Simplifying the structure to meet your company’s current needs can generate direct cost savings.  It may also allow the company to eliminate levels of bureaucracy that can distract the company’s officers from their primary responsibility, increasing the company’s revenue.

Whether by design or accident, an improper corporate legal structure can cause the corporate functions to become more bureaucratic, which, in turn, can lead to unnecessary expenses, employee dissatisfaction, complacency, and other common issues encountered in bureaucracies.  In addition, a complex legal structure can create inefficiencies in data management and financial and tax reporting.  If your company has such issues because of its legal structure, a reorganization by consolidating and dissolving unnecessary entities can quickly produce real cost savings.

Even if you manage to keep bureaucratic issues at a minimum, you cannot escape the legally-required tax reporting requirements that federal, state, and local governments may impose upon multiple entities.  This can affect your company’s income, property, and payroll tax efficiencies both in its compliance burdens and its overall tax payments.

In the worst case scenario, a company without legal guidance over time may actually increase its tax liabilities by improperly using the entities.  By not knowing the function or tax treatment of each entity, a manager could, for instance, easily use an improper entity for purchasing a property.  You should have your company’s legal structure regularly reviewed to ensure it is producing the lowest possible effective tax rate.

A company with an overly complex structure will have increased legal costs.  There are direct costs associated with a company having unnecessary entities, such as additional resident agent and filing costs.  But there are also indirect legal costs, such as inter-company transaction agreements, licensing agreements, and unnecessary inter-company documentation costs.  Further, the company may lose some of its bargaining power with third-parties, and may unknowingly be negotiating deals as weak individual divisions.  Some third-party contractors may not even realize the size of your business, given many company’s data systems separately log purchases by different entities.

In determining whether your company’s legal structure is too complex, you should involve the key members of your company and its tax and legal advisers.  Untrained tax staff alone may not know the legal ramifications of dissolving or merging entities, so your legal advisers certainly should be involved.  Conversely, an attorney without business or tax training may not understand the effects of changing a company’s structure.

Any company that has entered or left a line of business, bought or sold properties, or underwent a corporate merger or acquisition could very well have lingering legal entity appendages that drain the company’s cash and resources.  Reducing corporate legal complexity to meet current needs provides both foreseeable and unexpected cost benefits to proactive businesses.

For further information, please contact Jeff Rogyom at (410) 929-4578.

Beside the practical business and tax benefits, a buy-sell agreement also allows the parties to plan in advance of the moment when the ownership change will eventually occur, and, thus, allows the parties to avoid much of the tension and emotion that can result from delaying such discussions.  In addition, the buy-sell agreement also forces the parties to consider financial issues that often can only be solved if addressed well in advance, such as whether the company should purchase life insurance to fund the transfer.

The buy-sell agreement is a legal contract that dictates how, when, and for how much a company or remaining owners will be required to pay to acquire the interests of a departing owner.  The buy-sell agreement will typically provide for various triggering events that will either gives one party the obligation or the option to buyout the interests of another.  Typical events include: death, disability, divorce, bankruptcy, retirement, or otherwise changing their role in the company.  Many owners will be concerned about the ownership rights and control of the company.  Other owners will want to ensure payment for the departing owner, and still other owners will want the buy-sell agreement to minimize the tax burdens of the company and the departing and remaining owners.  Thankfully, buy-sell agreements are not one-size-fits-all, and an attorney will be able to address many, if not all, of these concerns.

While an attorney is virtually unlimited in choices that can be made in drafting and implementing the buy-sell agreement, there are primarily two types of agreements: the redemption agreement and the cross-purchase agreement.  Of course, even this choice can provide alternatives, such as a mixed agreement that allows members or shareholders the option to purchase the interests of the departing owner before requiring the company itself to purchase the owner’s interests.

Redemption Agreements

A redemption agreement will cause the entity to purchase the interest of the departing owner.  Many favor using the redemption agreement for buy-sells because of its simplicity, particularly when there are numerous owners.  If life insurance is needed to fund the purchase, a redemption agreement will typically require the purchase of only one policy.  And, since the company purchases the interests of the departing owner, no particular owner will have their interests increased in relation to the other remaining owners.  Of course, if one remaining owner already controls a substantial position of the company, then this could push that owner over a threshold such as the 50% ownership mark or other critical amount designated in the company’s bylaws or operating agreement.

While a redemption agreement has its advantages, it does have its limitations as well.  The redemption agreement will cause the entity to purchase the interests of the departing owner.  Thus, while the value of the remaining owners’ interests will increase in value, the shareholders of a c-corporation will see no increase in their tax basis.  So, when those shareholders sell their interests in the c-corporation, they will pay gain on the increased value of their shares.  In contrast, the tax basis of remaining s-corporation shareholders and partners in an LLC or partnership can be increased, regardless of whether the chosen method is a cross-purchase or a redemption.

In addition, if the entity using the redemption agreement is a c-corporation, then attribution rules may prevent the redemption from being considered a “complete redemption”, and, thus, may be considered taxable as a dividend to the departing owner.  This is particularly relevant when the remaining owners are closely related to the departing shareholder.  Further, a redemption of c-corporation shares may have alternative minimal tax consequences if the corporation receives insurance proceeds to fund the transfer.

Regardless of the entity’s tax status, insurance proceeds going to an entity to fund a buy-sell redemption agreement may be subject to claims of the entity’s creditors.   A redemption agreement, on the other hand, requires only one life insurance policy per owner and is typically the simplest transfer to structure and implement.

