John Vandenhoff continues his exploration of  the tax implications of the new health care law. There’s also more in a series of informational podcasts on the Web site of the Law Firm Alliance, of which we are a member.

In our previous posts (here and here), we talked about the new healthcare legislation which was signed into law (H.R. 4872, the Healthcare and Education Reconciliation Act of 2010 (Reconciliation Act P.L. 101-152)) (the “Healthcare Act”) and described a couple of the major mandates contained within that Act.

In these, we present a brief overview of some of the key tax changes affecting individuals and businesses. Please call our Virginia and North Carolina business lawyers for details of how the new changes may affect your specific situation.

Amongst other provisions, the Healthcare Act codified the common law Economic Substance Doctrine which had been developed by the Internal Revenue Service (“IRS”) and the courts. Essentially, the courts have denied claimed tax benefits if the transaction that gave rise to those benefits lacked economic substance independent of tax considerations, even though the purported activity actually occurred. In other words, the IRS was empowered to set aside a transaction that, although technically in compliance with all tax statutes and regulations, lacked true economic substance and was entered into almost entirely for the purported tax benefit.

New in IRS Code

The Healthcare Act enacted new Section 7701(o) of the Internal Revenue Code, which provides that a transaction will be treated as having economic substance only if the transaction changed in a meaningful way (apart from federal income tax effects) the taxpayer’s economic position; and, the taxpayer has a substantial purpose (apart from federal income tax effects) for entering into such transaction. The transaction must satisfy both tests in order for it to be deemed as having economic substance.

There has been speculation as to the extent the new codified doctrine will be applied. The statute states that the determination of whether the Economic Substance Doctrine is relevant shall be made as if the statute were never enacted. See Section 7701(o)(5)(C) of the Internal Revenue Code. The Joint Committee Report further states that “if the realization of the tax benefits of a transaction is consistent with the Congressional purpose or plan that the tax benefits were designed by Congress to effectuate, it is not intended that such tax benefits be disallowed.” However, it still remains that both prongs of the two-part test must be met in order for the transaction to be deemed to have economic substance.

Codification Imposes Penalties

The teeth for the codification of the Economic Substance Doctrine is that a new penalty applies for an underpayment attributable to a transaction lacking economic substance. The penalty rate is 20% of the amount of the underpayment, but is increased to 40% if the taxpayer does not adequately disclose the transaction on the taxpayer’s return or on a statement attached to the return. It is also important to note that the reasonable cause and good faith exception (which have generally been held to be exceptions to paying penalties for underpayment of tax) do not apply to any portion of an underpayment which is attributable to a transaction lacking economic substance.

The codification of the Economic Substance Doctrine (and the penalties on resulting underpayments) are effective for all transactions entered into after March 30, 2010.

Please see future posts for information regarding other tax affects of the Healthcare Act which take effect in years beginning after 2010. As business and tax attorneys, we invite you comments below about the new healthcare law and its effects on your and your business.

If you lend money to a friend, expect to lose the friend and the money. And in North Carolina, if you help a friend buy a house, you could also be committing a class 3 misdemeanor.

Until recently, the North Carolina Mortgage Licensing Act made it a criminal act for a non-licensed individual to loan money to someone else for the purchase of a property to be used for “personal, family or household use.” In English, much to the dismay of the real property bar, this means, it was illegal for parents to lend money to their children for the purpose of buying a home.

This law was modified about this time last year, and now specifically allows an individual to provide a residential mortgage loan to an immediate family member. “Immediate family member” means a spouse, child, sibling, parent, grandparent, or grandchild, or the spouse of an immediate family member. This term includes stepparents, stepchildren, stepsiblings, and adoptive relationships.

It is still illegal for an aunt and uncle to loan money to a niece or nephew, or a good family friend to loan you money to buy a house. A lot of real estate attorneys think an individual should be permitted to make a few loans to friends or family over the course of his lifetime, without having to register as a mortage lender, broker or originator. 

I was also reminded recently that there could be tax consequences to loaning money at below-market interest rates (or at no interest). If you don’t charge interest, the interest you didn’t collect could be considered income, according to the IRS. They could also be considered gifts. 

