Will California Keep Some of its Gig Workers?

Over the last two years we have continued to keep you updated regarding the controversial court decision and subsequent California law that significantly restricts which workers can be classified as independent contractors. As a compromise, Proposition 22 is on November’s ballot. It may offer voters the chance to decide the fate of gig companies and their contractors.

Starting in January 2020, a new California state law, known as AB5, required that all “gig” workers be treated as employees. As such, these workers had to be offered benefits like paid sick leave, overtime pay, healthcare plans, unemployment insurance, and workers’ compensation. Not surprisingly, the new law sparked protest from gig workers and legal action from large employers and transportation industry associations.

Companies employing gig workers, such as Uber and Lyft, were ordered by the Superior Court to classify all contractors as regular employees. The companies say that this decision threatens hundreds of thousands of jobs, along with the possible suspension of their services in the state of California.

If Prop 22 passes, benefits would be tied to each gig worker’s “engaged time” on the job. In the case of Uber and Lyft drivers, this would include time spent completing customer routes (but not lag times in between jobs). Pay would be enforced at a rate of at least 120 percent of minimum wage, and health care subsidies and accident insurance would be included.

The proposal also includes stronger consumer safety standards, such as increased driver background checks and a zero-tolerance policy for drug or alcohol violations.

Proponents of the new measure, which is aimed at drivers in the gig economy, say that companies such as Uber and Lyft offer the opportunity for much-needed flexible employment. More than 80 percent of these contractors work less than 20 hours per week, and cannot commit to set shifts due to other jobs or responsibilities. By a four-to-one margin these drivers say that they prefer to be contractors, not employees.

For customers, failure of Prop 22 could mean longer wait times for rides, limited availability, and higher prices (according to Berkeley Research Group).

Opponents of Prop 22 say that gig workers are exploited by these companies, and need protections from the law. They point to the pandemic as a primary example of the need for paid sick leave, health care benefits, and unemployment insurance.

The issue will be decided on November 3, along with the general election.

What Business Owners need to know – Paycheck Protection Program

PPP Explained

As most business owners know by now, the Paycheck Protection Program (PPP) was launched in April 2020 with $349 billion in funding. The first round was exhausted in less than two weeks. Congress then voted on April 21 for an additional $310 billion in funding. However, the program soon ran into trouble due to controversies over publicly traded companies and other large enterprises being awarded loans. Additionally, concerns and confusion about the attainability of loan forgiveness under the program’s unclear rules, plus a lack of access for small businesses without an established banking relationship, have plagued the program since its inception.

Congress established the PPP to provide relief to small businesses during the coronavirus pandemic as part of the $2 trillion Coronavirus Aid, Relief, and Economic Security (CARES) Act, P.L. 116-136. The legislation originally authorized Treasury to use the SBA’s 7(a) small business lending program to fund loans of up to $10 million per borrower that qualifying businesses could spend to cover payroll, mortgage interest, rent, and utilities.

Changes to PPP

On June 3, the U.S. Senate passed the House version of the Paycheck Protection Program Flexibility Act (PPPFA), giving small businesses more time and flexibility to use their PPP loans with the aim of maximizing loan forgiveness.

Possibly the most significant change to the PPP is the reduction in the requirement that 75% of loan proceeds be spent on “payroll costs.” Under the PPPFA now, 60% of loan proceeds must be spent on “payroll costs.” The PPPFA also extends the 8-week “covered period” during which borrowers were required to use their PPP loan proceeds, to a much longer 24-week period.

Here are some other important changes:

  • The PPPFA extends, until December 31, 2020, the current June 30, 2020 “safe harbor” deadline for borrowers to rehire employees and reverse salary cuts of greater than 25 percent.
  • The legislation includes two new exceptions allowing borrowers to achieve full PPP loan forgiveness even if they do not fully restore their workforce. Previous guidance already allowed borrowers to exclude from those calculations employees who turned down good faith offers to be rehired at the same hours and wages as before the pandemic. The PPPFA will also exempt borrowers from the proportional reduction in loan forgiveness due to a reduction in employees, if the borrower is able to document in good faith that for the period of February 15 to December 31, 2020, the borrower was unable to:
    • Rehire employees who had been employed on February 15, 2020, or hire similarly qualified employees for unfilled positions by December 31, 2020; or
    • Return to the same level of business activity at which the borrower was operating before February 15, 2020, due to compliance with federal requirements or guidance set forth between March 1 and December 31, 2020, relating to standards of sanitation, social distancing, or other worker or customer safety requirements related to COVID-19.
  • New borrowers now have 5 years to repay the loan instead of 2. Existing PPP loans can be extended up to 5 years if the lender and borrower agree. The interest rate remains at 1%.
  • The bill allows PPP loan borrowers to also delay payment of their payroll taxes, which had been prohibited under the CARES Act.

