No Fraud Here

For some strange reason, I've always had a sneaking suspicion that the statute of frauds tends to be used more to effect fraud or, perhaps more appropriately stated, to protect the perpetrator of a fraud, then it does to prevent fraud. In Salisbury Building Supply Co., Inc. v. Krause Marine Towing Co., the Maryland Court of Special Appeals turned back an attempt to protect the perpetrator.

Prior to the formation of the towing company, its principal, Joseph Krause, and the building supply company signed a document that purported to be a memorandum of understanding between the two companies. The memorandum provided that the towing company would supply services to the building supply company for a period of five years. Shortly thereafter, the towing company was organized as a corporation and for two years it provided services pursuant to the terms of the memorandum. At that point, the building supply company sold substantially all of its assets to a new company and then ceased operations. Neither the new firm nor the old entity honored the arrangement with Krause. Krause then sued the building supply company. Krause produced unchallenged evidence that it suffered lost profits for the unexpired term of the deal in an amount in excess of $165,000 and received an jury award in that amount. Salisbury appealed, contending that the agreement was unenforceable due to the application of the statute of frauds.

Under the Maryland statute of frauds, a contract that cannot be performed within one year is not enforceable unless the agreement "or some memorandum or note of it, is in writing and signed by the party to be charged." The Court stated that "in analyzing whether a memorandum or note is sufficient to satisfy the statute of frauds, courts should focus upon the statute’s purpose, namely, prevention of fraudulent claims" and quoted Williston on Contracts as follows:

In determining the requisites and meaning of "a note or memorandum in writing," courts often look to the origin and fundamental purpose of the Statute of Frauds. In fact, a failure to do so will often result in a futile preoccupation with the numerous and conflicting precepts and decisions involving the clauses providing for a note or memorandum, and a corresponding failure to see the forest for the trees.

The Statute of Frauds was not enacted to afford persons a means of evading just obligations; nor was it intended to supply a cloak of immunity to hedging litigants lacking integrity; nor was it adopted to enable defendants to interpose the Statute as a bar to a contract fairly, and admittedly, made. In brief, the Statute "was intended to guard against the perils of perjury and error in the spoken word." Therefore, if after a consideration of the surrounding circumstances, the pertinent facts and all the evidence in a particular case, the court concludes that enforcement of the agreement will not subject the defendant to fraudulent claims, the purpose of the Statute will best be served by holding the note or memorandum sufficient even though it is ambiguous or incomplete.

The Court allowed the enforcement of the deal the parties had reached even though the memorandum was entered into prior to the date of formation of the plaintiff and it affirmed the judgment in favor of the towing company.

At least in this case, the statute of frauds was not used as a shield to protect the party breaching the contract.

What's Fair?

In Della Ratta v. Larkin, 382 Md. 553 (2004), the Maryland Court of Appeals held that four limited partners had the ability to withdraw from the limited partnership and to recieve the "fair value" of their partnership interest. The case was remanded to the Circuit Court for Anne Arundel County for a determination of what constituted fair value. In March, the Circuit Court rendered its opinion in the case. (The opinion is found on the website of the Maryland Business and Technology Case Management Program.)

The limited partnership had but one asset, a shopping center. The Court first determined the value of that asset. While several points of the Court's discussion of the appraisal issue are of some interest (particularly the Court's rejection of the use of the assessment used to determine property tax), the importance of the case for me is in its discussion of the meaning of term "fair value."

The Court held that the purpose of the statutory provision calling for withdrawing partners to be paid fair value for their interests "is to indemnify the withdrawing partners for the interests that they are giving up upon withdrawal, in the same proportion as the partner[s] would participate in distributions from the partnership." The Court then concluded "that fair value is a legal concept which differs from fair market value." (Emphasis by the Court.) To determine fair value, "the valuation must be viewed from the perspective of the withdrawing partners who are surrendering their interests back to the partnership."

Since there was no direct Maryland precedent with respect to the meaning of the term, the Court looked to the dissenters' rights provisions of the Maryland corporate statute, Section 3-202, et seq. of the Maryland Corps. & Ass'ns Article. The Court quoted Warren v. Baltimore Transit Co., 220 Md. 478, 483 (1959) to the effect that:

the real objective [of the dissenters' rights provision] is to ascertain the actual worth of that which the dissenter loses because of his unwillingness to go along with the controlling stockholders, that is, to indemnify him. The textwriters and cases agree generally that this is to be determined by assuming that the corporation will continue as a going concern – not that it is being liquidated – and on this assumption by appraising all material factors and elements that affect value, giving to each the weight indicated by the circumstances, including the nature of the business and its operations, its assets and liabilities, its earning capacity, the investment value of its stock, the market value of its stock, the price of stocks of like character, the size of the surplus, the amount and regularity of dividends, future prospects of any industry and of the company, and good will, if any.

Most significantly, the Court rejected the use of a minority or marketability discount applied to the partnership interests of the withdrawing partners to determine the purchase price. This is consonant with the theory that the buyout represents a division of the business entity, not merely a purchase of the departing partners' interest in the entity. Thus, the Court found that this case was a

statutory redemption intended to make the withdrawing partners whole by allowing them to "cash out" their interests. If discounts were applied, the remaining partners would end up acquiring the interests of the withdrawing partners for less than they were worth if those interests had remained in the hands of the withdrawing partners . . . [and that] under the circumstances of this case, it is not appropriate to apply such discounts in order to determine the value of the interests of the withdrawing partners.

(Emphasis by the Court.)

The opinion seems to be correct. However, it should also serve as yet another warning that proper drafting of an agreement can control the outcome of a business dispute. Here, the parties had not addressed the possibility of a business dispute in their operative formation documents and, as a consequence, were left with a statutorily mandated result.

Responsible? Not My Call.

A recent trial court opinion from the Court of Federal Claims, Salzillo v. U.S. goes further than most other reported cases that I am familiar with in absolving an employee who exercised check signing authority from liability under Section 6672.

Salzillo was the Vice President of Finance and Chief Financial Officer of Star Food Processing, Inc. He was at all relevant times fully cognizant of all elements of the financial affairs of Star, including the fact that Star had failed to pay its federal payroll withholding. The IRS had assessed a Section 6672 "responsible person" penalty against Salzillo in the amount of $554,000.

Salzillo's principal contention was that, notwithstanding the fact that he had regularly made checks payable to suppliers and endorsed those checks in his capacity as the CFO of Star, he had no actual discretion to direct payments. In particular, he related an incident where he had paid employee withholding but his decision was countermanded by the CEO of the Company, Robbins. On that occasion, when Robbins learned that a supplier could not be paid because Salzillo had paid the withholding, "Robbins became irate and ordered Mr. Salzillo to wire the money to the meat supplier instead. He admonished Mr. Salzillo never to write a check to the IRS again." Salzillo's immediate subordinate testified that if Salzillo had "made any payments other than those directed to production related costs, Mr. Robbins would have threatened to fire him, but, given the company's dire circumstances, probably would not have done so."

The Court, while recognizing that virtually all company checks in the relevant time period had been indorsed by Salzillo, framed the issue as being whether Salzillo could have "by writing and mailing . . .a check [for the withholding], actually have transferred funds to the IRS in payment of the delinquent payroll taxes?" The Court found that, as a practical matter, he had no power to make payments to the Service.

In this regard, the Court made it clear that merely proving that he had been instructed not to pay the withholding would not have been sufficient to escape the Section 6672 net. Rather, it was the fact that Robbins:

so thoroughly controlled the extraordinarily limited finances of the company as to make it virtually impossible for Mr. Salzillo to send funds to the IRS without his actions being immediately detected and actual payment averted. Thus, the record reveals that, long before Mr. Salzillo became the so-called "chief financial officer," Mr. Robbins was constantly apprised of the company's precarious cash position, and that, as day-to-day needs arose, he allocated the scarcely available funds to maintain and maximize production. As prime indication of the depth and effectiveness of his controls, the record reveals – and IRS records confirm –- that when Mr. Salzillo attempted to pay the IRS $50,000 without obtaining Mr. Robbins' permission, the latter quickly detected the unauthorized use of funds and shifted money from the account in question to prevent the check drafted by Mr. Salzillo from being cashed by the IRS. Given the pervasive nature of Mr. Robbins' control, plaintiff had no reason to believe that subsequent attempts to pay the IRS would prove anything more than a hollow gesture.

The opinion is not listed on Court of Federal Claims' website either as a reported or an unreported opinion. However, I would be surprised if the Service did not appeal the case since it appears to run counter to most other reported decisions in this area. I also believe that, in the main, decisions in this area have been too automatic and reflexive. The true issue should always be the issue that the Court focused on here, namely, whether the taxpayer before the Court could have made a difference in whether the withholding was actually paid. If he or she was, effectively, powerless to act, there should be no penalty imposed under Section 6672. This should be the result even if the individual has check signing authority and actually directs payments to other creditors. The touchstone is whether, when the individual makes those payments to the creditors, he or she has the practical option to direct that the payments go to the taxing authority. If the individual lacks that power, there should be no penalty imposed.

