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RISKS? WHAT RISKS? IT’S A POT PARTY…BUT THE FEDS AREN’T COMING (OR ARE THEY?)

A.     Introduction.

It’s a gold rush! Cannabis business activity in California is booming! And …

All you read in the press … all you see in the media … is that you better jump in with both feet.

We’re business lawyers and we represent business clients. One of our most important duties is to advise our business clients of the legal risks associated with their business ventures.

When it comes to cannabis-related business activity, there are some significant legal risks that nobody is talking about. We think you need to know what they are.

This article summarizes some of the legal risks under federal law associated with engaging in cannabis-related business activities.

B.     Executive Summary.

Despite broad public support for legalization of medical and recreational marijuana, and despite state laws authorizing and regulating medical and recreational cannabis-related business activity, marijuana is not “legal.” Federal law, which applies even in California and other states which have legalized medical and/or recreational marijuana, treats marijuana as a dangerous drug akin to heroin or cocaine. Engaging in, assisting, funding, serving or facilitating marijuana-related activities are fraught with risk, both criminal and civil. Those risks include possible prosecution for commission of a felony, aiding and abetting a criminal activity, conspiracy to commit a felony, and civil forfeiture of assets used in, or received from, illegal activity. In addition, participants in cannabis-related activity may not be able to enforce contract rights, seek redress from state or federal courts, or be entitled to rights afforded to “legal” business activities. In summary:

  • Compliance with California marijuana laws doesn’t protect you from federal prosecution.
  • The U.S. Department of Justice has rescinded a key element of the prior protections against enforcement of federal marijuana laws against state-compliant medical marijuana activity. No federal protections exist for state-legal recreational marijuana activities.
  • Even peripheral involvement, by serving, funding or assisting a cannabis-related activity, may subject you to criminal liability as an aider and abettor, or co-conspirator.
  • Your real property and other assets can be seized in a civil forfeiture action.
  • Your liability and casualty insurance may not cover you in the event of a loss.
  • You may not be able to enforce your contracts in state or federal courts.
  • You may not be able to deduct your business expenses on your tax returns.
  • Your activity may cause you to be in default under your loan documents or other contracts.
  • Your bank accounts may be closed, and you may not be able to open new accounts.
  • You aren’t entitled to bankruptcy protection if your business fails.
  • Your conversations with your lawyers may not be privileged.
  • Your lawyers may become witnesses against you in a federal enforcement action.

Each of the above risks is discussed in more detail, below.

C.     State Marijuana Law.

The State of California has legalized cannabis-related activities under statutes permitting certain “medical marijuana” business activities, and as as of January 1, 2018, certain recreational marijuana activities. This results in two categories of cannabis-related business activity: (1) businesses operated by Licensees; and (2) businesses operated by third parties who do business with Licensees, including by financing them, selling or leasing buildings or land to them, or providing them with services or products. Such ancillary service providers include investors, bankers, lawyers, accountants, landlords, real estate brokers and vendors.

“Legal” marijuana use in California is big business. On October 9, 2017, the Sacramento Bee published an article entitled “Pot Growers Take Over Warehouse Space in Sacramento.” Among other things, that article stated that more than 100 businesses were seeking special permits from the city of Sacramento to run indoor marijuana growing operations as of July 2017, and some officials predicted that up to 200 might apply before the end of 2017. According to the article, legal pot growers are pushing prices and rents for industrial properties to unheard-of heights in some areas of the city of Sacramento. The Bureau of Cannabis Control, the agency responsible for regulating commercial cannabis Licensees, announced in early January 2018 that more than 400 licenses had been issued and more than 1,800 applications for licenses had been submitted. The legalization in California, under State law, of medical marijuana and certain recreational uses of marijuana, has engendered widespread business activity related to the cannabis industry that has been characterized by some as the “next California gold rush.”

“Legal” marijuana use in California is limited in scope, complicated and fraught with traps for the unwary. Local governments can pursue illegal cannabis operators and their landlords for administrative code enforcement, civil nuisance abatement actions and criminal actions. The remedies available to local governments include recovery of attorneys’ fees and costs associated with abatement, through liens and special assessments against the property of the operator and the landlord. The state can also prosecute and pursue illegal cannabis operators and pot-adjacent parties under various state criminal and civil laws.

D.     Federal Marijuana Law.

          1.     “Legal” marijuana does not exist in the United States. Federal law still broadly criminalizes growing, distributing and/or possessing marijuana, including “medical marijuana.” Knowingly or intentionally growing, distributing or possessing marijuana with the intent to manufacture, distribute or dispense is punishable by up to life imprisonment. 21 U.S.C. § 841(a). All activities involving the cultivation, distribution and/or sale of cannabis remain illegal under the United States Controlled Substances Act. Cannabis is classified as a Schedule I drug under that act, no different from heroin. The fact that a cannabis-related business activity is legal under state law and fully compliant with applicable state law does not make such activity legal under federal law. A number of bills have been introduced in the U.S. Senate and the House of Representatives, each of which addresses, in some form, the criminalization of marijuana under federal law. At present, and notwithstanding broad public support for decriminalization, no bill has the necessary support to become law.

          2.     On January 4, 2018, the Department of Justice took the first step in overriding guidance given under the Obama administration that limited federal enforcement of marijuana laws against “state legal” medical marijuana activities. In October 2013, the U.S. Department of Justice (“DOJ”) promulgated the “Cole Memorandum,” under which the DOJ outlined its marijuana enforcement priorities under the Controlled Substances Act. The Cole Memorandum did not list as an enforcement priority state-legal medical marijuana-related conduct so long as the state regulatory scheme contained “robust controls and procedures on paper” and was “effective in practice.” The Cole Memorandum has been viewed in the cannabis industry as providing a “safe harbor” for medical marijuana business activity operated in strict compliance with state law.

The guidance in the Cole Memorandum was subject to change at any time. In September 2017, Deputy U.S. Attorney Rod Rosenstein signaled a change in the DOJ’s enforcement priorities and has been quoted as saying, “[The Cole Memorandum has] been perceived in some places almost as if it creates a safe harbor, but it doesn’t. And it’s clear that it doesn’t. That is, even if, under the terms of the memo you’re not likely to be prosecuted, it doesn’t mean that what you’re doing is legal or that it’s approved by the federal government or that you’re protected from prosecution in the future.”

On January 4, 2018, Attorney General Jeff Sessions announced the rescission of the Cole Memorandum:

“It is the mission of the Department of Justice to enforce the laws of the United States, and the previous issuance of guidance undermines the rule of law and the ability of our local, state, tribal, and federal law enforcement partners to carry out this mission. Therefore, today’s memo on federal marijuana enforcement simply directs all U.S. Attorneys to use previously established prosecutorial principles that provide them all the necessary tools to disrupt criminal organizations, tackle the growing drug crisis, and thwart violent crime across our country.”

As a result of the rescission of the Cole Memorandum, federal enforcement of marijuana laws now resides in the 93 U.S. Attorneys. The recently appointed U.S. Attorney for the Eastern District of California (Sacramento and 33 other California counties) is McGregor “Greg” W. Scott, a Trump appointee who already held the position under President George W. Bush. While in office, Scott targeted large-scale cannabis operations and developed a reputation for seeking harsh sentences. On January 18, 2018, a Sacramento Bee article quoted Omar Figueroa, a Sebastopol lawyer specializing in marijuana cases: “He used to be a hardcore, anti-cannabis drug warrior. I hope he has evolved.”