Cross-Purchase Agreements

A buy-sell agreement can also be structured as a cross-purchase agreement.  The cross-purchase agreement can be more complicated.  The cross-purchase agreement requires that some or all of the remaining owners be required to purchase the interests of the departing owner.  If life insurance will be used to finance the purchase, then each owner may need a policy on each of the other owners.  The individual owners would receive the insurance proceeds and will then use the proceeds to purchase the interests of the departing owner.  Since the individual owners, rather than the corporation, purchases the shares, this removes the tax basis issues that exist for c-corporations under a redemption agreement.  Further, for c-corporations, since the individuals receive the life insurance proceeds, the corporation should not encounter any corporate alternative minimum tax issues.

Mixed Agreements

Mixed agreements are those providing options to buy the interests by either the entity or the remaining interest holders followed by either the remaining interest holders or the entity having the right or obligation to purchase.  Either of these parties may purchase life insurance to fund the transfer.  Of course, the agreement can allow new parties to purchase the interests, such as a child of the departing owner.

Funding the Transfer

While much has been discussed in this article regarding the use of life insurance policies to fund buy-sell agreements, life insurance may not be  helpful if it is likely an owner will desire to sell their interests to fund their retirement.  In such case, the entity has several options.  The entity or remaining interests holders could, of course, stockpile cash over time through investments.  In addition, the parties may use insurance policies that will accumulate a cash value.  Still another possibility is the use of an installment agreement whereby the shares are purchased over time from either the entity’s future earnings or through dividends to the remaining interest holders.  Again, if the departing interest holder continues to have interests in the entity, whether directly or through IRS attribution rules, the departing owner of a c-corporation may be considered to have received dividends rather than capital gains.  Depending upon the tax rates then in effect, the IRS the reclassifying the payments as a dividend may have a negative effect.

Estate Tax Uses

The buy-sell agreement generally provides some method of valuation of the owners’ interests, whether by calculation or a fixed amount.  The value, as calculated under a buy-sell agreement, can often be used for estate tax valuations.  The IRS; however, may challenge values to be used for inter-family buy-sell agreements, particularly when the amount is less than reasonable and cannot be justified.  In choosing whether to use a cross-purchase agreement or redemption agreement, a person concerned about estate taxes may favor a cross-purchase agreement.  If an owner dies controlling the majority of a business that used a life insurance policy to fund a redemption buy-sell agreement, then both the business and the life insurance policy could be considered owned by the person’s estate.  Since entity-owned policies are typically used for redemption agreements, this situation may favor the use of cross-purchase agreements for owners with estate tax issues.

In Summary

Buy-sell agreements provide many benefits to business owners, but careful consideration should be used when determining how the buy-sell agreement should be structured.  Since buy-sell agreements are naturally forward-looking, reasonable projections must be made regarding financial requirements, both for funding and valuation purposes.  Moreover, when ultimately the success of the buy-sell agreement requires that the business survive, consideration should be given to ensure the future owners are given the necessary means and training to make this transition successful.  Your attorney, in drafting your buy-sell agreement, should be willing to meet with the owners, financial planners, accountants and any other individual needed to ensure the buy-sell agreement meets the current and long-term goals of the owners and the company.

For additional information or to obtain a buy-sell agreement for your company, please contact Jeff Rogyom at (410) 929-4578.

The most common way to minimize your potential liabilities would be to have your properties held by and managed by a separate entity with limited liability.  While you may consider the property to be separate from your personal assets, unless you proactively create that separation, an attorney will pursue your personal assets in addition to the value of the property itself…

To make your LLC effective, it is usually advisable to have the LLC own the property, rather than just manage the property.  If you already own the property, there may be costs associated with transferring the property to the LLC.  Further, your lenders will often need to approve the transfer and will request that you personally guarantee their loans.  Nonetheless, the risk of owning an investment property in your own name often far outweighs the associated costs.

All property owned by an LLC will still be at risk for any liabilities.  Thus, you may consider forming multiple entities if you own several properties, particularly if the properties have significant equity or if one property is very likely to create liabilities.  Further, if you flip properties, then you may wish to create new entities.  Lingering liability from a former property could affect your current holdings.  While allowing the property itself to remain at risk may not sound appealing, the alternative is for all of your personal assets to be subject to claims, including your personal home and your future income.

For tax purposes, the most commonly used entity for real estate investments is the limited liability company, otherwise known as an LLC.  A tax benefit of owning real estate through an LLC is that if the LLC is owned by a single member, then the entity is disregarded for tax purposes.  This means all income and losses from the property would not need to be reported on a separate return, and the amounts can be directly entered on the owner’s personal income tax return.

In addition to transferring your property to the LLC, it will be necessary for all business of the property to be handled exclusively by the LLC.  For instance, tenant leases, the roofer’s contract, and the checkbook should name the LLC as the contracting party, rather than your name.  These formalities will make it less likely that an attorney will be able to pierce the LLC veil of protection that prohibits you from being sued personally.

Often, real estate investors believe their liability insurance will protect them.  Unfortunately, you should not assume a jury will limit its sympathy for an injured tenant to the amount covered by your liability insurance.  Therefore, the only way to truly be certain that liability from an investment property will not lead to you losing your personal assets is to form an LLC.

In conclusion, holding or managing a property in your own name creates many opportunities to be personally sued.  The only way to truly limit your potential personal liability is to form an entity with limited liability protection.

For further information, please contact Jeff Rogyom at (410)929-4578.

Many believe their businesses will receive tax or legal benefits for forming in an alternative state, and legal document mills often perpetuate these beliefs to sell incorporation packages… While some businesses benefit from the differing tax laws of other states, the vast majority of small business realize no benefit and forming in another state only creates financial and administrative burdens. For instance, many sell Nevada as a place to incorporate since there is no corporate income tax, but most businesses will not be able to legally take advantage of that tax difference. In addition, your home state often provides adequate legal attributes and liability protections for your business, despite the often promoted liability protection benefits of having a Delaware entity.

