Update: Coronavirus (COVID-19)
In February of 2020, the novel coronavirus began spreading rapidly throughout the world. There has been widespread economic upheaval and uncertainty as businesses around the US reel from the destabilized supply chain, volatile stock markets, and prolonged shelter-in-place orders. The strategies in this piece for weathering an economic recession are more important than ever as we stare down the barrel of the economic fallout of a global pandemic.
In the wake of the financial crisis and the Great Recession, the country has been on an unprecedented economic upswing. July 2019 marked the 121st month of our current economic expansion, making it the longest expansion in U.S. history. However, the growth we’re seeing now will eventually level off or reverse course, and the effects of that on small businesses can be catastrophic. Just ask the more than 1,000,000 privately-held businesses that died during the Great Recession.
Economists and TV pundits are split on the imminence and inevitability of a recession, but the market indicators are there (e.g. the recently-inverted yield curve). Regardless of whether you think the current fears of an economic slowdown are warranted or overhyped, every business owner should take steps to recession proof a business before a recession hits.
Most financial- or management-related tips will involve increasing cash reserves or decreasing spending. But with proper legal planning you can do more than outlast the slump; you can shore up your cash flow and actually ensure that it stays positive. We’re going to see how three contract provisions are your secret weapon against an economic recession.
Reasonable Owner Compensation
Business owners are always looking for ways to reduce their tax burden. Some strategies are entirely aboveboard, but others can put you at risk. One common method used by shareholder employees is to skew the wage-distribution ratio to avoid paying payroll taxes.
Since distributions are not subject to payroll taxes like W2 wages, it’s clear why this strategy has appeal. For example, if an owner was compensated $30,000 of distributions instead of wages, he could avoid paying roughly $4,500 in payroll taxes.
Owners can be tempted to try to game the system and forego a reasonable salary in lieu of distributions to save even more on taxes. The problem is that the tax code says that an owner must take a reasonable salary. If you don’t take a reasonable salary, the IRS can come knocking, reclassify thousands or hundreds of thousands of dollars of distributions as wages, and leave you with an enormous tax burden.
JD & Associates v. United States
Jeffrey Dahl was the sole shareholder of a successful accounting firm, who had been operating as a CPA for more than 20 years. He reported a salary of $19,000 in 1997 and a salary of $30,000 in 1998 and 1999. Mr. Dahl also took $47,000 of distributions in 1997 and $50,000 of distributions in 1998 and 1999.
Unfortunately, the IRS argued that Mr. Dahl wasn’t taking a reasonable salary. The District court agreed with the IRS and recharacterized more than $111,000 of distributions as wages over the three-year period. This also meant Mr. Dahl was subject to the nearly $17,000 in payroll taxes arising from those wages.
Credit Where Credit Is Due
Recessions can put companies with distribution-heavy owner compensation in a tough spot because distributions are dependent on profits. Of the money your company makes, the creditors have to be paid first before any money is distributed to owners or shareholders. If owners take money out of the business during times of reduced profits and there isn’t sufficient money to pay creditors, the owners can be held personally liable for the amounts due those creditors.
It’s important to establish reasonable salaries for owners and also to include owner compensation rates in your shareholders agreement. This way you can avoid a situation where one owner, who is used to receiving $50,000 of distributions each year, continues to take that amount even though that year’s profits only allow for $20,000. The business’ creditors could come after that owner personally for the $30,000 difference.
Termination
Here, I’m using “termination” here in two slightly different senses. The first refers to laying off employees, and the second refers to discontinuing a contract. Both, unfortunately, are aspects that owners need to be prepared to handle during a recession.
At Will Employment
Each employee should have a signed employment agreement with clearly defined termination procedures. This provision protects the business from the former employee bringing litigation if there are layoffs during the recession. If you are making cuts because of cash shortages, the cost of litigation could be disastrous.
Independent contractors should also have signed agreements with clearly defined at will termination provisions. Many “standard” independent contractor agreements include a 30- or 60-day notice period for termination. Again, if you are experiencing a financial crunch, you don’t want to have to continue to pay an independent contractor for 30 more days.
