Risky Business: The Hidden Risks of Handshake Agreements with Rachel Partain [Ep. 163]

Transcript:

[00:00:00] Voiceover: Welcome to the Life Unlimited Podcast with Larry Heller. You deserve complete financial advice so you can confidently live your life your way for life. Now let’s get into this week’s podcast episode. 

[00:00:19] Matt Halloran: Hello and welcome to another Life Unlimited podcast with your host Larry Heller. Today we’re talking about the top five risks of running a business on a handshake with Rachel Partain.

[00:00:28] Matt Halloran: Now she’s a partner at Forchelli Law, specializing in complex tax advisory and tax controversy services. She guides businesses and structuring transactions to be tax efficient and handles general corporate and transactional matters. Rachel represents clients at every stage of federal and tax state DIS or state tax disputes, including audits, appeals, litigation, and collections recognized for hers expertise.

[00:00:52] Matt Halloran: She holds an AV preeminent Martindale Hubble peer review rating and is frequently quoted in national publications. Rachel’s also an accomplished author and speaker on tax related topics. Larry, take it away. 

[00:01:06] Larry Heller: Rachel, thank you so much for, for joining us. I know Matt kind of gave you a little bit of background on kind of what you do, but why don’t you kind of tell the audience in your own words, what you really do, what your background is before we talk about the risks, running a business on a handshake, which I still can’t believe people do, but we’ll get into that.

[00:01:24] Larry Heller: So give us a little bit background and thanks for joining us, Rachel. 

[00:01:27] Rachel Partain: So I’ve been practicing for over two decades. [00:01:30] I have an l Im in tax. So I’m predominantly a tax attorney. but I, in representing businesses, I’ve obviously morphed into representing, you know, businesses and in regular transactions anywhere from forming a business, operating a business day to day or, or big, inflection points for a business.

[00:01:48] Rachel Partain: And then ultimately, uh, usually sell side exit of the business or, or taking on new, uh, owners. and then, uh, on the tax side is anything from advisory, uh, as well as, controversy as Matt noted. So IRS audits. New York State audits specifically are the, the main focus, 

[00:02:03] Larry Heller: right? So anyone that has a tax issue or a tax situation, call Rachel.

[00:02:08] Larry Heller: But let’s talk about the five risks of running a business on a handshake. First of all, in this day and age, how common is this, Rachel? Do you, do you still see people doing this 

[00:02:19] Rachel Partain: constant? It is a constant. I, I, I, it’s shocking, frankly. I mean, we see businesses that form on legal Zoom, right? They just get a basic kit.

[00:02:28] Rachel Partain: They don’t do an operating agreement. And now, now, which is fine if you’re gonna start it up and you’re, you know, things are running, but you, you wanna bring in somebody else. Well, where’s your document? How are you running? How is this? Or, or, or a concern comes up, right? We, uh, our member, our manager is, is ill, we need to replace a manager.

[00:02:46] Rachel Partain: How do we go about doing that? Well, you don’t have an operating agreement. Oh, we’re gonna take on a new investor here. They give us a check for $20,000. Okay, well, are they, are they a member? Are they owner? Are they getting shares? What’s their interest? What’s the profits of? Right? [00:03:00] loss distribution.

[00:03:00] Rachel Partain: You know, it happens all the time. I see it all the time. 

[00:03:03] Larry Heller: So the people just starting a business with another person and they don’t even bother getting any type of legal data to say, let’s go ahead and do it, and we’ll worry about anything else late, later on. Okay. so that must lead into a lot of different.

[00:03:18] Larry Heller: Problems and issues. So let’s talk about some of them. So what are kind of, what are the economic and maybe management risks of doing, business with a handshake? 

[00:03:29] Rachel Partain: Sure. Perfect example. In New York, uh, there’s the, uh, limited liability company law. So specific to LLCs under New York State law, the default rule for an LLC is that five and losses, distribution and management, uh, member voting rights are all based on.

[00:03:47] Rachel Partain: As reflected on the books of the company, and this is again, assuming you don’t have an operated agreement and you’re in default rule land. the standard is that it’s based on the values of the contributions of the members as reflected on the books of the business, which sounds fine if you have 50 50, we each putting tests, but if you have a service partner.

[00:04:08] Rachel Partain: You haven’t reflected what the value of those services are in the books of the rep of the company, which by the way, you wouldn’t, like, why would you ever think to say, oh, your services are worth x? then automatically that service partner is lopsided in the value that they’ve contributed to the company, which means that their distributions of profits, losses, voting rights, everything is, decreased [00:04:30] based on what the partners agreed at the time.

