Articles Posted in Business Formation & Planning

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IrelandTaxes, as the saying goes, are one of only two certainties in life. This part of the adage applies just as much to businesses as it does to individuals. (The extent to which the other part of the adage—“death”—applies to businesses is a question for another day.) Starting and operating a business requires a careful consideration of tax-related consequences, as well as ways to minimize tax obligations. The tech company Apple, based in Silicon Valley but operating all over the world, has recently been the subject of a dispute over tax benefits it has received from the government of Ireland. While the nature of this dispute might not be applicable to most businesses that are smaller than Apple, it offers a demonstration of how businesses obtain tax benefits from various governments.

Corporations, partnerships, and other types of business entities must pay income tax to the federal government and many state governments, along with various other types of taxes, such as sales tax and payroll tax. Tax planning can include not only preparing for future tax obligations but also minimizing those obligations within the boundaries of state and federal tax regulations. A business might be able to take advantage of a “tax loophole,” and it might also be able to obtain tax benefits or concessions directly from a government.

Perhaps the most common way for both individuals and businesses to reduce their tax bill is by reducing their amount of “taxable” income. While they could do this simply by earning less money, the preferred method is to take various deductions, such as business operations and payroll expenses. Their taxable income equals their gross annual income minus all lawful deductions.

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KVDP (Own work) [CC BY-SA 3.0 (http://creativecommons.org/licenses/by-sa/3.0)], via Wikimedia CommonsThe California Transparency in Supply Chains Act (CTSCA), Sen. Bill No. 657 (2009-2010 Reg. Sess.), was signed into law in 2010 and took effect in 2012. It requires manufacturers and retailers doing business in the state of California to “disclose their efforts to eradicate slavery and human trafficking from their direct supply chains.” Id. Additionally, it gives the state Attorney General access to a list of businesses required to make these disclosures. It is important to note at the outset that most manufacturing and retail businesses are not subject to the CTSCA’s disclosure requirements. The law only applies to businesses with “annual worldwide gross receipts” of $100 million or more. Id. Its provisions are important for all California businesses to understand, however, as it is part of a series of laws targeting human trafficking and forced labor.

The federal Victims of Trafficking and Violence Protection Act (VTVPA) of 2000 defines “‘severe forms of trafficking in persons,” in part, as “recruit[ing], harboring, transport[ing], provi[ding], or obtaining…a person for labor or services,” using “force, fraud, or coercion” in order to subject the person to “involuntary servitude,” slavery, or other forms of forced labor. Pub. L. 106-386 § 103(8)(B) (Oct. 28, 2000), 114 Stat. 1470. It defines “involuntary servitude” as a condition in which a person believes that they must perform services in order to avoid “serious harm or physical restraint” or “abuse…of the legal process.” Id. at § 103(5), 114 Stat. 1469.

The Legislature noted in the CTSCA’s preamble that human trafficking is illegal under state, federal, and international law. It further noted that, while various legislatures have passed numerous laws imposing criminal penalties on traffickers and protecting the rights of trafficking victims, few laws have “address[ed] the market for goods and products tainted by slavery and trafficking.” S.B. 657 at § 2(f). Market forces generally drive demand for less-expensive goods, and the Legislature acknowledged that consumers are in the best position to influence the market through purchasing decisions. The goal of the CTSCA is therefore to make information about trafficking and forced labor available to consumers, with the hope that consumers will reward businesses that avoid goods associated with forced labor, or that take direct action to fight human trafficking.
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13048311844_426bfa9bee_z.jpgThe Office of the Chief Counsel of the Internal Revenue Service (IRS) issued a memorandum late last year addressing a question about the rights of shareholders in a corporation that switched from subchapter S to subchapter C and then switched back to subchapter S. IRS Chief Counsel Memorandum (“IRS Memo”) No. 201446021 (Nov. 14, 2014) (PDF file). C corporations face “double taxation,” in which the corporation pays tax on its net income, and shareholders pay tax on the same money when they receive it as dividends. Under subchapter S of the Internal Revenue Code (IRC), 26 U.S.C. § 1361 et seq., qualifying corporations can elect to be taxed much like a partnership, meaning that shareholders pay taxes directly on a pro rata share of corporate profits. Losing subchapter S status can result in the loss of tax benefits, as demonstrated by the IRS memorandum.

