Law News and Tips
When someone comes in to talk to me about starting a new business, the question that inevitably comes up is whether they should form an LLC or go with an S-Corporation. I wish the answer were a simple one, but it is a little involved.
I tend to shy away from corporations now. Too much reporting and too many meetings. Under Missouri law (but I have found that this is similar to the laws of other states), you have to file articles of incorporation. You have to adopt bylaws. Generally, you have to have a board of directors, although with certain closely held corporation forms, you can dispense with that. The board must elect a president and a secretary, at least. Each year, you have to file annual reports with the State telling them who your officers and directors are. And then you need to have annual meetings of the shareholders and directors, which most small businesses neglect to do until an emergency comes up.
With an LLC, you file articles of organization (again, this is pursuant to Missouri law, although I believe that most states have similar provisions). Then you must execute an operating agreement. Then you’re done. Yes, you can make this more complicated, but that is the end of your legal requirements. So an LLC is simpler.
Then there comes the question of taxes. If you are taxed as a sole proprietor or a partnership, all of your earnings are subject to the federal self-employment tax, which is currently 15.3%. That’s a bad thing.
If, however, you opt to be taxed as a corporation and file an election to be treated as an S-corporation, with proper planning, you can avoid the self-employment tax on amounts in excess of a reasonable salary for your job. But the interesting thing is that you don’t have to be a corporation to opt to be taxed as a corporation and file the S-election. You can do that as an LLC. So you have the simplicity of an LLC for operations and the tax savings of an S-corporation. That’s a good thing.
The problem is that the S-election brings with it some additional paperwork. As a sole proprietor, you report all of your income on the Form 1040, Schedule C (you also have to file a Schedule SE). With a partnership, you have to file a Form 1065. With an S-Corporation, you finally Form 1120-S, and you’d have to file a periodic employment tax return.
My suggestion is always to discuss this with your accountant. If you think that your business operation is going to be more of a hobby than a big money maker, maybe the simplicity of a sole proprietorship or a partnership is better for you. However, if a new entrepreneur realistically thinks he or she is going to make more money than what would be a reasonable salary, then the S-election route should be seriously considered with the accountant.
There was a recent US Tax Court case, Cavallaro v. Commissioner of Internal Revenue , that is a case study in what not to do in a family business. Formalities seem so out – of – place in family businesses.
In that case, a mother and father had a machine shop (“Knight”) that came up with a plan to build and sell a machine that could glue components onto computer circuit boards. That was back in 1982, a good time to invent that kind of a machine. They formed the company (“Camelot”) to make it.
The problem with a bright idea is that it can cost money to get it to market. After consulting with accountants and advisors, the parents’ three sons formed the sales company to market the machine. The idea was that Camelot would own the machine and hire Knight to manufacture it.
Here is where the informality tripped them up. The dad “transferred” the design of the machine to the sons by simply handing them the Camelot company records, saying, “Take it; it’s yours.” The sons, however, continued to get a paycheck from Knight, and not from Camelot or the sales company. In fact, it’s almost impossible to see where one of the companies ended and another began. They almost completely overlapped.
Over time, the sons (on the Knight payroll) modified the machine design, working with other Knight employees and engineers. The redesigned machine became very profitable. Sales boomed.
Then they got some more advice. They were told to merge the businesses. Working with an attorney and an accountant, they figured out relative values for the company’s and merged them, assuming that Camelot owned the machine design.
The IRS disagreed. To the tune of $12,900,000. The problem is, the Tax Court agreed with the IRS. The IRS determined that Mr. and Mrs. Cavallaro had given their sons the machine design (the value of which had grown immensely over time) in the process of the merger. Fortunately (or maybe not), the family had sold the business for almost $60 million in cash. However, Mr. and Mrs. Cavallaro received less than $11 million of that money, with the rest going to their sons. They were obviously about $1 million short. The case doesn’t explain how they made up that million dollar shortfall.
Years ago a woman came to see me about her son. She told me that he wouldn’t let her have her investments. Kind of an odd statement, don’t you think? So here’s the story.
The woman (I’ll call her Rachel) had been married for years to a successful businessman, and they had had four children. Her husband died when she was 69. She lived alone for 10 years, but eventually the loneliness got to her. So what does any 79-year-old woman looking for love do? That’s right. She ran an ad in the Riverfront Times.
