Avoiding Disputes for Small Business and How to Handle Unavoidable Conflict

Avoiding Disputes for Small Business and How to Handle Unavoidable Conflict 

by Elizabeth A. Brown

Sowerby Law Office, PLLC

An Ounce of Prevention

                Business disputes are one area were an “ounce of prevention is worth a pound of cure.”  I have seen many small business disputes escalate into the tens of thousands of dollars because the parties did not have a written agreement, the agreement failed to include important terms, or worse still, contained blanks. Sometimes the parties have attempted to avoid paying the attorney by drafting their own agreement or taking a form off the internet.  Unfortunately, the parties don’t anticipate the types of issues that arise or they choose the wrong forms or fail to complete them correctly.  A properly drafted agreement would have saved the parties a lot of money in the long run and would have avoided the significant distraction that occurs because of the dispute.

Business Formation       

Many times start-ups and entrepreneurs want to move quickly in getting their new business up, running and turning a profit so they don’t want to get bogged down in the details such as:  determining the percentage of overall ownership interest between the partners; ownership of intellectual property; putting a value on services versus monetary capitalization. Decisions need to be made at the time of formation about how the business relationship is going to work:  how will ownership be determined; what is the time commitment expected from the partners; what are the roles of the partners; who will be in charge of making decisions; how will partners be paid for their efforts on behalf of the company; and how will company profits be divided.  Decisions on these issues should be memorialized in the limited liability company operating agreements, guaranteed payment agreements, employment agreements, and services agreements.

 Likewise, start-ups need to make sure that they have necessary intellectual property licensing agreements and non-compete agreements to protect the intellectual property that the business depends upon. All of these important documents need to get executed before the business opens its doors. Getting the parties to agree to these issues upfront can be tricky, but getting the parties to agree to these terms after the fact is far more difficult – and sometimes impossible – and results in litigation.

Avoiding Internal Business Disputes    

   Litigation can be emotionally exhausting for the owners of a small business and may be a distraction to the parties and a drain on the bottom line.  In the same way that divorce destroys a family, a partnership dispute can destroy a successful business. The best way to avoid conflict between business partners is to: 

Ø  Have a written agreement that thoroughly determines how important issues will be decided

Ø  Have a written agreement that sets forth the role and requirements of each partner

Ø  Regularly communicate and share financial and other business information and data

Ø  Hold regular meetings so that the partners are aware of business operations and the financial status of the business

Alternative Dispute Resolution

Sometimes, despite everyone’s best efforts to plan ahead to avoid conflict, disagreements arise.  Often when the small business partner meets with their attorney and determines how much that litigation will cost him or her; they decide that there has to be a better way to resolve the dispute. 

Alternative dispute resolution (ADR) developed, as a means of avoiding much of the costly and time-consuming litigation procedure. The goal of ADR is to allow the parties to engage a person or persons (a third party neutral) to assist the parties in reaching a settlement without having to go through the complex and expensive pretrial litigation discovery and trial. There is no one ADR process or procedure.  Parties can decide what methods to use. For example, if the dispute involves a construction company, the parties might choose to select the owner of another construction company to serve as the third party neutral. Two popular methods of ADR include arbitration or mediation. 

Arbitration is an agreement between parties to allow a third party, called an arbitrator, to evaluate each party’s case and make a decision regarding the dispute between the parties.  Arbitration can take many forms, including that of a mini-trial where each party can call witnesses and bring in a court reporter so that testimony is under oath.  The parties can agree for arbitration to be binding or non-binding. If the arbitration is non-binding, the arbitrator’s decision is merely a recommendation of how the parties should resolve the conflict.

Mediation, on the other hand, is a negotiation led by a third party who can provide an objective analysis of each party’s side of the dispute.  Mediation is not binding, so either party can end the negotiation and there is no requirement that the parties settle.  The mediator can use any method that the feel will be beneficial to resolving the dispute.  The mediator may choose to talk to both sides together or may use shuttle diplomacy to help the parties reach consensus.  A successful mediation results in neither side feeling that they have “won” nor “lost.”

