Risk Management for In-House Counsel By John A. Chamberlain Introduction otherwise be reluctant to bring to manage- ment’s attention. A risk manager who knows Everyone manages risk every day. On a pro- how to read financial statements can glean fessional and personal level, everyone is a important information from standard finan- risk manager. For in-house counsel, risk cial statements, especially if there is a history management is especially crucial because of statements to review. Reviewing balance the risk management and legal processes sheets, income, and cash flow statements for overlap. A legal department that helps its the past five years is an excellent place to business partners determine the most cost- start. Process diagrams (flow-charts) are effective method of managing risk will assist effective for many different types of opera- the business in becoming more competitive, tions. They assist in identifying potential efficient, and profitable. Risk management is bottlenecks in the manufacturing process a process that reduces accidental or business that could put an operation at risk. For losses to an acceptable level and allows a example, if an entire manufacturing opera- business to avoid or survive situations that tion depends on one assembly plant, and might lead to serious problems. What types that plant happens to be one-half mile from of risk are there? Although there are too the San Andreas Fault, it would be a good many to be listed here, a short list would idea to manage the risk of a possible earth- include property, liability, crime, product lia- quake. This may sound simple, but opera- bility, transportation, environmental, finan- tions become very complex very quickly. cial, professional, regulatory, and personnel Once the investigation process is complete, a risks. The risk management process identi- risk manager should have a good idea of the fies risks and determines how to manage types of risk that exist for the organization. them effectively. Techniques that managers The hard part is dealing with risks in a cost- use to handle risk vary; there are as many effective manner. Organizations do this both different ways of handling risk as there are by controlling accidental losses and by figur- risk managers. Some managers are interest- ing out how the organization will pay for ed in long-term stability while others are losses that occur. The balance of how losses interested in improving the bottom line of are controlled and financed will determine the corporation immediately. The important the effectiveness of the risk management factor for senior management of any organi- process. zation is the ability to make informed deci- sions. Controlling Losses Identifying Risk There are several ways to control losses. If a The first step of the risk management particular activity is too risky, an organiza- process is to determine the risks faced by the tion can avoid it, but that is not usually prac- organization. Good risk managers will know tical. Since risk is associated with virtually as much, if not more, about an organization every activity, risk managers determine how than any other employee in the organization. to reduce the frequency and severity of loss- They should know as much as possible es. Risk managers also control risks by main- about the organization’s operations. How taining geographic diversity, by duplicating does a risk manager obtain this knowledge? crucial operations, and by using subcontrac- Some common methods include confidential tors. Subcontracting high-risk portions of an questionnaires, financial statement analysis, operation to another party equipped to han- personal visits to physical locations, and dle the risk (either because of its financial sit- process diagramming. Confidential ques- uation or expertise in a particular area) is tionnaires are effective because they allow very common. employees to identify problems they may One of the easiest methods of controlling 10 RISK MANAGEMENT FOR IN-HOUSE COUNSEL 11 risk is to avoid it. If the risks associated with overall liability an organization may face a particular business operation are too great, because of the spill. Delay and dishonesty by the best method of handling the risks is to management when dealing with a loss may avoid them. Building a manufacturing plant make matters worse and could turn a bad on an earthquake fault, a flood plain, or in situation into one that threatens the exis- close proximity to another high-risk opera- tence of the organization. tion (such as a nuclear facility, a large oil/gas Using contractors to reduce risk may facility, or a manufacturing facility that pro- reduce both the frequency and severity of duces toxic chemicals) may simply not be loss. Contractors may be in a better financial worth the risk, no matter how inexpensive it position or have more expertise to deal with is to construct a facility on that site. If an a particular aspect of an operation. The most organization does not have the requisite common example of this form of loss control knowledge or resources necessary to effec- is leasing property. The risks associated with tively deal with the risks associated with an owning the property are accepted by the activity, it should not become involved (at landlord (at least if the lease is properly least until it has the minimum expertise nec- worded) who is in a better position to accept essary to make informed decisions). this risk because it is the landlord’s business Reducing the frequency of losses is one of to know real estate and manage its risk. the easiest and most cost-effective means of Manufacturers may be unwilling to accept dealing with risk. To know how to reduce risks associated with a certain aspect of their the frequency of losses, an organization manufacturing process because the environ- needs to know what causes them. Perils mental risks are too high. There may be Risk come in different varieties (natural, human, organizations that specialize in handling management and economic). Examples of natural perils these operations that can accept the risk. is a process include wind, lightning, tidal waves, and earthquakes. Human perils include error, Paying for Losses that reduces criminal activity, or espionage. Economic accidental or perils include inflation, market decline, and Once an organization has identified its risks currency fluctuations. A good example of a and has a plan in place to reduce the fre- business method used to reduce the frequency of loss- quency and severity of losses, how will the losses to an es attributable to crime involves security organization pay for the losses that occur? Options include treating the loss as an acceptable measures (such as fencing or regular securi- ty patrols of a plant). To reduce the frequen- expense, creating a reserve (either funded or level and cy of earthquake losses, organizations unfunded), borrowing funds, creating a cap- allows a should minimize their physical locations tive insurer, purchasing insurance, or hedg- near areas prone to earthquakes. Regardless ing via the purchase of certain investment business to of the actions taken to reduce the possibility vehicles. Purchasing insurance is the most avoid or of loss, losses will occur; but even though a common form of paying for losses, but insurance is not available or economically survive loss has already occurred there are ways to reduce the severity of the loss. viable for all risks. The best financing plans situations There are several ways to reduce the combine elements of several risk financing that might severity of losses. Organizations should techniques to create an overall risk plan that diversify operations geographically. A peril allows an organization to achieve its objec- lead to (especially weather-related) affecting an tives in the most efficient manner possible. serious operation in California should not affect Invariably, a plan includes some amount of another operation in Michigan. Sometimes risk retention by the organization. problems. organizations even create an entire duplicate Risk retention is a common technique for operation that remains idle until required. financing losses. Over a long period of time, The government’s use of duplicate com- it is cheaper for an organization to retain risk mand centers is a good example of this tech- because insurance premiums include over- nique. This is an expensive option, but if an head and profit for the insurance company. organization must continue operations, it However, bad timing may place an organiza- may be worth the investment. Diversifying tion at risk if sufficient funds are not avail- operations also has the advantage of making able to pay losses. The different retention losses easier to predict, and that makes techniques include paying losses as an financing the risk easier to accomplish. expense, using an unfunded or funded Taking quick action to control an environ- reserve account, borrowing funds, or using a mental spill is an example of reducing the captive insurer. Expensing losses when they 12 THE MICHIGAN BUSINESS LAW JOURNAL—SPRING 2005 occur is the least expensive and easiest pay for losses. Typically, organizations option, but it is not practical for large losses arrange for lines of credit in advance because that could force an organization into bank- if an organization waits until after a signifi- ruptcy. An organization may also find itself cant loss has occurred, it may have a difficult short of cash because of a business slow- time obtaining the funds. Financial institu- down that affects the cash reserves necessary tions may not have confidence in the organi- to pay the loss. Risk managers should keep zation’s recovery. The arrangement can take in mind that one of the goals of risk manage- the form of a letter of credit, catastrophe ment is to ensure the long-term viability of bond, or promissory notes. Catastrophe the organization. Small, predictable losses bonds are becoming more popular, especial- that an organization can afford, given its cur- ly for insurance companies looking to insure rent financial situation, are good candidates a particular risk, such as hurricanes. The to expense. Usually, the higher the amount at bonds work much the same way as normal risk, the more formalized and complex the corporate bonds, except that there is a provi- risk financing technique. The advantage of sion in the bond that allows the issuer to stop expensing losses as they occur is that admin- making interest and capital payments istrative costs are very low, since there is no should a particular event occur. The issuing formal risk management infrastructure to company uses the invested funds to pay support. losses incurred because of the specified Using an unfunded reserve is also a pop- event instead of paying the investor. For ular risk financing technique. Although this example, an investor purchases a catastro- Reducing the technique is more complex than expensing phe bond from XYZ Insurance Company frequency of losses, the administrative support necessary with a face value of $10,000. A provision in losses is one to create an unfunded reserve is minimal. the catastrophe bond states that if a Category The accounting department for the organiza- 3 or higher hurricane strikes Broward of the easiest tion creates a reserve account equal to the County, Florida, the principal and interest and most amount of expected or typical losses. Assets payments cease, and XYZ Insurance are not set aside to fund the reserve, but the Company uses the funds to pay for losses cost-effective amount reserved does offset the profits or incurred because of the hurricane. In return, means of accumulated earnings of the organization, so investors receive a higher rate of interest for dealing with management has a better picture of the the higher risk associated with catastrophe financial health of the organization. bonds. risk. Although the unfunded reserve technique is Captive insurers are insurers formed by better than expensing losses, there are risks an organization or a group of organizations associated with this technique. The most to insure the specific needs of the organiza- obvious is that no assets are set aside to pay tions. A pure captive insurer is formed to for the losses. An organization may find serve the insurance needs of one parent, a itself with insufficient assets to pay the loss- group captive serves multiple parents, and a es. The intent of this technique is to notify group of related or similar organizations management that funds are required to pay may band together to form association cap- for expected losses, and that the funds are tives. There are several advantages to form- unavailable for other purposes. ing a captive insurer. They allow an organi- The next alternative to consider in risk zation greater control over the insurance and financing is the funded reserve. This tech- risk management process, carry financial nique works the same way as the unfunded and tax advantages, and allow an organiza- reserve, except that assets are set aside to tion to purchase insurance that otherwise pay for the losses. The risk manager typical- may not be available. Captive insurers are ly invests cash in a liquid investment vehicle especially popular with organizations that that earns interest and uses these funds to have a difficult time obtaining commercial pay losses as they occur. There are also risks insurance because of unusual risks associat- associated with this technique, the first being ed with that organization’s operation. that a large loss may occur before sufficient Organizations usually form captives off- reserves have been established to pay the shore because capitalization requirements loss. The second is that management may and regulation are less burdensome. use the earmarked funds for another use, When people think of risk, they usually leaving no funds to pay losses. think of insurance. Organizations purchase An organization can also borrow funds to insurance because it is a good risk financing RISK MANAGEMENT FOR IN-HOUSE COUNSEL 13 option, is relatively efficient, and the insured