An easy way to mistakenly give up your protection is by not properly signing agreements with the appropriate signature block that designates your representative capacity.  When signing a LLC the signature block should contain the LLC’s name and the title of the signing member, or manager.  Mishandle this important step and the courts may not be so forgiving.

In Hazer v. Zabala, 26 A.3d 1166, 2011 Pa. Super. LEXIS 2227 (Pa. Super. Ct. Aug. 11, 2011), Juan Zabala signed his name to a lease, and underneath printed “DBA/ZABALA BROKER, LLC.” The landlord sued Zabala when the rent was not paid, and Zabala defended on the ground that the LLC, not Zabala, was the party to the lease.

The court disagreed.  It found the “DBA” was an abbreviation for “doing business as” and saw Zabala’s signature and an indication that Zabala Broker LLC was just another name for Juan Zabala.  The problem for Mr. Zabala is his signature did not identify his representative capacity in the LLC.  Without such a designation Mr. Zabala obligated himself personally under the lease.  Here are some common errors I have come across:

John Doe on behalf of ABC, LLC  — (John has not indicated his position)
John Doe, ABC LLC  — (John has not indicated his position or representative capacity)
John Doe Manager  — (John has indicated his position but not his representative capacity)
John Doe President  — (LLCs do not typically appoint officers)

When signing on behalf of you LLC you should sign as follow:
John Doe on behalf of ABC, LLC as its Manager (in the case of a member managed LLC you would use Member/Manager) or in the case of a Corporate Manager – John Doe, President of XYZ, Inc, on behalf of ABC, LLC as its Manager.

Another issue in Zabala the court recognized was Zabala Broker LLC was not in existence at the time Mr. Zabala signed the lease.  Thus, by not forming your entity prior to entering into a contract no signature block, no matter how correct, will save you from personal liability.

This should serve as a reminder that it is the details that matter.  The weakest link in your asset protection planning is also the strongest because it can break your protection.

In a recent Texas case, Lentz Engineering, L.C. v. Brown, two individuals were hit head on with such a boomerang.  In Lentz, William Wilkins and Alden Brown, planned to purchase and develop real estate together.  Eager to move forward, Wilkins entered into a contract to purchase some property, followed by Brown and Wilkins meeting with an attorney in February 2005 to form a Texas LLC to carry out the development. In March Brown gave Wilkins $400,000 to purchase the property, and Wilkins acquired the real estate in April. One day later, the attorney filed articles of organization for the LLC, which identified Brown and Wilkins as the LLC’s managers.

Like most partnerships, this one had the shelf life of a tomato and by the summer the parties were at odds. Brown wanted out and his money back while Wilkins entered into a contract in his own name with Lentz Engineering for engineering services on the LLC property.  Lentz performed its work under the contract but was not paid.

Lentz then sued both Wilkins and Brown for breach of contract. Lentz’s theory was that Wilkins was directly liable on the contract, and that Brown was liable because he was partners with Wilkins and was therefore fully liable for the debts of the partnership.  Of course Brown agued he and Wilkins were not partners but members in a LLC and therefore he was not liable to Lentz.  Lentz argued that Wilkins and Brown had formed a partnership to run their business and a LLC to hold the property.  Therefore, both parties were liable as a general partnership.

UGH, what a mess.  The court looked at the issue and considered several factors in determining if a partnership has been created which include:

• sharing of profits of the business;
• sharing of losses or liability for claims;
• contributing or agreeing to contribute money or property to the business;
• participating in control of the business; and
• expressing an intent to be partners in the business.

Thankfully for Brown the court found that a partnership did not exist because a LLC was formed before Wilkins entered into the contract with Lentz and only two of the factors above existed bewteen the parties.  However the lessen to take from this case is be very careful of your actions and terminology prior to forming an entity to conduct your business.  If one partner signs a contract before the LLC is formed, and then things fall apart and the LLC is not formed, the organizers may find that as partners they are all jointly and severally liable on the contract.

How to avoid this outcome? Expunge the word “partners” from any description when referring to a business associate. One of the great benefits of LLCs is their limited liability; don’t open the door to personal liability by calling yourselves partners.

Investors who plan to work together should create their entity early before any contracts are signed or negotiated. 

