Picture a small tech start-up that has struck gold with a game-changing product. As the founders begin planning for expansion, they reach out to their trusted business lawyer, who seamlessly handles the legal side. But when asked about tax implications, the lawyer hesitates, revealing a gap in expertise.
This scenario highlights a common issue for business lawyers who may overlook the tax consequences of major decisions such as raising capital or planning an exit. Similarly, tax lawyers often excel at tax-saving strategies but may miss the broader legal context, such as corporate governance and regulatory compliance, that influences these tax plans.
In today’s hybrid law practice, attorneys advising growing businesses need to understand both tax law and business law. The intersection of these fields is vital, as tax consequences touch every aspect of a business’s operations. Ignoring them can lead to costly mistakes or missed opportunities. This article will explore key tax issues that business lawyers should know about and the business law challenges tax lawyers must navigate.
As a business lawyer, you’re often at the helm of decisions that shape your client’s growth. Every decision—whether it’s selecting the right business structure, raising capital, or planning employee compensation—carries tax consequences that impact a company’s long-term success. Understanding these tax issues allows lawyers to offer comprehensive advice that aligns with their clients’ financial strategies and helps clients avoid liabilities while maximizing profits and reinvesting in growth. By staying proactive and informed on tax matters, business lawyers can become trusted advisors, guiding clients through each stage of growth with confidence.
Consider Sarah, a small business owner who launched a software development company. Initially, she operated as a sole proprietor but soon realized that her structure was not efficient for tax or liability protection. She debated between an LLC, S-Corp, or C-Corp, each of which would shape her company’s tax burdens and future growth.
For example, forming an LLC allows for pass-through taxation, meaning profits flow directly to the owners, who then report them on personal returns. However, LLC members must pay self-employment taxes on their share of profits. As Sarah’s business grew, this tax burden became significant, cutting into her ability to reinvest in the business.
If Sarah had chosen a C-Corp, the company would be taxed at the corporate level, currently at 21 percent. Although this results in double taxation—once at the corporate level and again on dividends—a C-Corp structure allows profits to be retained for growth without immediately taxing shareholders.
Alternatively, Sarah could have formed an S-Corp, which offers the best of both worlds for many small businesses. It allows pass-through taxation like an LLC but enables owners to take a portion of profits as dividends, which are not subject to self-employment tax. However, S-Corps have limitations, including a cap on the number of shareholders and restrictions on who can own shares.
In the early years, Sarah’s LLC saved her from double taxation, but as her profits grew, so did her self-employment taxes. Transitioning to an S-Corp allowed Sarah to pay herself a salary, subject to payroll taxes, and take the remaining profits as distributions, which were not taxed as heavily. However, if Sarah wanted to attract investors or go public, converting to a C-Corp would be the best path despite the cost of double taxation.
The choice of business entity should take into account not only the immediate tax liabilities but also the long-term goals of the business. Whether the client is seeking tax savings or preparing for expansion, the right structure is crucial.
As Sarah’s business grew, she realized that her LLC structure was no longer the best fit. She decided to transition to an S-Corp to lower her self-employment taxes. However, converting entities is not without its challenges. Transitioning from an LLC to an S-Corp may trigger capital gains taxes if the business holds appreciated assets. Moreover, failure to comply with IRS requirements, such as filing IRS Form 2553, could result in costly penalties.
For many businesses, restructuring is necessary to keep pace with growth, but careful planning is essential to avoid triggering unexpected tax liabilities during the conversion process.
As Sarah’s company expanded, she needed capital to support growth. Business owners typically choose between debt financing (borrowing money) and equity financing (selling shares of the company). Each option comes with its own tax considerations.
When opting for debt financing, interest payments are tax-deductible, reducing the company’s taxable income. However, debt repayment can strain cash flow if the company experiences a downturn. Equity financing, on the other hand, does not require repayment but can lead to double taxation on dividends, which are not tax-deductible.
As Sarah sought to incentivize her employees, she turned to stock options. Offering incentive stock options (ISOs) allows employees to defer taxes until they sell the stock, and even then, any gains are taxed at the favorable capital gains rate. However, ISOs can trigger the alternative minimum tax (AMT), creating unexpected liabilities for employees.
Non-qualified stock options (NSOs), on the other hand, are taxed as ordinary income when exercised but provide the company with a tax deduction for the compensation. Sarah had to carefully weigh which option suited her company’s goals and her employees’ financial interests.
As Sarah continued to invest in new equipment and technology to support her growing business, she took advantage of Section 179 and bonus depreciation to deduct the cost of these assets. Section 179 allowed her to deduct the full purchase price of qualifying equipment in the year it was purchased rather than depreciating it over several years, which provided her with an immediate tax benefit and improved her cash flow.
She also explored the research and development (R&D) tax credit, which offered a dollar-for-dollar reduction in tax liability for money spent on developing new products. This credit was particularly beneficial for Sarah, as her software company was continuously innovating and experimenting with new technologies. The R&D credit not only reduced her company’s tax burden but also encouraged her to reinvest in future growth.
Sarah knew that offering competitive compensation packages would help her attract top talent. She structured a 401(k) plan for her employees, which allowed them to defer a portion of their salary into the plan, reducing their taxable income. Sarah’s contributions as an employer were also tax-deductible, which reduced her company’s taxable income.
She also implemented health insurance benefits, which were tax-free to employees and fully deductible for the business. These benefits not only improved employee satisfaction but also provided significant tax savings for her company.
Eventually, Sarah began to think about her exit strategy—whether through selling the company, merging with another business, or transitioning ownership to family members. The way she structured this exit would have enormous tax implications.
