A noncompete agreement is a standard business agreement to prevent a former employee from competing against you upon his departure from the company. When such an agreement is not in place, employers have to scramble for a solution to prevent the former employee from disclosing confidential information to the new employer. In particular, litigators are using the inevitable disclosure doctrine to stop the former employee from working for the competitor because confidential information will inevitably be disclosed. Across the country, and in Florida, courts are reluctant to apply this doctrine unless there is some bad faith conduct. Prevailing under this theory is unlikely and it should be used when there is no noncompete agreement in place.
Derek P. Usman, The Usman Law Firm, P.A.
After making the decision to dispose of a corporation, entrepreneurs and business owners should consider tax consequences and plan accordingly. Often, an exit strategy utilized by a private corporation is the acquisition of the corporation by a public company whose shares are readily saleable because they have a public market. Under this scenario, the target corporation is merged into the acquiring corporation with the target’s shareholders receiving the buyer’s (or acquiring corporation) stock. The transaction qualifies as a reorganization under section 368(a)(1)(A) of the Internal Revenue Code of 1986 which provides that “the term ‘reorganization’ means a statutory merger or consolidation.”
Code section 368 reorganizations allow target corporation shareholders to exchange target stock for buyer corporation stock without gain recognition. The acquisition would be tax free to the target corporation and its shareholders when the transaction satisfies the requirements of one of the paragraphs of section 368(a). Even though section 368(a) describes several different forms of reorganization, the statutory merger effected under state corporate law is the easiest of the subsections under which to qualify. Furthermore, this statutory merger or consolidation under section 368(a)(1)(A) is commonly referred to as an A Reorganization. The A Reorganization allows the use of up to 60 percent of consideration in the form on non-stock, e.g., cash (“boot”). Additionally, a transaction qualifies for A reorganization treatment irrespective of whether the target corporation retains substantially all of its assets, and whether or not the acquiring corporation issues voting or non-voting stock to the target shareholders.
Similar to an A Reorganization, a B Reorganization under section 368(a)(1)(B) also involves an exchange of stock for stock but prohibits the use of boot altogether. While a C Reorganization (section 368(a)(1)(C)), a stock for assets acquisition, generally limits boot to 20 percent of total consideration. Therefore, the structure of a transaction will determine which particular reorganization provisions are applicable. For example, as just mentioned, the presence of boot would not qualify a transaction as a B Reorganization.
In the merger, shareholders of the merged, or target, corporation, receive their “new” shares from the acquiring company tax free. The shareholders take a basis in the new shares they receive equal to the basis that had in their old shares. Therefore, any tax on the disposition is deferred until sale of those shares.
Target corporation shareholders may determine tax basis in buyer stock using a tracing method. Under the tracing method, shares of new stock may be designated as having been received in exchange for particular blocks of target stock. This allows the target corporation shares purchased at a higher price, than other target corporation shares, to be “traced” to buyer shares received in an exchange. Therefore the higher basis share are sold first. Alternatively, under an “averaging method”, a shareholder’s basis in target shares would be spread pro-rata to the newly received shares.
The ability to sell the new shares on a piecemeal basis allows the shareholders to have liquidity and diversification in their investment. Also, as mentioned previously, if the target company’s shareholders receive some cash (within the statutory constraints to qualify for reorganization treatment), the shareholders will recognize gain to the extent of the cash received.
Since, a shareholder recognizes gain to the extent of cash or property (other than stock or securities), the proper treatment of the boot should be considered. Under 356(a)(2), the recognized gain will be ordinary income (to the extent of the shareholder’s undistributed share of the target corporation’s earnings and profits), if the boot received has the effect of a dividend.
The IRS in Rev. Rul. 93-61 has stated that it would follow Clark, 489 US 726 (1989) in determining the treatment of boot as ordinary income or capital gain. Specifically, in acquisitive reorganizations, the treatment of the boot as ordinary income or capital gain should be resolved by comparing the interest the shareholder actually receives against the interest that would have been received if only stock and no boot was involved.
Here’s some numbers to make things a little simpler. The shareholder of a wholly owned corporation receives an offer, consisting of two choices, by a publicly held corporation to purchase the private corporation. The publicly held corporation offers the choice of 425,000 shares of its stock or 300,000 shares plus $3,250,000 cash. The shareholder chose the stock plus the cash. In Clark, the Supreme Court analyzed the transaction by asserting that, first, the shareholder exchanged all of the shareholder’s shares for 425,000 shares of stock in the publicly held corporation. Next, the shareholder is deemed to have had 125,000 shares redeemed for $3,250,000 in cash. The portion of the transaction involving the 125,000 shares has to meet the requirements for a redemption to qualify for capital gain treatment (a meaningful reduction of the shareholder’s interest and thus a redemption not essentially equivalent to a dividend). Otherwise, the boot is designated as a dividend and thus, ordinary income to the extent of any accumulated earnings and profit of the target corporation.
Still yet, to qualify as a reorganization under section 368(a), a transaction must satisfy the continuity of business enterprise requirement. Section 1.368-1(d)(1) requires that the acquiring corporation either continue the target corporation’s historic business or use a significant portion of the target’s historic business assets in a business for a reorganization to satisfy the continuity of business enterprise requirement. Nevertheless, the doctrines underlying the continuity of business enterprise requirement are easy to satisfy.
Of the various codified reorganization choices, an A reorganization is a popular way to structure the transaction for income tax planning purposes. The principal benefit of having a transaction meet the requirements of a type A reorganization is the deferral of income taxes. Similar to other exchange provisions of the Internal Revenue Code, a shareholder’s existing basis is carried over to the stock received. By utilizing the reorganization exit strategy, business owners are able to sell their business while deferring their gain.
Derek P. Usman, The Usman Law Firm, P.A.
