All posts by RobertJGrossman

Alright, Now Do I Own the Name?

Doing business in California generally involves forming an entity.  (Why? To limit the business’ liabilities to the business’ assets.)  One of the required steps in forming an entity is selecting a name for it.  And whether one does business in an entity or not, one will probably find it advantageous to have a business name.

Business entities such as corporations, limited liability companies, limited liability partnerships, and limited partnerships are formed by filing a document with California’s Secretary of State.  The Secretary of State cannot accept an entity’s charter document for filing with a name that is the same as, or which closely resembles, the name registered (or reserved for use) by another entity of the same sort.  Nor may it be a name likely to mislead the public, nor a name that contains the words “bank”,”insurance”, “trust” nor corporation, if that is not the case.

Since there have been many corporations formed in California, and a fair number of limited liability companies and limited partnerships, it gets hard to find a name distinct enough to pass muster with California’s Secretary of State, which generally relies on a computer algorithm for this purpose.  Clients are sometimes dismayed to learn that their first several choices for their entity’s name are unavailable.  Finally, out of desperation, they may form an entity with some strange name which may utilize their business address, a combination of their founders’ names, or some other strange combination of letters merely to secure corporate (or other entity) existence.

This is okay, I assure them because the entity may conduct its business under a fictitious business name, sometimes colloquially referred to as a “dba.”  And it is true that anybody and any entity may do business under a fictitious business name without any pre-screening or advance approval being necessary.  You merely have to publish a notice that you are doing so in the proper form, in a proper newspaper, and file an affidavit of such publication with the clerk in the county in which you are doing business.

Now Do I Own the Name?

Not exactly.  You formed your entity, you published your fictitious business name, what more do you need to do?

Names are kind of a tricky thing.  It is tricky enough forming an entity and securing the name you wish. But that is just a technical matter of filing certain documents with California’s Secretary of State.  It is important to the State of California to make sure that all the corporations and other entities it authorizes are distinguishable, but that is just the beginning of matters.  Frankly, the State’s objectives might be accomplished by assigning numbers to entities, like license plates on a car.

But ownership of a name in the context of commerce is governed by a fairly complex set of rules which rarely provides the type of clarity and predictability businesses wish.  For this reason, there is a fair amount of litigation in this field.

As a general rule, you acquire common law trademark rights in a name used commercially to the extent you are the first to use it, both geographically and with respect to the product (or service) areas in which it is used.  For example, if you are the first to operate an Italian restaurant in Westwood California called Guido’s, you might own that name for Italian restaurants in Westwood.  Do you own the name Guido’s for any kind of restaurant anywhere in Los Angeles?  California?

Maybe.  The standard for opposing registration or asserting infringement of a junior user’s similar or identical trademark is whether a “likelihood of confusion” would result in the minds of the relevant consumers if both trademarks were allowed to be used.  This “likelihood of confusion” analysis is primarily based upon (1) the similarity of sight, sound and meaning of the respective trademarks, in conjunction with (2) the relatedness of the respective goods/services offered under the trademarks such that an unknowing consumer would be confused. One purpose for these rules is to avoid confusing the public regarding the source of services and products.  Thus, it will depend upon who else is doing what else in the business and geographic vicinity.  A search of these other uses is crucial, because these other uses will determine the extent of your ownership of your name, or whether you can use it for your contemplated business at all

At this point, I must offer a caveat.  I am not a specialist in intellectual property law, nor in any of the subareas such as copyright law, trademark and patent law, and the law of trade and service names and service marks.  (A trademark or a service mark is a word, name, symbol or device used by a business to identify its goods or services and distinguish them from the goods and services of others.  Coca-Cola, Kleenex, are familiar examples. A trade name identifies an enterprise, such as GE or Microsoft.  The dividing line between a trade name and a trademark or service mark can be unclear, since occasionally the same word is used for all those functions.)  This is the province of specialized counsel.

Accordingly, when a client contemplates a substantial investment in a trademark or service mark or a trade name I usually refer that client to an intellectual property attorney.  Intellectual property counsel will identify the appropriate elements of the mark or  name, conduct a search to identify possibly conflicting uses, and register the name or mark as appropriate.  The search is particularly crucial.

If you have formed the entity, published your notice of fictitious business name, and registered your trade name and service or trademark, then do you own the name?  Perhaps.  Doing all those things does not confer rights against prior users.  Hopefully, your search, which will include a search of phone books, state and federal filings and the internet, will disclose such prior users, but it may not.  Trade name and trademark rights are based on use, and the first to use a name or a mark generally has superior rights at least in the geographic and business area where the mark is used or known.

A comprehensive search is likely to generate an exhaustive list of similar names and identify their uses, and perhaps give some clues as to territory of use.  It is very unlikely to come up with nothing.  Rather, you are likely to be in a position of scrutinizing this list and making a business decision regarding risks and rewards.  How much are you about to invest in the new name?  How difficult will it be to change names if that becomes necessary?  How much does the name benefit you?  How close are you coming to the predecessor uses, as to geographical location and business scope?  Certainly some risks will be encountered; it seems almost impossible to do business without running some risks.  Intellectual property counsel can help assess these risks.

Is there anything that can be said definitively?  I would recommend against using famous names such as “McDonalds” or “Apple” for any business, even if it’s not related to hamburgers or computers.  Of course,  I do not believe Apple poses any problem for those actually selling fruit of the similar name.  Do you see how things get tricky?

Tax Consequences in the Sale of a Business

The Bullet Points

I. Introduction

As one may imagine, the sale of a business entails tax consequences which may be larger than any other single issue faced in the negotiations. It is best to understand these consequences before price negotiations start, so that the price takes account of them. Mistakes made early may be difficult to correct later.

Most businesses are owned by entities, frequently corporations. Generally, the corporation may sell its assets, or its owners may sell their shares. The tax consequences can differ greatly.

There are taxable sales and non-taxable sales (whether of assets or of stock). Speaking very generally, non-taxable1 sales require, among (many) other things, that the seller receive stock in the purchaser in exchange for the stock or assets sold. To the extent cash or other nonstock consideration is received, the transaction is taxable.

Taxable sales, on the other hand, involve the receipt of cash, notes, and other types of consideration, or for other reasons do not qualify for tax-free treatment.

Sellers love tax-free treatment, but buyers suffer a detriment in that seller’s old basis in the underlying assets is carried over to the buyer. This will reduce the buyer’s depreciation deductions in the future. In a taxable transaction, the buyer receives a “stepped up” basis in the assets acquired, though the seller receives a tax bill.

In viewing the parties collectively, it is a choice between paying a capital gains tax now (the seller’s) or receiving a (possibly ordinary) deduction later (the buyer’s). It has always been my approach to minimize the aggregate of taxes being paid, in the belief that making the pie larger should result in larger pieces for everyone. 2

II. The Tax Consequences of a Taxable Transaction

A. Sale of Shares

The seller’s ideal transaction is a sale of shares. In this event, there will be one level of capital gains tax, which the shareholders will pay. For 2010, the maximum capital gains rate for most people is 15%. This is considered so low that some sellers in this position eschew tax-free sales, preferring to receive cash, which they can receive in a taxable transaction, rather than receiving stock, with its attendant risk, which they must receive in a tax-deferred transaction.

There is another reason for sellers to prefer a sale of stock. A non-corporate seller may currently exclude 100% of the gain, up to the greater of $10,000,000 or ten times its value of the stock sold attributable to the sale of “small business stock” held more than five years under Internal Revenue Code Section 1202. 3

B. Sale of Assets

A corporation’s taxable sale of its assets may represent a worst case scenario for the seller. A corporation is not entitled to preferential capital gains rates under federal or California tax laws. Accordingly, the corporation will pay taxes on its gain on sale at ordinary rates: a maximum of 39% for federal purposes and about 10% for California purposes.

