FAQS: Business Law

Business law encompasses the many rules, statutes, codes, and regulations that are established which govern commercial relationships and provide a legal framework within which businesses may be conducted and managed. Business law is highly diverse and includes areas such as:

  • business formation and organization
  • transactional business law (contracts)
  • business planning
  • business negotiations
  • mergers and acquisition
  • divestitures

Although there are many important things to think about when choosing a business form, some of the main considerations include your preference of tax treatment, how you intend to capitalize the business, whether you plan to issue stock and trade it publicly, how you intend to structure the management of your business and issues surrounding the liability of the business owners, among other things. It is very important to plan your business and to work closely with someone who can help you choose the business form that will meet your needs.

The Internal Revenue Code allows for two different levels of corporate tax treatment. Subchapters C and S of the code define the rules for applying corporate taxes.

Subchapter C corporations include most large, publicly-held businesses. These corporations face double taxation on their profits if they pay dividends: C corporations file their own tax returns and pay taxes on profits before paying dividends to shareholders, which are subsequently taxed on the shareholders’ individual returns.

Subchapter S corporations meet certain requirements that allow the business to insulate shareholders from corporate debts but avoid the double taxation imposed by subchapter C. In order to qualify for subchapter S treatment, corporations must meet the following criteria:

  • Must be domestic
  • Must not be affiliated with a larger corporate group
  • Must have no more than one hundred shareholders
  • Must have only one class of stock
  • Must not have any corporate or partnership shareholders
  • Must not have any nonresident alien shareholders.

Additionally, after a business is incorporated, all shareholders must agree to subchapter S treatment prior to electing that option with the Internal Revenue Service.

Sometimes, courts will allow plaintiffs and creditors to receive compensation from corporate officers, directors, or shareholders for damages rather than limiting recovery to corporate assets. This procedure bypasses the usual corporate immunity for organizational wrongdoing, and may be imposed in a variety of situations. The specific criteria for piercing the corporate veil vary somewhat from state to state and may include the following:

  • Courts may not allow owners to benefit from a corporation’s limited liability if the underlying business is indistinguishable from its owners.
  • If a corporation is formed for fraudulent purposes.
  • Courts may impose liability on the individuals controlling the business if a business fails to follow certain corporate formalities in areas such as record-keeping.

Joint ventures and partnerships share certain characteristics. A joint venture is a sort of partnership where two or more entities join together for a particular “short term” purpose. In both partnerships and joint ventures, each partner has equal ability to legally bind the entire entity. A partner can represent the entire organization in the normal course of business and his or her legal actions on behalf of the joint venture or partnership create legal obligations.

Though the powers of individual partners in a partnership or joint venture can be limited by agreement, such agreements do not bind third parties. Because business contacts outside of the partnership may have no knowledge of the limitations, they may be entitled to rely on the apparent authority of an individual partner as determined by the usual course of dealing or customs in the trade.

A non-profit corporation is a corporation formed to carry out a charitable, educational, religious, literary, or scientific purpose. A nonprofit corporation doesn’t pay federal or state income taxes on profits it makes from activities in which it engages to carry out its objectives. This is because the IRS and state tax agencies believe that the benefits the public derives from these organizations’ activities entitle them to a special tax-exempt status.

The most common federal tax exemption for nonprofits comes from Section 501(c)(3) of the Internal Revenue Code, which is why nonprofits are sometimes called 501(c)(3) corporations.

Any time a corporation undertakes a major change or transaction, it should be reflected in its minutes. In addition, meetings of shareholders and directors should take place at least annually if for no other reason than to elect new officers and directors. Failure to adhere to the formality of regular meetings can jeopardize the corporation’s ability to shield its officers, directors and shareholders from personal liability for the corporation’s actions.

Corporations with more than one shareholder should seriously consider a buy-sell agreement. A shareholder’s death, divorce, disability or termination of employment can create serious problems for a corporation and its other shareholders. A buy-sell agreement can help minimize these problems by providing for an orderly succession in such plans. Similar provisions are recommended for partnership.

Like most corporate law, mergers are regulated at the state level. While these laws vary by jurisdiction, many aspects of the merger process are the same across the nation. Generally, the board of directors for each entity must initially approve a resolution adopting a plan of merger that specifies the names of the entities involved, the name of the proposed merged company, the manner of converting shares of both entities, and any other legal provisions to which the corporations agree. Each entity notifies all of its shareholders that a meeting will be held to approve the merger. If the proper number of shareholders approves the plan, the directors sign the papers and file them with the state. The secretary of state issues a certificate of merger to authorize the new corporation.

Each state has its own corporate statutes that govern the procedure for mergers. Furthermore, state or federal agencies may wish to investigate the potential anticompetitive effects of a proposed merger. Because of the requirements and variables involved in merging, a corporation considering a merger should consult a lawyer who is experienced in mergers and acquisitions law.

Personal liability arising from business obligations can devastate the accumulated wealth of a lifetime of work. Personal liability may extend to business losses, but other obligations may also reach individuals, including:

  • Damage awards in lawsuits
  • Tax penalties
  • Back wages and benefit payments

Limited liability offered by corporations and other business entities shelters business owners from personal liability. Nonetheless, if an owner or director performs certain personal acts, behaves illegally, or fails to uphold statutory requirements for corporate status, he or she may face personal liability despite the corporate shelter.

