26 Nov 2012
This year, Ohio made important updates to both its corporate and LLC codes. Overall, the changes to the corporate code were well warranted and should be seen as an improvement over the previous iteration of the code. However, the updates to the LLC code, especially in the area of fiduciary duty, may prove to be too broad and might have the effect of causing Ohio businesses to more frequently organize LLCs in alternate jurisdictions such as Delaware. Importantly, these changes apply not only to new entities, but entities that have already been formed in Ohio.
Revisions to the Corporate Code.
The revisions to both the general corporate code and the limited liability code went into effect in Ohio on May 4, 2012. The revisions to the corporate code add flexibility and certainty to the code, making Ohio a slightly more attractive jurisdiction in which to organize a corporation than before.
Board of Directors
First, bringing the Ohio code in line with Delaware, ORC 1705.56 now allows for a board of directors to have only one member no matter how many shareholders there are. Under the previous rule, a one-member board was not allowed if the company had more than one shareholder.
Voluntary Dissolution and Creditors Claims
Next, the corporate code saw changes to the laws pertaining to voluntary dissolution of a corporation. Now, a resolution to dissolve can set out the future dissolution date as well as provide for authorization for the directors or officers to abandon the proposed dissolution before filing the certificate of dissolution. This gives companies greater flexibility when planning for dissolution.
Next, the statute sets out a procedure for notifying creditors and any party holding a potential claim against the company about the impending dissolution and allows the company to set a deadline to make a claim before such claim is statutorily barred. This notice procedure, which is now similar to that used by Delaware, will add some procedural complication to the dissolution process; however, it will give dissolving corporations greater certainty in the dissolution process – which is ultimately good for both the corporation and for legitimate creditors of the corporation.
The corporate code also now provides that indemnification provisions for directors and officers cannot be eliminated after a claim has arisen. This provides certainty for directors and officers serving Ohio corporations.
Revisions to the Limited Liability Company Code.
Overall, the changes to the LLC code are troubling – working to make the LLC both less flexible and less certain than before. It is also important to note that these changes apply to already existing Ohio LLCs, not just to LLCs formed after the effective date of the changes.
Fiduciary Duties of Members and Managers
The LLC Code now clarifies many of the fiduciary duties of members and managers and limits how these duties can be adjusted in the operating agreement. These changes make Ohio LLC law divert pointedly from Delaware law.
First, the duty of loyalty is now defined in 1705.281(B):
(B) A member’s duty of loyalty to the limited liability company and the other members is limited to the following:
(1) To account to the limited liability company and hold as trustee for the limited liability company any property, profit, or benefit derived by the member in the conduct and winding up of the limited liability company’s business or derived from a use by the member of the limited liability company’s property, including the appropriation of a limited liability company opportunity;
(2) To refrain from dealing with the limited liability company in the conduct or winding up of the limited liability company’s business as or on behalf of a party having an interest adverse to the limited liability company;
(3) To refrain from competing with the limited liability company in the conduct of the limited liability company’s business before the dissolution of the limited liability company.
Importantly, unlike in Delaware, these duties of loyalty may no longer be eliminated from the operating agreement. However, these duties may be limited by “identifying specific types or categories of activities that do not violate the duty of loyalty if not manifestly unreasonable, and all of the members of a percentage specified in OA authorize or ratify, after full disclosure of all material facts, a specific act or transaction that otherwise would violate the duty of loyalty.”
This is important for any member of an LLC who also participates in or even plans to participate in a possibly competing company. In the tech and startup community, these “competitive” practices are very common and will now need to be expressly set out and agreed to by the other members. Furthermore, it may prove difficult to adequately set out just what the competitive practices may be since nothing can be eliminated that is “manifestly unreasonable,” a term that is by its nature, not entirely defined. It will be up to a court to decide what is or is not “manifestly unreasonable,” which will lead to uncertainty for owners and potential litigation costs in the event of a dispute.
Delaware, the likely alternative candidate for a company considering LLC formation in Ohio, allows the duty of loyalty to be entirely eliminated, and because of this, some companies may elect to choose Delaware over Ohio for organization.
