The Principal-Agent Relationship

The principal-agent relationship is formed when one party (the agent) agrees to act on behalf of and subject to the control of the other party (the principal). There are three requirements for forming a principal-agent relationship (which can be remembered by the mnemonic “ABC”): assent, benefit, and control.

● Assent: the principal and agent agree to create this agency relationship.

● Benefit: the agent will act for the benefit of the principal

● Control: the principal has the right to control the ultimate objective of the agent’s work.

Note some important things that are NOT requirements to forming a principal-agent relationship:

● Intent is not required. Two people can enter into a principal-agent relationship without even knowing it.

● Writing: the formation of the principal-agent relationship does not need to be in writing. A simple conversation between two people can give rise to a principal-agent relationship.

● Compensation is also not required. The agent can be gratuitous.

What are the ramifications of the principal-agent relationship? If a principal-agent relationship exists, the principal may be liable for contracts that the agent enters into on behalf of the principal. In addition, a principal may also be liable (vicariously) for tortious misconduct committed by the agent.

Business Structure and Tax Returns

The type of business structure determines which income tax return a business needs to file. The most common business structures are:

● Sole proprietorship: A sole proprietorship is an unincorporated business owned by an individual. There is no distinction between the taxpayer and their business. As a result, a sole proprietor reports business income and expenses on Schedule C of the sole proprietor’s personal tax return (Form 1040).

● Partnership: A partnership is an unincorporated business with ownership shared between two or more people. A partnership must file an annual information return (Form 1065) to report income and expenses, but it does not pay income tax. Instead, it "passes through" any profits or losses to its partners.

● C Corporation: A standard corporation (also known as a “C” corporation) is a legal entity that is separate and distinct from its owners. It must file a Corporation Income Tax Return (Form 1120) to report income and expenses of the corporation. The corporation pays taxes on its profits, and the shareholders must also report their dividends on their personal tax returns.

● S Corporation: An “S” corporation elects to pass corporate profits or losses through to its shareholders. An S corporation files Form 1120S. Like a partnership, an S corporation does not pay tax. The income flows through to the shareholders, who report their share of the income on their personal tax returns, regardless of whether the income was distributed or re-invested in the company.

● Limited Liability Company: A Limited Liability Company (LLC) is a business structure allowed by state statutes. Since they are created by state law, the IRS does not recognize the LLC business structure. By default, the IRS considers an LLC to be a sole proprietorship if there is one owner or a partnership if there is more than one owner, unless the LLC elects to be treated as a corporation.

Recordkeeping for Small Businesses

Small business owners should keep good records. This applies to all businesses, whether they have a couple dozen employees or just a few. Keeping good records is an important part of running a successful business.

Good records will help the business owner:

● Monitor the progress of their business.

● Prepare financial statements.

● Identify income sources.

● Keep track of expenses.

● Prepare tax returns and support items reported on tax returns. (The burden of proof is on the small business owner to validate expenses deducted on tax returns.)

A good recordkeeping system includes a summary of all business transactions. Except in a few cases, the law does not require special kinds of records. Small business owners may therefore choose any recordkeeping system that fits their business. They should choose one that clearly shows income and expenses.