Recently in Business Formation & Development Category

April 2, 2014

Profit Interests in California Limited Liability Companies

A limited liability company is a type of legal entity that possesses many of the same characteristics as a standard corporation. A limited liability company, or LLC, is attractive to many business owners because it combines the limited liability feature of a corporation with the flexibility of a partnership. A key component of the flexibility offered by an LLC is related to how it is taxed. The members of an LLC may elect to have it taxed like a partnership, thereby allowing for pass-through taxation. Although these unique characteristics offer a clear benefit, they can also make compensating LLC members for their equity in the company more complicated.

90376_accounting_calculator_tax_return.jpgOne common way that LLCs motivate their employees or service providers to grow and improve the business is to give them an equitable interest in the company. There are two basic forms of equity compensation in an LLC: the profit interest and the capital interest. A profit interest allows the holder to share in the profits and residual value of the LLC, while a capital interest is an ownership in both the LLC's future profits and its current and future assets upon liquidation.

The recipient of a profit interest receives distributions of future profits of the LLC and an equity interest based on the increased value of the company after the grant of the profit interest. For example, ABC, LLC grants a 5% profit interest to an employee on January 1, 2014 at which time the value of ABC, LLC is $10,000,000. At the time ABC, LLC is sold, it is valued at $15,000,000. The employee's interest at the time of sale is equal to 5% of $5,000,000 (the increase in the value of the company since the grant date) or $250,000.

Issuing profit interests to employees or service providers of an LLC is similar to a corporation issuing stock options. Like a stock option, a profit interest has little worth unless the LLC increases in value after the date the interest is granted. Usually, a profit interest will be conferred through a written agreement establishing the specific terms of the interest including in most cases a vesting schedule. Further, a profit interest will generally be subject to a repurchase right or right of first refusal by the LLC should the holder cut ties with the LLC or attempt to transfer or sell the interest.

Tax Implications Of Profit Interests

As mentioned above, the grant of a profit interest can create some complex tax issues. Because each member of an LLC is treated as a direct owner of the company's assets, liabilities and operations, each member is subject to tax on the LLC's operations. Accordingly, each member must individually report their respective shares of the LLC's profits and losses. A holder of a profit interest will be a member of the LLC to the extent of their interest and will therefore receive a share of any pass-through items of income, loss and deductions from the company. This also means that the profit interest holder may, for tax purposes, be considered self-employed and subject to the self-employment tax.

Continue reading "Profit Interests in California Limited Liability Companies" »

January 3, 2014

Fiduciary Duties of Officers and Directors in a California Corporation

Generally, corporate officers and directors have a fiduciary obligation to the corporation and its shareholders that requires them to act in good faith, use their best judgment, and do their best to promote the corporation's interests. Collectively, this set of obligations is known as an officer or director's fiduciary duty and arises from the legal relationship between the individual and the corporation or shareholder.

a-business-mans-path-313281-m.jpgAn officer or director's fiduciary obligations under California law can generally be distilled into two duties: the duty of loyalty and the duty of care. With regard to corporate directors, both of these duties have been codified in California Corporations Code section 309(a) which provides:

"A director shall perform the duties of a director, including duties as a member of any committee of the board upon which the director may serve, in good faith, in a manner such director believes to be in the best interests of the corporation and its shareholders and with such care, including reasonable inquiry, as an ordinarily prudent person in a like position would use under similar circumstances."

Generally, officers have the same fiduciary duties as directors.

The Duty of Loyalty

The duty of loyalty requires a corporate officer or director to always act in the corporation's best interest, and forbids the officer or director from engaging in "self-dealing." Self-dealing is conduct by a corporate officer or director that involves taking advantage of his or her position in the corporation to benefit his or her own interests rather than those of the corporation or shareholders.

For example, assume John is the CEO of a major computer corporation, ABC, Inc. ABC needs to buy a considerable amount of computer chips to install in its computers, so it begins shopping for a manufacturer. John happens to own a large amount of stock in XYZ, Corp., a manufacturer of computer chips.

John, without notifying anyone of his personal interest in XYZ, uses his authority as CEO to ensure that ABC hires XYZ to produce the necessary computer chips, giving XYZ's share price a significant bump and, in the process, earning John a nice return on his investment in XYZ.

The type of transaction will not always necessarily amount to self-dealing. Had John disclosed to the board of directors that he held an interest in XYZ, and the board elected to contract with XYZ anyway, John would not have violated any fiduciary duty to ABC or its shareholders. However, because John failed to disclose his personal interest in XYZ, his conduct constituted a breach of his duty of loyalty.

