48th Semi-Annual Tax & Estate Planning Forum

48th Semi-Annual Tax & Estate Planning Forum

By:  Kevin F. Murphy

A. IMPACT OF FORM OF ENTITY ON EMPLOYEE BENEFITS

1. IRS Position with Respect to Owner/Employees

In 1969, the Internal Revenue Service released Revenue Ruling 69-184¹ in which the Service formally stated that bona fide members of a partnership are not employees for purposes of federal employment tax. Although the pronouncement addresses a situation involving a “true” service partner to the partnership, devoting “his time and energies in the conduct of the trade or business of the partnership,” the general informal position of the IRS is that workers that receive a partnership interest, regardless of how small an interest and regardless of their other “partner-like” responsibilities (i.e., managerial, decision-making authority, etc.), such an individual is to be treated as an independent contractor and not as an employee of the business.

Set forth below are a few of the differences that an LLC or partnership which gives equity interests to all or, some of its employees may have with respect to the administration of the above-referenced different forms of compensation arrangements.

2. Differences with Respect to Treatment of Wages

Although an employer is generally required to withhold income taxes and federal employment taxes from an employee’s wages, if an individual is treated as being self-employed, such individual’s wages are not subject to withholding. Instead, such individuals are required to pay estimated taxes². Similarly, whereas taxable wages for an employee are reportable each year on a form W-2 (or a Form 1099 for an independent contractor), taxable income is reportable on a Form K-1 for partners or members of a limited liability company.

¹ Rev. Rul. 69-184, 1969-1C.B. 256.
² I.R.C. § 6654.

3. Differences with Respect to Treatment of Retirement Benefits

Generally, the vast majority of the rules governing qualified retirement plans are the same for partnerships and LLCs as they are for businesses that are corporations. Nevertheless, as provided in the bullet-points below, a few significant differences do exist.

• LLCs and partnerships are prohibited from receiving tax deductions for contributions made on behalf of “self-employed” individuals to the extent such contributions exceed the earned income of the individual from the business sponsoring the retirement plan³ For purposes of determining the earned income of the individual, the contributions made to the qualified plan are disregarded.

• LLCs and partnerships who employ individuals who own an equity interest in such companies may also encounter problems in calculating the definitions of compensation for purposes of Section 415 and 414(s) of the Code.

• Previously, an “owner-employee” of a partnership or LLC, which is defined to include a partner or member who owns more than 10% of the capital profits interest in the partnership or LLC, is not exempt from the prohibited transaction rules in the Code and ERISA when receiving a plan loan from a qualified retirement plan. This law changed effective January 1, 2002. Thus, after such date, such owner-employees will be eligible to receive plan loans without the loans automatically being deemed to constitute a prohibited transaction.

• As ERISA only covers retirement plans that an employer sponsors for its employees⁴ retirement plans that cover only partners are not subject to ERISA. Presumably, the same treatment would apply to retirement plans that cover only LLC members. Thus, unless such a retirement plan contained an anti-alienation provision that was valid under state law or another non-bankruptcy law, a participant’s interest in his or her plan may be included as part of his or her bankruptcy estate.

³ I.R.C. 404(a)(8).
⁴ 29 CFR § 2510.3-3(b).

4. Differences with Respect to Treatment of Welfare Benefits

Like retirement plans, most welfare benefit arrangements provided by limited liability companies and partnerships are subject to the same tax laws and rules as welfare benefits provided by corporations. Nevertheless, a few differences LLCs and partnerships should be aware of are the following:

• Because Code sections 105 and 106 apply only to coverage of employees, self-employed individuals are required to include in their taxable income the value of any employer provided health care coverage. Likewise, self-employed individuals must include in gross income the value of any group term life insurance coverage they receive from their employer. Self-employed individuals are also prohibited from participating in a cafeteria plan as all participants in Section 125 cafeteria plans are required to be common-law employees⁵

⁵ I.R.C. §125(d)(1)(A).

5. Differences with Respect to Treatment of Equity-Based Compensation

From a legal standpoint, there are minimal differences between the rules governing equity-based compensation arrangements for corporations and such rules as they apply to partnerships and LLCs. The few differences are as follows:

• A potentially significant administrative and legal issue to deal with when discussing equity-based compensation alternatives with respect to partnerships and LLCs concerns how to treat the eventual transfer of the member or partnership interest to the employee. Potentially different tax consequences may result depending upon whether there was a transfer of a profits interest or a capital interest in the entity⁶ In addition, it is widely believed that partners’ or members’ assets and capital accounts in a partnership or LLC should be “booked-up” at the time the entity transfers either a profits interest or a capital interest. The book-up essentially enables both the service provider and the existing-owners of the entity to receive the economic deal that they anticipate, as well as prevent a situation in which a service provider expecting to receive a profits interest to be deemed for tax purposes as receiving a capital interest in the partnership or LLC.

• One advantage of, offering equity-based compensation, or any type of compensation arrangement for that matter, through an LLC or a partnership is that partnerships and LLCs are not subject to Section 162(m)’s $1 million dollar limit on deductible compensation⁷
• In addition to not being subject to Section 162(m)’s limitations, the golden parachute rules imposed under Section 280G and 4999 of the Code also do not generally apply to payments made by LLCs or partnerships.

• As mentioned above, one disadvantage of the LLC or a partnership is that incentive stock options are not generally available to be granted. Although some practitioners believe it may be possible for an LLC to sponsor an incentive stock option plan which qualified for the special tax treatment. There is no formal guidance from the IRS with respect to the issue.

⁶ For a good discussion on the underlying theories for taxation, see James W. Forsyth, Compensatory Transfers of Partnership interests, 42 Tax Mgmt. Memo 251 (June 4, 2001).

⁷ I.R.C. § 162(m)(1)

B. QUALIFIED PLAN SELECTION

1. Introduction

a. Essentially, there are two types of plans: defined contribution plans and defined benefit plans. A plan (whether a defined contribution or a defined benefit plan) will be tax-qualified only if the contributions or the benefits provided under the plan do not discriminate in favor of employees who are highly compensated.

i. Defined contribution plans are typically tested by examining how contributions, forfeitures, trust income and gains or losses are allocated to participants.
ii. Contributions and forfeitures allocated to highly compensated participants as a percentage of their compensation must not be appreciably higher than for non-highly compensated participants.
iii. Trust income, gains and losses, must generally be allocated to participants in proportion to their account balances.

b. A limited exception to discrimination in favor of highly compensated employees is allowed in plans that are “integrated” with social security.

i. The integration level used is the social security “taxable wage base” for each year (the maximum amount of compensation subject to social security taxes) or may, in certain circumstances, be a stated dollar amount which is less.
ii. The assumption is that the company’s plans and the company’s contribution to the social security system should be considered together, or “integrated” in testing for discrimination under the company’s plan.

c. Distributions from qualified retirement plans are subject to spousal protection requirements. Unless spousal consent is obtained, benefits must be paid in an annuity form such that the participant’s spouse is protected. A profit sharing plan may be exempted from this requirement provided that any death benefit under the plan is fully payable to the surviving spouse.

2. Defined Contribution Plan

a. Under a defined contribution plan, company contributions are usually made to a trust and invested as a whole, and separate bookkeeping accounts are maintained to record each participant’s share of the net worth of the trust.

i. At retirement, a participant is entitled only to the amount in his account, or to a pension or annuity that amount will supply.
ii. The amount in a participant’s account in turn depends upon how long he is a participant in the plan, his share of contributions made by the company, and the result of trust investments and forfeited accounts of other participants.

b. The term “defined contribution” may be somewhat misleading in that it implies that specified contributions must be made. Defined contribution plans include profit sharing plans, where contributions may be discretionary, and money purchase pension plans which call for a specified contribution.

c. How each participant’s share of plans assets is determined must be specified in the plan document. This requires the plan to specify:

i. How the company contributions are allocated among plan participants;
ii. How changes in plan assets are to be allocated, such as dividends, interest, realized gains or losses on sales of trust investments, and unrealized gain and losses in the value of trust investment;
iii. The percentage of a participant’s account which he cannot be deprived of even if he resigns or is discharged before retirement and the part which will then be lost or forfeited; and
iv. How forfeited accounts of participants who leave before retirement (“forfeitures”) are allocated among accounts of the remaining participants.

d. Allocations must be made at least once a year. Immediately after the allocation, the total of participants’ accounts will equal the net worth at market value of the trust holding the plan assets.

e. Under the garden variety defined contribution plan, contributions and forfeitures are allocated in proportion to the compensation of participants, and dividends, interest, realized and unrealized gains and losses are allocated in proportion to the account balances of each of the plan participants.

i. A defined contribution plan may also allocate contributions and forfeitures in proportion to units; for example, each participant may be assigned a certain number of units based on compensation, and additional units for years of service.
ii. Use of units in certain instances will be discriminatory and not permissible.

f. Another important governing rule for defined contribution plans is the concept of annual additions. This limits the amounts that may be allocated to a participant’s account in a particular year. There is no limit on dividends, other trust income, or on realized or unrealized gains which may be added to a participant’s account. Other items, which are limited, are given the term “annual additions” and consist principally of company contributions and forfeitures. If a plan requires or allows contribution by employees, these contributions also fall within the term annual additions. Beginning January 1, 2002, total annual additions allocated to a participant in any year under all defined contribution plans of a company may not exceed $40,000.

3. Profit Sharing Plan

a. Profit sharing plans often provide for contributions which are completely discretionary. Where the formula is discretionary, the board of directors must adopt a resolution setting the amount of the contribution. Once the resolution is adopted, the contribution may be made up to the time required for filing the corporation’s income tax return and any extensions of the time to file. The plan could lose its qualification if contributions are not substantial and recurring.

b. Some profit sharing plans require the company to contribute a specified percentage of profits each year. Complex formulas are sometimes used to determine what part of profits are to be contributed to the plan.

4. Money Purchase Pension Plan

a. Use of the term “defined contribution” may be more logical in the case of a money purchase pension plan. Under a money purchase pension plan, a company is required to make contributions specified in the plan document.

b. Although called a “pension plan”, the money purchase pension plan, just as the profit sharing plan, does not promise any specified pension.

i. Bookkeeping accounts are kept to record each participant’s share in the trust holding plan assets.
ii. At retirement, a participant receives whatever pension the balance in his account will purchase.
iii. The amount of the pension cannot be predicted because it depends upon the results of trust investments, the participant’s compensation, and how long the participant is in the plan.

5. Defined Benefit Plan

a. The distinguishing feature of a defined benefit plan is that a specified pension is promised. No separate bookkeeping accounts are maintained for participants, and company contributions are actuarially determined to provide payment of the promised pension.

b. A pension is defined or promised by one of several methods which consider service and compensation in varying degrees in setting the maximum pension payable by the particular plan.

i. A flat benefit plan provides that each participant receives a pension of the same amount. Neither years of service with the company nor compensation level has a bearing.
ii. A fixed benefit plan provides that a participant’s compensation level plays a part in determining the amount of his pension. However, service is not taken into account. For example, a plan provides an annual pension of 30 percent of average compensation.
iii. A unit benefit plan provides a pension which varies directly with both compensation and service. For example, a plan might provide an annual pension of 2 percent of average compensation for each year of service.

c. A defined benefit plan will not be discriminatory if anticipated pensions of highly compensated employees as a percentage of their compensation is approximately the same for the non-highly compensated employees. Because of this, substantial sums may be contributed to a defined benefit plan to fund pensions for older employees, including those who are highly compensated employees.

d. There is a limit on the annual pension payable under a defined benefit plan. A participant’s annual pension payable in the form of a straight life annuity is limited to the lesser of:

i. $90,000 per year (this limit is subject to increases for cost of living adjustments); or
ii. 100 percent of a participant’s average compensation, based on the average of his highest three consecutive years while a participant in the plan.
iii. Both of these limitations above, must be reduced pro rata if a participant has less than 10 years of either participation in the plan or service with the company.

6. Vesting

a. A participant’s accrued benefit must vest over a period of time, based on years of service with the company. The plan must include a vesting schedule which is at least as good as one of the two minimum vesting schedules required by law, i.e., 5 year vesting, or 3 to 7 years graded vesting.

i. Under 5 year vesting, sometimes referred to as “cliff vesting”, a participant must be fully vested once he has 5 years of service. No vesting at all is required prior to that time.
ii. The 3 to 7 year graded vesting schedule requires 20 percent vesting after 3 years of service, increasing by 20 percentage points each year for the next 4 years. A participant with 7 years of service will be 100 percent vested.

b. A company can, of course, be more generous and provide for vesting at a faster rate than prescribed in the minimum schedules above.

c. The plan must provide contingent vesting provisions in the event that it becomes “top heavy”. A plan is top heavy if 60 percent of the accrued benefits under that plan are allocated to the accounts of key employees.

i. A participant must be 100 vested once he reaches the plan’s normal retirement date (even if he has less than the years of service otherwise required for 100 percent vesting).
ii. A participant must also be 100 percent vested in any account pertaining to employee contributions (if any).

