the hands of individual partners. (Code section 702(b), see, e.g.,Treas. Reg. 1.856-3(a), on real estate investment trust income.) Thus, partnership income received by the corporation would not be treated as personal holding company income, and so would reduce the passive proportion of organizational income. A determination on whether to use partnership form (pass-through) or subchapter C form (taxed at corporate levels) will depend on your analysis of income splitting, new finance source, and other tax savings options in each form.
6. Loss of deductions for business expenses proportionate to shift to new venture or acceptance of new investment in C corporation
To the extent that you choose to shift business expenses which your C corporation would otherwise incur to a new joint venture, your C corporation would incur a tax disadvantage. The deductions from income that would be allowed for such ordinary and necessary business expenses would be attributed to individual partners proportionate to their right to share in the income of the new organization, as would the taxable income of the new organization. Thus, if you choose to employ workers in a new venture with your potential investor, instead of employing them as C corporation employees, the ordinary and necessary business expense proportion you could claim as a deduction from C corporation net taxable income for every dollar of such costs would be reduced to the proportionate share of your right to receive income from the joint venture. This reduction, and the taxes payable on same, may, of course, be more than offset by the income likely to be received from the new venture.
7. Income splitting to reduce tax rate immediately payable
The use of your C corporation (or another jointly owned C corporation, and in either case with such control preservation features of ownership interests as you deem appropriate) as a vehicle for receipt of some of your potential investor's funds and some of your net income provides an opportunity for tax-advantaged income splitting. This can also be done, of course, with a larger amount of corporate income potentially able to benefit from income splitting, if you bring in investors of equivalent amounts of funds not in need of salaries, and take deductions for payment of dividends to them. The differential between what you would need to pay your potential investor in profits (including mutually agreed and tax-advantaged salary distributions) and the amount which would have to be paid to other investors as a return on their investment of the same amount, plus salary which would have to be paid to an employee who would do the management work your active investor could do, is one measure of the economic value of your potential investor's investment and services contribution to you. This analysis gives the detail for an income split between individually taxable income and corporate income for a new venture with both you and your potential investor involved.
A new and jointly owned C corporation could avoid the "controlled group" regulations, which specify that all organizations in a group may be treated as one corporation for tax purposes (Code section 1552) if, among other things, an organization has over 80% control over other members of the group (Code section 1504). The difference in control between your corporation and the new organization would also help avoid the Code section 482 possibility of reallocation of income and deductions among entities "owned or controlled directly or indirectly by the same interests."
Income splitting works by paying out only such salary amounts as are tax advantaged, and retaining in a corporation amounts which are taxed at a lower rate, so long as the retained earnings and personal holding company taxes can be documented not to apply. Alternatively, income can be paid out to an individual or to multiple individuals if it would be more highly taxed at the corporate rate. Since double taxation applies to any corporate earnings which are paid out, the retained earnings savings must be applied to new investments and held long enough for the appreciation on these, plus any corporate tax on appreciation, plus individual tax on the appreciation, when paid, to exceed the difference in rates between individual and corporate taxation. Otherwise, use of a subchapter S or LLC or other partnership vehicle for the holding organization or new venture, which eliminates the exposure to corporate taxation on profits, will give more tax benefits than retained earnings.
The opportunity for tax savings by allocation of income to a corporation or to an individual filing at the married person filing joint returns rate exists at the $42,350-$50,000 net revenue range, where the 15% corporate rate is lower than the 28% individual rate, in the $50,000-75,000 income range, where the 25% corporate rate is lower than the 28% individual income tax rate, does not apply in the $75,000-$100,000 range, in which the 34% corporate rate is higher than the 28% individual rate, does not apply in the $100,000-102,300 range, where the 39% corporate rate is higher than the 28% individual rate, does not apply in the $102,300-$155,950 range, where the corporate rate of 39% is higher than the 31% individual rate, does not apply at the $155,950-278,450 range, where the corporate rate of 39% is higher than the 36% individual rate, does apply (though marginally) at the 278,550-335,000 range, where the corporate rate of 39% is lower than the individual rate of 39.6%, and applies again at the 335,000-1,000,000 income range, where the corporate rate of 34% is lower than the individual rate of 39.6%. If the organization is classifiable as a qualified personal service corporation, then it pays a uniform 35% rate of tax on all increments of income, with corresponding disadvantage and advantage over different increments of individual tax rates.
Thus, for example, if you are each able to invest enough money to produce $2 million in net income from the consultancy, and $1,443,100 is kept in a subchapter C qualified personal services corporation performing consulting work and paying only 35% on income from $556,900-2,000,000 (with $278,450 paid to each owner as salary) produces a corporate tax of $505,085 instead of the 39.6% individual tax rate on that increment, which would be a tax of $571,467.60. The tax savings from use of the qualified personal service corporation with C corporation election is $66,382.60.