[00:04:32] Larry Heller: So, but even going back further, how does somebody, you got two people, they wanna start a business together. Don’t they need to at least have an EIN number or a social security number? I mean, how do they even, 

[00:04:42] Rachel Partain: you can send a company super basic right articles with the state, get an EIN number done. I mean, that’s really all you need to have a business, right?

[00:04:52] Larry Heller: Right. So you have an EIN number, but you, you’re saying you don’t have any agreement, you have no handshake on how much, how the business is gonna, is gonna work, and they just go ahead and do that. And they don’t, they, they’ll worry about that later on, is what you’re saying? I 

[00:05:07] Rachel Partain: mean, they’re operating fine in the beginning.

[00:05:10] Rachel Partain: You’re gonna provide services. I’m gonna provide the money, we’re gonna split 50 50 done. And that’s fine when it’s working, but it’s not fine when it isn’t. And that’s the problem, right? Like you have to plan for what is when it isn’t, in case it isn’t, right. You have to think ahead. This, this could be an issue between my member, my partner and I, we we could bring in a new partner.

[00:05:32] Rachel Partain: Like you have to document these things sort of, and I’m not talking about like 30 page, 40 page agreements, right? Three page operating agreement. But it should at least say profits are 50 50. We’re, we’re forgetting the New York statutory defaults. And this is, this is what we’re gonna operate our business by.

[00:05:49] Larry Heller: So one of the risks that you kind of alluded, about is kind of transactional risk. What do you mean by kind of transactional risks? 

[00:05:58] Rachel Partain: Sure. so you’re gonna take on a loan. [00:06:00] What are they gonna, you know, they’re gonna, the lender’s gonna do due diligence. but on what? Right. You don’t have an operating agreement.

[00:06:05] Rachel Partain: You don’t say. Maybe you’re a member managed or a manager managed company, but you never have the operating agreement to tell them who the manager is. So who’s signing the loan document? I mean, something as simple as that. Like if you don’t have an operate, if you say you’re a manager managed and you don’t name a manager in a piece of paper, then the bank is not gonna know who’s gonna sign the document, sign the law, but who has the authority to divide into the company?

[00:06:28] Rachel Partain: Or worst case scenario, the default rule is member managed. So say you have four people, you form an entity. If you don’t stay manager managed, each and every one of those four people can bind the company to something and the other three people may not even know about it because they have that power under state law.

[00:06:45] Larry Heller: Hmm. So, but when you, when when they’ve started this and you, and you declared an an EIN number, have you listed all the people in there? You don’t even have to list the name of the people in there. 

[00:06:54] Rachel Partain: Well, I think form asks for one, the social security number of one responsible person, but that’s vis-a-vis the IRS.

[00:07:02] Rachel Partain: That’s not vis-a-vis state law, third parties, you know, interacting with your entity, providing funding or, or if your, or if your entity’s gonna be sold, right? The, the buyer’s gonna do due diligence on who the owners are, what the percentages are, and, and if there’s no documentation that you know, how are they gonna know?

[00:07:20] Larry Heller: But how does, how do you file, how do you, how does the accountant do even books when there is no company along those, along those lines? 

[00:07:29] Rachel Partain: Well, [00:07:30] presumably the, the CPA, like the owners will, will tell them, this is what we agreed to, a 50 50 split, and that’s fine as long as, like I said, everybody’s getting along.

[00:07:38] Rachel Partain: But as soon as you have, you typically a minority, a service partner like, owner. That says, Hey, no, I, we, we got this payment in. I should get more of that. And now you have like a, conflict or a dispute. Now you’ve triggered, a potentially litigious situation because you haven’t put sort of your operating parameters down on paper.

[00:07:58] Larry Heller: Right. And, and of course it becomes a bigger problem if the two partners or multiple people want to split. I guess it’s like getting married and you don’t have any agreement or prenuptial set up. Oh, if you wanna split. So now what, happens? What are some of the risks of creating something like this?

[00:08:19] Larry Heller: The business has grown and somebody’s unhappy and there is no agreement. Do you, I guess you would try to work something out and if you don’t, you go to court. Is that the kind of 

[00:08:31] Rachel Partain: Yeah. I mean, so I, I, I call it like business divorce, but really shareholder dispute and business divorce. Right. Maybe they’re gonna continue on.