The statutory provisions providing limited liability to shareholders of Illinois business entities were undermined recently when the Illinois Supreme Court endorsed “direct participation” as a viable theory of tort liability under Illinois law. In Forsythe v Clark USA, Inc., 2007 WL 495292 (Ill. Sup. Ct.), our state’s Supreme Court considered whether a parent company could be held liable under a theory of direct participant liability for controlling its subsidiary’s budget in a way that led to a workplace accident. Subsequently, the court recognized that the parent company’s “participation” in the subsidiary’s conduct could subject the parent to direct liability. Even though Illinois statutes permit separate incorporation for the purpose of limiting liability, the direct participation theory may now be used to eliminate the protection of limited liability for a parent (or affiliate).
Justice Garman’s opinion in Forsythe concluded that evidence of budgetary mismanagement, accompanied by the parent’s negligent direction or authorization of the manner in which the subsidiary accomplishes that budget could lead to liability for the parent. Furthermore, the elements required under the direct participant theory are a parent’s specific direction or authorization of the manner in which an activity is undertaken and the foreseeability of injuries—budgetary mismanagement alone is insufficient. The court then remanded the case back to the trial court. (In the same opinion, the court also held that upon a finding of liability under the direct participation theory, the parent-defendant would not be protected by the exclusive remedy provision of the Workers’ Compensation Act available to the subsidiary because there is a direct action against the parent and not the subsidiary).
Under the court’s analysis, once the parent company directs or authorizes the manner in which an activity is undertaken, the company owes a duty of care to the plaintiff. The court explicitly asserted that this duty of care arises from policy-based factors courts utilize to determine the existence of a duty. Then the court stated that the corporation had a duty to utilize reasonable care in directing or authorizing the manner in which an activity is undertaken. Next, when the duty was breached, the breach was the proximate cause of the injury. Specifically, the court found that the corporation directed the implementation of the subsidiary’s budget in such a manner that there was a disregard for the interests of the subsidiary and dangerous conditions were created.
The Illinois Supreme Court is following other jurisdictions around the nation that have endorsed theories that erode limited liability for shareholders of business entities. Aside from the emergence of the direct participant liability theory in the Illinois legal landscape, Illinois entities need to be wary of a myriad of alternative theories that courts are upholding to erode the limited liability of incorporated businesses. These theories have been upheld not just in a tort context but contract situations as well. One such theory is termed “single business enterprise” where business connections, common ownership and various other means are utilized to establish that two distinct entities are operating in a coordinated manner. Seem familiar?
The primary purpose for the enactment of incorporation statutes is to insulate shareholders from unlimited liability for corporate activities. Upon reliance on these longstanding statutes and principles, holding corporations create subsidiaries as a common strategy to minimize risk for shareholders. These same shareholders are attempting the preservation of their investments by relying on laws that explicitly limit liability. Apparently, mandatory capitalization laws, insurance requirements, product safety requirements, etc. are deemed insufficient by courts that allow novel theories that undermine limited liability protection provided to shareholders of entities created under statutory authority.
The court in Forsythe has opened the door to utilize another theory, direct participation, to disregard corporate form and impose liability against a statutory entity. Still yet, let’s not forget the ever-popular veil piercing lawsuit. Cases raising veil-piercing issues are the most frequently litigated in all of corporate law and limited liability in Illinois is undermined whenever a veil piercing lawsuit is initiated. As a starting point, Illinois courts may look at as many as eleven factors before piercing the veil. A renowned commentator on the erosion of limited liability has stated that the list of possible factors used in veil piercing cases is aimed at satisfying particular public policy goals. Similarly, the furtherance of public policy aims is also a significant consideration underlying the adoption of the direct participation theory by the court in Forsythe. However, a recurring problem is that later judges often capriciously modify (if remember at all) public policy aims.
Additionally, abuse must usually be demonstrated to pierce the corporate veil. However, abuse tends to become an elusive term when courts attempt to apply the word in litigation. In Forsythe, the opinion’s analysis provides that a parent corporation’s power to control the subsidiary, by itself, does not impose a duty. However, an abuse of the power, by exerting too much control, could lead to liability for the conduct of its subsidiaries as an alter ego. This alter ego theory is not based upon any clear abuse but upon control exercised by a parent (or individual shareholder).
The court’s opinion also asserted that parent corporations are not held directly liable for their own wrongdoings but for their actions against third-parties through the agency of subsidiaries. Therefore, even in situations where corporations are deemed not to be alter egos of each other, liability is possible under an agency theory. The Illinois Supreme Court has authorized the use of the agency theory to impose liability on the parent for the subsidiary’s acts. The court reasoned that the subsidiary has the power to bind the parent because the subsidiary acted as the parent’s agent in a transaction(s). However, since shareholders or parents always have the potential to control, an agency theory is always a viable option to bypass limited liability protection. The end result is a movement away from the stringent abuse standard utilized in veil piercing cases, where an alter ego must be established, to the more accessible agency theory where just the presence of control is seemingly sufficient to dispense with limited liability.
As is evident by court decisions, not only in Illinois, but also across the country, the threat to eliminate the protection of limited liability is real. Companies conducting business in Illinois need to adjust their operating procedures to avoid the pitfalls associated with emerging theories that undermine limited liability protection. In particular, liability based upon the direct participant theory looks towards holding parent companies, and not their subsidiaries, for redress. At the expense of eliminating the protection of limited liability, the attachment of liability is moving away from being based upon reprehensible, abusive conduct and towards, simply based upon, shareholder control.
Derek P. Usman, The Usman Law Firm, P.A.
While public corporations thrive on share trading in a dynamic market, private corporations often seek to restrict transfer of their shares. In particular, entrepreneurial enterprises foster the inclusion of non-management investors. These silent partners of closely-held corporations often require protective measures for their interests. Therefore, a buy-sell agreement may be utilized to define the parameters under which shareholders may transfer shares.