It does not end there. There may be California sales taxes to pay on any tangible personal property sold in the transaction, and perhaps a Proposition 13 impact on any real property involved in the transaction.

It does not end there. Another level of taxation may be incurred when the sales proceeds are distributed from the selling corporation to its shareholders. This distribution to the shareholders may be taxed as a dividend at a federal rate of 15% and a California rate of 10%.

III. Tax-Free Transactions

As mentioned above, a tax-free transaction requires an exchange of stock or assets solely for stock of the acquiring corporation. To the extent anything other than stock in the acquirer is received, the transaction will be taxable. Thus, the seller must be satisfied with retaining its investment in an illiquid and non-diversified portfolio. As soon as the shares which the seller receives are sold for cash, tax will be triggered. Since the shareholders’ old basis is retained for the new shares, the gain will include the amount previously unrecognized.

Only corporations can participate in tax-free reorganizations under Internal Revenue Code Section 368. The transactions can take several forms, and each has its own requirements and consequences. Without getting into the nomenclature used by the Internal Revenue Code, these forms include:

• a statutory merger

• a stock-for-stock exchange

• a stock-for-assets exchange

• triangular mergers in which a transitory subsidiary merges into the target and the parent’s stock in the subsidiary is converted into the target’s outstanding stock

• various other permutations and combinations of the above

Requirements contained in the Internal Revenue Code are complex but crisply defined (for the most part). However, courts have consistently held that the requirements of the Internal Revenue Code are not the only requirements. Rather, a long line of cases that predate the Internal Revenue Code provisions retain their vitality. Thus, there are judicially imposed requirements in addition to those of the Internal Revenue Code. These requirements include:

• a valid business purpose

• a continuity of business interest (the successor corporation must continue the historic business of the seller)

• a continuity of shareholder’s interest (the shareholders must have a continuity of equity interest in the surviving corporation.)

IV. The Purchaser’s Considerations

While the seller is concerned about avoiding tax on gains and income, the buyer may be concerned about maximizing its post-closing tax deductions. There are certain rules a purchaser needs to be aware of.

A. Amortization of Intangibles

Internal Revenue Code Section 197 requires that amounts allocated to goodwill, non-competition covenants purchased in the acquisition, and various similar items, such as going concern value, know-how, information base, licenses, permits or other governmental grants, in-place value, franchises, trademarks or trade names must be amortized on a straight-line basis over a 15 year period regardless of the actual useful life of the intangible. That sure takes the fun out of these kinds of assets.

B. Merger and Acquisition Expenses and Fees

Who does not want to deduct legal fees? Unfortunately, under Internal Revenue Code Section 263, transaction fees and costs must be capitalized rather than deducted if incurred to facilitate an acquisition.

C. Net Operating Loss Carry-Forwards

Buyers also want to preserve net operating loss carry-forwards and any tax credits of the acquired corporation. Generally, the rules in this area are found in Internal Revenue Code Section 381 and sections thereafter. The carryover of such losses and credits after an acquisition is substantially limited.

In general, no carryover is available if assets are purchased.

If corporate shares are purchased, and there is an ownership change entailing any increase of more than 50% by one or more of 5% shareholders, taxable income against which the net operating loss may be used in any later year is limited to the fair market value of the loss corporation’s stock immediately before the ownership change multiplied by the “long- term tax-exempt rate” published periodically by the IRS. However, this assumes the business enterprise is continued for at least two years after the ownership change.

V. Excluding Certain Assets From the Sale

This is no problem when the transaction is structured as a taxable asset sale. There is tax to be paid on the gain on assets sold. Assets retained do not result in any tax consequences.

Retained assets can be a problem in certain tax- free reorganizations in which substantially all of the properties of the seller must be acquired. Disposing of unwanted assets or withholding assets which the seller wishes to retain might violate this requirement.

Tax-free divisions under Internal Revenue Code Section 355 (e) have always been possible. However, if this is part of a plan under which 50% or more of either corporation is acquired by another party, the distribution is no longer tax-free. The gain is recognized to the distributing corporation. And there is a rebuttable presumption that the separation is part of a plan if the disposition of 50% or more occurs either within two years before or two years after the split up.

VI. Conclusion

The tax consequences to the seller of business assets can range from zero to almost 50% of the sales proceeds. The buyer’s situation will also be affected by the tax structure of the transaction. In fact, there may not be any other single issue with as large an impact on the transaction. Accordingly, tax considerations should be considered early in the negotiating process so that neither party makes a pricing mistake which could prove difficult to correct.

1 At this point, I had better make an important correction to the terminology I have been using. “Tax-free” is really tax-deferred. The basis in the assets given up (in a “tax-free” sale) will be “carried over” to the assets acquired. The assets acquired will take the lower basis of the assets disposed of, so that at some time in the future, if those assets are sold in a taxable transaction, the gain presently going unrecognized will then be taxed. Accordingly, it is more technically accurate to refer to these transactions as tax-deferred rather than nontaxable.

2 It may be that, upon weighing these two tax alternatives, one of them outweighs the other. For example, for reasons unique to seller’s situation, the seller may be relatively capital gain indifferent, perhaps because of capital loss carry-forwards from other sources, or perhaps the seller is a tax exempt entity or is confronting very little gain on the transaction. In such an event, the sale should be structured to maximize the buyer’s benefits, with the seller sharing in those benefits, based on their negotiations.

3 This represents a limited time offer. At the end of 2011, the 100% exclusion reverts to 50%, as it has stood until recently. Generally, this applies to domestic subchapter C Corporations with aggregate gross assets of not over $50,000,000 actively conducting a qualified trade or business. (However, 42% of the exclusion will be treated as a tax preference item for the alternative minimum tax. I did not say this was easy.)

Revisiting California’s Anti-deficiency Legislation

Revisiting California’s Anti-deficiency Legislation

California’s real estate market has been heading south for a while now, and the journey may not be over. A real estate developer I spoke with recently told me he had about $200 million of land sales in escrow and expected none of the sales to close. In his opinion, raw land could not be sold today under any circumstances.

Property owners trying to arrange a “short sale” have called wondering about their lender’s remedies. I will discuss “short sales” briefly below, but first I think it is instructive to understand the remedies available to a lender. As a matter of fact, there is a lot more to discuss when it comes to lenders’ remedies than there is when it comes to short sales.

California has long had a variety of statutes which limit lenders’ remedies in the event of a default. A number of these, known as the anti-deficiency rules, were enacted after the collapse in real estate values during the Great Depression of the 1930’s. Each of these rules operates a bit differently, but each serves to limit a lender to foreclosing on its collateral and precludes a lender from seeking a monetary judgement against the borrower personally, which the lender could satisfy out of other assets of the borrower. This is considered good news, however that is certainly relative. The bad news is, you may lose your property, which may be your home. The good news is, that is all you will lose.

You are in this happy situation if any one of the following situations described below applies to you. For purposes of this discussion, I will assume the rather typical situation of a loan secured by a borrower’s residence, though a number of the anti-deficiency rules apply equally to commercial contexts.

A. No Deficiency after a Trustee’s Sale

California’s Code of Civil Procedure Section 580d absolutely precludes any deficiency judgement when the lender has elected to foreclose under the power of sale contained in its deed of trust. Well this is great. It is not limited to residences, first liens, noncommercial property, purchase money mortgages, or anything (except that it does not apply to publicly issued debt permitted by the Commissioner of Corporations or made by a public utility under the Public Utilities Act.)

