Case Law Articles and Resources

Cancel Culture in a Petri Dish

by Ted Sutton | May 2, 2023 | Case Law

Cancel Culture in a Petri Dish

When Free Speech Mutates into Contract Interference

You have your opinions. Must everyone else agree with you? How far will you go? Will you end up in court?

If a business does something you don’t like, would you stage a boycott? Would you take it a step further, and attempt to put them out of business? Having the right to express your views under the First Amendment is crucial to a healthy nation. But when do such actions mutate and land you in court?

Recently, activists’ angry reactions have led to businesses suffering. The law provides a defense: Tortious Interference with Contractual Relations (or “TICR”). This claim is brought when a defendant intentionally interferes with a valid contract, and the plaintiff suffers damages from the interference. As the cases indicate, significant money damages are awarded.

Of course, many activities where people voice their displeasure are protected under the First Amendment. But there have been several recent cases where free speech has crossed the proverbial line into one of TICR. Each is discussed below.

City of Keene v. Cleveland

City of Keene v. Cleveland is different from the other cases that follow because it involves activity that was protected under the First Amendment, and did not amount to a contractual interference.[1] In this case, some of the city’s residents were displeased with the city of Keene’s issuance of parking tickets by their parking enforcement officers (PEOs). These resident protesters would follow the PEOs around daily while they were issuing parking tickets. They would hurl slurs at the PEOs, calling them thieves, cowards, and racists. Many PEO’s quit their jobs due to this type of harassment. This prompted the City of Keene to file suit against the protesters. One of the claims was TICR.

Unlike the following cases, the court ruled against the plaintiffs. The court found that because the encounters did not involve acts of significant violence, the protesters’ actions were protected under the First Amendment.

On the other hand, the next three cases involve activity that is not only unprotected under the First Amendment, but which also amounts to TICR.

Texas Campaign for the Environment v. Partners Dewatering International, LLC

The first case is Texas Campaign for the Environment v. Partners Dewatering International, LLC.[2] Here, Partners Dewatering International (PDI) entered into a 10-year contract with the city of Rio Hondo, Texas, where PDI ran a liquid waste dewatering facility. PDI had operated other similar facilities around Texas.

The first five years of PDI’s contract went smoothly. Then the Texas Campaign for the Environment (TCE) stepped into the picture. One TCE member received notice from the Texas Commission of Environmental Quality (TCEQ) that PDI was going to accept nonhazardous waste at its Rio Hondo facility. PDI had accepted this type of waste at another one of their facilities.

Even though PDI’s actions were appropriate, TCE still took action. TCE’s members encouraged Rio Hondo residents to pressure the city to cancel their 10-year contract with PDI. In doing so, TCE members made false statements to the residents. They said that PDI’s facilities were not in compliance with environmental regulations, which was a lie. Another lie they told was that PDI was going to accept toxic industrial waste at its Rio Hondo facility. With pressure from the TCE and the Rio Hondo residents, the city cancelled their contract with PDI five years after it was signed.

One of the claims PDI brought was tortious interference of contractual relations. Because TCE made blatantly false statements that lead to the contract being cancelled, the court found that TCE intentionally interfered with PDI’s contract. PDI was awarded $6.5 million in TICR damages.

Hurchalla v. Lake Point Phase I, LLC

The next case is Hurchalla v. Lake Point Phase I, LLC.[3] In this case, Lake Point attempted to develop a limestone mining project in Martin County, Florida. Once the mining pits were complete, they would be used to store stormwater, a useful public benefit.

Documented reports described the usefulness of the project. But Maggy Hurchalla, a former county commissioner, decided to step in the way. Despite having read these reports herself, Hurchalla still pressured her former colleagues to oppose the project. Hurchalla made false statements about the project, and even gave the commissioners instructions on how to obstruct the project. Hurchalla’s efforts succeeded, and the board of county commissioners vetoed the project.

Lake Point filed suit, bringing a TICR claim. Because Hurchalla lied about the project despite knowing of its benefits, the court held that Hurchalla intentionally interfered with Lake Point’s contractual relations. The court required Hurchalla to pay $4.4 million in damages to Lake Point.

Gibson Bros, Inc. V. Oberlin College

This next case is Gibson Bros, Inc. v. Oberlin College.[4] This is perhaps the most egregious example of contractual interference.

Gibson Bros runs Gibson’s bakery in Oberlin, Ohio, where Oberlin College is located. The incident at issue involved three black students and the owner’s son, a bakery employee. As the son rung up the students’ orders, the son believed that one of the students was shoplifting. After the son confronted him, the student fled the store, and the son chased after him. Then, the son and the other three students got into a physical altercation. Once the police came to the scene, they arrested the three students.

Oberlin students got word of this incident and staged a protest outside of the bakery. They passed out flyers stating that, without evidence, the bakery was racist and had a long history of racial profiling. The student government then passed a resolution indicating such, and encouraged the student body to stop supporting the bakery.

The matter got worse when the Oberlin College administrators got involved. Some attended the protests. Others took it a step further. Because Gibson’s bakery supplied food to Oberlin College, administrators demanded that their food supplier cancel their contract with Gibson’s bakery. Private texts also revealed that the administrators wanted to rain fire and brimstone on the bakery and were happy with the students’ actions.

Gibson’s Bakery filed suit against the College for TICR and other claims. The court found this to be a clear-cut case. Because the students made false statements, and because the College administrators cancelled their contract with Gibson’s without looking at the evidence, the court found that Oberlin College intentionally interfered with the Gibson’s relationship. The court made Oberlin College pay $36.5 million to Gibson’s, which included an award of punitive damages.

Are students and administrators in higher level education still regarded as the best and brightest? Are they self-aware? A culture of cancellation can become a cancer, dividing everything in its path. Can the courts, as a last line of defense, provide some sanity to the situation?

Analysis

So where exactly is the line drawn between conduct being protected under the First Amendment, and conduct being actionable under a theory of tortious interference with a contractual relationship? From the cases reviewed, we can gather what is acceptable and unacceptable:

Acceptable

Unacceptable

Expressing your First Amendment rights, without violence

Partaking in actions that do not interfere with a contractual relationship

Making false statements about an existing contract

Making false statements about a potential contract

Ignoring evidence before making false statements to the contrary

Pressuring others to cancel contracts

When people peacefully express their displeasure and do not interfere with a contract, that activity is protected under the First Amendment. But when a company has an existing or expected contract and a third party interferes with that, that company has a clear and actionable TICR claim. As the cases here indicate, the courts will assess significant penalties against self-righteous bad actors.

Conclusion

In reviewing these TICR claims the questions become: Will the courts continue to punish extreme behaviors? Will more people continue to cross the line? We don’t know. What we do know, however, is that if a third party does cross that line, you may have a TICR claim against them. Given today’s climate, this type of protection may be crucial to safeguard businesses against coordinated bad faith acts from both left and right.

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[1] City of Keene v. Cleveland, 167 N.H. 731 (N.H. 2015)

[2] Texas Campaign for the Environment v. Partners Dewatering International, LLC, 485 S.W.3d 184 (Tex. App. 2016)

[3] Hurchalla v. Lake Point Phase I, LLC, 278 So. 3d 58 (Fla. Dist. Ct. App. 2019)

[4] Gibson Bros., Inc. V. Oberlin College, 2022-Ohio-1079

Incorporate First – Deduct Second

by Garrett Sutton, Esq | Mar 27, 2021 | Case Law, Forming an LLC, Starting a Business

Should you set up a corporation or LLC before you start trying to deduct expenses? A recent case suggests you should.

Many think that they can deduct all of their start up expenses before formally incorporating a business. But in Carrick v. Commissioner of Internal Revenue (T.C. Summ. Op. 2017-56, July 20, 2017) the Tax Court ruled otherwise.

The Facts of Carrick

The taxpayer had a bachelor’s degree in electrical engineering. For approximately 15 years, he was employed in the oceanographic industry. Before the years in issue, and during 2013 and 2014, he was employed by Remote Ocean Systems (ROS), building underwater equipment such as cameras, lights, thrusters, control devices, and integrative sonar.

During the years in issue, ROS was experiencing financial difficulty. The taxpayer was provided some flexibility in his work schedule, and he began exploring business ventures with other individuals, using the name Trifecta United as an umbrella name for the activities, which he named Local Bidz and Stingray Away.

The Local Bidz activity involved creating a website with features similar to those of the websites of Angie’s List, Yelp, and eBay, which would permit people to bid on hiring contractors for products and repairs. The taxpayer first had the idea for Local Bidz in 2012, and he went “full force in the beginning of 2013,” spending time accumulating data and developing software and the website.

At some point in 2013 the web developer moved to Los Angeles and other individuals left the project. For some unspecified period in 2013, the taxpayer traveled weekly from his home in San Diego to Los Angeles to consult with the web developer. The taxpayer abandoned the Local Bidz activity before the end of 2013. Sometime in 2014, the taxpayer began the Stingray Away activity, which involved researching and developing a device to prevent surfers and swimmers from being injured by stingrays.

The taxpayer initially noticed that sonar devices might affect the behavior of sharks and other species, so he conducted research at beaches in La Jolla, where swimmers and surfers often were stung and bitten by stingrays. The taxpayer did not fully develop any devices nor list any devices for sale in 2014. He had had no gross receipts during 2013 or 2014 from either the Local Bidz activity or the Stingray Away activity.

The Decision in Carrick

In Carrick, the taxpayer asserted that his reported expenses were deductible as ordinary and necessary business expenses relating to the activities of Local Bidz and Stingray Away. The Tax Court noted that 26 U.S.C. § 162(a) provides the general rule that a deduction is allowed for “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” The Tax Court stated that it was clear that the taxpayer was not “carrying on” a trade or business in 2013 or 2014 when the expenditures for the Local Bidz and Stingray Away activities were made.

Carrying on a trade or business requires more than preparatory work such as initial research or solicitation of potential customers; a business must have actually commenced. Expenses paid after a decision has been made to start a business, but before the business commences, are generally not deductible as ordinary and necessary business expenses. These preparatory expenses are capital expenditures.

The Tax Court pointed out that, while the taxpayer may have been conducting research in 2013 with respect to Local Bidz, or in 2014 with respect to Stingray Away, neither activity reached the point of actually commencing. There was neither sales activity nor evidence of the offering of products or services to the public. The taxpayer was still in the very early stages of research and development in each of these activities.

The Tax Court observed that there was nothing in the record indicating that the taxpayer had commenced any business activity as a sole proprietor. The taxpayer had not set up a formal business entity. Therefore, the Tax Court concluded that the taxpayer was not “carrying on” a trade or business in 2013 or 2014. See, 26 U.S.C. § 162(a); Frank, supra, 20 T.C. at 513-14 (1953); Shea, supra, T.C. Memo. 2000-179, 2000 WL 688593, at *5n. 10; Christian, supra, T.C. Memo. 1995-12, 1995 WL 9151, at *5.

Brief Discussion

If you’re preparing to open a new business, then you need to make certain that you understand the tax rules. It is crucial that you offer the product or service to the public and that you begin sales activity, because start-up expenditures, i.e., expenditures paid before a business begins, are not deductible in the years they are actually incurred. Instead, they are capital expenditures, which generally must be amortized over a 15-year period, once business begins, meaning gradually write off the cost over 15 years. See, 26 U.S.C. § 195. Thus, in order for an expenditure to be an ordinary and necessary trade or business expense, it must be related to more than a preparatory expenditure.

So, if the taxpayer in Carrick had opened his business first, then he might have been able to deduct his expenditures in the years they were actually incurred, instead of amortizing them over a 15-period.

Conclusion

The moral of the story is: Open your business first, and deduct later.

Courts Limit Pension Payouts

by Garrett Sutton, Esq | Mar 27, 2021 | Asset Protection Resources, Case Law

Is Your Retirement Safe?

Are you certain of your pension? Can you count on Social Security to pay you in the future?

A recent case allowed the State of Rhode Island to unilaterally – and retroactively – reduce public employees’ pension benefits.

The case, Cranston Firefighters vs. Gina Raimondo, governor of Rhode Island, was decided by the U.S. Court of Appeals for the First Circuit on January 22, 2018.

The unions claimed they had a binding contract. They had put in their time. The state claimed they faced ‘fiscal peril’. There was no way to pay. The lower court decided the state was not obligated to pay out as ‘promised.’

The public employees claimed: “But we had a deal!” They appealed to a higher court.

The Appeals Court responded:

“A claim that a state statute creates a contract that binds future legislatures confronts a tropical-force headwind in the form of the ‘unmistakability doctrine’.” Parker, 123 F. 3d at 5. This doctrine precludes finding that a statute creates a binding contract absent a clear and unequivocal expression of intent by the legislature to so bind itself. Nat’l R.R. Passenger Corp. vs. Atchison, Topeka & Santa Fe Ry. Co., 470 U.S. 451, 465-66 (1985). The doctrine recognizes that “the principal function of a legislature is not to make contracts, but to make laws that establish the policy of the state.” Id. At 466. It also serves “the dual purposes of limiting contractual incursions on a State’s sovereign powers and of avoiding difficult constitutional questions about the extent of state authority to limit the subsequent exercise of legislative power.” United States v. Winstar Corp. 518 U.S. 839, 875 (1996) (plurality opinion).

Never once has our court found that state or federal legislation clearly and unequivocally expressed a legislative intent to create private contractual rights enforceable as such against the state.”

In other words, the court ruled that the primary function of those who pass laws is not to create contracts and comply with them, but to legislate.

How does this case affect you?

Are you counting on Social Security?

The Social Security Board of Trustees has stated that their trust funds will “become depleted and unable to pay scheduled benefits in full on a timely basis in 2034.”

In 16 years, Social Security will not be able to pay out all that they’ve promised.

And now we have a federal case saying they won’t have to do so. More such cases will likely follow. The courts can’t print money. But they can limit what is paid out. They can limit previous government promises made to anyone.

The real issue in all of this is: are you prepared for the coming pension crisis?

