Legal Pitfalls for Business


Businesses face many pitfalls and challenges every day. Many small businesses are not prepared to meet some of these situations, resulting in lost time and resources. A few of these pitfalls are:


  • Insurance
  • Workers’ Compensation
  • Disaster Planning
  • Taxes
  • Security and Records Keeping
  • Independent Contractor or Employee?
  • Employer Liability for an Employee’s Bad Acts
  • Contracts


1. Insurance

The pitfall is having the wrong type of coverage, the wrong amount of coverage, or no coverage at all

Insurance is a risk management technique primarily used to hedge against the risk of a contingent, uncertain loss that may be suffered by those individuals or entities who have an insurable interest in scarce resources, by transferring the possibility of this loss from one interested person, persons, or entity to another. The scarce resources referred to here fall into three divisions: human resources, financial resources, and capital, or tangible resources. In the context of insurance, scarce resources are also known as “exposures,” because they are “exposed” to perils, those things, or forces, which cause destruction or reduction, in the usefulness, or value, of an exposed resource. Human resources are thus exposed to perils such as illness or death; financial resources to legal judgments that may result from negligent acts, and capital resources to physical perils such as fire, theft, windstorm, and vandalism, to name but a few. A hazard is the cause of a peril. It is that thing or condition which increases the likelihood of a peril. Thus perils and hazards are identified by the exposure that they threaten. For example a slippery roadway could be viewed as a financial hazard, capital hazard, or human hazard by automobile owners, and rightly so, since this condition increases the likelihood of an automobile accident that might result in an unfavorable legal judgment, automobile damage, and bodily injury.

Insurance involves pooling funds from many insured entities (known as exposures) to pay for the losses that some may incur. The insured entities are therefore protected from risk for a fee, with the fee being dependent upon the frequency and severity of the event occurring. In order to be insurable, the risk insured against must meet certain characteristics in order to be an insurable risk. Insurance is a commercial enterprise and a major part of the financial services industry, but individual entities can also self-insure through saving money for possible future losses.

Risk which can be insured by private companies typically share seven common characteristics:

  1. Large number of similar exposure units: Since insurance operates through pooling resources, the majority of insurance policies are provided for individual members of large classes, allowing insurers to benefit from the law of large numbers in which predicted losses are similar to the actual losses. Exceptions include Lloyd’s of London, which is famous for insuring the life or health of actors, sports figures and other famous individuals. However, all exposures will have particular differences, which may lead to different premium rates.
  2. Definite loss: The loss takes place at a known time, in a known place, and from a known cause. The classic example is death of an insured person on a life insurance policy. Fire, automobile accidents, and worker injuries may all easily meet this criterion. Other types of losses may only be definite in theory. Occupational disease, for instance, may involve prolonged exposure to injurious conditions where no specific time, place or cause is identifiable. Ideally, the time, place and cause of a loss should be clear enough that a reasonable person, with sufficient information, could objectively verify all three elements.
  3. Accidental loss: The event that constitutes the trigger of a claim should be fortuitous, or at least outside the control of the beneficiary of the insurance. The loss should be pure, in the sense that it results from an event for which there is only the opportunity for cost. Events that contain speculative elements, such as ordinary business risks or even purchasing a lottery ticket, are generally not considered insurable.
  4. Large loss: The size of the loss must be meaningful from the perspective of the insured. Insurance premiums need to cover both the expected cost of losses, plus the cost of issuing and administering the policy, adjusting losses, and supplying the capital needed to reasonably assure that the insurer will be able to pay claims. For small losses these latter costs may be several times the size of the expected cost of losses. There is hardly any point in paying such costs unless the protection offered has real value to a buyer.
  5. Affordable premium: If the likelihood of an insured event is so high, or the cost of the event so large, that the resulting premium is large relative to the amount of protection offered, it is not likely that the insurance will be purchased, even if on offer. Further, as the accounting profession formally recognizes in financial accounting standards, the premium cannot be so large that there is not a reasonable chance of a significant loss to the insurer. If there is no such chance of loss, the transaction may have the form of insurance, but not the substance. (See the U.S. Financial Accounting Standards Board standard number 113)
  6. Calculable loss: There are two elements that must be at least estimable, if not formally calculable: the probability of loss, and the attendant cost. Probability of loss is generally an empirical exercise, while cost has more to do with the ability of a reasonable person in possession of a copy of the insurance policy and a proof of loss associated with a claim presented under that policy to make a reasonably definite and objective evaluation of the amount of the loss recoverable as a result of the claim.
  7. Limited risk of catastrophically large losses: Insurable losses are ideally independent and non-catastrophic, meaning that the losses do not happen all at once and individual losses are not severe enough to bankrupt the insurer; insurers may prefer to limit their exposure to a loss from a single event to some small portion of their capital base. Capital constrains insurers’ ability to sell earthquake insurance as well as wind insurance in hurricane zones. In the U.S., flood risk is insured by the federal government. In commercial fire insurance it is possible to find single properties whose total exposed value is well in excess of any individual insurer’s capital constraint. Such properties are generally shared among several insurers, or are insured by a single insurer who syndicates the risk into the reinsurance market.


2. Workers Compensation

One pitfall is believing OH workers comp will cover workers working in KY or IN.

You will need to insure your employees against on-the-job injuries.  Every state is different. But, most states have put into place some form of workers’ compensation system.  Workers’ compensation is a system where the employee is not allowed by statute to sue their employer for on-the-job injuries; but, in return, the employer must participate in a system that provides nearly automatic payment to the employee in case of injury for medical bills and damages.  There are many options for workers’ compensation coverage.  Some states allow an employer to opt-out of the system if the employer is self insured, some run the system through private insurers (KY & IN) while others use state agencies (OH). Finally, some states, by virtue of case law or statute, require additional insurance above workers’ compensation such as “stop-gap” coverage or “scaffolding liability” as just two examples.


