July 26, 2019
Legal Landmines Savvy Entrepreneurs Can Dodge
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Speaker 1: It's time for In Process: Conversations about Business in the 21st Century, with Evelyn Ashley and John Monahon. Presented by Trusted Counsel, a corporate and intellectual property law firm. For more information, visit trusted-counsel.com.
John Monahon: Welcome to In Process. We are back with another episode, and I have my colleagues, Valerie Barton and Allen Bradley, with me.
Valerie Barton: Hey John. Thanks.
Allen Bradley: Hello.
John Monahon: Hello. This is an episode that we've never done before, but we thought that it was worth visiting. It is basically a list of things that we think businesses should be doing, but are not. And these are just low-hanging fruit that when it comes to us in the office, we just think, oh, gosh, that was such an easy thing that we could've done for you, or we could have given you the tools to do. And now we're faced with a much bigger situation here, and it's just such easy planning to get. But the problem is it's about recognition, and so that's what this episode is about. What are the things that we see that businesses could be doing. And we'll go through these relatively fast.
I'll start it off. One of the first ones I see is not putting restrictive covenants in place on employees, particularly salespeople. This is something that I get calls on all the time. People have not bound their employees to non-solicitations, and next thing you know they have a falling-out or they have to fire someone, and they go across the street and they start soliciting the customers from their old employer. The first thing they say is, "Well, what can I do?" And, it's well, you can't do much unless you have an agreement with them, which is a restrictive covenant agreement saying that they can't solicit. And certainly that piece of paper is a lot easier to put in place than fighting a lawsuit later. Now maybe you still have to do that, but certainly having a restrictive covenant in place would help.
Val, I'll let you take number two.
Valerie Barton: Number two is a good one for us. Not getting work assignments from independent contractors. So one of the questions that we're frequently asked is, "I've got Bob, my programmer, working for me. He's drafted code. And because I paid Bob for the code, I obviously own the code, right?" Well, if you didn't put that in writing, chances are you don't own the code, and Bob hasn't assigned ownership in the work product to you. So you've spent a lot of money on somebody who then owns what he's developed for you. So you need to make sure that when you're dealing with your employees, with your independent contractors, even if they're at will, it's not because you're guaranteeing them employment over a certain term, it's just that you need to guarantee the terms of employment while they're there.
John Monahon: I once saw that happen to the tune of six figures and that was very painful to see.
Valerie Barton: Why? Why six figures?
John Monahon: Well, someone paid someone else six figures to complete some code for them, only to-
Valerie Barton: That they didn't own.
John Monahon: Then they didn't own at the end, and the contractor exploited. That was very painful to see.
Valerie Barton: I think that's part of what you talk about in terms of monetizing intellectual property. If you're actually going to try to sell your business down the road and you haven't protected it, you can't commercialize it, you can't monetize it, and you can't sell it.
John Monahon: Absolutely. Number three is not trademarking the company or product name. If you got a really bad company name, as in everybody else has it, maybe this doesn't affect you much or maybe you don't rely on your company name as much. But most people like to think of themselves as distinctive. They like to be found on the Internet. They don't like to be confused with other people. This is important. If you have a trademark and you have a company name, go ahead and get it registered because one day you're going to be on the Internet and you're going to find someone else who's now set up a website, which people are going to be going to, and they're going to start confusing your company with theirs. And the only way that you can stop them is if you have the proper trademark. So I think one thing that's important is if you're launching a company, if you're launching a product, make sure you have the rights and that'll allow you to be able to stop other people from using your name, and basically confusing the public as to who's providing these services.
Allen Bradley: And John, I think it's important to recognize that the trademark registration, in addition to the offensive nature of it that you just described, the defensive nature, so that if someone brings a claim against the company for allegedly infringing, if you have some kind of registration, ideally federal, but even state, that will be a big defense on your behalf to stop that person that's brought a claim against the company.
John Monahon: Absolutely. And the other thing is, better to do it up front when you're first starting a business, because once you've built all that value in it and you're five years in or six years in, you don't really want to rename that product or rename that company. Get it searched at the beginning and save yourself some headache.
The next one, Allen, this is something that you encounter a lot. Not issuing equity in a timely manner. What sort of headaches can that cause?
Allen Bradley: A large headache, John. Not issuing equity in a timely manner, is that the time equity is promised the company had a very low value, it was almost a startup or just founded. And then when the paperwork is finally done a decade later, the company is successful, has a value, and people don't want to pay tax on the quote phantom income. If you gave a person 10% when the company was worth $10 million, and they've had income of a million dollars, and they have a tax bill of about 300 and something thousand dollars. And so that's an issue with that procrastination. So it's important to go ahead, get that stock issued at the time it's been awarded.