If you are thinking of starting a new business or are a small business owner and do not have the necessary business agreements in place or if you find yourself with a dispute with your business partners, please contact me to learn about options available for your business.

Multi-member LLC vs Single Member LLC

Why is the Liability Protection Greater?

A limited liability company ("LLC") provides a certain amount of liability protection that is very similar to the protection offered by a corporation. For example,  Samantha buys shares in ABC, Corp.;   ABC Corp goes bankrupt and Samantha loses her investment. However, as we all know, ABC's creditors cannot attach Samantha's other assets- her home, bank accounts, etc are safe from ABC's creditors. The same will hold true if instead of ABC Corp, Samantha buys shares in XYZ LLC. She will lose her investment but nothing else.

However, if the reverse happens: Samantha's assets are attached by a creditor, are the subject of a divorce action or a lawsuit,  then her creditors will be able to access all of her assets including her stock in ABC Corp. If that happens, whomever ends up with the stock will receive the dividend, attend meetings and vote her stock. That would not happen if she owned the shares in XYZ LLC because of a legal theory known as "Choose your Partner." LLC law is at least partially derived from partnership law. (In fact, the NH LLC Act, RSA 304-C, is found under the title "Partnerships" along with the law on limited partnerships, general partnerships, etc). This theory is that if Samantha enters into an agreement with Bob and Ted to invest in a business venture, SBT Investments, LLC, Bob and Ted had no intention in being partners with Samantha's soon-to-be ex-husband or any other creditor. Thus, Samantha's creditors cannot take her membership in the LLC; what they can do is place a lien on any distributions from that LLC. This lien is called a charging order. The creditor may receive money originally destined for Samantha, but the creditor doesn't get to sit at the table and vote her membership rights. All of this is assuming that there are distributions to Samantha. If the LLC isn't making any distributions, the creditor does not receive anything. This concept is codified in the NH LLC Act at RSA 304-C:126. and that statute provides that a charging order is the sole remedy a creditor may bring against an LLC membership for debts not related to the LLC. Therefore, it can be said that an LLC offers more liability protection that a corporation because an LLC offers "two-way" liability protection while a corporation does not.

Okay, so how can this work with a single member LLC? There are no partners. However, there is no exception in most states for single member LLCs and no specific statutory protection for them either. It is assumed that single member LLCs get the same protection but there is always the risk that a court will find otherwise. The New Hampshire Act dealt with this in a manner that was hoped would clarify the issue but still give some protection to creditors. A single member LLC could not make any distribution at all but keep property that was appreciating and therefore a creditor might not ever receive anything- or at least not for a long time. RSA 304-C:126 specifically authorizes charging order protections for single member LLCs but then limits those protections to give some ability of legitimate creditors to challenge the protection if the creditor can show that the judgment cannot be satisfied in a "reasonable time." If the creditor is successful, a sale of the membership rights can be forced. See RSA 304-C:126 (VI).

For all of the reasons above, I frequently will recommend that clients wishing to form a single member LLC at least consider bringing in a spouse or an adult child for a minority interest. I usually recommend at least 18 or 19% if not a full 50%. The activities of the second member can be limited in a number of ways, including making the LLC manager-managed with the original founding member the manager. If the second member is not really going to participate much in the company, then I will try to keep the percentage ownership under 20% as that is the number at which many banks will require personal guarantees of the members. A really small percentage such as 1% or 2% may be seen as illusory so I want to keep the number up if at all possible.

Obviously, there be be downsides to bringing in a minority member and those potential pitfalls must be thoroughly discussed with the clients and one of those pitfalls for the attorney- a trap for the unwary- is the question of "Who is the client?" Does the attorney represent the person who originally approached him/her, both potential members or the LLC itself? Who can the attorney represent if the "partnership" breaks up- can the attorney represent any of the parties in that case or must s/he recuse and refer to another attorney? Another question is "What effect, if any, does a divorce have on multi-member LLCs involving spouses?"

Need Funding for Your Business? Can You Use Your 401 (k) or IRA????

Are you considering purchasing a business? Buying a franchise? Need money? There may be a pot of it in your 401 (k) or IRA. Can that be used? I am hearing lots of ads on the radio that promise a way to use your retirement accounts as a source of funding for a start-up or to purchase an existing business. Is it a good idea? What about the taxes and penalties for early withdrawal???




