Corporation, Securities
& Business Law Forum
April 2000 Vol. 45, No. 2
Statements or expressions of opinion or comments appearing herein are those of the editors or contributors, and not necessarily those of the association or section.
Contents
* Using public record searching to enhance due diligence
This is the first regular newsletter for 2000. The Corporate & Securities Section Council has worked diligently on a variety of matters affecting the practitioner. For example, we had a special edition on Y2K published in October, 1999. This issue include articles on enterprises and finance, income tax analysis, tax bills, restrictive covenants, and the use of public record searching to enhance due diligence.
The section council officers for the coming year are:
Chair: Mary Lee Faupel
Vice-chair: Alan J.Goldstein
Secretary: Zane M. Cohn
Newsletter editor: Robert C. Knuepfer, Jr.
As always, we look forward to your comments and suggestions. We also welcome your submissions to the newsletter.
Robert C. Knuepfer, Jr.
Baker & McKenzie
130 East Randolph Drive
Chicago, Illinois 60601
312/861-8913
robert.c.knuepfer.jr@bakernet.com
I am both honored and privileged to serve as Chair to the Corporation, Securities and Business Law Section Council. My predecessors have set a high standard to follow and have proved excellent role models. We will continue to offer section members an outstanding newsletter and informative seminars on topics of interest and importance to our members.
One of my goals this year is to place an emphasis on technology. We have established a technology subcommittee to facilitate gathering and disseminating information about technological issues to you. Watch our minutes and this newsletter for updates in this area.
The importance of technology cannot be understated, especially the impact of the Internet on our practices. Via the ISBA Web site we have access to many legal resources. Members of this section are able to sign up for a case law digest as well as a discussion group open only to members of this section.
On an almost daily basis the case law digest provides summaries of recently decided Illinois and Seventh Circuit cases, in many cases with hyper-links to the full text. In addition there is a compilation of previously decided cases via a link to the Illinois Courts Bulletin. You have the option of receiving all cases decided or only those pertaining to your areas of practice.
Another ISBA feature that I have found helpful is the e-mail discussion group. While not widely used at this time it has the potential to replace your local lawyer gathering spot as a place to bounce ideas and questions off your colleagues.
Did you know that you can now access statutes and public acts at the Illinois General Assembly Web site? The ISBA hopes to have section council members use the Internet to review and evaluate proposed legislation. Potentially all section members would be able to easily review pending legislation and register their comments with the section council. If you are currently in the habit of reviewing pending legislation that impacts corporate, securities or business law and have an opinion you wish to share, please contact me with your thoughts.
I would encourage each of you to take the time to check out the ISBA's Web site and explore the opportunities that are available to you as a member of the ISBA and this section. Thank you.
Mary Lee Faupel
Faupel Law Offices
Eureka, Illinois
By William A. Price, Attorney at Law and Adjunct Professor, High Technology Entrepreneurship Illinois Institute of Technology
I. Introduction
A business lawyer can serve many roles, for many different sizes of company. Some consideration of the client size, stage of company growth, and transaction or other legal problem type the individual or firm can best serve may be useful in directing your program of reading, research, networking, and publication.
II. Numbers of organizations
Now: The total number of business organizations is difficult to estimate, since single businesses often file multiple tax returns for various organizational affiliates, and may operate in a variety of combinations with other organizations, in establishments scattered across all 50 states. The U.S. Small Business Administration estimates that there are between 13 and 16 million business establishments in the country, of which about 5.4 million had employees in 1995. Most were small. Only about 15,000 enterprises employed aver 500 people in that year, the last for which comprehensive data is available. About 5.2 million corporation income tax returns were filed in 1997, as against about 1.7 million partnership and 16.8 million sole proprietorship returns. (United States Small Business Administration, Office of Advocacy, "Small Business Answer Card 1998," http://www.sba.gov/ADVO/stats/ answer/html, 10/24/98, 11:16 A.M.)
Y2K: Demographers have estimated that there may be as many as 30 million firms in existence by the start of the next century. (Swain, Frank, Office of Advocacy, Small Business Administration, speech cited in "Current Matters" section, Privately Owned And Emerging Businesses newsletter, Ernst & Whinney, Oct. 6, 1988, cited in Timmons, Jeffrey A., New Venture Creation, 4th Ed., ISBN 0-256-11548-6, Irwin 1994, at p. 5.)
