Crafting Advice

Well, it's been over a month. Moving to a new office was far more complicated and difficult than I anticipated, but I'm back. And just in time to comment on a new development with respect to any lien asserted against tenancy by the entirety property when the tax liability is that of only one spouse.

In Notice 2003-60, the IRS has just issued its first post-Craft detailed guidance on collection from property held in tenancy by the entirety where only one spouse is liable for outstanding taxes. The guidance first articulates six general principles and then discusses them in nine questions and answers.

The principles are as follows:

Same As It Ever Was The federal tax lien has always attached to all property held by a taxpayer. This was the case even before Craft and Craft does not represent new law. By way of example, the Service cannot rescind an accepted offer in compromise or terminate an accepted installment agreement, since the Service presumably entered into the arrangements with knowledge of what the law was. But a pre-Craft lien that is in effect post-Craft will be as effective as a lien that went into place after the opinion was handed down.

The Rules Don't Change in the Middle of the Game Notwithstanding the "same as it ever was" principle, the Service will not act to enforce any pre-Craft liens if third parties, prior to Craft, reasonably relied upon the belief that state law precluded the attachment of a lien against only one spouse. This rule would apply only in "full bar" states (such as Maryland) in which creditors of only one spouse have no claim whatsoever against tenancy by the entirety property.

A Repo Man Is Practical The administrative sale of entireties property presents practical problems that limit the usefulness of seizure and sale procedures. Those practical problems are not presented when the entireties property is cash and cash equivalents, thus the fact that cash or cash equivalents are held in a tenancy by the entirety will not deter a levy. And, the entire property can be foreclosed upon with the Service only obtaining the equity of the delinquent spouse.

Share and Share Alike Generally, the value of each party's interest in tenancy by the entirety property will be deemed to be one-half of the total value of the property.

Whither Thou Goest, So I Will Go If tenancy by the entirety property is encumbered by a lien, the lien will be deemed to attach a one-half interest in the property taken by any transferee unless the transaction that effected the transfer extinguished the lien.

Of the nine q & a's, two deal with liens that arose prior to Craft, with the remainder dealing with liens that arise post-Craft.

Initially, the Service states that, as a matter of administrative grace, in so-called "full bar" states (states where property titled as a tenancy by the entirety cannot be attached by any creditor of only one spouse) it will not assert its lien rights against the class of creditors protected under I.R.C. Section 6323(a)--essentially, bona fide transferees for value who took their interest without knowledge of the lien. However, the Notice also makes it clear that in so-called "partial bar" states, transferors will not be so graced.

In cases of divorce, the Service will generally treat a spouse who received full title to formerly tenancy by the entirety property as having obtained the interest of the other spouse as an exchange for value. Of course, this would not extend to a transaction that the Service concludes is fraudulent. And, as is seen below, this rule only applies to pre-Craft transfers.

The Service's position with respect to property received via gift is somewhat unclear. It appears that it will only honor a transfer to a related party when there is some overriding equity on the side of the donee. Generally, no such overriding equity need be present if the donee is an arm's length third party, such as a charity.

The second question deals with deals the Service entered into with taxpayers pre-Craft. Here, the Notice takes the common sense approach that a deal is a deal and what is done is done. However, the Notice states that decisions as to uncollectibility can revisited in light of Craft.

The next four q & a's deal with the continued attachment of the lien in the case of subsequent events. Thus, notwithstanding a subsequent transfer to a third party in an arm's length transaction, the lien will continue to attach to one-half of the property. Similarly, neither a transfer incident to a divorce nor a subsequent mortgage will terminate a lien.

However, in all of these cases, the Notice sets up the possibility of some hard-nosed planning. Specifically, the Notice recognizes that death terminates the deceased spouse's interest in tenancy by the entirety property. The Notice states that if the deceased spouse is the spouse against whom the lien is filed, the property will no longer be encumbered by the lien. Of course, the converse is also true. That is, if the non-delinquent spouse dies, the entire property becomes subject to the lien. This brings new meaning to the phrase "Till death do us part."

A lien will continue to attach to property that is transferred in a transaction that "breaks the unity" of ownership if the deliquent taxpayer dies after the transfer. Thus, a lien will follow property conveyed pursuant to a divorce, because the divorce breaks up the unity of ownership. The lien will continue in effect even if the delinquent spouse dies after the divorce. Similarly, the lien follows property that is foreclosed upon, unless the delinquent spouse dies before the foreclosure. (Thinking about those planning possibilities?).

The final three q & a's deal with the ways in which the Service can turn its lien into cash. Interestingly, the Notice states that an adminstrative sale is "not a preferable method" of dealing with property, such as realty, that is not easily divisible, since it might be difficult to realize anything from the sale of a one-half tenant by the entirety interest. (For instance, how would a prospective purchaser value the likelihood of succeeding to the entire property if the delinquent spouse dies second versus losing the entire property if the delinquent spouse is the first to die.) Cash and cash equivalents, of course, do not pose this problem and the Service will just go in and take its share of these assets.

However, the Service believes that foreclosure, as opposed to an administrative sale, can be used to convert the delinquent spouse's interest into cash. The difference between an administrative sale and a foreclosure is that in the latter proceeding the entire property is sold and the proceeds divided. Thus, the Service does not face the problem of a sale at a depressed price due to the fact that the buyer is purchasing a somewhat speculative commodity.

Finally, the Notice discusses issues pertinent to discharge and subordination. In essence, the Service takes the position that the value of the lien is one-half of the equity to which it attaches. Thus, in the event of an insolvency proceeding, the Service gets one-half of the value of the property after payment of any senior encumbrances.

This post is somewhat longer than most of my postings, but I thought that it would be helpful to set forth the position taken in the Notice in some detail. Over the next week or two, I hope to offer some additional commentary on the Notice.

Changes

The law firm that I had been with since this before weblog unveiled will be dissolving at the end of the month. Thereafter, I will be at Fisher & Winner, LLP just a block up the street.

Spy v. Spy

In Robinson v. U.S., the United States Court of Appeals for the Federal Circuit allowed the employer a substantial deduction for the "bargain element" inherent in stock distributed to an employee, even though the employee had filed a Section 83(b) election that valued the bargain element at zero. The opinion has been praised by Janell Grenier at Benefitsblog (see here). Regardless of the merits of the decision as a matter of tax law, the facts are vaguely reminiscent of an installment of Spy v. Spy.

The Robinsons owned all of the stock of a related group of corporations known as Morgan Creek. In 1995, they granted the COO, Gary Barber, 10% of the stock in the enterprise. Barber paid $2 million for the stock and filed a Section 83(b) election stating that the bargain element in the transaction, that is the fair market value of the stock in excess of what he had paid for it, was zero. As required by the regulations under Section 83, he sent a copy of the election to the corporation, namely himself acting as the COO.

In 1998, the Robinsons and Barber had a falling out. To resolve the dispute, in June of 1998, Morgan Creek redeemed Barber's stock for $13.2 million. Morgan Creek (presumably after the closing on the purchase of Barber's stock) issued him a revised W-2 for 1995 reflecting additional compensation of $26,759,800 (i.e., a stock valuation of $28,759,800, less the $2 million paid for the stock by Barber) as a result of the bargain element inherent in the 10% of the company's stock he received in that year. And, of course, Morgan Creek claimed an ordinary deduction for compensation paid to Barber in 1995 of the $26,759,800 bargain element.

The Service argued that Morgan Creek was barred from taking the deduction since the corporation's deduction was limited to the amount included in Barber's income. Since Barber had included nothing in his income, the Service's position was that Morgan Creek was not entitled to any deduction. The Court of Appeals, reversing the Claims Court, disagreed, holding that the term "included" means not the amount actually shown on the employee's return, but also the amount that, as a matter of law, should have been included on the return.

I will leave the analysis of the legal questions involved in the decision to commentators like Grenier. Instead, I will focus on the human factors behind the case.

I don't know whether in 1995 the parties addressed the Section 83 issues inherent in the stock grant to Barber. I'm willing to bet that they did not and that Barber, finding a vacuum, seized upon it to structure the transaction to confer some tax benefits on himself. Later, however, in the course of what must have been acrimonious negotiations over Barber's departure from the company, the company (read: the Robinsons) realized that it could settle its dispute with Barber and, as soon as the ink was dry on the contract, amend the 1995 returns to obtain tax benefits that would substantially fund the settlement. Thus, Morgan Creek paid Barber $13.2 million, but its amendment of the 1995 income tax returns resulted in federal income tax benefits of over $8.85 million, plus interest from 1995. Of course, Morgan Creek will likely enjoy additional state income tax benefits as well. Assuming the state tax benefits to be about $2 million, the company virtually broke even on the deal, since Barber had paid $2 million for the stock. (The arithmetic: $8.85 million, plus $2 million, plus $2 million, plus interest, comes pretty damn close to $13.2 million.) Barber, on the other hand, could end up with additional tax on $26,759,800, plus substantial penalties and interest from 1995, and a long term capital loss in 1998, that he may or may not be able to use, of about $15 million. Not a pretty picture.

