San Diego Business Lawyer Blog

Trading "sweat equity" for a share in ownership of a California Limited Liability Company (LLC) or Partnership is common these days particularly because the recession is forcing people out of the main stream work force and into creative forms of income generation.  Trading "sweat equity" is a practical way for financial investors and motivated human capital to combine forces to start and/or grow a new business.  Unfortunately, most people are unaware of the potential pitfalls and move forward without any thought to potential conflicts between partners or the tax consequences.

There is little doubt that new and growing businesses benefit from sweat equity.  The young business gets an infusion of much needed human capital and the sweat equity provider earns ownership.  It's a win-win situation for the fledgling LLC or Partnership.  However, business owners considering trading ownership for sweat equity need to be acutely aware of two important issues.  

First, it's critical that the economic relationship between the members or partners be clearly defined in the LLC's operating agreement or in the partnership agreement.  Otherwise, the business' future will be froth with peril.  The company must anticipate potential conflicts that would arise should for instance the sweat equity partner fail to perform as expected or either partner expose the company to liability.  A well drafted LLC operating agreement or partnership reduces the possibility of future conflict and/or litigation.  A partnership attorney will ensure that all eventualities are addressed.  

Second, the sweat equity partner (the person trading sweat for equity) is in effect earning dollars that she is trading for a percentage ownership in the business (her capital contribution).  This is a complex issue that has important tax implications.  In the simplest terms, the dollars earned are taxed when the ownership is vested and the tax will be based on the value of the percentage ownership in the LLC or Partnership at the time. For example, say the LLC was formed by a member who contributed $50,000 for 50% ownership and a sweat equity member who contributes one year's future services valued at $50,000 for 50% ownership.  The $50,000 is compensation for services and is considered taxable income.  This can have a sizeable impact on the sweat equity's tax burden.  Moreover, if the company never proves profitable, it's much like paying tax on phantom income. 

Continue reading "Sweat Equity for Ownership in California Limited Liability Companies and Partnerships" »

The excitement that comes with starting your first business is most often tempered by the myriad of critical decisions you have to make.  New businesses are sprouting up all over San Diego, and a common question for young entrepreneurs is "How do I pay myself?"  The question is usually asked well after the new business is underway.  It is common for new business owners to forge ahead with the expectation that as soon as they see a profit, they'll simply pay themselves.  However, as they think more about "how much" and "how" to pay themselves, they begin to wonder just how to accomplish the task.  Do they withdraw profits for themselves?  If so, can they do this any time or must they wait until year's end?  Do they pay themselves a salary including the withdrawal of state and federal deductions?  What are the tax consequences?  What about my partner?  

The answer depends on your business' structure.  If you have formed a corporation, you would typically pay yourself as the corporation would pay any employee including the withdrawal of state and federal deductions.  You would also have the option of paying out dividends.  Determining what to pay and how to pay yourself requires careful consideration of the corporation's anticipated profits.  It makes little sense to pay yourself more than the corporation makes (whether via salary or dividends).  The decision becomes more complicated if you have multiple shareholders but your Articles of Incorporation and By-Laws should be set up to clearly address management compensation and dividends.  

As a sole proprietor, you pay yourself a draw from the company profits.  When and the amount you draw from the business has no tax implications.  You and the company are the same entity for tax purposes, and you pay yourself whatever you like.  However, the ability to pay yourself and whether paying yourself makes good business sense are two different things.  Withdrawing all of the company's revenues leaving the company unable to pay expenses is never a good idea.  It's also important to know that what you pay yourself is not an expense for tax purposes.  You don't get to write it off.  For a single member Limited Liability Company (LLC), you would pay yourself exactly the same way as you would for a sole proprietorship.  LLC's are considered pass through entities (as long as you did not elect to be taxed as a corporation) which means you are taxed the same as if you were a sole proprietor - you pay yourself a draw from the company profits.  

