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Bridge financing for Silicon Valley start-up companies is a fairly standard, relatively inexpensive method to raising money pending a larger investment round. This type of financing is typically provided in the form of debt that converts into shares issued in the next funding round, often at a discount from the per share purchase price.

Recently, the simple convertible bridge loan has changed to provide substantial tax incentives to investors. For any qualified small business stock, or QSBS, purchased before December 31, 2011, the recently enacted 2010 Tax Relief Act allows 100% of the gain recognized from the stock to be excluded from taxable income.

Although a convertible loan will not qualify as QSBS, the stock that a start-up company issues normally will. Bridge loan investors have a great incentive to purchase stock in exchange for their bridge funds instead of a convertible note. Designing stock that has many of the same attributes as convertible debt has provided some additional complexities to what was formerly a plain vanilla transaction.

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Over many years of working with real estate investors, one question has come up over and over again: “Can I qualify as a real estate professional so I can deduct my passive losses against my ordinary income?” The last time was from a San Jose full-time professional who has rental property in Sunnyvale. I almost always have to disappoint my clients with the answer that they do not qualify. Several times I have had my Silicon Valley clients and their advisors disagree with me, despite explaining the rules to them. Many of them go on to report it the way they want to, and take the risk.

The United States Tax Court just answered the same old question again. In Yusufu Yerodin Anyika et ux. (TC Memo. 2011-69, March 24, 2011), the taxpayers were a married couple that had been buying, renovating, managing and selling rental real estate for years. He worked 37.5 hours per week, 48 weeks per year as an engineer and she worked 24 hours per week as a nurse. During 2005 and 2006 they had two rental properties, which Mr. Anyika considered to be his second job as well as their investment property. They filed their tax returns themselves with TurboTax, claimed he worked 800 hours per year managing the real estate, and deducted their rental real estate losses. The Tax Court held that for them to be able to deduct their rental real estate losses he must have worked more than 750 hours and over half of his working hours on their real estate investments. Mr. Anyika then re-estimated his real estate hours to be 1920, just over the 1800 he spent in his day job. Unfortunately for Mr. Anyika, the Tax Court did not believe his new, unsubstantiated re-estimate and held that he did not qualify as a real estate professional. The Tax Court did hold that Mr. Anyika qualified for a $25,000 deduction for materially participating in real estate, but this deduction was not available to him because his adjusted gross income was too high.

Something to note, which was not an issue in the Anyika case, is that the rules are even worse for short term rentals. Time spent on properties with average rental periods of seven days or less does not count towards the 750 hour test, and losses on those properties are also ineligible for the $25,000 deduction for actively managed real estate. (Source: Kiplinger Tax Letter, March 18, 2011, Vol. 86, No. 6)

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Acquiring a financially troubled company, whether in San Jose, Palo Alto, or New York often requires consideration of the bankruptcy process. If the seller is already in bankruptcy, the buyer must convince the bankruptcy court that it represents the best source of funds to repay existing creditors. If the bankrupt company has attractive technology, there may be other buyers, and the court will typically award that company to the buyer who will pay the most money.

If the seller is not yet in bankruptcy, the parties may decide to purchase the company through a bankruptcy proceeding. If planned properly, the bankruptcy process can provide the buyer with a number of advantages. First, the seller’s assets are purchased free of any liens or other claims (although courts continue to wrestle with allowing subsequent successor liability claims). Second, because the assets are purchased “as-is,” sale documentation is typically shorter than for sales outside of bankruptcy, and stockholder approval is not required.

Planning for purchasing a company through a bankruptcy involves entering into arrangements with the selling company’s creditors and other stakeholders before the bankruptcy filing. As part of these arrangements, a reorganization plan and acquisition agreement may be prepared and agreed to prior to the filing. Once the appropriate pieces are in place, the seller will file for bankruptcy and include the pre-agreed reorganization plan in its bankruptcy documentation. The sale can be completed in a few months barring no other suitors or other unforeseen impediments. Bankruptcy counsel is necessary for both parties to properly shepherd the transaction through the proceedings, and corporate counsel is critical to insure that documentation is accurate and necessary corporate formalities are followed.

Financially troubled companies often provide the opportunity for others to purchase businesses at a relatively lower cost. Reaping the advantages successfully requires balancing the needs of all the business’s stakeholders.

