Articles Posted in Small Businesses

The issuance or sale of securities is subject to regulation by the United States Securities Exchange Commission and by authorities in every state, including the Securities Division of the Office of the Indiana Secretary of State.   Depending on the situation, a member’s interest in a limited liability company may or may not be within the definition of a “security” and, therefore, may or may not be subject to federal and state securities laws.  If the securities laws apply, the consequences can be signficant because, as my friend and retired securities lawyer Steven Lund says, “There are three types of securities:  registered, exempt, and illegal.”

Contrary to what you may sometimes hear, there is no exemption for securities that are issued or sold to family members or close friends, and there is no sale of securities that is exempt solely because the value is less than a certain amount.  In addition, certain parts of the securities laws, such as those prohibiting securities fraud, apply to every securities transaction, even if it is exempt from registration requirements.  An illegal sale of securities can have serious ramifications, including civil lawsuits and potentially even criminal charges.  And there can be ramifications even if there is never a lawsuit or governmental enforcement action  For example, a debt incurred through a securities violation cannot be discharged in bankruptcy.  Owners of small businesses who set up new LLCs, or bring new members into existing LLCs, without obtaining the advice of a lawyer with experience in corporate and LLC law expose their businesses and themselves to signficant risk.

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I sometimes run across small business owners who have set up their business as a corporation, and I often ask why they chose a corporation rather than a limited liability company (or LLC).  Sometimes the answer is that the business was incorporated before LLCs existed, or when LLCs were new and the lawyer who advised the owner was not familiar with LLCs or was not comfortable with using them, and that makes sense.  Another relatively common answer is that the owner’s lawyer or, more often, accountant advised the owner that there were advantages to being taxed as a Subchapter S corporation rather than being taxed as an LLC, so the business was organized as a corporation rather than a limited liability company.  That doesn’t make as much sense, at least not since 1997.

Although the history of LLCs can be traced back to earlier statutes in Germany and other European countries, there were no LLCs in the United States until 1977 when Wyoming passed the first LLC statute in the country.  For several years after that, the use of LLCs was suppressed by uncertainty surrounding their status for income tax purposes.

The Internal Revenue Code did not (and still does not) include provisions specifically written for taxing LLCs.  The question was whether they would be taxed as partnerships or as corporations, and the answer was not clear.  In 1995, the IRS issued guidance identifying four specific attributes Continue Reading

iStock_000041719054Small.jpgThe Department of Labor’s Office of Federal Contract Compliance Programs (“OFCCP”) has issued a notice of proposed rulemaking that would require certain government contractors to submit an Equal Pay Report to the government as a supplement to the Employer Information Report (EEO-1) that is already required.

If a final rule is adopted as proposed, the Equal Pay Report will require companies to report the number of workers within each EEO-1 job category, the total W-2 wages of all workers in each job category, and the number of hours worked by all workers in each job category, all broken down by race, ethnicity, and sex. Only aggregate information will be reported; no information regarding individual wages will be required. In addition, the reports will not include any information on worker qualifications or experience that might help explain any differences among the groups within a job category.

Small Businesses Excluded

Small businesses — those with fewer than 100 employees — are excluded from the new reporting requirements. In addition the new reporting requirements apply only to companies that hold a contract, subcontract, or purchase order with the Federal government that, including modifications, covers a period of more than 30 days and is worth at least $50,000.

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iStock_000023649013Small.jpgLast year the Indiana Court of Appeals decided a case that illustrates some of the hazards of operating a business as a general partnership. The case is Curves for Women of Angola vs. Flying Cat, LLC.

In 2001, a married couple, Dan and Lori, purchased a fitness and health franchise known as Curves for Women that they intended to operate in Angola, Indiana. The franchise agreement, which Dan and Lori both signed, contained the following affirmation:

We the undersigned principals of the corporate or partnership franchisee, do as individuals jointly and severally, with the corporation or partnership and amongst ourselves, accept and agree to all of the provisions, covenants and conditions of this agreement[.]