Most major corporations choose to register their companies in a handful of states, and this sometimes creates the perception that companies are doing so solely to limit their tax liabilities. Often these decisions are based upon those states’ corporate governance requirements, meaning certain states do not impose many requirements on how a company must be run or funded. Start-up companies that anticipate selling stock to the public often form in Delaware. Other states provide benefits to companies in certain industries, such as the lax usury laws that may attract banks or credit card companies. This does not necessarily mean, however, that the average small business will receive any benefit by following the lead of these corporations.

For tax purposes, if your company operates in Maryland, then it will be required to file a Maryland income tax return in Maryland. Further, the company’s income that originates in Maryland must be reported on the Maryland tax return as Maryland income. The Maryland tax return must be filed regardless of the state that the company chose for formation or incorporation.  Therefore, unless your company has operations in multiple states, then your company usually has no tax reason to form outside its home state.

A small business registering in another state will run into several problems. First, even if the company is registered in another state, most state’s require the business to also register as a “foreign business” in their state and pay the associated fees. Second, the state may also require the company to obtain an in-state mailing address and hire an in-state person to be the company’s “registered agent”. Unless you have a contact living in the state, then you often will need to pay the local person to perform these duties. Finally, by registering in another state, you may find yourself being sued in that state’s courts. Your registration state’s courts will have jurisdiction to accept a lawsuit filed against your small business and may require you to defend your company in a very inconvenient or unfriendly location.

In conclusion, unless you can identify a specific benefit of being registered in a certain state, then you should generally choose to register in your home state. Few businesses benefit from forming in another state. Further, filing in another state may cause you to incur substantial costs and many administrative and legal burdens.  You should certainly consult your attorney before making a choice that may be very costly to reverse.

For further information, please contact Jeff Rogyom at (410) 929-4578.

Most states, including Maryland, provide you with the following popular state entity choices: the sole proprietorship, the general partnership, the limited liability company, and the corporation. Other entities for more specialized purposes also exist, such as the limited partnership and the professional association (a P.A. or P.C.).

I. Brief summaries of the four most popular entities:

Sole Proprietorship: A sole proprietorship is the default business entity for any business owned by a single person. The sole proprietorship provides no limited liability (discussed in Section III below) protection for its owner. If you have not chosen an entity and have no partners, then this is likely your current entity. It is not recommended that any active business operate in this form given the owner’s exposure to the company’s liabilities and lawsuits. For tax purposes, the IRS requires income from this form of business be reported on your Form 1040′s Schedule C, or, if real estate, Schedule E.

General Partnership: A general partnership is the default business entity for any business owned by multiple owners. Similar to the sole proprietorship, there is no limitation of liability for the business owners, known as its “partners”. The business generally does not need to file with the state to be considered a general partnership. State laws determine if a partnership exists, whether the owners intend to or not. If the state laws determine the group is a “partnership”, then the partners can be liable for acts of the business and their fellow partners. Similarly, IRS tax laws determine whether the group is a partnership for income tax purposes. For income tax purposes, the IRS requires groups it considers partnerships to file a partnership tax return, Form 1065. The partnership issues a K-1 to each partner which informs both the IRS and the partner how much income and expenses the partner should report on their Form 1040.

Limited Liability Company: The Limited Liability Company, or “LLC”, is today’s most popular entity form. It is the most popular because of its flexibility both in its operation and its available tax classifications. To form an LLC, the entity must be registered with the chosen state’s department that registers businesses, such as the Maryland SDAT (State Department of Assessments and Taxation) or the Delaware Secretary of State. The LLC offers limited liability to its owners, known as its “members”. Thus, if the LLC is sued or otherwise becomes in debt, then the members in most situations will not be personally liable to the creditors of the LLC. LLC members can choose how they want the IRS to tax the entity. Without making an IRS election, an LLC generally will be ignored for tax purposes if it has only one member or will be taxed as a partnership if it has multiple members. But, when making IRS elections, an LLC member or members can choose that the LLC to be taxed as a c-corporation or as an s-corporation (discussed in Section II below). A tax attorney would be able to guide you toward the optimal tax classification for your LLC.

Corporation: The corporation, in its modern form, has existed as a business entity for more than a century. Unlike more recently developed entities, such as the LLC, the laws governing corporations are well-developed. Thus, shareholders can be assured there will be few opportunities for a judge to surprise shareholders with their own new laws. The corporation’s business owners, the “shareholders”, have limited liability. This is the entity form best-suited for companies that foresee themselves “going public” in the near future. But the corporation does have its downsides. Corporate laws usually impose administrative burdens, such as annual meetings, that the more flexible LLC laws usually do not. Further, for tax purposes, the corporation must be taxed as a corporation, i.e. unlike the LLC, the corporation cannot choose to operate as a sole-proprietorship or as a partnership, even when the tax filing requirements seem unreasonable. The corporation may; however, elect to either be taxed as a c-corporation or as an s-corporation (discussed in Section II below). To make the corporation more flexible for small businesses, some states have created simplified corporate forms, such as the Maryland close corporation.

II. Tax Issues in Entity Choice:

While states can create new and unique entities, such as Delaware’s “series LLC”, the IRS lumps them together into a limited number of possible tax entities. For instance, there is no IRS tax form for an LLC. Through IRS eyes, a business with multiple members will be either a partnership, a c-corporation, or an s-corporation with few exceptions.

As stated above, while an LLC is normally taxed as a partnership, an LLC may choose to be taxed as an s-corporation or as a c-corporation. If operating as a c-corporation, the corporation pays taxes upon its income, and the shareholders pay taxes when the income is distributed. Thus, a c-corporation’s income is taxed twice. If operating as an s-corporation, the corporation itself generally pays no income tax and the corporate income is taxed only to the shareholder, regardless of whether the income is distributed. Today, most businesses operating as c-corporations are those that have no choice, such as a widely-held or publicly-traded company, and those with out of the ordinary tax situations.