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Technology start-up companies in Silicon Valley exist in a highly dynamic environment, where survival can be crushed by competition from a kid in a garage or a fund partner refusing further investment. As a last gasp, some companies may try to be acquired. Companies which have had to take refuge from their creditors may be able to sell their business through bankruptcy proceedings.

When compared to a standard sale of a business, sales of financially troubled companies require the professional advisors to manage a number of different stakeholders to successfully close a transaction. More so than in standard transactions, professional advisors play an important role in helping a transaction proceed smoothly. Under certain circumstances, their fees may be paid by the buyer or the bankrupt estate.

Most acquisitions of financially troubled companies are structured as an asset purchase. This prevents the acquirer from having to automatically assume liabilities that it doesn’t want. The existing creditors are then left with satisfying their claims out of the proceeds from the sale. Most companies, however, need the products or services of its creditor vendors to survive. In the case of technology companies, these vendors often include technology and hardware suppliers who are core to the company’s business. Irritated suppliers may not want to deal with the company even after its acquisition. Creditors and stockholders of the company may have claims against the company’s board of directors if a company is sold for less than the reasonably equivalent value of its assets. At the same time, key employees of the company, aware of the company’s financial stress, may be looking for alternate opportunities. The importance of these stakeholders, and how they are managed as part of the acquisition, is at the heart of any purchase of a financially troubled company.

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Over the last two years I have often been asked to answer the question of what the consequences will be if a client walks away from a property, letting the bank take it back. The previous decade of incredible real estate appreciation resulted in many people without previous real estate investment experience becoming real estate investors. The most common situation I see is the condo owner who had enough income to keep his condo as a rental and still buy himself a single family residence. Then the recession hit and both properties are now underwater. Now, he thinks he can walk away from the property thanks to the Mortgage Debt Relief Act. Unfortunately, that Act was put into place to help people who were losing their homes, not to help people with investment properties. Even more unfortunate is that a lot of these beginner real estate investors thought that they could handle their taxes themselves without an accountant.

California is now focusing on finding those people and making them pay tax on the cancellation of debt income they should have recognized on giving up their underwater investment property to the bank. According to Spidell’s California Taxletter, (March 1, 2011, Volume 33.3), California is mailing letters for tax years 2007 and 2008 to taxpayers who had debt relief on properties that were reported on Schedule E and therefore, probably do not qualify for the principal residence exclusion. The letter calculates the potential additional tax owed as well as a 20% accuracy related penalty and interest on the unreported income.

If it is too late and you have already been given notice of an audit on cancellation of debt income, there are still some other exclusions that you may qualify for, such as business and farm indebtedness. If you are thinking of giving an investment property back to the bank, be sure to bring in a good accountant to analyze the tax situation for you first.

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Just like estate planning is so important for those we leave behind when we die, a good shareholder or partnership agreement is crucial for the well-being of a business after a traumatic event for one of the owners. Death, disability, retirement, bankruptcy, insolvency, divorce, and even a partnership disagreement can be traumatic events for a company to endure, and could result in the end of a business if they are not planned for in advance. Planning includes deciding whether the company or the other owners have an optional right or a mandatory requirement to purchase the interest of the subject owner, at what price, and on what terms.

Any business with more than one owner needs a good shareholder, LLC or partnership agreement. It is equally as important for family owned businesses. For years, I worked with a real estate investment family business in Saratoga. When the father died after years of working together with his adult children, the LLC agreements we put in place were absolutely critical to keep the management control in the one child who was capable of running the business. In this case, the agreements put in place the succession plan which enabled the business to go on after the death of the majority owner.

A good shareholder or partnership agreement should consider what restrictive covenants the owners want to impose, including restrictions on sale and rights of first refusal. Agreements for companies involving sweat equity should deal with the amount of time, effort and capital (if any) required of each owner, and the vote required to remove someone from the company. Companies that are considering a sale as an exit strategy should consider rights to force the minority owners to go along with the majority owners on a sale, and rights of the minority owners to force the majority owners to include them in any sale.

The value of the company should be decided in advance of an event, and should be reviewed regularly. A formula or a method for valuation should be clear in the buy-sell agreement. And if the death or disability of one owner could materially impact the value of the company, the owners should consider funding the buy-sell agreement with life insurance and disability insurance. The future of the company is dependent on the agreements the business owners put into place now. Failure to have a buy-sell agreement could be a fatal mistake.