At no time did Dan and Lori form a corporation or limited liability company to own the franchise – not before signing the franchise agreement and not after.

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iStock_000017700348Small.jpgOwners of Indiana LLCs (and their lawyers) can learn some lessons from a recent case involving an Alabama LLC. The case is L.B. Whitfield, III Family LLC v. Virginia Ann Whitfield, et al.

The Whitfield Case

L.B. Whitfield, III owned half of the voting stock in a business that had been in his family for generations. The other half had belonged to L.B.’s brother, who died and left the stock to a trust for the benefit of his son.

L.B. had four children, his son Louie, and three daughters. After his brother’s death, L.B. became concerned that the 50/50 voting balance might be disturbed if, after he died, his stock were to be divided among his four children. To prevent that from happening, L.B. created a manager-managed Alabama limited liability company to hold his half of the voting stock. L.B. was the sole member, and he and Louie were the two managers. His will provided that his interest in the LLC would pass to his four children in four equal shares.

After L.B. died, Louie continued as manager, and the four children were treated as members of the LLC, with each of them holding 25% of the interest in the LLC. About 10 years later, a dispute arose between Louie and his sisters, and the dispute escalated into litigation. Ultimately, the litigation was resolved on a theory that was not argued in the original pleadings and apparently did not even occur to the parties’ lawyers until several months into the case.

The Alabama Supreme Court noted that L.B. had been the sole member of the LLC and that, after he died, the LLC had no members. Although L.B.’s will gave his children equal shares of his economic rights in the LLC (his “interest”), economic rights in an LLC and membership are two different things, and the will did not make his children members. The Court further noted that, under the Alabama LLC statute, a limited liability company that has no members is dissolved and its affairs must be wound up, a process which includes payment of its debt and distribution of its remaining assets to the holders of interest in the LLC. Accordingly, the Court held that the assets of the LLC should be distributed in four equal shares to Louie and his sisters.

Interestingly, the Alabama statute provides a way that L.B.’s heirs could have become members and avoided the dissolution of the LLC, but they had to do it by mutual written agreement within 90 days of L.B.’s death, and there was no such written agreement.

How does it work in Indiana?

If the Whitfield case had involved an Indiana LLC, the results might well have been the same. Unless other provisions (discussed below) have been made to avoid the result, when the single member of an LLC dies, that member will be dissociated (i.e., will cease to be a member, Ind. Code 23-18-6-5(a)(4)), the LLC will have no members, and, as a result, it will be dissolved, at least if the LLC was formed after June 30, 1999, (Ind. Code 23-18-9-1.1(c)). As a result, the member’s heirs will not receive an ongoing business; instead, they will receive only the rights to receive distributions from the dissolved LLC after all obligations are satisfied — which may be far less valuable than the business would have been as an ongoing concern.

Note that there are other scenarios that can create a similar result. Under Ind. Code 23-18-6-4.1(e) (which applies only to LLC’s formed after June 30, 1999), a member who assigns her entire interest to another person ceases to be a member. If the person making the assignment is the sole member, the person who receives the interest can become a member under Ind. Code 23-18-6-4.1(b), which provides that the person who receives the interest can become a member “in accordance with the terms of an agreement between the assignor and the assignee.” But what if there are no such terms? What if the agreement simply says, “Seller hereby assigns her interest in the LLC to Buyer,” but doesn’t mention membership? In that case (unless the operating agreement already deals with the situation some other way), the LLC will have no members, and it will be dissolved. In other words, the person who thought he bought an ongoing business may well have bought only the rights to receive distributions from a dissolved LLC.

Now, what if there are multiple members and one of them dies? In that case, the LLC is not dissolved, at least not if it was formed after June 30, 1999, but the member’s heirs may not become members. Although they may inherit the deceased member’s interest (i.e., rights to receive distributions), they will become members (and therefore have the right to participate in the management of the company), only if the operating agreement makes them members or the other members unanimously consent.

