Sales Tax Nexus

sales tax nexusI received a phone call recently from the founder of an Internet business. He wanted to know what the rules were for collecting and remitting sales taxes. His company sold items of taxable personal property off his company’s website.

I asked him, “Where are you located?”

He said, “We’re not located anywhere. We’re an Internet company.”

“Well,” I said. “You have to be physically located somewhere.” He insisted “No, we are a virtual company. We exist only on the Internet!”

I told him this wasn’t possible. That it wasn’t possible to solely exist on the Internet. I am not sure he believed me. He seemed incredulous.

“Where do you live?” I asked.

He said, “Seattle.”

“Do you run the business out of your house?”

“Yes,” he said.

“Well, then, you will have to collect sales tax on sales made to residents in this state, the state in which you do business.”

Again, he didn’t want to believe me.

If you entertain the same thought as the founder of this Internet company, then hopefully you enjoy unpleasant surprises. Physical presence exists in every business, and depending upon the state where that physical presence exists, you may or may not have a sales tax collection responsibility with respect to sales made in that state. Whether you do have an obligation to collect and remit sales tax in a particular state will depend on that state’s laws. Subject to some exceptions, generally, any state where you have physical presence that helps you establish or maintain a market for your sales establishes nexus for purposes of collecting sales taxes.

You should always consult a lawyer or a tax consultant as your business grows to ensure that you are withholding and remitting sales taxes correctly. In addition, stay tuned, Congress might change the game entirely if it passes the Marketplace Fairness Act.

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“Golden Parachute Payment” Taxes Excessively Hard On Founders

Golden Parachute Payment(2)

Suppose you are the founder of a hot startup. You and your other co-founders have worked hard. You’ve been at it for years. And now, you have finally gotten what you have been working for. A healthy buyout offer. The kind of offer you want to take. You’ll be living differently in a few months, happy with what you accomplished, but first you have to navigate through the chaos of the deal.

Along the way, you are going to have to figure out a whole host of issues. How will your board react to the indemnification provisions in the buyout agreement? Will the buyer stick and refuse to budge on an unreasonable provision of some kind that will jeopardize an approval you need? Will the buyer want to subject your deal consideration to some kind of sticky and gross retention requirement? That is, are you going to have to warm a chair and fog a mirror in the office for the next 12-18 months in order to get/keep your money?

You will haggle. You will negotiate hard. Emotions from some of the parties involved will boil over.

Then, just when you nearing the end of the frightfulness, your lawyers will tell you that they think you may have a problem.

“You had an unusually low salary for the past several years,” one of them will say. You will think to yourself–”D’uh, bozo. But look at me now! Ha!”

“This is problematic,” the lawyer will intone, “because it makes your ‘base amount’ unusually small.” A small voice in the back of your mind will start to crackle. “What the heck is this guy talking about?” you will think to yourself.

“Taxes!” the lawyer will scream, and you will almost jump out of your chair. “You are going to have to pay penalty taxes!”

Suddenly the world will start swimming. You will feel dizzy, faint. “Oh my God,” you will think. “I have made it this far. Please God, please don’t say I am going to have to pay penalty taxes.” But you will recover and collect yourself.

“What are you talking about?” you will say casually, coolly. You didn’t get this far by losing your head in negotiations.

“Well,” the lawyer will say. “You see, there is this federal tax code provision called Section 280G. And it provides that if you receive deal consideration or other payments in the nature of compensation in connection with the deal that equal or exceed 3X your ‘base amount,’ you owe penalty taxes on the amount in excess of 1X your base amount–unless you disclose the amount of these payments to all voting shareholders and agree to forfeit some of the payments if more than 75% of the disinterested shareholders don’t agree to approve them in a separate vote.”

“What the hell?”

“Yes,” the lawyer says. “That’s right. It is a horrible tax. Brutal. Congress must have passed it in a fit of apoplectic rage at the wealthy.”

“But hey, wait a minute,” you will say. “I’ve owned my stock since day one. I am not getting anything but stock consideration in this deal. No cash bonuses. Nothing. Plus, I’ve worked for years for a pittance.”

“It is true. It is true,” the lawyer will say. “But because your founder stock was subject to service-based vesting (remember that stuff your investor wanted to put on you?), and some of it is still unvested and is accelerating on this deal, the value of that accelerated vesting counts as compensation in calculating the 280G payment amounts.” And he will go on, “Your pitiful salary over the last several years actually makes your situation now worse, because 3X your base amount is so small…” As he drones on, your mind will wander. You will be thinking of sandy white beaches, the heat of the sun on your body. And you won’t want to think of these dastardly matters any more.

[Story to be continued in my next novel.]

The Technicalities

Section 4999 of the Internal Revenue Code imposes a 20% excise tax on any person who receives an “excess parachute payment.”

An “excess parachute payment” is the excess of any “parachute payment” over the portion of the “base amount” allocated to it.

The “base amount” is generally an individual’s average taxable compensation from the corporation over the last 5 years, excluding the year in which the transaction occurs.