Finally, it is especially important to document the terms of a loan with a friend or family member, even if you just assume you’ll never see the money again. If the money is going to starting up a business, the business owner may not be able to get a bank loan or other financing down the road if he can’t show where his start-up capital came from. You may also think you own a piece of the business (equity) while the owner thinks you gave a loan (debt).

When in doubt, please consult a business attorney about the consequences of loaning money to friends and family.

In a previous post, John Vandenhoff briefly talked about the new Healthcare legislation which was signed into law (H.R. 4872 the Healthcare and Education Reconciliation Act of 2010 (Reconciliation Act, P.L. 101-152)) (the “Healthcare Act”) and described a couple of the major individual mandates contained within that Act.

In this and future posts, we continue to present a brief overview of some of the key tax changes affecting individuals and businesses in the Healthcare Act. Please call our Virginia business lawyers and North Carolina corporate attorneys in our Richmond office and Research Triangle office for details of how the new changes may affect your specific situation.

Income Tax Credit for Eligible Small Employers.
The Healthcare Act provides for an income tax credit for “Eligible Small Business Employers” (defined below) that: i) offer health insurance to employees; ii) pay at least fifty percent (50%) of the cost of the insurance, and iii) contribute a uniform percentage (at least fifty percent (50%)) of the premium cost of each employee who enrolls in the employer’s employee health plan. The maximum credit of thirty-five percent (35%) is available for tax years beginning after 2009. The maximum credit increases to fifty percent (50%) for tax years beginning after 2013. The credit is only available to an employer that purchases health insurance coverage for its employees through a state exchange , and is only available for a maximum coverage of two (2) consecutive tax years.

The credit is only available to employers that meet the definition of “Eligible Small Employers”, andother specified criteria. Only premiums paid by the Eligible Small Employer under an arrangement meeting certain requirements are counted in calculating the credit.

An “Eligible Small Employer” is generally defined as a employer with no more than twenty-five full-time equivalent employees, and whose employees have annual full-time equivalent wages that average no more than Fifty Thousand and 00/100 Dollars ($50,000.00). However, because of certain phase-out rules, the full amount of the credit is available only to an Eligible Small Employer with ten (10) or fewer full-time equivalent employees and whose employees have average annual full-time equivalent wages from the employer of less than Twenty-Five Thousand and 00/100 Dollars ($25,000.00).

To determine whether an employer is eligible for the credit, and the amount of the credit, the employer must first calculate how many full-time equivalent employees the employer employs and the average annual full-time equivalent wages. The number of full-time equivalent employees is determined by dividing the total employee hours worked for the year (counting all full-time and part-time employees) by 2,080. The result of this computation is rounded to the lowest whole number. Average annual full-time employee wages are determined by dividing the employer’s aggregate wages for the year by the number of full-time employees (rounded down to the nearest 1,000).

Therefore, during the years in which the credit is available, small employers have incentive not to hire as many employees nor pay them wages which would increase their average full-time equivalent wages above Fifty Thousand and 00/100 Dollars ($50,000.00).

The credit is not allowed for health insurance premiums paid for partners, sole proprietors, more than two percent (2%) shareholders of an S corporation, more than five percent (5%) owners of a regular C corporation, or “non-qualifying family members” of the foregoing owners. Further, seasonal workers (individuals who work for less than one hundred twenty (120) days for the employer) are not included in the computation for full-time equivalent employees or full-time equivalent wages.

Adoption Credit.
For tax years beginning after 2009 and before 2012, the Healthcare Act increases the adoption tax credit from Twelve Thousand One Hundred Seventy and 00/100 ($12,170.00) to Thirteen Thousand One Hundred Seventy ($13,170.00), and the credit is refundable for those years.

Expanding Health Coverage to Adult Children Under 27 Years of Age.
Effective March 30, 2010, the Healthcare Act requires that group health plans provide coverage to an enrollee’s dependents up to age twenty six (26). The requirement applies regardless of factors such as a young adult’s marital status, student status, financial dependence on the primary enrollee, eligibility for other coverage or any combination of those factors.

Excise Tax on In-Door Tanning Services.
The Health Care Act imposes a new ten percent (10%) excise tax on customers of in-door tanning salons , for services performed after June 30, 2010. The tax is imposed on the full amount of the charge for the service and is imposed regardless of who pays the ultimate cost for this service. It is curious (or maybe entertaining) to note that originally the excise tax was proposed to be applied to services for plastic surgery. However, the imposition of this excise tax was changed to tanning services by the enactment of the final bill.