What should you do?

If you own an LLC, or if you own part of an LLC, and these possibilities make you uncomfortable, you need a business succession plan that includes two different components. First, it should include appropriate estate planning tools to make sure that your economic interest in the LLC goes to the people you want to taken care of after your death. For example, you may want to designate a transfer-on-death beneficiary to inherit your interest in the LLC. Second, the LLC should have an operating agreement with appropriate provisions to ensure that your heirs benefit not only from the right to receive distributions from the LLC but also receive the other rights of membership, including the right to participate in the management of the business. There are different ways to do that; an attorney with experience in business succession planning, particularly with Indiana LLCs, can help you choose the best one for you.
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iStock_000034659194Small.jpgA primary reason to organize a business as a corporation or a limited liability company (LLC) is to protect the owners from personal liability for the debts of the business. Sometimes, however, a court may “pierce the corporate veil” of a business to hold the owners of the business personally liable for the company’s obligations.

In deciding whether to pierce the corporate veil, Indiana courts examine and weigh several factors, including whether the owners of the business have observed the required formalities for the particular form of organization. One of the reasons we generally favor LLCs for small businesses is that there are fewer required formalities for LLCs than for corporations, which in turn means that there is not only a lower administrative burden associated with LLCs, but also fewer opportunities for business owners to miss something. However, there are a few requirements, discussed below.

1. An Indiana LLC must have written articles of organization, and the articles must be filed with the Indiana Secretary of State .

There’s almost no need to mention this one because an LLC does not even exist until its articles of organization are filed with the Secretary of State, but for the sake of being complete . . .

The articles of organization must state:

  • The name of the LLC, which must include “limited liability company,” “LLC,” or “L.L.C.”
  • The name of the LLC’s registered agent and the address of its registered office (discussed in more detail below).
  • Either that the LLC will last in perpetuity or the events upon which the LLC will be dissolved.
  • Whether the LLC will be managed by its members or by managers. (Technically, the articles can remain silent on this point, in which case the LLC will be managed by its members, but the Secretary of State’s forms call for a statement one way or the other.)

2. An Indiana LLC must have a registered agent and a registered office within the State of Indiana.

The purpose of this requirement is to give people who sue the LLC a way to serve the complaints and summons. The registered office must be located within Indiana, and it must have a street address. A post office box is not sufficient. The registered agent must be an individual, a corporation, an LLC, or a non-profit corporation whose business address is the same as the registered office’s address.

The registered office and registered agent must be identified in the articles of incorporation and in the business entity reports (discussed below) filed every other year with the Indiana Secretary of State, but the requirement to have a registered office and registered agent applies all the time, not just when those filings are made. If the LLC’s registered agent resigns, the LLC must name a new one and file a notice with the Secretary of State within 60 days.

In addition, LLCs formed after July 1, 2014, are required to file the registered agent’s written consent to serve as registered agent or a representation that the registered agent has consented. That new requirement was established by Senate Bill 377, passed by the 2014 General Assembly and signed into law by the governor.

3. An Indiana LLC must keep its registered agent informed of the name, business address, and business telephone number of a natural person who is authorized to receive communications from the registered agent.

This is another new requirement contained in Senate Bill 377. It takes effect on July 1, 2014.

4. An Indiana LLC must maintain certain records at its principal place of business.

The required records are:

• A list of the names and addresses of current and former members and managers of the LCC.
• A copy of the articles of organization and all amendments.
• Copies of the LLC’s tax returns and financial statements for the three most recent years (or, if no tax returns or statements were prepared, copies of the information that was or should have been supplied to the members so they could file their tax returns).
• Copies of any written operating agreements and amendments, including those no longer in effect.
• A statement of all capital contributions made by all members.
• A statement of the events upon which members will be required to make additional capital contributions.
• The events, if any, upon which the LLC would be dissolved.
• Any other records required by the operating agreement.


