Law News and Tips
Interfaith Partnership annual dinner celebration on October 30, 2014. I don’t have the name of the Rabbi right now, but I’ll add it as soon as I get it:
“I’d like to tell you about a young adult friend of our family, a young man named Rafi, who grew up with my stepchildren in St. Paul, Minnesota. Our friends, Mari and Jeremy, adopted both of their children as babies from Central America. Both of the children have very dark skin. But that is not what we saw when we looked at them. They were close friends, weekly attendees at our synagogue, students at our Jewish day school, virtually members of our extended family. Rafi was a sweet, thoughtful, loving kid. It was a pleasure to have him in our lives.
Shortly after Ferguson, Rafi, now 28 years old, gave a sermon at our synagogue and told the story I don’t believe I’d heard years ago when it happened. Rafi said that he had never before seen himself as different from his friends or schoolmates, until one day in middle school, a member of an opposing team at a school soccer game referred to him as “burnt toast.” He said that, with that racial slur, he experienced “the sting of being different for the first time,” and that he was completely alone: different from the white Jews who had always been his friends and his family, but also, as it turned out, different from the kids of color in the public school to which he transferred, because after all, he’d grown up at a private Jewish day school, in a close-knit Jewish suburb. Rafi spent years in a difficult journey of sorting out the different strands of his identity.
In Rafi’s own words: “I understand why the police are there [at our synagogue on the holy days]. I know the risk that comes with openly celebrating Judaism. They are there to protect us! And trust me, I appreciate their presence – until all eyes are on me…. Even my gold Star of David necklace doesn’t seem to faze them. When I arrive, the officers usually stop what they’re doing, get out of their cars, get right up behind me, and follow me as I walk in, as if I am the threat. I am dressed for the occasion, including a kippah on my head. I am greeted with smiles and warm welcome embraces from old friends and fellow congregants as I walk through the parking lot. The police officers usually don’t stop pursuing me until I have hung up my code in the coat room, and the [congregant volunteering as a] greeter [at the door] has given the officers a thumbs up, to let them know that I am “safe.”
I’ve never seen this happen to anyone else, for as long as I’ve come to the synagogue. I’m left to think that the only possible sign of threat would be the color of my skin….
Rafi continued in a sanctuary so quiet one could hear the sound of breathing and crying. He needed to tell us some
“safety tips that every person of color should follow when stopped by an officer of the law:”
[he said these things entirely without anger, animus or disrespect. He was simply telling us fax that he had learned about being a black man in America.]
• Place both hands where they are clearly visible. Do not reach in your pockets or purse.
• Do not reach into your jacket. And do not move without informing the officer first.
• If you’re in a car, take the keys out of the ignition and place them on the dashboard so that they are clearly visible.
• Leave your seat belt on, and slowly turn on your interior lights so that you’re fully visible. This proves that you pose no threat.
• Speak clearly and respectfully, and stick to these four phrases: “yes, officer”, “no, officer”, “thank you, officer”, and “I want a lawyer.”
Individual retirement accounts (“IRAs”) are used for retirement savings. In the case of a regular IRA (we are not talking about Roth IRAs here), pretax income is put into an IRA and allowed to grow tax-free until retirement, or at least until the owner reaches 70 ½. At that time, the owner has to take out a minimum amount referred to as the “required minimum distribution.”
IRAs typically are invested in publicly traded stocks and bonds. However, in what is called a self-directed IRA, it is possible to invest in other assets. Recently, after attending seminars, a number of clients have talked to me about investing their IRAs in real estate. Although this is a permitted investment, IRA investors need to be very careful.
The first rule to note is that an IRA owner cannot be paid a salary or fee from his or her IRA for any services provided. That simply is not permitted.
Then there is the question of income. IRAs are generally taxed on any income from a trade or business. There are certain exceptions: dividends, interest, rents, royalties, and gains from the sale or exchange of property other than inventory or property held for sale in the ordinary course of a trade or business. The trade or business limitation requires frequency, so a one time or infrequent sale is not going to run afoul of this rule. However, we don’t really know how many sales you can have before the IRS is going to treat the activity as a trade or business.