Valerie Barton: We had a client actually who spent and worked with an employee for over 20 years, having made a commitment to issue equity. And then it's, "How can we it?" And fixing it in a tax efficient manner, there're certain things we can't help with if you don't let us know them sooner.
John Monahon: Yeah, and I think this is an easy one to fall into, because if you're not in our world, you assume if I promise it to them, my word is good.
Valerie Barton: Right.
John Monahon: That's it. I'm going to make good on my word one day. Which maybe you will, but the IRS, they don't really care about when you promised it. There are certain rules about-
Allen Bradley: And remember it's not just the IRS didn't really care about the fact that this person made a promise. The IRS works off annual returns. And so an item that is 10 years old, 10 annual returns had been filed. Now we're in the 11th year and that's when the issue arises.
John Monahon: Exactly. And so it's hard to change it at that point. So this is one thing, if you're going to issue equity, issue it in a timely manner, get it documented, or at least find out what the consequences of issuing that equity are.
Val, the next one is not reviewing a letter of intent or not letting counsel review a letter of intent.
Valerie Barton: Let me explain myself by saying that I'm a mergers and acquisitions lawyer. So I work in transactions and my goal when I work in a transaction is to try to make the transaction efficient for both sides. I'm a consensus builder. I want both sides at the end of a deal, since typically you're going to be working together after we're done, I want everyone to be happy. Now, one of the ways that I can help you is if when you start those conversations with a buyer or a seller, let me help structure the conversation for you. And one of the ways that we do is we work into the letter of intent stage. Unfortunately, oftentimes we receive, and I have two of them in front of me, we receive letters of intent that have been fully executed, and then we read them and think, "My goodness, there is so much I could've done." And my goodness is not what I'm thinking. There is so much we could have done, whether you made it a stock purchase or an asset purchase, because you didn't know the difference. There's no reason for you to know what the difference is between a stock and an asset purchase. It's just not what you do for a living.
So before you commit yourself in a letter of intent, whether it's binding or not, sets the tone. I think Allen had mentioned before, once you write down that the purchase price is a million dollars, it's going to be hard to backpedal. It's going to be hard to increase it. It's going to be hard to decrease it. And if you bring it to me after you've signed it, then I'm going to be doing documentation, but I'm not giving you advice as counsel that I could have given you, had you given me the chance.
John Monahon: The next one, Allen, is not recognizing when there could be a phantom income problem. This one, taxes issues, see all the time.
Allen Bradley: This issue arises quite a bit in the compensation arena. Owners think they can award stock, stock is not cash in a profit company, is not liquid, let's say in an S Corporation that only has two or three owners, that the stock is not taxable. Well, the IRS takes a different position. That stock is property just like cash, and therefore we have to pay tax on it. And if that stock is worth $100,000, that's $33,000 of tax.
John Monahon: That ties in a lot with sort of issuing it in a timely manner. That's one step, which was one of our gripes. But this one is about recognizing whether you're even going to have this issue at all. And also they come to you, Allen, there're some tricks that we can do to help make this be a little bit more tax efficient sometimes.
Allen Bradley: Sure. Age-old alternative is stock options, but the downside of a stock option is that when it is turned into cash it's ordinary income, and a profits interest. I worked recently with Valerie on profits interest, and that is kind of a best of all worlds. The structure needs to be an LLC or other partnership structure, and the idea of a profits interest that allows the employee to participate in the upside, in the growth of the company, but the gain is taxed at capital gain rates. And profits interest have been in the paper quite a bit recently, and it's viewed as somewhat of a loophole to allow basically service compensation to be converted into capital gain.
Valerie Barton: A perfectly legal loophole.
Allen Bradley: Right. Since it's viewed as a loophole by many people, it's time to take advantage of, because who knows when that loophole is going to close.
John Monahon: I think this is why some of the low-hanging fruit that's so frustrating is something that could be avoided with a little bit of planning. And again, just we see it one too many times not being avoided.
The next thing that we normally see is people assuming that rollover equity is tax free. So Allen, can you tell us what rollover equity is?
Allen Bradley: Sure. Rollover equity is basically just the sellers acquiring some kind of equity interest in the buyer. If it's an LLC, it's a membership interest, if the buyer's a corporation, it's a stock interest. And I think the assumption is that since the interest is typically not liquidated into cash, that it's somehow not income, when of course the IRS takes the position that rollover equity is income. But there are many exceptions to the general rule, and there are ways to document it so that the rollover equity is tax free, and so that no tax has to be paid on the phantom income, the value of that rollover equity.
