Get ready. In February, 2010, the Internal Revenue Service (IRS) launched what one tax expert has called “the most comprehensive set of audits in about 20 years.” The IRS estimates that United States taxpayers fail to pay $345 billion dollars annually in federal taxes. Of that, an estimated $54 billion represents unpaid employment taxes—Social Security, Medicare, federal unemployment taxes and federal income tax withholding. The new audit program is intended to determine who is not paying and provide information for further IRS efforts to ensure that employment taxes are collected. The IRS intends to audit approximately 6,000 employers over a three-year period and has reportedly trained an additional 200 new field agents to assist in the program. The audits reportedly will concentrate on small businesses and self-employed persons with under $10 million in assets.

Worker classification has always been a potential problem area for employers, and the IRS audit program will focus heavily on the issue. For those who have been fortunate enough to avoid this topic, “worker classification” in context, refers to whether a worker is an employee or independent contractor for federal tax purposes. Employers generally have to pay employment taxes for employees, but not for independent contractors. Errors in this area can have horrendous consequences, including personal liability, and can create costly problems in respect to employee benefit plans. A column does not provide enough space to do more than scratch the surface of this issue, but here are some key considerations for employers:

The IRS does not care how you classify a worker. How an employer classifies a worker is generally irrelevant for federal tax purposes. You may have a contract with the worker stating that the worker is an independent contractor, or you may have a contract with an employee leasing company stating that the worker is their employee, not yours, but that is not binding on the IRS.

High risk situations. Circumstances that tend to create a high risk of worker misclassification problems include use of “leased” employees, hiring former employees as “consultants,” using “temporary” workers for long periods of time and using workers supposedly employed by a professional employer organization (PEO). Three-month “temp-to-perm” arrangements usually do not create problems, but having a third of your workforce classified as independent contractors or PEO employees is usually asking for trouble. Don’t believe me? Ask Microsoft about its multi-million dollar lawsuit involving “temporary” employees.

Personal liability. In addition to the typical consequences of a tax violation – payment of back taxes, penalties and interest – worker misclassification can create personal liability for employees, officers and directors who either are involved with compensation and payroll or have authority over those areas.

Check your benefits for potential worker claims. Beyond the tax consequences, you may have employee benefit plans and insurance policies that state that “employees” are eligible to participate and receive benefits. If a determination is made that someone you thought was an independent contractor or employee of an employee leasing company is reclassified as your employee, that employee now may have a—retroactive—claim against your company for benefits. That can be really painful if, for example, you have several hundred reclassified workers claiming retirement plan contributions going back five or ten years. Many modern retirement plan documents are drafted to avoid this problem, but other retirement plans, and many medical plans and employee benefits insurance policies are not.

Worker classification is for professionals only. It is dangerous to analyze worker classification issues without an attorney or tax accountant experienced in the area. Worker classification and the potential issues created if there is a misclassification are highly technical matters.

The basic underlying issue when you discuss stock options with a client is incentive compensation—what can the client do with compensation to get employees to give their best for the business? Often, the client is also dealing with a related issue—employees want, or the client wants to give them, a “stake in the business” so they will act and feel like owners, not hired hands who punch the clock for a paycheck. Stock options should not be used without careful consideration, however. Some key issues include the following:

1. Options as compensation for lower pay. Stock options can make sense for companies that use them to make up for lower cash compensation. Most commonly, this is done by new and growing companies that simply do not have the cash to pay the kind of salaries that their employees could obtain elsewhere.

2. Options to provide competitive compensation. For certain positions and in certain industries, stock options are seen as a basic component of compensation, and you simply cannot attract good talent unless you offer stock options. Historically, this has been particularly true with various types of technology companies such as software companies. Stock options or other stock compensation are also a necessary part of the compensation package for executives at public companies.

3.  Options for key employees. The incentive value of stock options is greatest for key executives whose actions can directly affect the value of the company, and therefore the value of the options. Lower level employees in most companies generally are not going to think that they personally can increase the value of the company.