The Duty of Care

The duty of care requires a corporate officer or director to carry out his duties as would any ordinarily prudent person in similar circumstances. For example, a corporate officer or director might violate his duty of care by contracting to buy a company without first conducting due diligence to find out if it is an economically sound decision.

Continue reading "Fiduciary Duties of Officers and Directors in a California Corporation" »

November 5, 2013

Forming A Professional Corporation In California

The professional corporation or the professional limited liability company are similar to their traditional counterparts, but are organized for the purpose of providing professional services, such as medical, legal, or accounting services. Unlike other states however, California does not provide for the formation of a "professional limited liability company". California only provides for the formation of a "professional corporation". A "professional corporation" is a service corporation that is licensed by the State of California. With an ever increasing prevalence of professionals in California, the professional corporation is becoming more and more prevalent. This article is specifically directed at the California Professional Corporation.

1270499_beach_playa_6.jpgA professional corporation is formed, just as a traditional corporation, by the filing of articles of incorporation with the California Secretary of State. However, unlike traditional corporations, a professional corporation generally has to comply with the rules and regulations of the appropriate licensing body. For instance, a professional corporation for medical doctors must register with the Medical Board of California. Moreover, there are specific requirements regarding who may own shares and who may hold title as an officer and/or director of a professional corporation. Typically, only licensed professionals of like professions may share in the ownership and serve as officers and/or directors.

Shareholder Limitations On Professional Corporations

In California, shares of stock in a professional corporation can only be issued to individuals that hold a license in the professional service which the business provides. Further, a shareholder of a professional corporation is prohibited from entering into a voting trust, proxy, or any other arrangement that would permit a non-shareholder to vote his or her shares of stock. In the event a shareholder is disqualified from rendering professional services or dies, the professional corporation must acquire all of his shares.

Choosing A Name For The Professional Corporation

In California, the name of a professional corporation must end with specific designations such as "a Professional Corporation" or the abbreviation "PC." The name requirements vary from profession to profession. In addition, the name cannot be the same as, or "deceptively similar" to, that of any other professional corporation licensed in California. The California Secretary of State maintains a database of current business names that may be checked to see if the name chosen is available. If a name is available, it can be reserved for up to sixty days by filing a reservation request with the office of the California Secretary of State. It's important to review the particular state licensing board for the requirements of any given profession to ensure compliance.

Continue reading "Forming A Professional Corporation In California" »

August 19, 2013

Forming A Close Corporation In California

One of the most important decisions entrepreneurs face when starting a new business is how to organize the new venture.  Although the flexibility provided by a limited liability company (LLC) is enticing, California's gross receipts tax is distasteful to many business owners.  Moreover, the rigidity and formality of the standard corporate structure can prove cumbersome for young businesses.  California's statutory Close Corporate (meaning that the form of business entity was created and governed by statute) provides entrepreneurs a third option offering much of the same flexibility LLC's provide while simultaneously avoiding California's gross receipts tax.  Because the ultimate choice will vary from business to business, it's important to consult with a San Diego business attorney and a tax professional such as a C.P.A. before moving forward.  

corporate-955464-m.jpgA close corporation is one in which the shares of the corporation are not freely traded and are held by a limited number of individuals.  Significantly, the shareholders of a close corporation can authorize the elimination of the board of directors and run the corporation themselves, actively managing and operating the company's day-to-day affairs. Most states have statutes specifically limiting the number of shareholders (generally between 30 and 50),and requiring that certain transfer restrictions appear on the stock certificates.  California's Corporation Code Sec. 158(a) requires that a close corporation's Articles of Incorporation state, "This Corporation is a close corporation and that the number of shareholders shall not exceed 35."  In order to properly establish the corporation as closely held, the shareholders must prepare a written agreement (shareholder's agreement) outlining the method by which management decisions are to be made and determining what, if any, restrictions are applicable to the sale of the ownership shares.