First, a bit of background. In a typical real estate loan, the borrower signs a promissory note, which evidences the debt, and a deed of trust with its power of sale, which is a security device creating a lien on the real property to secure the note. The lender holds the promissory note until it is paid off, at which time the lender must return it to the borrower and release the deed of trust.

Without Section 580d, a lender would have the prerogative of suing, in a regular civil suit, to enforce its promissory note as well as the lien created by the deed of trust. The lender suing on the promissory note could get a judgement for the full unpaid balance of the note, along with all the other amounts provided for in the note, such as continuing interest, perhaps default interest, late charges and all of the fees and costs that the note provided, including the costs of suit. This would be a personal judgement against the borrower. Any proceeds from a foreclosure sale would be applied to that judgement and reduce it, but any remaining unpaid balance would be the personable obligation of the borrower, satisfiable out of other assets of the borrower, if any. This difference between the amount due on the promissory note and the amount the collateral fetches at sale is called a deficiency, and the judgement in that amount is called a deficiency judgement. (Not exactly. See the discussion of the fair value limitation in section C below)

In fact, under common law, a lender could do both: sue on its note and obtain a deficiency judgement and foreclose under its power of sale. It could only collect its debt once; any proceeds recovered from the collateral would be applied to reduce the debt. However, the lender would have the best of all worlds: a quick and easy resort to the collateral and the deficiency judgement as well.

California Code of Civil Procedure Section 580d flatly precludes this. If the lender resorts to its collateral privately and expeditiously, without going to court, as its power of sale provides, it can do no more. And this is the case whether the loan is a commercial loan, a second, third or fourth lien on the property or any other “note secured by a deed of trust or mortgage upon real property.”

Why is this so great for borrowers? Because the lender almost always prefers to foreclose under the power of sale in its deed of trust. Doing so is (relatively) quick and certain, and in a falling real estate market time is money. I do not know what percentage of defaulting loans result in a sale under the power of sale provisions in a deed of trust, but my experience has been that it is virtually 100%. Trustees who specialize in these matters have told me that they have never seen a judicial foreclosure which is the alternative to a trustee’s sale. As for myself, I have only seen them in circumstances where the situation is very unusual, such as borrower fraud that resulted in substantial borrower assets other than the collateral which may have been seriously overvalued as part of the borrower fraud. (See “An Old War Story” for an example) However, the normal lender analysis must weigh the benefits of quick resort to the collateral versus the rather lengthy and peril-filled process of a civil lawsuit with the only upside being a judgement that may be difficult or impossible to collect on. Lenders seem to virtually automatically prefer the former, with the result that borrowers are almost always let off the hook.

However, this is a lender election, technically, and the homeowner/borrower cannot compel it. This must be born in mind when discussing short sales, which I promise will take place below.

Sold Out Juniors. Foreclosure sales extinguish all estates “behind” or recorded later in time than the foreclosing lien. Thus, the lien of second and subsequent financing will be extinguished when the first lien forecloses. California’s Supreme Court has held that the junior lienholder’s rights should not depend on the senior’s election of remedies and consequently permit the sold-out junior to bring an action directly on the note despite the fact that the senior foreclosure was via power of sale in a deed of trust. This benefits the junior lien holder at the expense of the borrower, who may lose the property via trustee sale and remain subject to personal liability on the second.

B. No Deficiency for Purchase Money

California’s Code of Civil Procedure Section 580b provides that “purchase money” loans may not give rise to a deficiency judgement. However, this section is a little trickier. Purchase money is defined as either:

  • Credit extended to the buyer by the seller to finance the purchase of the property which is secured by that property; or
  • funds lent to the buyer by a third party if used to pay for a dwelling of four units or less occupied at least in part by the purchaser.
  • Thus, this applies to all seller financing and to institutional financing for homes and small unit properties.

This is relatively good news. It means that if you have not refinanced, your loan is probably not recourse no matter what. It also means if you are a seller, and take back paper, you may only look to your collateral, the property you are selling, for repayment. This is a risk you should bear in mind. It is a risk that the law expressly wants to place on sellers. One of the purposes of the rule is to make sellers responsible for the value of the property being sold.

C. The One Action Rule

As mentioned above, under the common law, lenders have the prerogative of suing on their promissory note, foreclosing on the collateral via their security device, and perhaps bringing another action to obtain possession of the premises. California Code of Civil Procedure Section 726 (a) forces lenders to elect between a judicial proceeding and a trustee sale. The lender may pursue a money judgement against the debtor only if it elects judicial foreclosure and pursues all of its remedies against the debtor in California court where the lender must run the gauntlet of all of the perils and pitfalls encountered along the path of obtaining a judgement and enforcing it.

In addition, California Code of Civil Procedure Section 726(b) limits a deficiency to “the amount by which the indebtedness exceeds the fair value of the property.” Thus, a new issue, the property’s value, is added to the equation. The deficiency is not simply determined by the amount the property fetches at sale. After obtaining its judgment, the creditor must return to court within three months of the judicially supervised sale of the property and conduct a fair value hearing.

Oh yeah, and the debtor has a one year right to redeem the property, something a bidder at the judicial sale must take into account. Is it any wonder trustees sales look so good?

D. Conclusion

The foregoing rules are a folksy oversimplification. Crafty lenders’ lawyers have constantly sought ways to circumvent these rules. Crafty borrowers counsel have constantly sought ways to abuse them. Thus the law has evolved. The courts have been forced to invoke notions of “standard” transactions to determine whether a set of facts justified the protections of the law based on the policy of law. Complex lending transactions, including subordination agreements in multi-tiered lending arrangements have created problems for relatively straightforward code sections dealing with the relatively straightforward notions such as “purchase money.” And then there is the guy that lives in his boat installed on his lot in the desert. (The lender really didn’t plan on making a residential loan.) And of course, there are a handful of other statutes that bear on the matter, including federal truth in lending statutes. The good news is that borrowers have an array of protection. The bad news is that the protections can be unpredictable, and expensive to access in the sense that counsel familiar with these matters can be expensive.

E. Epilogue

And so you want to know about short sales. By “short sales” I am talking about a sale of a property which will bring less than the outstanding indebtedness on the property, so that the lender will fall short of being fully paid off. These require the lenders’ consent, since each lender is only required to release its lien when it is fully paid off.

These always make sense to a borrower in default, and such borrowers think they should make sense to a lender as well. After all, as noted above, a lender’s principal remedy will almost always prove to be a trustee sale. A defaulting homeowner thinks a sure “normal” sale gets the lender to a better position without incurring the trustee’s fees and without the market stigma of a trustee’s sale. The defaulting borrower always thinks the lender ought to accept this, and release the borrower from liability.

For some reason, lenders have never seemed to look at matters quite that way, though maybe this will change. Perhaps lenders simply prefer to thoroughly test the market, though this means a bit of a delay and the pain of some trustee fees, which they may not recoup. Perhaps lenders distrust their borrowers, fearing a collusive sale at less than market value to a straw purchaser or some other consideration flowing to the borrower outside of the sale transaction. Perhaps it is simply bureaucratic inability to make an entrepreneurial type of decision. For whatever reason, my experience has been that borrowers have had a difficult time obtaining their lender’s consent to a short sale. A recent Los Angeles Times article on the subject confirmed this. Multiple liens on the property complicate things a great deal. The priority between the lienholders assure that the most senior lenders will recoup a far higher percentage than the more junior lenders. Getting everyone to agree will be problematic at best.