Public backlash against the rescission of the Cole Memorandum has been significant. On January 24, 2018, a bi-partisan group of 54 members of Congress sent a letter to President Trump encouraging reinstatement of the Cole Memorandum. Nevertheless, as of the date of this article, the White House has not issued any policy statements addressing the rescission of the Cole Memorandum.

          3.     Leadership at the DOJ continues to support and lobby for enforcement of federal marijuana laws and funding to do so. Under what was known as the “Rohrabacher-Farr Amendment” to the House appropriations bill of 2015 (currently known as the “Rohrabacher-Blumenauer Amendment”) (the “Rohrbacher Amendment”), the DOJ is presently prohibited from using appropriated funds to enforce federal marijuana laws against “state compliant” medical (but not recreational) marijuana operations. The Rohrbacher Amendment has been extended through March 23, 2018, at which time it will expire absent renewal by Congress or further extension. While there is significant support in Congress for further extension of the Rohrbacher Amendment, the Attorney General and the House Rules Committee have opposed its renewal. If the Rohrbacher Amendment is not renewed, the DOJ will have no restrictions on the use of federal funds for enforcement of federal marijuana laws.

          4.     Federal restrictions under the Cole Memorandum and the Rohrbacher Amendment applied only to state-legal medical marijuana activity, not recreational marijuana activity. Neither the Cole Memorandum nor the Rohrbacher Amendment limit federal enforcement or prosecution against state-legal recreational use of marijuana. No “safe harbor” exists to limit or prohibit DOJ funding for the enforcement of federal law against state-legal recreational marijuana cultivation, manufacturing, distribution or use. Members of Congress proposed an addition to the latest emergency appropriations bill that would have extended the Rohrbacher funding limitations to state-legal recreational marijuana use (the “McClintock-Polis Amendment”), but the McClintock-Polis Amendment did not have sufficient support for inclusion in the latest emergency funding bill.

          5.     Licensees are not the only parties at risk of criminal prosecution. Those who facilitate the marijuana business are also at risk of criminal prosecution. These parties include owners, operators, investors, bankers, landlords or vendors for a marijuana business. It is a separate federal crime to manage or control any place, permanently or temporarily, for the purpose of manufacturing, distributing, storing or using marijuana. 21 U.S.C. § 856. The statute is commonly used to prosecute owners and operators of marijuana-related businesses. A landlord, lender, investor or ancillary service provider (including a lawyer) to a Licensee may also be subject to prosecution under this statute as a principal, co-conspirator, or an aider and abettor. Under federal law, whoever commits an offense against the United States, or aids, abets, counsels, commands, induces, or procures its commission, is punishable as a principal. 18 U.S.C. § 2. Non-Licensee pot-adjacent parties are also at risk for money laundering, financial reporting, and facilitation crimes. For example, Licensees generally don’t have access to banks and must engage in cash or barter transactions. Receipt of large amounts of cash requires financial reporting and failure to report can result in prosecution and fines. 31 U.S.C. §§ 5321, 5322. Receipt of large amounts of cash from a known marijuana business or facilitating a financing transaction to further a marijuana business are subject to prosecution, with punishments of up to 20 years imprisonment. 18 U.S.C. §§ 1956, 1957.

         6.     The federal government can seize your property or your assets in a civil forfeiture action. Even absent prosecution, civil forfeiture remedies are available to federal prosecutors. Civil forfeiture allows the government to seize all the assets involved in operating the marijuana business and any property traceable to the proceeds of the business. 18 U.S.C. §§ 981, 983. This includes vehicles, land used to grow marijuana, buildings used to house marijuana operations, investor capital and profits, and other assets related to the involvement in the illegal activity. Even under the more lenient Obama DOJ, U.S. Attorneys used civil forfeiture against landlords leasing to medical marijuana businesses. For example, in two 2013 forfeiture actions brought against the owner of a retail shopping center in Oakland, and the owner of a retail shopping center in San Jose, each of which housed, as one among several tenants, a medical marijuana facility, the United States sought civil forfeiture against the property owners (who had knowledge of the business of the tenant) of the entire retail project. The government’s theory was premised on the knowing receipt by the landlords of rent payments (proceeds) from illegal businesses (medical marijuana clinics) situated on the landlord’s property, with the landlord’s permission (under a lease). The current administration views civil asset forfeiture as an important tool in combatting crime. In a July 19, 2017, DOJ press release (accompanied by new DOJ Policy Directive 17-1), Attorney General Jeff Sessions stated:

“President Trump has directed this Department of Justice to reduce crime in this country, and we will use every lawful tool that we have to do that. We will continue to encourage civil asset forfeiture whenever appropriate in order to hit organized crime in the wallet. At the same time, we must protect the rights of the people we serve. Law-abiding people whose property is used without their knowledge or without their consent should not be punished because of crimes that others have committed.”1

          7.    The criminal penalties are stiff. Growing, distributing and possessing marijuana is punishable by up to life imprisonment. First time offenders with 1-50 plants or under 50 kg are subject to a fine of $250,000 to $1 million and imprisonment up to 5 years (Trafficking 21 U.S.C. §§ 841, 960, 962 and 46 U.S.C. § 70506). Mandatory fines and sentences for incarceration increase when multiple offenses and/or increased numbers or weights are involved. In addition to criminal prosecution, civil monetary penalties, civil forfeitures and/or regulatory sanctions can occur without anyone being charged with a crime. For example, even without a criminal case pending, a person who manages or controls a premises for growing, distributing or selling marijuana can be fined up to $250,000 or twice the gross receipts of the business, whichever is greater (21 U.S.C. § 856(d)). Being the owner, operator, financier, banker, landlord or vendor for a marijuana business is illegal. In addition to the potential life felony for dealing marijuana, it is a separate federal crime, punishable by up to 20 years in prison, to manage or control any place for manufacturing, distributing, storing or using marijuana (21 U.S.C. § 856). The mere receipt of a payment of more than $10,000 from a known marijuana business (including payment for services rendered) may be a federal crime punishable by up to 10 years in prison (18 U.S.C. § 1957). Engaging in a financial transaction for the purpose of promoting or furthering a known marijuana business may be a federal crime punishable by up to 20 years in prison (18 U.S.C. § 1956). Aiders and abettors to the foregoing crimes, or co-conspirators in the foregoing criminal activity, are liable to the same extent as the principal.

          8.     Your liability and property insurance may not cover you or your activities. Insurance policies routinely contain exclusions for criminal acts. Non-Licensee pot-adjacent parties may not have liability or casualty coverage if sued for conduct related to the marijuana business. This includes malpractice insurance for doctors, lawyers and other professionals aiding marijuana businesses. Property insurance carriers may deny coverage if the premises were used for, or the loss is related to, criminal activity. A typical exclusion from coverage for commercial property insurance is:

Dishonest or criminal act by you, any of your partners, members, officers, managers, employees (including leased employees), directors, trustees, authorized representatives or anyone to whom you entrust the property for any purpose:

  1. Acting alone or in collusion with others; or
  2. Whether or not occurring during the hours of employment.

More broadly, insurers have successfully denied claims arising from illegal activities on the basis that coverage would violate public policy. The opportunities for large casualty claims arising from a marijuana business are many – fire from excessive electrical requirements, water damage and mold damage from humidification, illness from evacuated production air into other tenant or common areas and explosions from cannabis oil distillation systems.2

          9.     You could lose your professional licenses. Many professional licenses require good conduct and may be subject to revocation if a licensed professional knowingly engages in illegal conduct. Accountants, doctors, general contractors, real estate brokers and similar licensees are at risk.

