By: Thomas Fafinski
Published in WealthCounsel Quarterly April 2016
A client’s decision to retain you is often overwhelming. Are you the best person for the role as their business counselor? Are you going to be too expensive? How do you compare to the competition? Do you have the appropriate experience?
An effective way to forge a relationship with a new business client is to guarantee that your initial services will not cost them anything. This makes you free to the client and the only risk is whether they want to invest the time working with you. We have developed a product from our combined service offerings that accomplishes this objective: the Legal Assessment.
Why is a Legal Assessment Useful?
Most business owners do not think twice about having regular physical healthcare examinations. Yet none of the privately-held business prospects that I have encountered in 25 years of practicing have participated in a legal check-up of their current business operations or enterprise. Initially, most regard the project as an expense to eliminate remote risks that they have decided to bear – simply to avoid the expense.
Rather than trying to sell over these concerns, embrace them. Make their buying decision easy by removing the complicated and difficult analysis they inevitably undergo. A prominent tech sector investment banker, Michael Harvath of Revenue Rocket, explained to me that “your client’s buying decision can’t be a science project… make the decision an easy one for them by being able to explain it in 5 minutes.”
Our “productized” service addresses the irrational expense reluctance emotion by guaranteeing the solutions presented will result in savings that exceed their cost in the first year. We bundle the respective disciplines within our firm to complete a comprehensive assessment akin to a medical physical.
What are the Components of a Legal Assessment?
The assessment entails a review of the client’s business structure, enterprise operations, contracts (employment, vendor and customer) and their business and personal tax burden. Following our analysis, we make detailed written suggestions on ways to improve their defense. The written analysis is comprehensive and includes a graphic depiction of most of the solutions. We deliver the written assessment and then schedule a time to verbally explain the recommendations and solutions to them.
We title the client deliverable a “Legal Assessment.” We do this legal assessment of their entire enterprise for a flat rate and guarantee (by reducing their fee to the savings) that if they implement our recommendations, they will save more money than it costs to do the assessment.
We always explain that the assessment is not the actual solution. It is just an assessment of what solutions are appropriate. Implementation of the solutions may involve additional fees.
I always use a “broken arm” example when explaining an assessment. If you think you have a broken arm, you go to the doctor for an x-ray. The x-ray does not fix anything, rather, it is a diagnostic procedure meant to assist the doctor in discerning an appropriate remedy, i.e. ace bandage, soft cast, hard cast, operation. I explain that our fixed fee does not include the cost of implementing the solution, although many of the solutions we will suggest will not involve any additional legal fees to implement. In fact, we find that the low hanging fruit (observations which require little or no legal fees to implement), actually generate enough savings to pay for the assessment.
Our analysis involves systematically and methodically reviewing and analyzing the enterprise and operations, payments made to owners and key employees, the level of profitability and the intrinsic protection afforded by their current structure from an asset protection perspective. We attempt to convert the character of income and ensure they are taking full advantage of available deductions and tax credits. We evaluate the financial products employed to fund retirement, key employee programs, buy-sell agreements and healthcare alternatives. We normally end with melding the business succession opportunities with an estate plan design.
How Does the Legal Assessment Uncover Cost Savings for Clients?
Where does the expense savings come from to generate enough to fund the cost of the assessment? Tax mitigation and expense mitigation are the primary avenues of recovering the investment.
First, we design a reorganization of operations to improve asset protection. This generally yields opportunities to implement income tax efficiencies that their current structure does not offer. Our solutions normally involve a combination of entities, including limited liability companies, entities taxed as an S corporation, C corporations, and often, irrevocable trusts.
For example, most enterprise structures should include an entity taxed as an S corporation so that wage-related income can be defined (normally pursuant to a relevant salary survey) so as to minimize payroll withholding expenses. It is important, in our opinion, to be sufficiently capitalized to warrant the return on investment income too. This necessarily involves evaluating the method and manner of capitalizing the business.
Rental of personal and business use property between the enterprises often generates income tax mitigation opportunities. The use of personally owned assets in exchange for fair market rent can generate opportunities too. Develop a list of strategies geared toward changing the character of income such that active income (subject to withholdings) is converted to passive income (like interest income on savings accounts). Next, develop a list of strategies that take passive income and convert it to long-term capital gains (like appreciation of physical assets). Finally, develop a list of strategies that convert capital to deferred recognition or “never to be taxed income” (i.e. ESOPs, 1031 exchanges or life insurance related solutions).
Next, we evaluate the deductions to ensure the enterprise is availing itself of all opportunities. For example, many accountants still counsel that a home office deduction is a “red flag” for audit. Most business owners use some of their personal assets in the business but have never considered paying rent, let alone a sale and leaseback strategy that normally yields results in year two or three. These strategies are the less complicated solutions but we find that many clients are open to advanced strategies too. We often recommend a C corporation to create a synthetic deferred compensation program for key players. Another example of an advanced solution is a captive insurance company, which tends to generate tax deductions at the operating level and permanently change the character of some of the enterprise income.
Third, we look to tax credit strategies like the research and development tax credits, credits available for hiring certain persons (i.e. economically disadvantaged or felons). In our experience, most clients are not taking full advantage of the tax credit opportunities that are available out of fear or ignorance.
Fourth, sometimes we review insurance costs (life, health, property and casualty) and compare them with competitors. Not only are we potentially assisting our client in saving on premium costs, we are also creating referral opportunities for insurance professionals who may refer clients back to us in the future.
Fifth, we review retirement plans or opportunities and analyze cost saving opportunities.
What are other Benefits of the Legal Assessment for your Clients?