III Business failures
Businesses can fail, of course, as well as start. Business terminations recorded for 1997 numbered 857,073, as against 885,416 new employer firms. That same year recorded 798,917 new incorporations. Termination rates record closures of establishments, not the termination of entire business entities. 1997 business failures were recorded at only 83,384 across the country, and more detailed SBA studies of Dun & Bradstreet data from 1992 through 1995 indicated a survival rate of 90.5% for firms with employees. (United States Small Business Administration, Office of Advocacy, "Small Business Answer Card 1998," http://www.sba.gov/ADVO/stats/answer/html, 10/24/98, 11:16 A.M., op. cit.) Businesses which close may produce offspring, if they are successful. The SBA Dun and Bradstreet study found that 57.4% of firms with employees and 36.4% of those without employees were successful on termination.
IV. Capital investments
Capital investments in new and expanded business organizations cause substantial numbers of transactions each year. Many are in organizations whose ownership interests are not publicly traded.
1. At the high end, 349 companies went to IPO in 1998, and 760 companies across the United States received venture capital financing in 1997, with an average investment of $4.8 million per company. (The Illinois Coalition, "Venture-Backed Technology Investments In Illinois, 1998 B Second Quarter," citing data from PriceWaterhouseCoopers Money Tree survey, data for 1997, author's estimate from multiple studies, 1998.) The PriceWaterhouseCoopers survey for the third quarter of 1999 showed 19 deals in Illinois, with more than $117 million in total investment.
2. "Angel investors" (investors with substantial assets or income, to whom investment offerings can be made without public offering registration) fund approximately 30,000 companies each year, with an average investment of approximately $666,000 per deal and about $80,000 per investor in each deal.
3. Smaller investments may come through a varety of governmental programs, loan guarantees, friends and associates, and individual capital contributions. (U.S. Small Business Administration, The Process and Analysis Behind ACE-NET, http://ace-net.sr.un.edu/ what/process/body/html, 04/20/1998.)
V. Stages of financing
The typical stages of capital formation for an entrepreneurial organization include:
(1) Friends and family
(2) Angel investments (private placements)(can be multiple rounds)
(3) Other outside creditors/assistance sources
(4) Loans, once bankable
(5) "Mezzanine" finance
(6) IPO
(7) Additional offerings/financing mechanisms
(8) Harvest and new deal
The cycle is best expressed by a joke: Go to Menlo Park, California. Find a tree. Shake it, and a venture capitalist will fall out of the branches. Grab her by the ankle, and rapidly repeat the words "Internet, e-commerce, active server page, broadband, digital media, vertical portal." She will give you $1 million dollars. Go and establish a $1 billion dollar business without income. Sell all the shares and give the kind venturer 90% of what results. Then go to Menlo Park, and find another tree.
VI. Conclusion
Whether or not you need to go around shaking trees, you should know how and why your business customers use the organizations they form. 25,000 limited liability companies have been set up in Illinois in recent years, many for reasons that used to produce limited partnerships or subchapter S corporations. Even more corporations continue to be spawned. As many of those as possible should, of course, have their corporate seals sitting in folders on your office bookshelf.
By William A. Price, Attorney at Law and adjunct professor, high technology entrepreneurship, Illinois Institute of Technology, Wheaton, Illinois
The following is a draft letter to a client with $1 million in net earnings who is considering a joint business venture with an active investor. For discussion's sake, the investor is assumed to also have $1 million in net income from another business. The note suggests ways to use a C corporation with retained earnings or a new jointly owned organization to structure income for tax minimization. The note does not deal with ownership dilution, liability limitation, or other issues that should also be considered in acceptance of new capital investments. The note also cautions the client that such retained earnings will still be taxed again if distributed to an individual.
Tax analysis, like the making of books, is never finished, only sent off to serve the requirements of a deadline. Members of the section are encouraged to add to the analysis, by submitting additional pros and cons of C corporation or partnership taxation for a new investment or business venture. The author can be contacted at wpriceiit@ hotmail.com, or via fax at 630/682-06010, or via telephone at 630/682-06042. Interesting contributions will be posted on the section Website or provided in later editions of this newsletter.