Short sales may become even more difficult to arrange now that so many mortgage loans have become securitized. Rather than a lender being asked to make a decision about one of its loans, that loan is packaged with hundreds or thousands of other loans, and held by distant lenders, or syndicates of investors. The decision making is that much more attenuated. As a simple matter of administrative convenience, I would expect a short sale to become increasingly difficult to arrange.

Limited Liability Companies (LLC’s)

California has become the forty-sixth state to enact legislation enabling creation of limited liability companies (“LLC’s”). A new star has been added to California’s firmament of business entities and business lawyers are excited about it.

Advantages

Briefly, an LLC is an entity designed to combine the best features of corporations and partnerships. It has the following advantages:

Limited Liability. All members of an LLC enjoy protection from its creditors, even though they may actively participate in the LLC’s business.

No Entity-Level Taxation. An LLC is ordinarily taxed as a partnership, imposing a single level of taxation on its members. Transfers to and from the LLC may be tax-free.

Operational Flexibility. An LLC is governed by an operating agreement which is virtually unlimited in the terms it may contain. It may be managed by its members, which seems to be a likely scenario, or managed by non-members. The operating agreement may dispense with formal procedures, such as the annual meetings required of corporations.

Financial Flexibility. The operating agreement may allocate income and distributions in virtually any fashion. Thus, the rigidity of corporate allocations are avoided. It is the only entity allowing partnership-like special allocationsand complete limited liability.

Even More Flexibility. Unlike S corporations, there are no particularized requirements as to who may be a member of an LLC in order for it to qualify for its tax benefits. Members may receive their interest in an LLC in exchange for money to be paid in the future or services to be rendered in the future, in addition to the contributions corporations and limited partnerships must receive for an interest: money, property, antecedent debt, or services previously performed.

Formation

An LLC is formed when its Articles of Organization have been executed and filed with the California Secretary of State’s office. The Articles of Organization are a Secretary of State one page form. An LLC may have one or more members at the time of formation and its members are required, either before or after filing the Articles of Organization, to enter into an operating agreement, which may be written or oral and may be as simple as an agreement among the members to form the LLC. The name of the LLC must include the words “Limited Liability Company”, or the abbreviation “LLC”. The word “Limited” may be abbreviated to “Ltd.” and the word “Company” may be abbreviated to “Co.”

Generally, filing fees are more moderate than those pertaining to corporate formation, but there is an annual fee based on gross income each year (which may be as much as four thousand five hundred dollars ($4,500.00) if gross income exceeds five million dollars ($5,000,000.00)). It is difficult to compare an LLC’s fees to those imposed on corporations, and other entities which pay taxes based on net income, without an income projection. However, annual fees are deductible for income tax purposes.

Potential Uses

LLC’s make particular sense where limited partnerships have previously been used, such as the single asset real estate entity and other stationary investments. In such cases, they avoid the need of a general partner to be liable for all the enterprise’s debts while preserving the flow-through of tax benefits and enabling special allocations which such limited partnerships have typically preferred. However, certain practitioners avoid LLC’s for build and sell real estate projects due to the fee based on gross income, which would include the project’s selling price. In such cases a limited partnership may be preferable, with perhaps an LLC as the general partner.

They are also useful in lieu of S corporations, avoiding the eligibility restrictions of S corporations, the one class of stock rule, the rigidity of corporate formality and income allocation, and limitations on shareholders. LLC’s make particular sense in joint ventures between existing corporations or other entities, since management activity will not impose unlimited liability and no extra level of taxation is created.

Unfortunately, the present California Act precludes the use of LLC’s for the practice of professions, including medicine, accounting, and law. Limited Liability Partnerships are available to law and to accounting practices. The LLC may also have disadvantages in the estate planning area. Member interests may not qualify for minority valuation discounts as limited partnership interest do. Finally, there are troubling IRS regulations indicating that a member with management rights may have to pay self employment taxes on profit allocations, even if the member is a passive investor. Bills are presently pending to remedy these problems however.

Because of the apparent advantages of LLC’s over most other entities, they must be the first entity to consider when forming a new business venture. It may also make sense to convert existing entities into an LLC, especially existing pass-through entities. However, there can be adverse tax consequences when a C corporation holding appreciated property is converted to an LLC, or when an S corporation is converted to an LLC in certain circumstances.

LLC Operation and Other Post-Formation Matters

The purpose of this article is to provide information regarding the basic elements of operating a California limited liability company (“LLC”) and the roles of the following:

(a) the owners of the LLC, called “members”;

(b) the “managers” of the LLC which may be elected by the members to operate the LLC business; and

(c) the governing agreement for the LLC, called the “operating agreement”.

Failure to observe some of the requirements may harm the LLC or result in personal liability to managers and members.

This article is intended to outline certain of the basic legal requirements to which an LLC is subject. It is a summary of certain provisions of the California Limited Liability Company Act (the “Act”), which is a very lengthy and detailed statute, and accordingly this article cannot be considered a comprehensive description of the Act and its requirements.

I. Basic Structure of an LLC

An LLC is formed when its Articles of Organization have been executed and filed with the California Secretary of State’s office. The Articles of Organization are a Secretary of State one page form. An LLC may have one or more members at the time of formation and its members are required, either before or after filing the Articles of Organization, to enter into an operating agreement, which may be written or oral and may be as simple as an agreement among the members to form the LLC. This is the instrument which governs the LLC and it will typically contain provisions specifying capital contributions, profit sharing percentages, management and control, admission of new members and restrictions on transfer of memberships and perhaps special tax provisions specifically allocating gains and losses and perhaps specific items of each.

LLCs are but one of a number of forms of organization in which people can conduct a business. The LLC is owned by the members who can either (i) manage the business of the LLC themselves, in which case the LLC would be a “member-managed LLC”, or (ii) elect a manager or managers to manage the business of the LLC, in which case the LLC would be a “manager-managed LLC.” One of most important differences between a member-managed LLC and a manager-managed LLC concerns the authority of the members to bind the LLC to LLC obligations:

(a) In a member-managed LLC, each member has the power to bind the member-managed LLC (like general partners in a partnership).

(b) In a manager-managed LLC, no member has the power to bind the LLC (just as no shareholder of a corporation can bind the corporation); only a manager or authorized officer of the LLC can bind the manager-managed LLC.

Management duties include decisions about key policies and LLC transactions and establishment of guidelines within which the business of the LLC will be conducted. The managers can hire officers and employees to perform the LLC’s day-to-day business.

The principal distinguishing feature of an LLC is the limitation of liability which the members of the LLC enjoy (like a corporation), as well as the pass-through income tax treatment enjoyed by the LLC and members (like a partnership). So long as the LLC is properly formed and in existence, and is properly operated, the members will not be personally liable for the LLC’s debts, obligations, and liabilities. In other words, if the LLC’s debts exceed the value of the LLC’s assets, the LLC’s creditors should not be entitled to seek repayment from the members’ personal assets.

Of course, a personal guarantee by an LLC member of an LLC obligation would give rise to personal liability of that member to the extent specified in the guarantee (as it would for a shareholder in a corporation). Failure by a member to remit employee withholding taxes can provide another basis for personal liability of a member (as it would for a shareholder in a corporation). Liability based on the personal tortious behavior of a member would of course provide the basis for personal tort liability of that member (as it would for a shareholder in a corporation). But generally the LLC liability shield, like the corporation’s liability shield, should protect individual members from LLC debts, obligations, and liabilities.

The following is a brief description of the roles of the major parties in an LLC — the members and the managers. Although the following is written as if members and managers are separate persons, the same individuals could serve as members and managers.

