Closely-Held Corporations Need a Reasonable Compensation Analysis

This is a great article from Fulcrum Inquiry.

Reasonable compensation questions affect millions of closely-held corporations whose owners actively participate in the business. The issue involves how much payroll taxes are due from the earnings of the business. Amounts not characterized as salary are reported as S-corporation income on the shareholder’s personal tax return, where it is not subject to payroll taxes. In re: Watson P.C. vs. United States, no. 11-1589 8th Cir. (2/21/12), the Eighth Circuit affirmed the district court’s decision, holding that an S-corporation shareholder-employee (Watson) characterized too little of the amount paid to the owner as taxable salary.

While one might view the case as an IRS victory, the case also stands for the proposition that a professional services business does not have to classify all of its earnings as taxable compensation subject to payroll taxes. In most of the earlier S-corporation reasonable compensation cases, the shareholder-employee failed to take any salary, leaving the IRS and the courts the simple task of reclassifying the distributions as compensation for services. In Watson, the employee-shareholder took as salary an amount that the IRS viewed as being too small. Although Watson has to pay additional payroll taxes, the trial and appellate courts allowed Watson to receive substantial distributions that were not subject to payroll taxes.

As long as one pays a reasonable salary, significant tax savings are possible and appropriate.

The taxpayer in this case unsuccessfully asserted that the objective and analytical reasonableness of salary was not a factor. Instead, the intent of the taxpayer should be controlling. The Eighth Circuit summarized the taxpayer’s position as follows:

“DEWPC [the taxpayer] repeatedly asserts that there is no statute, regulation, or rule requiring an employer to pay minimum compensation. And, by requiring proof of reasonable compensation, DEWPC argues, the district court imposed a minimum compensation requirement. Rather than looking to whether compensation was reasonable, DEWPC contends that the district court should have focused on taxpayer intent when characterizing the payments.”

The trial and Eighth Circuit rejected this contention. Instead, the courts relied on an Internal Revenue Code §162(a)(1) compensation deduction analysis. This code and related Treasury Regulation §1.162-7(a) indicate a deduction may be made if salary is both (1) "reasonable" and (2) "in fact payments purely for services".

Another appellate issue involved whether the IRS expert witness should be allowed to testify on the reasonableness of compensation. The IRS witness is a valuation “engineer” who addresses financial issues other than compensation. The valuation expert testified on the health and financial performance of the employer, the compensation of others in the industry, the results of third-party salary surveys, and how these factors should be used in arriving at a reasonable compensation result. The trial and appellate courts agreed that the valuation professional was an appropriate expert witness on the compensation questions.

 

If you need a reasonable compensation analysis contact me at (800) 730-5691 or The Out-House General Counsel.

5 Legal Matters That Can Make or Break a Small Business

When you’re running a business, making mistakes is a fact of life. But making legal mistakes – especially when they are avoidable – can mean the difference between the success and failure of your company. 

For your reference, a look at five legal areas that could break your business:

1. Contracts…

“What’s in the small print does matter. Businesses will sometimes use the same generic purchase order, order acknowledgement or delivery confirmation form for every deal, assuming that the same form works in all circumstances or that the boilerplate, microscopic type does not really matter… The order of the exchange, subject matter of the terms and even the size and font of the type face can affect which terms will be enforced.” (10 Things Every Small Business Owner Should Know About Contract Law by Dinsmore & Shohl LLP) 

See also: Ten Things You Must Know before Entering into a Contract (Frederic Abramson) 

2. Trademarks…

“… it is advisable to clear up any trademark issues before launching a new product or services. To do otherwise can be expensive and aggravating. Taking the time and money to choose a strong, non- infringing mark, and to protect it with a federal registration, is a worthwhile investment for the growth and expansion of your brand.” (Launching Your Business or Product? Pick a Good Trademark by Akerman Senterfitt) 

See also: Trademarks 101 (Delain Law Office, PLLC) 