Policies also contain provisions exclud- obtains the risk management expertise of the ing coverage. These provisions eliminate insurance company’s employees. In some insurance coverage under certain circum- cases (auto insurance and workers’ compen- stances. For instance, a liability policy may sation insurance), the law requires insurance be willing to accept liquor liability for an and even sets forth minimum coverage organization that is not in the restaurant or amounts. Large organizations usually pur- bar business. To provide coverage for social chase a commercial package policy that con- events, but not bar operations, the insurance tains several components. Common compo- company inserts an exclusion into the policy nents include coverage for property (both eliminating liquor liability coverage for all real and personal), liability, crime, equip- events in which the insured sells alcohol for ment breakdown (f/k/a boiler and machin- a profit. Typical clauses also exclude cover- ery coverage), inland or ocean marine, auto, age for such events as war, earthquakes, and director and officer liability, professional lia- floods, although earthquake and flood insur- bility (attorneys, architects, and doctors), ance coverages are available. business income loss, workers’ compensa- Conditions are lists of items an insured tion, and employment practices coverage. must comply with in order to receive pay- Small businesses may qualify for a busines- ment from the insurer. Common conditions sowners policy that includes these compo- include the duty to file claims timely, pay nents in one comprehensive package that is premiums, file affidavits of loss if required, easier to administer and purchase. Complex and generally cooperate with the insurer organizations typically work with a com- during the claim process. Policies also gener- Purchasing mercial insurance broker to obtain all of the ally contain miscellaneous provisions that insurance is required coverage for the best possible price. do not fit into one of the preceding cate- the most Even though there are several standard com- gories. They usually dictate the administra- mercial insurance policies (the two major tive processes between the parties (arbitra- common form providers are the Insurance Services Office tion, mediation, etc.). of paying for and the American Association of Insurance Commercial property insurance covers Services), the policies differ and organiza- real property and personal property owned losses, but tions must understand the policies to protect by the insured (there is generally also a small insurance their interests. This discussion focuses on amount of coverage for personal property is not Insurance Services Office forms. owned by others, but that is beyond the Insurance policies contain different sec- scope of this article). Coverage is also avail- available or tions. Although policies differ, they all con- able for leased real and personal property. economically tain declarations, definitions, insuring agree- The insurance policy declarations list the ments, exclusions, conditions, and miscella- insured, along with the policy limits and viable for all neous provisions. The declarations are usu- applicable deductibles. Property insurance risks. ally contained in a single page and declare may also be subject to coinsurance require- the parties, the property insured, policy lim- ments. Essentially, a coinsurance provision its, deductibles, premium information, and requires an insured to maintain minimum the coverage dates of the policy. It is general- insurance on a property (usually 80 percent ly a good overall summation of the policy. of the value). If the insured does not main- Definitional sections define specific terms tain minimum levels of insurance, unexpect- for policy purposes. Terms such as you, your, ed out-of-pocket expenses may result. and even auto are defined in these sections. Coinsurance is a mathematical formula. Judges usually consider insurance policies In determining claim payments, insurance contracts of adhesion, and insurance compa- companies divide the amount of insurance nies insert definitional sections to avoid carried by the insured by the amount of varying interpretations of the policy. insurance required by the coinsurance provi- Insuring agreements consist of a policy state- sion and then multiply this amount by the ment in which the insurer agrees to provide claimed loss. For example, ABC Corporation coverage to the insured as long as no exclu- owns an office building worth $1 million. sion applies and the insured satisfies XYZ Insurance Company insures the build- the conditions of the policy. A policy may ing by issuing a policy requiring ABC to contain more than one insuring agreement insure the building at 80 percent of its value (each individual coverage category may ($800,000). ABC decides to save money on have its own). its insurance premium, only insures the 14 THE MICHIGAN BUSINESS LAW JOURNAL—SPRING 2005 building for $600,000; and then suffers a fire the policy period). Claim forms differ in that loss estimated at $400,000. ABC may believe they pay when the insured files a claim with that XYZ will cover the entire loss (excluding the insurance company. Insurance compa- deductible) because the loss is less than the nies using claim-based forms pay for claims policy limit, but the coinsurance provision filed with the insurance company during the prohibits a full recovery: $600,000 divided by policy period. Commercial liability policies $800,000 equals .75, which XYZ multiplies typically cover three different exposures: against the loss, $400,000. The result premises and operations liability, products ($300,000) requires ABC to pay $100,000 of liability, and certain intentional torts. the loss from its own funds. ABC may General liability policies exclude many com- believe it saved money, but ultimately the mon causes of claims, including auto, work- $100,000 expense outweighs the benefit of a ers’ compensation, and pollution liability cheaper premium. (organizations purchase these coverages as Insureds face several other decisions endorsements to the general liability policy when buying property insurance, the most or as a separate policy). important being what perils to insure the Liability coverage depends on condi- property against. Property insurance comes tions. A claim must occur during the covered in three basic forms: basic, broad, and spe- period, in a covered location, and subject to cial. The forms differ, but a basic policy cov- the miscellaneous conditions, limits, and ers property against fire, lightning, explo- exclusions of the policy. Premises and opera- sion, windstorm, hail, smoke, riot, vandal- tions coverage is a crucial part of a liability Risk ism, sprinkler leakage, sinkhole collapse, policy. This coverage pays liability claims managers volcanic action, and limited damages caused resulting from the organization’s premises should keep by vehicles. Broad form coverage includes and operations. A classic example of a prem- all the basic coverage as well as coverage ises claim is a slip-and-fall injury by a cus- in mind that against falling objects, weight of snow and tomer in a store. A good example of opera- one of the ice, limited water damage, and collapse. tions liability is a customer injury caused by Special form coverage includes all perils an employee’s negligent operation of a goals of risk except those specifically excluded by the power tool on covered premises. management policy. Obviously, the premium increases as Products liability coverage typically cov- is to ensure an insured purchases more coverage. ers liability claims arising from completed Insureds must analyze their policies careful- products or operations of the insured. For the long-term ly to ensure they obtain the coverage need- the products/completed operations cover- viability of the ed, without obtaining too much and thereby age to apply, the product or completed oper- increasing premium cost. ations should not be in the physical posses- organization. With organizations cutting expenses to a sion of the named insured (the organization minimum, a risk manager must analyze the producing the product), the product or oper- options carefully. Another item an organiza- ations must be complete, and the property tion should remember when considering damage or bodily injury must occur away property insurance is the loss of business from the named insured’s premises. If these income and increased expenses resulting conditions are not satisfied, the insurance from a loss. If a manufacturing plant or company will consider the claim a premis- warehouse is lost to fire, the owner/operator es/operations claim that is subject to a dif- of the plant loses the income generated by ferent coverage limit and deductible. Like the plant’s operation. This loss is insurable premises and operations coverage, product for profit and nonprofit organizations and and completed operations coverage is sub- helps the organization become fully opera- ject to many exclusions and conditions. An tional. organization must be familiar with the Liability insurance is crucial to protect exclusions and conditions associated with organizations from claims filed by unrelated this coverage to ensure proper risk financ- parties and the costs associated with defend- ing. ing the organization from those claims. The last major category covered by gen- There are two basic forms of commercial lia- eral liability policies is coverage for selected bility policies, occurrence forms and claim intentional torts. Claims for false arrest, forms. Occurrence forms pay claims that wrongful eviction, defamation, privacy inva- occur during the policy period (the event sion, and assault (as well as others) are typi- forming the basis of the claim occurs during cally included in this coverage. Like the RISK MANAGEMENT FOR IN-HOUSE COUNSEL 15 other liability coverages, this coverage is instruments) use inland marine policies. subject to many exclusions and conditions. Sometimes this coverage is available Crime insurance is necessary because of through an endorsement to the commercial the exclusions contained in many commer- property policy. cial property and inland marine (to be dis- Commercial auto policies operate simi- cussed later in this article) policies. Most larly to personal auto policies. The policies commercial property and inland marine protect against physical damage to the auto policies exclude coverage for money, securi- and liability related to the use of the auto. ties, and employee theft. There are many dif- Organizations must ensure that all necessary ferent forms of crime insurance. Common state requirements are satisfied. Some states coverages contained in crime policies are have pure no-fault systems, others modified employee theft, forgery, theft of money and no-fault systems, and others are tort based. securities inside the insured’s premises, rob- Coverage requirements also differ among bery or safe burglary inside the insured’s the states. premises, and computer fraud (which is Director and officer liability insurance especially important for most organiza- provides liability protection for individual tions). directors and officers of an organization and Equipment breakdown insurance (for- the collective group. Organizations typically merly known as boiler and machinery insur- agree to indemnify directors and officers for ance) covers many different forms of equip- defense costs incurred because of a lawsuit, ment, not just boilers. Commercial property but the corporation may submit a claim policies exclude losses because of the break- under the directors and officer liability poli- Liability down of electrical equipment, mechanical cy for these costs. Director and officer liabil- insurance is failure, and boiler explosion. Equipment ity policies have increased in importance crucial to breakdown insurance covers losses resulting and cost because of the corporate gover- from these types of perils. Examples of the nance scandals in recent years. protect types of equipment that are typically cov- The remaining types of policies are pro- organizations ered include electrical generators, transform- fessional liability, workers’ compensation, ers, steam boilers, pumps, HVAC equip- and employers’ liability insurance. from claims ment, copiers, fax machines, and sometimes Professional liability insurance is specialized filed by unre- even computing equipment. Steam boiler coverage for certain classes of professionals. lated parties coverage is a highly specialized product that Architects, accountants, lawyers, and doc- very few companies offer. These insurers tors all have specific professional liability and the costs require a strict inspection and maintenance forms that pertain to their field. associated program for the boilers for coverage to Organizations purchase workers’ compensa- apply. tion insurance to pay medical, lost wages, with defend- Inland and ocean marine coverage are and rehabilitation costs because of work- ing the organ- also common components of a comprehen- related injuries suffered by employees. ization from sive commercial insurance package. Organizations purchase employers’ liability Traditional inland and ocean marine cover- insurance to pay for claims associated with those claims. age provided protection for property in tran- certain employee-related suits. Employers’ sit, but that coverage has expanded. Ocean liability insurance protects organizations marine coverage has three main categories: from wrongful termination, discrimination, hull insurance for the ship, cargo insurance, and harassment suits filed by employees. and protection and indemnity (essentially Unlike workers’ compensation insurance, liability coverage). Inland marine insurance the employee is not the beneficiary. also covers property in transit (typically over land), but insurance companies have Conclusion expanded coverage to personal property Risk management is a challenging and com- used in various locations. Commercial prop- plicated field. Risk managers should have erty policies