[Note: Ind. Code 23-18-4-8(e) provides that the failure to keep the above records is NOT grounds for imposing personal liability on members for the obligations of the LLC. It’s more likely to become an issue in the event of a dispute among the members. Thanks to Josh Hollingsworth of Barnes & Thornburg for reminding me. MS:4/7/2014].

5. An Indiana LLC must file a business entity report with the Secretary of State every two years.

The report is due at the end of the month that contains an even-numbered anniversary of the filing of the articles of organization. Failure to file the report within 60 days of the due date is grounds for administrative dissolution of the LLC.
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iStock_000005953904Small.jpgI just read a report by the Small Business Administation that includes a wealth of statistics and other information about small businesses in the United States. As useful as the report is, it contains a mistake that, although commonly made, one would not expect from the SBA. The last item in the report asks the question, “What legal form are small businesses?” That’s a good question, but the SBA didn’t answer it. Instead, it answered another question, “What is the tax status of small business?” Even though the two questions are related, they are nonetheless distinct, and answering the second question does not answer the first.

Legal Form of a Business or Nonprofit

As we’ve discussed before, businesses are commonly organized according to one of a handful of legal forms: sole proprietorships, general partnerships, corporations, and limited liability companies. There are a few others used less frequently, including limited partnerships, limited liability partnerships, and professional corporations. Tax exempt organizations are commonly organized as nonprofit corporations, but they can also be organized as unincorporated associations, charitable trusts, and sometimes limited liability companies.

The legal form of a business or tax exempt organization is primarily related to two fundamental attributes: who controls the organization, and who is liable for the organization’s obligations. For example, if a business is structured as a general partnership, the partners collectively control the business and the partners are individually liable for the obligations of the partnership. In contrast, if a business is structured as a corporation, it is probably controlled by a board of directors, elected by the shareholders and acting through the officers. Unless something goes wrong, neither the shareholders, the directors, nor the officers are liable for the corporaton’s obligations.

Tax Categories

Although selecting the legal form of an organization determines the attributes of control and liability, it does not determine how much income tax the organization must pay. There are four common possibilities of tax status for businesses and nonprofit organizations, categorized by the applicable subchapter of Chapter 1 of Subtitle A of Title 26 of the United States Code (also known as the Internal Revenue Code): Subchapter C (the default provisions for corporations), Subchapter S (which is an alternative to Subchapter C that can be elected by small business corporations that meet the eligibility criteria), Subchapter K (for partnerships), and Subchapter F (for tax exempt organizations). Finally, some types of legal forms that have a single owner, such as sole proprietorships, are diregarded for income tax purposes, with their income reported on the owner’s income tax return. Those businesses or nonprofit organizations are known as, appropriately enough, “disregarded entities.”

Each of these tax categories can apply to more than one type of legal form of organization, and with two exceptions (sole proprietorships and general partnerships), each legal form has more than one possibility for the tax category, as shown in the chart below. Even nonprofit corporations have more than one possibility; while most nonprofit corporations are organized with the intent of qualifying for Subchapter F (exempt organizations), if a nonprofit corporation fails to meet the criteria for tax exemption, it will be subject to taxation under Subchapter C.

Legal Form Tax Status Table cropped

Now you won’t make the same mistake that the SBA made.

[Note:  The above table was corrected on May 7, 2015 to include all the possibilities for the tax status of partnerships.]

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Reports.jpgThe Internal Revenue Service’s application for an employer identification number (or EIN) requires the applicant to submit the name and tax identification number (usually a social security number) of the applicant’s “responsible party.” That is true whether the application, Form SS-4, is submitted on paper or online, and it is true for any type of organization applying for an EIN, including corporations, limited liability companies, partnerships, trusts, and tax exempt organizations. That is the last time most organizations ever think about the “responsible party.” Until now.

On May 6, 2013, the Internal Revenue Service published a final rule that requires any business, nonprofit organization, trust, or other entity with an EIN to report any change in the entity’s responsible party. Here are the answers to some questions that essentially every business and tax exempt organization should know.