7. Integration with Social Security

a. Defined contribution plans are integrated by establishing an integration level or breakpoint, and by providing a higher contribution percentage for compensation above the integration level than for compensation below that level. The differential, or spread, between these rates cannot exceed certain limitations. The integration level cannot exceed the social security taxable wage base in effect at the beginning of the plan year.

b. The spread in both corporate and self-employed defined contribution plans is limited to the employer’s share of the OASDI tax.

c. Under the integration rules, the spread (permitted disparity) cannot, exceed the lesser or (1) the base contribution percentage, or (2) the greater of 5.7 percent or the portion of the OASDI rate that is attributable to old age insurance.
Example. A plan providing for contributions equal to 10 percent of compensation below the integration level will be permitted contributions of 15.7 percent of compensation above that level, whereas a plan providing for a contribution of only 2 percent of compensation below that level will be limited to a 4 percent contribution with respect to compensation above the integration level.

d. The integration level can be lower than the social security taxable wage base if the lower level will not discriminate in favor of highly compensated employees.

e. The defined benefit plan integration rules are extremely complex.

i. An excess defined benefit plan is integrated by establishing an integration level, and by providing a higher benefit percentage for compensation above the integration level than for compensation below that level. In general, the integration differential in an excess plan is limited to .75% for each year of the participant’s years of service with the employer (up to a maximum of 35 years of service).
ii. An offset defined benefit plan is integrated by reducing a participant’s benefit by a portion of the participant’s social security benefits. In general, the maximum offset is .75% of the participant’s final average compensation for each of the participant’s years of service (not to exceed 35 years of service).

8. Factors in Choosing a Plan

a. The following general principles should be considered in deciding between a defined benefit plan and a defined contribution plan.

i. Defined benefit plans require contributions necessary to fund promised pensions, without regard to a company profit. A company should not adopt such a plan unless it can afford to make the necessary contributions. A company subject to extreme fluctuations in profits and cash flow should probably avoid adopting a defined benefit plan.
ii. A defined benefit plan is subject to minimum funding standards in making pension plan contributions. If a plan is terminated and does not have sufficient assets to pay a minimum pension, the company may be liable to the PBGC.

b. If the intent is to obtain the largest possible pension for management and if management is older than most of the other employees, a defined benefit plan should seriously be considered. Similarly, if management is younger, a defined contribution may be more attractive.

c. A profit sharing plan is particularly useful where a company’s profits or cash flow is unpredictable. The greatest flexibility will exist where discretionary contributions may be made.

C. THE ECONOMIC GROWTH AND TAX RELIEF ACT OF 2001

Currently, the first and second largest tax expenditures for the United States government are attributable to the available exclusions from income of pension contributions and earnings and the exclusion of employer contributions for medical insurance premiums and medical care, respectively. For the 2000 fiscal year, the tax expenditures for these two items alone amounted to more than $162 billion in lost revenue. Given the magnitude of tax expenditures allocated to these employee benefit issues, tax laws associated with employee benefit issues are continually being changed by the government. Unfortunately, constant change in the employee benefit laws and regulations often can be a significant burden for small businesses sponsoring employee benefit plans. Despite having much fewer resources available than large employers to deal with such changes, small businesses are often subject to the same regulatory burden. An exhaustive list of all of the legislative changes applying to employee benefit plans is beyond the scope of this paper. Set forth below, however, is a summary of the employee benefit provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001.

Increased Contributions and Benefit Limits.


Workers who participate in an employer-sponsored, deferral-type retirement plan (such as 401(k), 403(b) and 457) can defer more of their pre-tax income, as follows:

The annual limit is increased to $40,000 in 2002 and indexed for future years. The corresponding percent of compensation limit is raised from 25% to 100%.

  • Profit Sharing Plan Contribution/Deduction Limit

The employer annual deduction limit for profit sharing plans has been increased from 15% to 25% of eligible payroll.

  • Defined Benefit Plan

The defined benefit plan annual benefit limit is increased to $160,000 for 2002 and indexed for future years.

  • Compensation Limitation.

The limit on compensation that may be taken into account under a qualified plan for the purpose of determining contributions and benefits under Code Section 401(a)(17) is increased to $200,000 in 2002, and then indexed in $5,000 increments thereafter.

D. PLANNING FOR SMALL BUSINESSES

1. Solo 401(K) Plans

The Economic Growth and Tax Relief Reconciliation Act of 2001 encouraged the adoption of retirement plans by small employers with the enactment of the Solo 401(k) plan legislation. It is specifically targeted at any business that employs only owners and their spouses.
For an owner/employee, he or she can contribute up to 100% of the first $11,000 of his or her 2002 compensation or self-employment income ($12,000 if he or she is 50 or older at year-end). For 2003 and beyond, the numbers will rise as follows:

In addition, he or she can contribute and deduct an amount of up to 25% of his or her compensation, or 20% of his or her self-employment income. This is significantly more than he or she could contribute to a SEP-IRA or SIMPLE-IRA. The following charts compare contribution limits for various types of retirement plans.

2. SEP IRAs

These are designed for small businesses. The maximum SEP contribution per participant is the lesser of 25% of compensation, subject to the $200,000 limitation, or $40,000. an employer must contribute the same percentage or amount for each eligible employee.
Vesting is immediate.
The advantage of this type of plan is that administration and tax filings are minimal.

3. SIMPLE IRAs

These are designed as low cost alternatives for small businesses to 401(k) plans. Plan participants, including an owner, can contribute up to $7,000 (in 2002) per year on a pre-tax basis into an individual SIMPLE IRA account.
Employers avoid the complex discrimination rules applicable to 401(k) plans. However, the employer must match dollar-per-dollar up to 3% of compensation for participating employees, or can contribute 2% for all eligible employees.
All employer contributions are immediately and 100% vested to the employee.

Contact Lum, Drasco & Positan

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Phone: 973-403-9000
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Our law office is located in Roseland, New Jersey.

To speak with an attorney at our firm about your legal needs, call 973-403-9000.

Current Developments In Executive Compensation

Current Developments In Executive Compensation

I. TYPES OF NONQUALIFIED DEFERRED COMPENSATION PLANS

A. Elective Deferral Compensation Plans.

1. Employer adopts deferral plan to provide retirement benefits to a select group of management or highly compensated employees.

2. Participants elect to defer regular and/or incentive compensation. Amounts deferred are subtracted from the participant’s compensation when it becomes payable and are credited to the participant’s deferral account. Interest will be credited on the deferrals at the rate provided in the plan.

3. The deferral plan balance is solely a bookkeeping entry. Participant is a general, unsecured creditor of the employer with respect to the amounts deferred under the plan.

4. The benefits payable under the plan are represented solely by the employer’s unsecured promise to pay the benefits. To this extent, the participants and their beneficiaries will be general, unsecured creditors of the employer.

B. Supplemental Executive Retirement Plans (SERPs).

1. The employer promises to pay the employee a benefit equal to a specified dollar amount or a percentage of final compensation.

2. No salary reduction.

3. The promise to pay is unfunded and unsecured. An employee is a general, unsecured creditor of the employer.

4. Typically, the benefit is subject to a vesting schedule. In some cases, there is a 100% forfeiture of benefits if the employee terminates prior to a designated retirement age for reasons other than death, disability, or change in control.

C. ERISA Excess Plans.

A SERP may be designed as an ERISA Excess Plan as defined in ERISA Section 3(36). Such a plan provides benefits which would have been paid but for the limitations on contributions and benefits contained in Section 415.

II. TAX CONSEQUENCES

A. Employer Tax Consequences.

1. Pursuant to Code Section 404(a)(5), amounts accrued under a plan which defers the receipt of compensation are not deductible until the year in which the amounts are includible in the employee’s gross income, and then only to the extent such amounts represent reasonable compensation.

2. The employer should be able to deduct death benefits paid to beneficiaries in the year of payment if the payments are reasonable in amount and in duration.

B. Employee Tax Consequences.

1. IRC §451(a) provides that a cash basis taxpayer will be taxed on income prior to actually receiving it if the income is constructively received or received under the economic benefit theory.

Therefore, by avoiding the constructive receipt and economic benefit theories, the participant will recognize income only upon actual receipt of the deferred plan benefit payments.

2. The election to defer compensation must be made before the compensation has been constructively received in order to also defer the income tax on the deferred amounts. Rev. Proc. 71-19, 1971-1 C.B. 698.

3. Income is constructively received when it is credited to an employee’s account, set apart for him, or otherwise made available to be drawn upon at any time. See Treas. Reg. §1.451-2(a).

4. The opinions of early courts discussing constructive receipt as it applies to deferral arrangements look to when the compensation is earned, when it is calculable, and when it is payable.

5. In the Veit decisions, Mr. Veit agreed with his employer on January 2, 1939 to defer until July and October of 1941 the payment of incentive compensation earned during 1939 and 1940. On November 1, 1940, during the service period but before the compensation was calculable, the parties agreed to further defer payment from July and October of 1941 to quarterly installments payable in 1942. Finally, on December 26, 1941, after the incentive compensation was both earned and calculable, but before it became payable, the parties again agreed to defer payment. This final agreement was that the compensation would be paid in 5 equal installments over the years 1942 to 1946. The Tax Court addressed the November 1, 1940 and the December 26, 1941 agreements in separate opinions given that both years were not before the court in the initial case.

a. Veit I. Regarding the November 1, 1940 agreement, the Tax Court held that a deferral during the service period but prior to the time the compensation was calculable or payable was effective to defer the tax on such amounts. See Veit v. Commissioner, 8 T.C. 809, 818 (1947). The Service acquiesced in this Veit opinion. See 1947-2 C.B. 4.

b. Veit II. In Veit v. Commissioner, 8 T.C.M. 919 (1949), the Tax Court held that the December 26, 1941 deferral was also effective even though it occurred after the services were performed and after the amounts were calculable. The court noted that prior to the agreement “there was never a time when the compensation was unqualifiedly subject to petitioner’s demand or withdrawal.” 8 T.C.M. (CCH) at 992. The Service did not acquiesce in this Veit opinion.

6. The taxpayer in Oates v. Commissioner, 18 T.C. 570 (1952), aff’d. 207 F.2d 711 (7th Cir. 1953), was a life insurance agent. At retirement, the agent elected to have renewal commissions paid to him at the rate of $1,000 per month rather than as the carrier received the renewal premiums. The precise amount of the previously earned renewal commission was not calculable at the time of the deferral, but “it was well known that considerable amounts would be due [the agent] as commissions out of the renewal premiums.” Nevertheless, the Tax Court held, and the Seventh Circuit agreed, that the agent’s deferral at retirement was effective to defer the income tax on the commissions until they were actually paid to the agent. The Service later acquiesced in the Tax Court’s decision.

7. In Martin v. Comr., 96 T.C. 814 (1991), Executives were allowed to choose between two non-qualified deferred compensation plans, the original plan which only provided installment payments and a new plan which permitted both lump sum payments and installment payments. The IRS contended that the Executives constructively received the full amount of benefits under the new plan because they had the choice to receive a lump sum payment. The Tax Court held for the Executives.

C. FICA Tax Consequences.

1. Section 3121(v)(2)(A) provides compensation deferred under a deferral plan is subject to FICA taxes at the later of when the services are performed, or when there is no substantial risk of forfeiture of the rights to such amount. Amounts deferred are typically always 100% vested and thus are subject to FICA taxes in the year the services are performed.

2. Deferred compensation and interest it earns is subject to FICA taxes only once. Therefore, deferred amounts paid to the participant will not again be subject to FICA taxes.

3. Section 1402(a) provides that for purposes of self employment tax and earnings for Social Security purposes, an outside director is deemed to have earned his or her fees in the year in which the services are performed regardless of when the fees are paid.

4. Final regulations on the employment tax treatment of deferred compensation have been issued recently. Key aspects of the final regulations include the following:

a. The grant of a stock option, stock appreciation right, or other stock value right is not a grant that is subject to Section 3121(v).

b. Special rules for early window programs.

c. Payments made under a non-qualified deferred compensation plan in the event of death are death benefits, but only to the extent the total benefits payable under the plan exceed the lifetime benefits under the plan. Similarly, payments made under a non-qualified deferred compensation plan in the event of disability are disability benefits, but only to the extent the disability benefits payable exceed the lifetime benefits payable under the plan.

III. ERISA REQUIREMENTS

A. Top Hat Exemption.

1. Plans that are “unfunded and maintained by an employer primarily for the purpose of providing deferred compensation for a select group of management or highly compensated employees” are excepted from the participation, vesting, benefit accrual, joint and survivor annuity, funding and fiduciary requirements of ERISA. However, such plans must comply with the reporting and disclosure requirements, and must also provide a claims and review procedure.

2. Although ERISA, its regulations and its legislative history are silent on the meaning of “unfunded” and “select group of management or highly compensated employees”, 3 cases and several DOL opinion letters have provided some standards for determining which plans qualify under the exception.

3. In Dependahl v. Falstaff Brewing Corp., 491 F.Supp. 1188 (E.D. Mo. 1980), rev’d on other grounds, 653 F.2d 1208 (8th Cir.), Cert. denied, 454 U.S. 968 (1981), an employee claimed that a death benefit only plan was funded because the employer had purchased life insurance contracts on the lives of participants.

a. The district court found that the plan was funded because the benefits would “eventually be paid through the insurance contracts purchased and maintained by [the employer].” 491 F. Supp. at 1195.

b. The Eighth Circuit Court of Appeals agreed that the plan was funded because the life insurance policies constituted “a res separate from the corporation” to which the beneficiaries could look for payment. See 653 F.2d at 1214.

c. The Dependahl opinions appear to hold that a plan is funded if the employer purchases a life insurance policy on the life of a participant. However, the insurance policies in Dependahl were directly tied to the payment of plan benefits — the insured key executives were named in the plan documents; letters to the executives explaining the plan benefits directly tied the policies to the computation and payment of benefits; and the plan was explicitly “secured” by the policies.