The parameters present in a buy-sell agreement provide obligations and place restrictions on share disposition when a shareholder leaves a business. Share transfer restrictions allow control over a transfer of shares to avoid undesirable business associates and preserve existing interests. Just as importantly, these transfer restrictions must be drafted to allow transfers in a manner to allow shareholders a market for their shares.
A buy-sell agreement is a contract among business owners or between each owner and the company. Once the agreement is executed, it becomes a part of the corporate bylaws, shareholder agreement or partnership agreement. While shareholders’ agreements address broad concepts of corporate structure, buy-sell agreements contain narrow provisions that should be considered upon the occurrence of particular scenarios. For example, forced buyouts allow for a resolution to deadlocks or to remove unwanted shareholders. Similarly, buyout provisions in a buy-sell agreement might also come into effect upon the occurrence of particular events. Such a provision provides for a forced transfer of shares or an option for the other shareholders to purchase the shares.
One such event addressed in a buy-sell agreement is when an owner contemplates retiring or withdrawing from a business. An appropriate provision for this event would require the owner to first offer to sell his shares back to the remaining shareholders (or to the company) before accepting an offer from an outsider. Also, buy-sell provisions are appropriate when an outside party makes an offer for an owner’s shares. That owner must first offer the shares to the company or its other shareholders on the same terms. If the insiders decline to purchase the shares, then the owner may sell to the outsider. Still yet, the death of a shareholder would prompt the company, or other individual shareholders, to purchase the deceased owner’s shares from his estate. Of course, the estate would be required to sell those shares to the company.
Another event that is accounted for when drafting a buy-sell agreement is when a shareholder has a spousal separation. Again, the avoidance of unwanted business associates is accomplished if the shares are subject to forced transfer to the company or the remaining shareholders under these circumstances. Finally, a couple of financial situations that a business may encounter underline the significance of share transfer restrictions. If a business’ ongoing financial needs prompt additional contributions from a shareholder or when a shareholder faces insolvency (bankruptcy), the company might realize that the shareholder in question is not able to contribute further to the company or the shareholder’s shares are subject to seizure from creditors. Thus, it would be wise for share transfer provisions to be present in a buy-sell agreement for these occasions.
Another important consideration is when a closely held corporation elects to be taxed under Subchapter S of the Internal Revenue Code. To preserve S-Corporation status, a buy-sell agreement for a C-Corporation might not be adequate and the agreement must be tailored for a S-Corporation. A S-Corporation election would be terminated if a shareholder transfers shares to a corporation, certain trusts or a partnership.
Another caveat with S-Corporation agreements is the prevention of any breach of the agreement. While share transfer restrictions will limit how or to whom a shareholder’s interest may be transferred, other provisions might be desirable. These additional provisions would assert that attempted transfers in violation of the agreement are void on their face; that the corporation’s or other shareholder’s purchase options are given effect prior to the breach; and that the occurrence of an attempted breach automatically vests title of the shares in the corporation. Additionally, practitioners may also utilize liquidated damage provisions to help deter the occurrence of a breach.
The presence of share transfer restrictions should also provide a mechanism for establishing a fair price for the shares. There are as many methods of setting the purchase price of shares, as there are members of the Illinois Bar. The facts and circumstances of the business operations should dictate the method employed in setting a fair price. The important thing is to have a pricing method in place before the need arises.
For reference, please note the following relevant Illinois statutes that provide validity to share transfer restrictions contained in buy-sell agreements. In fact, Illinois law imposes share transfers restrictions on an entity that incorporates in the form of a Close Corporation. 805 ILCS 5/1.80(s) states: “Close corporation” means a corporation organized under or electing to be subject to Article 2A of this Act, the articles of incorporation of which contain the provisions required by Section 2.10, and either the corporation’s articles of incorporation or an agreement entered into by all of its shareholders provide that all of the issued shares of each class shall be subject to one or more of the restrictions on transfer set forth in Section 6.55 of this Act.”
As a point of interest, in Edmonton Country Club v. Case  1 S.C.R. 534 it was held that even with a presumption that shares are freely transferable, a transfer of shares can be restricted. So long as there is no absolute restriction on transfer, share transfer restrictions are generally valid.
Without an agreement restricting share transfers, corporate shares would be freely transferable and prevent the remaining shareholders from maintaining a desirable ownership structure. The provisions drafted in buy-sell agreements allow shareholders to control ownership and create a market for shares that are otherwise likely to be illiquid. Consequently, buy-sell agreements allow for a smooth transition after the occurrence of the aforementioned situations.
Derek P. Usman, The Usman Law Firm, P.A.
Shareholders of a corporation taxed under Subchapter S of the Internal Revenue Code may elect a “pass-through” taxation system. Subsequently, a corporation’s profits pass through directly to its shareholders on a pro rata basis and are reported on the shareholder’s individual tax returns.
The basis of S-Corporation stock is increased by the shareholder’s distributive share of corporate income and gains. The basis is increased to reflect the fact that the shareholder is taxed on his share of the corporation’s undistributed income. The corporate income, whether or not distributed, is taxed to the shareholders. Conversely, the basis is decreased if this previously taxed income is distributed to the shareholder.
Also, the basis is decreased (but not below zero) by the shareholder’s distributive share of corporate deductions and losses. Even though the Internal Revenue Code allows a shareholder to deduct his pro rata share of the corporation’s annual losses, a shareholder must have sufficient basis to utilize the entire deduction. A shareholder may not deduct an amount larger than his basis for the stock and any corporate indebtedness owned by him. Otherwise, any unused losses may be carried forward indefinitely. If there are excess corporate losses and deductions from prior years, the shareholder must reduce the basis of the stock to reflect the fact that these amounts have been passed through for use on his individual tax return. Regulations under Section 1367 provide for adjustments to stock basis and debt basis.
