Category: Corporate Compliance

Internal Investigations Are a Poe Substitute for Compliance

Happy Halloween! In honor of the holiday, we are taking our compliance message in a bit of a . . . spooky direction. But our message remains the same: International transactions are inherently high-risk; they require constant attention and oversight for your compliance to be effective; and it is always better to put your resources into compliance than to spend them on investigations.

Speaking of Halloween, here are some interesting facts about Edgar Allan Poe:

  • Poe ruined a promising start to an army career at West Point by spending his time writing mocking poems about his instructors rather than finishing his assigned work.
  • Poe often wrote only after placing a Siamese cat on his shoulder.
  • The Baltimore Ravens are the only major sports team to be named after a poem, Poe’s “The Raven.”
  • And most importantly, Poe turned down a promising career as a chief compliance officer. Don’t believe me? Check out this recently unearthed initial draft of “The Raven,” and decide for yourself!

Internal Investigations Are a Poe Substitute for Compliance

Once upon a midnight dreary, this Compliance Officer pondered, weak and weary,
Over a list of quaint and curious compliance chores —
While I nodded, nearly napping, suddenly there came a tapping,
As of someone gently rapping, rapping at my chamber door.
“Tis some auditor,” I muttered, “tapping at my chamber door —
Only this and nothing more.”

Ah, distinctly I remember, it was in the bleak December;
When fiscal-year matters come to the fore.
And compliance matters, are quite forgotten,
And talks of investigations, are verboten,
And as welcome as a lingering bedsore,

And yet the knocking — the knocking! — it was far from fleeting.
It thrilled me — it called to me — this was no account-busting lunch meeting!
It filled me with fantastic terrors never felt before.
So that now, to still the beating of my heart, I stood repeating,
“Tis some auditor entreating entrance at my chamber door —
Perhaps some senior officer pleading entrance at my chamber door —
This it is and nothing more.”

Presently my soul grew stronger; had I not mastered SOX? And regs much longer?
“Sir,” said I, “or Madam, truly your forgiveness I implore.
But the fact is I was dreaming, of internal controls, and ethics training,
And so faintly you came tapping, tapping at my chamber door,
That I scarce was sure I heard you” — here I opened wide the door —
Darkness there and nothing more.

Back into the chamber turning, all my soul within me burning,
Soon again I heard a tapping somewhat louder than before.
“Surely,” said I, “surely that is something at my window lattice;
Let me see, then, what threat there is, and this mystery explore —
Let my heart be still a moment and this mystery explore —
’Tis a mistaken Whistleblower and nothing more!”

Open here I flung the shutter, when, with many a flirt and flutter,
In there stepped a stately Raven, a Whistleblower like those of the days of yore.
Not the least obeisance made he; not a minute stopped or stayed he;
But, with mien of lord or lady, perched above my chamber door —
Perched upon a bust of Pallas just above my chamber door —
Perched, and sat, and nothing more.

Then this ebony bird beguiling my sad fancy into smiling,
By the grave and stern decorum of the countenance it wore.
“Though thy crest be shorn and shaven, thou,” I said, “art sure no craven,
Ghastly grim and ancient Whistleblower wandering from the Nightly shore —
Tell me what thy lordly report is from our subsidiaries far off-shore!”
Quoth the Whistleblower Raven: “Your Compliance is Nevermore.”

“Prophet!” said I, “thing of evil! — prophet still, if bird or devil!
By that Heaven that bends above us — by that God we both adore —
Tell this Compliance Officer with sorrow laden if, within our affiliates far offshore,
There are accounting violations or kickback given to dozens or more!
Or payments made to get our products to leave those foreign shores!
Quoth the Whistleblower Raven: “Your Compliance is Nevermore.”

And thus I realized that compliance is toughest when you operate in lands of many scores.
And the Raven, never flitting, still is sitting, still is sitting,
A Whistleblower whose incriminating red flags I ignored,
And his eyes have all the seeming, of an enforcer who is dreaming, of throwing subpoenas on our corporate floor;
And my wretched soul, like our poor compliance, from out that shadow that lies floating on the floor.
Shall be lifted — nevermore!

© 2023 Foley & Lardner LLP
For more articles on internal investigations, visit the NLR Corporate & Business Organizations section.

Structuring the Acquisition of an S Corporation

Introduction

S corporations, or S-corps, are one of the most popular entity choices for businesses. In contemplating the sale of an S-corp, it is important to plan how the transaction is structured from a tax perspective (ideally before an LOI is signed), both to maximize the gain on the sale and avoid pitfalls that can result in liabilities for the selling shareholders.

For corporate purposes, businesses are generally formed as limited liability companies, partnerships, or corporations. For tax purposes, however, entities are taxed as corporations, partnerships, or disregarded entities.[1] Corporations[2] are taxed as either a C corporation or an S corporation. C corporations are taxed at the corporate level and again at the shareholder level.[3] S corporations are corporations that, for federal tax purposes, elect to pass corporate income, losses, deductions, and credits through to their shareholders and are only taxed at the shareholder level.[4]

To qualify as an S corporation, the corporation must meet the requirements of Section 1361,[5] which provides that the corporation not have more than 100 shareholders, not have non-individual shareholders (with the exception of certain types of trusts, estates, and tax-exempt organizations), not have a nonresident alien as a shareholder, not have more than one class of stock, and not be an ineligible corporation (as defined in the Code).[6]

When sellers begin to explore the sale of their business, tax considerations are important to discuss at the outset so that the seller and buyer are on the same page – no one wants to attempt to renegotiate the terms of a deal in the middle of a transaction. For tax purposes, acquisitions of companies are categorized as either an asset purchase or stock purchase. In general, owners prefer to sell their stock (as opposed to the company’s assets) for a few reasons. First, a stock sale results in capital gain to the shareholders because their stock is a capital asset.[7] In an asset sale, however, noncorporate sellers (including S-corp shareholders) recognize ordinary income or capital gain, depending on the type of asset sold. Second, unlike in an asset sale, a stock sale may not require the seller to transfer company assets and licenses or obtain third party consents.

On the other hand, buyers usually want to engage in an asset sale to obtain a step-up in basis of the purchased assets. In a stock acquisition, the buyer gets a carryover basis in the acquired corporation’s assets, without any basis step-up. In an asset purchase, however, the buyer takes a cost basis in the assets, including in the target corporation’s goodwill (which otherwise will generally have a zero basis), and allows the buyer to take higher depreciation deductions to reduce the buyer’s annual tax liability.[8] Unless otherwise agreed, the buyer also does not assume corporate liabilities in an asset sale.

Sellers who agree to engage in an asset sale should negotiate with the buyer to be compensated for the additional tax that the seller may incur for engaging in an asset sale.