          10.    Accepting money from, or paying, a marijuana business could be illegal. Most banks will not accept legal marijuana businesses as clients, so these businesses operate extensively in cash. Federal law requires banks, trades, and businesses (including lawyers) to report any cash transaction, or series of transactions, that exceed $10,000. Failing to file these reports could result in monetary fines or prosecution. Federal money laundering laws also apply to certain common financial transactions with legal marijuana businesses. For example, merely receiving a cash payment of more than $10,000 from a known marijuana business may be a federal crime punishable by up to 10 years in prison. Engaging in a financial transaction for the purpose of promoting or furthering a known marijuana business may be a federal crime punishable by up to 20 years in prison. Therefore, a vendor who supplies packaging material or agricultural equipment to a legal marijuana business, knowing that those goods will be used to help the business operate, may be committing a 20-year felony by accepting payment for those goods. Similarly, an accountant who receives payment for maintaining the financial records of a legal marijuana business could be violating the federal money laundering laws.

          11.     Your bank may cancel your accounts and you may have difficulty finding new banking arrangements. Most financial institutions do not accept deposits representing funds generated from cannabis-related business, and will not establish banking relationships with cannabis-related businesses. According to testimony from the director of the Financial Crimes Enforcement Network (FinCEN), in August 2014 only 105 banks nationwide were accepting deposits from marijuana businesses. As of June 30, 2017, that number had risen to only 390 banks and credit unions across the country. The Recorder, a legal industry publication, reported in a December 28, 2017 article, that Umpqua Bank closed the accounts of an attorney representing state-legal cannabis businesses, after learning of the attorney’s connection with cannabis-related businesses and the attorney’s refusal to document for the bank specific information about his marijuana-related clients. One attorney interviewed for the article was quoted as saying “It’s definitely frequent that they kick marijuana businesses out.”

          12.     You may not be able to deduct your business expenses. Section 280E of the Internal Revenue Code prohibits businesses involved in “drug trafficking” from deducting normal business expenses from their gross income. It provides that “[n]o deduction or credit shall be allowed” for expenses related to a trade or business that consists of trafficking in Schedule I or Schedule II controlled substances in violation of state or federal law. In a 2012 case, the U.S. Tax Court denied all business deductions to a California marijuana dispensary. In July 2015, this decision was affirmed by the U.S. Court of Appeals for the Ninth Circuit. You should discuss with your accountant and tax advisors the tax and accounting implications of involvement in a transaction related to the cannabis industry.

          13.     A bankruptcy may not protect you if your marijuana-related business fails. The Tenth Circuit and several bankruptcy courts have ruled that a marijuana business cannot use bankruptcy for protection from creditors. The rulings are supported by the Office of the United States Trustees, a division of the DOJ with oversight responsibilities concerning bankruptcy trustees and bankruptcy administrators. So, even if the federal government does not take all assets of the business in forfeiture or taxes, its creditors might. The same limitations may exist for businesses that facilitate or serve the marijuana industry.

          14.     You may be in default under contracts to which you are a party or which affect your property or occupancy. If you own real property encumbered by a loan, the loan documents typically require that you and the businesses operated on your property comply with federal and state law. Engaging in a cannabis-related business or allowing a cannabis-related business on your property may be a default under your loan. Other types of agreements under which defaults may be triggered by operation of, or in connection with, cannabis-related activity, include leases and rental agreements (and rules and regulations promulgated thereunder), agreements with vendors to your business or companies to whom your supply services or products, distribution and supply agreements, common area declarations and restrictions on use, property CC&Rs, bank or credit agreements, and any agreements providing for federal assistance, funding or support for your business or properties.

          15.     You may not be able to enforce your rights under contracts with marijuana-related businesses. Contracts with marijuana-related businesses may not be enforceable in state or federal courts. In a recent case of great note, Arizona private-party lenders loaned a Colorado medical marijuana dispensary $500,000. After the dispensary failed to make payments, the lenders commenced an action in state court in Arizona to collect on their promissory note. Despite both Arizona and Colorado recognizing legalized marijuana, the trial court granted the defendant’s motion to dismiss because the contract was void for illegality and against public policy. After quoting from the loan agreement which stated that “Borrowers shall use the loan proceeds for a retail medical marijuana sales and grow center,” the court held:

“The explicitly stated purpose of these loan agreements was to finance the sale and distribution of marijuana. This was in clear violation of the laws of the United States. As such this contract is void and unenforceable. This Court recognizes the harsh result of this ruling. Although Plaintiffs did not plead any equitable right to recovery such as unjust enrichment, or restitution, this Court considered whether such relief may be available to these Plaintiffs. Equitable relief is not available when recovery at law is forbidden because the contract is void as against public policy….[O]ne who enters into such a contract is not only denied enforcement of his bargain, he is also denied restitution for any benefits he has conferred under the contract.”

          16.     Your conversations with your lawyer may not be privileged. Confidential communications between a lawyer and client are generally privileged and not subject to discovery by a third party. However, what is known as the “crime-fraud” exception to confidential communications with a lawyer does not apply to communications with a lawyer in furtherance of illegal activity. Therefore, an adverse party – either the government or a third party – could assert that all attorney-client communications about the operations and transactions of the state-legal marijuana business are not privileged and are discoverable in litigation.

          17.     Your lawyer’s advice may not provide you a criminal defense and your lawyer may be compelled to be a witness against you. One defense to state or federal criminal prosecution is that the client relied on the advice of counsel. The advice-of-counsel defense requires that before taking an action the client fully discloses its plans to its lawyer and thereafter complies with its lawyer’s advice. The advice-of-counsel defense negates the element necessary to many crimes of “specific intent to commit a crime.” However, the advice-of counsel defense would not protect the client from drug crimes which merely require knowledge that the client is interacting with a marijuana business, i.e., a “general intent” crime that does not require proof of willfulness. See, e.g., 18 U.S.C. § 841. In addition, the mere assertion of the advice-of-counsel defense waives the attorney-client privilege. If the client’s lawyer complied with its ethical rules and advised the client that the marijuana business is illegal under federal law, the lawyer could be called as a damaging witness in a federal drug prosecution case.

1California property owners will encounter difficulty asserting an “innocent owner” defense to federal forfeiture actions because state law requires property owners to provide written consent to cannabis activity before the tenant obtains a license. Bus. & P C §26051.5(a)(2).

2Such explosions are increasing in frequency, with 32 such blasts in Colorado in 2014. See, New York Times, Odd Byproduct of Legal Marijuana: Homes That Blow Up, Jack Healy, January 17, 2015.

Please contact Doug Hodell at dhodell@boutinjones.com, or Mark Gorton at mgorton@boutinjones.com, if you have any questions regarding this article.

