Unincorporated Business Law Prof Blog

Taxing Hot Asset Sales

Prof. Karen C. Burke's (San Diego) article, Taxing Hot Asset Sales, was published in 8 Fla. Tax Rev. 327 (2007).  Recently, this blog noted Prof. Burke's follow-up article, More on Collapsible Real Estate Partnerships.

Hat-tip to the TaxProf blog.

posted by Gary Rosin

Partner Expulsions for Public Conduct: An Agency Perspective

While Hurricane Ike had me off-line, Professor Stephen Bainbridge noted that a partner in a large California law firm had sent out a firm-wide email that argued another partner's highly-visible contribution to an anti-GBLT proposition put the firm's reputation at risk.  Bainbridge used dispute to pose a series of exam-style questions about partner expulsions and fiduciary duty.  Professor Larry Ribstein responded with his analysis of the law on partner expulsion.

Suppose the lawyer had been an associate, rather than a partner?  That is not just a matter of employment-at-will doctrine.  Under agency law, an agent has a duty of good conduct:

§ 8.10 Duty Of Good Conduct

An agent has a duty, within the scope of the agency relationship, to act reasonably and to refrain from conduct that is likely to damage the principal's enterprise.

Rest. 3rd of Agency § 8.10 (2006).  Illustration 4 of Comment b shows how wide-ranging the duty of good conduct can be:

Illustration:

4. P operates a health-food store, "Veggie Delight," located in a shopping mall. P's store markets itself as an enterprise dedicated to promoting vegan eating habits. P requires its employees to wear T-shirts throughout the workday that bear the insignia: "Veggie Delight. The Vegan Way." P employs A as manager of Veggie Delight. Wearing the T-shirt provided by P, A regularly eats lunch at the steak house, "Cattle Call," opposite Veggie Delight in the mall, publicly consuming large orders of meat. A's conduct breaches A's duty of good conduct to P. The nature of P's business requires A to refrain from public consumption of meat and other substances inconsistent with vegan eating habits. By publicly eating meat on a regular basis, A reflects adversely on the credibility of P's enterprise. The close proximity of Cattle Call to Veggie Delight makes it more likely that prospective customers of Veggie Delight will notice A's lack of adherence to vegan eating habits and infer that A does not endorse P's message.

To be sure, A in Illustration 4 has a right to eat meat, but A's right to eat meat is qualified by A's duties to P. The manner and context of A's conduct are also significant. The connotations of A's public consumption of meat, in close physical proximity to P's vegan premises and while garbed in a promotional T-shirt furnished by P, are in conflict with P's reasonable interest that a high-level representative not deliberately flaunt a challenge to a basic premise underlying P's business.

Id., cmt. b.

Something to chew on if you think your personal life is unrelated to your work life!

posted by Gary Rosin

Standards for Implied Covenant of Good Fiath and Fair Dealing. Armisaleh v. Board of Trade (Del Ch. 2008)

In a recent case involving the implementation of a merger agreement, the Delaware Court of Chancery discussed the standards for determining whether a party had breached of the implied covenant of good faith and fair dealing.  Armisaleh v. Board of Trade, C.A. No. 2822-CC (Del. Ch. September 11, 2008) (Mem. Op.) (Chandler, C.).  The deadline for electing the form of compensation to be received in the merger was January 5, 2007, but the parties accepted late elections through January 17.  Plaintiff's election was received one day later, on January 18.  Because the parties chose to extend the deadline, the court treated the deadline as one to be set in the discretion of the parties.  The court found that there was a fact question as to the breach of the implied covenant, and denied a motion for summary judgment.

Chancellor began by noting the linkage between the inherent incompleteness of all contracts and the implied covenant:

No contract, regardless of how tightly or precisely drafted it may be, can wholly account for every possible contingency. In fact, contracting parties often explicitly defer key decisions when constructing their written agreement, and instead endow one side or the other with the discretion and authority to make those decisions during the course of performance. Such a course of action is undoubtedly a risk-shifting device, but the law presumes that parties never accept the risk that their counterparties will exercise their contractual discretion in bad faith. Consequently, in every contract there exists an implied covenant of good faith and fair dealing.

Id. at 1.  That said, Chancellor Chandler recognized that

While the existence and applicability of the implied covenant are well established, its substance and defining contours remain somewhat imprecise.

Id. at 19.  While both parties recognized that the question turned on denying another the benefit of the contract, Defendant argued that the use of "oppressive and underhanded tactics" was required, id., while plaintiff argued that only "arbitrary and unreasonable" conduct was required.  Id. at 20.

