Business Law Notes
Spring 2008 Edition
By F. Stephen Glass
The limited liability company (LLC) is a relatively new form of business entity, having been created in North Carolina by the legislature in 1993. Notwithstanding its recent vintage, the LLC has become the entity of choice for most real estate and mortgage investors who "buy and hold" their investments. When real estate is bought and held, it becomes a capital asset of the LLC.
There are many good reasons to prefer the LLC as the entity to hold title to real estate Oust as there are many good reasons to prefer S corporations as the entity to own business). Some of the key reasons that the LLC is more appropriate than an individual or corporation: to own real estate
- LLCs provide protection from personal liability to all owners (members), including its managers, similar to that of a corporation. Individuals and partnerships owning real estate investments do not have this protection.
- LLCs are taxed for federal tax purposes as a partnership (unless the LLC elects to be taxed as a corporation). Thus, LLCs get the benefit of protection from personal liability for the members who also receive the tax benefits of partnership taxation.
- Unlike corporations, the distribution of appreciated property in an LLC typically will be non-taxable.
- LLCs may make an Internal Revenue Code (IRC) §754 election to "step up" the basis of LLC assets upon the sale of an interest or the death of a member. This can be a significant tax advantage over corporations if the LLC holds appreciating property such as real estate or securities.
- LLC members may transfer appreciated property to the LLC without recognition of gain under IRC §721 .
- LLCs have greater flexibility than S corporations in the capital structure as well as the flexibility to allocate profits and losses (rather than the strict per share corporate rule).
- If owners wish to part ways, with each taking a parcel of real estate, in many cases the split-up will be taxable. However, if the real estate is owned by an LLC, and if the real estate was either contributed to the LLC more than seven years earlier or was bought by the LLC, in many cases the distribution would not be taxable.
Investors who buy and hold real estate or other appreciating assets should consider the tax and organizational advantages that are available through the use of LLCs to own those assets.
The Federal Trade Commission's Franchise Rule is probably the single most important legal pronouncement affecting franchising. A major rewrite of the Rule became effective on a voluntary basis on July 1, 2007 and becomes mandatory nationwide on July 1, 2008. One of the pro-franchisor innovations of the new Rule is the creation of a class of "sophisticated investors." If you are a sophisticated investor, to a large extent you are on your own as far as the FTC is concerned.
The new Rule considers any prospective franchisee to be a "sophisticated investor" if the initial investment (excluding purchase of raw land and funds obtained from the franchisor) is $1 million or more. If your total expenses in the start-up phase (at least three months) are likely to be $1 million or more, you will find that you are exempted from the pre-contract disclosure protections of the FTC Franchise Rule. The estimated costs of opening two or more units will be aggregated, making it more likely that you will be considered a sophisticated investor. Also, regardless of the amount of the initial investment, investors who have been in business for five years and have a net worth of $5 million or more are considered sophisticated and able to protect themselves.
If the FTC considers you to be a sophisticated investor, it is essential that you act like one - conduct a thorough due diligence review of the franchise opportunity, including the following:
- Insist on receiving a Uniform Franchise Offering Circular (UFOC) even though it may not be a technical requirement that you receive one.
- Exercise even greater care than you normally would. Rights available to most franchisees arising from the initial sale of the franchise may not be available to you, substantially limiting your claims and defenses in the future.
- Document your requests for information and the franchisor's responses and keep them with your permanent records. These documents could be critical if you ever have a dispute with the franchisor.
- Expect brokers or salesmen to coax you into estimating that your initial investment (including bank loans) will exceed $1 million and ask you to sign an acknowledgment to that effect. If you are borderline or do not expect your investment to exceed that amount, do not sign the acknowledgment.
- Thoroughly examine the financial feasibility of the franchise, including interviewing other franchisees, past and present, and obtaining the advice of a competent accountant or other business advisor.
- Have the franchise agreement reviewed by competent legal counsel before you sign. The typical franchise agreement today is a mine field for the unwary franchisee.
- Try to negotiate a better deal, especially relief from any overreaching contract terms. After all, if you are willing to invest over $1 million in the franchisor's system, the franchisor should be willing to grant you at least a few concessions.
NOTE: A number of commentors on the proposed Rule, including the author, strongly urged the FTC to focus on the capabilities of the investor, rather than the size of the investment.