Loan Forgiveness – Dealing with Confusion and Uncertainty

There is no doubt that there is still much uncertainty over some of the program details. However, business owners should be aware that there is no necessary rush to file their PPP loan forgiveness applications. Currently, lenders who will ultimately be responsible for processing forgiveness applications are still waiting for final guidance from the Small Business Administration (SBA) and U.S. Treasury. There is no definite timeline for when needed guidance will be received from the federal government. Additionally, the deadline for filing new PPP loan applications has been extended through August 8, 2020.

Even still, all business, and especially small business, are now understandably agonizing over whether they will meet the requirements necessary to maximize loan forgiveness. Being a patient and prepared business will ultimately be the key to maximizing forgiveness. Make sure that you keep good books and records relative to how loan proceeds are used. Be sure to gather and safe keep documentation necessary to support costs/expenses (i.e., non-payroll costs, mortgage interest, lease payments, or utilities).

Finally, remember that while the recent changes to the PPP provide needed flexibility and are generally good for borrowers, there will be more changes and added complexities. If you have any questions about the PPP program or need additional guidance contact one of our attorneys. We are here to help.

UPDATE: The Death of the Independent Contractor

Recently we provided an update on the continuing saga of the controversial new court decision and new California law which aim to significantly restrict which workers can be classified as independent contractors. Here are some new developments in this contentious case.

In late 2018 the California Trucking Association (“CTA”) filed a lawsuit in response to the landmark California Supreme Court decision in Dynamex Operations West v. Superior Court of Los Angeles (“Dynamex”). In November 2019 the CTA amended its complaint to include arguments designed to prevent the enforcement of Assembly Bill 5 (“AB 5”), which is set to go into effect on January 1, 2020.

The CTA’s suit is currently pending in the United States District Court for the Southern District of California. The CTA seeks to prevent enforcement by arguing that AB 5 violates the Commerce and Supremacy Clauses of the United States Constitution, as well as provisions of other federal law.

In addition to the CTA lawsuit, protestors showed up in National City on December 14, 2019 to protest AB 5 and Assemblywomen Lorena Gonzalez, who authored the new law. Additionally, ride share companies have pledged a reported $100 million to support ballot measures that would overturn the bill.

Background

On September 18, 2019, California Governor Gavin Newsom signed Assembly Bill 5 (“AB 5”) shortly after it passed the California Assembly and Senate. As we discussed in our articles over the last several months, the new law creates significant restrictions on how California employers classify their workers.

To refresh your understanding, the controversial new law sets forth the intent of the Legislature to codify the decision in the Dynamex case and clarify its application. In Dynamex, the court abandoned the long-standing “control test,” instead applying a much stricter “ABC test” used to determine whether a worker is properly classified as an independent contractor.
Under the ABC test, a worker will be deemed to be an employee for wage order purposes, unless the putative employer proves:

  • that the worker is free from the control and direction of the hiring entity in connection with the performance of the work, both under the contract for the performance of the work and it fact;
  • that the worker performs work that is outside the usual course of the hiring entity’s business; and
  • that the worker is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed.

Importantly, each of these requirements needs to be met in order for the putative employer to rebut the presumption that a worker is an employee. It is also important to keep in mind that the Dynamex ruling is being applied retroactively, which means that the ABC test will be applied to cases going forward, as well as to disputes dating back to before the new test was articulated.
AB 5 provides that the factors of the ABC test be applied in order to determine the status of a worker as an employee or independent contractor for all provisions of the Labor Code and the Unemployment Insurance Code, except if a statutory exemption exists. The new law currently exempts a number of occupations from the new statutory scheme, including doctors, securities broker-dealers, insurance agents, accountants, barbers, hairstylists, lawyers, engineers, architects, and a number of other professions.

Despite aggressive public campaigns to defeat the bill, major gig employers like Uber and Lyft will now have to comply with AB 5. In fact, it is estimated that many thousands of California workers across hundreds of industries throughout not only the “gig” economy but elsewhere will now be classified as employees. Therefore, beginning in January 2020, not only will these workers be reclassified as employees, but employers will be required to comply with minimum wage and overtime rules, and provide certain worker compensation protections, including paid sick leave and a myriad of other employment benefits.

Just as the application of the Dynamex applies retroactively to existing court claims, the new law will also apply retroactively to existing misclassification claims. Misclassification is a very expensive mistake. Regardless of the employers’ size, AB 5 applies to all California employers. Now is the time for employers to take action to change worker classification, conduct employment audits and revise employment agreements.

Despite the uncertainty regarding AB 5, the new law is still set to go into effect January 1, 2020. As a result, all employers who currently utilize independent contractors should contact an attorney to review their current situation and discuss necessary changes relative to their workforce classification. We will continue to monitor the situation and keep you informed as new information becomes available.”

