By Jerry Meek (August 9, 2013)

Is a non-competition provision in a franchise agreement similar to a non-compete between employer and employee or to one between the seller and buyer of a business?  According to the North Carolina Court of Appeals, it is both.  The “hybrid” nature of such provisions when used in a franchise agreement requires that a new standard be applied to determine if they are enforceable.

In Outdoor Lighting Perspectives Franchising, Inc. v. Harders, COA12-1204 (August 6, 2013), the franchisor sought to enforce a provision in the franchise agreement which purported to bar a former franchisee from involvement in any business “operating in competition with an outdoor lighting business” or “any business similar to” the former franchisee’s business, for a period of two years.

As the Court of Appeals noted, non-competition agreements in employment contracts are “more closely scrutinized” than those contained in a contract for the sale of a business.  The Court rejected the franchisor’s argument non-competition provisions should be analyzed under the more lenient standard applied to the sale of a business.  Instead, franchise agreements involve a “hybrid situation which does not fit neatly within either” category.  A franchisee often possesses a skill set “that makes him capable of earning a livelihood in a variety of different businesses,” thus rendering him less dependent than the typical employee on a specific type of work.  On the other hand, unlike the situation that typically arises from the sale of an established business, the franchisor is likely to benefit from the goodwill created by the franchisee and can sell some of that goodwill to a new franchisee.

Adopting a new standard, the Court held that a non-competition provision in a franchise agreement will be enforceable only if it is “no more restrictive than is necessary to protect the legitimate interests of the franchisor,” considering “the reasonableness of the duration of the restriction, the reasonableness of the geographic scope of the restriction, and the extent to which the restriction is otherwise necessary to protect the legitimate interests of the franchisor.”  Armed with this new standard, the Court of Appeals concluded that the non-competition provision before the Court failed to meet two prongs of this test and was therefore unenforceable.

First, the provision purported to bar the franchisee from engaging in the outdoor lighting business within the territory assigned to any of the franchisor’s “affiliates.”  But, the franchisor had two affiliates engaged in lines of business totally unrelated to outdoor lighting.  Thus, the geographic scope of the restriction was unreasonable.

Second, and more relevant to the typical franchise agreement, the Court held that the non-competition provision was not necessary to protect the franchisor’s legitimate interests.  The provision before the Court purported to restrict the former franchisee from being involved in any business “operating in competition with an outdoor lighting business” or any business “similar” to the franchisee’s former business.  If enforced, this would prohibit the former franchisee from owning a franchise that sold and maintained indoor lighting or from working at a major home improvement store that sold outdoor lighting supplies, equipment, and services, even if the former franchisee were not involved in those operations.  The non-competition agreement, the Court concluded, “would prevent [the former franchisee] from engaging in activities that have no tendency to adversely affect [the franchisor’s] legitimate business interests.”  The provision is therefore unenforceable.

The Court’s ruling reinforces the need for franchisors to give careful, measured consideration to the scope of such provisions when drafting franchise agreements.

By Jerry Meek  (April 12, 2013)

This year, Americans will file an estimated 140 million federal tax returns.  Dreading the process, many of us wait until the very last day – April 15^th – to file.  But could there be cause to celebrate on tax day?

In fact, there is.  That’s because with each passing due date the window of opportunity closes for the IRS to assess new taxes against you from years you’ve probably long since forgotten.

Here’s how it works.  If the IRS looks at your tax return and decides you owe more taxes than you reported owing, they’ll come after you to collect the unpaid tax.  To do this, the IRS mails you a “Notice of Deficiency” – also called a “90-day letter” – which tells you how much the IRS plans to assess against you.  Until the IRS sends this letter, it can’t assess the additional tax, nor can it take any steps to collect the tax it claims you owe.

But here’s the important point.  Generally, to assess a tax against you for any given tax year, the IRS must mail its 90-day letter within three years of either the date that you filed the return for that year or the return’s due date, whichever is later.

