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Day: June 15, 2022

When to Call Your Business Attorney

Posted on by Lindy Laurence

Let's just say it: entrepreneurs are scrappy. We're curious, resourceful, gritty, independent. We are good at figuring things out and thrive when we're navigating new situations.

Most of the time, this works out great! Sometimes, it doesn't.

One of the most common questions business owners ask is "When should I involve an attorney? What should I be looking out for?" Here are six common areas of your business where there are legal issues to navigate. When you encounter one of these areas, it should trigger a call to your attorney! Discussing these things with your business attorney first will help you avoid some common mistakes.

1. Choosing Your Business Entity Type

The first step when forming a business is to decide what type of entity is the best form for your business. This decision depends on your business goals, timeline, structure, liability, management, and tax considerations. Non-tax factors are usually the primary considerations because, in some instances, an entity can choose how it's treated for tax purposes.

Businesses are formed under state law and can be corporations, partnerships (which come in several flavors), and limited liability companies (which can also come in several flavors). The state law classification of a business is not always the same as the federal tax classification of a business. For tax purposes, a business is treated as a disregarded entity, C-corporation, S-corporation, or a partnership. The tax classification is important because the tax rules are quite different for each classification.

You should discuss your business goals and timeline with an attorney so you can select the ideal entity type from the start. Entity selection isn't one-size-fits-all, and it's important your attorney understands your future growth and capital-raising plans to avoid future changes to the entity type. Some entity types that are commonly recommended for other businesses may not be a good fit for your growing startup, so being aware of how your unique factors impacts your overall decision is important. A lawyer can help you choose the type of legal entity that best supports achieving your goals from legal, tax, and early-stage investment perspectives. 

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2. Business Governance Documents

Your choice of entity will determine what specific business governance documents you need; corporations will have bylaws, an LLC will have an operating agreement. These foundational governing documents formalize the relationship between the company founders and keep you from doing business based on an unwritten, informal understanding. Business owners should avoid acting through oral agreements -- even (especially!) with friends and family members. Good governing documents protect important relationships and the strengthen your business.

Your attorney can provide you with recommendations for what documents you need and what they should include. A comprehensive set of governing documents will set out each founder's role and responsibilities, including the day-to-day operations of the business. These documents will also memorialize each founder's ownership percentages, as well any loans made to the business. They will specify how you and your co-founders will make key decisions, for example, about capital raises and the sale of the business, and identify a mechanism for solving disputes between the founders (such as how to break a tie if two founders disagree). 

This process requires a modest commitment of time and expense, but it will go a long way in identifying and resolving any fundamental differences between the founders at the outset. The company and its leadership will be stronger as a result. 

3. Raising Capital and Issuing Equity

a. Raising Capital

When raising capital, it's essential that your business complies with federal and state securities laws, which apply to all offers and sales of securities, including to friends and family. If your company will be issuing securities (selling shares, issuing membership interests, convertible debt instruments, conducting a SAFE financing, etc.), you must have a valid exemption from federal and state registration. If no exemption applies, then you must register your offering with the SEC. 

An attorney can help you identify a federal registration exemption and comply with state blue sky laws. If your company will issue securities to non-accredited investors, even close friends and family, you should proceed with extreme caution. Rule 506 of Regulation D, the most commonly relied on exemption from federal securities registration, is generally only practical in securities offerings made solely to accredited investors. Talk to an attorney before you begin raising money so you can take appropriate action. It's worth it to avoid regulatory action or harming the economics of a future investment in your company. 

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b. Issuing Equity

Security laws also apply when issuing equity compensation, so talk to your attorney before you issue any shares or membership interests to non-founders. Many companies don't have the cash flow to pay the high salaries or match the benefits offered by established businesses. As a result, most new companies offer some form of equity compensation (for example, stock options, restricted stock, or a profits interest) to compensate, retain, and motivate their employees.

Consider how much equity your company should designate for employees, and then consider how that will impact your overall funding strategy. Your attorney can help you understand the legal implications, tax consequences, and accounting treatment of granting each type of equity award, including any vesting requirements.