Case Study: How Does Reverse Veil Piercing Occur?

by Garrett Sutton, Esq | Mar 27, 2021 | Asset Protection Resources, Books by Garrett Sutton, Case Law, Corporate Veil

An Evolving Way To Attack Assets

reverse veil piercing

Piercing the corporate veil. It sounds painful, and it is. A judgment is entered against a corporation with no assets. To collect the court allows the judgment creditor (the winner in the case) to pierce through the corporation and reach the personal assets of the shareholder.

A new twist on this method of collection has appeared. It is called reverse piercing of the corporate veil. It is reversed because instead of a judgment against a corporation there is a judgment against an individual. The individual has no assets, but their entity does. So in this case the court allows the judgment creditor to go past the individual and gain access to assets of their corporation or LLC. Graphically, the difference is:

diagram of reverse veil piercing

California has joined the list of states allowing for reverse piercing. The following goes through the Curci case in question. If you don’t have time to read the entire case write up, please know that asset protection is a constantly evolving area of law. If the following case write up interests you, you will find further information on this subject and more in my book Veil Not Fail: Protecting Your Personal Assets From Business Attacks (RDA Press, 2022).

Buy it on Amazon

Issue

What is the potential impact on outside reverse veil piercing of the recent California Court of Appeal, Fourth District, decision in Curci Investments, LLC v. Baldwin, 14 Cal.App.5th 214, 221 Cal.Rptr.3d 847 (Cal.App., Aug, 10, 2017)

Applicable Law

In Curci Investments, LLC v. Baldwin, 14 Cal.App.5th 214, 221 Cal.Rptr.3d 847 (Cal.App., Aug, 10, 2017), the California Court of Appeal, Fourth District, concluded that a judgment creditor was not per se precluded from outside reverse piercing the corporate veil to add a Delaware limited liability company (LLC), and that the California statute providing for charging order levying distributions from an LLC to a debtor member did not preclude application of outside reverse veil piercing to allow a judgment creditor to add an LLC as a judgment debtor on a judgment against the holder of an LLC interest.

The Facts of Curci

In January 2004, James P. Baldwin (“Baldwin”), a prominent real estate developer, formed JPB Investments, LLC (“JPBI”), a Delaware limited liability company, for the exclusive purpose of holding and investing Baldwin and his wife’s cash balances. Over the course of his lifetime, Baldwin had formed and held interests in hundreds of corporations, partnerships, and LLCs. JPBI had two members: (1) Baldwin with a 99 percent member interest; and (2) his wife with a one percent member interest. Baldwin was a manager and the chief executive officer (“CEO”) of the company. In these roles, and given his member interest, Baldwin determined when, if at all, JPBI made monetary distributions to its members, i.e., Baldwin and his wife. Two years after forming JPBI, Baldwin, individually, borrowed $5.5 million from Curci’s predecessor in interest. The loan was memorialized in a promissory note executed by Baldwin and the managing member of Curci’s predecessor (the “Curci note”). In the Curci note, Baldwin agreed to pay back the principal amount of the loan, with interest, by January 2009. Curci was assigned the lender’s interest in the Curci note shortly after it was executed. One month after executing the Curci note, Baldwin settled eight family trusts to provide for his grandchildren during and after their college years (the “family trusts”). Baldwin’s children were the designated trustees. (At least one of his sons, however, was unaware of the family trusts despite his signature on the trust documents.) Not long after the family trusts were settled, JPBI loaned a total of approximately $42.6 million (the “family notes”) to three general partnerships (the “family partnerships”) formed by Baldwin for estate planning purposes. Because the partners of the family partnerships were various combinations of the family trusts, certain of Baldwin’s children signed the family notes in their capacity as trustees. Baldwin signed the family notes in his capacity as manager of JPBI. Each family note indicated the principal amount of the loan was to be repaid by July, 2015. Although all the family notes were in favor of JPBI, Baldwin and his wife listed them as “Notes Receivable” on their personal financial statements.

When the Curci note came due in January, 2009, Baldwin had not made any payments. Curci filed a lawsuit against him to recover the amount owed. Not long thereafter, the parties entered into a court-approved stipulation establishing a payment schedule for Baldwin to avoid entry of judgment. About a year later, the trial court approved an amended stipulation that modified the payment schedule due to Baldwin’s continued failure to make the agreed upon payments. Baldwin ultimately failed to make the agreed upon payments, so Curci sought entry of judgment against him. In October, 2012, the trial court entered judgment in favor of Curci and against Baldwin in the amount of approximately $7.2 million, including prejudgment interest and attorney’s fees and costs. In the year after entry of judgment, Curci propounded extensive post-judgment discovery requests aimed at understanding the nature, extent, and location of Baldwin’s personal assets. Baldwin did not timely respond to the discovery, and Curci filed a motion to compel. Though the motion was moot by the time it was heard, the trial court awarded sanctions against Baldwin.

As of February, 2014, no payments had been made on the family notes. Baldwin, as manager of JPBI, and for reasons unexplained, chose to execute amendments to the family notes to extend their terms by five years, to July, 2020. No consideration was provided in exchange for the extensions. A few days later, Baldwin responded to a discovery request made by Curci one year earlier. Among the documents he produced were the family notes, including the five-year payment extensions. Based on Baldwin’s discovery responses, and Baldwin’s failure to pay any of the judgment, Curci filed a motion seeking charging orders against 36 business entities in which Baldwin had an interest. Among those entities was JPBI. The trial court granted Curci’s motion in August, 2014. From and after that date, any monetary distributions made by JPBI to Baldwin, in his capacity as a member, were ordered to be paid to Curci instead. Curci received no money as a result of the charging order.

Although Baldwin caused JPBI to distribute approximately $178 million to him and his wife, as members, between 2006 and 2012, not a single distribution had been made since the October, 2012, entry of judgment on the Curci note.

This is a key factor. When that much money has been previously distributed, courts will ask why Curci can’t be paid. As well, there had been no payments made by the family partnerships to JPBI on the family notes. In June, 2015, Curci filed a motion to add JPBI as a judgment debtor pursuant to California Code of Civil Procedure, Section 187. Curci based its motion on the outside reverse veil piercing doctrine. Curci argued that JPBI was Baldwin’s alter ego, that Baldwin was using JPBI to avoid paying the judgment, and that an unjust result would occur unless JPBI’s assets could be used to satisfy Baldwin’s personal debt. Baldwin did not initially oppose the motion. The trial court issued a tentative ruling denying Curci’s motion, based upon the earlier California Court of Appeal, Fourth District, decision in Postal Instant Press, Inc. v. Kaswa Corp., 162 Cal.App.4th 1510, 77 Cal.Rptr. 3d 96 (Cal.App., Aug. 27, 2008). Following additional briefing from the parties on that issue, and a hearing, the trial court adopted its tentative ruling as its final decision. Because it believed outside reverse veil piercing was not viable in California, it did not make any factual findings related to Curci’s arguments thereunder. Curci timely appealed.

The Decision in Curci

Curci sought to add JPBI as a judgment debtor on the $7.2 million judgment it had against Baldwin personally. Curci asserted that Baldwin held virtually all of the interest in JPBI and controlled its actions, and that Baldwin appeared to be using JPBI as a personal bank account. Curci argued that, under these circumstances, it would be in the interest of justice to disregard the separate nature of JPBI and allow Curci to access JPBI’s assets to satisfy the judgment against Baldwin. Citing Postal Instant Press, Inc., supra, the trial court denied Curci’s motion based on its belief the relief sought by Curci, commonly known as outside reverse veil piercing, was not available in California. On appeal, Curci asserted that Postal Instant Press was distinguishable, and urged the California Court of Appeal to conclude that outside reverse veil piercing was available in California and appropriate in this case. The California Court of Appeal agreed with Curci, that Postal Instant Press was distinguishable, and concluded that outside reverse veil piercing was possible under these circumstances. Therefore, the California Court of Appeal reversed and remanded the case to the trial court to make a factual determination as to whether JPBI’s veil should be pierced.

The Rationale in Curci

In Curci, the California Court of Appeal noted that the question presented was whether outside reverse piercing of the corporate veil could be applied under the circumstances of this case, giving Curci the ability to reach JPBI’s assets by adding it as a judgment debtor. Curci contended that the facts of this case justified making such a remedy available, and argued that neither the decision in Postal Instant Press, nor state statutory law, precluded such a result. Baldwin disagreed, asserting that Postal Instant Press established a broad and all-encompassing rule of no reverse piercing in California; and, alternatively, that California Corporations Code, Section 17705.03, provided the sole remedy available to Curci with respect to JPBI. The Court agreed with Curci, and found that remand was appropriate, in order to allow the court to make the factual determination of whether the facts in this case justified piercing JPBI’s veil.

A. CCP 187.

In Curci, the Court initially noted that, pursuant to Code of Civil Procedure, Section 187, a trial court has jurisdiction to modify a judgment to add additional judgment debtors, and that granting or denying a motion to add a judgment debtor lies within the discretion of the trial court.

B. Veil Piercing and the Alter Ego Doctrine

In Curci, with respect to traditional veil piercing, the Court noted that, ordinarily a corporation is considered a separate legal entity, distinct from its stockholders, officers, and directors, with separate and distinct liabilities and obligations; and that the same was true of an LLC and its members and managers. The Court pointed out that legal separation may be disregarded by the courts when a corporation or LLC is used by one or more individuals: (1) to perpetrate a fraud; (2) to circumvent a statute; or (3) to accomplish some other wrongful or inequitable purpose. The Court observed that in those situations, the corporation’s or LLC’s actions will be deemed to be those of the persons or organizations actually controlling the corporation, in most instances the equitable owners; and that the alter ego doctrine prevents individuals or other corporations from misusing the corporate laws by the device of a sham corporate entity formed for the purpose of committing fraud or other misdeeds. The Court stressed that, as an equitable doctrine, its essence is that justice be done. The Court stated that, before the alter ego doctrine will be invoked in California, two conditions generally must be met: (1) first, there must be such a unity of interest and ownership between the corporation and its equitable owner that the separate personalities of the corporation and the shareholder do not in reality exist; and (2) there must be an inequitable result if the acts in question are treated as those of the corporation alone. The Court observed that, while courts have developed a list of factors that may be analyzed in making these determinations, there is no litmus test to determine when the corporate veil will be pierced; rather the result will depend on the circumstances of each particular case.

C. Outside Reverse Veil Piercing

In Curci, the Court noted that outside reverse veil piercing is similar to traditional veil piercing in that when the ends of justice so require, a court will disregard the separation between an individual and a business entity; however, the Court emphasized that the two serve unique purposes and are used in different contexts. Rather than seeking to hold an individual responsible for the acts of an entity, outside reverse veil piercing seeks to satisfy the debt of an individual through the assets of an entity of which the individual is an insider. The Court observed that outside reverse veil piercing arises when the request for piercing comes from a third party outside the targeted business entity; and that as outside reverse piercing has evolved, a growing majority of courts across the country have adopted it as a potential equitable remedy.

D. Postal Instant Press

In Curci, the Court noted that another panel had addressed outside reverse veil piercing in Postal Instant Press, supra. In that case, Postal Instant Press (“PIP”) obtained an $80,000 judgment against an individual, then sought to amend the judgment to add as a judgment debtor a corporation in which the debtor formerly held shares. The PIP court reversed the trial court’s order amending the judgment, based on the conclusion that a third party creditor may not pierce the corporate veil to reach corporate assets to satisfy a shareholder’s personal liability. In reaching its conclusion, the PIP court echoed concerns expressed by non-California courts about making outside reverse veil piercing available with respect to corporations. Among those concerns were: (1) allowing judgment creditors to bypass standard judgment collection procedures; (2) harming innocent shareholders and corporate creditors; and (3) using an equitable remedy in situations where legal theories or legal remedies are available. In Curci, the Court stated that PIP did not preclude application of outside reverse veil piercing of LLCs for several reasons: (1) Curci sought to disregard the separate status of an LLC, not a corporation, and the court’s decision in PIP was expressly limited to corporations; (2) the nature of LLCs did not present the concerns identified in PIP, because Baldwin, the judgment debtor, held a 99 percent interest in JPBI and his wife held the remaining one percent interest, but she was liable for the debt owed to Curci under California community property law, and there simply was no “innocent” member of JPBI that could be affected by reverse piercing; and (3) a creditor does not have the same options against a member of an LLC as it has against a shareholder of a corporation. The Court reasoned that, under California law, when the debtor is a shareholder, the creditor may step straight into the shoes of the debtor, and may acquire the shares and, thereafter, have whatever rights the shareholder had in the corporation, including the right to dividends, to vote, and to sell the shares; whereas, in stark contrast, if the debtor is a member of an LLC, the creditor may only obtain a charging order against distributions made to the member. Thus, the debtor remains a member of the LLC with all the same rights to manage and control the LLC, including, in Baldwin’s case, the right to decide when distributions to members are made, if ever.

In Curci, Baldwin asserted that Corporations Code, Section 17705.03, preempted the Court from making reverse piercing available with respect to an LLC, because it provides the sole remedy creditors have against a debtor who has a member interest in an LLC. However, the Court disagreed, and pointed out that Section 17705.03 was not as all-encompassing as Baldwin suggested, and that it more narrowly provided a charging order levying distributions from the LLC to the debtor member is the exclusive remedy by which a judgment creditor may satisfy the judgment from the judgment debtor’s transferable interest. The Court reasoned that, because outside reverse veil piercing was a means of reaching the LLC’s assets, and not the debtor’s transferable interest in the LLC, Section 17705.03 did not preclude outside reverse veil piercing. The Court noted that its rationale was underscored by the drafters’ comments to the Revised Uniform Limited Liability Company Act, from which Section 17705.03 was adopted without substantive change; and that those comments state the charging provisions are not intended to prevent a court from effecting a “reverse pierce” where appropriate.