Should the appellate court rule in Salzillo's favor, the practical effect would be enormous since the jurisdiction of the Federal Claims Court can be invoked in any Section 6672 contest once the taxpayer had made a partial payment of the tax due. The opinion represents a fairly taxpayer-friendly application of Section 6672 (which is to say a fairly restrictive interpretation of what constitutes a "responsible person" under the statute) and would likely attract to the Claims Court a fair portion of the contested claims in this area.

Advertisement for Myself (and Others)

I will be lecturing at the ALI-ABA course Partnerships, LLCs, and LLPs to be held in Charleston on June 2-4. This course coincides with the 17-day Spoleto Festival U.S.A. 2005 in Charleston, considered by many to be the world’s most comprehensive arts festival.

Anyone interested in attending can find more information here.

Fools and Knaves, Wall Street Journal Edition

I have developed a simple rule of thumb in analysing conservative policy pronouncements, the Knaves and Fools Rule. The rule is simple: Conservative policy pronouncements are made by knaves and then the pronouncements are believed and repeated by fools. It is with some sadness that I have to report that someone who is no fool, Paul Caron, got fooled by the the knaves at the Wall Street Journal.

At his justifiably well-regarded TaxProf Blog, he notes what he feels is a "interesting editorial" in today's WSJ. The editorial is available online only to subscribers, but it's thesis is that "[e]ven the most ardent class warriors have no choice but to concede that the U.S. income tax code is steeply progressive -- that is, that it soaks the rich." The article goes on to quote from a study that purports to support this conclusion. Among other things, the study shows that since 1979, the proportion of the federal income tax burden borne by the wealthiest Americans has grown. (As is shown below, the "other things" that were reported in the study and which were critical to the ultimate conclusion reached by the study's authors were conveniently omitted in the WSJ editorial.)

Caron pulls a table from the study which shows that the percentage of total taxes paid by the really wealthy and the really, really wealthy increased dramatically from 1979 to 1999, and declined thereafter. He is fooled into believing that the chart illustrates that there was a dramatic increase in progressivity in the tax system in the 1979 to 1999 period and then a slight decrease thereafter. Had Caron thought about this proposition for a moment, he would have realized that the chart did not support either his or the WSJ's conclusions. Simply because X pays a higher percentage of all taxes in 1999 than he did in 1979 does not mean that the tax structure has become more progressive with respect to X. It may mean that X is making a whole lot more money in 1999 than he did in 1979. In fact, this is precisely what the study relied on by the WSJ reports.

The study, authored by Michael Strudler and Tom Petska of the IRS and Ryan Petska of Ernst and Young, can be found here. Among the points made in the study were the following:

• Between 1979 and 2002, the threshold for the top 0.1 percent grew from $321,679 for 1979 to $710,661 for 2002, an increase of 121 percent. Similarly, the threshold for taxpayers in the 1-percent group rose from $109,751 for 1979 to $175,618 for 2002, an increase of just over 60 percent. However, the thresholds for each lower percentile class show smaller increases in the period; the top 20-percentile threshold increased only 5.6 percent, and the 40-percent and all lower thresholds declined. In other words, over the period studied, the rich got a whole lot richer than everyone else and began to put real distance between themselves and the middle class.


• The share of income accounted for by the top 1 percent of the income distribution has climbed steadily from a low of 9.58 percent (3.28 for the top 0.1 percent) for 1979 to a high of 21.55 (10.49 for the top 0.1 percent) for 2000. To put it another way, the rich have become real hogs with respect to the portion of the total economic pie they consume.

What is the conclusion of the paper with respect to the increase or decrease of progressivity in the federal tax system? Rather than give you my slant on this, I will just quote the paper's conclusions verbatim:

So what does this all mean? First, the high marginal tax rates prior to 1982 appear to have had a significant redistributive effect. But, beginning with the tax rate reductions for 1982, this redistributive effect began to decline up to the period immediately prior to TRA 1986. Although TRA became effective for 1987, a surge in late 1986 capital gains realizations (to take advantage of the 60-percent long-term capital gains exclusion) effectively lowered the average tax rate for the highest income groups, thereby lessening the redistributive effect.

For the post-TRA period, the redistributive effect was relatively low, and it did not begin to increase until the initiation of the 39.6-percent tax bracket for 1993. But since 1997, with continuation of the 39.6-percent rate but with a lowering of the maximum tax rate on capital gains, the redistributive effect again declined. It appears that the new tax laws will continue this trend. Analysis of panel data shows that these trends are not quite as great as seen by looking at annual cross-section data, but the trends cited above are still apparent.

Contrary to the WSJ's conclusion, overall, the various changes in the tax code since 1982 have made the federal tax system less, not more, progressive. That is, the rich are paying a lower portion of the overall tax burden relative to their income now then they did in 1982 and the system's progressivity is headed for further declines.

The Moral of the Story: Only fools rely on "facts" bruited about by knaves.

Update

TaxProf links to the posting above and also to a previous posting of his that discussed an article, The Matthew Effect and Federal Taxation, 45 B.C. L. Rev. 993 (2004), by Martin J. McMahon, Jr., of the University of Florida, that illustrates that, over the last 25 years, the rich really are getting richer.

I would be remiss if I did not note that Brendan Nyhan was the first to call the WSJ's lie. Kevin Drum also covered the story. His posting includes a nifty illustrated chart.

One question: The WSJ editorial page lead the pack seeking to sack Dan Rather and other CBS editorial personnel when they relied on material they later discovered was false. Shouldn't the unnamed writer and his or her editor(s) responsible for yesterday's piece be cashiered? After all, the article plainly misrepresented (that is, lied about) the study that it discussed.

Just asking.

Timing Is Everything

11 U.S.C. Section 523(a)(1)(A) excepts from discharge under 11 U.S.C. Section 727 any tax liability that would be classified as a priority tax under 11 U.S.C. section 507(a)(8). Section 507(a)(8) states that a priority tax claim involves any tax liability for a tax year in which the tax return, "including extensions" is due within three years before the filing of the bankruptcy petition. The case of Dippel v. U.S, (Bankruptcy Ct. S.D.Fla., March 23, 2005), demonstrates that the early bird does not necessarily get the worm.

In 2001, the Dippels filed for an automatic extension to file their income tax return for 2000, extending the filing deadline within which they could file a timely return to August 15, 2001. They actually filed a return on April 22, 2001, but the Service marked it as being filed on or before April 15, 2001. They filed a Chapter 7 bankruptcy on June 15, 2004, more than 3 years after their 2000 return was filed, but less that 3 years after the due date, with extensions, for the filing of the return.

The court rejected the request for discharge, noting the unanimity of other courts that taxpayers cannot nullify their previously filed requests for extension. One cannot tell from the facts recited in the opinion whether the taxpayers had any ability to defer their bankruptcy filing by 61 days, but if they could have, they clearly should have.

I Stole this Article

Larry Ribstein makes a serious point in his post, Steal this Article, namely that he has "now awakened to the beauties of free dissemination of . . . academic writings." He refers explicitly to his articles, but I understand him to be in favor of free dissemination of a wide variety of academic writings.

While I strongly agree with Larry's position (some time ago I commented on the miracle of the freely available Public Library of Science jounals), I might not have posted about Larry's posting except for the fact that he provides a link to a free download of Abbie Hoffman's Steal This Book. Like Larry, I may be middle-aged (but, unlike Larry, not old), but there's still a little bit of Yippie left in me and it might be quite some time before I can work in a reference to Abbie on this blog, let alone link to a free download of his book.

Power to the People Larry.

Bad Idea for a Good Cause

Jane Galt suggests that one way to avoid the complications of the estate tax is to (i) have all inherited property receive a basis of $0.00, except for (ii) cash that is inherited, which would be taxed as income. Mark Kleiman thinks that this is a good idea. It's not.

I don't know whether there's been an economic analysis produced as to where the tax burden created by such a provision would fall, but I am aware that there have been analyses done with respect to proposals to do away with the estate tax, but which would also do away with the basis step-up rule. (That is, the basis of assets that are inherited are "stepped-up" to their fair market value as of the date of death.) Such a change would be less radical than the rule that Galt has proposed. The analyses that I'm aware of (I'll try to link to some this evening) show that net effect of the repeal of both the estate tax and the basis step-up rule would be to shift the burden of a tax triggered due to the death of the owner of property from families who are in the high end of familial wealth to those who are less wealthy. The reason is that only the very wealthy pay any estate tax when, as will be the case in a few years, the lifetime credit equivalency is $3M, whereas a good number of people, even people of modest means, receive some sort of inheritance. Almost all of these people would be paying additional tax if the basis step-up rule is eliminated.

My guess is that the Galt plan would, effectively, accentuate this downward shift in where the tax burden lands. For instance, in the 2 minutes since I read Galt's posting, I've already thought of a number of ways to minimize the tax bite where the asset is a family business. (I won't share my ideas with you---I consider them proprietary.) In other cases, families with significant wealth could defer the income tax for long periods of time by, for instance, borrowing against the assets. Families with less wealth who need to tap into inherited assets to buy homes, pay for college educations, etc., could not, since they will likely have to sell assets rather than merely borrow against them.

Like I said, a bad idea, unless you want to shift taxes from the wealthy to those less wealthy.