The case illustrates the virtue of having both sides (i) recognize that there are Section 83(b) issues inherent in any grant of an equity interest to an employee, and (ii) agree to a consistent (and reasonable) position with respect to the manner in which the "bargain element" is to be reported.

Accepting an Invitiation

The SW Virginia Law Blog on the 20th noted two articles in the Virginian-Pilot (here and here) that reported that "[i]nsurance companies licensed to do business in Virginia can only underwrite group policies to cover family members defined as spouses or dependent children," thus excluding gay or lesbian partners and children of such a partner that the non-biological partner nevertheless considers as his or her progeny.

SW Virginia Law Blog then suggests that the problem was not one of state law, but rather of federal law, more particularly federal tax law, and it put out a request to other blogs that focus on business and tax issues, including yours truly, to offer their view of the locus of the issue. Well, here goes.

There is obviously a federal tax slant to this issue. As the SWVa Law Blog correctly noted, medical insurance benefits paid by an employer that provides insurance to a non-family member of the employee (meaning non-married "significant others" and children of such individuals) is taxable to the employee, unless the significant other or his/her child is (are) dependents of the employee. However, the authority cited by SWVa Law Blog, CCA 200117038 makes it clear that a plan may provide benefits to such individuals, even though the benefits are taxable.

I am not admitted to practice in Virginia, but I suspect that the concept that is at the core of the problem the news articles focus on is that of "an insurable interest." This is a well-known concept in insurance law. In essence, one can only be the owner of a policy of insurance that insures against some hazard occuring to some other individual if the owner has an "insurable interest" in the person insured. Thus, I cannot obtain a policy of insurance on the authors of the SWVa Law Blog because, even though I like reading their publication, I do not have an insurable interest in their lives. Going one step further, insurance companies have been found to be liable for damages for the tort of "insuring" when they enter into contracts of insurance with an individual with no insurable interest in the named insured party. (The damages are usually derived from the premature death of the named insured due to the active intervention of the policy owner. In simple English, someone buys a life insurance policy on someone else's life and then knocks them off to obtain the proceeds. I am willing to bet, however, that for every lawsuit for the tort of insuring, there have been fifty murder mysteries based on the practice.)

The question originally posed by the SWVa Law Blog was whether this was an instance of state law creating a due process or equal protection issue. To the extent that my hypothesis as to the derivation of the rule discussed in the newspaper articles is correct, I believe that the application of the state law does create a Constitutional issue. There would seem to be no question but that an individual has a strong interest in seeing to it that the medical needs of the others in his/her household are met. A state law that attempt to stretch the concept of "insurable interest" to bar the issuance of such coverage is nothing more than an attempt to limit the free association of individuals based upon their marital status or sexual orientation by making it difficult or more expensive for them to obtain medical insurance for everyone in their household.

Manic's Better Than Depressed

I previously commented on the case of Keeley v. Commissioner, a Tax Court summary decision that denied relief from the 10% penalty imposed on a premature withdrawal from a qualified plan. The relief had been sought because the taxpayer suffered from clinical depression and contended that he was entitled to relief because he was disabled. The Court denied relief because the taxpayer's condition did not require that he be institutionalized or have constant supervision.

I criticized the opinion, noting that it relied on a regulation that was more restrictive than the Code required and that was inconsistent with current treatment modalities.

Tuesday, in the case of Mary L. Coleman-Stephens v. Commissioner, the Tax Court reached an entirely different conclusion based on essentially identical facts. Because Keely was a summary disposition and could not be relied upon as precedent, the Court in Coleman-Stephens did not seek to harmonize its conclusion with that of the prior opinion.

Since Coleman-Stephens, like Keely, is a summary disposition, taxpayers cannot rely upon it for authority. Given the relative small amounts involved in these cases (Coleman-Stephens involved only $510 in taxes), they are unlikely to get appealed to the circuit court level. The Tax Court ought to step in and issue a formal opinion, even if it's only a memorandum decision, addressing the issue. Better yet, the Service might issue a ruling stating that it now concludes that the regulation is overly broad and, to the extent that it requires institutionalization or some other type of custodial care before the penalty can be avoided, it will be disregarded.

One Tough Veil

With the possible exception of claims for intentional infliction of emotional distress, I doubt that there is no action that is bruited around more often and results in fewer successful prosecutions than attempts to pierce the corporate veil. The recent opinion in the case of Iceland Telecom, Ltd. v. Information Systems & Network Corp. illustrates the rather restrictive limits placed on this doctrine, particularly in Maryland.

Iceland Telecom brought the action against Information Systems & Networks Corp. ("ISN"), ISN Global Communications, Inc. ("Global"), and an individual, Arvin Malkani ("Malkani") for breach of contract and unjust enrichment. Neither ISN nor Malkani were parties to the disputed contract. Iceland Telecom sought to hold them liable for the obligations of Global via the application of the piercing the corporate veil doctrine, seeking to apply either the "instrumentality" theory or the "alter ego" theory, or because Global allegedly acted as the agent for ISN and Malkani.

To say the least, Global was operated on a fairly informal basis. It never held stockholder or director meetings. Two of the three individuals who the extant corporate documents indicated were directors (Malkani's mother and sister) apparently did not know that they were directors. ISN picked up most of Global's expenses and Malkani, Global's president, had his salary paid directly by Global. Global shared ISN's office space, with the rent being paid by ISN without any contribution from Global. Indeed, Global used ISN's phone numers, office furniture, and some of its office staff.

Significantly, in the negotiations leading up to the execution of the contract, it often appeared that Iceland Telecom was dealing with ISN. For instance, Malkani, negotiating on behalf of Global frequently referred to that company as ISN. In fact, the court specficially stated that Iceland Telecom "thought it was dealing with ISN." However, the written contract executed by Iceland Telecom identified Global as the other contracting party.

Nevertheless, the court concluded that neither the piercing the veil doctrine nor the agency doctrine applied to this case. The court emphasized that the Maryland courts had set the bar high with respect to the ability to pierce the corporate veil (quoting Dixon v. Process Corp., 38 Md.App. 644, 645 (1978) to the effect that it is a "herculean task" for a creditor to attempt to "rip away the corporate facade.") The court rejected the approach outlined in the well-known 4th Circuit case of DeWitt Truck Brokers v. W. Ray Fleming Fruit Co., 540 F.2d 681 (1976) where the court, applying South Carolina law, allowed the corporate veil to be pierced because of such factors as the lack of corporate formalities, gross undercapitalization, and the non-functioning of officers or directors other than the sole shareholder. Instead, the court concluded that, under Maryland law, nothing short of actual fraud would suffice to sustain a veil piercing effort.

Iceland Telecom's attempts to rely on an agency or an agency by estoppel theory to impose liability were similarly unavailing. Iceland Telecom had, after all, entered into a written contract that had clearly identified the other party as being Global. There was no evidence that it believed that Global was acting as ISN's agent nor that it entered into the contract upon reliance upon a belief that Global was acting as ISN's agent. Thus, neither of these two "agency" theories could apply.

Even though I've used it as authority, I've always thought that DeWitt Truck Brokers was problematic. After all, most, if not all, closely-held corporations have significant gaps in their adherence to corporate formalities. The rationale behind veil piercing should be anchored in the rational expectancies of the various actors. A plaintiff should not be able to look beyond the limited liability shield of a limited liability entity if it entered into a contract with full knowledge that there were limited liability walls in place. Only if the plaintiff suffers loss that is unexpected (e.g., being told that the entity was solvent, when, in fact, the owners were draining it of assets) should it be able to avoid the limitations in collectability that it tacitly acknowledged when it entered into the deal.

Seeing Double?

Subscribers may have noticed that they have been getting two copies of each posting. The reason is that for several months I have attempted to use a subscription service called Bloglet. While subscription requests found their way to Bloglet (via the subscription box on the right), for some reason the postings were never circulated. In response, I created a mailing list and copied all of the addresses in Bloglet to that list. Each posting was directed to circulate to the list.

This weekend, Bloglet suddenly began working again. Of course, subscribers began getting each posting twice, once from Bloglet and once from my mailing list. I will cure the problem tomorrow and subscribers will be back to getting only one copy of each posting. One other housekeeping note.

I have finally figured out how to syndicate this weblog via RSS coding. By the end of the week there should be a way to click and get the RSS syndication information.

More on Verne

David Giacalone at ethicalEsq has offered some comments on my posting Putting Strains on My Friends about the Verne opinion. Although I agree with most of what he has to say (he does a good job, for instance in detailing most of the salient facts that were not presented in the opinion), I have one area of disagreement.

