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Buy-Sell Agreements Prevent Disruptive Changes of Ownership | Part 2

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In Part 1 of this series, I discussed concepts that balance the interests of the company and its owners through voluntary transfer mechanisms like the right of first refusal and permitted transfers.  You can read Part 1 here.  In this second article, I cover involuntary transfer circumstances, things to consider, and potential action steps to take.

TABLE OF CONTENTS:

Involuntary transfers occur when the shares of an owner are transferred as a result of the occurrence of any event that is unexpected or outside of the control of the owner.  The typical circumstances that trigger involuntary transfers include the (i) death of the owner, (ii) disability or incompetence of the owner, (iii) termination of marriage of the owner, and (iv) termination of the owner’s employment.

Death:

When a person passes away, his assets (including the shares of the company) will be transferred to his estate or a designated third party (like a foundation or non-profit organization).  Thus, the transferee will have full voting rights and the rights as an owner.  

If the company and the other owners are interested in being able to control who ends up acquiring the shares, then a provision that grants the company and/or the other owners the ability to buy the shares can alleviate this concern.  On the other side, if an owner is interested in being able to cash out of the shares or being able to allow his estate to retain some of the shares, then the same provision can be negotiated to address these concerns.

Typically, this provision grants the company and/or other owners the right to purchase some or all of the shares of the deceased owner.  It binds the owner’s estate to sell those shares.  The company and/or other owners have to exercise this right to purchase within a certain period of time (usually 60 to 90 days), and the purchase price and payment terms are agreed in advance. 

The purchase price can be set in the agreement as a fixed dollar amount or can be determined based on a formula that is applicable at the time of death or based on a valuation of the company at the time of death.  The purchase price can be paid at the closing or over time under a promissory note structure which bears interest and can extend over a period of years.  

When drafted and executed properly, this provision creates a liquidity event for the estate and allows the company to retain ownership.  The company and the owners may consider obtaining life insurance on the key owners in order to fund this buy-back situation.  The company usually funds and owns this policy, and the proceeds can be used to pay for some or all of the purchase price.  If the insurance proceeds are not enough to cover the purchase price, then the remainder can be paid either in cash or over time under a promissory note.        

Disability or Incompetence:

The disability or incompetency provision works similar to the death provision.  Upon the disability or incompetency of an owner, the company and/or the other owners have the right to buy some or all of the disabled owner’s shares.  Unlike in the death scenario, the owner may still be alive and may be functional enough to make decisions affecting the shares. Thus, the parties should consider whether it is appropriate to include this provision, and if so, what constitutes disability so as to trigger the provision.  For example, should disability be defined to be inability to use limbs, inability to perform daily job functions, inability to make decisions or control mental faculties, etc.  

Also keep in mind that if there is a provision addressing death, then even if a disability provision is not available, eventually the death provision will apply and address the ownership issue at that time.  Similarly, if a termination of employment provision is available (see discussion below), then it may not be necessary to include a disability provision because if the owner is no longer able to perform his or her job duties, then the employment provision may be triggered.  

The parties have the option of funding the buy-out through permanent disability insurance, which the company can pay for and which can help pay for some of the purchase price.  However, the parties should understand the mechanics of permanent disability insurance, as they are not the same as life insurance.

Termination of Marriage:

If an owner lives in a community property state, then his/her spouse owns half of the shares that the owner owns unless there is an agreement otherwise.  An owner’s marriage can be terminated either through divorce or the death of the spouse.  If either of these events occurs and the owner does not end up owning all of the shares (either because in the divorce context the spouse claims some portion of ownership of the shares or in the death context, the spouse left his/her portion of the shares to someone else through a will or other mechanism), then this type of buy-sell provision ensures that the owner, the company and/or other owners can retain ownership of the shares.   

In the event one of these instances occur, the spouse or his/her estate is required to first sell all of the shares he/she owns (or claims an interest in) to the owner.  And if the owner does not purchase all of the shares, then the company and/or the other owners have the right to purchase the shares.  These rights must be exercised within a certain period of time.  