Update

In a research paper published in 2000, The Distributional Burden of Taxing Estates and Unrealized Capital Gains a the Time of Death, James M. Poterba and Scott Weisbenner conclude that:

[A]mong those with small estates ($1 million or less), taxing capital gains at death would collect more revenue than the current estate tax from roughly half of the decedents. For those with larger estates, replacing the estate tax with a tax on unrealized gains at death would result in a substantial reduction in total tax payments.

While the figures used in the report are from 1998, there is no reason to believe that the conclusion does not continue to apply today. In fact, since the unified credit amount has been dramatically increased, limiting the estate tax to taxable estates of over $4M, one would expect that the results today would be even more skewed in favor of the wealthy.

For an excellent primer on various policy questions pertaining to the estate tax, one should take a look at Estate and Gift Taxes: Economic Issues, by Jane G. Gravelle and Steven Maguire for the Congressional Research Service. They discuss a good number of the issues surrounding the estate tax, including how the tax works, whether the tax causes individuals to prematurely sell family businesses and farms (it doesn't, since "one can conclude that most farmers and business owners are unlikely to encounter estate tax liability"), and the claim that the costs of administering the tax eat up the revenue generated (they don't--the costs of administration are approximately 6-9% of the revenues generated).

Peanuts and Cracker Jacks

Via A Taxing Blog, I have come across the important academic paper, Identifying Moral Hazard: A Natural Experiment in Major League Baseball by Professors John Charles Bradbury and Douglas Drinen of the University of the South. The abstract of article is as follows:

In baseball, allowing a designated hitter (DH) to bat for the pitcher creates the potential for moral hazard among pitchers, who may then hit more batters without the fear of retaliation by the opposing team. The use of the DH in only one of Major League Baseball's two leagues provides a natural experiment to test for the existence moral hazard in a controlled setting. We develop a new micro-level dataset of individual plate appearances, which allows us to control for detailed cost-benefit attributes that affect the decision calculus of the pitcher. We find that moral hazard explains 60 to 80 percent of the difference in hit batsmen between leagues and find evidence of direct retaliation against plunking pitchers.

In other words, the DH rule not only does violence to the purity of the game, it also promotes violence on the field by removing disincentives to throwing pitches at batters.

The publication of the article raises once more the question of when that famous scholarly work, The Common Law Origins of the Infield Fly Rule, 123 U. Pa. L. Rev. 1474 (1975), will appear on the web.

Waiting for the Plumber, or Somebody Like Him

I am strongly in favor of the publication of greater numbers of judicial opinions. For instance, I see no reason that the Court of Special Appeals cannot publish all of its opinions on the web in the same way that the Fourth Circuit does, with opinions that the court feels should not constitute binding precedent being denominated as "unpublished.

I am also in favor of specialized courts to deal with serious business disputes. I believe that such specialized courts will lead to swifter and more certain resolution of business disputes, in the long run reducing the economic friction caused by disputes. A recent opinion by the Circuit Court for Baltimore City disappoints on both fronts.

The Circuit Court for Baltimore City publishes, on the web, a number of its decisions. The website is here. That's good. It allows businesses and their counsel insight into how nisi prius courts deal with business disputes and, theoretically at least, encourages settlements by reducing uncertainty. However, the opinion, in the case of Carnegie International Corp. v. Grant Thornton, LLP, is a disaster as a roadmap. It also reveals structural weaknesses in what, in Maryland, are termed Business and Technology Cases, that is, cases specially singled out for special treatment because of the complex business issues they present.

Carnegie is a 63 page opinion. (I read it while waiting for the sewer clearance people from Baltimore County to arrive to clear a sewer blockage at my home. It was a long wait. It is a long opinion.) One has to go at least 7 pages into the opinion to find what may be a concise statement as to the essential claims made by the plaintiff. Even then, it is not clear to me that this description applies to all of the claims, but that appears to be the case. The gist of Carnegie's claims seems to be that Grant Thornton caused Carnegie damage by taking actions or failing to act with the result that the trading of Carnegie stock on the American Stock Exchange was halted. The opinion, which probably reaches the correct legal result, fails as a cogent discussion of the case and the legal issues because it doesn't start with the type of opening that all good essays start with ("Once upon a time . . . .") and doesn't tell a story. As I tell my students, anyone who can tell a good dirty joke, and by this I mean a real joke, not merely a one-liner, can probably write a good brief, memorandum, or contract. Remember, a good joke starts with a factual premise, clearly stated ("A priest, a minister, and a rabbi walk into a bar . . . .") and moves logically forward from there.

What is even more disturbing is that the case reveals that the business and technology track may be certain, but it is hardly swift. The case was filed in May of 2000. The bench trial in the case began on November 5, 2001. It continued through April 4, 2003, and subsequent testimony was presented by depositions. Both parties submitted proposed findings of fact and conclusions of law on June 13, 2003. The opinion was not delivered until April 13, 2005, almost five years after the case was filed and almost two years after the Court had all of the evidence before it. By comparison, the Baltimore County sewer service acted with great dispatch.

Finally, the opinion fails to mention, even in a footnote, the bizarre activities of some of the players in the case, involving cults, alleged aliens, sexual slavery, and attempted contract murders. (If you want the salacious details, see here.) If you have to read a 62 page opinion, it ought to at least be well-written and have something to hold the reader's attention.

A Living Will for Our Times

Lawyers are constantly on the prowl for forms that they can incorporate into their practices. Via The Law Librarian Blog, I've found a great estate planning form designed for use in Florida which, with some tweaking, will probably work in Maryland as well. It can be found here.

Quick Pickup on Bankruptcy Reform Act

While President Bush has indicated that he will sign the bankruptcy bill, the exact date on which he signs the bill could be significant. BJ Haynes notes that:

[t]he bill has a 180 day delay in the effective date. If it is signed on or after April 19th, then October 15th would be within the 180 day period. October 15th is significant because it is three years from the extended due date of 2001 tax returns and thus the date on which 2001 tax liabilities would satisfy the three-year-from-due-date rule of Bankruptcy Code Section 507(a)(1).

He advises that:

[i]f you have clients who might benefit from using bankruptcy to discharge their unmanageable tax debts, time is now most definitely running out. It is strongly suggested that you go through your inventory of cases to see whether you have folks who owe large amounts of tax for tax years 2001 and prior. Discharging taxes under the new bill will be much more difficult, but to get the benefit of the existing law the petition must be filed within the 180 day effective date delay period.

Small Businesses and the Estate Tax

In a weblog comment opposing the repeal of the federal estate tax, Matt Yglesias argues that:

[t]he government ought, perhaps, to facilitate some kind of lending arrangement so that people who prefer to keep the store and pay the tax down over time out of operating revenues can do so.

Note to Matt: The tax code already has such a provision. Specifically, Section 6166 of the Internal Revenue Code allows the estate to elect to pay the estate tax attributable to an interest in a closely held business in installments over, at most, a 14-year period. If the election is made, the estate pays only interest for the first four years, followed by up to ten annual installments of principal and interest. Even better, a reduced interest rate of 2% per annum applies to the amount of deferred estate tax attributable to the first $1,000,000 in value (adjusted for inflation) of the closely held business. Even above that amount, the rate is fairly low: 45% of the annual rate applicable to underpayment of taxes. (The annual rate applicable to underpayment of taxes is currently 6%. That's right, even above the $1M threshold, the rate is only 45% of 6%, or 2.7%. Not a bad deal.)

Of course, the benefits of Section 6166 are not available to all estates. The value of the business must exceed 35% of the adjusted gross estate. By the way, farms can consitute a qualifying business.

This provision gives lie to the contention that the estate tax is devastating to small businesses. The fact that it is not widely publicized in policy debates in the mass media is due less to any political bias of the media than it is to the unfortunate tendency of the media to avoid examining technically complex issues. Stated another way, Section 6166 cannot be easily explained in a sound bite.

Sign of the Times

A change in administrative practice in Maryland shows the degree to which the internet has become woven into the fabric of business life.

In this state, businesses must file an annual tangible personal property tax return by April 15 of each year. In order to remain in good standing, certain entities, such as corporations and LLCs, must file annual returns and pay a $300 filing fee even if they have no tangible personal property. In previous years, extensions were routinely granted if a request for extension was mailed and postmarked by April 15 or faxed to the State Department of Assessments and Taxation by that date.

Beginning this year, in order to obtain an extension via a paper document, the document must be postmarked by March 15 and there is a $20 fee. Extension requests filed over the internet, however, are free and can be filed as late as April 15. Extension requests are no longer granted via fax or telephone. The change is explained here.

Of course, the number of personal and business income tax returns that are e-filed has grown geometrically in the past few years. But this is the first instance of which I am personally aware that the use of a traditional method of communication is discouraged by a governmental organization through the imposition of a transaction fee and the erection of other hurdles. It is a signal that the ownership of a computer and the use of the internet is coming to be viewed as being no more exceptional than the ownership and use of a telephone.

One Man's Loophole Is Another Man's . . .

The Washington Post has a summary of the results of the 2005 session of the Maryland General Assembly. One of the entries is a proposal that would have "[raised] money for construction by closing a corporate tax loophole." This alleged loophole closer died in a Senate committee.