Ohio audits more companys workers compensation filings than the IRS audits Ohio companys.


3. Disaster Planning

The pitfall is having no plan or not placing a copy of the plan in several places where it can be accessed in case of disaster.

The planning process should take an “all hazards” approach. There are many different threats or hazards. The probability that a specific hazard will impact your business is hard to determine. That’s why it’s important to consider many different threats and hazards and the likelihood they will occur.

Strategies for prevention/deterrence and risk mitigation should be developed as part of the planning process. Threats or hazards that are classified as probable and those hazards that could cause injury, property damage, business disruption or environmental impact should be addressed.

In developing an all hazards preparedness plan, potential hazards should be identified, vulnerabilities assessed and potential impacts analyzed. The risk assessment identifies threats or hazards and opportunities for hazard prevention, deterrence, and risk mitigation. It should also identify scenarios to consider for emergency planning.

A risk assessment is a process to identify potential hazards and analyze what could happen if a hazard occurs. A business impact analysis (BIA) is the process for determining the potential impacts resulting from the interruption of time sensitive or critical business processes.

There are numerous hazards to consider. For each hazard there are many possible scenarios that could unfold depending on timing, magnitude and location of the hazard. Consider hurricanes:

A Hurricane forecast to make landfall near your business could change direction and go out to sea.

The storm could intensify into a major hurricane and make landfall.

There are many “assets” at risk from hazards. First and foremost, injuries to people should be the first consideration of the risk assessment. Hazard scenarios that could cause significant injuries should be highlighted to ensure that appropriate emergency plans are in place. Many other physical assets may be at risk. These include buildings, information technology, utility systems, machinery, raw materials and finished goods. The potential for environmental impact should also be considered. Consider the impact an incident could have on your relationships with customers, the surrounding community and other stakeholders. Consider situations that would cause customers to lose confidence in your organization and its products or services.

As you conduct the risk assessment, look for vulnerabilities—weaknesses—that would make an asset more susceptible to damage from a hazard. Vulnerabilities include deficiencies in building construction, process systems, security, protection systems and loss prevention programs. They contribute to the severity of damage when an incident occurs. For example, a building without a fire sprinkler system could burn to the ground while a building with a properly designed, installed and maintained fire sprinkler system would suffer limited fire damage.

The impacts from hazards can be reduced by investing in mitigation. If there is a potential for significant impacts, then creating a mitigation strategy should be a high priority.

A business impact analysis (BIA) predicts the consequences of disruption of a business function and process and gathers information needed to develop recovery strategies. Potential loss scenarios should be identified during a risk assessment. Operations may also be interrupted by the failure of a supplier of goods or services or delayed deliveries. There are many possible scenarios which should be considered.

Identifying and evaluating the impact of disasters on business provides the basis for investment in recovery strategies as well as investment in prevention and mitigation strategies.

The BIA should identify the operational and financial impacts resulting from the disruption of business functions and processes.

4. Taxes

The pitfall is failing to file returns or pay taxes on time. These debts can generally NOT be relieved in bankruptcy and the fines accrue quickly.

Commercial Activity Tax (CAT) – General Information (Ohio)

Taxpayers – The commercial activity tax (CAT) was enacted in House Bill 66, which was passed by the 126th General Assembly. The CAT first applies for taxable gross receipts received on and after July 1, 2005. The CAT is an annual privilege tax measured by gross receipts on business activities in this state. This tax applies to all types of businesses: e.g., retailers, service providers (such as lawyers, accountants, and doctors), manufacturers, and other types of businesses. The CAT also applies whether the business is located in this state or is located outside of this state if the taxpayer has enough business contacts with this state. The CAT applies to all entities regardless of form, (e.g., sole proprietorships, partnerships, LLCs, and all types of corporations). A person with taxable gross receipts of more than $150,000 per calendar year is subject to this tax, which requires such person to register with this department as a taxpayer. Please note that certain receipts are not taxable receipts, such as interest income. The tax does have limited exclusions for certain types of businesses, such as financial institutions, dealers in intangibles, insurance companies and some public utilities if those businesses pay specific other Ohio taxes.

Taxable Gross Receipts – Gross receipts subject to CAT are broadly defined to include most business types of receipts from the sale of property or realized in the performance of a service. The following are some examples of receipts that are not subject to the CAT: interest (other than from installment sales), dividends, capital gains, wages reported on a W-2, or gifts. In general, for the sale of property, such receipt is only considered a taxable gross receipt if the property is delivered to a location in this state. For services, the receipt is sitused (sourced) to Ohio in the proportion that the purchaser’s benefit in this state bears to the purchaser’s benefit everywhere. The physical location where the purchaser ultimately uses or receives the benefit of what was purchased is paramount in making this determination. In other words, receipts from sales to out-of-state purchasers or the proportion of the services where the benefit is primarily received outside of this state are not subject to the CAT.

Registration – Taxpayers having over $150,000 in taxable gross receipts sitused to Ohio for the calendar year are required to file returns for the CAT. In order to file returns, a taxpayer must first register for CAT with the Department of Taxation. Registration is available electronically through the Ohio Business Gateway. Alternatively, taxpayers may register by submitting the CAT 1 registration form. The CAT 1 registration form is available through the Department’s Web site at Tax Forms or may be requested by calling 1-800-282-1782.

