Terminating S-Corporation Status

Have you decided that, following passage of the Tax Cuts and Jobs Act of 2017, you would be better off if your business were a C corporation instead of an S corporation? Are you regretting that you ever made that S election or wishing you had thought this through and acted sooner? Fret not … there is still time to terminate your company’s S-election and be taxed as a C-corporation for the entire 2018 year! As long as it is done by March 15th, the termination will be retroactive to January 1st and effective for the 2018 tax year.

First, you will need to make sure that at least a majority interest of shareholders (i.e. shareholders who collectively own more than 50% of the voting interest in the corporation) are on board because a majority is needed to terminate the S election. You should also check your Bylaws and Shareholders Agreement for whether a super majority or unanimous consent is required to terminate S election. Accordingly, your first step should be drafting a corporate resolution seeking the appropriate consent of the shareholders to terminate S status. Once that has been accomplished, the next step is filing the papers with the IRS, which basically consists of submitting a letter of consent to the IRS that demonstrates consent by the shareholders to terminate S status and includes a slew of required information. Finally, you should check with your state to see if there are any additional state filing or notification requirements. And of course, be sure to keep your accountant in the loop!

One note of caution is that once you terminate S status, you generally cannot re-elect S status for 5 years. So before you make the change, be sure to consult with your legal, tax, and financial advisors to be sure that this is the right move for the company and its shareholders.

 

Electing a Partnership Representative Under the New Law

As of this year, following implementation of the Bipartisan Budget Act of 2015, LLC’s, partnerships, and other pass-through entities must have a designated Partnership Representative. The Partnership Representative replaces the Tax Matters Partner. This is more than just a title change. The Partnership Representative has far more authority and responsibility than the Tax Matters Partner. Under previous law, the Tax Matters Partner was responsible for being the entity’s representative in the event of an IRS audit or any other contact with the IRS, but had limited authority to bind the other partners. As of January 1, 2018, that role has been eliminated and replaced with the Partnership Representative. The Partnership Representative will have significantly more authority to bind the other partners with respect to an IRS audit proceeding. That means that the Partnership Representative can have full and absolute discretion to settle with the IRS, pay the imposed taxes and penalties, proceed to litigation, agree to extend the statute of limitations, etc., all without consulting or even notifying the other partners.

Unlike a tax matters partner, the Partnership Representative need not be a partner/owner of the entity. In other words, the partners can designate a non-owner third party to be the Partnership Representative. Even if the partners have not formally elected a Partnership Representative, when the entity files its tax returns, it will be asked to provide the name of the partnership representative each year. Failure to do so could result in the IRS appointing a Partnership Representative for the partnership.

Accordingly, owners of pass-through entities should take action now, such as appointing a Partnership Representative by resolution and/or amending their partnership/operating agreements to address this and other related changes to pass-through entity law under the Bipartisan Budget Act of 2015 that came into effect this year. For example, beyond merely appointing a Partnership Representative, the partnership/operating agreement can dictate how the representative is appointed and replaced, and can provide for certain parameters, such as requiring the representative to keep the other partners in the loop. Agreeing on these terms now will be far easier than waiting until the company is faced with an IRS audit.

Did C Corporations Just Become More Attractive?

Pass-through entities, such as S corporations and LLCs, have been all the rage for small business owners for the past few decades. Pass-through entities offer all of the liability benefits of traditional C corporations but without that pesky corporate level tax. Now that the maximum corporate tax rate just plunged from 35% to 21% under the new tax law, might people start looking at C corporations in a new, more favorable light? Might people start forming C corporations or even converting their S corporations and LLCs to C corporations?

But wait, didn’t the law also provide significant tax relief to pass-through entities in the form of a 20% tax deduction? Well, yes, but with some catches. One catch is that, unlike the corporate tax rate cut, the pass-through tax deduction is set to expire in 2025. Perhaps it will be extended, but there’s no way to know for sure. (Then again, a future Congress could raise the corporate tax rate back to 35%.)

Another catch is that there are significant limitations for certain services providers, such as doctors, lawyers, accountants, and engineers. If you are one of the specifically excluded professions and operate as a pass-through entity (e.g. an engineer providing services through a firm structured as an LLC), the 20% deduction begins to phase out after $157,000 in income for single taxpayers, $314,000 for married taxpayers. This could lead some people to consider splitting their businesses into two entities if, for example, one aspect of their business is offering engineering services (subject to the income exclusions) and another aspect of their business is offering architectural services (not subject to the income exclusions). They could end up with a C corporation for their engineering services and an LLC or S corporation for their architectural services.