If an IRA owner wants to buy a single family or multifamily residence, the owner must pay cash (loans create other problems). If the IRA owner then rents the property, the rent is tax-free to the IRA.
If, however, the IRA owner wants to buy property, rehab it, and then sell it, there is a risk that the IRS will treat the income as taxable. If it does, then the IRA is taxed at the trust tax rates, which means any income over $12,150 is taxed at 39.6%.
An alternative to this would be to form a corporation, pay taxes at the 15% corporate rate, and distribute tax-free dividends to the IRA. This might seem like adding an unnecessary layer, but it may be the best option out there if you are going to rehab and sell property.
Several years ago when Congress was debating what to do with the federal estate tax, one of the favorite canards of many politicians was that the estate tax was killing the family business. The thing is, none of the studies that were done ever proved that. They consistently showed that it wasn’t the estate tax that kills a family business; it was the family.
Oftentimes the younger generation is ill-prepared or ill-equipped to take over the family business. They are ill-prepared, because mom or dad never take the time to train a son or a daughter to run the business. They never introduce them to the key players. They may be ill-equipped because their personality or skill set is just not suited to running a business. Maybe they can be a critical piece in the puzzle, just not the person who puts the entire puzzle together.
If a child is not prepared to take over the family business, that can spell disaster for the parents’ retirement. It is nearly impossible to get a bank loan to buy a family business without a guarantee. Banks won’t accept a guarantees from a child without substantial assets of their own, so either the parents will have to guarantee the loan or will have to take back a promissory note.
In either case, the parent is at risk of the child’s failure. I recently heard of the case where the parents had to come out of retirement and take a business back from their son when the family business faltered under the son’s management. More often than not, what I see is the parent selling the business to a third party, maybe even a competitor. Or even worse, as in the case of my grandfather’s construction company, the surviving spouse just liquidates the company to be done with it.
There are ways to keep family businesses in the family if that is what the parents want. But it takes some planning. Typically, the people involved need to be evaluated. Maybe some outside players need to be added to create a team. Control of the business will need to be carefully orchestrated. The structure doesn’t have to be permanent, but it can last for the duration of the buyout to make sure that mom and dad can retire in peace and financial security.
This is not necessarily as easy as the sale to a third party, but it may accomplish a family goal. And family goals are important.
As I said, it isn’t the estate tax that kills a family business, it’s the family. But it doesn’t have to be.
Probate is one of those unknown things that scare people. They feel that probate is the monster that eats your assets when you die. They have either heard horror stories or been through a bad probate experience that they never want to do again. When you clear away all of the smoke and dust and debris, probate really isn’t as bad as what people say it is, but it is something to be avoided.
Historically probate developed in Merry Olde England as a way to make sure that your bills got paid. (It’s not about protecting the widows and orphans like I used to think.) When a person dies, any individually owned (not jointly owned) property is frozen. If there is a will, it must be filed with the Probate Court within a year of the person’s death or it is invalid. Someone is appointed as personal representative. A notice is published telling people to file a claim if the decedent owed them any money. Within 30 days of their appointment, the personal representative has to file an inventory listing what the decedent owned.
Once the inventory is filed, then it is a waiting game basically. People file claims. The personal representative may or may not pay them. The personal representative collects the assets and sells what needs to be sold. Bills are paid. But mainly you wait.
If a person has a claim against an estate, they have to file the claim within six months of the opening of probate, or they are barred from collecting whatever is due. Once the six months is over, the personal representative prepares an accounting saying what they started with, what they earned, what they paid, and what’s left. Then they file a proposed schedule of distribution, and if it’s approved, they distribute the assets and they’re done.
Probate isn’t the end of the world, but it’s annoying. Everything is a public record; there are time delays; and there are fees that run between 1 ½ and 2 ¾%, depending upon the size of the estate.
When someone comes in to talk to me about starting a new business, the question that inevitably comes up is whether they should form an LLC or go with an S-Corporation. I wish the answer were a simple one, but it is a little involved.
