Buying, Owning and Selling a Business

The following article by James N. Phillips appeared in the February 13, 2019 issue of the Business Law Section Blog of the State Bar of Wisconsin and is being reposted from that site with the permission of the author and the State Bar of Wisconsin.


Jim Phillips, Iowa 1979, is a shareholder in the Milwaukee office of Godfrey & Kahn, S.C., where he practices tax and corporate law.


Section 1202 of the amended Internal Revenue Code of 1986 allows exclude up to 100 percent of the gain on sale of stock held more than five years, if such stock meets the definition of “qualified small business stock.” Jim Phillips discusses some of the requirements and traps of Section 1202.

An owner of C corporation stock may be able to exclude up to 100 percent of the gain on sale of stock held more than five years, if such stock meets the definition of “qualified small business stock” (QSBS) under Section 1202 of the Internal Revenue Code of 1986, as amended.

The gain might also be excludable from Wisconsin tax if the corporation is a qualified Wisconsin business and the requirements of Wis. Stat. section 71.05(25)(b) are met.

Given the significantly lower federal income tax rate on C corporation income (21 percent) compared to the federal income tax rate on flow-through income of S corporations and LLCs (37 percent or 29.6 percent, depending on whether the 20 percent deduction of Section 199A applies), the availability of the Section 1202 exclusion can, in some cases, tip the scales toward C corporation status when evaluating the proper choice of entity.

Here is a summary of the requirements and traps of Section 1202.

Section 1202 Offers Partial or Total Exemption from Tax for Certain Capital Gains

Section 1202 exempts from tax a specified percentage of a taxpayer’s gains from the sale of QSBS provided the taxpayer held the QSBS for more than five years (among other requirements discussed below).

The applicable exemption percentage for stock acquired on or after Sept. 27, 2010, is 100 percent. For stock acquired earlier, the exemption may be 50 percent or 75 percent, depending on the taxpayer’s stock acquisition date.

Congress has repeatedly changed the amount of the Section 1202 exemption with varying effective dates. For stock for which the 100 percent exclusion applies, the excluded gain is not a preference under the alternative minimum tax (AMT).

For other exclusion percentages, a portion of the excluded amount is an AMT preference.

The table below summarizes the interaction of Section 1202, AMT, and other code provisions.

 

Date of Stock Acquisition § 1202 Tax Exemption Percentage § 1202 Capital Gain Rate Effective Capital Gains Rate Effective Net Investment Income Tax Rate Effective AMT Tax Rate AMT rate savings vs. 23.8% regular capital gain rate
On or after Aug. 11, 1993, but before Feb. 17, 2009 50% 28% 14% 1.9% 14.98% 6.92%
On or after Feb. 17, 2009, but before Sept. 27, 2010 75% 28% 7% 0.95% 8.47% 14.38%
On or after Sept. 27, 2010 100% 28% 0% 0% 0% 23.8%

For example, assume that individual X acquired $1 million of Y corporation stock in 2019, and Y stock is a capital asset in X’s hands. If the Y stock is not QSBS and X sells it in 2026 for $6 million, then X realizes a gain of $5 million. In that case, X could potentially owe federal income taxes of $1.19 million ($5 million gain x 23.8 percent capital gains rate).

However, if the Y stock were QSBS in X’s hands, then X’s entire Section 1202 gain on the sale would be excluded and X would owe no federal income taxes attributable to the sale. Thus, X would have tax savings of $1.19 million. This would be in addition to the lower C corporate income tax rate over the 6-year period. However, choice of entity is usually not just a current or future tax rate issue. A number of factors need to be considered: expected dividend distributions, the flexibility of structuring a potential future sale as an asset sale, estate planning considerations, etc.

Requirements for the Section 1202 Exemption

For stock in a corporation to qualify for the exemption in Section 1202(a), the following requirements must be satisfied:

  • Five year holding period – the taxpayer must have held the stock for at least five years.
  • Shareholder other than a corporation – the taxpayer claiming the Section 1202 exclusion must not be a corporation.
  • Acquisition at original issuance for cash or services – the taxpayer must have acquired the stock at its original issuance either (i) in exchange for money or other property (not including stock) or (ii) as compensation for services provided to the corporation. However, this requirement is waived in certain cases. For instance, if QSBS is transferred by gift or at death, the donee or heir, respectively, steps into the donor or decedent’s shoes for purposes of the Section1202 original issuance requirement and five year holding period.
  • Domestic C Corporation – the stock must be a corporation created or organized in the U.S. or any State that is taxed under subchapter C of the Code.
  • Gross Asset Test – The aggregate gross assets of the corporation prior to and immediately after the taxpayer acquires the stock must not exceed $50 million. For this purpose, aggregate gross assets includes the amount of cash and the combined adjusted bases of other property held by the corporation. However, the adjusted basis of any property contributed to the corporation is determined as if the basis of such contributed property were equal to its fair market value at the time of contribution.
  • Qualified Active Business – The corporation must have conducted a “qualified trade or business,” which is defined in the negative to exclude the following types of businesses:
    • any business involving performing services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any business where the principal asset of the business is the reputation or skill of its employee(s),
    • any banking, insurance, financing, leasing, investing, or similar business,
    • any farming business (including the business of raising or harvesting trees),
    • any business involving the production or extraction of products of a character with respect to which a deduction is allowable under section 613 or 613A, and
    • any business of operating a hotel, motel, restaurant, or similar business.

Additionally, the corporation must be an “eligible corporation,” which primarily excludes a regulated investment company, REIT, REMIC or cooperative.

  • 80 percent of assets by value used in a qualified active business – At least 80 percent of the corporation’s assets must have been used in the active conduct of one or more qualified trades or businesses during “substantially all” of the taxpayer’s holding period for the shares.

Common Situations that Prevent Stockholders from Taking Advantage of the Section 1202 Exclusion

Stock redemptions may cause all stock not to be QSBS

Given that the Section 1202 exclusion is designed to incentivize new business investment, the code has two provisions designed to prevent the exclusion from applying when newly issued stock is simply a replacement of a prior investment.

Stock is not QSBS if at any time during the four-year period beginning two years before the stock was issued, the issuing corporation purchases more than a de minimis amount of its stock from the taxpayer or a person related to the taxpayer. Redeemed stock exceeds a “de minimis amount” only if (i) the amount paid for it is more than $10,000 and (ii) more than 2 percent of the stock held by the taxpayer and related persons is acquired.

Under the second provision, stock is not QSBS, if during the two-year period beginning one year before the stock was issued, the corporation repurchased stock in one or more transactions (i) each of which involves a repurchase of more than $10,000 of stock where more than 2 percent of all outstanding stock by value is repurchased and (ii) the sum of all repurchases during the two-year period have a value, at the time of redemption, in excess of 5 percent of the aggregate value of all the corporation’s stock at the beginning of the two-year period.

Large rounds of venture capital financing may cause the corporation to fail the qualified active business test or the gross asset test

The qualified active business test requires that during “substantially all of the taxpayer’s holding period” at least 80 percent (by value) of the corporation’s assets must be used in active conduct of a one or more qualified trades or businesses. Subject to certain allowances for working capital and financing research and experimentation, this means that if more than 20 percent of a corporation’s assets become cash or other non-qualified assets immediately after a venture capital round of financing or at any other time, such corporation may fail this “substantially all” test.

Additionally, in order for stock to qualify as QSBS, the aggregate gross assets of the corporation cannot exceed $50 million at either (i) any time prior to the taxpayer’s stock acquisition date and (ii) immediately after the taxpayer’s stock acquisition date.

