. This underscores the importance of a formal partnership agreement.
Management
The division of power in the partnership can be established in many ways. All partners can be given an equal voice or some can be given more authority than others. A few partners might be allowed to manage the business entirely, while the remaining partners are given a vote only on specifically designated issues. Besides voting, three other areas of management should be covered.
First is the question of who can sign checks, place orders, or enter into contracts on behalf of the partnership. Under state partnership laws, any partner may do these things so long as they are in the usual course of business. Such a broad delegation of authority can lead to confusion, so it might be best to delegate more narrowly in the written agreement.
Second, it is a good idea to determine a regular date for partnership meetings. This way, partners can plan their schedules to ensure their attendance at meetings. Not only does this allow for more productive meetings, it can protect the other partners from charges that they were trying to exclude a particular partner from important decisions.
Third, some consideration should be given to the possibility of a disagreement among the partners that leads to a deadlock. One way to avoid this possibility is to distribute the voting power in a way that makes a deadlock impossible.
In a two-person partnership, this would mean that one partner would be in absolute control. This situation might be unacceptable to the other partner. If instead the power is divided evenly among an even number of partners, as is often the case, the agreement should stipulate a neutral party or arbitrator who could settle any dispute and thereby avoid dissolution of the partnership.
Prohibited Acts
By law, each partner owes the partnership certain duties by virtue of being an employee or agent of the partnership. First is the duty of diligence. This means the partner must exercise reasonable care in acting as a partner. Second is a duty of obedience. The partner must obey the rules of the partnership and, more importantly, must not exceed the authority the other partners have vested in him or her. Finally, there is a duty of loyalty. A partner may not, without approval of the other partners, compete with the partnership in another business. A partner may not seize upon a business opportunity that would be of value to the partnership without first telling the partnership about it and allowing the partnership to pursue it. A list of acts prohibited to any partner should be made a part of the partnership agreement, elaborating and expanding on these fundamental duties.
Dissolution and Liquidation
A partnership is automatically dissolved upon the death, withdrawal, bankruptcy, or expulsion of a partner. Dissolution identifies the legal end of the partnership, but need not affect its economic life if the partnership agreement provided for the continuation of the business after dissolution. Nonetheless, dissolution will affect the business. The partner who withdraws, declares bankruptcy, or is expelled, or the estate of a deceased partner, will be entitled to a return of the proportionate share of capital that the departing partner contributed.
Details such as how this capital will be returned should be decided before dissolution, because at the time of dissolution, it may be impossible to negotiate. One method of handling this situation is to provide for a return of the capital in cash over a period of time. Some provision should be made so the remaining partners will know how much of a departing partner’s interest they may purchase.
After a partner leaves, the partnership may need to be reorganized and recapitalized. Again, provision for this should be worked out in advance, if possible. Finally, since it is always possible that the partners will eventually want to liquidate the partnership, it should be decided in advance who will liquidate the assets, which assets will be distributed, and what property will be returned to its original contributors.
UNINTENDED PARTNERS
Unintended partnerships can occur when writers collaborate on a work, but their relationship is not described formally. In situations such as ghostwriting, illustrating, or when portions of another person’s work are used, it is important for the parties to spell out in detail the arrangements between them or they are at risk of being treated as a partnership under state law. In such cases, a person could legally be held to be a partner and thus entitled to half of the income of the partnership, even though his or her contribution was minimal. Such situations can be avoided by hiring parties as contractors or specifying that their compensation will be a percentage of the proceeds. Whichever arrangement is chosen, it is important to have a clearly drafted written agreement that specifies that the other person’s contribution is in a capacity other than as a partner.
THE LIMITED PARTNERSHIP
The limited partnership is a hybrid containing elements of both partnerships and corporations. A limited partnership may be formed when one or more parties wish to invest in a business and share in its profits, but do not wish to participate in the control of the partnership. In effect, the limited partner is very much like an investor who buys a few shares of stock. Because of the limited partner’s passive role, the law limits his or her liability only to the amount invested.
In order to establish a limited partnership, it is necessary to have one or more general partners who run the business and one or more limited partners who play a passive role. A general partner will have the same potential liability, duties, and authority as a member of a regular (general) partnership. To form a limited partnership, a certificate must be filed with the proper state agency. If the certificate is not filed or is improperly filed, the limited partner could be treated as a general partner. The limited partner must refrain from trying to influence the day-to-day operation of the partnership. Otherwise, the limited partner might be found to be actively participating in the business and thereby held to be a general partner with unlimited personal liability.