However, before forming or converting your pass-through entity to a C corporation or splitting your business into two separate entities, keep in mind that there is still a corporate level tax, albeit a much lower one. Whether it’s 35% or 21%, if you are paying yourself all or most of your company’s profits, you will still probably want to avoid that corporate-level taxation. However, if your entity retains a significant portion of profits in order to grow the business, then a C corporation may make sense, especially if you fall under one of the professions subject to the pass-through exemption income restrictions.

The bottom line is that you should consult with your accountant to crunch the numbers and your lawyer to discuss the process. Which brings up another downside to converting – the fees you will have to pay professionals, along with any filings fees charged by your company’s state. Those costs need to be factored in. If the tax savings will be minimal, it may not be worth the costs of conversion. However, if you will be enjoying significant tax savings, it may be well worth the costs now to enjoy tax savings over the long haul.

Should You Quit Your Job To Take Advantage of the New Tax Law?

You love your job. You earn a good living. But what if quitting your job could actually save you money? Under the new tax law, there are people who could enjoy significant tax cuts by quitting their jobs and getting re-hired by the same employer as an independent contractor.

The Tax Cuts and Jobs Act of 2017, which was signed into law on December 22, 2017 and takes effect for tax years beginning January 1, 2018, offers some significant tax advantages to individuals who offer services through a pass-through entity, such as an LLC or S corporation. In a typical structure, the individual forms a pass-through entity, and then the entity is engaged as an independent contractor by a company in need of the individual’s services. Utilizing a pass-through entity to offer the owner’s services has been a common practice for a lot of professional service workers, such as computer programmers, architects, and web designers, because an entity offers liability protection, and a pass-through entity means that the individual does not have to pay taxes at the corporate level (avoiding the so-called double taxation). The new tax law just sweetened the deal even more by allowing many owners of pass-through entities to deduct twenty percent of their revenue from their taxable income.  That’s why working for your employer as an independent contractor through a pass-through entity instead of as a traditional employee could save some individuals a lot of money in taxes. (Certain professions, such as doctors, engineers, lawyers, and accountants, are subject to income phaseouts that start at $157,000 for single taxpayers, $314,000 for married taxpayers.)

But wait, there’s more! Not only did the deal get sweetened for people who offer services as independent contractors through pass-through entities, but it also made life a little tougher (or, at least, a little more expensive) for traditional employees. Employees who have been deducting their unreimbursed work-related costs will no longer be able to do so. That’s because the new law eliminates this itemized deduction. Depending on how much in unreimbursed expenses an employee incurs, that could be a significant tax deduction that will no longer be available to them starting this year.

So with the new tax laws being skewed in favor of independent contractors and against employees, should employees be turning themselves into independent contractors? Should, for example, an architect who is employed by an architectural firm consider approaching her firm about switching from being an employee to being an independent contractor? Since she’s not limited by the specified service businesses rules (architects were essentially specifically excluded), she could set up an LLC of which she is the sole member, her firm could pay her LLC for her services, and all the income received by the LLC would pass through to her. She would then be able to deduct 20% of her income. Additionally, she would not have to worry about those unreimbursed expenses not being deductible because she would be able to deduct any work-related expenses as business expenses. Sounds like a pretty good deal, right? Well, from a purely tax standpoint, it is! But there are some potential downsides that need to be considered.

By changing over to an independent contractor she would be giving up her status as an employee. This means that she would be giving up certain protections and benefits. For example, the Title VII anti-discrimination laws protect employees, not independent contractors. So if her firm terminated her employment while she was still an employee, she could file a Title VII violation claim against them if she felt she was fired for being a woman. However, once she is an independent contractor, she loses that protection. Additionally, if she has been enjoying certain employee benefits, such as group healthcare, matching 401(k) contributions, paid vacations, etc., she loses all of those too. She also loses FMLA and workers comp protection (if she gets pregnant or sick or is injured on the job) and unemployment protection and COBRA (if she loses her job). There are many benefits to being an employee over an independent contractor that would be lost to anyone making the switch.

With all that said, because the new tax law so heavily favors independent contractors over employees, employees will want to consider whether they should form a pass-through entity and operate as an independent contractor through their entity. Anyone considering doing so, should first speak with their accountant and seek legal advice to make sure that the pros outweigh the cons for their particular circumstances. Additionally, employees may be able to negotiate the terms of their switch with their employer, since switching could benefit the employer too.