Next, the statutory duty of care for members under 1705.281(C) is now limited to “refraining from engaging in grossly negligent or reckless conduct, intentional misconduct, or a knowing violation of the law.” Under 1705.81 this duty cannot be “unreasonably” reduced. Similarly for the duty of good faith and fair dealing, 1705.081(B)(5) states that the duty cannot be eliminated, but the operating agreement may “prescribe in writing the standards by which performance is to be measured or specify types or categories of activities that do not violate the duties in each case if not manifestly unreasonable (emphasis added). Along those same lines, under 1705.081(B)(6) the duty of a manager to act in good faith may not be eliminated from the operating agreement, but it may “prescribe in writing the standards by which performance is to be measured or specify types or categories of activities that do not violate the duties in each case if not manifestly unreasonable.”
Again, Delaware allows for the full elimination of these duties in LLC operating agreements. Entrepreneurs should consider whether the elimination of flexibility and the potential for greater risk for managers or investors merits forming a Delaware rather than Ohio LLC, or possibly even whether it would be prudent to convert an existing Ohio LLC to a Delaware LLC.
While the changes to the corporate code are welcome and work to make Ohio a better jurisdiction in which to incorporate, the changes to the LLC code will likely make business owners less confident in choosing to organize an LLC in Ohio. The new statutes have reduced some of the flexibility associated with LLCs and reduced the certainty of a court’s treatment of the operating agreement.
26 Jan 2012
Each month the Gillespie Law Group compiles the most recent legislative and regulatory developments that could affect startups, tech companies, and website owners.
“Crowdfunding” Update: As we reported last month, the House approved the Entrepreneur Access to Capital Act, H.R. 2930, known to many as the “crowdfunding” bill. This bill would allow businesses to raise money selling unregistered securities using “crowdfunding,” which is the raising of money through mass aggregation of small investments. Although the bill is strongly supported by the Obama administration, the Senate corollary bill, the Democratizing Access to Capital Act, S.1791.IS, is having a hard time getting out of the Senate because of efforts by the North American Securities Administers Association (NASAA) who has been lobbying heavily against the bill because it would infringe on state regulatory power. Additionally, the bill has been slowed because of two Senate hearings that highlighted the potential for increased fraud under the bill.
The House version of the bill would allow issuers, in any 12-month period, to raise up to $2 million if the issuer provides potential investors with audited financial statements, which is not always cheap. Crowdfunders then must comply with a variety of protective measures including warning investors that certain risks are associated with the issuer and that resales are restricted, as well as by providing the SEC with certain other information. Importantly for crowdfunders wanting to avoid SEC registration, investors who purchase securities under the crowdfunding exemption would not count toward the 500-shareholder threshold for SEC registration in Section 12(g) of the Securities Exchange Act of 1934. The Senate version of the bill does have some significant differences from the House version:
- Securities could only be issued through a “crowdfunding intermediary,” which would exclude raising funds through websites like Facebook and Twitter
- Each investor would be limited to investing only $1,000 in any 12-month period
- While the House bill preempted State registration law, the Senate bill would allow for some State registration requirements
A second Senate bill over this issue is also in the Senate, S.R. 1970, painfully entitled “CROWDFUND,” for “the Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act.” The CROWDFUND bill even more narrowly defines what intermediaries investments can be sold through as “funding portals” and investors are limited to the greater of $500 or a 1-2 percentage of his or her annual income, per company to invest in.
General Solicitation. In addition to the the Access to Capital for Job Creators Act, H.R. 2940, the House bill we reported on last month, the SEC’s Advisory Committee on Small and Emerging Companies had made formal recommendations that the SEC should permit general solicitation and advertising in private offerings under Rule 506 where the securities are only sold to accredited investors.
The Access to Capital of Job Creators Act, which passed in the House, would amend Section 4(2) of the Securities Act of 1933 by exempting from SEC securities regulation “transactions by an issuer not involving any public offering, whether or not such transactions involve general solicitation or general advertising.” Importantly, both this bill and the SEC Advisory Committee’s recommendations would generally go against the long-held goal of the securities exemption rules of prohibiting general solicitation of investors by general and open advertising. Instead, both would actually permit general solicitation or advertising provided that all purchasers of the securities are accredited investors and that the issuer has taken reasonable steps to verify that purchasers of the securities are accredited investors.