Limited partnership may be appropriate for writers who need economic backing and wish to reward their sponsors with a share of the profits from the sale of the work without exposing them to personal liability. A limited partnership can be used to attract investment when credit is hard to get or is too expensive. In return for investing, the limited partner will generally receive a designated share of the profits. This way to fund your business can be attractive, since the limited partner receives nothing if there are no profits except potential tax write-offs, whereas if you had borrowed money from a creditor, that person could sue if you failed to repay.
Another use of the limited partnership is to facilitate reorganization of a general partnership after the death or retirement of a general partner. A partnership, remember, can be terminated when any partner requests it. Although the original partnership is technically dissolved when one partner retires, it is not uncommon for the remaining partners to agree to buy out the retiring partner’s share and keep the business going. A practical problem arises, however, if a large cash source is not available, in which case the partners might be forced to liquidate some or all of the partnership’s assets to return the retiring partner’s capital contribution. Rather than withdrawing, if the retiring partner simply becomes a limited partner, he or she can continue to share in profits, which are at least in some part the fruits of that partner’s past labor. This can be done while removing personal assets from the risk of partnership liabilities, yet not forcing the other partners to immediately come up with return of capital.
THE CORPORATION
Many people assume that corporations are large companies with many employees and an impersonal demeanor. This misconception is in large part due to people lambasting the uncaring and profit-minded entities that they describe as corporations or the even more perfidious multinational corporation. In reality, a corporation is an entity created by law that is set up for the purpose of doing business. There is nothing inherent in the nature of a corporation itself that requires it to be large or impersonal and many states allow incorporation by an individual.
There are advantages and disadvantages to incorporating. When it appears advantageous to incorporate, many writers are surprised to learn that it can be done easily and at modest expense.
A good way to understand a corporation is to compare it to a partnership. Perhaps the most important difference is that, like limited partners, the owners of the corporation, commonly known as shareholders or stockholders, are not personally liable for the debts and liabilities of the corporation. They stand to lose only their investment if the corporation becomes insolvent. But, unlike a limited partner, a shareholder is allowed to participate in the control of the corporation through the shareholders’ voting privileges.
For the small corporation, however, limited liability may be something of an illusion in many situations, because creditors will often demand that the owners personally cosign for any credit extended. In addition, individuals remain responsible for their wrongful acts. Thus, a writer who infringes on a copyright or creates a defamatory work may still be personally liable, even if incorporated. Nevertheless, the corporate liability shield does protect a writer when a contract is breached and the other contracting party has agreed to look only to the corporation for responsibility. For example, publishing contracts frequently require authors to make certain guarantees and statements of fact. If the publisher will contract with the writer’s corporation, rather than with the writer as an individual, then the corporation alone will be liable if there is a breach.
The corporate shield also offers protection when an employee of the writer has committed a wrongful act while working for the writer’s corporation. If, for example, a research assistant runs over a pedestrian while driving to the library to pick up some books for the writer, the assistant and the corporation may be liable, but the writer who owns the corporation will probably not be.
Another difference between corporations and partnerships is the continuity of existence. There are many events that can cause the dissolution of a partnership that will not have the same effect on a corporation. It is common to create a corporation with perpetual existence. Unlike partners, shareholders cannot decide to withdraw and demand a return of capital from the corporation. All they can do is sell their stock. A corporation may, therefore, have both legal and economic continuity. But the continuity can also be a tremendous disadvantage to shareholders or their heirs if they want to sell their stock but cannot find anyone who wants to buy it. Agreements can be made, however, that guarantee a return of capital should the shareholder die or wish to withdraw.
Other differences between corporations and partnerships are the free transferability of ownership and the structure of management and control. In a partnership, no one can become a partner without the unanimous consent of the other partners unless otherwise agreed. In a corporation, however, shareholders can generally sell their shares, or a portion of them, to whomever they wish. If the shareholders do not want a corporation to be open to outside ownership, transferability may be restricted. Partners generally have equal say in the governance of a partnership, but common shareholders are given a vote in proportion to their ownership in the corporation. A voting shareholder uses the vote to elect a board of directors and to create rules under which the corporation will operate.