In my next blog post, I will discuss the employer-side pros and cons and what an employer should consider if an employee approaches them about making the switch to independent contractor status. In the meantime, for more details on the tax implications of incorporating, or for other scenarios involving incorporation, see Kelly Erb’s post at Forbes.

State of Incorporation

State of Incorporation

Alas, not the most popular state to incorporate in

Europeans often think that they are catching up to the US, at least in terms of harmonized and consistent laws, but in many instances our system is actually more federalized than that of Europe. Whereas you can now form a European corporation, US corporations are formed under the laws of a particular state, rather than under the federal (United States) law. Typically, that means you’ll have to decide between the state in which you’ll actually be headquartered or operating (assuming you know which state that is) and one of the states which has advantageous tax or corporate laws for corporate formation.

Traditionally, Delaware has been the first choice of most corporations because of its favorable tax and corporation laws, but other states such as Nevada, Alaska, and Wyoming have also been trying to get into the lucrative business of corporate services in recent years. If you’ll be operating completely within the border of a single state, you might as well incorporate in that state, but most German businesses are seeking to sell throughout the United States so a Delaware (or other law-tax state) corporation will be more advantageous. There is no equivalent to the European Corporation (SE) in the United States, so every US company will have to choose a state of incorporation.

Even more confusing, if you will be operating in a state outside of your state of incorporation you will have to file for authorization to do business in that state (or those states) as a foreign corporation. That’s right, a Delaware corporation doing business in California or even neighboring Pennsylvania is considered “foreign” for the purposes of state law, just as a German corporation would be, and may have to register as a foreign corporation. Although state laws regarding filing for authorization differ, it’s a safe bet to say that if you’ll have employees or physical assets based in a particular state you’ll be required to register in that state.

So, for example, if you form a corporation under the laws of Delaware, but will have your offices in New Jersey, you’ll form the corporation in Delaware and then file for authorization to do business in New Jersey. If you also have branch offices in California and North Carolina, you’ll need to file for authorization in those states as well. Filing for authorization in a particular state triggers other obligations as well, including the obligation to file an annual tax return and, usually, to file papers with the state relating to labor, taxes, and other fees. For any state in which you do not have a physical presence you’ll also need to pay a registered agent to accept mail and service of legal process on your behalf, which usually costs no more than $200 per year.

This is the first in an occasional series of posts on starting your business in the US.

So long e-signatures, it was nice to know you.

DocuSign screenshot

We recently bought a house or, more accurately, a bank bought a house which we own a teeny-tiny part of. That, of course, resulted in an unending series of requests by mortgage companies, banks, title companies, realtors, sellers, etc. for signatures on long and seemingly duplicative documents. In most of those cases, our signatures were obtained via DocuSign. That’s become pretty standard practice in the real estate industry these days, and also in other industries which require large numbers of signed documents. While it’s annoying, I suppose it beats having an equally large pile of signed originals in a file somewhere.

Or maybe it doesn’t. According to a recent memorandum in a California court, however, a “signed” DocuSign document might not be enough. The judge in that case sanctioned an attorney for relying on DocuSign signatures in the context of bankruptcy law, pointing specifically at a requirement that electronic signatures are only valid if a copy of the “original” signed document was retained. DocuSign, of course, has based its entire platform on the idea that the digitally signed document is the original, which may now be in serious doubt.

For now, the memorandum serves as a reminder that users of digital or e-signatures have to be certain that the laws pertaining to that particular transaction allow e-signatures without a “wet signature” to fall back on in the event of a dispute. Bankruptcy lawyers in particular, take note. That being said, the logic behind the memo calls into question the entire premise behind electronic and digital signatures and, if followed, may end up being a really good development for paper companies. After all, if I sign by putting my name following /s/ in an e-mail, or using the signature function in Apple’s Preview application, the potential authentication issues raised in the memo are exactly the same as raised in this case.

I’ll keep that in mind if we have second thoughts about this whole home-ownership thing.

Hat tip to Whitney Merrill (via Twitter, @wbm312)

Hey, I’ve lost my company’s domain name!

Whois screengrab

I love me some VT 220 (ok, faux VT 220, but close enough)

The registration system for domain names isn’t really set up for corporate ownership, since the “owner” of a domain name is typically the person who is listed as registrant rather than the corporation. The down side of this system is something we see all the time, particularly with small companies – a domain name is registered by a well-meaning, tech-savvy employee (all too often in his or her personal account) and, when that employee moves on, the company is stuck without control over critical domain names and related accounts. If the employee is fired, it’s even worse, since the now-disgruntled employee may well have control over the company’s entire online presence for an indeterminate period of time.