The purchase price can be determined in advance, through a valuation process or a valuation formula.  The payment terms can be set as a lump sum payment or over time through a promissory note structure.  Some buy-sell provisions addressing these scenarios even go so far as to substantially discount the purchase price payable to the divorcing spouse to disincentivize him/her from seeking ownership of the shares.

The key thing to remember about all involuntary transfer provisions, but in particular ones addressing termination of marriage, is that the spouse must consent and agree to these provisions in advance to be binding on the spouse and his/her estate.  Thus, there is usually a spousal consent that the spouse must sign when the buy-sell agreement is signed.  

Termination of Employment:

If an owner’s employment with the company is terminated, then the company may have an interest in obtaining the shares, especially if the termination is for cause because most likely there will be some sort of animosity.  Similarly, the owner may have an interest in cashing out of the company if he/she is no longer working for the company and has no control over its growth and direction. 

A buy-sell provision can address these interests.  Under this provision, upon termination of employment, the company and/or other owners have the right to purchase the departing owner’s shares.  Oftentimes, the company’s exercise can be structured to require approval of the majority of the remaining shares, which sets a higher bar for the company’s exercise of this right.  

The purchase price for the shares can be determined in advance or pursuant to an independent valuation or a predefined formula.  The payment terms can be lump sum or over time pursuant to a promissory note.  

Oftentimes, this provision will distinguish between termination at-will vs. for cause, where a for-cause termination will see a substantially reduced purchase price as a means to disincentivize bad behavior.  Thus, one of the key concepts in this provision is the definition of “for cause” termination and what processes and/or mechanisms may be involved in determining “for cause” and related termination of the owner.  

Conclusion:

It is possible that some or all of these voluntary and involuntary buy-sell provisions may not be applicable to the company and its owners.  However, it is still a useful exercise to have a discussion among the ownership of the company to determine whether a buy-sell agreement is appropriate. The last thing business owners want is a difficult ownership situation that could have been avoided with just a bit of planning ahead.  

Parts 1 and 2 of this article are intended to provide an overview of the various types of buy-sell provisions. If we at Tri Nguyen Law Office can provide a complimentary initial call to better understand your business situation, please do not hesitate to call us at 844.9BIZLAW or schedule your complimentary call here. All business owners should consult with an experienced attorney to address their specific situation. 

About the Author:

Tri Nguyen has served as general counsel and company lawyer to businesses, executives, startups and entrepreneurs for over 18 years.  He particularly enjoys helping companies grow and achieve their strategic plan, and believes that every business needs a Chief Legal Advisor.  He can be reached at www.trilawoffice.com.    

Buy-Sell Agreements Prevent Disruptive Changes of Ownership | Part 1

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Buy-Sell Agreements Prevent Disruptive Changes of Ownership | Part 1

If a business entity has multiple owners and those owners are interested in preventing or minimizing disruptions that arise when interests (or shares) of the entity are transferred, then they need to invest in a buy-sell agreement.  Whether the transfer arises voluntarily or involuntarily, a well-drafted buy-sell agreement can alleviate uncertainty, surprises and possible litigation between and among the company and its owners.

This article is the first in a two part series. This first article series focuses on voluntary transfers of ownership interests.  The second article will address involuntary transfers in the context of death, permanent disability, termination of marriage, and termination of employment.

TABLE OF CONTENTS:

What is a Buy-Sell Agreement

A buy-sell agreement is an agreement among the business entity (corporation, limited liability company, etc.) and its owners that specifically addresses voluntary and involuntary transfers of ownership.  It sets a predetermined road map that springs into effect when certain conditions are met or events occur.

Typically, these conditions or events include (i) the voluntary transfer of ownership interests to a third party and (ii) the death, permanent disability, divorce or termination of employment of one of the owners that could result in or trigger an involuntary transfer of ownership interests.  What should happen to the ownership interests in these situations should reflect each company’s unique ownership structure, development timeline, and the needs and circumstances of the owners and their families.     

Ownership Interests and Restrictions

The governing documents of a company typically will restrict any sort of transfer of ownership interests without the consent or approval of the other owners and/or the company.  If that is not the case, then transfers can be made freely (subject to certain federal and state securities law requirements not discussed here).  Not having this restriction allows one owner to sell or transfer its ownership interests to any third party without any say-so from the other owners or the company.    