Application of the Rationale in Curci to the Facts of Curci

In Curci, the Court noted that the case before it presented a situation where outside reverse veil piercing might well be appropriate, because Curci had been attempting to collect on a judgment for nearly half a decade, frustrated by Baldwin’s non-responsiveness and claimed lack of knowledge concerning his own personal assets and the web of business entities in which he had an interest. The Court pointed out that, although the formation of JPBI predated the underlying judgment, its purpose had always remained the same–to serve as a vehicle for holding and investing Baldwin’s money; and that, with Baldwin’s possession of near complete interest in JPBI, and his roles as CEO and managing member, Baldwin effectively had complete control over what JPBI did and did not do, including whether to make any disbursements to its members, i.e., to Baldwin and his wife. The Court observed that, since the time judgment was entered in Curci’s favor, Baldwin had used that power to extend the payback date on loans made to ultimately benefit his grandchildren (loans on which not a single cent had been repaid), and to cease making distributions to JPBI’s members, i.e., himself and his wife, despite having made $178 million in such distributions in the six years leading up to the judgment.

For all of these reasons, the Court concluded that outside reverse veil piercing might well be available in this case; however, the Court expressed no opinion as to whether JPBI’s veil should actually be pierced. Instead, the Court remanded the matter for the trial court to engage in the required fact-driven analysis in the first instance. The Court stated that, as with traditional veil piercing, there is no precise litmus test; rather, the key was whether the ends of justice required disregarding the separate nature of JPBI under the circumstances. In making that determination, the trial court should, at minimum, evaluate the same factors as are employed in a traditional veil piercing case, as well as whether Curci had any plain, speedy, and adequate remedy at law.

Brief Discussion

The following observations may be noted with respect to Curci:

1. To date, it does not appear that Baldwin has filed an appeal with the California Supreme Court; after all, the case was remanded to the trial court for further evaluation.

2. The decision in Curci applies only to LLCs, and it does not apply to corporations. Conversely, the court’s decision in PIP was expressly limited to corporations, and it did not preclude application of outside reverse veil piercing to LLCs.

3. In Curci, the California Court of Appeal did not even mention the internal affairs doctrine, even though JPBI was a Delaware LLC. This is just more evidence that courts in general, and California courts in particular, apply local law to determine judgment enforcement issues.

4. In Curci, the Court recognized that JPBI was, in effect, a single-member LLC with no non-debtor members. The Court could have rested its decision upon the alternate ground that JPBI was akin to a predominantly single-member LLC, and that limiting judgment creditors of members of predominantly single-member LLCs to a charging order would run afoul of the California Corporations Code relating to LLCs by creating in essence an exempt personal piggy bank.

5. Outside reverse veil piercing always is easier, where, as here, the judgment debtor rather clearly was attempting to conceal assets from his judgment creditor. In Curci, the facts were fairly extreme.

6. In Curci, the Court concluded that, although a charging order was the exclusive remedy for reaching a judgment debtor’s “transferrable assets,” it was not the exclusive remedy for reaching an LLC’s assets. In reaching this conclusion, the Court relied in part upon the Revised Uniform Limited Liability Company Act, which included comments that the charging provisions “were not intended to prevent a court from effecting reverse veil piercing where appropriate.”

7. The Curci decision makes it easier for a creditor to reach an individual LLC member’s assets when they use a predominantly single-member LLC to avoid paying a judgment.

8. In Curci, it is arguable that Baldwin blatantly misused the LLC, acted arbitrarily and capriciously, and that he got precisely what he deserved in the end.

9. In Curci, the Court instructed the trial court on remand that, in making its determination as to whether outside reverse veil piercing was appropriate with respect to JPBI, the trial court should, at a minimum, evaluate the same factors as are employed in a traditional veil piercing case, including presumably such factors as: (a) commingling of funds and other assets of the two entities; (b) the holding out by one entity that it is liable for the debts of the other; (c) identical equitable ownership in the two entities; (d) use of the same offices and employees; (e) use of one entity as a mere shell or conduit for the affairs of the other; (f) inadequate capitalization; (g) disregard of corporate formalities; (h) lack of segregation of corporate records; and (i) identical directors and officers. However, it should be noted that California Corporations Code, Section 17703.04(b), explicitly provides that “the failure to hold meetings of members or managers or the failure to observe formalities pertaining to the calling or conduct of meetings shall not be considered a factor tending to establish that a member or the members have alter ego or personal liability for any debt, obligation, or liability of the limited liability company where the articles of organization or operating agreement do not expressly require the holding of meetings of members or managers.” (Emphasis added.)

Conclusion

On the one hand, the decision in Curci highlights the fact that asset protection is never a sure thing. It is, as previously noted, an evolving area of the law.

On the other hand, members of a predominantly single-member LLC, who are using the LLC as their personal piggy bank, cannot reasonably expect for the LLC to be respected, when they deliberately are using the LLC to take advantage of their judgment debtor. As we have said before, bad facts make bad law. Still, Nevada and Wyoming continue to protect single member LLCs. In traditional cases absent the extreme facts of the Curci case they will serve you well. But again, the law does evolve and it is important to stay updated on it.

Win, lose, or draw, it should be anticipated that the decision by the trial court on remand in Curci will once again be appealed to the California Court of Appeal and then to the California Supreme Court. We will keep you informed.

Mom’s Mistake is No Excuse – You Need a Professional Registered Agent

by Garrett Sutton, Esq | Feb 13, 2021 | Asset Protection Resources, Case Law, Maintaining Your LLCs, Running a Business

Mom’s Mistake Is No Excuse!

Do you have your registered agent service properly in place?

A recent Ohio case illustrated the significant pitfalls of lax procedures.

Your registered agent’s job is to accept service process, meaning notice of a lawsuit. If you don’t receive that notice the persons suing you can get a default judgment – meaning, since you didn’t respond to the charge in time, they win by default. You’ve just lost a case you had no idea was even brought against you!

The new case is John W. Judge Co. v. USA Freight, L.L.C, 2018-Ohio-2658 (Ohio App., July 6, 2018). The facts are that Judge alleged USA Freight owed them $4,405.05. They served their complaint by certified mail upon the registered agent and service was accepted by the mother of USA Freight’s owner. The mother didn’t speak much English, didn’t know the U.S. legal system and didn’t give the lawsuit papers to anyone.

By not responding to the lawsuit USA Freight had a default judgment entered against them. This is when they first learn of Mom’s mistake. They immediately tried to vacate (set aside) the judgment on the basis of “excusable neglect.”

But the Court concluded that when a company is required by law to maintain a statutory agent for service of process, and when certified mail service is successful at the statutory agent’s address that is on record with the Ohio Secretary of State, then the subsequent mishandling of the served documents by the person who signed for and received the documents at the statutory agent’s listed address did not amount to “excusable neglect.”

A full discussion of the case follows. Know that the lesson here is that you want a professional resident agent service to accept important notices for you. Excuses for not responding – even an excuse involving dear ol’ Mom – will not pass muster in the courts.

The Facts of Judge

Judge filed a complaint against USA Freight for money damages arising from alleged unpaid engineering services in the amount of $4,405.05. Judge requested that the complaint and summons be served upon USA Freight via certified mail at the address of USA Freight’s registered statutory agent, Mukhabbat Vasfieva. The trial court received the certified mail receipt, showing that the complaint and summons had been delivered and signed for by “Mukhabbat Koch” on March 24, 2016. USA Freight failed to file a response to Judge’s complaint; accordingly, Judge moved the trial court to enter a default judgment in its favor. The trial court granted Judge’s motion and entered a default judgment against USA Freight for the amount requested plus interest and costs.

After obtaining a certificate of judgment, Judge obtained a writ of execution ordering the court bailiff to levy on the goods and chattels owned by USA Freight.

Three weeks after the writ of execution was filed, USA Freight filed a Rule 60(B) motion to vacate the default judgment on grounds that it never received the complaint and summons, and was otherwise unaware of who signed for the certified mail service. USA Freight attached a supporting affidavit from Baris Koch, who averred that he was the General Manager of USA Freight and that his father was the owner. Koch also averred that he did not receive notice of Judge’s complaint until the court’s bailiff contacted him regarding the writ of execution. Koch further averred that he spoke with the members and employees of USA Freight to ascertain if anyone affiliated with the company had signed for service of the complaint and that he was unaware of anyone who had. Lastly, Koch averred that USA Freight had meritorious defenses to Judge’s lawsuit, which included a claim that USA Freight had paid Judge in full for its services and that any unpaid amounts were owed by Garrett Day, LLC, and/or Mike Heitz. In addition to the affidavit, USA Freight attached several invoices from Judge and copies of checks that USA Freight made payable to Judge. USA Freight also attached a written description and map of the property on which Judge provided its engineering services, indication that Garrett Day, LLC owned part of the property on which Judge’s services were rendered.

Judge filed a response opposing the motion to vacate on grounds that USA Freight failed to establish the necessary elements for such relief under Rule 60(B). The trial court then held an evidentiary hearing on the motion to vacate. At the hearing, the parties submitted no additional evidence, but simply gave oral arguments.

During that time, USA Freight explained that the certified mail receipt was signed by the mother of USA Freight’s owner. USA Freight explained that the owner’s mother was not part of the company or involved in its day-to-day operations, but that she happened to be present when the complaint was served and did not provide it to any of the members of the family who were involved in the business. USA Freight further explained that the owner’s mother understood and spoke very little English, and had very little knowledge of the legal system. USA Freight therefore claimed it was entitled to relief under Rule 60 (B)(1) for excusable neglect.

At the close of the hearing, the trial court invited the parties to submit post-hearing memoranda in support of their position. After receiving the parties’ memoranda, the trial court issued a decision and entry granting USA Freight’s motion to vacate. In granting the motion, the trial court found “excusable neglect,” noting that USA Freight’s conduct was not willful and that it did not exhibit a disregard for the judicial system. The trial court further found that USA Freight had demonstrated that it had a meritorious defense to Judge’s claim for money damages. Judge appealed from the trial court’s decision granting USA Freight’s motion to vacate.

The Decision in Judge

On appeal, Judge argues that the trial court erred in granting USA Freight’s motion to vacate the default judgment under Rule 60(B), because USA Freight failed to establish that it was entitled to relief under Rule 60(B). More specifically, Judge claimed that USA Freight failed to establish that it did not respond to Judge’s complaint due to excusable neglect.

After reviewing the necessary requirements for USA Freight to obtain relief from a final judgment under Rule 60(B), the Ohio Court of Appeals noted that, because Judge did not dispute the existence of a meritorious defense or that USA Freight filed its motion to vacate within a reasonable time, the only issue before the Court was whether it was an abuse of discretion for the trial court to conclude that USA Freight was entitled to relief under Rule 60(B)(1) on grounds of “excusable neglect.” The Court noted that, in considering whether neglect is excusable under Rule 60(B)(1), a court must consider all the surrounding facts and circumstances. The Court pointed out that the phrase, “excusable neglect” in Rule 60(B)(1) is an elusive concept which has been difficult to define and to apply.

The Court observed that the Ohio Supreme Court had determined that neglect is inexcusable when the movant’s inaction revealed a complete disregard for the judicial system and the right of the appellee. The Court also observed that the Ohio Supreme Court had held that “excusable neglect” in the context of a Rule 60(B)(1) motion generally means the failure to take the proper steps at the proper time, not in consequence of the part’s own carelessness, inattention, or willful disregard of the processes of the court, but in consequence of some unavoidable or unexpected hindrance or accident, or reliance on the care and vigilance of his counsel or no promises made by the adverse party. The Court explained that courts generally find “excusable neglect” in those instances where there are unusual or special circumstances that justify the neglect of a party or the party’s attorney. That said, the Court cautioned that the concept of “excusable neglect” must be construed in keeping with the proposition that Rule 60(B)(1) is a remedial rule to be liberally construed, while bearing in mind that Rule 60(B) constitutes an attempt to strike a proper balance between the conflicting principles that litigation must be brought to an end and justice should be done.

After discussing the conflicting principles that must be borne in mind in ruling upon a Rule 60(B) motion, the Court pointed out that the supporting affidavit signed by USA Freight’s General Manager, Baris Koch, averred that he first learned of Judge’s lawsuit against USA Freight when he trial court’s bailiff notified him that a writ of execution had been filed against the company. The Court noted that the record indicated that the bailiff was ordered to levy execution against USA Freight, and that USA Freight filed its motion to vacate approximately three weeks later. The Court further noted that Koch has averred in his affidavit that he was unaware of any member or employee of USA Freight who had signed for or received service of the complaint; and that, as of the date he signed the affidavit, Koch claimed he did not know who signed for the complaint; and that it was not until the hearing on the motion to vacate that USA Freight explained, through counsel, that service of the complaint and summons was signed for by the mother of the owner of USA Freight. USA Freight explained that the owner’s mother had no role within the company and that she happened to be present when the complaint was delivered by certified mail. USA Freight further explained that the owner’s mother understood and spoke very little English, and that she did not provide the complaint to any of the family member who were involved in USA Freight’s business operations. Although no testimony or affidavits were submitted to verify this information, the trial court found USA Freight’s explanation credible and that it constituted “excusable neglect” under Rule 60(B)(1).

Judge argued that the trial court’s decision was an abuse of discretion because USA Freight failed to provide any evidence establishing that the person who received and signed for the complaint was the non-English speaking mother of USA Freight’s owner. The Court noted that the owner’s mother did not appear at the hearing; that her name was never disclosed on the record; and that USA Freight also never disclosed what the owner’s mother did with the complaint after she received it. In an effort to establish that the person who signed for the complaint was not the owner’s mother, Judge provided the trial court with two prior certified mail receipts with signatures that matched the signature on the receipt at issue. Judge pointed out that one of the prior receipts indicated that the signatory was an “Agent” of USA Freight.