Who is a “responsible party”?

The answer differs a bit for various types of organizations. For companies with shares traded on a public exchange or securities registered with the U.S. Securities Exchange Commission, the responsible party is defined fairly unambiguously:

For corporations, the responsible party is the principal officer.
For partnerships, the responsible party is a general partner.
For trusts, the responsible part is the trustee, grantor, or owner.
For disregarded entities, the responsible party is the owner.

For other entities, the definition is more ambiguous:

The responsible party is “the person who has a level of control over, or entitlement to, the funds or assets in the entity that, as a practical matter, enables the individual, directly or indirectly, to control, manage, or direct the entity and the disposition of its funds and assets.”

For business corporations, the responsible party may be the president or chairman of the board; for LLCs, a member; for partnerships (including limited partnerships, such as family limited partnerships), a general partner.

The issue of identifying a responsible party for a nonprofit organization may be particularly problematic because, in many organizations, no single person who has the authority to control, manage, or direct the organization and — in particular — to control the disposition of its funds and assets. In fact, we often tell the boards of directors of our nonprofit clients that, collectively, they have full authority to control the organization but, individually, they have no authority at all. Even so, the IRS requires the designation of a responsible party, and the organization must decide who best fits the definition. For some organizations, that may be the executive director or CEO; for others, it may be the president or chairman of the board.

Our LLC has three members, all with the same rights and authority. Who is the responsible party?

If more than one person qualifies as a responsible party, the entity must select one of them by whatever criteria the entity chooses.

When and how must changes be reported?

As of January 1, 2014, any change in an entity’s responsible party must be reported on IRS Form 8822-B within 60 days after the change takes effect. Changes made prior to January 1, 2014 must be reported before March 1, 2014.

Our organization obtained an EIN years ago, and we have no idea who was listed as the responsible party. But Form 8822-B requires us to list not only the new responsible party, but also the old one. What do we do with that?

The best course is probably to submit Form 8822-B without the information about the old responsible party and attach a statement explaining what you have done to locate the information and why it is unavailable despite those efforts. [Revised February 21, 2014, to include the idea of attaching a statement — a suggestion from James W. Foltz, Attorney at Law, of Indianapolis, Indiana.]

Our nonprofit has filed Form 990 (or 990-EZ or 990-N) every year, and we always have to list the organization’s principal officer. Isn’t that good enough?

From what we know at the moment, probably not. Even if the responsible party and the principal officer are the same person, Form 8822-B calls for the responsible party’s social security number, but Form 990 does not. The same thing is true for the tax matters partner identified on Form 1065 filed by partnerships and by LLCs taxed as partnerships.

I called the IRS and tried to get some more specific information about the new reporting requirement, and the person I spoke with had never heard of this new requirement. Are you sure about it?

We had the same experience, but, yes, we’re sure. We hope the IRS will issue guidance that clarifies some of the details, but we’re sure the rule is in effect.

What happens if we do not file Form 8822-B or file it late?

That’s the good news. As far as we can tell, there is no penalty for failing to file or for filing late. Even so, everyone with an EIN, including small businesses and tax exempt organizations, should comply with the rule using the best understanding of the requirement and the best information available.
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Odometer.jpgIf you use a vehicle for business, medical, or moving purposes, or in providing volunteer services to a charitable organization, you may be able to deduct at least a portion of the cost on your income tax return. There are two alternatives for calculating the amount of the deduction, but the simplest is to keep track of the number of miles driven and multiply by the appropriate standard IRS mileage rate.

The standard mileage rates are based on an annual study of the costs of operating a motor vehicle, conducted by the IRS and an independent contractor. The information used in deriving the standard rate for business purposes include both fixed and variable automobile costs, such as insurance, fuel, maintenance, and repair costs. Only variable costs are considered in calculating the standard rate for medical and moving purposes. The charitable rate is fixed by statute.