Similarly, if you choose to create a new subchapter C holding organization (or to use your C corporation) to fund your various projects, and the net income works out to $2 million, the income split works as follows. Assuming you each pay yourselves $278,450 in salary, the individual income taxes on the two salaries (ignoring all other deductions, tax credits, etc...) would total $167,740. With additional corporate tax on the income from $278,450 to $335,000 at 39%, and that from $335,000 to $1,443,100 (the net available after the two salaries) at 34%, the corporate income tax payable would be $398,808.50. The individual income tax payable on that increment at 39.6% would be $461,201.40. The tax savings from income splitting and retention of earnings in the C corporation which would fund miscellaneous joint activities would be $62,392.90.
Remember, again, that care must be taken to document that the retained earnings are being kept for purposes which will not trigger the retained earnings tax, and that individual income tax would still have to be paid on the savings amount and income earned from it if distributed in later years, if other means of reducing tax incidence on distributions cannot be found.
Regards,
Your lawyer
Using public record searching to enhance due diligence
By Carol L. Helfrich, Legal Assistant, Baker & McKenzie, Chicago
Understanding all aspects of a business, including potential liabilities, is the objective of due diligence investigation. Verifying the overall accuracy of the disclosures made by the opposing party is usually also a crucial goal. Often, public records can be extremely useful in accomplishing these objectives.
With respect to U.S. companies, the amount of information available to the public varies widely depending on: (i) whether or not the company's securities are registered with the Securities and Exchange Commission (such companies are required to provide extensive periodic public reporting with respect to financial condition, material transactions or events, corporate affiliations, and other matters); (ii) the relative size of the company (generally, the smaller the company, the less data will be available); (iii) the nature of the company's business (for instance, certain regulated industries, such as banks, insurance companies and public utilities are generally required to make more comprehensive public disclosure); and (iv) the company's jurisdiction of incorporation (Delaware, for example requires only minimal information from companies incorporated or qualified there, while Texas requires relatively extensive information).
Some of the more typical types of public information available with respect to companies in the U.S., along with a very rough estimate of the cost of obtaining such information, is summarized below. Exact costs and timing vary depending on the jurisdiction and the type of search conducted. For instance, most states will expedite corporate document orders for an additional fee, however the cost and benefit of such expedited handling differs significantly. Other searches, such as lien searches and pending litigation searches, generally also incur a per page copy fee which can greatly add to the cost of the particular search. Finally, public record searching that cannot be performed electronically (i.e. through Lexis-Nexis, the Internet, or otherwise) also requires the use of a third-party service provider (e.g. CT Corporation or Corporation Service Company), which will extract a fee of its own (generally, these service fees add approximately $20--$50 to the cost of each search or document order).
1. Good Standing Certificates can be obtained from each state in which a company is incorporated or where the company has applied for a license ("qualified") to transact business (which is typically required in all states where a company maintains an office, owns property or otherwise conducts sustained business activity). A Good Standing Certificate typically means that the company has filed its annual report, has paid its franchise taxes and taken all other actions necessary to avoid administrative dissolution. In some states, to obtain the equivalent of a Good Standing Certificate one must obtain both a tax certificate and a corporate existence certificate. These documents are issued by two different state agencies. Depending on the jurisdiction, it takes one week to ten days to obtain a Good Standing Certificate, and costs $10--$50, plus handling and delivery fees. However, one may usually obtain a Good Standing Certificate in one to two days for an additional fee of $10--$50.
2. Long Form Good Standing Certificates are available in a few states. In addition to providing a statement concerning the company's status (i.e. "good standing"), a Long Form Good Standing Certificate also lists all documents filed with the secretary of state (or equivalent agency) that amend or affect the company's charter. This document typically costs $100 and can be obtained on an expedited basis for an additional fee of $50--$100. The purpose of a Long Form Good Standing Certificate is to confirm that a certified copy of a company's charter, as amended, is complete. It is important to note that a Long Form Good Standing Certificate does not include copies of the filings to which it refers; those must be ordered separately.