The alleged loophole is the entity transfer tax bill. This bill would have imposed transfer and recordation taxes on the transfers of controlling interests in LLCs, partnerships, and corporations.

Let's be clear--the ability to freely transfer interests in entities that hold real property is not a "loophole." There are perfectly sound reasons not to impose a tax on such transfers, not the least of which is that such a tax would be difficult to enforce and, when applied to transactions that take place outside of Maryland between non-Maryland residents, unconstitutional as well.

Going one step further, the economic analysis of the revenue effect of the bill is suspect. That analysis depends solely on the estimated tax revenue that would be raised from the tax. The analysis does not factor into its conclusion the lost property tax revenue due to the depressive effect that the extension of the transfer and recordation tax would have on property valuations. The transfer and recordation tax is imposed on the entire value of the real property. Because real property is typically purchased using borrowed funds, the tax will reduce the amount that can be paid to purchase a property by about 4 or 5 times the amount of the tax itself. Since property taxes are annual levies, the tax loss from the reduced prices paid for commercial properties would recur year after year.

A friend of mine who was deeply involved in efforts to oppose the entity transfer tax bill bitterly complained about what he perceived to be left-wing bias on the part of the newspapers on the issue. While I thought that coverage was biased, the bias was that reporters like a simple story, e.g., rich, greedy developers attempt to preserve self-serving tax loophole.

There is no left-wing or right-wing bias. In fact, the actual systemic bias has worked to the benefit of the Bush Administration on numerous issues. (Think for a moment--does the President have a plan to reform Social Security? If so, would that plan resolve the current actuarial deficit with respect to the benefits due to current participants in the system? If one were to read the papers, one might conclude that there is an explicit plan (there's not) and that the plan will resolve the actuarial deficit (to the extent that any plan has been outlined by the Bush Administration, it does not address the actuarial deficit in any way, shape, or form).)

In fact, the bias is a dumb bias. That is, unless a story is simple, the press cannot digest it at all. The papers simply cannot seem to get their arms around anything that is even remotely complex, such as the concept of unintended consequences.

Stephanie Says

I just received a call from Stephanie of the Internal Revenue Service. Last week I filed for an employer identification number for a client for a newly formed LLC. The LLC in question will ultimately be classified as an S corporation. On line 8.a. of the Form SS-4, I had checked the box for the type of entity as "Corporation" with the form number to be filed as "1120S." In the box, "Other (specify)" I had stated "LLC electing corp", but did not check that box.

Stephanie informed me that this was incorrect and that the box "Other (specify)" should have been checked, with the description "single member" in the line provided. While I did not complain (after all, Stephanie corrected the form and the application will be processed in the ordinary course), it seems to me that my initial submission was correct. In the Q&A section of the web EIN application area, it is stated that LLCs "without type of entity" cannot obtain an EIN over the web. My interpretation of this is that one should check the box for the type of taxable entity (i.e., sole proprietorship, partnership, corporation) and put in a further description next to the "Other (specify)" box.

On the same day as the filing of the SS-4 that Stephanie called about, I filed another LLC that will be electing to be an S corporation. I have not yet received a call from the Service about that application. Given the lack of clarity in this area, I may not receive such a call.

Update

I did receive a call from "Jim" about the other filing. He asked but one question: Was the LLC a single-member LLC or a multi-member LLC? This leads me to suspect that the correct way to apply online for an EIN for an LLC that's an S corporation would be to check the box for a corporation filing a Form 1120S and then, in the line next to "Other (specify)" state either single member LLC or multi-member LLC.

Writer's Block

Last week, I was on the telephone with a stockbroker discussing a tax question one of her clients had raised. I told her that I had discussed a similar question on my weblog and gave her the URL. She tried to get to the weblog via the brokerage firm's internet connection and was told that the site was blocked and not accessible from that computer.

My guess is that I am neither so famous nor so notorious that the computer actually singled me out. Rather, I think that the brokerage house programmed its internet access to block all websites operated by Blogger not merely selected sites. It would not surprise me if the computer were somehow programmed to block weblogs that use any of the larger weblog hosting services (e.g., Blogger, Typepad, etc.).

If would appreciate it if anyone could send me information as to (i) whether this is a common practice among brokerage companies, (ii) whether the block is applied only to weblogs using the larger weblog hosting services, (iii) how the personnel of the brokerage company can get around the block, or (iv) any other pertinent information.

I understand that the People's Republic of China and Saudi Arabia block websites that they find offensive, but I would have thought that the stock brokerage houses, being champions of the free market, would not try to impede the free market of ideas.

Family (Dis)Harmony

On Friday, the Court of Appeals handed down decisions in two separate cases involving estate administration questions. I will not comment on one of these cases, Piper Rudnick v. Hartz, because another attorney in this firm was involved in the case. The question before the Court in that case was the grounds that would support the approval by the Orphans' Court of attorneys' fees incurred by a personal representative.

The other case decided by the Court, Brewer v. Brewer, deals with so-called "family settlement agreements" (also referred to by the Court as "redistribution agreements") whereby members of a family agree to divide an estate differently than is prescribed by the decedent's will. The Court held that:

(1) redistribution agreements are permissible and, so long as they comply with the requirements of basic contract law, neither the personal representative nor the court has any authority to disapprove or veto them, but (2) if they are to be implemented as part of the Orphans' Court proceeding, through a deed from the personal representative pursuant to an approved administration account, they must be attached to that account or otherwise made part of the Orphans' Court record. The account must not simply show the distribution in accordance with the agreement but must identify the agreement, incorporate it by reference, and clearly reflect that the distribution is being made pursuant to the agreement rather than pursuant to the Will.

There are two major practical questions that were not addressed by the Court.

First, what does it mean to "comply with the requirements of basic contract law"? In the course of the opinion, the Court noted that "the existence of a dispute is not ordinarily a prerequisite" to the enforcement of such an agreement. However, absent a dispute which a redistribution agreement purports to settle, what is the consideration that supports the contract? Presumably, in certain cases there could be property swaps that would provide consideration (e.g., the will provides that legatees John and Mary will each receive a one-half interest in both Blackacre and Whiteacre, but John and Mary agree that John will receive a 100% interest in Blackacre and Mary will receive a 100% interest in Whiteacre). However, in other cases (e.g., John is rich and Mary is not, so he agrees to forego some or all of his inheritance) this would not necessarily be the case.

Second, there are potential tax implications that must be considered. Of course, these tax issues were not before the Court in Brewer, but should be taken into account when weighing a redistribution agreement. Specifically, if the agreement is entered into after the nine month disclaimer period, it would seem likely that it could be argued the parties to the agreement have created either a taxable event for income tax purposes (as could be the case in a Blackacre/Whiteacre swap illustrated in the first example) or a taxable gift (as could be the case if one sibling waived part or all of his or her inheritance, as might be the case in the second example).

Oddly, the outcome of the case did not turn on the substantive issue concerning the enforcement of redistribution agreements, but rather on whether the plaintiff could reopen the estate after it had been closed for 20 months. Judge Raker dissented, contending that since this issue had never been raised either below or in the petition for certioari, it was not before the Court.

I Remember Momma?

When looking at reported decisions, I'm always reluctant to criticize arguments attorneys make in tough cases. For one thing, courts have been known to misunderstand or misconstrue perfectly reasonable, even if incorrect, arguments in order to fortify their own decisions and the reported opinion may actually make a plausible case appear to look preposterous. For another, the facts that are presented at trial may not be the facts upon which counsel based the decision to undertake representation. Every attorney who has been in practice for even a few years has horror stories about cases that looked great at the beginning, but which crumbled as "new" facts came to light. There are, however, a small class of cases that raise the question: "Why did they bother?" Maloof v. Commissioner decided today by the U.S. Tax Court is such a case.

In Maloof, the taxpayer was a sole shareholder of an S corporation that suffered a long succession of tax losses. Because his ability to use the losses of the corporation were limited to his basis in the corporation's stock, the taxpayer attempted to increase his basis in the stock by including in basis $4 Million in bank loans made to the corporation. Apparently, except for a pledge of his stock in the corporation, the taxpayer was not at risk with respect to the loans.

The opinion reads like the Children's Goldenbook of S Corporation Taxation with the Court walking through fairly basis principles of S corporation taxation. The taxpayer's positions were so adverse to established law that I'm surprised that there was no mention of possible sanctions for taking a frivolous position. (My favorite ludicrous position taken by the taxpayer is that he was a resident of Florida and thus the precedent of the 11th Circuit applied to the case. Why was he a resident of Florida: He lived with his mother, not his wife, who lives in Ohio. Note to Counsel: Your client's name is "Maloof" not "Oedipus.")

The case is instructive on one point: LLCs classified as partnerships or as disregarded entities have benefits over S corporations. Were the company an LLC classified as a partnership or a disregarded entity, the taxpayer would have obtained the benefits he sought. And, he wouldn't have had to run home to momma.

Tough to Breakup

In Renbaum v. Custom Holdings, Inc., the Court of Appeals made it clear shareholders must jump a high bar if they seek to force a judicial dissolution of a corporation on the grounds that the directors are deadlocked. In the Court's view, not any deadlock will do. The deadlock must be over an issue or issues that prevent the corporation from "perform[ing] its corporate powers."