 

Legal disclaimer: The information in this article (i) is current only as of the above date, (ii) is a broad overview provided for general informational purposes only and does not address every risk or the nuances of each risk, (iii) is not provided in the course of and does not create or constitute an attorney-client relationship, (iv) is not intended as a solicitation, (v) is not intended to convey or constitute legal advice, and (vi) is not a substitute for obtaining legal advice from your own, qualified attorney. You should not act upon any of the information in this article without first seeking qualified professional counsel on your specific matter.

Printable Copy: Risks – What Risks – It’s a Pot Party – But The Feds Aren’t Coming Or Are They

Printable Copy: Risks - What Risks - It's a Pot Party - But The Feds Aren't Coming Or Are They

Practices

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The Gift and Estate Tax Exemption Has Been Doubled – But for a Limited Time Only?

New tax legislation, known as the Tax Cuts and Jobs Act (the “Act”), doubles the gift and estate tax exemption (the “exemption”), which is the amount that an individual may transfer free of tax either by gift during lifetime or at death.

In 2017 the exemption was $5,490,000. The Act temporarily doubles the exemption to approximately $11,180,000* per individual (or $22,360,000 for married couples). This temporary increase expires on December 31, 2025, and then the exemption reverts to its current level ($5,000,000 per person, adjusted for inflation).

Of course, future legislation could reduce the exemption prior to 2026, or extend the higher exemption beyond 2026.

The Act directs that Treasury issue regulations to address the treatment of gifts made when the exemption is at a high level (during 2018 to 2025, for example) if the donor dies when the exemption is dropped to a lower amount (for example, if the donor dies in 2026 or later years). We will be reviewing these Treasury regulations when issued; however, many commentators believe that these regulations will provide that tax savings associated with prior gifts will not be reduced if the exemption is decreased in the future.

The increased exemption available between 2018 and 2025 presents significant opportunities for some clients to make additional tax free gifts.

In addition, adjustments to existing estate plans may also be necessary given the higher exemption. For many clients, estate taxes may not be a concern, and estate plans should be reviewed to take advantage of a step up in income tax basis of assets on death.

Please contact Kent Silvester, Stuart List or Stacey Brennan if you have any questions regarding this article, or if you would like to discuss the impact the Act may have on your estate plan and the opportunities it may present to you.

 

*Approximate because the IRS needs to compute and announce the actual inflation adjusted exemption amount.

 

 Legal disclaimer: The information in this article (i) is provided for general informational purposes only, (ii) is not provided in the course of and does not create or constitute an attorney-client relationship, (iii) is not intended as a solicitation, (iv) is not intended to convey or constitute legal advice, and (v) is not a substitute for obtaining legal advice from a qualified attorney. You should not act upon any of the information in this article without first seeking qualified professional counsel on your specific matter.

Practices

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New Reduced Tax Rate for Qualified Business Income

The legislation formerly known as the Tax Cuts and Jobs Act (the “Act”) adds section 199A to the Internal Revenue Code (the “Code”). The provision provides a new deduction that reduces the effective tax rate on qualified business income (“QBI”) for owners of businesses taxed as sole proprietorships, partnership, limited partnership, limited liability company, S corporation and similar pass-through entities (herein after “pass-through entity”).

Qualified Business. Most businesses owned and operated by a pass-through entity within the United States, including real estate rental and investment activities, will satisfy the qualified business requirement. However, certain “specified service businesses” including health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services and any other trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees, are subject to more significant limitations. Firms providing engineering or architectural services are not treated as specified service businesses even though they would seem to meet the foregoing definition.

Qualified Business Income. QBI is defined as the net amount of items of income, gain, deduction and loss attributable to each qualified business conducted by a sole proprietor or pass-through entity. QBI excludes wages and reasonable compensation by an owner received from an S corporation, and guaranteed payments received by a partner for services provided to a partnership’s business. Also excluded are specified investment-related items including capital gains or losses, dividends, interest income, qualified REIT dividends, qualified cooperative dividends or qualified publicly traded partnership income. The amount of QBI allowed as a deduction is subject to the limitations discussed below.

Allowable QBI Deduction. An owner or investor in a qualified business may deduct up to 20% of QBI, subject to the following limitations:

W-2 Wage Limitation. The QBI deduction may not exceed the greater of: (i) 50% of W-2 wages paid to employees of the qualified business during the taxable year, or (ii) the sum of 25% of W-2 wages plus 2.5% of the unadjusted basis (usually, the original acquisition cost) of qualified property. “Qualified property” means tangible, depreciable property, including tangible property and real property improvements, used in the qualified business for the production of income, and for which the depreciable period has not ended before the close of the tax year.  Under an exception to this limitation, the W-2 wage limitation does not apply to reduce the amount of the full QBI deduction until an owner’s taxable income exceeds $157,500 or $315,000 for joint filers (the “Threshold Amount”). In other words, the full 20% QBI deduction is allowed for owners with taxable incomes under the Threshold Amount. The W-2 wage limitation is phased in for taxable income over the Threshold Amount and is fully applicable for taxable incomes which exceed the Threshold Amount by $50,000 for individuals and $100,000 couples (i.e., $207,500 for individuals, and $415,000 for joint returns).

Specified Service Businesses. Owners of specified service businesses (as described above) with taxable income below the Threshold Amount are eligible for the full 20% QBI deduction. Unfortunately, the QBI deduction is phased out and eliminated for owners with taxable incomes in excess of $207,500 for individuals, and $415,000 for joint returns.

Trusts and Estates. Trusts and estates are eligible for the 20% deduction under Code section 199A. Rules similar to the rules under present-law Code section 199 (as in effect on December 1, 2017) apply for apportioning W-2 wages and unadjusted basis of qualified property between fiduciaries and beneficiaries.

Example:   Taxpayer owns an office building that has an unadjusted basis when purchased of $10,000,000, of which $8,000,000 is allocated to a depreciable building.  Taxpayer has four employees with a total W-2 wages paid of $300,000.  Taxpayer’s net income from the building is $1,000,000.

Information Needed to Calculate the QBI Deduction:

20% of qualified business income: $200,000

50% of W-2 wages: $150,000

25% of W-2 wages: $75,000

2.5% of the unadjusted basis of depreciable property: $200,000

The lesser of: (i) $200,000 (QBI) or (ii) the greater of: (a) $150,000 (50% of W-2 wages) or (b) $275,000 (25% of W-2 wages plus 2.5% of unadjusted basis of depreciable property).

Answer: The maximum QBI deduction is allowed since $200,000 is less than $275,000 which results from the combined wage and depreciable basis calculation. The result would remain the same if the taxpayer in the above example had no employees since 2.5% of $8,000,000 is $200,000, an amount equal to $200,000. If the value of the unadjusted basis of the building is reduced to $7,000,000 and there are no employees, the QBI deduction would be limited to $175,000 (which is 2.5% of $7,000,000).

Sunset: The Section 199A provisions discussed above expire on December 31, 2025, unless Congress extends or eliminates the sunset date.

If you have questions, please contact either Jim Leet (jleet@boutinjones.com) or Jon Christianson (jchristianson@boutinjones.com) at (916) 321-4444.