Contributions of appreciated property in exchange for stock are subject to further limits

For purposes of the requirement that a qualified small business have aggregate gross assets of $50 million or less, aggregate asset value is generally measured as cash plus the adjusted basis of the other assets. However, the basis of any property contributed to the corporation is deemed to be equal to its fair market value (FMV) for purposes of this gross asset test.

The contribution rule also affects a shareholder’s basis in his QSBS and the calculation of gain on later sale. When a shareholder has contributed property to a qualified small business, the shareholder’s basis in her QSBS is also deemed to be the FMV of the contributed property at the time of contribution, even though for all other tax purposes, the shareholder has carryover basis in her stock equal to her adjusted basis in the contributed property. Only future appreciation is eligible for the Section 1202 exclusion.

Stock must be acquired at original issuance to qualify for Section 1202

Generally, a shareholder must acquire stock at original issuance in exchange for cash or other property or as compensation for the stock to qualify as QSBS. A purchase from an existing shareholder will not qualify for the exclusion.

This strict rule is relaxed a bit, however, in the realm of corporate reorganizations. When a shareholder exchanges QSBS for other stock in a tax-free reorganization, such as a merger or stock for stock acquisition, the new stock received by such shareholder can qualify as QSBS with the holding period tacking. However, the exception only applies to the built-in gain in the stock at the time of the tax-free reorganization. Future gains in the stock received do not qualify for the Section 1202 exclusion, unless the new corporation is also a qualified small business.

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Image result for public domain images navigationSmall business owners looking to sell their business in the near future need to be prepared for the complexities that will arise during the exit process. One complexity is the tangled web that comes with the Buyer of the business obtaining a loan backed by the Small Business Administration 7(a) program. Buyers of businesses are using the SBA 7(a) program in business acquisitions more and more frequently. The terms of the SBA financing package are favorable to Buyers compared to conventional financing, and due to a change in the SBA’s rules in early 2018, more Buyers are eligible for SBA financing because the down payment requirement minimum is now only 10% of the loan cost. Because the SBA is a federal government program backed by federal dollars, there are necessarily many rules and regulations that affect a Buyer’s eligibility for SBA backing as well as each individual lender’s underwriting process.

These complexities not only affect Buyers, but also affect Sellers, often impacting the flexibility of the terms of the transaction that would otherwise be available to the parties in a cash deal or even purely Seller financed transaction.  The reality of the market also makes SBA financing a common component of most small business sales.

While a cash transaction is ideal for a Seller looking to liquidate his or her equity in the business and carry no risk of reliance upon the success or failure of the business post-closing, cash buyers are scarce, and finding a cash Buyer may be difficult, especially if the Seller has legacy interests in transitioning to the next generation of the family or a top level employee that doesn’t have the financial wherewithal to pay cash.

On the other hand, a Seller financed deal  is a substantial risk to the Seller because it involves the Seller continuing to bear the risk of success or failure of the business post-closing to get paid, but without giving the Seller any direct control over the business operations.

The SBA 7(a) financed transaction may be an ideal middle ground for the Seller who wants to maximize the amount of cash received at closing, wishes to avoid the risk of Seller financing, but who doesn’t have a Buyer with the cash or that can qualify for conventional financing.

When negotiating a letter of intent or even the final purchase contract with a Buyer using the SBA 7(a) program, the Seller should know how the SBA 7(a) program may affect his or her goals and preferred terms of the transaction before even entertaining a deal involving such financing. Contemplating these issues  before signing a letter of intent or a purchase contract is critical for the Seller because it allows the Seller to pre-emptively deal with the issues at a time where the Seller still has significant leverage in the negotiations.

Here are some items of which a Seller should be aware before signing a letter of intent or purchase contract with an SBA Buyer:

Minimum Buyer’s Equity.

The SBA 7(a) program requires the Buyer to come to the table with 10% of his or her own money to pay toward the total loan cost (which includes the entire purchase price of the business and some SBA and lender fees and costs). For example, in a $2M transaction, this means that the Buyer will need over $200,000.00 from his or her own pocket to be able to close the deal. As a Seller, determining whether the Buyer has sufficient assets to meet the 10% down payment requirement is important to know before the Seller expends significant costs proceeding with a transaction.

Even if the Buyer doesn’t have the 10% in cash, the SBA will allow the Buyer to use a Seller financed promissory note for up to 5% of the down payment requirement. So, on a $2M transaction, if the Buyer only has $100,000.00 to put down, if agreeable to the Seller, the Buyer could execute a promissory note of $100,000.00 to the Seller to meet the 10% down payment requirement.

But, there’s a catch! No payment can be made by the Buyer on that $100,000.00 note during the entire term that the note to the bank is outstanding (typically 10 years). Not only that, but the bank providing the Buyer the financing will surely require that that note to the Seller (and any liens on collateral securing that loan) be subordinated to all of the bank’s notes and liens for the purchase, putting the Seller second in line to collect from the Buyer in the event of default. In transactions with much of the purchase value being in goodwill, this puts the Seller at a significant of risk of not receiving the 5% of the purchase price to be paid on that note if the Buyer were to default.

In light of this, when negotiating the letter of intent or contract, it is advisable for the Seller to obtain and analyze the Buyer’s financials to determine the likelihood of the Buyer being able to meet the equity requirements to go through with the transaction, as well as to determine the likelihood of the Seller being able to collect on any Seller financing that is involved in the transaction in the event of default.

Post-Closing Employment and Health Insurance

As a Seller, the SBA 7(a) program prohibits you from staying on as an officer, director, stockholder or key employee of the business after the Closing (though allows the Seller to be paid as a consultant for up to 12 months after closing for management transition purposes only). This is especially important for business owners who are not yet eligible for Medicare, yet need to have health insurance to bridge the gap until they are Medicare eligible. In a non-SBA financed transaction, the seller may stay on as an employee eligible to obtain benefits given to all other full-time employees, one of which is the group health insurance plan. An SBA rule prevents that arrangement.

The alternatives are to obtain such insurance out of pocket on the open market via an individual plan, or, if the Seller has a spouse that is employed and is offered health insurance, obtaining insurance through the spouse’s plan. Since having health insurance is so critical, finding a cost-effective way to bridge the gap from the date of a sale of the business to the date of Medicare eligibility is a major concern for many business Sellers.

Where a post-closing employment arrangement which includes health care can be structured into the deal in non-SBA transactions, it’s paramount for a Seller to be aware of this restriction on post-closing employment from the beginning of the negotiations of an SBA transaction, especially in negotiations of price or interest rate on an allowable Seller note. This additional out-of-pocket cost for health insurance should be accounted for by the Seller in these negotiations. In the very least, the Seller needs to have a plan in place for health insurance after the sale.

Required Independent Valuations

The SBA requires that where the parties are related (either by family or a close relationship such as a key employee, or co-owner), that an independent appraisal be conducted to justify the loan amount and/or purchase price. The SBA also requires this in transactions where the initial appraisal or purchase price allocation shows that the purchase price less fixed assets equals $250,000.00 or more. For many businesses, this latter scenario is common, as much of its value is in goodwill (typical in-service oriented businesses or where the price is based heavily on sales numbers, not the value of fixed assets). Often in the initial stages of negotiations, the Buyer may forego the cost of an appraisal and merely justify the purchase price based upon a review of the Sellers’ financials.

If the appraisal report determines the value of the business is a lower price than the agreed upon purchase price, in order for the transaction to occur, the bank may require that the Buyer infuse additional equity (either with cash or via a Seller standby note for the difference), or possibly allow an additional, non-standby Seller note to cover the difference between the appraised price and the agreed upon purchase price.