Here is generally the way it works: First, create a state law corporation or LLC that reports its taxes as a Subchapter C corporation. That means that the company will pay taxes as an entity rather than passing all profits/losses through to the owners. Generally used for larger companies and has serious tax implications. Please don't make this election without competent accounting and legal advice. Anyway, once you have the corporation set up, the company adopts a 401 (k) plan. You then join the company as an employee and also join the 401 (k) plan. You then roll-over your existing retirement account into the new plan which  promptly buys all of the stock of the new corporation. Now the plan has the stock and the corporation has the funds to buy the franchise or existing business. You have successfully taken money out of your retirement account without incurring the penalties or paying the income tax on the funds held by your IRA or 401 (k). Or have you?




If you think this sounds too good to be true, you are probably right! This plan or something similar is being promoted by franchise companies, brokers and promoters and it is possible that it could work. The IRS has indicated that while it is not per se unlawful, they do not like it. If done absolutely correctly- and you will need sophisticated legal and accounting counsel, not just the promoter- this may work but the complications are immense:

1. The first issue is that the overriding rule regarding these retirement plans is that the retiree is not supposed to gain a "benefit" from them until retirement at least 59 1/2 year old. Is there a direct benefit from this plan? Presumably so but maybe it is only an "indirect benefit."
2. The stock in the new company must be fairly priced otherwise this may be a prohibited transaction, not just an investment by the 401 (k). How does one determine a fair price? The best way would be with a qualified business appraisal but that can be expensive and most accountants and appraiser's will tell you that an accurate appraisal of the worth of a start-up is difficult if not impossible.
3. The investment in the stock must be a reasonable investment. If this type of investment was made by the trustee of your current plan, i.e., someone else invested your retirement money in a start-up, would you be pleased? Would you think that was appropriate? Enron anyone???
4.  Once the investment has been made, the franchise bought and the company is up and running, all employees must be given the right to participate in the 401 (k) plan and for their account to purchase company stock, other wise the plan is unlawfully discriminating. You could lose control of your own company.
5. Who will vote the shares in the new company? Presumably the Trustee of the 401 (k) plan. Who will that be? If that is you, the entrepreneur, you run the risk of a prohibited transaction. If it is not you, again, you run the risk of losing control of your own company.
6. Tax consequences: A subchapter C Corporation reports its profits and losses directly. Theoretically, profits (after wages, of course) are paid out as dividends to the plan. Taxes on those profits are presumably deferred as with all 401 (k)s. But what about losses? Most new business suffer losses, usually real but sometimes paper losses. These are advantageous to the investors as offsets to other income. Here losses will also go to the 401 (k) not the entrepreneur.  In addition, there is the very real possibility of double taxation both on operating profits but also when, and if, you sell the business.
7. This idea creates two distinct entities: the state law corporation and the 401 (k) plan. Each has its own rules and reporting requirements. A 401 (k) plan falls under the federal law known as ERISA (The Employee Retirement Income Security Act of 1974 (ERISA) (Pub.L. 93–406, 88 Stat. 829, enacted September 2, 1974, codified in part at 29 U.S.C. ch. 18)). This law is very complicated and it takes a lawyer and accountant who concentrates in this area to truly understand it and properly advise you.. Not every lawyer or accountant is competent to offer advice or to provide the reporting necessary. Again, please do not lean solely on the broker or promoter for advice- thee have a vested interest.
8. And last but not least, a large number of new business fail. If this new business fails, you will have lost your retirement account and you may then be subject to taxes, fines and penalties from the IRS with no money with which to pay!

In summary, this kind of financing may work but it is not for the unsophisticated investor nor for the faint of heart. If you are considering such a plan, please, please, seek advice from a competent attorney and accountant. Do not rely solely on the promoter or franchise company!