A limited liability company (an “LLC”) generally protects members’ personal assets from the creditors of the LLC. If an LLC member treats the LLC as a separate entity (i.e. treats it as if it were an unrelated business and follows formalities) and does not abuse the LLC form, then courts have a strong presumption against an LLC’s creditors accessing an LLC member’s personal assets. In a nutshell, the more an LLC member treats the LLC as a separate bona fide business enterprise versus a mere instrumentality or piggy bank or means to defraud customers, the stronger the limited liability protection will be provided.

The following is a brief summary when the limited liability veil can be pierced:

  1. Undercapitalization: An LLC should be capitalized so it can reasonably meet its debts that would arise in the normal course of business as opposed to having a razor thin capitalization and constant injections of the capital whenever expenses arise. There is no set amount or set ratio, but it is what is reasonable based on the nature of the business and the industry. As a rule of thumb, you should never intentionally underfund the LLC, when it is formed, to defraud the business’s creditors.
  2. Failure to Follow Formalities: While formalities are relaxed for an LLC, the more followed, the better the protection. The LLC should have minutes, hold meetings, have their own bank accounts,…. In addition, if a member is acting on behalf of the LLC, his or her signing of any document or contract should clearly signify in what capacity he or she is signing such as “John Doe, Member” or “John Doe, Manager” instead of simply “John Doe.” Last, it is important to use the LLC moniker after the name (i.e. LLC) to place the public on notice of your limited liability status. The more a member meets the common law and statutory LLC formalities, the less likely a creditor can access a member’s personal assets.
  3. Intermingling of Assets: In addition to formalities, it is important that the LLC’s business assets and the member’s personal assets not be comingled. Each entity should have its own bank account and pay its own expenses. Business funds should not pay personal expenses or vice versa at any time. As a rule of thumb, you should treat the LLC as two strangers would treat each other. Would you pay for a stranger’s vacation, personal meals or new personal car? Would you have one bank account paying the bills for yourself and a stranger? It is absolutely imperative to not co-mingle personal assets with the LLC assets the same way you would treat a stranger.
  4. Use of the LLC to Perpetrate a Fraud: If an LLC is used to create or perpetrate a fraud, then a creditor may access a member’s assets. An LLC should be used to protect an investor if a business transaction goes bad, not to assist a member to defraud customers or clients or to make a string of absurdly risky ventures relying on the limited liability protection. For example, if a member has a substantial tort liability and closes up shop and simply opens up the same business with the prior LLC’s equipment under a new LLC, that member’s personal assets may be accessed. Further, if a member embezzles funds from clients or investors his personal assets may be accessible to creditors. The key is whether the member is intentionally or willfully using the LLC form to defraud the public versus simply having a bona-fide business transaction gone bad. Generally, the more the member has a true business intent versus an intent to defraud future creditors the more protection will be provided.
  5. Alter-Ego: This focuses on the level of control a parent/member/owner has over the LLC and requires some major injustice or wrong. It is when a parent/member/owner and the LLC are blurred and the LLC is a mere instrumentality of the parent/member/owner. For example, if a parent LLC owns an LLC subsidiary with the identical management, and the LLC subsidiary performing the contracts is thinly capitalized, uses the parent’s equipment, materials, and employees, is under the parent’s strict control and has no other real purpose/substance then it is more likely that the LLC creditors will have access to parent/member’s personal assets. In other words, the LLC subsidiary is a mere instrumentality acting vicariously for the parent/member/owner. Thus, it is important to allow an LLC subsidiary to have its own autonomy.
  6. Direct Suit: Last, a member may be liable for criminal acts and/or intentional torts. If a manager/member/owner knowingly, voluntarily and intentionally participates in any aspect of the crime or tort he can be personally liable.Empirically, the LLC limited liability protection is more likely to be pierced where the manager or member engages in a criminal act, intentional tort or fraud, there is under capitalization or the LLC is an alter ego of the manager/member. It is important to avoid these situations, think of the LLC as a completely separate self-contained being/entity, and treat it that way.Please feel free to contact this office and meet with one of our experienced attorneys to further discuss these issues to determine if a limitation provision would be beneficial to your company.

The use of Intentionally Defective Grantor Trusts (IDGT), Limited Liability Companies (LLCs) and Family Limited Partnerships (FLPs) are clever and efficient ways to transfer family wealth to your children or future generations, remove assets from your estate, and reduce potential federal estate taxes. However, proposed IRS Treasury Regulations may severely limit or eliminate part of the benefits of using these advanced estate planning techniques.

Benefits of Using IDGTs, LLCs and FLPs

Two reasons a grantor would intentionally create an IDGT is to remove the assets he/she transfers to the trust from his/her federal taxable estate and to allow the assets in the trust to grow income tax free. If structured properly, IDGT’s are useful for transferring wealth because for estate tax purposes, the grantor is not considered as owning the IDGT, however, for income tax purposes the grantor is still the owner. Therefore, when income taxes are paid by the grantor rather than from the trust fund, more money is removed from the grantor’s taxable estate and kept in the trust to be distributed to the beneficiaries outside of the grantor’s taxable estate. In all, the grantor will have removed from his/her estate the value of the trust assets, any future appreciation on those assets, and the amount of money used to pay income taxes on the earnings of the trust assets.

