You may have heard the saying, “substance over form”. In the legal context, this is an established principle that is used by judges and business regulators throughout the country, particularly in the tax arena. As a small business owner, it is important that in all your business dealings, this phrase remains on the forefront of your mind. Here are three common scenarios a small business owner may encounter in which the principle, “substance over form” applies:
- Employee v. Independent Contractor. Recently, the company, Lyft, a transportation company, was sued by its drivers. In part, the lawsuit was centered on whether these drivers are independent contractors or employees. In form, Lyft characterized these drivers as independent contractors, but the question was whether in substance, they were treated more like employees. Typically, it is cost effective for a business to characterize its workers as independent contractors. This means less paperwork and less in costs, e.g., employment taxes, workers compensation, unemployment, etc. Therefore, the IRS is well aware that many small business owners will try to characterize a worker as an independent contractor rather than an employee. There are a number of factors the IRS will look at to determine whether a worker is actually an employee or an independent contractor, and they will give very little regard to how you, the business owner, characterize them. The main theme among issues the IRS looks at is control, e.g., how much control do you the employer, have over the worker. The moral of the story is that if you are going to pay your workers as independent contractors, make sure your workers are independent contractors in substance and not just form, otherwise, there are penalties in addition to the taxes and interest owing for payroll withholdings that should have taken place. See Internal Revenue Code § 3509 and also IRS Publication 1779.
- Investor v. Partner. Raising capital for your business can be one of the most important activities you do as a small business, and it is important that you understand the difference between a partner and an investor. The SEC does not regulate the relations between business partners but it does regulate relations between an investor and an issuer. If the person who is providing capital to your business is really an investor even though you call them a partner, the SEC will consider you an issuer of securities and you will be subject to securities law. The more control you give the person providing capital to your business, the more likely they will be considered a partner. But if that person provides capital to your business with the expectation of profit and they have no control or say in how the business is ran, that is the text book definition of a security. See Williamson v. Tucker, 645 F. 2d 404 (5th 1981). The issue is not that you have investors; rather, that you fail to realize you have investors and are subject to securities law.
- Licensor v. Franchisor. This last example comes up less frequently for my clients than the other examples in this article, but it is nevertheless an important one and a small business owner would be wise to know how the “substance over form” principle can affect this situation. It is not uncommon for a business owner to want to receive a license to certain intellectual property rights or to grant a license to the same, particularly if the intellectual property rights include a trademark. In that event, the licensor has a right to establish a certain amount of control over the licensee to ensure that the trademarks are being used appropriately in the licensee’s business. But a line can be crossed such that if too much control is exercised, then even though the agreement may be titled a “Licensing Agreement”, a court could construe it as a franchise agreement. The consequence of unintentionally creating a franchise relationship in which you are the franchisor is that you are now subject to a myriad of federal and state regulations and if you are under the impression you are not subject to them, the chances are slim to none that you are in compliance with them. The Federal Trade Commission (FTC) defines a franchise as any continuing commercial relationship that contains (1) a right to use a trademark, (2) right to payment, and (3) significant controls are imposed upon the franchisee by the franchisor. As these three factors establish, the only material difference between a franchise relationship and a trademark license agreement is the amount of control established by the one party over the other party. The key is to establish no more control over the licensee than is necessary to protect the use of the trademark. The issue is not that you enter into a franchise agreement; rather, that you unknowingly enter into a franchise relationship despite signing a trademark license agreement.
There are many other scenarios in which the principle, “substance over form” should be in the mind of a small business owner, but these are just a few of the main situations. As a business owner, it is important to run your business in compliance with the established principle that in the law, particularly tax law, substance prevails over form. If your situation involves any of the above scenarios, please contact our office.