Specifically, Dave states that "[i]f Verne never held himself out as being an attorney and he reminded his clients that they might want to consider getting legal advice or having additional documents drafted for their business, he may have been giving them just what they wanted and needed -- and chose -- given their situation and their willingness to risk future problems." (Emphasis is Dave's.) I'm not at all certain that this clears Verne under the circumstances.

One of the lessons I learned in law school is that it is less important to know the answer to a question than it is to know the correct questions to ask. Theoretically at least, lawyers are by training supposed to be able to ask the right questions. Accountants, as to the majority of issues that go into operating agreements, for instance, simply do not have this training.

I think that Dave is on the right track when he suggests various elements of cost benefit analysis that should go into the decision as to whether Verne should be penalized for his actions or omissions. However, in many cases, even highly skilled and experienced counsel do not have the knowledge to make the appropriate cost benefit analysis. By way of example, assume that most small businesses, such as Verne's clients, typically rely on a form LLC operating agreement that does little more than restate the default provisions in the state's LLC act. Is the lawyer who prepares such a document (i) underlawyering, (ii) overlawyering, or (iii) getting it just right. As I suggested in my first post, I really don't know the answer to this question.

Government Undercover Uncovered

I don't ordinarily use my postings to announce links to specific websites, but I'll make an exception today.

MIT just opened its Open Government Information Awareness site. The site offers a remarkable amount of information about all three branches of the federal government. The amount of information now at your fingertips is simply daunting. By way of example (and certainly not in limitation), the site gives a list of contributors to the campaigns of members of Congress, a detailed listing of the expenditures of those members, and their financial disclosure filings.

Well designed sites such as this raise any number of questions. For instance, given the proliferation of bloggers of all stripes (both in topic choice and political viewpoint) and the ready accessibility of information, the market for commercial alternatives, newspapers for instance, would seem to be seriously eroding. The implications are huge.

In Baltimore, I grew up with three daily newspapers, The Sun (often known to residents as The Morning Sun), The Evening Sun, and The News American. We're now down to just The Sun. Since you can get The Washington Post, The New York Times, and The Wall Street Journal delivered to your home or office, The Sun becomes a secondary (or, given the web, a tertiary) source of national and international news. It is thus limited to being a primary source only of local news. And, even here, is challenged by The Washinton Post with respect to statewide coverage. Give The Sun the competition of a few good local bloggers and it's out of business. I suspect that the knowledge of its tenuous position by its reporters was one of the reasons they made significant concessions in their most recent contract negotiations with the paper.

2003 State Tax Update

The Spring issue of Tax Talk, the newsletter of the Section of Taxation of the Maryland State Bar Association has two summaries of tax legislation passed in the recent session of the Maryland General Assembly. One is by Evelyn Pasquier, the other by the Comptroller's Office.

H.B. 438 is worthy of note because it imposes upon various officers and owners of corporations and LLCs personal liability for unpaid vessel excise that the business entity is required to collect and pay over. The language is identical to a similar provision with respect to sales tax that I argued, to no avail, constituted a violation of due process. It’s significant because previously the sales tax provision stood alone in its sweeping imposition of personal liability. (OK, I'm a sore loser.)

Now that this broad imposition of liability has been extended with respect to another tax, there is a possibility that it might be further extended. For instance, the failure to collect and pay over withholding taxes might create personal liability by virtue of an individual's status rather than, as is currently the case, the individual's dereliction of duty.

Putting Strains On My Friends

While some of my best friends are accountants, I may be straining our friendship with this posting.

The Ohio Supreme Court, in the case of Columbus Bar Assn. v. Verne, recently enjoined an accountant from "preparing legal documents that constitute the unauthorized practice of law." Verne, the accountant in question, had formed an LLC on behalf of two of his clients by drafting and filing articles of organization with the Secretary of State. The articles used, as a baseline, forms that were available in the secretary of state's office.

In the real world, the practice of law by accountants, insurance agents, stock brokerage houses, and banks is rampant. A few good lawsuits resulting in liability might encourage a reduction in the unlicensed practice of law.

The opinion correctly focuses on the types of advice that clients need that are particularly within the province of attorneys, namely those issues that ought to be reflected in an operating agreement. However, in its conclusion, the Court focuses on the one area in which Verne’s transgression was relatively benign: the drafting of the articles of organization. Thus, the order merely enjoins him from "preparing legal documents."

In fact, as the opinion reveals, Verne's sins that caused his clients serious harm were not found in the simple document that he drafted, but in the complex document that he didn't even think about. Verne failed as a lawyer because he apparently did not even attempt to explain to his clients the importance of addressing and memorializing the various elements of their deal. The order does not focus on this problem. And, perhaps, it cannot. After all, it would come dangerously close to an infringement on free speech rights to block Verne from opining, to clients or prospective clients, as to the relative merits of different types of entities and the issues that should be addressed in organizing a business.

Going one step further, however, a more difficult issue underlies this case. What should it cost to form a relatively simple business deal? In this sense, law faces the same economic problem that medicine faces. In medicine, doctors often order or perform too many tests in order to reduce their exposure to malpractice claims. In forming a business, lawyers face the problem of how detailed an operating agreement (or shareholders' agreement or partnership agreement or lease or etc.) needs to be in order to meet the needs of the client and, to cover all of their bases, there is a tendency to "overlawyer" a deal.

Of course, "overlawyering" is in the eyes of the beholder.

Although no facts as to this are set forth in the opinion, I'm willing to bet that Verne's clients' business involved little initial capital and they were operating on a shoestring. How much upfront capital should they be willing to spend to draft the "appropriate" documents addressing all of the "pertinent" issues? Appropriateness and pertinency are, after all, fluid concepts. Maybe the default provisions in the Ohio LLC statute were sufficient for their purposes. Of course, Verne probably lacked the training (and certainly lacked the appropriate license) to give his clients the requisite information that would have allowed them to make a knowing choice with respect to these matters. Thus, his real crime was not the document he drafted, but the document he didn't draft.

Two other points about the opinion.

First, I had not previously been to the Ohio Supreme Court's website. The opinions give not only the "book" official citation (that is, a citation to the hard bound volumes of published opinions) but an official "cyber" citation as well. All courts should emulate this practice.

Second, the Court's opinion cited as authority Henning & McQuown, Ohio Limited Liability Company: Forms and Practice Manual (December 2001). A disclaimer: I have a slight (very slight) financial interest in that publication, but (and?) I was happy to see it relied upon as authority.

An Act of Faith

One of the best things about participating in Bar activities is that you get exposed to a group of people who have a high degree of pride in their profession. That is, for them, being a lawyer is not merely a job, but a calling as well.

Now most of those who populate these meetings are what I call "average smart guys." That is, they're people who are well-educated and very bright, but not necessarily on the intellectual level of a Brandeis or Holmes. (By the way, on my best days, I rate myself at the lower rungs of the "average smart guy" scale.) Occasionally, however, you get the opportunity to meet people who go to the top of the scale and then beyond.

Once of the people who I've had the opportunity to meet and who is beyond the category of "average smart guy" is Susan Pace Hamill. (Ok, she's not a guy, but you get the idea.)

Susan was with the I.R.S. when LLCs were in their infancy and, I suspect, did a great deal to advance their acceptance within the Service. Subsequently, she became a professor at the University of Alabama School of Law. More recently, she has caused a bit of stir by publishing an article in the University of Alabama Law Review entitled An Argument for Tax Reform Based on Judeo-Christian Ethics. (Susan also has a Masters in Theology from the Beeson Divinity School.)

The article focuses on Alabama's tax system, labeling it unfair to the poor. It is easy to see, however, that a similar analysis would apply to most state and local tax regimes in this country, since, to a great degree, they all rely on regressive taxes. And the President's welfare bill for the wealthy? Although not a theologian, I think that to ask the question is to answer it.

In an editorial piece in the New York Times on Tuesday, Adam Cohen outlined the impact that Susan's article has had on tax policy in Alabama, moving even an arch-conservative governor to back tax reform. But don't hold your breath waiting for the alleged conservatives in the White House to get religion.

Hatchett Link

You can link to the opinion in Hatchett v. U.S. by clicking the title.

A Hatchett Job

The Sixth Circuit just issued an opinion applying U.S. v. Craft. It is certain to send shivers down the spines of title insurance companies.

The case, Hatchett v. U.S., arose out of an assessment that grew from the tax fraud of Mr. Hatchett, formerly a prominent Detroit trial attorney. While the Craft case was wending its way to the Supreme Court, the Hatchetts had been contesting the government's attempt to enforce its lien against Mr. Hatchett by attaching their tenancy by the entirety property.