typically exclude personal extensive knowledge of the organization’s property losses that occur outside a specific operations, as well as expertise in risk con- distance from the insured’s premises— trol and financing. They ensure that the sometimes the distance is as short as 100 feet. organization’s objectives are met by ensur- Organizations wishing to protect property ing that the organization will survive losses, used at different locations (construction disasters (both man-made and natural), and tools, photographer’s equipment, or musical financial upheavals. Insurance is a major 16 THE MICHIGAN BUSINESS LAW JOURNAL—SPRING 2005 risk-financing tool but it has limitations and is potentially expensive and ineffective if not used correctly. The most important point to take away from this article is the importance of understanding an organization’s insur- ance coverage. Insurance policies differ, and to be most effective, a risk manager must know the coverages, conditions, and exclu- sions contained within each policy held by the organization. Although revenue-generat- ing departments generate more attention and accolades, when disaster strikes, all eyes turn to the risk management area of a busi- ness. John A. Chamberlain is an assistant gen- eral counsel and legal affairs manager for The Auto Club Group, which is a regional AAA organization that includes AAA Michigan. Mr. Chamberlain received a Juris Doctorate Cum Laude from the Detroit College of Law in 1991 and a Master of Law Letters from Wayne State University in 2001. In 2004, he received the chartered property casualty under- writer (CPCU) designation from the American Institute for Chartered Property Casualty Underwriters. He has also received the associate in risk manage- ment (ARM) and associate in regulation and compliance (ARC) designations from the Insurance Institute of America. He currently serves as treasurer for the MSU/Detroit College of Law Alumni Association and Candidate Development Chair for the Greater Detroit Chapter of CPCU, and serves on the New Designee Task Force for the CPCU Society. Pension Funding Basics for the In-House Attorney By Michael D. Fitzpatrick Introduction declining, and foreign competition has stymied price growth. In the typical compa- With the decline of the equity markets and ny, these issues usually fall in the finance record-low interest rates over the last sever- department, but in-house counsel must also al years, liability for defined benefit plan be involved. Pension-funding rules are obligations has become a larger part of com- statutory and are governed by ERISA. In- panies’ balance sheets. For defined benefit house counsel needs to be aware of the risks plans, today’s economic climate is similar to these plans pose to the financial health of the that of the 1980s, when much of the steel company. It will be the responsibility of the industry filed for bankruptcy protection, in-house counsel to work with employee divesting their legacy retirement programs benefit, actuarial, and financial advisors to to the federally chartered pension insurance develop a strategy to deal with pension lia- agency, the Pension Benefit Guaranty bilities and, potentially, the PBGC and the Corporation (PBGC). The most notable case Internal Revenue Service (IRS). Before that was Bethlehem Steel, which eventually shift- first meeting, counsel should become famil- ed $3.7 billion of liability to the PBGC. iar with the financial statements of the com- Recently, the airline industry, already fragile pany, especially the footnotes, with an from a slowing economy when the events of understanding of the funding rules and how September 11, 2001, happened, has faced a they differ from the accounting rules. similar economic climate. Many airlines Although pension funding and accounting have filed for bankruptcy protection and concepts are similar, the rules for calculating have terminated their defined benefit plans, the relevant amounts of liability are very dif- leaving the PBGC to administer the plans. ferent. The PBGC became trustee for the remaining This article provides a basic understand- plans of US Airways, amounting to a total ing of the funding requirements of single- claim of $3 billion.1 Many predict that the employer defined benefit plans. For any pro- automotive industry will be the next indus- fessional who does not regularly deal in pen- try hit with pension woes. The pension plan sion accounting and funding, these rules can of General Motors made news when it seem extraordinarily complex, and it can issued $13 billion in bonds to fund a portion take a good deal of time to understand the of its $25.4 billion unfunded pension liabili- basics of how the accounting and funding ty. Oxford Automotive, the Troy, Michigan- rules work and how they differ from each based auto-parts supplier, terminated its other. Pension plans have a vocabulary all undefended pension plan, allowing the their own. Actuaries and accountants will PBGC to take over responsibility.2 It is now speak of normal cost, past service amend- nearly impossible to pick up a national ments, full funding limitation, the discount newspaper without reading a headline rate for Generally Accepted Accounting claiming that the crisis in private pensions is Principles (GAAP) versus the discount rate going to become the Savings & Loan debacle for funding, plan year versus fiscal year, of this decade and that the federal govern- plan experience, and other terms and ment will be required to bail out the PBGC. assumptions. However, understanding the The agency has reported a deficit for the basic structure of the funding system and 2004 fiscal year of $23.3 billion.3 applying some rudimentary finance and Pensions are becoming more of a concern accounting skills will make pension financial for smaller companies as well. The liabilities analysis relatively straightforward. As an for benefits promised in healthier economic accounting professor of mine once said, if circumstances are growing more rapidly you love accrual accounting, it doesn’t get than the current workforce, margins are any better. 17 18 THE MICHIGAN BUSINESS LAW JOURNAL—SPRING 2005 The Basic Principles of Pension erly funded, the government exercises con- Funding trol by imposing an excise tax and interest penalties.6 The simplest way to understand a pension The plan sponsor must maintain the min- obligation is to think of a zero-coupon bond. imum funding standard for all plan years A zero-coupon bond is a debt instrument that the plan is a qualified plan under the that does not bear interest like a normal Internal Revenue Code (IRC). The minimum bond. Rather, the bond is sold at a substan- funding standard will be met if there is no tial discount from its par, or face, value. At accumulated funding deficiency for the plan maturity, the holder of the bond receives the at the end of the plan year, which means that full face value of the bond. In a typical zero- the plan is, at a minimum, fully funded. The coupon bond, a company would borrow the minimum funding standard is looked at on a market value of the bond from the bond- plan year basis, regardless of the fiscal year holder and agree to pay the face amount to of the plan sponsor. The plan year and the the bondholder at maturity. The market fiscal year do not have to coincide,7 but it is value of a zero-coupon bond is determined typically a calendar year.8 by calculating the present value of the face amount, using the current day’s interest rate for notes having similar terms and risks. For Calculating the Standard Funding example, a $10,000 zero-coupon bond with a Account semiannual market interest rate of 5 percent, In-house payable in 20 years, would have a market In General counsel needs value of $1,420. With a pension plan, the concept is simi- Thus far, pension funding has been straight- to be aware lar, except that the company does not receive forward; there must be sufficient assets to of the risks any cash in the transaction. Rather, the com- cover the present value of the future liabili- pany receives labor from its employees and ties. Calculating that number is, however, these plans compensates them with cash and a promise difficult. Using the zero-coupon bond analo- pose to the to pay additional cash at retirement. For tax gy, the value of a pension liability, like that of purposes, the company values that obliga- a bond, changes over time. Unlike bonds, financial which mainly fluctuate because of interest tion and deducts it from its normal operating health of the expenses. rate changes, the value of a pension liability company. Although this is a gross oversimplifica- changes because of a number of different fac- tion of pensions, it serves to illustrate some tors including assumptions about wage key principles. The legal obligation to fund growth, mortality, investment rates, and the retirement benefit arises when the other economic and demographic factors. employee renders the service, i.e., a liability If it were possible to determine with is created; the retirement benefit is a current absolute certainty how long a person was expense to the company; and the value of the going to work, what wage increases a person benefit in today’s dollars is substantially less would get during their career, how long after than at the time the benefit is paid. retirement a person was going to live, how Once the liability is determined, the com- long his or her spouse was going to live, and pany must set aside sufficient assets to how the financial markets were going to per- secure the promise. To fund a plan, ERISA form during that time, then determining requires a plan to maintain a standard fund- pension liability would be simple. It would ing account.4 The standard funding account be a matter of determining how much that is the accumulation of the liabilities and person was going to receive during retire- credits of the plan over the plan’s life. In ment, starting in the year of retirement and other words, take the current assets5 in the ending at death. That amount would be dis- plan and subtract the present value of the counted to a present value using the certain future liabilities to determine the status of return that the market was going to give the standard funding account. This amount during that same period. Then, each year, as will fluctuate in any given year such that the the person worked, the company could put account will be fully funded, overfunded, or the appropriate amount of money into the underfunded. The purpose of the standard pension plan so that the beneficiary receives funding account is to allow the government the last pension payment at or slightly before and the employer to know when a plan is death. properly funded. When the plan is not prop- Life is not that certain. When a company PENSION FUNDING BASICS FOR THE IN-HOUSE ATTORNEY 19 hires an employee, it has no way of knowing have accrued in that year of service. The pro- if that employee will stay until retirement or jected benefit method, on the other hand, leave early because of layoff, disability, or calculates the estimated benefit that will be death. In some instances, some of these earned over the entire time of the plan and unknowns will have an economic benefit to spreads it out equally over working years of the pension plan: an employee switches jobs employees covered by the plan. In the before the vesting of his or her benefits or a accrued method, there is a smaller liability beneficiary dies before his or her actuarially recognized earlier in the employee’s work- projected life span. In other instances, these ing life. Because the benefits earned in year unknowns will have a negative economic one of employment, assuming 29 years until impact on the pension plan: salary increases retirement, are less on a present value basis are greater than expected or beneficiaries than benefits earned in year 29 with one year live longer than actuarially projected. All of until retirement, this method will recognize these changes get reflected either as a credit higher costs when the workforce is closer to or charge to the standard funding account. retirement. Under the projected benefit All of these factors are used to calculate method, there is an attempt to spread the the standard fuding account. For a plan year, cost out over the length of the employees’ the standard funding account will be work life with the company. In early years, charged for eight items: (1) normal cost, (2) this number will be higher than the accrued amortization of past service liability, (3) benefit cost method, but will decrease rela- amortization of past service liability because tive to the accrued benefit cost method as the of the adoption of plan amendments, (4) the worker nears retirement. For any amortization of the net experience loss, (5) To illustrate the effects of these two meth- professional the amortization of the net loss occurring ods, assume that a worker is 35 years old who does not because of changes in actuarial assumptions, and normal retirement age under the plan is (6) waivers of funding deficiencies, (7) the 65. The projected length of employment for regularly deal amount necessary to amortize amounts cred- this individual is 30 years. Under the in pension ited to the funding standard account,9 and (8) the amount of the unfunded current lia- accrued benefit cost method, the first year accounting will be looked at in isolation. There is no bility, which consists of the deficit reduction and funding, assumption that the person will be working contribution and the unpredictable contin- these rules for the company the following year. The gent event amount.10 The standard funding account will receive credits for the following actuary simply looks at what retirement ben- can seem six items: (1) amounts contributed by the efit this person would have at the normal extraordinari- employer,11 (2) the amortization of the net retirement age for working this single year. If the plan states that a person will earn 1 per- ly complex. decrease in unfunded past service liability resulting from plan amendments, (3) the cent of