A. Members

The members own the LLC and provide the capital with which the LLC commences its business. In a member-managed LLC, members by definition manage the business of the LLC. In a manager-managed LLC, members as a group often do not take an active role in running the business. Normally one or two members will be intimately involved in day-to-day operations of the LLC, and other members will be passive, non-active investors. Beyond electing the managers and voting on certain key events in the LLC’s life, the members of a manager-managed LLC entrust management of the LLC to the managers (much like the shareholders of a corporation entrust management of the corporation to the directors and officers of the corporation). Matters requiring member votes are discussed in “Member Votes” below.

B. Managers

Managers are elected by the members. At the outset managers can simply be specified in the operating agreement, which is of course approved and signed by all members. Thereafter, if the operating agreement so permits, members can hold annual or other regularly scheduled meetings and elect the general manager and any other managers of the LLC. Managers manage the business and affairs of the LLC and exercise the LLC’s powers. Managers may either perform these responsibilities themselves or these responsibilities can be performed by officers and employees under the direction of the managers.

In performing these responsibilities, the Act imposes on managers the same fiduciary duty with respect to the LLC and its members that a general partner owes to a general partnership and the other partners of that partnership (the Act does not specify a fiduciary duty for members). It is permissible to modify and otherwise refine the fiduciary duty of the manager in the operating agreement. Indeed it is advisable to do so. Typically the operating agreement will specify fiduciary duties such as the “duty of loyalty” and the “duty of care” for LLC managers.

The duty of loyalty dictates that a manager must act in good faith and must not allow personal interests to prevail over interests of the LLC and the LLC’s members. A standard example that raises these issues is a proposal that the LLC enter into a transaction which benefits a manager, or involves the manager in a conflict of interest between the manager and the LLC or its members. Such transactions are often called “self-dealing” transactions. They are not prohibited, but such transactions must be predicated upon (i) full disclosure, (ii) proper approval from disinterested managers and members, and (iii) fairness to the LLC and its members.

The duty of care requires a manager to be diligent and prudent in managing the LLC’s affairs. This is sometimes referred to in corporate law as the “business judgment” rule. If a manager makes a decision, conscientiously and without fraud or conflict of interest, such manager will not be second-guessed by courts based on how that decision happens to work out for the LLC. A manager is not held liable merely because a carefully made decision turns out badly.

C. Officers

Like a corporation, the LLC members and managers can appoint officers for the LLC who serve at the pleasure of the managers, subject to contracts of employment (if any) such officers may have with the LLC. The officers perform the bulk of the day-to-day operation of the LLC’s business. Normally an LLC will want at least a general manager (or president), a chief financial officer, and a secretary. More than one of these offices can be held by the same individual. An LLC may have additional officers. These additional officers are either appointed by the general manager or another officer if such officer has been delegated authority to make such appointments.

The following is a brief summary of the standard duties of the following officers. All of these could be modified by the managers.

  1.  General Manager or President. The general manager is the chief executive officer and general manager of the LLC unless the LLC has a chairman of the board and has designated the chairman as chief executive officer. The general manager has general supervision, direction, and control over the LLC’s business and its officers. The general manager can also be called the president of the LLC.
  2. Chief Financial Officer. The chief financial officer keeps the books and records of account of the properties and business transactions of the LLC. These duties include depositing corporate funds and other valuables in the name of the LLC and disbursing funds as directed by the managers.
  3. Secretary. The secretary of an LLC keeps the LLC’s articles of organization, operating agreement, record of members’ addresses and holdings in the LLC, and written minutes (if any) of the proceedings of the LLC’s members and managers. The secretary usually has the duty of giving notices to members and managers of members’ and managers’ meetings.

II. Member Votes; Manager Actions

A. Member Votes.

Certain fundamental changes in the life of an LLC, such as a merger or liquidation of the LLC, require a vote by the members. These fundamental changes include the following:

  1. Amendment of the articles of organization (requires at least a majority vote of the members; this requirement can be modified upward by the operating agreement).
  2. Amendment of the operating agreement (requires unanimous vote of the members; this requirement can be modified downward by the operating agreement).
  3. Merger or consolidation of the LLC with or into any other LLC (requires at least a majority vote of the members; this requirement can be modified upward by the operating agreement)
  4. Winding up and dissolution of the LLC (requires at least a majority vote of the members; this requirement can be modified upward by the operating agreement).

B. Manager Action.

Matters of general operating policy should be considered and authorized by the general manager or managers of the LLC. Although there is no statutory requirement with respect to how frequently the managers should act, it is advisable that the managers meet at least quarterly. In addition, a specially convened meeting of the managers may be called if action is required before the next regular meeting of the managers. Action by the managers may also be taken by the unanimous written consent of the managers. Although case it is likely that most manager actions will be taken by unanimous written consent without a meeting, it may prove useful to schedule a regular managers’ meeting to address significant matters which have arisen on a quarterly or, at least, annual basis. Manager meetings can be held either in person or by conference telephone so long as all managers in attendance can hear each other simultaneously.

Matters appropriate for manager action, which can be immediately approved by written consent or which might arise and be accumulated, pending approval by the managers, include the following:

  1. Appointment of officers, setting of salaries, and declaration of bonuses (at least annually, typically at a meeting of the managers immediately following the annual meeting of members).
  2. Appointment of manager committees, if any.
  3. Opening of LLC bank accounts and the designation and change of LLC managers and officers authorized as signatories. Any bank’s LLC account form will usually include a resolution which the party executing the form represents to have been adopted by the managers of the LLC.
  4. LLC borrowing and delivery of collateral in connection with such borrowing.
  5. Consummation of material contracts for the purchase or lease of significant assets or services or the disposition of LLC assets or for the rendition of services outside the ordinary course of the business of the LLC.
  6. Policy decisions with respect to the construction of material assets or the investment of material amounts in research and development projects.
  7. The adoption of pension, profit-sharing, bonus and other employee benefit plans.
  8. The repurchase of LLC interests.
  9. Amendment of LLC bylaws (if any).
  10. Review of financial statements of the LLC.
  11. Appointment of auditors, if any.
  12. Any action which requires a member vote.
  13. The issuance and sale by the LLC of additional interests in the LLC.

In the case of any such actions, the secretary of the LLC should prepare minutes of the meeting at which such actions were approved or prepare the form of written consent evidencing any such manager or member actions.

III. Observance of “Corporate Formalities” Not Required

Unlike a corporation, the observance of “corporate formalities” is not an important part of maintaining the shield from liability and other protections and advantages offered by the LLC form of doing business. The term “corporate formalities” normally means holding annual (or other regularly scheduled) meetings of the owners and managers, providing written notice in advance of such meetings, preparing detailed minutes of matters decided upon at such meetings, and so forth. The Act specifically states that the failure to observe such corporate formalities “shall not be considered a factor tending to establish that the members have personal liability for any debt, obligation, or liability of the” LLC where the articles of organization or operating agreement of the LLC do not specifically require such formalities to be observed.

This does not mean that LLC members are completely free to ignore the separate legal identity of the LLC. For example, members must always keep in mind that the LLC assets and funds are in the name of and owned by the LLC, not by the LLC’s members. Separation of LLC assets from personal assets of the members is very important. See “Separation of LLC and Personal Assets” below.

IV. Separation of LLC and Personal Assets

It is important for any company to respect the difference between the company’s bank accounts, property, equipment, and other assets and personal assets owned by the company’s owners. An LLC, like a corporation or other legal “person”, is a separate legal entity with assets that are owned by the LLC. Any attempt by an LLC member to dispose of or use LLC property would be no more proper than an attempt by that member to dispose of or use another member’s personal property. Members must respect the fact that the LLC’s assets are the property of the LLC, not the members. Similarly, an LLC member should not intermingle such member’s personal assets with the company assets of the LLC.