I tend to shy away from corporations now. Too much reporting and too many meetings. Under Missouri law (but I have found that this is similar to the laws of other states), you have to file articles of incorporation. You have to adopt bylaws. Generally, you have to have a board of directors, although with certain closely held corporation forms, you can dispense with that. The board must elect a president and a secretary, at least. Each year, you have to file annual reports with the State telling them who your officers and directors are. And then you need to have annual meetings of the shareholders and directors, which most small businesses neglect to do until an emergency comes up.
With an LLC, you file articles of organization (again, this is pursuant to Missouri law, although I believe that most states have similar provisions). Then you must execute an operating agreement. Then you’re done. Yes, you can make this more complicated, but that is the end of your legal requirements. So an LLC is simpler.
Then there comes the question of taxes. If you are taxed as a sole proprietor or a partnership, all of your earnings are subject to the federal self-employment tax, which is currently 15.3%. That’s a bad thing.
If, however, you opt to be taxed as a corporation and file an election to be treated as an S-corporation, with proper planning, you can avoid the self-employment tax on amounts in excess of a reasonable salary for your job. But the interesting thing is that you don’t have to be a corporation to opt to be taxed as a corporation and file the S-election. You can do that as an LLC. So you have the simplicity of an LLC for operations and the tax savings of an S-corporation. That’s a good thing.
The problem is that the S-election brings with it some additional paperwork. As a sole proprietor, you report all of your income on the Form 1040, Schedule C (you also have to file a Schedule SE). With a partnership, you have to file a Form 1065. With an S-Corporation, you finally Form 1120-S, and you’d have to file a periodic employment tax return.
My suggestion is always to discuss this with your accountant. If you think that your business operation is going to be more of a hobby than a big money maker, maybe the simplicity of a sole proprietorship or a partnership is better for you. However, if a new entrepreneur realistically thinks he or she is going to make more money than what would be a reasonable salary, then the S-election route should be seriously considered with the accountant.
There was a recent US Tax Court case, Cavallaro v. Commissioner of Internal Revenue , that is a case study in what not to do in a family business. Formalities seem so out – of – place in family businesses.
In that case, a mother and father had a machine shop (“Knight”) that came up with a plan to build and sell a machine that could glue components onto computer circuit boards. That was back in 1982, a good time to invent that kind of a machine. They formed the company (“Camelot”) to make it.
The problem with a bright idea is that it can cost money to get it to market. After consulting with accountants and advisors, the parents’ three sons formed the sales company to market the machine. The idea was that Camelot would own the machine and hire Knight to manufacture it.
Here is where the informality tripped them up. The dad “transferred” the design of the machine to the sons by simply handing them the Camelot company records, saying, “Take it; it’s yours.” The sons, however, continued to get a paycheck from Knight, and not from Camelot or the sales company. In fact, it’s almost impossible to see where one of the companies ended and another began. They almost completely overlapped.
Over time, the sons (on the Knight payroll) modified the machine design, working with other Knight employees and engineers. The redesigned machine became very profitable. Sales boomed.
Then they got some more advice. They were told to merge the businesses. Working with an attorney and an accountant, they figured out relative values for the company’s and merged them, assuming that Camelot owned the machine design.
The IRS disagreed. To the tune of $12,900,000. The problem is, the Tax Court agreed with the IRS. The IRS determined that Mr. and Mrs. Cavallaro had given their sons the machine design (the value of which had grown immensely over time) in the process of the merger. Fortunately (or maybe not), the family had sold the business for almost $60 million in cash. However, Mr. and Mrs. Cavallaro received less than $11 million of that money, with the rest going to their sons. They were obviously about $1 million short. The case doesn’t explain how they made up that million dollar shortfall.
Years ago a woman came to see me about her son. She told me that he wouldn’t let her have her investments. Kind of an odd statement, don’t you think? So here’s the story.
The woman (I’ll call her Rachel) had been married for years to a successful businessman, and they had had four children. Her husband died when she was 69. She lived alone for 10 years, but eventually the loneliness got to her. So what does any 79-year-old woman looking for love do? That’s right. She ran an ad in the Riverfront Times.
