Monday, January 3, 2011

Breaking Up Is Hard To Do

By Samuel Lewis Published in The Business of Photography
Breaking Up Is Hard To Do
While Neil Sedaka's signature 1962 hit "Breaking Up Is Hard To Do" may have attempted to put an upbeat spin on an otherwise painful experience, the reality of business breakups is that they're generally far more complicated than simply facing another person and saying "goodbye." However, the breakup can be less painful if certain issues are taken into consideration when you form your business.

For example, suppose you establish a studio with another photographer. Since your lawyer or accountant advised you to form a corporation to help limit personal liability, you and your co-owner formed a corporation. And because you were trying to save some money on the front end, when setting up the corporation, you and your co-owner filed the minimal set of paperwork and perhaps even had a simple operating agreement prepared. Having gone through the steps of forming a corporation and observing the basic corporate formalities, you and your co-owner then started working the business, creating images for clients and drawing a salary.

Now, suppose that you and your co-owner have a falling out. One of you realizes that he or she is doing the lion's share of the work, while the other is still receiving the same compensation for doing less of the work (even the most altruistic of people only will allow this sort of situation to go on for a time). Regardless of the reason for the falling out, you and your co-owner decide that the best solution is for each of you to go your separate ways. Now you're faced with difficult questions. Who owns the rights to the images? Who owns the goodwill associated with the business? Who has the right to continue using the business name? And, of course, there's the question that comes up again and again in disputes following the breakup of a business: Who "owns" the customers?

While there are some "default rules" associated with the breakup of a business, these rules will be anathema to most photographers. For example, after the business' creditors have been paid, the remaining assets of the business generally are divided among the owners based upon each owner's respective interest. When applied to the example above, the result is that one co-owner may end up owning rights to images that the other co-owner created; stated differently, the photographer/co-owner who did the majority of the work won't be able to walk away from the business with the rights to his or her own images!

It's possible to avoid some of these problems, however, by considering these and other issues on the front end, when you're forming your business. If you follow a few basic steps, you should be able to avoid some of the more unpleasant aspects if your business breaks up.

STEP 1 Decide On A Business Form

While your lawyer or tax advisor may recommend a certain business "form" for your studio (e.g., sole proprietorship, partnership, corporation, limited liability company), depending upon a variety of state law issues, tax-related issues, and even personal philosophy and experiences as to which form may be best for a certain type of business, odds are good that they won't be considering issues such as who will own the rights to the images that you create while working for the business. Indeed, while this sort of ownership issue may not have any impact upon the business form selected, it's nonetheless information that you'll need in order to prepare a proper escape plan (which we discuss in Step 3).

Generally, lawyers and tax advisors will advise a business owner to incorporate for a variety of reasons. One of the reasons why professional advisors recommend incorporating is due to the limitation on personal liability that the corporate form provides to its owners. For example, most businesses enter into contracts (e.g., leasing studio space). If the business ultimately fails to honor its contractual obligations, the amount of even a minor judgment may be more than enough to bankrupt the business. However, provided that corporate formalities have been followed (and absent a personal guaranty), the judgment creditor would only be able to recover against the business and not against the owner of the business personally.

Partnerships generally don't provide the same limitation of personal liability as do corporations, although the tax issues associated with operating a partnership generally are simpler than those relating to corporations. It's important to note that in most states a partnership will be deemed to exist when two people operate a business together as partners. (Partnership law generally is a matter of state law and varies from state to state. While the old Uniform Partnership Act of 1914 was adopted by all states except for Louisiana, the current, revised Uniform Partnership Act has been adopted by somewhat more than half of the states.)

A more recent business form (in the U.S.) that seems to be gaining in popularity is the limited liability company (LLC). Similar to a corporation, LLCs often enjoy the same limitation of personal liability as do corporations. They also provide more flexibility than corporations when dealing with issues such as management and distribution of profits. However, there are some disadvantages to LLCs, not least of which is the fact that the business form is relatively new to the U.S. and its court systems.

There are also tax considerations associated with each of the business forms. A typical corporation may face what's commonly referred to as "double taxation." First, the corporation is required to pay corporate income tax on its profits; second, dividends that the corporation pays to shareholders are taxed. There's a legal way to avoid this sort of "double taxation," but it requires qualifying corporations to file paperwork—commonly referred to as a Subchapter S election—with the IRS so that the corporation will be taxed like a partnership, with the corporation's income being taxed at the shareholder level (regardless of whether the income is distributed).

...the result is that one co-owner may end up owning rights to images that the other co-owner created...
This approach also may permit owners of small businesses to avoid other tax-related problems. For instance, late last year the IRS announced its plans to crack down on corporation owners/operators who attempted to avoid paying payroll tax by compensating themselves through dividends or other non-salary distributions from the corporation.

STEP 2 Sort Out The Rights Up Front

Once you and your advisors decide upon the type of business form you're going to operate, it's critical that you understand the default rules for the rights to the images that you'll create, and perhaps most importantly, whether you or your company will own those rights. As strange as the notion may seem, you could very well find yourself in a situation where you're only an indirect, or fractional, owner of the rights to your own images.

Under the current U.S. Copyright Act, a "work made for hire" is defined as "a work prepared by an employee within the scope of his or her employment," and it's owned by "the employer or other person for whom the work was prepared." Given the definition of a "work made for hire," there's generally no requirement for an employer to require or use a written agreement with an employee in order to take advantage of the rights conferred by the Copyright Act. Thus, once the photographer/owner creates images within the scope of his or her employment, the corporation owns the images. The only way to avoid this result is for the photographer and business to agree to some other scheme in a signed writing or agreement.