The Sixth Circuit admitted that the Supreme Court in Craft had enunciated "a new rule of federal law" since, prior to that decision, "several federal and state courts, including [the Sixth Circuit], as well as the IRS, had assumed that entireties property was excluded from the definition of 'all property and rights to property' as defined by the tax code." However, the Court applied the rule found in Reynoldsville Casket Co. v. Hyde, 514 U.S. 749, 752 (1995), that: "[W]hen (1) the Court decides a case and applies the (new) legal rule of that case to the parties before it, then (2) it and other courts must treat that same (new) legal rule as 'retroactive,' applying it, for example, to all pending cases, whether or not those cases involve predecision events."

The problem with Sixth Circuit's application of the rule is that it assumes that the litigation contesting the lien is the applicable "case" for purposes of the Reynoldsville Casket rule. The problem this raises is not obvious, but is extremely troublesome.

Assume that a tax lien was filed prior to the date the Craft decision was handed down. The parties subsequently (either before or after Craft, I don't think that it matters) sold tenancy by the entirety property to a third party bona fide purchaser for value. The third party's title insurer issued title insurance because, after all, the IRS's administrative practice in the state in which the property was located was not to attempt to levy against tenancy by the entirety property to enforce a lien against one spouse and the title insurer, correctly it seems to me, assumed that the lien did not attach to the property.

Now, the IRS attempts to assert its lien against the property. After all, Craft holds that the lien was good when it was initially filed and when the third party purchased the property. Presumably, the third party (or its title insurer) will attempt to judicially challenge the lien. However, by applying the Reynoldsville Casket rule to the "case," that is, the filing of the challenge to the lien, the third party loses because the case was instituted subsequent to Craft.

If the foregoing analysis holds, there are numerous tax liens that title insurers thought were dead, at least as to tenancy by the entirety property that had been conveyed, but which can presumably spring back to life. Thus, if the hypothetical third party in my illustration attempts to subsequently convey the property, should (or will) a title insurer issue a policy without a specific exception? And, if an exception is noted, will a lender participate in the purchase?

The Sixth Circuit's website is down this evening. When it comes back up, I will post a link to the Hatchett opinion.

On-Line EIN/TIN--It's Baaaaaack!

Thanks to Andy Sandler who brought to my attention that the IRS EIN/TIN website was back in operation.

One aspect of the site that appears to be different is its treatment of LLCs. When applying for an EIN/TIN for an LLC, for question 8.a., one needs to check the box for the tax classification of the LLC (sole proprietorshp, partnership, or corporation) and then, on the spot in the question 8.a. area marked "Other," state whether the LLC is a single member or multi-member LLC. However, you should not check the box marked "Other."

Got that? Now go there.

A Depressing Opinion

I think that the general public believes that the answers to questions of law, in general, and tax law, in particular, are found by investigating arcane points of case law and statutory construction. Of course, that is often the case. However, just as often, answers turn on facts and knowledge that is outside of the hermetic world of cases and statutes. Oliver Wendell Holmes was right: "the path of law is experience, not logic." This basic precept was ignored by the U.S. Tax Court in the case of Keeley v. Commissioner.

In 1996, Mr. Keeley left a well-paying job because in each of the previous 3 to 4 years at the job his compensation had been cut. He attempted to become a commissioned life insurance agent without success. As a consequence, in 1997 he had a mental breakdown. He suffered from and was treated for moderate to severe depression. His income from employment suffered as a result.

In 1997 and 1998, as a result of this diminution in income, he and his wife had to make premature withdrawals from their qualified retirement plans. In order to avoid the imposition of the 10% penalty on these premature withdrawals, they attempted to invoke the provisions of I.R.C. Section 72(t)(2)(A)(iii). That section provides that a premature withdrawal of funds from a qualified plan is not subject to the penalty if the taxpayer is disabled within the meaning of Code Section 72(m)(7) which provides that "an individual shall be considered to be disabled if he is unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or to be of long-continued and indefinite duration. An individual shall not be considered to be disabled unless he furnishes proof of the existence thereof in such form and manner as the Secretary may require."

Section 1.72-17A(f)((2)(vi) of the Treasury Regulations gives, as an example of a disability, "Mental diseases (e.g., psychosis or severe psychoneurosis) requiring continued institutionalization or constant supervision of the individual." The Regulations also provide that an impairment that is remediable does not constitute a disability. Specifically, Treas. Reg. Section 1.72-17A(f)(4) provides that: "An individual will not be deemed disabled if, with reasonable effort and safety to himself, the impairment can be diminished to the extent that the individual will not be prevented by the impairment from engaging in his customary or any comparable substantial gainful activity."

The Court concluded that Keeley did not suffer from a mental disease because he did not require continued institutionalization or constant supervision. Additionally, the Court concluded, without any real discussion, that Keeley's condition was not irremediable.

The first part of the Court's conclusion is based on precedent (i.e., logic) not real world experience. Anyone who has walked through the District of Columbia or any other major city should be aware of the mentally impaired homeless who populate the streets. They're there because we have medications available that allow us to dump them there and we thus avoid the expense of "continued institutionalization or constant supervision" of these individuals. Nevertheless, no one would argue that they suffer from mental illness. To pretend otherwise is simply to ignore reality. And, in this case, it was clear from the evidence presented that Keeley actually suffered from mental illness. However, the court applied the restrictive definition of the concept found in the regulations (but absent from the statute).

The court may have reached the conclusion that Keeley's condition was not irremediable based on the fact that, by 1998, he had been able to obtain gainful employment. However, the test of whether the disability is reasonably expected to be of long-continued and indefinite duration should be made based upon the condition of the taxpayer when the withdrawal from the qualified plan is made. In this case, at least in 1997, it seemed clear that Keeley's depression met this standard and there was no evidence to the contrary.

The case is also troubling because the court ties the overly restrictive test for disability set forth in the regulations to the statutory provision in Section 72 that requires the taxpayer to provide "proof of the existence [of a disabling mental illness] in such form and manner as the Secretary may require." Here, the court mistakes the grant of authority to set forth the manner in which the disability must be reported with a grant of authority to the Treasury define what constitutes a long-term disability for purposes of the statute.

The best part of the decision is that it is a summary disposition and cannot be treated as precedent for any other case. Thus, the Court is not bound by the opinion and free to ignore the holding in the future.

Update on IRS Web EIN/TIN Applications

Apparently, the on-line TIN process has, at least temporarily, been suspended. No explanation has been offered by the Service.

If anyone has additional information on this, could you please pass it along through the posting of a comment. Thanks.

Humpty Dumpty On a Roll

Humpty Dumpty articulated a principle that remains the lodestone of contract interpretation: "When I use a word . . .it means just what I choose it to mean-neither more nor less." The problem that gives rise to most contract litigation is HD’s admonition that: "The question is . . . which is to be master-that's all." (For the complete quote, go here.) A recent LLC case out of Connecticut, brought to my attention by Professor Gary Rosin, illustrates the hazards of not exercising the power of the master.

In Radding v. Freedom Choice Mortgage, LLC, Radding was an at-will employee of Freedom Choice, a mortgage broker. In late 1995, Freedom Mortgage instituted an incentive profit sharing plan for certain of its employees wherein the employees became members of the LLC. The LLC's operating agreement had a provision that no member of the company would be eligible to receive income from the production bonus or profit sharing programs until he or she had been a member for one full calendar year.

The admission of Radding and several other employees as members to the company was memorialized in an amendment to Freedom Choice's operating agreement that was dated December 12, 1995. That amendment stated that Radding and the other employees had become members of the LLC as of that date.

While Radding did not sign the operating agreement until December 28, 1995, he did execute a waiver of workers' compensation benefits on December 22, 1995, asserting that the company did not have to provide workers' compensation insurance coverage on him because he was a member of the LLC.

Radding and the principal owner of the company got into a dispute in late 1996. As a result, Radding was discharged as an employee on December 13,1996.

As a threshold matter, the company argued that Radding was not entitled to any benefits for the 1996 year since he had not been a member of the LLC for a full year. However, the court reviewed the terms of the operating agreement which provided that the date a person becomes a member "shall be stated on Schedule A [to the operating agreement]." The minutes to the meeting of the owners of the LLC, held on December 12, 1995, adopting the revised Schedule, stated that Schedule A was "hereby" amended to include Radding and the others as members. The court's conclusion was fortified by the fact that Radding was holding himself out as a member of the LLC at least by December 22, prior to the December 28, 1995, date that he executed the operating agreement.

What no doubt came as even a greater surprise to the principal owners of the company was the conclusion that Radding was still a member of the company even after he was discharged as an employee. The reason was that while the majority owners of the LLC could remove an individual as a member, they hadn’t bothered to formally do so. Thus, the court concluded that Radding remained a member of the LLC through at least 1998.