3. Certified copy of the company's charter (i.e. Certificate or Articles of Incorporation) can be obtained from the secretary of state (or equivalent agency) of the state of incorporation. This document will reveal such information as the name and address of the registered agent for service of process, the number and class of shares of authorized capital stock (but not the number of issued shares or to whom such shares have been issued), the rights, powers and privileges of each class of stock, the company's business or purpose (which may be specific or very general), and other express provisions relating to the management or governance of the particular company. The by-laws of a company are only available with respect to public companies (as they are required to be filed with the Securities and Exchange Commission). It is customary to order a copy of "all documents on file" which would include amendments, mergers, registered agent changes, etc. The cost of ordering these documents is approximately $20-$50, plus per page copy fees (usually $0.50-$1.50 per page). This document may typically be obtained in one week to ten days. However, the delivery may usually be expedited to one to two days for an additional fee of approximately $10-$50.
4. Certified copy or regular copy of the annual report of a company may be obtained from the secretary of state (or equivalent agency) of the state of incorporation or from the states where the company is qualified. The annual report, depending on the state in which it is filed, will typically provide such information as the officers and directors of the company, the location of the principal office, the nature of the business, and the authorized and issued stock. Again, it will not reveal the identity of the stockholders nor will it reveal the company's by-laws. The cost of ordering this document is approximately $10-$20 and it typically can be obtained in a week to ten days. However, the delivery may usually be expedited to one to two days for an additional fee of $10-$50.
5. Lien Searches can be conducted for such liens as federal or state tax liens, litigation judgment liens, liens filed against real estate (such as mortgages) and general liens on personal property. Additionally, many states now maintain electronic databases with respect to these types of filings, which contain brief synopses of the actual lien filing. These types of searches can be helpful in identifying creditors of the company, as well as material contracts (e.g. equipment leases or supplier contracts which underlie the liens). A lien search conducted with the jurisdiction (as opposed to searching the database) costs approximately $20-$40 per search per jurisdiction, including per page copy fees (usually $1-$2 per page), and they can take up to two weeks to obtain. In order to conduct such searches, we generally need to know the complete mailing addresses of the company's offices, facilities and properties (i.e. complete mailing address).
6. Pending litigation or bankruptcy searches can be performed in virtually all state and federal courts in the U.S. Additionally, many courts now maintain electronic databases with respect to their docket, which contain brief synopses of the actual court filing or case. These searches can provide information with respect to suits filed by or against a particular company. Documents available from the courts typically include a copy of the docket sheet, if available, and a copy of the complaint. Copies of pleadings, memoranda and other documents (including exhibits) filed by both sides in a litigation can often be obtained by additional request. These types of searches cost approximately $20-$50, plus a per page copy fee (usually $1-$2 per page), and they can take up to two weeks to obtain.
7. Dun & Bradstreet or Experian reports can be performed on-line for no cost (other than LexisNexis or Westlaw search costs, if applicable). Dun & Bradstreet and Experian (formerly, the Credit Bureau of TRW) each provide corporate summaries which list general business information, annual sales and profit figures, overall business credit profile and trade payment data. Often however, very small or closely-held businesses often do not have profiles available in these databases.
8 Other on-line public record databases are available through the Internet or through various fee-based providers (such as LexisNexis and Westlaw). Most secretaries of state maintain searchable electronic databases concerning domestic or qualified corporations, uniform commercial code lien filings, and non-corporate entities such as limited partnerships and limited liability companies, which are accessible through the Internet or the fee-based providers. Certain other governmental agencies (such as the Environmental Protection Agency and the Securities Exchange Commission) also maintain searchable electronic databases on the Internet. Additionally, both LexisNexis and Westlaw offer general news, business, environmental, patent and trademark databases which can provide, among other things: (i) Securities and Exchange Commission filings, stock quotes and analysts reports (with respect to public companies); (ii) biographical information on corporate executives; (iii) subsidiary affiliations; (iv) information concerning sites listed on state or federal environmental priorities lists (which means the site is in immediate need of environmental remediation or currently being investigated by the relevant agency); (v) whether the company has been named (and informed of such) as a "potentially responsible party" responsible for clean up of an Environmental Protection Agency superfund or CERCLA site; (vi) other environmental matters such as whether any facilities of the company are being inspected or identified as having potentially violated any major environmental laws, whether any facilities have waste discharge permits and whether there is any record of underground or above ground storage tanks; and (vii) whether a company has registered any trademark or has been issued any patents. It is important to note, however, that some of these databases are outdated or not entirely comprehensive. They may, nonetheless, uncover potential business, environmental or intellectual property issues. The cost per search with respect to the fee-based providers generally ranges from approximately $30-$100 per search, depending on the database.