UPDATE: Death of the Independent Contractor? The Dynamex Decision and Beyond

Last month we discussed the landmark California Supreme Court decision in Dynamex Operations West v. Superior Court of Los Angeles (“Dynamex”), and the pending legislation that attempts to codify the controversial decision by changing how a hiring company would determine whether a worker is an independent contractor or an employee.

On September 18, 2019, California Governor Gavin Newsom signed Assembly Bill 5 (“AB 5”) shortly after it passed the California Assembly and Senate. As we discussed last month the new law creates significant restrictions on how California employers classify their workers. The new law takes effect on January 1, 2020.

AB 5 provides that the factors of the ABC test be applied in order to determine the status of a worker as an employee or independent contractor for all provisions of the Labor Code and the Unemployment Insurance Code, except if a statutory exemption exists. The new law currently exempts a number of occupations from the new statutory scheme, including doctors, securities broker-dealers, insurance agents, accountants, barbers, hairstylists, lawyers, engineers, architects, and a number of other professions.

To refresh your understanding, the controversial new law sets forth the intent of the Legislature to codify the decision in the Dynamex case and clarify its application. In Dynamex, the court abandoned the long-standing “control test” instead applying a much stricter “ABC test” used to determine whether a worker is properly classified as an independent contractor.

Under the ABC test, a worker will be deemed to be an employee for wage order purposes, unless the putative employer proves:

A) that the worker is free from the control and direction of the hiring entity in connection with the performance of the work, both under the contract for the performance of the work and in fact;

B) that the worker performs work that is outside the usual course of the hiring entity’s business; and

C) that the worker is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed.

Importantly, each of these requirements needs to be met in order for the putative employer to rebut the presumption that a worker is an employee. It is also important to keep in mind that the Dynamex ruling is being applied retroactively, which means that the ABC test will be applied to cases going forward, as well as to disputes dating back to before the new test was articulated.

Despite aggressive public campaigns to defeat the bill, major gig employers like Uber and Lyft will now have to comply with AB 5. In fact, it is estimated that many thousands of California workers across hundreds of industries throughout not only the “gig” economy but elsewhere will now be classified as employees. Therefore, beginning in January 2020, not only will these workers be reclassified as employees, but employers will be required to comply with minimum wage and overtime rules, and provide certain worker compensation protections, including paid sick leave and a myriad of other employment benefits.

Just as the application of the Dynamex applies retroactively to existing court claims, the new law will also apply retroactively to existing misclassification claims. Misclassification is a very expensive mistake. Regardless of the employers’ size, AB 5 applies to all California employers. Now is the time for employers to take action to change worker classification, conduct employment audits and revise employment agreements.

Before the new law goes into effect, all employers who currently utilize independent contractors should contact an attorney to review their current situation and make the necessary changes relative to their workforce classification.

UPDATE: Death of the Independent Contractor? The Dynamex Decision and Beyond

Last month we discussed the landmark California Supreme Court decision in Dynamex Operations West v. Superior Court of Los Angeles (“Dynamex”), and the pending legislation that attempts to codify the controversial decision by changing how a hiring company would determine whether a worker is an independent contractor or an employee.

On September 18, 2019, California Governor Gavin Newsom signed Assembly Bill 5 (“AB 5”) shortly after it passed the California Assembly and Senate. As we discussed last month the new law creates significant restrictions on how California employers classify their workers. The new law takes effect on January 1, 2020.

AB 5 provides that the factors of the ABC test be applied in order to determine the status of a worker as an employee or independent contractor for all provisions of the Labor Code and the Unemployment Insurance Code, except if a statutory exemption exists. The new law currently exempts a number of occupations from the new statutory scheme, including doctors, securities broker-dealers, insurance agents, accountants, barbers, hairstylists, lawyers, engineers, architects, and a number of other professions.

To refresh your understanding, the controversial new law sets forth the intent of the Legislature to codify the decision in the Dynamex case and clarify its application. In Dynamex, the court abandoned the long-standing “control test” instead applying a much stricter “ABC test” used to determine whether a worker is properly classified as an independent contractor.

Under the ABC test, a worker will be deemed to be an employee for wage order purposes, unless the putative employer proves:

A) that the worker is free from the control and direction of the hiring entity in connection with the performance of the work, both under the contract for the performance of the work and in fact;

B) that the worker performs work that is outside the usual course of the hiring entity’s business; and

C) that the worker is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed.

Importantly, each of these requirements needs to be met in order for the putative employer to rebut the presumption that a worker is an employee. It is also important to keep in mind that the Dynamex ruling is being applied retroactively, which means that the ABC test will be applied to cases going forward, as well as to disputes dating back to before the new test was articulated.

