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Potential Perils of Book Publishing Partnerships

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by Jonathan Kirsch, the Law Offices of Jonathan Kirsch —

Jonathan Kirsch

Book publishing attorney Jonathan Kirsch presents an overview of the legal issues that can occur while running your publishing business.

Author’s Note: This article offers an overview of the legal issues and does not take the place of consultation with an attorney. Readers are encouraged to consult an attorney with appropriate expertise rather than relying on the contents of the article.

Publishing is a business, and the law provides more than one way to own and operate a business. Some are riskier than others, and if you do not make a decision on a business entity, you will end up doing business in the riskiest ways of all.

Sole Proprietor

An individual who owns and operates a business is called a sole proprietor. The problem with sole proprietorship is that there is no legal distinction between the business and the human being who owns it. If the publishing business owes money to anyone—an author, a printer, a landlord, or someone who files a lawsuit against the business and prevails in court—the sole proprietor’s personal assets are at risk. The creditor can enforce a debt or judgment against the assets of the business as well as the personal property of its owner—their personal bank account, home, car, jewelry, and other things of value.

Partnership and Joint Venture

If more than one individual owns and operates the business, then a partnership or joint venture is created. The risk of personal liability when doing business through a partnership or joint venture is even more acute and wide-ranging than doing business through a sole proprietorship for at least two reasons.

(As a technical matter, “partnership” is the term that is used to describe a business entity based on an agreement between two or more individuals or business entities to engage in an ongoing business. By contrast, “joint venture” usually refers to a business entity with a limited and specific goal. An agreement to operate a publishing company, for example, results in the creation of a partnership; an agreement among collaborators to write a book is more likely to result in the creation of a joint venture.)

First, like a sole proprietorship, a partnership or joint venture provides no barrier between the debts and obligations of the business owners and their personal assets. What’s even worse is that the debts and obligations incurred on behalf of the business by one partner are fully enforceable against the personal assets of the other partners or joint venturers. For that reason, partnerships and joint ventures represent the greatest risk in operating a business.

As a practical matter, and by way of example, suppose that Partner No. 1 enters into a contract in the name of the partnership for a lease of computer equipment without consulting Partner No. 2. Even if the two partners agreed not to incur obligations without their joint knowledge and approval, the equipment lessor is not bound by their agreement and can proceed against the personal assets of Partner No. 2. Since partners are “jointly and severally” liable for the debts and obligations of the partnership, the equipment lessor can seek to enforce 100% of the debt against the personal assets of a single partner.

Second, a partnership or joint venture may come into existence without any signed agreement among the partners or joint venturers. As long as two or more individuals (or business entities) orally agree to engage in a business enterprise, a partnership or joint venture comes into existence, and the risk of personal liability comes with it. As noted above, the partners may agree between themselves to allocate rights and duties among themselves in a signed written agreement, but if they fail to sign an agreement, the partnership or joint venture is still in existence.

Barrier to Personal Liability

To put a barrier between an entrepreneur and their personal assets, the law provides—and has long provided—various business entities that exist as legal “persons” separate and apart from their owners. One is the corporation, and another is the limited liability company (or LLC). While there are differences between these two entities, they both serve to protect the individuals who own the business from personal liability for its debts and obligations. (Other business entities that protect against individual liability are available, but they are not discussed here.) Unlike a sole proprietorship, a partnership, or a joint venture, the creditors of and claimants against a corporation or an LLC may enforce their rights only against the assets of the business entity and not against the assets of its owners. This alone is the single best reason to operate a business through a business entity.

Corporations and LLCs

Both corporations and LLCs are governed by the laws of the state in which they are organized. The owners of a corporation are called shareholders, and the owners of an LLC are called members. With a few exceptions that vary from state to state, both a corporation and an LLC can engage in any lawful business. Once organized, both entities remain in existence until they are dissolved by their owners.

As discussed below, corporations are regarded as requiring more “formalities” than an LLC. For example, a corporation is required by law to have officers and a board of directors, to convene meetings of the board of directors at regular intervals, to keep minutes of the meetings, and to make a record of their decisions in written resolutions, all of which are supposed to be maintained in the corporate books and records.

By contrast, an LLC is governed by the decisions of its members. Although one member may be designated as the managing member (or several members may be designated as co-managing members), an LLC does not have officers, a board of directors, or a requirement for meetings, minutes, and resolutions. That’s why the LCC is regarded a more flexible and informal way of operating a business.

The choice between a corporation and an LLC requires a careful consideration of various legal, financial, tax, and employment issues. Depending on the circumstances of any particular business, one entity may be preferable over another. The decision should be made with the advice and assistance of attorneys and accountants with applicable expertise.

Business Entity Formalities

The members of an LLC and the shareholders of an “S” corporation are both required to observe various formalities in setting up, maintaining, and operating the business entity. The formalities may arise under both federal and state law, and the laws will vary from state to state. For example, the business entity must have its own Employer Identification Number (which performs the same function as a Taxpayer Identification Number as used by individuals), its own bank account, and its own books and records. The business entity must be adequately “capitalized,” that is, the original members or shareholders must contribute a sufficient amount of money to the operating capital of the entity to permit it to do business. The business entity must comply with all applicable federal, state, and local laws and regulations, which may include a local business license and the filing of a Fictitious Business Name Statement (or a “DBA”).