If there is a restriction on transfers, then an owner will need to seek such approval before effecting the transfer.  However, this approach can be cumbersome, and from the transferring owner’s perspective, can create concern that consent may not be granted at all.  Sometimes, an owner will want some sort of mechanism to be able to exit from the company.  But from the other owners’ and company’s perspective, they want to be able to control who becomes a new owner.  Imagine the surprise of waking up one day and finding out that one of the owners has transferred its ownership interests to a competitor or to someone who has an undesirable reputation or doesn’t know anything about the company’s business.     

Two typical concepts that can address the concerns of all parties in the voluntary transfer context are the right of first refusal (ROFR) and the permitted transfers.  

Right of First Refusal

The ROFR is intended to allow an owner to sell its ownership interests to a third party if the other owners and the company do not purchase all (or some predetermined portion) of the ownership interests.  Under the typical ROFR, an owner seeks a buyer and negotiates the terms of sale of the ownership interests.  After the negotiated terms are finalized, the owner then is required to offer to the company and other owners the right to purchase the interests based on the negotiated terms.  The company and other owners have a certain period of time to elect to purchase based on those negotiated terms or pass on the opportunity.  If they pass, fail to elect to purchase or fail to close the purchase, then the owner can proceed with the sale to the third party; and if the sale to the third party doesn’t occur or if the negotiated terms change in a material way, then the offer process starts over again.  

Some key features to consider under the ROFR:

1.     It allows the transferring owner a way to exit the company and the other owners and the company to prevent unwanted buyers to become an owner of the business.  However, for the owner desiring to transfer, it may be difficult to find a buyer to purchase the minority ownership interests of a private company, especially if the buyer will not have much control over the business, operations, and timing of cash flow distributions of the company.  For the other owners and the company, if they want to prevent the third party from becoming an owner of the business, they will have to purchase the ownership interests on the same terms that were negotiated between the selling owner and the third party buyer.  Those terms may not be desirable (such as the valuation is too high) or may not be performable (such as full payment of the purchase price at closing, which means the other owners and the company will have to come up with the funds by the closing date).

2.     Establish reasonable time periods for events to occur.  The ROFR will have specific time periods for (i) the other owners and the company to elect to purchase the shares being offered for sale, (ii) the closing between the selling owner and the other owners and the company to occur, and (iii) if the other owners and the company elect not to make or fail to make an election to purchase the shares, the closing between the selling owner and the third party to occur.       

3.     An ever green provision (or intentional lack of one) that states that an election not to purchase or a failure to elect to purchase the shares is not a waiver of the ROFR in future situations.  For example, if the closing between the selling owner and the third party doesn’t occur, then the next time the selling owner finds a new third party buyer, the selling owner should go through the ROFR process again.

4.     A material change provision that states that if the terms of the transaction with the third party changes materially from when it was offered to the other owners and the company, then the selling owner must re-offer those changed terms and conditions to the other owners and the company.  This provision eliminates the possibility that the terms may be changed later to be more favorable to the third party and the other owners and the company are denied the benefit of the more favorable terms.

Permitted Transfers

Just as the phrase implies, permitted transfer provisions allow an owner to transfer its ownership without being subject to the consent or other voluntary transfer restrictions.  Although permitted transfer provisions can by varied, they usually contemplate a transfer in which the original owner retains some sort of control over the shares being transferred.  Transfers for estate planning purposes is an example.  Owners may want to put ownership of the shares in a trust, family limited partnership, or other estate planning vehicle in which they retain control over the shares either as the trust trustee or as the general partner of the limited partnership.  Alternatively, owners may want to gift (or transfer) the shares to family members.  

Similarly owners may want to restructure how they hold shares of a company, and thus move the ownership of those shares from a personal holding into a limited liability company, corporation or other entity.  These entities are usually established and controlled by the owner.  

All of these transfer circumstances are conducive to allow the original owner to retain control over the shares.  That is the key to permitted transfers.  There are usually conditions that the transferring owner (i) retain control over the shares (i.e., the voting of those shares), (ii) notify the company of such transfer, and (iii) ensure that the same terms, conditions and restrictions of ownership applicable to the transferring owner are imposed on the transferee.  It is important to impose these conditions in permitted transfers to ensure that the original owner, who the other shareholders and company know and originally agreed to enter into business with, continues to be the primary point of contact with the company.

