Articles Posted in Corporations

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I recently did a blog about California clients wanting to form LLCs outside of California in order to avoid California franchise taxes, and how the Franchise Tax Board has been steadily trying to eliminate those possibilities. In response to that blog, I was asked about other non-tax considerations for choosing a state for the formation of a business. So, here is a brief analysis of some of the things I consider when helping my clients choose the right jurisdiction for their new corporation.

When a client comes into my office in San Jose and asks about forming a business entity outside of California, the most common jurisdictions they are considering are either Delaware or Nevada. Delaware has traditionally been the favorite jurisdiction, and Nevada is gaining in popularity.

Why incorporate in Delaware?

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In negotiating a recent acquisition for a client selling a business in Santa Cruz, we were presented with a letter of intent outlining the terms of the transaction. The letter was well-constructed, and contained the material aspects of the deal, all of which were nonbinding. There were, however, a number of terms that were expressly made binding.

There are four binding terms most commonly used in nonbinding letters of intent for acquisitions of privately held companies. The first is that the parties will agree to standard nondisclosure obligations. The second is that the acquirer will be allowed to conduct a diligence investigation of the target. The third is that each party will pay its own fees incurred in connection with the transaction. If the transaction is a stock transaction, there may be some negotiation over whether the target can pay fees, under the theory that a stock deal is a deal among stockholders, rather than the corporation.

The fourth is the most hotly negotiated term – the “no shop” or “exclusivity” provision. The no shop is just as it sounds: the target company agrees not to “shop” itself while the transaction is in process. Acquirers usually demand this term so that their offer is not used by the target to get a better deal, and so that the time and expense they spend in the due diligence and negotiation process is not thwarted by another suitor. An acquirer will also ask that the target company stop any discussions with any other potential acquirer, and notify the acquirer if the target company receives any other acquisition inquiries.

Target companies attempt to insert a number of qualifications and limitations to the no shop clause. First, the target will request a “fiduciary out”. In this exception, the no shop is ineffective where an unsolicited alternate offer must be accepted in order for the target’s board of directors to satisfy its fiduciary duties. Second, the target will attempt to impose strict time deadlines which, if not met, will cause the no shop to expire. The primary deadline will be on the parties entering into a definitive agreement. Other deadlines include the acquirer’s completion of its due diligence investigation, and the closing of the acquisition.

Other binding terms include break-up fees where one party, typically the acquirer, will pay the other party, typically the target, if the acquirer decides not to proceed with the transaction.

As with most deals, the extent of number and type of binding terms in a letter of intent depends on the relative bargaining strength of the parties.

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I was recently working with some doctors who co-owned their Sunnyvale medical office building. They were concerned about the liability of having the property in their own names, so we worked with their lender and transferred the property into an LLC. Then, I suggested forming a professional corporation to operate their medical practice. Although doctors cannot avoid personal liability for their own malpractice, the corporation will limit their vicarious liability for the acts of their professional partners.

The California Professional Corporations Act allows licensed professionals in the fields of law, medicine, dentistry and accountancy to conduct business in a corporation, through the licensed individual shareholders. The Articles of Incorporation must include special language about the professional corporation. In addition to registering with the California Secretary of State, the corporation must also follow the naming and registration rules of the professional agency. The shareholders must be licensed, and transfers may only be to other shareholders or back to the corporation.

If a shareholder dies, the shares must be transferred within six months. If a shareholder is no longer qualified to practice medicine, the shares must be transferred within 90 days. For these reasons, I always recommend a shareholder buy-sell agreement to give the corporation or the remaining shareholders time to pay for the shares so it does not create financial difficulties for the company. Ideally, the corporation will also obtain life insurance on the professionals to fund a cash buy-out of a deceased shareholder’s shares.

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I was talking to a client in Cupertino this week about helping his friend with a start-up business in San Jose. Originally, my client wanted to form a corporation online by himself, but he was not sure if the company should be an S corporation (“S-corp”) or a C corporation (“C-corp”). He was only thinking about the pass-through implications of an S corporation and the “double taxation” of a C corporation, but was unaware of the small business stock tax exclusion in C corporations and the potential benefit to investors.