Because the shareholders manage a close corporation, they owe greater fiduciary duties to each other, and the controlling shareholders owe minority owners the highest duty not to oppress them.  In the normal corporate structure, if a minority shareholder disagrees with the manner in which the company is conducting its business, typically his only recourse is to sell the stock (assuming the company's officers or directors are not violating the law or the corporation's bylaws).  In a close corporation, however, sale of the stock is generally not an option.  As such, the law allows minority shareholders to sue the majority shareholder(s) and seek court intervention in the management of the company

Continue reading "Forming A Close Corporation In California" »

August 12, 2013

The Business Judgment Rule Held Not Applicable To Corporate Officers in California

A 2011 decision by a federal court highlighted the applicability of a legal theory known as the business judgment rule to corporate officers in California.  Codified at section 309 of the Corporations Code, the business judgment rule establishes a presumption that a corporate director, in the performance of his or her duties, acts on an informed basis, in good faith, and in the honest belief that his or her actions are in the best interest of the corporation.

man-on-a-bridge-3-1427249-m.jpgIn Federal Deposit Insurance Corp. v. Perry (C.D. CA December 13, 2011) (Case No. CV 11-5561 ODW), the U.S. District Court for the Central District of California held that the business judgment rule is inapplicable to decisions made by corporate officers (as opposed to "directors") on behalf of the corporation.  In Perry, the Federal Deposit Insurance Commission ("FDIC") sued the defendant, Matthew Perry, in his capacity as CEO of Indymac Bank, alleging that Perry breached his fiduciary duties by negligently allowing the bank to generate over $10 billion in risky residential loans.

Due to the volatility of the secondary market in which the loans were slated to be sold, Indymac was forced to absorb the loans into its own investment portfolio, resulting in losses of more than $600 million.  In July of 2008, Indymac Bank closed and the FDIC was appointed as receiver.  Perry moved to dismiss FDIC's complaint, claiming it had failed to allege facts upon which it could state a claim for recovery.  Specifically, Perry contended that the business judgment rule protected him from liability stemming from decisions he made as a corporate officer of the bank.  FDIC countered that the business judgment rule does not apply to corporate officers in California.

Continue reading "The Business Judgment Rule Held Not Applicable To Corporate Officers in California" »

August 8, 2013

What is Considered the "Sale Of A Security"?

A security is a financial instrument or a tradable asset of some type.  The Federal Securities Act defines a "security" as a laundry list of items which can be boiled down into three broad categories:
  • Debt securities (banknotes or bonds).
  • Equity securities (stocks or interests in partnerships or limited liability companies (LLCs)).
  • Derivative securities (futures or options).
man-made-world-4-167269-m.jpgFor the purposes of this discussion, the focus will be on whether ownership in a corporation or limited liability company constitutes a security, thereby requiring compliance with U.S. securities laws in its sale or purchase.  Usually, an offering of securities must be registered under the Securities Act of 1933, unless it falls under an exemption.  The standard as to whether stock is a security in any given circumstance was set forth nearly forty years ago in the U.S. Supreme Court cases of United Housing Foundation v. Forman, 421 U.S. 837 (1975) and Landreth Timber Co. v. Landreth, 471 U.S. 681 (1985).

In Forman, the stock at issue was that of a non-profit corporation that allowed its holders to rent a dwelling within a housing cooperative.  The Court concluded that this stock was not a security because it did not have any of the traditional indicia of investment stock, specifically: (1) the right to receive dividends; (2) transferability; (3) voting rights; and (4) the capacity to appreciate in value.

In Landreth, the holders of stock in a corporation sold 100% of it to the buyers, thus giving control over the corporation to the purchasers.  Nevertheless, the Supreme Court applied the Forman test, ultimately deciding that, unless the sale of stock involves selling shares where there is no investment motive, the stock must be considered a security.

The holdings of Forman and Landreth and provisions of the Securities Act are of particular importance to owners of close corporations and limited liability companies that want to sell or transfer their interests while avoiding being subject to securities laws.  The sale or transfer of stock in close corporations are automatically exempt from securities law when the following requirements are met:
  • The transfer or sale is limited to ten or less people who are organizers of the company or who invested through direct solicitation.
  • The transfer or sale did not involve any use of the mails, telephones or the internet.
  • The transfer or sale was limited to one state.

Continue reading "What is Considered the "Sale Of A Security"?" »

July 22, 2013

Starting a New Business In California - Hiring Employees

Continued from "The Commercial Lease and Your New San Diego Business".

Perhaps one of the most important aspects of starting a new business is the hiring of employees.  Employees are often both the face and backbone of any company and their hiring comes with a host of legal obligations, liabilities, and expenses.  Some estimates place the cost of finding, interviewing, hiring, and training a new employee at nearly $4,000.  In addition to each employee's salary, employers need to add approximately 18% to employment costs for withholdings, payroll taxes, worker's compensation, and compliance with labor laws and this is exclusive of employee benefits. 

