Tag: LLC

Five Benefits of the Solo 401K

November 6, 2017 Retirement Planning, Tax Planning Comments Off on Five Benefits of the Solo 401K

For many Americans, saving for retirement is like exercising or eating healthy, we know we should do it but most of us don’t.   In fact, a survey published by the Washington Post reported that over 70% of Americans are not saving enough for retirement and a study by the US Government Accountability Office reported that as many as half of American households 55 or older have NO retirement savings at all!   A recent Merrill Lynch report estimates the average cost of retirement to be nearly $750,000 but this obviously depends on your standard of living and life expectancy.   With advances in technology increasing our lifespans, we need to plan accordingly in order to have what we need in retirement.

The Solo 401K is the ideal vehicle for small business owners with no full time employees to save for retirement through its generous contributions limits which can offset your taxable income.  If your small business generated a profit this year and you are looking for a nice year-end tax deduction, the Solo 401K may be the perfect solution for you.  We have compared the other available retirement options for small businesses and the Solo 401K consistently wins hands down.  Some of the benefits include:

1. Tax Savings: In 2017, the employee contribution limit is $18,000, or $24,000 if you are 50 or over.  Compare this with the contribution limit of $5,500 for IRAs.   In addition, the business itself can do an employer match up to 25% of the employee’s W-2 compensation.  For an example, let’s assume you have a net income of $100,000 in your s-corp business and you took $35,000 as your salary.  Your contributions (traditional) and tax savings are as follows.

Employee traditional 401K Contribution                                 <$18,000>

Employer Match at 25% of $35K                                                <$8,750>

Total Solo K Contributions                                                            $26,750

 

Tax Savings (approx. 25% federal):                                           $6,700 (approx.)

Plus State Income Tax Savings Depending on State

For a calculator that allows you to determine your contribution levels based on your income, refer to this website, check your business entity type (sole prop LLC, partnership, s-corp) and it will calculate the solo K contribution amounts.

2. The Ability to Self Direct: The solo 401Ks established by KKOS  allows you to self-direct your retirement account which means, with very few exceptions, you can invest in virtually any type of investment you want.  Rather than be stuck with the investment options that Merrill Lynch or Charles Schwab offers, with a self directed 401K, you can invest in “what you know.”    Do you want to be a lender and get a fixed rate of interest through your 401K?  Or perhaps purchase a rental property if your interest is real estate?  Maybe a startup company in an industry you have an interest.  All of these options are possible with a self directed 401K.

3. No Third Party Custodian: By contrast to an IRA which requires a third party custodian, the 401K owner in a solo 401K can acts as his/her own trustee.  The other options to self-direct is through a self-directed IRA, however, in a self-directed IRA (without an IRA/LLC) all of your transactions needs to be processed through the third party IRA custodian.  Some clients have reported that they were unable to secure a deal due to the delays of having to go through the third party custodian.  On the other hand, with a solo 401K, you, as the trustee of the 401K, have the freedom enter into transactions or make investments on behalf of the 401K thereby eliminating the expense and delay of involving a third party custodian.  You’ll also have a checking account and “checkbook control” such that you can sign checks or send wires to make investments or to pay expenses. With freedom, of course, comes responsibility and so you must be intimately familiar with the rules and restrictions for self directing your 401K to avoid penalties and taxes with the IRS.

4. You can take a Personal Loan from your 401K: With an IRA, there are  very limited circumstances where you can use money from the retirement account for personal reasons and because of these restrictions, using IRA money for personal purposes is not a viable option.  With a 401K, you can take a loan of up to $50,000 or 50% of the value of the 401K, whichever is less, and use those funds for any purpose.   401K loans must be in writing using a compliant 401(k) participant loan note and, must provide for, at a minimum, quarterly repayments within five (5) years.  However, for individuals who need quick access to cash, the 401K loan is usually a much better options compared with those available for IRAs.

5. No UDFI Tax:   When you leverage your investment in an IRA with borrowed funds, any income that is received that is attributable to those leveraged funds is subject to Unrelated Debt Financed Income Tax (UDFI).   For example, if you buy a $100,000 rental property through your IRA, but 50% of the purchase price was from a non-recourse loan, 50% of any income from that investment will be subject to this UDFI tax.    By contrast, there is no UDFI tax for 401K investments arising from debt on real estate.   So any income you generate from that $100,000 property in your 401K would grow tax deferred even though you only really used $50,000 of retirement funds to generate the income.   That’s having your cake and eating it too!

In order to qualify for a solo 401K, you must have a small business that generates business income (sorry, rental properties alone generally do not qualify as a small business).   The 401K must be established before the end of this year in order to obtain the tax benefits for this year.   For those business owners who are looking for year-end tax strategies to lower your taxes, the solo 401K may be the perfect fit.

For more information on how the Solo 401K works, take a look at our 1 hour solo 401K webinar available here.

Essential Tax & Legal Tips for the NEW Business Owner

August 28, 2017 Business planning, Law, Tax Planning Comments Off on Essential Tax & Legal Tips for the NEW Business Owner

Starting a business is a process.  It is MUCH more than filing the one or two page articles/certificate of formation with the state.  At the same time, it doesn’t have to be so complicated and overwhelming that you never start.   Further, not only is starting a business a process, it’s a process that is unique to YOU.  It is not a cookie-cutter one size fits all proposition.  What your business and YOUR situation require may be completely different than anyone else you might know who is self-employed.  Having said that, here are 8 tips that apply to all businesses, but how to USE these tips will be different for each business owner:

  1. Operate out of and properly maintain the appropriate entity formation for YOUR situation. While it is true you can operate your business as a sole proprietorship, I think it’s generally better to operate your business out of an entity such as an LLC or corporation.  First, I think it has a positive impact on your mindset as a business owner in that it makes you feel more “legit”and others will see you the same. More importantly, it is always better to operate your business out of an entity such as an LLC or corporation as those companies prevent liability of the business from extending to the owners.  Lastly, operating out of an entity can in certain situations produce tax savings such as when operating out of an S-corporation to save self-employment taxes. This is generally recommended for operating businesses who have $30-$40k net annual income.
  2. Make sure you have a partnership/ownership agreement if there are other owners. If you have somebody that you trust to own and run your business WITH YOU, that’s a great thing, and hopefully you continue to have a great business relationship with that person(s).  But don’t let that be a reason to NOT get your relationship in writing through a written agreement that you both/all would sign to memorialize the rights and obligations of each other.  If the business fails or one of the owners wants out or isn’t “pulling their weight” and you didn’t address this in writing BEFORE the crisis/event has occurred, that friendly business partner could wind up AGAINST YOU.
  3. Embrace bookkeeping. Embrace the fact that bookkeeping is one of the keys to maximizing tax write-offs and commit to either obtain the right training to do it yourself OR see the value in outsourcing it to someone who knows what they’re doing.  Maybe your strength as an entrepreneur is the marketing/sales side of business, or you have the relationships to be successful, but when it comes to taxes, you must keep good records, and for all your strengths, if you’re not organized, you’re going to get killed in an IRS audit.  So either learn to be organized with your records in terms of tracking expenses and use a good bookkeeping software (Mark Kohler offers a great set of videos that train on how to use Quickbooks), or outsource it to someone else who is good at it so you can focus on what you do best. The clients who embrace bookkeeping usually have more write-offs and deductions come tax-time as they rarely miss an opportunity to expense something.
  4. Have periodic tax and legal consults with your attorney and CPA. Unfortunately, many small business owners don’t use a business attorney ever, and maybe only meet with their CPA once a year, assuming they even use a CPA.  I think the cost of meeting with a good business attorney and CPA at least twice a year is worth the cost.  Prevention is much less expensive than the cost of getting “sick”, whether “sick” is an unnecessary amount or risk exposure that leads to a lawsuit, or whether “sick” is failure to maximize tax write-offs and you’re paying more than necessary to Uncle Sam, OR, maybe without a good CPA you’re TOO aggressive on your taxes or even worse, you don’t file a return at all and the IRS comes knocking.  Not to mention meeting with your attorney and/or CPA is a tax write-off!  On the legal side, it is good to get periodic “checkups” on how your business is structured, what has changed, what’s coming up that is new in your business, etc., so that your business attorney can guide you on mitigating your risks and protecting against liabilities.  On the tax side, it’s good to also get periodic “checkups” to talk about tax strategies and which ones you aren’t maximizing or implementing, or which ones you’re doing wrong that is going to be a problem in an audit, i.e. health care, paying kids, auto, home office, dining, entertainment, travel, tax deductible contributions to retirement plans, owning real estate, etc.
  5. Be sure to have adequate insurance for your business. This legal tip is not new or cutting edge by any means, but the failure to follow it could be catastrophic to your business.  A good insurance broker can help a great deal to match up the appropriate amount of insurance (in terms of amount and policy types) for YOUR business.   You don’t want to spend TOO much of your business income on insurance premiums but if you don’t have any insurance, if/when a liability comes up in your business, and you don’t have an appropriate insurance policy to divert that financial responsibility for that claim/liability to an insurance company, it puts the full force of that claim or liability on potentially ALL of the assets and income of your business.
  6. Make sure to use contracts in your business and don’t rely on verbal conversations or handshake deals. You may have heard that under the law in most situations verbal contracts are enforceable.  That doesn’t mean you should RELY on them, especially with the core aspects of your business i.e. your clients, your vendors, your business partners, etc., you want to properly memorialize the agreement IN WRITING.  This will make it SO much easier to prove your case in court if the other party violates/breaches the written contract versus trying to prove they breached/violated a contract that is not in writing and signed by all parties.  You should have a good service contract or something applicable that is provided to your customers.  This not only helps with enforcing any liabilities or claims you have against them (non-payment for example), but it also is REALLY helpful to clarify the SCOPE of what your business WILL do for them and what your business will NOT do for them.  If you don’t clarify that in writing, you have no idea what your customer assumes or expects, so even it doesn’t result in a lawsuit, it can create a rift between your business and that client and result in bad press about your business on social media, etc.
  7. Make sure you are properly characterizing your workers (independent contractor v. employee). There is a temptation for the small business owner to view/consider ALL of their workers as independent contractors.  The small business owner loves to do that because there’s no payroll tax, no added costs for worker’s compensation, unemployment, employee benefits, etc.  Unfortunately, the federal and state taxing authorities do not take YOUR word alone that your workers are actually independent contractors.  IF you improperly classify workers as independent contractors and the government (state or federal) determines they are employees, you will have fines and penalties.  Don’t misunderstand, you can have workers that ARE independent contractors, so long as they are TREATED as independent contractors, and the key word there is “independent”.  If you’re going to micro-manage what they wear, when they work, how they work, where they work, etc., that doesn’t sound very “independent” and it sounds at lot like an employee, which it is sometimes necessary to have that much control of your workers, but you can’t have it both ways, if you treat them like employees, you have to accept that it comes with things like payroll taxes, unemployment, worker’s comp, etc.
  8. Have an exit strategy (including an estate plan). Understandably your primary concern is getting the business STARTED, so you might think it would be unproductive to think about an exit strategy so early in the “game”, but it is so important to have that in your mind.  Do you want to grow the business and sell it soon as possible or hold onto it and pass it loved ones, or maybe you want to buy out your partner’s ownership (or vice versa).  There are many unknowns that make it difficult to have any certainty about what WILL happen, but it’s very productive to consider the ways in which it COULD happen and form an opinion on what seems most appealing to you.  But REGARDLESS of what your exit strategy is, you should make sure your business ownership and estate plan is coordinated.  Even if you plan to sell the business as soon as possible, and you have no plans of owning the business for the long-term, the spontaneity of death requires that even in that situation, your business ownership be coordinated with your estate plan.  Don’t forget about incapacity either.  This could mean you have power of attorney documents in your estate plan that contemplates ownership/operation of your business if you become incapacitated.

In sum, your business needs you as the business owner to make sure your business is healthy from both a tax and legal perspective.  These tips are a great starting point to make sure that happens.  Our office is available to assist and would love to help you and your business with implementing these and other tips specifically to you and your business.

Owner’s Liability After Your LLC is Closed or Dissolved?

April 25, 2017 Asset Protection, Business planning Comments Off on Owner’s Liability After Your LLC is Closed or Dissolved?

Many business owners wonder whether their LLC will protect them from claims and liabilities after their LLC is closed. Does the limited liability protection of the LLC still apply? Does it only apply for claims when the LLC was active? What about after the LLC is closed or dissolved? What if the claim is about something that arose when the LLC was in good standing but was something you never knew and filed after the LLC is dissolved?

Here are a five tips that answer these questions and that will help you decide when to dissolve your LLC.

First, when you close an LLC, a process known as dissolution, you must pay known/present LLC creditors before distributing assets and profits to the owners of the LLC.  If you fail to pay known creditors of the LLC and if you instead distribute assets of the LLC to the owners, then the owners can be sued by those creditors to collect on the assets distributed from the company.  Part of the process of properly dissolving an entity includes sending notice to known creditors.  In other words, if the LLC has current debts/liabilities and/or known creditors, you can’t simply “shut down the doors”, take all of the assets personally, and refuse to pay the creditors.   If the LLC is insolvent (i.e. the debts exceed the assets) and if there are no assets distributed to the LLC owners, then their is no personal assets which a creditor can pursue against the LLC owners.

Second, dissolve the LLC once business operations have ceased and once known creditors have been paid or otherwise resolved. If you have known creditors in your business, you cannot close down an LLC for the sole purpose of evading those creditors and then re-open your business with another LLC if it’s essentially the same business. As a precautionary measure, if you are aware of a liability issue but you are unsure whether it is a legitimate claim, you should wait until the statute of limitations for that potential claim has passed until you dissolve the LLC.

Third, follow the LLC operating agreement and/or state statutes regarding the voting rights required for dissolution and for the order of events to dissolve an LLC. A common order of events is as follows; pay-off all known creditors, return contributed capital to the members, distribute profits/assets to the members.  Many states have a notice requirement to creditors of the LLC which can actually be helpful in some cases to shorten the time limit they may have to file a claim. If you have known creditors you will want to send them notice of the dissolution to shorten the period upon which they have to file a claim for the assets of the LLC.