Shareholders in S corporations are liable for taxes on their share of corporate income whether they receive dividends or not. The IRC provides a way for shareholders to obtain this money, on which they have already paid income tax, from the corporation without any additional tax liability. S corporations must maintain an “accumulated adjustments account” (AAA), which consists of corporate profits already taxed to shareholders but not distributed. 26 U.S.C. § 1368(e)(1), 26 C.F.R. § 1.1368-2. The AAA comes into existence with a balance of zero on the first day of a corporation’s first year as an S corporation.

If a corporation’s subchapter S election is revoked, a “post-termination transition period” (PTTP) begins on the date of revocation and ends after one year or on the due date of the tax return for the corporation’s last year as an S corporation, whichever is later. 26 U.S.C. § 1377(b). A corporation can distribute the balance of its AAA to its shareholders during the PTTP as though it still had subchapter S status. 26 U.S.C. § 1371(e). The question presented to the IRS was whether an AAA survives the transition from S to C, then back to S. The IRS concluded that it does not.
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Triple_Bottom_Line_graphic.jpgThe “one and only social responsibility of business,” according to the Nobel Prize-winning economist Milton Friedman, is “to increase its profits so long as it stays within the rules of the game.” Making money is the goal is just about any for-profit business, but a common criticism of much of American business is that acting to serve its own ends often fails to benefit society. Some business owners, in addition to making a profit, might want to work towards goals that have a social, economic, or environmental benefit. Several states, including California, have enacted laws allowing the establishment of “benefit corporations,” also known as “B corporations,” which let businesses balance goals related to “general public benefits” with the duty to maximize returns for shareholders. A nonprofit organization known as B Lab offers private certification for B corporations that maintain certain standards.

A B corporation is a for-profit business entity organized under state law. At least 27 states have enacted B corporation statutes, and another 14 states have pending legislation. The idea of the B corporation has gained popularity in recent years, as consumers who already seek out companies with compatible values have become more aware of issues like corporate responsibility. In some surveys, nearly half of all consumers have stated that they would boycott companies that they believed were not acting in society’s best interest. At the same time, the level of trust that consumers have in corporations is declining, and corporate campaigns aimed at one social issue or another might meet with skepticism as easily as support from consumers.

California’s B corporation law, CA Corp. Code § 14600 et seq., took effect in 2011. It allows corporations to be formed under California law for the purpose of a “general public benefit,” defined as something that has a “material positive impact on society and the environment” when “assessed against a third-party standard.” CA Corp. Code § 14601(c). A California B corporation may identify more than one specific public benefit. Examples provided by the Legislature include “preserving the environment” and “improving public health.”
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Form_2553,_2005.pngThe minority shareholder in an S corporation argued that he was not liable for federal tax on the corporation’s income because the majority shareholder had shut him out of management, and the corporation had not paid him any salary or distributions. The Internal Revenue Service (IRS) found him liable for the tax and assessed a penalty. He appealed to the United States Tax Court, which rejected his argument that he was not the beneficial owner of the shares and therefore not responsible for the tax. Kumar v. Commissioner of Internal Revenue, T.C. Memo 2013-184. Small businesses, especially those that have elected subchapter S status, should have comprehensive shareholder agreements that address management rights and income distributions.

The petitioner in Kumar owned 40 percent of the shares in Port St. Lucie Ventures, Inc. (PSLV), a medical practice in Florida organized as an S corporation. A dispute arose between him and his business partner, who owned the remaining 60 percent of the shares, in 2003 or 2004. The majority shareholder allegedly shut the petitioner out of PSLV management and operations in 2004. The corporation did not pay the petitioner a salary, nor did it make any distributions to him, in 2005 or in any year thereafter. It issued a Schedule K-1 for tax year 2005 that reported the petitioner’s taxable shares of the corporation’s business and interest income in the amounts of $215,920 and $2,344, respectively. The issue for the petitioner would ultimately be whether he personally owed tax on these amounts.

Subchapter S corporations, unlike subchapter C corporations, do not pay federal income tax directly. 26 U.S.C. § 1363(a). The income and losses of an S corporation “pass through” to the shareholders, who pay taxes or deduct losses on their personal tax returns in proportion to their ownership of outstanding shares. If the record owner of shares in an S corporation is holding them for the benefit of another, the income and losses pass through to the “beneficial owner.” 26 C.F.R. § 1.1361-1(e). In determining whether a person is a “beneficial owner” for tax purposes, courts generally look to whether the person and another party have “some agreement or understanding” of their relationship, such as an estate and an heir. Hightower v. Commission, 2005 T.C. Memo 274, slip op. at 20 n. 12.
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Futura.svg.pngA lawsuit pitting two of the world’s most famous typeface designers against each other has brought a great deal of attention to an often obscure area of design. Choosing the right typeface has been an important part of marketing one’s business for about as long as printing has existed. Thanks to the internet and advances in digital technology, popular typefaces may generate millions of dollars in licensing fees. The parties in Frere-Jones v. Hoefler, No. 650139/2014, complaint (NY Sup. Ct., NY Co., Jan. 16, 2014), are considered superstars among typeface designers. The plaintiff is seeking $20 million in damages over an allegedly broken promise to share the business 50/50, and many valuable typefaces hang in the balance.