In Renbaum, the corporation was a holding company, the sole business of which was to invest in publicly traded securities. The corporate stock was owned by two brothers and their wives. A serious dispute arose over the company's relationship with an attorney who simultaneously acted as the general counsel to the corporation and as the personal attorney for one of the brothers. Part of the dispute centered on the legal bills submitted to the corporation by the attorney. In addition to their inability to agree on who should serve as general counsel, the brothers also argued over whether and in what amount dividends should be paid. However, this dispute was resolved prior to the entry of a final judgment. Thus, by the time that the case was presented to the appellate courts, the only dispute extant between the parties was the general counsel issue. Curiously, however, the parties were in harmony concerning the management of the company's investment portfolio, agreeing to delegate that task to a specific third party investment manager.

Holding that, in order to justify a judicially ordered dissolution, there must be a deadlock concerning a "transcendant corporate function" which, if not broken, made "the object of corporate existence unobtainable." In order to make this determination the Court found that

[u]seful factors [that should be considered] . . . include: (a) whether the corporate function(s) have ceased; (b) the power in dispute is expressed as a discretionary or mandatory power in the corporation’s Articles of Incorporation, by-laws, or other corporate governing documents; (c) the role of that power in achieving the corporation’s primary function(s); and, (d) whether the corporation has exercised, as a matter of practice, that power routinely in its operations.

This case is significant because typical "canned" corporate forms (i.e., articles of incorporation, bylaws, etc.) often default to provisions that allow bare majorities of the shareholders to elect the majority of the members of the board of directors and allow a majority of directors to control the board. Absent fraud or some other basis upon which to demand a judicial dissolution, the minority shareholders can be frozen out. Thus, the ability of minority shareholders to pull the nuclear option of judicial dissolution is a power that the minority shareholders must bargain for at the inception of their relationship with the corporation.

It should be noted that the corporation in Renbaum is a general corporation, not a Maryland statutory close corporation. In the case of a close corporation, §4-602(a) of the Md. Corps. & Ass'ns Art. provides that a judicially ordered dissolution is available on the basis that "there is such internal dissension among the stockholders of the corporation that the business and affairs of the corporation can no longer be conducted to the advantage of the stockholders generally." That standard does not come into play outside of the context of a statutory close corporation. In the case of an LLC, it appears that the stricter standard applicable to general corporations applies, since LLCs can only be judicially dissolved if "it is not reasonably practicable to carry on the business [of the LLC] in conformity with the articles of organization or the operating agreement." See Md. Corps. & Ass'ns Art. §4A-903.

Stuffed and Mounted

The Washington Post reported today on an abusive tax avoidance scheme involving the donation of mounted big game animal trophies to various museums. Apparently, one particular appraiser has specialized in both valuing the trophies and arranging the donations. The valuations are often 5 to 10 times what the trophies will bring at established auctions. In one case, a museum sold mounts that had a total appraised value of $4.2 Million for only $67,000.

In addition to the tax abuse or, perhaps, tax fraud angle, the practice is in the sights of conservationists who content that "the trophies hunted are often endangered animals illegally brought into the United States." The question then is, Who Gnu?

Update

Senator Chuck Grasslely's office yesterday issued a press release where he said in part:

The phoniness of this kind of donation calls out for congressional action. It looks like it's time for these self-enriching hunters to become the hunted. Big-game trophies and other non-cash contributions that give more tax benefits to donors than help to the needy are in the Finance Committee's cross hairs. There's mounting evidence that some taxpayers are using these gifts to play big-money games for personal enrichment. This abuse is no different than what we saw with car donations. With car donations, someone cheated on his taxes to the tune of hundreds of dollars and the charity got $50 out of it. With taxidermy donations, the museum gets a pittance for a dusty boar's head that sits in a railway car until it sells, while the donor gets big tax breaks. This is completely unacceptable. We need to take the tax cheating out of taxidermy. We need to close loopholes in the tax laws intended to foster charitable donations, and Tuesday's hearing sets the stage for reform legislation.

"Take the tax cheating out of taxidermy"? Who writes this stuff?

Scout Update

On March 28, H.B. 296, the bill to award college scholarships to all Eagle and Gold Star Scouts (my previous discussion here) was reported out of the Appropriations Committee unfavorably. This effectively kills the bill for this year.

Making an S of Yourself

The Service today issued a new Form 2553, Election by a Small Business Corporation. The revised instructions can be found here.

Previews of Coming Attractions

Maryland follows the so-called lex loci delicti rule with respect to choosing the law to apply in tort actions. That is, the courts will apply the law of the jurisdiction where the wrong occurred. However, it is unclear where the "wrong" occurs in cases of fraud or negligent misrepresentation if the alleged wrong and alleged loss occur in different jurisdictions. In the case of Hardwire, LLC v. The Goodyear Tire & Rubber Co., Judge Bennett certified that question and sent it to the Court of Appeals. He also certified the similar question of what jurisdiction's substantive law governs in the case of tortious interference with economic relationships where the wrongful act and the plaintiff's injury occur in two different jurisdictions.

Choice of law issues presented in cases such as Hardwire are taking on new importance due to the rapidly falling telecommunications prices and the growth of the internet. Even as late as fifteen years ago, most business activity could be tied to a specific physical location. For instance, business deals, even if negotiated via fax or letter, were typically concluded at a discrete place. That is no longer the case, since negotiations are often concluded electronically with even the closing of a deal taking place in more than one location.

Gut Equity

In a case that is likely to be appealed, Judge Deborah Chasanow of the District Court re-affirmed that hard cases make, if not bad law, then strained law. The case, Valley Forge Life Insurance Co. v. Liebowitz, involved a $2 Million life insurance policy.

Bruce Liebowitz was married to Shelley Liebowitz. His father, Howard Liebowitz, is an independent insurance agent. In the late spring of 2000, Bruce applied for a life insurance policy from Valley Forge with a death benefit of $2 Million. His father was the issuing agent. The policy was formally issued on November 1, 2000. Bruce died of esophageal cancer on September 5, 2002.

The application for the policy directly asked about the insured's foreign travel, both past and prospective. Bruce had traveled extensively in the Mideast and had lived in Spain in the two years prior to the date of the application and continued to travel extensively after the application was submitted. However, on the application he denied any foreign travel in the two years prior to the date of the application and he denied any plans to travel out of the country in the future. After his death, Valley Forge brought this action alleging that Bruce had made a material misrepresentation with respect to the policy application and requested that the policy be declared a nullity.

On cross motions for summary judgment, the Court ruled in favor of Mrs. Liebowitz, holding that (i) Howard was the agent of Valley Forge, (ii) that Howard knew of the falsity of the statements on the applications, (iii) Howard's knowledge could be imputed to Valley Forge, and therefore (iv) Valley Forge was estopped from denying coverage due to Bruce's false statements concerning his foreign travel. The Court also ruled that the statements on the application were representations, not warranties, and that Valley Forge, due to its knowledge of the misstatements (via imputation from Howard) waived its right to rescind the contract. The Court did not address the question of whether the misstatements were material, perhaps because that would have required a weighing of conflicting facts, taking it out of summary judgment territory.

Cases like this give insurers a bad reputation. Even though Bruce essentially lied on his application, it is unlikely that Valley Forge would have refused to issue the policy even had it known about Bruce's extensive foreign travel, although there may have been a slight surcharge added to the premium, a trivial amount in the context of this case. Moreover, Bruce's death can in no way be traced to his foreign travel. Going one step further, had Bruce lived another 55 days or so, the policy would likely have become incontestable. Thus, under the circumstances of the case, it appears that Valley Forge was asking to be relieved of its obligations under the contract due to misrepresentations that caused it no material harm.

On the other hand, Howard and Bruce do not present an altogether savory picture. At the least, Howard failed to honor his fiduciary duties to Valley Forge. However, the claimant here was a young widow who was left to care for the toddler child of the deceased. There were no facts that would indicate that she had been in any way complicit in a scheme to cheat the insurer. Under these circumstances, the gut equities clearly favored her and the judgment followed.

There Will Be Some Changes Made, Part I

Recently, the Staff of the Joint Committee on Taxation prepared a report entitled Options to Improve Tax Compliance and Reform Tax Expenditures. The proposals in the report would change a broad variety of tax procedures. Even though these proposals have not yet been set forth in a specific bill, it is almost certain that in due course legislation will be introduced that reflects some of these ideas.

Today, and in forthcoming posts, I will address some of the proposals. The first that I will discuss are the proposal to modify the determination of amounts subject to employment or self-employment tax for partners and S corporation shareholders and a related proposal to treat guaranteed payments to partners as payments to nonpartners.

It will come as no surprise to regular readers of this blog that, as the Committee Report notes:

[T]here are significant differences in the employment tax treatment of individuals who are owners of interests in passthrough entities and who perform services in the business. S corporation shareholder-employees are treated like other employees (i.e., subject to FICA), whereas a broader category of income of some partners (other than limited partners) is subject to self-employment tax. These discontinuities cause taxpayers choice-of-business form decisions to be motivated by a desire to avoid or reduce employment tax, rather than by nontax considerations.

