Tag: corporations

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

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

What Brokers, Company Insiders, and Others Need to Know about Securities Litigation

Individuals, companies, and firms involved in all aspects of the securities industry face litigation risks daily. From whistleblower lawsuits and U.S. Securities and Exchange Commission (SEC) enforcement actions to Financial Industry Regulatory Authority (FINRA) arbitration and private-right-of-action cases under the Securities Exchange Act of 1934, all types of securities litigation present risks for civil liability. In some cases, securities litigation can present risks for criminal penalties as well.

With this in mind, there is a lot that brokers, company insiders, investment advisers, and others need to know when targeted in lawsuits and investigations. When brokers, company insiders, and others make informed decisions based on the advice of experienced counsel, they can significantly mitigate their risk in both private and governmental securities litigation.

“Securities litigation can present substantial risks for individuals, companies, and firms. Whether facing allegations in civil litigation, SEC enforcement proceedings, or FINRA arbitration, the key to mitigating these risks is to build and execute a comprehensive, strategic and forward-thinking defense.” – Dr. Nick Oberheiden, Founding Attorney of Oberheiden P.C. law firms.

Answers to 10 Frequently Asked Questions (FAQs) about Securities Litigation

Here are answers to 10 frequently asked questions (FAQs) about securities litigation:

1. What Are Some of the Most Common Claims Against Brokers and Brokerage Firms in Securities Litigation?

Brokers and brokerage firms have faced a growing volume of litigation in recent years. This includes private litigation involving individual investors as well as litigation involving the SEC. Investigations, lawsuits, and arbitration filings targeting brokers and brokerage firms primarily focus on acts and omissions constituting investor fraud, though brokers and brokerage firms can face a variety of other claims in securities litigation as well.

Some examples of common claims against brokers and brokerage firms in securities litigation include:

  • Making unsuitable investment recommendations

  • Unauthorized trading and account churning

  • Charging excessive fees and commissions

  • Failing to disclose or misconstruing material information (especially in connection with structured products and other high-risk investments)

  • Failure to supervise or implement adequate internal controls

2. What Are Some of the Most Common Claims Against Company Insiders and Issuers in Securities Litigation?

Securities fraud lawsuits and enforcement actions targeting company insiders and securities issuers can also involve an extremely broad range of allegations. These cases are typically very different from those targeting brokers and brokerage firms; and, while both falls under the umbrella of “securities litigation,” the resemblances between the two categories are minimal. Some examples of common claims against company insiders and issuers in securities litigation include:

  • Accounting and recordkeeping violations

  • Submitting false SEC filings

  • Insider trading

  • Market manipulation

  • Selling unregistered securities and conducting unregistered IPOs

3. What Are Some of the Most Common Triggers for Securities Fraud Lawsuits and Investigations?

Many securities fraud lawsuits and investigations result from investor complaints. Typically, investors will have concerns about losses in their portfolios that they believe cannot be explained by ordinary market forces. These concerned investors will contact plaintiffs’ lawyers to help them file claims alleging fraud in federal courts, district courts or FINRA arbitration.

In some cases, concerned investors will file whistleblower claims with the SEC. The SEC has an obligation to investigate all whistleblower complaints that meet the basic filing requirements, and SEC whistleblowers can receive substantial compensation awards.

The SEC also initiates investigations on its own. Questionable EDGAR filings, market activity, media reports, and referrals from other federal law enforcement agencies can all trigger SEC investigations that may lead to civil or criminal enforcement action. The SEC also monitors activity on social media and other online platforms, and activity on these platforms is increasingly serving as the basis for SEC enforcement activity.

4. What Types of Claims Are Most Likely to Lead to Class Action Securities Litigation?

While all securities litigation presents liability risks for the individuals or entities targeted, companies and firms targeted in class action litigation face risk on an entirely different scale. Class action lawsuits lead to devastating liability that can threaten companies’ and firms’ viability as a going concern.

The types of claims that are most likely to lead to class action securities litigation are those that involve violations affecting large groups of investors. Inadequate brokerage controls that lead to systemic unsuitable investment recommendations, omitting material information from companies’ 10-K or 10-Q filings, mismanagement of investors’ funds, and market manipulation resulting in widespread losses are all examples of issues that can lead (and have led) to securities-related class action lawsuits.