Fourth, if you dissolve the LLC when no known/present LLC creditors exist, the owners of the LLC are still afforded the protection from creditors for any claims that arose when the LLC was in good standing.  For example, if you dissolved your company in 2015 and were later sued in 2017 for an act that occurred in 2014, then so long as the company was unaware of the incident giving rise to the claim then the members of the LLC would be personally protected from the liabilities of the business.

Fifth, if you are aware of a potential liability (no judgement or lawsuit exists) and dissolve the LLC, the members may be personally liable up to the amount distributed from the LLC upon dissolution. This situation was the 2014 case of CB Richard Ellis v. Terra NostraIn this case, an LLC failed to pay a commission to their broker pursuant to a listing agreement and then dissolved their LLC. The real estate broker eventually obtained a judgement against the dissolved LLC and was able to pursue the members of the LLC for the liability of the LLC up to the amounts distributed to the LLC owners.

In Sum, if the purpose of the LLC has legitimately come to an end, and there aren’t any known/present creditors, then depending on the laws in your state and your situation, you may decide either to (a) keep the LLC open until, for example, the statute of limitations runs out, or (b) shut down the LLC so long as it was in existence and in good standing during the time in which the business had operations. If you dissolve the LLC when there are known/present creditors, the members of the LLC will generally be liable for amounts distributed from the LLC to the owners.

Note:  This article, like all of our articles, is to provide some general guidelines – always get specific advice for your situation.

“Piercing the Veil” – Are you Appropriately Maintaining your LLC or Corporation?

January 17, 2017 Asset Protection, Business planning Comments Off on “Piercing the Veil” – Are you Appropriately Maintaining your LLC or Corporation?

Our law firm takes the position that an entity (such as an LLC or corporation, etc.), if properly maintained and used, can serve an important function in terms of liability protection, in addition to other forms of risk management such as insurance. This may be a business owner looking to put some distance between him and his business operations, or it may be an entity which forms subsidiaries or has sister companies setup for legitimate operational reasons.

However, there are limits to how much liability protection an entity can serve to provide. Even though the presumption is that a legal entity such as an LLC or corporation is separate from the owners and management, i.e., “veil piercing” is rare, don’t shoot yourself in the foot by doing things, such as commingling business and personal funds, or failing to do things such as entity maintenance or appropriately title assets that would rebut this presumption.

With that in mind, here is a brief snapshot of a few recent court cases throughout the country that have discussed “piercing the veil” and some of the factors that were considered:

In a case called Knopf v. Phillips (S.D.N.Y., 2016), which was decided last month (December 2016), the number one factor as to whether or not the “veil” of corporate/entity protection should be “pierced” was the disregard of corporate formalities. The court ruled that the plaintiff’s adequately pleaded a claim for veil piercing/alter ego because the defendant had “abused the corporate form” to defraud the plaintiffs. Another factor which is often analyzed in these cases, including this one, is the fact that the defendant has “undercapitalized” his business as evidenced by the inability to pay debts, in conjunction with the fact that the defendant had diverted thousands of dollars from one entity to another entity despite the inability to pay its debts. The takeaway from this case is that if you’re going to setup an entity, take the time to treat it as a separate entity and be sure you have enough funds inside the business to service debts of the business.

A few months earlier (October 2016), 5th Circuit Federal Court of Appeals, a case called Janvey applied some of the same analysis as in Knopf yet because of the facts, reached a different conclusion. In Janvey, it involved a parent company and a subsidiary and whether the parent company should be liable for the actions of the subsidiary. Here, the outcome was in favor of the parent company that the “veil” should not be pierced between the subsidiary and the parent company, and one of the factors the court looked at was how assets of the subsidiary were titled and how the subsidiary was operated. Had there been a disregard and failure to appropriately hold title of the subsidiaries assets in the name of the subsidiary rather than the parent company, or had the overall operations of the subsidiary collapsed into the parent company where it would have been indistinguishable to differentiate between the subsidiary’s business operations and the parent company’s operations, the court might have more seriously considered allowing the veil to be pierced. This is one reason why in the real estate context it is important to ensure that if a parent company with subsidiary’s is going to be utilized, that assets are appropriately held and maintained by the subsidiaries rather than everything in the name of the parent company.

A case in Ohio in November 2016 called Premier Therapy v. Childs, provides further instruction. Some of the factors the court looked at were “lack of corporate records” and “disregard of corporate roles”, as well as the entity’s inability to pay its debts to due siphoning of funds for personal use. In this case, the business had been unable to pay its debts and was essentially insolvent at the time the plaintiff was injured by the acts of the business, so the court (appellate court) decided there was more than enough facts to allow a jury trial to make a determination whether to pierce the LLC/corporate veil. This case highlights the importance to keep corporate records such as annual minutes.

Lastly, a case out of California last year (2016) called Boeing v. Energia highlights the importance of properly maintaining entities with the state, holding annual meetings, and keeping corporate records. The defendant was a parent company which had setup multiple subsidiaries to hold various assets such as licenses, etc., and some of the main reasons the court disregarded the corporate veil was because the subsidiaries were not properly maintained (Delaware) in terms of annual filings and payment of franchise taxes, and also because there was a dearth of corporate meetings and records held and maintained by the subsidiary. In applying Delaware law, despite a court’s reluctance to pierce the veil, it may do so when a “parent and subsidiary operate as a single economic entity” and there is an “overall element of injustice or unfairness that is present”.

Although a typical requirement for the veil of your entity to be pierced by a plaintiff or injured party is that the entity was used to perpetuate fraud, illegal acts, or unlawful behavior, and certainly we hope you aren’t committing such acts, you nevertheless don’t want to open up yourself to a “pierce the veil” claim for failure to appropriately maintain your entity.

For more on this general issue in the LLC context, which would receive the about the same analysis for “veil piercing” as a corporation, please read http://kkoslawyers.com/llcs-and-limited-liability-protection-a-primer-for-the-small-business-owner/ . For a brief list of our suggestions for best practices in operating your entity, please read http://markjkohler.com/piercing-the-corporate-veil-what-you-need-to-know-that-t/ . Our office not only sets up entities for clients, but just as important, we offer services such as our company maintenance program, “corporate cleanup”, registered agent services, and mail forwarding services, all of which can to varying degrees provide support to a small business owner in terms of entity maintenance.  In fact, the New Year is a good time to consider setting up annual company maintenance with our office through our discounted rates that are being offered right now.

Hulk Hogan & Asset Protection Lessons from Bollea v. Clem

December 6, 2016 Asset Protection, Business planning Comments Off on Hulk Hogan & Asset Protection Lessons from Bollea v. Clem

In one of the more highly publicized cases of this year, in March 2016, a Florida jury in the case  Bollea v. Clem  awarded Hulk Hogan $115 Million in compensatory damages and $25M in punitive damages against the owners and operators of the Gawker website.  Gawker was a website founded by Nicholas Denton devoted to media news and gossip.   In the lawsuit, Gawker was accused of violating Hulk Hogan’s privacy by posting private videos of Hogan engaged in sex acts.