The lesson of Humpty Dumpty is not merely that one who drafts a contract can be the master of its terms. Humpty Dumpty also teaches that, because one is the master of the terms of a written document, one is bound by the common sense meaning of the words unless a "special meaning" (that is, a meaning defined by the master) is intended.

Look Before You Leap

A short opinion recently handed down by Judge Nickerson of the United States District Court for the District of Maryland illustrates the potential dangers inherent in entering into a settlement agreement without complete assurance that the terms of the agreement can be fully consummated.

Under the facts of the case, Columbia Gas Transmission Corp. had brought an action in federal court based upon a federal, as opposed to state, claims. The parties had entered into a settlement agreement that called for the action to be dismissed without prejudice, subject to the right of either party to move to reopen the case within thirty days. If neither party moved to reopen within the thirty day time period, the dismissal became a dismissal with prejudice.

After the thirty day period had expired, Columbia Gas moved to enforce the settlement agreement. The Court rejected the request holding that the settlement agreement was a state law contract that replaced the original claims. Since the settlement agreement was a state law contract and there were no longer any federal claims upon which the court's jurisdiction could be invoked, Columbia Gas's motion was dismissed.

As a consequence, Columbia Gas, which has now lost its previous (presumably greater) claims, must bring a totally new action in Maryland state court to enforce or obtain damages under the settlement agreement. While the state court action will likely be limited (i.e., what were the terms of the agreement, have they been breached, and, if so, what are the damages), Columbia Gas is still exposed to greater costs and will lack the advantage of having the matter heard by the judge who was presumably familiar with the settlement agreement and the underlying dispute. As a practical matter, Columbia Gas might have to make further concessions to the defendant since its upside is likely limited. Not a happy result.

Update on LLCs & EINs

The IRS website setting forth the directions for obtaining EINs over the web now has been modified to provide additional instructions for LLCs. These instructions make it clear that LLCs can apply for EINs over the web and direct how to do so. The revised web page can be reached by clicking here.

God Bless The Child Who's Got His Own

Delauter v. Shafer, decided by the Court of Appeals on May 2, is a little outside of my normal haunts, but the facts are somewhat interesting. Going beyond the specific holding of the case, it gives an insight into the dynamics of dispute resolution through the courts.

In 1944, Shafer married one of the daughters of Mr. and Mrs. Deibert. Shafer and his wife lived with his parents until 1968 when then moved to the Deibert family farm. Mr. and Mrs. Deibert had previously moved their personal residence to a parcel across the road that they had purchased, but, even after the Shafers moved in, they were on the farm virtually every working day.

The Shafers paid virtually nothing to the Deiberts over the years. In fact, they had borrowed money from the Deiberts from time to time. The Deiberts paid all of the property taxes on the farm, and, except for certain improvements that the Shafers had made, the Deiberts paid all of the insurance premiums on the farm and its improvements.

Mr. Shafer declared bankruptcy in 1996. He did not list the farm as an asset in his bankruptcy estate.

Mr. Diebert died in 1990 and Mrs. Diebert died in November, 1998. In May of 1998, Mrs. Shafer died. In Mrs. Diebert's will she made a provision with regard to the farm, declaring it to be an "advancement" on the bequest to Mrs. Shafer under the will, with the amount of the advancement being $125.00 times the number of months that the Shafers had lived on the farm from March 1, 1969. Subject to the advancement and some other advancements noted in the will, Mrs. Diebert bequeathed her estate in equal shares to her children.

Trouble had begun brewing even before Mrs. Diebert's death. Shortly before she died, Mrs. Diebert's two other daughters, acting under a power of attorney from their mother, entered into a contract to sell the farm for a little less than $600,000.00 and attempted to get Mr. Shafer to vacate the farm. Mr. Shafer refused to vacate the premises. After Mrs. Diebert's death, these same two daughters, acting as the personal representatives of her estate, brought an ejectment action against Mr. Shafer.

Shafer responded with a counterclaim that a lease had existed for over 20 years, but that no rent had been paid or demanded. Thus, under the provisions of Section 8-107 of the Real Property Article of the Maryland Annotated Code, he argued that the estate could not seek rent or any right of reversion with respect to the property.

The matter was tried before a jury. The jury returned a special verdict in favor of Shafer, finding that a lease existed and that no rent had been paid or demanded for more than twenty years. Consequently, the trial court entered a judgment declaring that Shafer had title to the property.

The Court of Appeals rejected Shafer's position, resting its conclusion on two principles.

First, one of the pivotal issues was whether Shafer's possession of the farm was pursuant to a license from his in-laws or pursuant to a lease. The Court concluded that, because there was no dispute as to the underlying facts, the question of whether the arrangement was a lease or a license was a question of law for the court to determine and should not have been submitted to the jury.

Second, the Court outlined the distinction between a license and a lease. In particular, two elements that would argue that Shafer had leased the farm, the right to exclusive possession and the obligation to pay rent, were not present. Shafer lacked the right of exclusive possession to the farm, since the Dieberts had both been present at the farm virtually every working day, ceasing that activity only when physical infirmity overtook them. Additionally, it was clear that there was never a request or demand that either of the Shafers pay rent. Thus, the Court concluded that the arrangement was a license, not a lease. Consequently, the Court held that the provisions of Section 8-107 were not applicable and it reversed the circuit court.

What are the lessons with respect to dispute resolution?

First, it is likely that, as a practical matter, the case could not be settled since Shafer lacked the financial resources to make a reasonable settlement. After all, for the first 24 years of his marriage he lived at home with his parents. Thereafter, he lived rent free on his in-laws' property. Even then, he had to declare bankruptcy.

Second, the circuit court had abdicated its role when it allowed a jury to make the legal conclusion that the property was held by Shafer pursuant to a lease. To the extent that trial judges allow basic legal questions (as opposed to factual questions) to be resolved by a jury, litigation becomes a crap shoot. Litigants such as Shafer, who feel that they have nothing to lose, thus have an incentive to go to the legal gaming table.

An All Bright Opinion

I've always believed that most legal concepts are fairly simple. A corollary to that belief is my feeling that the prevalence of bad writing, both among members of the bar and the bench, is a product of muddled thinking. It is a happy day when one comes across a judicial opinion that is both well written and well reasoned. Today was such a happy day because I came across the opinion of the United States Bankruptcy Court for the District of Colorado in the case of In re Allbright.

Allbright was the sole owner and member of an LLC that owns real estate in Colorado. The trustee in Allbright’s bankruptcy asserted the ability to take over the LLC, liquidate its property, and then distribute the proceeds pursuant to the bankruptcy proceeding. Allbright contended that "at best, the Trustee is entitled to a charging order and cannot assume management of the LLC or cause the LLC to sell" its assets.

The court noted that, under Colorado law, an interest in an LLC is personal property. By virtue of the bankruptcy filing, all of Allbright's personal property, including her interest in the LLC, was transferred to the bankruptcy trustee. Brushing aside Allbright's attempt to parse the difference between the right to manage the property and the right of a member to distributions from the LLC, the court went to the nub of the matter and said: "[T]he charging order, as set forth in [the Colorado LLC Act] exists to protect other members of an LLC from having involuntarily to share governance responsibilities with someone they did not choose, or from having to accept a creditor of another member as a comanager. A charging order protects the autonomy of the original members, and their ability to manage their own enterprise. In a single-member entity, there are no non-debtor members to protect. The charging order limitation serves no purpose in a single member limited liability company, because there are no other parties’ interests affected."

In a footnote, the court provided a common sense guide to future cases involving multi-member LLCs, when it stated: "The harder question would involve an LLC where one member effectively controls and dominates the membership and management of an LLC that also involves a passive member with a minimal interest. If the dominant member files bankruptcy, would a trustee obtain the right to govern the LLC? Pursuant to [the Colorado LLC Act], if the non-debtor member did not consent, even if she held only an infinitesimal interest, the answer would be no. The Trustee would only be entitled to a share of distributions, and would have no role in the voting or governance of the company. Notwithstanding this limitation, [the provision of the Colorado LLC Act dealing with charging orders] does not create an asset shelter for clever debtors. To the extent a debtor intends to hinder, delay or defraud creditors through a multi-member LLC with 'peppercorn' co-members, bankruptcy avoidance provisions and fraudulent transfer law would provide creditors or a bankruptcy trustee with recourse. 11 U.S.C. Sections 544(b)(1) and 548(a)."

There are numerous charlatans who contend that there is some secret hocus-pocus inherent in charging orders. Somehow, against common sense, they argue that if one puts assets in an LLC, the setup will has the same effect on the creditors of the members of the LLC as garlic does to vampires. They contend that not only are the assets themselves beyond the reach of the creditors, but the creditors can get allocated taxable income without the benefit of receiving cash to pay the resulting tax. (If you don’t believe me, punch the term "charging order" into any search engine.)