5. How Does the SEC’s Whistleblower Program Work?

The SEC’s Office of the Whistleblower accepts tips from company employees, investors, and others who believe they have information about securities fraud. When a whistleblower complaint spurs enforcement action resulting in sanctions of $1 million or more, the whistleblower can receive between 10% and 30% of the amount collected.

As a result, individuals have a strong financial incentive to come forward and work with the SEC. Additionally, even if the SEC declines to pursue enforcement action based on a whistleblower’s tip, the whistleblower can still choose to pursue a claim directly, and whistleblower compensation awards are higher in these cases. Due to these incentives, whistleblower litigation is a key component of the SEC’s overall securities law enforcement strategy.

6. When Is It Advantageous to Settle a Securities Fraud Lawsuit or Arbitration Claim?

When facing substantiated allegations of securities fraud, settling will often prove to be the most cost-effective solution. However, targeted individuals and entities must be careful not to settle too soon, as there are numerous ways to fight securities fraud allegations even in scenarios that seem highly unfavorable (more on this below).

So, when is it advantageous to settle? Simply put, the costs of settling need to be less than the costs of any other alternative. This includes not only legal costs and any potential judgment liability, but reputational and administrative (i.e. suspension or debarment) costs as well.

7. When Can the U.S. Department of Justice Pursue Criminal Securities Fraud Litigation?

The U.S. Department of Justice (DOJ) pursues criminal securities fraud litigation in cases involving intentional (or apparently intentional) securities law violations. According to the DOJ’s website, the Department’s Market Integrity and Major Frauds (MIMF) Unit, “focuses on the prosecution of complex securities, commodities, cryptocurrency, and other financial fraud and market manipulation cases.” In criminal securities fraud cases, the DOJ can seek penalties ranging from substantial fines to long-term imprisonment for company executives and other insiders.

8. What Remedies Can Investors Seek in Securities Litigation?

In private securities litigation and FINRA arbitration, retail investors can seek compensatory damages for their fraudulent investment losses. An investor’s losses may be deemed fraudulent if they result from either: (i) broker fraud or mismanagement (i.e., making unsuitable investment recommendations), or (ii) a drop in the value of their securities that is not attributable to ordinary market forces. Along with the recovery of their lost principal and investment earnings, investors can seek to recover interest, fees, and other costs as well.

9. What Remedies Can the SEC Seek in Securities Litigation?

When pursuing enforcement actions against brokers, brokerage firms, company insiders, and issuers, the SEC can seek a range of civil and administrative penalties. These include fines, disgorgement, and restitution as well as cease-and-desist orders, suspension, and debarment from the securities industry.

10. What Defenses Can Individuals, Companies, and Firms Use to Protect Themselves in Securities Litigation?

While securities litigation can involve a broad range of allegations and present substantial risk for liability and other penalties, targeted individuals and entities may be able to successfully defend themselves by several means. Whether securing a favorable result means avoiding liability entirely or negotiating a favorable settlement, the key to success is making informed decisions in light of the available opportunities.

For brokers and brokerage firms, some examples of potential defenses include:

  • Misguided Allegations – In many cases, investors (and their counsel) simply lack an adequate understanding of the law. Demonstrating that an investor’s allegations are misguided can serve as an efficient and complete defense against liability.

  • Investor Authorization – One particular area of confusion for many investors is the area of authorization (including discretionary authorization). If an investor is challenging a trade that he or she authorized, providing documentation of authorization can be sufficient to avoid liability.

  • Statutory and Regulatory Compliance – Brokers and brokerage firms will also be able to successfully defend against securities fraud allegations by demonstrating compliance with the relevant statutes, regulations, or FINRA rules.

For company insiders and issuers, some examples of potential defenses include:

  • Compliance with Pre-Arranged Trading Plans – In cases involving insider trading allegations, company insiders can avoid liability by demonstrating compliance with a pre-arranged trading plan.

  • Good-Faith Disclosure – Issuers accused of withholding material information or publishing incomplete or misleading information can often defend against fraud allegations by demonstrating good-faith efforts to maintain disclosure compliance.

  • Qualifying for a Registration Exemption – Issuers can qualify for registration exemptions in various scenarios. If security is exempt, then offering security without registration is 100% permissible.