compensation for every year that the amortization of the net experience gain, (4) person is employed by the company and the the amortization of the net gain due to a person earns $25,000 a year in compensation, change in the actuarial assumptions, (5) the then the employee is entitled to receive $250 amount of the waived funding deficiency, a year starting at normal retirement until and (6) the excess of the deficit balance death. Assuming that the person will live 20 between the alternative minimum funding years after retirement and that the invest- standard account and the resumption of the ment will earn a return of 8 percent, the standard funding account.12 amount that would be needed to purchase Actuarial Methods and Normal Cost an annuity at normal retirement age is $2,455. This amount however needs to be Before going through each of the credits and charges, it is necessary to return to the calcu- discounted back to present day to determine lation of pension liabilities. Although we how much would have to be invested today, used the analogy of zero-coupon bonds to to grow to $2,455. Assuming an 8 percent develop the conceptual framework of pen- investment rate of return and 30 years until sion plans, a more detailed explanation is in normal retirement age, the amount needed order. Actuaries use two basic methods to today is $244. value the pension liability, the accrued benefit However, the chance that this individual cost method and the projected benefit method. will make it to normal retirement is not The accrued benefit cost method calcu- absolutely certain. The person could leave lates the liability based on the benefits that for another job or die before the normal 20 THE MICHIGAN BUSINESS LAW JOURNAL—SPRING 2005 retirement date. This amount is reduced fur- fits based on service that has been rendered ther because of that possibility. This method by the employee in prior periods. The terms is done annually for each employee. As the used for this increased liability are past serv- years continue, the probabilities change with ice liability, prior service cost, or retroactive ben- regard to mortality and job continuity and efit. Because employers are expected to see adjustments are made to take these changes future economic benefits from granting these into account. retroactive benefits, the accounting rules do Under the projected benefit cost method, not require these additional costs to be rec- the assumption is that the employee will ognized at the time of the adoption of the continue to work at that wage level until increased benefit. Rather, these additional normal retirement age. Assuming 30 years costs are amortized in an equal amount over until retirement, the employee would be due the periods in which the employee is expect- an annual benefit of $7,500 ($25,000 x 1 per- ed to work. The converse is also true. When cent x 30 years of service). $73,636 would a plan amendment reduces the cost of the need to be accumulated at retirement age to pension, the reduction is used to offset any pay a $7,500 benefit annually for 20 years. In existing unrecognized prior service cost, and order to accumulate that money, assuming any excess is amortized on the same basis as an 8 percent rate of return on investment, the cost of the increase. In pension funding, $650 would have to be contributed each year these additional liabilities are amortized for 30 years. Again, because of the uncertain- equally over a 30-year period. ty over the tenure of the employee, this pres- Actuaries use ent value amount is reduced to account for Experience Gains and Losses two basic that possibility. Experience gains and losses are the changes methods to Actuarial methods can have a profound in the amount of projected benefit obliga- effect on how much must be contributed in tions or the change in plan assets resulting value the any given year. In the above example, there from what has actually happened and what pension is a difference of $406, which is 2½ times was assumed to have happened. Recall that more under the projected cost method than the likelihood that a person would retire at a liability, the certain age or live to a certain age was taken under the accrued benefit cost method. This accrued can be a significant amount and make a dif- into account in discounting the pension obli- gation. In actuality, actuaries use statistical benefit cost ference in the deductibility of the contribu- methods to determine the liability based on tions for the company. If the company method and expects to make more money in later years, it the population of the beneficiaries. An actu- the projected ary does not assess how long a particular will want to recognize a higher pension individual will live or when he or she will benefit expense later. Because an actuarial method is retire. Rather, the actuary will estimate, difficult to change once it has been estab- method. lished, consideration should be given to the based on the population’s size and charac- teristics, that a certain percent will retire or needs of the business.13 die. The actuary uses that statistical predic- The discussion on actuarial methods is tion to calculate the liability. At the end of meant to get to normal cost. Normal cost is every plan year, those statistical assump- the total amount of benefits provided to the tions are checked against what actually hap- beneficiaries in a particular year. In the pened. If 2 percent of the population is example above, if the accrued benefit cost expected to die, but only 1.9 percent actually were used, the normal cost would be $244 dies, then the plan would have an experi- multiplied by the number of participants ence loss. For funding purposes, this addi- with the same pension benefit. In the tional obligation would be amortized over accounting context, this is referred to as serv- five years. ice cost. Changes in Actuarial Assumptions Prior Service Cost Because pension benefits will be paid at If a company did not change the benefits it some indeterminate time in the future, actu- gave its employees, pension funding and aries make assumptions on a litany of differ- accounting would not be too difficult. ent factors that affect the amount of money However, employers often increase benefits needed to fund retirement benefits for a cur- provided to employees. This increase is done rent group that will be quite different in the through an amendment to the plan. In some future. Some will die young, others will live cases, employers will increase future bene- longer than expected, some will retire early, PENSION FUNDING BASICS FOR THE IN-HOUSE ATTORNEY 21 and others will suffer a disability. Economic but can be up to three months earlier. If the history 40 years hence will be different from measurement date is June 30, the company current economic history. Markets may rise selects a discount rate based on applicable at historical levels or they may remain flat, factors external to the company and the plan. wage growth may be as expected or it may The discount rate that is selected is used to stagnate, interest rates may remain at the discount the pension liability as of that date. current low levels, or rampant inflation of This interest rate is really a spot rate. It is the 1970s could return. Since no person can also used to determine the pension expenses know the future course of events, actuaries for the next fiscal year. Once the discount make assumptions about these events. These rate is selected, it does not change until the assumptions fall into two broad categories: following June 30, unless a significant event economics and demographics. Economic occurs. assumptions include salary increases, inter- est rate changes, inflation, and investment Required Funding of the Standard Account returns. Demographic assumptions take into Once the calculation of the funding for the account life expectancy, employment termi- standard account has been made, it is a sim- nation, and disability of the beneficiaries. ple calculation to determine whether a com- Taken together, these actuarial assumptions pany is required to put additional money can have a profound impact on the pension into the pension plan. The IRC requires liability and funding requirements. quarterly payments to fund the plan liabili- ty.17 For a calendar year plan, the quarterly [A]ctuaries Interest Rates payments are made on the 15th day of April, When the term interest rate is used in pension July, October, and January, with correspon- make funding, it commonly refers to the rate at ding dates for fiscal year plans. The plan assumptions which the future liabilities are discounted to assets18 are compared to the plan liabilities arrive at the present value. It is also called on a percentage basis. If the liability percent- on a litany of the valuation interest rate. The valuation age is at least 100 percent, then quarterly different interest rate is meant to be a reasonable payments are not required.19 Nevertheless, a factors that approximation of the future rate of return on company can contribute additional money the plan’s assets. For accounting purposes, to the plan. However, the full funding limita- affect the this interest rate will fluctuate from plan to tion may limit the contributions a company amount of plan, reflecting the different investment can make to the plan. If the full funding lim- strategies, asset allocation, and opinions itation is reached, contributions made to the money about future returns on the plan. As with plan are not deductible. Practically speaking, needed to bond prices, when the valuation interest rate companies do not make contributions fund increases, the pension liability decreases. greater than the full funding limitation. Any Conversely, when the valuation interest rate contributions greater than that number are retirement decreases, the pension liability increases. not deductible and are subject to an excise benefits for a The Treasury Department and the IRS are tax.20 There are additional funding require- current group responsible for issuing the valuation interest rate. In 2004, the Pension Funding Equity ments for severely underfunded plans. that will be Act replaced the 30-year Treasury bond rate These additional funding requirements are quite different with a new rate using a four-year average of called deficit reduction contributions (DRCs). A plan is required to make DRCs if in the future. high-quality, long-term corporate bonds.14 its funded current liability percentage for the They also replaced the method used to deter- current plan year is less than 80 percent or if mine the new rate.15 The PBGC publishes it is less than 90 percent for the two immedi- the discount rate to be used to determine the ately preceding years. Like calculating the variable premium paid to PBGC as the insur- standard funding account, determining the er of the pension plan.16 applicable DRC payments involves a com- For pension accounting, the interest rate plex calculation and an understanding of is referred to as the discount rate and reflects arcane technical definitions, which is beyond the rate of return on high-quality fixed the scope of this article. The issue of DRCs, income securities on the measurement date. however, is the subject of much of the leg- The measurement date is a date that is select- islative efforts in Congress today and the ed by the company that usually corresponds reason many companies are calling for pen- to the last day of the company’s fiscal year, sion reform. 22 THE MICHIGAN BUSINESS LAW JOURNAL—SPRING 2005 Conclusion Year 2004, Pension Benefit Guaranty Corporation, avail- able at http://www.pbgc.gov/publications/annrpt/ Pension funding and deficit reduction con- PAR1104.pdf (Nov 15, 2004). tributions in particular have been receiving a 4. IRC 412 (b); ERISA 302(b)(29 USC 1082(b)). 5. The funding standard account actually contains good deal of press lately. The Bush more items than just financial assets. A more detailed Administration has indicated that it is an explanation of the credits is contained in the next sec- tion. area that will receive legislative attention. 