4.  Option plan and administration requirements. Stock options are complex and need to comply with multiple areas of law, most notably tax, securities and corporate law. So unless you have an unhealthy appetite for risk, you need experienced legal counsel to draft stock option plan documents and advise you on the specific actions necessary to properly establish the plan. Once the plan is established, there are numerous administrative tasks that require careful attention to ensure that stock option awards are properly granted and the vesting, forfeiture and exercise of options are correctly handled. Failure to properly establish and administer the plan leads to employee lawsuits and/or legal violations.

5.  Securities law liability. Speaking of legal violations, stock options are securities. If you don’t handle stock options properly, you can expose the company to civil and criminal liability under state and federal securities laws. In the worst cases, company officers and directors can also face personal civil and criminal liability.

6. Minority shareholder rights. An employee who exercises a stock option is no longer just an employee. They are now also a shareholder. As a shareholder, they have all of the legal rights of a shareholder as well as an employee, which can add to your headaches if the company and the employee part on bad terms. This risk is primarily an issue for private companies, and there are ways to reduce this risk significantly, but again the company must be careful and get experienced legal advice to use stock options.

7.  Alternatives to stock options. Given the complexity and legal issues associated with stock options, a company should always consider whether another type of compensation structure could better accomplish the company’s goals. Alternatives such as restricted stock and cash bonus programs have their own complexities and risks, of course, but after reviewing the pros and cons of options, there are many cases where a client will find that an alternative better fits their objectives.

Thanks to Bryan Jeter from Lister, Jeter, & Lloyd CPA’s who schooled us on Tax 101 as part of the Greer Community Chamber Convention. For more information on tax related subjects, be sure to consult with a professional.

Here are some key points that we learned about taxes:

• Keep track. Have an eye on your taxes throughout the year. One thing that Bryan hates having to say to a client is that they have to pay $10,000 to the IRS next week. Keeping tabs on your taxes doesn’t change the amount you have to owe, but you’ll be able to tell in June what you will owe in April. At least you will know what you will have to pay, so maybe you could scale down a little during the year. Don’t take that trip around the world and 86 the remodel of your home.

• You can still get good tax cuts on buying energy efficient products in 2010, but not as much as you would for the tax year of 2009. If you buy solar panels or geothermal heating elements, tax credits could take up to 30% off of your purchase, making that break-even analysis more toward your favor.  Also, there is a good tax credit for buying an electric vehicle. These tax cuts don’t justify the purchase in itself, but if you were going to purchase a car or already looking for a new energy source, green is the way to go.

• Under the new HIRE Act, if you hire an employee in 2010 that had been unemployed for at least 60 days, you’re eligible for a tax credit. If you continue to employ that person for a year, you get an additional tax credit of $1000. This is a brand new tax credit that goes into effect this month, and it’ll give employers more incentive to help your community by employing those who currently don’t have a job.

Through new litigation going through the United States Congress, personal income tax is dramatically changing, and the tax cuts of earlier in the decade will expire after last year. For more information on the changes, sit down with a tax preparer, and they’ll be able to talk you through what’s coming up.

A company created by two or more individuals is often like a new marriage—the newlyweds look forward to a successful and happy future together until death (or sale of the business and retirement to the Caribbean) do they part. No one wants to think about the possibility of divorce. It is hard to even imagine it happening. But not considering the possibility of divorce can lead to a nightmare that in many cases could have been avoided.

For example, one all too common scenario is the Three Musketeers—three friends go into business together and in accordance with the Musketeers’ motto, “all for one and one for all,” they split up ownership and control of the company equally. Then the nightmare begins. The company needs cash to operate, but only two friends are willing or able to put in money. The other friend not only does not contribute funding but does not work as hard as the other two, or turns out to be incompetent. The third friend finally leaves, still owning one-third of the company; one-third of any value that the first two friends create in the company therefore will belong to the third friend who has made no real contribution to the company.

The two friends can mitigate this result if they can agree with the third friend on a price to buy out his or her interest and find the money to pay that price. Even so, paying the third friend any amount is typically painful, and the (now probably former) friends may not be able to agree on a price.