Related reading:

  • Equity Compensation

4. Protect Your Intellectual Property

a. Clear Your IP

Before you invest any value in your brand name, logo, and domain name, be sure to clear the rights to them. Do this while your business is still in the conceptual stage to avoid spending time and money creating IP that may not be useful in the long run. Protecting the IP will secure the right to use those trade designations when and where you want to sell your products or services. And, registration will prevent other similar businesses from using your them. 

b. Develop an IP Strategy

It is essential that founders develop and implement a comprehensive IP strategy to ensure that the company has (and retains!) essential IP rights. A comprehensive IP strategy should cover IP creation, acquisition, and protection. It should also factor in your anticipated growth and expansion. Startups must ensure that the core IP is owned by (or at least securely licensed to) the business. Work with your lawyer to determine the appropriate kind of IP protection for your company, taking into account how likely you are to obtain that protection, the time and costs required to obtain it, and the length and strength of that protection.

c. Protect Your IP Rights

Founders can plan for growth and success by filing proactively for rights protection in the U.S. and in foreign jurisdictions where your company reasonably expects to do business. Startups should make a list of all the countries where the company plans to operate, then decide where the company can afford to file. Consider taking advantage of intent-to-use U.S. trademark registration, which allows your company to register a trademark before actually using it, if the company has a genuine intent to use the mark in connection with the goods or services listed in the application.

It's also essential to protect your company's IP in early-stage business activities. There are many practical steps you can take to safeguard confidential business information and trade secrets. For example, ask your attorney about confidentiality and nondisclosure agreements, registering copyrights and using copyright notices, and clearing and registering trademarks and using appropriate notices. 

Lastly, if you'll be using third-party content, it's a good idea to work with your attorney to create a process for adequately clearing that content and consider what rights must be obtained (including for social media and other non-commercial uses). 

5. Paper Up Key Relationships

It's also important to properly document the key relationships for your company. Your attorney can prepare form agreements you can use for your core business activities early in the company's life-cycle. Don't rely on oral arrangements with customers, suppliers, and employees -- not even with friends and existing business contacts. And when you're negotiating contracts, don't assume that you have to accept all of the proposed terms. Your attorney can help you understand how contracts shift risk between the parties through indemnification, exclusive remedies, limitations on liability, and warranty provisions, and ensure you agree to the right contract terms. 

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6. Hiring Employees

Companies must comply with state and federal wage and hour laws for all employees from the outset. All employees must first be properly classified as exempt or nonexempt from the federal minimum wage and overtime laws under the Fair Labor Standards Act. Nonexempt employees must be paid at least minimum wage and compensated for all overtime. For exempt employees, you must ensure that they perform the job functions necessary to qualify for the exemption.

If your employees work remotely, be aware that state and local laws govern the employment relationship, and there are many laws that may be more generous to employees than the federal laws. For example, some states or cities require employers to provide paid sick leave or other benefits, and many have a higher minimum wage than the federal wage.

It's also essential you properly classify independent contractors and unpaid interns. Failure to do so can lead to substantial liability in several areas, including overtime pay, taxes and penalties, and employee benefits. Pay college students or recent grads performing services for the company at least minimum wage and overtime unless they meet the strict qualifications for unpaid interns under the FLSA.

If hiring employees is on your horizon, then plan ahead for payroll and benefits administration. However, don't assume that using a professional employer organization (PEO) or temporary staffing agency insulates your startup from liability for employment law violations. Founders must understand that they may be personally liable for unpaid wages, even if the business fails. 

Related reading:

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Lumin Law can help you navigate these issues and ensure they are properly addressed in a way that furthers your business goals. If these topics are on your horizon, please reach out and connect. 

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Tax Treatment of Business Entities

Posted on by Lindy Laurence

This is an overview of how U.S. federal income tax laws impact different types of for-profit business entities. These tax rules apply to startup companies that are U.S. corporations, partnerships, and limited liability companies. The tax rules that apply to trusts, tax-exempt organizations, banks, insurance companies, and other specialized industries are not addressed. 

The first decision a founder must make is what type of business entity to form (corporation, partnership, limited liability company). This determines the legal structure of your business. This choice of entity leads to the second decision, the federal tax classification of the business. This post walks you through the choice of entity considerations, then explores the tax classifications available to each entity type. 