Please see future posts for information regarding the codification of the economic substance doctrine and for other tax affects of the Health Care Act which take effect in years beginning after 2010.

These changes are substantial and affecting individuals and businesses profoundly. We already know of one business that will be gone due to the new bill. Are you seeing any negative impacts of the reform yet?

Thanks to John Vandenhoff  here is the first in a series of articles on the tax implications of the new health care law. There’s also more in a series of informational podcasts on the Web site of the Law Firm Alliance, of which we are a member.

John Vandenhoff

On Mar. 30, 2010, President Obama signed into law H.R. 4872, the Health Care and Education Reconciliation Act of 2010 (Reconciliation Act, P.L. 111-152 ), effectively completing a massive overhaul of the U.S. health care system that will affect nearly all taxpayers, many employers, and many elements of the health care industry. The Reconciliation Act modifies H.R. 3590, the Patient Protection and Affordable Care Act (Health Care Act, P.L. 111-148 ) where the bulk of the legislation became law on March 23, 2010.

In the next few posts, we present a brief overview of some of the key tax changes affecting individuals in the recently enacted health reform legislation. Please call our offices for details of how the new changes may affect your specific situation.

Individual Mandate

The new law contains an “individual mandate”-a requirement that U.S. citizens and legal residents have qualifying health coverage or be subject to a tax penalty after 2013. In Virginia, this is resulting in a court battle because the Virginia legislature passed a law in its recent session exempting citizens from this requirement. If enforceable under the new law, those without qualifying health coverage will pay a tax penalty of the greater of: (a) $695 per year, up to a maximum of three times that amount ($2,085) per family, or (b) 2.5% of household income over the threshold amount of income required for income tax return filing. The penalty will be phased in over three years starting in 2014.

Beginning after 2016, the penalty will be increased annually by a cost-of-living adjustment. Exemptions will be granted for financial hardship, religious objections, American Indians, those without coverage for less than three months, aliens not lawfully present in the U.S., incarcerated individuals, those for whom the lowest cost plan option exceeds 8% of household income, those with incomes below the tax filing threshold (in 2010 the threshold for taxpayers under age 65 is $9,350 for singles and $18,700 for couples), and those residing outside of the U.S.

Premium Assistance Tax Credits for Purchasing Health Insurance

The health care legislation provides tax credits to low and middle income individuals and families for the purchase of health insurance. Specifically, for tax years ending after 2013, the new law creates a refundable tax credit (the “premium assistance credit”) for eligible individuals and families who purchase health insurance through an Exchange. The premium assistance credit, which is refundable and payable in advance directly to the insurer, subsidizes the purchase of certain health insurance plans through an Exchange. Under the provision, an eligible individual enrolls in a plan offered through an Exchange and reports his or her income to the Exchange. Based on the information provided to the Exchange, the individual receives a premium assistance credit based on income and IRS pays the premium assistance credit amount directly to the insurance plan in which the individual is enrolled. The individual then pays to the plan in which he or she is enrolled the dollar difference between the premium assistance credit amount and the total premium charged for the plan. For employed individuals who purchase health insurance through an Exchange, the premium payments are made through payroll deductions.

The premium assistance credit will be available for individuals and families with incomes up to 400% of the federal poverty level ($43,320 for an individual or $88,200 for a family of four, using 2009 poverty level figures) that are not eligible for Medicaid, employer sponsored insurance, or other acceptable coverage. The credits will be available on a sliding scale basis.

I recently advised an employee who wanted to start setting up a potentially competing new business before leaving his current job.  There were some provisions of his employment contract that applied to the situation.  I told him what the letter of the agreement said, and how I thought his employer would interpret it. 

“How do I get around it?” he wanted to know. 

Along with a  lot of other advice regarding not using his current employer’s trade secrets, I told him under no circumstances should he do any outside work during company time, and further, he should not make any new-business calls on his company-provided cell phone or even check Gmail or Yahoo or Hotmail accounts via a company-provided computer, laptop or smartphone.  He didn’t want to do anything that would show up on his employer’s radar. 