Internet Law. SOPA and its detractors became major news in the past month with websites such as Google and Reddit actually removing their services from the web for 24 hours on January 18. Recently SOPA and PIPA, a similar bill in the Senate, have been opposed by President Obama and have seemingly been shelved for the time being, however it is likely that new legislation or changes to these proposed bill are coming. For an in-depth look at SOPA, please read our analysis of the bill: SOPA – Cutting Through the Hype.
Prior to entering into negotiations with an angel investor or venture capitalist there are multiple due diligence-related items the VC will want evaluate in order to make the decision whether to invest in your company, and if so, how much they want to invest. Failing to properly plan for these issues can at best slow down the process and at worst completely derail the deal. However, the good news is that with some forethought and preplanning, you can have many these issues squared away from the beginning.
Register Your Company
First, regardless of whatever entity type you have chosen (Delaware C-Corp is the most typical for venture capital investment), you need to make sure that you have properly registered with the formation state and that all of your formation documents are in place and organized in a way that can easily be shared with an investor. These documents should clearly state the ownership, include vesting provisions for the founders, and be structured in a way that will allow for future investment from outside parties without too much procedural difficulty. Additionally, it is important to keep detailed corporate records. The lawyer who helps you with your initial formation can help you understand and plan these details.
When it comes to intellectual property, an investor is going to want assurances that no one outside the company will have any claim to the IP the company claims to own. To do this, somewhere in the company’s formation agreements should be language that assigns all IP to the company and if not, it should explicitly outline what is owned by whom and under what arrangement the Company is using those rights. Additionally, you may want to have started registering any trademarks, copyrights, or patents your company has created.
Similar to IP ownership, you should make sure to have all of your contractual agreements solidified. This includes everything from referral agreements to perhaps the most important, employment agreements. You should be able to identify who is an employee and who is an independent contractor and have the documentation to back it up. Not only will documentation suggest to the investor that you are highly organized and a good investment, but these agreements will ensure no surprises down the line with employees and independent contractors, regardless of whether there is impending investment or not. Employment issues, especially when dealing with intellectual property ownership, can be a particularly difficult problem if not dealt with early.
Having these issues dealt with before engaging with an investor will help to ensure smoother negotiations and possibly more company-friendly terms once V.C. or angel investment becomes a reality. While you may be able to handle some of these issues on your own, your lawyer can help to ensure that some of the trickier issues like vesting provisions and intellectual property assignment are completed properly.
30 Sep 2011
Over the past year, the tech startup world has seen a significant increase in the number of incubators throughout the country. Incubators – sometimes called startup accelerators – are organizations that work with entrepreneurs to develop their startups. Often, in exchange for a small stake in the startup, an incubator’s staff of advisors and mentors assists the startup in areas such as product development, concept evaluation, capital acquisition, strategic business planning, and technology support. Many also provide their clients a small amount of funding to develop their products. The best incubators may be most valuable for the access they can provide to potential investors and a huge pool of talent.
Entrepreneurs and startups have taken notice of the resources incubators can offer as both supply and demand of the incubator market has increased drastically over the past year. As of August 2011, we’ve counted at least 64 known U.S. incubators. This number has grown from 34 in 2010, and new incubators are springing up from California to Texas to Massachusetts and to most major cities in between. Existing incubators are also expanding their operations and increasing their number of startup clients.
Although the incubator market has undeniably taken off, the recent expansion of the number of incubators has led to questions over whether the incubator market is sustainable. Some critics argue that the increase of incubators has created (or perhaps just indicative of) a bubble that is bound to pop. Under the typical model, an incubator earns money when one of its clients hits it big, and the incubator is able to sell the stake it holds in the company for a profit. Obviously not every startup an incubator works with is going to be the next Facebook, so there is no guarantee that an incubator will profit from working with and investing in a given startup. Since the number of incubators looking to work with startups keeps growing, critics worry that there will not be enough successful startups to keep incubators profitable. Plus, the more startups that incubators produce, the harder existing startups will have to compete to attract investor attention.
In contrast, proponents argue that the current incubator boom is sustainable and has even become a necessity in some areas of the country. With the Obama administration, other government agencies, and private investors pledging billions to spurring startup development lately, supporters of incubators point to the increase of startups looking for professional help. The rise of incubators is simply a response to the rise of startups and the increased focus on small business development. In communities like Detroit that are in desperate need of an economic boost, incubators are needed to rapidly develop and refine startups so that they can start having an impact on the local economy as soon as they are financially viable.