I explained that as an incentive to investors to make long term investments in small businesses, for investments made after September 27, 2010 but before January 1, 2012, 100% of the capital gain from qualified small business stock held for more than five years will not be taxed. The amount of gain excluded is the greater of $10 million or ten times the taxpayer’s basis in the stock (usually the amount paid for the shares).

To qualify for this incentive, there is a list of rules. The taxpayer must acquire the stock upon its original issuance for cash, property or services. The corporation must be a C corporation with a maximum of $50 million in assets, including the investment. It must not be a regulated investment company, real estate investment trust, real estate mortgage investment trust or other type of entity with special taxation, must not own investments or real estate with a value exceeding 10% of its total assets, must not own portfolio stock or securities with a value exceeding 10% of net assets, and must use at least 80% of the value of its total assets in the active conduct of a trade or business. The corporation’s trade or business cannot include professional services, banking, insurance, financing, leasing or the hotel or restaurant business.

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I was recently asked by a Cupertino real estate investor whether he should form his limited liability company in Nevada or some other state in order to avoid California taxes. I had to tell him that if anything, this would just increase his overall costs and taxes.

California franchise taxes can be much higher than taxes in other states, and include a minimum tax of $800 per year. As a result, companies often do not want to be classified as doing business in California. One way to avoid this classification used to be to form your entity in another state, and not register it in California. Some of my clients have numerous Delaware LLCs or Nevada LLCs. Often, those LLCs own other LLCs, which own property in California. In order to avoid the California minimum franchise tax for multiple entities, they just register the entity that actually owns the property in California.

However, a new ruling says that if the entity is doing business in California, owns property in California, or is managed by people in California, this exemption is no longer available at the parent LLC level.

The California Franchise Tax Board just issued FTB Legal Ruling 2011-01, stating that activities of a disregarded entity will be attributed to the entity’s sole owner. A disregarded entity is a single member LLC or a Qualified Subchapter S subsidiary (“QSub”) which is disregarded for income tax purposes so that its income passes through to its parent for tax reporting purposes. Therefore, if the disregarded entity is doing business in California, the 100% owner will be considered to be doing business in California and, if it is an entity, will have to register with the Secretary of State in California. This is true even if that owner entity has no other activities in the state, other than owning the disregarded entity.

This ruling is in addition to a previous California Franchise Tax Board ruling that an entity will be considered to be doing business in California if its managing person(s) are in California, even if all of its other activities are out of state.

For real estate investors, lenders often require a special purpose entity (“SPE”) to hold the property, which is structured as a single member Delaware LLC. Under these new Franchise Tax Board rulings, the single member LLC holding the property must be registered in California, and its 100% owner parent company must be registered in California as well. The bad news is that both entities are required to pay the $800 minimum franchise tax to California. However, the LLC gross receipts tax is not incurred twice on income that flows through from one LLC to another.

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Bridge financing for Silicon Valley start-up companies is a fairly standard, relatively inexpensive method to raising money pending a larger investment round. This type of financing is typically provided in the form of debt that converts into shares issued in the next funding round, often at a discount from the per share purchase price.

Recently, the simple convertible bridge loan has changed to provide substantial tax incentives to investors. For any qualified small business stock, or QSBS, purchased before December 31, 2011, the recently enacted 2010 Tax Relief Act allows 100% of the gain recognized from the stock to be excluded from taxable income.

Although a convertible loan will not qualify as QSBS, the stock that a start-up company issues normally will. Bridge loan investors have a great incentive to purchase stock in exchange for their bridge funds instead of a convertible note. Designing stock that has many of the same attributes as convertible debt has provided some additional complexities to what was formerly a plain vanilla transaction.

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Acquiring a financially troubled company, whether in San Jose, Palo Alto, or New York often requires consideration of the bankruptcy process. If the seller is already in bankruptcy, the buyer must convince the bankruptcy court that it represents the best source of funds to repay existing creditors. If the bankrupt company has attractive technology, there may be other buyers, and the court will typically award that company to the buyer who will pay the most money.

If the seller is not yet in bankruptcy, the parties may decide to purchase the company through a bankruptcy proceeding. If planned properly, the bankruptcy process can provide the buyer with a number of advantages. First, the seller’s assets are purchased free of any liens or other claims (although courts continue to wrestle with allowing subsequent successor liability claims). Second, because the assets are purchased “as-is,” sale documentation is typically shorter than for sales outside of bankruptcy, and stockholder approval is not required.