4. In Belka v. Rowe Furniture Corp., 571 F.Supp. 1249 (D.Md. 1983), an ex-employee claimed that a deferred compensation plan was funded because the employer had purchased life insurance policies on the lives of plan participants. The employer was the owner and beneficiary of the policies.

a. The court found that Dependahl was distinguishable because it involved a death benefit only plan for which “the insurance policies would certainly assist in paying, if not completely funding, the benefits due.” Conversely, benefits under the Rowe plan were lifetime retirement benefits that would be paid from the employer’s general assets rather than out of insurance proceeds.

b. The Dependahl plan allowed the employee’s estate to look to the insurance proceeds directly if the employer was unable to pay the death benefits. The Rowe plan, on the other hand, expressly provided that neither the employee nor his beneficiary had any preferred claim to the insurance policy or its proceeds. Rather, the employee depended solely upon the employer’s general financial soundness for benefit payments.

c. Because the insurance under the Rowe plan was not interwoven with the payment of plan benefits as was the insurance in Dependahl, the Rowe court found that the plan was unfunded for ERISA purposes.

5. In Belsky v. First National Life Insurance Company, 818 F.2d 661 (8th Cir 1987) following the bankruptcy of his employer, a bank, a nonqualified plan participant brought suit to obtain a life insurance policy owned by the bank. The participant claimed that the policy was a plan asset of the employer’s funded employee benefit plan and that, therefore, the policy could not be transferred to the FDIC. The court followed the Rowe rationale, distinguishing Dependahl for the following reasons:

a. The Belsky plan provided for retirement and disability benefits in addition to a death benefit.

b. The plan did not require that the employer hold or acquire assets to finance the liabilities; and

c. The plan expressly provided that neither the employee nor his beneficiary had a preferred claim to the policy or its proceeds. Rather, it specifically provided that plan participants were general, unsecured creditors of the employer.

6. In DOL Op. Ltr. 81-11A, an advisory opinion was issued to Tandy Corporation regarding its death benefit only plan, the Department of Labor (“DOL”) stated that the insurance would not cause the plan to be funded if certain conditions were met:

a. The insurance proceeds were payable only to the employer;

b. The employer had all the rights of ownership under the policy;

c. Neither the participants nor the beneficiaries had any preferred claim against the policies or any beneficial ownership in the policies;

d. No representations were made to the participants or the beneficiaries that the policies would be used to provide benefits or were security for benefits; and

e. Plan benefits were not limited or governed in any way by the life insurance policies.

B. ERISA Excess Plans.

1. An unfunded ERISA Excess Plan is exempt from all of the Title I ERISA requirements. ERISA §4(b)(5).

a. Reporting and disclosure (Part 1);

b. Eligibility, participation, and vesting (Part 2);

c. Minimum funding and benefit accrual requirements (Part 3);

d. Fiduciary rules (Part 4); and

e. Enforcement provisions (Part 5).

2. A funded ERISA Excess Plan is exempt from the following ERISA requirements:

a. Eligibility, participation, and vesting (Part 2). ERISA §201(7).

b. Minimum funding and benefit accrual (Part 3). ERISA §301(a)(9).

IV. INCENTIVE STOCK OPTIONS (ISOs)

A. ISOs Versus Nonqualified Options.

1. With an ISO, the employee does not recognize current compensation upon the exercise of the option. Any gain on the exercise is deferred until the stock is sold and all the gain is characterized as capital gain.

To qualify for capital gain treatment, the employee must hold the stock for at least 2 years after the date the ISO was granted and at least one year after it was exercised.

2. An employee does not receive tax-favored treatment on the exercise of a nonstatutory or “nonqualified” stock option. Under section 83(a), a nonqualified stock option results in ordinary income to the employee in the year of exercise on the spread between purchase price and fair market value at exercise and capital gain on the appreciation realized between exercise and sale.

3. The employer sponsoring the ISO never receives a tax deduction for the compensatory bargain element in the ISO. A nonqualified stock option is more favorable for the employer because it gets a deduction.

B. ISO Requirements.

1. The employer must have a written option plan that sets forth the maximum number of shares that may be issued under the plan, as well as the class of employees eligible to receive options.

The plan must be approved by a majority of the stockholders of the company within 12 months of its adoption by the board of directors.

The plan must provide that the aggregate value of the stock with respect to which ISOs are first exercisable by the optionee in any calendar year cannot exceed $100,000.

2. Assuming that the plan satisfies these requirements, the option grant must also conform to a number of statutory prerequisites under Section 422(b), including:

a. The option exercise price must be no less that the fair market value of the shares (as determined by the board of directors in good faith) on the date of the grant.

b. The option must be granted within 10 years of adoption of the plan.

c. The option, by its terms, cannot be exercisable for a period longer than 10 years after the date of the grant.

d. The option may be granted only to a person who is an employee of the company (or its parent or subsidiary) on the date of the grant.

e. The option must be exercised by the employee no later than 3 months after termination of employment (except in the case of death or disability, after which an ISO can be exercised for up to one year).

f. The option, by its terms, cannot be transferable (other then by will or laws of descent) and can only be exercised during the employee’s lifetime by the employee.

g. If an option is granted to a more-than-10% shareholder of the company (or its parent or subsidiary), the exercise price can be no less that 110% of the fair market value at the date of grant and the option cannot be exercised for a period longer than 5 years after the date of the grant.

C. Sequential Exercise Rule.

Prior to the 1986 Tax Reform Act, pursuant to the sequential exercise rule, an ISO could not be exercisable before any prior ISO granted to the same optionee by the same company had been exercised in full or had expired (by lapse of time) under the terms of the grant.

This rule was repealed by the 1986 Tax Reform Act.

D. Grant Limitation Rule.

Prior to the 1986 Tax Reform Act, the grant limitation rule required that the terms of the ISO plan provide that no employee could be granted ISOs for more that $100,000 worth of stock in any calendar year.

This rule was repealed by the 1986 Tax Reform Act. Post-1986 ISOs are subject to a $100,000 exercise limitation rule rather than a grant limitation rule.

E. Alternative Minimum Tax.

The spread on exercise of an ISO is a tax preference for alternative minimum tax purposes.

F. Third-Party Stock Options.

These programs consist of plans whereby employees receive options to purchase third-party (i.e. non-employer) stock or mutual funds. Generally, a bargain purchase price on the date of grant is part of these programs.

The use of this type of program would allow a tax-exempt employer to provide deferred compensation to its executive in an amount in excess of the annual limitation imposed under Section 457.

V. ESTATE PLANNING WITH STOCK OPTIONS

A. General Rules

In general, there are two types of stock options. They are Incentive Stock Options and nonqualified stock options.

The key with Incentive Stock Options is that an employee does not recognize gain on the grant or exercise of the option, but only on the sale of the underlying security. The gain at that time will be characterized as capital gain if the employee holds the security for two years from date of grant and one year from date of exercise. Incentive Stock Options are not transferable by the employee during his or her lifetime, therefore, they do not offer estate planning opportunities.

Nonqualified stock options provide greater flexibility in estate planning. There is no statutory provision limiting transferability.

If an option does not have a readily ascertainable FMV at the date of grant, income will be recognized at the date of exercise. Gain will be characterized as ordinary income.

B. Disposition of Option

In an arm’s length disposition or sale of an option, compensation is realized at the time of the transaction pursuant to 1.83-1(b).

In a non-arm’s length disposition or sale of an option, compensation is realized by the transferor at the time of exercise by the transferee pursuant to 1.83-1(c).

1. These rules were recently confirmed in PLR 200005006. The IRS addressed the issue of whether a husband is taxed under Section 83 when stock options are transferred to his former wife pursuant to a divorce decree. The IRS concluded that this was an arm’s length transaction and that the husband had to recognize compensation income at the time of the transfer.

2. In PLR 199952012, a stock option agreement was amended to provide that options were transferable to immediate family members. The taxpayer wanted to make a gift of options. The plan stated that options were exercisable only after the optionee had been continuously employed for at least one year. Since the taxpayer had satisfied this service requirement, the IRS ruled that the proposed transaction was a completed gift on the date of transfer. There was a discussion of Rev. Rul. 98-21 in the ruling. In that instance the IRS ruled that a gift of a stock option from a mother to her child was not a completed gift because the exercise of the option was conditioned on the employee’s performance of services.

Rev. Proc. 98-34 sets forth how to value a stock option for gift and estate tax purposes. It establishes a safe harbor if certain conditions are met, otherwise the taxpayer may obtain an independent appraisal. One of the conditions necessary to qualify for the safe harbor is that the company must be subject to Statement of Financial Accounting Standard No. 123 (Accounting for Stock-Based Compensation).

VI. SPLIT DOLLAR LIFE INSURANCE PLANS

A. Definition of Split Dollar.

1. “Split dollar” refers to an arrangement between parties, typically an employer and an employee, for the purchase of a life insurance policy. The benefits payable under the policy are “split”, and the premiums paid for it may be split, by the parties.

2. The cost sharing at the heart of a split dollar plan enables the flow of benefits from, for example, an employer to an employee. In the employment context, this “nonqualified” plan can channel current and future benefits to key employees.

3. A hallmark of split dollar life insurance is flexibility. The costs and benefits may be split in any number of ways, with different tax consequences. An employee’s share of the premiums may even be zero. While the plan must use a life insurance policy with a cash surrender value, the policy may take the form of whole life, universal life, or variable life insurance.

B. Policy Ownership.

1. Either the employer or the employee may “own” the policy, subject to the rights of the other party.

2. If the employer owns the policy, the employee’s right to a share of the benefits is secured by an endorsement to the policy. Hence, a split dollar arrangement structured in this manner is said to follow the “endorsement method”. This approach may be used when it is intended that the employer retain control of the policy.

3. If the employee owns the policy, the employer’s right to a share of the benefits is secured by a collateral assignment of the policy. Hence, a split dollar arrangement structured in this manner is said to follow the “collateral assignment method.” This approach may be used when it is intended that the employee should eventually own the entire policy, or as part of an effort to provide the employee the benefit of the policy’s “inside buildup.”

C. Typical Structure.

1. The employer pays an annual premium not exceeding the anticipated increase in the policy’s cash surrender value during the year.

2. The employee’s premium is the balance of the annual premium due or scheduled.

3. The employer’s share of the death benefit under the policy is the greater of the cash surrender value and the sum of the employer’s premium payments. This “repays” the employer’s contribution, with or without interest.

4. That balance is the employee’s share of death benefit i.e., the amount that the employee may direct to be paid to his or her death beneficiary under the policy. This is the policy’s “net amount at risk” or pure insurance element, more or less.

5. If the policy is surrendered, the employer receives all of the cash surrender value.

D. Employee Tax Consequences.

1. The longstanding foundation of split dollar plan taxation was Rev. Rul. 64-328, 1964-2 C.B. 11, holding that traditional split dollar plans involving employers and employees, whether following the endorsement method or the collateral assignment method, provide compensatory benefits to employees includible in their gross income.

2. Rev. Rul. 64-328 requires an employee who is party to a split dollar plan to include in income the value of current benefits received as a result of the employer’s premium payments. This application of the economic benefit doctrine was held appropriate in Howard Johnson v. Commissioner, 74 T.C. 1316 (1980).

a. The value of the benefits is measured as the employer paid cost of the face amount of term life insurance equal to the coverage under the plan that the employee may direct to his or her death beneficiary.

b. For this purpose, the cost per unit of coverage is determined by applying the “P.S. 58” rates. See Rev. Rul. 55-747, 1955-2 C.B. 228. However, such cost may be based instead on actual 1-year term insurance rates of the insurer providing the coverage, if those rates are lower. Rev. Rul. 66-110, 1966-1 C.B.12. To be used for this purpose, the insurer’s rates must be those generally available to standard risks and therefore cannot be as low as “fifth dividend” rates or other preferred rates. Rev. Rul. 67-154, 1967-1 C.B. 11; PLR 8547006.

c. Since Rev. Rul. 64-328 seeks to include in income only the employer-provided cost of coverage, any amount paid by the employee (or other owner) during the year for coverage received that year reduces the imputed income dollar-for-dollar. (There is no carry-over of “excess” payments, however.) Such payments are, of course, nondeductible by the employee.

3. According to Rev. Rul. 64-328, the death benefit received by the employee’s beneficiary is excluded from the beneficiary’s gross income under Section 101(a)(1). This assumes, of course, that the transfer-for-value rule of Section 101(a)(2) is not invoked and that the policy qualifies as life insurance under Section 7702.

E. Employer Tax Consequences.

1. According to Rev. Rul. 64-328, the death benefit received by the employer as beneficiary under the policy is excluded from gross income under Section 101(a)(1) (again assuming that Section 101(a)(2) is not invoked and that the policy qualifies under Section 7702).