Suppose S-Corporation Acme incurs an operating loss of $100,000 in 2006. Also, Craig is the sole shareholder of Acme and Craig’s basis in his stock is $20,000. Furthermore, if Craig is a creditor of Acme for the amount of $50,000 then Craig may only deduct $70,000 in 2006. Nevertheless, if during 2006 it appears that Craig’s basis will be insufficient to absorb Acme’s operating loss then Craig needs to plan accordingly by increasing his basis prior to year-end. Craig has a few options to increase his basis and deduct the loss. Craig could purchase additional shares, contribute to the capital or paid-in surplus of the corporation, or loan money to the corporation.
Under Section 1366, a shareholder’s basis increases when a shareholder loans money to the corporation. Furthermore, it is the shareholder’s burden to establish his basis under Section 1366. Unlike a partnership, any borrowing conducted by the corporation does not allow a shareholder to increase his basis in stock. The courts have determined that Congress intended to limit a shareholder’s loss deduction by the amount the shareholder invested in the corporation.
If Craig decides to loan money to Acme, his investment must meet certain criteria. Thankfully, the courts have had ample opportunities to establish clear guidelines for S-Corporation shareholders like Craig. Practitioners need to look no further than the recent tax court case, Miller v. Commissioner of Internal Revenue, T.C. Memo 2006-125, for guidance when advising clients. For an injection of resources by Craig to be deemed an investment, the investment must be an “actual economic outlay” of money. Furthermore, the actual economic outlay must leave the Craig “poorer in a material sense”. The “poorer in a material sense” standard is simply a restatement for the analysis of an ordinary deduction. In other words, as a shareholder, Craig’s financial position should not remain the same after the transaction. If a shareholder is only secondarily or contingently liable then shareholder is unable to increase the basis. For example, a shareholder’s guarantee of a bank loan to the corporation or a pledge of property as security will be insufficient to increase the shareholder’s basis because the shareholder will only be deemed to be secondarily or contingently liable. Even though both a guarantor and lender assume a risk of default, when distinguishing between a guarantor and a lender, the analysis focuses on the lender supplying funds for the borrower. On the other hand, by assuming a risk of default the guarantor only enables the funds to be supplied to the borrower.
In Oren v. Commissioner, T. C. Memo 2002-172, the taxpayer unsuccessfully argued that a direct loan, in itself, is sufficient to increase basis. The court rejected the idea that an economic outlay is required only when there is a shareholder guaranty. The economic outlay doctrine is even applicable to transactions masked as direct loans. If the source of funding is originally from a related party, then a sufficient economic outlay by the shareholder to create basis has not occurred. The courts continue to reason that there is no economic outlay because repayment of the funds is uncertain. The shareholder must be directly liable or must loan his own money to the S-Corporation. In fact, the presence of a third-party lender does not negate basis-generating indebtedness. On the contrary, the third party lender becomes a significant factor in the determination of the loan as a valid economic outlay. An arm’s length transaction from an unrelated party provides certainty that the lender will enforce repayment form the shareholder. The funds loaned to a S-Corporation from a “back to back” loan borrowed by the shareholder results in an economic outlay.
Another scenario where Craig could create genuine indebtedness is the when there is a note substitution. If Craig becomes an obligor by substituting his own note for the note of his S corporation (whether or not he was initially a guarantor), there is an economic outlay. In a “note substitution” scenario, the S-Corporation’s is no longer liable to the third-party lender for the note after the shareholder assumes the debt. Nevertheless, the S-Corporation’s indebtedness to the shareholder is deemed a constructive furnishing of funds by the shareholder and thus, an economic outlay.
The presence of appropriate documentation such as notes creating enforceable legal obligations and certified financial statements reflecting a debtor-creditor relationship between the S-Corporation and the shareholder will give substance to the arrangement. Craig should borrow directly from the lender and then loan the funds to the S-Corporation. Furthermore, the lender should record the loan as a loan to Craig. Subsequently, the S-Corporation should record the funds as a loan from Craig, the shareholder. The courts, in particular the Court of Appeals for the Seventh Circuit, apply substance-over-form principles when analyzing a transaction to determine whether an economic outlay took place.
Still yet, even if there is an “actual economic outlay” that increases basis, the funds must be “at risk” within the meaning of Section 465 before a subsequent deduction is deemed proper. As a starting point, section 465(b)(1) states that generally a taxpayer is at risk in an activity to the extent of money contributed or amounts borrowed for use in the activity. Then, 465(b)(2) designates a taxpayer as at risk for the borrowed amounts if there is personal liability for repayment of the loans or if property unrelated to the business has been pledged as security for loan repayment.
However, if there is a loss limiting arrangement, evidenced by non-recourse financing, guarantees or stop loss agreements, a taxpayer will not be considered to be at risk. While the loan must be fully recourse and the obligation to repay must be absolute, the existence of an indemnification clause is often construed as stop loss agreement. Furthermore, the presence of a guarantor will require an inquiry into the extent to which the shareholder is, in any way, protected against loss. Specifically, the Service has specifically stated that, “If the investor is liable for the loan only upon occurrence of a specific event, the taxpayer is effectively protected against the loss if the likelihood of the event is slim”.
Still yet, even though a guarantor is able to recover from the primary obligor any amounts that the guarantor is required to pay to satisfy the indebtedness, a waiver by the guarantor of his rights will not necessarily preclude the shareholder from being “at risk”. Agreements and arrangements must be reviewed to detect events that trigger or relieve taxpayers of personal liability. The question is always whether the taxpayer who assumes personal liability is ever required to satisfy the liability, or whether he or she is protected in any way from being required to do so out of his or her own funds. Even though a guarantor is able to recover from the primary obligor any amounts that the guarantor is required to pay to satisfy the indebtedness, a waiver by the guarantor of his rights will not necessarily preclude the shareholder from being “at risk”.
After examining all the facts and circumstances, there must be a realistic possibility that the money invested in the business might actually be lost before the amount will considered at risk. The Court of Appeals for the Seventh Circuit has cited the “realistic possibility of loss” standard with approval but has not expressly adopted it.
