3 KEY CONTRACT TERMS BUSINESS OWNERS & INVESTORS TAKE FOR GRANTED

by Mat Sorensen | Aug 27, 2013 | Uncategorized

Many business owners and investors are entering into contracts for investments, equipment, services, and other business needs. Many of these contracts contain “boilerplate” clauses at the end of the contract that are often overlooked and are taken for granted. This article outlines some of those key terms and explains why you should seek to have them in your contracts.

1. Indemnification. You’ve seen this clause and you’ve maybe even read the language and thought, what does this cover? Let’s take a contract between a Buyer and Seller in a business sale. In that contract the indemnification clause may read something like this, “Buyer agrees to indemnify Seller from all causes of action, losses, damages, and claims made against Seller that are a result of Buyer’s actions.” In other words, if the Seller is sued by a third party for something that the Buyer did then the Seller has a contractual claim to bring against Buyer to make the Buyer responsible for the damages or claims they caused. This is an important contractual term between service providers, customers, joint venture partners, and buyer’s and seller’s of investments or assets, and it essentially shifts the burden from the innocent party to the party responsible for creating the liability. Now, in the example outlined above the clause is between Buyer and Seller but the clause as written only protects Seller from Buyer’s actions. What about the Buyer? Are they protected from Seller’s actions. When reviewing contracts make sure that the indemnification clause provides protection for you and your business and not just for the other guy. Often times the indemnification clause will only provide the indemnification protection to one party and leaves the other party to fend for themselves. This can be remedied by creating a similar clause in favor of the other party.

2. Severability. This clause usually says something like, “If a Court holds that there is an invalid or illegal term in the contract that specific provision shall be severed from the contract but the rest of the contract’s terms shall have full effect.” Generally, if a contract has an invalid or illegal term it typically makes the entire contract invalid, unless the contract contains a severability clause as explained above. For example, lets say you loan money to someone and your promissory note to the borrower contains an interest rate that is too high and is usurious under law. If that happens, the contract would be ineffective entirely, however, with a properly drafted severability clause, the contract can survive and the usurious rate itself would be reduced to the maximum rate allowed by law.

3. Attorney’s Fees. Many investors and business owners who win cases in Court are often disappointed with the legal process because even though they’ve won their case they are typically left with a large legal bill that they end up having to pay. However, if the lawsuit is regarding a contract and if the contract contains a provision for attorney’s fees then the party who wins in court not only wins the case but can also get their attorney’s fees paid by the other party.

Understanding your contracts is vitally important and having clauses that protect your interests will limit your liability and will allow you to more fully recover your losses. Remember, in cases between parties in a contract, the terms of the contract are the law. You might as well write them in your favor.

INHERITING AN IRA: STRETCH OPTIONS AND SEE THROUGH TRUSTS

by Mat Sorensen | Aug 20, 2013 | Uncategorized

When an owner of a retirement account passes away, their retirement account is passed on to the heirs of that account as they are designated on the account owner’s beneficiary designation form. The taxation and distribution rules are different depending on whether the beneficiary of an account is a spouse or a non-spouse beneficiary. If the beneficiary is a spouse, there are additional tax deferral options. The recently enacted Pension Protection Act took effect a few years ago and significantly changed the rules with respect to taxation and distribution of retirement accounts. Please find a summary of the new options below.

Stretch Option only for Spouse

1. Stretch Option. A spousal beneficiary has the most opportunity to continue to defer payment of tax since a spouse can roll their deceased spouses account over to a new or existing IRA in the surviving spouse’s name. If the surviving spouse has not yet reached the date by which he or she is required to take distributions from the IRA account (age 70½), the assets can remain in the account and can continue to grow tax-deferred until the surviving spouse reaches 70½. If the surviving spouse is years away from age 70½ , naming the spouse as a beneficiary is the best strategy to take advantage of the continued tax deferral because you delay the payment of tax and can continue with tax deferred growth until the surviving spouse reaches age 70½.

Options for All Beneficiaries

1. Disclaim the IRA. Any beneficiary can disclaim his or her interest in the deceased persons retirement account and thereby pass the account to secondary beneficiaries who may be in a lower income tax bracket. This may be beneficial to a surviving spouse who is already 70½ and cannot stretch out the tax deferral benefits of the account and who is also in a high income tax bracket. By disclaiming the account interest, the account would go to the secondary beneficiaries (typically children) who may be in a lower income tax bracket.