The basic rules of the corporation are stated in the articles of incorporation, which are filed with the appropriate state agency. These serve as a sort of constitution and can be amended by shareholder vote. More detailed operational bylaws should also be adopted. Both shareholders and directors may have the power to create or amend bylaws. This varies from state to state and may be determined by the shareholders themselves. The board of directors then makes operational decisions for the corporation and might delegate daily control to a president.
A shareholder, even one who owns all the stock, may not act contrary to a decision of the board of directors. If the board has exceeded the powers granted to it by the articles or bylaws, any shareholder may use the courts to fight the decision. But if the board is acting within its powers, the shareholders have no recourse except to remove the board or any board member. In a few progressive states, a small corporation may entirely forego having a board of directors. In such cases, the corporation is authorized to allow the shareholders to vote on business decisions just as in a partnership.
Corporations have more legal ways available of raising capital than partnerships. Partnerships are restricted to borrowing money, taking on additional partners, or requesting additional capital from existing partners. However, all the partners must generally be in agreement for any of these actions. A corporation, on the other hand, may issue more stock, and this stock can be of many different varieties; for example, recallable at a set price or convertible into another kind of stock.
A method that corporations frequently use to attract new investors is to issue preferred stock. This means that the stock has some form of preference. This can be dividend preference, liquidation preference, or both. A dividend preference is the corporation’s agreement to pay the preferred shareholder some predetermined amount before it pays any dividends to other shareholders. Liquidation preference means that if the corporation should go bankrupt or liquidate, the preferred shareholders will be paid out of the proceeds of liquidation before the common shareholders are paid, though after the corporation’s creditors are paid. In most cases, the issuance of new stock merely requires approval by a majority of the existing shareholders. In addition, corporations can borrow money on a short-term basis by issuing notes or for a longer period by issuing debentures or bonds. In fact, a corporation’s ability to raise additional capital is limited only by its lawyer’s creativity and the economics of the marketplace.
Taxation
The last distinction between a partnership and a corporation is the manner in which a corporation is taxed. Under both state and federal laws, the profits of the corporation are taxed to the corporation before they are paid out as dividends. Then, because the dividends constitute income to the shareholders, they are taxed again as personal income. This double taxation constitutes the major disadvantage of a corporation. There are, however, several means of avoiding double taxation. First, a corporation can plan its business so as not to show very much profit. This can be done by drawing off what would be profit in payments to shareholders for a variety of services. For example, a shareholder can be paid a salary, rent for property leased to the corporation, or interest on a loan made to the corporation. All of these are legal deductions from the corporate income.
The corporation is entitled to larger deductions than sole proprietorships or partnerships for various retirement benefits provided its employees. For example, within certain limits, a corporation can deduct all of its payments made to an employee retirement plan and the employees are not subject to personal income tax on the employer’s contribution to the plan.
The corporation can also reinvest its profits for reasonable business expansion. This undistributed money is not taxed as income to the shareholders as it would be to the owners in a partnership. Reinvestment has at least two advantages. First, the business can be built up with money that has been taxed only at the corporate level. Second, the owners can delay the liquidation and distribution of corporate assets until they are in lower tax brackets, thereby possibly lowering their personal tax liabilities.
S Corporations
In addition to the standard corporation, Congress has created a hybrid form that allows the owners of a small corporation to avoid the double taxation problem. This form of organization is called an S corporation (small business corporation) which is taxed differently than a C corporation (the regular corporation discussed above), but it is otherwise like a regular business corporation. The corporation owners must make an election in their corporate documents and through the IRS (IRS form 2553), and if that is properly accomplished, the corporation will not be subject to federal income tax (although they must file tax returns)—instead, the owners will be responsible for any taxes on income and will be able to deduct losses, take deductions, and so forth like a partnership. This can be particularly advantageous in the early years of a corporation, because the owners of an S corporation can deduct the losses of the corporation from their personal income, whereas they cannot in a standard or so-called C corporation. They can have this favorable tax situation while simultaneously enjoying the corporation’s limited liability status.
To qualify as an S corporation, the corporation must have fewer than one hundred shareholders, all of whom must be individuals (with some limited exceptions); no shareholder may be a nonresident alien; and there can be only be one class of stock. There are both benefits and detriments to this form of business organization and there are many rules and regulations that apply that are beyond the scope of this book. A good accountant can help you make a determination if an S corporation is a good choice for you based on all your circumstances.