Judge further argued that it was USA Freight’s responsibility to maintain a valid statutory agent who is designated to receive service of process at the agent’s listed address; that it was indeed neglectful for USA Freight to use an address where certified mail could be received and mishandled by a non-English-speaking individual who was not affiliated with USA Freight’s business; and that such conduct did not constitute “excusable neglect.” In support of this claim, Judge cited the following three unpublished decision, providing that insufficient or negligent internal procedures in an organization may not comprise “excusable neglect” and that, therefore, may not support vacation of a default judgment: (1) Middleton v. Luna’s Resturant & Deli, L.L.C., 201-Ohio-4388, 2011 WL 3847184 (Ohio App., Aug. 29, 2011) (unpublished decision); (2) LaKing Trucking, Inc. v. Coastal Tank Lines, Inc., 1984 WL 6241 (Ohio App., Feb. 9, 1984) (unpublished decision) (summons received in a corporate mail room but lost before being brought to the attention of the proper office does not rise to excusable neglect); and (3) Miller v. Sybert, 1975 WL 7351 (July 25. 1985) (unpublished decision)(ordinary mail delivered to defendant when mail is accessible to other persons and where it was never picked up by defendant’s friends while he was out of the state does not constitute “excusable neglect”). The Ohio Court of Appeals noted that the above-cited three unpublished decisions were in accord with the following two decisions: (1) Andrew Bihl Sons, Inc. v. Trembly, 67 Ohio App.3d 664, 667, 588 N.E2d 172 (Ohio App. 1990) (ignoring mail for more than three months due to illness and failing to delegate a competent agent to handle business affairs does not constitute “excusable neglect”); and (2) Meyer v. GMAC mtge., 2007-Ohio-5009, 2007 WL 2773653 (Ohio App., Sept. 25, 2007) (unpublished decision) (employee’s failure to forward the complaint to the appropriate corporate department does not constitute “excusable neglect”).

Finally, Judge argued that the mother’s ignorance of the legal process did not amount to “excusable neglect.”

The Rationale of Judge

Having reviewed the record, the Ohio Court of Appeals found that Judge had presented strong arguments in support of its position that the trial court had abused its discretion in finding “excusable neglect,” especially with regard to USA Freight’s responsibility to maintain a valid statutory agent. The Court cited the Ohio Revised Code for the proposition that “[e]ach limited liability company [such as USA Freight] shall maintain continuously in this state an agent for service of process on the company.” See, R.C. 1705.06(A). The Court pointed out that a limited liability company is required to provide the Ohio Secretary of State with a written appointment of its statutory agent that sets forth the name of the agent and the agent’s address in this state. See, R.C. 1705.06(B)(1)(a), (C); and that the Ohio Secretary of State then kept a record of the statutory agent’s name and address. See, R.C. 1705.06(C). The Court noted that Rule 4.2(g) of the Ohio Rules of Civil Procedure provided that, to serve a limited liability company, a plaintiff may direct service of process to “ the agent authorized by appointment or by law to receive service of process”’ that [c]ertified mail service upon such an agent is effective upon delivery, if evidenced by a signed return receipt”; and that Rule 4.1 (A)(1)(a) provided that “[s]ervice is valid if ‘any person’ at the address signs for the certified mail, whether or not the recipient is the defendant’s agent.”

Applying these principles to the facts and circumstances of Judge, the Ohio Court of Appeals noted that Judge had served its complaint on USA Freight’s statutory agent via certified mail at the address on record with the Ohio Secretary of State and that the certified mail was received at the address of USA Freight’s statutory agent and signed for by the mother of the owner of USA Freight. Under these circumstances, the Court concluded that service of the complaint, because the mother of USA Freight’s owner mishandled the complaint, this type of scenario had not been found to constitute “excusable neglect.”

In support of its conclusion, the Court cited the following decision of the United States District Court for the Northern District of Ohio: Chicago Sweetners, Inc. v. Kantner Group, Inc., 2009 WL 1707927 (N.D. Ohio, June 17, 2009) (unpublished decision) (finding no “excusable neglect” where a defendant company was properly served with a complaint via certified mail to its statutory agent’s address, the certified mail was received and signed for by an administrative assistant of the defendant company, who was also the mother of the defendant company’s president, and the mother thereafter mishandled the complaint so that the defendant company never received the notice of it).

In reaching its decision, the Ohio Court of Appeals agree with Judge, that insufficient or negligent internal procedures in an organization may not compromise excusable neglect and that, therefore, they may not support the vacation of a default judgment,” citing, Middleton, supra, and Denittis v. Aaron Costr., Inc., 2012-Ohio-6213, 2012 WL 6738472 (Ohio App., Dec. 31, 2012) (unpublished decision). In so agreeing, the Court stressed that USA Freight was, by law, responsible for maintaining a valid statutory agent that was calculated to receive service of process at the agent’s listed address; that USA Freight has chosen a statutory agent address where it was possible for a non-English-speaking person who was unaffiliated with the company to receive important documentation that was served at the address; and that, due to USA Freight’s negligence in choosing its statutory agent and/or failure to implement internal procedures to ensure that documentation served at the statutory agent’s address was directed to the appropriate person, the complaint at issue was mishandled by the owner’s mother.

The Court emphasized that “excusable neglect” does not result from the party’s own carelessness, inattention, or willful disregard of the processes of the court, but in consequence of some unavoidable or unexpected hindrance or accident; and that, had USA Freight chosen a better statutory agent, or had better procedures in place for receiving service of process at the statutory agent’s address, then the mishandling of the complaint would likely have been avoided.

Accordingly, the Ohio Court of Appeals concluded that the circumstances in Judge did not constitute an unavoidable or unexpected hindrance or accident. In addition, the Court pointed out that, while abuse of discretion was an extremely high standard of review that required the Court to find the trial court’s “excusable neglect” decision unreasonable, the Court, nevertheless, had reached that conclusion. The Court reiterated that the trial court’s decision was unreasonable, because the mishandling of the complaint was the result of USA Freight’s own negligence, and stated that, a company should be adequately prepared to receive service of process at the statutory agent’s address.

Although the Court recognized that Rule 60(B) motions are to be liberally construed in favor of the movant, the Court, nevertheless, found that USA Freight’s negligence in choosing its statutory agent and its procedures for receiving service of process was in willful disregard of the processes of the Court. Therefore, the Court narrowly held that, when a company is required by law to maintain a statutory agent to receive service of process, and when there is successful service of process via certified mail at the statutory agent’s address that is on record with the Ohio Secretary of State, the subsequent mishandling of served documents by the person who signed for and received the documents at the statutory agent’s listed address does not amount to “excusable neglect.”

Conclusion

The Ohio Court of Appeals decision in Judge should serve as a warning to companies and LLCs to check their statutory agent procedures in order to ensure that documents served at their statutory agent’s address are directed to the appropriate person(s); otherwise, they may by subject to enforceable default judgments against them in lawsuits of which they were entirely unaware.

Don’t let this happen to you!

Schedule a Consultation

U.S. Supreme Court Unanimously Rules: States Can’t Tax Out-of-State Trusts

by Garrett Sutton, Esq | Aug 1, 2019 | Asset Protection Resources, Case Law

Do you live in a high-tax state? Would you be better off having assets in a trust in a state with no taxes? The U.S. Supreme Court just answered the second question with a resounding “Yes” in the Kaestner case. States cannot tax out-of-state trusts. A case summary of this important decision follows:

ISSUE

Can a State lawfully tax the income of a trust merely because a beneficiary of the trust lives in the State?

APPLICABLE LAW

In North Carolina Department of Revenue v. The Kimberley Rice Kaestner 1992 Family Trust, 588 U. S. _ (2019) WL 2552488 (decided June 21, 2019), the United States Supreme Court unanimously conclude that the North Carolina state residence of a trust beneficiary did not supply the minimum connection with North Carolina to support the State’s imposition of tax on trust income, and thus the State’s tax as applied to the trust violated the Due Process Clause of the United States Constitution.

The Decision in Kaestner

Justice Sotomayor delivered the opinion for a unanimous Court, and Justice Alito filed a concurring opinion, in which Justices Roberts and Gorsuch joined.

The court stated that this case was about the limits of a State’s power to tax a trust, and observed that North Carolina imposes a tax on any trust income that “is for the benefit of” a North Carolina resident. The court noted that the North Carolina courts interpret this law to mean that a trust owes income tax to North Carolina whenever the trust’s beneficiaries live in the State, even if—as was the case here—those beneficiaries received no income from the trust in the relevant tax year, had no right to demand income from the trust that year, and could not count on ever receiving income from the trust.

However, the Court pointed out that, even the North Carolina courts held the tax to be unconstitutional when assessed in such a case, because the State lacked the minimum connection with the object of its tax that the Constitution requires. The Court agreed, and affirmed the decision of the North Carolina courts, because, as applied in these circumstances, the Court concluded that the State’s tax violated the Due Process Clause of the Fourteenth Amendment.

The Facts in Kaestner

Originally, the precursor of the trust in question was formed nearly 30 years ago when New Yorker Joseph Lee Rice III formed a trust for the benefit of his children. Rice decided that the trust would be governed by the law of his home State, New York, and he appointed a fellow New York resident as the trustee, who was later succeeded by a Connecticut resident as trustee.

The trust agreement provided that the trustee would have “absolute discretion” to distribute the trust’s assets to the beneficiaries in such amounts and proportions as the trustee might from time to time decide. When Rice created the trust, no trust beneficiary lived in North Carolina. That changed in 1997, when Rice’s daughter, Kimberley Rice Kaestner, moved to the State. She and her minor children were residents of North Carolina from 2005 through 2008, the time period relevant for this case.

A few years after Kaestner moved to North Carolina, the trustee divided Rice’s initial trust into three subtrusts. One of these subtrusts—the Kimberley Rice Kaestner 1992 Family Trust (the “Kaestner Trust”)—was formed for the benefit of Kaestner and her three children. The same agreement that controlled the original trust also governed the Kaestner Trust. Critically, this meant that the trustee had exclusive control over the allocation and timing of trust distributions.

North Carolina admitted in the state-court proceedings that the State’s only connection to the Trust in the relevant tax years was the in-state residence of the Trust’s beneficiaries. From 2005 through 2008, the trustee chose not to distribute any of the income that the Trust accumulated to Kaestner or her children, and the trustee’s contacts with Kaestner were “infrequent”; there were only two meetings between Kaestner and the trustee I those years, both of which took place in New York.

The trustee also gave Kaestner accounts of trust assests and legal advice concerning the Trust. The Trust was subject to New York law; the grantor was a New York resident; and no trustee lived in North Carolina. The trustee kept the Trust documents and records in New York, and the Trust asset custodians were located in Massachusetts.

The Trust also maintained no physical presence in North Carolina, made no direct investments in the State, and held no real property there. The Trust agreement provided that the Kaestner Trust would terminate when Kaestner turned 40, after the time period relevant here. After consulting with Kaestner and in accordance with her wishes, however, the trustee rolled over the assets into a new trust instead of distributing them to her. This transfer tool place after the relevant tax years.

Between 2005 and 2008, North Carolina required the Connecticut trustee to pay more than $1.3 million in taxes on income earned by the assets in the Kaestner Trust. North Carolina levied this tax solely because of Kaestner’s residence within the State.

Course of Proceedings in Kaestner

The Court noted that North Carolina taxes any trust income that “is for the benefit of” a North Carolina resident, and that the North Carolina Supreme Court interprets the statute to authorize North Carolina to tax a trust on the sole basis that the trust beneficiaries reside in the State. Applying this statute, the North Carolina Department of Revenue assessed a tax on the full proceeds that the Kaestner Trust accumulated for tax years 2005 through 2008 and required the trustee to pay it. The resulting tax bill amounted to more than $1.3 million.

The trustee paid the tax under protest and then sued in state court, arguing that the tax as applied to the Kaestner Trust violated the Due Process Clause of the Fourteenth Amendment. The trial court decided that the Kaestner’s residence in North Carolina was too tenuous a link between the State and the Trust to support the tax and held that the State’s taxation of the Trust violated the Due Process Clause.

The North Carolina Court of Appeals affirmed, as did the North Carolina Supreme Court. A majority of the State Supreme Court reasoned that the Kaestner Trust and its beneficiaries “have legally separate, taxable existences” and thus that the contacts between the Kaestner family and their home State cannot establish a connection between the Trust “itself” and the State. The Court granted certiorari to decide whether the Due Process Clause prohibits States from taxing trusts based only on the in-state residency of trust beneficiaries.

The Rationale in Kaestner

Initially, the Court noted that, in its simplest form, a trust is created when one person (a “settlor” or “grantor”) transfers property to a third party (a “trustee”) to administer for the benefit of another (a “beneficiary”). As traditionally understood, the arrangement that results is not a distinct legal entity, but a fiduciary relationship between multiple people.

The trust comprises the separate interests of the beneficiary, who has an equitable interest in the trust property, and the trustee, who had a legal interest in that property. In some contexts, however, trusts can be treated as if the trust itself has a separate existence from its constituent parts, and that trusts are treated as distinct entities for federal taxation purposes.

The court noted that the Due Process Clause provides that “[n]o State shall…deprive any person of life, liberty, or property, without due process of law.” The Court pointed out that the Clause centrally concerns the fundamental fairness of governmental activity; and that in the context of state taxation, the Due Process Clause limits States to imposing only taxes that bear fiscal relation to protection, opportunities, and benefits given by the state. The Court observed that the power to tax is essential to the very existence of government, but cautioned that the legitimacy of that power requires drawing a line between taxation and mere unjustified confiscation.

The Court concluded that the boundary turns on the simple but controlling question whether the state has given anything for which it can ask return. In this regard, the Court applied a two-step analysis to decide if a state tax abides by the Due Process Clause. First, there must be some definite link, some minimum connection, between a state and the person, property, or transaction it seeks to tax. Second, the income attributed to the State for tax purposes must be rationally related to values connected with the taxing State.

To determine whether a State has the requisite “minimum connection” with the object of its tax, the Court borrowed from the familiar test of International Shoe Co. v. Washington, 326 U.S. 310, 66 S.Ct. 154, 90 L.ED. 95 (1945). Thus, a State has the power to impose a tax only when the taxed entity has certain “minimum contacts” with the State such that the tax does not offend “traditional notions of fair play and substantial justice.” The Court stated that the “minimum contacts” inquiry is flexible and focuses upon the reasonableness of the government’s action. Ultimately, only those who derive benefits and protection from associating with a State should have obligations to the State in question.