Annual and Quarterly Filers – Annual CAT taxpayers (those taxpayers with taxable gross receipts between $150,000 and $1 million in a calendar year) must pay an annual minimum tax of $150 per year. Beginning in 2010, the annual minimum tax is due on May 10 of the current tax year and will be paid with the filing of the annual return (CAT 12). The annual return reports the taxable gross receipts for the prior year’s activity and prepays the annual minimum tax of $150 for the current calendar year. The annual return may also be filed electronically through the Ohio Business Gateway.

Taxpayers with annual taxable gross receipts in excess of $1 million must file and pay returns on a quarterly basis. Quarterly returns are required to be filed electronically through the Ohio Business Gateway. Quarterly taxpayers owe the $150 annual minimum tax for receipts up to $1 million. In addition, quarterly taxpayers pay a rate component for taxable gross receipts in excess of $1 million. Beginning in 2010, the annual minimum tax is paid with the filing of the first quarter return, which is due on May 10. Prior to 2010, the annual minimum tax was paid as part of the fourth quarter return due on February 10.

Consolidated Elected Taxpayer Groups and Combined Taxpayer Groups – A consolidated elected taxpayer group is a taxpayer that has elected to file as a group including all entities that have either 50 percent or more common ownership or 80 percent or more common ownership. In addition, the group can elect to include or exclude non-U.S. entities with the same common ownership in the group. A major benefit of making this election is that receipts received between members of the group may be excluded from the taxable gross receipts of the group. However, taxpayers making this election must agree that all commonly owned entities are part of the group even if nexus does not exist. This election is binding for eight calendar quarters. If such election is not made, any taxpayers with common ownership of more than 50 percent must file as a combined taxpayer group. Combined taxpayer groups may not exclude receipts between members of the group; however, such groups need only include in the group those members that have nexus with Ohio.


Payroll Taxes and Trust Fund Recovery  (Federal)

It’s easy to get yourself in hot water when it comes to payment of trust fund taxes to the Federal government. Business cycles, cash flow problems, and unexpected events can cause a business to use trust fund taxes to pay other expenses. It’s understandable, unless you are the IRS.

The IRS continues to use Enforced Collection when it comes to unpaid payroll taxes and unfiled payroll returns. Enforced Collection can include a levy on the assets of the business, including the accounts receivable, equipment, automobiles and the bank account. The IRS can also close a business for non-payment of payroll taxes. If the business is closed or files for bankruptcy protection, the IRS will look to the owner of the business for collection of the penalties, interest, taxes and trust funds. In the case of a corporation or a partnership, the IRS will look to the person responsible for paying the payroll taxes to collect the trust funds. This is known as the Trust Fund Recovery Penalty.

The IRS, Criminal Investigation Division is shifting its focus from drug crimes and money laundering to traditional tax crimes involving abusive trusts, employment taxes, nonfilers, and return preparers.

For many businesses, when they start to have financial problems one of the first things to happen is the payroll taxes are not paid on time and the payroll returns are not filed on time. Both of these are among the worst things to do when a business has fallen upon hard times.

IRC Section 6672(a): Any person required to collect, truthfully account for, and pay over any tax imposed by this title who willfully fails to collect such tax, or truthfully account for or pay over such tax, or willfully attempts in any manner to evade or defeat any such tax or the payment thereof, shall, in addition to other penalties provided by law, be liable to a penalty equal to the total amount of the tax evaded, or not collected, or not accounted for and paid over.

This is commonly known as the 100% penalty. The penalty is assessed for the Trust Funds not paid. Trust funds are the money you withhold from an employee’s paycheck, which includes federal income tax and the employees’ share of FICA and Medicare. This money is held in trust until you pay it to the Internal Revenue Service.

  • Are you the “responsible” person?
  • Did you “willfully” fail to collect or pay over such tax?
  • Did you have knowledge that the payroll taxes were unpaid?
  • Did you have the power to control payments to creditors or the IRS?
  • Did you prepare or sign the 941 returns?

Who is a responsible person? It may be the person who has the power to direct the collection of trust funds, the power and authority to pay trust funds and other creditors, or power and authority to determine who gets paid first or last.

According to the IRS, a responsible person is a person or group of people who have the duty to perform and the power to direct the collecting, accounting and paying of trust funds. This person may be:

  • an officer or an employee of a corporation
  • a member or employee of a partnership
  • a corporate director or shareholder
  • a member of a board of trustees of a nonprofit organization, or
  • another person with the authority and control to direct the disbursement of funds.

The IRS may assess the penalty against anyone:

  • who is responsible for collecting or paying withheld income and employment taxes, and
  • who willfully fails to collect or pay them.

According to the IRS, for willfulness to exist, the responsible person must:

  • Have known about the unpaid taxes, and
  • Have used the funds to keep the business going or allowed available funds to be paid to other creditors.
  • Other standards regarding willfulness include intentional, deliberate, voluntary, reckless disregard, knowing or accidental, free will or choice.

The issues presented in determining who the responsible person is and whether or not willfulness exists depends upon the facts and circumstances in each case. If the taxes are not paid, the IRS will be looking for someone to penalize. It may be you.

Failure to Pay Payroll Taxes on Time

When a business fails to pay the payroll taxes on time, penalties and interest start to accrue. This causes additional cash flow problems for the business when cash is such an important commodity.

Late Filing of Payroll Returns

If the payroll returns are not filed on time the penalties are substantially increased. Failure to file a return on time can incur penalties of 5% per month to a maximum of 25%. Add that to other penalties, along with the compounded interest and you can have a very serious tax problem


5. Security and Records Keeping

The pitfall here is not protecting confidential information well enough or long enough.