You also pay yourself a draw from company profits in partnerships and multi-member LLCs (that do not elect to be taxed as corporations), although as with corporations, paying yourself becomes more complicated because there are multiple owners.  In these circumstances, it is important to plan ahead and ensure that a well drafted partnership agreement or LLC operating agreement is executed.  Otherwise, partners and LLC members will struggle with how to divide up profits and this can be devastating to young and growing businesses.  

In the end, how much you pay yourself will be more important than how you pay yourself.  You will want to balance your personal needs with the needs of your business.  Whatever your financial goals, it remains important that you begin your new venture by carefully considering which business entity to choose, and this decision shouldn't be made without first consulting your accountant or tax attorney.

Most people don't think about zoning laws when they first decide to start a business out of their home, and most home-based businesses never hear from local governments about zoning violations even where they are clearly in violation of local zoning laws. The reason why is that most home-based businesses are stealthy. Modern technology allows entrepreneurs to conduct virtually all aspects of a business' operations (short of manufacturing and direct sales) without leaving the computer. Employees can work from their own homes, products can be delivered via on-line companies and services can be provided off site. So long as signs aren't posted, traffic isn't increased beyond what is normal for residential neighborhoods and excess noise isn't a factor, no one notices that a home-based business even exists. In fact, a neighbor's complaints are generally the only thing that ever puts a home-based business on a local government's radar.

So what's all the fuss about zoning laws? Although most home-based businesses are stealthy, some business owners are looking to more visible home-based options. The recession has encouraged many would be entrepreneurs to consider starting a business, and one of their first major cost decisions is location. For a small business requiring employees, product assembly and manufacturing, customer visits, vendor deliveries or any combination of the preceding, understanding local zoning ordinances is critical. Otherwise, they risk being shut down. 

Some localities forbid home based offices completely. Others allow home based offices for professionals such as lawyers, doctors and accountants. Even the most liberal of localities will allow home based businesses only under certain circumstances, and the zoning laws can vary greatly from municipality to municipality. Generally, they have the following in common: they require that the business be only incidental to the home as living quarters taking up less than a certain percentage of the home's overall space; they require that all employees of the business reside in the home; they require that increased vendor and customer traffic is not beyond what is normal for the residential neighborhood; they prohibit the use of equipment that creates a nuisance such as noise, vibration or fumes that are detectable outside of the home; they prohibit the use and storage of hazardous materials; they prohibit the warehousing of business inventory; and they prohibit any changes to the outside appearance of the home (including signage).

If you are considering a home based business that for any reason will be noticed by neighbors, it's important to know the zoning laws in your locality. The easiest way to check your local zoning laws is at the main branch of your public library. You can also contact your local Planning or Zoning office. However, it's probably better not to put yourself on their radar. It may be better to have a friend in the neighborhood call and check for you. You can also try contacting the city clerk's office or your local Chamber of Commerce, or check your city's home page online. If you live in or are considering moving to a planned community with a homeowner's association, the CC&Rs (covenants, conditions and restrictions) are likely even more restrictive than those set forth above.

Continue reading "What You Need To Know About Home-Based Businesses and Zoning Laws" »

Credit card companies' decisions to unilaterally lower credit limits can have a severe impact on start up San Diego businesses.  During recessions, high unemployment rates drive many to consider going out on their own.  As they contemplate the decision, young entrepreneurs often factor in their credit worthiness.  Start up costs and monthly expenses loom heavy.  In addition, the young business owner worries about personal expenses.  If possible, they set aside funding to help pay personal expenses six months out or more providing breathing room while the business has an opportunity to grow.  Credit worthiness provides comfort during these initial months and impacts a business' future ability to obtain company credit.

Today, many young entrepreneurs with a history of responsible financial planning and credit management are unexpectedly finding themselves with lower credit scores despite exceptional credit histories.  Credit companies are reevaluating credit reports and lowering credit limits based on high balances on other revolving debt despite the fact that their customers have stellar records with them.  The negative impact is twofold: first, needed credit lines disappear; second, credit scores are lowered making it more difficult to look elsewhere for alternative credit lines particularly in the midst of this current credit crunch.  For the entrepreneur, this can be devastating.  

