March 2018 eNewsletter
Personal Guaranties: What Every Business Owner Needs to Know
R. David Weber, Esq., Cors & Bassett, LLC
Your business is growing, and you are hiring to meet increased demand. To accommodate your new employees, you must purchase more office furniture, new computers, and upgrade the telephone system and computer server. To finance these necessary capital improvements, you approach your trusted lender to seek a business loan. Your lender is happy to extend the loan, however, there is one “small” condition: the lender wants you, as the business owner, to personally guarantee the loan. What does this mean, and what should you do?
A personal guaranty is a written promise to pay the debt of another. Personal guaranties work to effectively sidestep the limited liability protections of incorporating your business or registering it as limited liability company. If you personally guarantee a business loan or line of credit, you are promising repayment out of your personal assets if your business cannot meet its obligations.
Guaranteeing a business loan with personal assets, including your home, vehicles, and bank accounts has risk. However, many times, a lender will not lend to a business without a personal guaranty. Given this reality, what can business owners do to protect themselves?
Seek to Limit the Scope and Duration of Personal Guaranty
While saying “no” to the personal guaranty typically ends the negotiations, other counterproposals may not. If possible, try to limit the dollar amount, duration and scope of the assets covered by the personal guaranty. In addition, always be wary of guaranty terms which make you personally liable for the lender’s attorney’s fees and expenses if the lender initiates collection efforts against your business. While a lender may not be willing to negotiate on all of these key points, winning just one or two concessions can make a significant difference if the lender ever attempts to enforce a personal guaranty.
Understand your State’s Relevant Laws
In all states, including Ohio, personal guaranties must take the form of a clear and unambiguous writing. Any personal guaranty that is not in writing will generally be unenforceable.
Kentucky, however, places additional restrictions on personal guaranties. In Kentucky, a personal guaranty will only be enforceable if it: (1) is written on the document it guarantees; or (2) expressly refers to the document it guarantees; or (3) is signed by the guarantor and specifies the guarantor’s maximum liability and the personal guaranty’s termination date. Any personal guaranty that does not comply with these requirements is generally unenforceable in Kentucky.
Because of Kentucky’s strict statutory requirements regarding personal guaranties, lenders will often try to ensure that another state’s laws will apply by inserting a “choice of law” clause into the personal guaranty. While many courts will enforce these clauses, there are exceptions, especially when all parties are located in Kentucky and the personal guaranty was signed in Kentucky. Ensuring that Kentucky law applies when possible will typically add some measure of protection versus other states’ laws.
Finally, Kentucky permits married couples to title real property in such a way that protects the real property from creditors of an individual spouse. Thus, if one spouse signs a personal guaranty, real property titled “by the entirety” is typically protected as long as the couple remains married.
Look to Other Owners of the Business
If a lender asks you to sign a personal guaranty, but your business has more than one owner, consider asking the other owner(s) to also sign the guaranty. Alternatively, you could execute an indemnification or contribution agreement in which you agree to sign the personal guaranty in exchange for the other owners’ agreement to reimburse you should your personal assets be tapped to pay a business debt. Either arrangement ensures that each owner of the company shares in the risk of the transaction. Be careful, however, if your spouse is one of the other owners of the business. In that case, it is generally not advisable to have both spouses sign a personal guaranty, even if real property is titled by the entirety.
Beware of Cognovit Provisions
A cognovit provision, which lenders may add to a promissory note or a personal guaranty, operates to cut off a debtor’s available defenses in the event of default. Once exercised, the cognovit provision allows the creditor to take a judgment against the debtor without notice and begin collection immediately. Consequently, congovit provisions are a very powerful tool for debt collectors.
Creditors who use cognovit provisions are required to place a warning in bold-type letters at the end of the instrument. Thus, if you are presented with an instrument containing a cognovit provision, you will likely know it. Properly presented and executed cognovit provisions are legal and enforceable in commercial settings in Ohio, but they are generally not legal or enforceable in any setting in Kentucky. Businesses operating in Ohio should exercise extreme caution when entering into a transaction or signing a personal guaranty containing a cognovit provision.