Rachel met George (not his real name either). George was 10 years younger than Rachel. Rachel’s son, Billy, did not like George.
The problem was that to avoid probate, Rachel had put her home and investments in joint names with Billy. With a joint bank account, either joint owner can withdraw the money. That’s not the case with any other assets. In all other cases, both joint owners must agree to cash out or retitle the joint assets.
Billy refused to cooperate. The assets were frozen. He did give Rachel an allowance, but how demeaning is that? Years of litigation followed.
Although people hate to think about dying or to spend the money on an estate plan, joint ownership is not the solution. It usually ends in a mess. It simply is a bad idea.
As baby boomers have been growing older, there’s been a lot of talk about parents passing their businesses down to their kids. The funny thing is that, although I’ve seen some of that, more frequently, I see that the parents are selling their businesses to an outside third party. Those sales present their own issues, but that’s for another article.
Passing the business down to younger generations requires very careful planning. One of the first issues that needs to be addressed is whether the younger generation is even capable of running the business. Although politicians and pundits often complain about how estate taxes destroy family businesses, a number of studies have shown that actually families destroy family businesses. Since these deals often involve a buyout over time, the failure of the business can be catastrophic for everyone involved. There are ways to measure the skills of a younger family member and using that information form a succession plan with the possibility (no guarantees here) of success. But developing this plan requires time and careful attention to details.
If you can put together a viable succession plan, then the question is how to implement it. Family dynamics can bring catastrophic results. Children who are not involved in the business can feel cheated. The descendent taking over the business can take advantage of the situation for his or her own benefit. Simple misunderstandings can grow into huge, may be insurmountable, problems.
I personally know all of this from experience. Growing up, we weren’t even allowed to mention the other side of the family because of something that happened in 1918. Two brothers who worked together for years, even living next door to each other, were irrevocably alienated. Family business can be really tricky.
Sylvia (not her real name) had been married for years to Dave, and they had four kids together. As happens many times, Dave predeceased Sylvia. Sylvia was fairly young, and over time, she got lonely.
Sylvia met Louie at a seniors’ event at their church. Louie was also a widower. They enjoyed each other’s company and started spending time together. They were sort of old-fashioned, so they ended up getting married. Not a bad thing really.
Sometime after that, Sylvia got sick. Louie nursed her all during her illness, but in the end, she died. Louie had loved Sylvia, and after losing his second wife, he was brokenhearted. He didn’t live that much longer himself.
After the funeral, Sylvia’s kids started asking about the estate only to come to a rude awakening. You see, Sylvia and Dave had executed wills when their kids were younger, but they had never done anything else. After Dave’s death, when Sylvia married Louie, she put her assets in joint names with him. This all seems very innocent.
The problem is that with joint property, on the death of the first joint owner, the asset belongs entirely to the surviving joint owner. When Sylvia died, everything went over completely to Louie. Louie probably didn’t have a plan, but even if he did, it certainly didn’t take Sylvia’s kids into account.
I got a call some time ago from a woman who was in tears. She was crying so hard I could barely understand her. When I finally got her to compose herself a little, the first thing I heard was “My daughter won’t let me sell my house.”
That, of course, raised a lot of questions in my mind, so I started asking my questions. It turns out that a bank teller (typically a source of batted five’s, by the way) had been talking to the mom. The mom and heard horror stories about probate, and the teller told her she could avoid probate by putting her daughter’s name on things.
I understand why she said that, but it was bad advice. A bank account is governed by federal law that says either joint owner can deposit or withdraw any or all of the money in the account.
That isn’t the case with any other joint property. In all other cases of jointly held assets, all joint owners must join in transactions affecting the joint property. So when the mother put her daughter’s name on the house, she gave up control.
Time passed, and the mother aged. Now she needed to go into a nursing home. To do that she needed to sell her house, and her daughter was saying no. It was her inheritance, so why would she want to jeopardize that. Mom would have to make do.
I don’t know how this situation got resolved. Did the daughter relent or did the mother have to stay in the house until she died? In any case, the moral of the story is that joint ownership can be a real problem.