There sometimes are tax benefits to being a c-corporation, and the proponents of c-corporations often proclaim its superiority with a certain level of fanaticism. But, in general, the advantage of an s-corporation’s single-layer of tax far outweighs any benefits offered by a c-corporation. My experience as a tax attorney is that when a small business operates as a c-corporation, there is a temptation to illegally deduct personal expenses through the business in order to avoid the two-layers of tax. An IRS audit of those businesses can be devastating when discovered personal deductions suddenly turn into huge tax bills for both the corporation and the now dividend-receiving shareholder, plus penalties and interest.  Sadly, many such individuals were placed in that position by a tax consultant’s poor advice. Currently, few small companies have a legitimate reason to choose to be taxed as a c-corporation, and the only reasonable decision for most small companies is choosing to be taxed as either a partnership or as an s-corporation.

III. Limited Liability:

Some entities, such as the LLC and the Corporation, offer limited liability to their owners. Limited liability roughly means that the owners are not personally responsible for the company’s debts and that the company’s creditors can only seize the company’s assets, but there are exceptions. If an owner guarantees or “co-signs” for a company debt, then the company’s limited liability will not protect that the person from the co-signed debt. Despite an entity’s limited liability, individuals also can be personally responsible for tax debts created for “trust fund” taxes, such as employment taxes or state sales taxes. Often, by law, certain liabilities cannot be limited by forming an entity, such as civil or criminal penalties or professional liability. Further, if a court determines that an entity’s owners never truly honored the entity’s existence, then courts can sometimes “pierce the corporate veil” to go after the owners. Veil piercing generally occurs when owners fail to properly separate their personal life from that of the entity, such as commingling checking accounts or doing business in the owner’s name. Additionally, courts can pierce the veil when the owners egregiously fail to adhere to corporate formalities, such as never holding required meetings or never seeking corporate approvals when required.

IV. Conclusion:

In conclusion, taking these factors into consideration, a tax attorney should be able to guide you toward the proper entity choice. The excitement of starting your own business should not cause you to rush this very important decision. Seeking proper advice before committing your company to years of high taxes is well worth the investment.

For further information, please contact Jeff Rogyom at (410)929-4578.

All states are becoming more aggressive in locating non-filing businesses, particularly those operating largely outside their state. Unfortunately, many businesses first realize their filing obligation to another state when visited by the state’s auditor. An analysis of your company’s connections, or “nexus”, to the states it touches, directly and indirectly, will be beneficial regardless of whether your business is a start-up or established, expanding or contracting.

Each state’s laws for determining whether your company has a filing obligation vary, but all states are limited by the “minimum contacts” standards established under the U.S. Constitution. Adding to many companies’ confusion, there are separate standards applied for sales and use tax nexus and income tax nexus. For instance, a company with a representative in a state may not have an income tax filing obligation but may have a sales tax obligation.

The Risk

A company should not find comfort in its distance from its customers’ states. States have numerous ways of discovering a company’s activity: an audit of your customer reveals your invoice, your company’s online advertising lists a local phone number, your in-state agent innocently mentions your business during an audit.

The consequences of not filing can be severe. A state’s statute of limitation generally begins to run when a return is filed. Thus, for unfiled returns state laws will not limit an aggressive comptroller or revenue department from seeking long overdue tax returns and payments, plus interest and penalties. If your company properly reports sales taxes, the seller is merely collecting the tax from the buyer. If your company fails to collect the sales tax, your company will be forced to pay the tax on behalf of the buyer, even if the buyer could have presented you an exemption certificate. And, your payment can rarely be recovered from your customers. With the national average sales tax rate being 8% of the sales price, few companies can painlessly absorb the cost of failing to file six or more years’ sales tax returns. Conversely, a company can be equally harmed by erroneously collecting sales tax or filing income tax returns in states in which it no longer has, or never had, an obligation.

The Solution

Many tax attorneys and large accounting firms offer state tax nexus studies or reviews. These nexus studies or reviews will evaluate your business and its direct and indirect connections to states and will provide written determinations regarding your state filing obligations. Tax advisers can be hired on a state-by-state or comprehensive basis, or may be hired simply to coordinate your in-house compliance efforts.

The tax adviser may offer voluntary disclosure services to minimize the past returns required to be filed and minimize the penalties and interest. With proper planning your company may actually receive a refund depending upon whether income allocations can be adjusted or if certain states’ filings are determined unnecessary. Further, some customers may have paid use tax for which your company may be entitled to a credit.

When choosing a tax adviser for nexus issues, you should consider a tax attorney or an accountant with a legal background. Often, Federal laws and court opinions alone restrict how far states typically will go to tax out-of-state companies, and the states’ guidance to accountants often reflects the states’ expansive intent. Hence, using state guidance without knowledge of the states’ legal limitations will lead to unnecessary filings. Make no mistake, nexus determinations are legal opinions.

The Laws

The governing laws for nexus determinations evolved through court decisions, particularly U.S. Supreme Court cases regarding the Commerce Clause and Due Process Clause of the U.S. Constitution.

For sales and use tax nexus, physical presence in the state is required, but, once found, often is conclusive of the company’s sales and use tax collection and filing obligation. Typical elements indicating sales tax nexus and physical presence can be seen by viewing Maryland’s sales tax nexus statutes:

♦  Permanently or temporarily maintaining, occupying, or using any office, sales or sample room, or distribution, storage, warehouse, or other place for the sale of tangible personal property or a taxable service directly or indirectly through an agent or subsidiary;
♦  Having an agent, canvasser, representative, salesman, or solicitor operating in the state for the purpose of delivering, selling, or taking orders for tangible personal property or a taxable service; or
♦  Entering the state on a regular basis to provide service or repair for tangible personal property.

