Ward on Iowa Limited Liability Company Law

Recent Delaware Cases on Director Liability

It is interesting to watch the Delaware Chancery Court struggle with the Disney concept of the breach of the obligation of good faith which results in the breach of the duty of loyalty by boards of directors.  

A quick recap.  The breach of the duty of care usually requires a finding that the board of directors' actions rose to the level of gross negligence.  It has been defined as "reckless indifference to or a deliberate disregard of the whole body of stockholders or actions which are without the bounds of reason."  Tomczak v. Morton Thiokol, Inc., 1990 Del Ch. LEXIS 47 (Del. Ch. April 5, 1990).

The breach of the obligation of good faith means the board "consciously and intentionally disregarded [its] responsibilities."  In re Walt Disney Co. Deriv. Litig., 825 A.2d 275, 289 (Del. Ch. 2003).

Application of these test matters because Delaware corporations can exculpate boards from the breach of the duty of care by inclusion of the proper provision in the certificate of incorporation.  Thus, the board is off the hook if they are merely recklessly indifferent but liable if they consciously and intentionally disregard their responsibilities.  See the difference?

Check out these three recent Delaware cases regarding the duty of loyalty.  Ryan v. Lyondell Chemical Co., 2008 WL 2923427 (Del. Ch. Jul. 29, 2008); McPadden v. Sidu, 2008 WL 4017052 (Del. Ch. Aug. 29, 2008); and In re Lear Corp. Shareholder Litigation, 2008 WL 4053221 (Del. Ch. Sept. 2, 2008).

-Marc Ward

NOLs and Bank Acquisitions

When the market gives you lemons, the IRS sometimes hands you sugar; at least for banks.

Bad debts and loan losses held by a bank never looked so good.  The Internal Revenue Service issued Notice 2008-83, dated today, which permits an acquiring company to deduct losses on loans or bad debts when purchasing a “bank”, as defined in section 581.  After an ownership change (defined in section 382(g)), a proper deduction relating to losses on loans or bad debts is not treated as a built-in loss or attributed to the period before the change.  The result is a tax deduction that is not subject to the limitation rules of Section 382 when purchasing a bank.

With many banks sour with loan losses and bad debts, this Notice apparently hopes to increase the acquisitions of banks by providing tax benefits to sweeten the deal.  Not knowing the future of the debts and loans, the deal keeps getting sweeter as those items become deductible losses in the future.  And with limited restrictions, a potential 3 year retroactive applicability, and no end date in sight, this Notice may help stir up acquisitions.

Before you can sit on your porch and enjoy your IRS lemonade, you should know that there are serious questions being raised as to whether this change is within the authority of the Internal Revenue Service.  Others are still calculating the financial impact of this change and some estimate the loss of tax revenue to be in the billions.  The impact of this Notice has yet to be fully recognized, but the IRS may have found the secret ingredient to stimulate the banking acquisition market.

IRS Circular 230 Disclosure:  Although this written communication may address certain tax issues, it is not intended to constitute a reliance opinion as described in IRS Circular 230 and, therefore, it cannot be relied upon by itself to avoid any tax penalties.

Contact Christine Halbrook at chalbrook@dickinsonlaw.com or at 515.246.4544 with further questions.

SMLLCs: Beware of Minnesota!

As Joe Kristan points out in his blog, www.taxupdateblog.com, the Minnesota Department of Revenue has adopted a new rule that will tax transfers of tangible personal property between a single member limited liability company (SMLCC) and its member, if the SMLLC does not elect to be treated as a corporation for federal income tax purposes.  It is the only state to make this distinction and tax such transfers.

The rule may be technically consistent with the Minnesota Tax Code (which on this issue is also unique) but it does not make a lot of sense to treat SMLCCs differently for state sales tax purposes based on an election for federal income tax.  The substance of the transaction is not different.  The intent of the exemption is to exclude from taxation the transfer of assets when there is only a change in legal title and not a change in beneficial ownership.  This intention is thwarted by this new rule.

And as Joe points out, it is a real trap for the unwary.  Who would think a SMLLC which is disregarded for tax purposes at the federal income tax level would have to pay sales tax on transfers between the owner and the "disregarded entity."

-Marc Ward

When Does Inadvertence Become Negligence? IRS Excuses Another

Here are the facts of PLR 200841007 (June 30, 2008).  An S corporation was owned entirely by an individual through his or her wholly-owned LLC, a disregarded entity for tax purposes.  The individual transferred interests in the LLC to five trusts, all wholly-owned grantor trusts with respect to the individual.  Later in the same year as the transfer to the trusts, the individual dies an the LLC becomes a partnership for tax purposes, ineligibleto be a shareholder in an S corporation.  Again in the same year, the LLC was liquidated and its stock in the corporation was distributed to the trusts.

The corporation represented to the Service that the circumstances resulting in the termination of the S election were inadvertent and not motivated by tax avoidance or retroactive tax planning.  The IRS granted the corporation's request to be treated as an S corporation despite the disqualifying events.

The shareholder's death was foreseeable and the consequences predictable.  What will the Service consider not to be inadvertent?

-Marc Ward

Piercing Thyself: The De Facto Merger

The facts of 24/7 Records, Inc. v. Sony Music Entertainment, Inc., 566 F. Supp 2d 305 (S.D.N.Y. 2008) should not come as any surprise to a business lawyer with a few years of experience.  A corporation is formed to produce records.  It enters into a contract with a record distributor.  Later, because a new investor would bust the corporation's S election, the owners form an LLC.  It is the LLC that continues the business and the corporation falls into disuse and was eventually administratively dissolved for failure to file its annual report.  Competent counsel would not have allowed this, but who wants to pay for a lawyer?

So when there is an alleged breach of the contract by the record distributor (and tortious interference claim by a third party to boot) how does the LLC have the right to bring the claim?  The district court helped out the recalcitrant plaintiffs and concluded that a de facto merger had taken place because there was continuity of ownership (well, not quite, there was a new investor), cessation of the business of one entity, continuity of the business including assumption of liabilities, and most important of all in this case,the defendants also disregarded the technical distinction and treated the entities as one in the same.