Planning for purchasing a company through a bankruptcy involves entering into arrangements with the selling company’s creditors and other stakeholders before the bankruptcy filing. As part of these arrangements, a reorganization plan and acquisition agreement may be prepared and agreed to prior to the filing. Once the appropriate pieces are in place, the seller will file for bankruptcy and include the pre-agreed reorganization plan in its bankruptcy documentation. The sale can be completed in a few months barring no other suitors or other unforeseen impediments. Bankruptcy counsel is necessary for both parties to properly shepherd the transaction through the proceedings, and corporate counsel is critical to insure that documentation is accurate and necessary corporate formalities are followed.

Financially troubled companies often provide the opportunity for others to purchase businesses at a relatively lower cost. Reaping the advantages successfully requires balancing the needs of all the business’s stakeholders.

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Just like estate planning is so important for those we leave behind when we die, a good shareholder or partnership agreement is crucial for the well-being of a business after a traumatic event for one of the owners. Death, disability, retirement, bankruptcy, insolvency, divorce, and even a partnership disagreement can be traumatic events for a company to endure, and could result in the end of a business if they are not planned for in advance. Planning includes deciding whether the company or the other owners have an optional right or a mandatory requirement to purchase the interest of the subject owner, at what price, and on what terms.

Any business with more than one owner needs a good shareholder, LLC or partnership agreement. It is equally as important for family owned businesses. For years, I worked with a real estate investment family business in Saratoga. When the father died after years of working together with his adult children, the LLC agreements we put in place were absolutely critical to keep the management control in the one child who was capable of running the business. In this case, the agreements put in place the succession plan which enabled the business to go on after the death of the majority owner.

A good shareholder or partnership agreement should consider what restrictive covenants the owners want to impose, including restrictions on sale and rights of first refusal. Agreements for companies involving sweat equity should deal with the amount of time, effort and capital (if any) required of each owner, and the vote required to remove someone from the company. Companies that are considering a sale as an exit strategy should consider rights to force the minority owners to go along with the majority owners on a sale, and rights of the minority owners to force the majority owners to include them in any sale.

The value of the company should be decided in advance of an event, and should be reviewed regularly. A formula or a method for valuation should be clear in the buy-sell agreement. And if the death or disability of one owner could materially impact the value of the company, the owners should consider funding the buy-sell agreement with life insurance and disability insurance. The future of the company is dependent on the agreements the business owners put into place now. Failure to have a buy-sell agreement could be a fatal mistake.

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In my last segment, I mentioned a recent deal involving a Northern California company structured as a stock sale. Having tax advisors assist at the early stages helped keep the transaction on track. The next major issue was allocating the risk of business liabilities between the buyer and the seller.

Like any stock purchase transaction, liabilities of the seller stay with the business. This is often a significant disincentive to the buyer, because it must hold an entity that cannot escape its past liabilities. Two mechanisms are commonly used to alleviate the buyer’s risk.

First, a working capital cushion may be created to provide a source of funds to pay the ongoing debts of the business. The amount of the cushion is agreed in the purchase documentation. A portion of the purchase price is then held back at the closing in an escrow. The amount of net assets as of the closing is determined through a post closing audit, and the held back amounts are distributed following the audit to the buyer or seller depending on any difference between the agreed amount and the amount determined under audit.

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In a recent acquisition that I handled for a company in Santa Cruz, the buyer decided to purchase, with cash, the stock of the company rather than its assets. Acquisitions through stock or equity purchases are a common method of buying a company. From an administrative standpoint, equity purchase acquisitions are one of the easiest deal structures to implement.

In an equity purchase acquisition, a company is bought by purchasing all of the ownership interests of that company. If the company is a corporation, a buyer purchases all of the company’s shares of stock from the company’s stockholders. If the company is a limited liability company or partnership, a buyer purchases all the ownership interests of the company from its members, in the case of a limited liability company, or its partners, in the case of a partnership. This discussion will focus on a stock purchase, although the basic issues outlined here are the same when dealing with a limited liability company or partnership.

The administrative benefit of a stock purchase transaction is that ownership changes simply by transferring all of the company’s shares. Contrast this with an asset purchase structure, where each desk, chair and personal computer must be accounted for and sold to the buyer.

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