Wednesday, January 26, 2005

This Fiesta Ain't No Party

Professor Daniel Kleinberger brought the case of Movitz v. Fiesta Investments, LLC to the attention of the LNET-LLC listserve. This case arises from the bankruptcy of a member of a family limited liability company. It should serve as a warning to those who believe that LLCs are bulletproof asset protection vehicles.

The debtor was a member of Fiesta, a family LLC that had two assets, interests in a leasing company and in another LLC. The leasing company was sold shortly after the debtor filed bankruptcy. Fiesta received cash distributions in the amount of $837,000 from the sale of the leasing company and regular quarterly cash distributions from the LLC.

Rather than distribute the cash to its members, "substantial amounts of cash . . . flowed out of Fiesta to or for the benefit of . . . members [other than the debtor or the bankruptcy trustee], including $374,500 in loans to members or to corporations owned or controlled by members, a $42,500 payment to one member, and $124,000 paid to another member to redeem his interest." In response to the bankruptcy trustee's demand for information and distribution, the managing member of Fiesta, the debtor's father, stonewalled. He stated that he "created 'Fiesta a few years ago to remove assets from our estate for estate tax purposes, and to accumulate investments for the benefit of our children after our deaths . . .[W]e see no reason to accede to the wishes of any member or assignee of any member which runs contrary to our original goals.'" The court rather dryly noted that "the outflow of over half a million dollars does not seem to be consistent with the original goal 'to accumulate investments for the benefit of our children after our deaths.'"

Fiesta argued that under Arizona law and under the terms of Fiesta's operating agreement, an assignee of an LLC interest remains a mere assignee and does not become a member of the LLC. Thus, it contended that the assignee would "only [be] entitled to receive to the extent assigned the share of distributions . . . to which such Member would otherwise be entitled with respect to the assigned interest." The court totally rejected that argument, concluding that:
All of the limitations in the Operating Agreement, and all of the provisions of Arizona law on which Fiesta relies, constitute conditions and restrictions upon the member’s transfer of his interest. Code § 541(c)(1) renders those restrictions inapplicable. This necessarily implies the Trustee has all of the rights and powers with respect to Fiesta that the Debtor held as of the commencement of the case.
The court was able to reach this conclusion because Fiesta, more specifically, its operating agreement, did not constitute an executory contract. As the court noted:
not only do there not appear to be any obligations imposed upon members by the Fiesta Operating Agreement, but there are certainly none with respect to either receipt of a distribution or proper management of the company by its managers. Members do not have to do anything to be entitled to proper management of the company by the managers. The Trustee’s complaint does not involve the Debtor’s lone arguable obligation not to voluntarily withdraw.
In responding to Kleinberger's posting, Jay Adkisson noted that the:
court's reasoning as to the executory/nonexecutory issue is probably correct.

But doesn't this have the potential to effectively gut charging order protection for a non-managing membership interest, at least to the extent that a creditor can maneuver a debtor-member into bankruptcy?
While Adkisson's analysis may be correct, the case could have been decided on much narrower grounds. Specifically, even if the trustee were merely an assignee of the debtor's rights to distributions, the actions of the other family members were nothing short of an attempt to fraudulently divert assets (i.e., the distributions) that rightfully should have been paid over to the trustee. The court's action in making the trustee a member is problematical since there are arguably some remaining obligations imposed upon the members.

While it is true that the members had no real management responsibility, they certainly had the right to participate in making certain types of decisions with respect to Fiesta's business. By way of example, it is reasonable to expect that at some point in time the members might have to consider refinancing or selling Fiesta's remaining asset. To the extent that each of the members entered into the LLC predicated on their faith in each of the other members' business acumen and judgment, their legitimate expectancies are being frustrated when the trustee becomes a member. At that point, they will have a partner that they did not bargain for.

Typically, I will draft operating agreements that allow members to assign most of their economic rights to family members, but require that voting rights be retained by the true "partners" in the deal. The reason is simple--the members agreed to join with each other in large measure due to their faith in the judgment of those specific individuals who are entering into the deal, not their spouses, their children, or trustees of family trusts. To the extent that any residuum of management decision making remains, the LLC remains an executory contract and the trustee should not be admitted as a substitute member.

Monday, January 24, 2005

Contingent Attorneys' Fees Not Really Deductible

In November, I commented on the cases cases of Commissioner v. Banks and Commissioner v. Banaitis. I also commented on Rev. Rul. 2004-109 and Rev. Rul. 2004-110. In concluding, I pointed out that:
If the Service prevails in Banks and Banaistis, as a practical matter, pro athletes will not be able to deduct the consideration paid to their agents since virtually all of these athletes are subject to the alternative minimum tax. Of course, this dramatically increases the transactional costs that they incur in the course of the negotiation.
Today, by an 8 to 0 vote, the Supreme Court upheld the Service's position in Banks and Banaistis.