If Sarah decided to sell her company, she had two primary options: a stock sale or an asset sale. In a stock sale, Sarah would sell her ownership shares, and the buyer would take over the entire company, including all its assets and liabilities. From a tax perspective, this was ideal for Sarah because stock sales are generally taxed at the lower capital gains rate, minimizing her tax liability.
However, buyers often prefer asset sales because they allow them to “step up” the basis of the purchased assets, leading to larger depreciation deductions in the future. For Sarah, an asset sale could result in a higher tax bill, especially if some of the assets sold triggered ordinary income tax rates instead of capital gains rates.
To mitigate the tax burden of a large sale, Sarah considered an installment sale, which would allow her to receive payments over time rather than all at once. By spreading the payments out over several years, Sarah could also spread out the tax liability, potentially keeping her in a lower tax bracket each year and reducing the overall tax bill.
Tax lawyers advising business clients often face overlapping issues from both tax law and business law. Tax lawyers must understand the legal frameworks that shape their clients’ business operations. Corporate governance, contract drafting, and compliance with legal formalities are all intertwined with tax strategy. By addressing these business law issues, tax lawyers can help clients avoid pitfalls, optimize tax benefits, and ensure long-term compliance. Whether it’s navigating mergers and acquisitions, handling IRS audits, or managing litigation settlements, tax lawyers must blend their tax expertise with a solid grasp of business law considerations to fully support their clients’ growth and success.
Take the example of Bright Innovations, a rapidly growing tech company. As it expanded, the founders were focused on product development but neglected key corporate formalities such as holding regular board meetings or issuing formal resolutions for major decisions. Such oversights may seem minor, but they can have serious tax implications. For instance, if stock options were issued without proper board approval, the IRS could challenge the company’s tax deductions related to these options, potentially disqualifying them.
Tax lawyers advising businesses like Bright Innovations must ensure that corporate governance practices are maintained. Proper board resolutions, shareholder meetings, and documentation of major transactions aren’t just legal formalities—they also affect tax filings and IRS audit outcomes. Failure to comply with these governance protocols could trigger IRS audits, penalties, or the loss of tax benefits. For tax lawyers, understanding the legal significance of these formalities is crucial for protecting their clients’ tax positions.
Contracts are a central part of business operations, and they often carry significant tax consequences. Consider United Fabrics, a company leasing a new warehouse. The way this lease is structured can determine whether the rental payments qualify as tax-deductible expenses. If the contract isn’t properly drafted to meet IRS requirements, the business may miss out on these valuable deductions.
Similarly, in purchase agreements, the allocation of the purchase price between different types of assets, such as equipment and goodwill, plays a big role in maximizing tax benefits. For instance, assigning more value to depreciable assets such as equipment results in larger tax deductions than assigning it to non-depreciable items such as goodwill.
Tax lawyers need to be actively involved in contract drafting to ensure tax efficiency. Collaborating with business attorneys to align contract terms with both legal and tax objectives helps clients minimize their tax burden and avoid unintended consequences.
Mergers and acquisitions (M&A) often require tax lawyers to navigate complex business law issues. For example, GreenLeaf, a start-up merging with a larger competitor, seeks to avoid triggering major tax liabilities in the process. By structuring the transaction as a tax-free reorganization under IRS Section 368, the tax lawyer helps the company defer taxes on stock holdings, ensuring the merger proceeds without immediate tax penalties.
Similarly, in the case of buy-sell agreements, such as when Johnson Manufacturing’s owners are planning for a transition, tax lawyers ensure that the agreement is structured in a tax-efficient way. Without careful tax planning, the seller could face significant capital gains taxes, and the remaining owners could be left with an unfavorable ownership structure.
Tax lawyers must work closely with business attorneys to ensure that mergers, acquisitions, and business succession plans are structured in a way that minimizes tax liabilities while meeting legal and financial goals.
Litigation also brings unexpected tax challenges. For instance, BlueSky Solutions, a software company, was sued for breach of contract and eventually settled the case. The way the settlement is categorized for tax purposes significantly impacts BlueSky’s tax liabilities. Compensatory damages for lost income are typically taxable, while deductions for legal fees may only be allowed if they are correctly allocated to business expenses.
Failing to categorize the components of a settlement properly can result in hefty tax consequences. Tax lawyers play an important role in evaluating settlement agreements to ensure the appropriate portions are taxable or deductible. They must also ensure legal fees are properly categorized, allowing businesses to deduct allowable fees, which can save the company substantial amounts in taxes.
As businesses grow, the likelihood of an IRS audit increases. Consider Skyline Builders, a construction company that rapidly expanded across multiple states. The company’s tax filings included numerous deductions, credits, and depreciation schedules, which triggered an IRS audit.
In preparation for the audit, Skyline’s tax lawyer works with management to ensure all documentation—such as employee payroll records, receipts for purchased equipment, and depreciation schedules—is in order. Without proper documentation, the IRS could disallow deductions and impose penalties.
Tax lawyers must help businesses prepare for audits by ensuring accurate recordkeeping and compliance with IRS rules. If the audit results in a dispute, tax lawyers may also represent the company in tax court, working to reduce penalties and protect the business’s tax positions.
The intersection of tax and business law is vital for growing companies. Business lawyers must grasp tax implications when advising on entity selection, raising capital, and structuring employee compensation. Meanwhile, tax lawyers must understand the legal frameworks of corporate governance and contract drafting to ensure that tax strategies align with broader business goals.
Attorneys who develop cross-discipline expertise will better serve their clients, ensuring that both legal and tax concerns are handled comprehensively. Whether advising a start-up or a mid-size company, embracing a hybrid law practice will position lawyers as invaluable partners in their clients’ long-term success.