6. IRC 4971. The current pension funding scheme is in 7. In the spirit of keeping this explanation simple, need of an overhaul. Both the full-funding the assumption will be that the plan year and fiscal year of the sponsor coincides. limitation and DRCs have contributed to the 8. Once a plan year is adopted, it cannot be changed PBGC’s woes. These two concepts are count- without the authorization of the IRS. IRC 412(c)(5). er-cyclical and counter-productive to a 9. This item relates to receiving a funding waiver from the IRS. Funding waivers are beyond the scope of healthy pension system. When the economy this article. A funding waiver greatly increases the com- is doing well, the market is usually increas- plexity of explaining the pension funding rules. It is ing, interests rates are higher, and pensions enough to know that a funding waiver allows a company to withhold the cash contribution to the plan for a given are calculated as fully funded. When these plan year. However, for the sake of calculating the fund- stars align, companies are making money ing standard account and balancing it for the affected but are unable to put additional contribu- plan year, it is assumed that the entire amount was con- tributed. The waiver amount is then amortized and paid tions into their pension plans because of the over five years. full-funding limitation. It does not make 10. This item will occur in instances where a single- sound economic sense to put money into a employer pension plan has become severely underfunded and an additional funding mechanism is employed. Because this plan without getting a tax deduction. Even if These additional funding requirements are called deficit area is likely a company did want to put money into the reduction contributions. Deficit reduction contributions plan and forgo the deduction, the company are beyond the scope of this article. Nonetheless, in a sit- to receive uation where a company is looking at a severe shortfall in would be subject to an excise tax for putting funding, deficit reduction contributions and funding greater public too much money into the plan. Similarly, waivers are two factors that will figure prominently in any planning to stabilize a pension plan. DRCs are required when a company can and legisla- least afford it, like the economic situation in 11. For single employer plans, these amounts include money contributed during the plan year, within 2½ tive attention early 2005 when interest rates are low, months thereafter and within 8½ months after the end of extreme pressure is on company margins, the plan year. IRC 412(c)(10) and ERISA 302(c)(10), 29 in the next and market returns are anemic. USC 1082(c)(10). Much like making quarterly tax pay- ments, the contributions are made quarterly with a catch few years, in- Because this area is likely to receive up payment due 10½ months after the end of the plan greater public and legislative attention in the year. house counsel 12. The alternative minimum funding standard next few years, in-house counsel should account is a way to avoid paying the excise tax required should take a take a proactive role with the finance staff to by IRC 4971 and to avoid a reportable event, which proactive role manage the risk. The risk is not just financial. requires notification to plan participants and the PBGC. Pension liabilities can affect covenants in The alternative minimum funding standard account is with the loan documents and can also have an impact calculated in a similar fashion to the funding standard account: the charges are netted against the credits. The finance staff on the negotiation of acquisitions and charges to the account are (1) the lesser of normal cost to manage divestitures. using the funding method the plan uses or the normal Without a rudimentary understanding of cost calculated using a form of the accrued benefit cost the risk. these issues and the potential risks they method, (2) the excess of the accrued benefits over the fair market value of the assets, and (3) the excess of any impose, a pension plan can become a trap for credits in the alternative minimum funding account counsel negotiating matters separate from from prior years. This third charge effectively prevents a employee benefits. However, awareness of company from building up credits in this account to avoid making a necessary contribution. On the credit the issues can increase the chance of a suc- side of the alternative minimum funding standard cessful negotiation and the management of account, the only item that gets counted is the amounts significant risk. contributed during the plan year and within 8½ months of the end of the plan year. 13. See Rev Proc 78-73, 1978-2 CB 540; Rev Proc NOTES 85-29, 1985-1 CB 581, as modified by Rev Proc 92-48, 1992-1 CB 987. 1. See Testimony of Bradly D. Belt, Executive 14. Treasury Report, Weighted Average Interest Rate Director, Pension Benefit Guaranty Corporation, Before Modification, Notice 2004-34, available at the House Committee on Education and the Workforce, http://www.treas.gov/press/releases/reports/notice.pdf available at http://www.pbgc.gov/news/speeches/testi- (last checked Mar 24, 2004). mony_030205am.htm (Mar 2, 2005). 15. Id. 2. Press Release, Pension Benefit Guaranty 16. See, Report, Pension Benefit Guaranty Corporation, PBGC Protects Pensions at Oxford Corporation, Required Interest Rates for Valuing Vested Automotive, available at http://www.pbgc.gov/ Benefits for PBGC’s Variable Rate Premium, available at news/press_releases/2005/pr05_27.htm (Feb 25, 2005). http://www.pbgc.gov/services/interest/VRPRATE.HTM 3. Performance and Accountability Report: Fiscal #1989 (last modified Mar 15, 2005). PENSION FUNDING BASICS FOR THE IN-HOUSE ATTORNEY 23 17. IRC 412(m)(1). 18. The assets are measured using the actuarial value of assets (AVA). The AVA may be equal the fair market value of the assets or it may be assessed to take into account unrealized or unexpected gains over a period of time, which are amortized for a period not to exceed five years. The AVA may not be below 80 percent of the fair market value or greater than 120 percent of the fair mar- ket value. 19. See ERISA 302(e)(29 USC 1082(e)) and IRC 412(n). 20. IRC 4972. Michael D. Fitzpatrick is the general counsel for Phillips Service Industries, Inc. (PSI), a Livonia, Michigan based manufacturing and service company. PSI maintains manufacturing plants throughout the United States and pro- vides products and services worldwide. Mr. Fitzpatrick obtained his undergradu- ate degree from Albion College, his law degree from Wayne State University, and an MBA from the Ross School of Business at the University of Michigan. He is a member of the American Corporate Counsel Association and the Business Law Sections of the State Bar of Michigan and the American Bar Association. Documentary Letters of Credit in International Transactions By Chad West Introduction the use of the documentary LC in an interna- tional transaction. The drafters of the revisions to Article 5 of the Uniform Commercial Code (UCC), which covers documentary letters of credit The Documentary Letter of Credit (LC), noted that the lack of uniformity with The documentary LC is the primary way in U.S. law and international customs and which sellers and buyers of goods in an guidelines necessitated the revisions to international transaction can assure that Article 5.1 The drafters desired, among other both the goods and the proceeds to pay for things, to conform Article 5 to current inter- the goods are in transit at roughly the same national customs and standards provided in time. This payment device is essentially a the Uniform Customs and Practices (UCP).2 line of credit opened by the buyer’s bank in The UCP is a body of guidelines and cus- a commercial transaction that is payable toms developed by the International only when the proper documents, agreed on Chamber of Commerce to facilitate the use of by the parties involved in the underlying documentary LCs in international sales commercial transaction, are presented to the transactions. As is the case with most inter- bank. As discussed in more detail below, this national conventions, the UCP is not auto- transaction is facilitated by banks and gov- matically applicable to these types of docu- erned by the UCP. The individual party’s mentary LCs; the parties to the transaction bank, whether it is the issuing/buyer’s bank, must expressly agree that the UCP will gov- or the confirming/seller’s bank,5 replaces ern their rights and remedies, as well as the the risks associated with cash on delivery, mechanics of establishing and drawing on cash in advance, or sales or credit terms. If documentary LCs. Developed by the the LC transaction serves its purpose, the International Chamber of Commerce in credit risks to both the buyer and seller are 1933, the UCP has been revised over the reduced considerably, with the primary risk years, with the 1993 revisions influencing the being whether the banks follow the proper recent revisions to Article 5 of the UCC. procedures provided in the letter of credit as Bankers, who often find themselves on supplemented by the UCP and Article 5 of either end of a documentary LC, favored the the UCC. development of uniform, easy-to-apply answers that recur in practice. Moreover, as a codification of international law and cus- The Transactions toms, revised Article 5 both follows and sup- The LC transaction should be viewed as ports international LC practice.3 For exam- three separate transactions: the sales con- ple, if UCC Article 5 is not excluded from the tract, the LC agreement, and the agreement LC by agreement of the parties, Section 5- involving the carrier of the goods. Each has 108(e) of the UCC provides a court with the its own law and guidelines governing the power to determine whether international transaction, and although areas of the laws customs, such as the UCP, are authority, as and regulations overlap, it is important to well as the power to provide aggrieved par- distinguish between them. ties with other remedies.4 The fundamental concept of the LC trans- This article is intended to familiarize the action is the independence of the LC from practitioner with the basic concepts and the sales transaction.6 The sales contract and transactions associated with the documen- the relationship between the buyer and sell- tary LC and provides a general description er and their respective banks exist separate- of the documentary LC in an international ly from each other. In other words, the banks business transaction. The article also are not concerned with a breach of the sales includes a sample diagram to conceptualize contract because, pursuant to the UCP 24 DOCUMENTARY LETTERS OF CREDIT IN INTERNATIONAL TRANSACTIONS 25 and/or the UCC, they must pay regardless ed below represent some of the forms that of a breach of the underlying sales contract. the Buyer and Seller may agree to include in The other two transactions, the sales con- the documents to be described in the LC. tract and the contract between the carrier These documents are separate from the B/L and the parties, are governed by (1) Article 2 and the draft (described below). Documents of the UCC, (2) the Convention on the to be included in the group of documents International Sale of Goods (CISG),7 (3) the include the following: Pomerene Act,8 and (4) the Carriage of 1. Certificates of Insurance. A certificate of Goods by Sea Act (COGSA),9 respectively. insurance evidences insurance that protects Taken together, these three transactions against the loss or damage of the goods encompass the international LC transaction while in transit. Normally the buyer requests and are discussed in more detail below. that the seller obtain this insurance at the buyer’s expense. For example, if the parties agree on the INCOTERM, CIF,10 the seller The Parties must procure insurance at its expense for the Transaction #1: Buyer and Seller benefit of the buyer or risk being in breach of (Beneficiary) the sales contract. 2. Inspection Certificate. This document is The interaction between the buyer and the needed with a CIF transaction. See UCC 2- seller is minimized in a documentary LC. 513. This certificate requires the carrier to The banks facilitate the transaction with inspect the goods to ensure quantity and minimal risk and delay. Outside of the sales conformity with the sales contract. In an FOB The UCP is a contract between the parties, the buyer and body of transaction under UCC 2-319, the inspection seller agree on which documents to include certificate is not necessary; the buyer has the guidelines for issuing an LC for the seller/beneficiary. inherent right under the sales contract to The main documents involved in this trans- inspect to ensure conformity with the con- and customs action are discussed below. tract. This certificate is “negotiated” in the developed sales contract and will be included in the LC Customs Documents if agreed on. by the Bill of lading (B/L) or airway bills. These embody the contract between the seller and The draft. This document provides the International the carrier to deliver the goods to the buyer. payment mechanism and is a negotiable Chamber of The B/L may either be negotiable or non- instrument under Article 3 of the UCC. The draft contains the reference number of the Commerce to negotiable—the distinction being that, if negotiable, the carrier must deliver the LC and other information referencing the facilitate the documents agreed on in the underlying sales goods to the holder of the B/L. The holder of transaction. The parties will agree in their use of the B/L may in fact be a third party that receives the B/L from the buyer: for exam- negotiations on whether the draft will either documentary ple, a holder would receive a negotiable be a “sight” draft, i.e., payable on demand, LCs in instrument and be a holder in due course. or a “time” draft, payable by no later than a certain date. The time draft is especially international A nonnegotiable B/L, however, contains the name of the buyer as the consignee and valuable when the buyer becomes insolvent; sales the issuing (and conferring bank, if one is the carrier that is issued a nonnegotiable B/L involved) bank still must pay the presenter transactions. discharges its duty by delivering the goods to the consignee. The timing of the negotia- of the draft notwithstanding the insolvency. bility of the negotiable B/L is described in As shown in figure 1, the draft and the B/L figure 1. are the two fundamental documents of the Commercial invoice. This document evi- transaction and represent the title and pay- dences the precise goods bargained for in the ment of the goods agreed upon in the sales sales contract between the buyer and the contract. seller. The UCP provides that the description Transaction #2: Buyer’s Bank (Issuing of the goods in the commercial invoice be Bank) and Seller’s Bank (Advising or identical to the description in the LC. Other documents included in the transaction only Confirming Bank) need to provide a general description to As explained above, the main purpose of an determine their applicability to the transac- LC transaction is to place the financing of the tion. international transaction on the credit of Documents agreed on. The documents list- banks rather than the parties. Documentary 26 THE MICHIGAN BUSINESS LAW JOURNAL—SPRING 2005 L/Cs are what are technically referred to as lem, the informal and unknowing relation- credit enhancement devices—they shift the ship between the buyer and seller, and trans- risk of loss from the parties to the sales trans- fers those risks into three separate smaller action. issues: the relationships between the buyer The buyer’s bank is always the issuing and the issuing bank (if the buyer becomes bank; it opens the LC in favor of the seller insolvent, the issuing bank provides pay- and lists all of the documents and protec- ment); the seller and the advising/confirm- tions afforded both parties in the transaction ing bank (if the advising bank refuses to pay, (e.g., revocability of the LC and the agreed- the seller is in