Conclusion

Owners of businesses should give serious thought to these voluntary transfer issues.  They may decide that a blanket restriction on transfer is appropriate such that any transfer would require the approval of the company and/or the other owners.  However, this approach exposes the minority owners to the whims of the majority owners.  Not having a restriction on transfer at all exposes the other owners and the company to an unwanted partner.  Properly drafted and thoughtful voluntary transfer provisions can address these issues.  

In my next article in this series, I’ll address the key considerations for involuntary transfers that protect both the company and ensure equitable treatment of the departing owner.  Business owners should give serious consideration to voluntary transfer issues and seek the advice of experienced counsel to discuss their specific situation.

About the Author:

Tri Nguyen has served as general counsel and company lawyer to businesses, executives, startups and entrepreneurs for over 18 years.  He particularly enjoys helping companies grow and achieve their strategic plan, and believes that every business needs a Chief Legal Advisor.  He can be reached at www.trilawoffice.com.     

Top Three Things You Should Know About Forming an LLC in Texas

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Top Three Things You Should Know About Forming an LLC in Texas

The act of forming a limited liability company (LLC) in Texas is fairly straight forward.  All you have to do is file a Certificate of Formation with the Texas Secretary of State and pay the filing fee.  The Certificate of Formation form can be found here.  But before you get to that stage, consider and give real thought to these top three things about formation of LLCs in Texas:  the LLC name, management structure, and LLC operating agreement. 

Name of the LLC

Name Availability in Texas

For many businesses the company name is also their business name.  These are actually two separate concepts because it is entirely possible to have one company name and operate under a separate business name (like a DBA or doing business as).  In Texas, an LLC company name cannot be the same as the name of an existing entity formed or registered in the State of Texas. 

There are specific rules that the Texas Secretary of State follows in determining whether your proposed company name is the same as an existing entity name in Texas.  These rules can be found here. 

​If you don’t want to go through the hassle of reading administrative codes, then you can also call the Texas Secretary of State’s office at (512) 463-5555 to check on the availability of your proposed name or email the Corporations Section of the Texas Secretary of State at corpinfo@sos.texas.gov.  It is advisable to have a couple of backup names in case your first choice is unavailable.

Domain Names

If you want your website domain name to match or be similar to your company name, then you should also conduct a domain name availability search as part of the company naming exercise. 

For example, if you want your company name to be Best Ever Widget, LLC and your website domain to be www.besteverwidget.com, then you’ll need to see whether that domain name is available before you form the LLC. 

If matching the company name with the domain name is not that important to you, then this step isn’t essential.  As I mentioned earlier, it is possible to have a company name that is different from the business or brand name.  For example, Best Ever Widget, LLC can operate under the business name of Hi-Tech Widgets.  Which brings us to trademarks and branding.

Trademarks and Branding

Another consideration in choosing a company name is whether it will also serve as the business or brand name.  If you intend to use the company name as the business name or tradename as well, then you will need to do a broader name availability search.  This is especially important if your business has a broader reach.  If the business that the LLC will operate is local in nature, such as owning and operating a specific piece of real estate, a retail or manufacturing business serving the local market, or if you generally don’t intend to establish or register a brand name or tradename for the business, then this type of search may not be important.  

However, for those who may or intend to establish a unique business name, brand name or tradename that is similar or the same as the company name, then you should also do a trademark or tradename search by visiting the U.S. Patent and Trademark Office website and performing a trademark search, or just seek the professional advice of an attorney. If your company name is going to be Best Ever Widget, LLC and you want the domain name www.besteverwidget.com, then it’s best to make sure that www.besteverwidget.com is actually available.     

Member-Managed vs. Manager-Managed

During the formation process of filling out the Certificate of Formation, you must decide whether you want the LLC to be member-managed or manager-managed.  The biggest difference between the two is who makes decision for the LLC and has authority to bind and act on behalf of the LLC.

