In a previous blog post, I talked about how Not Incorporating is Risky Business, which was directed at the sole proprietor and why they should consider incorporating their business. Suppose, however, you’re considering signing up as a partner into a pre-existing company, such as a partnership, limited liability corporation (or LLC), or S-Corporation? Is there anything to be concerned about?
Turns out, there is much to be careful about, when signing up as an equity partner to a pre-existing company, whether it’s a partnership, LLC or S-Corporation. These concerns are also shared by shareholders, members or partners leaving a company (either through retirement or for other reasons).
What you need to look out for before you sign
Do you know exactly what you’re getting into when you join a new partnership?
Congrats! You’ve been invited to become a member of an LLC, shareholder in a S-Corp, or partner in a partnership. This is prestigious, and you have much to be grateful for. However, be aware that as a partner or owner of a tightly held corporation, you immediately share the burdens, risks and liabilities of that company. Are you getting in over your head? Have all the risks been fully disclosed to you? Are you prepared to share in the liabilities?
Some questions you need to answer for yourself, BEFORE becoming an equity partner in any company, no matter how prestigious, successful, new or old the company is, are the following:
- Are there any outstanding judgments, lawsuits or liens on the company or the threat of such events to the company?
- Is the Operating Agreement or By-Laws fair and balanced, or are their inequities between partners or class of partners?
- Are the financials audited and/or is there adequate transparency to understand and evaluate the financial condition and health of the company?
- Is there an appropriate system of checks-and-balances, and operational segregation, to prevent “commingling of funds” between one or more partners and the company?
- Is the value of the company adequately protected against double-dealing, or disinterested or uninvolved partners?
- If you’re contributing capital (i.e. buying equity), is your money protected? Is the value for your money fair?
- Are you aware of the tax implications for yourself personally?
Each one of bullets above are ripe for an entire book, and therefore one blog article cannot go into sufficient depth to cover everything. I’ll go into more detail in subsequent blog articles. In the mean time, however, consider just some of the issues.
Judgments, lawsuits or liens
When you sign up to a new company, you are essentially becoming a part of that company. The value you place in that ownership is immediately at risk, when you sign up, if there are judgments, potential lawsuits or other risks facing the company. Worse, your personal wealth and assets are at risk, if the company is not managed well such that a plaintiff can “pierce-the-corporate-veil” and go after the personal assets of the shareholders, members or partners of a company. You need to make sure the company has fully disclosed these risks to you, or has agreed to indemnify and hold you harmless against such risks.
Operating Agreement or By-laws
Often, I see companies founded by individual entrepreneurs who have been slow to let go of the reigns and extend true ownership and power to their partners. As a consequence, the operating agreement or by-laws are written heavily in favor of one or two individuals, posing unfair risks to the other partners. Sure, this may be fine and dandy in the short-term, because everyone gets along and trusts the main partner. What happens, however, when the main partner dies or becomes incapacitated? Or, the main partner wants to sell the company and the remaining partners do not?
Make sure your new company is protected in case of a death or incapacity of an owner.
In a death or incapacitation situation, the operating agreement or by-laws are crucial. Will the family become your new partner, or worse, your new boss? Does the company have the right of first refusal, to buy up the main partner’s equity? Can the company afford to do so? It is my strong recommendation that the operating agreement, or by-laws, are written such that the company has the right of first refusal to purchase the equity from a deceased or incapacitated member, shareholder or partner. This gives the company (i.e. through a vote of the surviving partners) the ability to maintain control of the company, and increase everyone’s share in the company pro rata. Keyman, or Key Person, life insurance is one method to ensure the company has the cash available to purchase the shares, units or ownership percentage from the estate of the deceased’s membership or ownership in the company. Keyman life insurance is a form of life insurance, that a company can take out against each partner, so that the company can use the proceeds to buy out the estate should a member become deceased or incapacitated.
Don’t be too eager to sign up with a company as its newest shareholder or member, and don’t let them tell you it’s a “take it or leave it” proposition. Everything is negotiable, and remember, the worse case happens more times than you might think. If it didn’t, people wouldn’t need lawyers.
The tax implications are often overlooked, and present some serious issues for the new shareholder, member or partner. If you buy into a company, for the exact value it is worth, you have NO tax implications at first. However, if the value of the equity you receive is greater than what you pay for it, you DO have tax implications. In the simplest example, if you’re simply given equity without paying for it, you are receiving value. This is taxable, and it’s ordinary income at that. Just because it’s equity in a company, doesn’t mean it’s taxed as capital gains. You only pay capital gains on equity, when it increases in value and a triggering event occurs (i.e. you cash out). So, think about what this means: If you’re given equity in a company, that is worth $250,000, it is as though the company paid you $250,000 in that tax year. This means you will be responsible for paying the ordinary taxes on $250,000 worth of income, even though you received no cash. This is your risk: Will that $250,000 in equity really payoff for you, or are you paying taxes on money you will never see?
The next biggest tax issue most people overlook, is one of vesting. In the same scenario above, what happens if that $250,000 in equity given to you vests over time? This is what the IRS calls “at risk,” and of course, the IRS has a rule on it. It’s called Rule 83. In particular, what every partner, shareholder or member needs to know, is Rule 83(b). If your equity is “at risk,” such that it can be taken from you (i.e. it doesn’t vest fully, because you may leave at some point; or you own all of it, but the company retains the right to buy some portion of it back from you for whatever reason), then the IRS makes you factor in the ordinary income of your equity as it vests — at the time it vests.
Taking IRS Rule 83 into account can save you a lot of money when it comes to paying taxes.
What does this mean? Well, suppose you’re given enough shares equivalent to $250,000 that vests monthly over two years. To keep this example simple, we’ll say each share is worth $1. At the end of year one, 1/2 of your grant has vested and therefore in the beginning, you’re expecting to pay ordinary taxes on $125,000 of income. However, suppose the fair market value of the shares have doubled in that year? Without filing an 83(b) exemption with the IRS (within 30 days of your grant), the IRS requires you pay the ordinary taxes for the equity you receive, at the time of grant, at their fair market value. This means, at the end of the first year, you are now paying the taxes on stock worth $2/share, not $1/share. It’s as though your stock grant has increased, although it has not. You are now paying a lot more taxes because the value of your shares has increased.
Filing an 83(b) exemption with the IRS within thirty (30) days of your grant of equity, however, gives you the option of paying your taxes at the fair market value at the time of grant, not the fair market value at the time of each vest (i.e. keeps the taxes on ordinary income at $250,000). The gamble is, will the value of your stock go up, or go down, over the vesting period?
Consult an expert before you sign
Each situation is very fact specific and complicated. It behooves you to consult with an accountant, tax adviser or CPA, before you accept equity and/or sign on the dotted-line.
Law 4 Small Business (L4SB). A little law now can save a lot later.