3. Organizational documents…

“Part of the formational process for any of the three types of limited liability entities involves a filing with and certification by the state… Proper tax elections also need to be made. There are also statutory operational formalities involved with those entities (bylaws, formal notice, meetings, and voting, with written minutes or resolutions, etc.), unless properly provided otherwise by an LLC Operating Agreement providing for operational informality, or filing a Corporation as a Close Corporation with a Shareholders Agreement allowing for lack of formality.” (Business Formation Q&A by D. Lee Gwinn) 

See also: Even in Deals with “Yourself,” You Still Need Proper Legal Documents (Davie Law Group) 

4. Employment agreements…

“Do not assume that handshakes and a shared sense of adventure will insulate the company from misunderstandings with the stakeholders/founders… Hence, often a separate employment agreement on top of the operating agreement (LLC) or shareholders agreement (Corporation), is necessary to set out specifics about the founder/ employee’s relationship to the business entity (e.g., at-will employment, duties, obligations, confidentiality, termination, equity incentive and other forms of compensation, etc.).” (Top 10 Legal Documents For Any Technology Venture by Wahab & Medenica LLC)

See also: Barbie / Bratz Dispute Highlights Importance of Employment Contract and Policy Language (Hopkins & Carley) 

5. Non-compete agreements…

“While you may read your employment agreements and understand what you intended, a judge may not. In two recent cases, circuit courts examined non-compete agreements in light of entire employment contracts. The cases show that terms buried within a separate portion of an employment agreement might give the court a reason to decline to enforce your non-compete agreement. Specifically, courts have declined enforcement because the agreements were written in an inconsistent manner or because the employee’s job title changed after signing the agreement.” (Are Your Non-Compete Agreements Enforceable? by Warner Norcross & Judd) 

See also: A Twist on Non-Compete Agreements: Don’t Let Your Vendors and Customers Squeeze Your Margins (Alan Bush) 

—- 

Related Reading:

• Legal Resource Guide for Entrepreneurs (Fenwick & West LLP) 

• Starting a Small Business? Remember These 10 Essential Steps 

• Business Structures: What’s Right for My Company? 

• Funding a Small Business: 7 Financing Sources to Consider 

• Legal Contracts: 6 Drafting Tips for Small Businesses 

• 7 Employment Law “Hot Buttons” for Small Business – A Legal Roundup

If you are contemplating starting a small business, please consult an attorney who specializes in Small Business Law.  You can always contact me at (800) 730-5691 or The Out-House General Counsel.

Deadlocks Between Owners Of Corporations And Limited Liability Companies

Deadlocks Between Owners Of Corporations And Limited Liability Companies

Business disputes are common. Here are some typical ways to deal with them.

by Dion Persson

One of the most common small business situations we encounter is dealing with conflicts, or "deadlocks," among stockholders or a corporation or members of a limited liability company.

These are particularly difficult situations, especially when there is not an effective operating agreement or shareholders agreement providing for the resolution of deadlocks.
One draconian remedy is available through the courts.  Courts often require at least three items before getting involved.  These three items are:

1. There is such dissension among the stockholder/members, directors or officers that the company cannot successfully carry on its functions.
2. The imminent danger of loss of assets is threatened.
3. No other remedy appears to be adequate.

In these cases, the court can appoint a receiver to protect the interests of the company and its owners.
In setting up a company with equal members where a deadlock is possible, the owners should consider a number of common provisions for dealing with deadlocks.  These provisions include:

• Mediation.  Mediation allows the owners to meet, usually with a trained mediator, to try to come to a resolution.
• Arbitration.  Arbitration allows a neutral third party to make a decision.  This is a difficult option for business issues because there are often not right or wrong decisions involved in business disputes.
• Russian roulette.  A russian roulette provision requires one of the owners to serve a notice on the other party naming a price at which it values an interest in the company.  The owner receiving the notice has the option to buy the other owner's share or sell its share to the other owner at that price.
• Texas shoot-out.  Each owner sends a sealed bid to a third party setting a price at which they are willing to buy out the other owner.  When the bids are opened, the owner with the highest bid can purchase the other owner's share in the business at that price.
• Dutch auction.  Like the Texas shoot-out, each owner submits the minimum price at which he or she will sell their share in the company.  The owner with the higher bid then has the option to purchase the other owner's share at the price in such other owner's bid.