Notice, agents and other non-employees can create a physical presence. Hence, states can find your company has sales tax nexus even if a single employee has never visited the state. Nonetheless, some states will provide their own safe harbors for policy purposes. For instance, some states with large convention industries exclude a company representative’s physical presence if there to attend a trade show.

For income tax nexus, the Commerce Clause and the Due Process Clause similarly limit states, but, to the behest of companies and their advocates, courts have been reluctant to similarly require companies to have a physical presence. There are; however, separate limitations only applicable to income tax nexus determinations. In 1959, the U.S. Congress, using the power granted it through the Commerce Clause, enacted Public Law 86-272. PL 86-272 provides a safe harbor for certain activities under which states cannot impose an income tax filing obligation.

Further intricacies based upon court opinions and based upon each state’s law will determine whether nexus does indeed exist. Since company facts often fall into nexus gray areas, it is your adviser’s knowledge of these intricacies that will be needed to accurately determine your company’s filing obligations.

The Relevant Facts

When beginning a nexus study or review, the adviser will likely have you complete a questionnaire regarding your company’s activities. Some typical questions to companies include the following:

In state X:

♦ Does the company have a place of business?
♦ Does the company have employees of independent contractors?
♦ Do the representatives have home offices?
♦ Do the representatives use company property, such as laptops?
♦ Does the company have any equipment, inventory, product samples?
♦ Does the company install or repair its product?
♦ Does the company participate in trade shows, host sales meetings, or train users?
♦ Do out-of-state employees or representatives visit?

Each state is different, so the conclusion reached from your responses will also differ.

Conclusion

Many companies take an unnecessary risk by not filing required state returns, particularly sales tax returns. By proactively determining your company’s tax nexus issues, you can minimize your company’s exposure to unexpected tax audits and assessments. Tax professionals can assist you with these nexus determinations and are trained to minimize the burdens of any discovered issues.

For further information, please contact Jeff Rogyom at (410)929-4578.

Posted in Business Planning & Corporate Law, Tax - Maryland, Tax - Multistate & Nexus, Tax - Sales & Use, Tax - State Corporate, Tax - State Income Tagged: Corporate Taxes, Income Tax, linkedin, Maryland Business Attorney, Maryland Corporate Attorney, Maryland Tax Attorney, Maryland Tax Consultant, Maryland Tax Lawyer, Sales & Use Tax, State Tax Nexus Review, State Tax Nexus Study ]]> http://towsontax.com/2009/07/21/state-tax-nexus-reviews-studies/feed/ 0 Jeff Rogyom http://towsontax.com/2009/07/12/buying-or-selling-a-maryland-business-financing-the-purchase/ http://towsontax.com/2009/07/12/buying-or-selling-a-maryland-business-financing-the-purchase/#comments Mon, 13 Jul 2009 02:39:41 +0000 Jeff Rogyom http://towsontax.com/?p=482 ]]> The seventh article in a series on the purchase and sale of a Maryland business. In this article I address obtaining the necessary financing to fund a business purchase.

Many business buyers’ greatest challenge is obtaining financing.  While a business purchase requires substantial funding, the buyer’s financing options are numerous.  Factors determining the best financing choice include: the seller’s needs, the buyer’s ability to pay, the company’s cash flow and assets, and the general economic climate.

In certain situations, the buyer’s only available financing source will be the seller, and buyers regularly use installment payment agreements to purchase businesses.  But if the seller needs immediate payment, seller financing may be limited or may require higher interest payments.  The buyer would then need to explore other financing options.

Funding methods generally fall into two categories: debt financing and equity financing.  But business purchases regularly combine both debt and equity financing to meet cash requirements.

Debt Financing

Debt financing means borrowing money in the form of a loan from a third-party.  The source for debt financing can be a bank or other business financing company, but can also include friends and family.  Remember, a buyer’s loan collateral can include both the buyer’s personal assets and the target business’s assets as well.  The buyer should seek a pre-qualified loan, even if the target business has not been identified.  A buyer’s pre-qualifying can improve the buyer’s price negotiations and reduces risks should lending terms change.

The buyer may also obtain financing through Small Business Administration loans and local business promotion programs, such as those provided by Maryland’s Department of Business and Economic Development.  SBA-guaranteed loans generally provide longer terms than loans regularly offered by the bank.  Most commercial financing sources will fund up to 75% of the purchase price.  If the buyer cannot contribute the remaining 25%, the buyer may seek equity financing for at least that portion.

Equity Financing

Equity financing means selling an interest in the business to be purchased.  While not always appealing to a buyer, a silent or limited partner’s contributions will assist with immediate cash needs.  Using a silent or limited partner generally requires the buyer give up some control and profits.  As co-owners, the buying group’s documents such as partnership agreements, LLC operating agreements, and corporate bylaws should consider each owner’s rights and obligations to the company.  These agreements may address issues such as: how much the partner must contribute, whether there will be required payments to the partner, whether the partner has an equity (ownership) interest or only a profits interest, how much control the partner will have, whether the partner can sell their interest, whether the company can purchase the partner’s interest, and, if the company exercises that option, how much the partner will be paid.

Third parties always complicate a transaction, and attorneys may be needed to negotiate the terms and draft the necessary agreements.  You should never presume business partners will honor the deal, and the result of poorly drafted agreements is often litigation and soured relationships.

