Legal Reference & Blog

Capital Gains Exclusion for Startups and Small Businesses

May 11th, 2011 Posted in Legal Reference, Recent Developments | No Comments »

One under-publicized tax planning opportunity contained in the 2010 Tax Relief Act that was passed at the end of December 2010 (the “Act”) is a provision extending the 100% capital gains exclusion for investments in “qualified small business stock” (“QSBS”).  The 100% tax exclusion is an attempt to encourage investment in startups, new ventures, and small businesses.  Although originally set to expire at the end of 2010, this capital gains exclusion now runs for any purchase or investment in QSBS on or before December 31, 2011.

Any new startup deciding on the choice of entity should consider the valuable benefits of this capital gains exclusion.  Under the Act, a taxpayer will not have to pay taxes (federal only) from any capital gains in the sale of any QSBS that is held for more than five years, as long as that stock was purchased after the enactment date and before January 1, 2012

In order for the QSBS to qualify for the capital gains tax exclusion, the QSBS must satisfy the following requirements:

(1) It must be stock (warrants do not themselves qualify but exercise of a warrant for stock is an acquisition) acquired at its original issuance for money, property or services provided to the issuing corporation.

(2) The corporation issuing the stock must be a qualified small business, which is defined as a C Corporation, with aggregate gross assets of less than $50 million at any time before the issuance of the QSBS to the applicable taxpayer or related person, as well as immediately after the issuance of the stock.

(3) The corporation must satisfy the active business requirement.  It cannot be a holding company.

(4) The taxpayer must hold the stock for more than five years.

The amount of capital gain exclusion is capped to the greater of $10 million or ten times the taxpayer’s investment in the QSBS.  A taxpayer should consider taking advantage of this temporary capital gains exclusion in any of the following scenarios:

(1) Forming and issuing stock in a “C” corporation startup before the end of 2011.

(2) Exercising an employee stock option or investor warrant.

(3) Investing in additional stock of an existing startup that qualifies as a QSB.

(4) Converting an existing LLC or partnership into a QSB corporation to attract investors that wish to take advantage of this temporary tax exclusion.

(5) Converting convertible debt to stock.


The Revised “Accredited Investor” Standard Under the Dodd-Frank Wall Street Reform Act

November 11th, 2010 Posted in Recent Developments | No Comments »

The “accredited investor” status of a potential investor is a crucial element in determining the availability of the safe harbor under private placements and other Regulation D offerings.   Previously, Rule 215 and Regulation D defined “accredited investor”  as any natural person who satisfied the Net Worth or Income Test.

To qualify as an accredited investor under the Income Test, the investor must have individual income in excess of $200,000 in each of the two previous years or joint income (with his or her spouse) in excess of $300,000 in each of those years.  Furthermore, the investor must have a reasonable expectation of reaching those same income levels in the current year.  Or to qualify as an accredited investor under the Net Worth test, the investor must have individual net worth, or joint net worth (with his or her spouse), in excess of $1,000,000 at the time of his purchase.    This calculation of net worth includes the value of an investor’s primary residence.

Effective as of July 21, 2010, the Dodd-Frank Wall Street Reform Act (the “Act”) has amended the Net Worth test to qualify as an “accredited investor.”   Section 413(a) of the Act now amends the definition of “accredited investor” to exclude the value of an investor’s primary residence from the $1 million net worth calculation.  The other provisions of the “accredited investor” definition, including the net income test for natural persons, remain unchanged.

It is important to note that the amount of indebtedness secured by the primary residence (i.e. the mortgage) up to its fair market value may also be excluded from the Net Worth calculation.  However, any indebtedness secured by the residence in excess of the value of the home will probably be considered a liability and deducted from the investor’s net worth.

This amendment to the accredited investor definition is effective immediately, with no grandfathering for private offerings that have commenced but have yet to close.    Accordingly, this will have a severe impact on companies conducting private offerings under Regulation D, including companies, who accept additional subscriptions from existing investors.  For such companies, it will be necessary to update their subscription documents and investor questionnaires to ensure that they are in compliance.