Despite aggressive public campaigns to defeat the bill, major gig employers like Uber and Lyft will now have to comply with AB 5. In fact, it is estimated that many thousands of California workers across hundreds of industries throughout not only the “gig” economy but elsewhere will now be classified as employees. Therefore, beginning in January 2020, not only will these workers be reclassified as employees, but employers will be required to comply with minimum wage and overtime rules, and provide certain worker compensation protections, including paid sick leave and a myriad of other employment benefits.

Just as the application of the Dynamex applies retroactively to existing court claims, the new law will also apply retroactively to existing misclassification claims. Misclassification is a very expensive mistake. Regardless of the employers’ size, AB 5 applies to all California employers. Now is the time for employers to take action to change worker classification, conduct employment audits and revise employment agreements.

Before the new law goes into effect, all employers who currently utilize independent contractors should contact an attorney to review their current situation and make the necessary changes relative to their workforce classification.

Death of the Independent Contractor: The Dynamex Decision and Beyond

On Thursday, May 2, 2019, the 2018 California Supreme Court ruling that created a strict standard for determining who is an employee, and making it almost impossible for companies to classify workers as independent contractors, was upheld by the U.S. Court of Appeals for the Ninth Circuit. Further, the ruling which creates a new test for determining whether a worker is an independent contractor or an employee will be applied retroactively. It is an understatement to say that the Ninth Circuit opinion has major implications for California workers and employers.

BACKGROUND
The original case, Dynamex Operations West v. Superior Court of Los Angeles (“Dynamex”), stems from a claim made by Plaintiff Charles Lee who in 2005 entered into a written independent contractor agreement with Dynamex to provide delivery services for the Company. As many may know, Dynamex is a nationwide same-day courier and delivery service. Prior to 2004 the Company classified all its delivery drivers as employees. However, beginning in 2004, Dynamex converted all its drivers to independent contractors in order to cut costs.

Mr. Lee’s complaint alleged that Dynamex misclassified its drivers as independent contractors in violation of various sections of the California Labor Code and Industrial Welfare Commission (“IWC”) wage order No. 9, which is the applicable wage order governing the transportation industry. The complaint further alleged that as a result of the claimed violations, Dynamex also engaged in unfair and unlawful business practices pursuant to California Business and Professional Code section 17200.

After an early round of litigation regarding class certification, the Court of Appeals rejected Dynamex’s argument that asserted that the traditional multi-factor “common law” classification analysis, outlined in S.G. Borello & Sons, Inc., v. Department of Industrial Relations (“Borello”), should be applied where there was an employer obligation imposed by an IWC wage order.

As a result, the California Supreme Court granted review in order to clarify the correct standard for determining employee or contractor status where there is a governing wage order.

Consequently, the Court created a new and substantially more restrictive test known as the “ABC test.” Under the ABC test, a worker will be deemed to be an employee for wage order purposes, unless the putative employer proves:

A) that the worker is free from the control and direction of the hiring entity in connection with the performance of the work, both under the contract for the performance of the work and it fact;

B) that the worker performs work that is outside the usual course of the hiring entity’s business;

C) and that the worker is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed.

It is important to understand that each of these requirements needs to be met in order for the putative employer to rebut the presumption that a worker is an employee. In addition, the May 2 ruling will be applied retroactively, which means that the ABC test will be applied to cases going forward, as well as to disputes dating back to before the new test was articulated.

UNINTENDED OR INTENDED CONSQUENCES – THE EFFECT OF DYNAMEX

The determination regarding whether a particular worker should be classified as an employee or independent contractor is of great importance to workers, businesses and the general public. Workers classified as employees create significant employer obligations with regard to Social Security and payroll taxes, worker compensation insurance, unemployment insurance and state employment taxes, not to mention the complicated framework of federal and state statutes governing wages, hours and working conditions.

Additionally, the Dynamex ruling has considerable implications for employers and workers participating in the “gig” economy like Uber, Lyft, GrubHub and Postmates. The decision could compel some employers to reclassify contractors as employees and change pay and benefit schemes, a cost that will no doubt be passed along to the consumer.

The ruling has already prompted new litigation against “gig” employers. Also, it has far reaching implications for existing Ninth Circuit cases, including the worker classification case against Grub Hub, which is considered to be a test case for the gig economy’s current business model. It is widely believed that these employers face an uphill battle in asserting that their businesses are their apps rather than the service provided to the customer.

Further, the ruling also has an effect on major franchises because the Dynamex decision retroactively subjects employers (franchisors and franchisees) to liability for misclassifying workers as independent contractors going back four years before the 2018 decision based on California’s statute of limitation. Because the Court held that the ABC test applies to both a franchisee and the parent franchisor when deciding whether workers are employees, it naturally creates increased liability exposure for the franchisor. Matthew Haller, a senior vice president at the International Franchise Association believes that unless there is legislative relief or intervention from the U.S. Supreme Court, which is unlikely, “California’s 76,000 franchise hotels, gyms, restaurants and retail stores will live in legal uncertainty for the foreseeable future.”