Dear client,
1. As I understood your and your potential investor's situation, you have approximately $1 million in net profit available from a C corporation for 1999, and he anticipates having about $1 million of net profit from his business (an S corporation) for 1999. The two of you are interested in finding a way to shield the respective income streams from taxation, to the extent legitimately possible, and to create a vehicle for cooperation which will maintain your individual independence and preserve your respective capital contributions while enabling you to fund joint projects, such as a consultancy.
2. As you know, your biggest tax exposures will result from failing to do anything. A C corporation can be subject to entity level income tax on any retained earnings, can be subject to entity level retained earnings taxes, and could also become subject to a personal holding company tax on retained earnings. Any amounts you pay yourself may qualify as legitimate expenses, reducing corporate income tax and retained earnings tax exposure, but they are then potentially subject to individual income tax.
1. Corporation income tax
The C corporation is subject to entity level income taxation on income at rates up to 39%, per the tax table in I.R.S. Publication 542, assuming that you have not structured the organization as a qualified personal service corporation, which pays a flat rate of 35% on net income. The tax table in question results in the following data for your C corporation, absent any action to produce deductions or avoidance of recognition of income:
This tax can be reduced if income is not received by the organization, if there is a legitimate deduction from income (such as an ordinary and necessary business expense, which would include reasonable salary or dividends and costs of expansion which are accrued during a tax year), or if there is a credit towards tax recognized under the Code.
2. Retained earnings tax
To the extent that the income is held in the organization, it may also be subject to an additional 39.6% of retained earnings tax if the retained earnings (especially those above $250,000, per IRS Pub. 542) cannot be demonstrated to be for the "reasonable needs of the business." Such needs include:
(1) Bona fide expansion;
(2) Replacement of physical plant;
(3) Acquisition of a business;
(4) Retirement of bona fide business indebtedness;
(5) Provision of necessary working capital, including acquisition of inventories;
(6) Provision of investments, loans to suppliers, loans to providers, and other such items necessary to maintain the business of the corporation; and
(7) Provision for reasonably anticipated product liability losses.
Tax authority: Treas. Reg. 1.537-2(b).
Avoidance of incidence of this potential additional $396,000 of tax depends on documenting plans which would put the retained earnings in a category recognized under the Code as matching the reasonable needs of the business, and implementing such plans, by making expenditures from retained earnings, to show that the plans represent the real business of the corporation. Creation of a new C corporation division, or investment of C corporation assets in one or more intermediary joint venture organizations and/or subsidiaries of the joint venture should help avoid this tax. So would retention of earnings for investment in expenses you anticipate as a part of your business plan.
3. Personal holding company tax
A corporation may avoid incidence of the retained earnings tax if it is characterized as a personal holding company because it draws more than 60% of its income from passive investments (See Code section 541 ff.), but would in that case be subject to a personal holding company tax of 31% (potential additional tax $310,000 on $1 million of income), in addition to the initial corporation income tax. (Code section 541). Your affairs should be structured so neither the retained earnings tax nor the personal holding company tax applies. At this point, your C corporation does not appear to have a major exposure to such characterization, but you should be careful, when setting up a structure to receive new investments, to avoid taking on an investment which could be characterized as producing passive income.
4. Individual income tax
Assuming that you can prove a $1 million salary is not unreasonable for a company of your C corporation's size and age (which would be done by documenting equivalent salary packages from other CEO's at other companies), and ignoring any personal income or estate tax reduction strategies (which are the subject of a different memo), you can eliminate taxability under the corporate income, retained earnings, or personal holding company taxes by paying yourself the $1 million as salary. The tax on that amount would be, if you are a married person filing a joint return, $369,603.80. The amount of individual income tax for your potential investor for net income from his solely owned subchapter S corporation would be the same.
5. Joint venture income protection against personal holding company status
To the extent that your due diligence determines the investment of funds in one or more joint business ventures with your potential investor to be reasonable, there is a tax advantage to C corporation. A corporation can help avoid the personal holding company tax by having joint venture income. That tax depends on what proportion of assets are merely assets held by the organization. By contrast to such mere holdings, partnership income is attributable to individual partners or partner organizations according to their proportionate right to receive income from the partnership. (Code section 702(c).) Partnership income streams from various sources retain their character in