Whether the current incubator boom is sustainable or not, these companies can serve as a valuable resource and guide for tech startups. Leading incubators like Y Combinator and TechStars have paved the way for successful startups like Dropbox and Justin.tv. Incubators have the potential to rapidly accelerate an entrepreneur’s business over a relativity short period of time and can sometimes provide much needed sources of funding and expertise. Not all programs are created equal, however, and as always it’s important to do your homework before entering into any equity sharing arrangement.
The good news for local startups looking for an incubator is that they do not have to travel to the west coast as Ohio is home to a number of established incubators. Three of the most established are highlighted below:
The Brandery, a Cincinnati incubator, was recently rated the 10th best startup accelerator in the U.S. (click here for the Top 15 list). In exchange for a 6% diluting warrant in a startup, The Brandery offers $20,000 in seed funding, free office space, product development, consumer research, legal support, brand identity, and a number of other services. The incubator also maintains a staff of over 50 mentors comprised of chief marketing officers, company executives, attorneys, and marketing experts.
TechColumbus, based in Columbus, OH, focuses on working with information technology, bioscience, and advanced material startups. TechColumbus offers office and lab space, a team of experts, executives, and Ph.Ds, and access to capital from a variety of sources. An incubator with a proven record, TechColumbus has had almost 90 companies gradate from its program, and 75% of those companies have realized sales or commercialization success.
JumpStart, Inc. focuses on startups in Northeast Ohio. A private, nonprofit organization, JumpStart seeks to assist startups who have the potential to generate $30-50 in revenue within five to seven years after working with the incubator and who will be located in the 21-country-area of Northeast Ohio. JumpStart invests in a startup using convertible debt, i.e. providing a loan that eventually converts to equity, and in exchange, the company provides 18 to 24 months of intensive development and $250,000 or more in early-stage investment.
For more information on incubators, see this list of Ohio startup accelerators maintained by The Gillespie Law Group.
The chart is embedded below, but you can access it directly by clicking here.
12 Apr 2011
Wikipedia defines a “social enterprise” as “any for-profit or non-profit organization that applies capitalistic strategies to achieving philanthropic goals.” The concept has been getting quite a bit of attention recently–without a doubt, for good reasons. Within the past few years, the Low Profit Limited Liability Company (“L3C”) and the Benefit Corporation (“B Corp.”) have arisen as sort of quasi entity classifications to allow social enterprises to distinguish themselves in a formal manner from their more profit-focused counterparts. We’ve been getting questions about them, so…here’s what they are, and more importantly, what they’re not.
A number of states have enacted L3C statutes, although Ohio is not one of them. L3C entities are similar to LLCs but have certain features which attempt to make them more attractive to private foundations seeking to make an investment. In order to maintain its charitable (tax-free) status, a private foundation must disburse much of its profit each year. But, if a private foundation makes a qualifying investment related to the foundation’s purpose, then the investment will count toward the annual distribution and will not jeopardize the foundation’s charitable purpose. However, the private foundation must bear significant costs to ensure that an investment meets IRS requirements (usually by seeking a private letter ruling from the IRS). The L3C entity is designed to remedy this problem by baking the IRS’s requirements for a qualifying investment directly into the authorizing statute, thereby eliminating the need for a private letter ruling. So, theoretically, an L3C should be more attractive to private foundations because the foundation will have lower investigation costs associated with making the investment.
Unfortunately, the IRS has not formally recognized L3C status as meeting its requirements (and there has been no indication that they will do so in the near future). The concept is great–enabling private foundations to more efficiently invest in social enterprises would certainly enable a number of very noble causes to gain funding. But unless and until the IRS does formally recognize the L3C, the benefits may amount to little more than branding, especially since any associated governance provisions can be included in the Operating Agreement of a normal LLC.
First, a B Corporation is not an entity in its own right (except in Maryland and Vermont, where a company can incorporate as a state-sanctioned entity known as a Benefit Corp). It is a certification offered by a third party—B Lab. To be certified as a B Corporation, your company must agree to take on additional corporate responsibilities. These responsibilities include redefining the best interests of the corporation to include the consideration of employees, consumers, the community, and the environment. The certification process involves several steps and requires that specific language be included in your company’s governing documents. In addition to goodwill in the community, certification may help attract funding from socially conscious investors and may entitle the company to certain tax breaks (for example, in 2009 Philadelphia created a tax break for B Corporations).