Often, when the independent appraisal is required by the bank, the parties are already under contract, with the Buyer obtaining a financing commitment being a contingency to closing. Where the contract has already been signed or a letter of intent heavily negotiated, there are costs that have been incurred by the parties in getting to that point. These sunk costs may make it a hard decision for the Seller to determine whether he or she is willing to walk away from the deal, and gives the Buyer leverage by threatening to walk. This may force the Seller to begrudgingly accept a lower price or unfavorable terms to accommodate the appraisal. The seller may not have been willing to accept these terms if they were contemplated before signing the letter of intent or purchase contract.

Taking pre-emptive steps to avoid getting into this position before signing the letter of intent or purchase contract can help avoid these outcomes. One good way to do so is for the Seller to obtain an independent valuation themselves prior to entering into a contract or letter of intent. Often Sellers have a rough idea of how much they believe their business is worth. It’s possible that that price is accurate, but sometimes the Seller’s idea may be completely unrealistic.

Getting a reality check on price via an independent valuation may save everyone’s time and money before signing a letter of intent or purchase contract. Or, if the Seller has a particular price in mind for his or her retirement that doesn’t match the valuation, if the Seller can afford to do so, knowing the realistic price ahead of time will give Seller the knowledge of how to get that desired price. The Seller may elect to hold onto the business for a period of time to earn enough income to bridge the gap between the valuation and the desired price, or take the time to look for a non-SBA Buyer willing to pay that price. If the conditions for an SBA required independent appraisal are present, having a realistic idea of price before signing a letter of intent or purchase contract will allow a Seller to avoid those outcomes or at least plan accordingly.

Contract to Closing Timing.

It’s also important for the Seller that the Buyer choose a lender that is reputable and experienced with the SBA 7(a) process. Some banks are deemed “preferred” lenders, which essentially means that the lender can make all of its own underwriting decisions without the requirement of the SBA going through an additional and independent underwriting process (which takes more time). A Seller looking to avoid a long, drawn out financing contingency period and get a deal closed quickly is advised to insist upon the Buyer using a preferred SBA lender from the start of the negotiation process and in the letter of intent or purchase contract if the deal is to be SBA financed.

The business attorneys at Schober Schober & Mitchell, S.C. are experienced in all types of privately held Wisconsin business purchase and sale transactions, including transactions involving SBA financing. Though the focus of this blog post is on Sellers, the business attorneys with Schober Schober & Mitchell, S.C. represent both Buyers and Sellers in such transactions. When considering buying or selling a business, it’s important to have an experienced attorney advising you at the beginning stages of the negotiations all the way through closing. Whether you’re a Buyer or Seller, the business attorneys at Schober Schober & Mitchell, S.C. will be happy to assist with your transaction. Contact me at jmk@schoberlaw.com or call me at 262-569-8300 to talk to me about how we can help you navigate through your deal.


This article was originally written for the Business Law Section blog of the State Bar of Wisconsin and appears here with the permission of the State Bar and the article’s authors.


THOMAS J. NICHOLS & JAMES DECLEENE

Thomas J. Nichols, Marquette 1979, is a shareholder with Meissner Tierney Fisher & Nichols S.C., Milwaukee, where he focuses his practice on business law and tax law.

James W. DeCleene,Marquette 2015, is an attorney with Meissner Tierney Fisher & Nichols S.C., Milwaukee, where he practices in business law, estate planning, health care law, and intellectual property law.

 

 


Investing in a qualified Wisconsin business may provide certain tax benefits to individuals. Thomas Nichols and James DeCleene discuss these benefits and some potential pitfalls.

 

Wisconsin law currently provides tax-favored status to certain investments made in qualified Wisconsin businesses.

First, where an individual realizes long-term capital gain from the sale of an investment in a qualified Wisconsin business made after 2010 and held for 5 or more years, that individual may be entitled to exclude all or a part of that gain in determining his or her Wisconsin taxable income.1

Second, where an individual realizes long-term capital gain from the sale of any capital asset, that individual may be entitled to defer that gain so long as he or she invests all of the gain in a qualified Wisconsin business within 180 days of the sale.2

Qualified Wisconsin Businesses

A business is treated as a qualified Wisconsin business for a given year only if it is registered with the Wisconsin Department of Revenue.3

Importantly, the registration filing must be made before the end of the calendar year when it takes effect.4 The sole exception to this deadline is that, for the first year in which an entity begins doing business in Wisconsin, that business must register in the following calendar year.5

Since each filing only covers one calendar year, businesses desiring continuous qualified status should file every year.6 These filing requirements create hard and fast deadlines. There are no procedures for retroactive filings.

Only certain businesses can register with the department as a qualified Wisconsin business. In particular, a business must, with respect to its taxable year ending immediately prior to its registration, meet the following requirements:

  1. The business must have had 2 or more full-time employees.
  2. 50 percent or more of the business’s payroll must have been paid in Wisconsin.
  3. 50 percent or more of the value of the business’s real and tangible personal property (owned or rented) must be located in Wisconsin.7

With respect to the year in which a business first starts doing business in Wisconsin, these requirements are deemed satisfied if the business registered for the following year.

For purposes of the two 50-percent requirements listed above, persons employed by a professional employer organization or group are considered as employed by the organization’s or group’s client, and property owned by the business is valued at its cost, while property rented by the business is valued by taking the annual rental paid by the business for such property, subtracting out the annual sub-rental received by the business for such property and multiplying by 8.8

Lists of the businesses that have requested to be classified as qualified Wisconsin businesses for calendar years 2011-18 can be found on the Department of Revenue website.

Businesses are automatically added to these lists as part of the registration process for a given year.9

Since a business’s registration for its first year is determined by reference to the following year, a business must request to be added to the list for the first year in which it does business in Wisconsin. This request is made by sending an email to DORISETechnicalServices@wisconsin.gov and providing the business’s legal name as well as the confirmation number for its registration for the following calendar year.

Be aware that these lists do not signal the department’s acknowledgement that a business is in fact a qualified Wisconsin business for a given year. Rather, it merely identifies those businesses that have self-identified as meeting the above requirements.

Accordingly, obtain representations, covenants, or other assurances as to a business’s qualified status when helping clients identify a qualified Wisconsin business in which to make an investment.

Exclusion on Sale of Investment

As noted above, one of the benefits of investing in a qualified Wisconsin business is that the long-term capital gain on the eventual sale of that investment may be wholly excluded.10

To qualify for this exclusion, the business must be a qualified Wisconsin business “for the year of investment” and “at least two of the four subsequent” calendar years, provided that the investment was made after 2010 and held for at least five uninterrupted years.11 To claim this exclusion, an individual must file a Schedule QI with his or her Wisconsin tax return.

There are a number of issues to be aware of in applying this provision. To start, this exclusion only applies after the sale of an “investment” in a qualified Wisconsin business.12 For these purposes, an investment is defined as an “amount[] paid to acquire stock or other ownership interest in a partnership, corporation, tax-option corporation, or limited liability company treated as a partnership or corporation.”13

While the statute requires an “amount[] [to be] paid” for such stock or ownership interest, we confirmed in a phone call with the Wisconsin Department of Revenue that this definition is broad enough to cover transactions involving noncash consideration. We also confirmed that the statute should also apply to cross-purchases where the ownership interest is being acquired from an owner of the entity, rather than from the entity itself. In order for an investment in a single member LLC to qualify, the LLC must have elected to be treated as an S or C corporation for Wisconsin purposes. 2017 Form I-177.

