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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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Any Silicon Valley mergers and acquisitions lawyer helping clients buy and sell high technology companies is invariably provided with a simple letter of intent, happily signed by a couple of companies without input from their tax and legal advisors, and asked to prepare binding documents. In one case, my San Jose business client was not too worried about the lack of detail in the letter because, after all, it was just a “letter of intent”. She was less than happy when I told her that she had actually signed a binding agreement, particularly since very little due diligence had been performed on the target company and a number of ‘minor’ issues that were important to her still required resolution.

A letter of intent (also called “LOI”, or memorandum of understanding, or “MOU”) is usually a short letter that outlines the basic business terms of a deal. Without language expressly stating that the letter is nonbinding, and that no obligations arise except under a definitive agreement, however, that letter you signed may be a legally binding contract. Even with this kind of language, a letter of intent can morph into a binding contract IF the parties conduct themselves as if the target company has been acquired. Announcing a deal (when not otherwise legally required), combining operations before a closing, and similar actions, can create a contract from conduct. With no definitive agreement signed, the letter of intent may be used as evidence to set the terms of the deal.

Why do you want an LOI to be nonbinding? Letters of intent are usually prepared and signed after the initial business proposition and marketing analysis have been performed. They are typically signed before the acquirer has a chance to really investigate the target. This is because neither party will want to conduct an expensive diligence investigation until each is sure they have a deal. If the letter of intent is binding, then the acquiring company may find itself purchasing a lot of problems of which it wasn’t aware when it signed the letter of intent.

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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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Over many years of working with real estate investors, one question has come up over and over again: “Can I qualify as a real estate professional so I can deduct my passive losses against my ordinary income?” The last time was from a San Jose full-time professional who has rental property in Sunnyvale. I almost always have to disappoint my clients with the answer that they do not qualify. Several times I have had my Silicon Valley clients and their advisors disagree with me, despite explaining the rules to them. Many of them go on to report it the way they want to, and take the risk.

The United States Tax Court just answered the same old question again. In Yusufu Yerodin Anyika et ux. (TC Memo. 2011-69, March 24, 2011), the taxpayers were a married couple that had been buying, renovating, managing and selling rental real estate for years. He worked 37.5 hours per week, 48 weeks per year as an engineer and she worked 24 hours per week as a nurse. During 2005 and 2006 they had two rental properties, which Mr. Anyika considered to be his second job as well as their investment property. They filed their tax returns themselves with TurboTax, claimed he worked 800 hours per year managing the real estate, and deducted their rental real estate losses. The Tax Court held that for them to be able to deduct their rental real estate losses he must have worked more than 750 hours and over half of his working hours on their real estate investments. Mr. Anyika then re-estimated his real estate hours to be 1920, just over the 1800 he spent in his day job. Unfortunately for Mr. Anyika, the Tax Court did not believe his new, unsubstantiated re-estimate and held that he did not qualify as a real estate professional. The Tax Court did hold that Mr. Anyika qualified for a $25,000 deduction for materially participating in real estate, but this deduction was not available to him because his adjusted gross income was too high.

Something to note, which was not an issue in the Anyika case, is that the rules are even worse for short term rentals. Time spent on properties with average rental periods of seven days or less does not count towards the 750 hour test, and losses on those properties are also ineligible for the $25,000 deduction for actively managed real estate. (Source: Kiplinger Tax Letter, March 18, 2011, Vol. 86, No. 6)

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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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Technology start-up companies in Silicon Valley exist in a highly dynamic environment, where survival can be crushed by competition from a kid in a garage or a fund partner refusing further investment. As a last gasp, some companies may try to be acquired. Companies which have had to take refuge from their creditors may be able to sell their business through bankruptcy proceedings.

When compared to a standard sale of a business, sales of financially troubled companies require the professional advisors to manage a number of different stakeholders to successfully close a transaction. More so than in standard transactions, professional advisors play an important role in helping a transaction proceed smoothly. Under certain circumstances, their fees may be paid by the buyer or the bankrupt estate.

Most acquisitions of financially troubled companies are structured as an asset purchase. This prevents the acquirer from having to automatically assume liabilities that it doesn’t want. The existing creditors are then left with satisfying their claims out of the proceeds from the sale. Most companies, however, need the products or services of its creditor vendors to survive. In the case of technology companies, these vendors often include technology and hardware suppliers who are core to the company’s business. Irritated suppliers may not want to deal with the company even after its acquisition. Creditors and stockholders of the company may have claims against the company’s board of directors if a company is sold for less than the reasonably equivalent value of its assets. At the same time, key employees of the company, aware of the company’s financial stress, may be looking for alternate opportunities. The importance of these stakeholders, and how they are managed as part of the acquisition, is at the heart of any purchase of a financially troubled company.

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Over the last two years I have often been asked to answer the question of what the consequences will be if a client walks away from a property, letting the bank take it back. The previous decade of incredible real estate appreciation resulted in many people without previous real estate investment experience becoming real estate investors. The most common situation I see is the condo owner who had enough income to keep his condo as a rental and still buy himself a single family residence. Then the recession hit and both properties are now underwater. Now, he thinks he can walk away from the property thanks to the Mortgage Debt Relief Act. Unfortunately, that Act was put into place to help people who were losing their homes, not to help people with investment properties. Even more unfortunate is that a lot of these beginner real estate investors thought that they could handle their taxes themselves without an accountant.

California is now focusing on finding those people and making them pay tax on the cancellation of debt income they should have recognized on giving up their underwater investment property to the bank. According to Spidell’s California Taxletter, (March 1, 2011, Volume 33.3), California is mailing letters for tax years 2007 and 2008 to taxpayers who had debt relief on properties that were reported on Schedule E and therefore, probably do not qualify for the principal residence exclusion. The letter calculates the potential additional tax owed as well as a 20% accuracy related penalty and interest on the unreported income.

If it is too late and you have already been given notice of an audit on cancellation of debt income, there are still some other exclusions that you may qualify for, such as business and farm indebtedness. If you are thinking of giving an investment property back to the bank, be sure to bring in a good accountant to analyze the tax situation for you first.

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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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