In a closely watched 5-to-4 decision authored by retiring Justice Kennedy in South Dakota v. Wayfair, 585 U.S. ___ (2018), the U.S. Supreme Court reversed decades of Supreme Court precedent, giving state and local governments the right to collect sales taxes from out of state retailers on online sales made into the local jurisdiction.

Business Taxation
Copyright: yupiramos / 123RF Stock Photo

The case involves Wayfair, a furniture and home company which sold products over the Internet into the state of South Dakota.  The law in question required the payment of a 4.5% sales tax by out-of-state retailers that make at least 200 sales or sales totaling at least $100,000 in South Dakota.

Prior to the Wayfair case, the standard, from two Supreme Court cases named Bellas Hess and Quill, was that a company had to have a physical presence in the state in order to be required to pay local tax.  A “physical presence” was something like a retail outlet, employees or property in the jurisdiction.

The Supreme Court stated, overruling decades of precedent, that the physical presence rule is unsound and incorrect. The Court noted that the rule has become removed from economic reality as technology has advanced.  The Court stated that the physical presence rule creates market distortions and puts local businesses and others at a competitive disadvantage given the new online marketplace.

The court concluded that, if a retailer establishes a substantial nexus with a state, that state can tax the sales in that state.  In this case, they concluded that the South Dakota law’s requirements of number of sales or total value satisfies the substantial nexus requirement.

Given that so many states rely on sales tax revenue for huge portions of their budgets and state governments have a strong aversion to new income taxes, this green light from the Supreme Court means that other states are likely to take a hard look at their laws and consider the enactment of laws calling for the collection of online sales taxes like the one in South Dakota.

This information does not constitute legal or tax advice.  You should, of course, consult an attorney or tax adviser regarding any taxation issues you might have, as each situation is unique.

In an Alert published on Thursday, Andrea Ravich provides an update on changes to Minnesota corporate law regarding limited liability companies (LLCs) that will take effect in January 2018, and notes action items for companies to ensure compliance.

Copyright: tashatuvango / 123RF Stock Photo

An overhaul of Minnesota corporate law on limited liability companies, or LLCs, that was phased in over three years will take full effect in January 2018. The new act differs significantly from the old act, but is modeled after the Revised Uniform Limited Liability Company Act and is similar in many ways to LLC laws in Delaware and other states.

Action Items Prior to January 1, 2018

Now is the time for Minnesota companies to ensure compliance. Within the next 120 days, LLCs should:

— Confirm that your LLC is registered and in good standing with Minnesota Secretary of State (file annual reports and/or renewal, as applicable).
— Review your LLC’s existing governing documents (i.e., any agreements between the members). Unless your LLC adopts a new operating agreement in writing, its current governing documents will continue in effect under the new act.
— With guidance of legal and tax counsel, consider whether there may be any opportunities to update, clarify and/or amend your LLC’s existing membership agreement.

To read Andrea’s full discussion of the impending changes, please visit the Fox Rothschild website.

Andrea L. Ravich is an associate in the firm’s Corporate Department, resident in its Minneapolis office.

Ethan Zook and Jacob Oksman write:

Attracting and retaining high-performing employees is critical to the success of any emerging company. A key ingredient to securing the right talent base is an attractive and aligned remuneration plan. Most emerging companies will structure their remuneration plan leveraging three key elements: a competitive base salary, a short-term bonus plan, and a long-term incentive plan (LTI) that typically comes in the form of a stock option plan. The base salary and bonus plan are typically structured to align the individual and the company against critical objectives, and normally present in the form of cash compensation. The LTI plan, on the other hand, is structured with a longer-term horizon in mind, and is intended to align the company, employees, and shareholders for long-term value creation.

Business Taxation
Copyright: yupiramos / 123RF Stock Photo

While an integral way for emerging companies to attract top talent, employees need to understand the type of LTI vehicle used, and tax implications from a vesting, exercising and selling perspective.

In general, there are two basic kinds of stock options: statutory stock options and nonstatutory stock options (NSOs). Both generally allow the recipient to buy stock at a fixed price for a defined number of years into the future. By doing so, the option holder takes part in the overall value creation of the company. The award will typically vest over a pre-determined period of time, or upon certain milestone achievements. Once shares are vested, the holder has the option of selling the earned shares. There are, however, significant differences between the two types of awards from a tax perspective.