Several months after this jury award, both the LLC and corporation which allegedly ran the Gawker website, along with Nicholas Denton filed for bankruptcy.  The Gawker website which reportedly had over 23 million visitors per month in 2015 was permanently shut down in August 2016.   A review of the case along with Gawker’s structure as revealed in the bankruptcy documents illustrates some important asset protection principles to remember.

  1. Keep your Asset and Businesses Separate. In general, our approach to asset protection involves separating your assets from your business so that if your business gets hit with a big lawsuit, your assets are less likely to be at risk because they are held in entities separate from the business.   In this case, the Gawker website was operated by Gawker Media LLC.  Bankruptcy documents show that Gawker Media LLC was in turned owned 100% by Gawker Media Group, Inc.  Nicholas Denton owned approximately 30% of the shares of Gawker Media Group, Inc.   Certainly there could be other practical benefits from this hierarchical parent/subsidiary structure, but one of the risks of having everything owned in this linear structure is the possibility that a significant liability could cause the entire house of cards to fall.     Moreover, bankruptcy documents further show that the operator of the website, Gawker Media, LLC also owned substantial interests in real estate and intellectual property, all of which would be exposed to a significant liability from the website activities.   If you are running a website that posts negative information about rich and famous, does it make sense to also own valuable real estate and other assets in the same entity?  In the case of Gawker Media, LLC,  it also owned other websites and branding which were eventually sold to Univision through the bankruptcy process, but whenever you own significant assets, you should consider whether to segregate these assets into different entities to spread out the risk so that a liability coming from one direction does not infect the entire pool.
  1. Entities are not a License to Engage in Misconduct. One of the main reasons for using an entity like a corporation or LLC is to take advantage of the “corporate veil” which generally protects the owners from being personally responsible for debts incurred by the entity.  However, the corporate veil is not absolute.   In the Gawker case, despite the existence of a multi-entity structure, the jury specifically found that Nicholas Denton personally participated in the posting of the explicit videos that resulted in the lawsuit, in addition to allegations that he personally edited the video that ultimately appeared on the site, which contributed to a finding of personal liability.   Courts will generally disregard or “pierce the corporate veil” if the owners are using the entity to perpetrate fraud or engage in other wrongdoing, and so don’t think that the corporate veil will be there to protect you if you are committing fraud or other intentional misconduct.
  1. There is no 100% Guaranteed Asset Protection Strategy, but the Goal Should be a Multiple Barrier Approach.  As further discussed in Mark Kohler’s book “Lawyers are Liars,” there is no 100% guaranteed approach to asset protection.  Instead, the goals should be to implement as many barriers as you are willing to utilize depending on the cost, complexity and degree of protection afforded by the strategy.  Whether it is having the right insurance, ensuring your contracts are sound, stripping your assets of equity available to creditors, or multiple LLCs, the goal is to implement as many strategies as you can to make it as hard as possible for a creditor who would pursue you.

The Gawker case is a good illustration of the possibility that any asset protection strategy could be toppled if you have a motivated, resourceful litigant.   It was no secret that Hulk Hogan’s lawsuit is and was assisted by financing from billionaire venture capitalist Peter Thiel, who was also a previous target of Gawker’s posts, and was therefore motivated to financially assist Hulk Hogan and other litigants suing Gawker.  Denton has reportedly admitted that Thiel’s campaign against Gawker Media made the Gawker.com website too risky for Univision to purchase, and as a result, the website that had previously drawn the ire of Peter Thiel had to be shut down.

The outcome of litigation is often impacted by the financial resources of the parties, and having a well-designed multiple barrier asset protection strategy could make other adversaries (Peter Thiel excepted) think twice about how far they are willing to go.

The Gawker case, currently on appeal and in bankruptcy, is still pending and given the unpredictability of litigation, the ultimate outcome has yet to be decided.   Nevertheless, Denton has reportedly admitted that, even if the judgment is reversed on appeal, “Peter Thiel has already achieved many of his objectives.”     Therefore, the case is just another reminder that, regardless of whether you are an entrepreneur/executive worth hundreds of millions of dollars, or simply have a 401K and a rental, we all need to be cognizant of the potential legal consequences of our actions, and have a concrete strategy for protecting the fruits of our labor if and when an unexpected liability arises.

Thinking About Starting a Business? Consider These Ten Tax Tips

November 21, 2016 Business planning, Corporations, Tax Planning Comments Off on Thinking About Starting a Business? Consider These Ten Tax Tips

As the end of the year is fast approaching and 2017 will be here soon, if you’ve been thinking about starting a new business, keep in mind that once you are self-employed, a huge portion of the tax code opens up and becomes available to you for tax write-offs.  Of course there are a lot of risks and rewards of starting your own business, but one of those rewards is the availability to take tax write-offs that you wouldn’t otherwise be able to take including dining, travel expenses, and entertainment.  Here are a few tax tips to give you an “eye in the sky” perspective of the tax landscape as you consider if and/or when you will start that new business:

  1. Keep Your Day Job (If You Want To). You can keep your day job / “9 to 5” career while you build your business on the side AND still take all of the tax write-offs that are available to someone who is building their business full-time.  For example, if you leave your day job for the day and meet a potential client of your part-time/side business for dinner that night, you can write-off 50% of that meal JUST LIKE the business owner sitting next to you who runs his business FULL-TIME and is likewise meeting with a potential client for dinner. It’s probably wise in terms of your budget to keep your day job while you start your business but I’m simply pointing out that you have full access to the tax code for business write-offs the same as the guy who is running his business full-time.
  1. Take a Tax Write-off for Business Start-up Costs. The IRS allows up to $5,000 of qualified “start-up expenses” as a tax deduction in the year the costs were incurred.  If you have more than $5,000 of qualifying start-up expenses then the rest is amortized / spread out over a fifteen year period.  For example, if you spend $7,000 of qualified start-up expenses in the year your business began then you can claim a write-off in that first year in the amount of $5,000 and the remaining $2,000 is spread out over 15 years.  If your business closes down prior to that, you can claim the rest as a deduction at that time. HOWEVER, you need to make a sale or receive income in your business in order to write off these start-up costs.  For example, if you had $8,000 of qualified start-up expenses in 2016 but you have no income from your business for 2016, you can’t write-off $5,000 of that for tax year 2016 – You need to have income for your business in 2016 in order to claim that $5,000 deduction for that year. ADDITIONALLY, not every expense qualifies as a “start-up expense”; however,  many expenses DO qualify such as consulting fees and fees for similar professional services, costs to organize your business, cost of travel to meet with potential customers, suppliers, distributers, etc., advertising costs to announce your business opening, and costs to analyze the market/industry in which your business will compete.  IRS Publication 535.  As a practical matter, once your business has received income, expenses after that are no longer “start-up” expenses and are analyzed under Tip #3 below. There are some other rules and caveats regarding start-up expenses but in sum, this is a powerful incentive to get your business started now!
  1. Understand Which Expenses are Tax-Deductible. With some exception, as a general rule, any business expense that is ORDINARY and NECESSARY is tax deductible, i.e., it’s a tax write-off.  The IRS has stated that the word “ordinary” means common and accepted in the industry of your business and the word “necessary” means helpful and appropriate to your business.  For example, if your business sells products online and it is common and accepted in your industry to pay advertising fees and such fees are helpful and appropriate to your business, you can write-off those fees as a tax deduction.  There are many deductions which need to be analyzed further particularly those in which the IRS has set forth specific rules and guidelines such as the home office deduction and the auto deduction but this gives you the general idea of what expenses are typically going to be tax-deductible and which are not.
  1. Keep Good Records. Good record-keeping is the key to claiming tax deductions.  You need to have records that substantiate the tax deductions that you claim on your tax return.  This includes receipts and bank statements as well as good book-keeping using a chart of accounts to track each item of income and expense.  A chart of accounts is also helpful for tracking your business assets and liabilities, which can then generate balance sheets, profit and loss statements, and other financial statements that may help with qualifying for loans, etc.  Quick Books or similar software can help with this.  If organization and record-keeping is not a strength of yours but you are otherwise very entrepreneurial and have many other skill sets to run your business, you may find it helpful to outsource some of these tasks.
  1. Most Tax Deductions are Entity-Agnostic. Almost all of the tax deductions that we discuss for the typical small business owner are available to claim as a tax write-off REGARDLESS of whether your business is a sole proprietorship, LLC, s-corporation, partnership, etc.  For example, with some exception, you can take advantage of many, if not, all of that low hanging fruit such as dining, travel expenses, entertainment, retirement plan contributions, paying kids in your business, health care expenses, home office, etc. and you can be a sole proprietor, an LLC, an s-corporation, etc., it generally does not matter!
  1. Don’t Let the Tax Tail Wag the Dog (Your Business). Be smart about what you purchase in your business.  Simply because an expense is tax-deductible doesn’t mean you should buy it.  Don’t let the tax tail wag the dog, i.e., make the decision to buy business related expenses based on the needs and circumstances of your business.  For example, even if you can deduct that very expensive laptop that might not be the best use of your business capital whereas it could be spent somewhere else in your business much more efficiently and a moderately priced laptop could be sufficient for your business needs.
  1. Some Business Expenses Must be Spread Over Multiple Years. When you purchase an asset in your business you generally cannot claim a deduction for the full cost of the asset in the year of purchase – rather, the cost generally determines the basis meaning when you sell the asset you only pay income tax on the sales price minus the basis.  Further, the cost is generally spread out over multiple years and allows you to claim a portion of the cost each year as a tax deduction, i.e., depreciation. For example, if you purchase office furniture for $8,000 – the cost is generally spread out over seven years (IRS Form 4562).  However, IRS Code Section 179 would allow you to make an election to write-off the full cost in the year of purchase.  Section 179 is a powerful tool for the small business owner!
  1. Consider an accountant/CPA. Once you begin working for yourself, even if only part-time, it pays off to hire an accountant/CPA to do your taxes.  It also pays off to get some training on bookkeeping using software like Quick Books or at least until you’re knowledgeable it may be wise to outsource that task to a competent bookkeeper.  Also, you probably primarily think of federal income tax – don’t forget state income tax, as well as self-employment tax, payroll tax, as well as potentially excise tax, franchise taxes, etc.  All the more reason to consider an accountant/CPA.
  1. There isn’t a legitimate “Pay No Tax Quick” Scheme.  Just like Get-Rich Quick Schemes are usually too good to be true, similarly, the “tax game” is one in which the winner is the one who is steady, aggressive (not too aggressive – remember pigs get fat but hogs get slaughtered), and utilizes sound strategies over the course of many years.
  1. Understand the Type of Income Generally Determines How It is Taxed. Income you make in your business (after subtracting all those tax deductions) is generally included with your other income such as W-2 income to determine what personal income tax bracket you’re in.  But not all income is taxed in the same manner.  For example, income you make in your business is generally subject to self-employment tax whereas other type of income, such as rental income, dividends, and capital gain income is not.  The more you understand how various types of income is taxed then you can learn to be strategic with how you spend your time pursuing some types of income over others.  This where your business can ultimately build wealth for you and your loved ones for many years.

There are many other tips I could give a potential new business owner including the hobby loss rule as well as specific rules regarding home office deductions, auto deductions, Rule 179 deductions, health care deductions, and self-employment tax savings, etc., but these Tips hopefully give a baseline starting point to consider.  Note: many specific tips on various tax deductions can be found at www.markjkohler.com and www.kkoslawyers.com.  If you need assistance with business and tax planning, please call our office at 602-761-9798.

Putting the Pieces Together: Tax, Asset Protection, Small Business Law, Real Estate, Raising Capital, Self-directed IRA Law, and Estate Planning

September 20, 2016 Business planning, Real Estate Comments Off on Putting the Pieces Together: Tax, Asset Protection, Small Business Law, Real Estate, Raising Capital, Self-directed IRA Law, and Estate Planning

As an Attorney at KKOS Lawyers, I work under Mark Kohler and Mat Sorensen, the managing partners of the Firm.  Mark is also a CPA and advises clients in the areas of small business tax planning, asset protection, etc.  He has written books on these subjects (Lawyers are Liars – a great book on asset protection, What Your CPA Isn’t Telling You – excellent for small business tax strategies), and The Tax and Legal Playbook – maybe the best one, an excellent summary of many applicable aspects of tax and legal planning).  He speaks across the country on those subjects and is truly an expert.  Likewise, Mat wrote The Self-Directed IRA Handbook – the seminal book in the self-directed IRA industry.  He speaks across the country and is the expert of experts in that industry.  They both practice in these areas and have helped literally thousands of small business owners and investors in these areas of the law for many years.  They both even host a radio show and put out a weekly newsletter on these same topics.

Working under Mat and Mark, I accordingly advise clients in the areas of tax, small business, asset protection, estate planning, real estate, raising capital and self-directed IRA’s/401(k)’s.  Clients are interested to find out how that works.  Actually, these areas of the law complement each other very well and are intertwined in many ways.   Like most things in life, the law as applied to your situation is not always perfectly compartmentalized into one specific practice area and requires a bit of a holistic approach.  It is not uncommon for a client to approach us for one particular issue and begin to appreciate the more holistic approach.  Here are a few examples, in no particular order:

  1. The Small Business Owner Client. KKOS Lawyers is known as the Entrepreneur’s law firm.  Many small business owners have come to KKOS Lawyers for initial help with entity structuring (s-corp, c-corp, LLC, etc.) in terms of both asset protection and tax liability.  Like any small business owner, they are always looking for legitimate tax deductions (hiring the kids, health care, travel, auto, dining, retirement plan deductions, etc.) and legitimate ways to save on self-employment taxes.  It would be typical that they have one or more business partners, in which case we would help them draft partnership agreements, buy-sell agreements, etc.  On the topic of contracts, we would then help them use contracts appropriately in their business including licensing agreements, vendor contracts, franchise agreements, employment contracts, waivers, etc.  At any point in time, they may acquire another company or be acquired in which we may help structure the deal in the best manner possible in terms of tax and legal liability.   They also may need to raise capital for their business in which case we would advise on the pros and cons of raising capital through financing, additional partners, or investors, possibly through a “Reg D” offering or even crowd funding.  In terms of real estate, for any of our brick and mortar clients, we have helped many of them draft/negotiate their commercial lease.   We have many small business owner clients in the real estate industry generally, including brokers, lenders, property managers, and syndicators. Regardless of their industry, hopefully they have a SEP IRA or 401k for the tax benefits and depending on their industry of expertise, they may decide to make alternative investments into real estate (see #2 and #3 below).  Finally, these clients spend many years building a business and want to make sure they have a sound exit strategy, which might be to sell the business to a third party, to a business partner, or pass the business on to the kids.  This leads to making sure they have an estate plan that encompasses business succession (see #5 and #6 below).   So you can see that with just one client, KKOS Lawyers can help them in terms of tax, asset protection, contracts, raising capital, real estate, self-directed IRA’s/401k’s and estate planning.
  1. The Self-directed IRA/401k Owner Client. Many clients come to KKOS Lawyers primarily for guidance in the area of self-directed IRA law for their alternative investment into real estate, privately held companies, precious metals, etc.  Without proper guidance, this type of investing is fraught with peril including prohibited transactions and UBIT (unrelated business income tax).   They may also ask for assistance with setting up an IRA LLC for their self-directed retirement account investments.  The typical self-directed retirement account investment consists of real estate in some form or fashion.  This leads to a review or draft of a real estate contract whether it is a purchase contract, a lease, or loan documents.  It is also common for our clients to invest their retirement account into a fund/syndication in which case they will ask us to review the private placement memorandum and other “Reg D” documents involved in that investment.  Frequently, the topic of asset protection comes up in terms of these types of retirement accounts (see #5 below).  Additionally, these accounts require a beneficiary designation and we will advise clients on the beneficiary status as it relates to their estate plan in terms of required minimum distributions (RMD’s) and inherited IRA’s and IRA Trusts for example (see #6 below).  Not to mention that many of these self-directed IRA investors are also small business owners (see #1) and may in fact be investing through a self-directed solo 401k, which can be setup by KKOS Lawyers.
  1. The Real Estate Investor Client. We have many clients who are real estate investors.  As such, they invest in long-term holds, short-term flips, and everything in between.  This typically entails a conversation about asset protection and LLC’s as well as tax matters including the pros and cons of being designated a real estate professional for tax purposes.  It also entails various contracts that we will either prepare or review including contractor agreements, joint venture agreements, purchase contracts, wholesale contracts/assignments, promissory notes, security instruments, warranty deeds, and commercial and residential leases.  The manner in which our clients acquire real estate is also very diverse and includes subject to deals and seller financing.  Not to mention that a number of our clients are investing in real estate in a tax deferred way either through a 1031 exchange or through a self-directed retirement account.  It is also typical that our real estate investor clients invest in a fund/syndication and that requires reviewing the private placement memorandum and “Reg D” documents.  Lastly, we discuss making sure all of these real estate assets don’t get stuck in probate court upon their death and might recommend a combination of both a revocable living trust and LLC’s as appropriate to help with that (see #6 below).  As previously mentioned in #1, many of our clients are brokers, property managers, lenders, etc., or have some business they own in real estate and are also investing in real estate in some capacity on the side.
  1. The Real Estate “Dealmaker” Client. We have a number of clients who are fund managers, i.e., syndicators.  The primary issue with these clients is to advise them when securities law is implicated and the various legitimate ways to structure deals without implicating securities law.  In the former situation, we have helped these clients properly form a fund/syndication in order to comply with securities law including private placement memorandum and “Reg D” documents.  This includes knowing the requirements of when advertising is allowed and when only accredited investors are allowed, including self-directed IRA investors.  These fund managers, like any other business owner have business partnership issues and may need protection including non-competes and buy-sell agreements as well as the need for proper entity structuring in terms of both asset protection and saving taxes (per #1 above).  Lastly, like all of our clients, they want to ensure their hard work doesn’t get inadvertently dragged through probate court upon their death, hence proper estate planning including business succession and dealing with estate tax issues (#6 below).
  1. The Asset Protection Client. The client whose most pressing need is asset protection is typically a high net worth individual.  One of the first items we’ll discuss is the differences and similarities between asset protection and privacy, and also the difference between legitimate asset protection and fraudulent transfers/conveyances to avoid creditors.  We’ll discuss their assets and the appropriate level of protection in terms of insurance, trusts, and charging order protection entities.  Asset protection and estate planning often go hand-in-hand because what often times is effective protection from creditors is also effective to minimize estate taxes.  Many of these clients own significant real estate (#3 above) and/or are business owners who also need tax planning and business structuring per #1 above and/or have a self-directed IRA (per #2 above).
  1. The Estate Planning Client. We have setup thousands of estate plans for business owners, real estate investors, and other individuals and families.  Of course the primary objective of estate planning is to pass assets to loved ones efficiently and minimizing tax (legitimately), including estate tax, gift tax, and generation skipping transfer tax.  It seems as though almost every estate planning client owns real estate in some form or fashion (per #3 above) and also a retirement account (see #2).  Many of our estate planning clients are also small business owners (see #1).

In sum, these areas of the law are interwoven in a real way as illustrated above by a few “types” of clients.  If you are a small business owner, real estate investor, or otherwise need assistance in the areas of self-directed IRA law, asset protection, tax, small business law, raising capital, real estate, or estate planning, please contact our office.

LLC’s and Limited Liability Protection: A Primer for the Small Business Owner

August 16, 2016 Asset Protection, Business planning, Real Estate Comments Off on LLC’s and Limited Liability Protection: A Primer for the Small Business Owner

KKOS Lawyers is the Entrepreneur’s Law Firm.  By definition, an entrepreneur is someone who assumes the financial risks of a new enterprise and who undertakes to provide its management. The LLC or an s-corporation are typically the preferred business entities of choice for the entrepreneur / small business owner.  This article focuses on the LLC. An LLC typically consists of Owner/Member(s) and a Manager(s), although an LLC could be setup as Member-Managed.  One reason for its popularity is that the LLC provides limited liability for the Member(s) and Manager(s).    Hence, the purpose of this article is to help the small business owner recognize the benefits and the limitations of the limited liability that an LLC provides to the owner(s) and manager(s).  First, the Owner/Member:

LLC Owner/Member Liability

  1. Cash Investment (Capital Contribution). An Owner/Member of an LLC is always at risk to lose their cash investment in the business.  An LLC cannot prevent that.  If the business fails, the Owner(s)/Member(s) lose(s) their cash.  But that is typically the extent of their exposure.
  2. Liability to the Other Owners/Members. Typically, except for criminal acts or gross negligence, an Owner/Member is not personally liable to the other Owner(s)/Member(s) of the LLC.
  3. Liability to Third Parties under Contract Law. Generally, a contract signed by the LLC on behalf of the LLC Manager(s) does not expose an Owner/Member to personal liability.  However, this is only true if the contract does not require a personal guaranty, e.g., in the context of a business loan or other financing.  In such an event, the Owner/Member who personally guarantees the loan will be personally liable for the debt obligation.
  4. Liability to Third Parties under Tort law. An Owner/Member of an LLC is not liable for a tort committed by the Company or under the direction of the LLC Manager, or for a tort committed by the LLC Manager acting outside the scope of the Manager’s authority.  However, an LLC is not a license for an Owner/Member to act criminally or even negligently, especially if the LLC is such that the Owner/Member is also the LLC Manager and/or has direct dealings with third parties on behalf of the LLC, such as if the LLC is Member-Managed.  In such a situation, if the Owner/Member has in fact taken action that results in a tort against a third party, there can be personal liability.
  5. Liability to Third Parties as a Professional. If the Owner(s)/Member(s) of an LLC is/are licensed professionals, such as doctors, lawyers, accountants, etc., an LLC will not protect from malpractice and related negligence.  This is a good example of how insurance is always important regardless of the form of business.

The manager(s) of an LLC is also protected from liability in certain respects, similar to the CEO or Chairman of a corporation.  The policy behind this protection is so a company can recruit the best and brightest individuals to manage and run the day-to-day operations of the company without being exposed to personal liability:

LLC Manager Liability

  1. Liability to the Owners/Members under Fiduciary Law. Typically, the LLC Manager has a fiduciary duty to the Company and therefore serves the interest of the Owners/Members as a whole.  If the LLC Manager breaches that fiduciary duty, there can be liability.  In short, a fiduciary duty means a duty of care and a duty of loyalty.  In the case of duty of loyalty, that means a duty to subordinate self-interest to the interest of the LLC, such that any conflict of interest must be disclosed, although a conflict of interest that has been disclosed can typically be waived in the LLC Operating Agreement.
  2. Liability to Third Parties under Contract Law. A Manager who signs a contract in its role as Manager on behalf of the LLC has no personal liability to the other party(ies) to the contract.  But as mentioned previously, this is only true if the LLC Manager does not personally guarantee the contract, whether the contract is a loan, lease, etc., and only if the LLC Manager is authorized to enter into such a contract on behalf of the LLC.
  3. Liability to Third Parties under Tort Law. Typically, a Manager is indemnified by the LLC for actions the Manager takes that are within the scope of her role as Manager.  This is one of the benefits of having an LLC because it allows a Manager to run the business without fear of personal liability.  But, a Manager may be held personally liable for criminal action and intentional actions that are outside the scope of its authority.

As you can see, LLC liability is not as simple as it is sometimes described.  Also, this article is focused on personal liability of LLC Owners and Managers.  The liability of the Company is another matter, such as when the actions of an employee of the Company result in liability for the Company under the legal principle of Respondeat Superior, which is Latin for, “don’t hire dummies” (it’s actually Latin for, “let the master respond.”)  But fortunately, with an LLC or other business entity type that limits the liability of the owners, only the Company and not the Owner is liable for the negligent actions of the employees.

However, beware that in rare situations, an LLC will be disregarded by a judge in a lawsuit involving the business.  If that happens, all of the benefits of the LLC discussed herein are also disregarded.  This might happen if the LLC is being used to perpetuate a fraud, circumvent the law, or some other illegitimate purpose.  This also might happen if the LLC is setup to be insolvent, i.e., not adequately capitalized, or personal and business interests are commingled to the extent that the LLC has no separate identity.

Also, please note that some of what has been discussed herein can be modified in the LLC Operating Agreement, except where prohibited by law.  Additionally, LLC’s are typically governed under state law, which are not uniform across the Country.

In sum, the LLC provides liability protection but it is not the end-all, be-all and should be used in concert with insurance in all its forms, e.g., liability, errors & omissions, etc.  Our office regularly assists small business owners and real estate investors with all of the questions that should be asked when considering an LLC.  If you are not sure whether an LLC is an appropriate legal structure for your situation, please contact our office to schedule an appointment.

Airbnb Lawsuits, Short-Term Rentals, and Real Estate Investors

July 25, 2016 Real Estate Comments Off on Airbnb Lawsuits, Short-Term Rentals, and Real Estate Investors

You may have heard about the lawsuits involving Airbnb in San Francisco and New York City.  Although such lawsuits involve, in part, the question of whether Airbnb can list on their website those properties that have not been duly registered with the local municipality, these cases highlight the importance of knowing the local rules that govern short-term rentals, as discussed below.

The issues surrounding short-term rentals are becoming more prevalent as many clients are constantly looking to add a vacation rental to their existing portfolio of real estate investments, or to convert a “long-term” rental to a vacation rental.  The prospect of owning a property that provides income and a place to get away every now and again is pretty great, but if you are thinking about acquiring a vacation property / short-term rental, here are a few tips to keep in mind:

  1. Comply with the local rules and ordinances of the municipality where your rental is located. I won’t bore you with details of the Airbnb case v. San Francisco, but in short, there is a local law that provides that you cannot operate a short-term/vacation rental unless you are a resident of San Francisco and unless you register the property with the city.  So before you convert a traditional rental to a vacation rental, or add a vacation rental to your real estate portfolio, check with the local laws to find out if there are any restrictions and to what extent registration of the property is required.
  1. Obtain a business license where appropriate. If you are operating a vacation rental, this can, depending on your circumstances, be comparable to a hotel as opposed to a tenant with a long-term tenant.  If your vacation property is like a hotel in which services are provided to the guests, then it is an operating business, and would likely require a business license.  Contrast that scenario with rental properties with long-term tenants, particularly residential.  Although it depends on the jurisdiction, typically a business license is not required for a residential rental property with a long-term tenant, however, it is becoming more common for municipalities to enact ordinances that specifically provide that collecting rental income via residential real estate rises to the level of activity that requires a business license.
  1. Understand the tax implications of operating a short-term rental / vacation property as opposed to a “traditional” or long-term rental. Rental income is typically not subject to self-employment tax.  However, rental income that is received in connection with services performed could subject such income to self-employment tax.  It is much more likely that services would be performed in a short-term rental / vacation property scenario than a rental situation with a long-term tenant.  One example would be a cleaning service while the property is occupied, bed and breakfast, or any other services that are “hotel-like”.  If you’re planning to provide those types of services to the guests of your vacation rental, be prepared as you’re likely going to be subject to self-employment tax.
  1. Consider setting up a business entity for liability protection. It is almost always a good idea to setup a business entity that limits the liability of the entity owners to own the rental property, whether it is a long-term rental or a vacation rental.    Your particular situation will determine the type of business entity to setup, including how the rental income is taxed.  Remember that using a business entity to own a rental property should be a supplement to placing appropriate insurance on the property.
  1. Do not evict a long-term tenant simply to convert a rental into a vacation property. Assuming you own a rental in an area where there is a market for vacation rentals, you may be tempted to kick out your tenant so you can begin marketing the property as a vacation rental.  This is happening more and more but I advise you to read carefully the terms of your rental agreement and applicable law and do not evict a long-term tenant simply to expedite the process of converting a property to a vacation rental.  However, you could always work out an agreement with the long-term tenant to entice them to voluntarily terminate the contract. So called “cash for keys” where you give the tenant cash to move out early usually does the trick. However, make sure you get that agreement to terminate the lease early in writing. Also, use a check you can show they deposited and not actual cash.
  1. No personal use of the vacation rental if using a self-directed IRA/401k. We have many clients who use a self-directed retirement account to invest in real estate.  If you’re planning to acquire a vacation property with a self-directed IRA or similar retirement account, you, or any other disqualified persons, cannot stay on the property, even for a weekend.  I know, that is one of the main reasons to own a vacation rental, but if the owner of the property is your self-directed IRA, you can’t do it. It’s a prohibited transaction as you cannot have personal use of IRA owned assets.