This nightmare can be avoided. For example, the friends could have required that each contribute an equal amount of cash to the company as initial financing, or they could have agreed that the ownership interests would vest over several years.

Some nightmares occur even though the original business partners never have a disagreement. For example, two partners may start a company and build a valuable business. One then dies, and the deceased owner’s children inherit his or her stock. The children do not work in the business, and the business does not pay dividends. The surviving owner wants to continue to reinvest the profits of the business back into the company to grow it further. If the children have control of the company, they may decide to sell the business to get value out of it. If the children do not have control, they may sue the surviving owner to try to force a buyout or sale or liquidation of the company in order to get value out of the company. The parties may or may not be able to strike a deal. The situation could have been a lot easier to handle if the original owners had put in place life insurance on themselves to fund a buyout of their stock in the event of death.

Prior planning cannot guarantee a harmonious future for business partners, and some business partners never have problems with each other. Failing to consider and plan for a potential breakup, however, too often leads to an expensive and painful divorce that might have been avoided.

1. Use good advisers. If you are experienced in selling businesses, you already know this. If you are not, be advised that selling a business without good advisers is like walking through a minefield blindfolded—it is possible to avoid a catastrophe, but the risk is generally not worth it. The basic lineup typically includes a corporate attorney, a tax attorney and/or accountant, a financial accountant and an investment banker.

2. Make a plan before you get started. Talk to your advisers before you talk with potential buyers. If you are not experienced with selling a business, you need to understand what you are getting into—the time required, the distraction in operating your business, costs such as valuation fees, etc. In any event, you need a plan of attack outlining the desired terms of the deal, identifying key issues to be addressed and mapping out action items and timing. This usually will change over time, but failure to plan can have nasty consequences, such as realizing just before closing that you failed to consider a tax issue that will significantly reduce what you are going to get paid. Initial planning can involve as little as an hour or two with your advisers.

3. Know what price you want and whether it is justified. Don’t bother to get into the selling process unless you have a good idea of what you are willing to sell your business for and whether or not that is a reasonable price to expect. Advisers can help you determine what a third party might pay. There is no use going further if you determine that the minimum price you will accept is significantly higher than what others will pay. Either your expectations are unrealistic, or you need to wait until the market for your company improves.

4. Sell when you don’t need to. Try to sell at a time when not doing a deal is a comfortable option for you. The ideal business to sell is a very profitable, growing company, but a company that is generally stable and profitable can certainly do a respectable deal. Waiting to sell after the business founder with all of the key customer relationships dies is a recipe for disappointment.

5. Term sheets are your friend. Relatively early in the selling process, you usually want to sign a term sheet that covers the material terms of the deal. If you and the buyer can’t agree on a term sheet, there is no reason to waste time on full due diligence and negotiation of deal documents.

6. Know when to walk. Some buyers will try to renegotiate deal terms based on problems later uncovered in due diligence or issues with their financing. This may be entirely legitimate.
On the other hand, attempts to renegotiate can be a red flag that you have a buyer likely to cause you other problems. The buyer who insists on putting a lot of the purchase price in escrow due to minor due diligence issues may be a buyer who will drag you into litigation over questionable indemnification claims after closing. Even if the buyer is being reasonable, you need to consider whether the proposed revisions make the deal unacceptable. Do not get caught up in “deal fever.” No deal can definitely be better than a bad deal.

7. Don’t forget taxes. Rarely do sellers actually forget the issue of taxes, but timing can be a key issue. Different deal structures can dramatically affect the tax consequences to the seller. You don’t want to try to renegotiate the purchase price after you sign the term sheet because you failed to analyze tax issues before you signed.