So why the background information on Code Sec. 162?  Because many small business owners sometimes forget that reasonableness is inherent in the phrase “ordinary and necessary.”  I will often joke with people when discussing possible tax deductions that if the through of writing something off as a business expense brings a smirk to your lips you probably shouldn’t.  (This is known as the giggle test, i.e., if you find it funny the IRS will not.)

For the small business owner, the reasonableness concept has particular significance when dealing with management fees, rents, consulting fees, etc. between commonly controlled business entities.  Do these payments represent ordinary and necessary expenses?  In a recent Tax Court case this was at issue when a taxpayer was denied the ability to deduct management fees, in amounts greater than IRS allowed, that his single-member limited liability company (LLC) paid to his wholly owned C corporation.

In this case, the taxpayer’s LLC paid his C corporation (classic income shifting strategy to reduce tax at the individual level and move it into a corporation where he can find additional deduction) a monthly consulting fee of $9,000.  (Note: the taxpayer claimed this as an “other expense” on his tax return e.g., $96,000 a red flag for any auditor.) When audited the taxpayer could not establish how the monthly fee were determined, provide a written contract, produce a detailed invoice or provide an evidence of special skills that might warrant the consulting fees.  Essentially the taxpayer thought all he had to do was set up a C corporation and begin charging his LLC a monthly fee.  The court disagreed and the taxpayer’s management fee was reduced by 60% on audit.   

For the real estate investor or small business owner who would like to utilize a management company for tax savings this case should serve as a warning that the details matter.  I run into many people who believe entity planning can be accomplished by reading a book, listening to a lecture, then filing a few entities with the state and everything will be roses.  For many it usually is until an audit or lawsuit develops and then you will discover what it is you don’t know.

A good asset protection planner must know the difference between these entities from a tax and asset protection standpoint, where is the appropriate state to file the entity, and when one entity type should be used over another (this is not an exhaustive list).  For example, this past week I met a real estate investor in Orlando while speaking at an asset protection workshop.  This person, whom I shall refer to as Sally, was distraught over a lien that was about to be levied on her condo by the Condo Owner’s Association.  Sally was completely beside herself because she thought she made the right move when she transferred her condo into a LLC for asset protection.  Through conversing with Sally, she informed me that she had read and subsequently heard from her local REIA that rental property should be held by LLCs for asset protection.   Sally wanted to know why no one had told her that in transferring her property she would face a fine for implementing this strategy.  What Sally did not understand is generally speaking this is sound advice but not knowing the nuances of holding title will create problems as Sally discovered. 

In Florida, it is very common for community associations to limit who may own property.  When these communities where planned the developer and subsequent owners did not want landlords buying up the property and turning the community into a rental pool.  To combat this, rules were adopted to prevent business entities from owning property within the community.  If Sally had consulted my firm we would have told her to first utilize a land trust (see Land Trust Part 2 for more information on land trusts and holding title to property) to hold title to her property.  After the property was recorded in the name of her trust, Sally could have easily transferred her trust into a LLC for asset protection and no one would be the wiser. 

This post is not about land trusts but about not knowing or understanding the nuances of asset protection.  Many of the people I met last week planned to embark on their own asset protection planning without realizing that it is the details that can spell the difference between success and disaster.  Just because it sounds like the right thing to do does not necessarily mean that it will work.  In a prior post, Running your Real Estate Business out of Nevada or Wyoming, I addressed the use of a Nevada or Wyoming LLC registered in a different state to hold rental real estate.  Investors falsely assume that the charging order protections offered by Nevada or Wyoming will apply even if the investor is sued in the state where the LLC is foreign filed.  I explained how a court would most likely apply the foreign state’s law in deciding what protections will be afforded to its members.  In a recent Utah case, American Institutional Partners, LLC (“AIP”) v. Fairstar Resources LTD (“Fairstar”), this was exactly this issue.

In that case, Mark Robbins established AIP in Delaware then foreign filed it in Utah to conduct business.   Mr. Robbins was later sued in Utah court and a judgment was entered against him in favor of Fairstar.  Fairstar later reduced this judgment to a charging order against AIP and then sought to foreclose on Mr. Robbins interest in AIP i.e., Fairstar was seeking to take AIP from Mr. Robbins. 