[00:08:38] Rachel Partain: They just need this point hammered out. But yeah, I mean, you’ve essentially bought yourself a ticket to court and the attorney fees that go along with it. 

[00:08:44] Larry Heller: So, what are some of the other business succession risks that you see without having an agreement? 

[00:08:49] Rachel Partain: Sure. So take a, you know, a multi-generational, you know, founder based, business where, the founder’s up in years, right?

[00:08:57] Rachel Partain: They’re managing their business. They were the founder and they may [00:09:00] have given off pieces and there may be some people, you know, working, you know, family members working for the business. But really it’s, it’s still the founder’s business, right? If that founder dies and there’s no plan for who’s taking over, if states a manager managed entity or say it was a, a corporation and they were the president, secretary, like all the positions right?

[00:09:22] Rachel Partain: And they just up and die. Without having on paper the plan for the entity. Sure, they need a personal plan, but I mean, we’re just talking about for the entity who’s the manager, who’s signing checks the next day, who’s, who’s responsible? And if you don’t have that in your corporate documents, you’re now going potentially through probate and you’re having heirs fighting over who’s, you know, controlling the business.

[00:09:47] Larry Heller: yeah, so without having any type of an agreement in there, none of you have to worry about if you split up, you have to worry about if one of somebody gets, I guess not only dies, gets sick and there’s no nothing in there on, on how to, how to address all that. Right. and I guess part of the, planning ahead of time, and I don’t know if they would discuss this with you, but based upon the type of business, I guess, would determine sometimes what type of entity that they would, that they should form.

[00:10:13] Larry Heller: So kind of like what would be some of the entities like that. It would make sense to do, uh, I guess an S-Corp or an LLC or a partnership. So those conversations. Do they have those conversations with you beforehand to see what works better? 

[00:10:29] Rachel Partain: Yeah, so [00:10:30] I that’s, that’s like my primary value add. When, when someone’s about to form, like before you hit legal Zoom, like before, and please don’t use legal Zoom, but before you hit form, right?

[00:10:40] Rachel Partain: Like should you be an LLC? Should you be a corporation, right? That’s like your basics. Generally you can file as a partnership under state law, but. Right. Would really be a limited liability partnership. Right. But the two entities predominantly right, are LLC and corporation for state law. Right. Then the next question is, now what should you be for tax, because you can elect S Corp as an LLC and you can ask SS Corp as a, corporation for state law.

[00:11:06] Rachel Partain: So it’s really do wanna be an LLC and that’s really mostly where we do, tend to recre. I do tend to recommend client support. Then yeah, the next question is, do you wanna be a C corp? Do you wanna be an S corp or do you wanna be a partnership pass through entity? 

[00:11:20] Larry Heller: Right? But so obviously it’s better to figure out one of those corporations and do one of those than have no agreement in place.

[00:11:28] Larry Heller: And, depending upon, I guess the business will depend upon which of those makes better sense for them. 

[00:11:34] Rachel Partain: For example, if you’re gonna be in a real estate entity, you’ll be an LLC taxed as a partnership, period, end of story, right? You will never put real estate in a corporation. And if you don’t get that advice beforehand and you check, oh, we’re, we should be a corporation, and you just put real estate or purchase real estate with a corporation, like worst case scenario, 

[00:11:52] Larry Heller: why is that?

[00:11:52] Larry Heller: Why, why is that? 

[00:11:53] Rachel Partain: it’s just for tax purposes. The corporate S Corp is taxable itself. Now the C [00:12:00] Corp actually files a return and pays tax, and then separately when it dividends, income out to its owners, they also pay tax. And s corp pays tax on its assets, which just means it eventually its shareholders do.

[00:12:14] Rachel Partain: But there is a sort of a charge, a tax charge on the sale of assets. A partnership doesn’t have that, so you would never wanna put a taxable property. Into a corporate solution. Now, a lot of people had to back when there was no, LLCs, you know, that’s, it’s a relatively new creature of statute. but currently if someone says, I’m, I’m doing real estate, the answer’s LLC.

[00:12:38] Larry Heller: Okay. So I mean, can you give us like some examples that you’ve seen that. People have come to you and they set up the wrong corporation from a tax situation or they didn’t have an agreement and, out there and what some of the problems that you’ve faced. 

[00:12:53] Rachel Partain: I think, um, issue that crossed my desk was, a pre-existing business, 100% owned by one person.