8. Beware delayed or contingent payment. Consult with your advisers before agreeing to any delayed or contingent payment of the purchase price. Delayed payments are only as good as the credit of the person who is promising to pay.
If the buyer loads your company up with debt and the company is supposed to pay you 50 percent of the purchase price over two years, you may never see that 50 percent if the extra debt causes the company to fail. Contingent payments—such as an “earnout” where payments are made based on the earnings of the company after the sale—can be a nightmare for the seller. They are often very difficult to structure and enforce.
Buyers may accelerate expenses to reduce earnings, and it is often very difficult for the seller to ensure that the buyer is reporting accurate performance numbers. A seller may have to resort to litigation to determine whether the buyer is cheating and/or to enforce the earnout.

When considering the legal matters of your business, there are typically large situations—taxes or liability, for example—that people take great notice of. However, there are many, more common legal agreement mistakes that I see in my practice. You may regard these mistakes as obvious errors that only a fool would not recognize and avoid. If so, congratulations, and by all means go find something else more interesting to read.

Experience, however, suggests that many are not aware of these potential pitfalls or do not recognize them until it is too late. The catastrophe may not materialize, but when it does it is invariably costly, time consuming and even painful when you realize that a little extra effort on the front end could have avoided the problem.

Here are a few pitfalls that you can avoid.

Don’t sign anything you have not read. Nothing is more depressing than talking to a client who did not carefully read a contract and is now asking you how to avoid a contract provision that “should not be in the agreement” because “that is not what we agreed to” and/or “I did not know it was in the contract.”

There are a lot of court decisions stating that if you sign a written agreement, you are legally deemed to have read it, even if you did not. Ignorance is no defense. Most agreements also include specific language stating that the written agreement supersedes prior communications, so it is difficult or impossible to rely on prior conversations or emails to contradict the terms of the agreement.

Make sure the deal described on paper is the same deal that you approved. A specific variation of the first problem is the failure to ensure that the written agreement actually describes the same deal that the parties previously discussed. I have seen clients spend weeks working out a deal, only to find myself pulling teeth to get them to spend a few hours to make sure that the written agreement accurately reflects the terms that they so carefully negotiated. A careful review of the written document can avoid critical errors.

In the worst cases, the other party drafts the agreement and deliberately puts in terms different from the approved terms or adds terms that were not discussed that significantly change the deal. Even innocent mistakes can be catastrophic. I once reviewed an agreement where the other side mistakenly flipped the numerator and denominator on a fraction – an error that would have cost them millions of dollars had it not been caught.

Always read the “boilerplate.” You can change a few words in agreement “boilerplate” and completely change the commercial benefits and risks under an agreement. Sophisticated clients negotiating commercial contracts often spend as much or more time negotiating limitation of liability and indemnification clauses than any other terms because the potential dollars and risks at stake in those provisions are equal to those in any other part of the contract, including pricing and warranties.

Beware of business people writing agreement schedules. Schedules usually describe things such as product and service specifications and pricing about which business people know far more than lawyers. The problem is that most business people do not spend their time writing documents with detail and clarity sufficient for a judge or jury that knows nothing about the business to determine what the deal was if there is a dispute.

The most interesting case that I have heard of involved a software development contract. A year or so after the contract was signed, the parties had a disagreement about the work performed. They reviewed the contract schedule describing the work to be performed, and the schedule was sufficiently unclear that no one could determine what they had agreed to, including the owner of the software company who had written the schedule.

There certainly are business people who need no assistance from a lawyer in writing schedules, but this is an issue that should be considered.

In difficult economic times, companies must worry about the financial condition of their customers. The classic problem is simply delivering products or services to a customer who does not pay. But if your customer goes bankrupt, it can get even worse— you can be required to pay back to the bankruptcy trustee payments previously received from the customer.

That is the bad news. The good news is that you can protect your company and reduce the risk of having to return payments to bankrupt customers.

Payments that a bankruptcy trustee can reclaim are called “preference payments.” Only certain payments by a bankrupt customer are preference payments. To be a preference payment, the payment generally must be: made to a creditor; on account of a pre-existing debt; while the customer was insolvent; within 90 days before the bankruptcy filing; and enabled the creditor to receive more than it would have through the normal bankruptcy process.

What happens?