 

Legal disclaimer: The information in this article (i) is provided for general informational purposes only, (ii) is not provided in the course of and does not create or constitute an attorney-client relationship, (iii) is not intended as a solicitation, (iv) is not intended to convey or constitute legal advice, and (v) is not a substitute for obtaining legal advice from a qualified attorney. You should not act upon any of the information in this article without first seeking qualified professional counsel on your specific matter.

Practices

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Employment Law Practice Alert: California's New Salary History Ban

California has joined a handful of jurisdictions in banning employers from prompting applicants for salary history. The law, Assembly Bill 168 (“AB 168”), takes effect January 1, 2018, and employers must ensure that their policies, procedures and practices comply with the new ban. AB 168 applies to both private and public employers.

AB 168 is the next step in the evolution of California’s equal pay landscape. California has had its own Equal Pay Act since 1949, which was recently amended in 2015 by the California Fair Pay Act. That existing statutory scheme already prohibits employers from relying solely on salary history to justify pay discrimination. However, the wage gap has persisted. According to the U.S. Department of Labor Bureau of Labor Statistics, in 2016 women in California earned approximately 88 percent of the median salary of male counterparts.

AB 168 prohibits employers from inquiring about or utilizing salary history in making a decision as to whether to hire an applicant or how much salary to offer the applicant. However, if an applicant volunteers his or her salary history, such as by including prior salaries on a resume, an employer can consider that information only in connection with making a salary determination for the applicant, but not in the decision as to whether or not to hire the applicant.

One unique aspect to AB 168 is that it requires an employer to provide a pay scale for the position at the applicant’s reasonable request. The law does not explain or define what may be considered a reasonable request, although it is difficult to imagine a scenario in which it is unreasonable for a job candidate to ask about compensation. Failure to comply with AB 168 could subject an employer to civil liability.

Therefore, compliance with AB 168 should be a multi-step approach. First, employers should review any written policies and procedures governing hiring practices, beginning with employment applications. Employment applications should not include any questions regarding prior salaries. Even including a space for salary information could be viewed as “prompting” the applicant for a salary history in violation of the new ban. The safest approach will be to delete any reference of prior salary on an employment application altogether.

Second, employers should consider their hiring practices. Human Resource managers or other persons conducting interviews or engaging in the hiring process should be informed of the change to the law. Asking a candidate about salary history during the interview process is a violation of the ban and could expose an employer to liability. Employers should consider taking the extra precaution of training interviewers to disregard any salary information volunteered by an applicant during an interview.

Finally, employers should be prepared to disclose a pay scale to an applicant upon reasonable request. Employers should use the time before the law takes effect to assess or create pay scales, ideally for all positions, but most urgently for any open positions or soon to be open positions.

Please contact Julia Jenness, Kimberly Lucia or another member of our Employment Law Group if you have any questions or concerns about AB 168.

Legal disclaimer: The information in this article (i) is provided for general informational purposes only, (ii) is not provided in the course of and does not create or constitute an attorney-client relationship, (iii) is not intended as a solicitation, (iv) is not intended to convey or constitute legal advice, and (v) is not a substitute for obtaining legal advice from a qualified attorney. You should not act upon any of the information in this article without first seeking qualified professional counsel on your specific matter.

 

Practices

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New Partnership Audit Rules Require the Amendment of Existing Partnership Agreements and Operating Agreements to Avoid Future Adverse Economic Results for Partners

Practice Alert

By: Jonathan Christianson and Brian Bowen

October 2017

Under existing law, except for small partnerships, Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”) partnership audits of partnerships and limited liability companies that file as partnerships (“Partnership Entities”) occur at the partnership level, but the income tax due is assessed and collected at the partner level.  As a result, audits of Partnership Entities are currently burdensome and expensive for the Internal Revenue Service (“IRS”). In an attempt to simplify TEFRA audit procedures and to streamline the collections process, Congress has enacted new rules governing partnership audits in The Bipartisan Budget Act of 2015 (the “New Rules”) which will replace the existing rules governing partnership audits for most Partnership Entities.

Audits for 2017 and before will continue to be under the old TEFRA audit rules. The new rules apply to audits of tax years beginning after December 31, 2017; that is, for partnership tax years beginning on January 1, 2018 or later. Under the New Rules, additional tax resulting from audit adjustments will be assessed and collected at the Partnership Entity level and, with certain exceptions discussed below, the Partnership Entity will be responsible for payment of any taxes and penalties that are assessed or will receive any refund that may be allowed. As a result, the tax burden or refund benefit from a prior tax year may be shifted from former partners in the year under review to partners who continue as partners at the time of the audit adjustment. For example, a person admitted as a partner in 2019 might be required to bear the tax liability resulting from an audit adjustment relating to a tax period before that person became a partner. Unless addressed in the Partnership Entity’s governing documents, potential new investors may be reluctant to become partners, especially if the entity has previously engaged in tax deferred transactions such as like-kind exchanges.

Under the New Rules, a “partnership representative” replaces the “tax matters partner” required under existing law. Unlike the tax matters partner, the partnership representative has exclusive authority to act on behalf of the Partnership Entity with respect to the resolution of an audit, including the authority to appeal an assessment or settle with the IRS or other taxing agency. The actions of the partnership representative will bind the Partnership Entity and all of the partners at the time of the assessment. Beginning on January 1, 2018, the Partnership Entity’s governing documents must identify the partnership representative. The governing documents should also specify how a successor is appointed or removed and define the scope of the partnership representative’s discretion to resolve audit issues without the consent of the partners. Decisions made by the partnership representative in connection with an audit may have significant economic effects on the Partnership Entity and the continuing partners.

A particularly vexing feature of the New Rules is that the assessment of tax at the Partnership Entity may result in the imposition of tax on individuals who were not partners during the audited year and, conversely, the avoidance of tax by partners who withdrew as partners before the assessment of additional tax. As a result, the Partnership Entity should consider whether an indemnification provision should be included in the partnership agreement so that all persons who were partners during the audited year are ultimately responsible to the IRS or the Partnership Entity for any tax liability that would have been allocated to and paid by such partners. Similarly, the partners might consider whether a former partner should be compensated for any additional loss allocation or refund that would have benefitted such former partner.

Certain Partnership Entities may elect out of the New Rules (in which case the old audit rules apply). To qualify, the electing partnership must have 100 or fewer partners, and all of its partners must be individuals, corporations, estates of deceased partners or foreign entities treated as C corporations.  If a Partnership Entity has, as a partner, another partnership, a disregarded entity, a trust or even, it appears, a revocable living trust, then the Partnership Entity is not eligible to elect out of the New Rules. The election out of the New Rules is made with a timely filed tax return for the Partnership Entity for each taxable year and includes a disclosure of the name and taxpayer identification number of each partner of the Partnership Entity. The Partnership Entity must also notify each partner of such election.  Since most Partnership Entities are owned by legal entities, disregarded entities or trusts, we expect that few Partnership Entities will be eligible to elect out of the New Rules.

