Risk Management for In-House Counsel by ygh20234


									     Risk Management for In-House
     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-
     zation is the ability to make informed deci-
                                                        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

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
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
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
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.
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-
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-
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-

     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.
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
                   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
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-
                   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).

    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
    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

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
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.
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
                                                                                                          and the
                                                                                                          involving the
                                                                                                          carrier of the

  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
     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
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-
                  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).

    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/
or to non-Partners at http://www.icle.org/store/seminar-
    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/
or to non-Partners at http://www.icle.org/store/seminar-
    31. Id.
    32. 64 Fed Reg 75839 (Dec 20, 2001).

To top