The Act’s revised “accredited investor” standard may render ineligible to invest some investors who were previously qualified to invest in private offerings.  Companies should pay close attention to such non-qualified investors to avoid mistakenly blowing their applicable exemption from the registration requirements under the Securities Act.

Forming a Statutory Close Corporation

April 18th, 2009 Posted in Legal Reference | 2 Comments »

Surprisingly, many entrepreneurs neglect to take the time to strategize the appropriate entity to operate their business. Indeed, businesses should consider the various tax and legal advantages and disadvantages of the various entities.

I find that many businesses would like to operate as a corporation and take advantage of certain tax benefits. But, many decline to do so because they are intimidated about having to follow the corporate formalities such as corporate meetings, annual election of officers and directors, and preparation of written corporate minutes and resolutions, etc. As you may be aware, the failure to follow these formalities will be grounds for a claimant suing the corporation to “pierce the corporate veil” and subject a business owner to personal liability.

One overlooked entity that many businesses fail to take advantage of is the “statutory close corporation” which is established under California Corporations Code section 158. It was designed to give small businesses the benefits of a corporation, but allow them the freedom to disregard corporate formalities and manage the corporate business with the flexibility of a LLC or partnership. You can take advantage of this “loophole” as long as your business has no more than 35 shareholders. Even if you plan to have more than the statutory limit of 35 shareholders in the future, you can still incorporate as a statutory close corporation for the time being, and then amend the articles of incorporation to become a regular corporation when you exceed that 35 shareholder limit.

California Corporations Code Section 300 provides that, “The failure of a close corporation to observe corporate formalities relating to meetings of directors and shareholders in connection with the management of its affairs, pursuant to an agreement authorized by subdivision (b), shall not be considered a factor tending to establish that the shareholders have personal liability for corporate obligations.” Thus, a close corporation may be managed in an informal manner, using procedures established in the shareholders’ agreement, without the necessity of compliance with certain provisions of the Corporations Code that otherwise might require formal action by the board of directors or the shareholders.

In addition to waiving the corporate formalities, the shareholders’ agreement should also provide for other matters, such as restrictions as to whom a shareholder can sell or otherwise transfer his/her stock, or requiring a shareholder to sell his/her shares upon certain triggering events (i.e. breach of fiduciary duties or embezzlement).

A statutory close corporation therefore offers greater protection in that you are bulletproof from allegations that you failed to follow the corporate formalities. In addition, it also saves a business owner from the time and expense of having to follow these corporate formalities, which can be better spent building up the business.

California Targeting Employers For Not Providing Workers’ Compensation Coverage.

December 30th, 2008 Posted in Miscellaneous | No Comments »

The State of California (through the CA Department of Industrial Relations) has greatly increased its enforcement efforts to investigate and penalize employers that fail to provide workers’ compensation coverage for their employees. As many of you are aware, all California employers are required to purchase workers’ compensation insurance for their employees or to obtain regulatory consent to self-insure (which requires a net worth of at least $5 million, net income of $500,000 per year and posting of a security deposit). Workers’ compensation insurance is required even if you have only one employee.

Failing to have workers’ compensation coverage is a criminal offense. California Labor Code Section 3700.5 makes it a misdemeanor punishable by either a fine of up to $10,000 or imprisonment in the county jail for up to one year, or both. Additionally, the state issues penalties of up to $100,000 against illegally uninsured employers. And if an employee gets hurt or sick during work and the employer is not insured, then the employer is responsible for paying all bills related to the injury or illness. Moreover, if the Division of Labor Standards Enforcement (CA labor commissioner) determines that an employer is operating without workers’ compensation coverage, a stop order will be issued. This order prohibits the use of employee labor until coverage is obtained, and failure to observe it is a misdemeanor punishable by imprisonment in the county jail for up to 60 days, or by a fine of up to $10,000, or both. The Division of Labor Standards Enforcement will also assess a penalty of $1,000 per employee on the payroll at the time the stop order is issued and served, up to $100,000.