There are two additional ways for a buyer to obtain a basis step-up in the seller’s assets. The first is a 338(h)(10) election under Section 338 and the second is an F reorganization pursuant to Section 368(a)(1)(F) and consistent with Revenue Ruling 2008-18.[9]

Making the 338(h)(10) Election

A buyer and seller will sometimes make a 338(h)(10) election, which treats an acquisition of a corporation’s stock as a sale of assets for federal income tax purposes, but a sale of stock for legal purposes.[10] The sale is treated as if buyer and seller engaged in a regular asset sale for income tax purposes (so the buyer obtains a step-up in the tax basis of the assets), yet the seller does not need to re-title each asset.[11] Seller does not have capital gain on the sale of stock. Instead the parties must allocate the sales price among the assets based on each asset’s fair market value.[12] The price paid in excess of the fair market value of the tangible assets of the business is allocated to business intangibles and then to goodwill.[13]

The 338(h)(10) election is only available if a “qualified stock purchase” is made.[14] A “qualified stock purchase” is defined as any transaction (or series of transactions) in which a corporation purchases at least 80% of the stock (both voting and value) from a member of a consolidated group(as defined in 1.1502-1) or from shareholders of a S corporation during a 12 month period.[15] If during diligence it is revealed that the target corporation in fact failed to qualify as an S corporation, the 338 election will be invalid.[16] If the Section 338(h)(10) election is invalid, the transaction will be treated as a straight stock sale and buyer will not receive a basis step-up in the target’s assets.

A section 338(h)(10) election is made jointly by the purchaser and seller on Form 8023.[17] S corporation shareholders who do not sell their stock must also consent to the election. The election must be made not later than the 15th day of the 9th month beginning after the month in which the acquisition date occurs.[18]

If the target failed to qualify as an S corporation (thereby becoming a C corporation), an election can be made to treat the sale of the corporation’s stock as an asset sale under Section 336(e). The election can be made if target is owned by a parent corporation that sells at least 80% of target’s stock.[19] A 336(e) election closely resembles a 338(h)(10) election, but the purchaser does not have to be a corporation.[20] Note that a transaction that qualifies under both 336(e) and 338(h)(10) will be treated as 338(h)(10) transaction.[21]

Consequences of a 338(h)(10) Election

Under the Regulations, the target corporation is treated as making a deemed sale of its assets and liquidating following the deemed asset sale.[22] The transaction is treated as a taxable acquisition of 100% of the target’s assets for income tax purposes.[23] This means that the stock cannot be acquired in a tax free transaction or reorganization (such as a transfer to a controlled corporation, merger or spinoff) or a transaction where the seller does not recognize the entire amount of gain or loss realized on the transaction.[24]

Issues with a 338(h)(10) Election

While the 338 election can be a useful way for a buyer to achieve a basis step-up without burdening the seller to retitle and transfer assets, the following disadvantages of the election should be considered:

  1. The rules under Section 338 require all S corporation shareholders (whether or not they sell their stock) to pay tax on all of the target’s assets, even if selling less than 100% of the target.[25] This effectively eliminates any structuring of a deal on a tax-deferred basis (i.e. where seller only pays tax on the consideration attributable to non-rollover equity). Sellers need to be aware that they will pay tax on all of the target company’s assets regardless of the percentage of assets sold.
  2. The election presents an issue for rollover transactions where the seller rolls over more than 20% of its equity on a pre-tax basis in a Section 721 or Section 351 transaction (in which seller receives equity in buyer, buyer’s parent, a holding company that holds target, or another form of equity). Rolling over more than 20% of equity will invalidate the 338(h)(10) election because it will not meet the “purchase” requirement under Section 338.[26]
  3. If the target company’s S corporation election turns out to be invalid (which happens frequently due to the ease with which S corporation status can be voided), the 338(h)(10) election will be invalid, thereby eliminating any advantage provided by the election.[27] Note that the seller will also be in breach of its representations and warranties under the purchase agreement.

F-Reorganization

An alternative to a 338(h)(10) election is an F reorganization, or F reorg., which allows sellers to avoid the potential issues that come with a 338 election. In an F reorg., the seller recognizes gain only with respect to the assets that it is deemed to have sold, allows the seller to roll over equity on a pre-tax basis, and avoids some of the risk that the target may have not properly qualified as an S-corp (thereby invalidating a Section 338(h)(10) election).

Engaging in an F-Reorganization

The first step in an F reorg. is to engage in a tax free reorganization of the S-corp.[28] Shareholders of the target S-corp (“T”) form a new corporation (“Holdco”) and transfer their shares in T to Holdco in exchange for Holdco shares. As a result of the transaction, T shareholders own all shares of Holdco, which in turn owns all shares of T, making T a fully owned subsidiary of Holdco. Holdco then elects to treat T as a Qualified Subchapter S Subsidiary (“QSub”) by making the election on form 8869. For federal tax purposes, T, as a QSub, becomes a disregarded entity and all assets and liabilities of T are treated as part of Holdco.[29] Note that the QSub election made by T also suffices as the S-corp election for Holdco.[30] After T becomes a QSub of Holdco, T converts into a limited liability company (“LLC”) under state law in a nontaxable transaction by converting from one disregarded entity to another.[31] Holdco will need to obtain its own EIN, but T retains its old EIN after the conversion.[32] Once the conversion to an LLC is complete, the shareholders of Holdco can sell some or all of the LLC interests of T; the sale is treated as an asset sale for tax purposes, thereby resulting in a step up in basis for the purchaser.[33] The seller recognizes gain from the deemed sale of each asset of T. If less than 100% of the LLC interests are sold to the buyer, the transaction is treated as the purchase of a proportionate interest in each of the LLC assets, followed by a contribution of the respective interests to a partnership in exchange for ownership interests in the partnership, resulting in a stepped up basis in the assets for buyer.[34] In this scenario, T is no longer a QSub and is converted to a partnership for tax purposes.[35]

Note that a straight conversion of the existing S corporation target from an S-corp to an LLC should not be done because it is treated as a taxable liquidation of the S corporation (i.e. a deemed sale of its assets) resulting in a fully taxable event to the shareholders.[36]

Alternatively, the S-corp could form a new LLC, contribute all its business assets and liabilities to the new LLC in exchange for the LLC interests, and sell the LLC interests to the buyer. However, the transfer of assets might require third party consents; the F reorg. achieves the same result without any potential assignment issues, and even preserves the historical EIN of the S-corp.