In addition to gig employers and franchises, the Dynamex decision effects an array of California workers by creating a presumption that a worker is an employee unless they meet the difficult criteria that would make them independent contractors. Therefore, the ruling will certainly effect hair stylists, barber, beauticians, exotic dancers, contract lawyers, outside sales agents, insurance agents, and maybe even real estate professionals.

CODIFYING DYNAMEX – A DIFFICULT CERTAINTY

In December of 2018, Assemblywoman Lorena Gonzalez introduced Assembly Bill No. 5 (“AB 5”) which is designed to codify the decision in Dynamex and clarify its application. In May of 2019 the California Assembly voted to pass AB 5 by a vote of 55 to 11, and the bill is now headed to the California Senate for a vote at the end of the summer.

The controversial law would set forth the intent of the Legislature to codify the decision in the Dynamex case and clarify its application. The bill would provide that the factors of the ABC test be applied in order to determine the status of a worker as an employee or independent contractor for all provisions of the Labor Code and the Unemployment Insurance Code, except if a statutory exemption exists. AB 5 currently exempts a number of occupations from the new statutory scheme, including doctors, securities broker-dealers, direct sales agents, licensed real estate professionals, and hairstylists. The exempted workers’ classification will be determined using the multi-factored Borello test.

Of course, major gig employers like Uber and Lyft have launched aggressive public campaigns to defeat the bill. If passed, gig workers would get labor protections and benefits that all employees get, like unemployment insurance, health care subsidies, paid parental leave, overtime pay, worker’s compensation and a guaranteed $12 and hour minimum wage. Moreover, California stands to benefit by taking in as much as an additional $7 billion in tax revenue each year that the state currently loses because of employee misclassification.

Currently, California Democrats have a veto-proof supermajority in the State Senate and Assembly. Therefore, there is a pretty good chance that AB 5 will become law.

Also, in December of 2018 Assemblywoman Melissa Melendez introduced Assembly Bill No. 71 (“AB 71”) which is designed to protect the independent contractor by rolling back the precedent set by the Dynamex decision. Melendez believes that Dynamex will have a chilling and harmful effect on the business community and hurt the almost 2 million California workers that choose to work flexible schedules as independent contractors.

AB 71 would effectively overrule Dynamex by removing the ABC test as the method for determining worker classification and replacing it by codifying the almost 30-year old common law factors outlined in Borello. Certainly, the eight-factor test outlined in Borello is a more flexible test emphasizing the extent of the employers control over the worker. Both the California Chamber of Commerce as well as the state’s business and tech communities support AB 71. However, AB 71 has so far lacked the momentum of AB 5 and it failed to make it to an Assembly vote. Currently, AB 71 is again awaiting approval from the Assembly Committee on Labor and Employment.

CONCLUSION

No matter where you stand on the issue of business use of independent contractors, it is clear that there is a new legal standard in California for determining whether workers should be classified as employees or independent contractors. Employers and workers should take note and contact an attorney to discuss their particular situation. Further employers need to reevaluate any workers currently classified as independent contractors. Below are some specific things to remember about the new case law.

An employer must satisfy all three factors outlined in the Dynamex decision to correctly classify a worker as an independent contractor. Beware of factors B and C. In Dynamex the Court recommended that the analysis begin with factors B and C. This is a departure from previous law because the analysis previously focused on the amount of employer “control” which is now addressed in factor A. Employers should be prepared to make their case on factors B and C before they address questions of control.

Employers have the burden of proof. The Dynamex’s ruling makes it abundantly clear that the burden of proving a worker is an independent contractor rest entirely with the employer. The Court found that it was “appropriate, and most consistent” to require the hiring entity [employer] to establish not just one or a majority of the factors in the standard, but instead must stratify each of the three factors outlined in the ABC test.

Adding to the burden and difficulty of the new standard, the Dynamex decision applies retroactively and the federal courts agree. The Ninth Circuit provided that “retroactive application is neither arbitrary nor irrational” in violation of the due process and that the ABC test remains “faithful… to the fundamental purpose of [California’s] wage orders.”

For employers, the Dynamex decision will have a major impact. Retroactive application of a new standard that puts the burden squarely on the employer will most certainly open the door to potential employer liability going back several years. The Dynamex decision coupled with new legislation has the effect of forever changing the way we classify workers. In California we may be in the beginning stages of the death of the independent contractor.

Business Divorce and the Benefit of Buy-Sell Agreements

Despite the name, a buy-sell agreement (sometimes referred to as a shareholder agreement or cross purchase agreement) doesn’t directly pertain to buying and selling a business in the traditional sense. Co-owners of companies enter into these agreements in order to detail the terms and conditions for a buyout in the event of the death, disability, bankruptcy, retirement, or even divorce. In other words, business owners are often advised to enter into a buy-sell agreement so that the parties can agree ahead of time regarding the restrictions, terms and conditions of the sale of their ownership. When an owner desires to, or must give up his or her ownership and role in the business, each party has certain rights regarding when their interest in the company can be sold, to whom, and under what payment and purchase price terms.