2. The ruling also denies the employer a deduction for any part of the premium paid under the policy, pursuant to Section 264(a)(1), because of the employer’s interest in the policy.

3. Under a split dollar plan, the employer may have the right to borrow against the policy’s cash surrender value, such as to pay a premium.

a. Interest on the borrowing is deductible by the employer subject to rules of Section 264.

b. If the policy fails the “7-pay” test of Section 7702A and is therefore treated as a “modified endowment contract,” such a loan or any other cash distribution from the policy (including a dividend) will be includible in the employer’s gross income to the extent of the income on the contract under Section 72(e)(10), with application of the 10% penalty tax imposed by Section 72(v).

F. The Split Dollar “Rollout”.

1. When an employee covered by a split dollar plan terminates employment, as by retirement, the plan itself may be terminated and the policy “rolled out” to the employee. The rollout may be accomplished by a sale of the employer’s interest to the employee or by a “bonus” of such interest to the employee. The sale may be financed by borrowing from the policy’s cash surrender value.

2. The amount of the cash surrender value transferred to an employee in the rollout of a traditional split dollar plan, net of the employee’s payment for the transfer, is includible in the employee’s gross income pursuant to Section 83. See PLRs 7916029 and 8310027.

a. Although a policy used in a split dollar plan under the collateral assignment method is not itself transferred in the rollout (since the employee or some other party already owns it), the employer’s interest in the cash value is transferred. See Treas. Reg. §1.83-3(a).

b. It appears that the employee may not count as part of his or her “payment” the previous premium payments made to reduce income imputation. See PLR 7916029.

c. If the policy is a modified endowment contract, amounts borrowed or withdrawn to effectuate the transfer may be includible in income and subjected to the 10% penalty tax.

3. The employer may deduct the amount transferred to the employee upon the rollout under Section 162 as provided in Section 83(h). However, any gain in the policy (i.e., any excess of the policy’s cash surrender value over the employer’s premium payments) will be includible in the employer’s income under Treas. Reg. §1.83-6(b). See PLR 8310027.

4. The transfer-for-value rule of Section 101(a)(2), limiting the death beneficiary’s exclusion for life insurance proceeds to the premium and other consideration paid therefor, should be take into account in structuring a rollout. Under that rule, e.g., a rollout of a policy to the insured thereunder would not trigger the limitation, but the policy’s transfer to a third party owner may well do so.

New Interim Guidance

1. In 1996, the IRS released Technical Advice Memorandum 9604001, which set forth a new position regarding the income taxation of split dollar life insurance. Under this TAM, the IRS held that, in addition to the economic benefit, an employee has income under Section 83 each year as a policy’s cash value exceeds the premiums recoverable by an employer.

In Notice 2001-10, 2001-5 IRB 459, the IRS announced a new interpretation of split dollar life insurance taxation. The Notice applies either Section 83 or Section 7872 to employer payments under split dollar plans. Taxpayers have a choice of characterizing employer payments as loans (subject to Section 7872), non-loans (subject to Section 83), or as payments of compensation (subject to Section 61).

The Notice makes several major changes to the term rates used to value the economic benefit of the life insurance protection.

VII. RABBI TRUSTS

A. General Definition.

1. In a nonqualified unfunded deferred compensation plan, the employee, generally, is an unsecured general creditor of the employer subject not only to the solvency and credit risks of the employer, but also to the employer’s good faith payment of benefits. As a practical matter, delay and expenses associated with litigation to enforce a right to unfunded deferred compensation against a solvent employer can substantially reduce or eliminate the value to an executive of such benefits.

2. One method of securing the anticipated deferred compensation benefit is for the employer to establish a trust, to segregate the deferred compensation assets from its other assets and protect the employee’s benefit. Although a trust can provide actual protection from loss of benefits (e.g., in the event of a hostile takeover), at best it may offer only psychological assurances in the event of employer insolvency or bankruptcy since the assets held in the trust must be available to the general creditors of the employer.

3. A rabbi trust is essentially an irrevocable grantor trust used to fund and secure nonqualified deferred compensation benefits for eligible employees. In order to establish a rabbi trust, the employer transfers assets to the trustee, either on a discretionary or actuarially determined basis (depending upon the form of the underlying deferred compensation program). Such funds may then be invested, and are generally available for the payment of benefits. As a form of grantor trust, its earnings are generally taxable to the employer and contributions deposited are not deductible until the employee receives the benefit and takes it into income.

4. In Private Letter Ruling 8113107, a congregation entered into a deferred compensation arrangement with its rabbi in order to provide benefits in the event of his death, disability, retirement, or separation from service. The congregation, as the plan sponsor, established an irrevocable trust to segregate the deferred amounts contributed by it. In accordance with its terms, the trust could not be amended or terminated; however, the trust corpus remained at all times subject to the claims of the congregation’s general creditors. The IRS held that since the trust corpus was subject to the claims of general creditors, including the claims of the rabbi for his deferred benefits, and because of the anti-alienation provisions of the trust, there was no “funding.” Therefore, the rabbi would not be currently taxed.

B. DOL Requirements.

1. Section 4(b)(5) of ERISA exempts from the coverage of all of Title I of ERISA a plan which is both “unfunded” and an “excess benefit plan” as defined in Section 3(36) of ERISA. Section 3(36) defines an excess benefit plan as “a plan maintained by an employer solely for the purpose of providing benefits for certain employees in excess of the limitations and contributions and benefits imposed by Section 415 of the Code on plans to which this Section applies, without regard to whether the plan is funded.” Sections 201(2), 301(a)(3), and 401(a)(1) of ERISA exempt from the application of parts 2, 3 and 4 of Title I, respectively, “a plan which is unfunded and is maintained by an employer primarily for the purpose of providing deferred compensation for a select group of management or highly compensated employees.”

Therefore, if a rabbi trust constitutes a “funded” deferred compensation plan for purposes of ERISA, such a plan would be subject to the ERISA rules requiring that benefits vest over prescribed periods of time and that assets be held in trust for the exclusive benefit of the participants and beyond the reach of the employer’s creditors. Such plan would also be subject to the ERISA fiduciary, enforcement, reporting, disclosure and other rules.

2. In a letter to the IRS dated December 13, 1985, the DOL gave its opinion on the application of ERISA requirements to a rabbi trust. In its letter, the DOL limited its opinion to top-hat plans and excess benefit plans. The DOL stated that it would use a facts and circumstances test in order to determine whether a plan was “funded” for purposes of Title I of ERISA, including looking to relevant non-ERISA law (e.g., relevant Code provisions). The DOL further stated that it was “the working premise of the Department that a ‘top-hat’ plan or excess benefit plan would not fail to be ‘unfunded’ solely because there is maintained in connection with such a plan a ‘rabbi trust,’ and noted that it would accord significant weight to the IRS’s position that a rabbi trust does not constitute a funded plan when the DOL makes its case-by-case determinations.

C. Employer Stock.

In PLR 9235006, the IRS issued a private letter ruling regarding the funding of rabbi trusts with employer stock. Under the facts of the ruling, the parent of an affiliated group of corporations, set up a trust to provide nonqualified deferred compensation benefits for the executives of the company and its affiliates. According to the trust, the trust assets were to be comprised principally of the company stock, purchased by the trustee on the open market. The IRS held:

1. The contribution of assets did not constitute a transfer of property within the meaning of Section 83;

2. The contribution of assets did not cause a participant to recognize, under either of the constructive receipt or economic benefit doctrines, income prior to the taxable year in which the assets are paid or made available;

3. The employer will be able to deduct the benefit payments in the year includible in the participant’s income;

4. The employer will not be taxable on dividends to the trust as long as it remains the owner of the trust; and

5. The employer will not recognize any gain or loss on account of the receipt of money on other property by the trustee in exchange for the stock as long as it remains the owner of the stock.

D. Insurance.

In Private Letter Ruling 9344038, the IRS ruled that an employee’s purchase of an insurance policy from an insurer to secure the future payment of nonqualified deferred compensation benefits from a rabbi trust conferred no economic benefit on the participant. Thus, the issuance of the policy did not cause the deferred compensation benefits to be includible in the participant’s gross income prior to the time the benefits were paid or made available to the employee.

Under the economic benefit doctrine, employees must include in gross income any income from an economic or financial benefit received as compensation, including benefits not received in cash. An employee receives an economic benefit when assets are unconditionally and irrevocably paid into a fund or trust to be used for the employee’s sole benefit.

When the employee independently purchased the policy, the IRS found the employer had not transferred property to the employee that was protected from the employer’s creditors. Thus, no economic benefit was conferred on the employee by the employer. Under the policy, the employee paid all of the premiums and negotiated the terms of the policy without any involvement by the employer. In addition, the insurer issued the policy without entering into any collateral agreement with the employer and without obtaining any information about the employer other than publicly available information. The IRS noted, however, that if the employer reimbursed the employee for premiums paid, this amount would be includible in the employee’s income at the time of reimbursement.

E. Model Rabbi Trust.

In Rev. Proc. 92-64, 1992-2 C.B. 422, the IRS designed a model rabbi trust. This Revenue Procedure provides that the IRS will not issue a private letter ruling for a nonqualified deferred compensation plan that uses a rabbi trust other than the model rabbi trust.

F. Offshore Rabbi Trusts.

There recently has been much commentary in compensation planning journals regarding the advantages of offshore rabbi trusts. As set forth above, a rabbi trust is a means to secure an Executive’s deferred compensation. However, the assets within a rabbi trust are subject to the claims of the general creditors of an employer in the event of the employer’s insolvency or bankruptcy. By placing the rabbi trust offshore, the various authors suggest that it will become more difficult for general creditors to go after these assets because of secrecy laws, etc. found in offshore jurisdictions and therefore the general creditors may not pursue collecting them.

Contact Lum, Drasco & Positan

Lum, Drasco & Positan LLC
103 Eisenhower Parkway
Suite 401
Roseland, NJ 07068
Phone: 973-403-9000
Fax: 973-403-9021

Our law office is located in Roseland, New Jersey.

To speak with an attorney at our firm about your legal needs, call 973-403-9000.

The IRS Gets Its Swagger on When It Comes to IRA Beneficiary Trusts

The IRS Gets Its Swagger on When It Comes to IRA Beneficiary Trusts

By: Kevin Murphy

Vast amounts of wealth are held in individual retirement accounts, 401(k) plans and other retirement plans. The importance of proper estate planning for such retirement benefits was recently illustrated in private letter ruling 201021038. In this ruling, the Internal Revenue Service rejected a post-mortem reformation of a trust and concluded that the designated beneficiary of an IRA must be identifiable on the IRA owner’s date of death.

There are many reasons that it may be advisable to fund trusts with retirement assets. For example, a trust can be used to optimize a decedent’s exemption from federal and New Jersey estate taxes. Under current law, beginning on January 1, 2011, the exemption from federal estate tax will be $1,000,000 and the exemption from New Jersey estate tax will be $675,000. A trust could be designated as the beneficiary of retirement benefits to use such exemptions. In addition, trusts can be helpful in protecting children or grandchildren who may have spendthrift tendencies.

Paramount to planning with retirement benefits is “stretching” the mandatory distributions so that the income tax triggered by such distributions is deferred to the maximum extent. The key here is to qualify the trust as a “designated beneficiary” under the Internal Revenue Code.

In PLR 201021038, mother and father created a revocable trust that provided for the establishment of a testamentary trust upon the death of the first spouse. Some estate planners refer to this form of trust as a bypass trust. Upon the death of the first spouse, the bypass trust captures the deceased spouse’s exemption from federal and state estate taxes. Mother died first. After her death, father designated the bypass trust as the beneficiary of his IRA. When father died all of the various testamentary trusts created by mother, including the bypass trust, were collapsed. The assets from the collapsed trusts were distributed to what the ruling referred to as “protective” trusts for each of their daughters. 

The trusts for the daughters were what are generally referred to as “accumulation” trusts. The trustee of the respective protective trust had the discretion to distribute appropriate amounts of income and principal for the health care, maintenance, support and education of the respective daughter. There was no requirement for mandatory distributions to the respective daughter.

Also under the protective trusts, the daughters each had a broad power of appointment over the assets of her protective trust, which power extended to descendents of the daughters or to charities.

As a general rule, only individuals can meet the definition of a designated beneficiary under the code. If a person other than an individual is designated as a beneficiary, the IRA owner will be treated as having no designated beneficiary and accelerated income taxation shall result because the distributions cannot be paid out over the lifetime of the beneficiary. For example, if an estate is designated as an IRA beneficiary, accelerated distributions are mandated.

Contact Lum, Drasco & Positan

Lum, Drasco & Positan LLC
103 Eisenhower Parkway
Suite 401
Roseland, NJ 07068
Phone: 973-403-9000
Fax: 973-403-9021

Our law office is located in Roseland, New Jersey.

To speak with an attorney at our firm about your legal needs, call 973-403-9000.

Letters of Intent: Use Caution in Drafting to Avoid the Unintended

Letters of Intent: Use Caution in Drafting to Avoid the Unintended

By: Jack P. Baron

Though not every transaction commences with a letter of intent (LOI), the use of letters of intent has become more frequent, particularly given the uncertain economic environment during the last several years. An LOI can be a useful preliminary step in the negotiation of commercial transactions, which often require substantial time, due diligence and expense prior to the parties proceeding to a formal agreement. 