The words “typeface” or “font” refer to a set of symbols, including letters, numbers, and punctuation, with common design elements. Many well-known typefaces, such as Arial and Courier, are included with many computers and software applications. Typefaces are also available to license for use in marketing and other business publications. Licensing fees allow designers the opportunity to continue making money from their creations in much the same way that musicians receive income through royalty payments. Businesses may also commission typefaces for their own exclusive use. Copyright law generally protects typefaces, although trademark law may cover a specific use of a typeface in a logo or other design.

The plaintiff, Tobias Frere-Jones, claims in his complaint that he has designed more than eight hundred fonts during his career, which are used all over the world in more than 145 languages. The defendant, Jonathan Hoefler, is the founder of a New York design firm known as The Hoefler Type Foundry (HTF), which did business under the name Hoefler & Frere-Jones from 1999 until recently. Their firm has created fonts for newspapers like the Wall Street Journal, Barack Obama’s 2008 presidential campaign, and countless logos appearing on televisions, product packaging, and elsewhere. According to a description of the company in Bloomberg Businessweek, the two designers are like rock stars in the design world, with one colleague comparing their business partnership to the musical group Crosby, Stills, Nash & Young.
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Farmers_and_Merchants_Bank_Building_2_(Nampa,_Idaho).jpgA federal court ruled in late January 2014 that the acquisition of a physician group by a large hospital system violated § 7 of the Clayton Antitrust Act, 15 U.S.C. § 18, as it left the hospital in control of a substantial majority of the physicians in a relatively small market. Two lawsuits, Saint Alphonsus Medical Center, et al v. St. Luke’s Health System, Ltd., No. 1:12-cv-00560, and Federal Trade Commission, et al v. St. Luke’s Health System, Ltd. et al, No. 1:13-cv-00116, were combined in the U.S. District Court for the District of Idaho. The case is reportedly the first antitrust lawsuit brought by the Federal Trade Commission (FTC) challenging the merger of a hospital and a medical group.

In its Findings of Fact and Conclusions of Law, the court addressed the high cost of healthcare in the U.S. and its relatively low quality as compared to other nations. It noted that St. Luke’s, which operates a statewide hospital system, identified a need to integrate primary care physicians and specialists in order to focus more on patient health. To this end, St. Luke’s began buying independent physician groups in order to create integrated medical teams with compensation based on patient outcomes.

St. Luke’s acquired a physician group, the Saltzer Medical Group, in Nampa, Idaho. After the merger, eighty percent of the primary care physicians in Nampa, a town of about 83,000 people, worked for St. Luke’s. St. Alphonsus Medical Center and other medical groups in the area filed an antitrust lawsuit against St. Luke’s in 2012. The FTC and the state of Idaho filed a similar suit in 2013. They alleged that the merger of St. Luke’s and Saltzer made St. Luke’s the overwhelmingly dominant primary care provider in the Nampa area, which would give it substantial leverage to bargain with health insurance companies and, ultimately, drive up costs.
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US_Statutes_at_Large.jpgA new statute governing limited liability companies (LLCs) took effect in California on January 1, 2014. The California Revised Uniform Limited Liability Company Act (RULLCA) replaced the Beverly-Killea Limited Liability Company Act. The new law has several important changes for both existing and new LLCs, and the California Secretary of State (SOS) has revised its regulations to reflect the changes to the law. Existing LLCs, to name just one change, may find that they need to modify their operating agreements and other internal governing documents to comply with the new law. New LLCs filers should be aware of changes to the standards used by the SOS for LLC names.

The RULLCA passed the California State Legislature in 2012 as Senate Bill No. 323, and California Governor Jerry Brown signed it into law on September 21, 2012. Legislators based the new law on the Uniform Limited Liability Company Act drafted by the Uniform Law Commission (ULC) of the National Conference of Commissioners on Uniform State Laws, an organization that proposes uniform laws for state legislatures. Eight U.S. states, including California, and the District of Columbia have enacted versions of the ULC’s proposed law, and legislation to enact it is pending in South Carolina.