Chancellor Chandler indicated that the appropriate focus was whether a party

[A party's] conduct frustrate[d] the "overarching purpose’ of the contract by taking advantage of [its] position to control implementation of the agreement’s terms..."

Id.  at 23 (internal quotation marks and citations omitted).  That language seems to take a more objective approach to the breach of the covenant.  On the other hand, Chancellor Chandler noted that

there is a genuine issue of material fact as to whether [the partie’s] clandestine and unexplained decision to stop accepting late forms frustrated the purpose of the Merger Agreement’s election provision....

Id.  That language seems to shift the focus towards a more subjective, bad motive, approach.

It will be interesting to watch Armisaleh, and other Delaware opinions for further development of the contours of a breach of the implied covenant of good faith and fair dealing.

Hat tip to Francis G.X. Pileggi.

Family Limited Partnerships

Walter Schwidetsky (Baltimore) has posted on SSRN the abstract of his article, Family Limited Partnerships:  The Beat Goes On, 60 TAX LAWYER 277 (2007).  Here's the abstract:

It is increasingly common for the older generation to form family limited liability entities (FLLEs), which are usually either limited partnerships or limited liability companies. The older generation then gifts the FLLE interests to the younger generation and/or leaves them to the younger generation as part of its estate. For estate or gift tax purposes, substantial valuation discounts are taken off what would be the proportional value of the underlying assets. These valuation discounts are commonly taken because the relevant FLLE interests lack control and are usually not as readily marketable as the underlying assets would have been. Discounts of 35% or greater are not unusual.

If unqualifiedly allowed, this technique would be an estate tax bonanza. With a bit of slight of hand, the value of an estate could be dramatically reduced with perhaps little change in the underlying beneficial ownership or use of the assets. Tax advisors and their clients love it. The Service does not. The Tax Court has taken a tough line, usually applying I.R.C. - 2036 to ignore the FLLE and include the assets contributed to the FLLE in the decedent's estate. The 3rd and 5th Circuits (and to a much lesser extent the 1st Circuit) have had something to say on the subject as well. They have not been particularly taxpayer-friendly either. The article discusses and analyzes the relevant case law and makes recommendations for reform.

posted by Gary Rosin

Fiduciary Mechanics

Robert Flannigan (Saskatchewan) has on SSRN an abstract for an article, "Fiduciary Mechanics," in Canadian Law & Employment Law Journal, Vol. 14.  Here's the abstract:

There is a stubborn confusion as to the scope of fiduciary accountability. That confusion may be relieved in part by examining the fiduciary aspects of the mechanic undertaking. Some might think it fanciful to regard mechanics as subject to fiduciary accountability. That, however, is only the sequelae of the existing confusion. Mechanics are engaged in limited access arrangements, and all such arrangements are regulated by fiduciary accountability. It does not matter that an arrangement may be of modest character, or may not involve subjective trust. Other employment and independent contractor arrangements further illustrate the nature of the opportunism mischief that fiduciary regulation is designed to control. Professors, lawyers, police officers and interior designers have fiduciary obligations to the extent of their limited access. That fuller appreciation of the nature of the fiduciary jurisdiction leads to rejection or reconstruction of a number of propositions that enjoy currency in the courts today.

posted by Gary Rosin

Business Lawyers as Enterprise Architects

George W. Dent (Case Western Reserve) has posted on SSRN an article upcoming in The Business Lawyer,  "Business Lawyers as Enterprise Architects."  Here's the abstract:

In 1984 Ronald Gilson published Value Creation by Business Lawyers: Legal Skills and Asset Pricing. It began: "What do business lawyers really do? Embarrassingly enough, at a time when lawyers are criticized with increasing frequency as nonproductive actors in the economy, there seems to be no coherent answer." He dismissed lawyers' own answer that "they 'protect' their clients, that they get their clients the 'best' deal." He also rejected the academic literature which offered a laundry list of roles the business lawyer plays: "a counselor, planner, drafter, negotiator, investigator, lobbyist, scapegoat, champion, and, most strikingly, even as a friend." Dissecting the corporate acquisition as his specimen, Gilson concluded that lawyers add value as "transaction cost engineers." In particular, lawyers bridge the parties' divergent expectations about returns on the asset to be transferred by drafting an earnout which makes the price contingent on its returns between the signing of the deal and the closing; and overcome lack of information (principally of the buyer) by arranging efficient production and verification of information. From these findings Gilson also recommended that legal education for business practice downgrade traditional subjects (like analysis of appellate cases and knowledge of relevant regulatory law) in favor of corporate finance and transaction cost economics.