Customized Financing

As stated above, many buyers choose to combine both debt and equity financing, but the transaction itself can be structured to ease financial constraints as well.  For instance, if the company owns real estate, it may be possible to strip the real estate from the business for a separate sale using traditional real estate financing.  Using a similar transaction, a buyer may be able to locate an investor interested in owning the property, but not the business.    The business buyer would have to be satisfied with leasing the property, but a lease with an option-to-buy or right-of-first-refusal may be a way to make these transactions work for everyone.  Further, certain leasing companies will actually purchase the company’s equipment and lease it back to the company.  There can be both cash flow and tax benefits to such arrangements.

In addition, certain financing companies provide loans on or will purchase outright otherwise illiquid assets, such as the business’s accounts receivable.  While not always the best financing source, certain companies will purchase promissory notes offered by buyers.  For a seller primarily interested in receiving cash, this may be incentive enough to allow a buyer to purchase a business using only a buyer’s note.

In conclusion, while the business purchase requires substantial funding, the financing options are numerous.  Before signing the bank loan, the buyer should consider the benefits of other funding sources.

For further information, please contact Jeff Rogyom at (410)929-4578.

A business transfer’s success or failure often depends upon retaining the company’s employees and their knowledge of the business.  Many times, a company’s most valuable employee is its soon-to-be former owner.  Further, the buyer must consider the company’s obligations to the employees and consider whether employee departures could harm the company.  Of course, the seller showing confidential company information to prospective buyers has concerns as well.

Agreements for Employees:

Generally, businesses will limit their employee obligations through employment agreements.  Companies often require employees accept confidentiality agreements, non-compete agreements, and non-solicitation agreements.  Confidentiality agreements restrict persons from sharing information, while non-compete agreements restrict the person from working for a rival.  Non-solicitation agreements limit the employee’s ability to encourage fellow employees to follow them to a new employer.  In addition, employment agreements should limit an employee’s ability to claim ownership of their work-product, such as client lists.  As a buyer of a business, you cannot assume your predecessor properly protected the business.

The buyer should analyze the company’s employment contracts and related agreements.  Inevitably, some employees will either be dismissed or leave following an ownership or management change.  But do not focus solely upon those employees.  The buyer’s attorney should review all existing contracts and determine whether the company will need new employment agreements.

Further, the buyer’s attorney should be asked to determine whether the current contracts create any contractual commitments to these employees, particularly any clauses overriding employment-at-will laws or granting severance packages, sometimes referred to as “golden parachutes”.  Other contractual obligations the business buyer can inherit include previously agreed upon compensation, bonuses, and fringe benefits.

Non-compete, or Non-competition, agreements can be crucial to preserving a business.  It is not only salespeople who are worthy of a non-compete agreement.  Any employee with knowledge of your business, its contacts, or its processes could be a valuable asset to your competitor.  The laws regarding non-compete agreements are extensive and vary greatly from state-to-state.  The slightest mistake can make the non-compete agreement unenforceable, so I suggest seeking professional assistance.

Agreements for Sellers:

On a positive note, employment agreements or consulting agreements are sometimes used to retain an otherwise departing owner.  Rather than compensating the owner outright through a lump sum or installment payment, it is often worthwhile to keep the seller involved to make the ownership change less shocking to the business and its partners.  The seller may not be thrilled to remain active in the business, so the consulting agreements should consider delegating specific functions or tasks as a requirement for the employment or consulting agreement.

The seller should be required, as part of the sale, to agree to confidentiality agreements, non-compete agreements, and non-solicitation agreements.  No matter how intent the seller is to leave the business, the buyer will want to protect their interests should the seller have a change of heart.

Agreements  for Buyers:

Finally, the business seller should consider requiring prospective buyers sign confidentiality agreements. During the business sale process, the seller will be disclosing sensitive business information.  This could be particularly damaging if the potential buyer is in the position to use the information.

For further information, please contact Jeff Rogyom at (410)929-4578.

When purchasing a Maryland business, the buyer must ensure all desired assets are properly transferred regardless of the chosen sale method. As discussed in earlier articles, attorneys will consider many issues when deciding to structure a sale as either an asset sale or a stock sale, including tax and liability issues.  When utilizing an asset sale, the transferring documents must reference and account for all assets purchased. Even if the attorney structures the transaction as a stock sale, the buyer should confirm the purchased company actually owns the desired assets.

All desired assets will need to be documented for an asset sale. A bill of sale can be used to account for most equipment, inventory, and supplies. New deeds must be issued for each transferred real estate parcel. Company vehicles will need to be retitled with Maryland’s Motor Vehicle Administration. If leased equipment is included in the asset sale, then the lease will need to be assigned to the new owner.  Real property transfers and leases are discussed in more detail in a separate article.

In addition to these material assets, the buyer should not forget the company’s intellectual property. If the company has client lists, business processes, trade names, trademarks, or patents, then the buyer should specifically address these assets. Careful attention should be given these assets as many state and federal laws govern intellectual property. In some instances, it can be difficult to determine the true owner of the intellectual property. For example, is the company or an employee the real owner of a valuable patent? A review of the employees’ contracts may be necessary.

Assuming the ownership transfer is successful, intellectual property owners must regularly submit notices to regulatory agencies to preserve their rights. The time of sale would be a proper occasion to investigate upcoming trademark filing deadlines.

For further information, please contact Jeff Rogyom at (410)929-4578.

For many businesses, the business location is its most valuable asset.  This remains true even if the company only leases the location.  Therefore, maintaining the right to use the property following the transfer is of utmost importance.  If the lease is valuable to the buyer, it should not be assumed the seller has the right to sublease or assign the lease to the buyer.

As early as possible, an attorney should review any lease agreements and should contact the landlord to gain approval for a sublease or assignment.  Generally, lease agreements will not permit a sublease or assignment, but do not lose hope.   First, the lease agreement often allows a business to retain the lease if the business entity’s ownership changes.  Second, the landlord may be more willing to allow a sublease or assignment than the landlord’s lease agreement indicates.