The fact that these are just examples cannot be overemphasized. Securities litigation can involve an extraordinarily broad range of allegations under numerous laws, rules, and regulations. In many cases, targeted companies and individuals will be able to assert a successful defense by focusing on discrete elements of the plaintiff’s or SEC’s burden of proof. From asserting the applicable statute of limitations to preventing class certification, several technical defenses can prove highly effective in securities litigation as well. As with all types of litigation, the key is to explore all viable defenses, build a comprehensive and cohesive defense strategy, and then execute that strategy while remaining prepared to adapt as necessary.

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

For more securities and SEC legal news, click here to visit the National Law Review.

Oberheiden P.C. © 2022

Large Corporate Bankruptcy Filings Continue to Decrease through First Half of 2022

Most industry groups saw bankruptcy filings decline from mid-2020 pandemic highs.

New York—Following the spike in large corporate bankruptcy filings triggered by the COVID-19 pandemic, filings in 2021 and the first half of 2022 fell to levels below historical averages, according to a Cornerstone Research report released today.

The report, Trends in Large Corporate Bankruptcy and Financial Distress—Midyear 2022 Update, examines trends in Chapter 7 and Chapter 11 bankruptcy filings by companies with assets of $100 million or higher. It finds that 70 large companies filed for bankruptcy in 2021, down significantly from 155 in 2020 and below the annual average of 78 filings since 2005. In the first half of 2022, only 20 large companies filed for bankruptcy, compared to midyear totals of 43 in 1H 2021 and 89 in 1H 2020. The 20 bankruptcies in 1H 2022 were the lowest midyear total since the second half of 2014.

“U.S. government stimulus programs, low borrowing rates, and high debt forbearance helped disrupt predictions of continued growth in the number of bankruptcy filings,” said Nick Yavorsky, a report coauthor and Cornerstone Research principal. “Looking ahead, however, there are some concerns that increased corporate debt levels, rising interest rates and inflation, and a potential global recession may contribute to an increase in bankruptcy filings.”

In 2021, there were 20 “mega bankruptcies”—bankruptcy filings among companies with over $1 billion in reported assets—a substantial decline from the 60 mega bankruptcy filings in 2020. The first half of 2022 saw four Chapter 11 mega bankruptcy filings, compared to nine in the first half of 2021 and at a pace significantly lower than the annual average of 22 filings in 2005–2021.

Most industry groups saw bankruptcy filings decrease in 2021 and the first half of 2022, including those industries with the highest number of filings following the pandemic’s onset: Mining, Oil, and Gas; Retail Trade; Manufacturing; and Services.

Read the full report here.

Article By Allie Schwartz, Joseph B. “J.B.” Doyle, Nicholas D. Yavorsky, and Diego Vega San Martin of Cornerstone Research

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

Copyright ©2022 Cornerstone Research

Practical and Legal Considerations for Extending Cash Runway in a Changing Economy

The funding environment for emerging companies has fundamentally shifted in 2022 for both venture capital and IPOs, particularly after a banner year in 2021. Whether these headwinds suggest significant economic changes or a return to previous valuation levels, companies need to be realistic about adapting their business processes to ensure they have sufficient cash runway to succeed through the next 2-3 years.

This article provides a comprehensive set of tactics that can be used to extend cash runway, both on the revenue/funding and cost side. It also addresses areas of liability for companies and their directors that can emerge as companies change business behaviors during periods of reduced liquidity.

Ways to Improve and Extend Cash Runway

Understanding Your Cash Runway

Cash runway refers to the number of months a company can continue operations before it runs out of money. The runway can be extended by increasing revenue or raising capital, but in a down economy, people have less disposable income and corporations are more conservative with their funds. Therefore companies should instead focus on cutting operating costs to ensure their cash can sustain over longer periods.

As a starting point, companies can evaluate their business models to determine expected cash runway based on factors such as how valuations are currently being determined, total cash available, burn rate, and revenue projections. This will help guide the actions to pursue by answering questions such as:

  1. Is the company currently profitable?
  2. Will the company be profitable with expected revenue growth even if no more outside funding is brought in?
  3. Is there enough cash runway to demonstrate results sufficient to raise the next round at an appropriate valuation?

Even if companies expect to have sufficient cash runway to make it through a potential economic downturn, tactics such as reducing or minimizing growth in headcount, advertising spend, etc. can be implemented as part of a holistic strategy to stay lean while focusing on the fundamentals of business model/product-market fit.