Use of a well-drafted LOI to confirm expectations regarding certain key aspects of the transaction, often will provide the parties the requisite level of comfort needed before investing the time, effort and expense of moving the transaction beyond the LOI stage. As an example, a potential purchaser of a business may be reluctant to incur the costs associated with the drafting and negotiation of a contract, as well as the obligations arising thereunder. An LOI containing a due diligence period, among other provisions, may provide the purchaser with sufficient information and confidence to proceed to the next stage of drafting and negotiating the contract.

Inasmuch as many clients and practitioners may be more familiar with drafting the definitive acquisition documents (such as an asset purchase agreement or stock purchase agreement), they may underestimate the importance of properly drafting the LOI, so that neither party is subject to unintended obligations, liabilities or consequences. In addition, practitioners may be under the misimpression that an LOI is not binding, when, in fact, the LOI may be binding, in whole or in part, either by design or as the result of inartful drafting.

To What Extent, if Any, is the LOI Binding?

Whether an LOI is binding on the parties depends on the intent of the parties. “If the parties intend to be bound by their preliminary agreement and view the later written contract as merely a memorialization of their agreement, they are bound by the preliminary agreement.”1 “On the other hand, if the parties intend that their preliminary agreement be subject to the terms of their later contract, they are not bound by the preliminary agreement.”2 The language of the prelimi­nary agreement, the course of dealing between the parties before and after the preparation and execution of the preliminary agreement, and the facts surrounding its preparation are factors a court will consider in deter­mining whether the parties intended to be bound by the preliminary agreement³.

On the one hand, parties to a transaction frequently are concerned that the LOI will constitute a binding contract, requiring them to proceed with and consum­mate the underlying transaction. On the other hand, the parties often want to be bound by specific provisions of the LOI, such as due diligence, confidentiality, exclusiv­ity and various other provisions.

Avoiding Construction of the LOI as a Binding Contract

If it is the intent of the parties not to be bound by the LOI, the following points should be considered when drafting an LOI in order to avoid creating a bind­ing contract:

1. The LOI should clearly, unambiguously and unequivocally state that the LOI is not intended to be a binding contract, is not an offer to proceed to contract, and should not be construed as a contract or offer to contract.

2. The LOI should also state that the parties do not intend to be bound by the terms of the LOI, unless and until the parties agree upon and execute a definitive agreement (such as an asset purchase agreement or stock purchase agreement, as the case may be).

3. Limiting the inclusion of material terms likely indicates that the parties intend not to be bound by the LOI, but rather by a formal, definitive agreement following the LOI. Examples of such material terms and details would be purchase price, representations and warranties, terms of indemnification, closing date and the like. The LOI should specify the terms that have not been agreed upon, and that are subject to further negotiation. The LOI should further provide that the parties intend not to be bound unless and until all terms have been negotiated and agreed to in an executed definitive agreement. 

4. Similarly, deferring inclusion of certain key aspects of a transaction from the LOI stage to the signing of the definitive agreement tends to indicate that the parties intend not to be bound by the LOI. Examples of such elements would include commencement of the due diligence period, undertaking of search and title work and tendering of the deposit. The deferral of due diligence may be unacceptable to the purchaser given that many purchasers want to commence due diligence once the LOI is signed.

5. Specify a deadline by which the definitive agreement must be reached. Further provide that if the parties fail to negotiate a definitive agreement within the specified time frame, negotiations shall cease and the parties shall have no further obligation to one another.

Contact Lum, Drasco & Positan

Lum, Drasco & Positan LLC
103 Eisenhower Parkway
Suite 401
Roseland, NJ 07068
Phone: 973-403-9000
Fax: 973-403-9021

Our law office is located in Roseland, New Jersey.

To speak with an attorney at our firm about your legal needs, call 973-403-9000.

Contact Lum, Drasco & Positan

Lum, Drasco & Positan LLC
103 Eisenhower Parkway
Suite 401
Roseland, NJ 07068
Phone: 973-403-9000
Fax: 973-403-9021

Our law office is located in Roseland, New Jersey.

To speak with an attorney at our firm about your legal needs, call 973-403-9000.

NJ Outline on Accounting & Auditing Liability Issues

New Jersey Outline on Accounting and Auditing Liability Issues

A. Nature of Malpractice Claim (Tort, Contract, etc) 

In New Jersey, accountant liability is governed by the Accountant Liability Act (“the Act”), which provides that an accountant will be liable for negligence arising out of and in the course of rendering accounting services to a client¹. However, under the Act an accountant is not insulated from liability for intentional conduct, including aiding and abetting or fraud²

B. Standing/Existence of Duty

1. Clients

In New Jersey, under the Act a “client” is defined as the party directly engaging an accountant to perform a professional accounting service³. The Act specifically limits the liability of accountants to claims raised by clients, except for limited statutorily proscribed circumstances where knowledge and intent to rely upon the services of the accountant is established at the time of the work. Under New Jersey law an accountant’s liability is defined by the scope of the engagement it entered⁴. The duty owed to another is defined by the relationship between the parties and any negligence must be based on the scope of that, or related, understandings and agreements to determine whether the defendant violated any duty⁵. However, it has been held that an accountant did not have a duty to a third-party claimant when there was no contractual relationship between the parties⁶.

2. Trustees and Receivers

In New Jersey, the receiver or trustee of an insolvent or liquidated business has standing to assert accounting malpractice claims based upon duties to the prior business. New Jersey Courts may recognize a “deepening insolvency” theory to support such claims against accountants⁷. Such a claim contends that the accountant artificially prolonged, or contributed to the artificial prolongation of, the business’s life, thereby increasing the debt, depleting the assets and increasing exposure to creditors⁸.

3. Assignees of Clients

In New Jersey the assignment of an accounting malpractice claim may be recognized, but the assignee can have no greater rights than the assignor and can recover no more than the assignor could have recovered⁹.

4. Third Parties/Non-Clients

In New Jersey liability to non-client, based upon negligence, requires satisfaction of a three-prong statutorily proscribed test. Under the Act, an accountant will not be liable for damages arising from negligent professional accounting services unless the claimant was the account’s client or all three criteria are established¹⁰. Under the Act, non-client liability requires the claimant to establish: (1) the accountant knew at the time of the engagement that the accounting services would be made available to the claimant¹¹; (2) the accountant knew the claimant intended to rely upon the accounting services in connection with a specified transaction; and (3) the accountant directly expressed to the claimant by words or understanding to the claimant that the accountant understood that the claimant would rely upon the services¹². However, in the case of a non-client bank claimant, the accountant must have acknowledged the bank’s intended reliance on the accounting service in a written communication¹³.

Contact Lum, Drasco & Positan

Lum, Drasco & Positan LLC
103 Eisenhower Parkway
Suite 401
Roseland, NJ 07068
Phone: 973-403-9000
Fax: 973-403-9021

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General Jurisdiction and Multijurisdictional Practice

General Jurisdiction and Multijurisdictional Practice Following Daimler AG v. Bauman

By Wayne J. Positan

I. Introduction

Technology has made the world of lawyers a smaller, more interconnected place, with multijurisdictional practice across state and national boundaries now commonplace. Still, to borrow a line from Dorothy, often there’s no place like home when establishing personal jurisdiction for malpractice defense of a law firm or attorney in a transnational or interstate matter.

In light of recent case law developments, some corporations and multistate law firm defendants now face better odds of transferring claims by out-of-state plaintiffs to a preferred home jurisdiction on general jurisdiction grounds. Plaintiffs in such cases who are reluctant to bring suit where the activities giving rise to the claim actually occurred no longer can simply pick any forum (such as plaintiff’s home forum) where the defendant has been doing business generally. Now, for general jurisdiction to attach to defendants in such cases, the forum state must, with few exceptions, be either the state of incorporation or the headquarters location of the defendant. Consequently, the plaintiff’s opportunity to engage in forum shopping has been significantly limited. For law firm and attorney defendants, better odds of defending in the home jurisdiction may offer the great advantage of conserving litigation resources and reducing uncertainty.

This article will examine the impact of the United States Supreme Court decisions in Goodyear Dunlop Tires Operations, S.A. v. Brown, 131 S. Ct. 2846 (2011) and Daimler AG v. Bauman, 134 S. Ct. 746 (2014), as they relate to malpractice suits against law firms engaged in multijurisdictional practice. Here the term “multijurisdictional” refers to either transnational practice or practice in more than one US state, district, or territory either in litigation or transaction matters. The developments in Daimler and Goodyear ultimately will be beneficial to many prospective defendants from a liability risk standpoint. But in order to limit the number of jurisdictions in which a multistate law firm is properly considered “at home,” multistate law firms would be well advised to have a clearly defined headquarters, and to consider locating the firm’s headquarters in the state of registration or incorporation.

II. A Civil Procedure Refresher

As a brief civil procedure refresher, jurisdiction over a nonresident defendant can only be asserted where it is consistent with the Due Process Cause and is authorized by a state long-arm statue. The due process hurdle is met where either general or specific jurisdiction is established. General jurisdiction allows the nonresident defendant to be sued in a forum state, irrespective of the nature of the cause of action and even if the factual allegations are not connected with the defendant’s forum-state-related activities. International Shoe v. State of Washington, 326 U.S. 310, 320 (1945). Instead, general jurisdiction was traditionally established through the court’s analysis of all “systematic and continuous” affiliations of the nonresident defendant with the forum state. Id. On the other hand, specific jurisdiction over a nonresident defendant exists where the actual claims at issue in the suit arise out of the defendant’s actual contacts with the forum state. Helicopteros Nacionales de Colombia. S.A. v. Hall, 466 U.S. 408, 414 (1984). The specific jurisdiction inquiry focuses solely upon whether the nonresident defendant’s contacts with the forum state serve as the basis of the cause of action, and no consideration is given to the extent and nature of the foreign defendant’s unrelated contacts to the forum state. Id. 

In a very significant departure from precedent on the controlling jurisdiction analysis, in Goodyear and Daimler, the Supreme Court clarified that a multistate corporation will generally only be subject to suit in the state where it is incorporated or where its headquarters is located. This change in jurisdictional jurisprudence has critical implications for multistate law firms or law firms engaged in multijurisdictional practice, in connection with legal malpractice claims brought by out-of-state plaintiffs. By doing away with decades of federal and state jurisprudence, the Supreme Court has limited the prior “presence jurisdiction” standard and shifted the focus to whether a corporation or partnership can reasonably be considered “at home” in the forum state. For a corporation, “the place of incorporation and the principal place of business are considered the paradigm ‘bases’ for general jurisdiction.” Daimler, supra, 134 S. Ct. 746, 760 (quoting Goodyear, supra, 131 S. Ct. 2846, 2854). Following Daimler, courts have applied the “at home” standard to law firm defendants, whether they are organized as limited liability companies or as professional corporations. A court may assert jurisdiction over a case-in-controversy where either general or specific jurisdiction is established. However, a plaintiff may be able to successfully oppose transfer on specific jurisdiction grounds, if the conduct which forms the basis of the plaintiff’s claim arises from the defendant-attorney’s purposeful availment of the laws of the forum state.

It must be noted that the Daimler decision does not alter the standard for establishing specific jurisdiction over a law firm defendant. Where a law firm purposefully directs its activities to the forum state and the malpractice cause of action arises from those actions, a plaintiff can properly obtain specific jurisdiction over a law firm defendant in the forum state. Further, the locus of the underlying litigation or the transaction giving rise to the claim will generally be sufficient to allow the exercise of specific jurisdiction over the law firm in the forum state.

But following Daimler, issues surrounding the exercise of general jurisdiction over a law firm defendant are open to reexamination. As multijurisdictional practice becomes more common due to the ease of interstate travel and Internet communication, the frequency with which an aggrieved client may seek to initiate a legal malpractice complaint in its home jurisdiction will also rise. This change in law has implications for forum shopping by plaintiffs as well as the time and expense of defending a malpractice action in a distant or unfriendly jurisdiction. This article will explore the new contours of the exercise of general jurisdiction against law firm defendants following Goodyear and Daimler.

III. The Daimler AG v. Bauman Decision

In Daimler, the Supreme Court put an important gloss on the Goodyear decision, refining the rule as to where exactly, a corporation’s “home” is, for general jurisdiction purposes. In Goodyear, where the Supreme Court established the “systematic and continuous contacts” test of general jurisdiction, the Court reversed a North Carolina court’s assertion of jurisdiction over the foreign subsidiaries of a U.S. tire manufacturer. The plaintiffs were the parents of two North Carolina minors that were killed in a bus crash in France, and it was alleged that the crash was caused by a defective tire manufactured by the foreign subsidiaries. Id. at 2850-2851. The plaintiffs argued that general jurisdiction could be exercised over the foreign subsidiaries because their products reached North Carolina through the stream of commerce. Id. at 2852. The Supreme Court held that jurisdiction could not be established over the foreign subsidiaries in this manner, reasoning that a plaintiff seeking to establish general jurisdiction must demonstrate a foreign defendant’s continuous corporate operations within a state, so substantial and of such a nature as to render them essentially at home in the forum state. Id. at 2855. The Goodyear decision, in part, shifted the focus from the nature of the contacts, to whether the corporation could reasonably be considered “at home” in the forum state, based upon these circumstances.