a better position to deal with on documents). The UCP provides a strict it); and the relationship between the two standard with the inclusion of the agreed-on banks. As shown in figure 1, the LC in effect documents. If irrevocable, any deviation must shifts the payment and delivery of the goods be dealt with prior to issuing the LC. If revoca- (via the draft and B/L) from transaction #1 ble, the issuing bank may contact the seller to transaction #2. to negotiate what documents to include. In either case, the UCP provides for remedies if Transaction #3: Carrier and Seller/Buyer the issuing bank violates this provision. The third transaction involves the carrier of Moreover, the seller does have any input the goods agreed on in transaction #1, and in selecting the issuing bank. The seller may be either air freight or by vessel. For should confirm with its own bank or investi- demonstration purposes, delivery by vessel gate independently on the solvency of the incorporating the B/L will be discussed. The documen- issuing bank because the LC is predicated on The carrier’s obligations are governed by tary LC is the the solvency of the issuing bank to pay if the the COGSA and Pomerene Acts described primary way buyer becomes insolvent. The nomination of above. The carrier receives the goods from a a bank to review the documentation to be freight forwarder or other party designated in which delivered from the seller to the buyer is done by the seller. The B/L must conform to the sellers and by the issuing bank if the seller does not elect exact description of the goods in the sales an advising or confirming bank.11 If the sell- contract. Pursuant to the Pomerene Act and buyers of er chooses an advising bank, the bank is not the COGSA, the carrier is not liable for defi- goods in an liable for faulty documentation or any other ciencies in the goods unless it is obvious that liability, but rather is the gatekeeper of the the carrier should be aware of any fraud per- international petrated by any party in the transaction. seller’s documents.12 However, if the seller transaction decides that the issuing bank is not trustwor- Moreover, the carrier is not liable for any can assure thy or there exists political turmoil in the defect in the B/L nor responsible for wrong- issuing bank’s region, the seller may choose ful delivery of the goods against the B/L that both the unless the carrier has knowledge of the a confirming bank, which is usually the goods and the advising bank.13 defects. If negotiable, the carrier must deliv- er the B/L and the goods to the rightful proceeds to The issuing bank sends the LC directly to party or risk being responsible for misdeliv- the seller for review or to a confirming bank pay for the (usually seller’s advising bank). If the sell- ery.15 Finally, the COGSA provides that the goods are in er’s bank is agreed on to be a confirming carrier is liable for only the first $500 if the bank (usually at the behest of the buyer’s goods are damaged.16 Insurance is pur- transit at chased by the parties to protect against loss. bank to confirm the creditworthiness of the roughly the seller), the seller’s bank confirms the credit- The relationship between the buyer/car- same time. worthiness and becomes an obligor on the rier and seller/carrier is governed by LC.14 If the seller’s bank is an advising bank, whether the B/L is negotiable or nonnego- pursuant to the UCP the advising bank is tiable. If the B/L is negotiable, the buyer, only responsible for proper delivery of the once it has received the seller’s draft of the documents. It is not liable for the payment or B/L, may contract with any third party and performance of either the bank or the seller. sell the goods against the B/L. Because the LC is akin to a negotiable instru- If the B/L is nonnegotiable, the buyer’s ment, the main purpose for an advising bank and the seller’s duties are amplified. For is that it is paid directly by the issuing bank. example, if the parties agree on a CIF trans- It is usually the seller’s individual bank that action, the seller is considered in breach of provides the documentation and payment the contract if the seller does not procure the services necessary in the LC transaction. proper insurance to cover the goods while in In effect, the UCP takes one large prob- transit, regardless of whether the goods were DOCUMENTARY LETTERS OF CREDIT IN INTERNATIONAL TRANSACTIONS 27 actually lost or damaged (this is not applica- exchange of agreed-on documents. At this ble with the banks requesting insurance point, the banks may demand that a certifi- because that only occurs with a negotiable cate of insurance be included in any nego- B/L). Further, the seller may receive assur- tiable B/L agreement to protect against for- ances that the goods are not received by the gery, loss, or damage while the goods are in buyer until payment if the seller inserts the transit. bank’s name as the consignee of the non- The buyer or seller and issuing bank negotiable B/L instead of the buyer. This determine whether the seller’s bank is an assures that title to the goods does not pass advising bank (2a) or a confirming bank (2b). until the bank delivers the B/L to the buyer, If it is an advisory bank, the bank is not liable but not before the seller receives payment for paying the agreed-on contract price or from the bank. responsible for any loss or damage pursuant to the UCP. If the seller’s bank is a confirm- The Letter of Credit at Work ing bank (2b), it is now liable for any monies to be paid or damage to the goods while in Now that the three main transactions and transit. their respective parties have been defined, it 3. In step 3, the seller packs and sends the is time to put all of the documents and par- goods via freight forwarder to the docks to ties in context in the LC transaction. Figure 1 be shipped via the carrier (for this example, is designed to conceptualize this arrange- the carrier is an ocean vessel). Transaction #2 ment and the flow of documents between is entered into at this point. The freight for- the parties involved. warder delivers the goods to the carrier. The LC 1. Transaction #1 is entered into by the 4. The seller receives the B/L from the transaction buyer and seller. The parties agree to the carrier to include in the bundle of docu- terms of the contract and what documents should be ments to be sent via the banking channels. are to be included in the group of documents The B/L will include the name of the vessel viewed as to travel around the banking channels. and a general description of the goods three Negotiability of the B/L, revocability of the placed on the vessel for shipment to the LC, and other matters are agreed on at this buyer. separate point. 5. The B/L along with the draft is deliv- transactions: 2. The buyer selects the issuing bank, ered to the seller’s bank. The B/L evidences the sales which opens the LC and names the seller as the “title” to the goods, and the draft evi- beneficiary. The documents agreed on in dences “payment” for the goods. Both are contract, transaction #1 are listed on the LC, and the sent to the seller’s bank to facilitate the the LC UCP governs the banks in carrying out the exchange of the documents between the two agreement, and the agreement involving the carrier of the goods. Figure 1 Adapted from Ralph H. Folsom et al., International Business Transactions: A Problem-Oriented Coursebook 70 (1999). 28 THE MICHIGAN BUSINESS LAW JOURNAL—SPRING 2005 banks. As mentioned above, the draft may international transaction. As discussed either be a sight draft, where the draft is above, the B/L may either be negotiable or negotiated and paid for immediately, or a nonnegotiable. If it is nonnegotiable, the car- time draft, where the draft is paid pursuant rier will deliver the goods only to the con- to a set time included on the face of the draft. signee and to no other party. If the B/L is 6. The next step provides for one of the negotiable, then the buyer is free to sell the fundamental points of the LC: payment and title to the goods to a third party, which in the receipt of the goods happening at sepa- turn may sell to another party. The carrier is rate times. In step 6, the seller’s bank pays liable if it delivers the goods to a party other the seller as soon as the B/L and draft are than the “holder” of the B/L and may itself presented to the seller’s bank. This occurs be liable for conversion and other contractu- presumably while the goods are in transit al obligations. aboard the carrier. As such, the seller’s bank 12. The final step is the delivery of the steps into the shoes of the seller and the sell- goods. Once delivered, the banks’ and the er’s bank transacts with the buyer’s bank carrier’s roles in the transaction are finished. pursuant to the UCP. The sales contract and all of the rights and 7. The next two steps are considered duties afforded the parties under either the transaction #2, and figure 1 illustrates that UCC or CISG govern at that point. The trans- the responsibility to deliver the title and pay- action again centers on the sales contract. ment occurs between the banks. The inspec- tion certificate, insurance, and other custom Conclusion A documen- documents are exchanged along with the tary letter B/L and the draft. Pursuant to the UCP, if The practitioner drafting his or her first doc- the documents are in order, the issuing bank umentary letter of credit is often asked to of credit include terms and lists of documents includ- must provide the seller with credit, or pay- provides ment, for the delivery of the B/L and the ed in forms used in the past by his or her your client, draft. If the B/L is nonnegotiable, the seller firm. This article was meant to provide the should name as the consignee the issuing big picture of this transaction. A documen- whether a bank, which provides assurances that the tary letter of credit provides your client, buyer or buyer has indeed paid for the goods. The whether a buyer or seller, assurances that the consignee bank will not relinquish its title in goods and payment agreed on are not in the seller, control of one party or the other. the goods until it is paid by the buyer. assurances 8. This step is the one weak part of the that the goods whole cycle. The issuing bank may not issue NOTES credit to the seller’s bank at this point for a and payment variety of reasons. Article 5 of the UCC pro- 1. See Prefatory Note to Revised Article 5 of the UCC, 2003 ed Article 5 of the UCC also governs stand- agreed on vides sufficient remedies against the banks by letters of credit “Standby LCs.” These are beyond the at this point, as well as the UCP and interna- scope of this article. A standby LC is issued by a bank are not in that guarantees that the issuer will perform obligations of tional law and custom. Banks will generally one party under the terms of a contract. the control pay at this point to protect their credit repu- 2. Prefatory Note to Revised Article 5 of the UCC, 2003 ed. of one party tation in the banking industry. 3. Id. 9. Steps 9 and 10 may be interchanged 4. The remedies afforded all parties in the LC trans- or the other. and usually happen at the same time. If the action are provided in Article 5 of the UCC, e.g., warran- ty claims for wrongful dishonor, forgery, and liquidated B/L is negotiable and the issuing bank and damages. An analysis of all remedies is beyond the scope buyer have a strong relationship, the bank of this article. Please refer to Article 5 of the UCC, the may remit payment. In other instances, official commentaries, and the excellent treatise, John F. Dolan, The Law of Letters of Credit: Commercial and when the B/L is nonnegotiable for example, Standby Credits (2003). and the buyer does not have a strong rela- 5. In UCC Article 5 parlance, the following are tionship with the bank, the bank may statutory definitions for key terms found in UCC 5-102: demand payment on presentment of the 1. “Issuer”: a bank or other person that issues a letter of draft. credit 10. Step 10 provides for the payment to 2. “Applicant”: person at whose request or for whose account a letter of credit is issued. In a sales transac- the buyer, either in the form of monies pur- tion, this will normally be the buyer of goods. suant to the draft, or credit at the issuing 3. “Beneficiary”: a person who is entitled to receive pay- ment under a letter of credit. In a sales transaction, bank if the buyer and the issuing bank have this will normally be the seller of goods. a strong relationship. 4. “Confirmer”: a nominated person who undertakes to 11. Step 11 is another nuance of LCs in an pay a letter of credit issued by the issuer. For exam- ple, a buyer of goods from China may request a bank DOCUMENTARY LETTERS OF CREDIT IN INTERNATIONAL TRANSACTIONS 29 doing business in the United States to confirm that it Western District of Michigan. He is a will honor a letter of credit issued by a foreign bank. member of the Michigan, Illinois, and 5. “Honor” means payment of the monies required by the letter of credit. American Bar Associations. Fluent in 6. “Dishonor” means failure to make timely payment Japanese, Mr. West is actively involved in under a letter of credit. promoting both business and cultural ties between the United States and Japan. 6. See Article 3 of the UCP; See also UCC Article 5 Prefatory Note; UCC 5-103 and 5-108. Before beginning his law career, he stud- 7. The Convention on the International Sales of ied and worked in Japan. He taught Goods (CISG) is an international multilateral treaty that English to junior high school students on requires ratification by a state in order to have the effect the Japan Ministry of Education-spon- of law. The United States has ratified the CISG and sored JET program and provided transla- therefore, it is deemed federal law in the United States and applicable to an international sales transaction. tion services for visiting educators and Parties may waive the applicability of the CISG in any delegates. He currently serves on the transaction. board of directors of the Japan American 8. 