The opinion is relatively straight-forward, rejecting the taxpayers' claims that by entering into contingent fee contracts they had assigned something other than income or, alternatively, that they had entered into partnerships or quasi-partnerships with their attorneys. The Court also rejected the taxpayers' variations on these themes, where they contended that some state attorney lien statutes effectively divested them of a portion of their rights to recovery before those rights had ripened into income.

One part of the opinion is curious and, I think, clearly wrong. The Court took note of the passage of the American Jobs Creation Act of 2004 which amended the Internal Revenue Code by adding §62(a)(19). (A copy of the Conference Committee Report for the Act can be found here.) That portion of the Act allows a taxpayer, in computing adjusted gross income, to deduct "attorney fees and court costs paid by, or on behalf of, the taxpayer in connection with any action involving a claim of unlawful discrimination." It defines "unlawful discrimination" to include a number of specific federal statutes, §§62(e)(1) to (16), any federal whistle-blower statute, §62(e)(17), and any federal, state, or local law "providing for the enforcement of civil rights" or "regulating any aspect of the employment relationship . . . or prohibiting the discharge of an employee, the discrimination against an employee, or any other form of retaliation or reprisal against an employee for asserting rights or taking other actions permitted by law." These deductions are permissible even when the alternative minimum tax applies.

Taking note of the Jobs Creation Act, the Court stated that "[h]ad the Act been in force for the transactions now under review, these cases likely would not have arisen." While that might be true with respect to Banks' claims which were squarely articulated as civil rights claims, it does not seem to be correct with respect to Banaitis. As described by the Court, Banaitis contended "that Mitsubishi Bank willfully interfered with [his] employment contract, and that the Bank of California attempted to induce [him] to breach his fiduciary duties to customers and discharged him when he refused." I simply do not understand these claims to arise out of "a claim of unlawful discrimination."

The Court's action today underlines the concerns that I voiced in November concerning the "warping of the negotiation process . . . putting the employee at a severe disadvantage when negotiating the end of an employment relationship gone sour."

Tuesday, January 18, 2005

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

I've now uploaded additional documents in the ongoing litigation between the Sun and Governor Ehrlich. An index which describes and links to the documents can be found here.

The story has now gotten national attention, including a mention in The New Republic. (While some articles in TNR are available for free online, the weekly Notebook feature in which the comment appears is available to subscribers only.)

In a nutshell, Ehrlich is contending that all that he is doing is blocking reporter Nitkin and commentator Olesker from so-called "particularized" access to governmental officials. That is, direct, private interviews, off-the-record briefings, etc. The Governor is simply lying.

The initial memo (which can be found on page 8 of the Sunpaper's Complaint) is not limited in any way. It states categorically that no one in the Executive Department or any agency is to "return calls or comply with any requests" from Nitkin and Olesker. More recently, Nitkin was locked out of a public press conference on the pretext that it was by invitation only. See here. Thus, it is manifest that the Governor is attempting nothing less than to embargo governmental information from flowing to these two journalists.

There are actually three disturbing aspects to this case.

The first is, of course, that an elected official feels that he has the power to lock out specific reporters from access to information whenever they displease him. Ehrlich's arrogance in this regard is best illustrated by his reference to "his government" and his quite explicit intent to create a "chilling effect" upon the journalists.

The second is more subtle. The Sun has made overtures to the Governor that would resolve this matter in an amicable way. Obviously, I am not privy to the discussions between the Governor's office and the Sun, but it strikes me that the Sun's attempt to make nice is wholly inappropriate. What Ehrlich has done is unacceptable and the Sun should offer him nothing but the back of its hand and the rough of its tongue.

Finally, this is a matter that should not be reported merely in snippets. The Sun should do what I have undertaken to do--publish on the web the source documents from both sides.

Monday, January 17, 2005

Malpractice Corrective

Judge Richard A. Posner offered several comments concerning recent efforts at tort reform, in general, and medical malpractice, in particular. They appear on the weblog that he publishes with Professor Gary S. Becker.

First, he points out that the total cost of malpractice premiums are only about one percent of U.S. health costs.

Second, he notes that while so-called "defensive medicine" may be viewed as an additional cost derived from medical malpractice claims "there may be offsetting benefits, to the extent that defensive medicine actually improves outcomes for patients; and surely it does for at least some."

Third, he points out that "[n]o doubt capping judgments, which is the principal reform that is advocated, has some tendency to reduce premiums, but perhaps not much, because there is evidence that premiums are strongly influenced by the performance of the insurance companies' investment portfolios."