Since your 2009 tax return was due in April of 2010, this year’s tax due date probably means an end to the IRS’ ability to assess new taxes against you for the year 2009.  This is true even if you later amended your original 2009 return.

Thus, with each passing April you can smile, armed with the knowledge that the mathematical or other innocent error you made three years ago is now all in the past.

There are, of course, a few exceptions.   If, in your return, you omit more than 25% of your gross income, the IRS has six years to assess the tax instead of three.  In addition, if the IRS can prove that you filed a false or fraudulent return with the intent of evading taxes, or if you fail to file any return at all, then there’s no limit on when they can assess the tax.

Finally, the three year deadline only applies if you and the IRS reach different conclusions on the amount owed.  If you reported the correct amount on your return but simply didn’t pay up, the IRS can move forward with collection efforts without issuing a 90-day letter.  Generally, they’ll have ten years to collect what you owe.

So, there is cause to celebrate this April 15^th after all.  But get your 2012 return filed first.

 

By Jerry Meek

If you’ve decided not to establish a C-corporation, chances are you are considering either an S-corporation or a Limited Liability Company (or LLC) as the alternative.  Technically, S-corporation status is a federal tax status, while an LLC is a type of legal entity created under state corporate law.  But, as a practical matter, LLCs almost always stick with the default tax rules, under which they are treated either as a sole proprietorship or a partnership, depending upon the number of owners.  (In the discussion that follows, I assume that these default rules apply.)

In addition to the advantages of limited liability, both S-corporations and LLCs offer the benefits of pass-through taxation.  In other words, unlike the C-corporation, no tax is paid by the entity itself.  All of the business income passes through to the owners of the business, who report it on their own tax returns.

Although similar, there are important differences between the S-corporation and the LLC that ought to be considered when deciding which path to take.  Here are a few of the larger questions to ask.

How will the business be financed?

With both an S-corporation and an LLC, business losses flow-through to the owners and potentially can be used to offset the owners’ other income.  But there are limitations, the most significant of which is the rule that an owner cannot deduct a loss in excess of “basis.”  A complicated calculation, basis is intended to reflect the owner’s capital investment in the business.  With both an S-corporation and an LLC, basis is adjusted upward whenever the owner makes a loan directly to the business.  But, if the owner only guarantees a loan from a third-party instead of making a direct loan, there is an upward adjustment to basis for an LLC but not for an S-corporation.  As a result, if a significant source of financing will be third-party loans guaranteed by the owner(s), this favors the creation of an LLC.

In addition, an S-corporation is only allowed to issue one class of common stock.  While there can be both voting and non-voting common stock, no group of shareholders can have special preference to receive distributions (that is, there can be no preferred stock).  If you need flexibility in securing equity financing, this restriction may limit your options.

Can you save on self-employment taxes? 

Income from an LLC is subject to self-employment taxes in addition to income taxes.  That means that all of the income you receive from an LLC, up to (currently) $113,700, will be subject to a tax rate of 15.3%.  In addition, all of your LLC income will be subject to a Medicare tax of 2.9% (or more for upper income taxpayers).  These taxes are intended to mirror the FICA and Medicare taxes paid by employees and their employers.  While half of each tax is deductible, this is still a hefty tax bite.

S-corporation owners who also work for the corporation receive compensation in their role as an employee.  Only this portion is subject to FICA and Medicare taxes.  Any remaining income to the owner in the owner’s capacity as a shareholder is treated as a dividend and taxed as ordinary income, but not subject to payroll taxes.  This can result in tremendous savings on self-employment taxes.

Obviously, this creates an incentive for owners who work for an S-corporation to pay themselves less than they deserve.  The IRS is aware of this incentive.  It can – and does – recharacterize dividends as salary when it determines that an owner has not been paid reasonable compensation for his or her work.

Who will be the owners?