By contrast, Allbright is short, clear, and well-reasoned. It's message is surprisingly simple: What a debtor controls, belongs to his or her creditors, unless there are others who hold legitimate interests with legitimate expectancies that, unless they gave their consent, they would not have to deal with third-parties. This holding is consonant with such well-reasoned Maryland cases such as 91st Street Joint Venture v. Goldstein, 114 Md. App. 561 (1997). It ain't rocket science.

A Crafty Bash

In U.S. v. Craft, 535 U.S. 274 (2002), the Supreme Court held that a federal tax lien against one spouse attaches to the interest of that spouse in property held with the other spouse that is titled as a tenancy by the entirety. The Craft opinion gave no direction as to the manner in which that interest should be valued. In In re Basher, the United States Bankruptcy Court for the Eastern District of Pennsylvania gave one answer.

Mark Basher owned his residence with his wife as a tenancy by the entirety. The property had a net equity of $101,000.00. The IRS held a tax lien against him (but not his wife) in the amount of $285,000.00. As part of a "cram down" proceeding in a Chapter 13 bankruptcy proceeding, the court had to assign a valuation to the interest to which the lien attached.

Basher claimed that the value of the property to which the lien attached was zero since he had no power, due to the tenancy by the entirety interest, to force a sale of the property. The Court rejected that approach to valuation based on a line of bankruptcy cram-down cases which held that valuation of property that a debtor elects to retain in a cram down proceeding is based upon the value of the various interests to be retained by the debtor, here, Basher's right to the use and enjoyment of the property and his survivorship interest in the property. The court specifically rejected the use of a foreclosure valuation.

The Service contended that the value of Basher's interest was 50% of the net equity value of the property. The court rejected this approach as well, since Basher, who was 46, had a shorter life expectancy than his wife, who was 45. Without determining the precise allocation factors, the court noted that the valuation had to "give . . . consideration to the impact of the [husband's] survivorship interest vis a vis [his wife's]."

Basher will inevitably be cited for the proposition that one merely applies actuarial tables to properly allocate the value of tenancy by the entirety property as between spouses. It is not clear to me that the opinion goes quite that far. Moreover, numerous other factors may affect the determination of the value of the tax debtor's "interest" in tenancy by the entirety property. By way of example, in Basher, the court was specifically able to point to the stability of Basher's marriage. Assume a case in Maryland where that stability is not present. Can the non-debtor spouse argue that part of the value of the property is non-marital under Maryland law, thus further reducing the value of the interest of the debtor spouse? Even the procedural issues are not as clear-cut as the Basher court would indicate, since a good argument could be made that the non-debtor spouse is a necessary party to any proceeding. This would be a particularly significant issue if the proceeding between the debtor spouse and the IRS took place against a background of domestic strife.

Basher is merely the first in what will become a torrent of opinions attempting to fathom the meaning of Craft.

Editor's Note: This weblog now has a "comment" capability. That is, one can post comments in response to any posting. I just discovered that those of you who receive postings via e-mail may not be aware of this, since the posting message is apparently not sent out via the e-mail. If any e-mail subscriber wants to post a comment, simply go to the weblog for that posting and click on the link at the bottom of the posting.

Miracles Do Happen

As of today (finally), the IRS now will issue applications for Federal Tax ID/EIN numbers over the Internet. You can go to the site by clicking here.

While the IRS calls the number that is given a "provisional EIN," it is actually the permanent EIN, subject only to being voided if the name and social security number of the principal officer (or, as the IRS's site calls it, the "principle [sic] officer") do not match Social Security Administration’s records or the business has already been assigned an EIN.

Third parties may request EINs via the Internet on behalf of their clients. Third parties must maintain in their files a copy of the Form SS-4 signed by the client.

I applied for an EIN this morning and found the site incredibly easy to use. A few small nits: If you use commas or periods, the application will not be accepted. Thus, "Acme, L.L.C." will be rejected until the application is resubmitted as "Acme LLC." Also, the size of some of the blocks for inputing information may be too small, particularly the block for the address.

Although I will miss listening to the selection from Swan Lake ad nauseam while I’m holding on the phone, the site represents a major improvement in service.

All Things Must Pass

Thanks again to Evelyn Pasquier who has provided the following quick analysis of two tax bills, HB 753 and HB 935, which passed the Maryland General Assembly in its waning hours. Stay tuned, however, because the Governor is threatening to veto one or perhaps both of these bills.

HB 753:

A 2% insurance premium tax on HMOs and managed care organizations.

A surcharge on Maryland taxable income of a corporation equal to 10% of the normal 7% tax (i.e., a tax rate of 7.7% on corporate taxable income), effective for tax years beginning after December 31, 2002, but before January 1, 2006 (i.e., this provision will sunset in three years).

Authority to allocate income, deductions, etc., among related entities (Section 482 authority) (enacted without the exception for financial institutions that had been included in the House version). Note that the retroactivity provision in the original version were not included in the version as finally enacted. These provisions, therefore, will go into effect July 1, 2003, and the Comptroller will not be able to exercise this authority with respect to previous years, regardless of whether they are still open for other purposes.

The anti-Delaware Holding Company ("addback") provisions as enacted by the House, but with an exemption for intangible expenses incurred in the biotechnology industry to purchase, license, develop, or protect patents, trade secrets, copyrights, or trademarks.

Allocation to Maryland of non-operational income of a corporation whose principal place of directing or managing its trade or business is in this state.

The "throwback" rule bringing a corporation's sales of tangible personal property to an out-of-state purchaser into the numerator of the apportionment fraction if the corporation is not taxable in the state of the purchaser, and clarifying that a corporation is considered taxable in a state that has jurisdiction to subject it to a net income tax regardless of whether the tax is actually imposed. (Note that where a corporation does no more in a state than solicit sales of tangible personal property, that state does not have jurisdiction to impose an income tax on it.)

HB 935

HB 935, which originally was a straight budget reconciliation bill, now includes a number of items that were in the original corporate tax and "compliance" bills, to wit:

The provisions requiring tax clearance certificates from the Comptroller to renew licenses issued under the following articles: Business Occupations and Professions, Business Regulations, Environment, Health Occupations, Natural Resources, Tax-General, and Transportation (excluding in the last, motor vehicle registration and drivers' licenses).

Entity filing fees for Corporations, LLCs, LPs, LLPs: The annual report fees will be $300, and all other filings have also been increased.

Provisions moving up dates for payment of withholding taxes under certain circumstances.

Lowering from $20,000 to $10,000 the amount for which the Comptroller may require electronic payment of taxes.

Electronic versions of the bills have not yet been posted. I will provide an update when they are and when the Governor either signs or vetoes the bills.

Is That Reasonable?

Previously, I have commented on the growing number of controversies over whether owners of closely held businesses are paying themselves unreasonably low salaries in order to avoid FICA tax liabilities. The U.S. Court of Appeals for the First Circuit just issued an opinion that imposed heavy penalties on a closely held business for paying unreasonably high salaries.

The case is notable because the court adopted a multi-factor test to determine whether the compensation was reasonable, specifically rejecting the "independent investor" test articulated by Judge Posner of the Seventh Circuit in Seventh Circuit, Exacto Spring Corp. v. Commissioner, 196 F.3d 833 (1999).

The case is Haffner's Service Stations, Inc. v. Commissioner (Case No. 02-1761, March 31, 2003) and a copy of the opinion can be obtained through the First Circuit's website.

The Law Will (Sometimes) Protect a Volunteer

In a recent opinion, the Bankruptcy Court for the Middle District of Pennsylvania relieved the president of a non-profit organization of any responsibility for unpaid employee withholding taxes.

The individual in question became president of a social club at a time when its financial affairs were already in turmoil. During the early stages of his tenure in office, the organization continued to fail to pay withholding taxes on employee wages. However, the court accepted the taxpayer's assertion that he did not know that the taxes were not being paid and that, once he discovered the problem, he ordered the payroll service to be certain that all payroll taxes were properly withheld and paid over.

One fact clearly colored the court's approach to this case--the taxpayer did not profit from the failure to pay over the taxes. As the court noted, he was "an unpaid officer of a non-profit organization [who] had nothing to gain by keeping the club afloat while putting himself at great risk of substantial tax liability."

The underlying rationale of the opinion is found in a footnote where the court quotes from another case dealing with proposed Section 6672 claims against officers of a non-profit organization: "This matter portrays the government at its heartless, rigid, and Orwellian bureaucratic worst. The plaintiffs in this action were engaged in selfless, dedicated charitable activity. They gave of their time and themselves to assist those in need. They received no personal gain other than the satisfaction derived from their charitable endeavors. The compassionate federal government, and particularly the well known, warmhearted Internal Revenue Service, has chosen to reward them with personal liability for the nonpayment of withholding taxes."