THE LIMITED LIABILITY COMPANY
Doing business as a limited liability company (LLC) has become a very popular way to organize a small business and to limit the liability of the business owners. The LLC business form combines the limited liability features of the corporate form with tax advantages available to the sole proprietor or partnership. A writer conducting business through an LLC can shield his or her personal assets from the risk of the business for all situations, except the individual’s own wrongful acts. This liability shield is the same as that offered by the corporate form. Although it is a newer business form than partnerships or corporations, it is becoming more and more often the first choice for many businesses and is available for use even if there is a single owner. It is not a corporation and certain rules relating to corporations do not need to be followed, allowing more flexibility in its formation and management. Much less paperwork is required than for a corporation.
A one-owner limited liability corporation is taxed as a sole proprietor, and companies with more than one owner can be taxed as partnerships, or C corporations. A limited liability corporation may also be taxed as an S corporation if it first elects to be taxed as a corporation and then elects to be taxed as an S corporation. The correct boxes need to be checked and the right forms must be filed so that the company will be entitled to the sort of taxation model preferred. The LLC can have as many members as it wants and there is no residency or citizenship requirement.
LLCs do not have the same restrictions imposed on S corporations regarding the number and types of owners. Corporations, sole proprietors, and partnerships can own interests in LLCs. LLCs may also have more than one class of voting ownership. There is, however, a restriction imposed on the transferability of ownership interests in the LLC. Due to this restriction, this business form may not be as desirable for larger businesses as is the corporation or limited partnership form. The LLC form can be particularly useful because of its flexibility. Virtually any internal structure for an LLC can be provided for in the LLC’s operating agreement.
THE LIMITED LIABILITY PARTNERSHIP
For businesses that have been conducted in the partnership form and desire a liability shield, the limited liability partnership (LLP) is available. This business form parallels the LLC in most respects, though it is created by converting a partnership into an LLP. Generally, the partnership agreement is then replaced by an operating agreement, which may follow the same general pattern as the original partnership agreement.
Fairly recently, a new sort of business model is being used by socially conscious groups. Known as benefit corporations, they are established with more than profit in mind. The first state to authorize such corporations was Maryland in 2010, and they are now permitted in more than half of the states. It is a for-profit business form, the purpose of which also takes into consideration social goals and the impact of its decisions on its shareholders, society, and the environment. In some states, reports must be filed that discuss the success of its performance in these areas. This is a new and developing business form. There are significant variations between states that allow it as a choice. A good business lawyer will be able to tell you whether this company form is available in your state, the requirements for forming one, and what the reporting requirements are, if any.
PRECAUTIONS FOR MINORITY OWNERS
Dissolving any business entity is not only painful because of certain tax penalties, but it is almost always impossible without the consent of the majority of the owners. If you are involved in the formation of a business entity and will be a minority owner, you must realize that the majority owners will have ultimate and absolute control—unless minority owners take certain precautions from the start. There are numerous horror stories relating to what some majority owners have done to unprotected minority owners. Avoiding these problems is no more difficult than drafting an agreement among owners at the outset and before problems arise. Corporations, LLCs, and LLPs have bylaws or operating agreements that can be structured to provide for minority protection. You should always retain your own attorney to represent you during the business entity’s formation rather than relying on the entity’s lawyer.
FORMALITIES
The benefits of the corporate form, as well as those of LLCs, LLPs, limited partnerships, etc., derive from the state’s recognition that the business is a legal entity separate from its owners. To enjoy these benefits, a corporation must act like a corporation, and the other forms of business entities must act as such entities. Courts consider observance of formalities to be an important factor in deciding whether the business has, in fact, been operating as a separate legal entity. If the business is not properly operating as a separate entity, creditors or other claimants against the business are much more likely to be able to pierce the veil and hold the owner personally responsible for liabilities. An experienced business attorney can advise about basic formalities that will help preserve the business form and its protection.
CONSULTING AN ATTORNEY
It is important to determine which business form will be most advantageous. This can best be done by consulting with an experienced business lawyer. An attorney’s services should be used to help comply with state business organization laws and other formalities, and to ensure that agreements are enforceable and adequately protect individual interests.