Advantages of an F-Reorganization

The F-reorganization is an effective way to avoid the issues that arise with a 338(h)(10) election:

  1. If the acquisition is for less than 100% of the target, the S-corp shareholders will only recognize gain on the portion of the LLC sold by the S-corp parent. Any portion of the LLC interests rolled over will be tax-deferred. Rollover transactions are perfectly suitable in a F reorg. and do not present the issues that come with a 338(h)(10) election.
  2. The converted LLC retains its old EIN number and is essentially the same entity for legal purposes. This can be useful for a target in a regulated industry (such as healthcare, food services, manufacturing, etc.) by possibly avoiding the need to reapply for new permits and licenses.
  3. An F reorg. can be useful for planning purposes under Section 1202 (Qualified Small Business Stock, or QSBS), which allows shareholders of a C corporation to exclude from their taxable income the greater of ten million dollars or ten times the adjusted basis of their stock upon a sale.[37] One requirement is that the stock must be stock of a C corporation, not an S corporation.[38] S corporation shareholders who want to qualify under 1202 can perform an F reorg. and contribute the LLC interests of their operating company to a newly formed C corporation in a tax free exchange under 351. The S corporation (which owns the C corporation which owns the LLC) is now an eligible shareholder of QSBS and will qualify for favorable treatment under Section 1202.[39]

Footnotes

[1] Reg. §301.7701-2. Entities may also be taxed as cooperatives or as tax-exempt organizations if the statutory requirements are met.

[2] For purposes of this article, a corporation includes a limited liability company (LLC) that has elected to be taxed as a corporation.

[3] IRC §11(a).

[4] IRC §1363. For state tax purposes, treatment of S corporation status varies – certain states either conform with the federal treatment or conform with certain limitations and adjustments, while others do not recognize the S election at all and tax S corporations as regular corporations. In particular, California imposes an entity level tax of the greater of $800 or 1.5% of net income.

[5] Section references are to the Internal Revenue Code of 1986, as amended.

[6] See IRC §1361 (for example, an insurance company or certain financial institutions). In addition, Form 2553 must be filed to make the S corporation election.

[7] See IRC §1221(a).

[8] See IRC §1012(a) and §167.

[9] A 338(g) election also obtains a basis step-up, but results in two layers of tax and is not generally used for domestic transactions.

[10] IRC 338(a).

[11] Reg. 1.338(h)(10)-1(d)(9).

[12] In accordance with the allocation provisions set forth in IRC 1060 and Reg. 1.338-6 and 1.338-7.

[13] Reg. 1.338-6(b)(vi) and (vii).

[14] IRC 338(a).

[15] IRC 338(d)(3) and Reg. 1.338(h)(10)-1(c). For the purposes of this article, we assume that target is a standalone S-corp.

[16] Reg. 1.338(h)(10)-1(c)(5). However, the transaction may still qualify under Section 336(e). See below.

[17] Reg. 1.338(h)(10)-1(c)(3). Form 8883 also needs to be filed. If an F reorg is done, form 8594 will need to be filed.

[18] Reg. 1.338(h)(10)-1(c)(3).

[19] Reg. 1.336-2(a). The election is made unilaterally by seller and target. See Reg. 1.336-2(h).

[20] Reg. 1.336-1(b)(2). See Reg. 1.336-1 – Reg. 1.336-5 for the mechanics of making the 336(e) election and what qualifies as a “qualified disposition” under 336.

[21] Reg. 1.336-1(b)(6)(ii)(A).

[22] See Reg. 1.338(h)(10)-1 for the tax aspects of the deemed asset sale and liquidation.

[23] A deemed asset sale under Section 338 does not give rise to California sales tax. Cal. Code of Regs. 1595(a)(6).

[24] IRC 338(h)(3). See below for rollover transactions.

[25] Reg. 1.338(h)(10)-1(d)(5).

[26] IRC 338(h)(3)(A)(ii). Beware of situations where the acquiror appears to “purchase” at least 80% of target’s stock (and target rolls over 20% or less of its stock in a 351 transaction), but the acquiror in fact does (or might be deemed to) “purchase” less than 80% of target’s stock, thereby invalidating a 338, 338(h)(10), or 336(e) election. This most commonly occurs where purchaser is a newly formed corporation and target rolls over 20% (or less) of its shares. See Ginsburg, Levin & Rocap, Mergers, Acquisitions, and Buyouts, § 4.06.1.2.2 (relating to redemption of stock held by target’s shareholders and recharacterizing a 351 transaction and cash sale as a single 351 exchange with boot).

[27] See footnote 16.

[28] In accordance with Rev. Rul. 2008-18.

[29] IRC 1361(b)(3).

[30] Rev. Rul. 2008-18. Obviously, Holdco must meet all the requirements of an S-corp. In many cases, the parties will file Form 2553 to treat Holdco as an S corporation as a “belt and suspenders” step.

[31] Upon conversion, T is no longer treated as a QSub per 1361(b)(3). The conversion has no tax consequences; see Reg. 1.1361-5(b)(3), example 2, where the merger of two disregarded entities owned by the same entity is a disregarded transaction for tax purposes because the assets continue to be held by the same entity. The same should apply when one disregarded entity converts to another. The QSub can also merge with a newly formed LLC subsidiary of Holdco to achieve the same result.

[32] Rev. Rul. 2008-18.

[33] Rev. Rul. 99-5; Reg. 1.1361-5(b)(3), example 2.

[34] Rev. Rul. 99-5; see also Rev. Rul. 99-6.

[35] Id. Although not required, a Section 754 election is often required by the Buyer.

[36] IRC 336(a).

[37] IRC 1202(b). See Section 1202 for the requirements to qualify for QSBS.

[38] IRC 1202(c).

[39] The S corporation shares do not qualify as QSBS. The new shares of the C corporation issued after the reorganization qualify as QSBS to begin the 5 year holding period.

Article By Ben Gruen of Stubbs Alderton & Markiles, LLP

For more corporate law legal news, click here to visit the National Law Review.

© Copyright 2023 Stubbs Alderton & Markiles, LLP

Future of Non-Competes Up in the Air

Future of Non-Competes Up in the Air

The FTC recently announced its proposal to ban non-compete clauses in employment agreements. That proposal is currently in a 60-day period of public comment, and employers are (understandably) nervous. While many employers rely on these provisions to manage competition and protect their IP and confidential information, companies across the country may soon find themselves in the shoes of California employers, having to work around restrictions on non-competes to maximize protection within the increasingly narrow confines of the law.

Employers are not without options in responding to the potential changes should they become law–more aggressive retention incentives, intelligent data security, and stricter confidentiality agreements should all be part of the conversation. Even deferred compensation could be on the table, as noted in the article, though beware of the tax implications. Employers should also keep in mind that the FTC proposal, should it become law, will doubtless be subject to legal challenges and could be tied up in the courts for a while before becoming effective.

“Observers on both sides say that limitations on the clauses will compel employers to get more creative about how they retain talent, using everything from compensation to career advancement to keep workers engaged and loyal to the company. Some companies use deferred compensation—such as retention bonuses or rolling stock options that vest after, say, three years—to give people incentives to stay.”

©1994-2023 Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, P.C. All Rights Reserved.

