Ask the Startup Lawyer: Taxes and Lawsuits Edition

Clint Costa

February 28, 2013 · 5 minutes read

Uncategorized

Question #1: A friend of mine set up her company as an S Corporation to save on taxes.  How does that work?

Ahhh…the good old “save taxes with an S Corporation” trick. Not as old as a whoopee cushion, yet so much more refined than “pull my finger.”

So here’s the deal:

In a typical startup which is a S Corporation for tax purposes, the owners must be employees of the company. Once the company has revenues, the founders will pay themselves as employees. The result is that at the end of the year, each founder will receive a W-2 from the company just as if that founder was working for somebody else. Income taxes and employment taxes (Social Security and Medicare) are taken out of the founder’s salary, and the company also pays the employer’s share of employment taxes. Leftover profits are paid to the owners as dividends which are subject to income taxes, but not subject to employment taxes.

In a typical startup organized as an LLC (which is taxed as a partnership), the owners are not treated as employees and do not receive a W-2 at the end of the year. The owners receive either guaranteed payments (not dependent on whether the LLC makes money) or partner draws (technically, a share of LLC profits). In either case, the money that each owner receives as guaranteed payments, along with the owner’s share of profits, is subject to self-employment tax. The owner pays the self-employment tax entirely, which roughly equates to the employee and employer share of Social Security and Medicare.

In theory, the tax savings opportunity here is that if your startup is a S Corporation, you can minimize your salary (which is subject to employment taxes) and maximize your dividend payment (which is not subject to employment taxes). On the other hand, in an LLC taxed as a partnership, every dollar of guaranteed payments plus profits is subject to self-employment tax.

But hold on before you get your S Corporation conversion paperwork ready.

First, it’s an unintended fluke of the tax code that similarly situated S Corporation shareholders and LLC members are taxed differently. Equalizing the treatment has been the subject of proposed legislation (that never passed) before, and with all the talk of cutting loopholes out of the tax code, this one is primed for the chopping block.

In addition, taking advantage of this loophole requires some serious thought. IRS has an entire framework for determining if the salary portion of an owner’s compensation is reasonable. If IRS audits and decides that an owner’s salary was not reasonable, it can re-characterize previously paid dividends as salary and require payment of the unpaid employment taxes.

The bottom line is: tread lightly and lean on your tax advisor when it comes to using a S Corporation to save on employment taxes.

Question #2: I hired an engineer who agreed to develop my company’s first product (a houseware item).  He was supposed to develop a design, technical drawings, and interface with my manufacturer to create some prototypes for testing.  The total amount I was supposed to pay was $22,000.  I’ve already paid him $20,000 and I don’t even have technical drawings, and now he’s not returning my calls or emails.  Can I sue him?

The beautiful thing about America (for lawyers) is that anyone can sue anyone else at any time for any reason. Whether a lawsuit has any merit, won’t get thrown out of court, and won’t cause the person who filed the suit to get in trouble is a separate matter.

In all seriousness, though, you are facing a very common problem that many startups will face one day: to sue or not to sue.

Some lawyers recommend first spending the time and money to send threatening letters on a law firm’s letterhead to the engineer. I’ve seen this strategy work maybe 5% of the time. This isn’t to say that you should sue right off the bat, but my advice is usually to send one letter with a firm deadline on settlement and then sue if the deadline isn’t met.

Before suing, you first have to make sure you have a good case as to why the engineer breached your contract. Is the scope of the contract tightly drafted? Did you supply the engineer with all of the information he needed? Can the engineer claim that you also breached the contract?

The next question is one of leverage. Can you sue for more than $20,000?  For example, can you only hire a replacement engineer for $50,000? If so, you might also be able sue for the lost savings. Or, has the engineer’s delay caused you substantial harm by causing you to lose reputation or potential customers? It may be possible to sue for more than the $20,000 that you’ve paid; a greater amount of potential damages gives you leverage in the lawsuit.

Another issue is economics.

To use a lawsuit as leverage (in other words, without the intention of ever getting to a trial), the cost could run between $5,000 to $10,000. You need to consider whether the engineer can actually pay if you win. It would be great to win a $50,000 judgment, but once you get that judgment you could end up spending another $10,000 pursuing the engineer to get him to pay.

Finally, consider the time and energy you’ll need to put into the lawsuit. Obviously it is your attorney who will carry out the suit, but your efforts will be needed to gather facts and assess strategy throughout the lawsuit. Do you have the time to take away from your business for this?

While justice is available to everyone through our court system, it doesn’t come free. These are necessary considerations when you think about suing your engineer, or anyone else you’ve contracted to work on your business.

*From time to time, Chicago-based startup attorney Clint Costa will answer your questions about the legal or tax issues you’re facing. If you have questions, email them to ccosta@harrisonheld.com.*

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