Conclusion
For businesses, personal guaranties are often a fact of life when seeking access to credit. Yet, understanding personal guaranties and related cognovit provisions can help reduce personal exposure while also providing your business with necessary capital. Thoroughly reading and understanding any personal guaranty (and other loan/credit documents) prior to signing is vital to ensuring that personal assets are not needlessly risked when taking on business debt.
This article is for general informational purposes only, is not for the purpose of providing legal advice, and does not establish an attorney-client relationship. You should consult with an attorney to obtain advice as to your particular issue or circumstances.
The Impact of the Tax Cuts and Jobs Act on Executive Compensation
James W. Thweatt, III, Partner, and Michael G. Matthews, Associate, Dinsmore & Shohl LLP
On December 22, 2017, President Trump signed into law legislation known as the Tax Cuts and Jobs Act (the Act). The Act changed certain provisions of the Internal Revenue Code of 1986, as amended (the Code). Several of these amendments to the Code relate to the payment of executive compensation.
A transfer of property “in connection with the performance of services” triggers the application of Code Section 83. The Act amended Code Section 83 by adding a new subsection (i). Generally, Section 83 governs the amount and timing of income inclusion for property, including employer stock, transferred to an employee in connection with the performance of services. Under Code Section 83(a), an employee generally must recognize income for the tax year in which the employee's right to the stock is transferable or no longer subject to a substantial risk of forfeiture. New Section 83(i) provides non-executive and non-highly compensated employees of a privately-held corporation can elect up to a five year deferral in the taxation of illiquid shares issued to them upon the exercise of nonqualified options or the settlement of restricted stock units (RSUs) if certain conditions are satisfied. The options or RSUs must be granted under an equity compensation plan under which at least 80 percent of all full-time U.S. employees are granted awards with the same rights and privileges. The amounts of the awards may vary by employee as long as each employee receives more than a de minimis grant. This deferred tax election is not available to the CEO or the CFO (or certain persons related to them) or to any person who in the past 10 years was one of the four highest paid officers of the corporation or a 1 percent shareholder (excluded employees). Under this new regime, eligible employees of private companies receiving stock through equity compensation arrangements may consider making an election under section 83(i) to defer taxation on such compensation.
The Act also imposed new requirements on the payment of compensation to certain individuals by tax-exempt organizations. The Act implements new Code section 4960, which levies a 21 percent excise tax on tax-exempt organizations (and not on the executives themselves) to the extent such organization pays compensation in excess of $1 million (other than certain severance pay). The excise tax is payable at the time the applicable compensation becomes vested. Covered employees whose compensation is subject to this excise tax include anyone who is one of the five highest paid employees of the organization, unless such individual is not considered a highly compensated employee as defined by the Code (i.e., anyone whose compensation is less than $120,000 in 2018).
However, the change to the Code that has garnered the most attention involving executive compensation concerns an amendment to Code section 162(m). Prior to the Act, section 162(m) imposed a $1 million cap on the tax deduction a public company could take on compensation paid to each of its CEO and three other highest paid executive officers (other than the CFO)—generally, the “named executive officers” included in the annual proxy, other than the CFO. Historically, to avoid this limit, most companies relied on an exemption for performance-based compensation, which was fully deductible even if it exceeded $1 million. The Act eliminates the performance-based compensation exemption. In addition, the Act also expanded coverage of section 162(m) to apply to all Securities and Exchange Commission (SEC) reporting companies (i.e., companies required to file reports under Section 15(d) of the Securities and Exchange Act of 1934, which includes many companies required to file due to public debt), rather than solely those whose common stock is registered with the SEC. Lastly, it expanded the group of executives subject to the deduction limit to include not only the named executive officers during the current taxable year (including the CFO), but also any person who was a covered executive for any prior taxable year beginning after December 31, 2016. Companies subject to section 162(m) should review their incentive plan documents, incentive award agreements, severance agreements and employment agreements in light of the removal of the exception for qualified performance-based compensation. These documents may have been drafted with the requirements of the section 162(m) performance-based compensation exception in mind.