1. Choice of Business Entity

The first step when forming a business is to decide what type of entity is the best form for the business. This decision depends on your business goals, timeline, structure, liability, management, and tax considerations. Non-tax factors are usually the primary considerations because in some instances a business can choose how it is treated for tax purposes.

Businesses are generally formed under state law, and can be corporations, partnerships (which come in several flavors), and LLCs (also in several flavors). For tax purposes, a business is treated as a disregarded entity, C-corporation, S-corporation, or a partnership.

The state law classification of a business is not always the same as the federal tax classification of a business. For example, a LLC can elect to be taxed as a partnership or as a corporation. The tax classification of a business is important because the tax rules that apply to a disregarded entity, C-corporation, S-corporation, and partnership are quite different.

a. Disregarded Entity

A "disregarded entity" is a business entity with a single owner that is generally ignored for tax purposes, even though it's a separate legal entity for state law purposes. The owner of the disregarded entity is considered to own the assets (and be subject to the liabilities) of the disregarded entity for tax purposes and reports the entity's income and expenses on its own income tax return. In other words, a disregarded entity is treated, for tax purposes, like a sole proprietorship, branch, or division of the owner.

The advantages of a disregarded entity for a startup business are that the structure is simple with minimal administrative costs. But the owner of the disregarded entity must pay self-employment tax on any net earnings, and this structure is only available if there is only one founder or owner.

b. C-Corporation

All corporations other than S-corporations are C-corporations. C-corporations are the most common corporate form and generally are subject to two levels of tax on their income: first at the entity level when earned, then at the shareholder level when distributed. The burden of two levels of tax is currently somewhat reduced by the 21% corporate income tax rate that took effect in 2018, but this low corporate tax rate is likely to change with tax reform measures.

Most publicly traded companies are required to be taxed as C-corporations. However, for smaller and non-publicly traded companies, the decision to be taxed as a C-corporation should be carefully considered because an entity that is taxed as a partnership (for example, an LLC) may be a more appropriate entity for a startup company.

If a C-corporation becomes desirable later on, it is very easy to convert from a partnership or LLC to a C-corporation, but beware that it is extraordinarily difficult to do the reverse (meaning, convert from a C-corporation to a partnership or LLC). However, if a startup company wants to immediately raise venture capital and potentially go public, the startup company may want to start out as a C-corporation. Venture capital investors generally prefer C-corporations because of the ability to structure equity ownership and have multiple classes of stock.

c. S-Corporation

An S-corporation is a pass-through entity for tax purposes, which means it generally does not pay an entity level tax. The S-corporation's profits and losses instead generally pass-through to its shareholders, who include their respective share of those items on their income tax returns (whether or not the income is distributed).

S-corporations are less common than C-corporations because of the substantial limitations on the availability of the S-corporation election. An S-corporation can have only one class of stock, no more than 100 stockholders, and, with certain limited exceptions, can only be owned by US individuals (citizens or residents). In addition, only an eligible US entity can make the election (generally a US C-corporation or other US business entity eligible to elect C-corporation tax status).

S-corporations are useful for individual entrepreneurs because not all profits are subject to the self-employment tax. However, a startup company should carefully consider the significant limitations placed on the number, types, and residency of stockholders that can own an interest in an S-corporation. In many cases, a partnership or LLC may be a better choice for a startup company that desires pass-through taxation for its owners.

d. Partnerships

Like an S-corporation, a business entity taxed as a partnership is a pass-through entity for tax purposes, which means it does not pay an entity level tax. The partnership's profits and losses are instead computed and allocated among the partners annually and pass-through to the partners, which include their respective share of those items on their income tax returns (whether or not distributed). Partners are generally subject to self-employment tax on income allocated to them.