For the most part, if you want to put any of these provisions in your governing articles to better define your social enterprise, you can do so without paying for a B Corporation certification. And incorporating as a B-corp in one of the states that allow it may in fact create legal costs down the line as investors and other parties who you’ll do business with will have to get comfortable with the entity. That said, though, a B-corp certification, for the right organization, could be a very important branding tool, both internally and externally.
Startup and growing companies often use deferred compensation as an effective way to attract and retain important employees. Unfortunately, this process has been complicated by a recent tax change that significantly penalizes a broad range of “non-qualified” deferred compensation plans. Under Section 409A, deferred compensation which does not meet certain requirements is immediately taxable to the recipient and is subject to significant penalties. In order to avoid the penalties associated with this provision, startup companies should ensure that any deferred compensation meets IRS requirements.
Although Section 409A applies to many types of deferred compensation, stock option compensation is the most commonly implicated. Deferred stock option compensation is not subject to Section 409A penalties if the strike price (or exercise price) is greater than, or equal to, the fair market value of the shares on the grant date. Failure to set an appropriate strike price will subject the stock option recipient (employee) to the penalty provisions of 409A. The penalty provisions provide that the recipient of non-compliant stock options will: (1) be taxed at ordinary income tax rates for the value of the deferred compensation, (2) pay an additional twenty percent penalty, and (3) be subject to significant late payment penalties. Employees will, understandably, not be very happy about paying all of these extra taxes. Furthermore, the company may be subject to employee lawsuits for failing to set an appropriate option price.
Since the consequences of setting the strike price below fair market value are severe, you may be wondering how fair market value is calculated for your company’s stock. The IRS has provided several methods for complying with the strict requirements of Section 409A. Although compliance can be achieved through other means, there are three valuation methods that, if followed, create a presumption that the calculated fair market value is reasonable.
Independent Appraisal Presumption
The requirements under the Independent Appraisal Presumption are fairly straightforward. To fall within this presumption, the company must hire a qualified independent appraiser to value the company’s shares. The valuation provided by the independent appraiser is valid for a period of 12 months unless a subsequent event occurs which has a material effect on the company’s stock value. Examples of significant events might include a proposed merger or new equity financing. One downside to this method is the potential cost of hiring an independent appraiser. The upside is that an independent appraisal serves as an insurance policy against a subsequent IRS challenge. When selecting an independent appraiser it is important to ascertain that they are “qualified”. The surest way to do that is to select a professional that has certification credentials from one or more of the four national organizations that provide education and certification credentials for business valuation professionals. They are the National Association of Certified Valuation Analysts (NACVA), the American Institute of Certified Public Accountants (AICPA), the Institute of Business Appraisers (IBI) and the American Association of Appraisers (ASA). Selecting a professional that specializes in 409A valuations is also a good idea and may help keep fees to a minimum.
Formula Valuation Presumption
The Formula Valuation Presumption is only applicable for a narrow range of companies. To use this presumption, the company must already have in place a binding formula for determining the sale price of stock to other parties. For example, if a company’s stock had a permanent limitation which required the holder to sell or offer the stock according to a specific formula (e.g. a buy-sell agreement between the shareholders), that formula could be used to create a presumption of fair market value. These formulas are often based on a multiple of book value or earnings (or a combination of the two). However, if the shares may be sold or transferred in any way other than according to the formula, then this presumption is not available.
Illiquid Startup Presumption
Since startup companies are often difficult to value, the IRS has provided a special presumption for the stock of these illiquid companies. As long as certain requirements are met, the IRS will consider a valuation of startup company stock to be reasonable. However, if the company has any public stock or has been in business for more than 10 years, this presumption is not available. Furthermore, the valuation must be performed by a person with significant experience performing similar valuations and must be evidenced by a written report. But, unlike the Independent Appraisal method, the startup company does not need to hire a third party to perform the valuation (the startup may use in-house personnel as long as the relevant requirements are met). Since in-house personnel may conduct the valuation as long as they are qualified, this method is often cheaper than hiring an independent appraiser. For a full understanding of the requirements pertaining to this presumption, you should consult an attorney.