The Company’s books, records, and financial statements should be maintained clearly to reflect the separation of the Company’s assets from the personal assets of the members. The Company must conduct business in its own name (not in the individual name of any manager or member). All letterhead, business card, bills, checks, invoices, and other Company forms should show the Company’s full legal name (and fictitious business name, if any), and the Company’s current address, telephone number, and fax number.

As a statement of sound business practice the observations made about separation of personal assets from company assets are fairly obvious. There is an additional, less obvious reason to follow those rules.

Creation of an LLC shield from liability for LLC owners inevitably gives rise to attempts to pierce that shield by creditors of the LLC. This has long been the case for the liability shield of corporations. As long as there have been corporations, there have been attempts to “pierce the corporate veil”. Published cases in which such attempts have been successful usually involve a recitation by the court of a dozen or so factors in support of the court’s ruling that the shareholders of the corporation should be held personally liable for the debts, obligations, or other liabilities of the corporation. At the top of this list of factors are (i) failure by the shareholders to respect the corporation’s separate identity (by intermingling corporate and personal assets) and (ii) some other form of misconduct by the shareholders with respect to the corporation.

The LLC entity is sufficiently new in the United States so that there is virtually no case law specifically addressing the relevant issues in this area. Nonetheless, it should be pointed out that at least two specific statutory factors favor LLCs over corporations in this area.

First, the Act expressly states that LLC members are not liable for LLC debts, obligations, and liabilities merely by virtue of being a member in the LLC. There is no such explicit statutory enunciation of the shield from liability for shareholders in corporations (instead, the corporate shield is based on many years of case law and common law corporate principles). Second, one of the many factors often listed in piercing-the-veil cases for corporations is that the shareholders did not respect corporate formalities specified in the relevant corporation’s statute, bylaws and other charter documents. With regard to LLCs the Act makes it clear that the LLC need not respect corporate formalities. Failure of an LLC to respect corporate formalities cannot be considered a factor “tending to establish that the members have personal liability” for any LLC debt, obligation, or liability. See “Observance of Corporate Formalities — Not Required” above.

This is not to say that LLC members can ignore the many years of corporations law developments in this area. It is a safe bet that courts will apply some principles from this area to LLC piercing-the-corporate-veil actions. Until more clearcut guidance is provided by courts, LLC members and managers would be well advised to bear in mind the foregoing observations about piercing-the-corporate-veil case law applicable to corporations.

V. Adequate Capitalization

The Company should be adequately capitalized to carry on the Company’s business activities. This is of course an obvious statement of sound business practice. A less obvious reason to assure that the Company is and remains adequately capitalized concerns the piercing-the-corporate-veil case law discussed above. One of the factors enunciated by some of the courts that have ruled that creditors of a corporation should be allowed to hold the shareholders personally liable for debts and obligations of the corporation is that the corporation was not adequately capitalized. Hence, adequate capitalization is an additional, very important factor relating to the shield from personal liability provided by the Company for its members.

VI. Other Post-formation Matters

Although it is not intended to be exhaustive, the following checklist summarizes legal requirements applicable to a new LLC. Some of the requirements arise as a consequence of formation of the LLC; others apply to all new businesses regardless of the form of organization. Certain requirements are highly formal and technical; many must be satisfied within a specified time period. Care must be taken to comply with these matters as they arise because in many cases there are serious penalties which can be assessed for failure to comply.

A. Local Business License. The LLC may be required to obtain a business license from the city in which it intends to operate.

B. Employer Identification Number. Every employer must obtain an employer identification number which will be used on federal tax returns and certain other documents.

C. Annual LLC Statement of Information. Each year, the LLC must submit a Form LLC-12, providing a current list of names and addresses of the LLC managers (and if there are no managers, of the members), the LLC chief executive officer, and the LLC agent for service of process.

D. Estimated Federal Income Tax. The LLC members will be required to pay estimated federal income tax in installments (like a general partner in a partnership). Your accountant should keep you current with this requirement.

E. State Minimum Annual Franchise Tax. Every LLC organized, registered or doing business in the state of California is subject to an annual minimum franchise tax of $800 (payable by the 15th day after the 4th month following formation of the LLC).

F. State Graduated Gross Receipts Fee. In addition to the annual $800 franchise tax, an LLC in California is subject to a graduated fee determined as follows:

For tax years beginning on or after December 31, 1999:

  1.  $865 if the LLC’s total income from all sources is $250,000 or more, but less than $500,000;
  2. $2,595 if total income is $500,000 or more, but less than $1,000,000;
  3.  $5,190 if total income is $1,000,000 or more, but less than $5,000,000;
  4.  $7,785 if total income is $5,000,000 or more.

For purposes of the fee calculation, total income is defined as gross income plus the cost of goods sold. The fee is based on the LLC’s income from all sources, including income from sources within and without California. In certain cases, the fee is calculated by taking into account the income of “commonly controlled limited liability companies”. The fee is payable with the LLC’s California tax return. Your accountant should keep you current with the tax requirements in California.

G. Tax Returns. Both federal and state income tax returns must be filed on or before the fifteenth (15th) day of the third month following the close of the taxable year, unless a timely extension to file is obtained.

H. Personal Property Taxes. If the LLC owns significant personal property it may be required to file a property statement with the County Assessor and may be subject to a personal property tax. Forms may be obtained from the County Assessor.

I. Sales and Use Taxes. If the nature of the LLC’s business includes the sale at retail of tangible personal property (goods), then the LLC may be subject to sales and use taxes and would need to obtain a seller’s permit from the California State Board of Equalization. This may be applicable in your LLC’s circumstances.

J. Payroll Withholding.

  1. Federal. The LLC will be required to withhold income tax and social security tax from taxable wages paid to its employees. Funds withheld must be deposited in certain depositories accompanied by a Federal Tax Deposit Form 8109. An “Employer’s Quarterly Federal Tax Return” (IRS Form 941) must then be filed before the end of the month following each calendar quarter. Any manager, officer, or other person obliged to withhold taxes may become personally liable for a 100% penalty if he fails to pay the withheld funds to the Internal Revenue Service.
  2. California. The LLC will also be required to withhold California income tax from its employees’ taxable wages. Within fifteen (15) days after becoming subject to the personal income tax withholding requirements, the employer must register with the Department of Employment Development. A booklet entitled “Employer’s Tax Guide for the Withholding, Payment and Reporting of California Income Tax” may be obtained from this Department.

K. Federal Unemployment Tax. The “Unemployment Tax Return” (IRS Form 940) must be filed and any balance due paid on or before January 31 of each year. Details may be found in IRS Circular E, the “Employer’s Tax Guide.”

L. California Unemployment Compensation Insurance. Registration with the California Department of Employment Development can be accomplished at the same time that the LLC applies for a seller’s permit (if needed) from the Board of Equalization. Forms for returns are mailed automatically to all registered employers.

M. Workers’ Compensation. All employers must either be insured against workers’ compensation liability by an authorized insurer or obtain from the Manager of Industrial Relations a certificate of consent to Self-Insure. The required insurance may be obtained through the nearest local office of the State Compensation Insurance Fund, or it may be placed with a licensed workers’ compensation private carrier.

N. Trademarks; Trade Names; Trade Secrets. Company trademarks and trade names should be registered in the Company’s name with the U.S. Patent and Trademark Office. Trade secrets of the Company should be protected by obliging Company employees to sign confidentiality agreements.

