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Housecleaning for Businesses: Preventing the Inopportune Eruption of Explosive Issues

09.21.2005

Introduction
Why Your Business Needs Housecleaning
I. Maintenance of Current Address on The Records of the Secretary of State
II. Dissolution of Corporation by Proclamation
III. Recorded Liens and Judgements
IV. Withholding Taxes
V. Employees Versus Independant Contractors
VI. Strict Maintenance of Employee Welfare Plans
VII. Partner Buy-outs
VIII. Restrictive Covenants
Simplified Corporate Due Diligence Checklist

Introduction

The owners of a closely held corporation (or limited liability company) are often the chief cook and bottle washer. They handle everything from overseeing operations, to marketing, to accounting, to dealing with regulatory matters--on down to making the coffee. While the owners are overburdened attending to these numerous tasks, dust is collecting on the corporate records, the company's agreements are being overlooked and no one is paying attention to the corporate handbook. But that is the least of the concerns: unknown issues are festering, just waiting to explode, and at the most inopportune times. These forgotten and overlooked issues, documents and policies, once they do rise to the surface, have the potential to send the company reeling, and divert the attention of the owners and employees for days on end. They could cost the company a great deal of money. We address those areas with the greatest potential to damage the small business, and provide the owners with ideas for avoiding or minimizing these headaches. We also explain how to get the corporate records in order to enable the owners to deal with business partners, employee relations, suppliers, customers and regulators.

When we talk about Housecleaning for Businesses we mean that every business has to be aware of the procedures it must follow to keep its corporate records in order, that it must be aware of the terms of its binding agreements to remain in compliance, that it should be aware of ways to minimize hazards and risks to its business, that it should be aware of steps it can take to preserve its assets and business from outsiders or defecting employees. We provide suggestions on what records and issues need to be addressed, first as a means of preventing disaster, but also as a way to protect assets, ready the business for an audit or prepare the business for a valuation, or even a sale. We show the business owners what has to be done and how to do it. Addressing these matters at least once a year will save the company a great deal of money and time later on. It's like preventive medicine: everyone should do it to make sure that problems are caught early, and when problems are uncovered they get the attention they need at the earliest possible moment.

WHY YOUR BUSINESS NEEDS HOUSECLEANING

1. You are looking to sell your business or you have received an offer to purchase your business: You need to do to get your business in shape for a sale.

2. The IRS, the Department of Labor, your state taxing authority, the Department of Homeland Security or some other agency has sent you an audit notice, and you need to get your records in order, in a hurry.

3. A business partner has retired or, tragically, died unexpectedly, or just wants to sell his interest in the company. You need to figure out what your business is worth and what to pay for your partner's interest.

4. You may have neglected some issues either intentionally (matters get placed on the back burner, rarely to see the light of day), or unintentionally (you didn't know what you didn't know), and those issues are now coming back to haunt you.

5. Someone may have filed a lien or obtained a judgment against your company, and you didn't even know it: you need to know, and you need to know what to do about it. You ask how can this happen?

  • They filed it illegally; or
  • They served the secretary of state with a summons and complaint, and the secretary of state mailed it to an old address because you never updated your address on the secretary of state's records.

6. Your corporation was declared dissolved by the secretary of state for failure to file all returns and forms, and now you are operating without limited liability.

7. You have failed to keep your insurance at appropriate levels, leaving you dangerously exposed, or you have failed to obtain coverage that has recently become available which for a few dollars can protect your business from multi-million dollar liabilities.

8. You find yourself on the wrong end of an employment discrimination or sexual harassment lawsuit because you did not have basic procedures in place to protect your company.

9. Your key lieutenant opens up shop down the block with your key customers, and you did not have the proper restrictions in place to prevent this from happening.

10. You are leaving money on the table because you failed to review your agreements on a periodic basis, and failed to enforce rights that you forgot you even had.

11. You get a cease and desist letter claiming that the trademark you've been using for the past six years infringes someone else's rights, and you are looking at an enormous public relations problem, not to mention the cost of changing your trademarks.

I. MAINTENANCE OF CURRENT ADDRESS ON THE RECORDS OF THE SECRETARY OF STATE

PROBLEM: Your New York certificate of incorporation (or certificate of authority, if the corporation was formed in another jurisdiction) appoints the New York Secretary of State as agent for service of process. The certificate identifies the address where the Secretary of State mails a copy of any process he receives. If there is a failure to keep the mailing address current, the corporation will likely fail to receive notice of any court action, resulting in a default by the corporation and potential damages.

SOLUTION: Make sure your address with the Secretary of State is current. You can check the registered address online at the Secretary of State's web site.