Statutory stock options include incentive stock options (ISOs) and options granted under employee stock purchase plans. Upon grant and exercise of ISOs, there are generally no tax consequences to the employee. However, the employee may be subject to alternative minimum tax in the year of exercise. Upon sale of the stock received by exercising the ISOs, the employee will generally have capital gain or loss if the stock acquired on exercise is held for at least two years from the date of grant and one year after the ISOs were exercised.

NSOs are not taxed to the employee receiving them when granted unless the options have a readily ascertainable fair market value at that time (this generally includes marketable securities). If the options do not have a readily ascertainable fair market value when granted, the employee is taxed on the gain from the options at the time of exercise or transfer (even if the fair market value becomes readily ascertainable before the exercise or transfer). Unlike statutory stock options, upon exercise of NSOs, an employee will have compensation income (taxed as ordinary income) equal to the difference between the fair market value of the stock at the time of exercise and the price paid for the stock (if any). If the options are sold, then the employee will have compensation income equal to the gain on disposition. The sale of the stock received by exercising NSOs will generally result in capital gain or loss (and are not subject to the special holding period requirement discussed above for ISOs).

ISOs are generally considered more tax friendly than NSOs, but both employees and employers need to be aware of the tax scheme.

Navigating the tax treatment of options can get complex quickly; it would be wise to reach out to a tax professional before making the ultimate decision of receiving or exercising equity compensation.

Ethan Zook is an associate in the firm’s Corporate Department, resident in its Exton, PA office.

Jacob M. Oksman is an associate in the firm’s Taxation & Wealth Planning Department, resident in its New York office.

Robot Builder with Wrench
Copyright: kjpargeter / 123RF Stock Photo

A recent comment by Bill Gates that robots that take human jobs should “pay” taxes, or be taxed, has stirred debate in the artificial intelligence, economic and legal worlds. Numerous questions emerge from this debate, the most pertinent being who will actually be paying the tax. This may be solved by creating a legal entity for the robot to pay taxes, just as is done to tax corporations.

Many innovators in the emerging companies sector believe that automation, or at least partial automation, is inevitable in a capitalistic society, as we constantly strive for more efficient and accurate solutions.

Technology companies researching and developing robots have astronomically high costs, which is passed on to their customers, the businesses who purchase the robots. From an economic standpoint, a tax on the businesses for purchasing such robots is akin to a price increase, which lowers sales. If the companies sell fewer robots, it will be harder to justify their high initial investment in developing new technologies.  Overall, innovation in this sector could suffer if the robotic industry is burdened by heavy taxes.

Customers, on the other hand, simply will not see any of the savings inevitably reaped by businesses.  Assume a factory (or a restaurant, or customer service center) that is not automated employs 200 workers at $10 an hour (8 hours a day, 5 days a week, 52 weeks a year). This factory wishes to purchase “robots” to automate processes (an initial investment of up to millions of dollars) to decrease the burden of paying $4,160,000 in wages each year. This one time investment would bring their costs down and allow for lower prices. Most factories around the globe have already embraced this concept to some extent, and are not currently taxed for their automated processes. Any tax imposed on robots would narrow the savings gap that consumers would share in the form of lower prices.

On the other hand, if robots are taking over jobs ordinarily performed by humans, we could see a rise in unemployment and thus a corresponding drop in tax and social security payments made to the government. A tax on robots could help offset these losses.

Although robots have been replacing humans for years in many industries, the creation of more advanced robots has once again raised the question as to whether robots should be taxed like the humans they are replacing. Overall, despite the debatable philosophical standpoints on taxation, it is safe to say that there are consequences lying beneath the surface of such a proposed tax.

A recently passed House bill would permit certain start-up employees to defer taxes on stock options and restricted stock units (RSUs).  The proposed legislation aims to help emerging companies attract and retain talent by offering equity compensation on more attractive terms.

Business Taxation
Copyright: yupiramos / 123RF Stock Photo

Cash-strapped start-ups often grant an ownership stake to employees to compensate for below-market wages.  This strategy also aligns incentives by giving employees a share of the company’s growth.

However, current tax law makes such equity compensation less attractive than it might otherwise be.  When employees exercise their stock options or when RSUs vest, they must pay taxes on the excess difference between the current fair market value and the purchase price.  Of course, the employee hasn’t actually pocketed any cash.  So the income is “phantom” income, but the tax burden is real.  Public company employees have the option to sell shares on the open market, but there is typically no market for private company stock.  Employees must choose between paying taxes out of pocket or foregoing their ownership stake.  This Hobson’s choice can dilute the value of equity compensation, making it more difficult for emerging companies to attract top talent.