O. Securities Law Matters. If all members of the Company are actively involved in the management of the Company, and have the experience and ability necessary to manage the Company, then the interests in the Company would not constitute “securities” under California or federal law. If any of the members are “passive” investors, then the offer and sale of an interest in the Company to such investor would constitute the offer and sale of a “security”. Normally such offers and sales can be structured to satisfy the requirements for exemption from registration under federal and state securities laws (this was the case for the Company). If no exemption is available, then the securities would require registration pursuant to federal and state securities laws. Even if an exemption from registration is available, the sale by the Company of additional interests to new investors (or additional contributions of capital by existing members) should be accompanied by the filing of a “25102(f) Statement” with the California Department of Corporations.

P. Fictitious Business Names. If the Company intends to transact business using a name other than that specified in the Company’s articles of organization, the Company must file a fictitious business name statement with the clerk of the county in which it has its principal place of business. The Company must also file a fictitious business name statement in any other county in which it intends to transact business. Once a fictitious business name statement is on file with the county clerk, the statement must be published in a newspaper of general circulation in the same county once a week for four consecutive weeks. Within thirty (30) days after publication, an affidavit of publication must be filed with the county clerk’s office.

Q. Qualification in Other States. States universally require a “foreign LLC” (one not incorporated in that state) to “qualify” before “doing business” in such state. Qualification usually consists of the filing of documents, payment of a fee, and appointment of a resident agent for service of process. “Doing business” is more often defined by the exceptions than by an enumeration of specific acts which are covered by that term. However, if the LLC elects to do business (e.g. open an office) in another state, it will be required to qualify in that state. Failure to qualify may result in financial penalties as well as the inability to bring suit in the courts of the state with respect to acts and transactions in the state during the period of the violation.

R. Real Estate. If the LLC owns real estate, recordation of the articles of Organization in the County Recorder’s real estate records is advisable.

VII. General

A. Signing on Behalf of the LLC

Whenever the LLC managers or officers are signing agreements, documents, or correspondence on behalf of the LLC, care should be taken to include the LLC’s name in the signature block and to indicate the title of the manager or officer signing. An example of an appropriate signature block is included below:

[LLC name]

By: _________________________

Name: [name of individual]

Title: [General Manager, etc.]

Failure to do so may lead, in the context of litigation involving a signed document, to including the person who signed the documents in the lawsuit in his or her individual capacity.

B. Bylaws

This article describes a number of the important legal aspects of running a business in LLC form. It is important to remember that the operating agreement and articles of organization of the LLC are the authoritative source of advice as to how to do certain things that will come up from time to time. For certain types of LLC (normally those with a larger number of members), a form of bylaws similar to the type of bylaws applicable to a corporation may be advisable or useful.

C. Official Documents

A number of small LLCs have found it useful to designate one of the officers, usually the secretary, to be the recipient of all “official” correspondence concerning the LLC and its relationships with the various government agencies with which it deals. This helps to avoid forgetting to submit certain of the regularly filed forms, such as the Annual Form LLC-12 (see item IV.C above), which though simple documents can lead to troublesome problems if they are not taken care of promptly.

D. Finances

An important feature of post-formation LLC operation is scrupulously to keep the LLC’s money separate from the personal funds of members, managers, or employees. Failure to keep these separate is a common problem with closely held or newly formed LLCs. Such a co-mingling of funds is often seized upon by LLC creditors and other persons suing an LLC as a reason to disregard the LLC entity and impose liability on the individual members for the LLC’s debts, obligations, and liabilities as discussed in “Separation of LLC and Personal Assets” above.

Obviously, many issues may arise which are either out of the ordinary or of special importance to the LLC.

Limited Liability Partnerships

California has adopted legislation permitting California attorneys and accountants to practice as limited liability partnerships. This legislation, effective October 10, 1995, has been relatively unheralded. Yet, it provides important benefits to accountants and attorneys.

Limited liability partnerships are domestic general partnerships that elect limited liability status by following procedures described below. Importantly, creating a limited liability partnership may not entail the creation of a new entity as would be the case upon conversion to a limited liability company. Thus the effort and the tax risks associated with entity creation or conversion are reduced.

The liability shield for partners is as complete as the law can make it. Partners are not individually chargeable with any of the debts of the partnership, whether stemming from professional malpractice or contractual claims. They are not liable to the partnership nor other partners for contribution. Rather, they are only liable to third parties for their own tortious conduct.

To attain limited liability partnership status, a general partnership must be composed solely of those licensed to practice public accountancy or law and must:

(a) Register with California’s Secretary of State, after so electing by a vote of the partners.

(b) Register with the State Bar Office of Certification in the case of a law partnership or the State Board of Accountancy in the case of any accountancy partnership.

(c) Provide minimum security for claims. In most cases this will be malpractice insurance in the amount of one hundred thousand dollars ($100,000.00) per licensed person (whether partner or employee) with a maximum of five million dollars ($5,000,000) of coverage for accountants or seven million five hundred thousand dollars ($7,500,000.00) for attorneys. There are other ways to provide the required security.

Because this is a relatively new law and because it was enacted without the usual legislative effort, it contains some areas of ambiguity. Nevertheless, it probably represents the entity of choice for the practice of law and accountancy, much as limited liability companies represent the entity of choice for other endeavors. You and your clients may wish to consider conversion to a limited liability partnership.

Title Insurance – The Basics And Beyond

Virtually every California real estate buyer (as well as their lenders, and frequently owners of lesser estates in real estate, such as leaseholds, and their lenders) obtains title insurance. Most get a basic form of coverage. However, extended coverages are available, often at moderate fees. This article will briefly explain some of the basics of title insurance coverage, and discuss some of the additional coverages available.

Why You Buy It

A purchaser of California real estate takes title to that property subject to claims and liens that are:

(a) a matter of public record,

(b) ostensible, i.e. discernible from inspecting the property; or

(c) known to the purchaser

Title insurance is obtained because matters of public record, item (a) above, can be difficult to identify. Real property may be subject to liens from a variety of taxing authorities, judgment creditors, environmental agencies, workers performing services of improvement to the property, and mortgage lenders, which include equity line of credit lenders. Beyond this, property may be conveyed in a number of ways, such as incident to a divorce, lawsuit, through a probate proceeding, and the like. In fact, the record consists of every document recorded with the state of California since its exception, since even liens that have been paid off remain part of the record. Thus, discerning the state of record title is not for the faint of heart. In its most basic form, title insurance assures a buyer that the record state of title, item (a) above, is as reported in the policy.

Title insurance is different from other kinds of insurance. It does not insure against acts occurring after the date of issuance, unlike a casualty insurance policy. It only insures against problems in existence on the date of the policy. It does not expire as long as you own the property.

What You Get

The most basic form of coverage assures that you will take the title which the title company reports as the public record. The policy insures against damages resulting from “any defects in or lien or encumbrance on title.” Defects in the title include such matters as the lack of capacity of a grantor in the chain of title, or an off-record grant.

For residential purchasers in urban areas, this may be sufficient. Such property has generally been reviewed by a number of regulatory agencies. (The subdivision process which applies to developers and in particular condominium sellers is particularly regulated.) Furthermore, you may be quite familiar with the property you are purchasing, at least from the standpoint of knowing whether there are tenants or adjacent property owners with a potentially adverse claim.

What You Are Not Getting

You are not getting any assurances about off-record matters such as would be disclosed by an inspection (item (b) above). For example, you are not assured against a tenant’s claimed right to occupy your property. You are not assured that the property was lawfully constructed and conforms to zoning requirements. You are not getting any assurance that your building does not encroach on your neighbor’s property, nor your neighbor’s building on yours. (In fact, I have often wondered how purchasers know for sure that the property they think they are buying conforms to the legal description they see in their title insurance policy. The legal description is obtuse, frequently referring to other recorded documents, and rarely contains an address. The map that may or may not be attached does not form part of the policy.) There are very few assurances one receives of a physical nature.

