Editor’s note: Linda Markus Daniels is a founder of and principal in the Research Triangle Park law firm of Daniels Daniels & Verdonik, P.A. TechLaw is a regular weekly feature in LTW.
_______________________________________________________________________________________Every now and then I reflect on legal issues that I have seen arise repeatedly and think what a good idea it would be if I wrote a column on laws that seem to evade the knowledge of lots of technology entrepreneurs, where the lack of that knowledge can be harmful. So, here’s that column, and if you see yourself here you might want to contact your legal counsel to discuss what to do now.

1You Can’t Pay an Officer as a Consultant to Avoid Taxes

What a great idea. Instead of setting up payroll for the new company, let’s just have all the founders (who are also officers) be consultants. The company will send each “consultant” a 1099, and will not have to worry about withholding, the employer portion of social security and medicare or the payroll tax returns. Sorry, but this won’t work. Under Section 3401 of the Internal Revenue Code, all officers are deemed to be employees for withholding tax purposes.

Giving Stock to Employees Results in Taxable Income on the Shares

Well, if the company has to pay the officer as an employee, let’s just cut payroll and give him stock. This isn’t a great idea either. Any property given to an employee or consultant is considered taxable income. So, if you give the employee stock, you need to value the stock, withhold taxes on the value of the stock (which means the employee will need to give the company cash to cover the withholding), and the employee needs to pay taxes on the value of the stock.

Vesting Stock Options Based on Milestones Results in Expensing the Options

Ok. So the officer needs to be paid as an employee and giving him stock is not a great idea. What if he is paid part of the compensation in incentive stock options? The problem is that you aren’t interested in normal vesting over time, and you only want the officer-employee to be able to exercise the options if he achieves certain goals or milestones. New problem. As of today, unless there is a definite vesting schedule based on time in service, you are required to use “variable” accounting. So, unlike accounting for standard incentive stock options which vest over time, the milestone-vested options have to be “expensed.” This means that instead of there being no income hit on the books of the company until exercise of the options, if ever, as to these milestone-vested options there is an ongoing expense recognition on the company’s books for changes in the money value of the options. Of course, everything related to stock options is in flux and this is the situation as of today. It is expected that another set of major changes in accounting for stock options will occur later this year, and if the change does occur then it is likely all options will have to be expensed.

If You Incorporate in Another State, You Still Have To Register in NC

You’ve decided to incorporate your new business in Delaware, Nevada or some other state where you think there may be tax or corporate advantages or because your next-door neighbor told you it was a good idea. Then you open your office in North Carolina and are ready to go…wrong! Every corporation operating in North Carolina must be registered to do business in North Carolina with the Secretary of State. Lawyers call it “domesticating,” but basically it means that you need to more or less incorporate again in North Carolina. You will file a Certificate of Authority, together with $250 (incorporation only costs $125) plus a Certificate of Good Standing/Existence from the State of Incorporation. You also have to file an annual report in North Carolina each year, just as if you were incorporated here.

State Franchise Tax Bill Sent by Delaware Can be Recalculated Using Another Method

Speaking of incorporating in other states, if you do elect to incorporate in Delaware, each year you will receive from the State of Delaware a nice, very large tax bill for the franchise tax. This bill is based on the number of shares you have authorized, and often will be for tens of thousands of dollars. Don’t panic. While the tax notice doesn’t tell you, there is an alternative tax calculation based on assets that makes the tax bill much more reasonable for most companies. See: http://www.state.de.us/corp/frtaxcalc.shtml.

Filing Articles of Incorporation Alone is Inadequate To Authorize the Entity to Transact Business

Regardless of whether you incorporate in North Carolina or Delaware, filing of the Articles of Incorporation gets you nothing. Add $0.50 and you can buy a Pepsi, but you wouldn’t be authorized to buy it in the corporate name. In order to be authorized to actually transact business as a corporation, you have to fully organize the corporation. This includes among other things, having an organizational meeting or organizational resolutions, having bylaws and SELLING stock to at least one person. Remember, if you issue the stock in exchange for services, this is taxable income to the person who receives the shares.

Contractors Own the Intellectual Property They Create for Your Business

Once you finally are authorized to do business in North Carolina and you have folks working for you other than officers of the company, some of those folks may actually be consultants. You agree on the work to be done and you pay them…but you won’t own what they created. In a very counterintuitive twist of the law, consultants own what they create unless and until they provide a written assignment of whatever was created to the company that paid for it. Absent this the company only has certain usage rights in it…which rights do not include the right to sublicense the creation to third parties. So if your consultant created software, you better get an assignment before you try to start licensing the product to others.

You May be Able to Easily Dump (and Avoid Paying) that Invention Development Service Which Promised You the Moon and Has Produced Nothing

You’ve seen the ads on television: we can help you take your idea to a product, get it patented for you and find someone who will buy it, perhaps for millions of dollars. If you have contacted one of these services you should know that the contract they use must have a cover sheet which includes the following:

(a) the home, business and local address of the developer,

(b) a statement that no payment may be made until 4 days after you sign and receive a completed copy of the agreement;

(c) the total number of customers who have contracted with the developer for a stated period of time (at least a year); and

(d) of that number how many have received, by virtue of the developer’s performance, more money than was paid to the developer.

There are actually many other requirements as to what must be in the contract for services, which must be written. If these requirements are not met, the contract is voidable at your option, and if you are injured by the noncompliance you may bring suit for the damages + 3 times the damages + attorneys fees and court costs. Citing North Carolina General Statute §66-209 to 66-216 to the developer generally results in the developer quickly ceasing to try to pursue the collection of any amounts from you.

You Can’t Sell “Gift Cards” at Other Businesses Without a License

Now here’s a nifty idea. You and all your friends with compatible products will sell gift cards which can be used at any of the businesses…sort of like a gift card for any store in the mall or any business selling on Amazon. Alternatively you will make available on your website the ability to buy gift cards for either your own or your friends’ businesses.

You could easily put together a method of getting the money from the card sold to the business redeeming it, but that’s not the real problem. Unfortunately, in North Carolina (and in most states) it is not legal to sell such “prefunded” or “stored value” cards unless either the card is only redeemable by the issuer of the card for its own goods or services, or the issuer of the card has the necessary license.

The license, which in North Carolina is called a “Money Transmitter” license, is also required if you make available, from a location inside or outside the State, an Internet website that may be accessed by North Carolina residents in order to enter into any stored value transaction by electronic means.

In order to become a “Money Transmitter” you must meet the license obligations set by statute, as administered by the State Commissioner of Banks, including having a minimum net worth of $100,000, audited financial statements and the posting of a surety bond.
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Daniels Daniels & Verdonik, P.A. has been serving the legal needs of entrepreneurial and high technology clients for more than 20 years. Linda Markus Daniels concentrates her practice in the representation of entrepreneurial and technology-based businesses, focusing on corporate, technology and international matters. Comments or questions can be sent to ldaniels@d2vlaw.com