Judge Posner concludes that "it is simplistic to assume that the total annual malpractice premiums paid is a good index of the net social cost of malpractice liability, or that measures to reduce those premiums by capping malpractice liability would result in a net improvement in welfare." He thus warns that "[w]e should be cautious about tort reform. It would be unfortunate if interest-group politics, and anecdotes concerning outlandish lawsuits (such as the suit against McDonald's by the customer who spilled hot coffee in her lap), were allowed to obscure the difficult policy issues."

I have significantly abbrieviated Judge Posner's comments. One should read them in their entirety as well as Professor Becker's response. (Becker points out, inter alia, that the American tort system has a "tendency to underestimate compensatory damages." Of course, the principal suggested correctives to the alleged malpractice crisis generally involve reducing the availability of compensatory damages.)

Reading Posner's and Becker's comments make more obvious the conclusion that the current "debate" in Maryland over the malpractice issue is more of a shouting match than a debate, since the arguments on both sides, particularly those advanced by the Governor, are virtually devoid of any empirical support. By way of example, the proponents of capping compensatory damage awards have not offered any evidence as to the amount malpractice premiums might be reduced as a result of the caps.

Saturday, January 15, 2005

Genug Ist Genug!

One of the most hilarious websites is VidLit. Perhaps the funniest bit on Vidlit is Yiddish with Dick and Jane. While of immense artistic value in its own right (the concept of pediatric gynecology, standing alone, is simply brilliant), the web piece is really an extended advertisement for the "bestselling parody," Yiddish with Dick and Jane.

Today, the NY Times reports that "Pearson Education, the publishing company that owns the copyright to the Dick and Jane reading primers, has filed a lawsuit against [the publisher]in Federal District Court in Los Angeles claiming that the book . . . violates Pearson's copyrights and trademarks for the familiar characters."

Other weblogs have offered detailed, and even scholarly, economic and legal criticism of our copyright laws and their extension under the unholy alliance of Hollywood lobbying and Republican corporatism. But, really, the schmendricks at Pearson Education go too far. Can't these guys take a joke? I'm certain that the attorneys for the defendants will craft an appropriate formal legal response to the law suit, but shouldn't it be sufficient for them to merely say "Kush meer in toches?"

Tuesday, January 11, 2005

Acting Responsibly

In Lubetzky v. U.S., the First Circuit addressed the question of whether a individual who was designated as a corporate officer was a "responsible person" for purposes of liability for the 100% penalty for unpaid withholding taxes under IRC §6672.

The Court began its analysis by acknowledging that:
[T]here is a surprising gap at the center of [§6672]: it nowhere says who is so required or whether "required" refers to some statutory concept, common law doctrine, company by-laws or actual practice, or some mixture of all these.
According to the facts, there were a number of quarters at issue where the testimony was essentially uncontradicted that the taxpayer could only pay those bills that were approved by his superiors. The taxpayer testified that he would have regarded himself as "stealing" if he had acted contrary to his superiors'directions.

The Court acknowledged that if the taxpayer were a mere bookkeeper who only wrote checks, he would not be liable under §6672. However, the Court concluded that, because of the position held by the taxpayer (he was nominally the chief financial officer and had held himself out as an executive vice president of the company), the taxpayer had to confront what the Court termed a "harsh dilemma"--either confront top management and possibly resign from his position or face liability under §6672.

The Lubetzky opinion seems to me to say too much. If Lubetzky was truly a cypher, only executing the orders of others, he doesn't fall within the ambit of a statute that imposes some fairly harsh penalties. However, I am not certain that his actions fail the "responsible person" prong of the statute. Conceptually, it seems to make more sense to take the position that the willfullness prong is not satisfied, since he had no abililty to willfully make any payment other than as directed. The Court basically skipped any analysis of the willfullness requirement, stating that everybody agreed that the requirement was satisfied because Lubetsky knew that the taxes were due, but made other disbursements anyway.

The case is worth reading as well for the distinction the Court drew between the facts presented and those presentd in Vinnick v. Commissioner, 205 F.3d 1 (2000). In that case, the taxpayer, unlike Lubetzky,was "neither paid by the company nor engaged in day-to-day business affairs, had no office at the company, and did not sign checks in the relevant time frame."

Monday, January 10, 2005

Who's On First?

More often than not, private letter rulings and Chief Counsel Advice memoranda deal with fairly esoteric questions of tax law, but present facts that are clear and unambiguous. It is a somewhat refreshing change to read a Chief Counsel Advice memorandum that deals with the sort of factual pattern that real life lawyers deal with all the time. That is, nobody could say with any certainty what the facts were. In CCA 200501001, a simple transaction became so overwhelmingly screwed up that the Service couldn't determine whether an LLC had only one member, making it a disregarded entity, or two members, calling for classification as a partnership for income tax purposes.