And of course, you remain responsible for claims you create or know about, even if omitted from the title policy’s list of exceptions.

Expanded Residential Coverage

Traditionally, the basic form of residential title insurance was provided by the California Land Title Association, usually abbreviated as CLTA. This provided coverage against defects in record title. A broader form of coverage was available by obtaining an American Land Title Association, or ALTA, form of title insurance. These assured against certain off-record defects such as encroachments. A survey is required in order to obtain such a policy. In order to provide assurances regarding the physical condition of the property, necessary to assure against claims based on encroachments, or non-record tenants, a physical inspection was also necessary. These policies could get expensive and may not have been necessary in all situations.

Over the last several years, several major title insurers have begun to offer expanded residential owners’ coverage. Different companies have given these different names, but they are essentially an ALTA residential policy with further coverage. Uniquely, they include coverage for certain post-policy matters, including:

(a) subsequent forgery – either a forged deed conveying the property, or a forged deed of trust encumbering the property,

(b) construction by a third party which encroaches on the insured land,

(c) transfers to the owners’ estate planning trust. Such transfers are common

and might otherwise terminate title insurance coverage,

(d) forced removal of an existing structure because it was built by a previous owner without a building permit,

(e) loss due to inaccuracy in the map attached to the policy.

These policies usually contain increases in the policy coverage over time, to account for appreciation. They may cost an extra 10% of the title insurance premium. Because we regard this cost as nominal in relation to the increased coverage, I am inclined to recommend such increased coverage in almost every case.

Residential Endorsements

Endorsements are used to expand insurance coverage or reduce exclusions or exceptions. The extended form of residential title insurance described above would tend to supplant many of the endorsements that had become common to expand coverage. If such a policy is not being obtained, it is very common for homeowners to expand their coverage with what is known as a CLTA 126.1 Homeowner Endorsement which provides coverage for loss from lack of right of access, mechanics’ liens, encroachments, zoning violations and the like. There are similar endorsements for condominium owners, which also add coverage against loss from failures to separately assess taxes. For that matter, condominium purchasers obtain a condominium policy which specifically indemnifies from loss from prior CC&R violations, assures that the condominium was validly created and that the easements and common areas are properly defined. Additional endorsements are available to protect against inflation.

Commercial Title Insurance Endorsements: Even Further Beyond

The world can get quite interesting when commercial property is involved. Some of the available policy endorsements protect against loss from:

(a) a violation of CC&Rs

(b) existing encroachments from adjoining land onto the insured property, or from the insured property onto adjoining land,

(c) lack of access that is practical and usable,

(d) certain identified improvements, such as those with a specified address, not being located on the insured property, and that the attached map shows the locations and dimensions of the use of the insured property,

(e) two or more separately described parcels not being contiguous, so that if they have been assembled and developed jointly, the owner will be assured that there are no third party rights to interfere in between the parcels,

(f) parcels being separate tax parcels, so that there will be no risk of a tax sale

without notice,

(g) failure to conform with the Subdivision Map Act,

(h) failure to comply with zoning requirements, including parking restrictions,

(i) the property’s building encroaching on an easement,

They may further provide that dispositions. of ownership interests in the owning entity do not terminate the policy despite the fact that they may terminate the entity from a legal point of view.

There are a number of specialized endorsements for lenders on these transactions, including assurances that the loan is not usurious, that the variable interest rate on the loan is enforceable and that future advances will be covered.

Even Beyonder

There is a vast array of title insurance products beyond those described above. There are litigation guarantees for those bringing quiet title actions to identify all those who should get notice. There are trustee sale guarantees for those buying from a foreclosing trustee. There are guarantees that pertain to mechanics’ liens, judgment liens, mining claims and mineral rights. In fact, there are more than 75 separate, specific endorsements for a basic residential CLTA policy. Thus, the ability to obtain peace of mind for any particular matter of concern exists. Though some of these assurances may be pricey, some may be surprisingly inexpensive.

And even beyond this, custom drafted one-of-a-kind endorsements are available. Title insurers are bookmakers, and if they consider a bet reasonable, they will make it. Because they are relatively sophisticated, they may accept a risk which a buyer may not choose to. Accordingly, if there is an element of a transaction which you as a buyer find troubling, or you as a seller find problematic in its impact on marketing your property, you may be able to find a title insurance company to solve that problem at an acceptable cost. It is important to know that you have such options.

Accepting Partial Rent Payments

May a landlord accept a partial rent payment after filing an unlawful detainer action? The answer is a cautious yes, if the landlord provides “actual notice” to the tenant that the acceptance of the partial payment of rent does not constitute a waiver of the landlord’s right to recover possession of the property or to sue for the remaining balance owed.

On the other hand, if a landlord accepts a partial payment of rent without providing the “actual notice” required, the landlord may have waived the right to collect any other amounts due and the right to seek possession of the property with respect to that default.

As you might imagine, the timing and nature of the “actual notice” has been the subject of some dispute. A recent California appellate case has helped landlords, by providing that the “actual notice” could be language in the lease itself. Therefore, it is important that the lease contain proper non-waiver language. If it does, it may provide a safety net for landlords that do accept partial payments during the pendency of an unlawful detainer action. Of course, a landlord would be well advised to add appropriate non-waiver language to the 3-day notices and the unlawful detainer complaint filed by the landlord.

Tax Benefits of Tenant Improvements

Businesses that incur costs upgrading office, retail or commercial space during the next year may be eligible for a nice tax break contained in a relatively obscure provision of the Job Creation and Worker Assistance Act of 2002. A special first-year bonus depreciation allowance is provided for qualified property, importantly including tenant improvements, made after May 5, 2003 and placed in service before January 1, 2005. (A 30 % first-year depreciation allowance is provided for qualified tenant improvements made after September 10, 2001, and before January 1, 2005.) This is a significant benefit, though of course, future depreciation will be reduced by the deduction taken.

It does not apply to new buildings but rather buildings that have been in service at least three years. It only applies to interior construction of leased space. Thus, an owner-occupant is not eligible for this deduction and it does not apply to the cost of structural components. It applies to both landlords and tenants, to the extent each shares in these costs.

This bonus depreciation allowance must be taken in the first year that the improvements are placed in service. If not, this opportunity will be lost and only standard depreciation deductions will be available.

Health Savings Accounts

The Medicare Prescription Drug, Improvement, and Modernization Act signed by President Bush on December 8, 2003 creates a federal income tax deduction for contributions to health savings accounts, effective January 1, 2004. These accounts are similar to IRAs, and may provide even greater benefits. They should prove every bit as popular.

Health savings accounts are tax-free savings accounts that you establish and control. Your contribution to the account is deductible, and the interest it earns is tax-free. Amounts distributed are never taxed, making them better than IRAs, as long as distributions are used to pay for qualified medical expenses, such as health insurance deductibles, co-payments for medical services, prescriptions, or other health products. They can be used to purchase over-the-counter drugs and long-term care insurance, and to pay health insurance premiums. Funds may accumulate and grow tax-free from year to year. The funds are portable so that they go with you even if you change jobs.

Of course there are limitations and requirements. There is a contribution limit of $2,600 per year for individuals and $5,150 for families. (Individuals over 55 can make extra contributions to their accounts to “catch up.”) They are only open to individuals covered by a “high deductible health insurance plan”, however, this will not exclude many taxpayers. The annual deduction for a “high deductible health insurance plan” must be at least $1,000 for individual coverage and $2,000 for family coverage. Annual out-of-pocket limits must be less than $5,000 for individuals and $10,000 for families. Most people should be able to comply with these requirements