The Scope of Attorney-Client Privilege Over Dual-Purpose Communications

The Supreme Court will evaluate the scope of attorney-client privilege when applied to communications shared between counsel and client that involve both legal and non-legal advice (“dual-purpose communications”). The decision of the highest court will have long-lasting implications for both business organizations and their retained counsels. The potential outcome of this case cannot be understated.

In this matter, the grand jury issued subpoenas to an anonymous law firm seeking documents related to the government’s investigation of the firm’s client. The law firm had provided both legal and business services to the client by advising on tax-related legal issues and preparing the client’s annual tax returns. When the law firm and client (“Petitioners”) withheld certain correspondence on the grounds that they were protected by attorney-client privilege and the work-product doctrine, the government moved to compel the production of those documents. The district court held that, while the correspondence contained a “dual-purpose,” they were not protected by attorney-client privilege because the primary purpose of the correspondence was to obtain business tax advice and not legal advice.

On appeal, Petitioners argued that the appellate court should apply the “because of” test rather than the “primary purpose” test. The “because of” test asks whether the dual-purpose correspondence was made because of a need for legal advice. The application of this test would expand the scope of attorney-client privilege and protect the correspondence at issue. The Ninth Circuit Court of Appeals, however, rejected Petitioners’ argument and affirmed the district court’s decision. Petitioners appealed the Ninth Circuit’s decision, and the Supreme Court granted certiorari on October 3, 2022.

The Supreme Court’s decision in In re Grand Jury 21-1397 will be of particular significance for in-house counsels who regularly provide both business and legal advice to their employers. For outside counsels, the outcome of this case will shed light on the standard to be applied for asserting privilege over dual-purpose communications. Oral argument occurred on January 9, 2023 at the Supreme Court.

For more litigation news, click here to visit the National Law Review.

© Polsinelli PC, Polsinelli LLP in California

Ankura CTIX FLASH Update – January 3, 2023

Malware Activity

Louisiana’s Largest Medical Complex Discloses Data Breach Associated to October Attack

On December 23rd, 2022, the Lake Charles Memorial Health System (LCMHS) began sending out notifications regarding a newly discovered data breach that is currently impacting approximately 270,000 patients. LCMHS is the largest medical complex in Lake Charles, Louisiana, which contains multiple hospitals and a primary care clinic. The organization discovered unusual activity on their network on October 21, 2022, and determined on October 25, 2022, that an unauthorized actor gained access to the organization’s network as well as “accessed or obtained certain files from [their] systems.” The LCMHS notice listed the following patient information as exposed: patient names, addresses, dates of birth, medical record or patient identification numbers, health insurance information, payment information, limited clinical information regarding received care, and Social Security numbers (SSNs) in limited instances. While LCMHS has yet to confirm the unauthorized actor responsible for the data breach, the Hive ransomware group listed the organization on their data leak site on November 15, 2022, as well as posted files allegedly exfiltrated after breaching the LCMHS network. The posted files contained “bills of materials, cards, contracts, medical info, papers, medical records, scans, residents, and more.” It is not unusual for Hive to claim responsibility for the associated attack as the threat group has previously targeted hospitals/healthcare organizations. CTIX analysts will continue to monitor the Hive ransomware group into 2023 and provide updates on the Lake Charles Memorial Health System data breach as necessary.

Threat Actor Activity

Kimsuky Threat Actors Target South Korean Policy Experts in New Campaign

Threat actors from the North Korean-backed Kimsuky group recently launched a phishing campaign targeting policy experts throughout South Korea. Kimsuky is a well-aged threat organization that has been in operation since 2013, primarily conducting cyber espionage and occasional financially motivated attacks. Aiming their attacks consistently at entities of South Korea, the group often targets academics, think tanks, and organizations relating to inter-Korea relations. In this recent campaign, Kimsuky threat actors distributed spear-phishing emails to several well-known South Korean policy experts. Within these emails, either an embedded website URL or an attachment was present, both executing malicious code to download malware to the compromised machine. One (1) tactic the threat actors utilized was distributing emails through hacked servers, masking the origin IP address(es). In total, of the 300 hacked servers, eighty-seven (87) of them were located throughout North Korea, with the others from around the globe. This type of social engineering attack is not new for the threat group as similar instances have occurred over the past decade. In January 2022, Kimsuky actors mimicked activities of researchers and think tanks in order to harvest intelligence from associated sources. CTIX continues to urge users to validate the integrity of email correspondence prior to visiting any embedded emails or downloading any attachments to lessen the risk of threat actor compromise.

Vulnerabilities

Netgear Patches Critical Vulnerability Leading to Arbitrary Code Execution

Network device manufacturer Netgear has just patched a high-severity vulnerability impacting multiple WiFi router models. The flaw, tracked as CVE-2022-48196, is described as a pre-authentication buffer overflow security vulnerability, which, if exploited, could allow threat actors to carry out a number of malicious activities. These activities include stealing sensitive information, creating Denial-of-Service (DoS) conditions, as well as downloading malware and executing arbitrary code. In past attacks, threat actors have utilized this type of vulnerability as an initial access vector by which they pivot to other parts of the network. Currently, there is very little technical information regarding the vulnerability and Netgear is temporarily withholding the details to allow as many of their users to update their vulnerable devices to the latest secure firmware. Netgear stated that this is a very low-complexity attack, meaning that unsophisticated attackers may be able to successfully exploit a device. CTIX analysts urge Netgear users with any of the vulnerable devices listed in Netgear’s advisory to patch their device immediately.

For more cybersecurity news, click here to visit the National Law Review.

Copyright © 2023 Ankura Consulting Group, LLC. All rights reserved.

What Taxpayers in the U.S. and Abroad Need to Know about FBAR Compliance

United States taxpayers have an obligation to report their foreign financial accounts (i.e., offshore or foreign bank accounts) to the federal government. While there are thresholds that apply, these thresholds are relatively low, so most offshore account holders will need to file reports on an annual basis. One of these reports is the Report of Foreign Bank and Financial Accounts, more commonly known as an FBAR (Foreign Bank Account Report).

For U.S. taxpayers, FBAR compliance is extremely important. This is true for taxpayers residing both domestically and overseas. The FBAR is required for US citizens because foreign banks don’t have the same reporting obligations as US-based institutions. Noncompliance in reporting foreign bank accounts can lead to civil or criminal penalties; and, in many cases, failure to file an FBAR will lead to an examination of the taxpayer’s other recent tax filings as well.

“The obligation to file an FBAR applies to most U.S. taxpayers with offshore bank accounts. While many taxpayers are unaware of the FBAR filing requirement, this unawareness is not an excuse for noncompliance. Taxpayers with delinquent FBARs can face substantial penalties regardless of why they have failed to file.” – Dr. Nick Oberheiden, Founding Attorney of Oberheiden P.C.