The IRS will presumably issue guidance on these changes, particularly the changes to Section 162(m). Thus, stay tuned.
Emergence of Fractional/Outsourced Trusted Business Advisory Services
When I thought about moving back to private practice, I asked business owners what they were lacking from their current service providers. The answer was almost unanimous: Advice. I was completely floored! Digging deeper, I heard consistently that they needed (but weren’t getting) strategic, proactive, “get-to-yes,” risk-leveraging advice. Most, though, were not culturally or financially ready to bring this expertise in-house.
Hence, the recent resurgence of “fractional,” i.e. outsourced, CFOs, CIOs, general counsel and other trusted business advisors. Businesses turn to them for a competitive, “value-added” advantage by collaborating with them in developing the appropriate structure to support continued growth, proactively identifying challenges and opportunities and formulating response strategies. These advisors invest significant time up front to build trust, earn respect, and really learn the business. The trust and knowledge they develop enables these service providers to give advice the businesses can immediately use.
Several business owners described why they prefer good fractional/outsourced services over the current reactive, “one-off,” transactional model:
Seek First to Understand.
First, trusted outside business advisors start the relationship by asking probing, relevant questions to differentiate themselves: What is the business’s “value added proposition” to the marketplace? How does it make money? What are its greatest opportunities for and threats to growth? Who are their customers? What best practices are their competition implementing? How is the “war for talent” impacting them? What are their immediate and long-term business objectives?
By listening intently and gathering invaluable insight, these outside advisors build trust, appreciate the nuances of their client’s business and provide actionable advice versus reactionary, “off-the-rack” answers that fail to account for its impact on other aspects of the business. This requires significant time up front and throughout the engagement and must be on the service provider’s own “dime;” otherwise, it will sabotage the relationship before it ever begins. This long-term investment will bear tremendous fruit, because it establishes the necessary foundation of trust and insight to provide the creative, unique, “value add” advice businesses need.
Win Trust and Show Value by Helping Others Succeed.
Second, these advisors understand how their advice will be received throughout the company. Likely, the advisor works with two or three key people in the company. The best way to win their trust is helping them succeed within the organization and achieve their business goals, not be “where the deal goes to die.” Business advisors who know what makes their key contacts successful inside the organization and how that fits with the company’s culture and business goals tailor their advice for greater acceptance and adoption throughout the company.
Know Your Client’s Risk Appetite.
Third, these advisors are not intent on eliminating all risk and wrapping their clients in “bubble wrap.” They appreciate that business progress and growth entails risk, which is commensurate with reward, and their advice accounts for the business’ risk appetite. Nobody wants a million-dollar fix to a ten-thousand-dollar problem. With input from the business, these advisors first identify and prioritize risks based on the likelihood of occurrence and the severity of their impact. Solid advisors help their clients develop processes to mitigate reoccurring risks and get them off the “hamster wheel” of dealing with the same issues repeatedly. They equip their clients to deal with the less threatening risks themselves, and identify the more significant risks that should involve outside “get-to-yes” input.
Give Practical and Actionable Advice and Always Get to “Yes.”
Fourth, and most importantly, these trusted advisors deliver advice their clients can immediately use. Business moves fast, and clients need guidance (or a “sanity check”) to make decisions quickly and act. Clients don’t have time to decipher or translate advice into something usable. Also, just saying “NO” or giving six options (without recommending any of them) isn’t value-added advice. Businesses are under immense pressure to get deals done. The best advice gets them to “yes,” even if the recommendation is a different way to get there then the client originally envisioned.
In closing, private businesses are looking for more trusted business advisors to guide them, not just reactive “hired gun” specialists. Are you up for the challenge and immense opportunity to answer that call?