In 2007, California cited 2,536 California employers for penalties totaling $16.6 million. In 2006, California only penalized 1,353 employers for $10.8 million in penalties. In light of California’s budget crisis and the need to replenish the state coffers, I expect the 2008 numbers to reach at least 4,000 violators. Sacramento is also considering new legislation that would increase penalties by possibly forcing violators to pay up to three years worth of workers’ comp premiums that the employer should have paid.

Top 10 Pitfalls for any Business Owner

October 4th, 2008 Posted in Miscellaneous | No Comments »

1. Forget about 50-50 ownership. You believe you and your partner will get along forever. Such utopian thoughts rarely work in business. If a shareholder deadlock occurs, your recourse is to buyout the other party or to ask that a state court appoint a receiver to dissolve the company. To avoid these problems, consider a buyout provision in your shareholder or operating agreement and the use of outside directors to provide advice and to break director deadlocks.

2. Don’t put all of your eggs in one basket. If you have separate businesses or real estate ventures, set up separate corporate or limited liability company (LLC) entities to own these assets. This way if one suffers a financial decline, neither you nor the other entities should be affected.

3. Do not commingle personal funds with business funds. Owners use a corporate or LLC entity to protect themselves from the company’s business obligations. Excluded are obligations which the business owner has personally guaranteed, payroll taxes, and sales taxes. If a business owner commingles his personal funds with company’s funds or uses the corporate account as a personal checking account, and otherwise fails to observe the corporate or LLC structure, the company’s creditors may seek to pierce the corporate or LLC veil to hold the business owner personally liable for all the company’s debts. If you are paying personal debts (car and/or mortgage) from company funds, stop immediately!

4. Don’t throw good money after bad. Business owners sometimes advance personal funds to sustain the company’s operations. Unless you are certain that the company’s financial hurdle is short-term and can be managed through better controls on expenses and/or increased sales, you may be delaying the inevitable and destroying your own personal finances if the company does not survive. It is hard to watch a company you built go down the tubes, but make sure you personally can survive.

5. Properly document your loans to the company. If you loan money to the company, sign a promissory note. Also, obtain a security interest in the company’s assets, even if subordinate to other secured creditors. Absence of a note may make your loan look like a contribution to your equity in the company, and as a shareholder, you will not receive any distribution from the liquidation of the company’s assets until all other creditors are paid in full.

6. Do not use personal credit cards to fund the company’s operations. If the company suffers a financial decline, the owner is personally responsible for paying these credit card obligations, not the company. Also, make careful use of corporate credit cards. Often the individual and the company are jointly liable on such obligations.

7. Make sure all payroll taxes are paid. Business owners sometimes use payroll tax deposits to sustain their companies’ operations during a period of poor cash flow. If the company continues to have cash flow problems, the withholding tax obligations may mushroom into a large sum. The IRS imposes a 100% penalty on the business owner and other controlling officers to hold them personally liable for such taxes. This 100% penalty includes not only the amount that is actually owed, but can include additional penalties and interest.

8. Pay sales taxes. Business owners are personally liable for all sales taxes in California. Timely pay all sales taxes.

9. Hire a competent, trustworthy controller or CFO and pay attention to the numbers. Owners often do not have an accurate understanding of their companies’ finances until it is too late. Get accurate monthly income and balance sheet statements, and review them in detail. Do not forget historical data and economic forecasts to determine the company’s current financial position. Too often, business owners focus on sales, rather than on margins, so that a company can have strong sales while drowning in a sea of red ink.

10. Face your problems immediately. There is no substitute for identifying and fixing problems quickly or, if no fix is possible, recognizing that fact soon enough to salvage what you can. Wishful thinking is deadly in business!

Elevate Your Small Business.