[00:12:59] Rachel Partain: So it was a disregarded entity for tax purposes. And she, you know, ran everything. She needed a little bit of funding. She got some funding from a new, investor. and that was it, right? Oh, thanks for the money. All right, so this is like, you know, like, you’re like a 10% owner now. Thanks, but no documentation on the business itself, no documentation of the new money that came in.

[00:13:23] Rachel Partain: No documentation that the, the money wasn’t a loan. They weren’t, that they’re now an owner with owner [00:13:30] rights and member voting and profit distributions, right? So if you can’t prove you’re a shareholder and owner of the, of a business, you’ve really just given them a loan or potentially even a, a gift.

[00:13:41] Rachel Partain: so you kind of need to document, I’m an owner, or this is a loan, right? You can’t, A loan is another example. How many times does. A, a related party send money, you know, loan money to a business or one related business loan money to another related business, right? If you’re not documenting those as loans, right, you’re gonna, get into some trouble.

[00:14:02] Rachel Partain: Either IRS audit interest charges, like who, who should be paying interest and who should be booking interest expense. So that’s a, a particularly recent example that came up. 

[00:14:10] Larry Heller: So we talked a little bit about taxes, but you know, so what are really the tax risks for not setting up a corporation just acting with a handshake?

[00:14:20] Rachel Partain: well, the number one, risk is going to be a tax audit, right? So you’re running your business, everything’s fine, you’re paying expenses, paying. wages here, you’re, you’re doing marketing expense here. You have meals and entertainment, you have all these categories of expenses that are, are totally normal to a business.

[00:14:37] Rachel Partain: You haven’t documented any of that. Then the IRS is gonna come in on audit and zero all of your expenses out, and by zero I mean literally all. Like if you’re, let’s take a, A, a Schedule C, which is an LLC business disregarded for tax purposes. ’cause it’s as if the owner is running the business himself.

[00:14:55] Rachel Partain: I have seen countless, literally countless IRS exams [00:15:00] where they take all of the schedule, schedule C expenses, and just x 

[00:15:04] Larry Heller: Is it too late at that point to do anything? 

[00:15:06] Rachel Partain: It’s not too late, but unfortunately, you’ve, made it more difficult for yourself, right? So you’re, you’re gonna have an audit level where you lose, and then the IRS is, presumed correct, and it’s the taxpayer’s burden.

[00:15:20] Rachel Partain: To show that the IRS is not correct and that you did in fact incur those expenses, so now you’re gonna have to appeal it. So you’re gonna go to the next level above IRS exam, which is IRS appeals. And usually that’s where I’ll be like obviously companies have employees that they’ve paid, like obviously they’ve had marketing expense, right?

[00:15:38] Rachel Partain: So that’s where you’ll get a reasonable person, but it’s gonna take time to get there, and you’re gonna have to provide as much documentation as you had. So it’s gonna be a fact finding a persuasive presentation to IRS appeals and you’re not gonna get a hundred percent. ‘ cause you know, like mailings, entertainment, travel, there are certain categories where if you don’t keep documents, You’re not supposed to get anything. A travel log, you know, if you’re, if you have mileage, reimbursements, meal expenses, you’re supposed to say who you were with and when and why. Right? so you’ll usually get haircut, but you can, you can, win on audit and if. On, uh, on appeal, but worst case scenario is you’re gonna actually have to litigate it in tax court.

[00:16:13] Larry Heller: so that’s one of the risks that they deny deductions for you. What are some of the other tax risks? 

[00:16:18] Rachel Partain: You know, expenses you can lose, you can have, you could have done, shareholder loans and the IRS will say it was really equity, so the company loses out on interest expense. if you’re not, for [00:16:30] example, a bad debt is another area.

[00:16:31] Rachel Partain: If you’re not documenting the steps that you’re taking to try to collect your receivables that you then ultimately write off, they’re gonna say that you haven’t done enough. So really at every stage of, operations is, and everyone’s saying again, like, it’s short, you know, and we tried to contact you.

[00:16:47] Rachel Partain: We couldn’t collect, like we looked at, you know, you want bankrupt. Like it’s just you did, you want little, documentation trails of, of what, how you’re operating. To support the positions you’re taking on your financials, your tax returns, your other, your members. If you’re, if you, if you have a bunch of members, I mean, they could ask about it too.

[00:17:05] Rachel Partain: Like, Hey, are we doc, are we documenting that this, $20 million loan was really bad debt. so there’s a bunch of risk, issues in tax. It’s not. Only IRS, but it’s predominantly IRS. Hmm. 