Sonny Boy and another individual organized the LLC in Year 1. The LLC filed for a tax identification number. As part of that process, it indicated that it was a partnership for tax purposes. It had no articles of organization or operating agreement.

Subsequently, the LLC ran into employment withholding tax difficulties. It did not cooperate with the Service with respect to the Service's investigation of the employment tax issue, but Sonny Boy "represented that [Daddy] became a member of LLC atapproximately the time the TIN was requested and that x percent of LLC was owned by [Sonny Boy]and y percent by [Daddy]." Ultimately, a notice of tax lien was filed against the LLC.

The LLC's authorized representative contacted the Service and stated that LLC should be treated as a single member LLC and not as a multi-member LLC. The representative explained that Daddy was a mere investor, was not a member of the LLC. The representative further explained that Sonny Boy reported all of the income from LLC on his Schedule C for each year of LLC's existence. Daddy concurred in this analysis, contending that he was merely an "investor" in the LLC, without any knowledge of being a member.

The Service essentially declined to offer any certainty to the taxpayers. It said that "There is insufficient evidence to determine the number of owners of [the] LLC. There are apparently no ownership documents or articles of organization. Moreover, inconsistent information has been provided." In other words, you might be a partnership, but then again, you might not be.

There seems to be little question in my mind that Daddy was perfectly happy to be a "member" of the LLC until he faced the possibility of being tagged with liability for unpaid employment taxes or penalties for failure to file partnership returns. (In fact, absent additional facts, Daddy would seem to have no liability exposure for unpaid employment taxes. However, it would not surprise me if his advisors had informed his that this was a possibility, since the CCA indicates that their professional performance was less than stellar.) The Service made the right call in throwing this fish back into the taxpayer's (or, should I say, taxpayers') lap(s).

Sunday, January 09, 2005

The Write Stuff

Terry Cuff, a prolific writer and speaker on tax law subjects, was asked by a colleague, who was not a lawyer, to quickly summarize some general principles of writing for publication. Terry passed them on to some of his colleagues who are lawyers and I pass them on here because I think that they should be of interest to a wider audience.
  • Write for a reader who is bored, disinterested, and has little patience. That often will not be far off the mark.

  • Write for a reader who will only skim the text -- and perhaps pick what is interesting.

  • Write for the reader -- not for yourself. Try to know your reader--or potential reader -- and divine what he or she is interested in.

  • Be practical. Stress applications over rules. Use examples where appropriate.

  • Say something useful. If you can, say something original, but definitely say something useful.

  • Provide an introduction to capture the reader's attention. Assume that the reader has 100 manuscripts to read and that he will select only one of them based on the introduction. You are fighting for the reader's attention.

  • Write in an inverted pyramid, with most important material at the front and least important material at the end.

  • Have a strong summary close to the beginning. State all material conclusions in that summary.

  • Use strong subtitles that summarize.

  • Write introductory paragraphs of each section as if that is all the reader will read. Stress the conclusion of the section in the introductory paragraph.

  • Generally, write paragraphs as if reader will read only the first sentence of the paragraph. This often will be the case. Readers often merely skim material.

  • Write in a simple, direct style.

  • Avoid long sentences.

  • Minimize passive voice.

  • Avoid or minimize introductory clauses.

  • Stress subject-object-verb format.

  • Write unambiguously. Check all pronouns for ambiguity.

  • Readers tend to skip boxes, long quotations, etc. Summarize them in the text.

  • Drop citations and unimportant material that break up the text to footnotes. Citations in text slow a reader down and disrupt the flow. (I understand that some periodicals require citations in text. This is an unfortunate, outdated practice, but one I cannot reform.)

  • Edit ... edit ... edit ... edit. The best editing is multiple pass editing. On each pass, edit for a different purpose: content ... organization (does the text adhere to the best outline?) ... streamlining text for readability ... clarity and ambiguity ... subtitles ... section introductory paragraphs ... paragraph introductory sentences ... paragraph length ...sentence organization, simplicity, length and structure ... passive voice and personal writing quirks ... pronouns ... adverb placement ... punctuation ... spelling ... citations ... format and overall manuscript appearance ... finalread through. This represents many independent passes. Approach the material like a woodcarver who gradually shapes and forms his carved wood. Allow more time for editing the manuscript than for writing it in the first place. The key to excellent writing is excellent editing.
Terry states that, "I sometimes have not adhered to these principles quite so well as I should have. My writing would have been better if I had."

I have often said that there is no such thing as good legal writing. There is only good writing. While Terry's guidelines were designed to set out principles for drafting for publication, they are applicable as well to all written communication that is expositive (e.g., briefs, memoranda, letters to counsel and to clients, etc.)