Employees8.jpgThe first step in successfully completing the hiring process is to determine whether your company is, in fact, in need of an employee or employees.  For new businesses, knowledge and experience in the company's industry helps to guide the decision.  If you are opening a retail clothing outlet in a busy shopping mall, you will almost certainly have to hire employees.  The decision for existing businesses is more complex.  Although every business is different, there are several key warning signs: missing deadlines; making mistakes due to excessive workload; or being so overwhelmed with miscellaneous tasks that it becomes difficult to focus on key aspects of the business.  Whether starting a new business or considering the hiring of employees for the first time, it's important that the business has the resources to follow through. 

Once a business has decided that employees are necessary to its continued growth and success, there are a series of important steps that the business needs to take to ensure it complies with local, state and federal laws. 

Obtain an Employer Identification Number

Employer identification numbers (EIN) are tax identification numbers issued by the Internal Revenue Service ("IRS") which are necessary to report taxes and submit other tax documentation.  An EIN number can be obtained at the IRS website by completing a short application process.
 
Establish A System To Withhold And Record Employment Taxes
 
The IRScrequires that all employers withhold employment taxes and keep records of such withholdings for at least four years.  Further, employers must submit W-4s (forms that state how much will be withheld from each employee's paycheck) to the IRS and report annually how much they've paid in wages and withheld in taxes on their W-2s. In addition to being necessary for compliance with IRS and state tax regulations, the maintenance of tax records allows a company to monitor its growth, track expenses, and prepare tax returns.  For many small businesses, outsourcing payroll is an cost effective way of complying with employment and tax laws.

Continue reading "Starting a New Business In California - Hiring Employees" »

July 8, 2013

Taxation and Sweat Equity

"Sweat equity" allows individuals with little or no capital to obtain ownership in a business, usually a partnership or California Limited Liability Company ("LLC"), by trading labor for equity. It allows individuals with financial capital to partner with others who have expertise in a particular field for the purpose of starting a business together.

169849_tax.jpgIt is important however for individuals wishing to engage in a sweat equity arrangement to be cognizant of the tax implications associated with the transaction. Essentially, the sweat equity partner is earning money that she then exchanges for an ownership interest in the company. Because the IRS taxes income and defines income as both cash and non-cash compensation, a sweat equity partner's compensation, in the form of ownership in the company, is subject to taxation. Sweat equity is subject to income and payroll taxes when: (1) it is issued in connection with the performance of services; and (2) the person receiving the equity pays less than the fair market value for the equity obtained.

Sweat equity is not immediately taxable if it is subject to a substantial risk of forfeiture. Sweat equity is subject to a substantial risk of forfeiture when the partner's ownership in the equity is conditioned on future performance of services (e.g. the partner must work for the LLC for five years before her interest vests) or is contingent on the occurrence of a condition related to the transfer (e.g. the partner must attain a certain rank in the company). When the sweat equity is no longer subject to the substantial risk of forfeiture, it is considered vested and therefore subject to taxation.

Continue reading "Taxation and Sweat Equity" »

June 10, 2013

How To Form A Limited Liability Company In California

One of the most important decisions a person wishing to start a business will face is how to organize the new venture, i.e. whether as a corporation or a limited liability company ("LLC").  If the decision is to form an LLC, there are a number of steps that need to be taken to organize the new company.  To properly form an LLC in California, each of the following steps must be taken.
 
1246726_business_phone_.jpgChoose An Available Name For The LLC
In California, the name of an LLC must end with the words "Limited Liability Company" or the abbreviation "LLC" or "L.L.C." and the words "Limited" and "Company" are allowed to be abbreviated to "Ltd." and "Co."  The LLC's name may not contain the terms "bank," "trust," "trustee," "incorporated," "inc.," "corporation," "corp.," "insurer," "insurance company," or any words indicating that the LLC is in the business of insurance.  Finally, the name cannot be the same as, or deceptively similar to, that of any other California LLC or foreign LLC registered to do business in California.
 
The California Secretary of State maintains a database of current business names that may be checked to see if the name that has been chosen is available.  If a name is available, it can be reserved for up to sixty days by filing a reservation request with the office of the California Secretary of State.

File Articles Organization With The California Secretary Of State
An LLC is formally created when the Articles of Organization, Form LLC-1, are filed with the office of the California Secretary of State.  There is a $70 filing fee for Form LLC-1, which may be filed online at the Secretary of State's website or by mail.
 
The Articles of Organization must include: the name of the LLC, the purpose of the LLC, the duration of the LLC, the organizer's name and address, the name and address of the registered agent, and the whether the LLC will be member or manager managed.