There are generally no limitations on who can be an owner of an LLC or on how many owners there can be.  But that’s not true of an S-corporation.  An S-corporation must have 100 or fewer shareholders.  In addition, with a few exceptions (like estates or certain trusts), each shareholder must be an individual, none of whom is a nonresident alien.  When it comes time to find new equity investors, these rules could prove limiting.

Do you need flexibility in allocating income and losses? 

As pass-through entities, an S-corporation or LLC’s items of income, gain, loss, or deductions flow through to the entity’s owners.  In an S-corporation, these items pass-through only in direct proportion to each owner’s percentage of stock ownership.  There is no opportunity to allocate some items to some shareholders and other items to other shareholders.

Sometimes you want the flexibility to make special allocations of this sort.  An LLC taxed as a partnership allows you to do that, by putting those allocations in the LLC’s operating agreement.  Of course, this could lead to abuse, with taxpayers using the LLC as a vehicle to gratuitously transfer assets without paying gift taxes.  Consequently, there is a complex set of rules that establish when the IRS will and will not respect such allocations.

What’s your end game?

Whether it’s selling the business and retiring to the Caribbean or passing it along to your children, you probably have an idea of what the end game should be.

Under certain circumstances, a corporation can merge with, or by acquired by, another company in a tax-free reorganization.  Generally for a reorganization to be tax-free, you must receive stock of the acquiring company in exchange for your interest in the business.

These tax-free reorganization provisions apply to S-corporations, but not to multi-owner LLCs.  So, if you hope to one day be gobbled up by a large, publicly traded corporation in exchange for the latter’s stock, you’ll want to be an S-corporation. Of course, there are ways (if carefully planned) to convert an LLC into a C-corporation or an S-corporation in order to later achieve a tax-free reorganization.  But, if not done carefully, the IRS may treat the conversion and subsequent merger or acquisition as a single transaction, forcing you to pay unexpected taxes.

Can you follow corporate formalities?

One of the main reasons for incorporating a business is to achieve limited liability – limiting your exposure on debts or other obligations (including obligations arising out of tort claims) to the amount you have invested in the business.

In very unusual circumstances, a court may strip a corporation of this limited liability by “piercing the corporate veil.”  Usually this happens when a corporation’s owner uses the entity as a personal piggy bank, undercapitalizing it and treating it as a mere extension of the owner, instead of separate and distinct.

To avoid piercing the corporate veil, corporations are generally expected to follow certain corporate formalities – things like holding annual meetings of the shareholders and directors, electing officers, and preparing written minutes and corporate resolutions.  The required corporate formalities are prescribed both in the corporate bylaws or operating agreement and in any governing state statute.

Generally, LLCs are expected to follow fewer corporate formalities than S-corporations.  None of these formalities, mind you, are overwhelming.  But if you prefer to conduct the business less formally and without attention to all those procedural niceties, the LLC may better suit your style.

What are you now?

If you’ve already got a C-corporation up and running but you’d like to move towards a pass-through entity, your decision is likely easy.  Converting from a C-corporation to an S-corporation – though not without difficulties – is far easier than converting from a C-corporation to an LLC taxed as a partnership.

Under the tax code, a conversion from C-corporation to LLC is treated as a deemed liquidation of the C-corporation.  What does that mean?  It means that the C-corporation is deemed to have distributed all of its property to its shareholders in exchange for their stock and the shareholders, in turn, are deemed to have contributed this property to a new LLC.  The tax consequences can be extraordinary.  The C-corporation is deemed to have sold the property at fair market value, recognizing any gain – including any gain resulting from years of depreciation – in the process.  The shareholder, in turn, usually recognizes gain too, since the shareholder is deemed to have sold shares in exchange for property.

While a conversion from a C-corporation to an S-corporation is not without its hurdles and may come at a price, it is far easier than a conversion to an LLC.