September 4th, 2008 Posted in Miscellaneous | No Comments »

My colleagues Paul Coleman and Charles Vezinaw have published an E-book entitled, “15 Proven Principles for Business Success.”  The E-book outlines 15 strategies to strengthen your business, elevate it for maximum growth, and make it as recession-proof as possible.  Paul and Charles have graciously offered my clients the opportunity to download this E-book free of charge at the following link:

Paul and Charles operate Merchant Support Network (, which helps businesses of any size implement systems for electronic payments (i.e. credit cards, online payments, eChecks, etc.).  I cannot say enough good things about their business.   In addition to having terrific rates and outstanding customer service, they will also provide new clients with a free copy of Quickbooks accounting software and credit card processing equipment without charge.  They also donate a percentage of their profits to local charities in the Bay Area.  I recommend them highly!

California Supreme Court Invalidates Employee Noncompetition Agreements

August 29th, 2008 Posted in Recent Developments | No Comments »

On August 7, 2008, the California Supreme Court issued its much-anticipated decision in Edwards v. Arthur Andersen LLP (Case No. S147190), on the issue of whether Business and Professions Code section 16600 bars employee noncompetition agreements.

Noncompetition agreements are governed by Business & Professions Code section 16600, which states: “Except as provided in this chapter, every contract by which anyone is restrained from engaging in a lawful profession, trade, or business of any kind is to that extent void.” The law, however, allows noncompetition restrictions in the context of sale or dissolution of corporations (§ 16601), partnerships (§ 16602), and limited liability corporations (§ 16602.5). But, under the common law which is accepted by many states today, such non-compete restrictions were valid, if they were reasonably imposed (i.e the Ninth Circuit’s “narrow-restraint exception”). Under the “narrow restraint” exception, a noncompetition agreement would not violate Section 16600 if it involved a limited restriction and left “a substantial portion of the market available to the employee.” 

In this case, the employer Arthur Andersen required its employee Mr. Edwards to sign a noncompetition agreement upon acceptance of employment. The non-compete provision restricted Edwards from soliciting clients or providing accounting/financial services for a period of up to 18 months after termination or resignation. After Mr. Edwards sued, Arthur Anderson asked the Court to adopt the “narrow-restraint” exception, arguing that, under this exception only those restraints that bar one from engaging in a lawful profession, trade or business, and not those restraints that merely impose partial restrictions, are illegal under section 16600.

The Court rejected the “narrow-restraint” doctrine and the noncompetition restriction by asserting:

“The first challenged clause prohibited Edwards, for an 18-month period, from performing professional services of the type he had provided while at Andersen, for any client on whose account he had worked during 18 months prior to his termination. The second challenged clause prohibited Edwards, for a year after termination, from ‘soliciting,’ defined by the agreement as providing professional services to any client of Andersen’s Los Angeles office. The agreement restricted Edwards from performing work for Andersen’s Los Angeles clients and therefore restricted his ability to practice his accounting profession.”

The Court’s decision on this issue strongly reinforces California’s general prohibition on agreements in restraint of trade. But, it does not affect the right of an employer to enforce noncompetition agreements in the context of the sale or dissolution of a business, which is specifically exempt by statute. Likewise, the decision does not affect an employer’s right to use a non-compete provision to protect its trade secrets.  However, I do anticipate the court (or even the Legislature) attempting to close this “loophole” in the future. In the meantime, it is integral for businesses to review and update their employment agreements so that they comply with law.

Avoid Trouble with Unpaid Interns

August 3rd, 2008 Posted in Legal Reference | No Comments »

Before hiring that enthusiastic intern who is willing to work for free at your company, you need to be aware that the unpaid intern may be considered a nonexempt employee under the Fair Labor Standards Act (FLSA), and entitled to minimum wage for all hours worked. That “intern” may also receive one-and-a-half times the minimum wage for all hours worked in excess of 40 in a workweek.

To qualify as a true unpaid internship (and avoid payment of a minimum wage), the internship must satisfy the following conditions:

1. The internship must be an educational experience, similar to the training given in a vocational school.

2. The training must primarily benefit the intern, and not the employer.

3. The intern cannot do work that would otherwise be done by a regular paid employee, and must work under close supervision.

