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  Report From Counsel  
    Fall 2000  
   

BUSINESS ENTITY BASICS

Before even the most promising business can put down roots and prosper, its owners must make the threshold decision about what kind of legal entity it will be. Different options are available, with each option having strengths and weaknesses. Legal requirements may vary by state depending on the business form chosen. Following are some general characteristics of the most prominent business entities. As the variety of choices indicates, competent legal advice is necessary to make the proper decision.

Sole Proprietorship

The greatest virtue of a sole proprietorship is its simplicity. From a legal standpoint, the business and its owner are the same. This allows the proprietor to avoid most of the formalities required for some other business forms. For example, business income is reported on the proprietor's personal tax return. One significant drawback is that a sole proprietor has personal responsibility for all business debts and court judgments.

General Partnership

A partnership is a business run by two or more persons, but the "persons" can be individuals or business entities. In a general partnership, all partners are "general partners," which essentially means that their business fates are closely intertwined. Each general partner has unlimited personal liability for partnership debts, can incur obligations on behalf of the partnership, and acts as an agent for the other partners and the partnership. The partners usually share equally in managing the business and dividing the profits, but they may set their own terms for these and other matters in a written partnership agreement. Tax liability on partnership income is "passed through" to the individual partners so that each partner pays taxes on his or her individual share of the profits.

Limited Partnership

In a limited partnership, there are general partners and limited partners. General partners run the business's day-to-day operations and have personal liability for partnership obligations. Limited partners are usually passive investors in the business. They are not personally liable for partnership debts and the most they can lose is the amount invested in the partnership. A limited partnership allows money to be raised for the business from the limited partners, but the general partners do not have to share with them day-to-day decisionmaking or comply with requirements for creating a corporation and issuing stock.

In contrast with a corporation, a partnership dissolves and is liquidated upon the death or withdrawal of a partner unless the partnership agreement provides otherwise. For example, the agreement may allow a buyout of a deceased or withdrawn partner, election of a new partner, and continuation of the business. As a general rule, a limited partnership carries on unaffected by the loss of a limited partner.

Corporation

A corporation is an entity that is separate from its owners, with its own legal rights and responsibilities. The owners (the corporation's shareholders) are not personally liable for debts of the corporation. The shareholders elect a board of directors to supervise the corporation and the board hires officers to manage day-to-day matters. The major drawback for the corporate model is having its income taxed twice: first on the corporation's income and then on any dividends paid to the individual shareholders.

The S corporation, a hybrid creature of the Tax Code, has some characteristics of corporations and some of partnerships. If specific tax rules are satisfied, income in an S corporation is taxed only when it is passed through to the owners. Also, the owners retain their insulation from personal liability for corporate debts.

Limited Liability Company

An increasingly popular form of business entity is the limited liability company (LLC), another hybrid combining some of the best traits of the other entities. The owners, called members, are not limited in number or type, as are shareholders in an S corporation. While LLC members generally have the kind of limited personal liability associated with limited partners, they have flexibility to participate in the management of the business if the governing document, called "articles of organization," so provides. The earnings of an LLC are given the same advantageous passed-through treatment as are earnings of a sole proprietorship or partnership, thereby avoiding double taxation.

DIGITAL AUDIO RECORDING

Computers, the Internet, and intellectual property rights continue to clash in courts as technology allows users to copy, transfer, and manipulate copyrighted materials without the permission of the owners. Unauthorized use of musical recordings has recently been at the forefront of this controversy.

In the early 1990s, Congress took action to address one aspect of the conflict between technology and intellectual property rights in the music industry. The Audio Home Recording Act (AHRA) made it unlawful to import, manufacture, or distribute a digital audio recording device that does not conform to the Serial Copy Management System or a similar system designed to prevent unauthorized serial copying. The AHRA is not broadly aimed at serial copying of copyrighted music. Rather, it focuses on the means of recording through the use of a "digital audio recording device." The AHRA defines such a device as "any machine or device of a type commonly distributed to individuals for use by individuals . . . the digital recording function of which is designed or marketed for the primary purpose of, and that is capable of, making a digital audio recording for private use."

A lawsuit recently was brought against the manufacturers of the "Rio," a compact device that allows the user to play an audio file after it has been downloaded to the Rio. The Rio can store about an hour of music, is accessible to the listener only by headphones, and has no duplication, transfer, or upload capability. The court held that the statute did not apply to the Rio and, therefore, could not restrict the sale and distribution of it.