By Jerry Meek

Employees are typically reimbursed when they pay or incur expenses on behalf of their employer.  But, unless those reimbursements are made in compliance with federal regulations, they are treated as wages to the employee.  The consequences for both employer and employee can be crushing:  the employer may owe payroll taxes on the amount reimbursed; the employee may be forced to treat the funds as taxable income.

That’s why every business should have a written reimbursement policy that complies with prescribed Treasury regulations.  (You can find a sample policy here.)  When an employer adopts – and follows – an “accountable plan” for reimbursement, reimbursements are excluded from the employee’s income and exempt from payroll taxes.

To qualify as an “accountable plan” the policy must, at a minimum:

1.  Provide that employees will only be reimbursed for ordinary and necessary business expenses paid or incurred by the employee in connection with the performance of services as an employee.

2.  Require that all expenses be substantiated within a reasonable period of time.  Substantiation within 60 days of the expense is always deemed reasonable.  Generally, substantiation requires documentation of the amount of the expense, the date and time of the expense, the place of any travel (if applicable), and the business purpose of the expense.

3.  Require employees to return to the employer, within a reasonable period of time, any amount advanced to the employee for expenses which are not later substantiated.  For this purpose, 120 days is always deemed reasonable.

Having a proper, written reimbursement policy is especially important when an owner-employee incurs expenses on behalf of a business that doesn’t have the money to make a prompt reimbursement.  Such situations frequently give rise to thorny issues about whether the owner-employee has made a loan to the business or a capital contribution, with all of the resulting tax and other legal implications.  By substantiating the expenses in accordance with a proper reimbursement policy, you can eliminate questions about how these expenses should be characterized.

Of course, it is not enough to simply have a written policy.  The policy must also be followed and enforced.  The IRS decides how to treat reimbursements on an employee-by-employee basis.  In addition, if an employer’s actual reimbursement practices reflect a pattern of abusing the provisions relating to employee reimbursement, the IRS can treat all of the reimbursements as having been made under a nonaccountable plan, even when there’s a compliant plan in place.

By Jerry Meek

Elsewhere, I’ve written about the power of the implied covenant of good faith and fair dealing as a litigation tool.  Last week, a New York appellate court proved the point, holding that claims by two auto dealers, based both on the express language of the Dealer Agreements and the implied covenant of good faith and fair dealing, could move forward.

In Legend Autorama, Ltd. v. Audi of America, Inc., 2012 WL 5503626 (N.Y.A.D.2 Dept.), Audi appealed the lower court’s decision denying Audi’s motion for summary judgment.  The plaintiffs in the case were two franchised Audi dealers, operating pursuant to identical Dealer Agreements with Audi.  They filed suit after Audi appointed a new dealer to operate at a location within 13 miles of the plaintiffs’ location.

The plaintiff dealers asserted three claims against Audi.  First, they argued that Audi was in breach of the express terms of the Dealer Agreement.  Second, they argued that Audi’s conduct constituted a breach of the implied covenant of good faith and fair dealing implied in that agreement.  Third, they argued that Audi had breached fiduciary duties they owed to the dealers.

The appellate court rejected the plaintiffs’ breach of fiduciary duty claims, noting that “a conventional business relationship, without more, is insufficient to create a fiduciary relationship.”  But the court allowed the plaintiffs’ breach of contract claims – based both upon the express provisions and the implied covenant – to go forward.

Echoing other courts, the New York Court observed that “implicit in every contract is a covenant of good faith and fair dealing, which encompasses any promise that a reasonable promisee would understand to be included.”  Audi argued that, since the Dealer Agreement specifically provided that the plaintiffs would be nonexclusive distributors, Audi had discretion to add new dealers even within existing dealers’ territories.  The Court rejected the argument, noting that “even an explicitly discretionary contract right may not be exercised in bad faith so as to frustrate the other party’s right to the benefit under the agreement.”