Examining Alternative Sources of Financing

Even though traditional venture capital and IPO financing options have become more difficult to achieve with desired valuations, companies still have various other options to increase funding and extend runway. Our colleagues provided an excellent analysis of many of these options, which are highlighted in the discussion below.

Expanding Your Investor Base to Fund Cash Flow Needs

The goal is to survive now, excel later; and companies should be open to lower valuations in the short term. This can create flexibility to circle back with investors who may have been open to an earlier round but not at the specific terms at that time. Of course, to have a more productive discussion, it will be helpful to explain to these investors how the business model has been adapted for the current environment in order to demonstrate that the new valuation is tied to clear milestones and future success.

Strategic investors and other corporate investors can also be helpful, acting as untapped resources or collaborators to help drive forward milestone achievements. Companies should understand how their business model fits with the investor’s customer base, and use the relationship to improve their overall position with investors and customers to increase both funding and revenue to extend runway.1

If the next step for a company is to IPO, consider crossover or other hybrid investors, understanding that much of the cash deployment in 2022 is slowing down.

Exploring Venture Debt

If a company has previously received venture funding, venture debt can be a useful tool to bridge forward to future funding or milestones. Venture debt is essentially a loan designed for early stage, high growth startups who have already secured venture financing. It is effective for targeting growth over profitability, and should be used in a deliberate manner to achieve specific goals. The typical 3-5 year timeline for venture debt can fit well with the goal of extending cash runway beyond a currently expected downturn.

Receivables/Revenue-Based Financing and Cash Up Front on Multi-Year Contracts

Where companies have revenue streams from customers — especially consistent, recurring revenue — this can be used in various ways to increase short-term funds, such as through receivables financing or cash up front on long-term contracts. However, companies should take such actions with the understanding that future investors may perceive the business model differently when the recurring revenue is being used for these purposes rather than typical investment in growth.

Receivable/revenue-based financing allows for borrowing against the asset value represented by revenue streams and takes multiple forms, including invoice discounting and factoring. When evaluating these options, companies should make sure that the terms of the deal make sense with runway extension goals and consider how consistent current revenue streams are expected to be over the deal term. In addition, companies should be aware of how customers may perceive the idea of their invoices being used for financing and be prepared for any negative consequences from such perceptions.

Revenue-based financing is a relatively new financing model, so companies should be more proactive in structuring deals. These financings can be particularly useful for Software-as-a-Service (SaaS) and other recurring revenue companies because they can “securitize the revenue being generated by a company and then lend capital against that theoretical security.”2

Cash up front on multi-year contracts improves the company’s cash position, and can help expand the base where customers have sufficient capital to deliver up front with more favorable pricing. As a practical matter, these arrangements may result in more resources devoted to servicing customers and reduce the stability represented by recurring revenue, and so should be implemented in a manner that remains aligned with overall goal of improving product-market fit over the course of the extended runway.

Shared Earning Agreements

A shared earning agreement is an agreement between investors and founders that entitles investors to future earnings of the company, and often allow investors to capture a share of founders’ earnings. These may be well suited for relatively early stage companies that plan to focus on profitability rather than growth, due to the nature of prioritizing growth in the latter.

Government Loans, Grants, and Tax Credits

U.S. Small Business Administration (SBA) loans and grants can be helpful, particularly in the short term. SBA loans generally have favorable financing terms, and together with grants can help companies direct resources to specific business goals including capital expenditures that may be needed to reach the next milestone. Similarly, tax credits, including R&D tax credits, should be considered whenever applicable as an easy way to offset the costs.

Customer Payments

Customers can be a lifeline for companies during an economic downturn, with the prioritization of current customers one way companies can maintain control over their cash flow. Regular checks of Accounts Receivable will ensure that customers are making their payments promptly according to their contracts. While this can be time-consuming and repetitive, automating Accounts Receivable can streamline tasks such as approving invoices and receiving payments from customers to create a quicker process. Maintenance of Accounts Receivable provides a consistent flow of cash, which in turn extends runway.

To increase immediate cash flow companies should consider requiring longer contracts to be paid in full upon delivery, allowing the company to collect cash up front and add certainty to revenue over time. This may be hard to come by as customers are also affected by the economic downturn, but incentivizing payments by offering discounts can offset reluctance. Customers are often concerned with locking in a company’s services or product and saving on cost, with discounts serving as an easy solution. While they can create a steady cash flow, it may not be sustainable for longer cash runways. Despite their attractive value, companies should use care when offering discounts for early payments. Discounts result in lower payments than initially agreed upon, so companies should consider how long of a runway they require and whether the discounted price can sustain a runway of such length.