Although the Partnership Entity may be unable to elect out of the New Rules, a Partnership Entity can, in some instances, “push” the additional tax liability out to the partners. To do so, a Partnership Entity must make an election within forty-five (45) days after the final notice of adjustment. If the election is made, the Partnership Entity must provide to each partner a statement of the partner’s share of the final partnership adjustment for the year of the audit. Each partner for the year of the audit is then responsible for paying tax on such partner’s share of the adjustment, which includes a higher interest charge than normally imposed. For the election to be effective, the Partnership Entity must also provide the IRS with the current address and taxpayer identification number for each partner and any former partners who were partners in the year being audited. Failure to provide current information for all such persons renders the Partnership Entity liable for the additional tax or penalties assessed. As a consequence, the partners should consider amending the Partnership Entity’s governing documents to require each partner and any former partner for a specified period to advise the Partnership Entity of any change of address or taxpayer identification number.

A Partnership Entity’s governing documents should be drafted or amended to conform to the New Rules. At a minimum, a Partnership Entity’s governing documents must identify the partnership representative and should specify the scope, authority and obligations of the partnership representative, the current partners and the former partners with respect to an audit. In addition, the partners should consider whether it is in their interest to provide an indemnification mechanism in the partnership agreement designed to match the tax benefit or liability with the partners who were partners during an audited year.

If you have any questions on how the New Rules will affect your Partnership Entity, or desire to amend your entity’s governing documents, contact a tax attorney at Boutin Jones Inc.

Legal disclaimer: The information in this article (i) is provided for general informational purposes only, (ii) is not provided in the course of and does not create or constitute an attorney-client relationship, (iii) is not intended as a solicitation, (iv) is not intended to convey or constitute legal advice, and (v) is not a substitute for obtaining legal advice from a qualified attorney. You should not act upon any of the information in this article without first seeking qualified professional counsel on your specific matter.

 

Practices

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If Opportunity Knocks, Are You Ready to Open the Door? Being Sale-Ready in a Dynamic Business Environment

Historically low interest rates, demographics and market dynamics have created an environment where the opportunity to sell a business has never been better.

  • In 2008, business owners who may have been looking for an exit strategy were sidelined by the recession. Now, almost ten years later, many of these businesses have rebounded and their aging owners are looking for the exit as retirement looms ever closer.
  • After a few years of robust new company formation, an entire new generation of businesses are looking to be acquired by private equity groups and strategic buyers flush with cash seeking returns by consolidating new opportunities across regions, businesses and industries.

Most business owners are so busy running their businesses that they aren’t actively looking for an exit when an investment banker or business broker calls.

According to a recent survey of mid-market businesses, 53% of sellers are currently involved in or open to considering a sale in 2017 compared to only 34% in 2016. Even if you weren’t thinking about selling your business, your competitors might be. If you don’t answer the call, they might and there may not be a second chance. That call might be your first, last and best opportunity to maximize the value of your business.

Get Sale-Ready

If you get that call, would you be ready to sell? Fortune favors the well prepared, so being in a sale-ready state will allow you to take advantage of these opportunities when they arise. That state of readiness doesn’t happen overnight.

A recent survey showed that 37% of mid-market businesses considered themselves unprepared or neither prepared nor unprepared for sale. The flip side means that 63% of these businesses considered themselves prepared. As momentum shifts towards a buyer’s market, being prepared for sale can be the difference between success and failure.

Building your business into a sale-ready state will permit you to answer the door if opportunity knocks. It will also force you to focus on not only what drives the business but also what drives value in the business.

Assemble the Team

With a little advance planning, making your business sale-ready is a manageable task. The first step is assembling your team of key advisors—accountants, attorneys, tax advisors and financial planners. The goals should be to understand:

  • the sale process,
  • what your business will look like to a buyer,
  • steps you can take to increase the potential sales price for your company, and
  • how deal structures can impact how much you’ll be able to keep after the sale.

Engaging with your key advisors to model the potential outcomes can help set expectations appropriately and guide you to make any structural changes that could have a significant impact on your financial outcome if undertaken far enough in advance of any anticipated sale.

Confidentiality is key. The team must be made up of those you can trust to keep the process confidential. Revealing too early that you may be planning for a sale could send key employees packing or give valued customers a reason to go elsewhere.

Conduct Self-Diligence

A big piece of the sale process is the due diligence investigation conducted by the buyer and their advisors. That process will examine in excruciating detail all aspects of your business from finances to business processes to structural and legal matters. Your goal is to make sure the due diligence process goes as quickly and smoothly as possible, and does not reveal any deal-breaker issues.

Financial statements (and everything that goes into them) will be a prime target for scrutiny. Have they been prepared in accordance with GAAP? Are they compiled, reviewed or audited by a CPA? Have revenues and expenses been accounted for properly? Your company’s financials will form the basis for determining the value of your business. With advance work, policies and procedures can be implemented to increase their accuracy.

Ownership structure will be another key focus area. Are there any:

  • areas of dispute or uncertainty regarding ownership?
  • messy situations with former owners or departed employees?
  • promises or agreements regarding equity ownership that haven’t been resolved?

Key contracts are another area that can have a big impact on a sale. Are they assignable without the consent of the counterparty? Are long term contracts nearing expiration? Is there a new lease negotiation coming up in the near future?

Other areas that should be reviewed well in advance of a sale process include:

  • employment contracts and policies;
  • commercial credit arrangements;
  • pending or threatened disputes or litigation;
  • licensing and regulatory matters; and
  • intellectual property infringement issues.

With advance planning, all of these items can be reviewed and addressed in an orderly fashion and with a view to being able to deliver a thriving and stable business to a buyer with minimal delay and disruption and no post-closing surprises that could require you to forfeit a portion of the purchase price.

Preparing for Due Diligence

A prospective buyer’s due diligence investigation will require the review of a host of documents and business records. This usually means scanning and sharing pdfs of critical records and documents.

Collecting these documents and being prepared to make them available to a prospective buyer, their advisors and your advisors can be time consuming and disruptive. Often the flurry of activity required to respond to due diligence can tip off employees that something big might be in the works.

If key records and documents can be collected well in advance, it’s usually far less expensive and much less disruptive to the business. Many advisors, such as law firms, business brokers or accounting firms, can provide access to a virtual data room to allow you to upload these documents to a confidential and controlled site so they can be shared with one or more prospective buyers and their advisors without having to make and deliver physical copies or permit numerous on-site visits to inspect them.

Plan for Tomorrow Today

Even if you aren’t thinking about a sale in the near future, engaging in some thoughtful pre-planning is still wise. Market conditions, a health crisis or loss of a key employee, supplier or customer may force a decision sooner than desired. Engaging early will give you the time and information to preserve and enhance the value of your business so you have the choice to open that door when opportunity knocks.

You may find that, whether or not you sell your business, changes and improvements that you make as a result of the preparation-for-sale process increase the value and profitability of your company.

Contact Dennis Michaels or any of the attorneys in our corporate, tax or estate planning groups to begin planning for tomorrow today.

Legal disclaimer: The information in this article (i) is provided for general informational purposes only, (ii) is not provided in the course of and does not create or constitute an attorney-client relationship, (iii) is not intended as a solicitation, (iv) is not intended to convey or constitute legal advice, and (v) is not a substitute for obtaining legal advice from a qualified attorney. You should not act upon any of the information in this article without first seeking qualified professional counsel on your specific matter.

Practices

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Boutin Jones Welcomes New Shareholder

Jim McNairy has joined Boutin Jones as a new shareholder. Jim’s practice focuses on employment and business litigation, with a particular emphasis on protecting and enforcing intellectual property rights. He represents a wide range of companies and has been very effective in achieving excellent results, including never failing to obtain injunctive relief after initiating suit to help prevent unauthorized disclosure or use of client trade secrets. He is a graduate of the University of the Pacific, McGeorge School of Law.  