2. Lump Sum. Any beneficiary can take a lump sum distribution from the account free of penalty but if you take a lump sum distribution you will also take a lump sum tax bill.

3. Five Year Rule. Any beneficiary can take distributions from the retirement account over a five year period. This is beneficial because it allows for continued tax deferral over a period of five years and will help a beneficiary avoid taking a large lump sum distribution which will likely push that beneficiary into a high income tax bracket.

4. Life Expectancy Rule. This option is available when the retirement account holder passes away before he or she reaches age 70½. A beneficiary may take distributions from the retirement account based on the life expectancy of the inheriting beneficiary. If the inheriting beneficiary is younger in age the inheriting beneficiary will be able to maximize tax deferral over a longer period of time because the IRS gives them longer to live and therefore more time to make distributions. If the beneficiary is older in age, the IRS will require larger yearly distributions to make it more likely that the funds will be distributed over the inherited beneficiary’s life time.

See Through Trusts

The IRS has indicated that a “see through” trust may be named as a beneficiary of the retirement account and the IRS will “see through” the Trust itself directly to the Trust’s beneficiaries. Because Trusts pay taxes at higher rates than individuals, we need to make sure that the Trust is considered “see through” so that the account may pass directly through the Trust to the beneficiaries. The requirements of a “see through” Trust are as follows:

1. Trust must be valid under state law;

2. Beneficiaries must be determined from the Trust;

3. The Trust must be irrevocable or become irrevocable at the death of the retirement account owner;

4. Documentation of your trust must be provided to your plan administrator;

5. All Trust beneficiaries must be individuals.

If you are uncertain as to whether your Trust qualifies as a “see through” Trust, please contact the law firm for an analysis. If your Trust requires an Amendment so that it qualifies as a “see though” Trust, we can prepare an Amendment to the Trust.

When naming beneficiaries to your retirement accounts, we typically recommend that you name your spouse as a beneficiary first (if you have one) and then your “see through” Trust or your children second. There are some important estate planning considerations here when naming a trust so make sure you consult with a competent attorney.

IRA Owner Wins Appeal of Prohibited Transaction Ruling: What Can Self Directed IRA Investors Learn?

by Mat Sorensen | Jun 25, 2013 | Uncategorized

In Daley v. Mostoller, the U.S. Court of Appeals for the Sixth Circuit ruled that an IRA client account agreement which contains a “cross collateralization” or lien against the personal debts of the IRA owner does not constitute a prohibited transaction unless there is an actual execution or extension of credit based on the “cross collateralization” or lien against the IRA. Daley v. Mosteller (In re Daley), No. 12-6130 (6^th Cir. June 17, 2013).

The case arose when Daley, the IRA account owner, filed Chapter 7 bankruptcy in Tennessee. Under the bankruptcy rules, Daley sought to exclude his IRA from the collection of the creditors as is typical and permissible under bankruptcy laws. The bankruptcy Trustee in the case sought to disqualify the IRA as an exempt asset of Daley by arguing that the Merrill Lynch IRA client agreement violated IRC § 4975(c)(1)(B) of the prohibited transaction rules because it contained language which created a lien in favor of Merrill Lynch for amounts which the IRA owner may personally owe to Merrill Lynch. The argument made by the Trustee was that by agreeing to offer the IRA as collateral to Merrill Lynch for personal accounts the IRA owner was thereby making an extension of credit between his IRA and debts he may personally owe. The result of prevailing on a prohibited transaction claim is that the IRA loses its status as an IRA which results in a loss of the creditor protections which typically allow IRA owners to keep their IRA outside the reach of creditors.

Following argument in the bankruptcy case, the Bankruptcy Court agreed with the Trustee in the case and ruled that even though no actual extension of credit or execution on the IRA assets occurred, the actual verbiage in the Merrill Lynch client agreement nonetheless was an extension of credit. Fortunately, the 6^th Circuit disagreed and reversed the Bankruptcy Court by ruling that despite the language in the client agreement regarding a lien in favor of Merrill Lynch and the “cross collateralization” of the IRA, the 6^th Circuit held that a prohibited transaction had not occurred because the actual language of the rule requires an actual extension of credit between the IRA and the IRA owner personally. The 6^th Circuit held that the language in the client agreement did not in and of itself result in a prohibited transaction as not extension of credit actually occurred. While the case at first glance may not seem that applicable to self directed IRA investors it does make a number of important conclusions.