Unfortunately for Mr. Robbins, Utah’s LLC statute permits a creditor of a member in a LLC to foreclose on his interest i.e., the “charging order” is not the sole and exclusive remedy.  Mr. Robbins thought he held an ace up his sleeve because AIP was a Delaware LLC registered to conduct business in Utah.  Under Delaware’s LLC statute the charging order is the sole remedy therefore, he argued that Delaware law must apply.  The Utah court disagreed and issued an order that Utah law applies to all judgment execution proceeding including the creditor’s foreclosure of the debtor’s interests in limited liability companies whether such LLCs are domestic or foreign.  Only in internal matter of LLC business would Delaware law apply. 

A different result would have been reached had Mr. Robbins not filed his Delaware LLC in Utah and instead chose to create a Utah LLC that was wholly owned by his Delaware LLC.  In a structure such as this, the Utah court would not have had any jurisdiction over his Delaware LLC because it was not registered in Utah.  MR. Robbins might have walked away with his assets in tact. 

For those on the West Coast, I will record this event and post the replay for future viewing.

What is at stake? – At issue with the business or hobby determination is the treatment of the activity’s expenses. A for-profit business is able to deduct all of its business expenses even if the net result is a loss, whereas a not-for-profit activity (hobby) can only deduct the expenses related to that activity to the extent there is income from that activity. In other words, no loss is allowed. To further complicate the issue, the expenses of a not-for-profit activity are not netted against income like they are for a for-profit business. Instead, they must be deducted as a miscellaneous itemized deduction subject to the 2% of AGI limitation, and the income from the activity must be included in gross income. In addition, the tax code dictates the order in which the not-for-profit activity’s expenses can be used to offset its income:

• First the income is offset with otherwise deductible taxes related to the activity. These include taxes that would be deductible even if not related to the not-for-profit activity.
• Next comes all the other expenses, excluding asset depreciation.
• Then, finally, if any remaining income is left to be offset, asset depreciation can be claimed.

What is the definition of a for-profit activity? – A transaction is entered into for profit if the taxpayer intends to receive income from it overall. For a transaction involving property, the taxpayer must intend to receive income from it or to profit from disposing of it.

Profit must be the primary motive, not merely incidental. A loss deduction is possible where a secondary nonprofit motive exists, as long as the profit motive predominates. As you can see, the determination can be very subjective, and depends on the facts and circumstances of each situation. The following are factors that the IRS and the Tax Court take into consideration when making the determination:

• Does the time and effort put into the activity indicate an intention to make a profit?
• Does the taxpayer depend on income from the activity?
• If there are losses, are they due to circumstances beyond the taxpayer’s control or did they occur in the start-up phase of the business?
• Has the taxpayer changed methods of operation to improve profitability?
• Does the taxpayer or his/her advisors have the knowledge needed to carry on the activity as a successful business?
• Has the taxpayer made a profit in similar activities in the past?
• Does the activity make a profit in some years?
• Can the taxpayer expect to make a profit in the future from the appreciation of assets used in the activity?

For-profit Presumption – An activity is presumed by the IRS to be engaged in for profit for a tax year if it shows a profit for any three or more out of five consecutive years ending in that tax year (or two out of seven years, for breeding, showing, or racing of horses). A taxpayer who hasn’t engaged in an activity for more than five years (seven, for horse breeding, etc.) can elect (on Form 5213 ) to postpone the determination as to whether these presumptions apply until the close of the fourth tax year (sixth, for horse breeding, etc.) after the tax year in which the taxpayer first engages in the activity.

What the Tax Courts have had to say –

Airplane activities – A licensed airplane pilot and mechanic who worked full-time for a commercial airline also engaged in his own airplane activities such as building, improving, and flying several small airplanes. The taxpayer didn’t engage in those other airplane activities in a businesslike manner. He claimed his business plan was to build airplanes from kits and sell them for a substantial profit. Other than income tax returns, flight logs, and a business license (issued during the last month of the last year at issue), the taxpayer didn’t offer into evidence or any written documentation of his business plans or projections, payroll or other employee records, sales contracts he claimed to have entered into, or any other business records regarding his airplane activity. Activity was judged to be not-for-profit (Parker, John G., (2002) TC Memo 2002-76).