Be aware that late-year investments in entities that have not yet started doing business in Wisconsin may not be eligible for gain exclusion. For example, take the situation where an individual invested in an LLC in November 2017, but the LLC did not actually start doing business in Wisconsin until March 2018. Under those facts, the LLC would be prohibited from registering with the department as a qualified Wisconsin business for calendar year 2017 since it would not have started doing business in Wisconsin until 2018.14

Because of this, the business could not be qualified during the year of the investment, and no exclusion would apply on the eventual sale of the investment, even if the business registered as a qualified Wisconsin business for each calendar year in which it did business in Wisconsin.15 Thus, it’s good to advise clients whether to wait to invest in a business until the calendar year in which the entity starts doing business in Wisconsin.

Note that gain passed through to an individual from a partnership, limited liability company, limited liability partnership, tax-option corporation, trust or estate can qualify for the exclusion.16 As an example, an individual investing in a limited partnership that made an investment in an LLC would be able to exclude the gain passed through from the limited partnership’s sale of its interest in the LLC, provided that the limited partnership held the interest for five years and all other requirements are satisfied.

Deferral upon Rollover

Taxpayers may also be able to defer long-term capital gain so long as all of the gain is invested in a qualified Wisconsin business within 180 days of the sale of the capital asset.17 In addition to rolling the gain over into a qualified Wisconsin business, the individual must also file a Schedule CG with his or her tax return in order to claim this deferral.18 Note that this gain deferral provision is applicable to a large number of transactions, given that it could be used to defer any long-term capital gain.19

As with the gain exclusion provision above, there are a number of issues to be aware of when applying this deferral provision. For example, this deferral provision uses the same definition of “investment” noted above, so be aware that the investment in the qualified Wisconsin business for these purposes could also be made with noncash consideration or in a cross-purchase transaction.20

Additionally, the same problem with respect to late year investments in an entity that has not yet started doing business in Wisconsin is also applicable to this deferral provision. Further, gain passed through to an individual from a partnership, limited liability company, limited liability partnership, or tax-option corporation qualifies for deferral as well.21

For purposes of the deferral provision, however, it is unclear whether gain passed through from a trust or estate could be deferred since the instructions to Schedule CG are silent on this point. That being said, Form I-177, the instruction form for Schedule QI, allows for the exclusion of gain passed through from trusts and estates, and both the exclusion provision and the deferral provision have an identical definition of “claimant,” so it seems likely that an individual could defer gain passed through from such entities as well.22

On top of these overlapping issues, when advising a client with respect to the deferral provision, be careful to ensure that your client “invests all of the gain [from the sale] in a qualified Wisconsin business.”23 No partial deferral is allowed.

Also, given that this investment must be made within 180 days of the sale, apprise clients before the sale closing of this potential deferral opportunity and the relatively short deadline associated with it, in order to give clients time to make arrangements to acquire an interest in a qualified Wisconsin business.

Last, note that gain deferred under this provision will eventually be recognized. The statute accomplishes this by reducing the individual’s basis in the investment in the qualified Wisconsin business by the amount of gain deferred.24 Then, to prevent any slippage between the exclusion and deferral provisions, the statute prevents the deferred gain from being treated as qualifying gain for purposes of the gain exclusion provision.25

Note, however, that if the investment in the qualified Wisconsin business is held in a manner sufficient to qualify for the exclusion above, the gain on the eventual sale of the investment could qualify for exclusion to the extent it exceeds the gain previously deferred.

Conclusion

Investing in a qualified Wisconsin business provides clear benefits to individual taxpayers. If the investment is held long enough and all other requirements are met, the gain could be wholly excluded in determining the individual’s Wisconsin taxable income.

Additionally, if the investment closely follows the sale of a capital asset, the gain from that sale could be wholly deferred.

In either event, it’s good to bear these considerations in mind when navigating these provisions.

This article was originally published on the State Bar of Wisconsin’s Business Law Blog. Visit the State Bar sections or the Business Law Section web pages to learn more about the benefits of section membership.

Endnotes

1 Wis. Stat. § 71.05(25)(b).

2 Wis. Stat. § 71.05(26)(bm)(1).

3 Wis. Stat. §§ 71.05(25)(a)(1s), 73.03(69)(a).

4 Tax § 2.986(4)(a).

5 Tax § 2.986(4)(b).

6 Tax § 2.986(4)(a).

7 Wis. Stat. § 73.03(69)(b)(1)-(2).

8 Wis. Stat. § 73.03(69)(b)(1); Tax § 2.986(3).

9 Wis. Stat. § 73.03(69)(d).

10 Wis. Stat. § 71.05(25)(b).

11 Wis. Stat. § 71.05(25)(a)(2).

12 Wis. Stat. § 71.05(25)(a)(2).

13 Wis. Stat. § 71.05(25)(a)(1m).

14 Tax § 2.986(2), (4)(b); see Wis. Stat. § 71.22(1r) (defining “[d]oing business in this state” for this purpose).

15 Wis. Stat. § 71.05(25)(a)(2).

16 Wis. Stat. § 71.05(25)(a)(1); see 2017 Form I-177 (listing trusts and estates as well).

17 Wis. Stat. § 71.05(26)(bm)(1).

18 Wis. Stat. § 71.05(26)(bm)(2).

19 Wis. Stat. § 71.05(26)(bm).

20 Compare Wis. Stat. § 71.05(26)(a)(2m), with Wis. Stat. § 71.05(25)(a)(1m).

21 Wis. Stat. § 71.05(26)(a)(1).

22 Compare Wis. Stat. § 71.05(26)(a)(1), with Wis. Stat. § 71.05(25)(a)(1); see 2017 Form I-177.

23 Wis. Stat. § 71.05(26)(bm)(1) (emphasis added).

24 Wis. Stat. § 71.05(26)(c).

25 Wis. Stat. § 71.05(26)(f).​

This post was originally posted on the “State Bar of Wisconsin Business Law Section Blog” and was written by Attorney J. William Boucher.

Many business attorneys will recognize the WB-17 Offer to Purchase – Business Without Real Estate Interest form developed by the Wisconsin Department of Regulation and Licensing.  The WB-17 is popular because of its pre-printed nature, and thus apparent fairness, and its familiarity to attorneys, agents and business owners alike, especially in smaller sale-of-business transactions. Even though it is a pre-printed form, the WB-17 can be modified by addendum.   There are several important revisions that buyers and sellers should consider.

Buyer Considerations

Although it is more common that a buyer of assets submits the initial draft of a purchase agreement, the WB-17 is more pro-seller than a typical buyer’s first draft. Buyers should consider addressing the following issues:

  • Parties to the Contract. The WB-17 is worded to be a transaction between the buyer and a business selling assets. Therefore, shareholders, members, or other owners of the seller aren’t automatically parties to the transaction as defined at lines 6-12. Buyer’s counsel should be aware of this, as it affects the buyer’s remedies for any post-closing claims regarding the sale. Upon consummating the sale and distributing net sales proceeds to its owners, the seller may not have any remaining assets.  Any claim made by the buyer against the seller post-closing may be an empty remedy. For example, if the seller is a corporation, the buyer’s remedies against the shareholders of the corporation for claims under the WB-17 would be limited to amounts distributed to the shareholders in liquidation of the corporation (Wis. Stat. § 180.1408(2)). Unless the buyer is able to pierce the corporate veil of liability protection of the seller, this would be a difficult hurdle to overcome.
  • Definition of Purchased Assets. The buyer would normally agree to purchase all assets of the seller, other than those specifically excluded by the seller. The WB-17, on the other hand, requires the buyer to list all the assets it is buying. As a consequence, any asset inadvertently omitted by the buyer will remain an asset of the seller.
  • Excluded Liabilities. The WB-17 does not address assumed or excluded liabilities. The buyer will want to clarify that is not assuming any liabilities of the seller, other than any liabilities specifically assumed by the buyer in the agreement.
  • Working Capital Adjustment. A working capital adjustment to the purchase price (or other purchase price adjustments) would protect the buyer from actions taken by the seller before closing that were outside the ordinary course of business, such as accelerating the collection of accounts receivable. The buyer and the seller would agree on a target working capital amount at closing, and the purchase price would be adjusted up or down based on a post-closing calculation of the actual working capital of the seller as of the closing.
  • Qualifications of Seller’s Representations. Detailed at lines 91-102, all of the representations of seller in the WB-17 are qualified by the seller’s knowledge. There is no breach of a representation unless the seller had knowledge of the misrepresentation.  It is uncommon in a negotiated sale-of-business transaction for all representations to be qualified by knowledge, especially fundamental representations about the business. While the definition of Conditions Affecting the Business at lines 322-377 ostensibly provides protection for the buyer, adding clarity to the application of the knowledge qualifiers should be considered.
  • Additional Seller Representations. The buyer should strongly consider adding seller representations about the business that are not specified in the WB-17.  There are some glaring omissions, including the lack of any representations regarding  taxes, title to the assets, customers and suppliers, contracts, and due authorization.   The buyer may also want to strengthen the seller’s financial statement representation to provide that the financial statements fairly present the operations of the business or, if appropriate, were prepared in accordance with GAAP.
  • In lines 91-102 of the WB-17, the seller makes representations about Conditions Affecting the Business.   Buyers may want those seller representations to also be warranties of the seller for several reasons.   Elements of a cause of action for a warranty claim differ from those of a misrepresentation claim and may not require, for example, reasonable reliance by the buyer on the warranty.   In addition, the calculation of damages available under a warranty claim may in some instances be greater than the damages available under a misrepresentation claim.
  • The WB-17 does not contain an indemnification provision. Indemnification  provisions are very important, especially to the buyer, for several reasons:  (i) they allow  the indemnified party  to recover attorney fees; (ii) they expand the right to pursue claims against the seller to directors, officers, shareholders, employees, members, etc.; and (iii) they provide a mechanism for handling any third-party claims, including notice, and control of the defense .
  • Contingencies and Right to Cure. Other provisions that deserve review are the financing and appraisal contingencies at lines 394-471, and a seller’s right to cure at lines 472-479. While important for real estate deals or other deferred sign and close transactions, these provisions don’t serve much of a purpose for asset purchase agreements that utilize a simultaneous sign and close.
  • Non-Compete and Non-Disclosure. The WB-17 does not contain any language regarding non-competition or non-disclosure of confidential information by the seller or its owners. These issues could be addressed by separate agreements or an addendum, but identifying these issues and discussing the possible risks is paramount.

Seller Considerations

Even though the WB-17 is generally more favorable to sellers, several topics still deserve sellers’ attention.

  • Caps and Baskets. The seller should consider adding language via an addendum to limit claims brought pursuant to the seller’s representations at lines 91-102. While it mainly depends on the size and complexity of the deal, the concepts of caps and baskets limit the amount of recoverable damages. A cap provides a maximum amount that is recoverable from the seller, while a basket requires damages to reach a certain threshold before the buyer is able to recover any damages.
  • Survival Period. The WB-17 does not limit or state a survival period for the seller’s representations. As a result, claims for breach of any representation could be made within the statute of limitations (six years in Wisconsin for contract claims).   In a negotiated asset purchase agreement, the general survival period for representations is typically much shorter (e.g., 18-24 months), although a longer survival period is common for fundamental representations about the business.
  • Exclusive Remedy. Another method to reduce the seller’s exposure to potential claims is to add an exclusive remedy provision, which would limit the buyer’s remedies for breach of the seller’s representations to remedies specified in the agreement.
  • Non-Reliance on Other Representations. The seller should modify the WB-17 to confirm that the buyer is not relying on any representations or warranties made outside of the four corners of the WB-17.   This would limit the buyer’s ability to pursue a claim based on any statement made outside of the WB-17.
  • Specific Performance. Line 217 of the WB-17 states that the buyer may sue for specific performance if the seller defaults. The seller should strike this provision to eliminate the possibility of a forced sale in the event of a dispute.

Conclusion

The WB-17 Offer to Purchase – Business Without Real Estate Interest form contains many standard terms and conditions for the purchase and sale of assets of business and is a useful document for small sale-of-business transactions.  Nonetheless, sellers and especially buyers should consider modifying the WB-17 to suit their particular needs in a transaction.

J. William Boucher, University of Wisconsin Law School 2015, is an attorney with O’Neil Cannon Hollman DeJong and Laing in Milwaukee where he concentrates his practice on entity formation and organization, mergers and acquisitions and general business law.

 

How does a business stop a former employee from poaching the business’ employees after the employee has left employment of the business? Generally, to achieve this goal, employers have entered into a contract with the employee that includes a restriction called a “non-solicitation provision”. In a recent case, The Manitowoc Company, Inc., v. Lanning, the Wisconsin Supreme Court made a landmark decision which imposes significant limitations on employers with respect to non-solicitation provisions in employment contracts pursuant to Wisconsin Statute section 103.465.

Case Background

            I wrote about this case when the Wisconsin Court of Appeals issued its opinion in 2016, but to refresh my regular readers’ memories, here’s a brief summary of the facts of the case:

Lanning was an experienced, well-connected engineer for The Manitowoc Company, Inc. (“Manitowoc”) a company that manufacturers construction cranes and food service equipment. After working for Manitowoc in its construction crane division for over 25 years, Lanning left to work for a competitor. During his time with Manitowoc, he and Manitowoc had executed an agreement by which Lanning agreed that he would not “solicit, induce or encourage any employee(s) to terminate their employment with Manitowoc or to accept employment with any competitor, supplier or customer of Manitowoc.” (emphasis added) for a period of two years after the termination of his employment with Manitowoc.

Within the restricted two-year period after Lanning’s departure, Manitowoc alleged that Lanning breached this covenant by engaging in competitive activities such as actively recruiting (or poaching) some of Manitowoc employees to work for his new company. Manitowoc then sued Lanning for violation of the above quoted provision in the agreement. Lanning argued that the provision was unreasonable and violated Wisconsin Statute section 103.465, (the statute governing restrictive covenants in employment agreements) which would thereby make the whole provision unenforceable.

The Circuit Court ruled that the provision did not violate the statute, but Lanning appealed, and, as explained in my previous post, the Court of Appeals reversed, stating that the non-solicitation provision was unreasonably overbroad and violated section 103.465.

 

The Wisconsin Supreme Court’s Decision

            The Wisconsin Supreme Court agreed with the Court of Appeals, holding that because the clause in the Agreement restricted Lanning from soliciting, inducing, or encouraging any employee of Manitowoc to leave their employment, it was overbroad, and an unreasonable restriction on Lanning that violated Wis. Stat. section 103.465. The Court supported this holding by asserting that common law states that no business has a legally protectable interest in preventing the poaching of ALL of its employees from a stranger, and therefore, the provision attempting to do that is illegal under the statute. The Court went on to state that an employer only has a legally protectable interest in preventing the poaching of some of its employees, and those employees are limited to certain classes. The Court set forth some examples of these classes of employees that might warrant protection, such as top-level employees, employees with special skills or special knowledge important to the employer’s business, or employees with skills that might be difficult to replace. The Court did not elaborate any further beyond those general examples or apply them to Manitowoc, specifically.