SEXUAL HARASSMENT IN EMPLOYMENT

When sexual harassment by a supervisor creates a hostile or offensive environment in the workplace but results in no disciplinary action, an employer can avoid liability by showing: (1) that the employer exercised reasonable care to prevent and correct promptly any sexually harassing conduct; and (2) that the plaintiff employee unreasonably failed to take advantage of any preventive or corrective opportunities provided by the employer or to avoid harm otherwise.

An important part of the first element of the defense is the preparation and distribution of a well-drafted policy prohibiting sexual harassment. In fact, as a recent case illustrates, a policy that is unclear or is not comprehensive could damage or destroy an employer's ability to assert the second element of the defense.

In that case, Elizabeth was promoted to the position of a team leader at a bank. Shortly thereafter, she began to report to a male supervisor. He made Elizabeth's life miserable at work for over two years, until she finally complained to management about his behavior. While the supervisor's harassment did not involve sexual overtures or other sexually provocative comments or actions, it was driven by the supervisor's hostility toward women, generally, and Elizabeth in particular. The supervisor's conduct was offensive and sometimes threatening, ranging from stereotypical remarks about the deficiencies of women as managers to an apparent reference to the O.J. Simpson trial when the supervisor told Elizabeth that he could "see why a man would slit a woman's throat."

The presence of a policy against sexual harassment and a victim's lengthy delay before complaining will often help shield an employer from liability. In Elizabeth's case, however, the bank's policy against harassment described only sexual advances, requests for sexual favors, and other actions of a sexual nature. Although the conduct Elizabeth was enduring was unlawful sex discrimination, the bank's narrowly worded policy led her to think otherwise. The deficient policy would not support a defense for the employer, and its incomplete definition of prohibited harassment excused Elizabeth's delay in complaining.

Although Elizabeth's case shows the importance of having an accurate and complete policy against sexual harassment, that is only part of a policy of prevention that will minimize the risk of employer liability. Also contributing to the liability of Elizabeth's employer was the inadequacy of its investigation after receiving the complaint. The bank basically ignored the allegations of harassment, focusing instead on the supervisor's objectionable management style. No one at the bank actually asked the supervisor whether he had made any of the sexually harassing remarks, nor did anyone follow up on an allegation that another bank employee had left because of sexual harassment from the same supervisor. The only consequences for the supervisor had been a 90-day probation period and a directive to improve his management style and "smile more."

OSHA TELECOMMUTING RULES

After a trial balloon on the subject of regulating home offices caused an uproar, the federal Occupational Safety and Health Administration (OSHA) issued a formal directive that should soothe concerns about possible intrusions into workers' homes. The directive is intended to guide OSHA compliance officers charged with enforcing OSHA rules.

The crux of the directive is that OSHA will not inspect home offices for violations of federal safety and health rules, and it does not expect employers to do so either. The directive also states that an employer is not liable for an employee's home office. If OSHA receives a complaint about a home office and a specific request from an employee, it may informally let an employer know about the home office condition, but it will not follow up with the employer or the employee.

OSHA will conduct inspections of other home-based worksites, such as home manufacturing operations, when it receives a complaint or a referral indicating the presence of a violation of a standard threatening physical harm or posing an imminent danger. An employer is responsible for hazards caused in home worksites by materials, equipment, or work processes that the employer provides or requires to be used in an employee's home. Examples of activities that might prompt such an inspection include electronics assembly, using unguarded crimping machines, or handling potentially hazardous materials without adequate protection. Such an inspection, however, would be confined to the actual work environment, not to an entire dwelling.

ESTATE PLANNING

Medicaid Look-Back Rules

Both "Medicare" and "Medicaid" are programs established by federal law that are intended to assist individuals with the payment of medical expenses. Normally, as a matter of entitlement, Medicare is designed to assist older individuals based on their contributions to Social Security. Medicaid is a medical benefits program only for the aged, blind, and disabled who are in need.

Medicaid covers long-term nursing home costs while Medicare does not. In order to qualify for Medicaid, an individual may own no more than a home, personal belongings, a car, and a small amount of savings and can have an income of only a few hundred dollars per month. The precise levels of income and resources that a Medicaid applicant may maintain and still qualify for Medicaid are set by individual states.

If an individual needs nursing home care and does not already qualify for Medicaid, his assets may be quickly exhausted and his heirs will not receive an inheritance. Given these circumstances, it is understandable that the focus of Medicaid planning has been on the reduction, or "spending down," of assets so that qualification for Medicaid is achieved.