Vendor Payments

One area where companies can strategize and cut costs is vendor payments. By delaying payments to vendors, companies can temporarily preserve cash balance and extend cash runway. Companies must review their vendor agreements to evaluate the potential practical and legal ramifications of this strategy. If the vendor agreements contain incentives for early payments or penalties for late payments, then such strategy should not be employed. Rather, companies can try to negotiate with vendors for an updated, extended repayment schedule that permits the company to hold on to their cash for longer. Alternatively, companies can negotiate with vendors for delayed payments without penalty. Often vendors would prefer to compromise rather than lose out on customers, especially in a down economy.

Lastly, companies can seek out vendors who are willing to accept products and services as the form of payment as opposed to cash. Because the calculation for cash runway only takes into account actual cash that companies have on hand, products and services they provide do not factor into the calculation. As such, companies can exchange products and services for the products and services that their vendors provide, thereby reserving their cash and extending their cash runway.

Bank Covenants

In exercising the various strategies above, it is important to be mindful of your existing bank covenants if your company has a lending facility in place. There are often covenants restricting the amount of debt a borrower can carry, requiring the maintenance of a certain level of cash flow, and cross default provisions automatically defaulting a borrower if it defaults under separate agreements with third parties. Understanding your bank covenants and default provisions will help you to stay out of default with your lender and avoid an early call on your loan and resulting drain on you cash position.

Employee Considerations

As discussed extensively in our first article Employment Dos and Don’ts When Implementing Workforce Reductions, the possibility of an economic downturn not only will have an impact on your customer base, but your workforce as well. Employees desire stability, and the below options can help keep your employees engaged.

Providing Equity as a Substitute for Additional Compensation.

Employees might come to expect cash bonuses and pay raises throughout their tenure with an employer; in a more difficult economic period this may further strain a business’s cash flow. One alternative to such cash-based payments is the granting of equity, such as options or restricted stock. This type of compensation affords employees the prospect of long-term appreciation in value and promotes talent retention, while preserving capital in the immediate term. Further, to the employee holding equity is to have “skin in the game” – the employee now has an ownership stake in the company and their work takes on increasing importance to the success of the company.

To be sure, the company’s management and principal owners should consider how much control they are ceding to these new minority equity holders. The company must also ensure such equity issuances comply with securities laws – including by structuring the offering to fit within an exemption from registration of the offering. Additionally, if a downturn in the company’s business results in a drop in the value of the equity being offered, the company should consider conducting a new 409A valuation. Doing so may set a lower exercise price for existing options, thus reducing the eventual cost to employees to exercise their options and furnishing additional, material compensation to employees without further burdening cash flow.

Transitioning Select Employees to Part-Time.

Paying the salaries of employees can be a major burden on a business’s cash flow, and yet one should be wary of resorting to laying off employees to conserve cash flow in a downturn. On the other hand, if a business were to miss a payroll its officers and directors could face personal liability for unpaid wages. One means of reducing a business’s wage commitments while retaining (and paying) existing employees is to transition certain employees to part-time status. In addition to producing immediate cash flow benefits, this strategy enables a business to retain key talent and avoid the cost of replacing the employees in the future. However, this transition to part-time employees comes with important considerations.

Part-time employees are often eligible for overtime pay and must receive the higher of the federal or state minimum hourly wage. And if transitioned employees are subject to restrictive covenants, such as a non-competition agreement, they might argue their change in status should release them from such restrictions. Particularly since the COVID-19 pandemic, courts have shown reluctance to enforce non-competes in the context of similar changes in work status when the provision is unreasonable or enforcement is against the public interest.

Director Liability in Insolvency

Insolvency and Duties to Creditors

There may be circumstances where insolvency is the only plausible result. A corporation has fiduciary duties to stockholders when solvent, but when a corporation becomes insolvent it additionally owes such duties to creditors. When insolvent, a corporation’s fiduciary duties do not shift from stockholders to creditors, but expand to encompass all of the corporation’s residual claimants, which include creditors. Courts define “insolvency” as the point at which a corporation is unable to pay its debts as they become due in the ordinary course of business, but the “zone of insolvency” occurs some time before then. There is no clear line delineating when a solvent company enters the zone of insolvency, but fiduciaries should assume they are in this zone if (1) the corporation’s liabilities exceed its assets, (2) the corporation is unable to pay its debts as they become due, or (3) the corporation faces an unreasonable risk of insolvency.