While there’s no silver bullet here, there are a few best practices which make it easier to regain control over a domain under the control of a wayward (or simply unreachable) ex-employee. Those are:

  • Make sure the company name and address is listed as the Registrant, along with the name of an officer who is most likely to remain with the company. The tech savvy employee can be listed as administrator, to facilitate management of the domain without jeopardizing ownership.
  • Corporate web assets should be held in an account which is in the company’s name and paid for with a company credit card, and should be kept separate from other business or personal websites and domains.
  • Have an agreement in place making it clear that, upon termination of employment for any reason the domain name registrant and admin are to be changed to an officer of the company’s choosing. Ideally, this should be in a standalone agreement so you can provide it to the registrar without divulging hiring or salary information.
  • Make sure renewal notices and the like go to a generic e-mail address, ideally one which is monitored by more than one person, so that termination or resignation of an employee doesn’t result in a lapsed registration (although there are downsides to this as well).
  • Make sure someone other than the admin knows the password to the account (but be judicious, you also don’t want the password becoming generally known). For particularly active accounts, you may want to request a regular update confirming the password and listing all domain names along with expirations dates for the corporate account.
  • Make sure all domains are registrar locked against transfer and deletion

The above isn’t foolproof, since a knowledgeable or well-placed employee can manage to retain control no matter what the circumstances, and given that registrars differ in how they handle requests relating to domain name ownership. Also, be aware that some of the above suggestions may have downsides as well, so consider what’s best for your organization when determine who has access to accounts and how.

Of snow and “Acts of God”

IMG 4108

Once again, into the breach …

As we prepare for what weather forecasters are swearing will be a foot or foot-and-a-half of snow (I’ll believe it when I’m shoveling it off of my driveway), it got me thinking about snow and force majeure clauses in contracts. Yes, unfortunately, instead of sledding or snowball fights, that’s where the lawyer’s mind goes. Oh for the days of Calvin-esque excitement at the prospect of a heavy snowfall.

But I digress …

Force majeure clauses are those long paragraphs in contracts which refer to all sorts of horrible things which could happen, but likely won’t. For example, one picked at random from my files includes “acts of God, actions by any government authority (whether valid or invalid), fires, floods, windstorms, explosions, riots, natural disasters, wars, sabotage, acts of terrorism, or court injunction or order.” The term, adopted from the French for “superior force,” is meant to cover external events or circumstances which prevent timely performance of a party’s contractual obligations. The key issues are typically whether it the event prevents performance and whether the party in question has any control over the event or circumstances which caused the impossibility.

As with so many other areas of contract law, US lawyers have added language to these clauses which would seem to deviate from the original idea of an obstacle which simply could not have been foreseen or prevented. As one blogger noted, the drafting of these clauses has become “a kind of arms race, with drafters throwing in ever more scenarios [which] evoke someone’s fevered vision of the apocalypse. I half expect to see, one of these days, ‘the Rapture’ added as an element.” Frankly, I’m sure the Rapture has been added to one of these clauses before, although I don’t recall having seen it.

At any rate, that brings us back to snow. The coming snowstorm, as predicted, would probably qualify as a force majeure in this area, since it’s well beyond the norm (whatever that means for weather these days) and could well close many roads for 24 to 48 hours. Of course, whether that actually prevents timely performance or not depends on what you do for a living. As a lawyer, I can generally complete my work from my kitchen table if need be, so it would take more than just a snowstorm to prevent performance of my obligations unless the internet goes down. Construction workers, road workers, or others whose work depends on travel may well have an argument that force majeure resulted in a delay for which they should be excused. Where possible, parties to a contract should try to mitigate the effects of the force majeure wherever possible (as our milk delivery people are doing today by delivering our milk a day early, thanks, by the way). Fortunately for the local construction industry, the mild winter means many contractors are ahead of schedule, so a day or two of interruption might not matter as much. In that case, they may be fretting for bonuses lost because they can no longer finish as early as they might have, but that’s a topic for another post.

If it snows tomorrow, I plan to settle in in front of the fireplace with a hot coffee or tea and perform my obligations as best I can. Of course, that’s reckoning without the interference of a force majeure beyond anyone’s control, namely, my children, who will likely be home from school.

