An All Bright Opinion

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

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

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

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

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

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

A Crafty Bash

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

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

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

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

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

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

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

Miracles Do Happen

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

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

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

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

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

All Things Must Pass

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

HB 753:

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

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

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

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

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

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

HB 935

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

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

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

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

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

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

Is That Reasonable?

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

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

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

The Law Will (Sometimes) Protect a Volunteer

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

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

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

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

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