Multiple courts have held that upon reaching the “zone of insolvency,” a corporation has fiduciary duties to creditors. However, in 2007 the Delaware Supreme Court held that there is no change in fiduciary duties for a corporation upon transitioning from “solvent” to the “zone of insolvency.” Under this precedent, creditors do not have standing to pursue derivative breach of fiduciary duty claims against the corporation until it is actually insolvent. Once the corporation is insolvent, however, creditors can bring claims such as for fraudulent transfers of assets and for failure to pursue valid claims, including those against a corporation’s own directors and officers. To be sure, the Delaware Court of Chancery clarified that a corporation’s directors cannot be held liable for “continuing to operate [an] insolvent entity in the good faith belief that they may achieve profitability, even if their decisions ultimately lead to greater losses for creditors,” along with other caveats to the general fiduciary duty rule. Still, in light of the ambiguity in case law on the subject, a corporation ought to proceed carefully and understand its potential duties when approaching and reaching insolvency.

1 Diamond, Brandee and Lehot, Louis, Is it Time to Consider Alternative Financing Strategies?, Foley & Lardner LLP (July 18, 2022)

2 Rush, Thomas, Revenue-based financing: The next step for private equity and early-stage investment, TechCrunch (January 6, 2021)

Article By Natasha Allen, David W. Kantaros, Nikhil T. Pradhan, and Graham P. MacEwan of Foley & Lardner LLP

For more financial institutions and banking legal news, click here to visit the National Law Review.

© 2022 Foley & Lardner LLP

SEC Proposes to Clear-Up Clearing Agencies’ Governance to Mitigate Directors’ Potential Conflicts of Interest

Clearing agencies registered with the Securities and Exchange Commission (SEC) will have to make governance changes to their boards of directors under a new rule proposed by the SEC on August 8, 2022.

The SEC proposed the new rule1 to mitigate the conflicts of interests inherent in clearing agency relationships. The rule follows episodes of market volatility in 2021 that included large fluctuations surrounding COVID-19 and the meme stock craze.

The new rule would amend Section 17Ad-25 of the Securities Exchange Act of 1934 (Exchange Act) to require additional management and governance requirements for clearing agencies that register with the SEC. The proposed rules provide specific new governance requirements on clearing board composition, independent directors, nominating committees and risk management committees. The rule also requires the board to oversee relationships with critical service providers and includes a board obligation to consider various stakeholder views and inputs.

Rationale

The SEC’s rationale for proposing Rule 17Ad-25, titled Clearing Agency Governance and Conflicts of Interest, is to reduce the risk that conflicts of interest inherent in various clearing agency relationships substantially harm the security-based swaps or larger financial market. The SEC is proposing this rule to mitigate conflicts of interest, promote the fair representation of owners and participants in the governance of a clearing agency, identify responsibilities of the board, and increase transparency into clearing agency governance.

The SEC noted that those episodes of increased market volatility revealed certain vulnerabilities in the US securities market and the essential role clearing agencies play in managing the risk if securities transactions fail to clear.

The SEC observed three potential sets of conflicts of interest that the proposed rule attempts to address.

  1. The proposed rule addresses the different perspectives the various stakeholders involved in clearing agencies might have. In particular, a clearing agency owner’s potential interest in protecting the equity and continued operation of the clearing agency diverges from a participant’s potential interest in avoiding the allocation of losses from another defaulting participant. For instance, in the event of a loss, clearing agency participants might prefer to limit access to clearing, while owners may choose to expand the scope of products offered to collect fees.

  2. Larger clearing agency participants’ priorities may diverge significantly from the interests of smaller clearing agency participants. In particular, when a small number of dominant participants exercise control over a registered clearing agency concerning services provided by that clearing agency, those participants might promote margin requirements that are not commensurate with the risks they take, thereby indirectly limiting competition and increasing profit margins for themselves. In other words, a registered clearing agency dominated by a small number of large participants might make decisions designed to provide them with a competitive advantage.