The Committee Staff is more than aware of the growing number of taxpayers playing audit roulette in this area. Thus the report notes that:

S corporation shareholders may pay themselves wages below the wage cap, while treating the rest of their compensation as a distribution by the S corporation in their capacity as shareholders. They may take the position that no part of the S corporation distribution to them as shareholders is subject to FICA tax. While present law provides that the entire amount of an S corporation shareholders reasonable compensation is subject to FICA tax in this situation, enforcement of this rule by the government may be difficult because it involves factual determinations on a case-by-case basis.

The reform suggested by the Committee has three parts.

First, all partners of any type of partnership, general, limited, or LLC, would be subject to self-employment tax on their share of self-employment income. This general rule would be subject to a carve-out for certain specified types of income or loss, such as certain rental income, dividends and interest, certain gains, and other items. However, income from service partnerships, described by the report as being partnerships substantially all of whose activities involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting, would be entirely subject to SECA.

Second, the general rule would be further blunted in the case of a partner who did not materially participate in the business of the partnership. In such a case, only that portion of that partner's income that represented reasonable compensation for the services the partner actually rendered to the partnership would be subject to SECA.

Finally, in the most radical departure from current law, S corporation shareholders would be treated for all employment tax purposes as partners. That is, instead of being subject to FICA, they would be subject to SECA. More importantly, unless they did not materially participate in the business of the corporation, all of their income from the corporation (subject to the source limitations noted above) would be subject to SECA. Thus, S corporation shareholders could no longer engage in audit roulette by taking an aggressive position and hoping that the Service would either not challenge the position or that they could compromise with the Service if it did raise a challenge. The change to the manner in which employment taxes are imposed on S corporation shareholders would be coupled with an end to all income tax withholding for these individuals. In other words, they would not be treated in any way as employees for federal tax purposes.

The staff estimates that over a ten-year period beginning in 2006, this proposal would generate $57.4 Billion. It would be effective for tax years beginning after the date of enactment.

The proposal has several shortcomings, either perceived or real.

First, it rejects any carve-out of income from employment tax based upon some imputed return on invested capital. A proposal of this sort had been suggested by the AICPA. Thus income from a radiology practice, for instance, would be completely subject to SECA, even though a significant portion of the income represents a return on capital invested in the practice's expensive equipment. I haven't read the actual text of the proposal, but it would seem that there will have to be fairly complicated anti-abuse provisions to prevent businesses from forming separate equipment or real estate partnerships and entering into leases with their service partnerships to generate SECA-exempt income.

Second, the proposal does not address the "lowly employee" issue. That is, an employee who has only a small percentage of the equity of the business, but who works there full time. As I understand the proposal, all income paid to these employees would be treated as partnership income and none of the affected employees would be subject to withholding. This works a hardship on lower level employees who actually desire to have their taxes withheld from their wages. Also, the Report seems to have overlooked the possibility that it is likely that suddenly "partners" will be popping out the woodwork in order to allow unscrupulous employers to avoid their withholding tax obligations on compensation paid to their employees. Taken to its logical extreme, § 6672 could be, for all practical purposes, written out of the Code entirely.

In a closely related area, there is a seemingly contradictory proposal to repeal § 707(c). Specifically, it is proposed that all compensation for services or use of capital that is not based on the net income (or an item of net income) of the partnership is treated as arising from a transaction between a partnership and a nonpartner. The proposal with respect to employment tax is not discussed here, however it is noted that the under the § 707(c) proposal the income and deduction timing rule for guaranteed payments is repealed and such payments are subject to the income and deduction timing rules for nonpartner payments. What this means, I suspect, is that whether these payments are subject to SECA will continue to be governed by the rules proposed in the employment tax reform area.

If the employment tax law is changed along the guidelines suggested by these proposals, it can be fairly stated that justice in this area will be swift if not particularly fine.

Like Grant Taking Richmond

The Fourth Circuit issued an unpublished opinion today in the case of Chaplin v. DuPont Advance Fiber Systems that contains a passage that is so weird that I'm left muttering "WTF?"

The case involves Rule 11 sanctions against an attorney for bringing a case for alleged Title VII claims for national origin, religious, and racial discrimination without any evidentiary support. The Court upheld the imposition of sanctions because various factual elements of the plaintiffs' claims were missing entirely.

However, in the course of its opinion, the Court said as follows:

[I]t is quite possible that an employee could have cognizable causes of action for both national origin discrimination and race discrimination. An employer could discriminate against all Caucasian employees, as well as all employees of Confederate Southern American descent, or that employer could discriminate against only Caucasian employees who were also of Confederate Southern American descent. An attorney representing a member of both classes should not be threatened with the risk of sanctions for bringing causes of action for both race discrimination and national origin discrimination.

(Emphasis added.)

Now, employment and labor law is not my field of concentration. Nor do I have an advanced degree in American history. But I seem to recall that some time ago there was a group of rebels who attempted to secede from this nation and to form a government that went by the name of the Confederate States of America. This alleged government was never recognized by the United States of America and the rebellion was ultimately quashed. That being the case, how can anyone claim discrimination based on national origin if the claimed national origin is a nation that never existed?

Shouldn't someone tell the Fourth Circuit that the Civil War is over and that the Union won?

Update

The District Court in the Chaplin case got it right. The reported decision, found at 293 F.Supp.2d 622 (E.D.Va. 2003), shows the appeals panel here in even a worse light since the District Court relied on a previously unpublished Fourth Circuit opinion in support of the proposition that "Confederate-American" is not a protected class. ("This Court finds, as did the Fourth Circuit Court of Appeals in an unpublished opinion, that 'Confederate-American' is not a protected class. See Terrill v. Chao, 31 Fed. Appx. 99, 100 (4th Cir.), cert. denied, 537 U.S. 823, 154 L. Ed. 2d 32, 123 S. Ct. 108 (2002).")

Walking the Dog, Part I

One of the problems with attempting to respond quickly to new developments is that my comments are either incomplete or not well thought out. (Some would argue that this is true of all of my comments on any issue regardless of the amount of time that I have to consider them.) Frequently, I put up a post and then subsequently think of additional comments that I should have made or comments that I might want to retract. Often, this happens during my nightly walk with my dog, Houston.

Rather than merely post updates or addenda to existing posts, I will, from time to time, be posting comments under the "Walking the Dog" subject line that represent a more distanced perspective on matters that had been the subject of earlier postings. And, it represents a great excuse to post pictures of Houston as an antidote to those detestable cat-bloggers (but see here).


In any event, some additional thoughts on Chawla and on the practice of newspapers linking (or, in the case of the Baltimore Sun, not linking) to source documents for their stories.

Chawla

Chawla is technically an unpublished opinion. That is, it is not recommended for publication in the national reporting system and has no precedential authority. However, it still presents practical difficulties for planners.

The most well-known variety of trust that is designed to hold policies of insurance on the lives of the individual who established the trust is the so-called Crummey trust. Gallons of estate planning ink have been spilled describing these trusts and praising their virtues. I suspect that the total premiums paid to insurance carriers each year from Maryland residents for policies held by Crummey trusts is far in excess of the $2.45M that was at issue in Chawla.

Notwithstanding the fact that Chawla is technically "unpublished," it has been, for all practical purposes, published. Through this weblog for instance and in weblogs such as the E-LawLibrary. Is publication via a weblog with an admittedly limited readership sufficient to put practitioners on notice that there may be a fatal defect with the Crummey trust concept? Does the discussion in other professional internet outlets and the Washington Post create a situation wherein a practitioner should know of the case?

Even though the case is not precedential. What does that mean, as a practical matter, to a planner offering advice? Can he or she simply ignore the opinion? How does the planner deal with factors in the opinion that undermine its value? For instance, in Chawla the beneficiary of the trust was a person who had previously been informed that she had no insurable interest in the life of the creator of the trust. Does that mean that a trust has an insurable interest if it has as its beneficiary a person who does have an insurable interest in the creator's life (e.g., the trust settlor's child)?

As to the first question, I do not believe that we need to stop forming trusts that hold life insurance policies. At the worst, there should be a legislative fix in place by next year since there would seem to be no overarching public policy reason for the decision other than that the Court felt that it was constrained by the statute and rules of statutory interpretation. However, we are probably now required to tell clients that there is a decided case that casts a bit of a shadow on this planning technique. I believe that we are also required to inform clients who already have trusts in place that hold insurance policies if we have continuing contact and activity with respect to the clients and the trusts. We do not, however, have to contact all clients for whom we have formed trusts that continue to hold insurance policies, since we have no continuing obligation to these clients once our representation is concluded.

As to the second question, I think that we have to read the opinion as it was delivered. That is, the opinion holds, without any qualification, that trusts cannot be the beneficiaries of life insurance policies, except as set forth in the narrow exception explicitly set forth in the statute. We can tell clients that we hope that there will be a judicial "gloss" that limits the opinion, just as we could tell clients that it is, in our opinion, unlikely that other courts will reach the same conclusion. But we should not mislead clients as to what Chawla says. It says what it says, not what we hope it says.