The reasons for needing a buy-sell agreement, in the event of a death, disability, or retirement, seem obvious. However, there are less common situations that can arise during a company’s lifetime that could endanger owners’ interests or the business itself in the absence of a properly crafted buy-sell agreement. For example:

Bankruptcy. In the event of one owner’s personal bankruptcy, the entire business could potentially become tied up in bankruptcy court. In these situations, the company is sometimes liquidated, and then half of the assets claimed in order to cover the bankrupted owner’s debts. A buy-sell agreement could require owners to notify one another before filing bankruptcy. As a result, the buy-sell agreement serves as an automatic offer to sell the bankrupt owner’s share in the company to the other owner(s).

Divorce. In some divorce situations, a co-owner’s former spouse can ask for partial ownership of the business. This often happens in community property states like California, because in most instances all earnings and property acquired during the marriage are considered owned equally by both spouses.

A buy-sell agreement can require soon-to-be ex-spouses of owners, who will gain partial ownership in the company through the divorce, to sell their interest in the company to the other owner(s). A well-crafted buy-sell agreement should provide a valuation method so that the purchase price is set before these situations ever transpire. Of course, it is much easier to agree on purchase terms and price before there is an event that creates acrimony.

Starting and operating a business with more than one owner is often referred to as a “business marriage.” Agreeing ahead of time regarding how to handle a “business divorce” will provide business owners with peace of mind relative to how to handle a stressful change of ownership. And, in most cases, also help to ensure the business can continue to operate free of court intervention. One could view these contracts as a “prenuptial agreement” for businesses. Co-owners of businesses should create buy-sell agreements from the moment a business is formed in order to protect each owner’s financial interests, the continuity of the business, as well as the interests of legal heirs.

For more information on buy-sell agreements and their various benefits, contact our business planning attorney for more information.

Which is Better: A Sole Proprietorship, Corporation or LLC?

Many small businesses begin as a sole proprietorship. This is often the best choice early in the life of a small business. But over time, needs may change. Frequently, as a business grows, becomes more profitable, and adds employees or owners, business owners begin to evaluate the structure of their business and weigh the option of incorporating or forming a limited liability company. Here are a few basic facts.

Sole proprietorships

A sole proprietorship is a business that is owned and operated with one owner (or sometime as husband and wife) where the business and the business owner operate as one. Moreover, the assets of the business are owned by the business owner. Instead of filing a separate tax return for the business, the business owner pays income taxes on the net profit from the business on the owner’s individual income tax return. Less complexity, more cost effective startup, and possibly a less complex income tax return are all benefits of a sole proprietorship. However, as the business grows, unlimited personal liability for the debts and liabilities of the business, an increased chance of IRS audit, and less flexibility regarding income tax planning are all drawbacks to sole proprietorships. As a result of the foregoing, sole proprietors often realize that their needs have changed and they need to protect their personal assets from the liabilities of the business and allow for more situation specific tax planning.

Corporations

As a corporation, the business stands as a separate entity independent from its owner(s). Generally, corporate owners (referred to as “shareholders”) are not personally liable for the debt and liabilities of the corporation, except to the extent of their investment in the corporation and any appreciation on the investment. From an operational and asset protection standpoint all corporation are generally the same. However, how the corporation is taxed varies based on the tax election made at or after formation. There are two different types of corporations from an income tax standpoint. All corporations are formed as “C” corporation (“C-corps”). C-corps are taxed as entities separate from their owner(s). C-corps file a separate income tax return and pay income taxes at corporate rates. Owner-operators of C-corps receive compensation in the form of salary and potentially corporate dividends. Corporations can also elect to be treated as a “S” corporation (“S-corp”) by timely filing the appropriate election forms with the IRS. S-corps are “pass-through” entities from an income tax standpoint. This means that all the income, loss and deductions created from the operation of the business will “pass-through” to the shareholder(s) in direct proportion to their ownership. S-corps’ file a separate income tax return that is informational only, and net profit or loss are ultimately reported on the owner(s) individual income tax returns. With the exception of certain state specific taxes, any income tax due is paid by the shareholder(s)s at the individual shareholder’s individual income tax rates.