From the IRS

Everyone in business must keep records, especially those that will come in handy when it’s time to think about taxes on the business. Good records will help you do the following:

Monitor the progress of your business. You need good records to monitor the progress of your business. Records can show whether your business is improving, which items are selling, or what changes you need to make. Good records can increase the likelihood of business success.

Prepare your financial statements. You need good records to prepare accurate financial statements. These include income (profit and loss) statements and balance sheets. These statements can help you in dealing with your bank or creditors and help you manage your business. Remember, an income statement shows the income and expenses of the business for a given period of time. A balance sheet shows the assets, liabilities, and your equity in the business on a given date.

Identify the source of receipts. You will receive money or property from many sources. Your records can identify the source of your receipts. You need this information to separate business from non-business receipts and taxable from nontaxable income.

Keep track of deductible expenses. You may forget expenses when you prepare your tax return unless you record them when they occur.

Prepare your tax returns. You need good records to prepare your tax returns. These records must support the income, expenses, and credits you report. Generally, these are the same records you use to monitor your business and prepare your financial statements.

Support items reported on tax returns. You must keep your business records available at all times for inspection by the Internal Revenue Service (IRS). If the IRS examines any of your tax returns, you may be asked to explain the items reported. A complete set of records will speed up the examination.

Source: Internal Revenue Service


Following a good record keeping practice is beneficial for any business. Properly organized records provide a view of the present financial status of the company. It also provides with information on all transactions made during past years like bills, receipts, statements, invoices, proof of payment etc which is useful in filing the returns and claiming tax deductions. Maintaining records ensures proper documentation of all information pertaining to business that employees or owners can readily access and help in increasing productivity.

Helps In Future Planning

Proper documentation done in record keeping provides information about all transactions done in last several years towards filing tax returns, expenses, purchases etc. Through record keeping one can get information on all activities of business. The owner can judge whether the business is earning profits or going into losses. This information helps in future planning as the owner can decide where the funds need to be diverted, policy of business regarding expenses and purchases, product pricing etc. Useful insights into various aspects of business can help in formulating future course of business by means of expansion of current facility, establishing new enterprises, tie-ups, taking loans etc.

Helps Evaluate Performance of Business

Records maintain information about all the transactions done by the business in the past several years. Information about purchases made and expenses done can give the current financial status of the business. Records pertaining to financial, legal aspects of business provide access to old information which the owner can compare with present status. This helps the owner to judge the performance of business as to whether it is in profit or loss. This information can help to take key policy decisions which can take the business out from losses. The records provide owner with information on which products to include and products that are selling. This information helps in business performance evaluation.

Helps To Forecast Future of Business

A complete financial history of the business can be received through effective record keeping. As the owner can get detailed information about transactions done in past, he can know about present profit and can even forecast future of business. Record keeping helps to correlate information on income, expenses, and other financial data which gives picture of how the business is going to perform in future.

Helps In Effective Cash Flow Management

Good record keeping ensures that all the transactions pertaining to finances of business, expenses, and purchases made are readily available at one place. The owner can effectively check the inflow and outflow of cash in the business. Cash inflows and outflows are important factors in business management. The owner can prepare cash flow statement as information about how cash is received and spend is available through records. Thus record keeping allows good cash flow management by making owner aware when and where the cash needs will arise and arranging bankers and creditors to meet cash needs.

Shaping an affordable price for products and services is crucial for any business. Effective record keeping also helps to know whether the product is priced appropriately. Good record keeping helps to save time and money of businesses, improves productivity as employees and owner can engage in productive work, and focus on serving customers


6. Independent Contractor or Employee

The pitfall here is mis-classifying workers as subcontractors when they are actually employees as evidenced by their actual working relationship. Employers can become liable for the tax debts of subcontractors if they are mis-classified. If a worker works as a part of a team he cannot, be definition, be independent and therefore cannot be a sub.


The IRS test often is termed the “right-to-control test” because each factor is designed to evaluate who controls how work is performed. Under IRS rules and common-law doctrine, independent contractors control the manner and means by which contracted services, products, or results are achieved. The more control a company exercises over how, when, where, and by whom work is performed, the more likely the workers are employees, not independent contractors.

A worker does not have to meet all 20 criteria to qualify as an employee or independent contractor, and no single factor is decisive in determining a worker’s status. The individual circumstances of each case determine the weight IRS assigns different factors.

NOTE: Employers uncertain about how to classify a worker can request an IRS determination by filing Form SS-8, “Determination of Employee Work Status for Purposes of Federal Employment Taxes and Income Tax Withholding.” However, some tax specialists caution that IRS usually classifies workers as employees whenever their status is not clear-cut. In addition, employers that request an IRS determination lose certain protections against liability for misclassification.

Are Independent Contractors Employees?

Because FLSA applies only to employer-employee relationships, independent contractors are not covered. Court decisions interpreting FLSA coverage rules require that employers use an economic reality test in determining whether an employment relationship exists with respect to a given worker.

Similar to the common law test, the economic reality test focuses on the degree of control exercised by the employer as an essential factor in determining whether an employer-employee relationship exists. While no single factor is controlling or decisive in determining whether an employment relationship exists, the facts and circumstances that courts and federal enforcement officials examine in deciding whether an individual is an employee or an independent contractor are:

  • The degree to which the employer controls or directs the manner in which work is performed,
  • Whether the worker’s opportunity for profit or loss depends on his or her managerial skills,
  • Whether the worker’s duties are performed for the employer on an ongoing or permanent basis,
  • Whether the service performed by the worker is an integral part of the employer’s business,
  • The extent of the worker’s investment in equipment or materials needed to perform the job, and
  • The degree to which the worker is engaged primarily for the benefit of the employer.