Appoint A Registered Agent
California requires all LLC's to appoint an individual to act as the registered agent for the company.  The agent is an individual or corporation that agrees to accept service of process (service of legal papers) on the LLC's behalf.  If the designated agent is an individual, he or she must reside in California and the address must be recorded in the Articles of Organization. The agent may be affiliated with the LLC.  If the designated agent is a corporation, it must have filed a Certificate to Register as a Corporate Agent that places it on a list of companies that are permitted to act as agents.

Continue reading "How To Form A Limited Liability Company In California " »

May 15, 2013

Minimizing Self Employment Taxes

It is said that only two things in life are certain, death and taxes.  While everyone is required to pay local, state, and federal income taxes, business owners are generally subject to an additional burden - the self-employment tax (more commonly known as social security and Medicare taxes).  

911375_paper_work.jpgSelf-employed individuals are generally taxed at a rate of 15.3%.  This rate approximates the combined contributions of a regular employee and employer under the Federal Insurance Contributions Act (FICA), and is divided into two parts: 12.4% for social security on the first $113,700 and 2.9% for Medicare.  Usually, this self-employment tax is assessed on 92.35% of the self-employed  individuals' income.

There are, however, various ways in which business owners can reduce the amount of self-employment tax they are required to pay.

1. Form an S Corporation and Pay Dividends.

The self-employment tax is only applicable to wages or salary - what the Internal Revenue Service defines as "earned income."  The self-employment tax does not, however, apply to distributions or dividends paid by a corporation to its shareholders. This means that a business owner can form an S corporation, draw a reasonable salary (subject to the self-employment tax), and distribute the remaining corporate profits to the owners free from self-employment tax.  The reasonableness of the salary is important because if the IRS determines that a salary is too low, it will disallow all or a portion of the dividends resulting in a higher self-employment tax.  

2. Deduct All Legitimate Business Expenses.

Business owners are permitted to take tax deductions for all "ordinary and necessary" business expenses.  This means that business owners can deduct any expenses that legitimately went towards the generation of income. Common business expense deductions include: office supplies, advertising costs, travel expenses, and the costs of maintaining office space. If a business owner spends $20,000 in legitimate business expenses, he or she can deduct that amount from the business' yearly taxable income.  Assuming the company made $100,000 that year, only $80,000 would be subject to self-employment tax.  Claiming all possible business expenses of course makes sense economically under any circumstance but identifying all possible deductions isn't always so obvious.  Some less common expenses include a percentage of utility expenses for a home office or auto expenses (including mileage) for automobiles or trucks with dual purpose use (business and personal). Working closely with a CPA is the best way to ensure that you have all the tools necessary to accomplish this goal.  

3. Take Advantage Of a Section 105 Medical Reimbursement Plan.

Section 105 of the Internal Revenue Code allows sole proprietors, partnerships, corporations, and limited liability companies to take a full tax deduction for employee medical benefits under Health Reimbursement Arrangements ('HRA").  This deduction may include premiums paid for employee health insurance and medical expenses such as dental care.  Because HRA expenses are 100% deductible, they can reduce an employer's self-employment tax obligation.  However, it's important to note that sole proprietors, partners, owners in s-corporations and owners in limited liability companies that elect to be taxed as partnerships may not set up an HRA for themselves because the owners are employers, not employees.  However, the owners can set up HRAs for their employee/spouses who in turn can have family members covered under their HRA plan including their husband/owners.

4. Defer Income To Reduce Tax Obligations.

Deferring income allows a business owner to reduce his or her tax obligation by falling into a lower tax bracket during a given year.  You can defer income by billing late in the year or waiting until January of the next year to send out newer billings.  Assume that a company expects to earn $90,000 in net income in the 2013 tax year.  By deferring $2,150 or more of said earnings, the owner would fall from a 28% tax bracket (imposed on earnings between $87,850 and $183,250) to a 25% tax bracket (imposed on earnings between $36,250 and $87,850).  This is particularly beneficial if there were unexpected earnings in the current year putting you into an unusually high tax bracket.  

The U.S. Tax Code is complex and can be extremely confusing.  The best way to ensure minimization of your tax burden is to work closely with a tax professional and/or CPA and a San Diego business lawyer.
May 1, 2013

California's Gross Receipts Tax And How It Impacts Limited Liability Companies

One of the most important decisions individuals wishing to start a business face is how to organize the new venture under the laws of the state in which it is located.  Two of the most common ways to organize a business is as a corporation or a limited liability company ("LLC"), each of which has distinct benefits and disadvantages.  For the purposes of this article, it's important to distinguish between the C-Corporation and the S-Corporation.  The C-Corporation is subject to double taxation (a tax on corporate profits and a second tax on dividends to shareholders as income).  Like LLCs, the S-Corporation is taxed as a pass through entity (the company's profits are passed on to the owners as income - a single tax).  The distinction is important because businesses looking for pass through taxation opt between the S-Corporation and the LLC.  This article does not address the more complicated tax picture associated with C-Corporations.  