Key Takeaways

What does this mean for Wisconsin employers?

  1. The Court for the first time expressly acknowledged what most in the legal community had already predicted—that non-solicitation clauses in employment contracts are subject to the notoriously restrictive Wisconsin statute section 103.465. If there was any question about it, the question is now answered.
  2. The most obvious takeaway is that employers can no longer prohibit a departed employee’s solicitation of “all” employees in non-solicitation clauses. As such, all current agreements with employees containing restrictive covenants should be reviewed. If the agreements contain language prohibiting solicitation of anything other than specific groups of employees, the agreement should be amended, and additional consideration for the amendment must be provided to the employee in exchange for the amendment. Any language prohibiting solicitation of “all” employees should be removed, and all future agreements should be drafted without this broad prohibition to avoid having the agreement ruled unenforceable.
  3. The other major takeaway is that non-solicitation clauses in employment related agreements must now identify specific employees or classes of employees that an employee is prohibited from soliciting after the employment relationship ends. These specific employees or classes of employees must be those in which the employer has a “protectable interest.” Determining what employees fall within these classes may be challenging given that the Court did not provide much guidance on the permissible scope of these classes of employees that warrant protection. This will be fact intensive for each business, and will warrant an in-depth discussion with clients regarding the nature of its employment base. This is likely to be a controversial area of law in the future, probably to be tested soon in the courts given the lack of guidance on this point by the Supreme Court in Lanning.

Final Thoughts

I think this decision creates potentially unintended consequences for small businesses in Wisconsin. A majority of businesses in Wisconsin, and most of our firm’s clients, are small to medium sized businesses. A large business with 13,000 employees like the Manitowoc Company may not actually suffer significant detriment from losing entry level employees, and a restriction preventing solicitation of ALL of those employees probably is broader than necessary to protect its competitive interests. However, the loss of any employee for a small business may be significant. As such, it is possible that a restriction to prevent solicitation of all of a small business’ workforce might be reasonable in certain circumstances, but the Court’s holding now deters them from attempting to assure themselves that reasonable protection in non-solicitation agreements with employees. I am hopeful that the Court has the opportunity soon to clarify this holding as applied to small businesses to avoid these consequences.

There are many open questions still outstanding in this area, and it is inevitable that we’ll get the answers to these questions as they work their way through the courts. In the meantime, businesses will want to ensure they are protecting themselves against potential poaching of their employees to the maximum extent legally permissible. The business attorneys at Schober Schober & Mitchell, S.C. are experienced in drafting employee restrictive covenant agreements and pay close attention to the often-changing landscape of employment restrictive covenant law.

If you or your business need a review of your current employee restrictive covenant agreements or are looking into establishing these agreements in your business, we would be happy to help. Contact me at jmk@schoberlaw.com or visit our website at www.schoberlaw.com if you have any questions.

This article was originally posted on the “State Bar of Wisconsin’s Business Law Section Blog,” and was written by Attorney James Phillips.

 

The passage of the Tax Cuts and Jobs Act brings significant changes to the structure, financing, and agreements in mergers and acquisitions transactions. James Phillips details the more noteworthy provisions that apply in 2018 and beyond.

At the end of 2017, President Trump signed into law the Tax Cuts and Job Act (Act), with many provisions effective for tax years beginning after Dec. 31, 2017.

The Act contains a number of changes that may affect the structure, financing, and agreements related to mergers and acquisitions (M&A) transactions.

Here is a summary of the more significant provisions:

Tax Rate and Certain Deduction Changes

  • Corporate Rates. The Act changes the federal income tax rate applicable to C corporations to a flat rate of 21 percent (down from a maximum of 35 percent).
  • Individual Rates. The Act changes the maximum individual income tax rate on ordinary income from 39.6 percent to 37 percent. The maximum income tax rate on long-term capital gain and qualified dividends remains unchanged at 20 percent and the net investment income tax rate remains unchanged at 3.8 percent. The Section 1202 exclusion of 100 percent of the gain on the sale of qualified small business stock (among other requirements, C corporation stock) held for more than five years remains unchanged.
  • Individual Deductions. Itemized deductions for state and local taxes for individuals are now limited to $10,000 in combined income and property taxes for tax years 2018 through 2025, provided that the deduction for state and local taxes incurred in carrying on a trade or business or for the production of income is retained (such as business taxes imposed on pass-through entities and taxes on Schedules C and E).
  • Pass-through Business Rate. The Act provides for a deduction of up to 20 percent of “qualified business income” earned through partnerships, S corporations and sole proprietorships (including single member LLCs). There are a number of special rules and limitations. This deduction is not available for capital gains, dividends and interest (other than interest allocable to a trade or business). Owners of certain service businesses are subject to phase out rules, and the deduction can be limited to a percentage of wages and depreciable property. This deduction can result in an effective marginal income tax rate of 29.6 percent on qualifying income (plus the 3.8 percent net investment income tax [NII] if applicable).
  • Choice of Entity. The new, lower corporate income tax rate will require more analysis of the preferable way to conduct business operations and structures transactions. The lower corporate rate permits businesses to grow their equity and pay down debt at a faster rate. In many circumstances the ability to avoid the higher shareholder rate applicable to a pass-through, the benefit of shareholders not being involved in corporate tax planning and compliance, the ability to capture net operating losses at the corporate level for carryforward, the potential for the 1202 capital gain exclusion upon a stock sale, the new foreign tax regime, the decrease in the value of a step up in asset basis upon a sale due to the lower corporate income tax rate, the deductibility of state taxes, and others, will make C corporations more desirable. On the other hand, if a business is likely to produce sizable cash distributions to the owners on a current basis, or a sale is likely to be structured for tax purposes as an asset sale (whether asset purchase, forward merger or sections 336 or 338 elections) in the not too distant future, pass-through structures may continue to be preferable, although potentially more costly in the short run.
  • Blocker Entities. The new lower corporate income tax rate may make blocker entities much more common in a variety of situations.
  • Valuation. The change in the income tax rates could result in a change in the value of a variety of assets, but how it will affect transactions is unclear. Some changes could increase value (larger after-tax cash flow due to lower rates) but some changes could decrease value (a reduction in value of tax assets). For example, the value of a step up in basis upon a transaction structured as an asset purchase for tax purposes is worth less with lower income tax rates.

Interest Deduction Limitations

In general, net business interest expense deductions will be limited to 30 percent of “adjusted taxable income,” plus business interest income. The annual tax increment (ATI) is initially related to earnings before interest, taxes, depreciation, and amortization (EBIDTA), but after 2022 will more closely relate to earnings before interest and taxes (EBIT). The amount of interest not allowed as a deduction for a year is treated as paid in the succeeding year, subject to that year’s limitation.

  • Exceptions. The interest expense limitation does not apply in certain cases, including taxpayers whose average annual gross receipts for the three-tax-year period ending with the prior tax period do not exceed $25 million, and electing real estate activities for which the taxpayer must then use a longer depreciation life.
  • Debt versus Equity. The lower corporate rate tax benefit of interest deductions, combined with the potential for deferral of interest deductions and the more favorable individual income tax rate for dividends, is designed to decrease the benefit of debt compared to equity, and in certain cases may lead to less leverage.