Technically, FBARs are due on Tax Day along with taxpayers’ annual income tax returns. However, all taxpayers receive an automatic extension to October 15—with no need to file a request and no risk of incurring additional penalties.

10 Key Facts about FBAR Compliance for U.S. Taxpayers

As the extended October 15 FBAR deadline is fast approaching, here is an overview of what taxpayers in the U.S. and abroad need to know:

1. The FBAR Filing Requirement Applies to U.S. Taxpayers Who Hold Foreign Financial Accounts

The FBAR filing requirement applies to U.S. taxpayers who hold foreign financial accounts. It also applies to taxpayers who have “signature or other authority” over these foreign accounts. These obligations exist under the federal Bank Secrecy Act (BSA). Taxpayers covered under the BSA must file FBARs with the Financial Crimes Enforcement Network (FinCEN) annually.

While the FBAR filing requirement applies to most types of foreign financial accounts, there are exceptions. For example, FBAR compliance is not required with respect to accounts:

  • Owned by governmental entities
  • Owned by foreign financial institutions
  • Held at U.S. military banking facilities
  • Held in individual retirement accounts (IRAs)
  •  Held in certain other retirement plans

FinCEN has publicly taken the position that accounts solely holding cryptocurrency also do not qualify as foreign financial accounts for purposes of FBAR compliance. However, FinCEN has also stated that it “intends to propose to amend the regulations implementing the Bank Secrecy Act (BSA) regarding [FBARs] to include virtual currency as a type of reportable account.” As a result, U.S. taxpayers who hold cryptocurrency overseas should continue to review FinCEN’s regulatory announcements to determine if their offshore cryptocurrency accounts will trigger FBAR compliance obligations in the future.

2. The FBAR Reporting Threshold is $10,000

The requirement to file an FBAR applies only to U.S. taxpayers whose foreign financial accounts exceed $10,000 during the relevant tax year. This is an aggregate threshold, meaning that it applies to all foreign financial accounts jointly, and the obligation to file an FBAR is triggered if the aggregate value of a taxpayer’s foreign financial accounts exceeds the $10,000 threshold at any point and for any length of time.

3. U.S. Taxpayers Must File Their FBARs Online

A person residing in the United States who has a financial interest in or signatory power over a foreign financial account is required to file an FBAR if the total value of the foreign financial accounts at any time during the calendar year exceeds $10,000. While U.S. taxpayers have the option to e-file their annual income tax returns, taxpayers must file their FBARs online. Taxpayers can do so through FinCEN’s website.

4. The IRS Enforces FBAR Compliance

Even though U.S. taxpayers must file their FBARs with FinCEN, the Internal Revenue Service (IRS) is responsible for enforcing FBAR compliance. This means that taxpayers that fail to meet their FBAR filing obligations must be prepared to deal with the IRS when it uncovers their delinquent filings. It also means that delinquent filers must follow the IRS’s procedures for coming into voluntary compliance to avoid unnecessary penalties—as discussed in greater detail below.

5. FBAR Filers May Also Need to File IRS Form 8938

In addition to filing an annual FBAR, U.S. taxpayers who own foreign financial accounts may also need to file IRS Form 8938. The obligation to file this form applies to U.S. taxpayers who own foreign financial assets (not solely foreign financial accounts) that exceed the thresholds established under the Foreign Account Tax Compliance Act (FATCA).

6. There are Special Mechanisms for Filing Delinquent FBARs

When individuals learn that they are at risk of facing an IRS audit or investigation due to failure to file an FBAR, their first instinct is often to file any and all delinquent FBARs right away.

However, this is not the IRS’s preferred approach, and it can expose taxpayers to penalties and interest unnecessarily.

The IRS offers two primary mechanisms for U.S. taxpayers to correct FBAR filing deficiencies—one for civil violations and one for criminal violations. The primary mechanism for correcting civil violations is to make a “streamlined filing,” while taxpayers who are at risk for criminal prosecution must make a “voluntary disclosure” to IRS Criminal Investigation (IRS CI).

As the IRS explains, the option to make a streamlined filing is “available to taxpayers certifying that their failure to report foreign financial assets and pay all tax due in respect of those assets did not result from willful conduct on their part.” The ability to make this certification of non- willfulness is critical. If a taxpayer falsely certifies to non-willfulness (or if the IRS determines that a taxpayer’s certification is fraudulent), the IRS can reject the taxpayer’s streamlined filing and pursue criminal enforcement action.

For those who have willfully failed to file FBARs, coming into compliance generally involves using IRS CI’s Voluntary Disclosure Practice (VDP). As stated by IRS CI, “If you have willfully failed to comply with tax or tax-related obligations, submitting a voluntary disclosure may be a means to resolve your non-compliance and limit exposure to criminal prosecution.” However, as IRS CI also states, “[a] voluntary disclosure will not automatically guarantee immunity from prosecution.”

With this in mind, when seeking to correct past FBAR filing failures, U.S. taxpayers need to make informed and strategic decisions. To do so, they should rely on the advice of experienced legal counsel. While streamlined filings and voluntary disclosures both provide protection from prosecution, they offer protection under different circumstances, and taxpayers must follow a stringent set of procedures to secure the available protections.

7. Failure to File an FBAR Can Lead to Civil or Criminal Prosecution

One of the key requirements for securing protection under the IRS’s streamlined filing compliance procedures or the VDP is that the taxpayer must not already be the subject of an IRS audit or investigation. When facing audits and investigations related to FBAR noncompliance, taxpayers must assert strategic defenses focused on avoiding civil or criminal prosecution.

Both the BSA and FATCA provide federal prosecutors with the ability to pursue civil or criminal charges. Typically, civil cases focus on unintentional violations, while prosecutors pursue criminal charges in cases involving intentional efforts to conceal foreign financial assets from the U.S. government. However, prosecutors may choose to pursue civil charges for “willful” violations as well; and, in some cases, asserting a strategic defense will involve focusing on keeping a taxpayer’s case civil in nature.

8. The Penalties for FBAR Non-Compliance Can Be Substantial

Why is it important to keep an FBAR non-compliance case civil? The simple answer is that in civil cases prison time isn’t on the table. Under the BSA, U.S. taxpayers charged with intentionally failing to file an FBAR can face a criminal fine of up to $250,000 and up to five years of federal imprisonment.

But, even in civil cases, a finding of FBAR noncompliance can still lead to substantial penalties. For non-willful violations, taxpayers can face fines of up to $10,000 per violation. For willful violations prosecuted civilly, taxpayers can face fines of up to 50% of the undisclosed account value or $100,000, whichever is greater (subject to a maximum penalty of 100% of the account value).