Medicaid Estate Recovery- the Problem with Expanded Medicaid 

Expanded Medicaid Could Cost Some People their Inheritance

As many of you know, the State of New Hampshire is allowed by federal law to file liens against property and to recover from the estates of Medicaid recipients who have died. See ww.dhhs.nh.gov/oos/eru/index.htm for an explantion of how this works normally. Such liens and recoveries are only for Medicaid recipients who are age 55 or older. Your estate assets for this purpose include assets in the name of the estate, most assets held in joint tenancy, revocable trusts and most life estates.

Federal Law: Medicaid Agencies may (but are not required to) file liens against such assets as part of the eligibility process except in the case of the family home if he or she is reasonably expected to be discharged and to return home, 42 U.S.C. § 1396p(a)(1)(B)(ii) (and some other exceptions)

Those of us who work in Elder Law are well familiar with this in the nursing home context. However, the same concept applies to those who receive Medicaid help from several other programs such as Aid to the Permanently and Totally Disabled (APTD) cash assistance and/or from individuals who have received OAA, ANB, Medicaid for Employed Adults with Disabilities (MEAD), or APTD medical assistance (Medicaid).

Expanded Medicaid

So how does this work with Expanded Medicaid? Under the Affordable Care Act (Obamacare), the states had the option of accepting an expanded version of Medicaid. The idea was that while the very poor had Medicaid for health insurance, there were those who could not afford private health insurance even with the ACA subsidies. Accordingly, those people with an income (MAGI- Modified Adjusted Gross Income) of 138% of the federal poverty limit can be eligible for Medicaid to purchase health insurance through the ACA Exchange for them. As noted, there are income limits but no asset limits. Thus, recipients may well own homes or other assets but have fairly low income levels.If the recipient is between the ages of 55 and 65, the State of New Hampshire can recover any amounts paid on the recipient's behalf from his/her estate.

With monthly premiums for the Exchange insurance, this can add up in a hurry.

Managed Medicaid

Managed Medicaid raises the ante. With managed Medicaid, the State of New Hampshire pays a flat fee (called a capitated fee) to a management company for case management. The cost of case management is also a cost recoverable from the estates of the recipients. So even if the recipient is healthy and never actually receives medical treatment, the cost of the insurance and/or the cost of the case manager may by recovered from the estate. Such recovery may be well in excess of the total value of the estate. 

What to do?

One possible solution is to gift property now, either to children or to a properly drafted irrevocable trust. Since assets aren't counted, there is no look back period. This, of course, runs the risk that the individual will require nursing home care before the end of that look back period- 5 years or 60 months. If so, that person will be deemed disqualified from Medicaid for a period of time equal to the value of the asset transferred. If that happens, only a hardship appeal can offer a chance of receiving proper care.

Several states have changed their rules and will not pursue estate recovery in this situation. New Hampshire has so far not changed any such rule.

If you or a family member are between the ages of of 55 to 65, and you are eligible for Expanded Medicaid ,you should consult with a competent Elder Law Attorney

Limited Liability Companies (LLCs) - the Basics for Small Businesses

If you are a small business- one to five people who wish to join to together to run a business- you probably will want to create a Limited Liability Company or LLC. In fact, you may have already done so. It is incredibly easy. All you need to do to create an LLC is to fill out a very simple form( called a Certificate of Formation) and file it with the New Hampshire (or whatever state you wish) Secretary of State, along with a registration fee of $100.00. You need only state the name of your new company, address, name of registered agent, whether or not it will be managed by a manager or by the members,  and the purpose. You also need to answer a couple of questions regarding the sale of membership interests. Voila! you have a Limited Liability Company.

Do You Need A Lawyer to Form an LLC

As you can see from the process above, the basic steps are simple and do not require a lawyer. However, (isn't there always a "however"?) you may want to reconsider that decision, especially if there are two or more of you. I have highlighted some of the issues in the sections below.

Operating Agreement

An operating agreement is to an LLC what a partnership agreement is to a partnership. The agreement sets out the understanding between the members as to what the company is going to do, the rights and responsibilities of each member, the capital contributions expected of each member, how the company will be managed, voting rights and how profits and losses are to be allocated. it should also detail if, and how, membership interests can be transferred. If there is never any misunderstanding or dispute, the operating Agreement will probably never come out of whatever file drawer you put it in. That is not reality, however. A well-written agreement will be worth its weight in gold should the day ever come when there is a disagreement and one or more members want out.  Even if you are the sole member of an LLC you may want to have a well-written operating agreement.