  3. Certain participants may exert undue influence to limit access to the clearing agency based on their own interests, and thus could limit the benefits of the clearing agency to indirect participants.

Rule Requirements

The proposed rule would impose these seven requirements:

  1. define independence in the context of a director serving on the board of a registered clearing agency and require that a majority of directors on the board be independent, unless a majority of the voting rights distributed to shareholders of record are directly or indirectly held by participants of the registered clearing agency, in which case at least 34 percent of the board must be independent directors;

  2. establish requirements for a nominating committee, including with respect to the composition of the nominating committee, fitness standards for serving on the board, and documenting the process for evaluating board nominees;

  3. establish requirements for the function, composition, and reconstitution of the risk management committee;

  4. require policies and procedures that identify, mitigate or eliminate, and document the identification and mitigation or elimination of conflicts of interest;

  5. require policies and procedures that obligate directors to report potential conflicts promptly;

  6. require policies and procedures for the board to oversee relationships with service providers for critical services; and

  7. require policies and procedures to solicit, consider, and document the registered clearing agency’s consideration of the views of its participants and other relevant stakeholders regarding its governance and operations.

The proposing release will be published on SEC.gov and in the Federal Register. The public comment period will remain open for 60 days following publication of the proposing release on the SEC’s website or 30 days following publication of the proposing release in the Federal Register, whichever period is longer.

FOOTNOTES

1 https://www.sec.gov/rules/proposed/2022/34-95431.pdf

Article By Susan Light of Katten. Jacob C. Setton, an associate in the Financial Markets and Funds practice and candidate for admission to the New York State bar, also contributed to this advisory.

For more SEC and securities legal news, click here to visit the National Law Review.

©2022 Katten Muchin Rosenman LLP

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

Medical Marijuana, Workers’ Compensation, and the CSA: Hazy Outlook for Employers As States Wrestle With Cannabis Reimbursement as a Reasonable Medical Expense

While each state has its own unique workers’ compensation program, workers’ compensation generally requires employers to reimburse the reasonable medical expenses of employees who are injured at work. Depending on the injury, these expenses can include hospital visits, follow-up appointments, physical therapy, surgeries, and medication, among other medical care. In recent years, medical cannabis has become increasingly common to treat a myriad of ailments—as of February 2022, 37 states, the District of Columbia, and three territories now allow the use of medical cannabis.

While that is good news for patients seeking treatment for issues like chronic pain, medical cannabis laws can cause a major headache for employers. The federal law known as the Controlled Substances Act (CSA) classifies cannabis as a Schedule I substance, meaning that under federal law, it is not currently authorized for medical treatment anywhere in the United States and is not considered safe for use even under medical supervision. So, what happens when an employee is injured at work, is eligible for workers’ compensation, and is prescribed medical cannabis to treat their work-related injury in a state that authorizes medical cannabis?

Employers are faced with a tricky dilemma: They can reimburse the employee’s medical cannabis as a reasonable medical expense and risk violating the federal prohibition against aiding and abetting the possession of cannabis. Or, they can refuse to reimburse the otherwise reasonable medical expense and risk violating the state’s workers’ compensation law.

Usually, where it is impossible for an employer to comply with both state and federal law, federal law wins—a legal concept called conflict preemption. Unfortunately for employers, however, clarity on this issue will have to wait—the U.S. Supreme Court recently declined two requests to review state supreme court cases on this issue and definitively decide whether the CSA preempts state workers’ compensation laws that require reimbursement of medical cannabis. In the absence of federal guidance, national employers with workers in different states must follow the decisions of the handful of state courts that have taken up the question. The state courts who have decided the issue have come to inconsistent conclusions—thus, whether an employer should reimburse medical cannabis will vary depending on the state where the employee is injured.

For example, in Maine and Minnesota, both states’ highest courts have concluded that employers are not required to pay for their injured employees’ medical cannabis. These courts reasoned that employers would face liability under the CSA for aiding and abetting the purchase of a controlled substance. The employer, if reimbursing employees for using medical cannabis, would knowingly subsidize the employee’s purchase of marijuana in direct violation of federal law. However, in such a case, the employer would also violate state law for refusing to reimburse the employee’s reasonable medical expenses. Deeming it impossible for the employer to comply with both laws, these states’ courts concluded that the federal prohibition on cannabis preempts the state workers’ compensation laws.