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In my last segment, I mentioned a recent deal involving a Northern California company structured as a stock sale. Having tax advisors assist at the early stages helped keep the transaction on track. The next major issue was allocating the risk of business liabilities between the buyer and the seller.

Like any stock purchase transaction, liabilities of the seller stay with the business. This is often a significant disincentive to the buyer, because it must hold an entity that cannot escape its past liabilities. Two mechanisms are commonly used to alleviate the buyer’s risk.

First, a working capital cushion may be created to provide a source of funds to pay the ongoing debts of the business. The amount of the cushion is agreed in the purchase documentation. A portion of the purchase price is then held back at the closing in an escrow. The amount of net assets as of the closing is determined through a post closing audit, and the held back amounts are distributed following the audit to the buyer or seller depending on any difference between the agreed amount and the amount determined under audit.

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In a recent acquisition that I handled for a company in Santa Cruz, the buyer decided to purchase, with cash, the stock of the company rather than its assets. Acquisitions through stock or equity purchases are a common method of buying a company. From an administrative standpoint, equity purchase acquisitions are one of the easiest deal structures to implement.

In an equity purchase acquisition, a company is bought by purchasing all of the ownership interests of that company. If the company is a corporation, a buyer purchases all of the company’s shares of stock from the company’s stockholders. If the company is a limited liability company or partnership, a buyer purchases all the ownership interests of the company from its members, in the case of a limited liability company, or its partners, in the case of a partnership. This discussion will focus on a stock purchase, although the basic issues outlined here are the same when dealing with a limited liability company or partnership.

The administrative benefit of a stock purchase transaction is that ownership changes simply by transferring all of the company’s shares. Contrast this with an asset purchase structure, where each desk, chair and personal computer must be accounted for and sold to the buyer.

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In Parts I and II of this Article I talked about how important a complete and properly formed business entity is for estate planning and liability protection. There are also many other potential impacts of not having your corporation or LLC documentation in order. Here are just a few:

IRS Problems: Just over five years ago I got a call from a licensed contractor in Campbell who was being audited by the IRS and needed to present his corporate minute book to the auditor in five days time. His company had not done minutes of the shareholders or the board of directors for the previous six years. It took us much more time to go back and recreate the corporate minutes and ended up costing my client at least twice what it would have if we had prepared the minutes each year when the information was fresh. However, it was necessary to document certain shareholder loans which would not have been upheld by the IRS if they weren’t properly authorized by the corporation.

Securities: Many new business owners do not understand that an ownership interest in a corporation or a manager-managed limited liability company is considered a security and may require federal and/or state securities filings. Failure to make these required filings may result in shareholders having rescission rights whereby they can demand their investment back from the company, and any person controlling the entity could have personal liability to return those funds.

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Filing your Articles of Incorporation or Articles of Organization with the Secretary of State is only the first step in creating your corporation or LLC. Unfortunately, most online business formation services take your money and don’t do much more than that for you. And many do-it-yourselfers don’t perform the required tasks unless they are somehow notified that additional filings or documents are needed to complete the formation of their entity. Even some business owners that have an attorney form their company correctly initially often fail to keep up the required formalities. The problem with stopping at filing your Articles, or even your initial formation documents, is that if you do not treat the corporation or LLC properly, then the courts can do what is called “piercing the corporate veil” and look through the company to the business owners for liabilities of the business.

Some of the basic formalities required in order for the courts to maintain the liability shield of a corporation include:

• Holding annual meetings of the shareholders and the board of directors.
• Maintaining the corporate minute book, including organizational minutes, corporate resolutions authorizing or ratifying major decisions, and minutes of annual shareholders and board meetings.

• Issuing and canceling stock certificates as appropriate and maintaining an accurate stock ledger.

For both corporations and limited liability companies, requirements include:

• Having bylaws for a corporation or an operating agreement for an LLC.
• Not commingling funds with personal funds or funds of another entity, including maintaining separate bank accounts, paying company expenses out of the company only, and not running individual expenses through the company.
• Making required Secretary of State filings.
• Filing federal and state business tax returns.
• Making required federal and state securities filings

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