Deferred compensation in the form of stock option grants can be a powerful and effective tool for motivating and retaining startup employees. However, you must ensure that the strike price is set at, or above, fair market value to avoid significant penalties under Section 409A. By using one of the three presumptive methods for calculating fair market value, you place the burden on the IRS to prove that your valuation is unreasonable. Conversely, if you do not follow one of the above methods, you bear the burden of proving to the IRS that your valuation is reasonable.
An attorney experienced in this area can help you determining the best approach for your company by advising you of the myriad of practical and legal considerations as well as the associated costs and the risks.
17 Jan 2011
Small companies and startup businesses might view keeping corporate records as a low priority. Public companies and other large companies can usually have their attorneys keep their minute book up to date, but that can be expensive for small companies who may not have an attorney or law firm that they engage on a regular basis. This post describes what items should be kept in your minute book and why it is important to keep up to date with corporate records.
In general, your company’s minute book should have records for all formal board and shareholder actions as well as a complete record of stock ownership. In addition, your company’s minute book should include a copy of the articles of incorporation and bylaws as well as any amendments to these documents.
You might be wondering why you should keep current with your minute book or even have one at all. Below are a few of the important reasons to keep a minute book for your company.
- The minute book leaves a trail that enables owners and attorneys to look back at the decisions and transactions of a corporation. The minute book is an important audit backup. The minute book can help determine effective dates for tax purposes and establish justification for the accrual of expenses and fixed obligations.
- Up to date records can help you avoid challenges to the corporation’s authority to take certain actions. These challenges might come from minority shareholders, fellow directors, employees or government agencies. Your corporate minutes are important records of the authority granted to the corporate officers and directors to act on behalf of your company.
- The minute book establishes the background record needed by your lawyer to support certain legal opinions. When a corporation undertakes a certain transaction, it is often necessary to obtain a legal opinion regarding the corporation’s history as well as current authority for such a transaction. An example may be something as simple as securing financing from a bank.
- The corporation’s minute book should include stock records. This section needs to be carefully kept current because it is the one true ownership record of the stock of the corporation. Ownership is not officially recorded anywhere else. Your minute book should reflect exactly when and to whom shares of stock have been transferred. It is sometimes a good idea to keep the original stock certificates of the owners with the minute book – this prevents the certificates from becoming lost and prevents shareholders from selling their stock without the corporation’s knowledge.
- Your minute book is extremely important if you ever decide to sell your company. Any potential buyer is going to want to look at your minute book to ensure all actions have been properly taken. This will help the potential buyer evaluate any outstanding liability your company has. For example, if your company merged with a subsidiary in the past, but you do not have the records showing a board resolution approving the merger, a potential buyer might ask to decrease the purchase price based this outstanding liability.
If you can’t remember the last time you updated your minutes, now is a good time to give your attorney a call. Or, if you are just starting a company, you should contact an attorney to help you set up a minute book.
13 Jan 2011
- A disclaimer of warranties, and statement that the website is provided as-is;
- A Limit of Liability clause;
- A statement that all copyrights are owned by the website operator and that the visitor may make a copy only for personal use and must include all copyright and trademark markings included on the webpage;
- A choice of law and venue clause stating that any dispute will be litigated in the home state of the website operator;
- A prohibition against interfering with the website or using it for an illegal or improper purpose;
On December 17, 2010, President Obama signed the 2010 Tax Relief Act into law, and among other things, extended the 100-percent tax exclusion from capital gains of qualified small business stock (QSBS). As background, on September 27, 2010, President Obama signed H.R. 5297 Small Business Jobs Act of 2010 (P.L. 111-240) into law, creating additional tax incentives for businesses and individuals. The purpose of the Small Business Jobs Act is to encourage entrepreneurs and small business owners who may be sitting on the sidelines to make new investments and stimulate the economy. The expansion of existing Internal Revenue Code (Code) Section 1202 offered a way to fully exclude future tax gains to increase the after-tax return on the investment. Originally, this 100-percent tax exclusion from capital gains of qualified small-business stock (QSBS) expired at the end of 2010, but the 2010 Tax Relief Act extends the acquisition date to small business stock acquired on or before December 31, 2011. Under previous pre-2010 versions of the law, stockholders were generally permitted to exclude from recognition only 50 percent of the capital gain on the sale of QSBS, or 75 percent of the capital gain on such stock acquired after February 17, 2009 and before January 1, 2011.