What if I do not have an Operating Agreement?

You will have such an agreement. If you do not have one that you approved and signed, you will have one the State of New Hampshire has written for you. The statute enabling LLCs, RSA 304-C, has fifty or more provisions that start with language such as "Unless a written operating Agreement provides otherwise..."

One such example is RSA 304-C:110. This section states that unless the operating agreement provides otherwise, a member may not compete with the company. This may be fine for many companies and exactly what you would expect. However, if you have members who are passive investors, they may not want to be restricted in that way. Real estate investors, for example, may want to invest in similar properties that could be construed as competing.

Oral Operating Agreements

RSA 304-C:40 states " An operating agreement may be written, oral or implied by a course of dealing or otherwise."  This means that if you have orally agreed to certain practices or even if you have never really discussed how you operate, you may still have an enforceable Operating Agreement. Granted, this may be tough to prove, but a written agreement would go a long way towards disproving it. 

Operating Agreements as "Pre-nuptials"

One of the most overlooked features of an LLC is the potential for disaster upon the breakup of the "marriage" for often an LLC "divorce" is as financially messy as a marriage - and while an LLC dissolution doesn't carry the same potential for emotional trauma as a real marriage, it can be extremely hard on everyone involved. When drafting an Operating Agreement, due thought should be given as to how and under what circumstances a member may withdraw from the LLC.

Manager Managed or Member Managed?

One of the questions on the Certificate of Formation is whether the LLC will be managed by a manager or by the members. In most cases, small LLCs will probably be manged by the members. Member managed is the simplest form and should be used if the members actually do participate. Manager managed forms are usually used when there are passive investors, although I will sometimes used a Manager manged LLC for estate planning purposes. NOTE: I often see LLCs whose original Certificate of Formation states that it is not managed by a manager but sometime later, the annual reports are submitted using the title "Manager". This is sure to confuse a bank if that LLC is attempting to arrange financing. 

An Operating Agreement as an Estate Planning Tool

Another use of a written operating agreement is as an estate planning tool. A small business may be a very important part of an estate- many times the business is the primary asset. if that asset is tied up in Probate for an extended time, it may devalue quickly. Until someone is appointed Executor, there may be no one to make appropriate decisions. An operating agreement may include a "Transfer on Death" clause that simply transfers a member's interest to his/her beneficiary. Done properly, this may avoid probate. Another way to avoid probate would be to have the membership interest held by the Trustee of a trust, revocable or irrevocable. This, too, would avoid probate. These are somewhat sophisticated strategies and although they may be appropriate for even very small companies, they should not be used without counsel from an attorney experienced in both estate planning and LLCs. 

So Do I Need a Lawyer to Set Up My LLC?

If you can successfully draft an operating agreement that takes all of the above factors- and many more that I do not have time or space to list- into account, then maybe you do not. However, the lack of professional advice could prove to be far more expensive than the fee an attorney would charge. In short, yes, you do need an attorney!

This is a short overview of some of the issues surrounding LLC formation. It should not be construed as all-encompassing nor as legal advice. This blog cannot create a lawyer-client relationship.Each case is different and LLC formation will be fact specific, that is, what is right for one may not be right for another. Please consult a qualified attorney experienced in these matters.00

US Supreme Court: Inherited IRAs not safe from Bankruptcy!!!

The US Supreme Court recently ruled that inherited IRAs are not "retirement accounts" for purposes of bankruptcy protection. Normally, a tax qualified retirement account is not available to creditors in a bankruptcy action. The Court ruled, however, that an inherited IRA, that is, an IRA inherited from someone other than a spouse, does not qualify for such protection. See Clark v. Rameker 

What does this mean for estate planners? If a client has  a large IRA and wishes to provide a retirement pool for his or her heirs, an inherited IRA is a very good tool. However, if that IRA is available to creditors or if the heirs can take the money out prematurely- called a "blow out"- the plan may fail. An answer to this problem is an IRA conduit trust, sometimes called an IRA Trust,an IRA Beneficiary Trust,  an IRA inheritance trust, a stand alone IRA trust or an IRA protection trust.