By thinking ahead and including provisions like these, owners often have more incentive to resolve their disputes before triggering one of these types of provisions.

Important Tip There is often a lot of optimism at the time of starting a business among the business partners. Despite the optimism, it is a good idea to think through what happens if disputes arise down the road. Preparing for these disputes can help a business get off to a better start.

What If I Do Not Pay My Payroll Taxes

What if I don't pay my payroll taxes? We were asked this payroll question recently, and here's our answer: you should never ever fail to pay your business payroll taxes!


What happens if I don't pay my employer payroll taxes or my withheld employee payroll taxes?

When asked this question recently by a small business owner, we were shocked to think that somebody might think they could get away without paying payroll taxes.

It's very important to pay your payroll taxes because you will be held personally liable for them, even if you think you have limited your liability through your company's legal structure.

Personal Liability for Payroll Taxes

The federal tax code imposes personal liability on any "responsible person" who fails or refuses to collect and pay the required taxes.

A responsible person includes someone who controls the employer's money, has signature authority on a payroll account or is a corporate officer.

As outlined in Section 6672 of the Internal Revenue Code, the responsible person is personally liable for a 100% payroll penalty for any failure pay withheld taxes from employees. In other words, you personally will owe the IRS all of that money.

Note that this is for employee payroll taxes that you have withheld, not for the employer payroll taxes. The covered employee taxes include federal withholding and the employee FICA and Medicare taxes withheld.

Bankruptcy Won't Get Rid of Your Personal Liability for These Debts

A scenario in which a business owner might be tempted into not paying payroll taxes owed is when things are really tight.

Instead of missing a payroll or an important vendor payment, a desperate business owner might use the withheld payroll taxes from a previous payroll to pay current obligations.

You should never do this. If the business is struggling that much, a bankruptcy filing may be around the corner.

While filing for company bankruptcy will stall and/or eliminate many business debts, the IRS has taken steps to ensure that your debts to them will not go away.

Obligations to government agencies for taxes, interest and penalties survive bankruptcy proceedings.

You can close the company down and distribute assets to creditors on a pro rata basis, but you will need to pay the government in full, even if it comes out of your own pockets.

You can even go to jail if you fail to live up to your tax obligations, and ignorance or mistakes are no excuse in the "eyes of the government" for your not paying correctly.

So, a word to the wise – treat your payroll tax obligations to the IRS as sacrosanct. As tempting as it might be to use that money for other purposes, don't do it

If you find youself in a Payroll tax bind, contact me at (800) 730-5691 or The Out-House General Counsel.

12 Reasons for A Startup Not To Be An LLC

12 Reasons for a Startup Not To Be An LLC

By:  Davis Wright Tremaine 's Startup Law Blog

Jewels of Change: Lady Lawyers Impacting the World

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Small Business Horror Story #1: Shady Partner + Generic Operating Agreement = Disaster

This is a re-post from one of my favorite Business Attorneys (other than myself) Gina Bongiovi out of Las Vegas, Nevada.  She tells a story I have come across all too often.

When I sign a new monthly retainer client, I always conduct what I call a "legal checkup" on the business.  I review the company's formation, licensing, employee or contractor agreements, lease agreements, service agreements, etc. to find ways I can better protect the company and its owners. 

Wait, let me clarify.  I *request* these documents in order to review them.  Often, it takes the owners a while to gather all the information to give me and sometimes they simply ignore my requests, preferring that I instead put out fires.  While I'm great at putting out fires, my real value lies in working proactively - modifying these documents to better protect the company before a fire breaks out.