Corporate Alternative Minimum Tax and Net Operating Losses

The Act repeals the corporate alternative minimum tax (AMT), but puts in place new limitations on net operating losses (NOLs). The Act eliminates NOL carrybacks but allows indefinite carryforwards. NOL deductions can only offset up to 80 percent of taxable income. The inability to carry back a loss means NOLs arising from a transaction, such as extraordinary compensation payments or other transaction-related items, can no longer be carried back to produce a tax benefit for the seller. And the inability to carry back a loss of a target company to offset pre-closing tax liabilities may change the structure of tax indemnities.

Full Expensing of Certain Property

The Act provides for a deduction of the entire cost of certain property placed in service after Sept. 27, 2017, and before Jan. 1, 2023. Thereafter, the percentage immediately deductible is phased down over five years. The Act applies to not only new tangible personal property, but also used property and computer software.

  • Thus, a purchaser in acquisition structured as an asset sale for tax purposes could purchase tangible personal property at its tax basis and immediate expense the cost rather than step into the shoes of the seller and inherit the depreciation deductions that would otherwise could have been spread over seven years.
  • While asset-treatment acquisitions will still most likely be driven by purchase prices in excess of tax basis giving rise to increased intangible amortization and fixed asset depreciation, the ability to accelerate the cost of used property due to 100 percent expensing will produce some new and interesting negotiations for sellers and purchasers. The interplay of the 100 percent expensing and NOL and interest limitations for the purchaser, and recapture and tax cost for the seller, will require careful modelling of transactions.

Sale of US Partnership Interest by Foreign Partner

A foreign person’s gain on sales after Nov. 27, 2017, of interests in a partnership engaged in a U.S. trade or business will be taxed as effectively connected income up to the extent a sale of assets would have been so treated, requiring the selling partner to pay U.S. tax on the sale.

Sales of such partnership interests after Dec. 31, 2017, will be subject to withholding unless the seller provides an affidavit stating that the seller is a U.S. citizen. If the purchaser fails to withhold, the partnership is required to withhold from the transferee’s distributions the amount the transferee should have withheld.

  • The IRS has delayed the effective date for the withholding for administrative reasons for publicly-traded partnerships. The IRS has requested comments on the rules to be issued under the withholding requirement to, among other things, determine how liabilities of the partnership affect the amount realized.
  • Much like Foreign Investment in Real Property Tax Act of 1980 (FIRPTA) certificates in the case of the sale of U.S. real property or U.S. real property holding corporations, affidavits will likely become the norm in a sale of a partnership interest.

International Taxation

There are significant changes to the taxation of international activity that will require taking a new look at the structure of domestic and foreign operations.

In many cases taxes on international operations can be lower if the U.S. owner is a C corporation. M&A transactions often present an opportunity to reorganize international operations in a more tax efficient manner.

Note: The foregoing is a summary and is not tax advice directed at any particular situation. The specific statutory provisions and tax advisors should be consulted before taking any particular action.

This article was originally published on the State Bar of Wisconsin’s Business Law Blog. Visit the State Bar sections or the Business Law Section web pages to learn more about the benefits of section membership.

 

James Phillips, University of Iowa College of Law 1979, is a shareholder with Godfrey and Kahn in Milwaukee where he practices in the areas of domestic and international tax structuring, planning and controversy matters, corporate and business law, acquisitions and venture capital.

Sometimes keeping a corporation going serves no useful purpose. If you have such a corporation, here are some useful steps to consider.

Typical corporate terminations involve both a “liquidation,” the act of converting all corporate assets to cash, paying all outstanding bills, and distributing the remaining cash to the shareholders in exchange for their stock, and a “dissolution,” the legal steps necessary to end the corporation’s existence.

Five actions (and their associated paperwork), generally cover what needs to be done:

  1. Approving an intent to dissolve;
  2. Creating a Plan of Liquidation;
  3. Filing Articles of Dissolution;
  4. Completing the Liquidation; and
  5. Limiting future liability.
Empty Board Room
Empty Board Room of Inactive Corporation

The first step is accomplished at either a joint Shareholder and Director meeting with an appropriate action taken, or by unanimous execution of a joint Shareholder and Director Consent Resolution. At that time , a Plan of Liquidation will be approved, generally setting the timeframe within which the corporation’s assets will be converted to cash and bills will be paid; the shareholders will also sign over their stock certificates for a proportionate “liquidating distribution.” The Articles of Dissolution are then filed with the Department of Financial Institutions.

A Plan on Liquidation should reference that the Corporation’s Accountant will file Form 966 entitled “Corporate Dissolution or Liquidation”, a necessary action.

Once the initial resolution is passed, all future actions can be summarized as “winding up the affairs of the corporation.” See Wis. Stat. § 108.1405. After the Articles of Dissolution are filed, the Directors and Officers retain authority to act with respect to such wind up activities. This includes allowing an officer to sign the corporation’s final tax return as well as checks to shareholders, which will complete the liquidation.

Finally, in order to shorten the time claims may be filed against the corporation, it is advisable to publish a Notice of Dissolution per Wis. Stats. § 180.1407. Specific creditor’s claims may be further barred by following a simple Notice procedure set forth in Wis. Stats. § 180.1406.

If you or anyone you know needs to consider ending the existence of a corporation, please consider calling on our business law team at Schober Schober & Mitchell, S.C. You may reach us at (262) 785-1820 or (262) 569-8300.

 

For many business owners, retaining key employees is a paramount concern of running their business. Employers often have invested a significant amount of training, heavily rely upon their key employees for revenue and business operations, and, in many cases, the employee is a likely candidate to take over the business. Beyond these reasons, a business owner may also fear that a key employee will be poached by a competitor which would result not only in a loss of the investment, but also risk the business’ competitive advantage or risk losing customers to the employee.

One strategy to alleviate this fear is to have the employee sign a non-competition agreement. We’ve written on our blog about the importance of having a carefully drafted non-competition agreement in the past, but it’s worth a reminder that a poorly drafted non-competition agreements risks a court voiding the whole agreement even if only one contract term violates the law. This is the case because Wisconsin has a statute (Wis. Stat. sec. 103.465) that imposes certain restrictions on the enforceability of non-competition agreements between employees and employers. The statute puts heavy scrutiny on the terms and surrounding circumstances of a non-compete agreement, and typically favors the employee.

However, a recent Wisconsin Court of Appeals case, Karsten v. Terra Engineering  & Construction Company, reminds us that it is possible for non-competition agreements to be scrutinized outside of the context of the statute, under a less restrictive method called the “rule of reason”. Under the rule of reason, the terms of a non-competition agreement and the surrounding circumstances of its negotiation still must meet certain elements, but this method is much less restrictive and therefore, the agreement is more likely to be enforced by the courts. Notably, under the “rule of reason”, if the court thinks the non-compete’s terms are unreasonable, rather than voiding the whole agreement completely, the court can modify the scope of the contract to what it thinks is reasonable. This is a huge advantage compared to the penalty of voiding the entire contract under 103.465. The Karsten court ruled that the statute “does not apply” and that the rule of reason applies to a non-compete  “when the [non-competition agreement] is not a condition of employment and the employer does not possess an unfair bargaining advantage over the employee.”

With that in mind, what are some ways that these agreements can be drafted and/or negotiated in order to avoid being scrutinized under 103.465?

  • Don’t use employment as the consideration for the contract! Provide an adequate bonus or benefits such as deferred compensation plans or the purchase of life insurance, in exchange for their agreement to the non-compete. Many employers expressly state in the agreement that the consideration is the employer employing the employee in the first place, or if negotiating with a current employee, the continued employment of the employee (implying that they will not continue to be employed if they do not sign).
  • Don’t expressly state that you have the right to terminate the employment of the employee for breaching the covenant! Most employees are employees at will, so therefore could be terminated with or without cause (provided there aren’t any discriminatory reasons for your termination). Because of this, even if there’s a separate employment agreement, there’s really no reason to expressly tie breach of the non-compete to your right to terminate.
  • Play Fair! The courts require that there is not unfair bargaining advantage by the employer. Consider giving the employee the opportunity to ask questions, to negotiate the consideration they’re receiving, encourage them to speak to legal counsel, and don’t threaten any negative consequences regarding their employment for their failure to sign. Providing language in the agreement that acknowledges that the parties understand the terms and their legal effects may also be helpful in achieving this goal.

