Wednesday, March 14, 2012

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.

Thursday, March 8, 2012

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.

Thursday, March 1, 2012

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.
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.