Rachel met George (not his real name either). George was 10 years younger than Rachel. Rachel’s son, Billy, did not like George.
The problem was that to avoid probate, Rachel had put her home and investments in joint names with Billy. With a joint bank account, either joint owner can withdraw the money. That’s not the case with any other assets. In all other cases, both joint owners must agree to cash out or retitle the joint assets.
Billy refused to cooperate. The assets were frozen. He did give Rachel an allowance, but how demeaning is that? Years of litigation followed.
Although people hate to think about dying or to spend the money on an estate plan, joint ownership is not the solution. It usually ends in a mess. It simply is a bad idea.
As baby boomers have been growing older, there’s been a lot of talk about parents passing their businesses down to their kids. The funny thing is that, although I’ve seen some of that, more frequently, I see that the parents are selling their businesses to an outside third party. Those sales present their own issues, but that’s for another article.
Passing the business down to younger generations requires very careful planning. One of the first issues that needs to be addressed is whether the younger generation is even capable of running the business. Although politicians and pundits often complain about how estate taxes destroy family businesses, a number of studies have shown that actually families destroy family businesses. Since these deals often involve a buyout over time, the failure of the business can be catastrophic for everyone involved. There are ways to measure the skills of a younger family member and using that information form a succession plan with the possibility (no guarantees here) of success. But developing this plan requires time and careful attention to details.
If you can put together a viable succession plan, then the question is how to implement it. Family dynamics can bring catastrophic results. Children who are not involved in the business can feel cheated. The descendent taking over the business can take advantage of the situation for his or her own benefit. Simple misunderstandings can grow into huge, may be insurmountable, problems.
I personally know all of this from experience. Growing up, we weren’t even allowed to mention the other side of the family because of something that happened in 1918. Two brothers who worked together for years, even living next door to each other, were irrevocably alienated. Family business can be really tricky.
Sylvia (not her real name) had been married for years to Dave, and they had four kids together. As happens many times, Dave predeceased Sylvia. Sylvia was fairly young, and over time, she got lonely.
Sylvia met Louie at a seniors’ event at their church. Louie was also a widower. They enjoyed each other’s company and started spending time together. They were sort of old-fashioned, so they ended up getting married. Not a bad thing really.
Sometime after that, Sylvia got sick. Louie nursed her all during her illness, but in the end, she died. Louie had loved Sylvia, and after losing his second wife, he was brokenhearted. He didn’t live that much longer himself.
After the funeral, Sylvia’s kids started asking about the estate only to come to a rude awakening. You see, Sylvia and Dave had executed wills when their kids were younger, but they had never done anything else. After Dave’s death, when Sylvia married Louie, she put her assets in joint names with him. This all seems very innocent.
The problem is that with joint property, on the death of the first joint owner, the asset belongs entirely to the surviving joint owner. When Sylvia died, everything went over completely to Louie. Louie probably didn’t have a plan, but even if he did, it certainly didn’t take Sylvia’s kids into account.
I got a call some time ago from a woman who was in tears. She was crying so hard I could barely understand her. When I finally got her to compose herself a little, the first thing I heard was “My daughter won’t let me sell my house.”
That, of course, raised a lot of questions in my mind, so I started asking my questions. It turns out that a bank teller (typically a source of batted five’s, by the way) had been talking to the mom. The mom and heard horror stories about probate, and the teller told her she could avoid probate by putting her daughter’s name on things.
I understand why she said that, but it was bad advice. A bank account is governed by federal law that says either joint owner can deposit or withdraw any or all of the money in the account.
That isn’t the case with any other joint property. In all other cases of jointly held assets, all joint owners must join in transactions affecting the joint property. So when the mother put her daughter’s name on the house, she gave up control.
Time passed, and the mother aged. Now she needed to go into a nursing home. To do that she needed to sell her house, and her daughter was saying no. It was her inheritance, so why would she want to jeopardize that. Mom would have to make do.
I don’t know how this situation got resolved. Did the daughter relent or did the mother have to stay in the house until she died? In any case, the moral of the story is that joint ownership can be a real problem.
In the case of Hibbs v. Berger (Mo. E.D. App. 2014), the court considered what duties were owed by an LLC manager to members. The case was brought by a 5% owner of the LLC. The LLC manufactured doors, windows, and the like, and it got caught up in the “Great Recession.” The principal member lent large amounts of money to the LLC to keep it afloat, but in the end, the Recession won the battle. The lending-member had taken a security interest in all of the LLC’s assets, and on default, he took those assets as repayment, sort of like a foreclosure. The minority owner got nothing. The minority owner then brought suit alleging that the lending-owner had breached its fiduciary duties to him, and as a result, he had lost all of his interests in the company.