Non-compete law is constantly evolving in Wisconsin. The business attorneys at Schober Schober & Mitchell, S.C. keep a close eye on these changes to ensure our clients are always in the best position to mitigate risks in their business.

Questions? Contact me at jmk@schoberlaw.com.

If you’ve decided to create a startup business, one of the many decisions you face is the choice of what type of limited liability entity to form. In Wisconsin, the most typical choices are either the Limited Liability Company (“LLC”) or corporation. I frequently have people ask me whether I can help them set up an LLC for their business, and who often think, for whatever reason, that the LLC is their only option. My first response is always, “Is there a specific reason why you want to be an LLC?” and go on to explain that while there are some specific exceptions to this rule, a corporation is almost always the best type of limited liability entity for a startup small business compared to the LLC.

Why the Corporation is a Better Option

More Developed Law. In Wisconsin, the LLC has only been around since 1991, while the corporation has been around since 1848. Why is this relevant? There’s almost 160 years of law on corporations in Wisconsin, while there’s only 26 years of law on the LLC. This means there’s more settled law on issues with corporations and much more uncertainty within the law of LLCs. Where there are legal issues coming up in relation to your business, wouldn’t you rather have more certainty from years of developed corporate law than venture into the relatively undeveloped realm of LLC law?

Tax Considerations. Some argue that the LLC is preferable because it offers pass-through taxation to its members, meaning all income and loss the business has in a given year is spread according to the members’ equity stake in the business. You can easily elect for S-Corp status with the IRS to avoid the dreaded “double taxation” of C-Corporations and still get the same pass-through tax treatment given to LLCs. Corporations that elect S-Corporation treatment do have specific guidelines in regard to the number of owners, and the types of owners, but generally, those are irrelevant to most startups and small businesses. Since electing S-Corporation status allows for the same pass-through tax treatment for corporations, this puts the LLC and the Corporation on a level playing field.

Another huge tax benefit of the S-Corporation election is that, as an owner of the business, you only pay self-employment tax on the income that is attributable to the fair market value of your services provided to the business. If you are an LLC without a S-Corp election, you are taxed under Subchapter K of the Internal Revenue Code, and then must pay self-employment tax on all income allocated to you, no matter whether that income is attributable to your services as employee or not. For most small startup businesses, the owner also provides services as if she were an employee of the business, meaning that the employee/owner has to pay a self-employment tax on any income allocated to that individual in addition to income tax. In 2017, the self-employment tax is 15.3%.

In an LLC with no S-Corp election, no matter whether that allocated income is actually attributable to the services provided by the owner/employee, or whether that LLC level income is allocable to services provided by the employee owner and an employee non-owner, the owner pays all of the self-employment tax, AND income tax on top of that. For example, if an LLC had $100K of income that was allocated to the owner, the owner would pay the 15.3% self-employment tax as well as income tax on that amount, even if the owner only provided $50K worth of services as an employee of the LLC.

If the company had elected to be an S-Corporation, the employee/owner would only pay self-employment tax on the amount of income on the $50K attributable to her services as an employee/owner, and the remaining amount could be a tax-free “S-Corp” distribution that merely reduces the owner’s basis in corporation’s stock. This is a huge tax advantage, potentially saving thousands of dollars a year for S-Corp shareholders. Electing S-Corp is generally a good idea if your startup has employees or multiple owners, but you should always consult with a licensed CPA regarding whether this election would be beneficial to your particular business situation before doing so.

Investment Considerations. Finally, if you’re ever looking for equity investors like angel investors or venture capital groups, they generally prefer investing in corporations over LLCs. This is because, angels and VCs don’t want the extra income allocated to them for their share of profits from a pass-through tax structure at their higher tax rates, and prefer that their return on investment is paid through dividends (currently taxed at lower tax rates than ordinary income). When your business gets to the stage of looking for outside investment, depending on what your investors want, if you’ve elected S-Corp, you may want to revoke that S-Corp election to allow your investors to get the lower dividend rate, which is much easier than converting from an LLC to Corporation. Hopefully though, by that point in your business, you’re successful enough that the corporate level tax won’t be detrimental!

The Bottom Line

While there are situations where the LLC may be preferable for your particular business situation (which I’ll discuss in my next post), the corporate form is often still the better choice for most startups and small businesses . Choosing the type of entity now may seem like an insignificant decision now, but it may have a large impact on your business down the road. It’s best to consult with your legal professional to help you make the right choices when setting up a limited liability entity for your business. If you’re a startup that has already formed a limited liability entity or are thinking about starting a business and have questions about which type of entity to choose, email me at jmk@schoberlaw.com or call me at 262-569-8300 to set up an appointment to discuss your options.

The attorneys at Schober Schober & Mitchell, S.C. are excited about the recent news that a Commercial Court Docket (“CCD”) will be coming to circuit courts in the Fox Valley, as well as in Southeastern Wisconsin– right here in Waukesha County! On February 16, 2017, the Supreme Court of Wisconsin voted 5 to 2 to adopt a pilot program that creates a separate commercial court docket in these judicial districts. This specialized commercial court will be solely responsible for resolving disputes pertaining to businesses brought in these judicial districts.

Depending on the type of dispute brought in these circuit courts, a case may automatically qualify for placement in the CCD. Cases qualifying for the CCD  will begin being assigned in these courts starting July 1, 2017. Some examples of the types of cases that qualify are those involving internal governance issues, business torts and restrictions in trade, merger and acquisition issues, securities, intellectual property, and franchise issues. Initially, the judges assigned to the CCD will be chosen by the Supreme Court. The Court has said that it will likely choose those judges with business law backgrounds, at least for the initial rotation during the three years of the pilot program.

This is a welcome change to both the legal and business landscape here in Wisconsin, and will hopefully be here to stay. Twenty-Six other states in the U.S. have created some type of special commercial court docket in their states, and studies have shown that this has had a positive impact on communities as a whole within those states. Here are a few reasons why this addition should be celebrated by all Wisconsinites:

With at least the initial judges overseeing the CCDs having demonstrated business law backgrounds, parties will have greater confidence that resolutions of complex commercial disputes will  reflect an understanding of the realities of day to day business issues;

The CCD should attract more businesses—whether they be start-ups or established companies—to relocate and do more business in Wisconsin, because of increased confidence that disputes will be resolved more quickly, fairly, and at a lower cost. This creates jobs, greater tax revenue, and increased quality and quantity of services available to businesses and consumers alike;

Separating commercial issues from the civil docket should significantly speed up litigation time, giving businesses greater incentive to fully litigate complex issues. This creates consistency and reliability in the law for the entire business community, and also reduces costs for businesses that otherwise might be deterred from litigation for purely economic reasons; and

In states that have created commercial court dockets, there has been an increased level of capital investment by venture capital groups and angel investors into start-ups and other early-stage businesses—something Wisconsin desperately needs to help foster growth of the many entrepreneurs and startups seeking to grow in this state.

Have questions or comments about the new Commercial Court Docket and how it might impact you or your business? Contact one of the attorneys at Schober Schober & Mitchell, S.C.