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Fourth Circuit does, with opinions that the court feels should not constitute binding precedent being denominated as "unpublished.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.