He thought I was being paranoid.  Yet, the US Supreme Court ruled yesterday in  City of Ontario v. Quon, 08-1332, that it was reasonable in this particular case for a government employer to search the texts on a police-officer’s government-issued pager without violating the employee’s privacy rights. 

The specific facts are here or here. 

The lesson for employees is that you should not expect privacy on work-issued computers, pagers, smartphones or other devices. The lesson for employers is to have a social media policy and follow it.

If you need assistance with a social media policy, please contact our employment attorneys.

Like members of any group, lawyers tend to talk shop when we get together.  Lately, I’ve heard a lot of grousing from other business attorneys about “business divorces.” My colleagues are looking for solutions where there are few good options. 

Business divorces are when the principals of a business (shareholders, partners or members of an LLC) can no longer function together to run the business.  It might be caused by strained personal relationships, financial pressures or even bad business decisions.  These situations have significant financial implications for the business owners, and are as highly emotionally charged as the breakup of a marriage.

Often attorneys are asked something like this, “We own a restaurant.  My partner takes a lot of money out of the register and I don’t know where it goes.  He takes care of all the books.  I don’t think he’s paying all the suppliers, withholding taxes or reporting all our income.  Every time I try to talk to him about this, he gets hostile.  How can I force him out?”

Or this:  “I don’t like the direction our business is going.  My partner is too aggressive.  She’s promising things we won’t be able to deliver, and I’m too stressed out.  I want to leave the company.  She told me to go ahead, but how can I get her to pay me for my share?”

The somber fact is that without a pre-existing written agreement (shareholders agreement, buy-sell agreement, operating agreement, partnership agreement), there is often very little an attorney can do to preserve the value of the company while getting rid of one of the owners. 

So, we describe all the reasons it is worthwhile to negotiate a solution and can sometimes get the parties to the table to talk.  But if they are too emotional, often the only solution is to force the company to dissolve, and distribute the assets.  What a waste, all the way around. 

What makes this particularly frustrating to attorneys it that these situations are entirely preventable.  Every business with more than one owner should have a written agreement that states clearly what will happen if a principal:

• Dies
• Becomes disabled or incompetent
• Goes bankrupt
• Gets divorced
• Or simply wants to be able to leave the company. 

These agreements give a process for a principal to broach the subject of leaving, and a mechanism for setting the price and the payment terms.   It can provide an automatic mechanism for buying out the interest of a principal who dies or becomes disabled.  It can protect the business from the creditors of any individual owner. It can be funded with insurance, providing some security to the family member of a deceased or disabled business owner without stretching the business budget.   

A buy-sell agreement generally costs up to a couple thousand dollars to draft, yet a surprising number of business owners either don’t know to draw one up or are too cheap.  When things change, they are imploring their attorneys to help, and we can’t.

All corporations (C-corporations and S-corporations) are required by North Carolina law to hold annual meetings of Shareholders and Directors.  While corporations are always at risk for not holding these meetings in the event of an Internal Revenue Service audit or civil lawsuit, this year the IRS is focusing on small- and medium-sized businesses to audit employment classifications. 
There are a number of technical items that should be covered in an annual meeting, but we especially use this as a time to review the following:

• Review the operations of the company during the past year, including review of compliance with state and federal laws.
• Document the corporate activity for the past year (leases, loans, other transactions).
• Troubleshoot, identify and /or address key legal issues for the coming year. 

Although LLCs are not required by Statute to hold an annual meeting, it is a great idea to visit with your business attorney at least once a year to review the past year and plan for the upcoming year.

Businesses and their lawyers across North Carolina are buzzing over reports being sent by the North Carolina Secretary of State’s office to corporations and limited liability companies who are late filing annual reports. 

In my 15 years of practice, I’ve never seen reports go out like this.  Companies with one or more missing annual reports are getting letters warning them that their companies will be administratively dissolved if they don’t file the missing reports and fees within sixty 60 days.  While this is indeed the law of the state, typically the Secretary of State didn’t send notices until the company was five years late.

Apparently the Secretary of State has conducted an internal audit, and has contacted every company that is in violation of the statute.  The notices are not always right, so you need to check your company’s situation directly with the Secretary of State’s web site.