While many argue the practice is legal, there can be little doubt that there is something inherently wrong with it.  There are alternative ways for credit card companies to reduce their risk profile - namely higher standards for new applicants.  Penalizing good customers is a tough model to stand behind while maintaining even a modicum of goodwill.  More importantly, credit customers rely on the good faith of the companies they decide to pay interest to.  They had other options at the time they selected which card to apply for and use.  They cannot go backward and elect a different company (one of the many credit card companies today that are not engaged in the practice of lowering limits).  And worse, their current options are limited because of the lower credit score.  Other creditors are raising interest rates instead.  While not very pleasant for customers, it is far less impacting than reducing lines of credit and lowering credit scores.
 

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While the sole proprietorship might be the right business entity choice for many San Diego start ups, those thinking about forming a corporation or other business entity will want to examine the advantages and disadvantages of the various options, and discuss those options with an attorney or accountant. The ultimate decision will depend on the individual business and should be carefully considered. New and existing businesses have many options including incorporating, forming an LLC or forming a partnership. The following is a brief list of business entity features:

Corporations: A Corporation is treated as a unique business entity separate from those who own it. Because a Corporation is considered a unique business entity, the company does not dissolve when ownership changes. Under the corporate structure, shareholders are the owners of the corporation and elect a board of directors to oversee major policies, procedures, and decisions. Advantages of the corporate formation include ease of transferability of ownership (selling ones shares), limited liability for shareholders concerning debts or judgments against the corporation, deductions of the cost of benefits provided to officers and employees, and in certain circumstances advantageous tax rates. The Corporation must maintain corporate formalities.

Partnerships: In a General Partnership, two or more individuals share ownership in the business entity. The law does not distinguish between the business and its owners. The partners are liable for the debts and obligations of the partnership and are taxed on an individual level. The transfer of individual ownership usually requires the consent of all partners. The advantages of a general partnership include relative ease of formation and greater control over the management of the business. Limited Partnerships consist of at least one general partner (which may be a corporation) and at least one limited partner. The general partner manages the business' day to day operations and is liable for the debts and obligations of the partnership. The limited partner is a passive investor. A partnership agreement spelling out the rights and obligations of the partners is needed. The advantages of a Limited Partnership include greater control of the management of the business for the general partner and the ability to attract investors seeking limited liability.

Limited Liability Companies (LLC): An LLC is an unincorporated entity formed under state law whose owners are not personally liable for the debts, obligations or liabilities of the business. It is best described as a hybrid between a corporation and a partnership. The LLC's members manage the business like a partnership and are taxed on an individual level while being afforded liability protections similar to that of a corporation. The advantages of an LLC include the limited liability afforded its owners, individual tax treatment and less formalities to maintain than a corporation.

As business owners and new entrepreneurs navigate through the maze of information on the internet, they quickly discover a diverse range of views regarding the advantageous and disadvantageous of the various forms of business entities. The bottom line for any new or existing business considering incorporation or other business form is that the right decision is unique to your business. Learn as much as possible from all available resources before taking the next step. Contact a San Diego business lawyer to discuss your options.  The choices you make can have a profound impact on the future of your business.

Maintaining corporate formalities is critical for California businesses that have elected to incorporate. Often small business owners wrestle with the decision to incorporate and after considerable deliberation opt for incorporation largely because they seek to limit personal liability. When a corporation is properly maintained, stock holders are generally not liable for the debts and other liabilities of the corporation.