In addition, the buyer should note any limitations in the lease agreement on the tenant’s permitted uses of the property.  If not permitted, your dream to change the current coffee shop into a coffee & oil change shop may be dashed.

There are notable differences between a sublease and assignment, and the buyer and seller should be aware.  A sublease is typically a continuation of the current lease, with the seller/tenant remaining responsible should the buyer/subtenant default or otherwise create a liability.  An assignment is an agreement between all parties (current tenant, new tenant, and landlord) that the lease will, going forward, be between the new tenant and the landlord.  An assignment may relieve the former tenant of liabilities for the lease, but, ultimately, the written agreements between the parties will dictate the terms.

If the lease does not readily permit a sublease or assignment, negotiations between the seller, buyer, and the landlord may permit a discussion of the future lease price, term, uses, etc.  Of course, depending upon each party’s power, this may be either favorable or unfavorable.  The transfer of a lease can have tax ramifications as well, so your attorney should be notified of both the assignment and any changes made to the agreement.

Even if not required, it may be advisable to have the seller, buyer, and landlord sign a document acknowledging the sublease or assignment.  When leased real estate is an integral asset of the business, an abundance of caution is warranted.

For further information, please contact Jeff Rogyom at (410)929-4578.

A major consideration when purchasing an existing Maryland business should be minimizing the tax burden.  Certain transactions provide tax benefits to either the purchaser or the seller while providing a tax burden to the other.  Therefore, tax consequences should be considered when determining the appropriate purchase price.  The general rule is that the sale of a business is a taxable event; however, the parties may be able to structure the transaction using a tax-free reorganization.  The IRS provides several forms of tax-free reorganizations, but to qualify the parties must meet numerous requirements.  Since the IRS only allows tax-free reorganizations under limited circumstances, I will first discuss taxable transactions.

As a taxable transfer, the buyer and seller have two general options: using stock sale or asset sale tax rules.  Though conceptually similar, I will discuss the tax consequences of a partnership sale in a separate article.  The seller generally favors a stock sale because the seller is taxed upon sold stock using the capital gains rate (15%).  In contrast, an asset sale’s seller may be required to use the higher ordinary income tax rate for certain sold assets.  The buyer generally favors an asset sale, because an asset sale increases the basis of the company’s assets (rather than the basis of the purchased stock).  Therefore, following the purchase of the business, the buyer may sell assets realizing less income tax and may depreciate the acquired assets for tax purposes using the assets’ new, higher basis.

Balancing the buyer and seller’s opposing tax burdens and benefits requires an analysis by a tax expert.  While, as stated above, certain transaction forms are generally better for one party, an analysis of the company and the company’s assets may conclude the tax benefit to one party is minimal compared to the tax burden to the other.  Therefore, well-advised buyers and sellers generally choose transactions favoring the parties in aggregate, rather than favoring the IRS.

To qualify as a tax-free transaction, the transfer must meet IRS requirements.  Generally, it requires the “seller” to remain a partial owner of the resulting company.  There are several forms of tax-free reorganizations appropriate for buying or selling a business.  Each referencing a paragraph of the Internal Revenue Code, the relevant reorganization formats are known as Type A, Type B, and Type C reorganizations.

Each reorganization type requires some compensation be paid to the seller in the form of the purchasing corporation’s stock.  A Type A reorganization requires at least 50% of the compensation value be paid in stock, while a Type B requires at least 80%.  Type A permits compensation using either voting or nonvoting stock, in contrast to Type B which only permits compensation using voting stock.  A Type C reorganization requires the purchaser acquire 80% of the target’s assets and pay the target solely in voting stock.  Regardless of the tax-free reorganization type, amounts paid in something other than stock are immediately taxable.

State and local taxes must also be considered.  In addition to income and corporate taxes, most states will impose a sales tax upon owned or leased tangible personal property transferred during the sale.   This form of sales tax is generally referred to as a “bulk sales tax”.  The Maryland Comptroller’s bulk sales tax imposes a 6% tax on the price of tangible personal property included in the purchase, unless an exemption applies.  The Maryland bulk sales tax does not apply to inventory held for resale, titled vehicles, and certain production equipment.  The Maryland bulk sales and use tax specifically applies to furniture and fixtures, computer software, business records, customer lists, and non-capitalized goods and supplies.

For further information, please contact Jeff Rogyom at (410)929-4578.

Parties seeking to buy or sell a Maryland business must consider both known and unknown liabilities.  Certain business lines obviously raise more concern for liabilities than others, but you need not purchase a former asbestos company to inherit exposure.  If a buyer purchases a company without considering potential liabilities, the buyer may purchase the seller’s potential lawsuits and contractual liabilities with no recourse against the seller.  In addition, many regulatory and tax liabilities may pass to subsequent purchasers and put company assets at risk.

The transaction can be structured to limit some forms of liability.  If the buyer purchases a business using a “stock sale” transaction, the buyer purchased the entire entity, including its assets and liabilities.  But if the buyer purchases a business using an “asset sale” transaction, the buyer can purchase company assets and limit ongoing exposure to claims originating prior to the sale against the purchased business.

An asset sale alone, however, may not eliminate all liabilities.  The buyer should accept debts necessary to continue the business, and fraudulent conveyance rules limit the seller’s ability to fleece the company of assets at the expense of its creditors.  In addition, if the seller’s liabilities created liens against company assets, then those assets remain at risk.  Buyers must confirm purchased assets are not subject to undisclosed liens.  Liens can result either through commercial financing agreements, through tax debts, or by operation of law.

The buyer should consider these potential liabilities and either account for the liability in the purchase price or seek indemnity agreements with the seller.  Of course, indemnity agreements only have value if the agreement can be enforced against the seller.