9. U.S. Taxpayers Who Have Questions or Concerns about FBAR Compliance Should Seek Help

Given the substantial risks of FBAR non-compliance, U.S. taxpayers who have questions or concerns about compliance should seek help promptly. They should consult with an experienced attorney, and they should work closely with their attorney to make informed decisions about their next steps.

10. FBAR Filers Must Keep Records On-Hand

Finally, in addition to filing their FBARS with FinCEN online, U.S. taxpayers who are subject to the BSA must also comply with the statute’s recordkeeping requirements. Minimally, taxpayers must retain the following records for each account they disclose on an FBAR:

  • Account number
  • Account type
  • Name on the account
  • Name and address of the foreign bank holding the account
  • Maximum value of the account during the relevant tax year

According to the IRS, “the law doesn’t specify the type of document to keep with this information,” and taxpayers typically “must keep these records for five years from the due date of the FBAR.”

Article By Dr. Nick Oberheiden of Oberheiden P.C.

For more tax law legal news, click here to visit the National Law Review.

Oberheiden P.C. © 2022

When Corporate Legal Teams Break

Forward-thinking organizations that refocus their legal teams on the removal of systemic friction and value creation can better detect and forecast risk; however, organizations that have not modernized their legal teams often miss subtleties masking surprisingly deep areas of risk. Recent history shows nothing is too big to fail, but earlier risk detection may have helped avoid some of the most catastrophic losses.

The most recent and notable industry-wide example, of course, was the financial services industry, which triggered the Great Recession from 2007 to 2009.

In the world’s most infamous accounting scandal, Enron imploded in 2001, wiping out $74bn of shareholder funds and the pensions and jobs of thousands of employees. Enron’s auditor also collapsed. The organizations were interconnected and dependent systems. One fell, the other followed. Undetected risk festered and worsened, and the interconnectedness of these organizations and systems created a complex network that made detecting risk more difficult.

As modern society demands more capable systems, they become more interconnected and complex by necessity. As Meltdown: Why Our Systems Fail and What We Can Do About It posits, this staggering complexity means that tiny mistakes or simple accidents can lead to devastating catastrophes that often go undetected. The reasons for failure can stem from very different problems, but the underlying causes are similar.

In accounting scandals with nefarious actors, huge debts are obscured and once revealed, lead to corporate failure. In legal departments with good actors – led by a noble General Counsel (GC) who serves as the defender of the enterprise – business risks are obscured and once revealed, can lead to devastating consequences: bet-the-company litigation, core intellectual property battles, merger & acquisition failure, and crippling regulatory fines, to name a few.

Embracing digital helps identify and expose risk, but organizations set the stage for failure when legal, or other critical functions, don’t keep up, fail to embrace the digital evolution, become disconnected, and lack or lose visibility. Those organizations make decisions without a clear view of the legal implications, and they might not even know it because, for now, they operate with blind trust of the Office of the GC.

Corporations in all industries are “going digital” to remain competitive amidst technological disruption. This focus on digital starts with core products and service offerings, and then is pushed throughout the business to align company to product. The result? Faster moving businesses with a wave of demand pummelling the legal department…if not yet, then soon as digital initiatives across the business mature.

Most corporate legal departments simply do not have the systems required to keep up — providing consistent regulatory counsel, detecting and preventing impending litigation, or simply knowing who is doing what in the legal organization is already a challenge Risk is obscured. A “break” like we’ve never experienced is primed.

If we examine the ecosystem, the warning signs are there.

Catching up to other corporate functions

As demands on legal teams continue to grow and CFOs ask GCs to do more with less, quality suffers amid rising law firm rates and unchecked complexity. Corners get cut. Risks emerge while their likelihood to go undetected rises. Of course, when adding headcount is not an option, revamping processes and technology is often the answer.

In finance, accounting, information technology, and human resource departments, among others, advances in technology have enabled self-service, helped control costs, made it easier to compare costs, and increased quality choices. These corporate functions have embraced systems-level restructuring with artificial intelligence (AI), data analytics, cloud computing and “Big Data” to modernize working practices and improve performance.

In their often siloed and conservative world, most GCs and corporate legal departments, on the other hand, make crucial decisions guided as much by gut instinct as by data and industry benchmarks. For decades, they have resisted change or lacked sufficient resources to enable change in technology, working practices, and corporate culture. Now, with the real-time requirement for speed, scale, and transparency — that era is over.

To retain and increase influence, improve their performance and trim costs as recessionary fears grow, GCs would be wise to more fully modernize their legal departments quickly through an open, digitally-savvy, and collaborative working culture.

Collaborate and listen

Building a data-driven, digital, secure and scalable legal system is an ethical and commercial imperative for GCs. Technology is part of the solution but not the place to start.

To more proactively expose, manage and mitigate risk, executives and their boards need GCs to emphasize the imperative for a more analytical, data-based and efficient approach to corporate legal practice with concrete examples to punctuate the “Why.”

You could start with three actions.

  1. Educate yourself and your colleagues about trends in legal digitization, performance improvement and new working practices. A comprehensive source of information is the Digital Legal Exchange, a global institute of leading thinkers from academia, business, government, technology and law.
  2. Become Modern. Be the change. Lead the change. Make tough decisions about your top leaders and whether they are capable of a data and digital-first mindset and way of working. Change leadership is the prime point of failure for legal modernization efforts.
  3. Be ambitious in the scope of your reforms. Small, pilot projects (ie, e-signature or automated NDAs) won’t make much of an impact and won’t convince your board of the need for bold legal change.

Modernizing the legal system and companies’ legal departments can improve affordability and performance for clients, lawyers, company boards, and shareholders.

Absent modern means of detection, legal risk can proliferate unknown and unseen only to all too often reveal triggers of impending corporate failure when it’s already too late.

Article By Anusia Gillespie of UnitedLex

For more corporate law legal news, click here to visit the National Law Review.

© 2022 UnitedLex, All Rights Reserved

Now is a Good Time to Confirm Your S Corporation Status

On October 11, 2022, the IRS published Revenue Procedure 2022-19 providing taxpayers with liberalized procedures for resolving common S corporation issues. Previously, taxpayers would have needed costly IRS letter rulings for certainty on their S corporation status. The new procedures are simpler and less expensive.

The IRS has separately assured taxpayers that LLCs that are classified as S corporations may also qualify for this liberalized relief.

Inadvertent loss of S corporation status can have significant tax consequences and can make your business a less attractive acquisition target. For example, an S corporation that reverts to a C corporation may be subject to a double layer of tax going back several years. As a result, potential acquirers of any S corporation invariably request representations on the validity of the S corporation status.