The new law officially repealed and replaced the Beverly-Killea Limited Liability Company Act for all domestic and foreign LLCs in California on January 1, 2014. Since the prior LLC statute governed everything from the formation of the company to its dissolution, it is not yet clear how the change in the law will affect certain aspects of existing businesses. One provision clearly states that the RULLCA shall apply to all LLCs existing or or created after January 1, 2014, and to all manager or member actions taken on or after that date. CA Corp. Code § 17713.04(a). Any actions taken by members or managers before January 1, 2014, however, are still governed by the old law. CA Corp. Code § 17713.04(b). Ongoing actions may eventually be covered by both laws in some way.
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1038828_68900425.jpgForum-selection clauses are very common provisions often contained in commercial contracts. These clauses not only make future litigation on a contract more predictable and allow parties to avoid the threat of hostile foreign laws, judges, and juries, but they also have the capacity to make litigation less expensive. This is especially the case for companies that do business outside their home state and country. Nevertheless, in some cases, despite the existence of these clauses, defendants are oftentimes still sued by plaintiffs in courts that are not the contractually selected forums. That is exactly what happened in Atlantic Marine Construction Co., Inc. v. United States District Court for the Western District Court of Texas, a case recently brought all the way to the U.S. Supreme Court and decided on December 3, 2013.

The contract at issue was a subcontract between a general contractor, Virginia-based Atlantic Marine Construction Co. Inc. (“Atlantic”), and its subcontractor, J-Crew Management, Inc. (“J-Crew”), a material and labor supplier based in Texas, for a construction project in Texas. Like many contracts, the subcontract contained a forum-selection clause stating that all disputes under the contract would be litigated in the Circuit Court for the City of Norfolk, Virginia or the U.S. District Court for the Eastern District of Virginia, Norfolk Division. Notably, the contract did not contain a choice-of-law clause. After a payment dispute developed between the parties, J-Crew brought suit against Atlantic. However, J-Crew elected not to follow the terms of the contract and sued Atlantic in the U.S. District Court for the Western District of Texas, where the project was located.

Atlantic thereafter requested that the District Court transfer the litigation to Virginia. The Fifth Circuit performed an analysis using factors relevant to the litigation, including the existence of the forum-selection clause in the contract, to determine the proper venue for the dispute. The court determined that, while a forum-selection clause is a factor identifying the intent of the parties at the time of the contract, the final decision of the proper forum rests with the court. The court thereafter determined that the matter was properly venued in Texas and that Atlantic did not meet its burden of showing a transfer was proper.
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821422_77365549.jpgGovernor Jerry Brown signed a number of bills affecting employers and employment law into law at the close of the 2013 California legislative session. Many of these laws, scheduled to take effect in 2014, will have an impact on the day-to-day operations and policies of California business in coming year. An overview of some of the new laws is provided below.

SB 323 -New Regulations for California LLCs

The California Revised Uniform Limited Liability Act (SB 323), effective January 1, 2014, completely replaces the Beverly-Killea Limited Liability Company Act, a law which has governed LLCs in California since 1994. Some of the key changes in the new law include:

Operating Agreements: A written operating agreement among the members is no longer required. The new law requires only a record, or implication of an agreement. It is therefore important to create a clear, well-drafted operating agreement that limits the agreement between the parties solely to the written document to ensure that courts do not consider other items, such as emails among members or even phone calls, to be part of an agreement between the parties.

New Members: New members of the LLC will be bound by the terms of the operating agreement even if the new member does not sign or otherwise consent to the agreement.

Fiduciary Duties: The duty of loyalty owed by a manager or managing member to the LLC is no longer the same as the open-ended duties a partner owes to the partnership and other partners. Instead, the new law limits the duties to those expressly listed in the statute. In addition, as long as they are reasonable, members may now specifically set forth certain activities that will not violate fiduciary duties through the operating agreement.

Notably, while the Beverly Killea Act will continue to govern LLC operating agreements entered into before January 1, 2014, the new law will regulate all new LLCs formed on or after January 1st.

AB 44 – Requiring Submission of Subcontractors’ License Numbers in Public Construction Bids

Beginning July 1, 2014, AB 44, which amends Public Contract Code section 4104, will require a prime contractor to list a subcontractor’s contractor license number when bidding on public construction projects. The bill also requires public agencies to modify their public construction bid forms to require the license number in the subcontractor listing form. The law is intended to better enable public entities to verify that the listed subcontractors are in good standing with the Contractors State License Board and hold active licenses.
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