States such as New Jersey have gone the other way, requiring employers to reimburse employee’s medical cannabis. The New Jersey Supreme Court concluded that there was no conflict between the prohibitions of the CSA and the demands of the New Jersey workers’ compensation law. Thus, the federal law did not preempt New Jersey’s state law, and employers were required to comply by reimbursing medical cannabis as a reasonable reimbursement.

Meanwhile, Massachusetts followed Maine and Minnesota’s approach, but did so based on its own medical marijuana statute, not the CSA. The Massachusetts law explicitly exempts health insurance providers or any government agency or authority from the reimbursement requirement because doing so violates federal law.

Given this patchwork of state decisions, employers should be cautious in determining whether to approve or deny medical cannabis as a reasonable medical expense under state workers’ compensation laws. While the answer is relatively clear (for now) in the states discussed above, there are still over 30 states with medical cannabis programs that have not addressed this issue. It is important to note that many state medical cannabis laws include provisions like Massachusetts that exempt employers from reimbursing employees for cannabis—a clear indicator that these laws were designed with federal prohibitions in mind. But these provisions are not necessarily determinative—New Jersey’s medical cannabis law has a similar provision, yet New Jersey employers are still required to reimburse for medical cannabis.

The bottom line is that federal CSA violations can be hefty, including a mandatory $1,000 fine, possible incarceration of up to one year, and possibly more if “aggravating factors” are found, such as prior convictions. Employers should therefore pay careful attention to their respective state medical cannabis laws, workers’ compensation laws, as well as the CSA and consult with counsel to determine the best approach in their particular jurisdiction. It is likely that more of these cases will be brought in the future, so be sure to check back for further developments in this evolving area of law.

Article By Amanda C. Hibbler of Foley & Lardner LLP. This article was prepared with the assistance of 2022 summer associate Zack Sikora.

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

© 2022 Foley & Lardner LLP

For A Limited Time Only – California Is Giving Away Corporations, LLCs And More!

As a result of the recent enactment of California’s 2022-2023 Budget Bill, the California Secretary of State’s office has announced a temporary waiver of many business entity filing fees.   This waiver will last until June 30, 2023, the end of the state’s current fiscal year.

Here is the Secretary of State’s list of filings for which no filing fee is currently being imposed:

  • Articles of Organization – CA LLC

  • Registration – Out-of-State LLC

  • Articles of Incorporation – CA Corporation – Benefit

  • Articles of Incorporation – CA Corporation – Close

  • Articles of Incorporation – CA Corporation – General Stock

  • Articles of Incorporation – CA Corporation – Insurer

  • Articles of Incorporation – CA Corporation – Professional

  • Articles of Incorporation – CA Corporation – Social Purpose

  • Registration – Out-of-State Corporation – Accountancy or Law (Professional)

  • Registration – Out-of-State Corporation – Insurer

  • Registration – Out-of-State Corporation – Stock

  • Articles of Incorporation – CA Nonprofit Corporation – Mutual Benefit

  • Articles of Incorporation – CA Nonprofit Corporation – Mutual Benefit – Common Interest Development

  • Articles of Incorporation – CA Nonprofit Corporation – Mutual Benefit – Credit Union

  • Articles of Incorporation – CA Nonprofit Corporation – Public Benefit

  • Articles of Incorporation – CA Nonprofit Corporation – Public Benefit – Common Interest Development

  • Articles of Incorporation – CA Nonprofit Corporation – Religious

  • Registration – Out-of-State Corporation – Nonprofit

  • Articles of Incorporation – CA Corporation – Agricultural Cooperative Association

  • Articles of Incorporation – CA Corporation – Cannabis Cooperative Association

  • Articles of Incorporation – CA Corporation – General Cooperative

  • Certificate of Limited Partnership – CA LP

  • Registration – Out-of-State LP

Note that the Secretary of State will continue to impose other fees not listed above.

It is unlikely that this temporary suspension of fees will have any significant impact on the number of business entities being formed under California law.  Historically, these fees have been relatively modest.  For example, the fee for filing articles of incorporation is $100.  Cal. Gov’t Code § 12186(c).  The real costs are the ongoing costs associated with the crushing tax and regulatory burdens placed on businesses by the state.  According to the Tax Foundation, California ranks 48th in business tax climate (just ahead of New York and New Jersey).

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.

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