Member-Managed
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In a member-managed structure, then generally speaking each of the members (the owners of the LLC) by default has the authority to participate in the management and operation of the LLC, which includes being on bank accounts, signing contracts, etc.  Thus, this structure is suited for LLCs whose members want to or has to participate in the management and operation of the LLC. 

Manager-Managed

If there will be members who are more like investors, then generally speaking a manager-managed LLC is more appropriate.  Under this structure, the managers have duties and functions very similar to a board of directors of a corporation. 

Among other things, they make strategic decisions, set overall goals for the LLC, and manage and oversee the officers of the LLC.  The officers in turn are responsible for the day-to-day operation of the LLC.  Managers and officers can be hired, so they don’t have to be members of the LLC to serve these functions. 

​With a manager-managed LLC, members have very few decision-making authority, but the authority that members do have are generally of major (not day-to-day) importance, like incurring major debt, selling the business, dissolving the company, etc. 

 LLC Operating Agreement

Rule Book

An LLC operating agreement (also referred to as an LLC company agreement) sets out the rules, procedures, and processes for governing the LLC, the decision making on behalf of the LLC, and how the members (and managers, if there are any) interact with each other.  These rules, procedures and processes are important because if a disagreement arises on how to operate, manage, and make decisions on behalf of the LLC, then the members (and managers, if there are any) can turn to the LLC operating agreement for binding guidance.  These rules, procedures and processes essentially reflect the rights, duties, obligations, and responsibilities of the parties involved.  

The LLC operating agreement can include provisions on how managers are appointed and replaced, what authority do members have to make decisions, whether decisions have to be made by majority vote, unanimous vote or some sort of super majority vote, when and how members have to contribute funds to the company, and when and how the members can sell their ownership interests in the LLC.  The parties can be as creative and flexible as they want on setting these rules, procedures, and processes as long as they don’t violate the law or statute.

 Liability Protection

One of the main reasons people form LLCs to own and operate business ventures is for personal liability protection.  The LLC can own and operate the business under its own name, so if there is a liability claim against the LLC, then the members and their personal assets are not liable or at stake.  However, if members don’t have a guiding set of rules, procedures and processes for operating, managing and administering the LLC and its business, then it can be (and has been) argued that the business of the LLC is not being operated by a separate entity, but in fact by the members individually.  This is an argument for “piercing of the corporate veil” of the LLC, which tries to hold the members personally liable for the debt, liabilities and obligations of the business of the LLC.  

Having an LLC operating agreement and following the rules, procedures and processes for its operation, management, and administration is strong evidence that the members are taking the separate existence of the LLC seriously.  The LLC operating agreement can be used to defend against “piercing the corporate veil” attacks.      

Third Party Requirements

Sometimes, the LLC operating agreement is required to transact business.  Banks may require the LLC operating agreement for funding.  Governmental organizations may need an LLC operating agreement as part of licensing, permitting or certification requirements.  If the LLC seeks funding from investors, then investors may want to review (and possibly negotiate) the terms of the LLC operating agreement so they can understand or establish their rights, duties and responsibilities before making an investment.An Ounce of Preparation and Prevention Are WorthwhileIt is exciting to start a new company and get incorporated. As I know from personal experience and from my work with many Houston based new businesses, it is can be extremely rewarding. At the same time, failing to set up your company properly when starting can create huge headaches and even financial liabilities for you later on.

If you have any questions about the above or anything legal related to your new or existing business, know that I would be happy to see if I can help. Feel free to click below to schedule a complimentary initial call with me today.

CLICK TO SCHEDULE WITH TRI TODAY

About the Author:
Tri Nguyen has served as general counsel and company lawyer to businesses, executives, startups and entrepreneurs for over 18 years.  He particularly enjoys helping companies grow and achieve their strategic plan, and believes that every business needs a Chief Legal Advisor. He can be reached here or at +1-844-924-9529.

What You Need to Know About A Legally Compliant Internship Program

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What You Need to Know About A Legally Compliant Internship Program

Internship programs are extremely valuable to employers – they are an excellent framework for sourcing potential new hires and grooming innovative talent. However, as beneficial as they can be, it’s important that if you use unpaid or paid interns that you create an internship program that is legally compliant in order to avoid costly penalties and litigation down the road.