In the succeeding 24 years Gilson and others refined his thesis, but no one fundamentally challenged it. This literature about what corporate lawyers do (the "received model") is too narrow. This article takes a wider and deeper perspective. Part I describes the received model. Part II exposes several problems with that model. Part III offers a fuller vision showing that business lawyers perform a greater range of activities using a larger set of skills than in the received model. Although these activities and skills are extremely varied, it is less accurate to say that business lawyers are transaction cost engineers than that they are enterprise architects. Part IV discusses the implications of this revised model for legal education. It argues that, although a knowledge of corporate finance and transaction cost economics is useful for some business lawyers, it is more important that they understand the obstacles to optimizing the performance of business entities and the contractual mechanisms available to overcome these obstacles. They also need specific behavioral skills, including how to negotiate when all parties are trying to build mutual trust and confidence.

posted by Gary Rosin

Collapsible Real Estate Partnerships

Karen C. Burke (San Diego) has posted on SSRN a working paper, entitled "More on Collapsible Real Estate Partnerships."  Here's the abstract:

The commentary explains the operation of the section 1(h)(6)(B) limitation on gain taxed at 25% when a partner's only capital gain for the year consists of unrecaptured section 1250 gain on sale of a partnership interest. As clarified by the preamble to the final regulations, the section 1(h)(6)(B) limitation should be irrelevant in this situation, so that the selling partner's entire unrecaptured section 1250 gain is taxed at 25% (rather than the 15% rate for residual capital gain). While the preamble should dispel any confusion concerning the proper operation of the section 1(h)(6)(B) limitation under existing law, the problem would not arise if the character of section 1231 gain were preserved under the look-through rules applicable to sales of partnership interests.

posted by Gary Rosin

Unauthorized Practice of Law by LLC Member

In a decision rendered earlier this week, the Kentucky Court of Appeals addressed the issue of representation of an LLC.

John Rockaway and his wife owned an LLC that operated a mobile home park.  Rickey and Sandra Bobbett contracted to place their mobile home in the park.  Ultimately John Rockaway signed and filed a Forcible Detainer Complaint on behalf of the LLC seeking to evict the Bobbetts.

At the first hearing Rockaway admitted he was not an attorney and that he filed the complaint.  The matter was continued with it being ordered that Rockaway retain legal counsel on behalf of the LLC.  At the continued hearing (the LLC now represented by an attorney) the Bobbetts were evicted.  They then appealed to the Court of Appeals.

The Court affirmed that Rockaway had, by filing the complaint, engaged in the unauthorized practice of law.  Further, finding that Rockaway's actions violated the signature requirements of Rule 11, it was ordered that the Complaint be dismissed.

Nothing surprising about the determination of unauthorized practice of law, and while the remedy imposed is certainly effective for those in the know, the persons engaging in the unauthorized practice of law are not in the know. 

Bobbett v. Russellville Mobile Park, LLC, No. 2007-CA-00684-DG (Ky. App. Sept. 12, 2008).

Thomas E. Rutledge/Stoll Keenon Ogden PLLC/Louisville, Kentucky

Obligation to Close Short Sale is a Section 752 Liability. Marriott Int'l Resorts v. U.S. (Ct. Claims)

     posted on behalf of Professor Bradley T. Borden (Washburn):

In Marriott International Resorts v. U.S., Nos. 01-256T & 01-257T (consolidated) (U.S. Ct. Claims Aug. 28, 2008), the Court of Federal Claims held that the obligation to close a short sale is a section 752 liability and must be considered in determining partners' outside basis of a partnership.  The case is significant because it represents another taxpayer defeat in a case involving a variation of the Son of Boss tax shelter.  From a precedential standpoint, it provides that the obligation to close a short sale is not a contingent liability, adding to the body of law defining liability for section 752 purposes.  The court used an entity concept (recognizing the effect partnership liabilities have on outside basis) to prevent the taxpayer's abusive use of an entity provision of partnership tax law (effect of contributed assets on outside basis).  Perhaps the court could have considered disallowing the taxpayer's abusive use of the entity provision.  For further discussion of the interplay of aggregate and entity provisions in partnership tax, see my article, The Aggregate-Plus Theory of Partnership Taxation.