Linking

I attempt whenever possible to link the source of material that I am discussing. I do this because it allows the curious reader to jump to the material and determine for himself or herself whether my discussion was fair and complete. Where, as was the case with Chawla, the source material is not publicly available on the web, I post it on my website and link to that location. This procedure should be standard operating procedure for all news media.

It is all well and good for newspapers to discuss and excerpt, say, the President's State of the Union Address. But they should provide an easily available link to the text of the speech. In cases like The Sunpapers v. Ehrlich, where the documents are not freely available online, mainline media should make them available online and then link to them. In that way, the reader can make a decision as to whether he or she wants to read the reporter's views on the way in which the case is developing or to read the actual filings for himself or herself to make his or her own determination. Seen in that regard, newspapers and other media become not a final destination, but a point of embarkation.

As I mentioned at the time, I thought that the Sun was not serving it's readers well when it failed to make the source documents in its lawsuit with the Governor widely available. Obviously, in many cases, news media will be our only "eyes and ears" to current events. War reporting, for instance, cannot be formated in such a way that it can be easily linked to. But when reporting on public debates on policy issues, Social Security for instance, links to source documents should be readily available. Thus, readers should be informed that (i) the various predictions as to when, if ever, the Social Security trust fund begins to run dry were conclusions developed using a variety of statistical assumptions, (ii) that the assumptions and conclusions are set forth in lengthy reports which can be easily downloaded from the web,and (iii) the reader should be given the urls where the reports can be obtained. While most readers will lack the time or inclination to read the reports, at least the media will be acting as honest brokers in giving them a roadmap to further information.

Sweat the Big Stuff AND the Small Stuff

In Mission West Properties, L.P. v. Republic Properties Corp., the Court of Special Appeals spent a good deal of effort to establish a relatively simple proposition, namely that personal jurisdiction cannot be obtained over a limited partnership simply because personal jurisdiction can be exercised over a general partner.

In essence, a dispute broke out among a variety of parties. The dispute concerned various business ventures in California. So far as I can determine, the only connection to Maryland was that the general partner of Mission West Properties, L.P. was a REIT that was organized under Maryland law. (Actually, re-organized under Maryland law. The REIT had initially been organized under California law and had its principal place of business in that state. It subsequently reorganized under Maryland law, presumably due to this state's favorable and advanced REIT statute.)

Ultimately, the Court of Special Appeals ruled that (i) a limited partnership is a juridical entity separate and apart from its partners and (ii) due process requirements must be met with respect to the entity in order to allow the exercise of personal jurisdiction over the entity.

The most interesting aspect of the case, however, is the procedural path that it took to get the jurisdictional issue before the appellate court. It illustrates the inefficiencies of the procedural rule against piecemeal appeals, a rule that is designed to promote efficiency.

The challenge to the exercise of personal jurisdiction had been made early in the litigation process and the lower court had rebuffed the attack. Ultimately, there was a week long bench trial and numerous substantive questions at issue in the appeal. This course presumably cost the litigants a good deal of time and money, all for naught.

Indeed, the Court of Special Appeals was somewhat embarrassed by the awkwardness of this process. It noted that the statute of limitations had not been blown because a lawsuit had been filed in California and it had been stayed, essentially suspending the running of the statute. Had that not been the case, one presumes that limitations would have expired and the aggrieved party would be without a remedy.

The Mission West Properties case illustrates once again that a well drafted contract will outline the remedies available in the event that the contract breaks down, including a provision concerning the courts that have jurisdiction over any dispute and the agreement of the parties to submit to the exercise of personal jurisdiction by those courts.

Lawyers (Not) In Love

There can be significant value in reading "unpublished" judicial opinions. That is, opinions that, while available on the web, are not formally adopted by the issuing court for purposes of establishing precedent. A prime case on point is Sanders v. Mueller just handed down by the Fourth Circuit.

The case deals with the claims of Maryland attorney Robert Sanders against a Michigan law firm, Olsman, Ganos & Mueller, growing out of three product liability cases. The three cases involved allegedly defective auto airbags. All three cases had been referred to Olsman, Ganos by Sanders. He brought suit against the firm in order to recover a share of the attorneys' fees recovered by Olsman, Ganos.

In the lower court, Olsman, Ganos had been granted summary judgment in two of the cases, the Greer and Holtquist cases. In the third case, Ambrose, the lower court had set aside a jury award of $300,000 in favor of Sanders, reducing the award to $1.

In the Ambrose matter, the plaintiffs had initially been represented by local counsel. Subsequently, they sought advice from Sanders who ultimately referred them to Olsman, Ganos. The local firm and Olsman, Ganos agreed upon a 45/55 fee split.

Initially, Sanders and Olsman, Ganos had agreed to a one-third/two-thirds fee split. However, Olsman, Ganos asked to modify the fee split in light of the fee split with local counsel. Olsman, Ganos' proposed modification was to split the fee based upon the "totality of the circumstances," including how much work Sanders performed, his role in referring the client to Olsman, Ganos, how much of the litigation expenses he paid, and several other factors. This arrangement only applied where there was a fee split with local counsel, as in the Ambrose case. In other cases, the initial one-third/two-thirds arrangement would stand. It was also agreed that, in all events, Sanders would be allowed to work on the cases.

Sanders rendered substantial services in the Ambrose case, by his calculation working 1,500 hours over a two year period. At one point, he worked full-time on the case for a three month period. Days before the trial in Ambrose, the case settled. A total of $1M in attorneys' fees were paid, $550,000 ot Olsman, Ganos. Although Sanders had no agreement with the local firm involved, that firm gratuitously paid him $20,000 in appreciation for his efforts. However, his efforts to reach a deal with Olsman, Ganos broke down completely. Not only did Olsman, Ganos refuse to pay him a fee in the Ambrose case, it barred him from performing any work on the Greer and Holtquist cases. Subsequently, those two cases settled and Olsman, Ganos recovered attorneys' fees in both cases.

The Ambrose Case Claim

The lower court overturned the jury award with respect to the Ambrose case, holding that Sanders had failed to present evidence that would have allowed the jury to determine with any "reasonable degree of certainty" the fair value of his services in excess of the $20,000 he received from the local counsel. Thus, the lower court concluded that Sanders had proven liability, but not damages.

Sanders' claim with respect to the Ambrose case fee was based upon the theory of quantum meruit. The Fourth Circuit distinguished between two types of quantum meruit claims, one based upon an implied-in-fact contract, usually referred to as quantum meruit, and the other based on an implied-in-law contract, generally referred to as unjust enrichment. In the first type, the award is the reasonable value of the work performed by the plaintiff. In unjust enrichment cases, the award is based upon the gain bestowed upon the defendant. The Court held that Sander's claim was in the nature of a "true" quantum meruit claim. As applied to the facts of the case, the issue could then be reduced to the time and effort Sanders expended compared to the time and effort expended by all of the other attorneys in the case. Since there was evidence that Sanders' time and effort represented as much as 50% of the total time and effort of all of the attorneys, which would have supported an award of $500,000, the Court reinstated the $300,000 judgment awarded by the jury.

The Claims in the Greer and Holtquist Cases.

The district court had rejected Sanders' claims in the Greer and Holtquist cases because it concluded that the arrangement between Sanders and Olsman, Ganos constituted a "clear and flagrant" violation of Rule 1.5(e) of the Maryland Rules of Professional Conduct. That rule regulates agreements concerning fee divisions between attorneys. It requires (i) that the division be proportional to the services rendered by each lawyer or, by written agreement with the client, each lawyer assumes joint responsibility for the representation, (ii) that the client be advised of the participation of all of the lawyers involved, and (iii) that the total fee be reasonable. While it may extend to holding fee-sharing agreements in clear and flagrant violation of the rule unenforceable, a violation of the rule is not a per se defense to the enforceability of a fee-sharing agreement. Rather, it is in the nature of an equitable defense.

The Fourth Circuit held that a two-step analysis had to be conducted to determine whether Rule 1.5(e) should be applied to bar a claim for a fee-split. First, there has to be a finding that the rule had actually been violated. Second, if the rule had been violated, seven factors had to be weighed to reach a conclusion that the agreement is unenforceable.

Because there was no written agreement with respect to the fee split, Sanders had to show that his claim was proportional to the total work expended on the cases. However, Olsman, Ganos had prevented him from working on these cases. The Fourth Circuit rejected Olsman, Ganos' bootstrapping efforts and ruled that it was estopped to raise the proportionality requirement since Sanders' lack of work was due to Olsman, Ganos' actions. The appellate court also found that the clients had been informed of Sanders' participation and that there was no evidence that they objected. Since both sides agreed that the total fee was reasonable, the final element of the rule was met.

Significantly, the Court went on to state that, even if it had concluded that there had been a violation of Rule 1.5(e), it would have reversed the summary judgements since several, if not all, of the enumerated factors "militate in favor of enforcing the fee-sharing agreement." In particular, the Court ruled that a reasonable fact-finder could conclude that Olsman, Ganos was at least equally culpable for the violation of the rule as was Sanders and that Olsman, Ganos had raised the defense simply to escape an otherwise valid contractual obligation. The Court thus reversed the claims with respect to these two cases for further proceedings in the district court.