The plaintiffs also argued that Audi’s conduct breached an express provision of the Dealer Agreement, under which Audi agreed to “actively assist Dealer in all aspects of Dealer’s Operations through such means as Audi considers appropriate.”  There was evidence that, when other dealers were underperforming, Audi would permit them to implement action plans prior to opening new dealers in the area.  This they did not do in the case of the plaintiff dealers.  This evidence, according to the Court, was sufficient to allow the express breach of contract claim to move forward.

In the end, the Court’s decision to deny summary judgment on the implied covenant claim reflects the fact specific inquiry that any such claim requires.  Ordinarily, questions of good faith are to be decided by the jury and thus are inappropriate issues for summary judgment.  Here, the dealer plaintiffs got a bonus – even their express breach of contract claim survived.

By Jerry Meek

The United States Tax Court is a nationwide court, created by Congress pursuant to its powers under Article I of the U.S. Constitution.  The Court is composed of 19 Judges appointed by the President, former Judges serving on recall (known as “Senior Judges”), and Special Trial Judges appointed by the Court’s Chief Judge.  The Court’s Judges hold session in 74 designated cities across the country, permitting matters to be litigated in locations convenient to taxpayers.

The Court’s jurisdiction is defined by statute.  The four powers most commonly exercised by the Court are:

1. The power to redetermine tax deficiencies (I.R.C. § 6211 et. seq.).  When the IRS sends a statutory notice of deficiency to a taxpayer, informing the taxpayer that the taxpayer’s return understates the tax owed, the taxpayer has the right to appeal the IRS’s determination to the Tax Court.  The Tax Court is the only court empowered to adjudicate tax disputes before the taxpayer pays the tax demanded.  The U.S. district courts and the U.S. Court of Federal Claims, in contrast, exercise “refund jurisdiction,” deciding tax disputes only after the tax has been paid and a refund demanded.

2. The power to review claims for relief from joint and several liability (I.R.C. § 6015(e)).  When married taxpayers file joint returns, each spouse becomes jointly and severally liable for the entire amount owed.  This means that the IRS can pursue either spouse for the full amount, regardless of which spouse is to blame for the unpaid tax.  Taxpayers can ask the IRS for relief from joint and several liability.  If the request is denied, taxpayers can appeal to the Tax Court.

3. The power to review IRS decisions on liens and levies (I.R.C. §6320 and § 6330).  It may not seem like it, but there are significant procedural limitations on the IRS’s ability to collect the tax it says is due.  If the IRS files a Notice of Federal Tax Lien, for example, it must give the taxpayer an opportunity for an administrative hearing.  Similarly if the IRS intends to seize (or “levy” upon) the taxpayer’s property, it generally must first provide the taxpayer with an opportunity for a hearing.  The IRS’ decisions at such hearings – known as “collection due process hearings” – can be overturned by the Tax Court.

4. The power to review IRS decisions on installment agreements and offers in compromise  (I.R.C. § 6330).  If a taxpayer cannot pay an undisputed tax, the IRS has the power to enter into “installment agreements” or “offers in compromise.”  Under an installment agreement, the IRS agrees to accept payments over a period of time, suspending other collection efforts in the process.  Under an offer in compromise, the IRS agrees to accept less than the full amount owed.  IRS guidelines determine whether the IRS will enter into such agreements, and on what terms.  If a taxpayer disagrees with the IRS’s decision on a taxpayer’s request to enter into an agreement, and the proper procedural steps are followed, the Tax Court has the power to review the decision.

Except in certain cases designated as small cases (or “S Cases”), a decision of the Tax Court can be appealed to the U.S. Circuit Court for the State in which the taxpayer is domiciled.  As a result, under the “Golsen rule,” the Tax Court must apply the law in each case as that law has been interpreted by the Circuit Court of the taxpayer’s domicile.  See Golsen v. Commissioner, 54 T.C. 742 (1970).  Thus, in rare cases, the Tax Court will reach different rulings for different taxpayers, even on the same facts.