The name of the recent case is In Re: E. Harry Lartz. The opinion is not publicly available on the web, but I will supply a copy upon request.

Six Degrees of Separation

Today's New York Times had a story on the case of Norton v. Glenn regarding the issue of "reportage privilege."

Under the facts of the case, a member of the Parkesburg Borough Council characterized the Borough Mayor and the Borough Solicitor as "queers" and "child molesters" and referred to the Borough Solicitor as a "shyster Jew." The statements were reported in the local paper. The Mayor and Borough Solicitor brought suit against not only Glenn, the council member who made the statements, but against the reporter and newspaper as well.

The trial court had applied the so-called "neutral reportage privilege" to the case, based evidentiary rulings upon that privilege and gave jury instructions based upon it. The jury returned a verdict exonerating the reporter and the newspaper.

In essence, the privilege applies the standards of New York Times v. Sullivan, 376 U.S. 254 (1964). It allows reporting of newsworthy statements without fear of being sued for defamation, unless the plaintiff can show that the publication by the reporting organization was made with "actual malice." That is, the plaintiff must prove that reporting organization knew that the statement was false or reported the statement with reckless disregard of whether it was false or not.

The intermediate appellate court rejected the doctrine and the case is now on appeal to the Pennsylvania Supreme Court. Amicus briefs have been filed by numerous press organizations, including the Times.

The case has obvious ramifications for weblog authors. After all, a significant portion of weblog reportage consists of brief mentions of stories that appear in more traditional publications or even references to weblog references to weblog references (and so on) to articles that appear in more traditional publications. If there is no "neutral reportage privilege," the chain of potential defendants could be as long as the number of links to a particular story.

(Note: The quotes of the councilman that are set forth above were contained in the appellate court's opinion, which quoted from the trial court's opinon, which quoted from the evidence adduced at trial, which quoted from the allegedly offending news story, which quoted the councilman. I don't think that I can be sued for defamation for reporting about a court's opinion discussing a trial about an alleged defamation, but ya' never know.)

Hey, Let's Be Careful Out There!

One might think that maintaining a weblog is not a risky proposition. Speaking as a lawyer, I have to offer a lawyerly, "That depends."

There are weblogs that focus on hotly debated issues of public policy. It is not beyond the realm of possibility that a by-product of these debates might be a lawsuit for defamation. By way of example, Richard Perle is apparently bringing a lawsuit against Seymour Hirsh for a story authored by Hirsh that appeared in The New Yorker. The lawsuit is being brought in England, which is extraordinarily liberal in allowing recoveries for alleged defamation.

One can easily foresee the possibility of a similar lawsuit growing out of a weblog posting. In that regard, it is notable that the law is unclear as to where such a lawsuit can be brought. There is a case in Australia that holds that jurisdiction over a claim for an alleged defamatory statement can be exercised in that country over Dow Jones & Company, located in New York, for publishing Barron's Online. The theory is that the publication of the defamatory statement took place in Australia when Australian web surfers clicked on the site. Although I've heard that Australia's a nice country, I wouldn't want to defend a lawsuit there.

While The New Yorker has deep pockets and, most likely, an insurance policy that provides coverage for defamation claims, I doubt that many bloggers carry insurance policies that are specifically designed to provide such coverage. Let me suggest, however, that bloggers may, in fact, have such coverage in many cases.

Many, if not all, homeowner policies include within the definition of "personal injury," an injury caused by defamatory comments. Umbrella policies generally mirror that coverage. At the least, weblog authors should make certain that their homeowner's policies provide coverage. Additionally, since umbrella coverage is relatively cheap, they should consider acquiring an umbrella policy with significantly higher limits.

However, be aware that such policies generally contain exclusions for business activities. Thus, if a weblog is designed for what might arguably be considered to be a business purpose (such as a weblog by an attorney offering legal commentary), make certain that your business policy provides such coverage and has sufficient limits of coverage.

This brings me to the case of Applied Signal & Image Technology, Inc. v. Harleysville Mutual Insurance Co., decided last week by Judge Blake of the United States District Court for the District of Maryland. Under the facts of that case, Applied Signal was sued for, among other things, allegedly placing the plaintiff in a "false light." Harleysville agreed to defend the case under a reservation of rights. That is, it agreed to underwrite the costs of defense, but reserved the question of whether it had an obligation to contribute to any settlement or judgment obtained by the plaintiff.

At the end of the day, Harleysville contributed $25,000.00 toward a settlement of the case. It balked, however, at reimbursing Applied Signal for the total defense costs of $88,000.00, arguing that these costs should have been apportioned between those allocable to the covered claim and those allocable to claims that were outside of the policy's coverage.

Harleysville lost. The Court held that the policy provision that required Harleysville to "defend any 'suit' seeking . . . damages [covered by the policy]" was a covenant that was independent of its obligation to indemnify Applied Signal from any loss. The Court pointed out that Maryland requires an insurer to defend when there is a "potentiality that the claim could be covered by the policy" (emphasis by the Court). Furthermore, the Court awarded Applied Signal the reasonable attorneys' fees and costs it incurred in having to bring the action to force Harleysville to reimburse it for the attorneys' fees incurred in the defamation action.

The Moral: An ounce of insurance protection is worth a pound of litigation cure.

HB 753 Update

HB 753 has apparently been approved, but in a heavily amended form, by the Senate Budget & Taxation Committee. While business entity filing fees and yearly registration fees are still raised, the increases are not as radical as those in the version passed by the House. Furthermore, the provision imposing recordation and transfer tax on entity transfers has apparently been stricken.

I have not yet seen a copy of the bill as amended in the Senate, but I will post a more complete summary as soon as possible.

If This is Athens, Where's the Acropolis?

Evelyn Pasquier of Piper Rudnick has authored a summary of HB 753, a budget bill that has just passed the Maryland House of Delegates. She terms the bill "Draconian." Perhaps, "Draconian" is a little over the top, but it's a bad bill.

HB 753 dramatically increases the annual fees that all business entities registered in Maryland must pay. By way of example, all business entities would have to pay at least $400.00 a year. Currently, the annual fee is $100.00 for corporations and nothing for LLCs and partnerships. The fee rises to as much as $20,000.00, depending on the number of employees a business entity has. The fee will have a significant negative impact on the use of multiple entities to lower the liability profile of a business.

Maryland is the "corporate domicile" of many real estate investment trusts. This results in a good deal of money flowing into the state without any significant burden on governmental resources. Apparently determined to kill the goose that is laying this golden egg for the state, HB 753 imposes a $10,000.00 filing fee on REITs.

HB 753 also imposes transfer and recordation taxes on transfers of controlling interests in entities if the underlying real property owned by the entities is worth at least $1,000,000.00. I've commented in the past on the deficiencies of this tax, both legal and economic, and I won't repeat the criticisms here.

HB 753 also makes significant changes to the corporate income tax in Maryland. In essence, these changes extend the reach of Maryland's taxing authority over income that previously escaped taxation.

Ironically, HB 753, which places burdens on business activities in Maryland, has its roots in political rhetoric (mostly, but not exclusively, Republican) that condemns taxes. Voters have been told time and time again that they are heavily taxed. In general, and particularly in Maryland, this is not the case. As a consequence, elected officials in Maryland are unable (or, perhaps, unwilling) to state the obvious: The cuts in the Maryland income tax over the past few years were unwarranted and should be repealed. Attempting to patch the state's leaky fiscal ship by enacting "non-taxes" in the form of dramatically increased business fees will ultimately cost the state dearly in terms of economic development.

I Don't Want to Get Off on a Rant Here, But . . .

In general, this weblog is directed to discussing "technical" issues pertaining to tax and business law. In the course of these commentaries, it is impossible to avoid discussion public policy issues. After all, in some sense, the law is the articulation of public policy. However, I have avoided topics that are of a more general nature. Thus, I have not offered my opinions on, say, broader issues of tax policy such as tax rates, etc.

My approach has been driven by my view that this weblog is a semi-scholarly endeavor. If my postings were to deal with issues that are the subject of partisan debate, the weblog might be perceived as having a focus that is different from its original intent--to highlight and discuss technical developments in the field.

Readers can assume that I have a political bias. However, their assumptions as to the nature of that bias are often incorrect. For instance, because my work is, to a large degree, devoted to helping my clients minimize the taxes that they pay, there is often an assumption that I am anti-tax. Somewhat conversely, after hearing my opinions as to the necessity of increasing the audit capability of the I.R.S. and the Maryland Comptroller's Office, people sometimes conclude that I’m merely trying to bend public policy to indirectly drum up more business for myself (i.e., more audits, more clients). Neither of these assumptions are correct.