In Daimler AG v. Bauman, 134 S. Ct. 746, 760-761 (2014), the US Supreme Court further modified the “systematic and continuous” standard in its analysis of general jurisdiction, and clarified precisely where a corporation will be considered “at home.” There, the plaintiffs, twenty-two Argentina residents, filed suit against a German corporation, Daimler, claiming that its wholly owned subsidiary collaborated with Argentina’s state security forces during the 1976-1983 “Dirty War,” leading to the detention, torture, and death of Argentina residents, including the plaintiffs and their relatives, who were employed by Daimler’s subsidiary. Id. at 750-751. The question before the Supreme Court was whether Daimler’s affiliations with the State of California were sufficient to subject it to the general jurisdiction in California.

The Supreme Court reasoned that “only a limited set of affiliations with a forum will render a defendant amenable to all-purpose jurisdiction” in the forum state and determined that general jurisdiction in California was improper. Id. at 760. “[W]ith respect to a corporation, the place of incorporation and principal place of business” are the paradigm “bases” for general jurisdiction. Id. This holding rejected the traditional standard expansively allowing the exercise of general jurisdiction in every state in which a corporation “engage[d] in a substantial, continuous and systematic course of business.” Rather, the Court clarified, citing Goodyear, “[T]he proper inquiry, this Court has explained, is whether a foreign corporation’s “affiliations with the State are so ‘continuous and systematic’ as to render [it] essentially at home in the forum State.” Goodyear [reporter citation omitted]. The Daimler court further reasoned: “Neither Daimler nor [its affiliate] MBUSA is incorporated in California, nor does either entity have its principal place of business there. If Daimler’s California activities sufficed to allow adjudication of this Argentina-rooted case in California, the same global reach would presumably be available in every other State in which MBUSA’s sales are sizable. No decision of this Court sanctions a view of general jurisdiction so grasping.” The Court in Daimler thus greatly limited those jurisdictions where a defendant corporation or partnership that is operating in multiple jurisdictions could be deemed subject to general jurisdiction.

While the place of incorporation and the location of the headquarters were referred to as the primary “bases” for an exercise of general jurisdiction, the Supreme Court did not foreclose the possibility that a corporation’s “operations in a forum other than its formal place of incorporation or principal place of business may be so substantial and of such a nature as to render the corporation at home in that State.” Id. at 761 n. 19.

Some courts have specifically interpreted Daimler as effecting a drastic change in the law affording corporate defendants a previously unavailable personal jurisdiction defense. See Gucci America, Inc. v. Weixing Li, 768 F.3d 122, 135 (2d Cir. 2014); 7 W. 57th St. Realty Co., LLC v. CitiGroup, Inc., 2015 U.S. Dist. LEXIS 44031, *22 (S.D.N.Y. Mar. 31, 2015). The new recitation of the standard “bases” for general jurisdiction set forth in Daimler has significant implications for multi-state law firms and law firms engaged in multijurisdictional practice.

IV. Specific Jurisdiction

Any general jurisdiction analysis applying Daimler and Goodyear to attorney liability in a multijurisdictional practice setting, should start with recognition that the established legal standard for specific jurisdiction was not adjusted by the new rule. Provided that the selected forum state’s long arm statute permits personal jurisdiction over nonresidents to the extent allowed by the Due Process Clause of the Fourteenth Amendment, the issue turns upon whether the exercise of jurisdiction comports with due process. Specific jurisdiction over a defendant is satisfied where the defendant purposefully avails himself or herself of the laws of the forum state. Burger King Corp. v. Rudzewicz, 471 U.S. 462, 475 (1985). In general, where an attorney purposefully directs his activities to the forum state and the cause of action arises from those contacts, specific jurisdiction in the forum state will attach for a malpractice claim arising from those activities. See, e.g., Reliance Steel Products Co. v. Watson, Ess, Marshall & Enggas, 675 F.2d 587, 589 (3d Cir. 1982). However, specific jurisdiction over a nonresident defendant must arise from contacts the defendant itself has created with the forum state, as the “plaintiff cannot be the only link between the defendant and the forum.” Walden v. Fiore, 134 S. Ct. 1115, 1121 (2014).

Thus, where an out-of-state attorney appears pro hac vice in a matter in the forum state, it has been held there is a near presumption that specific jurisdiction is appropriate in claims arising from the matter in which the attorney was admitted pro hac vice. Jackson v. Kincaid, 122 S.W.3d 440, 449-450 (Tex. App. 2003) rev’d on other grounds. The procedural rules of some jurisdictions require that attorneys being admitted pro hac vice consent to the jurisdiction in the state for disciplinary matters or malpractice suits arising from the case in which pro hacvice was granted. Mississippi Rule of Appellate Procedure 46(6) (requiring an attorney to submit an affidavit consenting to jurisdiction); New Jersey Court Rule 1:21(2)(c)(2) (requiring an order appointing the Clerk of the State Supreme Court as agent for service upon pro hacvice attorney). Even when an attorney is admitted pro hac vice in a related case, if a nexus exists between the defendant attorney’s pro hac vice admission in the forum state and the underlying cause of action asserted by the legal malpractice plaintiff, specific jurisdiction may properly be exercised in the forum state. See Klein Frank, P.C. v. Girards, 932 F. Supp. 2d 1203, 1211 (D. Colo. 2013).

V. General Jurisdiction Applied

a. Introduction

As noted above, following Goodyear and Daimler, general jurisdiction can only be exercised over a corporate defendant if the defendant is reasonably considered at home in the forum state, which is interpreted as either the place of incorporation of the location of the headquarters. While Goodyear and Daimler involved corporations, recent precedent suggests that their holdings will apply equally to law firms organized as limited liability partnerships or professional corporations. See Cromenas v. Morgan Keegan & Co., Inc., No. 2:12-CV-04268-NKL, 2014 WL 1375038, at * 13-15 (W.D. Mo. Apr. 8, 2014)(dismissing suit against limited liability partnership based upon lack of contacts with forum state). Despite the manner in which legal malpractice complaints are frequently pled, general jurisdiction over a defendant law firm cannot be established on the basis of the residency or location of the claimant or the unilateral actions of a third party. See Keeton v. Hustler Magazine, Inc., 465 U.S. 770, 775 (1984). Contact with attorneys via phone or email is generally considered insufficient to trigger jurisdiction over an attorney. E.g., Porter v. Berall, 293 F.3d 1073, 1076 (8th Cir. 2002).

b. Residency/Bar License of a Partner in the Forum State

Plaintiffs frequently seek to exercise general jurisdiction over an out-of-state law firm based upon the residency or possession of a law license by one or multiple partners in the forum state. Based upon the decisions in Goodyear and Daimler, it appears that such contentions, on their own, would be insufficient to trigger general jurisdiction, as they would not reasonably establish that the firm would be considered “at home” in the forum state. In Cromenas v. Morgan, the plaintiff asserted that general jurisdiction was proper over an out-of-state law firm in Missouri because four of the approximately 800 attorneys possessed active Missouri bar licenses. Id. at *12. The plaintiffs based this argument upon standard partnership principles, arguing that the activities of one partner are generally attributable to the partnership. Id. at *12-13. A Missouri district court held that general jurisdiction over the firm was improper based upon the possession of a Missouri bar license by four members of the firm. Id. The Cromenas court clarified that if a partner of the firm possessed a Missouri bar license and utilized that license to practice law within Missouri, then specific jurisdiction would be proper “by reason of the activities.” (citations omitted). The Court reasoned that general jurisdiction was improper because the complaint was “not related in any manner to the Missouri bar licensed partners’ contacts with Missouri.” Id. at 13.

Prior to Goodyear and Daimler, the mere residency of a partner, without further contacts, was generally considered insufficient to trigger general jurisdiction in the forum state. E.g., Pappas v. Arfaras, 712 F.Supp. 307, 311 (E.D.N.Y.1989) (“mere fact” that limited partners of defendants were New York citizens does not amount to purposeful activity within the state); Citibank, N.A. v. Estate of Simpson, 676 A.2d 172, 177 (N.J. App.Div. 1996) (personal service of partner unrelated to transaction in New Jersey was insufficient establish general jurisdiction). Given the newly announced focus upon whether the partnership is considered “at home” in the forum state, the existence or presence of a minority of unrelated partners in the forum state is also unlikely to subject the partnership to general jurisdiction in the forum state.

c. Clients and Solicitation in Forum State

Goodyear and Daimler and their progeny also now appear to preclude establishment of general jurisdiction over a foreign law firm on the grounds that the defendant firm has represented other clients – besides plaintiff – located in the forum state or directing marketing efforts toward potential clients in the forum state. It is well established that representation by an out-of-state law firm does not, by itself, establish general jurisdiction in the home state of the client. E.g., Dillon v. Murphy & Hourihane, LLP, No. 14-cv-01908-BLF, 2014 WL 5409040, at *4 (N.D. Cal. Oct. 22, 2014). A Nevada federal district court, in declining to exercise general jurisdiction over a California law firm, drew an important distinction between “doing business” in a state and being considered “at home” in a state. Couvillier v. Dillingham & Assoc., No. 2:14-cv-00482-RCJ-NJK, 2014 WL 3666694, at *3 (D. Nev. July 23, 2014). Moreover, in light of the Goodyear and Daimler decisions, the fact that a firm represents unrelated clients in the forum state is insufficient to ascribe general jurisdiction to the firm in the forum state. See Cromenas, supra, 2014 WL 1375038, at *13-14. Interestingly, the Couvillier court did not directly explain its application of Daimler’s jurisdictional language regarding the home state of a corporation to a California law firm. The Nevada District Court merely noted “[t]here is no general personal jurisdiction over Dillingham, a California law firm, in Nevada, because Dillingham is not alleged to be ‘at home’ in Nevada, but is only alleged to ‘do[] business’ in Nevada, however extensively.” It should be qualified that this change in law only relates to general jurisdiction and is therefore somewhat limited. Specific jurisdiction is likely to apply to any circumstances where a foreign law firm engages in the representation of a client concerning a legal issue within the forum state and the complaint arises from that set of circumstances.

Practitioners should also be aware that how the defendant law firm is organized may be relevant to the extent that it relates to so-called “tag jurisdiction.” In the past, physical presence of a foreign individual defendant in a state was sufficient to confer personal jurisdiction. Burnham v. Superior Court, 495 U.S. 604, 619 (1990). In First American Corp. v. Price Waterhouse LLP, 154 F.3d 16 (2d Cir. 1998), a preDaimler case, the Second Circuit U.S. Court of Appeals allowed general jurisdiction over a partnership based on in-state service on one of its partners. In contrast, courts have refused to allow tag jurisdiction where personal service is effected on a director or officer of a corporation while that individual is physically present in the forum state. See Martinez v. Aero Caribbean, 764 F.3d 1062, 1069-70 (9th Cir. 2014); Topnotch Tennis Tours, LLC, 2014 U.S. Dist. Lexis 160271, *6-7 (E.D.N.Y., November 14, 2014). In reaching the holding that the “at home” standard articulated in Daimler is not satisfied where an officer is personally served in the forum state, in Martinez the Ninth Circuit explicitly did not extend the decision to partnerships stating “partnerships differ from corporations in the important respect that a partnership (unlike a corporation) has no separate existence from its partners.” Martinez, supra, 764 F.3d at 1069 (internal quotations omitted). In this regard, practitioners seeking to invoke the Daimler defense to personal jurisdiction for a law firm organized as a professional corporation or limited liability partnership might consider analogizing that entity to a corporation, to distinguish it from a partnership.

Prior to Daimler, in some jurisdictions, a defendant’s solicitation of business in the forum state was considered a factor supporting a sufficient-contacts finding in the forum state and the exercise of general jurisdiction. E.g., Grynberg v. Ivanhoe Energy, Inc., 490 Fed. Appx. 86, 95 (10th Cir. 2012) (solicitation of business is a factor considered by a court considering general jurisdiction). While the issue has not been conclusively resolved in a majority of jurisdictions, the fact a law firm actively solicited business in the forum state should not support general jurisdiction under the new “at home” jurisdictional standard advanced by Daimler. It appears fully consistent with Daimler that a law firm’s active solicitation of business in another jurisdiction should not influence the analysis of that firm’s “home” state, for general jurisdiction purposes. Again, the home state for these purposes will typically be the state of incorporation/registration or the location of the headquarters. 

d. The Ramifications of Temporary Practice and Appearance in Forum State

Prior to Daimler and Goodyear, evidence that attorneys from a foreign law firm were admitted pro hac vice into the state or federal courts of the forum state was insufficient to establish general jurisdiction over the law firm. See, Cerberus Partners, L.P. v. Gadsby & Hannah, LLP, 836 A.2d 1113, 1116 (R.I. 2003) (multiple pro hac vice appearances by a national law firm were deemed insufficient to establish general jurisdiction in Rhode Island); Wolk v. Teledyne Indus., Inc., 475 F.Supp.2d 491, 502 (E.D. Pa. 2007) (pro hac vice appearance in an unrelated matter in the forum state failed to establish general personal jurisdiction”). The “at home” standard of Daimler further supports this determination, as the act of seeking approval for pro hac vice admission and affiliating with local counsel for a specific case confirms that the firm cannot be reasonably considered “at home” in the forum state and therefore subjected to all-purpose jurisdiction on unrelated matters. See Cromenas, supra, 2014 WL 1375038, at *12 (limited and primarily pro hac vice appearances in Missouri do not suggest that a law firm . . . is at home in Missouri).