"Unprofitable" Companies, Judicial Dissloution & Managerial Discretion

In Further Thoughts on Youngwall and Judicial Dissolution of the Unprofitable LLC, Peter A. Mahler (New York Business Divorce blog), discusses the interplay between

1. an LLC member's right to seek judicial dissolution of an unprofitable LLC,
2. disputes between members as to the viability of the LLC's business,
3. the failure to have (or find soon enough) an operating agreement to help resolve disputes, and
4. how fiduciary waivers and the implied covenant of good faith and fair dealing might apply.

Mahler has an excellent summary of the facts, so I will not detail them here.

A couple of quick observations:

• Petitions for judicial dissolution generally speak to the equitable discretion of the court, even if the statute does not say so.  Like Spike Lee, courts just want to the "right thing".
• If the operating agreement gives one member managerial discretion, wouldn't the business judgment rule apply to the decision to "ride out the storm?"  Assuming, of course, that the dissident member did not have the right to approve a necessary action.  In close corporations, courts have held that the exercise of a veto is subject to fiduciary duties.  In any event, in states that recognize the implied covenant of good faith and fair dealing, presumably that would apply to the exercise pf the veto.

More Musings on Good Faith

     posted by Gary Rosin

Doug Moll recently asked a variation of the Tina Turner question:  “What’s good faith got to do with it?”  While he’s right in one sense, he is missing something.  Doug focuses on the role of good faith in determining the scope of a waiver of fiduciary duties.  As Doug suggests, that is a matter of determining the intent of the parties.  That said, traditionally, fiduciary waivers are interpreted more strictly than other contractual language.  Fiduciary waivers require more evidence of a specific intent to waive a particular fiduciary duty, as applied to particular facts; general language rarely suffices.  The failure to recognize that is one of the central problems of the “mere contractual entity” approach.

The “good faith” to which Chancellor Chandler referred in R&R Capital, LLC is the implied contractual obligation of good faith and fair dealing that, at least theoretically, limits the exercise of discretion by a party to a contract.  Chancellor Chandler suggests that that obligation shelters parties from over-reaching by the other parties.  As I've already suggested, that obligation usually is interpreted narrowly.  Does that protect the parties from anything, even Seinfeld’s "spite?"

Musings on Good Faith

Posted by Douglas Moll

Maybe I’m missing something, but what independent role does the implied covenant of good faith and fair dealing have in a dispute over a fiduciary duty waiver?  (There’s a $25,000 question).

Assume an LLC operating agreement that disclaims fiduciary duties and associated liabilities.  A lawsuit is brought asserting some type of misconduct against the controlling member/manager.  Given the contractual nature of the LLC, the first question is presumably a contract interpretation one – i.e., did the parties intend for the fiduciary duty waiver to apply to the circumstances at issue? 

If the answer to that question is yes, then there would seem to be no role for the implied covenant of good faith and fair dealing.  After all, the covenant, as I understand it, is designed to protect the implicit expectations of the parties.  A conclusion that the parties intended the fiduciary duty waiver to apply to the circumstances at issue surely means that application of the waiver is consistent with the parties’ expectations.

If the answer to the question is no, then the court has concluded that the parties did not intend for the waiver to apply to the circumstances at issue.  Thus, fiduciary duty principles are still applicable to the dispute.  It would seem that this result could be reached through basic contract interpretation principles with no resort to the implied covenant.

So what am I missing?  What independent use is the covenant?

Profits-Only Partnership Interests

     posted by Gary Rosin

Bradley T. Borden (Washburn) has posted this accepted paper on SSRN:

Profits-only partnership interests grant service-providing partners an interest in the profits of a partnership but not its capital. Such interests are a proverbial double-edged sword: they create economic arrangements needed in business, but provide opportunities for inequitable tax reductions. Business participants make economic decisions to use profits-only partnership interests to reduce agency costs and appropriable rents. The current law, however, empowers business participants to form partnerships that are equivalent to employment arrangements and use profits-only partnership interests to obtain long-term capital gains. Thus, with no economic consequences, they convert ordinary income (taxed at up to thirty-five percent) to long-term capital gain (taxed at fifteen percent). Commentators and lawmakers generally propose partnership disaggregation to eliminate the inequity. Partnership disaggregation changes the character of income (from capital gain to ordinary income) as it flows from the partnership to service-providing partners. It may enhance equity, but it ignores the nature of tax partnerships, threatens the partnership tax regime, and has other negative side effects. The Article suggests that partnership disregard is a better way to address the inequity profits-only partnership interests cause. Partnership disregard uses economic concepts to identify the policy-relevant differences between tax partnerships and disregarded arrangements, such as employment arrangements, leases, and loans. Partnership disregard distinguishes arrangements that should qualify for partnership tax treatment and those that should not. It eliminates inequity while preserving the integrity of partnership tax regime and other areas of the law.