The Court noted it had already held that a tax on trust income distributed to an in-state resident passes muster under the Due Process Clause, as does a tax based on a trustee’s in-state residence (this is a planning opportunity for creating Nevada based trusts, where there are no state taxes). The Court also suggested that a tax based on the site of trust administration was constitutional. However, the Court carefully distinguished the Kaestner Trust upon the following grounds: (1) the Kaestner Trust made no distributions to any North Carolina resident in the years in question; (2) the trustee resided out of State; (3) the Trust administration was spilt between New York (where the Trust’s records were kept) and Massachusetts (where the custodians of its assets were located); (4) the trustee made no direct investments in North Carolina in the relevant tax years; and (5) the settlor did not reside in North Carolina. The Court emphasized that of all the potential kinds of connections between a trust and a State, North Carolina sought to rest its tax on just one—the in-state residence of the beneficiaries.

For these reasons, the Court held that the presence of in-state beneficiaries alone did not empower a State to tax trust income that had not been distributed to the beneficiaries where the beneficiaries had no right to demand that income and were uncertain ever to receive it. In limiting its holding to the specific facts presented, the Court did not imply approval or disapproval of trust taxes that were premised on the residence of beneficiaries whose relationship to trust assets differed from that of the beneficiaries here.

In discussing its holding, the Court noted that, in the past, it had analyzed state trust taxes for consistency with the Due Process Clause by looking to the relationship between the relevant trust constituent (settlor, trustee, or beneficiary) and the trust assets that the State sough to tax. In the context of beneficiary contacts specifically, the Court noted that it had focused upon the extent of the in-state beneficiary’s right to control, possess, enjoy or receive trust assets. The Count pointed out that its emphasis on these factors emerged in the following two early cases: (1) Safe Deposit & Trust Co. of Baltimore v. Virginia, 280 U.S. 83, 50, S.Ct. 59, 74 L.Ed. 180 (1929) (rejecting Virginia’s attempt to tax a trustee on the whole corpus of the trust estate, and explaining that nobody within Virginia had the present right to the trust property’s control or possession, or to receive income therefrom); and (2) Brooke v. Norfolk, 277 U.S. 27, 48 S.Ct. 422, 72 L.Ed. 767 (1928) (rejecting a tax on the entirety of a trust fund assessed against a resident beneficiary because the trust property was no within the State, did not belong to the beneficiary, and was not within her possession or control).

Both of these cases invalidated state taxes premised on the in-state residency of beneficiaries, and in each of these cases, the challenged tax fell on the entirety of a trust’s property, rather than on only the share of trust assets to which the beneficiaries were entitled. On the other hand, the Court noted that the same elements of possession, control, and enjoyment of trust property had let it to uphold state taxes based upon the in-state residency of beneficiaries who did have close ties to the taxed trust assets, and where the trust income actually was distributed to an in-state beneficiary. The Court states that, in those circumstances, the beneficiary owned and enjoyed an interest in the trust property, and the State could exact a tax in exchange for offering the beneficiary protection.

The Court observed that its past cases reflected a common governing principle, i.e., when a State seeks to base its tax on the in-state residence of a trust beneficiary, the Due Process Clause demands a pragmatic inquiry into what exactly the beneficiary controls or possesses and how that interest relates to the object of the State’s tax. Although the Court stated that its resident-beneficiary cases were most relevant here, similar analysis also appeared in the context of taxed premised on the in-state residency of settlors and trustees; and that a focus on ownership and rights to trust assets also featured in the Courts; ruing that a trustee’s in-state residency can provide the basis for a state to tax trust assets.

In summary, the Court concluded that, when assessing a state tax premised on the in-state residency of a constituent of a trust—whether beneficiary, settlor, or trustee—the Due Process Clause demands attention to the particular relationship between the resident and the trust assets that the State seeks to tax. Because each individual fulfills different functions in the creation and continuation of the trust, the specific features of that relationship sufficient to sustain a tax may vary depending on whether the resident is a settlor, beneficiary, or trustee. However, when a tax is premised on the in-state residence of a beneficiary, the Constitution requires that the resident have some degree of possession, control, or enjoyment of the trust property, or a right to receive that property, before the State can tax the asset; otherwise, the State’s relationship to the object of its tax is too attenuated to create the “minimum connection” that the constitution requires.

Applying these principles to the Kaestner Trust, the Court concluded: (1) the residence of the Kaestner Trust beneficiaries in North Carolina alone did not supply the minimum connection necessary to sustain the State’s tax; (2) the beneficiaries did not receive any income from the trust during the years in question (if they had, such income would have been taxable); (3) the beneficiaries had no right to demand trust income or otherwise control, possess, or enjoy the trust assets in the tax years at issue; (4) the decision of when, whether, and to whom the trustee would distribute the trust’s assets was left to the trustee’s “absolute discretion”; (5) the Trust agreement explicitly authorized the trustee to distribute funds to one beneficiary to the exclusion of others, with the effect of cutting one or more beneficiaries out of the Trust; (6) the Trust Agreement authorized the trustee, not the beneficiaries, to make investment decisions regarding Trust property, thus making the beneficiaries’ interest less like a potential source of wealth that was property in their hands; (7) not only were Kaestner and her children unable to demand distributions in the tax years at issue, but they also could not count on necessarily receiving any specific amount of income from the Trust in the future; (8) Kaestner and her children had no right to control or possess the trust assets or to receive income therefrom; and (9) Kaestner and her children received no income from the Trust, had no right to demand income from the Trust, and had no assurance that they would eventually receive a specific share of Trust income. The Court concluded that, given these features of the Kaestner Trust, the beneficiaries’ residence could not, consistent with due process, serve as the sole basis for North Carolina’s tax on trust income. For these reasons, the Court affirmed the judgment of the Supreme Court of North Carolina.

Justice Alito’s Concurring Opinion

Justice Alito noted that he joined the opinion of the Court because he believed that it properly concluded that North Carolina’s tenuous connection to the income earned by the trust was insufficient to permit the State to tax the trust’s income. However, he cautioned that, because this connection was unusually tenuous, the opinion of the Court was circumscribed. He stated that he wrote separately to make clear that the opinion of the Court merely applies its existing precedent and that its decision not to answer questions not presented by the facts of this case did not open for reconsideration any points resolved by its prior decisions.

Justice Alito observed that, although states have broad discretion to structure their tax systems, in a few narrow areas the Federal Constitution imposes limits on that power. The Due Process Clause creates one such limit. It imposes restrictions on the persons and property that a State can subject to its taxation authority. The Due Process Clause requires some definite link, some minimum connection, between a state and the person, property or transaction it seeks to tax. North Carolina assesses this tax against the trustee and calculates the tax based on the income earned by the trust. Therefore, it is necessary to look at the connections between the assets held in trust and the State.

Justice Alito pointed out that it is easy to identify a State’s connection with tangible assets. A tangible asset has a connection with the State in which it is located, and generally speaking, only that State has power to tax the asset. However, intangible assets–stocks, bonds, or other securities–present a more difficult question. In the case of intangible assets held in trust, Justice Alito noted that the Court previously had focused upon whether a resident of the State imposing the tax has control, possession, or the enjoyment of the asset. Because a trustee is the legal owner of the trust assets and possesses the powers that accompany that status–power to manage the investments, to make and enforce contracts respecting the assets, and to litigate on behalf of the trust–the trustee’s State of residence can tax the trust’s intangible assets. On the other hand, the Court now was being asked whether the connection between a beneficiary and a trust is sufficient to allow the beneficiary’s State of residence to tax the trust assets and the income they earn while the assets and income remain in the trust in another State.

Justice Alito stated that the following two cases provide a clear answer: (1) Brooke, supra; and (2) Safe Deposit, supra.

In Brooke, supra, Virginia assessed a tax on the assets of a trust whose beneficiary was a resident of Virginia. The trustee was not a resident of Virginia and administered the trust outside the Commonwealth. Under the terms of the trust, the beneficiary was entitled to all the income of the trust and had paid income taxes for the money that had been transferred to her. But the Court held that, despite the beneficiary’s present and ongoing right to receive income from the trust, Virginia could not impose taxes on the undistributed assets that remained within the trust because the property was not within the State, did not belong to the petitioner, and was not within her possession or control. Even though the beneficiary was entitled to and received income from the trust, the Court observed that she was a stranger to the assets within the trust because she lacked control, possession, or enjoyment of them.
In Safe Deposit, supra, Virginia again attempted to assess taxes on the intangible

assets held in a trust whose trustee resided in Maryland. The beneficiaries were children who lived in Virginia. Under the terms of the trust, each child was entitled to one half of the trust’s assets (both the original principal and the income earned over time) when the child reached the age of 25. Despite their entitlement to the entire corpus of the trust, the Court held that the beneficiaries’ residence did not allow Virginia to tax the assets while they remained in trust, and noted that nobody within Virginia had the present right to the assets’ control or possession, or to receive income therefrom, or to cause them to be brought physically within her borders. The Court concluded that the beneficiaries’ equitable ownership of the trust did not sufficiently connect the undistributed assets to Virginia as to allow taxation of the trust, and that the beneficiaries’ equitable ownership yielded to the established fact of legal ownership, actual presence, and control elsewhere.

Justice Alito pointed out that in Kaestner, as in Brooke and Safe Deposit, the resident beneficiary had neither control nor possession of the intangible assets in the trust. She did not enjoy the use of the trust assets. The trustee administered the trust and held the trust assets outside the State of North Carolina. Justice Alito stressed that, under Safe Deposit and Brooke, that was sufficient to establish that North Carolina could not tax the trust or the trustee on the intangible assets held by the Kaestner Trust.

In summary, Justice Alito concluded that the Due Process Clause requires a sufficient connection between an asset and a State before the State can tax the asset. For intangible assets held in trust, the Court’s precedents dictate that a resident beneficiary’s control, possession, and ability to use or enjoy the asset are the core of the inquiry. Justice Alito stated that the opinion of the Court rightly concluded that the assets in the Kaestner Trust and the Trust’s undistributed income could not be taxed by North Carolina because the resident beneficiary lacked control, possession, or enjoyment of the Trust assets. Justice Alito emphasized that the Court’s discussion of the peculiarities of the Kaestner trust did not change the governing standard, nor did it alter the reasoning applied in the Court’s earlier cases. On that basis, he concur with the Court’s opinion.

BRIEF DISCUSSION

The gist of Kaestner was that a State cannot tax trust income merely because a beneficiary of the trust lives in that State; however, the discussion in Kaestner also provides some indication as to when it may be permissible for a state to tax the income of a trust. The following is a list of some of the factors to be considered:

Income Distributed to an In-State Resident. The Court noted that the in-state beneficiaries in Kaestner did not receive any income from the trust during the years in question; and that, if they had, then such income would have been taxable. The Court further noted that it had already held that a tax on trust income distributed to an in-state resident passes muster under the Due Process Clause. The court emphasized that, not only were Kaestner and her children unable to demand distributions in the tax years at issue, but they also could not count on necessarily receiving any specific amount of income from the Trust in the future; they had no right to control or possess the trust assets or to receive income therefrom; they received no income from the Trust; they had no right to demand income from the Trust; and they had no assurance that they would eventually receive a specific share of the Trust income.
Residence of Trustee. The Court noted that a tax based on a trustee’s in-state Residence also passes muster under the Due Process Clause.
Site of Trust Administration. The Court suggested that a tax based on the site of trust administration was constitutional.
Residence of Grantor/Settlor. The Court concluded that, although the residence of the grantor/settlor of a trust is an important factor to be considered, the mere fact that the grantor/settlor of a trust lives in the taxing state may not, in and of itself, be sufficient to support taxation of the trust.
Control, Possession, and Ability to Use or Enjoy Intangible Asset. The Court noted that the beneficiaries had no right to demand trust income or otherwise control, possess, or enjoy the trust assets in the tax years at issue. Justice Alito’s concurring opinion also emphasized that, for intangible assets held in trust, the Court’s precedents dictate that a resident beneficiary’s control, possession, and ability to use or enjoy the asset are the core of the inquiry.
Trustee’s Exclusive Control. The Court noted that the Trust agreement provided that the Trustee would have “absolute discretion” to distribute the trust’s assets to the beneficiaries in such amounts and proportions as the trustee might from time to time decide; that the Trustee’s exclusive control over the allocation and timing of trust distributions was “critical”; that the Trust agreement explicitly authorized the trustee to distribute funds to one beneficiary to the exclusion of others, with the effect of cutting one or more beneficiaries out of the Trust; and that the decision of when, whether, and to whom the Trustee would distribute the Trust’s assets was left to the Trustee’s “absolute discretion.” The Court stressed that the Trust Agreement authorized the Trustee, not the beneficiaries, to make investment decisions regarding Trust property, which made the beneficiaries’ interest less like a potential source of wealth that was property in their hands.
Trust Not Subject to Governing Law. The Court noted that the Trust was formed under New York law, and not under North Carolina law, and that the Trust was subject to New York law.
Physical Location of Trust Records. The Court indicated that the Trustee kept the Trust documents and records in New York, and not in North Carolina.
Physical Location of Asset Custodians. The Court indicated that the Trust asset custodians were located in Massachusetts, and not in North Carolina.
No Direct Investments in Taxing State. The Court noted that the Trust maintained no physical presence in North Carolina, made no direct investments in the State, and held no real property there.
Number of Meetings Between Trustee and Beneficiary. The Court noted that the Trustee’s contacts with Kaestner were “infrequent”; therefore, the number of meetings between the trustee and the beneficiary may be relevant.
Geographic Location of Meetings Between Trustee and Beneficiary. The Court noted that there were only two meetings between Kaestner and the Trustee, both of which took place in New York; therefore, the geographic location of trustee/beneficiary meetings may be important.
Termination of Trust at Specified Age. The Court noted that the Trust agreement provided that the Kaestner Trust would terminate when Kaestner turned 40; but that, after consulting with Kaestner, and in accordance with her wishes, and after the relevant tax years, the Trustee rolled over the assets into a new trust instead of distributing them to her. Thus, it would seem that drafting a trust as long-term trust, or even as perpetual trust, would be a safer option.