A preference claim is the claim that the bankruptcy trustee files against your company, claiming that you have received a preference payment that you must pay back. If the claim is valid, then your

company must return the payment to your bankrupt customer. The amount that you pay back will be used, together with any other assets that the customer has, to satisfy all of the customer’s outstanding debts. Your company will have a bankruptcy claim against your customer for the amount you paid back. You may recover some of that amount in the bankruptcy proceedings, but you will typically get only a fraction of the amount, if anything.

What do you do if a preference claim is filed against you?

If a preference claim is made against you by a bankruptcy trustee, that certainly does not mean that the claim is valid. You need to contact an attorney familiar with preference claims. That attorney can determine whether or not the payment in question is a preference claim and advise you of what you need to do to respond. If you do not respond in a timely manner to a preference claim, you can lose your ability to contest the claim—which means that trustee can obtain a judgment against you for the amount of the payment even if it really was not a preference payment. Because of this, you should contact an experienced bankruptcy attorney if you are contacted about a preference payment, even if the trustee merely sends you a letter rather than filing a formal claim.

How do I avoid this?

Probably the two most effective strategies for protecting yourself against preference claims are switching payment to cash-before- delivery and ensuring that you receive payments from customers

in the “ordinary course of business.” With cash-before-delivery transactions, goods or services are paid for before they are shipped or provided. Because payment occurs prior to performance, the payment is not “on account of a pre-existing debt,” which is one of the requirements for a preference payment. Obviously, you may find it impossible to get cash-before-delivery terms except in unusual circumstances. The more readily available defense therefore is the “ordinary course of business” defense. That defense is available when the payment at issue was made in the ordinary course of business between you and your customer or in accordance with ordinary business terms. This means that if no unusual circumstances accompanied the payment – such as a change in credit terms or unusual pressure from the creditor – the payment likely would not be subject to a valid preference claim. The cleanest situation is when you and your customer have agreed on payment terms in writing, and you can show that all of the payments that you have received from the customer were made in accordance with those terms. Changing payment terms, formally or in practice, when a customer is in difficult circumstances can make it more difficult to use this defense.

In the current economic turmoil, financing is an even greater challenge for those who need it and has become an issue for many who thought that their financing was secure. Although it can be stressful, there is still money out there, and with a focused effort, you can still get financed.

Accept reality. Obviously, financing is less readily available, investment and credit standards are higher and financing terms are tougher. Enough said. Accept the reality. Shop around for the best terms you can get, but don’t expect to get terms that would have been typical a year ago.

Know your financing sources. Obtaining financing is more challenging, but lenders are still lending, and investors are still investing. Focus your financing efforts, however, on sources that are likely to be a good match for you. Whether you are talking to bankers, venture capitalists, angel investors or strategic investors, you need to know their lending or investment profile – who do they want to lend to or invest in? Typical criteria are industry, company size, historical and current financial performance (EBITDA, debt-to-equity ratio, revenue growth rate, etc.), financial projections, market potential, intellectual property assets and available collateral (for lenders).

Strategic (industry) investors are looking for good investments. Companies with a lot of cash are searching for investment opportunities. Some typical advantages of financing with strategic investors are (a) they know their industry and can often move very quickly in making an investment decision and (b) even in these times, they may not impose terms that are as demanding as venture capital or private equity terms. Some typical disadvantages are (a) strategic investors are often very specific in what they are looking for, technology, access to certain markets, etc. (i.e., just being a great business in their industry may not interest them) and (b) a strategic investor may be interested only in buying the business, not in providing financing.

Advance preparation for due diligence is more critical than ever. If you are a good financing candidate, don’t screw it up because you don’t have a sharp business plan or proper financial statements, or can’t readily produce important documents and information. Keep in mind that lenders and investors in many cases are paying attention to documents and information that were ignored or glanced at just to check them off on the due diligence list when financing was easy and investors and lenders were still chasing deals.

Collateral is king; personal guarantees aren’t worth what they used to be. Bankers are often now insisting on collateral where none was required before or more collateral to back the same size loan. Where a personal guarantee used to be sufficient to back a loan, lenders may require the guarantor to provide collateral for the guarantee or even a letter of credit.