At first blush, whether the photographer or business owns the rights to the images may seem to be a difference without a distinction. However, there are a number of very real consequences to the difference. If the business owns the images, the images will also be within reach of the business' creditors. Even if creditors aren't a concern, the very fact that the business owns the images means that when the business breaks up, the rights to the images must be distributed to the business' owners, and if there's no agreement as to the value of the rights or how they will be distributed among the owners, the rights are potentially sold at auction with the proceeds divided among the owners.

Now, if you've been a working photographer for any length of time, you may think that you can avoid the impact of the "work made for hire" provisions of the Copyright Act by treating yourself as a contractor. However, this clumsy attempt to avoid the default provisions of the Copyright Act isn't without adverse consequences, such as tax problems (the IRS is scrutinizing companies that attempt to avoid paying payroll taxes by improperly classifying employees as contractors), insurance problems (the typical commercial general liability policy will include coverage for employees but not for contractors), etc.

While the application of the "work made for hire" provisions of the Copyright Act are relatively straightforward when applied to corporations, the application is far less certain with other types of business organizations. For example, court decisions involving partnerships are anything but uniform in their determination of whether copyrightable material produced by one partner belongs to that partner or to the partnership as a whole.

Ultimately, if you're establishing a business by yourself or with a co-owner, it's far easier to simply come to an agreement as to how the rights to the images will be owned when you form the business. Such an agreement, once in writing and signed, is the easiest way to avoid the "work made for hire" provisions of the Copyright Act and the uncertainty caused by various types of business organizations.

STEP 3 "Always Have An Escape Plan"

The late Desmond Llewelyn, in his portrayal of the character "Q", immortalized the phrase "Always have an escape plan." The phrase rings just as true for business relationships. And the best time to devise an escape plan is on the way into a business, when everyone is getting along. Just as emotions tend to run high during a breakup, emotions can run even higher in the breakup of a business because this breakup may have a significant impact on a person's livelihood. More importantly, if you and your business partner can't reach an agreement on these sorts of issues at the beginning of the business when everyone is getting along well, it's highly unlikely that the co-owners will be able to resolve these issues when contemplating the imminent breakup or shutdown of the business.

In addition to deciding who will own the rights to the images, if you're going into business with someone else, you should discuss the various scenarios that may occur in the future. The goal here is to avoid the typical default statutory provisions governing corporations, LLCs and partnerships, which contemplate the distribution of business assets to the owners or partners after the business has satisfied its creditors, and in some instances, contemplate the liquidation of the business in order to simplify the distribution of assets.

Consider, for example, what may happen if one of you wants out of the business. While the concept of buying out a business partner's interest may be simple, the nuts and bolts of these issues are hardly trivial, and are further complicated by the possibility that the business will be more valuable in the future (due to the acquisition of equipment and other property or to the business entering into contracts with clients, or both). Will the person who wants to continue operating the business have that right? How will the departing owner's interest in the business be valued? And when will the departing owner be paid for his or her interest? Indeed, if the person who wants to carry on the business alone can't afford to buy out the interest of the departing owner in one lump-sum payment, the result may very well be shutting down the business and liquidating its assets.

Even the issue of valuation isn't as simple as it may appear. Ordinarily, valuation involves consideration of a business' equipment, contracts, accounts receivable and other assets, less its debts and obligations, and attempting to arrive at a value at a given point in time. Adding intangible rights to the equation, such as copyrights and trademarks, can significantly complicate the issue. In some cases, it may be difficult, if not impossible, to assess the future licensing or sales value that copyrighted images may have; likewise, it may be difficult to place a value on whatever goodwill a business has developed with its customers and the consuming public. However, if you and your business partner agree at the outset how these sorts of rights will be valued for purposes of handling a buyout, you can avoid the acrimony associated with fighting over the value down the road.

Even if you and your business partner decide that the best thing to do is simply shut down the business should one of you decide to move on, it's still important to discuss the ramifications of this possibility when forming the company. For instance, if the business is to shut down, you should still consider who will take responsibility for (and presumably receive the benefits of) any customers who have contracted with the business. Since client relationships tend to involve a personal component, nobody who has taken the time to work with a client and develop a relationship wants to let the client down by simply saying that the business is ending and won't be able to honor its contract, if for no other reason than doing so may damage the relationship and discourage the client from sending business to the photographer in the future.

Once you've considered the various future scenarios, even if the possibility of such scenarios playing out seems remote, the decisions made regarding those future scenarios should be conveyed to an attorney so that the terms will be included in a formal, written agreement that will be signed by the business owners.

Parting Thoughts

Business breakups need not be heated or emotional experiences. There's no reason why photographers' business ventures can't begin and end without hard feelings or a loss of mutual respect for one another. The key to avoiding acrimony, however, is deciding issues relating to the breakup of the business when the business is formed, leaving nothing to fight over when the time comes to wrap up the business.

Samuel Lewis is a Board Certified Intellectual Property law specialist and partner at Feldman Gale, P.A., in Miami, Fla., and a professional photographer who has covered sporting events for a quarter-century. Reach him at This email address is being protected from spambots. You need JavaScript enabled to view it. or This email address is being protected from spambots. You need JavaScript enabled to view it..
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