James D. McNairy      |       jmcnairy@boutinjones.com      |       916.321.4444

 

 

 

 

 

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Practices

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California Supreme Court Decision on Documentary Transfer Tax

On June 29, 2017, the California Supreme Court held in 926 North Ardmore Avenue, LLC, v. County of Los Angeles, “Section 11911 [of the Revenue and Taxation Code] permits the imposition of a documentary transfer tax whenever a transfer of an interest in a legal entity results in a change in ownership of real property within the meaning of section 64, subdivision (c) or (d), so long as there is a written instrument reflecting a sale of the property for consideration.” So, whenever there is a change in control of an entity owning California real property or an original co-owner rule change in ownership of an entity owning California real property, documentary transfer tax applies, “so long as there is a written instrument” reflecting the sale of the interest in the legal entity for consideration.” In this case the written instruments were “six limited partner transfer and substitution agreements.”

The decision emphasizes the term “written instrument.” The statute refers to “each deed, instrument, or writing.” It is possible for a partnership interest, an LLC membership interest or a corporate stock transfer to occur without a written purchase and sale, transfer or substitution agreement, but the partnership agreement, LLC operating agreement and corporate stock register, respectively, would need to be updated to reflect the transfer of the partnership interest, membership interest or corporate stock. It remains to be seen whether in a case involving an oral transfer agreement a court would hold the update to the partnership agreement, LLC operating agreement or corporate stock register constituted a “written instrument.” We certainly know the counties and cities will take an affirmative position.

Legal disclaimer: The information in this article (i) is provided for general informational purposes only, (ii) is not provided in the course of and does not create or constitute an attorney-client relationship, (iii) is not intended as a solicitation, (iv) is not intended to convey or constitute legal advice, and (v) is not a substitute for obtaining legal advice from a qualified attorney. You should not act upon any of the information in this article without first seeking qualified professional counsel on your specific matter.

Practices

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LLCs Take Note: An Individual Who is Not a Manager or a Member Can Bind Your Company in Contract

In Western Surety Co. v. La Cumbre Office Partners, LLC, 8 Cal. App. 5th 125 (Cal. Ct. App. 2d Dist., Feb 2, 2017), a limited liability Company was subjected to claims for $6.07 million under an indemnity agreement even though the agreement was signed by an individual with no authority to bind the LLC and the agreement bore no relationship to the LLC’s business. The court determined that third parties benefit from a statutory safe harbor whereby an agreement is binding on an LLC even if the “manager” signing has no authority to sign, as long as the third party does not have actual knowledge of the manager’s lack of authority. Further, the court stated that third parties have no duty to conduct due diligence to ensure a signer is in fact an authorized signer.

Background:

La Cumbre Office Partners, LLC, a California limited liability company (the LLC), was managed by Melchiori Investment Companies, LLC (the Sole Manager). Mark Melchiori (Melchiori) was the managing member of the Sole Manager and the president of a separate corporation named Melchiori Construction Company, Inc. (Construction).

The purpose of the LLC was to hold and operate a single medical office building. The purpose of Construction was to engage in the construction business. Melchiori signed an indemnity agreement covering Construction’s projects. Even though the LLC received no benefit from, and had no relation to, the bonds underlying the agreement, the agreement included a signature block for the LLC to sign as an indemnitor. Melchiori signed the agreement in his individual capacity as the “managing member” of the LLC. Melchiori had no authority to sign the agreement and the agreement was not approved by any of the members of the LLC or by the Sole Manager.

The underwriter for the surety that prepared the agreement did not undertake any due diligence to determine whether or not Melchiori was authorized to sign the agreement on behalf of the LLC. Melchiori testified that when he signed the agreement he did not notice that he was signing on behalf of the LLC as its managing member, or that the LLC was listed as an indemnitor. He also testified he had no idea why the LLC was named as an indemnitor.

Construction defaulted on the contracts and the surety paid claims guaranteed under the bonds totaling $6.07 million. When the LLC refused to reimburse the surety for any of its losses or expenses, the surety filed a claim against the LLC.

Court’s Findings:

Despite the LLC receiving no benefit from, and having no relation to, the bonds, and despite the fact that an individual without any legal authority signed on behalf of the LLC, the court found that the LLC was bound by Melchiori’s signature on the agreement.

The court’s decision was based on Section 17157(d) of the California Corporations Code which provides as follows:

[A]ny… contract… or other instrument in writing… executed or entered into between any limited liability company and any other person, when signed by at least two managers (or [as here] by one manager in the case of a limited liability company whose articles of organization state that it is managed by only one manager), is not invalidated as to the limited liability company by any lack of authority of the signing managers or manager in the absence of actual knowledge on the part of the other person that the signing managers or manager had no authority to execute the same.1

This rule provides third parties with a statutory safe harbor whereby a written contract signed by an LLC’s manager is valid, even if the manager, without the knowledge of the third party, did not have authority. The court noted that the LLC did not claim that the surety had actual knowledge that Melchiori lacked authority to sign on behalf of the LLC. Thus, pursuant to the statutory rule, the LLC would be bound by the Agreement if it was found to have been signed by the LLC’s manager.

The LLC argued that the LLC’s manager did not sign the Agreement because the LLC’s manager was the Sole Manager, not Melchiori. The court found that a similar statutory rule applies to corporations. A prior case interpreting the rule held that corporate officers who sign on behalf of a corporation are not required to specify the office or offices they hold with their signature for the statute to apply, provided the signer is the person he or she is statutorily required to be (e.g., a president and CFO or secretary). In light of that case, the court found that had Melchiori signed his name without any official position, the LLC would have been bound by the agreement. Thus, the fact that the agreement mistakenly designated Melchiori as the managing member was a distinction without a difference. The actual manager of the LLC was a legal entity and therefore could sign the agreement only through the signature of a natural person. The natural person authorized to sign on the Sole Manager’s behalf was its managing member, Melchiori, and Melchiori did, in fact, sign the agreement. Therefore, the LLC was bound by the agreement despite the mistaken identification of Melchiori individually as its sole manager.

Lastly, the court found that whether a third party exercises due diligence to ensure a signer is in fact an authorized signer is irrelevant. The statutory rule does not require due diligence by third parties.

Does the LLC Have Recourse?

The LLC could sue Melchiori in his individual capacity for losses to the LLC sustained as result of his negligence or breach of fiduciary duty. However, any recovery would necessarily damage the relationship between the LLC and its manager and any recovery would be limited to the extent of Melchiori’s personal assets or insurance coverage, if any.

The Right Result?

This case appears to support the ability of a person (any person) to sign an agreement as the manager of a limited liability company (any limited liability company), causing the limited liability company to be legally bound in contract. This doesn’t seem like the right result. The court’s decision did not address two defenses the LLC might have made in this case: Without the LLC receiving any value or benefit by entering into the indemnity agreement, there wasn’t any legal consideration supporting the contract as between the surety company and the  LLC. Without consideration, there is no binding contract. Further, because Melchiori testified he didn’t notice he was signing on behalf of the LLC, an argument based on the defense of mistake also might have avoided this result. Because the court did not discuss these defenses, it appears they were not raised by the LLC in the litigation. Perhaps the court would have come to a different result had these defenses been asserted by the LLC.