QSBS may generally only be issued by a “qualified small business,” within the meaning of Code Section 1202, which generally requires that the issuer:
- be a domestic C corporation;
- have aggregate gross assets which, at all times on or after August 10, 1993, through and immediately following the issuance of the QSBS, do not exceed $50 million; and
- agree to submit such reports to the IRS and shareholders as the IRS may require to carry out the purposes of Section 1202.
A qualified trade or business specifically includes startup companies and certain research and experimentation activities. The term is otherwise defined as any trade or business other than certain specifically excluded activities (for example, professional activities such as law or medicine, banking and finance, farming, mining, and the operation of hotels and restaurants). In addition, certain entities that enjoy special tax privileges under other Code sections are excluded from the definition of an “eligible corporation,” e.g., domestic international sales corporations, regulated investment companies, real estate investment trusts and cooperatives may not issue QSBS.
Section 1202 also requires that securities meet the following conditions in order to qualify as QSBS:
- The stock must be “originally issued” to the taxpayer by a corporation that is a qualified small business on the date of issuance;
- During substantially all of the taxpayer’s holding period, at least 80 percent (by value) of the corporation’s assets must be used in the active conduct of one or more qualified trades or businesses;
- The corporation must be an “eligible corporation” during substantially all of the taxpayer’s holding period;
- The corporation may not (directly or indirectly) redeem more than a de minimis number of shares held by a taxpayer to which the QSBS is issued, or certain related parties, within a four-year period beginning two years prior to the issuance of the QSBS; and
- There may be no “significant redemptions” of the issuing corporation’s stock from any party during the two-year period beginning one year prior to the QSBS’s issuance.
To qualify for the exclusion, the gain, in any given tax year, from the sale or exchange of qualified business stock issued by a single issuer may not exceed the greater of:
- $10 million ($5 million for married taxpayers filing separately) reduced by the aggregate amount of eligible gain realized in prior taxable years attributable to dispositions of stock issued by such corporation; or
- 10 times the aggregate adjusted basis of qualified small business stock issued by such corporation and disposed of during the current taxable year.
Although the QSBS exclusion can provide significant tax benefits, some of the requirements and limitations may in the end make the structure not suitable for all startup investments. Entrepreneurs raising capital should analyze the various options available to them to maximize the potential return on investment for their investment.
It can be a huge money-saver for a small business to get into the practice of working with independent contractors. Using independent contractors will lower a companies tax bill, require less withholdings, and in some states, reduces the obligations under workers’ compensation requirements. As a result, many small businesses advantageously hire independent contractors and tell such contractors they are responsible for their own taxes.
Some companies push the line, however, and classify as independent contracts many workers who are in fact employees. The IRS is catching on and hoping to catch employers with discrepancies. A new IRS program, launched in early 2010, plans to randomly examine 6,000 companies over the next three years. The purpose of these examinations is to find misclassified employees. This new program makes the decision of how to categorize workers even more important.
In general the status of a particular worker is a product of the facts and circumstances surrounding the worker. A large factor in determining independent contractor status rests in the degree of control the worker has. An independent contractor would seemingly have more control over his or her hours, as well as the manner in which the work is performed. FindLaw, an internet website which compiles legal documents, publishes a twenty-factor checklist to help determine if a worker is an employee or independent contractor. To access this checklist click here.
Employers should think twice before classifying a worker as an independent contractor or employee, or risk writing a big check to the IRS for unpaid taxes, penalties and fines. In addition, an employer that misclassifies workers should be prepared to provide access to benefits retroactively for such misclassified workers. One example of this was the class action federal lawsuit filed against Microsoft Corporation, Vizcaino v. Microsoft Corp., the result of which was Microsoft having to pay approximately $ 97,000,000 to thousands of employees as well as the massive legal bill accumulated during the case.
The lesson is that employers cannot assume that independent contractors are necessarily “independent contractors” simply because that’s what their agreement states. The IRS and state agencies certainly will not be making this assumption. Employers should make an effort learn the rules in their respective state and on the IRS website or consult an attorney. If you want your independent contractor classification to be respected by the IRS, you need to tailor your relationship with your workers so that it meets the guidelines set forth by the IRS.