By F. Stephen Glass
Anyone considering buying or selling a business, or an interest in a business, must understand at least the basics of business valuation. The following are definitions of some business valuation terms.
Appraisal - the act or process of determining value. An appraisal is a qualified opinion on the value of an asset or an ownership interest in a business enterprise. A business can have many values, depending on the circumstances. Thus, an appraisal must have a specific definition of value.
Value - an imprecise term because it varies with the situation. Common definitions of value include: fair market value, fair value, investment value, intrinsic value, going concern value, liquidation value, and book value.
Fair Market Value (FMV) - Revenue Ruling 59-60 defines FMV as the price at which the property would change hands between a willing buyer and a willing seller when the former is under no compulsion to buy and the latter is under no compulsion to sell, both parties having reasonable knowledge of the relevant facts. The following factors are to be considered to establish FMV: (a) the nature and history of the business; (b) the general economic outlook and the outlook for the specific industry in which the business operates; (c) the book value of the ownership interest and the financial condition of the business; (d) the earning capacity of the business; (e) the ability of the business to distribute earnings to owners; (f) whether or not the business has goodwill and/or other intangible assets; (g) previous sales of ownership interests in the business and the size of the ownership interest to be valued; (h) the market price of ownership interests in similar businesses that are actively traded on an exchange or over the counter.
Investment Value - considers the owners or prospective owners knowledge, abilities, related business interests, expectations of risks and earning potential, and other factors. This is an owner-specific concept.
Intrinsic (Fundamental) Value - is based on the analysis and judgment of an independent security analyst, invest-banker, or financial manager. The term is ambiguous.
Multiples - valuation based, generally, on a multiple of EBITDA or EBIT, plus the amount of cash on hand at closing, less the amount of interest bearing debt outstanding at closing.
Going Concern Value - explicitly considers certain intangible factors such as a trained, qualified work force; an operating plant; and the required licenses, systems, and procedures.
Liquidation Value - assumes that a company's operations will cease and that its individual assets will be sold in reasonable period to maximize sales proceeds. A forced liquidation means selling the assets as quickly as possible, such as at an auction. Liquidation value (orderly or forced) considers not only the proceeds from selling the assets, but also the selling costs, the costs to hold the assets until their sale, and other expenses. Liquidation value of a business represents the lower limit of value.
Book Value - the historical cost of an asset reduced by any allowances for depreciation, amortization, unrealized losses, and impairment. For a company, book value is its shareholders' equity (the excess of total assets over total liabilities presented on the balance sheet).
Present Value - the value of an ownership interest in a company is equal to the present worth of the future benefits of ownership. Valuation methods that directly use this principle are: (a) capitalized returns and (b) discounted future returns. A rational buyer normally will invest in a company only if the present value of the expected benefits of ownership are at least equal to the purchase price. A rational seller normally will not sell if the present value of those expected benefits is more than the offered price.
By F. Stephen Glass
In an April 24, 2008 press release, the U.S. Department of Justice announced that popular movie actor Wesley Snipes had been sentenced to three years' imprisonment for failing to file income tax returns. Longer sentences were given to Eddie Ray Kahn and Douglas Rosile for conspiracy to defraud the IRS. Kahn is the founder and leader of American Rights Litigators (ARL), a tax protester organization based in Florida, while Rosile prepared returns for ALR clients, including Snipes.
A spokesperson for the Justice Department said the Snipes' long prison sentence should send a loud and crystal clear message to all tax defiers that if they engage in similar tax defier conduct, they face joining him and his codefendants, Kahn and Rosile, in prison.
About our authors:
M. Blen Gee, Jr. is an honors graduate of the University of North Carolina School of Law. His areas of concentration include business and corporate law, including sales of businesses; business litigation, including arbitration and mediation; franchise law; automobile dealer law; and insurance company insolvency. Mr. Gee has earned the highest peer-review rating for professional excellence and ethical standards by the national publication Martindale Hubbell.
F. Stephen Glass is the author of numerous publications on business and business entities as well as estate planning. He is a frequent presenter for the National Business Institute. His practice is concentrated in the areas of business and corporate law, business succession planning and estate planning. He serves on the Cary board of Capital Bank. Mr. Glass has earned the highest peer-review rating for professional excellence and ethical standards by the national publication Martindale Hubbell. He serves on the American Bar Association Business Law Committee on Corporate Governance.
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