‘Piercing the Corporate Veil’

The whole point of operating a business through an LLC or a corporation is to create a barrier against the liability of the owners for the debts and obligations of the business. Some creditors and claimants, however, may attempt to set aside the business entity and proceed directly against the owners, a legal strategy known as “piercing the corporation veil.” In order to do so, the creditor or claimant must prove that the entity was a mere sham and not a bona fide business entity.

To protect against “piercing the corporate veil,” it is essential to treat the entity as separate and different from its owners. To put it another way, the entity must observe all of the corporate formalities that apply to the applicable entity, whether it is an LLC or a corporation. Adequate capitalization is the single most important issue, but it is also important to show that the entity has always been operated separate and apart from its owners.

Thus, for example, if an owner puts money into the business, it must be recorded in the books and records of the entity as a loan or an additional contribution to capital. If an owner takes money out of the business, it must be recorded in the books and records of the entity as a loan or a draw against the distribution of profits. When paying a third party for an obligation of the business entity, the payment should be made out of the bank account of the entity itself and not its owners. The assets of the entity must never be intermingled with the assets of its owners.

As another example, contracts should be entered into and signed by the business entity and not by its owners in their individual capacities. The contract between my corporation and a third party will identify the business as “Jonathan Kirsch, A California Professional Corporation.” The signature block will be in the name of the corporation: “Jonathan Kirsch, A California Professional Corporation, by Jonathan Kirsch, its Chief Executive Officer.”

When doing business with an LLC or a corporation, and especially if the business entity is newly formed and does not have an operating history, some companies will require a personal guarantee from its owners. A printer or a landlord, for example, may ask the owner of the publishing company to sign a personal guarantee, which means that the printer can enforce its rights against both the business entity and its owner. Unfortunately, a personal guarantee defeats the purpose of using a business entity as a barrier to liability, but it may be unavoidable in some business transactions, especially in the early years of operation.

Another limitation on the barrier to liability arises when the publishing company is publishing a book that was written by an owner. If a book contains content that violates the rights of a third party—copyright or trademark infringement, defamation, invasion of privacy, etc.—the author and publisher have separate liability. That’s why a self-published author who uses an LLC or a corporation to operate their publishing company is not protected against individual liability for these kinds of claims.

Tax Issues

All businesses are subject to taxation, but there are crucial differences among the various kinds of business entities.

The owner of a sole proprietorship reports the income and expenses of the business on their personal tax return in an attachment known as a Schedule C, and the profits (or losses) are carried over to the taxpayer’s personal tax return. In other words, taxes on the profits of a sole proprietorship are paid by the individual on their tax return.

By contrast, a partnership or joint venture is a separate legal “person” and must prepare a tax document called a Schedule K-1, which reports the profits (or losses) of the business. However, the partnership or joint venture does not pay taxes; rather, the profits or losses are allocated among and passed through to the partners or joint venturers. Taxes on the income are reported and paid by the partners or joint venturers on their personal income tax returns.

As a general rule, a corporation—unlike a partnership or joint venture—is a tax-paying entity. As a result, the shareholders of an ordinary corporation are subject to the risk of double taxation. That is, the income of the corporation is taxed once at the corporate level, and the dividends paid to its shareholders are taxed on their individual tax returns.

To avoid the burden of double taxation, however, the Internal Revenue Service recognizes a so-called S corporation, which is a pass-through business entity.

(The “S” refers to 26 U.S.C. Subchapter S.) An S corporation is required to file a Form 1120-a, which also functions as a Schedule K-1, and the taxes on profits of an S corporation are paid by the shareholders on their individual tax returns. Thus, the tax is paid only once at the shareholder level and the problem of double-taxation is avoided.

Because of the tax issue, most entrepreneurs choose either an LLC or an S corporation rather than an ordinary corporation.

Important caution: Tax issues are crucial in deciding whether and how to operate a business through an LLC or an S corporation. It is essential to consult an appropriate tax attorney, certified public accountant, or other tax advisor before making these decisions. Also, there may be legal issues under state law that apply to who may be a member of an LLC or a shareholder of an S corporation, and an attorney should be consulted to make sure that the business entity is in compliance with both federal and applicable state laws.

Choosing Between an LLC and a Corporation

The conventional wisdom in choosing between an LLC and a corporation is that an LLC offers far more flexibility in allocating rights and duties among the owners and, at the same time, imposes far fewer formalities than a corporation.

As to the issue of formalities, the differences between the two entities are not always substantial. A corporation requires articles of incorporation, and an LLC requires the preparation of articles of organization. A corporation operates under a set of bylaws, and an LLC operates under an operating agreement. It may be to the advantage of the shareholders to prepare a shareholder’s agreement, but it is not required by law. By contrast, an LLC requires an operating agreement, which can be a lengthy and complicated document to prepare.

Still, the flexibility in allocating rights and duties among the members of an LLC is one of the reasons to choose an LLC over a corporation, and a well-drafted operating agreement is the place where the allocation is specified. That’s why a “canned” operating agreement may defeat the purpose of using an LLC.

Additional Advantages of Using a Business Entity

The primary reason for doing business through an LLC or a corporation is the barrier against liability. However, it is also true that a business entity may make a better impression on authors, distributors, printers, and others whom the publisher does business. If and when the owner of the publishing company is ready to sell, the perceived value of the business may be greater if the company is an LLC or a corporation rather than a sole proprietorship. These matters of perception, of course, may be especially important for self-published authors.

Jonathan Kirsch, who has long served as general counsel of the Independent Book Publishers Association, is an attorney specializing in copyright, trademark, privacy, and publishing law in Los Angeles.

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