Limited Liability Companies

A LLC is an entity structure whereby the owner(s) (referred to as “members”) of the company are not personally liable for the company’s debts or liabilities. Limited liability companies are hybrid entities that combine some of the characteristics of a corporation with that of a partnership or sole proprietorship. LLCs are the most flexible of all business entities and allow the business owner(s) to get the asset protection of a corporation with the ability to choose the income tax regime that best fits the needs of the business and its owners. If before formation the business was operated as sole proprietorship, then the LLC can elect to be taxed as either a disregarded entity, C-corp or S-corp. If the business has more than one owner, then the LLC can elect to be taxed as a partnership, C-corp or S-corp. Business owners should be aware that under California law not all types of businesses are allowed to operate as LLC. Therefore, business owners contemplating the formation of an LLC should take care to ensure that their business is allowed to operate as a LLC.

Asset Protection and Insurance

The primary difference between sole proprietorships, corporations, and LLCs lies in ownership of assets. When the business becomes its own separate entity, owners are generally protected from the debts and liabilities of the business.

Despite the asset protection provided by the forming of a corporation or LLC, business liability insurance is still recommended, and in many cases will provide essential benefits, such as paying for the cost of defense in the event of a lawsuit. Transitioning to a corporation does not eliminate the need for proper insurance.

Drawbacks of Operating a Business Through an Entity

If a business owner transitions to a corporation midway through the calendar year, he or she will be required to file tax returns for both the sole proprietorship and the new corporation during the following tax season. These situations can become complicated. Therefore, some business owners prefer to transition at the beginning of a new year, to avoid confusion and unnecessarily burdensome tax preparation. In addition, while forming an entity can limit the liability of business owner(s) and provide income tax benefits, business owners should be aware that running a business through an entity will likely increase your tax preparation costs, annual operational costs and complicate business operations.

If you’re a business owner considering a transition from sole proprietorship to a corporation or LLC, it would be wise to consult with a business planning attorney. A knowledgeable attorney can help you explore the different types of corporations, and assist you in deciding upon the structure that best suits your business needs.

A Little Known Gem in the Tax Code: Section 1042

For business owners evaluating wealth diversification and business succession alternatives can be a daunting and time consuming task. It is no secret that today’s business owners live in a complex and ever changing tax environment. However, to most business owners Employee Stock Ownership Plans (ESOP) and the rules and regulations governing them are little known and often misunderstood alternative in wealth diversification and business succession planning. However, few alternatives offer greater after tax proceeds than a little known tax planning gem often referred to as a “1042 Exchange.” A properly executed Internal Revenue Code Section 1042 tax-deferred sale to an ESOP for full fair market value can provide significant tax benefits.

WHAT IS INTERNAL REVENUE CODE SECTION 1042?

Internal Revenue Code Section 1042 provides for an election that allows individuals, partnerships, trusts, and estates that sell shares of stock of a C corporation to an ESOP to not recognize the long-term capital gain realized in connection with the sale for federal income tax purposes. Much like an Internal Revenue Code Section 1031 exchange in the real estate context, the recognition of the capital gain is deferred until a future point in time, or even eliminated. Section 1042 treatment must be properly elected by the taxpayer within the time frame for filing the tax return for the year of the sale to the ESOP.

HOW DOES A 1042 EXCHANGE WORK?

The basic requirements for making the 1042 Election include the following:

  • The company sponsoring the ESOP must be a C corporation. (In some cases it is actually worth converting from an S corporation to a C corporation, even though you cannot convert back for five years.)
  • Immediately following the sale to the ESOP, the plan (ESOP) must own at least 30% of the company’s stock.
  • The seller must, within 12 months, invest the proceeds of the sale in “Qualifying Replacement Property” (“QRP”) — U.S. domestic stocks and bonds. (Mutual funds, real estate, and certain other investments are not allowed.)
  • The seller must have held stock in the corporation for at least three years prior to the sale.

If all the requirements are met, the 1042 Election can have significant tax advantages for the seller. First, the capital gains tax that would be paid due to the sale of the company stock can be deferred. The basis in that stock becomes the basis in the QRP. The capital gains tax is not paid until those securities are sold. Second, for any replacement property still owned by the seller at his or her death, there is a step-up in basis to the market value at that time, thus eliminating the capital gains tax entirely.

EXAMPLE

  • Assume an owner’s basis in his company is $1,000,000. The market value of the company is $4,000,000 when he sells 100% of the company to an ESOP.
  • Unrealized appreciation at time of sale to the ESOP is $3,000,000.
  • Assuming a combined (federal and state) 30% capital gains tax rate, the tax would be $900,000 if there were no 1042 election.
  • Assume the seller makes a 1042 election (which must be filed with his personal tax returns) and all proceeds are invested into QRP.
  • The basis of the new securities is deemed to be $1,000,000.
  • Twenty years down the road, assume the QRP have grown to $11,000,000. (That’s appreciation of a little over 5% per year.) The unrealized appreciation would be $10,000,000. If the securities were sold at that time, the 30% capital gains tax would be $3,000,000.
  • Assume the individual dies 20 years from now, still holding the QRP. Then the basis is stepped-up to the $11,000,000 fair market value at death. Consequently, the $3,000,000 capital gains tax disappears completely.