Credit crunch 4.jpgIn California, the decision whether to form an S-Corporation or an LLC is often guided by the expected impact the state's tax scheme will have on the business.  Under California law, both S-Corporations and LLCs are required to pay an annual minimum franchise tax of $800.  LLC's, however, are also subject to an additional tax burden known as the gross receipts tax.

The gross receipts tax requires LLC's to pay an additional fee, in addition to the minimum franchise tax, calculated based on the company's gross revenues.  An LLC's gross receipts tax is calculated based on the following scale:
$0 to $249,999 Gross Revenue = $0
$250,000 to $499,999 Gross Revenue = $900
$500,000 to $999,999 Gross Revenue =$2,500
$1,000,000 to $4,999,999 Gross Revenue = $6,000
$5,000,000+ Gross Revenue = $11,790
In California, S Corporations are taxed at a rate of 1.5% tax of net income earned, whereas LLC's are taxed based on gross receipts pursuant to the above scale.  This means that depending on the amount of gross receipts and profit a business generates, the company will benefit differently by operating as a S-Corporation or an LLC.

As an example of how this might work in the real world, take the following hypothetical:
Assume a computer company has 2012 gross receipts in the amount of $2,000,000, and profits of $100,000.  If the company is organized as an S-Corporation, it must pay 1.5% of the $100,000 in profit in taxes for a total tax obligation of $1,500.  If, on the other hand, the company is organized as an LLC, it must pay in accordance with the sliding gross receipts tax scale.  Because its gross receipts fall between $1,000,000 and $4,999,999, its tax liability would be $6,000.

If, however, the same computer company increased its gross receipts to $5,000,000 and profits to $1,000,000, as an LLC it would only be required to pay the maximum $12,590 ($11,790 plus $800.00) gross receipts tax.  As an S-Corporation though, the company would pay 1.5% of $1,000,000, or $15,000 in taxes.
Obviously, businesses with high revenues and low profit margins and businesses generating losses will benefit substantially by organizing as an S-Corporation.  As demonstrated by the above examples, the benefits and disadvantage of electing to incorporate or to form an LLC are dependent on several factors which must be carefully considered for any new business entity.

A careful weighing of these issues is helpful in making the determination, but it remains advisable to consult with an attorney and a CPA before making a final decision as to the manner in which a new business will be organized.  If you have questions about your new business venture, make sure to consult with a San Diego business attorney before moving forward.
April 18, 2013

Ending Bad Partnerships

Maybe you've formed a business partnership with high hopes, only to later realize that it just isn't working out. Circumstances change and people move on. You might want out, your partner might want out, or maybe you both want out. Whatever the reason and whatever your goal, you have options.

1017221_business_silhouette.jpgDissolving the Partnership
If partners voluntarily agree to dissolve a partnership, the partners can collect the partnership assets, inventory them, and sell them to pay off creditors. They then divide any surplus between themselves. In addition, a statement of dissolution needs to be filed with the California Secretary of State. This isn't a very difficult process, but it is a good idea to consult with a San Diego partnership attorney for guidance. A partnership attorney will ensure that the statement of dissolution is filed properly and that the partnership is wound down efficiently. The attorney will also draft a dissolution agreement.  A dissolution agreement is a contract that spells out the terms of the dissolution in the event of a future dispute between the partners.

A voluntary dissolution agreed to by all partners can become a little tricky, but it is the best possible outcome when it comes to dissolving a partnership. The results can be disastrous in cases where one partner disagrees about the terms of the dissolution or refuses to cooperate in dissolving the partnership, In such cases, partners are left with few options. They can opt for mediation, but this option is not likely where an unwilling partner buries his head in the sand and refuses to participate. In such cases, the unwilling partner would often rather see the business go under than to see any surviving partners succeed on their own.

If an informal resolution cannot be reached, partners may be left with no choice but to sue each other. This option is costly, time consuming and emotionally taxing for most people. In such cases, a judge will ultimately determine how the partnership assets will be divided. Only then will the partnership finally be dissolved. It typically takes more than a year, sometimes more than two years to fully litigate a partnership dispute. Obviously, drawn out litigation is not good for business, and often the underlying goodwill that goes along with the partnership's assets does not survive the process.