The primary obstacle to such an "impoverishment" strategy is raised by the Medicaid "look-back" rules. If an asset is given away or sold by the Medicaid applicant for less than its fair market value, the Medicaid administrator must still count the transferred asset along with the Medicaid applicant's other assets if the transfer was made within 36 months (three years) preceding the date of the application. The look-back period is 60 months (five years) for assets transferred to a trust for less than fair market value. When such transfers are added back to other countable assets owned by the applicant, the total will often exceed the maximum level allowable for Medicaid qualification and result in a period of ineligibility.

The rules for calculating the waiting period are complex, but are generally intended to delay the application for Medicaid benefits until the look-back period is free of transfers that were for less than fair market value. The greater the value of the transfers that have occurred during the look-back period, the longer the period of ineligibility for Medicaid benefits. However, the transfer of a homestead for less than fair market value would not be counted if the transfer were made to the individual's spouse, to the individual's child who is under 21 years of age or who is disabled or who provides care to the individual, or to a sibling who has an equity interest in the homestead. Assets other than the homestead are exempt from the look-back/ineligibility period rules if they are transferred to a spouse, to a child who is under 21 or who is blind or disabled, or to a trust for the sole benefit of a disabled person who is younger than 65.

ASSUMPTION OF RISK

The law of negligence is based on the principle that people have a duty to use due care to avoid injury to others and that they may be held liable if their careless conduct injures another person. In sports, however, conduct or conditions that otherwise might be seen as dangerous often are an integral part of the sport itself. Accordingly, defendants are under no legal duty to eliminate or protect a plaintiff against risks that are inherent in the sport, but they do have a duty not to increase the risks to a participant beyond those that may be expected.

Albert was playing golf when his partner's hooked shot ricocheted off of a wooden yardage marker and struck him in the eye. Albert sued the golf course for negligence, but a state appellate court dismissed his claim. The court found that golf is an active sport, that Albert was injured because he subjected himself to an inherent risk in golf, and that the golf course had not increased the risks inherent in playing a round of golf.

An expert testified for Albert that the golf course increased the risks because the marker should have been made of softer material and placed farther from the fairway. The court disagreed. The fact that safer materials or conditions were possible will not give rise to a duty of care if the accepted standards for the sport were met. The construction and location of the yardage marker were typical of other courses. Moreover, there were no reports of prior injuries caused by any of the many such markers located all over the golf course.

FDIC INSURANCE PITFALLS

Depositors of banks and savings institutions sometimes lose substantial sums because they have not taken care to keep their deposits within the Federal Deposit Insurance Corporation's (FDIC) insurance limit of $100,000. Following are some typical situations that have caused deposited sums to be left uninsured.

Overestimation of Coverage for Joint Accounts

A depositor does not have a "new" $100,000 insurance limit for each joint account that he or she has with different parties. Instead, the FDIC totals each person's shares in all joint accounts at one institution and insures that sum up to $100,000.

Misunderstanding Coverage of Revocable Trust Accounts

The owner of a revocable trust account has the use of the money during his or her lifetime, after which the funds pass to specified beneficiaries. Each beneficiary's interest in such a trust is insured, up to $100,000, separately from any other accounts at the institution, but only if certain conditions are met. A beneficiary must be the depositor's spouse, child, grandchild, parent, or sibling. In addition, the $100,000 of insurance per beneficiary does not apply if the account owner puts conditions on the interests of the beneficiaries, such as requiring that they get a college degree or leaving payment up to a trustee's discretion.

Third-Party Deposits

Typically, an account owner is aware of all deposits made into the account. In some instances, however, such as the sale of a house or receiving money from a lawsuit, someone handling funds for the account owner will make a deposit into an escrow account at the same institution. When added to other accounts, such a deposit could put the account owner over the limit for insurance.

IRAs and Keoghs

It is a common misconception that retirement accounts are fully insured regardless of the amount. Instead, IRAs and self-directed Keogh funds are separately protected, up to a total of $100,000, from any nonretirement funds at the same institution. The Roth IRA is treated like a traditional IRA for purposes of deposit insurance. The new Education IRA is treated like an irrevocable trust account, not an IRA, for deposit insurance purposes. The coverage depends on the terms of the document creating the Education IRA.

It is prudent to review account balances and applicable FDIC rules periodically, or on the occurrence of events such as a death in the family, a divorce, a deposit of proceeds from the sale of a home, or a merger of two institutions in which the same person has accounts.

 
   
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