ADVANTAGES OF A 1042 ELECTION

A seller can postpone capital gains. If the QRP has not been sold by the time the seller dies, there is a step-up in basis, thus eliminating capital gains altogether. Even if not deferring capital gains until death, the seller gets to choose the year in which he sells the QRP, thus having some control over the timing of the taxes. A partial 1042 election is also permitted if the seller wishes to defer capital gains on only part of the proceeds of the sale.

Some brokerage firms and financial institutions are willing to lend around 70% on a portfolio including equities. Therefore, theoretically a person could put the sale proceeds into a QRP portfolio and then borrow up to 70% of that amount to generate a retirement income, paying only interest on the debt each year. At death, when the capital gains have been eliminated, the portfolio can be partially liquidated in order to pay off the entire debt.

DISADVANTAGES OF A 1042 ELECTION

If the corporation being sold is an S corporation, then it must first convert to a C corporation in order to use a 1042 election. The conversion to C corporation from S corporation can be made on or right before the stock sale transaction is closed.

In order to qualify, the proceeds from the sale must be available within 12 months of the sale to the ESOP. Therefore, to have all the proceeds qualify, the seller must get a lump sum, instead of taking a personal note over several years. This may require involving a lender.

If the intent is to only buyout one shareholder, who happens to own less than 30% of the company, then you can’t meet the requirement that the ESOP must own at least 30% of the company right after the sale. In order to qualify for the delayed capital gains, the sale must be directly to the ESOP, as opposed to retiring some shares and selling only part to an ESOP. There are times when a large sale to an ESOP creates problems with the debt service.

Deferring capital gains can be risky since capital gains rates could go up in the future. In order to purchase QRP, the seller must not buy mutual funds or foreign investments. The seller is limited to U.S. domestic stocks and bonds. If borrowing against a QRP portfolio in order to generate retirement income, then the seller needs to consider some worse case scenarios involving large drops in the stock or bond markets.

If the seller plans to be an employee after the sale, but makes a 1042 election, then he cannot participate in the ESOP allocation of the shares he is selling to the ESOP. (Family members would also be precluded from participating in those shares inside of the ESOP.)

CONCLUSION

When a business owner considers the income tax benefits possible with a sale to an ESOP, along with the likelihood that incentivized and rewarded employees will be more motivated and productive, he or she may conclude that a tax-deferred sale to an ESOP is the best wealth diversification or business succession alternative available.

Of course, every situation is different and there is no one size fit all solution for a business owner who is evaluating wealth diversification and business succession alternatives. Business owners should consider all of the available options and compare, the friction costs, investment restrictions, and the after-tax proceeds the business owner will receive under each alternative.

Our experienced business planning attorneys can help you with issues related to wealth diversification and business succession. Please call our office to schedule an appointment, and we will be happy to examine your situation and explain the options available to you.

What is Mediation?

Sometimes, when legal disagreements arise, one or both parties might suggest mediation before taking the case to a courtroom. Whether or not the case has already been filed with a court of law, mediation before the court date can often result in a settlement that is satisfactory to both sides.

Participation in mediation is voluntary, except in cases governed by statute or contract clause. Some examples of cases that frequently benefit from mediation are:

  • Divorce
  • Domestic relations
  • Workers compensation
  • Labor or employment cases
  • Personal injury
  • Commercial transactions

Why choose mediation? A skilled mediator can help all involved parties identify their primary goals, and work to craft a solution that is agreeable to all. Often mediation will allow both sides of the conflict to wrap up the case more swiftly, and avoid lengthy court proceedings. Mediation might also feel more “safe”, because involved parties have an opportunity to contribute to the eventual solution, rather than leaving the entire case (and judgment) in the hands of a judge.

Often, because mediation saves time and reduces court proceedings, both parties can save money on legal expenses by pursuing this course of action.

How does mediation work? At any point before the final court date, involved parties can agree to attempt mediation. Obviously, more time and money are likely to be saved when mediation is attempted early on in the dispute.

Mediation is held at a neutral location, and both parties are allowed (but not required) to bring legal counsel. Each side presents their account of the facts and circumstances that led to the conflict, and the mediator helps each to identify areas of agreement. Areas of dispute are weighed and negotiated as a settlement gradually takes shape.

If a settlement agreement is indeed reached, court proceedings and judgment are successfully avoided. If a settlement cannot be reached, the case will likely proceed to court.

Mediation does not solve every problem, but is often successful if both parties can keep an open mind. Rarely does anyone completely “get their way” in mediation, but most people feel more satisfied with a win-win solution to which they contributed, rather than leaving the whole matter in a judge’s hands.

For more information on mediation, contact our attorneys. We can help you decide if mediation might be the right way to proceed with your dispute.

 

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