Unfortunately, too often new small business owners burdened with the day to day operations of bringing a new business on line fail to heed their attorney's advice regarding corporate formalities and let them slip by the wayside. Others resort to self-help incorporation tools to reduce costs and simply fail to appreciate the importance of maintaining corporate formalities. More importantly, these young entrepreneurs move forward believing they have formed legitimate corporations and are therefore protected from personal liability. By commingling assets, using corporate assets for personal use, failing to adequately capitalize the corporation to meet current and anticipated debts, failing to hold annual meetings and keep written records (minutes), and/or failing to properly document corporate actions, the new corporation starts to look more like the alter ego of the new business owner and less like a corporation.  

This is not to say that young corporations must do everything perfectly.  Courts are unlikely to sanction piercing the corporate veil for minor technicalities.  When making the "piercing the corporate veil" decision, courts look to the totality of circumstances including whether there was fraud or other circumstances that would make insulation from liability unfair to a creditor.  The problem for the young corporation and its stock holders is that creditors are quick to take advantage of whatever technical violations they learn of.  The attempt to pierce the corporate veil itself creates a significant hardship for the targeted shareholder/owner of the corporation.  To avoid any risk, the best precaution young corporations can take is to diligently comply with all corporate formalities.

When starting a new business, San Diego's entrepreneurs are often confronted with a myriad of business and legal issues that they didn't anticipate when originally formulating their business plan. As they consider overhead, business formation, taxes, the need for an attorney and accountant and other expenses, somewhere along the line they learn they have to pay a self-employment tax. While some business owners are familiar with the concept - others ask, "Why do I have to pay this?"

So what is the self-employment tax? The new business owner will be comforted to know that the self-employment tax is not a tax paid only by the self-employed. Rather, the self-employment tax is the social security and Medicare tax that everyone pays. Those employed by others see these taxes withheld from their paycheck and in most cases without realizing that their employer is also paying a portion. The self-employed individual, on the other hand, must pay the entire amount. Essentially, your employer alter ego is paying the portion of your social security and Medicare taxes that would otherwise be covered by your employer in the conventional employer/employee relationship.

In the United States, an individual is considered self-employed for tax purposes if that individual operates a business as a sole proprietor, a partner in a partnership (including general partners in LLCs), or an independent contractor. The social security and Medicare taxes (the self-employment taxes) typically withheld from most wage earners are the equivalent of the combined contributions of the employer and employee under the FICA (Federal Insurance Contributions Act) tax structure. Under the FICA tax structure, employees and employers make equal contributions to both Social Security and Medicare. As stated, the self-employed individual pays the entire amount to Social Security and Medicare. Currently, self-employment tax in the United States is 15.3%. This rate consists of two parts: 12.4% for social security (capped after the first $106,800) and 2.9% for Medicare.

Having to pay the self-employed tax can be disconcerting. However, there are some advantages. Namely, the self-employed individual can deduct up to half of their self-employment tax from their adjusted gross income. Perhaps in the future, tax laws will be amended to further encourage entrepreneurs by reducing the self-employment tax. Until then, it must be considered part of the cost of doing business.

So you're ready to start up your new business in San Diego but are still wrestling with the idea of incorporating or forming an LLC (Limited Liability Company) instead of operating as a sole proprietor? Young entrepreneurs should be cautious. There is a misconception that a Corporation or LLC is always the right choice for new business. Law firms and attorneys and even do-it-yourself legal services sing the praises of incorporation and routinely dismiss the sole proprietorship. After all, small businesses do not need lawyers to obtain a business license. In reality, operating as a sole proprietorship may still be the right decision for many start-ups. When starting a new business, all forms of business should be considered including the sole proprietorship.

There are two key factors that influence the business formation decision - minimizing taxes and limiting personal liability.  In most cases, particularly in the small business context, tax savings from incorporation are negligible or non-existent.   While corporate tax rates might be lower than personal tax rates, small business owners still have to pay income tax on dividends and the salary earned as an employee of the corporation.  If taxes were the only benefit to incorporation, the hassle, expense and time necessary for incorporation would hardly seem worth it.  Individuals starting up a new business often find themselves bogged down with corporate formalities instead of focusing on the business at hand.

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