49 USC 80101-16. Society of West Michigan, the Grand 9. 46 USC Appx 1300 et seq. The Pomerene Act and COGSA both apply to ocean vessel carriers. Both are Rapids Sister City International Program, included in most bills of lading. The fundamental pro- and the Grand Rapids Urban Institute for tection afforded carriers under these regulations is that a Contemporary Arts. He also serves as an carrier is only liable for up to the first $500 for damage Omi-Hachiman/Grand Rapids Sister- to goods while in transit. For purposes of this article, the City Program committee member and is carrier will be an ocean vessel using the bill of lading. 10. INCOTERMS are provided for in Article 2 of actively involved in both the Japan the UCC as well as by the International Chamber of Business Society of Detroit and the Commerce. INCOTERMS define the parties’ responsi- Japan Chicago Chamber of Commerce. bilities in regard to the goods while in transit. Free On Board (FOB) is used with either the final destination of the goods or with the location in which they left port. For example, if a seller, located in New York, agrees with a buyer located in London that the goods are FOB London, then the seller is responsible for the loss of goods while in transit until they reach London. Conversely, if the INCOTERM FOB New York is used, then the New York seller is absolved of any duties to the goods once the goods are placed with a freight forwarder for delivery to the carrier. Cost Insurance Freight (CIF) in general terms places the responsibility on the seller to deliver the goods to the freight forwarder. Once completed, the seller is absolved of any risk of loss. However, in a CIF transaction, seller must procure insurance for risk of loss while the goods are in transit for the benefit of the buyer. The seller’s fail- ure to procure insurance may result in a breach of con- tract in the sales contract. 11. See UCP Article 9. 12. See UCP Article 10. 13. Id. 14. Id. 15. If the B/L is negotiable, and the carrier does not believe the holder of the B/L is the true recipient, the car- rier may demand assurances from the banks, i.e., letters of indemnity, before delivering the goods. 16. 46 USC Appendix 1304. Chad A. West is an associ- ate in the Grand Rapids office of Barnes & Thornburg LLP. He is a member of the Business, Tax & Real Estate Department and Inter- national Practice Group, concentrating his practice in mergers and acquisitions, corporate finance, general business transactions, and immigration. Mr. West is admitted to practice in Illinois and Michigan and the United States District Courts for the Eastern, Northern, and Western Districts of Illinois and the The 2004 Tax Acts: What You Need to Tell Your Clients By Paul L.B. McKenney Introduction out of the Internal Revenue Code (IRC) in 2010. Future Congresses will obviously In the final weeks before adjournment for have to deal with them, and the Bush last November’s election, Congress enacted Administration would like to make them two mammoth tax bills. The Working permanent. Families Tax Relief Act of 2004 (the Families The 15 percent refundability aspect of the Act)1 passed with broad bipartisan support. Child Tax Care Credit was accelerated one It contains approximately $146 billion of year to 2004 for low-income families. “middle class” tax relief. Shortly thereafter, There have been numerous definitions of the American Jobs Creation Act of 2004 (the a “child” for various purposes under the Jobs Act)2 passed by smaller, but still signifi- IRC. While the definition is most important cant margins. This article is an overview of for dependency exemption purposes, it also the Families Act and the Jobs Act, but it appears in over 25 other IRC sections. The should be noted that they total over 800 Families Act contains uniform definitions of pages and it is not to cover them in detail “child”4 as well as “head of household.”5 here.3 Moreover, the 2004 legislation will Department of Treasury projections proj- spawn regulation projects that will dwarf ect that over 32 million Americans will be these statutes. paying alternative minimum tax, or AMT, by The Jobs Act is the most significant the end of this decade. The Economic reform of U.S. taxation of businesses, of all Growth and Tax Relief Act of 20016 (2001 sizes, since the 1986 Tax Act. It solved a $5 Act) minimal increase in individual AMT billion trade problem with more than $140 exemption amounts were scheduled to billion of tax relief. The Jobs Act was “rev- expire at the end of 2004, but will continue enue neutral.” While it disbursed consider- through 2005. The exemptions will then able tax relief, it also increased taxes by a revert to the prior levels. Most Americans similar amount to balance out the cuts. As who pay AMT do so because real estate taxes discussed below, the largest sources of and state and local income taxes are increased revenue under the Jobs Act are deductible for regular tax purposes, but not restrictions on Congress’s newest preoccu- AMT purposes. Thus, they enter the AMT pation, tax shelters, and other tax avoidance liability world. schemes. Congress managed this act of jug- Legislation in 2002 allowed teachers an gling the deficit numbers by placing sunset above-the-line deduction for unreimbursed dates on many of the tax reductions and expenses incurred in connection with books, making the revenue-raisers permanent. It is supplies, and computer equipment for 2002 widely expected that Congress will extend and 2003 only. It was extended through 2004 the life of many of these tax breaks. and 2005.7 This is capped at $250. Thus, your teacher clients should be claiming this deduction, if applicable, on their 2004 Form Individuals 1040s. The primary beneficiaries of the Families Act were individuals. It extended through 2010 Business Tax Relief several individual tax cuts that were sched- uled to expire at the end of 2004 under prior U.S. Manufacturing legislation. These include the $1,000 child tax Congress singled out U.S. manufacturing credit, elimination of the marriage penalty activities for the largest dollar amount of tax for both purposes of the standard deduction relief: $76.5 billion over the next decade. This and for the 15 percent bracket, and expan- was achieved by creating a deduction of sion of the 10 percent bracket. These provi- income equal to 9 percent of the lesser of U.S. sions are currently scheduled to migrate qualified production activities income, or 30 THE 2004 TAX ACTS: WHAT YOU NEED TO TELL YOUR CLIENTS 31 taxable income.8 The 9 percent is phased in $400,000. The increased expense allowance over 5 years: 3 percent this year and 2006, 6 and investment limit were expanded by the percent in 2007–2009, and 9 percent in 2010 Jobs Act to include the tax years 2006 and and later years.9 The net effect is that a tax- 2007. The deduction for “heavy” (i.e., up to payer otherwise in a 35 percent tax bracket 14,000 pounds), SUVs was capped at $25,000 will effectively be in a 32 percent bracket for effective for vehicles placed into service on qualifying manufacturing activities. This or after the date of enactment, October 22, deduction is available to any taxpayer 2004. Thus, it is too late to buy your whether corporate, an entity that is taxed as Hummer now and expense it. You should a partnership (including almost all multi- also note that in 2004, the Treasury released member LLCs), and even individuals. To extensive regulations regarding IRC 179 encourage use of direct employment as expenses and bonus depreciation. opposed to independent contractors and outsourcing, there is a cap that the deduction Leasehold Improvement—Tax Matches may not exceed 50 percent of Form W-2 Reality income paid by the manufacturing taxpayer. As any professional leasing improved real A deduction is also allowed for AMT pur- property well knows, the 39-year deprecia- poses.10 tion life for leasehold improvements bears The definition of “qualified production absolutely no relation to economic reality. activities income” for a taxpayer’s domestic The Jobs Act introduces a short-term eco- production or extraction is quite expan- nomic stimulus provision—a 15-year recov- ery period for “qualified leasehold improve- The Jobs Act sive.11 It includes not only those expenses incurred in costs of goods sold, but also ment property.”12 Also note that because is the most direct costs such as marketing. Certain indi- such improvements are now 15-year significant rect expenses, such as general and adminis- Modified Accelerated Cost Recovery System (MACRS) property for depreciation purpos- reform of U.S. trative costs, are allowed. For example, engi- neering and architectural services performed es, they are specifically eligible for bonus taxation of in the United States for construction in the depreciation. Bonus depreciation is a valu- businesses, United States can qualify. This will undoubt- able tax benefit. “Qualified leasehold edly lead to cost segregation studies by tax- improvement property” is any improvement of all sizes, payers to capture as many of the expenses as in nonresidential real property made pur- since the possible to qualify for such tax relief. suant to the lease by either the tenant or the The lower manufacturing tax rate applies landlord (as long as they are not related par- 1986 Tax Act. to “domestic production gross receipts,” ties), in that portion of the building or the which include sale, license, lease, or other entire building as the case may be, occupied disposition of qualifying production proper- exclusively by the tenant or by a subtenant, ty manufactured, produced, extracted, or where the improvement is “Section 1250 grown in whole or significant part by the property” and is placed into service more taxpayer in the United States. This includes than 3 years after the building was first tangible personal property and computer placed into service.13 This does not apply to software and also applies to the sale, license, enlargements, structural components bene- and disposition (but not transmission) of fiting a common area, escalators and eleva- electrical energy, natural gas, or potable tors, and internal structural work. This water. Furthermore, U.S. construction activi- favorable depreciation will spawn cost seg- ties that directly relate to the substantial ren- regation studies. The 15-year life is effective ovation of residential and commercial build- for property placed into service after date of ings and infrastructure may qualify. The enactment and before January 1, 2006. That rules in IRC 199 are detailed and must be fol- later date requires that practitioners explain lowed. On January 19, the IRS issued this to clients now so that they can timely act lengthy, detailed guidance in Notice 2005-14, to take advantage of this significant one-time 2005-7 IRB 1. tax opportunity. This will provide a realistic benefit not only to clients, but also, to many Section 179 Expensing law firms. The 2003 Tax Act increased the IRC 179 Restaurant Property Depreciation. Before expensing allowance from $25,000 to the Jobs Act, restaurants depreciated real $100,000 for the years 2003–2005. The invest- property improvements over a 39-year life. ment cap was increased from $200,000 to “Qualified Restaurant Property” placed into 32 THE MICHIGAN BUSINESS LAW JOURNAL—SPRING 2005 service before January 1, 2006, will qualify carryover of suspended deductions as losses for a 15-year straight line MACRS deprecia- regarding that stock is now allowed.20 The tion.14 The qualifying property must be: transferee will be able to use them in subse- quent taxable years. Favorable technical • Section 1250 improvements to a building; amendments regarding deducting suspend- • Placed into service more than three years ed losses under the passive activity rules for after the building was first placed into qualifying subchapter S trusts (QSSTs) were service; and adopted.21 More generous rules regarding • More than 50 percent of the building banks, bank holding companies, and finan- square footage is devoted to the prepara- cial holding companies that are S corpora- tion of and seating for on-premises con- tions and interest pertaining to passive sumption of meals.15 The effective date income and dividends on assets required to is October 22, 2004. This provision be held were enacted.22 represents a short-term economic stimu- Some clients have technical problems lus/bailout for the restaurant industry. regarding S corporation subsidiaries’ elec- S Corporation Reform and Simplification tions and terminations. The Jobs Act now allows inadvertent and invalid qualified S A false perception of S corporation law is subsidiary elections and terminations to be that a corporation simply makes an S elec- waived.23 tion, and then all is well. Tax practitioners know better. A number of provisions have International Taxation Regime Change A false per- been made to make S corporations more In 2002, the World Trade Organization ception of S adaptable and user friendly and to eliminate appellate body upheld a challenge by the some, but far from all, traps for the unwary. corporation The most significant is a great expansion of European Union that the U.S. foreign sales corporation (FSC) regime constituted an ille- law is that a the number of shareholders. The former 75- gal export subsidy. Because of the United corporation shareholder limit was raised to 100 share- States’ failure to take remedial action, tariff holders.16 More importantly, an entirely subsidies were assessed against U.S. exports simply makes new, expanded definition of family was and were being ratcheted up. The Jobs Act an S election, introduced. Members of the qualifying fami- contains a true overhaul of multinational ly count as one shareholder. The geometric and then all increase in the number of family results from business taxation. It addresses, among other things, repatriation from controlled foreign is well. the inclusion of lineal descendents of a corporations (CFCs); changes to the subpart “common ancestor” as well as their spouses F; complicated antideferral rules; simplified and former spouses.17 For example, if