CONCLUSION

Although the decision in Kaestner generally was a favorable decision for taxpayers, it was, by its terms, a very narrow holding. The Court concluded that the residence of the Trust beneficiaries in North Carolina alone did not supply the minimum connection necessary to sustain the State’s tax; and could not, consistent with due process, serve as the sole basis for North Carolina’s tax on trust income. For these reasons, the Court affirmed the judgment of the Supreme Court of North Carolina. As noted by the concurring opinion of Justice Alito, for intangible assets held in trust, the Court’s precedents dictate that a resident beneficiary’s control, possession, and ability to use or enjoy the asset are the core of the inquiry.

Are Individuals Protected Within Their LLC?

by Garrett Sutton, Esq | May 1, 2019 | C Corps / S Corps, Case Law, Maintaining Your LLCs, Running a Business

New Texas Case Sends Shock Waves

LLCs are set up to make personal assets inaccessible for any obligations of the entity. Protection may be lost, however, if you are not aware of your personal conduct when managing business through your LLC. The case below deals with water and environmental issues, an area where governments like to hold individuals liable.

In State v. Morello, the Texas Supreme Court recently found that an agent or a member of an LLC can be found personally liable for any violation of statutes or regulations.

In Morello, the State of Texas brought a civil action under the Texas Water Code against both Bernard Morello and his single member entity, White Lion Holdings, LLC (White Lion).

In 2004, Morello purchased a piece of property that was subject to a hazardous waste permit and compliance plan under the Texas Commission of Environmental Quality (TCEQ). After the purchase, Morello assigned the TCEQ compliance plan and all other property interests from his own name into White Lion.

In hindsight, Morello should have first taken title in the LLC, as he would have removed his individual name from the chain of title. Once your name is associated with the title to environmental problems, you can be held personally responsible for the remediation and cleanup.

Over time, the obligations were not performed, and the state decided to press charges against both White Lion and Morello for violating the TCEQ compliance plan.

The state’s argument for targeting Morello as an individual rested on section 7.102 of the Texas Water Code stating that any “person who codifies, suffers, allows, or permits a violation of a statute…within the [TCEQ’s] jurisdiction…shall be assessed” civil penalties.

Morello’s argument depended on a section of the Texas Business Organizations Code which states that, “a member…is not liable for a debt, obligation, or liability of a limited liability company.”

Morello eventually worked its way up to the Texas Supreme Court. The high court ultimately ruled in favor of the State, writing that “the State’s position is not based on the Business Organizations Code; it is based on the Water Code.” The Texas Supreme Court also found Morello personally liable on three primary arguments.

First, the Court found no reason whatsoever to exclude an individual from the term “person” from section 7.102. Second, the Court found that White Lion being the sole owner and being solely responsible for the compliance plan was immaterial. Third, the Court cited cases stating that a corporate agent may not escape individual liability where that agent “personally participated in the wrongful conduct,” citing that Morello’s actions were in his capacity as an agent and member of White Lion.

The Court’s opinion stated that where a statute applies to any “person,” an “individual cannot use the corporate form as a shield when he or she has personally participated in conduct that violates the statute.”

Haven’t We Seen This Before?

Federal and state courts have consistently rejected the position that where an environmental statute applies to a “person,” corporate officers can avoid individual liability for violating a statute if they personally participated in the wrongful conduct:

Riverside Mkt. Dev. Corp. v. Int’l Bldg. Prods., Inc., 931 F.2d 327, 330 (5th Cor. 1991) (concluding that the federal act “prevents individuals from hiding behind the corporate shield” when they “actually participate in the wrongful conduct”)
U.S. v. Ne. Pharm. & Chem. Co., 810 F.2d 726, 745 (8th Cir. 1986), cert. denied, 484 U.S. 848 (1987) (“[I]mposing liability upon only the corporation, but not those corporate officers and employees who actually make corporate decisions, would be inconsistent with Congress’ intent to impose liability upon the persons who are involved in the handling and disposal of hazardous substances.”)
T.V. Spano Bldg. Corp. v. Dep’t pf Natural Res. & Envtl. Control, 628 A.2d 53,61 (Del. 1993) (concluding that the State could impose personal liability on an officer who “directed, ordered, ratified, approved, or consented to the improper disposal”)
People ex. Rel. Burris v. C.J.R. Processing, Inc., 647 N.E.2d 1035, 1039 (Ill. App. Ct. 1995) (“[C]orporate officers may be held liable for violations of the [state environmental act] when their active participation or personal involvement is shown.”).

While these cases involved different statutes than the one at issue here, it is important to know that under an environmental regulation applicable to a ‘person,’ an individual cannot use the corporate form as a shield when he or she has personally participated in conduct that violates the statute.

And Morello was not held liable for a debt, obligation, or liability of White Lion as he asserts is prohibited by the Business Organizations Code. See Tex. Bus. Orgs. Code § 101.114. Rather, he was held individually liable based on his individual, personal actions.

The Morello case is groundbreaking and could have a ripple effect across Courts in the United States. It is important for people to be aware of their behavior when acting as a member or an agent of an LLC, even before the entity is formed. This recent Texas case demonstrates that in certain specific circumstances individual persons may be found personally liable for any wrongdoing.

Ted Sutton is a graduate of the University of Utah. He will be attending Law School at the University of Wyoming in the Fall of 2019.

Case Study: Florida Single Member LLC’s and Charging Orders

by Garrett Sutton, Esq | Apr 1, 2019 | C Corps / S Corps, Case Law, Charging Order

When it comes to charging orders, the key asset protection feature of LLC’s and LP’s, there are two opposing trends.

First, some states do not provide charging order protection for a single member (one owner) LLC. The rationale is that the charging order exists to protect innocent partners, the people who were not sued by someone trying to reach their partner’s assets.

The second trend is to protect even single owners from an outside attack with a charging order. The states of Wyoming, Nevada and Delaware offer this strong protection in their state statutes. Everyone thought Florida offered strong protection until the Olmstead case was decided. The federal government was going after the single member LLC assets of a scamster named Olmstead.

The Florida Supreme Court, wanting to accommodate their government brethren found a way to declare multi member LLC’s protected by the charging order but not single member LLC’s. And so the feds were able to reach Olmstead’s assets.

But Florida law has been a bit confused ever since.

The Pansky Case

In Pansky v. Barry S. Franklin & Associates, P.A. (Fla. 4th DCA, Feb. 13, 2019), a judgment creditor brought a motion for a charging order and for transfer of the judgment debtor’s interest in an LLC. The trial court authorized both the charging order and transfer of the judgment debtor’s interest. The judgment debtor appealed, and the District Court of Appeal for the Fourth District reversed and remanded, holding that the exclusive statutory remedy available to a judgment creditor as to a judgment debtor’s interest in the LLC was a charging order.

More specifically, the Court of Appeal concluded that the exclusive statutory remedy available to a judgment creditor as to a judgment debtor’s interest in an LLC was a charging order, and that the trial court’s order transferring right, title, and interest in the LLC to the judgment creditor exceeded the allowable scope, at least where there was a factual dispute was whether judgment debtor was the sole member of the LLC.

The Facts of Pansky

The underlying facts in Pansky show that the law firm had previously represented Pansky in a divorce proceeding. The law firm withdrew as counsel, claiming it was owed attorney’s fees that Pansky had not paid. The law firm obtained monetary judgments for the claimed fees and attempted to collect on the judgments by filing a motion for a charging order against Daniel Pansky, LLC, in which Pansky had an ownership interest.

The law firm also sought transfer of Pansky’s ownership interest in the LLC to the law firm. Pansky conceded that the law firm was entitled to entry of a charging order, but objected to any transfer of his ownership interest in the LLC.

The trial court held a hearing on the law firm’s motion and orally ruled that, based on Pansky’s concession, an agreed order granting a charging order would be entered. The court stated that it would reserve ruling on any additional relief beyond a charging order that the law firm requested. The trial court entered a written order granting the charging order; however, the trial court also transferred Pansky’s “right, title, and interest” in the LLC. It is from this latter order that Pansky appealed.

The Rationale in Pansky

The District Court of Appeal for the Fourth District noted that above-quoted Section 605.0503(3), Florida Statutes, provides that a charging order is the sole and exclusive remedy by which a judgment creditor of a member or member’s transferee may satisfy a judgment from the judgment debtor’s interest in a limited liability company or rights to distributions from the limited liability company; and that above-quoted Section 605.0503(1) provides that a charging order constitutes a lien upon a debtor’s transferable interest and requires the LLC to pay over to the judgment creditor a distribution that would otherwise be paid to the judgment debtor.[1]

The Court of Appeal found that a factual dispute existed as to whether Pansky was the sole member of the LLC. Pansky maintained that it was a two-member LLC, such that only a charging order was authorized, and the law firm contended that Pansky was the sole member.

The Court of Appeal observed that, at the hearing on the law firm’s motion, the trial court stated, “I don’t have enough in front of me to show it’s a one-member LLC that I can give you-all [sic] that other relief. But since there’s no opposition to the entry of the charging order, that’s granted.”

As such, the trial court stated it would “reserve jurisdiction on the other prayers for relief, such as [a freeze order] and transferring Mr. Pansky’s ownership interest” until the factual disputes were determined at a later proceeding. The law firm contended that the trial court’s order did not make a transfer of conveyance of property or assets.

The firm asserted that the order merely adjudicated the law firm’s entitlement to a charging order. The Court of Appeal found this argument unconvincing, and stated that the trial court’s order plainly contained language transferring Pansky’s “Right, title and interest” in the LLC to the law firm.

The Court of Appeal disagreed with the trial court, and concluded that the trial court’s order plainly contained language transferring Pansky’s “right, title, and interest” in the LLC to the law firm and went beyond granting a charging order–as was agreed to by the parties and authorized by statute. The Court of Appeal noted that in Abukasis v. MTM Finest, Ltd., 199 So.3d 421, 422 (Fla. 3d DCA 2016), the District Court of Appeal for the Third District reversed a trial court’s order which transferred the appellant’s “membership interest” in an LLC toward the satisfaction of a debt, finding no authority for an order directly transferring an interest in property to a judgment creditor in partial or full satisfaction of a money judgment, and stating that the trial court failed to conform with even the most rudimentary requirements of Section 605.0503.

The Court of Appeal further noted that, in McClandon v. Dakem & Assocs., LLC, 219 So.3d 269, 271 (Fla. 5th DCA 2017), the District Court of Appeal for the Fifth District explained that a charging order should only divest a debtor of his or her economic opportunity to obtain profits and distributions from the LLC, and should charge only the debtor’s membership interest, and not managerial rights. The Court of Appeal further noted that, in Capstone Bank v. Perry-Clifton Enter., LLC, 230 So.3d 970, 971 (Fla. 1st DCA 2017), the District Court of Appeal for the First District explained that a charging order instructs the entity to give the creditor any distributions that would otherwise be paid to the member of the entity.

Because the Court of Appeal found that the trial court’s order went beyond granting a charging order, as was agreed to by the parties and authorized by statute, the Court of Appeal reversed and remanded the case to the trial court.

Discussion

It would appear that the opinion of the District Court of Appeal for the Fourth District did not go far enough. Section 605.0503(4), Florida Statutes, provides:

“(4) In the case of a limited liability company that has only one member, if a judgment creditor of a member or member’s transferee establishes to the satisfaction of a court of competent jurisdiction that distributions under a charging order will not satisfy the judgment within a reasonable time, a charging order is not the sole and exclusive remedy by which the judgment creditor may satisfy the judgment against a judgment debtor who is the sole member of a limited liability company or the transferee of the sole member, and upon such showing, the court may order the sale of that interest in the limited liability company pursuant to a foreclosure sale. A judgment creditor may make a showing to the court that distributions under a charging order will not satisfy the judgment within a reasonable time at any time after the entry of the judgment and may do so at the same time that the judgment creditor applies for the entry of a charging order.”

If the trial court truly believed that the LLC had only one member, rather than two members, and relied upon the provisions of Section 605.0503(4), then the trial court perforce should have adduced evidence that distributions under the charging order would not satisfy the judgment within a reasonable time. The trial court did not do so.

Although the Court of Appeal tacitly concurred with the District Court of Appeal for the Third District in Abukasis, supra, 199 So.3d at 422, that the trial court failed to conform with even the most rudimentary requirements of Section 605.0503, the Court of Appeal failed specifically to note the trial court’s failure to comply with the explicit provisions of Section 605.0503(4).

Conclusion

Thus, in Florida, it is safe to say that charging order protection is the exclusive remedy available to a judgment creditor of an LLC, at least where there is a factual dispute as to whether the judgment debtor is the sole member of the LLC.

[1]The Court of Appeal carefully distinguished single-member LLCs, and pointed out that above-quoted Section 605.0503(4) provides that, for single-member LLCs, a charging order is “not the sole and exclusive remedy by which the judgment creditor may satisfy the judgment”; rather, in the case of a single-member LLC, “if a judgment creditor of a member or member’s transferee establishes to the satisfaction of a court of competent jurisdiction that distributions under a charging order will not satisfy the judgment within a reasonable time … upon such showing, the court may order the sale of that interest in the limited liability company pursuant to a foreclosure sale.”

Does Asset Protection Trump the US Constitution?

by Garrett Sutton, Esq | May 17, 2018 | Asset Protection Resources, Case Law, Real Estate

An Alaska Supreme Court Rules on Alaska Domestic Asset Protection Trusts Created to Protect Assets from a Montana Lawsuit

Court Case: Toni 1 Trust, by Tangwall v. Wacker 2018 WL 1125033

For fraudulent conveyances,

Can one state assert exclusive jurisdiction over another?
Does asset protection trump the U.S. Constitution?