Similar to an IDGT, a parent often uses a LLC or FLP to remove property from his/her taxable estate. There are two basic steps taken when using a LLC or FLP as part of an estate plan. The first step is to transfer property to a newly-formed limited liability company or family limited partnership in exchange for a membership or partnership interest. Next, the parent can make gifts of the LLC or FLP interests to his/her children and grandchildren, which can be done gift/estate tax free using part of the Lifetime Gift and Estate Tax Exemption Credit and Annual Exclusion against Gift Tax. By using the exemption/exclusions against Federal Gift and Estate tax, a substantial amount of property can be transferred to lower generations entirely free of gift/estate tax.

Valuation Discounts of Family Business Interests

IDGTs, LLCs and FLPs are especially useful tax saving vehicles where the transferor has a family owned, privately held business and/or real estate and desires to transfer it to his/her children and/or grandchildren.. In addition to all the benefits described above, the transferor can take advantage of valuation discounts of family business interests and/or real estate. The value of the non-controlling interest of the privately held business/real estate can be significantly discounted because of the lack of control over the business/real estate, minority interest, restrictions on transferability and the lack of marketability of the business interest/real estate. The lack of marketability is due to the generally unattractive nature of the interest to outside investors. For LLCs or FLPs it is because minority membership or limited partnership interests are transferred to the lower generations and the members or limited partners do not participate in control and management of the business/real estate and lack liquidation or dissolution rights. . For IDGTs, generally only non-voting stock is transferred to the IDGT thereby precluding the trustee, as owner of that interest, from having any control over the business/real estate. Furthermore, the LLC and/or FLPs’ Operating Agreement usually contain restrictions on transfers which further curtail the value of such interest. There are few potential investors who would be willing to pay full price to buy an interest in a business or real estate wherein they cannot control, liquidate or dissolve their investment, force liquidation, or freely sell his/her interest to a willing buyer.

Proposed Treasury Regulations

The IRS Treasury has recently proposed regulations pertaining to Section 2704 of the Internal Revenue Code. Section 2704 is applied to closely held family entities and basically provides that a taxable event occurs when liquidation or voting rights lapse and that, in valuing property for federal estate and gift tax purposes, certain restrictions on an entity’s ability to liquidate are disregarded. This Section further grants the Treasury the authority to issue regulations to cause certain other restrictions that reduce valuation discounts are to be disregarded which is the purpose of the currently proposed regulations.

Regarding a lapse in voting and liquidation rights, the only persons who would be affected by the proposed regulations are those who transfer an interest within three years of his or her death. Under the current law, if an interest in a closely held family entity is transferred from one family member to another, and the original holder of the interest thereby loses the right to liquidate the entity, there is no lapse of a liquidation right as long as the right to participate in a liquidation vote was transferred along with the interest to the other family member. The same applies to voting rights; as long as the interest passing to the family member still has a voting right attached to it, no taxable lapse has occurred. The proposed regulations governing these transfers are meant to attack transfers within three years of death.

The most important valuation discount that may be eliminated is that valuation discounts for minority interest in closely held entities, which can easily range from 15 to 40%. Essentially, the regulations would ignore any restrictions in the governing documents and any applicable state laws governing minority interests and value the interest as though there were no restrictions. Under the current law, the only restrictions ignored for valuation purposes are those that are more restrictive than applicable default state laws. Examples include the ability of a limited partner to withdraw from a partnership or to force a liquidation of the partnership.

Instead of referring to applicable state laws, the proposed regulations create a new category of restrictions that will be ignored for valuation purposes called “Disregarded Provisions”. Disregarded Provisions includes any provision that limits or permits the limitation of the holder of an interest to compel liquidation or redemption. In other words, under the proposed regulations, the IRS will value all interests transferred between family members in closely held entities as though the transferee of the interest has the right to liquidate or redeem the interest for its proportionate share of the entity’s net asset value in cash or other property regardless of whether the transferee could actually compel such an action in a state court.

The public comment period is still open but if the Proposed Regulations go into effect as written on January 1, 2017, they will have a significant effect on advanced estate planning and the ability of owners of closely held family entities to receive a valuation discount when transferring minority interest to family members or trusts for the benefit of family members.

We strongly advise you to contact your local Congressman immediately to protest these proposed regulations.

For Pennsylvania residents, contact:

Pat Toomey at https://www.toomey.senate.gov/ and Bob Casey at https://www.casey.senate.gov/. Patrick Meehan at https://meehan.house.gov/ Robert Brady at https://brady.house.gov/ Brendan Boyle at https://boyle.house.gov/

For New Jersey residents, contact:

Robert Menendez at https://www.menendez.senate.gov/ Corey Booker at https://www.booker.senate.gov/. Michael Fitzpatrick at https://fitzpatrick.house.gov/