When considering whether or not to dissolve a partnership, it's important to understand every aspect of the partnership's business before moving forward. Are there contracts or commercial leases involved? Will the partnership remain liable to customers or suppliers? Does insurance adequately protect the partners from future lawsuits stemming from the partnership business? Does the partnership own trademarks, copyrights or patents? Is there goodwill that can be sold along with the partnership assets and will that goodwill survive dissolution. Working with an experienced partnership attorney is the best way to ensure that all of the partnership's interests are protected.

Continue reading "Ending Bad Partnerships" »

January 28, 2013

Avoiding California's $800.00 Minimum Franchise Tax for the Newly Formed LLCs that Haven't Transacted Business

It is common for entrepreneurs to get excited about new business ventures.  They often move forward with forming a formal business entity such as a California Limited Liability Company ("LLC") believing that all of the elements of success are in place.  They hire a San Diego business lawyer to set up their LLC and file Articles of Organization with the California Secretary of State.  Sometimes, however, unanticipated changes or barriers stop the fledgling business in its tracks (partners back out, expected funding falls through or needed capital  equipment becomes unavailable).  Suddenly, the organizers of the LLC find themselves faced with the task of dissolving the company and aren't sure what steps to take.  Some will simply ignore the situation assuming that no steps are necessary given that the company hasn't conducted any business - no income is generated so no taxes are due.  This may or may not be true depending on the circumstances.  California LLCs are subject to a minimum franchise tax of $800.00.  This is true whether or not the LLC generates revenue.  Presently, it does not appear that the California Franchise Tax Board is interested in pursuing individuals for an LLC's taxes so the organizers are not held personally liable in most cases.  Nonetheless, it makes sense to formally cancel or dissolve an LLC to ensure that any taxes due are paid and no outstanding obligations or liabilities come back to haunt organizers.  

1270512_boardwalk_paseo_entablado_3.jpgNewly formed LLCs may formally cancel the LLC and avoid California's minimum franchise tax if the following requirements are met:

1.    A Form LLC-4/8 Certificate of Cancellation is filed within 12 months from the date the Articles of Organization were filed with the California Secretary of State;

2.    The LLC has no debts or liabilities;

3.    The known assets of the LLC have been distributed to persons entitled thereto, or no assets have been acquired;

4.    The final tax return or a final annual tax return has been or will be filed with the Franchise Tax Board;

5.    The LLC has not conducted any business from the time of filing the Articles of Organization;

6.    A majority of the managers or members, or if there are no managers or members, the person or a majority of the persons who signed the Articles of Organization, voted to dissolve the LLC; and

7.    all investments received from investors for membership interests have been returned to those investors.

This is good news for those that have recently formed an LLC and want to dissolve before transacting any business.  The LLC-4/8 Certificate of Cancellation is relatively simple to fill out and file.  However, it is important not to forget to timely file a final tax return.  Consult with a San Diego business lawyer to ensure that your LLC is properly canceled or dissolved.
August 16, 2012

California Limited Liability Company versus the S-Corporation

As with most business decisions, the decision regarding which legal entity is best suited for your San Diego business depends on a variety of important factors. Most San Diego business owners interested in the benefits of a formal business organization without the burden of the double taxation that accompanies the C Corporation, turn to either the California Limited Liability Company (LLC) or the S Corporation. Both offer owners protection from unlimited liability and both offer pass through taxation (no double taxation). The question then becomes which is better, the S Corporation or the LLC. The decision is best made with the guidance of a San Diego business entity lawyer and a tax professional. However, with fewer restrictions on the allocation of ownership and profit interests and greater management flexibility, the LLC seems to be the better option although this doesn't mean it is the better option for every business.

1228344_architectural.jpgThe most significant benefit of the S Corporation is the ability to limit self employment taxes (social security and Medicare taxes). The benefit is available to stockholder/employees who minimize their salary (subject to self employment taxes) and then distribute excess profits as dividends (not subject to self employment taxes). In certain circumstances, this can be a valuable tool. For example, assume an S Corporation is owned entirely by two stockholder/employees (each owning 50% of the stock). The corporation's profits for the last taxable year were $200,000 of which each salaried stockholder received $50,000 in wages. Each owner would pay self-employment taxes on $50,000 and each would receive a dividend for $50,000 free from self-employment taxes. Based on the current social security and Medicare rates, each owner would save $7,650. However, this benefit is limited by two important factors. First, the IRS requires that salaries paid to owner/employees of corporations be reasonable. There is no guarantee that the IRS will accept the $50,000 incomes in this example, and it has recently become more aggressive in ensuring that stockholder/employee salaries are not too low. It may instead consider the dividend distributions to be wages subject to self-employment taxes. Second, most of the self employment tax is the social security portion which is currently capped when wages reach $106,000. This means that stockholder/employees who earn an annual salary above $106,000 only save 2.9% percent (the Medicare portion) for all dividends paid above their salary.