The IRS considers a worker to be your employee if you have the right to control not only what work will be done, but also how the worker will do it. If you treat a worker as an independent contractor, but the IRS decides you have sufficient control over the worker to create an employment relationship, the IRS can hit you with a costly bill for the employment taxes you should have been withholding and paying.

When deciding whether you can safely treat a worker as an independent contractor, there are two separate tests you should consider:




THE COMMON LAW TEST.  The common law test: IRS examiners use the 20-factor common law test to measure how much control you have over the worker. These factors are reflected on IRS Form SS-8, (this form can be downloaded at“Determination of Employee Work Status for Purposes of Federal Employment Taxes and Income Tax Withholding.”  You can fill out the SS-8, including the facts of your relationship with the worker, and submit it to the IRS to get a determination of whether the worker is your employee or not. However, many companies simply use the SS-8 as a self-audit to avoid a misclassification trap; they don’t actually submit the form to the IRS.   Of course, many workers – the IRS estimates as many as 85% of all Form SS-8 filers – submit the form to the IRS because they want to contest their treatment as independent contractors.  But the issue of who has the right to control is often not clear-cut, and the Tax Code doesn’t define “employee.” So, the IRS developed the “20-Factor Test” to arrive at an answer. The IRS later refined this test – it added four new, critical factors and added more weight to some and de-emphasized others in the original 20. You don’t need to have all the factors in your favor to be able to treat a worker as an independent, but you are more likely to pass the common law test if the more important factors point to independence.  According to the manual the IRS uses to train its worker classification auditors, the three most important factors are:

  1. Instructions to workers: Your worker is probably an employee if you require him or her to follow instructions on when, where, and how work is to be done. This is a very important factor. However, if you tell your electrician you want blue switch plate covers instead of white, you are not exercising control to a degree that would make the person an employee.
  2. Job training: If your company provides or arranges for training of any kind for the worker, this is a sign you expect work to be performed in a certain way; therefore, the worker is your employee. Training can be as informal as requiring the worker to attend meetings or work along with someone who’s more experienced.
  3. Worker’s ability to make a profit or suffer a loss: An employee may be rewarded, disciplined, demoted, or fired depending on job performance, but only an independent contractor can realize a profit or incur a financial loss from his or her work. In other words, an employee will always get paid; an independent contractor, however, has a financial stake in his enterprise.


IRS also gives high priority to the following factors:   W-2 or 1099: You report payments to independents (if they total $600 or more in a calendar year) on Form 1099-MISC. Reporting on a Form W-2 indicates that both your company and the worker consider the worker to be your employee.

  • Intent of your company and of the worker: To build a solid case, you and the worker should sign a written agreement stating the worker is an independent contractor who will be paid by the job or project, provide his or her own tools, etc.
  • Pay basis: If you pay a worker on an hourly, weekly, or monthly basis, the IRS will consider it a sign the worker is your employee. An independent is generally paid by the job, project, assignment, etc., or receives a commission or similar fee.
  • Benefits: Providing benefits other than pay are a strong indicator of employee status. Incorporated status: Workers who are incorporated are generally considered to be working for themselves, not as your employee.
  • Importance of the worker’s services: If a worker provides services that are integral to the success of your business, the worker is likely your employee.
  • Personal performance of services: An independent contractor should have the freedom to hire assistants or subcontract work to other workers or firms at his or her expense (this is where profit or loss could enter the picture). If you require the worker to perform the work personally, that’s a sign of control and therefore indicative of employee status.
  • Providing assistants: There’s likely an employer-employee relationship if your company hires, supervises, and pays assistants for the worker.
  • Ongoing relationship: The worker doesn’t have to work for you continuously to be considered an employee; it may be enough if the worker gets assignments at frequently recurring, even if irregular, intervals.
  • Setting the order or the sequence of the work: If you determine what gets done when, it indicates you control how the work is performed. Allow an independent to decide his or her schedule, both day-to-day and for the longer term.

THE REASONABLE BASIS TEST   While the common law test looks at the nature of the working relationship, the reasonable basis test is based on how the courts and the IRS have classified similar workers in your company or your industry in the past.  The reasonable basis test is considered a “safe harbor.”  That is, if you can show you had a reasonable basis for treating a worker as an independent contractor, the IRS is prohibited from reclassifying the worker as your employee either prospectively or retroactively. You have a reasonable basis for treating a worker as an independent if one or more of the following conditions exist:

  • A court ruling in favor of treating workers in similar circumstances as non-employees;
  • A ruling by the IRS (usually a Revenue Ruling) stating that similar workers are not employees subject to employment taxes;
  • An IRS Technical Advice Memorandum or Private Letter Ruling issued to your company, indicating that the particular worker isn’t an employee;
  • A past IRS payroll audit that didn’t find workers in similar positions at your company to be employees; or
  • A longstanding, widely recognized practice in your industry of treating similar workers as independent contractors.

NOTE: The Treasury Inspector General for Tax Administration has recommended that IRS pursue legislative proposals that would mandate withholding of income taxes on payments made to independent contractors and require monthly estimated tax payments.  TIGTA made these recommendations in order to curtail estimated tax payment noncompliance.

Behavioral Control  Behavioral control deals with whether you, as the employer, have the right to direct and control HOW the work is done. You do not have to actually direct or control how the work is done—as long as you have the right to direct and control the work. Instructions and training provided to a worker are important factors to be considered under behavioral control.