One particular client was in an LLC with another person.  We'll call them Jack and Bill.*  Jack requested the initial meeting with me, apparently without telling Bill.  Bill walked in during our meeting, demanded to know "who the hell" I was, and threw a fit, yelling at the top of his lungs that "we don't need no &*%$ attorney!"  Following that outburst, I gently asked Jack to send me a copy of the company's operating agreement.  He said it was the one that came with the corporate binder he got when he formed the company and he had no idea where the binder even was.  Seeing the writing on the wall, that this partnership was going to crumble sooner rather than later, I made a more urgent request to see the operating agreement.  And I requested the operating agreement every few days for the next two months with no response.

A month ago, Jack called to say Bill was leaving the company.  I again asked for the operating agreement to make sure Bill's exit was in compliance with its terms.  I also suggested that Bill be removed as a signer on all company bank accounts as soon as humanly possible.  No response.  

Last week Jack called in a panic.  While he was at the bank removing Bill as a signer on the account, Bill was at a different branch, withdrawing $21,000 in cash from the company's checking account.  

Because Bill was still a signer on the account, the bank had no choice but to give him the money.

Because the operating agreement didn't restrict an LLC member's ability to take money out of the account, Bill didn't breach any agreement.

And because Bill pulled the money out in cash, there was no way to stop payment.

Jack's only option would be to file a lawsuit against Bill, hope that he wins, and then hope that he could collect the money.  Of course, a lawsuit would drag on for months and more likely years, tying up company resources in what is probably a losing battle.  Plus, even if Bill lost, he could file bankruptcy and then the company would have lost the original $21,000, plus attorney fees, plus time lost while embroiled in a lawsuit.

Lessons learned:  

1) make sure your operating agreement is thorough and addresses issues like when a member can take money out of the account,

2) if someone leaves the company, remove them from the bank account IMMEDIATELY.  Unless you notify the bank that someone is no longer an owner, the banker has no way of knowing not to give an owner access to company funds. 

* Names have been changed to protect the innocent.

You can read Gina's original post at Shady Partner + Generic Operating Agreement = Disaster

If you have any questions or concerns about any of the above, you can contact me at (800) 730-5691 or The Out-House General Counsel.  

Saturday Academy of Law’s Fourth Commencement

The UCI Saturday Academy of Law staged its fourth commencement ceremony Saturday.  The 60 Santa Ana ninth graders were encouraged in their academic pursuits by the experiences of Dean’s Cabinet member Daniel J. Alexander II, the keynote speaker.  All graduates received a pocket copy of the U.S. Constitution, and will be followed by UCI undergrad mentors throughout their high school careers.

Half these ninth graders were taller than me, can you pick me out?

Top 10 Typical Labor Law Faults Done By Companies

The contemporary American workplace is susceptible to numerous federal, state, and local laws and regulations that impose strict obligations on businesses (e.g., wage and hour legal guidelines, nondiscrimination laws and regulations, etc.). Most companies, especially smaller organizations, tend not to know the scope of such obligations and, consequently, frequently (albeit inadvertently) violate legislation. These violations can cause costly lawsuits, and also civil and criminal penalties. In my experience of being a defense attorney in addition to being a plaintiff's lawyer, the most frequent employment law mistakes done by corporations are these (in no particular order): 

- Wrongfully classifying workers as independent contractors. Generally, only workers who operate their unique separate corporations are "independent contractors." Few workers meet this test; in reality, most personnel are considered "employees" for the law, meaning these are eligible to the total variety of workplace protections.

- Wrongfully classifying non-exempt personnel as exempt. Generally speaking, all workers are eligible for minimum wage and overtime pay, unless these are "exempt" under state and federal law. The exemption rules (e.g., for executive, administrative, and professional staff members) only apply in limited circumstances, however; therefore, many staff members who're claimed by businesses to become "exempt" in reality have entitlement to minimum wage and/or overtime pay.