Hat tip:  Paul Caron

Built-In Gain and Built-In Loss Property on Formation of a Partnership

     posted by Gary Rosin

Daniel L. Simmons (UC-Davis) has posted this accepted paper on SSRN:  Built-In Gain and Built-In Loss Property on Formation of a Partnership: An Exploration of the Grand Elegance of Partnership Capital Accounts:

This article is a primer on the issues faced by partners in dealing with the consequences of built-in gain or loss property contributed to a partnership. The article explores the tax consequences of almost every aspect of the partnership treatment of built-in gain and loss property.

The use of properly maintained capital accounts to answer tax allocation questions is a principal focus of the article. The first part of the article discusses basic principles of partnership taxation that provide for the formation of partnerships and allocation of partnership book and tax items. A thorough understanding of these fundamental principles is a prerequisite to discussing the problems of built-in gain and loss property. Part II considers the problems raised by contributions of built-in gain property. The analysis demonstrates that recent proposed Treasury regulations regarding contributed built-in gain or loss property and partnership mergers in some circumstances create mischief by failing to fully address deferred recognition. Part III looks at the complexity that is added by the existence of debt in the partnership. Part IV addresses special problems created by built-in loss property, including the issues raised by § 704(c)(1)(C), enacted in 2004. The analysis in this part demonstrates the need for analyzing partnership capital accounts in order to apply the basis limitation of § 704(c)(1)(C)(ii) in the context of its statutory purpose and suggests an interpretation of § 704(c)(1)(C)(ii) in conjunction with optional basis adjustments that produces proper allocations of loss. Part V considers partnership allocations that occur on the admission of a new partner to a partnership with built-in gain and built-in loss property.

Hat tip to Paul Caron.

ABA Record Owners Legislation Task Force

First, some background.  A pending bill in the U.S. Senate, S. 2956, 110th Congress, 2nd Session, would require each state to collect beneficial owner information for all corporations of LLCs formed, and to make that information available to Federal authorities.  The National Conference of Commissioners on Uniform State Laws has appointed a Drafting Committee on Record Owners of Business Act,withe the following charge:

This committee will draft an act to conform uniform entity laws, including the Uniform Partnership Act (1997), Uniform Limited Partnership Act (2001), Uniform Limited Liability Act (2006) and the Uniform Unincorporated Nonprofit Association Act (1996), to address the availability of information regarding the owners of entities established under state law.  The act would help address some national security concerns relating to companies operating for the purpose of organized crime, terrorist financing, securities fraud, tax evasion and other misconduct, while at the same time balancing important privacy concerns.

At the 2008 Annual Meeting, the Committee on LLCs, Partnerships and Unincorporated Entities authorized the formation of a Task Force to study the uniform and federal legislation.  According to Jim Wheaton, the Task Force is still seeking members.  Here is a note Wheaton sent out over the Committee email list:

At the annual meeting in New York a couple of weeks ago, our committee decided to form a task force to evaluate the Uniform Record Owners of Business Act legislation that is being prepared by NCCUSL, as well as related legislation (and threats of legislation) emanating from Washington.  The general concept is that there is a push, for anti-terrorism and other reasons, to create a way for the government to determine the identities of the owners of business entities.

This has proved to be a controversial issue within the committee, and we are going to devote a material portion of our November committee meeting in Washington to the topic.  Between now and then, we are asking a newly-created task force on business owner identification to report back to the committee in November with a recommendation for the position that should be taken by the committee.  Eric Feldman of Potter Anderson in Wilmington is chairing the new task force, and Eric is also our committee's representative to the NCCUSL project.  We solicited volunteers in New York, but I realize that most of our committee members were not able to make it to the New York meeting.  If you are interested in being appointed to the task force, and have the time to focus on the project over the next two months, please let me know by the end of the day Friday, so that we can finalize the task force membership list.

Thanks.

Jim Wheaton
Troutman Sanders LLP
222 Central Park Avenue, Suite 2000
Virginia Beach, VA 23462
jim.wheaton@troutmansanders.com
www.troutmansanders.com
W: 757-687-7719

So, a deadline of Friday.