9. Real estate title searches can be conducted in virtually all counties in the U.S. and are obtained through a title company. These searches can uncover such items as title ownership, liens against the property (such as mortgages, mechanic's liens, etc.), other claims to title (such as easements and leases), restrictive agreements, and other documents recorded against a particular property. Other information may also be available such as encroachments, zoning, and ingress and egress issues. The fees for title searches vary depending on the jurisdiction and the type of search requested. Generally, a title search on a commercial property in Cook County, Illinois would cost approximately $150 per hour of time spent on the search by title company personnel, plus a per document copying fee of $5 to $50, depending on the document's size. Additionally, most title companies provide what is commonly referred to as a "chain of title" search. This search is typically a computer printout listing all owners of record for a piece of property since a given time (1974 in Cook County). A "chain of title" search can be useful in investigating environmental liability issues and typically costs $20-$50 per address searched.
Restrictive covenants for independent contractors
By David E. Doyle, Chicago
In the recent case of Eichman v. National Hospital and Health Care Services, Inc., No. 97 CH 13460 (First District, October 18, 1999), the First District Appellate Court, affirming the trial court's decision, held that restrictive covenants contained in an independent contractor's agreement with a company were not enforceable. In this case, the defendant company was in the business of selling group health and life insurance products to small industrial and commercial employers. The defendant and plaintiff, a salesperson, entered into an independent contractor agreement that contained two restrictive covenants. In the first, the independent contractor agreed not to compete with any existing or future customer of the defendant after the execution of the agreement, although that it permitted competition for businesses that were not the defendant's customers. The second covenant provided that the independent contractor would not solicit, accept or contact any customer insured through the defendant, which obligation would continue as long as either the plaintiff or defendant continued to service one of the defendant's existing customers (as listed on a schedule to the agreement). This second covenant also had a provision that permitted it to be reformed in the event that it was declared invalid.
In determining whether the covenants were unreasonable as a matter of law, the court noted that they were both temporally and geographically unlimited. The court stated that restrictive covenants that are not geographically limited may still be upheld if they are limited to certain activities. In this case, the restrictive covenants did not prohibit all competition, but just competition or solicitation with respect to customers. If these activity restraints were for the purpose of keeping the defendant from losing customers to a former employee who, as a result of his employment, obtained knowledge and familiarity with the customer and its needs, then they could be upheld. However, if the covenants extended to customers with whom the employee had no contacts or never solicited during the term of employment, then this factor, combined with the lack of geographic limitation, would render it unenforceable. In the present case, the restrictive covenants prevented competition with or solicitation of any customer. Although the defendant argued that the agreement was intended to be limited to only those customers listed on the schedule attached to the agreement, and it only sought protection from the court with respect to those customers, the court found that this interpretation could not be supported by the language contained in the agreement. The court therefore found the covenants to be unreasonable. The court also noted that the covenants had no time limitation, and therefore they were over-broad and unreasonable on this additional basis.
The defendant argued that the court should modify the agreement to make it enforceable, but the court held that in this case such action would essentially require the drafting of a new agreement. The court stated that the fairness of the restraint as originally written is a relevant consideration in its decision as to whether to modify the agreement. The court ruled that in this case, the covenants had significant deficiencies and drastic modifications would be required to correct the problem. The court noted that such modification would discourage careful drafting of such agreements that should be required. Therefore, it declined the defendant's request to "blue pencil" the agreement.
It should be noted that the defendant argued that an independent contractor agreement should not be scrutinized by a court as rigorously as an employment agreement, as the independent contractor has more bargaining power than does a standard employee. The defendant compared the restrictive covenant in an independent contractor agreement to such a clause in a joint venture agreement or to one ancillary to the sale of a business. In such cases, the defendant argued, there should be a lower threshold for enforceability of a restrictive covenant. The court disagreed with this analysis, instead holding that restrictive covenants in the context of a sale of a business seek to protect goodwill of the business that has been sold, whereas in the instant situation, as is the case in an employment agreement, the covenant is designed to protect its current customers from former employees. Moreover, the court added that even in the case of the sale of a business, the restraints must be reasonable. The court, therefore, did not lower the level of scrutiny with which it approached the restraints in this case.
By James J. Moylan, Arnstein & Lehr, Chicago
The North American Securities Administration Association, Inc. ("NASAA") recently issued revisions to the Small Company Offering Registration ("SCOR") Form U-7 and the related SCOR Issuer's Manual. (Adopted, September 28, 1999).
The guidelines, "...provide for the uniform treatment of registrations of small company offerings which are exempt from federal registration under Rule 504 of Regulation D, Regulation A, or section 3(a)(11) of the Securities Act of 1933,...." See, "Statement of Policy Regarding Small Company Offering Registrations," NASAA Reports (CCH) ¶413, at p. 409 (Adopted, April 28, 1996).
The overarching amendment is the application of the Securities and Exchange Commission's ("SEC") "plain English" initiative to SCOR disclosures. In addition, Form U-7 begins with an Executive Summary section