Furthermore, if there are other shareholders, Craig would not be able to increase his basis by borrowing money from them to lend the money to the S-Corporation. Any funds borrowed from fellow shareholders are not considered at-risk under Section 465.
To sum up, to properly structure Craig’s loan to his S-Corporation, the transaction must first constitute an economic outlay. The substance of the transaction must leave Craig “poorer in a material sense” to be an economic outlay. Secondly, the loan proceeds must be “at risk” where there is a realistic possibility of loss by the shareholder.
Derek P. Usman, The Usman Law Firm, P.A.
Foremost, a capital interest is a share of the value of partnership assets. Each partner has a separate capital account that generally tracks that partner’s investment in the partnership. The value of the capital account represents the partners’ distributive share of partnership equity (partnership assets minus partnership liabilities—the capital account does not include a partner’s share of partnership liabilities). The interest in the partnership assets is distributable to the holder when either the partner withdraws from the partnership or the partnership liquidates.
Additionally, any partnership interest other than a capital interest is deemed a profits interest. A profits interest is merely a right to share in future earnings and profits. Unlike a capital interest, there is no current interest in partnership assets. The designation of an interest as a profits interest or a capital interest generally is made at the time of receipt of the partnership interest. Notwithstanding the lack of a capital contribution, partnerships are able to revalue capital accounts upon granting a profits interest to a service provider. Recent Treasury Regulations permit adjustments to capital accounts irrespective of whether a new or existing partner contributes services or money & property to the partnership in exchange for a partnership interest.
Rather than the fair market value, capital accounts are initially maintained at a historical cost of the partnership’s assets. Consequently, any subsequent appreciation or depreciation of contributed assets is not reflected in the capital accounts. The distorted value of capital accounts is of significance because a fair representation of the actual economic deal among the partnership might be absent. Any disparity between historical costs and fair market values also propagates adverse tax consequences. In particular, such a scenario arises when an individual purchases a partnership interest based on the fair market value of the partnership assets. Nevertheless, the presence of such a hypothetical (and other specified events), allows the partners to increase or decrease their capital accounts.
Upon the purchase of a partnership interest for its fair market value, the amount paid becomes the basis for the purchaser’s partnership interest (outside basis). The partner’s outside basis is determined without considering any amount reflected in the partnership books as capital account. Still yet, the new partner is allocated the seller’s pro rata share of the adjusted basis in property held by the partnership (inside basis). The inside basis is used by the partnership in computing depreciation, gain or loss on sale of assets, etc. The disparity between the inside basis and outside basis may result in foregoing depreciation deductions and inflating gains from subsequent property dispositions. Consequently, it might be wise for a buyer to negotiate a discounted purchase price to minimize the negative tax result. However, another option is for the partnership to trigger the Section 754 election to equalize the partner’s outside and inside basis. Revaluations permit gains or losses inherent in the property to be taxed to the partner to whom it is properly allocable. Section 755 specifies the rules for allocating the incoming partner’s basis adjustment to particular assets.
Let’s explore a straightforward example. In anticipation of high demand for premium rental property during the upcoming Super World Games, the ABC Partnership purchased a condominium at Trunk Tower. Alas, a volatile political election for a seat on the town council undermined C’s capitalist beliefs. Rather than indulging in her reverie of a free enterprise system, C has decided to take up painting seashells and offers Ronald her partnership interest in the condominium. A summary of the partnership balance sheet reflects a fair market value of $1,765,000 and an adjusted basis of $1,405,0000.
ABC BALANCE SHEET
- Partner A
- Partner B
- Partner C
- Adjusted Basis
Partner C offers to sell Ronald her one-third interest for $645,00 (one-third of the partnership’s FMV). In return, C expects a cash payment of $595,000 and an assumption of her share of partnership liabilities. After the sale, Ronald would have outside basis for his partnership interest of $645,000 ($595,000 + $50,000). However, Ronald’s share of the partnership’s basis for its assets (his inside basis) would be $475,000 (one-third of $1,425,000). The $170,000 basis disparity would distort depreciation deductions if there were no step-up in basis. Also, if the partnership sells the condominium, Ronald’s share of the taxable gain would be artificially inflated. A sale at the FMV of $1,1935,000, Ronald’s recognizable one-third share of partnership gain would equal $170,000 (($1,1935,000 – $1,425,000) / 3)—despite a lack of economic gain because of an outside basis of $645,000 reflects Donald’s one-third share of the condominium’s fair market value ($1,935,000).
Upon a partner’s transfer of a partnership interest, the partnership may elect under Section 754 to adjust the basis of partnership property. More specifically, a Section 754 election allows a step-up or step-down in basis in the manner provided in Section 743(b) to reflect the FMV at the time of the transfer. (Section 743(b) allows a basis adjustment that directly only affects an incoming partner.) Consequently, the election has the advantage of not taxing the incoming partner on gains or losses already reflected in the purchase price of the partnership interest. If the partnership proceeds with the Section 754 election, Ronald’s inside basis will equal his outside basis of $645,000. The $170,000 basis disparity would be allocated to Ronald’s share of the condominium.
It should be noted that revaluations are voluntary. A revaluation does not affect a partner’s “tax basis” but does result in an increase or decrease in the economic investment in the partnership for any subsequent profit or loss allocations under Section 704(b). Furthermore, a Section 754 election may also result in adverse consequences. If the incoming partner’s inside basis exceeds the outside basis, an election would create a negative basis adjustment. Subsequently, additional depreciation deductions are forfeited; gains are increased and losses decreased upon disposition of property.
If the optional basis adjustment is desired, the election must be filed by the due date of the return for the year the election is effective and normally is filed with the return. Nevertheless, there are provisions for relief upon a partnership’s inadvertent failure to file the election.
Derek P. Usman, The Usman Law Firm, P.A.