Direct marketing activities – Taxpayers’ activities weren’t engaged in for profit where the manner in which taxpayers conducted their distributorship activity (e.g., freely incurring expenses with no realistic plan for recouping them, maintaining detailed records for substantiation purposes but not for use as tools to increase the likelihood of profit, and relying only on the advice of insiders who stood to profit from taxpayers’ participation) virtually precluded any possibility of realizing a profit; they didn’t prove they had a profit motive. Although the court recognized the business reasons for the taxpayers’ recruiting of “downline” distributors (i.e., to benefit “upline” distributors under the manufacturer’s bonus program, and to earn commissions on the downline distributors’ sales), while selling products to customers and downline distributors at cost, it found the likelihood of taxpayers achieving their bonus point goals (their break-even points) was unrealistic, given that they recruited only family, friends, and acquaintances to be downline distributors. And despite four years of losses, the taxpayers had failed to change tactics to increase the likelihood of earning a profit (Lopez, Jorge N. v. Com., TC Memo 2003-142).

On the other hand, a taxpayer engaged in a similar direct marketing operation was held to be engaged in a profit-seeking activity because he kept records of income, expenses, the success rates of his mailings, and the size of his customer base. He changed methods and products to improve results. Although he didn’t have a formal business plan, the manner in which he conducted the activity evidenced an informal business plan. In addition, he didn’t derive personal pleasure from the operations, and didn’t use the business as an excuse to disguise personal travel as business trips (Dworshak, Duane A., (2004) TC Memo 2004-249).

Dog breeding – Taxpayers’ activities were engaged in for profit where the taxpayers, a husband and wife with full-time jobs, built a kennel adequate to house the dogs used in their dog-breeding activities and acquired supplies and equipment suitable for raising them. They exhibited their dogs at shows in attempts to establish a good reputation for their kennel, so that they could demand a higher price for their puppies. Furthermore, they advertised and sent cards to prospective customers to spur sales and kept records necessary to keep track of the kennel’s profitability (Larson, Ronald Dale Sr., (1991) TC Memo 1991-99).

On the other hand, a taxpayer’s activities weren’t engaged in for profit where only five of her 28 dogs generated any income, she didn’t maintain any records that tracked income and expenses attributable to particular dogs, didn’t have any business plan, didn’t do anything to develop a strategy that would make the activity profitable, and, even though the activity generated persistent losses, didn’t alter the manner in which she conducted the activity to increase the likelihood of a profit (Spranger, Melissa S., (1999) TC Memo 1999-93).

Race car driving – A taxpayer’s drag-racing activities were conducted for profit where he kept careful separate accounts and developed a business plan. He had substantial expertise in racing and considerable business knowledge, and devoted a good deal of time to it. The taxpayer had an income from other activities but not enough to enable him to engage in drag racing on a nonprofit basis. He incurred losses for seven years while developing the activity, but then acquired a sponsor and earned a small profit. Unexpected loss of the sponsor led to a return to losses. Significantly, when it became clear to the taxpayer that he wouldn’t be able to make the activity profitable, he terminated it. There was an element of personal pleasure in the activity for the taxpayer but many aspects that were unpleasant as well, such as heat and discomfort (Morrissey, John E., (2005, DC TN) TC Summary Opinion 2005-86).

A taxpayer’s activities weren’t engaged in for profit where the taxpayer was an expert on drag racing but didn’t conduct his drag-racing activities in a businesslike manner-i.e., he maintained no records, had no business plan, didn’t create budgets, didn’t seek business advice, and expected the cars to appreciate in value independently of the drag-racing activities. The taxpayer derived much personal pleasure from his drag-racing activities, and his expenses and losses greatly exceeded (by 54 times) the small amount of income (only $2,150) the activities generated (Zenzen, Ronald J., (2011) TC Memo 2011-167).

Writing – A taxpayer’s activities were engaged in for profit where the taxpayer carried on his television and movie screenplay writing activity in a businesslike fashion. He hired agents to help him negotiate prices for his screenplays, had numerous contacts in the business, and devoted much time and energy to carrying on this activity (Richards, Rick, (1999) TC Memo 1999-163).

A taxpayer’s activities weren’t engaged in for profit where some aspects of the taxpayer’s article- and novel-writing activity (relating to contemporary political commentary, guns, and travel) were conducted in a businesslike manner, but other aspects weren’t. The taxpayer maintained records of his expenses and regularly researched and submitted articles and novels to various periodicals and literary agents. But, although his articles weren’t accepted for publication (during a 17-year period), he didn’t develop a strategy to get published or make changes in order to succeed. And, the taxpayer, who wasn’t a gun-testing expert, conducted his testing and incurred gun-related expenses without determining if there was any interest in the articles, and without regard to the income he could objectively earn (McCarthy, John R., (2000) TC Memo 2000-197).