Instructions for checking the registered address online:

  • Go to the Secretary of State's web site: www.dos.state.ny.us.
  • Click on 'Search for Corporations or Business Entities.'
  • Type in the beginning of your corporate name in the box 'Entity Name' and click on 'Search the Database.'
  • Check for your corporation's name.
  • When you find your corporation, click on the name, and a screen will appear showing all the corporate information on file with the Secretary of State. Listed will be 'DOS Process' showing the address where the Secretary of State will send copies of process. This may be your corporate office, your attorney's or accountant's office or an agent's office. If the address is not correct (or if you wish to change the address), you will need to file a Certificate of Change with the Secretary of State, and you will need to do that immediately.
  • If after clicking 'Search the Database' you do not see your company on the list, make sure you typed in the correct name. You can change the search to a search that contains any part of your corporate name (changing the default search from 'Begins with' to 'Contains.') If you still do not find it, change the search to 'All' rather than the default of 'Active.' You may be getting into problem areas here, and you will need to find out why your corporation is not listed.

II. DISSOLUTION OF CORPORATION BY PROCLAMATION

PROBLEM: The corporation has been dissolved by proclamation of the Secretary of State, and you don't know it.

The effect is that you are no longer operating with limited liability, and the actions you thought you were taking on behalf of the corporation are illegal.

REASONS: Most likely, a failure to file correct tax returns or required corporate filings.

SOLUTION: Again, you can find out from the Secretary of State's web site what the status of your corporation is. Follow the same steps as above, and you will find out if your corporation is active. If it is not showing as active, then you or your professional must contact the Secretary of State's office and determine the source of the problem.

The good news is that in most instances you can re-instate the corporation and ratify the acts taken while under suspension. But this will require filing of all delinquent statements and payment of all outstanding fees, taxes and penalties.

III. RECORDED LIENS AND JUDGMENTS

PROBLEM: Someone filed a lien or obtained a judgment against the corporation, and you don't know it. There are mainly four categories to concern yourselves with: UCC lien, tax lien; mechanics' lien and judgments. These can all be problematic, first if you want to borrow money, since your lender will insist that you clear up any prior liens, second, if someone tries to enforce the lien or judgment and, third, if you want to sell your business.

SOLUTION:

UCC Liens: These are liens filed under Article 9 of the Uniform Commercial Code, and are based on your granting of a lien to the lienholder and on your agreement that the lienholder may file a financing statement. This would include liens filed by your bank or equipment vendors. If your corporation was formed in New York, you can check the New York Secretary of State's web site for recorded liens. Liens are now filed where the entity was formed, not where it has its headquarters or even where the inventory is located. The revisions to Article 9 no longer require the debtor to sign the UCC filing form, so you need to pay particular attention to unwanted filings.

Instructions for searching for a UCC Lien online:

  • Go to the Secretary of State's web site: www.dos.state.ny.us.
  • Click on 'UCC' on the menu on the left side of the home page.
  • Click on 'UCC Search.'
  • Click on 'NYS Standard Debtor Search.'
  • Type in your exact corporate name, ignoring only 'Inc.' or 'Corp.' This will take you to a page listing all filed liens against your company.

Tax liens, mechanics liens and judgments: You will need to engage a search service to determine whether you have any of these types of liens. The mechanics lien, arising from materials delivered to or work performed on your premises, must be enforced by the holder within a relatively short period of time, at most one year, so it is unlikely that such a lien will be of record for too long without your knowledge. However, the presence of a lien is likely to violate the terms of your lease since a landlord does not want liens on its building.

A judgment does not have to be enforced for ten years so it could present a problem. It is also good to know if someone obtained a judgment without your knowledge since there may be steps you can take to get the judgment reversed. Also, a judgment creditor can take steps to enforce its judgment, such as freezing your bank accounts.

A tax lien signifies a serious problem with the IRS. You want to get that cleared up quickly in order to stop penalties and interest from running and to prevent the government from taking steps to levy on your property.

IV. WITHHOLDING TAXES

PROBLEM: You fail to pay all of the required employment and withholding taxes, either because you have better things to do with your cash or because you think someone who does work for you is an independent contractor.

SOLUTION: If you are not paying withholding taxes, PAY THEM!! This is priority number one. Do not divert cash from this obligation. The IRS goes after delinquencies aggressively. And they hold the persons in the company who are responsible for payment PERSONALLY LIABLE for the tax and for penalties, which can be 100% of the tax.

If you are not withholding because you believe that person who is doing work for you is an independent contractor, examine this relationship very carefully, because the penalties apply and you can be held personally liable even if you innocently believed that person was an independent contractor when he or she was not.

V. EMPLOYEES VERSUS INDEPENDENT CONTRACTORS

PROBLEM: Someone performs work for you and you agree that he or she will be treated as an independent contractor, either innocently or perhaps as a means to avoid the ramifications of making him or her an employee.

SOLUTION: Examine these situations carefully. Not only do you have to face the tax issues noted above, but other consequences may flow from an incorrect designation, including improper inclusion or exclusion in retirement, medical and other employee welfare plans. Unfortunately, in close situations, there is no magic way of knowing which side of the line you may fall on. There is the historic 20 factors test from Revenue Ruling 87-41 which still has vitality. Generally, it comes down to a matter of control, control over how and when work is performed, compensation arrangements and ability to hire and fire.