Valerie Barton: So what would you do if you had a deal coming in and somebody was paying us a million dollars in cash, and a million dollars in so-called rollover equity? How would you do the deal differently to make that more tax advantageous to the seller?
Allen Bradley: So if I'm the seller, certainly I would not want to have to currently pay income tax on that rollover equity.
Valerie Barton: A million dollars’ worth of equity. Right.
Allen Bradley: Right. So a million dollars’ worth of phantom income. And so I would typically structure it, if it were a partnership interest relying on Section 721 of the Partnership Code, to characterize that as tax free. If it were a corporation, John and I have looked at several of these, we do a tax free merger, and the stock is tax free.
John Monahon: All right. So keeping with the tax theme, this next one is one that we see all the time, is not taking R&D tax credits. Allen.
Allen Bradley: I think, John, it is correct. And typically the vast bulk of our client base is technology companies. And typically technology companies, because technology companies do not own hard assets such as real estate or factories, then they rely on other things to put on the balance sheet such as inventions. But to capitalize that and also be able to get a tax benefit, people rely on what's called R&D tax credit. R&D stands for research and development. This tax credit has been available for decades, but oftentimes is overlooked. And things like a marketing company may be able to take advantage, for example, of the R&D tax credit. People tend to associate it only with very technical software, but there are many companies that can take advantage of the R&D tax credit.
John Monahon: I think not enough people are asking the right questions on this and talking to their CPAs about it. We've definitely seen clients who've gotten a hundred plus thousand dollars of R&D tax credits that they didn't know that they should be getting. And it just took a couple of questions and some research. So be aware the R&D tax credits, take them if you have them.
The next is not reviewing the tax situation enough. Again, it's another one, Allen, but people just don't revisit their corporate structures in their tax situation.
Allen Bradley: And I think, John, it's important to recognize that taxes are changing all the time. The recent tax legislation by President Trump is a good example. The documents need to be reviewed, the structure needs to be reviewed in light of the tax changes.
John Monahon: And also as a company grows, the considerations as to maybe some of their own tax elections changes a good bit too. What you might decide is the appropriate tax election when you are just starting, might not be the appropriate tax election if you're a multimillion dollar company later on.
Allen Bradley: Right.
John Monahon: And then finally, this is a favorite I'd probably of all of ours, not having an operating agreement. This one is... Val, tell us some frustrations with this.
Valerie Barton: Well, if you have a limited liability company and you don't have an operating agreement, there are rules. You're governed by the Georgia LLC Act, the Georgia Limited Liability Company Act, but do you really want the default rules to apply to you? You want to understand how you and your co-business owners are going to share responsibilities, how they're going to govern themselves, how they're going to divvy up money. Are they going to give you tax distributions for these distributions that they give you down the road, or else you're going to end up paying phantom income tax.
All these things need to be figured out in advance while you're still friends, while everybody still gets along really well, and you can argue about them in an agreeable, reasonable way. You don't really want to get into, "Wow, what happens when one of my co-owners dies? Is his spouse going to become a part of the business or not?" These are things that you don't want to have to figure out on the spur of the moment. You want to figure them out in advance, write them down and once you have them down, review them periodically down the road.
John Monahon: Or the dreaded 50 50 deadlock.
Valerie Barton: The deadlock. I own 50%, you own 50%. Who decides?
John Monahon: Just a ton of issues that need to be thought of in the operating agreement, if you're an LLC. Of course a shareholder agreement if you're a corporation.
Anyways, these are some of the things that we see in our practice all the time come up. They're easily avoidable, something that businesses should be thinking about. They're obviously things that we think are relatively basic, but they probably are not outside of our world. So think about these. If you're not doing them in your business, think about reviewing them, what you could be doing, and be aware of them.
That is it for this episode of In Process. It's a relatively quick one. I appreciate everybody for joining us. This is now three years that we've been on air, and we really appreciate everybody continuing to listen to us over that time. We've had a wonderful time recording these episodes and certainly look forward to a lot more years.
Al and Val, thank you for joining us.
Valerie Barton: Thanks John.
John Monahon: It was a pleasure.
Allen Bradley: Thank you John.
John Monahon: If anyone would like to learn more about In Process, please reach out to firstname.lastname@example.org. If you are interested in learning more about us, please visit our website at trusted-counsel.com.
Thank you for joining us.
Speaker 1: This has been In Process: Conversations about Business in the 21st Century, with Evelyn Ashley and John Monahon. Presented by Trusted Counsel, a corporate and intellectual property law firm. Are you interested in being a guest on our show? Email our show producers at email@example.com. For more information on Trusted Counsel, please visit trusted-counsel.com.