Unlike an S-corporation, a partnership does not have any restrictions on the number (other than the requirement that a partnership have two or more owners), type or residency of its owners. Therefore, a startup that desires pass-through taxation often chooses partnership tax status. However, partnership agreements can be complicated and outside investors may not interested in a startup company that is taxed as a partnership because it can complicate their tax filings.

e. Limited Liability Company (LLC)

Even though an LLC is a recognized type of business entity formed under state corporate law, LLCs do not have their own federal income tax regime. For tax purposes, an LLC is classified as a disregarded entity, C-corporation, S-corporation, or partnership. A single-member LLC is treated as a disregarded entity and a multiple-member LLC is treated as a partnership for tax purposes unless the LLC elects C- or S-corporation tax status. LLC members are generally subject to self-employment tax on income allocated to them.

LLCs often choose to be treated as a partnership for tax purposes, which means that the LLC does not pay an entity level tax. The advantages of using an LLC that is taxed as a partnership are that there is a single level of tax at the owner level, a flexible allocation of income and loss, and no restrictions on the number (other than the requirement that an LLC have two or more members), type or residency of its owners as there are with an S-corporation.

However, LLC operating agreements can be complicated and outside investors may not be interested in investing in a startup company that is taxed as a partnership because it can complicate their tax filings.

2. Choice of Tax Classification

The state law classification of a business is not always the same as the federal tax classification of a business. Under the "check the box" Treasury regulations, a business entity is classified either as a "per se" C-corporation or as an entity eligible to choose its tax classification (an "eligible entity").

a. Per Se C-Corporation

Under the "check the box" Treasury regulations, certain entities are automatically classified as per se C-corporations and cannot make an election to be treated as a disregarded entity or partnership for tax purposes. A corporation incorporated under state law is a per se C-corporation for tax purposes. However, a per se C-corporation that meets the requirements for the S-corporation election can elect S-corporation status on formation.

b. Eligible Entities

An eligible entity (any business entity not treated as a per se C-corporation) generally chooses its tax classification. Partnerships and LLCs organized under state law are eligible entities under the check the box regulations.

The check the box regulations have two default rules for eligible entities: (1) An eligible entity with a single owner is automatically classified as a disregarded entity unless it elects C-corporation tax status; and (2) An eligible entity with multiple members is automatically classified as a partnership unless it elects C-corporation tax status.

An eligible entity only needs to make a formal check the box election on IRS Form 8832 if it desires C-corporation tax status instead of its default tax status.

To avoid potential adverse tax consequences, an eligible entity should file a check the box election within 75 days of its formation. If an eligible entity elects C-corporation tax status after formation, it generally cannot make an election to change its tax classification to partnership or disregarded entity tax status for five years unless there is a significant ownership change (more than 50%) and the IRS permit it. This limitation on changing elective tax classification does not apply if the election to be taxed as a C-corporation is made by a newly formed eligible entity and is effective on the date of formation.

c. Tax Classification of a Partnership

A partnership organized under state law is automatically classified as a partnership for tax purposes unless it elects C-corporation tax status or is treated as a "publicly traded partnership." It is not common for a partnership to elect C-corporation tax status, or for a partnership to be publicly traded.

Technically, under the Treasury Regulations, a partnership meeting the requirements for the S-corporation election can elect S-corporation tax status on formation (or after formation if it elected C-corporation tax status), but it is not that common in practice. An S-corporation election is typically made by a corporation or an LLC.

d. Tax Classification of a Single-Member LLC

Under the default classification rules, a single-member LLC is treated as a disregarded entity for tax purposes unless it elects C-corporation tax status. A single-member LLC meeting the requirements for the S-corporation election can elect S-corporation tax status on formation (or after formation if it elected C-corporation tax status). If a single-member LLC (treated as a disregarded entity for tax purposes) adds another member, the LLC automatically converts to a partnership for tax purposes.

e. Tax Classification of a Multiple-Member LLC

Under the default classification rules, a multiple-member LLC is treated as a partnership for tax purposes unless it elects C-corporation tax status. A multiple-member LLC meeting the requirements for the S-corporation election can elect S-corporation tax status on formation (or after formation if it elected C-corporation tax status). If a multiple-member LLC (treated as a partnership for tax purposes) reduces its membership to a single member, the LLC automatically converts to a disregarded entity for tax purposes.

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Let Lumin Law help you navigate the decisions around choice of entity and federal tax classifications. Reach out today and let’s find a time to connect.

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