Long-term relationships are no guarantee that financing will be renewed. Banks are dropping longtime customers, even customers who have never made a late payment. In some cases, the lender has decided to stop lending to an industry or in a geographic region, so the creditworthiness of the borrower may be entirely irrelevant. Well before your financing expires, determine whether your lender will renew and review other financing options. Don’t rely on verbal assurances of renewal. Get a commitment letter or, even better, go ahead and get an extension. If you can’t, you will find out with plenty of time to line up other financing.

Close financing quickly. Letting a financing drag out has always raised the risk that a financing will fall through. Under current circumstances, only the foolhardy would not move to close on a financing as quickly as possible, and a disturbing number of deals fail due to delay. Typical situations are a financial investor whose bank financing commitment expires because the deal did not close on time or a strategic investor who shelved the deal because business difficulties came up that required them to focus on their core business.

Sir Francis Bacon said, “Time is the measure of business” in the 1600’s. Those words are truer today than ever. How many times have you sat through a meeting that was a waste of time? We all have, in fact, we have even set them up and in the end realized it was not time well spent. How many times have you met the same person or group and walked out of the meeting with comments like “great meeting”, nice people”, “that person is really smart”, but what was the outcome? Why did I just spend one hour of my day with this person or group.

There is a fine line between spending an incessant amount of time with people vs. being the business butterfly catching bits and pieces before moving to the next meeting. The key is to develop a strong habit of understanding what you want out of a specific person or group, determine how you can be of benefit, and what will be the achievable first steps as an outcome.

As we close on 2008 and enter a very challenging 2009, it will become increasingly important to maintain concise timeframes that connect with the people that we meet.

Do The Work
Read up on the person, company, market, product before the meeting. Coming to a meeting with more “intel” than the others is always a benefit to you.

Get To Specifics
You should be able to get through the intro, history, and current events within the first three minutes. The next step is to specifically state why you are having the discussion and what you hope to get out of it.

Bring Something
The assumption is that you have an idea why you are meeting. Make sure you have an inventory of how you can help the person or group you are meeting; your experience, your knowledge of the industry, market, or products. Don’t give it all away for free, but just enough so they know you are needed.

6 Degrees Of Separation
Most people meet other people through introduction; so do the same. Give the person you are meeting a name of someone that will be very relevant to your discussion, even if it does not help you directly. It will come in handy later.

Look For Opportunities
Disagree with every 3rd statement if you’re in one of those “me too” conversations. It helps to bring clarity to concepts and ideas as they’ll have to articulate. By the time you have finished you will both learn something.

The “Deal Junky”
As an entrepreneur or senior manager, it is important to pursue a steady stream of new contacts, while managing existing relationships. However, be skeptical of people who discuss deals that appear very attractive on the surface, especially when they bring up more than three in the same meeting. Some checks and balances are; what product or service do they bring to the table? What is their main function or core competency in the deal? Do they have real contacts and funding? Do the “Deal Junkies” do anything or do they just do everything?

What Are The Actions
There must be a reason to meet next time. If not, then the meeting did not follow the above steps and should not have been setup in the first place. What are very specific actions that are going to take place by you and for you that will require another discussion or meeting?

While you are making your new years resolutions, try to interweave time into your activities; it will be very important. Keep this inventory list in mind for your next “let’s have coffee”. In addition to helping you, it will be a relief to the person or group you plan to meet.

The U.S. Congress has gone after perceived abuses in executive compensation with complex new tax law restrictions on deferred compensation. Violation of these restrictions causes the employee to suffer harsh penalties, most notably a 20% excise tax. Unfortunately, the new tax rules affect many bonus and severance payment arrangements that no one would have previously considered “deferred compensation.” Even simple annual discretionary bonuses can violate these tax rules depending on how they are structured. The good news is that it is usually possible to structure bonus and severance payments to comply with the rules. The bad news is that unless you are a benefits attorney or a tax accountant, you need to get one to make sure your compensation arrangements will not get you and your key employees in hot water.