Moreover, you absolutely need to follow the IRS guidelines to certify that your independent contractors are independent contractors. If your “independent contractor” turns out to be an employee, they may be eligible for unemployment benefits.
Contract Termination
Business owners also need to understand how and when a vendor or supplier contract can be terminated. Review your important contracts and see how that relationship affects your business. An economic downturn will hurt businesses across the board, and you need to know what the process is for cancelling a contract with a supplier or vendor in there is a breach of contract.
An improperly written contract termination provision can leave you and your business in the lurch. Let’s say a vendor contract states that a breach of contract occurs after 30 days. But it also allows for a 30-day period to cure that breach before you can terminate the contract. This means your business could potentially go 60 days without that vendor’s product. If you were a coffee roaster and a bean supplier didn’t supply coffee beans for 60 days, how much would that hurt your business?
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Liability Limitations
Speaking of lost profits, nearly every commercial contract your business has should include a limitation of liability provision. Far from being a boilerplate section of a contract, it can be one of the most useful provisions to mitigate your risk and insulate you from liability and damages.
When dealing with limitation of liability provisions, it’s instructive to think about what the worst-case scenario would be if your business were to breach the contract. As a default, a party to a contract could be liable for all of the reasonably foreseeable damages to the other party, both direct and indirect.
For example, if your business provides the raw material that a company uses to make its product, a breach of that contract could leave you liable for the replacement cost of the raw material (direct damages) and for lost profits of the company from the sale of the end products (indirect damages). Should the company’s inability to deliver their product to customers trigger additional contractual penalties, you may be liable for those as well! The damages could quickly become insurmountable, especially if an economic recession is already hurting your revenue stream.
Businesses should negotiate and thoroughly understand the liability limitation clauses in their business contracts before a shaky economic environment makes everyone more risk averse. Consider the following:
- Liability caps and waivers: Implementing these lets you limit the amounts of damages your company could be liable for to specific amounts and take certain types of damages off the table.
- Deal-specific terms: Each business relationship has its own unique characteristics. What you should include or not include in the limitation of liability provision is highly contingent upon the nature of the deal.
- Interactions with other provisions: Liability restrictions don’t exist in a vacuum. Other contractual provisions (e.g. “Term” or “Indemnification”) interact with this provision, and you should make sure everything coheres.
Bringing It All Together
The moral of this story is that there’s more to be done to prepare your business for an economic slowdown than simply putting aside cash or cutting spending. You have legal tools at your disposal to safeguard your cash flow. The best time to make these legal preparations is while the economy is still going strong. If you start now, you will be in a much better position than other businesses who simply try to wait out the storm.
Everyone wants to believe their business is immune to a recession, until it’s not. Prepare before the storm:
- Check your partnership agreement or shareholders agreements to see if it adequately addresses owner compensation issues. If it doesn’t, or you don’t have a partnership agreement, contact a business attorney to have one drafted.
- Review your employee contracts, independent contractor agreements, and vendor contracts. Ensure you have the proper employment termination provisions in place so employees and independent contracts cannot sue for wrongful termination. You won’t be the only business taking a hit during an economic slowdown, so be clear in your vendor contracts how and when you can terminate a contract if a breach occurs.
- Revisit the limitation of liability provisions in your commercial contracts. Be sure you understand what liabilities you bear in each instance and put appropriate guardrails in to protect your business. Going into an economically unstable time, you don’t want to assume $1M in liability from a contract that will only provide $50k in profits.
Your best bet is to get the advice of a qualified business attorney to ensure your commercial contracts and partnership agreements are legally sound and up to date. With so much at stake, this is not a time to try to do it yourself.
Helping You Protect Your Business
Here at Alexander Abramson, we focus exclusively on business-related legal matters. Our attorneys have advised closely held businesses and business owners at every stage of the business life cycle. In particular, we focus on drafting comprehensive business contracts and partnership agreements that are tailored to the needs of our clients.
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