The legal theories bantered about were pretty extensive, but what interests me in this case are several findings of the court as follows:
1.Members of an LLC and LLC managers (whether members or not) owe a fiduciary duty to the LLC itself. We tend to think of an LLC as an extension of the members, but it is actually a separate entity with rights.
2.LLC managers (whether members or not) owe a fiduciary duty to the members of the LLC. We all kind of knew that, but this may be the first case where a court actually stated this principal.
3.However, an LLC in its operating agreement can reduce the fiduciary duties owed by the manager to the LLC or members. This duty is not a common law duty but is one created by statute, and the statute allows the members to agree to cut it back.
4.A non-managing member of a manager-managed LLC does not owe anyone a fiduciary duty.
On June 30, 2014, the US Supreme Court issued its much-anticipated decision in the case of Burwell v. Hobby Lobby Stores, Inc. This case dealt with
the conflict between what is called the HHS Mandate of the Affordable Care Act (otherwise known as “Obama Care”), and a business owner’s constitutional
right to the Free Exercise of Religion “guaranteed” by the First Amendment.
The government had argued that the Free Exercise Clause did not apply to corporations, but only to individuals. Among other things, the Solicitor General argued that it did not apply to the way you conducted your business. In her dissent, Justice Ginsburg argued that allowing business to opt out of the HHS Mandate on the pretense of “sincerely held religious beliefs” would frustrate the “constitutional” protection of a woman’s right to “control their reproductive lives.” She argued that birth control, including abortion inducing chemicals and devices at issue in this case, advanced a “compelling governmental interest”, and that trumped a person’s right to the exercise of their religious faith through the corporate form of doing business. She felt the protecting religious liberty would just be too difficult for the courts to do on a case-by-case basis.
Gratefully, the majority (albeit slim) disagreed. They held that when a business owner elects to do business in a corporate form, they do not check their faith and religious practices at the door. They found that “Protecting the free – exercise rights of closely held corporations, protects the religious liberty of the humans who own and control them.”
The Supreme Court’s ruling basically held three things:
1.The Religious Freedom Restoration Act (that was passed by Congress after the disasterous Smith case in 1990) protects the rights of owners through for – profit corporation;
2.HHS’s contraceptive mandate substantially burdens the exercise of religion; and
3.assuming that guaranteeing cost – free access to the four challenged contraceptive methods is a compelling governmental interest, HHS failed to prove that the mandate is the least restrictive means of achieving its “compelling interest.”
So what does the Hobby Lobby decision mean for faithful Christian business owners? Justice Alito, who delivered the opinion of the Court specifically stated that this decision does not mean that corporations owned solely by individuals religiously opposed to abortifacient contraceptives are not subject to the Affordable Care Act. They are just exempt from the offending portion of the HHS Mandate.
The question is a little more complicated for Catholic business owners who may be religiously opposed to any contraceptives. That is a broader objection than what the court considered in Hobby Lobby which involved evangelical Christian owners. However, I believe the reasoning would be the same for Catholic business owners.
The issue, of course, may come down to proving the religious objection. In Hobby Lobby, Justice Alito extensively discussed the actions the company had taken to institutionalize its Christian beliefs and practices. Business owners may want to give some thought to adopting policies and practices consistent with their beliefs.
One of the other points that Justice Alito discussed in his opinion was the “accommodation” that the Department of Health and Human Services afforded to religious nonprofits. That “accommodation” provides that religious nonprofits do not have to directly provide contraceptive chemicals and devices under their plans. Rather, the insurance companies are required to independently provide those chemicals and devices.
It should be noted that the question of whether this “accommodation” is adequate was not before the court in the Hobby Lobby case. That issue will come before the court in its next term, which will end in June 2015. In that case, the religious nonprofits are pointing out that it is absurd to think that insurance companies will voluntarily, without compensation, provide contraceptive chemicals and devices. They argue that the insurance companies will in fact collect enough revenue to pay for these chemicals and devices, albeit indirectly. In addition, those organizations believe that even this “accommodation” involves them complicity in a grave moral error. We will have to stay tuned to see how the Court rules on that issue.