The 3 Most Common Legal Mistakes Costing Companies Millions
By Kyle D. Winey, Esq.
Amazon CEO Jeff Bezos says there are two types of decisions every entrepreneur and business owner must make:
- Type I decisions: a decision that is not easily reversible, so it requires careful planning and execution.
- Type II decisions: a decision that is like walking through a door: if you don’t like it, you can always go back with minimal costs.
When it comes to the intersection of business and law, there are three Type I decisions that entrepreneurs and business owners repeatedly botch. These failures—what I call “Type I failures”—can cost companies millions of dollars. Fortunately, with the right planning, these commonly-made Type I failures are preventable.
Mistake #1: failure to make a Section 83(b) election
Imagine launching a business. Fortunately for you, sales take off like a rocket. In a few short years, your business transforms from $0 in revenue a year to $200,000 in revenue a year. That’s great, right? Yes…until you pay the Tax Man.
In general, when a person’s equity interest in a company vests, he or she is subject to ordinary income tax. Suppose your equity interest in our example above is valued at $100,000. That means your $100,000 interest in the company is subject to ordinary income tax. In 2016, the maximum ordinary income tax was 39.6%. As a result, assuming a tax rate of 39.6%, you must pay $39,600 as ordinary income ($100,000 * 39.6%) upon the vesting of your equity interest.
This tax is almost entirely avoidable by filing what’s known as a Section 83(b) election. By making a Section 83(b) election, you pay income tax on the value of the equity interest at the time of transfer, not at the time of vesting. Not surprisingly, in general, the value of an equity interest at the inception of a company with no cash flow is significantly lower than the value after years of cash flow—which means so is your tax bill.
For example, suppose you incorporate a business and grant yourself stock valued at a nominal amount (after all, you just started). Let’s say the value of your new stock equals $1,000. By filing a Section 83(b) election, you immediately pay taxes on $1,000. At an ordinary income tax rate of 39.6%, you owe $396 in taxes ($1,000 * 39.6%)—far better than the $39,600 tax bill caused by not filing a Section 83(b) election.
Companies commit a Type I failure by not filing a Section 83(b) election with the IRS within 30 days of the equity interest’s transfer. Once the 30-day window passes, individuals forever lose their ability to make a Section 83(b) election.
Paying taxes immediately on the receipt of an equity interest is one of the few times it makes sense to pay taxes sooner rather than later. In this case, filing a Section 83(b) election and paying taxes now can save you from paying thousands of dollars in taxes later.
Mistake #2: failure to create vesting schedules
Vesting schedules are agreements in which individuals accrue ownership in a company over a certain time period rather than all at once. Without vesting schedules, problems can quickly arise in business—and those problems can be costly.
For example, suppose Adam and Bob launch their own business. For the first year, everything is going smoothly. Then the second year arrives, and with it, adversity. In light of these new challenges, Bob decides he no longer wants to operate a business with Adam. As a result, Bob leaves Adam and the business behind. Here’s the catch: without a vesting schedule, Bob takes half of the company with him. That’s the Type I failure.
Vesting schedules would have prevented Adam from losing half of his business when Bob departed. Typical vesting schedules provide for full vesting—meaning the accrual of 100% interest—in four years with a one-year “cliff.” The cliff means that the transferee owns 0% interest in the company until he or she works for a full year. After a year, vesting occurs on a periodic basis (e.g. monthly, quarterly) until full vesting occurs.
Vesting schedules protect founders and business owners from one another. Without vesting schedules, entrepreneurs and business owners run the risk of their business partner walking away with a part of their company. Depending on the value of the business, that could be a million dollar mistake.
Mistake #3: failure to select the proper business entity
In the world of business, there are three common options in incorporating a business: S Corps, C Corps, and LLCs.
The world of startups is the world of corporations, not LLCs. To raise money and incentivize employees, corporations issue equity—a relatively straightforward process. To accomplish the same within the LLC context, business owners must issue a “profits interest”—a complicated way of granting investors claims to the company’s future profits. That’s why venture capitalists refuse to invest in LLCs.
The world of small business is typically a world of S-Corps or LLCs. How do you know which one? In general, if a business generates more than $50,000 in profit a year, the business owner should establish an S-Corp by filing, among other things, a Form 2553. Any small business generating less than $50,000 in profit a year—and expecting the same for the foreseeable future—should be formed as an LLC.
Within the entity selection arena, the Type I failure occurs in selecting the wrong entity. Suppose a business forms an LLC, but due to a spike in profit—seeks to convert to a corporation. Depending on the jurisdiction, some states allow “conversions,” the filing of a few documents to effectuate a change from an LLC to an S-Corp. Virginia is one of them.
Other states, however, are not so flexible. In that case, one approach is to dissolve the entire business and then recreate it from scratch. If the business has been operating for a while, this process can be complicated. If dissolution isn’t practical, the conversation can be executed through a full-blown merger—an even more complicated and costly process.
If you seek guidance in completing these forms, or if you desire to speak personally with an attorney about your options, please contact Simms Showers, LLP located in Leesburg, Virginia at either KDW@simmsshowerslaw.com or HRS@simmsshowerslaw.com or call 703.771.4671.
Legal Disclaimer: This Article and related material have been prepared specifically for INFORMATIONAL PURPOSES. It is not meant to provide legal advice or substitute for competent legal counsel that can address specifics. Any reader is encouraged to seek appropriately trained and experienced professional legal counsel prior to taking the step of incorporating and drafting documents and forms.