[00:17:17] Larry Heller: And then the last risk is, you know, litigation risk. So how does kind of litiga litigation risk come up when you’re Sure don’t have a corpor, don’t have a, uh, corporation or operating agreement?

[00:17:29] Rachel Partain: Sure. So we mentioned this earlier that, you know, the, your point about, you know, what do you do when there is now a dispute between shareholders? Like you’re gonna have to go to court to resolve that. but the number one risk. If you don’t keep proper documentations, there’s this concept called piercing the corporate veil.

[00:17:44] Rachel Partain: and what that is, is when you form an LLC under state law, that’s limited liability company, right? You’ve now shielded your personal assets from your business assets because New York State provides a limited liability for that [00:18:00] company. Same with a corporation, right? You have limited liability. If you don’t treat your entities properly, which means the things like having agreements and having boards and holding meetings and minutes and, not operating in good faith essentially with your entity, then there’s a risk that a court would say, this wasn’t really an entity to begin with, it was really you.

[00:18:23] Rachel Partain: And they’ll what’s called Pierce, that veil of limited liability of the company. And come after your personal assets directly. Whoa. Yeah. So that’s like, so on a scale of bad to worse, like we hit worse. 

[00:18:36] Larry Heller: So, and, and I’m guessing that most people don’t even think about that. ’cause if they did just the liability there, they wouldn’t make a move without making sure that they have something, set up.

[00:18:47] Larry Heller: So I guess, are you seeing this kind of in the beginning stages or you’re getting called in to situations down the road to try to help them, help them resolve the issues? 

[00:18:58] Rachel Partain: Yeah, it’s usually when an issue happens, right? Because if everything is operating according to plan and everyone’s still on the same page, their handshake is fine for them, right?

[00:19:08] Rachel Partain: So it’s usually an issue has happened. Either a minority service partner, an ISA audit has happened, or the, or some, some dispute the business could go bankrupt or, or out of, you know, insolvent or. Say it was a, a restaurant up the street and they, just close up. Right. What’s now the, rights and the obligations of the, [00:19:30] managers and, members now to, you know, sort of clean things up so that the entity is closed out properly and they don’t have individual liability for business assets, business liabilities.

[00:19:41] Larry Heller: So in, in, in summary, if you had to kind of just summarize, you know, some of these risks and some of the things that somebody should be doing, what would you, uh, what would you suggest? 

[00:19:49] Rachel Partain: So, definitely have an operating agreement or, a bylaws for a corporation and a, and a shareholder’s agreement at a, at a minimum.

[00:19:56] Rachel Partain: And it doesn’t have to be long, but just get your agreement. Whatever you handshake on, get that on paper. 

[00:20:02] Larry Heller: Yeah. So if you’re sitting out there and you’re listening to this and you’re hearing some of these risks and liabilities, and you’re one of those that have a business without an agreement in there, I would strongly suggest you give Rachel a call to get your ducks in a row and get yourself protected to minimize.

[00:20:19] Larry Heller: These five, five risks. So Rachel, where could somebody go ahead and, and reach you? What’s the easiest way of somebody to reach you? Uh, 

[00:20:27] Rachel Partain: sure. Uh, email is, uh, always the easiest. R partain, so P-A-R-T-A-I-N at for Shelly, which is F-O-R-C-H-E-L-L-I law.com. 

[00:20:38] Larry Heller: Rachel, thank you so much. I’ve learned a lot today about the different risks on here.

[00:20:42] Larry Heller: I hope some of the audiences learned about the risk. And if you’re, like I said, if you’re sitting there thinking about starting a corporation would be even better to speak to Rachel’s. ’cause then you can really plan ahead and, and put the, the best one together. But if you don’t, if you have one out there, much better to get ahold, get ahold of Rachel and figure this [00:21:00] out now before a situation arises.

[00:21:03] Larry Heller: So thanks again, Rachel, for joining us. 

[00:21:04] Rachel Partain: Thanks so much. 

[00:21:05] Matt Halloran: If you have not subscribed to the podcast yet, make sure that you do by, uh, just hitting that subscribe button. And if you know a business owner or somebody who might have been terrified by what you just listened to, uh, and I’m sitting back thinking to myself, oh my God, am I making any of these mistakes?

[00:21:20] Matt Halloran: If that thought crossed your mind at all, make sure that you share this podcast and of course, share Rachel’s contact information. So for Larry and Rachel, this is Matt Halloran, and we’ll see you on the other side of the mic very soon.