A “parachute payment” is any payment in the nature of compensation  made to or for the benefit of a “disqualified individual” that is contingent on a change in the ownership or effective control of a corporation, or the ownership of a substantial portion of the assets of a corporation, if the aggregate present value of such payments equals or exceeds three times the disqualified individual’s base amount.

Payments are “in the nature of compensation” if they arise out of an employment relationship or are associated with the performance of services.

For example, in the above scenario, if a founder had been fully vested in the shares for several years before the transaction, the transaction consideration he received for those shares  would not be a payment in the nature of compensation.

If, however, the founder’s shares, or some portion of them, were subject to the service-based vesting that was accelerating on the M&A deal, the acceleration of that vesting could give rise to 280G problems.


A “disqualified individual” is generally a service provider who is an officer, shareholder, or highly compensated individual (within the meaning of the Section 280G rules)


What Can Founders Do?

Unfortunately, sometimes founders get caught up in Section 280G complications. This can happen if a founder’s shares have not fully vested and are vesting on a deal. It could also happen if a founder is receiving a significant bonus payment in connection with the deal–for example, a retention bonus. It can also happen if the founder received a stock or option award within a year of the deal. Unfortunately, for founders, sometimes there is no escape from having to pay the excise tax unless the payments are disclosed and made subject to forfeiture if more than 75% of the disinterested shareholders don’t approve them in a separate vote.

The Lessons

If you are selling your corporation, engage with tax counsel early on in the deal on Section 280G questions. Don’t put off data sharing with counsel until the deal has progressed, because even though you might think you don’t have a problem–you might, and you should figure this out as early as you can in your process.  Also, your transaction agreement probably contains a representation that no excess parachute payments will be made in connection with the deal.  A breach of that representation can result in an indemnification claim by the buyer.

The Public Policy Lessons

Section 280G is a bad law for startups, because founders usually work for years for little or no pay. There are exceptions from 280G for S corporations (and C corporations that could make S elections) and for companies classified as partnerships for tax purposes.  The Congress, however, ought to pass an additional exemption for startups with less than a certain amount of assets (say, a billion). Section 280G is also bad because it unduly complicates transactions. We need simpler, less complex, less onerous laws.

*Section 4999 imposes the 20% excise tax on persons receiving the excess parachute payments. Section 280G denies a tax deduction for any excess parachute payments made. Colloquially, people use 280G to refer to both of these tax consequences.

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Section 1045: Let’s Fix It

Amend Section 1045If Congress is on the hunt for ideas to make life better for startups and emerging growth companies, here is another:

“Amend Section 1045 of the Internal Revenue Code to extend the 60 day rollover period to 6 months.”

First Off, What Is Section 1045?

Section 1045 is a tax code section that allows non-corporate taxpayers to rollover their gain on qualified small business stock, into other nonqualified small business stock. I’ve quoted the first part of Section 1045 below.

Why is Section 1045 important? Section 1045 is to startups what Section 1031 is to real estate. It encourages investments into startups. A noble objective!

Here is the operative provision I am recommending be amended:

    (a) Nonrecognition of gain
In the case of any sale of qualified small business stock held by a taxpayer other than a corporation for more than 6 months and with respect to which such taxpayer elects the application of this section, gain from such sale shall be recognized only to the extent that the amount realized on such sale exceeds—
(1) the cost of any qualified small business stock purchased by the taxpayer during the 60-day period beginning on the date of such sale, reduced by;
(2) any portion of such cost previously taken into account under this section.
    This section shall not apply to any gain which is treated as ordinary income for purposes of this title

Why Amend It?

60 days is a very short window in which to find a replacement investment. If you have ever done angel investing, you will know. To find and close an investment in 60 days is not an easy task. Usually investors hunt for months before they find an investment that they like. Then the paperwork to effectuate the investment can sometimes take weeks as well, if there is back and forth on various business points as the deal is negotiated.

In short, the Section 1045 statute exposes a lack of understanding on the part of the drafter as to how these transactions work. You can’t just call your broker and place an order. Most angel investments are not effectuated through a broker-dealer (which is one of the flaws of the crowdfunding bill–forcing companies who want to crowdfund to work through a broker-dealer).

Conclusion

We need is a Congressional representative to introduce a bill extending the 60 day window to 6 months. Very simple. Could someone please do this?

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Guest Post: Global Expansion for Startups

Guest post by Steve Wilson, Osborne Clarke

One of the clearest trends in recent years is that overseas expansion is becoming a consideration for every business almost from the point of start-up onwards.  It used to be the case that you wouldn’t need to worry about overseas operations until you had a minimum of 3 rounds of funding under your belt, but those days are gone.  The internet is truly viral and the result of that is that anyone anywhere can access your website and buy your goods or services.  Unless you pro-actively restrict access to US residents only (or in certain countries, the government will kindly put the restrictions in place for you!), you are likely to receive interest, orders and even complaints from customers located outside the United States.

