Ward on Iowa Limited Liability Company Law

Iowa Court of Appeals: Business Judgment Rule Applies to LLCs

In Terminal Properties, Inc. v. Hampton Propane Terminal, L.C., 2009 Iowa App. LEXIS 231 (March 26, 2009) the Iowa Court of Appeals confirmed that the business judgment rule applies to Iowa limited liability companies formed under Iowa Code Chapter 490A (for LLCs formed under Iowa Code Chapter 489 the business judgment rule is codified).  You can read the case here.

I am not sure I agree with the court's reasoning that allowed it to avoid the issue of whether the managers of the LLC had conflicts of interest when they voted in favor of the actions that became the subject of the litigation.  The appearance of conflicts would have negated application of the BJR and led to a much more interesting and helpful opinion, albeit a more difficult one for the court.

-Marc Ward

Seventh Circuit Opinion has S Corporation Implications

Judge Posner takes on the IRS again in a case that goes to the heart of the meaning of "reasonable compensation."  In the case the IRS challenged the $20 million compensation of Menard's CEO,John Menard.  Over $17 million of this amount was the result of a bonus equal to 5% of the company's net income before taxes; a bonus plan that had been in place since 1973!  Menard's is presumably a C corporation (the opinion does not say) with Mr. Menard owning must of the stock (all of the voting stock and 56% of the non-voting stock).  In such a case, a corporation and its dominate shareholder can benefit from treating compensation as salary (deductible by the corporation) rather than dividends; especially in 1998, the year at issue and before the 2003 tax rate reduction of dividends to 15%.

The IRS challenge was successful at the tax court where the judge disallowed all but about $7 million of the salary (after comparisons to Home Depot and Lowe's CEO salaries).  Judge Posner and the 7th Circuit reversed on the grounds that the IRC Section 162(a)(1) test for "reasonable compensation" must be related to the performance of the CEO vis a vis the success of the corporation.  You can read the opinion here: http://tinyurl.com/dmrh9z

Now for the S corporation connection for which I thank Maryland tax guru, Stuart  Levine, without whom I probably would have missed it.  If CEO compensation in the form of salary must be related to the performance of the corporation, those who "play fast and loose with respect to S corps and FICA" (in the words of Levine) should be careful, because it implies that paying such CEOs a low salary to avoid FICA tax and instead reward them with dividends may run afoul of the concept of "reasonable compensation."

-Marc Ward

100th Post - Bonus Document

To celebrate my 100th post on this Blog, I've added another form for your reference.  Whether or not you use an operating agreement for a single member LLC you should have organizational minutes.  A sample is attached here.

-Marc Ward

If it Quacks like a Duck, it must be a Duck

It is typical of acquisition agreements to provide for an earn out clause that captures that part of the value of a company that cannot be readily ascertained at the time a deal is consummated.  A standard provision would call for a formula to determine future profits and then pay that amount or a portion thereof to the seller.

In Harker's Distribution, Inc. v. Reinhart FoodService, LLC, 2009 U.S. Dist. LEXIS 3623 (Jan. 20, 2009), the United States District Court for the Northern District of Iowa was called upon to determine if such a clause was an arbitration agreement under Illinois law.  Like most such earnout clauses the final calculation of the purchase price called for the buyer to submit its calculation of the Preliminary Intangible Value to the seller.  The seller had 30 days to raise any objections to the calculation.  The parties then had another 30 days to resolve the objections.  If that could not be done, then the matter of the objections was to be submitted to a national accounting firm for resolution.

Needless to say, a dispute arose over the calculation.  Before the end of the 30 day period to resolve the dispute Harker's file a declaratory action seeking the court to determine that there was a unilateral mistake over the calculation of customers used to determine the intangible value.  Reinhart countered that the matter should be arbitrated pursuant to the earn-out provisions of the asset purchase agreement.

Applying the principles of Fit Tech, Inc. v. Bally Total Fitness Holding Corp., 374 F. 3rd 1 (1st Cir. 2004), the District Court held that the "accountant remedy" was an arbitration clause under Illinois law (the law chosen by the parties to apply to the agreement) and the matter of the accounting issues only should be determined by application of the provision, and not the other legal issues related to a mutual or unilateral mistake and the effect such a mistake might have on the enforceability or rescission of the agreement.

The key is the Fit Tech analysis that a provision can be an arbitration clause, regardless of whether the word "arbitration" is used, if application of the provision serves the purpose of arbitration, provides for a final remedy, by an independent arbitrator, applying substantive standards, with an opportunity for both sides to present its case.

-Marc Ward