From the seller’s perspective, the seller should ensure regulating agencies, suppliers, and other potential creditors no longer consider the seller or the selling business responsible for future company debts.

Only after analyzing potential liabilities should your attorney determine the desired structure for the sale of a Maryland business.  In addition to properly structuring the business sale transaction, the parties’ attorneys should also consider indemnification agreements, contingent payment arrangements, and the escrow of funds.

For further information, please contact Jeff Rogyom at (410)929-4578.

Buying or selling a business in Maryland can be a very exciting time but can turn into a nightmare if not planned correctly.  There are many things to consider, including what structure the transaction will take.  A list of typical structures include:

An Asset Sale – the buyer purchases the business’s assets but not the company itself;
A Stock Sale – instead of assets, the buyer purchases the seller’s corporate shares, LLC interests, or partnership interests;
A Business Merger – the purchased company merges with an existing business;
A Franchise Purchase – the buyer purchases the right to operate a business using the identity, property, or expertise of a franchisor.

The structure chosen by the buyer and seller of a Maryland business can sometimes rightfully ignore the intended result. For instance, a transaction whose ultimate purpose is to purchase the company assets can be structured as a business merger if a merger improves the tax or business consequences. Such a decision requires an attorney with tax and business knowledge.

Generally, the seller’s primary concerns are reducing taxes to be paid, obtaining relief from future liabilities, and ensuring any deferred payments are satisfied. Conversely, buyer concerns include acquiring the business or assets without interrupting the business, ensuring the seller’s claims about the business are truthful, obtaining relief from past or potential liabilities, ensuring the seller will not compete with his former business, and improving the business’s tax attributes, such as the tax basis of assets. Cautious business owners will not proceed through this process without the assistance of a business attorney addressing these concerns.

While the business sale documents address many concerns, there are additional necessary steps to accomplish a successful transition of company ownership.  In addition to the business sale documents, an attorney will often be needed to assign or negotiate the commercial leases, to amend the companies’ standard contracts with suppliers and customers, and to draft the many related agreements.

For further information, please contact Jeff Rogyom at (410)929-4578.

Updated 5/19/2009, Following publication, the Maryland Comptroller’s Office announced early filings and payments will not be eligible for amnesty. The Comptroller’s Office is drafting an official amnesty application. Payments “under protest” for contested liabilities are eligible for amnesty if otherwise meeting the amnesty requirements. To receive notice when the Comptroller issues the amnesty application or further updates, please feel free to e-mail me.

The 2009 Maryland Tax Amnesty bill was signed into law on May 7, 2009, but the Maryland Comptroller’s Office will need to consider certain policy issues regarding its implementation. One obvious question Maryland tax attorneys and tax accountants are asking is, “What if you file prior to the Maryland Tax Amnesty period?”

The Maryland Tax Amnesty bill that went to Governor O’Malley for signing, reinstates the original bill’s half-interest allowance, having backed away from forgiving “all interest”. The final Maryland Tax Amnesty bill also shortened the Maryland Tax Amnesty period to September 1, 2009 to October 30, 2009, omitting Saturday, October 31st.

The 2009 Maryland Tax Amnesty applies to the state and local individual income tax, corporate income tax, withholding tax, sales and use tax, and admissions and amusement tax.  The tax must have been due for a return due prior to December 31, 2008.

If the taxpayer meets the bill’s requirements, the taxpayer will not be subject to any civil or criminal penalties. In addition, the taxpayer will only be required to pay half the interest due prior to October 30, 2009, but the taxpayer will have full interest assessed during the collection period. If the Maryland Comptroller accepts an amnesty payment plan, the Maryland Tax Amnesty bill requires the Maryland Comptroller enter into an installment agreement whereby the taxpayer must pay the entire debt prior to December 31, 2010, a period often shorter than the taxpayer would otherwise be allowed.

There are several taxpayer classes ineligible for the Maryland Tax Amnesty. First, the amnesty does apply to taxpayers with more than 500 employees in the United States on September 1, 2009. Companies considered part of a “corporate group”, as defined by the bill, must count its corporate group’s employees. Second, taxpayers who utilized the 2001 Maryland Tax Amnesty will not get a second break.

In addition, via a later amendment, the Maryland General Assembly disallowed the amnesty for companies “eligible” to use the 2004 “Settlement Period” granted to companies with Delaware holding company corporate income tax issues following Maryland’s favorable ruling in the SYL and Crown Cork & Seal cases. While the bill disallows amnesty to this taxpayer class, contacts believe the Comptroller’s Office may will limit the class’s disallowance to corporate income taxes rather than all eligible tax types. Additional discussions indicate the Comptroller may further limit the corporate income tax disallowance solely to adjustments relating to Delaware holding companies.

So, should you wait until the Maryland Tax Amnesty period’s first day, September 1, 2009, to file your Maryland return? Many tax practitioners are likely asking this question. Given the tax amnesty is to accelerate rather than delay tax payments, the Maryland Comptroller will likely consider applying the amnesty provisions to earlier filed tax returns and payments as a matter of policy.

While a tax practitioner should never advise taxpayers to delay filing and remain out of compliance with Maryland tax laws, I am certain many Maryland tax returns are labeled “Hold Until September 1^st”. So, assuming Governor O’Malley signs the bill, many prudent Maryland tax practitioners will be waiting for the Maryland Comptroller to issue guidance regarding both how and when to file Maryland Tax Amnesty returns.

Taxpayers with tax liabilities should take advantage of this rare opportunity. In particular, out-of-state businesses not currently filing in Maryland should contact an advisor to resolve any possible Maryland tax issues.

The enrolled Senate Bill 552 can be reviewed on the Maryland Assembly website.

For further information, please contact Jeff Rogyom at (410)929-4578.