The Empowering Employees through Stock Ownership Act (the “Act”) seeks to alleviate this tax burden on illiquid income.  Qualified employees working at eligible companies could defer paying taxes on income from qualified stock for up to 7 years.  Let’s unpack those terms:

  • Qualified Employee:  To take advantage of the tax deferral, employees must be “qualified employees”.  This includes all employees except certain owners and officers:  owners of 1-percent or more of the company, certain executives (CEO, COO or individuals acting in such capacity), and the company’s four highest earning officers are excluded.
  • Eligible Companies:  The Act is intended to incentivize broad-based employee ownership.  If a company wants its employees to qualify, it must have a written plan under which at least 80% of all U.S. employees who provide services to the company are granted stock options or RSUs on an annual basis.  The company must also offer stock options or RSUs to employees on similar terms.  Finally, the company cannot be traded on an established market.
  • Qualified Stock:  Qualified stock includes stock received in connection with the exercise of a stock option or vesting of a RSU.  The stock must be received as compensation for services performed as an employee of the company.  Importantly, stock is not qualified if the employee has the right to sell the stock to the company at the time of exercise or vesting or to otherwise receive cash in lieu of the stock.
  • 7-Year Deferral:  Employees are currently required to pay taxes in the year in which they exercise stock options or their RSUs vest.  Under the Act, employees would not have to recognize (or pay taxes on) this income until 7 years after exercise or vesting.  Certain triggering events could cause employees to have to pay taxes prior to the 7-year anniversary:  if the stock becomes transferable (including to the employer), if the employee becomes an excluded employee, if the stock becomes tradeable on an established market, or if the employee revokes the election.

Despite some controversy over how this tax deferral will be paid for, the Act is generally receiving praise as a move to strengthen the economy and create jobs by helping early stage companies attract the talent that will help them succeed.

Founding a company is an exciting moment in an entrepreneur’s career.  But even on Day 1, there are steps entrepreneurs should take to avoid major financial and diligence issues in the future.  In this series of posts, we’ll cover some basics that often trip up founders to help guide you through those early steps.

Entrepreneurs often assume they own their company de facto (i.e., by virtue of the fact that they formed it, without any other required action)- a proposition that seems so logical and fundamental, it’s hard to believe its not true.

45594856 - fit and confident woman in starting position ready for running. female athlete about to start a sprint looking away. bright sunlight from behind.

Later in their company’s lifecycle (typically, when there’s pressure on due diligence because the founders either consult an attorney knowledgeable in the space or there’s an interested incubator, accelerator or angel investor), many founders are surprised to learn that after forming their company, they must take another critical step to become shareholders in the company they founded – purchasing their company’s stock.

This often overlooked step works to the founder’s benefit, when it’s done correctly.  In fact, we often tell founders that the ability to purchase their company’s stock on Day 1 is one of the core economic upsides to founding a business in the first place.  While this seems backwards (why should you have to buy stock in a company founded by you- isn’t that the investor’s role?), it makes sense considering the price the founders pay for that stock, as long as the stock is purchased at or near the time of formation of the company.  Because at formation of the company, there’s typically no assets or value associated with the company other than the nominal par value of the stock, allowing a founder to purchase their shares at a fraction of a penny per share (whatever the par value is set to).

Of course, there’s nuances and unique circumstances to each company formation that need to be discussed with your lawyer and financial advisor.  Sometimes, there is real value associated with the stock, even on Day 1 (for example, if the company is a spinout with assets).  And there are other steps that a prudent founder or founding team may need to take at inception along with the purchase of their stock (e.g., consider imposing vesting restrictions on the stock and filing an 83(b) election).

But first things first, make sure you purchase your stock on Day 1, before that hockey stick growth you’re projecting becomes a reality…

Fox Rothschild’s Emerging Company Resource Center includes formation document checklists developed by our nationally recognized emerging companies attorneys; information on relevant intellectual property issues (trademarks, patents, licenses); data room portals for investor due diligence; and other resources for emerging companies.  We encourage our entrepreneurs to reach out to us with questions as they grow their company with these resources. 

Ethan Zook writes:

Business Taxation
Copyright: yupiramos / 123RF Stock Photo

Starting a business can be both exciting and stressful for any new entrepreneur, and perhaps nothing adds more initial stress than the word “taxes.”  Understanding how a business will be taxed is among the many considerations entrepreneurs need to keep in mind when choosing a type of business entity for their company.  Below is a basic overview of the types of business entities typically used by entrepreneurs and a brief discussion of related tax considerations that entrepreneurs should keep in mind.