The Department of Labor moved from their “six-factor test” to a “primary beneficiary test” for employers to follow in 2018. The “primary beneficiary test” allows for more flexibility within company programs and increased opportunities for unpaid interns to gain valuable hands-on experience.

In order to comply with the DOL’s “primary beneficiary test,” unpaid internships must follow the seven guidelines as listed below:

  1. Both the intern and the employer must explicitly understand that there is no compensation for the internship.
  2. The program must provide hands-on training similar to an educational environment.
  3. The internship must be connected to the intern’s formal education either with coursework provided by the employer or program, or the intern’s receipt of academic credit.
  4. The internship must accommodate the intern’s academic schedule and commitments, which can be outlined in an academic calendar.
  5. The scope of the internship must be limited in time and duration, and during that period the intern must be provided with educational benefits and/or hands-on experience.
  6. The intern’s work should complement the work of paid employees, as a means of providing valuable educational benefits.
  7. The intern and the employer both understand that the internship does not come with a promise of a paid job at the end of the program.

As an employer, it’s important that if you run an internship program (especially unpaid) that it benefits the intern. The goal of any internship program is to create an environment where the intern can practice their skill. An employer should never implement such a program as a means for unpaid labor.

Of course, it’s important to always check with your state laws before creating an internship program for your business. Many states differ in their own wage and hour laws. As a precaution, the employer should create a one to two-page acknowledgement that describes the type of work that will be done during the internship and outlines the educational components of the program. The expectations of pay or no pay should also be put into the acknowledgement to ensure the intern’s expectations are managed.
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If the employer is still unsure whether their internship program complies with the DOL and state laws, it’s best to offer interns applicable minimum wage to avoid pricey penalties or litigation in the future.

In cases where employers have failed to follow the requirements necessary for an unpaid internship program, these companies ended up paying much more in attorney fees and lost time in comparison to the costs of paying the intern a minimum wage for the duration of the program.

DISCLAIMER: The information contained in this article is intended for informational purposes in order to give the reader a general understanding of this important topic. This article is not intended to be legal or tax advice, so if you need additional information, please consult a knowledgeable attorney. 

Texas Independent Contractors vs. Employees – the Legal Difference

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Texas Independent Contractors vs. Employees – the Legal Difference

According to Texas and Federal law, independent contractors operate on a different legal basis in comparison to traditional full-time or part-time employees. An independent contractor is often thought of as a worker who is self-employed, and a person who enters with a company for compensation under the assumption that they are “free from control” in regards to the company who is paying for their services.

An employee is a person who is hired by a company to do a job and is expected to follow instructions from the business as to when, where and how they are to perform their duties. Misclassifying a worker as an independent contractor when he or she is an employee can result in serious problems for the company. Misclassification can cost the business in taxes and interest, and can result in a fine of $200 per worker if the employer is operating under a government contract. A written or oral agreement between the parties does not change the status of the worker.

Breaking Down Independent Contractor Engagement Law in Texas:
Typically, independent contractors work with various parties freely, using their own name or business name, their own equipment and in their own setting. The engagement between the independent contractor and a business is usually outlined in terms of an agreement between the two parties, and their duties may be limited in time and scope. While some independent contractors will use the company’s equipment or follow a specific schedule, still they’re classified as an independent contractor.

In Texas, the main difference between an independent contractor and an employee is based on the level of control that may be exercised by the employer. To summarize, an employer will have much less control over an independent contractor’s daily schedule or activities in comparison to an employee.

In addition to the level of control the company has over the independent contractor, a second differentiating aspect is the ability of the independent contractor to negotiate their own terms and work as an independent party.

For example, when an employer presents an offer to a potential employee that person can either accept or decline the terms — there’s usually little room to negotiate. As for an independent contractor, those terms are usually negotiated beforehand and then outlined in the agreement between the two parties.

Common Engagement Aspects of Independent Contractors:

  • Does not receive or follow daily instructions.
  • Uses their own methods and/or equipment.
  • Has investment in an independent business.
  • Is hired for a specific job.
  • Determines their own hours of work.
  • Is paid per job.
  • Works for multiple clients/companies.
  • Can choose their own location.
  • Can advertise their own business.
  • Cannot be terminated at will, if outlined in their agreement.
  • Is liable for a breach of contract or non-completion of work.