“MINIMUM” GAIN ARISING FROM PARTNERSHIP NONRECOURSE DEBT
Section 702(a) provides a list of items arising from partnership operations that are to be separately distributed to each partner. Subsequently, the partner takes into account his distributive share of the partnership items in determining his income tax.
Unlike a corporation, where profits must be distributed based on a stock ownership percentage, a partnership agreement may allow custom allocations of income and expenses to flow through to the partners. These customized distributions do not have to be proportional to a partner’s interest in the partnership. Furthermore, since liquidating distributions to the partners are made in accordance to the partners’ capital accounts, legitimate economic allocations are necessary under the Code. As an ongoing matter, a partnership usually maintains capital accounts for each partner to properly reflect the economic allocations among the partners.
While a partner’s distributive share of partnership items is determined by the partnership agreement, Section 704(b) is the starting point to determine the validity of allocations to the partners. The allocations are respected under 704(b) if the allocations conform to one of the three criteria under the Regulations:
- the allocation is in accordance with the partner’s interest in the partnership,
- the allocation has substantial economic effect or,
- the allocation is deemed to be in accordance with the partner’s interest in the partnership (a facts and circumstances test)
Of the three provisions to validate an allocation, the primary method provided by the Regulations under 704(b) is the substantial economic effect test. The substantial economic effect test consists of a two-part test made at the end of the taxable year of the allocation. The two-part test requires that the tax allocation have economic effect and that the economic effect be substantial. The Regulations further state various requirements for meeting the economic effect test and the substantiality test.
Additionally, Treasury Regulation 1.704-2 contains rules to allocate deductions and losses attributable to non-recourse debt. Since partners aren’t liable for nonrecourse debt, deductions and losses from nonrecourse debt do not create any economic effect. Specifically, an economic effect is established when a tax burden results from an allocation of income or gain or a tax benefit arises from a loss allocation. Since a creditor alone bears any economic burden from the nonrecourse debt, any deduction allocations do not result in an economic effect. Therefore, the taxpayer must then attempt to allocate nonrecourse deductions in accordance with the partner’s interest in the partnership.
While determining the allocation of non-recourse deductions, the proper amount of minimum gain must also be calculated. Minimum gain provides tax responsibility for allocations of nonrecourse deductions. When a partner receives a non-recourse deduction, a proper share of minimum gain should also be provided to that partner. The amount of partnership minimum gain is determined by first computing for each partnership nonrecourse liability any gain the partnership would realize if it disposed of the property subject to that liability for no consideration other than full satisfaction of the liability. Simply put, minimum gain is the excess of nonrecourse debt over the basis of property subject to debt.
Minimum gain arises when depreciation deductions decrease the partnership’s basis below the balance of the nonrecourse debt. For example, if a building is purchased through nonrecourse financing for $800,000 and year 1 depreciation is $200,000, the basis would equal $600,000. Following Commissioner v. Tufts, nonrecourse debt, not the fair market value of the property, is used to determine the taxable gain upon disposition of the property. Consequently, a hypothetical sale of the property would result in a minimum gain of $200,000. This phantom or minimum gain must be allocated along with the corresponding nonrecourse deduction of $200,000.
However, often the potential taxable gain realized upon disposition of the property is not the gain used to determine the partnership minimum gain. If any of the partnership properties has a book basis that is different than its tax basis, then the book basis (capital account value) is used to determine minimum gain. Simply, the book gain is difference between the nonrecourse liability and the book value of the property. As an example, after a partner contributes property with a FMV of $10,000 and a tax basis of $6,000 to the partnership, the partnership uses the property as collateral to acquire a $10,000 nonrecourse debt. Under this example, there is no minimum gain because the book basis of $10,000 equals the amount of the nonrecourse debt.
Minimum gain attributable to a property may also decrease. A decrease results when there are reductions in the amount by which the nonrecourse liability exceeds the basis of the property. Such a decrease would occur when the basis of the property increases or upon the decrease of the nonrecourse debt upon repayment.
After the amount of minimum gain is computed separately for each property subject to a nonrecourse debt, the gains are aggregated to determine the partnership minimum gain. Next, the partnership minimum gain on the last day of the current taxable year is compared to the partnership minimum gain on the last day of the prior taxable year. Any net increase in the partnership minimum gain for the year will equal the amount of partnership nonrecourse deductions for a taxable year. In contrast, a net decrease from the prior year will result in a partnership minimum gain chargeback for the taxable year. Consequently, each partner must be allocated items of partnership income and gain for that year equal to the partner’s share of the net decrease in partnership minimum gain. It should be noted that any decreases in minimum gain due to revaluations of property are added back.
Since the minimum gain is a phantom gain, the allocation of the nonrecourse deduction still does not have an economic effect. Consequently, the nonrecourse deduction must be allocated according to the partner’s interest in the partnership. Regulation 1-704-2(e) provides a test that deems allocations of nonrecourse deductions to be in accordance with the partner’s interests in the partnership.
If that test is not satisfied, Treasury Regulation 1.704-1(b)(3) should then be utilized to determine the validity of a nonrecourse debt allocation. Section 1.704-1(b)(3) provides a facts-and-circumstances test that provides guidelines for a nonrecourse deduction to be allocated according to the partner’s interest in the partnership. Additionally, the Regulations also provide a safe harbor for a proper allocation in lieu of utilizing the facts-and circumstances test.
After nonrecourse deductions and minimum gain are calculated, it should be quite evident that minimum gain is just as real as Santa Claus.
Derek P. Usman, The Usman Law Firm, P.A.
Effective January 1, 2007, amendments to the Illinois Business Corporation Act now provide a more precise definition of the fair value of minority interests. The new Illinois legislation is quite similar to the 1999 amendments to the Model Business Corporation Act. The Illinois Business Corporation Act now explicitly states that “fair value…means the proportionate interest of the shareholder in the corporation, without any discount for minority status or, absent extraordinary circumstances, lack of marketability.”