The Basics of US Employment Law Part III: Vacation Time

This blog in the US Employment Law series focuses on vacation time.

One of the key differences between United States employees and employees in most of Europe is the amount of vacation time employees have come to expect. American employees think that four weeks vacation is extremely generous. Europeans, on the other hand, commonly enjoy four or more weeks of vacation even at entry-level jobs, and many European countries mandate a minimum amount of vacation time.

In the US, there are no federal laws mandating how much paid time off an employee must receive. Absent a collective bargaining agreement or other employment contract, most US employers do not have to offer any paid time off to their employees. However, some local laws mandate a certain amount of paid time off, including my home city of Philadelphia, which requires employers with a minimum number of employees to offer a certain amount of paid sick leave. There are also laws governing unpaid time off, such as the federal Family and Medical Leave Act. So employers should be sure to check with their legal counsel about their particular requirements.

It is also important for employers to understand that although they may not be legally required to offer any paid time off, a certain amount of paid time off has come to be expected in the US as a matter of practice. One might say that vacation time in the US is largely governed by custom. Most salaried (i.e. non-hourly) employees expect to receive one to two weeks of paid time off per year. This paid time off may be in the form of some combination of vacation time, sick days, and personal days. As employees advance in their careers, they expect to receive more vacation time. In general, it is customary for employees to receive between two and four weeks of vacation time per year, depending on their level of experience and years of service, with more senior executives enjoying more generous paid time off packages. Most entry-level jobs provide up to two weeks vacation. Six or more weeks of vacation time is generally reserved for the most senior executives – those who have worked hard, proven their loyalty, and are being rewarded towards the end of their career.

A common problem multi-national companies face is when they bring over an employee from Europe to work in the US office. The European employee often expects to continue to receive her four to six weeks of vacation. This, however, may not go over too well with her US colleagues working in the same office at the same level, but who are only getting two weeks of vacation. Employers need to be sensitive to this potential land mine.

The Basics of US Employment Law Part I: Protected Class Discrimination at the Federal, State, and Local Levels

For the next few weeks I will be doing a blog series on some of the key elements of United States employment law and how they differ from European employment law. This blog series is meant to familiarize Europeans (and others) who may be breaking into the US market and employing people in the United States. Topics covered in this series will include whether and how employees can be fired, vacation time, group benefit plans, and overtime pay.

Employment law in the United States is quite different than in most European countries. In general, the laws in Europe are considered much more protective of employees. For example, it is generally more difficult to fire an employee in most European countries than it is in the United States. While this may appear to benefit European employees, there is a flip side: an employer who does not have the ability to easily fire someone, may be more reluctant to hire in the first place, making the job market more competitive for employees. When employees are less willing to leave one job in search for another, the result is a more stagnant job market. While this may be great for people with good jobs, it may not be so great for those trying to break into the job market or make career changes. Proponents of United States employment law might argue that our less restrictive employment laws create a more productive work force as well as more job opportunities for the American worker. However, this blog series is not meant to be a commentary on the merits of one country’s employment laws over another’s. The purpose of this series is to explore some of the core principles of United States employment law.

One of the first concepts to understanding employment law in the United States is to understand that employment law is governed by both federal and state law. Accordingly, an employer located in Pennsylvania will be governed by both Pennsylvania employment law and United States federal law. In addition to state laws, there may be additional laws and ordinances for the city or township in which your business is located. While cities and states have a significant amount of authority to govern the laws that employers and employees are subject to, there are certain federal laws that trump any state or local law. The general rule of thumb is that while state and local laws can and often do provide additional protections for employees, state and local laws are not going to be less protective of employees than federal law.

One of the most notable categories of federal laws that apply to all employers and employees regardless of the state in which the business is located are the laws that protect employees against discrimination on the basis of certain protected classifications. These classifications include race, gender, religion, national origin, disability, and age. Accordingly, no state law can permit an employer to fire an employee, or chose not to hire a job applicant, on the basis of any of these protected classifications. State and local law can, and often do, go further and provide additional protections to employees. For example, while federal law does not prohibit private employers from discriminating against an employee on the basis of sexual orientation, many states and cities have enacted such prohibitions. Pennsylvania does not include sexual orientation in its listing of protected classes, but the City of Philadelphia (along with Pittsburgh and several other Pennsylvania cities) does prohibit employment discrimination on the basis of sexual orientation.

The next blog will examine the concept of employment at will.