This brings me to the subject of this posting. With the exception of the impending Iraq invasion and, perhaps, the Korean situation, the most heated debates in this country today are over tax policy. The public generally tends to ignore the nitty-gritty of tax policy, since tax policy discussions can cause even the eyes of insomniacs to glaze over. As a consequence, there is a vacuum in public discussions that tends to be filled with "cranks and charlatans." (The term is the appellation applied by the current president's chief economic advisor to the proponents of supply side economics. That being the case, I wonder what he really thinks about the President's tax proposals.) In this category are those who argue that the federal or state budget is bloated and that taxes could be cut and governmental deficits disappear if this bloat were properly attacked.

Access to the facts that refute this argument as it pertains to the federal budget are widely available. Thus, one need look no further than the budget proposed by the White House (which is easily accessible on-line) to discover that the non-military discretionary spending proposed by the White House is only 19.24% of the total proposed spending package. (Non-military discretionary spending is everything other than entitlements, such as Social Security and Medicare, and interest on the federal debt. It represents the cost of operating virtually every governmental agency from the State Department, to the Justice Department, to the FAA, to the FDA, to the costs of running the White House.) This is less than the “off-budget deficit” (the amount that is spent on all items other than designated trust fund programs such as Social Security). In other words, even if non-military discretionary spending were cut to zero, the federal government would still be running a deficit with respect to its current operations. And, this would be the case even before any costs of a war on Iraq are factored in.

It is often more difficult to find similar analyses of state spending, particularly with respect to relatively small states such as Maryland. A recent op-ed piece in The Baltimore Sun by Steve Hill, director of the Maryland Budget and Tax Policy Institute helps to fill this void. The article points out that (i) Maryland government is lean–it has fewer employees per capita than all but nine other states, (ii) that the higher education system in Maryland is underfunded when compared to the systems in other states, and (iii) that state and local governmental spending reflects a smaller share of our economy than in every other state but three.

I disagree with some of the Institute's suggested remedies to balance the state's budget. By way of example, in one paper addressing three alleged loopholes, the Institute urges the passage of the entity transfer tax bill, a step that I have opposed for a number of years. On the whole, however, the Institute and its website are a powerful resource with which to battle Maryland's cranks and charlatans.

Joseph K. Meets the Internal Revenue Code of 1986

In a recent opinion, the defendants opposed to the I.R.S. characterized their plight as being "Kafkaesque." The court, while admitting that the facts "tend[] to support that view," nonetheless denied relief.

The case, U.S. v. Ripa, involves a claim involving an assessment dating back to 1983 (that’s not a typo). The opinion was handed down on March 12 and the case is number 01-6099. It can be downloaded off of the Second Circuit's website.

In 1983, Romano attempted to enter Canada from the U.S. with $359,000.00 in U.S. currency in his trunk. The cash was the proceeds of "wildly successful, albeit illegal, gambling activities." Unfortunately, Romano had failed to complete the required currency reporting form. As a result, the cash was immediately seized by U.S. Customs officials.

More significantly, the I.R.S., later that same day, made a "termination assessment" against Romano. That is, the Service terminated his tax year as of that date and calculated the tax due. Under such circumstances, the tax becomes immediately due and payable and the I.R.S. files a tax lien. Ultimately, Romano was found to owe $169,981.00 in taxes on his gambling winnings. By 2001, due to interest and penalties, this assessment had grown to over $750,000.00. It is perhaps worthy of note that Romano had total tax liens of over $1.5 million by the time of the trial in this matter, thus the tax due with respect to the seized monies was not the only obligation he owed the I.R.S.

Over many years, Romano, represented by his attorney, Ripa, pressed his efforts in opposition to the Government's efforts to declare that the funds would be forfeited to the Government. Ultimately, he prevailed and, in 1997, the Federal District Court ordered the Government to refund to Romano $491,236.69, representing the monies seized and interest thereon.

In the case before the Second Circuit, Ripa, Romano's attorney, claimed that he was entitled to receive his legal fee for representing Romano in the forfeiture action, equal to one-third of the award, because the legal fee represented a lien with "superpriority," with priority over the tax liens. In general, an attorney's fee constitutes a lien on assets with superpriority if the legal fee was incurred in a successful effort to obtain a judgment that produced the assets. However, there is an exception to the superpriority rule when the judgment arises out of "a claim or . . . a cause of action against the United States."

Ripa argued that because the money never belonged to the Government, there was no judgement "against the United States." In fact, an earlier district court opinion out of Massachusetts supports this position. Two other district court opinions, out of Georgia and Kentucky, had reached the same conclusion as the Second Circuit here. The Second Circuit's decision was based upon its analysis that the purpose of the statute granting superpriorty status was to encourage the realization of assets that could be applied to pay taxes due. Since the monies returned by Romano would have been in the coffers of the Government in any event, the Government was no better off by dint of Ripa's efforts.

For Romano, the horror does not end here. After all, the total amount due, including interest and penalties, with respect to the taxes on money seized was more that Romano received when the Government's forfeiture claim was denied. The reasons are that the Government was not forced to pay any penalty with respect to its misguided efforts and the interest charged on delinquent tax obligations is greater that the interest allowed on the contested fund during the time the forfeiture action was pending. The Court denied Romano equitable relief with respect to this claim.

I'm wondering whether Romano was dealt one final insult. After all, he received just over $140,000.00 in interest on the returned funds. It is entirely possible that the Service could have or did seek to tax that income in 1997, the year of receipt.

Saving Your S

The ability of a corporation to retain its status as an S corporation is hedged by a variety of requirements. One of those is found in I.R.C. Section 1362(d)(3)(A)(i) which provides that an election under section 1362(a) is terminated if the corporation has accumulated earnings and profits at the close of each of 3 consecutive taxable years and has gross receipts for each of such taxable years more than 25 percent of which are passive investment income. PLR 200309021 shows how an S election can be retained even though the principal business of the corporation would otherwise cause it to run afoul of Section 1362(d)(3)(A)(i).

Under the facts of the ruling, the S corporation's primary source of revenue was rental income from leasing office space. This income was clearly passive investment income for the purposes of Section 1362(d)(3)(A)(i). See I.R.C. Section 1362(d)(3)(C)(i). However, the corporation purchased interests in three limited partnerships that were apparently engaged in the business of purchasing, gathering, transporting, trading, storage, and resale of crude oil, refined petroleum, and other mineral or natural resource. These sorts of business activities will not constitute passive investment income as defined by I.R.C. Section 1362(d)(3)(C)(i).

The ruling held that the corporation's distributive share of the gross receipts of the three partnerships that it purchased will be included in its gross receipts for purposes of Section 1362(a). Apparently, the amount of the corporation's distributive shares of partnership gross receipts from the three partnerships were sufficient to fall below the 25% threshold that would have put it in violation of Section 1362(d)(3)(A)(i). Just as importantly, this result holds even though there may have been little net income from the partnerships or even losses generated by them.

This ruling opens the way for some creative planning in situations where an S corporation has low basis assets that it wants to dispose of with minimal income tax impact or assets which may be subject to double tax because the corporation had been a C corporation that elected S corporation status within the previous ten years. I will post illustrations of these planning possibilities in the coming weeks.

All of Me, Why Not Take All of Me

In Rev. Rul 2003-28, the Service considered three different factual scenarios involving the contribution of rights in a patent to a charitable organization. In only one instance was the contributor allowed a charitable deduction.

In the first situation described, the taxpayer contributed a non-exclusive license for the patent to a university, retaining the right to grant other licenses. The Service held that Section 170(f)(3) requires that the taxpayer contribute an undivided portion of its entire interest in the patent. The ruling equated the non-exclusive license with the rent-free lease and the partial interest in the film rights to a motion picture, both of which are discussed in the regulations under Section 170. The regulations make it clear that no charitable deduction is allowed under these circumstances.

The Service's analysis of the first set of facts makes it clear that there would be no charitable contribution if the donor had retained any substantial rights. Thus, a contribution of the patent rights for one geographic area would not give rise to a charitable deduction if the donor had retained the rights to license the patent in other geographic areas.

In the second factual scenario, the patent rights would revert to the donor if a particular named professor was no longer a member of the faculty at the donee institution. The remaining life of the patent was 15 years and the Service determined that the possibility of the professor's leaving the institution before the expiration of the 15 year period was not "so remote as to be negligible." The ruling held that a charitable deduction was not allowed under this set of circumstances because it violated the rule set forth in Treas. Reg. Section 1.170A-7(a)(3) that a charitable contribution is not allowed if the transfer may be defeated by the performance of some act or happening of some event.

In the third case, however, a charitable deduction was allowed. There, the transfer to the institution was conditioned only upon the donee institution not further transferring or licensing the patent for the first 3 years after the initial transfer. However, the ruling warned that the restriction would reduce the value of the charitable deduction.

Rev. Rul. 2003-28 makes it clear that in making a charitable deduction, the whole is indeed greater than the sum of its parts.