The IRS position is set forth in its regulations which state: 'Generally such relationship exists when the person for whom services are performed has the right to control and direct the individual who performs the services, not only as to the result to be accomplished by the work but also as to the details and means by which that result is accomplished. That is, an employee is subject to the will and control of the employer not only as to what shall be done but how it shall be done. In this connection, it is not necessary that the employer actually direct or control the manner in which the services are performed; it is sufficient if he has the right to do so. The right to discharge is also an important factor indicating that the person possessing that right is an employer. Other factors characteristic of an employer, but not necessarily present in every case, are the furnishing of tools and the furnishing of a place to work, to the individual who performs the services. In general, if an individual is subject to the control or direction of another merely as to the result to be accomplished by the work and not as to the means and methods for accomplishing the result, he is an independent contractor. An individual performing services as an independent contractor is not as to such services an employee under the usual common law rules. Individuals such as physicians, lawyers, dentists, veterinarians, construction contractors, public stenographers, and auctioneers, engaged in the pursuit of an independent trade, business, or profession, in which they offer their services to the public, are independent contractors and not employees.'

VI. STRICT MAINTENANCE OF EMPLOYEE WELFARE PLANS

PROBLEM: There are numerous rules and regulations governing the operation of employee welfare plans. Violations of these rules and regulations can lead to severe consequences.

The IRS position is that a plan loses its tax-qualified status if it is not operated in accordance with its terms. Plans can also be disqualified if the terms of the plan document fail to accurately reflect the changing requirements of law or if the plan's coverage does not meet the coverage and nondiscrimination tests. When a plan loses its tax-qualified status, there are consequences to the plan sponsor, the plan participants and the trust that holds plan assets. The plan sponsor loses all or a portion of its deduction for contributions to the plan for the open tax years. The plan sponsor also may be liable for the failure to withhold and pay income and employment taxes. Where the violation involves nondiscrimination rules, highly compensated employees could find their entire account balances immediately and fully taxable. The trust could lose its tax-exempt status, and trust earnings could become taxable for the open tax years under the rules that apply to complex trusts.

SOLUTION: Make sure you have hired competent professionals for all aspects of your plans: formation, qualification, administration and discrimination testing. In addition, for retirement plans, how your plan is invested is a crucial element both in your compliance with your legal obligations to the plan participants and in the plan's value as an investment and retirement tool. You should also consider an outside audit (plans with a certain number of participants are required to be audited) to make sure your plan is in compliance before the IRS audits your plan and uncovers costly errors.

VII. PARTNER BUY-OUTS

PROBLEM: Your partner decides he wants to retire, becomes disabled or tragically dies. You have no plan in place to buy him out. You have no shareholder agreement in place to deal with these situations, you are not properly insured and you may end up with your partner's heirs as your partners.

SOLUTION: There is no simple solution, but open communications between partners is essential. The worst mistake is to ignore these situations. Every closely-held business should have an agreement in place to deal with the retirement, disability or death of its owners. Every situation is unique, and there are many ways to value an owner's interest, but the key is to find a solution and a valuation that is fair to the person who is leaving the company and to the owners who stay behind to continue to run the company. There are all sorts of formulas used to value a business, but one often overlooked factor is whether the formulas are properly adjusted to take into account the changes in the company resulting from the owner's departure.

VIII. RESTRICTIVE COVENANTS

PROBLEM: You come into work one day to find that your trusted office manager has quit and opened a competitive business down the street.

SOLUTION: In this complex and emotionally charged situation, there are steps you can take before you are ever faced with this problem, and steps you can take afterwards, to minimize the damage. However, you must understand that in our society, everyone is entitled to compete freely. Where the courts will step in is if an employee steals your property, including your trade secrets, or takes customers who you have spent a great deal of time and money cultivating.

There are several steps you can take to minimize this problem, before it occurs:

  • First, obtain agreements from each of your key employees restricting them from using your trade secrets and company's sensitive information and from opening a competitive business within a reasonable area and timeframe;
  • Second, use all reasonable means to protect your trade secrets and company's sensitive information from dissemination and disclosure;
  • Third, track your efforts at client development, including identification of source and the efforts of each employee in client development. Take steps to protect your client lists and key client data.

Whether or not you have taken these steps, if you find that a key employee has opened up a competitive business down the street, you may be able to stop him or her from doing too much damage, but it is going to require getting into court as quickly as possible. Your strongest weapon is going to be proof that the former employee has taken valuable – and protected – company information. You can argue that if he or she is not stopped, you will suffer severe damage to your business. If you can get an injunction relatively quickly, it will put you in a much better negotiating position. If you do not get an injunction, or if you get one but the former employee has the resources to fight you, then the facts and circumstances will be decisive in determining to what extent a court will provide you with protection.

SIMPLIFIED CORPORATE DUE DILIGENCE CHECKLIST

Click here for Simplified Corporate Due Diligence Checklist.

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