Instructions   If you give the worker detailed instructions on how work is to be done, the worker may be an employee.   Instructions can cover a wide range of topics, for example:

  • how, when or where to do the work,
  • what tools or equipment to use,
  • what assistants to hire to help with the work, and
  • where to purchase materials and services.

A subcontractor does not need or receive detailed instructions on how the work should be done. The subcontractor generally provides his own tools, equipment, and materials and can hire employees or subcontractors himself.

Training.  If you, as the employer, train the workers to perform tasks in a certain way, then they may be employees.

Financial Control.  The financial control category deals with whether you, as the employer, have the right to direct and control the ECONOMIC aspects of the work. Several factors of evidence considered under the financial control category are significant investment, expenses, and opportunity for profit or loss. There is no precise dollar amount that you can use to measure your financial control over the worker.

Significant Investment.  This rule covers the extent of the worker’s financial investment in the project. If the worker must own or rent costly equipment to do the work, he may be a subcontractor.

Expenses.  This rule deals with whether or not a worker is reimbursed for expenses and considers the amount of the expenses the worker must pay. A worker that has high, on-going expenses that are not reimbursed may be a subcontractor. Employees generally do not have high, un-reimbursed expenses.

Opportunity for Profit or Loss.  This factor covers the worker’s freedom to make decisions that can impact his profit or loss. An employee may make the same kind of decisions, but the decision usually does not affect his salary. Examples include deciding how much inventory to carry or whether to buy or lease equipment

Relationship of the Parties.  This category of evidence looks at how the business and the worker view their relationship. Several factors of evidence considered are employee benefits and written contracts.

Employee Benefits.  If you provide benefits such as paid vacation, sick days, health insurance, or a pension, the worker may be an employee. However, many workers whose status as employees is un-questioned do not receive employee benefits. Consequently, the absence of employee benefits may not be important in deciding the worker’s status.

Written Contracts.  While a contractual designation, in and of itself, is not sufficient evidence for determining worker status, a written agreement describing the worker as a subcontractor may be viewed as evidence that you and the worker intended the relationship to be independent. If the parties are not acting in accordance with the terms of the contract, however, the contract may be ignored. The actual facts in each situation are more important than a contract, but the contract may be a deciding factor, all other things being equal.

Type of Relationship covers facts that show how the parties perceive their relationship. This includes:

  • Written contracts describing the relationship the parties intended to create,
  • The extent to which the worker is available to perform services for other, similar businesses,
  • Whether the business provides the worker with employee–type benefits, such as insurance, a pension plan, vacation pay, or sick pay,
  • The permanency of the relationship, and
  • The extent to which services performed by the worker are a key aspect of the regular business of the company

The Economic Reality/ Economic Dependence Test.  This test is used typically to answer the question of who is the employer in cases where there is more than one potential employer. It can also be used to determine whether a worker is an employee or an independent contractor.  The test may only be used for finding coverage of workers under the FLSA, AWPA, EPA, and the FMLA. The factors listed below are to be applied with an eye to determining whether and on whom the worker is economically dependent for his or her earnings and working conditions.

A worker is more likely to be an employee of an entity when:

  1. The individual works in a production process or service that is an integrated part of the employer’s business.
  2. The individual works on the employer’s premises and equipment.
  3. The individual performs most of his/ her work for that employer.
  4. The worker had a steady and consistent working relationship with the employer.

The “Suffer or Permit to Work” Test

The broadest theory for finding an employment relationship is the “suffer or permit” test. This may only be used to find coverage under the FLSA, AWPA, EPA, and the FMLA. It is based on a return to the statutory definitions of employment contained in these statutes. It can be used to find an employment relationship where one would not be found under the more restrictive tests described above.

This test is more likely to be met when the worker:

  1. Works in a production process or service that is an integrated part of the employer’s business.
  2. Works on the premises and equipment of the business.
  3. Works for another business that is integrated into the business of the employer.
  4. Due to the low skill/ piece work nature of the work
  5. Due to the small investment of capital in that integrated business



7. Employer Liability for an Employee’s Bad Acts

The pitfall here is not exercising enough control over your workers to avoid them doing bad things that you have to pay for later.


If your employee hurts someone, you could be legally responsible.

In some circumstances, your company may be legally responsible for harm caused by its employees. Under a handful of legal theories, courts have held employers liable for injuries their employees inflicted on coworkers, customers, or total strangers. Here, we explain those legal theories — and a few commonsense steps you can take to steer clear of trouble.

Employers, and not the employees themselves, will often be held liable for the conduct of their employees. This is true even if the employer had no intention to cause harm and played no physical role in the harm. To understand why, you have to understand two basic concepts that underlie employer liability.

First, employers are seen as directing the behavior of their employees and accordingly, must share in the good as well as the bad results of that behavior. By the same token that an employer is legally entitled to the rewards of an employee’s labor (profit), an employer also has the legal liability if that same behavior results in harm.

Second, when someone is injured or harmed and needs to be compensated, who is the most likely to pay: the employee or the employer? Fair or not, the legal system is interested in making the victim whole, and assigning liability to the employer rather than the employee has the best chance of meeting that goal.

Job-Related Accidents or Misconduct

Under a legal doctrine sometimes referred to as “respondeat superior” (Latin for “Let the superior answer”), an employer is legally responsible for the actions of its employees. However, this rule applies only if the employee is acting within the course and scope of employment. In other words, the employer will generally be liable if the employee was doing his or her job, carrying out company business, or otherwise acting on the employer’s behalf when the incident took place.

The purpose of this rule is fairly simple: to hold employers responsible for the costs of doing business, including the costs of employee carelessness or misconduct. If the injury caused by the employee is simply one of the risks of the business, the employer will have to bear the responsibility.