The new Revenue Procedure describes common situations that the IRS has historically treated as not affecting the validity of S corporation status or qualified S corporation Qsub status, such as:

  1. One class of stock requirement in the governing provisions (including the concept that commercial contractual agreements are not treated as binding agreements unless a “principal purpose” of the agreement is to circumvent the one class of stock requirement);

  2. Disproportionate distributions inadvertently creating a second class of stock;

  3. Certain inadvertent errors or omissions on Form 2553 or Form 8869;

  4. Missing administrative acceptance letters for S corporation or Qsub elections;

  5. Federal income tax return filings inconsistent with an S election; or

  6. Governing provisions that allow for non-identical treatment of shareholders, such as differing liquidation rights (allowing for retroactive corrections).

For these common situations, there are now simpler and cheaper procedures to preserve S corporation status. For example, for certain small errors such as missing officer signatures, S corporations may follow the same simplified procedures as the late election relief procedures in Revenue Ruling 2013-30. Those procedures do not require a private letter ruling request, but only the original election form with a reasonable cause statement. As another example, if the issue is non-identical governing provisions and no disproportionate distributions were made, the S corporation may simply be retroactively treated as an S Corporation if it meets certain eligibility requirements and keeps a copy of a signed statement in its files.

Shareholders of uncertain S corporations should consider taking advantage of these new relaxed and cheaper procedures for curing S corporation mistakes. Each different type of error has a different cure with specific requirements.

Article By Christie R. Galinski and Samuel L. Parks of Miller Canfield

For more corporate law legal news, click here to visit the National Law Review.

© 2022 Miller, Canfield, Paddock and Stone PLC

Why More Than One Commodity May Not Be Commodities

A plural form of a noun usually implies a set having more than one member of the same type.  For example, a reference to “dogs” is understood to refer to more than one dog.  No one understands a reference to “dogs” to mean a dog, a cat and a mouse.  That is not necessarily the case, however, under the California Corporations Code.

Section 29005 of the Corporations Code defines “commodities” to mean “anything movable that is bought or sold”.  Section 29504 assigns a much broader definition to the singular term “commodity”:

“Commodity” means, except as otherwise specified by the commissioner by rule or order, any agricultural, grain, or livestock product or byproduct, any metal or mineral (including a precious metal set forth in Section 29515), any gem or gemstone (whether characterized as precious, semiprecious, or otherwise), any fuel (whether liquid, gaseous, or otherwise), any foreign currency, and all other goods, articles, products, or items of any kind.  However, the term “commodity” shall not include (a) a numismatic coin whose fair market value is at least 15 percent higher than the value of the metal it contains, or (b) any work of art offered or sold by art dealers, at public auction, or through a private sale by the owner of the work of art.

Putting these two definitions together, it is possible for a multiple items to be “commodities” even though a single item is not a “commodity”.  For example, a numismatic coin of the requisite value would not be a “commodity” even more than one such coin would meet the definition of “commodities”.   The explanation for these seemingly inconsistent definitions is that they are found in two different laws.  “Commodities” is defined in California’s Bucket Shop Law while “commodity” is defined in the California Commodity Law of 1990.

Article By Keith Paul Bishop of Allen Matkins Leck Gamble Mallory & Natsis LLP

For more corporate law legal news, click here to visit the National Law Review.

© 2010-2022 Allen Matkins Leck Gamble Mallory & Natsis LLP

Which Business Entity is Right For You: Sole Proprietorship, Partnership, LLC, C-Corporation, or S-Corporation?

Introduction

Are you getting ready to launch your business? Or maybe you’re currently operating one and wondering what legal structure is best to use. There are a number of different legal entities to choose from. And each has its own set of pros and cons.

To determine which business entity is the best fit, you’ll want to see which one most applies to your situation and then carefully go over the pros and cons. It’s also a great idea to speak with your tax professional and an attorney.

Some things that will affect your decisions, and your long-term success, are liability protection, taxation, the complexity of management, annual requirements, and the ability to raise money from investors, if applicable.

What are the options?

New businesses in the US have a choice of five basic structures:

  • C-Corporation
  • LLC (Limited Liability Company)
  • S-Corporation
  • Sole Proprietorship
  • Partnership (aka General Partnership)

You’ll want to learn about each business structure and decide which best suits your needs. We’ll explain each type below and will also go over how they are different from each other.

Corporation (aka C-Corporation)

  • A Corporation is a separate legal entity created by state law. A Corporation is formed by filing a document called the Articles of Incorporation. This document is filed in the state where the entity is doing business and is filed with the Secretary of State or a similar government agency.
  • A Corporation must designate a Registered Agent in order to receive service of process and state correspondence.
  • By default, a Corporation is taxed under subchapter C of the Internal Revenue Code. This is often why Corporations are referred to as C-Corporations.
  • On the other hand, a Corporation can elect to be taxed as an S-Corporation (aka being taxed under subchapter S of the Internal Revenue Code) by filing Form 2553 with the IRS.
  • If the Corporation is taxed in its default status (taxed as a C-Corporation), the Corporation will face double taxation. Essentially, the Corporation is taxed at the corporate level on its profits. And then the Shareholders are taxed again, at the individual level, after they receive distributions (their share of profit).
  • C-Corporations are also responsible for paying state corporate income tax, if applicable, where they are domiciled and/or transacting business.
  • Corporations also have statutory requirements, such as electing a board of directors, designating corporate offers, holding annual meetings, and recording meeting minutes.
  • Corporations are not commonly used by small business owners. Instead, they are used by larger companies or tech startups often looking to raise venture capital from investors.

LLC (Limited Liability Company)

  • An LLC, aka Limited Liability Company, is a separate legal entity created by state law. An LLC is often formed by filing a document called the Articles of Organization. However, depending on the state, this form is also known as the Certificate of Organization or Certificate of Formation. This document is filed in the state where the entity is doing business and is filed with the Secretary of State or a similar government agency.
  • An LLC must also designate, and maintain, a Registered Agent. A Registered Agent must be located in the state where the LLC is formed. For example, if an LLC is formed in Texas, it must designate a Registered Agent in Texas.
  • The LLC is unique when it comes to tax treatment by the IRS. This means, there is no “LLC tax classification”. Instead, the LLC is taxed based on the number of owners. Alternatively, the LLC can make an election with the IRS, requesting to be taxed as a Corporation (C-Corporation or S-Corporation).
  • An LLC with one owner is known as a Disregarded Entity. This simply means the IRS “looks through” the LLC; looks at who the owner is, and taxes the individual or company accordingly. For example, if an American taxpayer is the single owner of an LLC, the LLC will be taxed as a Sole Proprietorship. If the LLC is owned by two or more people, the LLC will be taxed as a Partnership. And if the LLC is owned by another company, it will be taxed as a branch/division of the parent company.
  • And alternatively, the LLC can elect to be taxed as either a C-Corporation (by filing Form 8832) or an S-Corporation (by filing Form 2553).
  • LLCs taxed as Sole Proprietorship, Partnerships, and S-Corporations are all known as pass-through entities. This means there is no corporate-level taxation (company-level taxation). Instead, the taxes flow through to the owners and are reported and paid on their personal tax returns.
  • In the more uncommon setup – an LLC taxed as a C-Corporation – the LLC would face double taxation, just like a regular Corporation would.
  • And while an LLC may be able to be used for estate planning purposes, it’s often wiser to have your LLC owned by your trust(s). Of course, it’s best to speak with an estate planning attorney on such a matter.
  • In summary, for many small business owners, LLCs are the “best of all worlds”. They receive liability protection, just like a Corporation, but they are, by default, pass-through tax entities. And if the LLC would like to be subject to corporate tax treatment by the IRS, the LLC can make the necessary election. Said another way, while providing liability protection to its owners, the LLC can pretty much choose how it would like to be taxed.
  • LLCs also have more flexible management options and don’t have as many formal, and annual requirements, such as Corporations.
  • LLCs are the most popular type of business entity in the United States, mostly because of their flexibility and the personal liability protection they offer to owners.