If children and grandchildren who inherit IRA funds keep the funds in the IRA over their lives and 

only take the required minimum distributions each year (the “stretch-out”), the amount of money that can be earned, accumulated and paid to the beneficiaries can be staggering. To illustrate how this compounding can work, I have calculated how much money a beneficiary can receive from a parent's $100,000 IRA account; I have used two different ages (10 and 35) for the beneficiary and have assumed that the account averages an annualized 8% return: 

 

Age      Years Paid Out      Paid Out        Remaining in Account     Total 

35             49                  $1,223,584           $5,046                   $1,228,630 

10             70                  $4,279,898           $1,083,614            $5,363,512 

 

This wealth accumulation strategy only works if the beneficiaries retain the inherited funds inside the IRA account. If a beneficiary takes all of the funds out of the IRA account at the time of the client's death (called a “blow-out” because it blows the stretch-out), this wealth accumulation technique will be lost. One of the reasons to create an IRA Beneficiary Trust is because it can insure the stretch-out and can prevent a blow-out. This blow-out happens more often than you may think. The beneficiaries may not be aware of the tax rules and their distribution choices, so they may immediately withdraw the IRA's at the first opportunity (or worse yet, do a prohibited rollover!). If the “stretch-out” isn't done properly by the beneficiaries and income taxes are paid up front shortly after the IRA's are inherited, the heirs may lose hundreds of thousands of dollars (or more). Even if you assume that your beneficiaries will do the right thing (that is, keep the funds in the IRA account for their lives to maximize the income tax “stretch-out” of the IRA's), the IRA's may still be seriously exposed to one or more of the following threats that can arise years after: 

1. Divorce. 
2. Poor spending habits
3. needs-based governmental programs

The New Hampshire Legislature is considering a change in the statute authorizing a Durable Power of Attorney for Healthcare. The proposed change would create a new category of decision-maker: Surrogate (under the current statute, one who is authorized to make such decisions under a written Power of Attorney is an "Agent".) A Surrogate would be selected by the healthcare provider if an Agent or Guardian is not "available, willing and able to act".  The provider is expected to choose from a list of priorities in the statute. the list is:

                 a)  The patient’s spouse, or civil union partner or common law spouse as defined by RSA 457:39, unless there is a divorce proceeding, separation agreement, or restraining order limiting that person’s relationship with the patient.

                  (b)  Any adult son or daughter of the patient.

                  (c)  Either parent of the patient.

                  (d)  Any adult brother or sister of the patient.

                  (e)  Any adult grandchild of the patient.

                  (f)  Any grandparent of the patient.

                  (g)  Any adult aunt, uncle, niece, or nephew of the patient.

                  (h)  A close friend of the patient.

                  (i)  The agent with financial power of attorney or a conservator appointed in accordance with RSA 464-A.

                  (j)  The guardian of the patient’s estate.

There are numerous issues with this legislation starting with the fact that the Surrogate is chosen by an APRN or physician without input from the patient- the patient is incapacitated! The person chosen by the healthcare provider may or may not know the patient's wishes or may not wish to follow known wishes because of personal beliefs. I understand the need for such legislation because not everybody has a Durable Power of Attorney for Healthcare. Indeed, most new clients are quite surprised when I tell them that neither spouses nor adult children have any power under current New Hampshire law to make healthcare decisions for an incapacitated spouse or parent. I understand that we are one of only five states without such legislation. We do need some sort of Surrogate law. Indeed, I lobbied for such a law in the late 80's or early 90's. Hopefully, some of the issues with this legislation will be worked out before it becomes law. you can see the current text at HB 1434

The answer, of course, is to have a carefully considered Durable Power of Attorney drafted and executed. This way you choose who your Agent will be and you have the opportunity to have a conversation with that Agent to make certain that your wishes are known and respected. This is especially crucial in end of life decisions.

For more information, feel free to contact me at Sowerby Law Office, PLLC 603-249-5925 0r dwight@sowerbylawoffice.com