Prior to 2007, “fair value” proceedings in Illinois courts have often resulted in the application of minority and marketability (liquidity) discounts. Even though the Illinois Supreme Court repeatedly discouraged the use of discounts, the position of trial courts remained inconsistent with the majority of courts throughout the country that disallowed discounts. Also, while other states considered discounts to be a question of law, Illinois considered the appropriateness of discounts as one of fact. During “fair value” proceedings, Illinois trial courts left the calculation of fair value to valuation experts and subsequently, the appellate courts deferred to the trial courts. Nevertheless, the newly enacted legislation explicitly prohibits the application of discounts in calculating the fair value of minority shares.
“Fair value” proceedings arise to resolve conflicts between the majority and minority shareholders where the controlling shareholders would benefit at the expenses of the minority shareholders. For example, a conflict is present when a minority interest is discounted in a merger or stock restructuring but the majority interest ends up retaining the discounted value after the reorganization. As a potential remedy, Section 8.60 of the Illinois Business Corporation Act requires the majority shareholders to demonstrate that a fair value was provided for the minority interests.
Sections 11.65 and 11.70 of the Illinois Business Corporation Act provide for dissenter’s rights to a shareholder of a corporation by allowing the shareholder to obtain payment for his shares in the event of certain corporate actions. Alternatively, the presence of oppressive conditions also avails remedies to an injured shareholder. Upon satisfying any of the conditions listed under Section 12.56(a)(1)(4), a petitioning shareholder of a private corporation may request judicial intervention. Subsequently, a possible remedy for the statutorily defined oppressive situations includes a court ordered share purchase after a determination of the fair value of shares.
As a starting point, the “fair value” standard must be distinguished from the “fair market value” standard in analyzing the reasoning behind prohibition of minority discounts in “fair value” proceedings. Illinois courts have stated that fair market value is “based on the price that would be agreed upon in an arms length transaction between a willing buyer and willing seller on the open market, neither under a compulsion to act, and both parties possessed of all relevant facts”. Furthermore, the fair market value standard is used in gift and estate tax valuations where minority and liquidity discounts are routine. On the other hand, fair value is often calculated for interests purchased by the remaining shareholders of an entity and the fair market value is inapplicable. The two standards are not analogous; nor are they utilized under similar circumstances. Therefore, the application of discounts is not necessarily appropriate under the “fair value” standard.
Still yet, a minority discount adjustment is based on the theory that non-controlling shares are not worth their proportionate share of the company’s value because they lack voting power to control corporate actions. On the other hand, a marketability discount is an adjustment for a lack of liquidity. Here the theory is that there are a limited number of potential buyers for the stock of a closely-held corporation. However, minority and marketability discounts are inappropriate when the purchaser of the stock is either the majority shareholder or the corporation itself. The application of a minority discount is not appropriate because different interests are present when a there is a sale to an outside third party. Upon a sale to a third party, the value of the shares remains constant or drop in value because the third party does not gain a right to control or manage the corporation. On the other hand, a sale to a majority shareholder or to the corporation increases the interests of those already in control. Consequently, the application of a minority discount in a sale to “insiders” would result in a windfall to the buyer.
Nevertheless, litigation is still inevitable because there is a lack of legislative history that discusses exactly when the statutory exception for “extraordinary circumstances” warranting a discount for lack of marketability arises. So, just what will these extraordinary circumstances entail? Even though the amended statutes are void of any guidance, the American Law Institutes’ Section 7.22 of the Principles on Corporate Governance is a good starting point. Illinois’ newly adopted definition of fair value mirrors the American Law Institute’s definition of fair value. The ALI endorses the national trend of interpreting fair value as the proportionate share of a going concern “without any discount for minority status or, absent extraordinary circumstances, lack of marketability.” The ALI has further recommended that to determine fair value, the trial court must determine the aggregate value for the firm as an entity, and then simply allocate that value pro rata in accordance with the shareholders’ percentage ownership.
Similar to Illinois, the ALI’s definition of fair value also includes the exception for “extraordinary circumstances”. Unlike the Illinois statute, the ALI provides guidance as to just when extraordinary circumstances might arise. Comment e to Section 7.22 clarifies that extraordinary circumstances must consist of more than an absence of a trading market in the shares. Furthermore, an ALI comment states that the extraordinary circumstances exception is “very limited” and is intended to apply only when the trial court “finds that the dissenting shareholder has held out in order to exploit the transaction giving rise to appraisal so as to divert value to itself that could not be made available proportionately to other shareholders.”
The comment also provides an example of “extraordinary circumstances”. In the example, a financially strained corporation lacking liquid assets makes relatively minor changes in its governance and structure which trigger appraisal rights. Since the corporation is financially troubled and only has illiquid assets, a fair value appraisal proceeding would likely result in a higher price per share than a market transaction for the shareholder’s shares. Furthermore, a shareholder dissents because he had been unsuccessfully attempting to persuade the other shareholders to purchase his shares. Therefore, the dissenting shareholder now has the opportunity to obtain a much higher price for his share by exploiting a relatively minor change. A marketability discount would be proper because the “fair value” proceeding is likely to produce an appraisal higher than the remaining shareholders could receive upon a sale of the corporation or its assets and the dissenter is taking advantage of a minor corporate change. Therefore, if a dissenting shareholder does not have a valid objection to the transaction, the shareholder is deemed to be exploiting a minor change in the charter. Consequently, a marketability discount should be applied to prevent an unfair wealth transfer to the dissenting shareholder. The comment does indicate that under identical facts, if the shareholder dissented to a fundamental corporate change, such as a merge, a marketability discount would be inappropriate.
In 2003, the Colorado Supreme Court analyzed the ALI’s definition and interpretation of “fair value” and “extraordinary circumstances” and asserted that that the “extraordinary circumstance” exception is intended to enable trial courts to utilize their equitable powers and provide a fair result when extraordinary circumstances are present. (For brevity’s sake I’m excluding a discussion of cases that analyze the applicability of the “extraordinary circumstance” exception. Nevertheless, all of those cases emphasize the limited nature of the exception.)