A petition for review by the California Supreme Court has been filed in this case by the LLC. This Article will be updated to reflect whether review was granted and, if so, the end result. Nevertheless, the court’s decision currently stands and presents a risk for limited liability companies.

How Can a Limited Liability Company Avoid this Scenario?

A limited liability company could expand the indemnification provisions in its operating agreement to make the manager of the limited liability company liable for losses resulting from the negligence of its officers or agents. Since Melchiori was an officer of the Sole Manager, such a provision could have been relied upon by the LLC to seek recovery of the $6.07 million from the Sole Manager. However, such a provision would be unusual, in that most operating agreements contain provisions aimed at limiting the liability of the manager of the limited liability company. It may be difficult to find an entity that would be willing to serve as the manager if you insist on including such a provision in the operating agreement of your limited liability company.

Perhaps the better course of action is to take measures designed to ensure that this scenario never applies to your limited liability company. For example, you may wish to communicate the findings of the Western Surety case with the members, managers and officers of your limited liability company. Remind those who regularly bind your limited liability company to be vigilant about what agreements they are signing and whether they are being executed properly on behalf of your limited liability company. All material agreements should be reviewed by counsel to your limited liability company before they are signed.

We’re here to help. Please contact Andrea Bacchi, Iain Mickle or any other member of the Boutin Jones Corporate and Securities Group if you have any questions regarding this article.

Legal disclaimer: The information in this article (i) is provided for general informational purposes only, (ii) is not provided in the course of and does not create or constitute an attorney-client relationship, (iii) is not intended as a solicitation, (iv) is not intended to convey or constitute legal advice, and (v) is not a substitute for obtaining legal advice from a qualified attorney. You should not act upon any of the information in this article without first seeking qualified professional counsel on your specific matter.

1    Even though this case was governed by the older LLC law, the Beverly-Killea Act, the court pointed out that identical language is contained in Corporations Code section 17703.01(d) of the California Revised Uniform Limited Liability Company Act, the current law governing LLCs formed on and after January 1, 2014.

 

Practices

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M & A Engagement Letters - Don't Get Stung by the Success Fee

You’ve decided to sell your company, and you’ve engaged a financial advisor to find a buyer. The financial advisor sends you its standard form of engagement letter, and you sign it. Agreeing to pay the financial advisor a commission based on the sales price seemed reasonable at the time.

The engagement letter contains the following provisions (based on an actual engagement letter):

“Success Fee:  If, during the term of this agreement, the Company consummates a sale of stock or assets, the Company agrees to pay financial advisor in cash at the closing a success fee

in the amount of $225,000 plus three percent (3.0%) of the Selling Price.

“Selling Price” means the sum of the fair market value of any consideration received by the Company and/or its owners including:

(a)  Cash, notes and/or other securities from the purchaser, plus

(b)  The fair market value as of the closing of any assets including cash, other working capital and any other assets, less liabilities retained by the Company or distributed to its owners, plus

(c)  Any interest-bearing debt of the Company as of the closing that is assumed by the purchaser or is satisfied by the Company and/or its owners as of the closing; plus

(d)  Any contingent payments, noncompete agreements, consulting agreements, employment contracts and other forms of remuneration associated with the transaction received by any of the owners of the Company.”

Congratulations, We’ve Got a Deal!

A buyer for your company is found and a deal is consummated! The agreement calls for the purchase and sale of all of the outstanding stock of your company for an aggregate purchase price of up to $15 million, consisting of $10 million paid on the closing date and $5 million in the form of an earn-out (i.e., payment is contingent on the achievement of certain financial milestones after the closing).

  • Of the $10 million payable at closing, $5 million is payable in cash and $5 million is payable pursuant to a five-year promissory note.
  • Of the $5 million of cash payable at closing, $1.5 million is deposited into an escrow account to be used to satisfy the sellers’ indemnification obligations.
  •  The agreement requires the company to have at least $1.5 million of working capital on the closing date and requires the sellers to pay off a $1 million outstanding line of credit.
  • You and the other three owners of the company are each given an employment contract by the buyer that provides for a base salary of $250,000 per year.

The success fee is due and payable at closing

At the closing, the financial advisor determines the Selling Price to be $18.5 million, consisting of:

  • $15 million (the cash deemed to be received by the sellers at the closing plus the principal amount of the seller note); plus
  • $1.5 million (working capital required at closing); plus
  • $1.0 million (line of credit paid off at closing by the sellers); plus
  • $1.0 million (the deemed value of the employment contracts to the four sellers).

Accordingly, at closing the financial advisor receives $225,000 plus three percent of $18.5 million, for a total success fee of $780,000.

Unfortunately, things don’t work out as anticipated

As it turns out, the buyer was in over its head and didn’t understand your industry. It files for bankruptcy and defaults on the $5 million seller note. Before filing for bankruptcy, however, the buyer is successful in obtaining indemnification payments for the full escrow amount of $1.5 million. Needless to say, the earn-out milestones are not achieved, so neither you nor the other sellers receive any of the $5 million earn-out. In the end, you paid a success fee based on a “Selling Price” of $18.5 million but only received $2.5 million after paying off the $1 million line of credit. (You shake your head at the concept of paying a commission on debt that you pay off. That’s just crazy, you think.)

Had you paid a success fee based on what you and the other sellers actually received, it would only have amounted to $300,000. In hindsight, you overpaid the financial advisor by $480,000, or 160%. You’ve been stung by the success fee.

How to avoid being stung by the success fee

As this example illustrates, it is critical to get advice from experienced counsel before you engage a financial advisor for the sale of your business. To avoid being stung by a success fee in an M&A engagement letter:

  • Don’t sign any engagement letter until you’ve had it reviewed by your legal counsel and you’ve had an opportunity to discuss its terms with your counsel.
  • Limit any success fees based on an earn-out to earn-out amounts actually received;
  • Don’t include assumed debt in the definition of sales price upon which the success fee is based (after all, the assumption of the debt was factored into the purchase price);
  • Don’t agree to pay a commission on debt you pay off;
  • Exclude ancillary items from the definition of sales price, such as payments for consulting or employment agreements (after all, you need to perform services to receive those payments);
  • Only pay a success fee based on amounts in an escrow account if you actually receive those amounts;
  • Ensure the success fee structure incentivizes the financial advisor to secure the most favorable economic terms (such as by using a progressive fee structure where the fee percentage increases the higher the sales price); and
  • Ensure the minimum fee, if any, is not structured to disincentivize the financial advisor from seeking the best price for the transaction.

We’re here to help. Please contact Iain Mickle or any other member of the Boutin Jones Corporate and Securities Group if you have any questions regarding this article.

Legal disclaimer: The information in this article (i) is provided for general informational purposes only, (ii) is not provided in the course of and does not create or constitute an attorney-client relationship, (iii) is not intended as a solicitation, (iv) is not intended to convey or constitute legal advice, and (v) is not a substitute for obtaining legal advice from a qualified attorney. You should not act upon any of the information in this article without first seeking qualified professional counsel on your specific matter.

M&A Engagement Letters - Don't Get Stung by the Success Fee (PDF)