However, following Daimler, courts have clarified that jurisdiction by consent of the defendant remains a valid and binding method for asserting jurisdiction. In Senju Pharm. Co., Ltd. v. Metrics, Inc., 2015 U.S. Dist. LEXIS 41504, *22 (D.N.J. Mar. 31, 2015), a District Court held that service was proper where the nonresident defendant had an agent authorized to accept service within the forum state. The Court made a distinction, however, between registering to do business in the state and accepting service in the state by an authorized agent, and noted that registering to do business in a state, without service upon a registered agent would likely not be sufficient to trigger consent jurisdiction. Id.

VI. Conclusion

Under Daimler, there is some leeway for consideration of the totality of the circumstances and the specific factors giving rise to the plaintiff’s assertion of general jurisdiction. The place of incorporation/registration and the location of the firm’s headquarters, however, are considered the paradigm “bases” for jurisdiction. In light of Goodyear and Daimler and their progeny, law firm defendants and defense counsel would be well guided to consider jurisdictional issues at the outset of cases and consider jurisdictional motions to dismiss in order to litigate in more appropriate and convenient “home” forums. The mere existence of multijurisdictional practice under ABA Model Rule 5.5 does not mean an attorney or law firm will be subject to general jurisdiction in each jurisdiction where practice occurs. In order to limit the number of jurisdictions in which a multistate law firm is properly considered “at home,” multistate law firms would be well guided to have a clearly defined headquarters, and to perhaps ensure that the headquarters is located within the state of registration or incorporation. And it should be noted that a forum selection clause in an attorney engagement agreement is another effective tool, permissible in many jurisdictions, for removing or reducing uncertainty as to eventual forum, in the event of a subsequent legal malpractice claim. See XR Co. v. Block & Balestri, P.C., 44 F. Supp. 2d 1296, 1300 (S.D. Fla. 1999). The developments in Daimler and Goodyear are ultimately beneficial from a risk liability standpoint, as a plaintiff’s ability to engage in forum shopping has been significantly limited, and some of the uncertainty concerning where a case will proceed has been curtailed.

Published in The Professional Lawyer, Volume 23, Number 3, ©2016 by the American Bar Association. Reproduced with permission. All rights reserved. This information or any portion thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association.

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Our law office is located in Roseland, New Jersey.

To speak with an attorney at our firm about your legal needs, call 973-403-9000.

The Economic Loss Doctrine in New Jersey

THE ECONOMIC LOSS DOCTRINE IN NEW JERSEY – APPLICATION AND EXCEPTIONS

By: Paul Alain Sandars III

Introduction

The Economic Loss Doctrine stands for the simple proposition that a party cannot recover for purely economic losses under tort theories where contractual remedies are available. Construction projects are comprised of numerous contracts between and among various parties. Thus, while a general contractor may have a contract with a project owner, the project architect or engineer is usually not a party to that contract subject instead to its own contractual arrangement with the project owner. Therefore, claims for money damages on a construction project must be made against a party with whom privity exists. This is the so-called “majority rule” which is adopted in New Jersey.

Since the Economic Loss Doctrine as it applies to construction projects is non-statutory, many reported and unreported decisions are seemingly contradictory and therefore analysis of the cases follows with the adage that perhaps the “exception swallows the rule”.

It is well-settled that the Economic Loss Doctrine prevents a party from being able to collect in negligence for solely pecuniary harm that is unaccompanied by personal injury or damages to property. 6 Bruner & O’Connor on Construction Law § 19:10 (“BOCL”). As stated above, New Jersey follows the majority rule of the Economic Loss Doctrine that a plaintiff cannot recover purely economic damages in tort. Thus, damages consisting of personal injury or damages to property are excluded from the ambit of the Economic Loss Doctrines’ claim preclusion. In addition, willful or malicious conduct causing damage is likewise not barred by the Doctrine.

In the construction law context, actions for recovery of damages from costs of repair or replacement of defective products, adequate value, consequential loss of profits, delay damages, and claims for differing site conditions are all considered purely economic and therefore are subject to the bar of the Doctrine. Alloway v. General Marine Insurance, 149 N.J. 620 at 627 (1997). The personal injury or property damage exclusions to the Economic Loss Doctrine do not appear to be at issue and are consistently applied.

While the second exception for lack of privity or a lack of contract is somewhat blurred, parties to construction projects are free to allocate risk by contract for reasonably foreseeable damages.

 

The Origins of the Economic Loss Doctrine in Commercial Transactions and Subsequent Application to Construction Projects

It is well settled that the Economic Loss Doctrine bars a tort remedy where an action arises from a contractual relationship. New Jersey courts have consistently held that contract law is better suited to resolve disputes which were within the contemplation of, or which could have been the subject of negotiation between parties to an agreement. Spring Motors Distribution v. Ford Motor Company, 98 N.J. 555, 489 A2d 660, 666, 670-71 (1985); Alloway v. General Marine Indus., 149 N.J. 620, 695 A.2d 264, 268, 275 (1997); Dean v. Barrett Homes, Inc., 406 N.J. Super. 453, 968 A.2d 192, 203-04 (App. Div. 2009); Menorah Chapels at Milburn v. Needle, 386 N.J. Super.100, 899 A.2d 316, 323-35 (App. Div. 2006).

In Spring Motors Distribution v. Ford Motor Company, 98 N.J. 555 (1985), the New Jersey Supreme Court considered whether a commercial buyer should be permitted to pursue a cause of action predicated upon principles of negligence and strict liability, solely for economic loss caused by the purchase of defective goods, or should instead be restricted to a cause of action under the Uniform Commercial Code. Id. at 560. The court held that “a commercial buyer seeking damages for economic loss resulting from the purchase of defective goods may recover from an immediate seller and a remote supplier in a distributive chain for breach of warranty under the UCC, but not in strict liability or negligence.” Id. at 561. Critical to the Doctrine was the Court’s rationale highlighting the distinctions between tort and contract duties and principles:

  • The purpose of a tort duty of care is to protect society’s interest in freedom from harm, i.e., the duty arises from policy considerations formed without reference to any agreement between the parties. A contractual duty, by comparison, arises from society’s interest in the performance of promises. Generally speaking, tort principles, such as negligence, are better suited for resolving claims involving unanticipated physical injury, particularly those arising out of an accident. Contract principles, on the other hand, are generally more appropriate for determining claims for consequential damage that the parties have, or could have, addressed in their agreement. [Id. at 579-80.]

Several years later, in Alloway v. General Marine Indus., 149 N.J. 620, 695 A.2d 264 (1997), where a purchaser of a boat sought to recover for economic losses from both the dealer and the manufacturer, the Court expanded upon the principles in Spring Motors, plainly disfavoring the application of tort law in what is an otherwise clearly contractual context. The Court in Alloway concluded that the purchaser’s tort claims were barred by the Economic Loss Doctrine, and noted that: “[i]mplicit in the distinction” between tort and contract principles “is the Doctrine that a tort duty of care protects against the risk of accidental harm and a contractual duty preserves the satisfaction of consensual obligations”. [Id. at 268]

Our Supreme Court has explained that, “economic loss encompasses actions for the recovery of damages for costs of repair, replacement of defective goods, inadequate value, and consequential loss of profits.” Alloway v. Gen. Marine Indus., 149 N.J. 620, 627 (1997). In Saltiel v. GSI Consultants, Inc., 170 N.J. 297 (2002), the Supreme Court emphasized that economic losses have no place in tort, because, “generally speaking, there is no general duty to exercise reasonable care to avoid intangible economic loss or losses to others that do not arise from tangible physical harm to persons and tangible things.” Saltiel at 310, quoting Prosser & Keeton

The Doctrine enunciated in Spring Motors and Alloway has been specifically applied to transactions involving construction and design. In New Mea Construction Corp. v. Harper, 203 N.J. Super. 486 (App. Div. 1985), a builder sued a homeowner alleging that sums were due and owing for the construction of a single-family residence. Id. at 489. The homeowner’s counterclaims for negligent supervision and negligent workmanship were dismissed because there was no personal injury or consequential property damages suffered. Id.

In Dean v. Barrett Homes, Inc., 204 N.J. 286 (2010) the Court summarized the history of the Economic Loss Doctrine in New Jersey, and discussed its application in determining whether a claim sounds in tort or contract. The Dean court affirmed the principles outlined in Spring Motors, namely that, “when addressing economic losses in commercial transactions, contract theories were better suited than were tort-based principles of strict liability”. Id. at 296.

These principles were reiterated in Spectraserve, Inc. v. The Middlesex County Utilities Auth., et al., 2013 N.J. Super. Unpub. LEXIS 2173, (Law Div. 2013), which held that the Economic Loss Doctrine barred a plaintiff’s negligence claim, finding that the plaintiff could have invoked remedies by virtue of its contract with another party in the case. Spectraserve outlined the particular policies underpinning the Economic Loss Doctrine which apply in litigation of construction disputes:

  • In the context of larger construction projects, multiple parties are often involved. These parties typically rely on a network of contracts to allocate their risks, duties, and remedies. Construction projects are multiparty transactions, but it is rarely the case that all or most of the parties involved in the project will be parties to the same document or documents. In fact, most construction transactions are documented in a series of two-party contracts, such as owner/architect, owner/contractor, and contractor/subcontractor. Nevertheless, the conduct of most construction projects contemplates a complex set of interrelationships, and respective rights and obligations. [Spectraserve, at *26-27]

In Horizon Group of New England, Inc. v. New Jersey Schools Construction Corp., et al., 2011 N.J. Super. Unpub. LEXIS 2271 (App. Div. 2011), the court was faced with extra work and differing site conditions claims. The Horizon Group court held that:

  • [A] plaintiff with a direct contractual relationship [and] with contractual remedies to address changes in the scope of work or unexpected conditions [cannot] jettison these remedies and procedures and proceed on a tort theory of recovery. Id. at 20.

The court affirmed that the Economic Loss Doctrine “bars resort to tort theories of liability when the relationship between the parties is based on a contractual relationship”. Id. at 13, citing Dean v. Barrett Homes. Inc.

As stated above, New Jersey law has long recognized that purely economic loss, if reasonably foreseeable, is recoverable against the party in the absence of contractual privity. Conforti & Eisele, Inc. v. John C. Morris Associates, 175 N.J. Super. 341 (Ch. Div. 1980) aff’d 199 N.J. Super. 498 (App. Div. 1985), and People Express Airlines, Inc. v. Consolidated Rail Corp., 100 N.J. 246 (1985).

In Conforti, the Superior Court held that a design professional was chargeable in tort to a contractor who has sustained purely economic damages as a result of the negligence of the design professional in the absence of privity of contract between the two entities. Conforti, at 344. The court held that denying the contractor the ability to bring a tort claim under these circumstances, “would in effect, be condoning a design professional’s right to do his job negligently or with impunity as far as innocent third parties who suffer economic loss. Public policy dictates that this should not be the law. Design professionals, as are other professionals, should be held to a higher standard”. Id.

In People Express, a commercial airline brought an action in tort against a railroad for economic damages it suffered due to the evacuation of its offices following a fire. People Express, at 249. The railroad moved for summary judgment arguing that the airlines purely economic losses were not recoverable. The Supreme Court of New Jersey denied the railroad’s motion characterizing the “per se” rule against recovery in tort for economic losses as “hopelessly artificial”. Id. at 261. The Court held that, “when the plaintiffs are reasonably foreseeable, the injuries directly and proximately caused by defendants’ negligence, and liability can be limited fairly, courts have endeavored to create exceptions to allow recovery”. Id. Notwithstanding the decisions in Conforti and People Express, many advocates on behalf of defendants seek application of the per se rule barring recovery of economic damages in tort in the form of the Economic Loss Doctrine. However, it has been observed that the Economic Loss Doctrine operates to bar tort claims only where plaintiff seeks to enhance the benefit of the bargain she contracted for”. Saltiel v. GSI Consultants, Inc., 170 N.J. 297 (2002). In Saltiel, claims of negligent design and misrepresentation by a landscape architect against the turf grass corporation were dismissed as the landscape architect’s claim for economic damages essentially involved a breach of contract claim arising from a contract between the parties. Thus, it is clear where a contract between the parties exists, the New Jersey Supreme Court has concluded that claims should sound in breach of contract rather than in negligence because the Economic Loss Doctrine helps to maintain the “distinctions between tort and contract actions” by precluding the parties’ “negligence action in addition to a contract action unless the plaintiff can establish an independent duty of care. Saltiel, at 310.

The case of SRC Construction Corp. of Monroe v. Atlantic City Housing Authority, 935 F.Supp.2d 796 (D.N.J. 2013) stands for the proposition that the Doctrine does not bar a plaintiff from asserting a tort claim for economic damages against the defendant with whom it does not have a contract. In SRC Construction, the contractor, SRC which was involved in the construction of an assisted living facility sued the owner for breach of contract for unjust enrichment and wrongful termination of the contract and conversion. In a separate action, SRC sued the architect on a project with whom SRC did not have a contract. The architect moved for summary judgment seeking protection under the Economic Loss Doctrine.

