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.
RESEARCH TRIANGLE PARK, N.C. – As the television show “MythBusters” proclaims, “It’s a tough job separating truth from urban legend, but the MythBusters are here to serve.” In this version I will take on three myths and use modern law to show what’s real and what’s fiction.
Myth Number 1: You need to form a LLC for your new business because it is the only way to protect your personal assets.
I have been told this by not less that 10 entrepreneurs over the last month. It is absolutely correct that a limited liability company (“LLC”) will generally protect the personal assets of its owners, called members. The applicable North Carolina statute provides: “A person who is a member, manager, director, executive, or any combination thereof, of a limited liability company is not liable for the obligations of a limited liability company solely by reason of being a member, manager, director or executive, and does not become so by participating, in whatever capacity, in the management or control of the business.
A member, manager, director, or executive may, however, become personally liable by reason of his own acts or conduct.” In other words, the LLC protective shell does not allow creditors of the LLC to reach into your personal assets solely because you are a member or manager. This does not, however, eliminate claims against your assets if you, personally, do something negligent or wrong. For example, if an employee of a LLC negligently causes an accident while driving on company business the LLC would have liability, but if the LLC were unable to pay, the party injured in the accident could not pursue a collection action against the members. On the other hand, if a member is driving on company business and causes an accident, the fact that he is a member does not shield him from personal liability.
Perhaps more interesting is the concept that this type of protection is only available if your business is operated in LLC form. The limited liability company form of business was first recognized in North Carolina on October 1, 1993. Was there no business form which limited the liability of its owners prior to this 1993 creation? Of course there was, and it is the most common form of business: the corporation. The corporation provides limited liability to its owners, called shareholders, in exactly the same manner as is provided to the members of a LLC. The applicable North Carolina statute provides: “a shareholder of a corporation is not personally liable for the acts or debts of the corporation except that he may become personally liable by reason of his own acts or conduct.”
In comparing the two forms we also note that they can have substantially similar, although not identical tax treatment. In most cases a LLC is taxed as a partnership, passing income and losses through to its member-owners (or if there is only one member then the LLC is ignored for tax purposes and the income and losses are reported directly on its sole member’s tax return); if an election is made under Subchapter S then the shareholders also receives pass-through tax treatment of the corporation’s income and losses. There are, however, certain limitations on who may be shareholders in a corporation making the Subchapter S election. Thus, if pass-through tax treatment is desired and the owners are not eligible to make the S election, the only option may be to use a LLC.
There are other differences in tax treatment of the corporate and LLC forms, as well as differences in how new owners can be added, the ability to grant optional equity interests to employees or others and the ability to transfer or sell ownership interests. You need to consult with a competent attorney or advisor to fully consider which form of business you should use.
BUSTED: The LLC is not the only way to protect your assets. The protection of assets afforded by the LLC (or corporation) is only with respect to you being an owner of the LLC and not from any personal actions you may take while working for or on behalf of the LLC.
Myth Number 2: You need to have a clause in your contracts which provides that if there is a dispute about the contract and you win, the other party will pay your attorney fees.
It’s only fair: the other party breaches the contract and you must take them to court to collect the damages. Why should you have to pay the legal fees to get them to do what they were supposed to do under the contract?
Fair or not, the law in North Carolina is that such clauses are considered to be against public policy and unenforceable unless there is a statute specifically allowing collection of attorneys fees on the applicable matter. This rule dates back to at least 1892 when the North Carolina Supreme Court refused to enforce a clause which allowed collection of fees in the event of a lawsuit to collect on a promissory note, explaining that such a clause is against public policy not only because it is punitive in nature but also because it tends to encourage litigation. In more recent times the North Carolina courts have refused to allow collection of attorneys fees in a contract for the sale of real estate, a contract for the sale of a business and enforcement of restrictive covenants. Further, the courts have held that you can’t get around the prohibition by drafting an indemnification clause where attorneys fees are included in a successful action.
While the rule against attorneys fees being paid by the losing party is long standing, there are now some North Carolina statutes which do permit attorneys fees to be added to judgments. In 1967 a statue was passed allowing attorneys fees to be added as part of collection on a note or on other evidences of indebtedness (which includes commercial leases)…although the fees are limited to 15% of the balance due under the note and there are a series of other actions which must be taken by the creditor in order to be able to collect the fees. Fees are also allowed in litigation brought under the unfair and deceptive trade practices statute, in certain cases brought by or against an agency of the State, and in cases to recover civil damages from the interception, disclosure or other prohibited uses of wire, oral or electronic communications.
BUSTED (in most cases): Such a clause is only enforceable in North Carolina if there is a specific statute permitting collection of the fees; it may or may not be enforceable in other states and jurisdictions.
Myth Number 3: The Internet Tax Moratorium means that a business does not need to collect sales tax on sales it makes to customers in other states.
The Internet Tax Moratorium is a prohibition on the imposition of taxes on services to access the Internet. The obligation to collect and remit taxes on the sale of goods is not related to this federal legislation. It is governed by state law, subject to limitations that have been imposed on these laws by various court decisions.
The limiting decisions are those of the United States Supreme Court, which has consistently held that states can only require retailers with a physical presence in the state (such as a store, warehouse or employees) to collect and remit sales and use taxes. So, for example, Amazon.com charges sales tax only to residents of Washington, where its headquarters are located, and to the two states where it operates distribution centers or other physical facilities.
Encroaching on this limitation, however, is a 2005 decision by the California Court of Appeals which held that Borders Online, LLC was required to collect the tax on sales in California even though it had no physical presence. That court found that the brick and mortar Borders stores, although technically part of a separate legal entity from Borders Online, served in an agency capacity since, among other things, products purchased from Borders Online could be returned for a refund or store credit at any Borders store. This provided an adequate physical presence to require the collection of sales taxes.
As an interesting variation on this issue, states are now expanding to collect tax on intangibles, such as downloaded software. At this time 15 states have passed legislation to charge sales tax on downloaded music and videos from services like Apple’s iTunes. It appears that the same rules will apply with respect to collection of sales taxes on such downloads, so if you have to collect taxes on tangible products you will also have to collect on these intangibles.
From the consumer side, just because there is no tax collected it does not mean there is no tax due. North Carolina residents are supposed to voluntarily pay use tax on such purchases and there is a line on the North Carolina income tax returns to report the amount due.
BUSTED: The Internet Tax Moratorium has nothing to do with the imposition and collection of taxes on tangible (and in some cases intangible) goods. The imposition of these taxes is set by State law and generally requires you to have a physical (or perhaps agency) presence in the state in order to be obligated to collect and remit such taxes to the State taxing agency.
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