What are the rates?

On December 6, 2013, the IRS announced the standard mileage rates for 2014. The rates as of January 1, 2014, are:

• 56 cents/mile for business miles driven for business purposes • 23.5 cents/mile for miles driven for a medical purpose or a moving purpose • 14 cents/mile for miles driven as a volunteer to a charitable organization.

These rates apply to the use of automobiles, including includes cars, vans, pickups, and panel trucks. With fuel prices generally decreasing, the standard rates miles driven in 2014 for business, medical, and moving expenses are one-half cent below the rates for miles driven in 2013. The charitable rate is the same in 2014 as it was in 2013.

What counts as “Business” miles?

While commuting to and from work does not count toward business mileage, there are many trips that may be characterized as business trips for purposes of calculating mileage, including driving to meet a client, driving to a bank to making a business transaction, driving to pick up mail from the post office, and driving to a supply store to make purchases for your business.

Of course it is easy to forget to keep track of your miles driven, but if you are disciplined about it, the savings can add up. For example, if you are in the 28% tax bracket, the deduction for 100 business miles may reduce your federal income tax by about $15.00.

Other considerations:

As mentioned above, the use of standard mileage rates is not the only alternative for calculating the deduction for the use of a vehicle. Taxpayers may instead calculate the actual costs of using their vehicle, including costs of gas, oil, registration fees, repairs, tires, and insurance. However, calculating the actual costs of using a vehicle for taxation purposes of often takes more time and effort. Broadly speaking, the more economical the vehicle is, the more likely that the standard mileage rate will give you a better deduction. Conversely, if the operating costs of a vehicle are high, the more likely the actual cost method will give you a better deduction.

If a taxpayer uses the depreciation method under the Modified Accelerated Cost Recovery System (MACRS), or claims a Section 179 deduction for a vehicle, she may not use the mileage rates. Additionally, the standard rate for business purposes cannot be used for more than four vehicles simultaneously.

100_3698.JPGEarlier this year the General Assembly passed HEA 1394 which made several changes to the Indiana Business Flexibility Act, the statute that governs limited liability companies. We have already looked at some changes to the Act that enhance the use of Indiana LLCs for estate planning purposes. This article discusses new alternatives for LLC management structure.

The Indiana Business Flexibility Act already provided for a great deal of flexibility for management structure. One of the key steps in designing the management structure of a limited liability company is to establish who has the apparent authority to bind the company, for example by signing contracts on behalf of the LLC. Prior to the changes there were essentially two choices. In a member-managed LLC, the members have that authority. In a manager-managed LLC, the members appoint managers (who may or may not also be members) who have that authority.

HEA 1394 provides a third choice — officers, who may or may not be members. At first blush, there may seem to be little difference between officers and managers because, like the managers in a manager-managed LLC, officers have the apparent authority to bind the LLC to third party agreements. But there is at least one important difference: In a manager-managed LLC, only the managers, and not the members, have the apparent authority to bind the company. The new revisions allow the members of an LLC to establish officers who have the apparent authority to bind the company, while also retaining that authority themselves. In fact, a manager-managed LLC can also have officers. In that case, both the managers and the officers, but not the members, have apparent authority to bind the LLC.

HEA 1394 includes other changes to the statute that enhance the alternatives for LLC governance. For example, the Act now permits the operating agreement to make certain significant decisions, including mergers, dissolutions, and amendments to the operating agreement, subject to the approval of a third party who need not be a member.

One context in which such provisions may prove useful is in estate planning. Imagine the founder of a business, held by a limited liability company, with multiple heirs, who wants the business to remain in the family. Although the operating agreement may create significant restrictions on transfers of membership interests and admission of new members, the heirs could later agree to amend the operating agreement to remove those restrictions. The Act now allows the operating agreement to name a trusted outside party who must approve any amendments to the operating agreement, thus increasing the likelihood that the founder’s desires will be honored.
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