  • Sole Proprietorships: A sole proprietorship is an unincorporated business owned by one owner who is referred to as a “sole proprietor.”  A sole proprietor reports income or losses from the business on his or her personal tax return and the business itself is not taxed.  Because income and losses pass through the business to the owner without being taxed at an entity level, this type of tax structure is often called “pass-through taxation.”
  • Partnerships: A partnership is generally defined as an association of two or more persons to carry on as co-owners of a business.  Much like sole proprietorships, partnerships experience pass-through taxation whereby the owners report income or losses from the business directly on their personal income tax returns, often based on each owner’s percentage of ownership in the business.  Unlike sole proprietorships, however, a partnership must file an information return, known as a Form 1065, which lets the government know about its annual income or losses.
  • Corporations: Corporations are formed under state law and are generally subject to what is commonly referred to as “double-taxation.”  Double taxation is effectively the opposite of pass-through taxation and requires that both the entity and its shareholders pay tax on each dollar of income.  For example, if a corporation reports positive earnings in any given year, it will generally be required to pay taxes on those earnings at the entity level.  In turn, when the corporation distributes some or all of those earnings to its shareholders, they must report those amounts on their personal tax returns and pay taxes on those amounts.  However, if a corporation meets certain criteria relating to, among other things, the type of stock it issues to its shareholders and the number and type of shareholders it maintains, it may elect to be taxed under Subchapter S of Chapter 1 of the Internal Revenue Code.  A corporation that makes this election is known as an “S Corporation.”  S Corporations have the benefit of avoiding double-taxation and are taxed on a pass-through basis, whereby any earnings at the entity level are passed through to the individual shareholders, much like partnerships.
  • Limited Liability Companies (LLCs): For tax purposes, LLCs are perhaps the most versatile form of entity.  LLCs are formed under state law and are owned by “members.”  In cases where an LLC has only one member and unless the member elects otherwise, the LLC will be treated as a “disregarded entity,” meaning that the LLC will be disregarded for tax purposes and any income or losses of the LLC will be passed through to the members who then pay taxes on those amounts, much like a sole proprietorship.  If there are two or more members of an LLC, the LLC and its members have the ability to elect whether the LLC will be taxed as a partnership or even as a corporation.  LLCs having at least two members will typically elect to be taxed as partnership and receive the benefit of pass-through taxation.  Why would an LLC elect to be treated as a corporation and subject itself and its members to double taxation for tax purposes?  There are many reasons, but this election is often seen in cases where an LLC desires to keep a significant amount of retained earnings in the LLC.

Please note that the above is a general summary of federal tax considerations for an entrepreneur to consider when choosing an entity.  State tax considerations, along with other topics such as protection from individual liability and ease of administration, should also play an  important role in making this decision.  It is crucial that an entrepreneur have a general understanding of the types of entities available and their tax treatment so that he or she can work more effectively with legal and financial advisors to make informed decisions.

For more information, visit the IRS Choosing a Business Structure page and their Limited Liability Company (LLC) page for small businesses and self-employed individuals.

Ethan Zook is an associate in the firm’s Corporate Department, resident in the Exton, PA office.

The Senate recently joined the House in approving a permanent ban on state and local governments taxing Internet access.  The White House has indicated that President Barack Obama intends to sign the measure into law.

Internet access tax
Copyright: hywards / 123RF Stock Photo

By a vote of 75-20, the Senate passed H.R. 644, the Trade Facilitation and Trade Enforcement Act, which contained a measure permanently extending the “Internet Tax Freedom Act” (the “ITFA”).  The ITFA was initially enacted in 1998 and temporarily extended seven times with robust bipartisan support.  The House passed the permanent extension in December 2015.

The measure is especially important to startup entrepreneurs who rely heavily on affordable Internet access to innovate, build their businesses and reach customers.  Since 1998, the ITFA has protected consumers from a potential patchwork of taxation by America’s approximately 9,600 taxing jurisdictions. The certainty of a permanent ban paves the way for innovators to take the calculated risks that strengthen the entrepreneurial ecosystem.

In a recent post, Michael Hart discussed a reported wave of shareholder lawsuits that may cause entrepreneurs to reconsider incorporating in Delaware. Now, he and Paul Wassgren note a new development in Nevada, another favorable state for entity formation, that could have the same effect there.