Here are some guidelines to help you in determining if your entity owes an annual report for certain situations. 

• LLCs that are formed between January 1 and April 15th of a given year will owe an annual report (and fee) on April 15 of their first year.  Many LLCs believe they don’t owe an annual report at all for the first year, so when they file in their second year of operation, the report is counted for the first year, putting the company one behind. 
• We have noticed that accountants routinely file annual reports for their corporate clients, but sometimes do not prepare them for LLCs.  It is important to ask your CPA what is going on.
• Business Corporations are required to file an annual report at the end of their first fiscal year, even if it is a short year.  Many corporations do not file until the end of their second year.  This report is counted toward the first year by the Secretary of State, and the company is behind on its annual reports.
• Often a company will file its report, but forget a piece of information or a signature.  The filing fee will be kept, but the document will be rejected and sent back with an explanatory letter. If these reports are not corrected and re-submitted, the company will be behind on its annual report. 

These notices have been sent to the company’s registered agent.  If your registered agent is your attorney, you will receive the notice and instructions on how to fix the problem.  If you serve as your own registered agent, make sure you file your missing reports and fees within 60 days, or you will not have a valid entity and could lose your limitation of liability.

The  North Carolina Secretary of State’s web site has posted an alert about a company called “Compliance Services” that is mailing official-looking notices to North Carolina corporations offering to prepare their annual minutes for a $125 fee. 

While corporations are required by NCGS Section 55-7-01(a) to hold an annual meeting of shareholders, minutes of these meetings are not required to be filed with the Secretary of State (or anywhere else).  Compliance Services is not affiliated with the Secretary of State’s office or any other state department or agency, and is the subject of an injunction prohibiting it from conducting business in NC. 

What must be filed with the Secretary of State, however,  is the corporation’s annual report.  The Secretary of State’s web site can prepare a pre-printed annual report for your review and submission. Corporate annual reports are due when the corporation files its income and franchise tax returns.  The fee is $18 if done online via the Secretary of State’s website or $25 if done manually and submitted to the Department of Revenue. 

Limited liability company annual reports are due on April 15, of each year, even if the company was formed between January 1 and April 15 of that year.  The fee for an LLC annual report is $200. 

Companies that do not hold annual meetings of shareholders or properly store the minutes could lose their limited liability, making the owners potentially liable for the debts and actions of the corporation.

I have already blogged once about Undercover Boss, but I thought it would be helpful to flesh out just why the pay-docking incident in the first episode stuck in my head.  In that episode a (well-meaning?) manager  of Waste Management, Inc. docked employee pay two minutes for every minute of late arrival after lunch. 

Payroll docking violates most state payroll laws (it is considered an unlawful forfeiture), including North Carolina.  Here, deductions in pay must be agreed to (in writing) in advance. 

If the amount of deduction is known, the employer must get a written authorization from the employee on or before payday stating the reason for the deduction and the amount to be deducted. 

If the amount is unknown at the time the employee authorized deductions generally, the employer must give written notice before payday that there is going to be a deduction, the amount, and the reason.  The employee must have opportunity to withdraw authorization. 

In addition, the docking must not result in the employee’s pay dipping under minimum wage. 

The practice also has some potentially serious consequences under the Fair Labor Standards Act.  If the employee was an exempt employee (a salaried employee who is exempt from overtime), docking the pay cancels the exemption, and the employee would be converted to an hourly employee who is now deserving of overtime. 

In addition, the company needs to make sure even if it correctly docking pay, it is not docking hours worked.  In the Undercover Boss example, the employee was one minute late returning from lunch, but the company can only exclude that one minute from the number of hours she worked that week — it can’t exclude the “penalty minute”  if she actually worked that minute. 

Thus, all the time the employee actually works must be used to calculate whether she worked 40 hours and whether she is entitled to overtime compensation.  It is unclear whether Waste Management docked just pay, or time as well. 

We often joke internally that the FLSA is so complex that no company is ever in complete violation, but violations are significant. 

The Department of Labor, which enforces the Fair Labor Standards Act, can go back three years to look for payroll violations, willful violations, and assess a civil penalty of up to $1,100 per employee. 

An attorney review of your employment practices can be worth every penny.