In sum, there is a lot of appeal to vacation rentals, but there are many issues to consider.  As the Airbnb lawsuits highlight, it is important for a real estate investor to know the local rules that govern short-term rentals.  There are many other tax and legal issues to consider, a few of which have been mentioned in this article.  If you are planning to acquire a vacation rental property and have tax or legal questions, please contact our office.

3 Reasons to have a Partnership Agreement

June 21, 2016 Business planning, Tax Planning Comments Off on 3 Reasons to have a Partnership Agreement

If you have your own business or are thinking about starting your own business, this article was written for you, particularly if you currently have or are considering having a business partner(s).  Some business owners are hesitant to mention to their business partner(s) the importance of having a written partnership agreement, but this an important step to a healthy business relationship.  Even if you’ve been in business with the same business partner(s) for years, if you don’t have a written partnership agreement, it’s never too late to get one.  Aside from the common reasons you might think someone should have a partnership agreement, such as to set forth what is expected of each partner, what each partner gets in return, and procedures for decision-making, this article is going to discuss three more crucial reasons to have a partnership agreement.

But first, for the sake of clarity, the term partnership agreement as used in this article is simply intended to mean an agreement between business partners.  I’m not suggesting your business should be a partnership; in fact, your business may be an LLC or some other entity type.  Regardless of what entity type you select for your business, if you have one or more business partners, you should have a partnership agreement in some form or another.  Also, if your business operates as an LLC, it is possible or even likely that you have an operating agreement, but an LLC operating agreement is not necessarily synonymous with a partnership agreement.  Typically the purpose of the LLC operating agreement is to help establish the legitimacy of the LLC as a separate legal entity from the owner(s)/member(s) of the LLC and to set forth some minimum standards in terms of management decisions, member meetings, etc.  In any case, you should have your operating agreement reviewed because, depending on your situation, you may want to amend your operating agreement, or you may decide to have a separate partnership agreement in order to make sure you’re properly protected.  You also may decide to have a separate agreement on just one of the items addressed below, i.e., a buy-sell agreement.  Each business partnership is unique and accordingly, the set of documents of the business should be unique and should fit the business arrangement of the partners.

With those caveats out of the way, here are three crucial reasons to have a partnership agreement:

  1. Restrictive Covenants. You have worked hard and put in many hours over the years to build your business.  How would you feel if your business partner left the business to setup shop down the street from you to become a competitor?  How would you feel if they took confidential and proprietary information of the business and used it in the new business?  What if they took clients away from the business for their new business?  Restrictive covenants can protect the legitimate interests of the business and prevent a business partner from taking such actions.
  • There are three main restrictive covenants: a non-compete, a non-disclosure, and a non-solicit.  A strong partnership agreement will contain all three restrictive covenants.  A non-compete can restrict a departing partner from competing with the business for a certain period of time, and within a certain geographical region, as appropriate.  A non-disclosure can restrict a departing partner from taking confidential and proprietary information and disclosing it to third parties or using it in an adverse manner to the business.  A non-solicit can prevent a departing partner from taking clients of the business.
  • Each state’s laws will vary as to what is a sufficient amount of restriction to protect the legitimate interests of the business.  Also, keep in mind that these provisions are like a double edged sword, i.e., you can use them to restrict your business partners but they can do the same to you, so it’s important to not get carried away and make certain the restrictions are reasonable.  Admittedly, it can be difficult to discuss these matters with your business partner(s), but it’s better to talk with them now and put it in writing rather than fight with them later in court over clients, etc.
  1. Buy-Sell Agreement. This can be a stand-alone agreement or drafted within the partnership agreement.  The purpose of the buy-sell provisions is to have a mechanism or procedure to address a situation such as when a business partner dies, or becomes disabled, etc.  Mark Kohler often times refers to the “four D’s”, death, disability, dissolution, and divorce.  You can even include in the buy-sell other situations sometimes known as “triggering events” such as bankruptcy.
  • Have you considered what would happen to your business upon your death or disability?  What if your business partner died, would you want to be “stuck” in the business with your partner’s spouse?  What if something happened to you, how can you be sure your spouse/family is fairly compensated given your ownership interest in the company?  The result of a well drafted buy-sell is that upon the happening of a triggering event, e.g., death of a business partner, the ownership interest of the business partner is bought back by the business or the surviving business partners from the deceased partner’s estate/heirs at a pre-determined price and upon the terms decided upon and set forth in the buy-sell.
  • The benefit of the buy-sell is that it eliminates having to make those decisions in the stress of the moment, when death, disability, divorce, etc., has occurred; it is easier to make those decisions before the crisis/event occurs.  You and your business partner(s) can put forth a mechanism or procedure for establishing the value of the business which will determine the purchase price.  You can also decide how the purchase price will be paid, e.g., lump sum, installment payments, etc.  In the context of death and disability, an insurance policy can be utilized to provide liquidity to pay for some or all of the purchase price.  It is never fun to talk about death or disability, but it is better to address it now rather than later when the event has already occurred, which can be difficult when emotions and stress levels are high.

Here is a great video on this topic by a partner in our firm KKOS Lawyers, Mark J. Kohler:

  1. Partnership Allocations. You and your business partner might have different financial situations, such that it is preferable to allocate partnership items of loss, income, etc., to you and your business partners in a manner other than based on the ownership/interest percentage in the business.
  • For example, your business partner might be in a high income tax bracket in a certain year and desire to claim disproportionately large items of loss, if any, to help reduce his or her income tax liability.  However, the IRS will not recognize such allocations unless they have a “substantial economic effect”.  Particularly, with a real estate based business in which there is the item of depreciation, the partners may want to be strategic about how to allocate depreciation among the partners.  Again, the IRS will not recognize those allocations unless they have substantial economic effect.
  • A well drafted partnership agreement can address these allocations to help the business partnership keep a proper accounting of the financial arrangement of the business so that such partnership allocations will be recognized by the IRS.  Even if the business doesn’t intend to make such allocations, a well drafted partnership agreement will address related matters such as contributions, distributions, etc.

These are just three reasons to have a partnership agreement.  There are many more.  Each business is unique and likewise each partnership agreement should be unique and should fit the business like a well-tailored suit.  If you and your business partner(s) don’t have a partnership agreement that sufficiently addresses these issues, I invite you to call our office.