The important “take aways” from the case for self directed investors are as follows.

1. The case held that a prohibited transaction only occurs when there is an actual transaction or actual extension of credit that violates the rule not just when there is language in a document allowing for such.
2. The case reiterated that there is a presumption that an IRA is exempt, if properly established with a custodian, until proven otherwise. In other words, the burden of proving a prohibited transaction is on the agency or person (e.g. IRS or Bankruptcy Trustee) making the allegation. 11 U.S.C. § 522(b)(4)(A).
3. The Court distinguished this case from cases where an actual extension of credit was made to the IRA owner personally based entirely or in part on a lien given against the IRA. All IRA owners need to be aware that they cannot personally receive an actual extension of credit nor should they actually obtain a loan whereby their IRA is pledged as an asset as those instances will likely result in a prohibited transaction.

IRA owners need to be careful to avoid situations where the IRAs assets are being pledged against the debts of an IRA owner. Additionally, IRA owners who have significant IRA accounts and whom are considering entering bankruptcy should carefully analyze their account activity, investments, and investment documents to determine whether there are potential prohibited transaction risks which could result in a bankruptcy trustee obtaining the assets of an IRA for the purpose of paying creditors.

Author: Mathew Sorensen is a partner at KKOS Lawyers and routinely advises clients on the prohibited transaction rules applicable to IRAs, on self directed IRA investment structures such as IRA/LLCs, and represents self directed IRA owners before the IRS and the U.S. Tax Court.

Self-Directed IRA Prohibited Transaction Costs Taxpayers Over $250K

by Mat Sorensen | May 28, 2013 | Uncategorized

The latest IRA prohibited transaction case is called Peek & Fleck v. Commissioner, U.S. Tax Court 140 T.C. No. 12 (March 8, 2013) and concerns two tax payers who used self directed IRAs to establish and fund a newly formed corporation which corporation purchased a fire and safety company that was for sale by third parties and was known as ASF Company.

Both Mr. Peek and Mr. Fleck funded the newly formed company with funds from their self directed IRAs and the company used those combined funds in the approximate amount of $400,000, as well as a bank loan for $450,000, and a loan from the sellers of the business of $200,000 to acquire all of the stock of ASF Company.  In entering into the $200,000 loan with the sellers, however, Mr. Peek and Mr. Fleck (who were not personally invested or owners in the transaction) signed personal guarantees and offered their personal residences as collateral as part of the terms of the loan with the sellers. This critical mistake, the personal extension of credit for their IRAs investment, resulted in the IRS alleging a prohibited transaction under IRC § 4975 (c)(1)(B).

The Tax Court agreed with the position of the IRS and disqualified the IRAs investment all the way back to when the prohibited transaction and the personal extension of credit for the IRAs occurred. This was extremely problematic for the self directed IRA owners as they were later able to turn their IRAs $200,000 investment into a return of over $1,500,000. However, the consequence of the prohibited transaction negated the IRAs tax favored status and resulted in the self directed IRA owners incurring taxes of over $250,000 per account owner. Using self directed IRAs in the investment was an excellent idea, however, the actions of using personal credit to solely benefit the IRAs clearly violated the prohibited transaction rules and literally cost the self directed IRA owners hundreds of thousands of dollars.

An alternative way to approach this issue would have been to avoid the personal guarantees and use of the IRA owner’s personal assets as collateral and to instead structure the loans used to purchase the business as non-recourse loans perhaps being secured in favor of the seller’s by the stock being sold. An additional alternative may have been to include other non-disqualified persons whose IRAs were not invested and to include them as partners and as possible personal guarantors to the loans. As a general rule of thumb, always avoid signing personal guarantees or offering personal assets as collateral when obtaining loans to fund self directed IRA investments. Seek out what are known as non-recourse loans where you do not have to offer your personal name or assets as collateral and you’ll keep your IRAs tax preferred status outside of scrutiny by the IRS.

Author, Mathew Sorensen is a partner at KKOS Lawyers and routinely advises clients on the prohibited transaction rules, on self directed IRA investment structures such as IRA/LLCs, and represents self directed IRA owners before the IRS and the U.S. Tax Court.