Several years ago Alaska put forth a legislatively strong asset protection statute. It was modeled after the popular asset protection trusts found in the Cook Islands and similarly small Caribbean island nations. These offshore trusts allowed you to both be the grantor (the person setting up the trust) and the beneficiary (the one benefitting from the trust.) Self settled trusts weren’t allowed in old England, the birthplace of common law. They were bad form. You can’t set up your own trust to protect your own assets was the guiding rationale. A ‘self-settled trust’ was akin to cheating. But Britain’s island dependencies needed an industry besides tourism. And the rich needed an island to park their money.

The foreign asset protection trusts became so popular that a number of U.S. states considered them. Alaska was first. Delaware, Nevada and 13 other states followed with their own domestic asset protection trusts (DAPT.) After a holding period where transfers into a DAPT could be challenged (Nevada’s is two years) the trust can’t be breeched or pierced.

Or can it?

In the Toni 1 case (decided on March 2, 2018) the Alaska Supreme Court had to take a hard look at their asset protection scheme. During a Montana lawsuit the Tangwalls transferred Montana real estate to an Alaska DAPT. A Montana court found the transfer was fraudulent under Montana law. (You can’t put assets out of reach once you have been sued or even threatened with litigation.)

Tangwall sought relief in the Alaska court arguing that only Alaska courts had jurisdiction over an Alaska DAPT. But when the transfer of Montana property was involved the Alaska Supreme Court under the full faith and credit clause of the U.S. Constitution could not limit Montana’s jurisdiction.

A full discussion of the case is below. The takeaway, however, is that asset protection-as we’ve noted before-is an ever changing area of the law.

Issue

What are the potential impacts of the recent Alaska Supreme Court decision in Toni 1 Trust, by Tangwall v. Wacker 2018 WL 1125033 (Alaska, March 2, 2018), on asset protection trusts?

Applicable Law

Alaska Statue 34.40.110(k) (the “Alaska statue”), which purports to grant Alaska courts exclusive jurisdiction over fraudulent transfer claims against Alaska self-settled spendthrift trusts, cannot unilaterally deprive other state and federal courts of jurisdiction.

The Facts of Toni

After a Montana state court issued a series of judgments against Donald Tangwall and his family, the family members transferred two pieces of property to the “Toni 1 Trust,” a trust allegedly created under Alaska law. A Montana state court and an Alaska bankruptcy court found that the transfers were made to avoid the judgments and were, therefore, fraudulent. Tangwall, the trustee of the Trust, then filed suit in the Alaska state court, arguing that Alaska state courts have exclusive jurisdiction over such fraudulent transfer actions under the Alaska statute. However, the Alaska Supreme Court concluded that this statute could not unilaterally deprive other state and federal courts of jurisdiction, and the Court affirmed the Alaska state court’s judgment dismissing Tangwall’s complaint.

More specifically, in 2007 Donald Tangwall sued William and Barbara Wacker in Montana state court. The Wackers counterclaimed against Tangwall; his wife, Barbara Tangwall; his mother-in-law, Margaret “Toni” Bertran; and several trusts and businesses owned or run by the family. In the ensuring years, several default judgments were entered against Tangwall and his family. In 2010, before the last of these judgments was issued, Bertran and Barbara Tangwall transferred parcels of real property to an Alaska trust called the “Toni 1 Trust” (the Trust). The Wackers filed a fraudulent transfer action under Montana law in Montana state court, alleging that the transfers were made to avoid the judgments. Default judgments in the fraudulent transfer action were entered against Barbara Tangwall, the Toni 1 Trust, and Bertran. After the fraudulent transfer judgments were issued, the Wackers purchased Barbara Tangwall’s interest in one of the parcels at a sheriff’s sale, as part satisfaction of their judgment against Tangwall and family. But before they could purchase the remaining half interest, Bertran filed for Chapter 7 bankruptcy in Alaska. Her interest in the trust property was therefore subject to the jurisdiction of a federal bankruptcy court. In December 2012, Donald Tangwall, as trustee of the Trust, filed a complaint in the bankruptcy court against the Wackers and bankruptcy trustee Larry Compton. Among other things, Tangwall alleged that service on the Trust in the Montana fraudulent transfer action was defective, rendering the judgment against the Trust void. Rather than litigate whether service in Montana was proper, Compton elected to bring a fraudulent transfer claim against Tangwall under the federal bankruptcy fraudulent transfer statute. A default judgment in Compton’s action was entered against Tangwall, who appealed from this judgment of dismissed.

Tangwall next sought relief in Alaska state court, where he filed the complaint that led to his later appeal. The crux of his argument was that the Alaska statute granted courts exclusive jurisdiction over any fraudulent transfer actions against the Trust. Specifically, he argued that the Trust contained a provision restricting the transfer of the beneficiary’s interest, and that the Alaska statute granted Alaska courts “exclusive jurisdiction over an action brought under a cause of action or claim for relief that is based on a transfer of property to a trust” containing such transfer restrictions. On this basis, Tangwall sought a declaratory judgment stating that all judgments against the Trust from other jurisdictions were void and that no future actions could be maintained against the Trust because the statute of limitations had run. The superior court dismissed the complaint, and Tangwall appealed. Most of Tangwall’s arguments on appeal were supported by little or no citation to relevant legal authority and were, therefore, waived. However, he preserved his argument that the state and federal judgments against the Trust were void for lack of subject matter jurisdiction under the Alaska statute.

The Decision in Toni

A. Under the Full Faith and Credit Clause, an Alaska statute cannot prevent Montana courts from applying Montana fraudulent transfer law.

The Alaska Supreme Court concluded that the Alaska statute, AS.40.110(k), which purported to grant Alaska courts exclusive jurisdiction over fraudulent transfer claims against Alaska self-settled spendthrift trusts, could not limit the scope of a Montana court’s jurisdiction over a fraudulent transfer action against a trust allegedly created under Alaska law, and thus, a fraudulent transfer judgment entered against a trust in a Montana court was not void for lack of subject matter jurisdiction. The Alaska Supreme Court noted that fraudulent transfer actions were transitory actions, and the Full Faith and Credit Clause did not compel states to follow another state’s statute claiming exclusive jurisdiction over actions and purporting to deprive other states of jurisdiction over all fraudulent transfer actions concerning Alaska trusts, even if the actions arose under other states’ laws.

B. The Bankruptcy Court’s judgment was based upon a cause of action arising under federal law, and states cannot restrict federal jurisdiction; furthermore, a federal statute specifically grants federal courts jurisdiction over fraudulent transfer claims.

Likewise, the Alaska Supreme Court concluded that the Alaska statue could not limit the scope of a federal bankruptcy court’s jurisdiction over fraudulent transfer claims against the trustee of a trust allegedly created under Alaska law, and this a fraudulent transfer judgment entered against a trustee in bankruptcy court was not void for lack of subject matter jurisdiction. In addition, the Court noted that the Alaska statue was preempted by the Federal fraudulent conveyance statute, 11 U.S.C. § 548(a)(1)(A), which permits trustees to avoid fraudulent transfers.

The Rationale of Toni

A. The Alaska statute, AK 34.40.110(k), cannot limit the scope of other states’ jurisdiction.

Initially, the Alaska Supreme Court recognized that the Alaska statute, AK 34.40.110(k), purported to grant Alaska courts exclusive jurisdiction over fraudulent transfer claims against Alaska self-settled spendthrift trusts. The Alaska Supreme Court stated that, “having reviewed the legislative history of AS 34.4.0110(k), we have no doubt the Alaska legislature’s purpose in enacting that statute was to prevent other state and federal courts from exercising subject matter jurisdiction over fraudulent transfer actions against such trusts.”

The Alaska Supreme Court noted that, more than 100 years ago, the United States Supreme Court held in St. Louis, Iron Mountain & S. Ry. Co. v. Taylor, 210 U.S. 281, 285, 28 S. Ct. 616, 52 L.Ed. 1061 (1908), that each state may, subject to the restrictions of the Federal Constitution, determine the limits of the jurisdiction of its courts, the character of the controversies which shall be heard in them, and, specifically, how far it will, having jurisdiction of the parties, entertain in its courts transitory actions where the cause of action has arisen outside its borders. The Alaska Supreme Court further noted that, just a few years later, the United States Supreme Court held in Tenn. Coal, Iron, & R.R. Co. v. George, 233 U.S. 354, 360, 34 S.Ct.587, 58 L.Ed.997(1914), that states are not constitutionally compelled to acquiesce to sister states’ attempts to circumscribe their jurisdiction over such actions.

In Tennessee Coal, an employee sued his employer in a Georgia court, relying on an Alabama statutory cause of action. His employer countered that Alabama state courts retained exclusive jurisdiction over the suit under the Alabama Code, and that the Full Faith and Credit Clause compelled Georgia courts to respect Alabama’s assertion of exclusive jurisdiction. The United States Supreme Court found the “Full Faith and Credit” does not require states to go quite so far. Instead, jurisdiction is to be determined by the law of the court’s creation, and cannot be defeated by the extraterritorial operation of a statute of another state, even though it created the right of action.

After discussing the facts of Tennessee Coal, the Alaska Supreme Court concluded that the Alaska statute crossed the limit recognized by Tennessee Coal by purporting to grant Alaska courts exclusive jurisdiction over a type of transitory action against Alaska trusts. Acknowledging that the analogy was imperfect, the Alaska Supreme Court held, nevertheless, that Tennessee Coal controlled. The Alaska Supreme Court pointed out that the Tennessee Coal court held that the Full Faith and Credit Clause did not compel states to follow another state’s statute claiming exclusive jurisdiction over suits based on a cause of action even though the other state created the right of action. The Alaska Supreme Court stated that the clear implication was that the constitutional argument rejected in Tennessee Coal would be even less compelling were a state to assert exclusive jurisdiction over suits based on a cause of action it did not create. Applying this rationale to the facts of Toni, the Alaska Supreme Court observed that, in seeking to void the Montana court’s judgment for lack of jurisdiction, Tangwall effectively was arguing that the Alaska statute could deprive Montana courts of jurisdiction over cases arising under Montana law. The Alaska Supreme Court rejected Tangwall’s argument and stated that it was a more extreme interpretation of the “full faith and credit” principle than the interpretation considered and rejected by the United States Supreme Court in Tennessee Coal.

Finally, the Alaska Supreme Court noted that the basic principle articulated in Tennessee Coal had not changed in the last century, and concluded, therefore, that the Alaska statue’s assertion of exclusive jurisdiction did not render a fraudulent transfer judgment against an Alaska trust from a Montana court void for lack of subject matter jurisdiction.

B. The Alaska statue, AK 34.40.110(k), cannot limit the scope of a federal court’s jurisdiction.

Similarly, the Alaska Supreme Court denied Tangwall relief from the federal judgment. The Alaska Supreme Court noted that, while Tennessee Coal addressed only a state’s ability to restrict the jurisdiction of its sister states, the more recent United States Supreme Court decision in Marshall v. Marshall, 547 U.S. 293, 314, 126 S.Ct. 1735, 164 L.Ed 480 (2006), had confirmed that the Tennessee Coal rule also applied to claims of exclusive jurisdiction asserted against federal courts.

In Marshall, the United States Supreme Court considered whether Texas probate courts could retain exclusive jurisdiction over a transitory tort arising under Texas law. Relying on Tennessee Coal, the court concluded that they could not, and that state efforts to limit federal jurisdiction were invalid, even though the state created the right of action giving rise to the suit.

Acknowledging that the analogy was imperfect, the Alaska Supreme Court held, nevertheless, that just as Tennessee Coal should control whether the Alaska statute could restrict state court jurisdiction, Marshall should control whether the Alaska statute could restrict federal court jurisdiction. The Alaska Supreme Court concluded that, just as a state could restrict federal jurisdiction, even though the state created the right of action, a state also could not restrict federal jurisdiction over suits based on a cause of action it did not create. In addition, the Alaska Supreme Court pointed out that, if the Alaska statute were interpreted to deny parties access to the federal courts without those courts’ consent, then the statute might well run afoul of the Supremacy Clause, which ultimately precludes state courts from limiting federal jurisdiction.

Observations by the Alaska Supreme Court in Toni

A. Observations on related state court decisions.

In reaching its decision in Toni, the Alaska Supreme Court acknowledged that the Alaska legislature’s attempt to grant Alaska courts exclusive jurisdiction over a class of claims in some circumstances was hardly unique, and that several other sister states had concluded that similar statutes do, in fact, restrict their jurisdiction. See, e.g., Carbone v. Nxegen Holdings, Inc., 2013 WL 5781103, at *4-5 (Conn. Super,. Oct. 3, 2013); Wilson v. Celestial Greetings, Inc., 896 S.W.2d 759, 761-62 (Mo.App.1995); State ex rel. U.S. Fid. & Guar. Co v. Mehan, 581 S.2d 897, 840 (Mo.App. 1979); Foti v. W. Sizzlin Corp., 2004 WL 2848398, at *1-2 (Va.Cir., Feb. 6, 2004).

The Alaska Supreme Court noted that those courts relied on reasoning that was not applicable to the Alaska statute. For example, the Alaska Supreme Court pointed out that some state courts had applied state-law distinctions between local and transitory action to make discretionary decisions whether to stay or dismiss an action in favor of another forum. However, the Alaska Supreme Court observed that Tennessee Coal had established that a state cannot create a transitory cause of action and at the same time destroy the right to sue on that transitory cause of action in any court having jurisdiction, which suggested that states are not barred from asserting exclusive jurisdiction when the cause of action is local rather than transitory; that the Alaska statute granted Alaska courts exclusive jurisdiction over fraudulent transfer actions against Alaska trusts; and that fraudulent transfer actions were transitory actions.

In addition, the Alaska Supreme Court pointed out that other state courts had declined to hear cases on the basis of an exclusive jurisdiction provision without addressing the Tennessee Coal rule. For example, in Foti, supra, a Virginia Circuit Court elected to respect an assertion of exclusive jurisdiction because “comity suggests that limitations one state’s legislature places on its own laws be universally acknowledged.” However, the Alaska Supreme Court noted that comity is not a legal rule; rather it is a principle under which the courts of one state give effect to the laws of another state out of deference or respect. In other words, while courts may elect to follow a statute like the Alaska statute out of comity, they are not compelled to do so. Furthermore, the Alaska Supreme Court pointed out that the Alaska statute is more than a limitation Alaska’s legislature placed on its own laws; instead, it purports to deprive other states of jurisdiction over all fraudulent transfer actions concerning Alaska trusts, even those based on causes of action arising under that state’s own law.