If your business is focused on B2B transactions, then you face fewer issues than if your customers are consumers.  Corporate customers will often be willing to trade on your terms of service, deal with the import and trade regulations and comply with the local tax themselves.  They will however, also insist that products delivered comply with local safety standards, include adequate labeling and packaging and are fit for them to onward sell.  Care must be taken on the contractual arrangements entered into with resellers, to avoid claims that they are employees or protected by other laws (in Europe, commercial agents have rights to compensation on termination).

If your business deals with consumers, then the level of compliance increases significantly.  In Europe, each country has its own laws, language, currency, taxes and culture: all of these combine to create numerous hurdles which most start-ups are neither equipped nor interested in dealing with.  As a result pragmatic approaches need to be taken to reduce risk, whilst while servicing customers and attempting to grow markets overseas.  Many tech companies approach these barriers by looking to comply across regions, rather than countries.  Although Whilst it’s not perfect, it does allow an element of compliance, recognizes that certain steps needs to be taken to protect consumer rights and provides a first line of defense if a serious complaint is made or action by an overseas regulator is taken.

To this point, it’s been assumed that there is no physical presence in-country.  As soon as an employee is engaged, a number of additional filings, registrations and steps need to be taken.  One of the most basic errors that companies make taken when expanding overseas is to assume that doing business must follow the same approach as at home.  This could not be further from the truth.  Not only does the concept of employment-at-will not exist in Europe, but employees have numerous rights and are well known for using them.  Incentivizing employees in the US through the issue of stock options is often vital in the war on talent: in certain overseas countries, it is neither expected nor advisable.  Tax rules can often make cash bonuses a better (and simpler) alternative or sometimes, with some basic amendments you can amend your US stock plan to be tax-efficient for overseas employees.

Setting up overseas subsidiaries is often advisable and needs adequate preparation on what entity to use, how long it will take and how much it will cost.  Each country has different filing requirements, many of which are the responsibility of the local directors.  Sometimes, the Board can be made up of parent company officers and other times a local resident must be on the Board or appointed to a particular position.

Not surprisingly, covering such a wide topic in a single blog is impossible.   However, hopefully the above illustrates the need to prepare, take proper advice and consider what approach you want to take to overseas sales.  There are lots of pitfalls for the unwary, but there are also lots of resources to help guide you through unfamiliar territories.  The world really is getting smaller, so it’s worth recognizing that from the word go!

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The Rule Against Entrepreneurs

You may have heard of the Rule Against Perpetuities. Maybe. If you went to law school. It is an absurd old rule, crafted by the English common law courts years and years ago.

But have you heard of “The Rule Against Entrepreneurs”?

Maybe not, because I am just coining the phrase right now.

Let me explain what I mean

If You Are An Investor, You Can Advertise That

If you are a venture capital fund, you can put up a sign on the side of the road which says–”Come to us startups. We have billions of dollars to invest in you. We are looking for the few, the select few, who are awesome.” This is a good strategy. This way, if you have the money, you can take a look at thousands of businesses before you decide which few you will invest in–increasing your likelihood of success.

But if you are an entrepreneur, and you put up the same sign, but it says: “Come to me. I have a startup. I need to raise money to grow my business and hire employees.” You will have violated the law and might go to jail. The SEC takes this sort of thing (a transgression in their eyes) very seriously.

This is what I mean by the “Rule Against Entrepreneurs.” (In keeping with the absurdity of this rule, hereinafter the rule will be referred to herein as the “Rule”)

The Rule gets even more ridiculous. It doesn’t just prohibit road signs. It prohibits putting on your company’s website a statement that you are raising money. It prohibits responding to a reporter’s inquiry–”Are you raising money?” Don’t say yes! If you do, and the reporter reports it, you might blow your securities law exemption.

The Actual Text of the Rule

Here is the actual text of the rule:

[N]either the issuer nor any person acting on its behalf shall offer or sell the securities by any form of general solicitation or general advertising, including, but not limited to, the following:

1. Any advertisement, article, notice or other communication published in any newspaper, magazine, or similar media or broadcast over television or radio; and

2. Any seminar or meeting whose attendees have been invited by any general solicitation or general advertising;

If you want to read the rule yourself, you can find it at this link: http://taft.law.uc.edu/CCL/33ActRls/rule502.html

Read The Rule Carefully

Read section 2 above carefully. If you are pitching for money at an event whose attendees have been invited by any general solicitation or advertising, you have violated the rule!

“Wait a minute,” you might say. “Doesn’t this happen all the time?” And I would say something lawyer-like, like, “Yeah, but that doesn’t mean it doesn’t violate the rule.”

“But wait!” you’ll say, “Didn’t the JOBS Act change this? Didn’t the JOBS Act say that entrepreneurs could generally advertise in all accredited investor Rule 506 offerings?”

And I’ll say, “Yes, it did, but not until the SEC Acts, and the SEC hasn’t got around to it yet. The last SEC commissioner apparently was ideologically opposed to repealing the Rule Against Entrepreneurs. So now we wait. And wait. And wait….”

Conclusion

When will we see Congress finally unleash the full power of the American entrepreneurial community? Probably never. It is a weird incongruity in our law. It is the startups that create the jobs. But the laws favor the money, not those seeking the money.

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