Copyright: klotz / 123RF Stock Photo
Copyright: klotz / 123RF Stock Photo

Despite the soaring summer temperatures in the deserts of Nevada, it appears that hell has finally frozen over in the Silver State.  Often perceived as a “tax-free state,” Nevada has enacted a commerce tax on businesses with Nevada-sourced income, effective July 1, 2015.  In truth, Nevada has had a Modified Business Tax in place for some time, but it was limited to certain industries such as gaming and mining.

The new commerce tax is more pervasive, and while still industry-specific, the tax applies to nearly all entities conducting business within the State of Nevada. In addition, all businesses are now required to file the Commerce Tax Return Form annually, even if there is no tax liability.  This is a sea change for the Silver State.

Finally, also effective July 1 of this year, the annual state business license application fee for Nevada corporations has more than doubled to $500, up from $200.  In light of these changes, entrepreneurs may start to reconsider the trend in favor of incorporating in Nevada.

Paul Wassgren is a partner in the firm’s Las Vegas and Los Angeles (Century City) offices, and Michael Hart is an associate in the Los Angeles (Century City) office.

Jeffrey M. Friedman, Andrew M. Halbert and Joseph Superstein write:

A series LLC is an entity structure permitted in certain states that allows for the formation of multiple segregated LLCs (or “series”) under the umbrella of a single “master” LLC. Generally, in the states in which they are recognized, these series LLCs are viewed as segregated entities which are permitted to have separate managers and members, distinct assets and individual operating agreements, and which can incur separate liabilities. However, the series LLC is still viewed from the states’ perspective as a single entity for filing and reporting purposes.

Copyright: tashatuvango / 123RF Stock Photo
Copyright: tashatuvango / 123RF Stock Photo

The most notable advantage of series LLCs comes in the form of cost savings associated with state business filing fees. In Illinois, where business filing fees are higher than most states, the cost to form a standard LLC is $600. While series LLC filing fees involve a higher up-front cost ($850), the benefit arises in the long-run because only a nominal registration fee is necessary to form each additional series by filing a Certificate of Designation ($50) and amending the master LLC operating agreement. To illustrate, an Illinois developer with ten properties would pay $6,000 to form a standard LLC for each property ($600 x 10 properties). Instead, by forming each entity as a series LLC, the developer would pay $1,350 in initial filing fees ($50 x 10 + $850). In some states, such as Delaware, only the initial filing fee is required to form a series LLC, and individual series can be created via the LLC operating agreement without any additional fees.

In addition to the administrative streamlining, a major benefit of series LLCs lies in the separate corporate liability protection of each series. Debts and liabilities of one series cannot spill over and be enforced against a different series so long as certain statutory conditions are met at formation. Essentially, if each series keeps separate records and bank accounts, and is treated as its own entity, the assets of each series will be unaffected by judgments against other series. However, not all state statutes regarding the series LLC are identical, and series LLCs are not available in all states. In jurisdictions where series LLCs are not available, each series may not be recognized as a separate entity or for state tax purposes.

Although the IRS has yet to issue official federal tax regulations governing the treatment of series LLCs, it has issued proposed regulations (Prop. Treas. Regs. Secs. 301.6011-6; 301.6071-2; and 301.7701.7701-1(a)(5)) providing insight into the IRS’ treatment of these entities :

  • Each series within a series LLC will be treated as a separate entity for federal income tax purposes;
  • Each series is allowed to choose its own entity classification independent of the classification of other series; and
  • Each series should only be liable for federal income taxes related to that series.

The proposed regulations do not address the entity status of a series organization for federal tax purposes nor do the proposed regulations specifically address whether each series within a series LLC should obtain a separate employer identification number (EIN) and file a separate federal tax return. It is anticipated that the Treasury Department will issue its official regulations regarding series LLCs by the end of the summer. Until final regulations are issued, we are advising clients to obtain separate EINs and file separate income tax returns for each separate series which, in turn, allows for each series to maintain their respective individual identities.

While the series LLC may appear to be an attractive investment vehicle, it does not come without risks. Series LLCs have largely been untested in the courtroom, and there is not much precedent as to how these entities will be respected going forward. In addition to questions regarding whether the separate liability protection of the series LLC structure will be respected in states that do not recognize series LLCs, various issues exist regarding how series LLCs will be handled in bankruptcy proceedings, and it is possible that a bankruptcy court will not recognize the separateness of the series within the LLC. As a result, until more courts have ruled on the legality of the series LLC structure, it is unclear whether the series LLC will be afforded all of the protections intended by the state statutes.

Jeffrey M. Friedman is a partner, Andrew M. Halbert is an associate and Joseph Superstein is a summer associate in Fox Rothschild’s Chicago, IL office.