grand- foreign tax credit, or baskets, for limitation mother and grandfather have 3 children, all purposes from nine to two; and makes of whom are married, and those 3 children numerous other important changes affecting have a total of 6 grandchildren, then assum- multinational taxpayers. Any discussion of ing that all of them and their respective those changes is beyond the scope of this spouses own stock in a qualifying S corpora- article.24 The author suggests that you con- tion, they would only count as one share- sult Michael Domanski’s excellent outline.25 holder, rather than 20 individuals or 10 cou- ples. In larger S corporations, this will be a Non-Qualified Deferred Compensation boon for allowing managers to become Plans—Virtually All Such Plans Must Be shareholders. Except in exceedingly rare Reviewed and Probably Revised cases, the number of family shareholders The extensive “protections” for employees generally becomes a nonfactor. in the area of nonqualified deferred compen- Other technical revisions make S corpora- sation plans grew out of Congressional hear- tion shareholder rules more user friendly. ings and extensive reports concerning For example, S corporation bank stock can Enron’s misdeeds. The Jobs Act imposes now be owned by IRAs.18 Unexercised pow- new requirements. If these criteria are not ers of appointment (very common in estate satisfied, the stick is that there will be planning documents) of potential current income inclusion on a current rather than a beneficiaries of an electing small business deferred basis. The key points are that all trust (ESBT) are disregarded.19 Furthermore, amounts deferred under a nonqualified when stock is transferred incident to a deferred compensation plan, as broadly divorce to a spouse or former spouse, a defined (including any arrangement that THE 2004 TAX ACTS: WHAT YOU NEED TO TELL YOUR CLIENTS 33 defers the receipt of compensation), are cur- IRC 6103 and the Fair Debt Collection rently taxable, plus a 20 percent penalty and Practices Act27 will apply to such private interest, unless there is a substantial risk of debt collectors. Michigan’s Department of forfeiture and the numerous specific require- Treasury has used a similar system for many ments of the Jobs Act are satisfied.26 years without the predicted privacy horrors Distributions from the plan may only be occurring. made on separation from service (as deter- Part of the problem with collecting IRS mined by the Treasury), on death, at a speci- debts was that the governing statute on fied time, pursuant to a fixed schedule or on installment agreements only allowed them if change in control of the corporation (only to the arrangement would result in the tax obli- the extent allowed by Treasury), at the occur- gations being paid in full. IRC 6159(c) now rence of an unforeseen emergency, or when authorizes partial collection agreements if the participant becomes disabled. These are the full payment cannot be made in three the only permissible distributions and they years. cannot be accelerated. The Treasury has In IRS audits a taxpayer often knows that already released practical and lengthy guid- some money will be due, but not the precise ance in Notice 2005-1, 2005-2 IRB 274. amount. Taxpayers are concerned that IRS Readers are cautioned that the effective interest continues to run, compounded daily. date is not just taxable years beginning after Under a 1984 administrative procedure, Rev December 31, 2004. It also includes material Proc 84-58, 1984-2 CB 501, taxpayers made modifications after the date of enactment, as cash payments in the nature of bond to stop well as any plan that is paying benefits after the running of interest. This longstanding The single that date. As stated above, this mandates administrative practice was codified and largest source review and typically revision of almost all expanded favorably to taxpayers in the new of increased nonqualified deferred compensation IRC 6603. It applies for income, gift, estate, arrangements. Existing plans must be and goods and services tax and certain tax revenue is amended no later than December 31, 2005. excise tax purposes. As before, the taxpayer restrictions on may request and receive the money back. On March 14, 2005, the IRS issued detailed guid- tax shelters. Paying for Tax Benefits ance in Rev Proc 2005-18, 2005-13 IRB 798. Overview Under the Jobs Act, the taxpayer will also receive interest, albeit at a low rate. The single largest source of increased tax revenue is restrictions on tax shelters. As is Combating Perceived Charitable Giving discussed below, Congress properly consid- Abuses ered shelters as a frontal assault on the For several years, the IRS and Congress were integrity of the federal tax system. Before justifiably concerned about abuses involving proceeding to tax shelters, this article first donations of certain types of property. discusses some important provisions that Because of the qualified appraisal rules are of more general application. requiring a qualified appraisal on gifts of Administrative Provisions Affecting Large over $5,000 in property, problems were pri- marily in the $500 to $5,000 property dona- Numbers of Taxpayers tion range. The Jobs Act addressed vehicle Congress was greatly concerned that donation program abuses. In general, the approximately 2.25 million federal tax col- new law requires that if a qualified vehicle is lection files have not been worked on at all sold by the donee charity without significant because of IRS staffing limitations. These are improvements or use by the charity, then (1) cases where there is an admitted, agreed-on the charity will notify the donor of the sales liability to the IRS, such as a Form 1040 price and (2) the donor must use that price as where payment in full was not made, but the the amount of the charitable deduction.28 liability has not been satisfied. These are The second set of new documentation quantified at $16.5 billion. To address these rules apply to property donations valued at concerns, Congress, after at least two more than $500 (with aggregation) but less decades of debate, finally authorized the IRS than $5,000. A taxpayer’s return must to use private debt collection agencies. This include a “description of such property and was done by an entirely new IRC 6306. There such other information as the [IRS] may are rather strident privacy and other safe- require.”29 The IRS has promised specific guards. All of the Privacy Act restrictions of guidance as this applies to 2005 donations. 34 THE MICHIGAN BUSINESS LAW JOURNAL—SPRING 2005 A Rejuvenated IRS What Every Business Lawyer Needs to One unmistakable trend of the last few years Know, and Will Intensely Dislike is that the tax enforcement pendulum has A business lawyer in virtually any transac- swung from its historic low, shortly follow- tion, such as the mundane sale of a division ing the IRS Restructuring Act of 1998, to an or subsidiary, is seeking to close the deal in exceedingly active high. In 30 years of prac- the most tax-beneficial manner for the client. tice, the author has never seen it swing this However, because tax avoidance is a pur- far this fast. Congress followed seven years pose of the transaction, an attorney render- of IRS budget reductions with four years of ing any written advice, even an e-mail, is increases. On February 1, 2005, President now subject to new rules under Circular 230, Bush proposed a $500 million increase in the which governs the tax practice before the IRS enforcement budget. With record budget IRS. Circular 230, post-Jobs Act, has virtual- deficits looming, Congress recognizes that ly supplemented, if not de facto over- each dollar of additional IRS enforcement whelmed, state bar licensing rules with uni- spending is an investment that immediately form rules of federal tax practice. The likely produces many dollars of enhanced govern- practical problem with a violation of these ment revenues. rules is not the IRS disbarring the practition- In addition, the IRS reorganization is er on a definitely non-criminal-type matter, now in place, generally resulting in higher but rather, if the transaction does not go as levels of effectiveness. The IRS successes in planned, including after an IRS audit, that [B]ecause tax the highly publicized tax shelter areas have practitioner may be defending himself or spilled over into other areas. While there is herself in a malpractice action for the failure avoidance is usually a time lag between perception and to satisfy the new federal tax standard of a purpose reality for those not actively practicing in a practice under Circular 230. tax controversy area on a daily basis, the The source of the problem in all of this is of the trans- reality is clear. The IRS is back, and then not an Internal Revenue Code provision, but action, an some. rather 31 USC 330(d), as added by Jobs Act attorney ren- Tax Shelter Wars section 822(b). It provides that: dering any Congress responded to the tax shelter scan- Nothing in this section or in any dals of the late 1990s, Enron, and other pub- other provision of law shall be con- written strued to limit the authority of the licized abuses with a strong web of inter- advice, even locking penalties and restrictions. Had those Secretary of the Treasury to impose an e-mail, is been in place a half-dozen years ago, the tax standards applicable to the render- shelter abuses of that era would not have ing of written advice with respect to now subject any entity, transaction plan or happened.30 The details of these are set forth to new in some detail at the author’s “Tax arrangement or other plan or arrangement, which is of a type rules under Controversies and Shelter Wars” outline.31 which the Secretary determines as The three main thrusts regarding shelters Circular were new or expanded: having a potential for tax avoidance 230, which or evasion. 1. Reporting rules and penalties against tax- governs the payers and promoters for failure to dis- (Emphasis added.) This became law when the Treasury was considering final regula- tax practice close shelters on their respective returns, tions on tax shelter opinions for Circular 230. violators also incur the virtual certainty before of a painful audit with the IRS and the As a direct result of that Jobs Act provision, the IRS. new arsenal of promoter disclosure sanc- the final regulations go far beyond what tions; anyone would remotely consider a tax shel- 2. Penalties now take all economic incentive ter to anything that has the “potential for tax out of promoters’ large fees; avoidance. . . .” These regulations were prom- 3. The Treasury can disbar not only individ- ulgated on December 17, 2004. As a tax prac- ual promoters, but also their firms, from titioner, I hope that everything I do has a potential for tax avoidance. If an individual tax practice under Treas. Circular 230.32 tells you that he or she is thinking of selling Additionally, severe monetary penalties a vastly appreciated marketable security that are authorized for the first time under he or she bought 11 months ago, would you Circular 230. not recommend that they wait until the hold- ing period is over a year and qualify for the THE 2004 TAX ACTS: WHAT YOU NEED TO TELL YOUR CLIENTS 35 15 percent long-term capital gain rate? If a Paul L.B. McKenney, of client is selling appreciated real estate, Raymond & Prokop, PC, would you not at least advise him or her of Southfield, is a tax practi- the potential to defer gain with a qualifying tioner. He is a member of the Taxation Committee of like-kind exchange? Such mundane advice the Oakland County Bar has a potential for tax avoidance. Association; the Sales, The only good news the author can con- Exchanges and Basis Committee of the vey is that the regulations released by the Taxation Section of the American Bar Treasury on December 17, 2004, do not go Association; and the Taxation Section of into effect until June 20, 2005. It behooves the State Bar of Michigan. He has pub- lished numerous articles and is a fre- any business lawyer to pay attention to the quent lecturer on tax topics before vari- considerable information that will be avail- ous organizations. Mr. McKenney is a able in the future regarding what will be a contributor on taxation issues to Torts: sea of change for business law practitioners Michigan Law and Practice (ICLE 2d ed as well as for tax planners. & Supps). NOTES 1. Pub L No 108-311, 118 Stat 1166 (2004). 2. Pub L No 108-357, 118 Stat 1418 (2004). 3. For more detailed discussion of this legislation, see the course materials for the After Hours Tax Series: The 2004 Tax Acts: What You Need to Tell Your Clients (spon- sored by ICLE and available at www.icle.org) 4. IRC 152(c)–(d). 5. IRC 152(b). 6. Pub L No 107-16, 115 Stat 38 (2001). 7. IRC 62(a)(2)(d). 8. IRC 199. 9. IRC 199(b). 10. IRC 199(d)(6). 11. IRC 199(c)(1). 12. IRC 168(e)(3)(E)(iv). 13. IRC 168(k)(2)(A)(i)(IV). 14. IRC 168(e)(3)(E)(iv). 15. IRC 168(e)(7). 16. See IRC §1361(b)(1)(A). 17. IRC 1361(c)(1)(B). 18. IRC 1361(c)(2)(A)(vi). 19. IRC 1361(d)(2) and (e). 20. IRC 1366(d)(2). 21. See IRC 1361(d)(i). 22. IRC 1362(d)(3)(F). 23. See IRC 1362(f ). 24. For further discussion of these changes, see Michael Domanski, “Multinational Tax Business Overhaul,” After Hours Tax Series: The 2004 Tax Acts: What You Need to Tell Your Clients (ICLE 2004), available to Partners at http://www.icle.org/partners/materials/ material.asp?book=2004CP7426&chap=20042D7426 or to non-Partners at http://www.icle.org/store/seminar- material.cfm?PRODUCT_CODE=2004207426. 25. Id. 26. See IRC 409A. 27. 15 USC 1692 et seq. 28. IRC 170(f )(12)(A). 29. See IRC 170(f )(11)(B). 30. See Paul McKenney, “Tax Controversies and Shelter Wars,” After Hours Tax Series: The 2004 Tax Acts: What You Need to Tell Your Clients (ICLE 2004), available to Partners at http://www.icle.org/partners/materials/ material.asp?book=2004CP7426&chap=20042C7426 or to non-Partners at http://www.icle.org/store/seminar- material.cfm?PRODUCT_CODE=2004207426. 31. Id. 32. 64 Fed Reg 75839 (Dec 20, 2001).
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