But if the employee acted independently or purely out of personal motives, the employer might not be liable. Here are a few examples to illustrate the difference:

  • A restaurant promises delivery in 30 minutes “or your next order is free.” If a delivery person hits a pedestrian while driving frantically to beat the deadline, the company will probably be legally responsible for the pedestrian’s injuries.
  • A technology services company gives its sales staff company cars to make sales calls. After work hours, a sales person hits a pedestrian while using the company car to do personal errands. Most likely, the company will not be held responsible for the incident.
  • A law firm issues cell phones to all of its lawyers, to allow them to call into the office and check in with clients when they are on the road. A lawyer, driving, hits a pedestrian because she is completely engrossed in her telephone conversation with a senior partner in the firm. The law firm will probably have to pony up for the pedestrian’s injuries.
  • A company loans its sales staff vehicles to enable them to make sales calls in the area. As part of doing business, the company encourages its sale staff to take potential clients out for dinner and drinks. One night, after taking a client out for drinks, the employee is driving home and hits a pedestrian. The employer likely will be held responsible since it encourages sales people to take clients out for food and drinks, and that is precisely what the employee was doing when the accident occurred. Employer liability would be more ambiguous in this example if the employee turned out to be intoxicated (something the employer might have expected to happen, but likely would have warned the employee against).
  • A medical billing company hires a fumigator, who sprays the company’s office with powerful pesticides. The next day, a dozen employees fall ill from the fumes. One of the affected employees is sent home; on her way, she suffers a dizzy spell and hits a pedestrian. The company is probably on the hook.


Workers’ compensation generally protects you from lawsuits by injured employees. If an employee injures a coworker while acting within the scope of employment, the coworker probably won’t be able to sue your company. Instead, the coworker can make a workers’ compensation claim to receive payment for lost wages, medical bills, and so on. Employees can sometimes sue outside the workers’ compensation system if their injuries were caused by their employers’ intentional misconduct, but that generally won’t be the case if they are hurt by another employee who is simply doing his or her job.

Careless Hiring and Retention

Negligent hiring or retention liability, unlike job related misconduct, arises from acts performed by an employee outside the scope of his or her employment. The most common example of this is to hold an employer liable for the criminal conduct of an employee, which is obviously outside the scope of employment. The basis for liability is that the employer acted carelessly in hiring a criminal for a job that the employer should have expected would expose others to harm. Under this legal theory, someone who is injured by your employee can sue you for failing to take reasonable care in hiring your workers (“negligent hiring”) or in keeping them on after learning the worker poses a potential danger (“negligent retention”). This rule applies even to what your workers do outside the scope of employment — in fact, it is often used to hold an employer responsible for a worker’s violent criminal acts while working, such as rape, murder, or robbery.

However, under this theory you are legally responsible only if you acted carelessly — that is, if you knew or should have known that an applicant or employee was unfit for the job, yet you did nothing about it. Here are a few examples:

  • An ice cream sales company hires a man convicted of sexually assaulting a minor to drive its ice cream truck and sell ice cream to children. The business is likely liable because it was negligent in hiring a man known to have assaulted minors, and then giving him access to those minors as customers.
  • An elder care facility hires a woman convicted of fraud and identity theft against elderly people to look after and care for the facilities patients. The business is likely liable because it was negligent in hiring a woman who was already convicted of scamming the elderly and giving her access to potential victims.
  • A cable company hires a man without a background check and directs him to go to customer’s houses and install cable equipment. It turns out he’s been convicted twice of rape, and while at a customer’s house to install equipment, he rapes the occupant. The business is likely liable because it was negligent in hiring someone who has access to private houses without a background check, as well as being liable for hiring someone with a history of rape to meet privately with customers in their home.
  • A pizza company hired a delivery driver without looking into his criminal past — which included a sexual assault conviction and an arrest for stalking a women he met while delivering pizza for another company. After he raped a customer, the pizza franchise was liable to his victim for negligent hiring.
  • A car rental company hired a man who later raped a coworker. Had the company verified his resume claims, it would have discovered that he was in prison for robbery during the years he claimed to be in high school and college. The company was liable to the coworker.
  • A furniture company hired a delivery man without requiring him to fill out an application or performing a background check. The employee assaulted a female customer in her home with a knife. The company was liable to the customer for negligent hiring.


Avoiding Claims of Negligent Hiring or Retention

The key to most negligent hiring and retention cases is providing employees with access to potential victims without doing the necessary examination of the employees’. Accordingly, to avoid liability for negligent hiring, an employer should always run a background check on an employee, and be especially careful if the employee has contact with the public. If you as an employer become aware of something after the fact, then handle the matter immediately to avoid negligent retention liability.

  • Perform background checks. Make it your policy to run a routine background check before you hire an applicant. Verify information on resumes, look for criminal convictions (to the extent allowed in your state), and check driving records. These simple steps will weed out many dangerous workers and help you show that you were not careless in your hiring practices.
  • Use special care in hiring workers who will have a lot of public contact. You are more likely to be held responsible for a worker’s actions if the job involves working with the public. These workers all require more careful screening:
    • Workers who go to a customer’s home (to make deliveries, perform home repairs, or manage apartment buildings, for example)
    • Workers who deal with vulnerable people such as children, the elderly, or people with disabilities, and
    • Workers whose jobs give them access to weapons.
  • Root out problem employees immediately. Under the theory of negligent retention, you can be responsible for keeping a worker on your payroll after you learn (or should have been aware) that the worker poses a potential danger. If an employee has made violent threats against customers, brings an unauthorized weapon to work, or racks up a few moving violations, you have to take immediate action.