How Employers Can Misclassify Independent Contractors:
There are various reasons an employer may try to classify their employees as independent contractors – the biggest incentives are for monetary and/or tax reasons. This is because when employees are hired, an employer will have added expenses and accounting obligations, such as payroll taxes, overtime wages, unemployment benefits, workers compensation, hourly rates and/or salary rates.

Therefore, when an employee is misclassified as an independent contractor there are financial and liability issues that arise.
If an employee is misclassified as an independent contractor then that employee may be losing out on earned benefits, bonuses, overtime pay, unemployment access and workers compensation. An employee may have a claim against the business for such lost benefits.

IRS Guidance on Independent Contractor vs. Employee:
​Aside from potential penalties under Texas law, a misclassification may result in penalties and fines from the IRS. The IRS has its own classification criterion that are similar, but not exactly the same, as those of Texas. You can find the IRS guidance here.

As a business owner or manager, if you are unsure of the classification, then the conservative route is to classify the worker as an employee. If you need further assistance or clarification on the proper classification of a worker, then please contact us.

DISCLAIMER: The information contained in this article is intended for informational purposes in order to give the reader a general understanding of this important topic. This article is not intended to be legal or tax advice, so if you need additional information, please consult a knowledgeable attorney.

Doing Business Out of State & Foreign Qualification

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Doing Business Out of State & Foreign Qualification

There are many reasons a company will expand its business to a different state. Whether it’s for tax or government concerns or your business is selling products or services outside of the state it was formed, you should familiarize yourself with the process of registering your company in a different state – known as foreign qualification.

What is foreign qualification?
Foreign qualification is the process of registering your company to do business in a state different from the place your corporation or LLC was formed. Typically, where you formed your business is the place where you do most of your business transactions. However, if you do business outside of that state, your business should consider a foreign qualification in those other regions.

What is considered a foreign transacting business?
If you are considering filing your business for foreign qualification, you should ask yourself the following questions:

  • Do you have a physical location (office, retail space, etc.) in that state?
  • Did you apply for a business license in that state?
  • Do you conduct in-person meetings in that state on a regular basis?
  • Does a large portion of your business’s income derive from revenue in that state?
  • Do you have employees working in that state?
  • Do you accept orders in the state?

If you’ve answered “yes” to these questions, then you may need to register your company for foreign qualification.

Understanding foreign qualification is especially important for tax concerns. When you register for a “Certificate of Authority” in the state where your LLC or corporation will be doing business, you pay the required state fees and perhaps even income taxes on revenue derived from that state.

When it comes to expanding your business or forming your business in a state different from where you are completing transactions for your business, it’s important to remember that your company may be required to submit ongoing fees and taxes in the states where you formed your company and the state(s) of foreign qualification.

When you don’t need foreign qualification:
Not every company who does business out of the state its LLC or corporation is registered in will need foreign qualification. An example of this would be if you are a consultant or an online business that primarily handles your work on the internet for clients in multiple states.

Even though you may be making revenue from clients in other states, this does not mean you are transacting business there and therefore may not need to register for foreign qualification in those states.
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Nevertheless, it’s important to consult an attorney and/or accountant when it comes to filing for foreign qualification.

Penalties for failing to register for foreign qualification:
It’s important to understand the consequences and penalties for neglecting to follow state law. Disregarding foreign qualification could take away the right for you to bring lawsuits in that state court – meaning you may not be able to enforce a contract or recover damages – or, your company could be fined for penalties and/or back taxes for the length of time your company has done or was doing business transactions within that state.

Before you file, it’s important to make sure your business is up-to-date on all of its taxes and fees, because many states will require proof that your company is in good standing in the state where your LLC or corporation was formed.

If you need further assistance or clarification on foreign qualification, then please contact us.

DISCLAIMER: The information contained in this article is intended for informational purposes in order to give the reader a general understanding of this important topic. This article is not intended to be legal or tax advice, so if you need additional information, please consult a knowledgeable attorney.