You can listen to the interview here.

P.S. – If after listening to the interview you would like to attend one of our upcoming asset protection workshops, our next event will be October 1 and 2nd in Chicago. You can sign up for the event here.

All the best in life and investing.

Clint Coons, asset protection attorney, Tacoma, WA

That will be changing starting in 2011, at least for security sales. Beginning in 2011, every broker who is required to file an information return reporting the gross proceeds of a security must include in the informational return the customer’s adjusted basis in the security and whether any gain or loss with respect to the security is short-term or long-term.

Securities initially covered under this new requirement include: (a) shares of stock in a corporation, (b) notes, bonds, debentures, or other evidence of indebtedness and (c) commodities, contracts, or derivatives with respect to the commodities.

The requirement is being phased in and will generally apply to: 

• Corporation stocks acquired after 2010, 
• Regulated investment companies (mutual funds) and dividend reinvestment plans after 2011,
   
• Certain other securities (as determined by the IRS) after 2012.

The IRS estimates that more than one in three taxpayers who sold securities may have misreported capital gains and losses—in many cases because they misreported their basis—and it expects the new basis reporting rules to go a long ways toward correcting that problem. However, since the effective dates for broker basis reporting will be based on the acquisition dates of the securities, there will still be many sales in the years to come for which brokers may not report the basis because they lack the information. For these sales, the basis of the securities that were sold will need to be determined by taxpayers, as in the past.

Under this new reporting requirement, the gain or loss reported by a brokerage firm will be based on a first-in first-out (FIFO) method unless the customer notifies the broker by means of making an adequate identification of the stock sold or transferred. In the case of securities where the “average cost basis” method is allowable, brokerage firms are to use the “average cost basis” method unless customers notify brokers that they elect another acceptable method with respect to the account in which the stock is held.

This is a complicated undertaking and, undoubtedly, there will be some confusion in terms of matching basis with transactions. For example, under these new rules, a customer’s adjusted basis is determined without regard to the wash sale rules unless the transactions occur in the same account. This will create basis matching problems where identical securities are held in other accounts.

Cast a pebble into the ocean while in Japan and the ripples will result in a tidal wave in Hawaii. Impossible in nature but our legal system, as you well know, is not bound by nature or common sense. The Florida Supreme Court in "Olmstead" (see my past posts on this decision) is illustrative of this point because its decision sent attorneys and legislatures scrambling for high ground to protect clients and business filings. The tidal wave of reaction a result of one, albeit bad, decision by one Court in a far away state. This wave struck Nevada and the legislature responded in force by reforming Nevada’s charging order protections for LLCs and Corporations. (Keep in mind that Nevada was already at the top of its game when it comes to asset protection but I guess a little improvement can never hurt.)

On June 16, 2011, Nevada’s governor signed a new law specifically making a charging order the exclusive remedy of a judgment creditor against owners of both LLCs and Corporations in Nevada. The legislation specifically includes a single member of an LLC and a single shareholder of a corporation (previously the law required there be more than one shareholder for the protections to apply).

(a) Provides the exclusive remedy by which a judgment creditor of a member or an assignee of a member may satisfy a judgment out of the member’s interest of the judgment debtor [.] , whether the limited-liability company has one member or more than one member. No other remedy, including, without limitation, foreclosure on the member’s interest or a court order for directions, accounts and inquiries that the debtor or member might have made, is available to the judgment creditor attempting to satisfy the judgment out of the judgment debtor’s interest in the limited-liability company, and no other remedy may be ordered by a court. (You can read it here!)

In addition to the single member LLC changes, you can read that Nevada went above and beyond by adding additional language specifying that no equitable remedies can apply. (Equitable remedies are remedies that the court will sometimes use where the legal remedies are insufficient for the judge to get to the desired result, i.e. Goodbye Veil Piercing!) This new law ties the judge’s hands and protects your assets.

Nevada is hands down the leading asset protection jurisdiction, there is no reason ever to use any other state. Given that you can pick any state, it is shocking that anyone would consider establishing their asset protection under the laws of Delaware, Wyoming, New Mexico, or any other state.