Workplace harassment of employees by other employees has become an increasingly problematic source of business liability for employers. Workplace harassment violates federal law if it involves discriminatory treatment based on: race, color, sex (with or without sexual conduct), religion, national origin, age, disability, genetic information, or the employee’s opposition job discrimination or participation in an investigation or complaint proceeding under the Equal Employment Opportunity Commission.

Workplace harassment does not include simple teasing, offhand comments, or isolated incidents that are not extremely serious. The conduct must be sufficiently frequent or severe to create a hostile work environment or result in a “tangible employment action,” such as hiring, firing, promotion, or demotion.

Even if the harassment did not lead to a “tangible employment action”, the employer can still be held liable unless it proves that:

  • The employer exercised reasonable care to prevent and promptly correct any harassment; and
  • The employee suffering the harassment unreasonably failed to complain to management or to avoid harm otherwise.

To avoid workplace harassment liability, employers should establish, distribute and enforce a policy prohibiting harassment, and set out a procedure for making complaints. Preferably, the policy and procedure should be in writing. Small businesses owners may avoid liability through less formal means. For example, if a business is sufficiently small that the owner maintains regular contact with all employees, the owner can tell the employees at staff meetings that harassment is prohibited, that employees should report such conduct promptly, and that a complaint can be brought straight to any supervisor or the business owner.

Finally, it is not enough to simply create a harassment policy. A business must also conduct prompt, thorough, and impartial investigations into any complaint that arises, and undertake swift and appropriate corrective action to fulfill its responsibility to “effectively prevent and correct harassment.”


8. Contracts

The pitfall here is that non-existant or poorly drafted contracts do not protect you from harm or do not allow you to collect what you are due.



Accounts receivable represents money owed by entities to the firm on the sale of products or services on credit. In most business entities, accounts receivable is typically executed by generating an invoice and either mailing or electronically delivering it to the customer, who, in turn, must pay it within an established timeframe, called credit terms or payment terms.

Since not all customer debts will be collected, businesses typically estimate the amount of and then record an allowance for doubtful accounts which appears on the balance sheet as a contra account that offsets total accounts receivable. When accounts receivable are not paid, some companies turn them over to third party collection agencies or collection attorneys who will attempt to recover the debt via negotiating payment plans, settlement offers or pursuing other legal action.

Every company has them…past due and slow pay accounts. Here are some ways to help keep your cash coming in the door and collect accounts receivables.

Commercial and industrial experience has proven the following percentages: Often new customers, six will pay on time, two will pay in 60 to 90 days and two will become collection problems.

Always watch your new sales. As money becomes tighter, you will receive one-time sales from firms that may be experiencing financial problems. These customers will bounce from business to business and need your close attention.

Be familiar with your customers’ credit. Only extend credit to organizations you feel confident will pay you. Make sure you don’t have to write off your hard earned sales through bad debt! Pay close attention to the credit terms you are offering your customers. One good way to collect accounts receivable  is to do so before you deliver your product and structure your terms accordingly. An example of this would be a propane company in the winter months; nothing works better than to be paid prior to delivery.

Make sure that you have a sales or service agreement with the new customer prior to the delivery or commencement of work.


Buy-Sell Agreement


A buy-sell agreement is a contract that provides for the future sale of your business interest or for your purchase of a co-owner’s interest in your business should certain contingencies arise.  Buy-sell agreements are also known as business continuation agreements, stock purchase agreements, and buyout agreements.

Under the terms of a buy-sell agreement, you and the other co-owners enter into a contract for the transfer of each others’ business interest at the occurrence of a specified triggering event such as death, disability, or retirement.  Ideally, buy-sell agreements are fully funded with life and/or disability insurance.  Thus, you can avoid the dilemma of being in business with your co-owner’s next-of-kin.

If you own a business with others and are concerned about how the death of a co-owner might affect the business operation, a funded buy-sell agreement can help by ensuring that you will be able to purchase your co-owner’s share, eliminating any doubts about the continuation of the business.  After determining a method to value the business, you, your advisors, and the other co-owners will determine the best way to fund the transaction, and the triggers appropriate for your business situation.

Buy-sell agreements offer other advantages, including assurance to lenders and investors of the continuity of the business, which may facilitate access to capital.



Listed below are several questions for business partners to answer before entering into a partnership. Partnerships can be the most difficult corporate structure to manage because each partner is 100% liable for the business, regardless of the business percentage owned. And, each partner can individually perform business transactions on the part of the company without the others’ permission. Therefore a written agreement between the partners is essential. Using a lawyer can often be beneficial.


  • What is each partner’s share in the business?
  • What is each partner’s title?
  • Does each partner have a job description & responsibilities?
  • What is each partner’s authority?
  • What is each partner required to invest?
  • What is each partner’s weekly time requirement?
  • What is each partner’s monthly distribution (profit, loss, depreciation)?
  • What happens if the business needs more investment?
  • What is each partner’s responsibility for future investment?
  • What happens if a partner can not meet his time obligations?
  • What happens if a partner can not meet investment obligations?
  • What happens if a partner is injured: time, investment?
  • What happens if a partner dies: what happens to his share?
  • Can a partner’s share be assigned to someone else?
  • How is each partners investment valued?
  • What happens if a partner wants to leave the partnership?
  • Should there be a non-compete agreement between partners?
  • Is a partner allowed to invest in a similar business?
  • What is each partner’s responsibility for any loans?
  • What business activities must be agreed to by all partners?
  • What business expenses must be agreed to by all partners?

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