Finally, the Alaska Supreme Court noted that in IMO Daniel Kloiber Dynasty Trust, 98 A.3d. 924 (Del.Ch.2014), the Delaware Court of Chancery had concluded that Delaware could not unilaterally preclude a sister state from hearing claims under that state’s law, citing Tennessee Coal.

B. Observations on similar related court decisions.

In reaching its decision in Toni, the Alaska Supreme Court noted that several federal courts had concluded that state law “exclusive jurisdiction” provisions did, in fact, deprive them of jurisdiction. See, e.g., Lynch v. Basinger, 2012 WL 6213781, at *5(D.N.J.,Dec. 12, 2012); Yale S. Corp v. Eclipse Servs., Inc., 2010 WL 2854687, at *3-4 (ND.Okla., July 19, 2010); Reserve Sols., Inc. v. Vernaglia, 438 F.Supp.2d 280, 288-89 (S.D.N.Y 2006). However, the Alaska Supreme Court pointed out that only one of these cases was reported, and that none of them addressed either Marshall or Tennessee Coal. Furthermore, the Alaska Supreme Court pointed out that other federal courts had reached the opposite conclusion. See, e.g., Superior Beverage Co. v. Schieffelin & Co., 448 F. 3d 910, 917 (6th Cir. 2006)(“a state may not deprive a federal court of jurisdiction merely by declaring in a statute that it holds exclusive jurisdiction”); Begay v. Kerr-McGee Corp., 682 F.2d 1311, 1315 (9th Cir. 1982) (states “have no power to enlarge or contract the federal jurisdiction”), quoting, Markham v. City of Newport News, 292 F.2d 711, 716 (4th Cir.1961); Duchek v. Jacobi, 646 F.2d 415, 419 (9th Cir. 1981)(same). The Alaska Supreme Court state that the reasoning in these latter cases was both persuasive and consistent with the approach set out in Marshall.

Brief Discussion

The following observations apply to the Alaska Supreme Court’s decision in Toni:

1. To date, sixteen (16) states have enacted asset protection trust legislation, and thirty-four (34) states have not. As such, conflict of law questions may arise concerning the ability of an asset protection trust to protect trust assets from the claims of a trust settlor’s creditors.

2. Toni involved a blatant fraudulent transfer of property to an asset protection trust. The transfers in Toni were made only after most of the default judgments were already entered by the Montana state court.

3. All fifty (50) states, including Alaska, interdict the fraudulent transfer of property. Indeed, Alaska statute AK 34.40.110(b) specifically provides that, “[i]f a trust contains a transfer restriction allowed under (a) of this section [asset protection trusts], the transfer restriction prevents a creditor existing when the trust is created or a person who subsequently becomes a creditor from satisfying a claim out of the beneficiary’s interest in the trust unless the creditor is a creditor of the settlor and…the settlor’s transfer of property in trust was made with the intent to defraud that creditor…”

4. It may be advisable to use a foreign asset protection trust rather than a domestic asset protection trust.

5. Asset protection trust works better when the settlor is a resident in the state with asset protection legislation.

6. Asset protection trust work better when the action is outside of bankruptcy.

7. Asset protection trusts work better when the settlor can avoid personal jurisdiction in a state without asset protection legislation.

8. Asset protection trusts work better when the asset transfer occurs more than ten (10) year limitation period set forth in 11 U.S.C. § 548(e).

9. The federal bankruptcy courts may not always recognize the asset protection features of a state with asset protection legislation, because these assets generally are regarded as property of the bankruptcy estate under 11 U.S.C. § 541.

10. The bankruptcy trustee always is free to commence a fraudulent transfer action under 11 U.S.C. § 548, assuming that the transfer to the asset protection trust occurred within ten (10) years prior to the commencement of the bankruptcy case.

Conclusion

Although states with asset protection legislation may purport to hold exclusive jurisdiction over asset protection trusts, this may not always be true when another state has personal jurisdiction over the debtor. However, as long as the funding of an asset protection trust is not voidable, it does not appear that the decision in Toni damages the usefulness of asset protection planning; rather, the decision in Toni stresses the importance of asset protection planning well before the need for an asset protection trust arises.

Do You Own California Real Estate? Courts Create New Tax for LLCs Holding Real Estate

by Garrett Sutton, Esq | Nov 9, 2017 | Case Law, Corporate Direct, Real Estate

Owners of LLCs Holding California Real Estate, Beware!

The State of California is at it again. A recent case decided by the California Supreme Court allows cities to asses Documentary Transfer Taxes like never before.

When property is transferred by a deed, counties and some cities can charge a transfer tax.

They have done so for over 150 years. In Los Angeles, for example, the transfer of a $1 million property results in a transfer tax of $5600. In San Francisco, a $5 million property transfer results in a $112,500 transfer tax. Although in many cases the tax is split between the buyers and sellers, the income for cities and counties is significant.

However, private transfers, where the deed was left intact and at no time transferred, were never taxed. An example of such a transaction would be where an LLC was on title to the property. The owners could sell their membership interests in the LLC and not pay a transfer tax. This was because the LLC was still on title, and thus no deeding occurred.

The case of 926 North Ardmore changed all this, resulting in higher taxes and many unanswered questions.

If you own California real estate you need to read the case summary below.

CASE SUMMARY

In 926 North Ardmore Avenue, LLC v. County of Los Angeles, 3 Cal.5th 319, 396 P.3d 1036, 219 Cal.Rptr.3d 795 (decided June 29, 2017), a single member limited liability company apartment building owner brought an action for a tax refund after it was required to pay a documentary transfer tax based on the value of the apartment building, when its single member partnership sold approximately 90% of its partnership interests to two trusts. The Superior Court, Los Angeles County, entered judgment for the County; the LLC appealed; and the California Court of Appeal affirmed. The California Supreme Court granted review, and in a 6-1 decision, held that: (1) a transfer tax is not a fee paid in connection with the recordation of deeds or other documents evidencing transfers of ownership of real property, but rather is an excise tax on the privilege of conveying real property by means of a written instrument; (2) that a written instrument conveying an interest in a legal entity that owns real property may be taxable under the Documentary Transfer Tax Act (“DTTA”), even if the instrument does not directly reference the real property and is not recorded; and (3) that the transfer is subject to the DTTA.

The Facts of 926 North Ardmore

Beryl and Gloria Averbook (the “Averbooks”) owned an apartment building at 926 North Ardmore Avenue in Los Angeles (the “Building”). They established a family trust and transferred the Building into it. Beryl died, and after his death, the family trust’s assets, including the Building, were transferred to an administrative trust maintained for Gloria’s benefit. Gloria’s two sons, Bruce and Allen Averbook, were named successor trustees, and they formed the following two entities: 926 North Ardmore Avenue, LLC (the “LLC”), a single-member limited liability company established to acquire and hold the Building; and BA Realty, LLLP, a partnership. The administrative trust was the sole member of the LLC. It also held a 99 percent partnership interest in BA Realty.

Initially, the administrative trust conveyed the Building by grant deed to the LLC. It then transferred its membership interest in the LLC to BA Realty, and divided its 99 percent interest in BA Realty and distributed it to four subtrusts also maintained for Gloria’s benefit. The survivor’s trust received 64.66 percent; the nonexempt marital trust 23.86 percent; the exempt marital trust 0.67 percent; and the bypass trust 9.81 percent. The net result of these transactions did not alter one central reality. When the Averbooks transferred the Building from themselves personally into the family trust, they retained a beneficial interest. The trust became the legal owner, but it was obligated to hold and manage the Building for their benefit. After Beryl’s death, Gloria held the sole beneficial interest. The subsequent transactions moved the Building’s legal ownership among the various entities. But Gloria’s beneficial interest remained unchanged.

Later, a different kind of transaction triggered imposition of the DTTA. The survivor’s trust, the nonexempt marital trust, and the marital trust transferred all of their interests in BA Realty to two trusts maintained for Bruce and Allen, who were each the sole beneficiary of their named trust. As a result, Bruce and Allen each acquired a beneficial interest in the Building they had not held before.

The later transfers were effectuated by written instruments, including six limited partner transfer and substitution agreements. The transaction did not involve the execution of a deed or other instrument transferring title to the Building. The agreements did not mention the Building or its location, nor were they recorded. After the transfers, Bruce’s and Allen’s trusts each held a 44.695 percent partnership interest in BA Realty, which was the sole member of the LLC, which, in turn, held legal title to the Building. In consideration for the transferred interests, Bruce’s and Allen’s trusts each executed promissory notes to Gloria’s three subtrusts. The amount paid by Bruce and Allen was based on an appraisal of the assets of BA Realty, including the Building.

The Majority Opinion in 926 North Ardmore

In a 6-1 decision, the Supreme Court of California noted that the DTTA permits the county to levy a tax “on each deed, instrument, or writing by which any lands, tenements, or other realty sold within the county shall be granted, assigned, transferred, or otherwise conveyed to, or vested in, the purchaser or purchasers,” if “the consideration or value of the interest or property conveyed (exclusive of the value of any lien or encumbrance remaining thereon at the time of sale)” exceeds $100. The Court pointed out that documentary transfer tax is not a fee paid in connection with the recordation of deeds or other documents evidencing transfers of ownership of real property, but rather is an excise tax on the privilege of conveying real property by means of a written instrument.

As such, a written instrument conveying an interest in a legal entity that owns real property may be taxable under the DTTA, even if the instrument does not directly reference the real property and is not recorded. The Court observed that the critical factor in determining whether the documentary transfer tax may be imposed is whether there was a sale that resulted in a transfer of beneficial ownership of real property. Thus, the imposition of a documentary transfer tax is permitted whenever a transfer of an interest in a legal entity results in a change in ownership of real property through a change in a legal entity results in a change of ownership of real property, so long as there is a written instrument reflecting a sale of the property for consideration. The Court concluded that the Building owned by the LLC changed ownership when the partnership interests were transferred, and thus was subject to documentary transfer tax. The Court stated that the following approach would elevate form over substance and would conflict with the purposes of the DTTA:

“[I]f A executed a deed transferring real property to B, that deed would be taxable. But if A created a limited liability company, executed a deed transferring real property to that company, and then executed a written instrument transferring the company to B, the tax would not apply.”

Justice Kruger’s Lone Dissenting Opinion in 926 North Ardmore

Associate Justice Kruger disagreed with the majority opinion, and she wrote a strong dissenting opinion. In her dissenting opinion, Justice Kruger noted the absence of any precedent to justify application of the California DTTA to “run-of the mill transfers of interests in legal entities that happen to own real estate.”

In her view, the majority opinion finds no support either in the language of the DTTA or in “the over-150-year history of the documentary transfer tax.” Justice Kruger concluded that the existing California DTTA requires a direct transfer of real estate to trigger the transfer tax, and that it was the job of the California legislature, and not the job of the California courts, to decide whether the California DTTA should be expanded to transfers of entity interests:

“The majority’s expansion of the DTTA may or may not be a good idea, but it ventures well beyond the statute’s language and historical practice. I would leave it to the Legislature to determine the circumstances under which an entity interest transfer should result in a deemed sale of the entity’s real estate, and how to calculate the tax due in those circumstances.”

BRIEF DISCUSSION

A number of California cities and counties, including, but not limited to, the City and County of San Francisco, Santa Clara County, and the City of Oakland, already have changed their ordinances to apply the DTTA to legal entity changes. In addition, Los Angeles County, the defendant in 926 North Ardmore, and other California cities and counties, have disclosed informally on their websites that the DTTA is due on legal entity changes. Most assuredly, other California cities and counties will apply the DTTA to legal entity changes.

The California Supreme Court’s decision in 926 North Ardmore raises a plethora of unanswered questions, such as: (1) Will the documentary transfer tax be imposed upon the buyers and sellers of the transferred entity interests, or upon the entity itself? (2) How will “value” be determined? (3) Will mergers, acquisitions, and restructuring transactions trigger a documentary transfer tax obligation for real property owned by the entities? (4) Will the documentary transfer tax be imposed upon the full value of the entity interests, or only upon the realty attributable to the transferred entity interests? (5) Will the holding in 926 North Ardmore be applied retroactively or prospectively only? (6) If so, then how far back can the cities and counties go? (7) Will penalties and interest apply? (8) Will taxpayers have to examine various internet websites to determine whether cities and counties will apply the DTTA to legal entity changes? and (9) Will cumulative transfers over time of more than 50% ownership of the entity interests trigger application of the DTTA?

Although no commentator has discussed or even mentioned the issue, it seems apparent that, if the California Supreme Court’s decision in 926 North Ardmore is applied retroactively, rather than prospectively only, then the big loser will be the Mortgage Electronic Registration System (MERS), which has been circumventing California cities and counties out of their documentary transfer tax fees for over two decades.

CONCLUSION

Once again, we see another tax grab by the State of California. Justice Kruger’s lone dissenting opinion basically “got it right.” There is no California precedent, either in the language of the DTTA or in “the over-150-year history of the documentary transfer tax,” to support the majority opinion in 926 North Ardmore. The existing California DTTA requires a direct transfer of real estate to trigger the transfer tax, and it is the job of the California legislature, and not the job of the California courts, to decide whether the California DTTA should be expanded to transfers of entity interests.

In any event, the California Supreme Court’s decision in 926 North Ardmore raises a plethora of unanswered questions that will not be decided for many years to come.

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Court Case: Toni 1 Trust, by Tangwall v. Wacker 2018 WL 1125033

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Owners of LLCs Holding California Real Estate, Beware!

The State of California is at it again. A recent case decided by the California Supreme Court allows cities to asses Documentary Transfer Taxes like never before.

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The Majority Opinion in 926 North Ardmore

Justice Kruger’s Lone Dissenting Opinion in 926 North Ardmore

BRIEF DISCUSSION

CONCLUSION

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