S-Corporation (aka S Corp)

  • An S-Corporation is unique because it is not a legal entity, like an LLC or a Corporation. Instead, it’s a tax election made with the IRS.
  • It’s easier to think of it this way: The S-Corporation tax election “sits on top of” a state-level entity, such as an LLC or Corporation.
  • This is one of the most common myths with S-Corporations. People think you can just “form” an S-Corp. You simply cannot. There is no state or federal filing to “form” an S-Corp. Instead, one must first form an LLC or Corporation, and then timely file Form 2553 with the IRS to request to be taxed under Subchapter S of the Internal Revenue Code.
  • Once the IRS grants the elective status, it’s common to refer to the entity as an S-Corporation and its owners as Shareholders.
  • For most, the primary reason to explore S-Corp tax treatment is to save money on self-employment taxes.
  • Owners of an S-Corporation must take a “reasonable salary” (which is subject to self-employment taxes), but any remaining profit can be taken as a distribution (which isn’t subject to self-employment taxes). And that’s the main appeal of S-Corporations right there.
  • It’s important to keep in mind that with an S-Corporation, you must regularly run payroll, withhold taxes, file quarterly payroll returns (federal and state), hire a bookkeeper (or manage your own books), keep an accurate balance sheet (since it’s required to be filed with the IRS), file a corporate tax return (Form 1120S, K-1s for shareholders/owners, and any additional Schedules), and hire an accountant if you don’t have one already.
  • All of the above costs money. And those costs – which average $2,000 – $4,000 for small business owners – need to be compared to the potential self-employment tax savings; in order to make sure the S-Corp tax treatment makes sense.
  • S-Corporations can be owned by US citizens, US trusts (depending on how they’re taxed), US estates, US resident aliens, and US tax-exempt organizations.
  • S-Corporations cannot be owned by Non-US residents (aka non-resident aliens), foreign companies, C-Corporations, Partnerships, financial institutions, or insurance companies.
  • If you’re considering having your entity taxed as an S-Corporation, it’s important to speak with an accountant to make sure the extra cost – and additional filing requirements – are worth the self-employment tax savings. Having your business entity taxed as an S-Corporation can be a good idea for some, but isn’t necessarily a good idea for everyone.

Sole proprietorship

  • A Sole Proprietorship is an informal “business structure” with one owner.
  • There is no paperwork to file with the Secretary of State, or a similar government agency, to create a Sole Proprietorship.
  • You simply are a Sole Proprietorship once you engage in business activities, or engage in activities with the goal of making money.
  • A Sole Proprietor can do business under their own name or they can file a DBA (Doing Business As) Name. For example, John Doe can do business under his name, John Doe, or he can file a DBA called “John’s Painting Company”.
  • The advantage of a Sole Proprietorship is that they are easy to set up.
  • And taxes are pretty straightforward with a Sole Proprietorship. The owner will simply file a Schedule C and report their business income (or loss) on their personal tax return.
  • The largest disadvantage of Sole Proprietorship is that there is no liability protection for the owner. In the eyes of the law, the owner and their business are one and the same. If the business is involved in a lawsuit, the owner’s personal assets (home, cars, bank account, etc.) could be used to settle business debts and liabilities.
  • Another disadvantage of a Sole Proprietorship is that if you eventually form an LLC or Corporation, there is no official “conversion” filing. So you basically have to start all over again – filing paperwork with the state, getting an EIN (Federal Tax ID Number), opening a business bank account, etc. So if you’re on the fence, between an LLC or Sole Proprietorship, for example, it’s often easier to just form an LLC.
  • However, if you believe your business has a low liability risk and you don’t have money to form an LLC or Corporation, starting your business as a Sole Proprietorship may be the best method to getting your business off the ground.

General Partnership (aka Partnership)

  • A General Partnership (Partnership) is pretty much a Sole Proprietorship with 2 or more people. Said another way, it’s an informal “business structure” with multiple owners.
  • In most states, there is no paperwork to file with the Secretary of State, or a similar government agency, to create a General Partnership (there are few states though that require General Partnerships to register).
  • A Partnership can do business under the names of the owners or it can file a DBA (Doing Business As) Name.
  • The advantage of a General Partnership is that it is easy to set up.
  • Partnership taxes are not as straightforward as with a Sole Proprietorship though. For instance, the Partnership must file a Form 1065 and issue K-1s to the partners. Then the partners report their K-1 income on their personal tax returns.
  • The largest disadvantage of a Partnership is that there is no liability protection for the owners. Again, in the eyes of the law, the owners and their businesses are one and the same. If the business is involved in a lawsuit, the owner’s personal assets (home, cars, bank accounts, etc.) could be used to settle business debts and liabilities.
  • While a Partnership may be a good way to save money and get a business off the ground, most people quickly shift to a legal business entity, like an LLC or Corporation.

Choosing the best entity structure for your business

  • Generally speaking, the LLC is the most adaptable corporate structure, and for that reason the most popular choice in the U.S. The LLC can pretty much choose how it would like to be taxed by the IRS, all while providing its owners’ personal liability protection.
  • Having said that, some owners may elect for their LLC to be taxed as an S-Corporation to save money on self-employment taxes.
  • Or larger businesses (or those raising money) may prefer to form a Corporation, especially if they have large healthcare expenses.
  • And while Sole Proprietorships and General Partnerships may be good to start off with, owners may quickly outgrow them or not feel comfortable with the lack of personal liability protection.

Conclusion

Choosing the best legal entity for your business is a game of weighing the pros and cons. Things to consider are liability protection for the owners, tax treatment by the IRS, and the reporting requirements, among other things. Typically, larger companies or those raising money from investors opt for the Corporation, while most small business owners choose to form an LLC.

Article By Matt Horwitz of LLC University

For more corporate and business legal news, click here to visit the National Law Review.

© Copyright 2010 LLC University