There are many aspects of the assessment that do not provide income tax or expense savings. We review these aspects as a part of the assessment because it creates a menu of items that the business enterprise should consider to reduce liability exposure. This review entails the corporate minutes (reducing the risk of liability to the principals), business succession plans (reducing the risk of unwanted owners), the estate plans of principals, employment manual and contracts (mitigating employer liability issues and generate key employee retention strategies) and customer and vendor contract review (mitigating liability risk). At the conclusion of the assessment, we list the recommendations and a brief summary of each, together with a cost for the solution.
A legal assessment provides real and significant opportunities for the small business attorney. We find that many of our client’s accountants spend more time on accurately reflecting past operations (looking through the rear view mirror on what has happened) rather than being strategic (looking through the windshield at what is to come). Perhaps a portion of this results from IRS penalty regulations that create a disincentive for accountants to be proactive in managing tax burdens.
Potential Attorney Liability
In performing a legal assessment, attorneys need to be aware of IRS penalty regulations.
First, you do not want to become a “tax preparer” as defined by the Internal Revenue Service Code and Regulations. The liability potential for tax preparers is actually a good marketing technique directed at the ultimate client (retail) and fosters a better relationship with our accountant referral sources (wholesale). IRC § 6694(a) creates penalties for tax preparers for understatement due to unreasonable positions.
While the penalty is not necessarily significant – the greater of $1,000 or 50% of the income derived by the tax return preparer with respect to the return or claim for refund – if the tax return preparer makes that recommendation for one client, it is likely that they are making the recommendation across the board. In the age of electronic filing and the ability to sort by preparer, the risk of multiple exposure is real and significant. If many clients’ returns are reviewed, not only does the tax return preparer expose clients to audit risk, the tax return preparer could sustain multiple penalties and the loss of his or her entire book of business . The penalty is also increased if IRC § 6694(b) is triggered, which deals with understatement due to willful or reckless conduct. In that case, the penalty is the greater of $5,000 or 50% of the income derived by the tax return preparer with respect to the return or claim for refund.
It is important that you do not assume liability as a tax preparer, but mostly from a marketing standpoint. 26 CFR 301.7701-15(b)(2) provides for non-signor liability if you prepare a substantial portion of a return with respect to events that have already occurred at the time of the advice (unless the advice is less than 5% of the total time expended on the subject position). Additionally, if the tax advice is given before the events occurred but primarily to avoid being treated as a tax return preparer, you may be considered a tax return preparer too. This penalty can be applicable to you, an attorney making recommendations, especially if the recommendations are solely for tax mitigation.
We believe it is important to have non-tax mitigation factors as the motivation for transactions anyway. When dealing in other states, we sometimes team with local counsel or are brought in by local attorneys, provided the unauthorized practice of law statute allows us to address the federal issues or some other exemption applies. Local co-counsel generates the state law based rationale for the proposed transactions.
Additionally, the incidence of liability when providing proactive advice is far more remote when the taxpayer does not receive any additional advice post-transaction, i.e. participating in the actual preparation of the return to reflect the transactions. Even with some participation in the generation of the tax return, provided it is less than 5 percent of the aggregate time spent by you in providing advice, you are still not considered a tax preparer. Simply refusing to review any portion of the return or comment on the tax ramifications may substantially eliminate liability exposure. Unlike a signing tax preparer, your book of business is not exposed to the search and sort characteristics of electronically filed returns.
Because the solutions presented often culminate in a combination of entities and strategies directed to the principals, we must address the issue of, “who is the client?” Often, strategies recommended during an assessment involve multiple entities and transactions with principals of the core organization. To complicate matters further, the attorney rendering the assessment is creating attorney-client communications.
The ABA Model Rules of Professional Conduct serves as a model for the ethics rules in most jurisdictions. Rule 1.13 makes it clear that a lawyer employed by an organization to be formed represents the organization through its authorized constituents. The lawyer should be careful not to presume the interests of the owners, officers and employees are in alignment with the company.
Rule 1.13(f) requires disclosure to the company’s directors, officers, employees, owners, or other constituents that the client is the company when the lawyer knows that the organization’s interest are adverse. Yet Rule 1.13(g) recognizes that the lawyer may also end up representing a principal or employee. See comment 12. Rule 1.7(a) prohibits representation leading to concurrent conflicts of interest. A concurrent conflict is one that is directly adverse or which leads to a significant risk of materially limiting the lawyer’s responsibilities to one of the clients. Concurrent representation is allowed under Rule 1.7(b) if the lawyer believes competent and diligent representation can be provided to each and it does not involve the assertion of a claim by one client as to the other. Even then, full disclosure and client consent is required.
When designing an enterprise structure through an assessment, lawyers often provide legal advice that could be protected by the attorney-client privilege, normally to more than one client. The privilege can be protected through a joint representation arrangement by the clients.
Lawyers are also allowed to provide joint representation to any number of clients if there is not a conflict of interest. Pursuant to a joint representation agreement, the clients share the attorney client privilege, provided the communication is (a) with a company employee, (b) at the direction of superiors, (c) for the company and the facts are needed to render the advice, (d) within the scope of duties of the employee, and (e) confidential. Upjohn Co. v. United States, 449 U.S. 383 (1981), See also Restatement Third, The Law Governing Lawyers §73.
You can set out the information that may be withheld from the other clients, otherwise the attorney-client privilege cannot be asserted as to each other. ABA Model Rule 1.7. Since there are no secrets between the clients with regard to joint representation, be careful not to include entities that you know will be spun out of the enterprise, or make sure to exclude the attorney-client relationship in the ultimate sale.
While there are some obstacles to implementation, associating with experienced counsel not only provides you the opportunity to implement the solutions being proposed, but it also deepens your relationship with existing clients. The Legal Assessment can forge a mutually rewarding relationship with current or prospective clients.