- Not complying with state wage payment laws and regulations. i.e. New York imposes several specific rules regarding how businesses be forced to pay their staff members. These rules include providing new personnel with written notice of the rate of pay and regular pay date; prohibiting deductions from wages unless for that employee's benefit and authorized in writing; requiring written contracts for commissioned salespersons; and providing terminated workers with written notice of the last day's work, their last day's benefits, and their right to make an application for unemployment benefits.  (Make sure you are aware of your state's specific rules).

- Not owning an employee handbook. A personnel handbook is a vital tool for effective employer-employee relations. It notifies personnel of the company's values, policies, and procedures; promotes compliance with labor and employment legislation; so it helps create an orderly, efficient, and transparent workplace.

- Not documenting employee job performance. A well-managed organization clearly communicates its employees' duties and responsibilities (e.g., through written position descriptions), trains and supervises workers to be sure they are meeting these requirements, and offers regular, objective, consistent feedback (e.g., through written evaluations and, where necessary, disciplinary actions). A deficiency of accurate, complete, contemporaneous documentation can cause liability in the case of a case by a staff member.

- Not training supervisors regarding EEO laws. Federal, state, and local equal employment opportunity (EEO) law regulations prohibit businesses from taking adverse actions against staff members (e.g., demotion, termination) for reasons not linked to an employee's job performance, including those according to an employee's race, color, sex, age, disability, religion, national origin, sexual orientation, and marital status ( to mention the most typical "protected characteristics"), plus retaliation for an employee's good faith complaints of discrimination. It is imperative that supervisors learn the way to manage personnel without violating (or appearing to violate) these law regulations.

- Not providing reasonable accommodations for disabled personnel. Most EEO law regulations prohibit businesses from taking adverse actions against employees depending on certain protected characteristics, but disability discrimination legal guidelines also impose an affirmative obligation on businesses to "reasonably accommodate" disabled workers in an attempt to make them perform the fundamental functions of these jobs. Such accommodations can include restructuring job duties, modifying work schedules, or providing assistive devices. Businesses must give a disabled laborer with needed accommodations unless this would cause an "undue hardship" for the company (e.g., very costly, too disruptive).

- Not obtaining releases from terminated staff members. When terminating a worker, businesses need to get a release that waives the employee's potential legal claims against the enterprise. The simplest way to get a release is in exchange for an offer of severance (where appropriate). Normally, companies are not necessary to pay for severance to staff members (unless essential to an employment contract or possibly a collective bargaining agreement). If they opt to do this (e.g., in association with layoffs), they must require personnel to sign a release in return for the payment.

- Not protecting confidential business information. Every organization depends upon certain vital, often confidential, information regarding its company operations, including trade secrets, marketing and advertising practices, and customer and client lists. Access to this information must be restricted to personnel with a "need to know" and may be protected by appropriate non-disclosure, non-compete, and/or non-solicitation agreements (depending on the nature of the information along with the employee's position).

- Not consulting an experienced employment law attorney. Perhaps the one most critical point to take away from this discussion is always that businesses must consult an experienced employment lawyer to ensure they are in compliance with all the increasingly numerous and complex legislation that carpet work just like a minefield. Large organizations will often have attorneys and hr professionals working to help them in this field. Small- and medium-size companies often don't. Their biggest mistake is wanting to navigate this minefield automatically.

And also you? What exactly are your top mistakes made in employment law?

The author Stacia Abner writes her blog, http://www.employmentlawtraining.org/, to help the public get all the information they need to raise awareness on labor rights and employment law and its associated benefits to support workers and companies on a daily basis.

Corporate Record Keeping - Company Records Explained

This article was originally posted by Imke Raschko of New York, but it is applicable to Corporate Record Keeping anywhere.  It is a real back to basics post and I hope you enjoy it.  If you have any questions about your corporate record keeping, do not hesitate to contact me at The Out-House General Counsel or (714) 432-6370.

To view to article hit this link Corporate Record Keeping Explained.