Finally, the Court rejected Sanders' quantum meruit claims in the Greer and Holtquist cases. He had based those claims on the contention that his work in the Ambrose case benefitted the prosecution of the two later cases. The court felt that he had not presented any evidence to support this contention.

A Few Comments

The case now goes back to the district court. Sanders has at least a $300,000 judgment in his pocket and a reasonable expectation as to an award in the second two cases.

The opinion by the Fourth Circuit is helpful because of its discussion of the concept of quantum meruit and because of its discussion of how Rule 1.5(e) operates in a fee-splitting dispute. As to the later issue, it correctly rejected a reflexive per se application of a Rule 1.5(e) bar in fee-splitting cases. This makes sense, since the rule was designed to protect clients, not as a sword for attorneys trying to wriggle out of arrangements that they had agreed to with other attorneys. Even if it does not establish explicit precedent, the opinion should be read at least as a partial road map for any attorney dealing with a fee-split dispute.

Quit While You're Ahead.

Older practitioners in Maryland will sometimes make reference to "Maryland Rule 2"--"Quit while you're ahead." Meaning, stop arguing when it's obvious that the Court is preparing to rule in your favor. (Maryland Rule 1 is, well, Rule 1.)

A recent decision from the U.S. District Court for Eastern District of Virginia, Chawla v. Transamerican Occidental Life Insurance Co. (February 3, 2005) serves to prove that judges would be well-advised to adhere to the spirit, if not the precise letter, of the rule. In that case, the Court had more than adequate grounds to apply well-accepted legal principles to decide cross motions for summary judgment. Then, the Court broke new ground merely to bolster its ruling. This additional basis for the Court's ruling, if widely adopted, would threaten the widely used estate planning technique of having a trust own life insurance policies.

In May of 2000, Geisinger, the decedent, applied for a $1M life insurance policy naming Ms. Chawla as the sole beneficiary. Transamerican refused to issue the policy on the basis that Chawla had no insurable interest in Geisinger's life. In response, Geisinger established a trust, with himself and Chawla as trustees, and had the trust purchase the policy. Later that year, the trust purchased additional insurance on Geisinger, bringing the total death benefit to $2.45M. Geisinger died in late September, 2001.

At the time that the policy was initially issued, Geisinger had serious health issues: In October of 1999, he had been operated on for the partial removal of a brain tumor. Thereafter, he suffered from a variety of residual neurological affects. Also, in October of 1999, he was diagnosed with "chronic alcohol poisoning in conjunction with known chronic alcohol abuse." In the period leading up to the point at which the initial insurance policy was issued, he was hospitalized on several occasions due to both the brain tumor and the alcoholism. After the issuance of the policy, Geisinger suffered further serious incidents due to the alcoholism. Of course, none of these issues were disclosed on the application for the insurance policy or the application for the increased death benefit. After the Geisinger's death, Transamerican acted to rescind the policy and refunded all of the premiums previously paid.

Applying Maryland law (the insurance contracts were entered into in Maryland), the Court had no difficulty in concluding that the policy and the increase in the death benefit had been procured through a material misrepresentation. After all, Geisinger's health was on a clear downward trajectory and he failed to disclose any of the relevant facts on his application. (It is worthy of some note that Ms. Chawla's husband, a physician, had examined Geisinger and his report was submitted with the insurance application. The report did not refer to the brain tumor or the alcoholism and confirmed Geisinger's "good health.")

The evidence to support the Court's ruling on the basis of Geisinger's misrepresentation was more than sufficient to allow the Court to rule in favor of Transamerican. The Court should have stopped there. Instead, the Court went on to offer an alternative basis for its decision, namely that the trust lacked an insurable interest in Geisinger's life.

For a variety of reasons, most significantly the minimization of estate taxes, individuals will often form a trust and have the trust acquire an insurance policy on their life. This is a fairly standard planning tool. The Court's ruling, if allowed to stand and broadly applied, would destroy this tool completely. (A practitioner quoted in an article in the Washington Post notes that the statute upon which the ruling was based has analogues in a "half-dozen" other states. While I am not an expert in this area, I suspect that the number of states with similar statutes may actually be higher.)

The Court's alternative holding is simply gratuitous. Even though the action was brought in a federal court in Virginia, choice of law principles should have been invoked to require the Court, if not counsel, to apply Maryland Rule 2.

All the News That's Fit to Link, Part III

Judge Quarles issued his opinion in the case The Baltimore Sun and two of its journalists filed against Governor Ehrlich. The opinion rejected all of the claims of the plaintiffs.

The rationale behind the relatively short opinion is neatly summarized in the following passage:

It is clear from the Nitkin and Olesker declarations, that their complaints--e.g., refusal of officials to comment on statements of legislators, refusals to comment on contracts between private firms and the state, refusals to provide information or views for columns, refusals to provide background discussions to identify issues or topics of interest to readers, and refusals to provide personal reasons or justifications for declining comment--are far beyond any citizen's reasonable expectations of access to his or her government. The enforcement of the Governor's memorandum has been implemented in a way that is reasonably calculated to ensure the Sun's access to generally available public information. The Sun seeks a privileged status beyond that of the private citizen; that desire is not a cognizable basis for injunctive relief.

The central premise of the opinion is that the plaintiffs were seeking some sort of special status. Here, Judge Quarles misses the point.

Assume that the Governor, in a fit of pique after reading one of my weblog postings, directs all executive branch employees not to speak to me. In such a case, the intent would be to chill my exercise of first amendment rights. The harm that would be suffered in such a case would be the blocking of my access to governmental officials, a right that I share with all citizens, not just journalists. Moreover, journalists, in common with all other citizens, have a reasonable expectation that the right to speak to governmental officials will not be limited due to their exercise of their First Amendment rights. In other words, Judge Quarles is correct in stating that the plaintiffs' rights are basically equal to that of ordinary citizens. He failed to recognize, however, that those rights were violated here.

Needless to say, the decision is being appealed.

Without Pay or Reward.

My eldest son is an undergraduate at the University of Maryland at College Park. He is an Eagle Scout.

My youngest son is a high school senior who will probably attend college at a state school in Maryland next year. He is a Life Scout and will hopefully attain Eagle rank by the cutoff deadline of his 18th birthday.

For both of my sons and for other men that I know, both young and now not-so-young, Scouting has been an extraordinarily valuable learning experience. It is troubling to me that the number of boys participating in Scouting is either stagnant or declining. Given that background, one might think that I would have responded immediately to the email that I received this afternoon requesting that I respond to a poll on the website of WBAL television asking readers whether they supported or opposed a bill pending before the Maryland General Assembly, HB 296.

HB 296 would waive tuition and fees at all Maryland colleges and universities for Eagle Scouts and recipients of the Girl Scout Gold Award. The fiscal note that accompanies the bill indicates that the cost of the bill in fiscal year 2006 would be between $2M and $2.9M. (Note: I don't put a high value on the accuracy of fiscal notes concerning bills before the Maryland General Assembly. This is not a knock against the people who prepare the fiscal notes. It seems more to be a result of a lack of sufficient resources.) Not only did I not cast my vote early and often in support of HB 296, I sent a reply email indicating that I opposed the bill.

First, as a matter of general public policy, I do not believe that private institutions, such as the Boy and Girl Scouts, should act as the gatekeepers to public benefits. There are innumerable problems giving private organizations this role. By way of example, the private organization would not be directly answerable to the public with respect to the standards it would require of, for instance, the award of Eagle. There would be immense pressure to water down the requirements given the significant financial benefits that would accrue with the award. Yet, there is no mechanism for public accountability.

Second, given the position of the Boy Scouts with respect to participation in Scouting by gay scouts and leaders, it would seem to me that Scouting, as an institution, should oppose the bill. In the case of Boy Scouts of America v. Dale, the Scouts succeeded in overturning a New Jersey statute that would have forced them to admit openly gay Scouts and Scout leaders. The Supreme Court's opinion rested on the Scouts' right of expressive free association. That is, as a private organization, the Scouts can accept or reject anyone they desire regardless of the reason for inclusion or exclusion. If the government were to offer significant financial rewards for participation in Scouting, the movement would, in essence, become a quasi-public organization and the premise that underlies Dale would disappear.

I believe that the policy of Scouting with respect to gay Scouts and leaders is wrong in principle and will ultimately weaken the Scouting movement. That, however, is an argument for another day. Suffice it to say for now that public funds should not be awarded based upon successful participation in the program of an organization that discriminates. Just as importantly, a private organization, if it wants to remain a private organization, cannot be a conduit for the award of public benefits based upon successful completion of its programs.

Update: Sometimes when addressing "hot" current questions, we miss more established issues. I certainly did here. HB 296 is clearly unconstitutional, at least as applied to the Boy Scouts, because the Boy Scouts require that their members profess a belief in some supreme being. There may be some debate as to whether the state can exclude gays and lesbians from receiving state benefits, but there is no question but that the state cannot direct benefits to the religious and exclude atheists and agnostics. (I don't know whether Girl Scouts require their members to profess a belief in a supreme being. I understand, however, that they do not have an exclusionary policy against lesbians.)