The United States District Court Judge disagreed and analyzed the decision of the Superior Court of New Jersey, Giuliano v. Gastone, 187 N.J. Super. 491 (App. Div. 1982) where the Appellate Division refused to apply the Doctrine to the plaintiff homeowners “negligence claims against the subcontractors who participated in the construction of their home.” In Giuliano, just like in SRC, there was no contract between the parties. Thus, the Giuliano court ruled that the negligence claims were not barred.

The SRC Construction court distinguished the two unreported decisions, Horizon Group of New England, supra and Spectraserve, supra observing that, “in both cases, the courts held that the Economic Loss Doctrine barred the plaintiff’s negligence claim even in the absence of a direct, contractual relationship between the plaintiff and defendants. Moreover, both courts’ decision seemed to turn on the finding that the plaintiffs could have invoked contractual remedies in their contract with another defendant in the case”. SRC Construction, at 800 (citations omitted).

The SRC court stated as follows:

  • “Horizon and Spectraserve, cannot be reconciled with Giuliano. Not only could the Giulianos have sued the homebuilder with whom they had a direct contract, they did sue the homebuilder in a separate suit and obtained a judgment. (citation omitted).

The SRC Construction court attempted to reconcile the tension between lack of privity cases, lack of contract cases and lack of available other remedies as follows:

  • Leaving open an avenue of redress because no other exists is one thing but foreclosing an avenue of redress simply because another exists is quite another. … the reason for foreclosing a tort claim is not simply because a contract claim exists, but rather that the tort claim is not really a tort claim at all; it is a contract claim in tort claim clothing. … but whether there is no direct contractual relationship between the plaintiff and the defendant, frequently there can be no contract claim at all and therefore any tort claim asserted cannot possibly be a contract claim in tort clothing. SRC, at 801.

The SRC Construction court’s analysis was followed in Bedwell Co. v. Camden County Improvement Authority, Civ. A.14-1531 JEI, 2014 WL 3499581 (DNJ 2014). The Bedwell court held that a general contractor’s claim for negligent misrepresentation against an architect alleging that the architect provided defective designs was not barred under the Economic Loss Doctrine because there was no contract between the parties. The Bedwell court further recognized that even though there were third party agreements between (1) the general contractor and the owner and, (2) the owner and the architect, the third party agreements had no effect on the law on the ability to bring a tort claim because “a contract cannot define the legal obligation between two entities unless those two entities are party to the contract *3. Therefore, it may be that New Jersey is backing off from the per se application of the Economic Loss Doctrine.

Conclusion

Where a contract exists between the parties there is agreement that the Doctrine would bar tort claims. Where there is another party involved in a construction team with whom the plaintiff has a contract and thus another remedy is available seems to imply that tort claims will not survive the ambit of the Doctrine. It is only where there is no contract between the parties and there is no other available means of redress for the plaintiff that the tort claims will survive the application of the Doctrine. Nevertheless, plaintiff practitioners should be wary of the potential filing of dispositive Economic Loss Doctrine motions by defendants with whom no contract exists.

Paul A. Sandars, III is a Member of the Firm of Lum, Drasco & Positan LLC and practices in the Firm’s Litigation Group.

Contact Lum, Drasco & Positan

Lum, Drasco & Positan LLC
103 Eisenhower Parkway
Suite 401
Roseland, NJ 07068
Phone: 973-403-9000
Fax: 973-403-9021

Our law office is located in Roseland, New Jersey.

To speak with an attorney at our firm about your legal needs, call 973-403-9000.

Executive Orders 242 and 243: New Jersey

EXECUTIVE ORDERS 242 AND 243: NEW JERSEY LIFTS OR MODIFIES CERTAIN COVID-19 RESTRICTIONS IN INDOOR PUBLIC SPACES AND WORKPLACES

Governor Murphy signed Executive Order No. 242 on May 24, 2021, and Executive Order243 on May 26, 2021, as part of New Jersey’s “multistage Road Back Plan for the methodical and strategic reopening of businesses and activities” based on the progress made within the state against the COVID-19 pandemic. A series of prior Executive Orders have recently allowed for thelifting of restrictions regarding masking and distancing in outdoor settings, and the lifting of restrictions on indoor and outdoor gathering limits in food and beverage establishments and other entertainment facilities. Executive Order 242 has now lifted masking and spacing restrictions for “indoor public spaces” that are open to the public “for purposes of the sale of goods, attendance atan event or activity, or provision of services” as of May 28, 2021.

In Executive Order 243, Governor Murphy has clarified his prior Order on “indoor publicspaces” and similarly lifted COVID-19 restrictions in certain circumstances for workplaces and businesses that are generally closed to the public and have limited visitors. More specifically, employers are advised of the following pursuant to Executive Order 243, which becomes effectiveJune 4, 2021:

● Paragraphs 10 and 11 of Executive Order 107 — which stated that all businesses or non-profits whether closed or open to the public, must accommodate their workforce for telework or work-from-home arrangements — have been rescinded, and employers are no longer required to permit employees to work remotely as was done during the pandemic;

● Employees who are fully vaccinated against COVID-19 (the CDC considers an individual to be fully vaccinated 2 weeks after their second dose in a two-dose series, or 2 weeks after a single-dose vaccine), and provide their employer with proof of their full vaccination status (completed vaccination card), are not requiredto wear face masks or social distance at the worksite;

● Where an employer is unable to determine an employee’s vaccination status, or the employee is not fully vaccinated, “employers must continue to require those employees to wear masks and practice social distancing” in the workplace, except when the employee is in their own office or work station;

● Employers are permitted to allow customers, visitors and other authorized individuals to enter the worksite without requiring the use of a mask or adherence to social distancing, regardless of their vaccination status;

● Regarding customers, visitors and other authorized individuals entering the worksite, employers have the option of establishing a policy that requires such individuals to wear a mask and/or social distance, provided that such policy on mask wearing complies with federal and state law regarding accommodations in the event of a disability that makes the individual unable to wear a mask.

Executive Order 243 also emphasizes the following points:

● An employer may impose stricter requirements regarding mask wearing and social distancing in indoor settings (consistent with federal and state law on accommodations in the event of a disability that makes an employee /individual unable to wear a mask);

● Employers cannot restrict employees, customers, visitors or other authorized individuals from wearing masks in the workplace setting for any reason;

● Employees, customers, visitors and other authorized individuals in the workplace shallnot in any way be penalized or retaliated against if they elect to wear a mask;

● Other health and safety standards applicable to all New Jersey employers as set forth in Executive Order No. 192, have not been superseded by Executive Order 243 and remain in full force and effect, including:

  • Employers must take measures to ensure a “health screening” of employees on a regular basis, with such measures consisting of either: (1) temperature screenings, (2) visual symptom checking, (3) self-assessment checklists, and/or (4) health questionnaires;
  • Employers must notify all employees if there is a known exposure to COVID19 in the workplace, consistent with employee confidentiality requirements under the Americans with Disabilities Act, and federal and state guidance;
  • Employers must provide all employees, visitors, customers, and any other individuals who access to the work location, with access to sanitizing materials, at the employer’s expense;
  • Employers must ensure high-access areas in the work location are routinely cleaned and disinfected, and provide all employees with break time throughout the day to wash their hands (unless gloves are provided to the employees);
  • Penalties may be assessed for violations of the health and safety standards in Executive Order 192 which remain in effect.

Executive Order 242 further notes that its lifting of mask-wearing and social distancing restrictions in “indoor public places” do not include child care centers, other child care facilities, youth summer camps, and public, private and parochial preschool program premises and elementary and secondary schools, including charter and renaissance schools, which continue to be governed by applicable standards issued by the Department of Health.

Employers are encouraged to consider how these new standards will be implemented and communicated to employees, customers, visitors and authorized individuals entering the workplace. The Firm is available to assist in this regard and further address any questions or concerns regarding the new Executive Orders as employers continue to engage in the workplace reopening process.

To discuss any of this please contact one of the employment attorneys below:

Contact Lum, Drasco & Positan

Lum, Drasco & Positan LLC
103 Eisenhower Parkway
Suite 401
Roseland, NJ 07068
Phone: 973-403-9000
Fax: 973-403-9021

Our law office is located in Roseland, New Jersey.

To speak with an attorney at our firm about your legal needs, call 973-403-9000.

Corporate Transparency Update Summer 2021

CORPORATE TRANSPARENCY UPDATE: July 2021

By: Steven J. Eisenstein, Esq.

On January 1, 2021 Congress enacted the National Defense Authorization Act overriding a Presidential veto. As part of this new law the Corporate Transparency Act was put into place. The CTA had failed several previous attempts at passage but as part of the annual Defense bill passage was assured. Ostensibly the rationale for including it was to ensure that foreign companies do not become unseen participants in our national defense. Whatever the rationale the law now exists and business owners must learn to deal with it.

Basically the CTA requires certain business to report the identity of their beneficial owners to the Financial Crimes Enforcement Network, a part of the Treasury Department. While there are still many open questions a brief examination of these three components seems to be in order.

What are the “Reporting Companies” which have these obligations? Any corporation, limited liability company or similar entity which is formed or registered to do business by the filing of a formation document with a state must comply unless they fall within one of 24 exceptions. Among the exceptions are publicly traded companies, public utilities, financial services companies and companies which employ 20 or more people in the U.S., filed a tax return in the prior year reporting at least $5,000,000 in gross revenue and have a physical presence in the United States. Since newly formed companies will not have filed a tax return yet is appears to be the intent of the law to require all newly formed private companies to supply the information.

Who is a beneficial owner? An individual who, directly or indirectly, either owns 25% or more of the equity of the company or exercises substantial control, an undefined term. Minors are not included nor are people who acquire their equity through inheritance. There will doubtless be substantial confusion over the issue of control but even the seemingly fixed standard of 25% equity may be in doubt when issues like options and warrants are considered. Close attention should be paid to further developments in this area.

What information needs to be reported? FINCEN is to receive the full legal name of each Beneficial Owner, the date of birth, the current business or residence street address and an ID number from a Governmental document such as a driver’s license or passport. A person who files the application for the formation may obtain a FINCEN ID number and that ID number may be supplied in lieu of anything else. The information is to be kept confidential by FINCEN but may be released to other Federal agencies in law enforcement, national security or intelligence, to local and state agencies pursuant to a court order or to financial institutions with the consent of the companies.

When will reporting begin? New companies must file reports upon formation or registration to do business. Existing companies have two years to file after the effective date of the anticipated regulations. Regulations have not yet been drafted and all reporting requirements are suspended until they are passed. The reported information will need to be kept current and changes reported within one year of the change.

Are penalties involved? Do you need to ask? Failure to comply may result in both civil and criminal penalties. Fines of up to $500 for each day of violation are possible and prison sentences of up to 2 years may be imposed. Criminal penalties for unauthorized disclosure or use of the violation can result in up to 5 years imprisonment and substantial fines.

Until regulations are drafted there is much that remains unknown. The issue of substantial control will be of great interest in the regulations. This will prove to be of interest to creditors who may be covered if they meet the definition of Beneficial Owner upon foreclosure of security interests. Anyone seeking to form a new company is advised to seek competent advice before doing so as getting it wrong can have serious consequences.

The Business Law Section of Lum, Drasco & Positan stands ready to assist. For more information please contact Steven J. Eisenstein,  Kevin Murphy

Contact Lum, Drasco & Positan

Lum, Drasco & Positan LLC
103 Eisenhower Parkway
Suite 401
Roseland, NJ 07068
Phone: 973-403-9000
Fax: 973-403-9021

Our law office is located in Roseland, New Jersey.

To speak with an attorney at our firm about your legal needs, call 973-403-9000.

Firm News Summer 2022

Firm News: Summer 2022

The Firm is pleased to announce that the following attorneys have been named to the 2022 New Jersey Super Lawyers list. These selections were based on a statewide survey, an evaluation process and a peer review by a blue ribbon panel of attorneys. The methodology for selection can be found at http://www.superlawyers.com/. (No aspect of this advertisement has been approved by the Supreme Court of New Jersey).

Dennis J. Drasco for Business Litigation (Top 100 Lawyers)

Wayne J. Positan for Employment and Labor (Top 100 Lawyers)

Paul A. Sandars, III for Construction Litigation

Kevin F. Murphy for Estate Planning and Probate (10th year)

Kevin J. O’Connor for Business Litigation

Daniel M. Santarsiero for Employment and Labor

PAUL A. SANDARS, III: Presented a lecture on the Economic Loss Doctrine at the New Jersey State Bar Construction Law Forum in June 2021.

KEVIN J. O’CONNOR: Has been appointed counsel to the Board of Trustees of Foundabilities, Inc., a charitable organization providing adults with disabilities a safe, secure and supportive environment that will promote a sense of self-worth and acceptance in the local community. This will be accomplished through social interaction, supervised events, and services through volunteer efforts.

Contact Lum, Drasco & Positan

Lum, Drasco & Positan LLC
103 Eisenhower Parkway
Suite 401
Roseland, NJ 07068
Phone: 973-403-9000
Fax: 973-403-9021

Our law office is located in Roseland, New Jersey.

To speak with an attorney at our firm about your legal needs, call 973-403-9000.