4. The employer cannot profit from the intern’s work.

5. The employer cannot (when hiring an intern) promise a paid job at the completion of the internship (however, its acceptable to offer a paid job after the internship ends.

6. The intern and the employer must agree that no wages will be paid for the training. I recommend putting this in writing.

Remember, it takes only one unhappy intern to notify the U.S. Department of Labor about labor law violations. In 2007, the Labor Department collection $221 million in back wages and received about 24,950 new complaints about wage and hour laws.

Furthermore, a misguided classification that an unpaid intern is actually an employee, can also lead to issues relating to workers’ compensation, state and federal taxes, benefits and unemployment insurance coverage. This can easily cost your company thousands of dollars in unpaid wages, overtime, fines and other costs. Here are some more helpful tips before you decide to take on an unpaid intern:

1. Interns can do actual work if they are closely supervised, are learning and not creating a final product.

2. Decide beforehand if your company has the time and resources to closely supervise and mentor an unpaid intern.

3. When in doubt, businesses can avoid legal problems by paying interns at least minimum wage.

Checklist to Maintain Corporate Shield from Personal Liability

June 24th, 2008 Posted in Legal Reference | No Comments »

There is nothing more frustrating than to spend the time and money to incorporate, but then later expose yourself to personal liability for failing to adhere to the corporate formalities. The term “corporate formalities” gets thrown around often, but what exactly are they?

Well, I submit a list of do’s and don’ts to serve as a checklist to help you maintain the limited liability of your shareholders and to establish other good practices for doing business in the corporate form.

A. Hold Meetings.

1. Your annual shareholders’ meeting is set in your bylaws.

2. Your bylaws call for an annual board of directors’ meeting to be held immediately afterwards.

3. Additional special meetings of the board should be held when matters of importance come up such as:

a. Entering into a lease of new premises;

b. Entering into a substantial funding commitment;

c. Entering into a substantial leasing commitment;

d. Entering into any other significant contractual agreement;

e. Changing an officer’s salary;

f. Filling a vacancy in the board or officer complement;

g. Entering into a significant new venture;

h. Considering the sale, in whole or in part, of the assets or the dissolution of the business.

B. Develop A Planning Mechanism.

1. Review each year’s activities during the final month of the fiscal year.

2. Budget ahead for the longest period reasonably possible and review and analyze results at least semi-annually.

3. Review the results of 1 and 2 with your CPA to ensure tax planning is properly emphasized.

4. Begin to develop formal long-range planning capacities beyond budgeting if not already in place.

C. Sign all contracts in the name of the corporation in substantially the following form:

_ _[Name of corporation]_ _

By _ _[name of presiding officer]_ _

_ _[Title]_ _

D. Issue all orders in the name of the corporation.

E. Keep Corporate And Personal Interests Separate.

1. Do not commingle corporate and personal funds.

2. Maintain corporate funds in a corporate account or accounts separate and apart from any other account.

3. Do not use corporate accounts for personal loans or other personal purposes.

4. Do not negotiate loans, leases, etc., between the corporation and a principal other than on an arm’s-length basis.

5. Do not use corporate assets continually for personal use.

F. Carry reasonable insurance on the corporation, having due regard to the risks inherent in the corporation’s business. In addition, have a reasonable initial capital base in the corporation.

G. Set up a review mechanism for decisions made, so that all aspects of a proposed course of action will be considered.


June 9th, 2008 Posted in Uncategorized | No Comments »

Welcome to my legal blog which I will use to educate my clients and any other visitors on various legal matters, and recent developments in the law.  I hope you enjoy it!



The Law Offices of Derek K. Yu make this Blog Site available to you only for the educational purposes of imparting general information and a general understanding of the law. This Blog Site does not offer specific legal advice, and is not a substitute for competent legal advice. The information on the blog may be changed without notice and is not guaranteed to be complete, correct or up-to-date.

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