California LLCs are also subject to a gross receipts tax. The tax is relatively small when compared to the revenues that trigger the tax. The gross receipts tax is $900 for gross receipts between $250,000 and $499,999, $6,000 on for gross receipts above $1,000,000, and $11,790 for gross receipts in excess of $5 million. Profitable businesses will barely notice this tax. For unprofitable businesses or for businesses with a very low profit margin, the gross receipts tax can be problematic since the tax is on gross revenue and not on profits.

For the stockholders in the above example, the tax savings seem to make sense. In fact, tax savings no matter how small always make sense. Nonetheless, the S Corporation suffers from several statutory limitations and lack many of the benefits LLCs offer. First, the S Corporation cannot be owned by another corporation or LLC; it cannot be owned by a foreign person; it cannot have more than 100 shareholders; it cannot issue different classes of stock; and it must distribute profits in equal proportion to ownership interests. While one owner in the example above could pay himself a higher salary for taking on greater responsibility, he would still have to take 50% of the dividends distributed. All distributions must be made simultaneously and on a pro rata basis. If one of the owners above preferred to purchase his interest in the S-Corporation directly from his existing LLC, he couldn't. The LLC suffers from none of these limitations. The LLC members are free to allocate profits however they like, make contributions however they like and are able manage the company with the greatest flexibility.

Continue reading "California Limited Liability Company versus the S-Corporation " »

May 29, 2012

How to Avoid Double Taxation for Small Corporations

One of the first decisions new San Diego business owners make is whether or not to incorporate or form some other formal business entity. The decision often seems daunting and turning to a San Diego Business Lawyer and tax professional are important first steps. If the business owner opts for a limited liability company ("LLC") or an S-Corporation (which is taxed like a partnership as opposed to the C-Corporation subject to double taxation), double taxation is not an issue. Thus, the first way to avoid double taxation is to choose a business entity that is not double taxed. This includes forming a California Corporation and then electing S-Corporation status with the IRS. Many small business owners have nonetheless formed corporations without electing S-Corporation status. This may be because a tax professional recommended it or because the business owner simply didn't consider the various business entities available when forming the corporation. Whatever the reason, the choice of a C-Corporation for small businesses isn't inherently a bad one. It does, however, become imperative that these C-Corporations take steps to avoid or at least limit double taxation.

369109_taxpapers.jpgThe easiest way to avoid double taxation is to elect to be taxed as an S-Corporation with the Internal Revenue Service. However, to qualify for S-Corporation status the IRS requires that your corporation be a domestic corporation, issue only one class of stock, distribute profits and losses in proportion to shareholder interests and have no more than 100 shareholders who are natural persons and U.S. citizens. Another corporation or LLC cannot own stock in an S-Corporation nor can foreign nationals. If opting for S-Corporation taxation, it is important to timely file Form 2553 with the IRS - no later than the 15th day of the third month following the date of incorporation. If a business is already incorporated, it can still opt for S-Corporation taxation the following year by filing Form 2553 by December 31st. However, it's important to consult with a tax professional before doing so especially where the company was initially advised not to elect S-Corporation status.

If you are a small corporation and do not elect S-Corporation status, the following is a short list of legitimate ways to minimize double taxation:

Accumulate Earnings: Leaving profits in the corporation avoids double taxation since there are no dividends to tax. Saving is advantageous so long as the money is eventually re-invested toward growth. It is a good short term plan. However, if too much profit is retained, the corporation can face an additional Accumulated Earnings Tax (a substantial penalty in addition to the regular corporate tax). The goal is to prevent corporations from accumulating profits for the sole purpose of avoiding income tax. The IRS looks to see if the corporation is accumulating earnings and profits beyond the reasonable needs of the business. Generally, accumulated earnings up to $250,000 ($150,000 for some personal service corporations) are considered reasonable. For earnings in excess of this amount, corporations may still show the IRS that the retained earnings are reasonable based on the needs of the business. If you choose to retain earnings, consult with your tax professional.

Continue reading "How to Avoid Double Taxation for Small Corporations" »