In addition to the strict statutory limitations on discounting minority shares, courts across the nation have recognized that discounts unjustly benefit the majority shareholders. As the Delaware Supreme Court stated in the leading “fair value” case in Cavalier Oil Corp. v. Harnett, “…to fail to accord to a minority shareholder the full proportionate value of his shares imposes a penalty for lack of control, and enriches the majority shareholders who may reap a windfall from the appraisal process by chasing out a dissenting shareholder, a clearly undesirable result.”
Derek P. Usman, The Usman Law Firm, P.A.
A shareholder may initiate a direct action lawsuit against a corporation to redress an injury inflicted by the corporation upon the shareholder. However, a shareholder may also assert a cause of action on behalf of the corporation. Such a suit, a derivative lawsuit, arises against officers or shareholders when the corporation has failed to commence suit for injuries to the corporation itself. The Illinois Business Corporations Act creates a statutory cause of action for such an event. Nevertheless, distinctive characteristics and needs of close corporations have resulted in these companies receiving disparate treatment upon litigation.
Foremost, derivative lawsuits must be distinguished for close corporations (and other closely-held firms) and widely-held and/or publicly held corporations. For the former, derivative lawsuits are categorized as “Closely-Held”. While public or widely-held corporation derivative lawsuits are designated either as “Corporate Impropriety” or “Exploitation of Control” derivative lawsuits. “Corporate Impropriety” includes derivative suits seeking to impose personal liability on the board for a discrete act of corporate wrongdoing (typically a violation of law or a regulatory requirement). Corporations in this category tend to be larger and shareholdings more widely dispersed. “Exploitation of Control” suits are limited to challenging transactions between the corporation and those who control it. The Exploitation of Control category involves corporate transactions with or on behalf of the persons who control it. For cases in this category, the corporations tend to be smaller, the plaintiffs tend to hold significant blocks of stock, and that stock tends to be thinly traded, especially compared to that of the corporations in the Corporate Impropriety category.
While public corporations tend to incorporate in Delaware, close corporations are incorporated in the state of their principal state of business. The unique treatment afforded close corporations is further evident in the adoption of special code sections governing close corporations. In Illinois, a corporation’s failure to elect close corporation status will not prevent the corporation to be treated as a close corporation if under common law principles it would qualify as a close corporation.
The most extreme statutory provision that impacts shareholders in close corporations is involuntary dissolution. The remedy of involuntary dissolution will be administered in derivative lawsuits if the defendant acts “oppressively”. While the Illinois statutes do not define oppression, the courts have supplied definitions of oppressive conduct in closely-held cases. In Illinois, there is an enhanced fiduciary duty to shareholders of a close corporation that is similar to that of partners in a partnership. The emphasis placed on fiduciary duties in closely-held cases negates a requirement of finding fraud or illegal conduct.
Close and public corporations differ in ways that make general corporate law ill suited to close corporations. A major distinction for close corporations is that shareholders of a close corporation often serve as the directors or officers. Corporate law gives controlling insiders considerable latitude to run the corporation as they see fit. Understandably, they will generally favor their own priorities and objectives over those of the minority. Aside from their investments, these shareholders are also actively managing the company. Unlike public corporation shareholders, most close corporation shareholders’ income derives solely from distributions from the corporations. Consequently, a minority shareholder is particularly vulnerable to the whims of the majority. A minority shareholder’s dependence on the corporation, lack of control and a lack of market for shares all create unique circumstances for the minority shareholder.
There are several recurring scenarios that lead to derivative litigation in the close-corporation context. For example, a “freeze-out” or exclusion of a minority shareholder from management of the corporation prompts litigation. Also, disparate treatment of different shareholders, e.g., purchase of one shareholder’s share for fair value and not the others. Another common scenario involves the frustration of “reasonable expectations” of a shareholder; often the minority shareholder is deprived of a prominent position (director, officer or employee). Still yet, a shareholder’s attempt at competing with the corporation in another business leads to litigation.
It should be noted that situations arise where majority shareholders are the ones with the scales tipping against them. Minority shareholders may have the capacity to overpower a controlling shareholder (especially where corporate actions require supermajority approval). Of course the share liquidity issue is just as relevant for majority shareholders. Also, it might very well be that the minority shareholder brings all the expertise to the table.
Generally, cases in the Exploitation of Control and Closely-Held categories involve applications of the duty owed to minority shareholders by the majority. Derivative litigation performs the task of translating the abstract concepts of fiduciary obligation, good faith and fairness into the specific limits on the insiders’ ability to favor themselves. To this end, Illinois courts have embraced the “enhanced fiduciary duty” as a solution. The expansion of the duties makes more sense since closely-held shareholders often neglect to have a shareholders’ agreement in place. Thus, the old adage, “an ounce of prevention is worth a pound of cure”, is quite relevant in the avoidance of derivative litigation. The presence of a shareholders’ agreement significantly reduces the likelihood of a corporate breakdown. Additionally, under a longstanding history of allowing the freedom to contract, courts traditionally uphold shareholder agreements. The trick is to balance the interests of the majority and the minority. A shareholders’ agreement requiring unanimous approval for corporate actions might curb arbitrary actions by the majority. Nevertheless, such a provision providing the minority with carte blanche veto power might result in the minority shareholders holding the majority shareholders hostage. Similarly, the emergence of venture capitalists as minority shareholders further necessitates the need for a well-drafted shareholders’ agreement to avoid litigation scenarios.
Shareholders would be wise to employ a competent legal draftsman to produce an explicit agreement that reflects acceptable conduct by close corporation shareholders. Practitioners must communicate to their clients that the presence of a shareholders’ agreement would reduce the risk of litigation. While courts navigate around the contours of fiduciary duties, a shareholders’ agreement goes a long way towards preventing inequitable treatment.