Ohio Practical Business Lawyer & Attorney : Teri Rasmussen : Lane Alton & Horst Law Firm : Commercial Law, Creditors, Business Formation : Columbus, Central Ohio

For some reason lately, I've had several questions come up that basically come down to I/my neighbor has built a fence across/used property belong to the adjacent property for years, the arrangement is now causing some sort of problem, and now someone wants to know if they can claim this land/if they can throw the interlopers off the land being "borrowed".

So I'd already decided to post on this topic when lo and behold the Ohio Supremes issue an opinion on precisely this question in Evanich v. Bridge, 2008-Ohio-3820.  (As always, the Ohio Supreme Court's Office of Public Information has issued an excellent summary of the decision.)  This case answers the question: does it matter if the use/occupation of the other person's land was unintentional, i.e. do you have to intend to take something you know is not yours?  In finding that the intent of one person to possess the land of another person is determined by an objective rather than subjective standard, the Ohio Supremes may have thrown a new wrinkle into the analysis. 

Adverse Possession Defined.  This sort of situation raises what lawyers call "adverse possession" - which is one of the few concepts from law school not directly part of my practice that I seem to remember all these years later.  The short answer is that it takes a a REALLY LONG TIME for "adverse possession" to kick in to alter the ownership rights to real property.

The longer answer is that the fence or other use of someone else's real property must be "open and notorious" for a number of continuous years that varies somewhat from state to state.  In Ohio, the magic number is 21 years.  Ohio courts require that the use/occupation of the land be such as to put the true owner on notice that someone is asserting an adverse/hostile claim to the property.  Thus if the use/occupation of the land was done with the express or implied permission of the true owner, "adverse possesssion" cannot be established. 

An Example.  A few years ago I represented a client interested in selling a portion of some commercial acreage he owned to another party who intended to construct a manufacturing facility on the real property.  Because the portion of the property being conveyed did not directly abut a public street, access was understandably a critical issue in the transaction for the buyer. 

Some years before a private drive had been constructed along the edge of the property being retained which could be extended to the portion destined for the new owner.  So the easy answer would seem to be simply to grant an easement to the buyer to provide access.  Unfortunately, when it came time to prepare the proper legal description for the easement and the survey showing the roadway had been examined, it turned out that a portion of the private drive had been constructed on the other side of the property line separating my client's property from his adjacent neighboring landowners' property.  Half the road had been constructed on the neighbor's vacant land.        

Aside from the obvious lesson that this is why it really is important to have a survey done before undertaking construction or purchasing real property, this illustrates how adverse possession can come about.  You can't get more "open and notorious" than running slabs of concrete across someone else's land, right?  On the other hand, why complain if someone else wants to build something potentially useful to you on your land, but doesn't bother to charge you for doing it?  In addition, the encroachment of the drive onto the adjacent property probably was inadvertent.   

In this particular case, the requisite time period had not yet expired.  However, it had been some time since the roadway had been constructed without objection and but for the desire to sell the property at that particular point, I think it quite likely that nothing would have disturbed the situation.

Evanich Case.  The recent Evanich case is interesting because it involves a set of facts that has probably been played out many many times.  After the Evanichs bought certain real property, they built a house on it and then in 1967 began doing some rather elaborate landscaping.  Based on where they thought the property line was, the Evanichs installed a split rail fence, decrative rail ties, and various plantings along what they thought was the edge of their lot.  When the neighboring property was sold ten years later, the landscaping was in place.

For some reason, the Evanich's neighbors decided to get a survey in 2002.  When that survey was done, it was discovered that the landscaping encroached on the neighbor's property by approximately 97/10,000 of an acre.  The neighbors then asked the Evanichs to remove the landscaping and they refused.  The lawsuit ensued.

The trial court saw it Evanich's way, as did a majority of the Court of Appeals, and held that the Evanichs could keep the landscaping because they had successfully satisfied the elements of adverse possession.  The dissenting Court of Appeals judge felt that the Evanichs had failed to demonstrate the requisite intent required to claim adverse possession since they never really intended to take their neighbor's land.   

The Ohio Supreme Court also sided with the Evanichs, saying

In a claim for adverse possession, intent is objective rather than subjective in determining whether the adversity element of adverse possession has been established, and the legal requirement that possession be adverse is satisfied by clear and convincing evidence that for 21 years the claimant possessed property and treated it as the claimant’s own. This has been the law in Ohio for over 140 years, and we are unwilling to alter a rule that has successfully directed the application of the doctrine of adverse possession for so long.

The court of appeals concluded that the Evaniches had acted in a way consistent with true ownership by installing landscaping that included railroad ties, stone blocks, fencing, bushes, flowers, and at least one tree. It held that the Evaniches possessed the necessary intent based on their exclusive control over the property for 35 years. (emphasis supplied)

Analysis.  Without giving it a heckuva lot of thought, I probably have assumed up to now that you had to have some sort of actual intent to take what's not yours to establish adverse possession - how else could it really be "adverse"?  However, sticking with only the outward consequence of actions leading to adverse possession certainly does make it easier to apply a bright line test.  

Ultimate Lesson.  The ultimate lesson here is that if your neighbor puts up a fence along your mutual property line or starts driving over your property, it's probably worth your time to either (1)determine for sure where that property line is so you don't lose that land; or (2) make it extremely obvious that if there is an encroachment, you're letting it stay there permissively. 

UPDATE:  for further analysis of the Supreme Court's decision in Evanich, visit this post entitled "Ohio Supreme Court Rules that Possession of Another's Property by Mistake, Still 'Adverse' Possession"  by Stephen D. Richman of the Ohio Real Estate Blog. 

• Email This
• Print
• Comments
• Trackbacks

Unless I’ve somehow agreed to get up at the crack of dawn to play golf, Sunday morning is a lazy relaxing time for me - definitely a law free zone.  I gradually become aware that I’m awake.  The cats and I have a little “quality” time while I lie in bed watching the CBS Sunday Morning television news magazine.  Eventually I rouse myself to get showered and go downstairs to read the newspaper while watching one of the Sunday morning news talk shows. 

THE HOOK.  After the politicians have had their debates, an infomercial typically comes on next which I sometimes leave on whilst I'm preparing lunch.  This week, it’s “JOHN BECK'S FREE & CLEAR REAL ESTATE SYSYTEM" which promises me that I can profitably invest in all manner of real estate by spending only a few hundred dollars at government “tax sales”.  I’ve seen part of this infomercial on other Sunday mornings, but this time I became intrigued and went on a mission, in part because a client had recently been asking me some questions about real estate investments.

For only $39.95, the infomercial promised to send me a kit explaining how I too could make wads of money  -- just like the folks giving testimonials  -- by taking advantage of government tax foreclosure sales most people don't even know exist.  According to the infomercial, by using the special "Free & Clear Real Estate System",  I will be able to buy tax foreclosure properties for "pennies on the dollar" and own them "free and clear" with no monthly payments.  The infomercial also tells me that all I have to do to get these properties is pay the back taxes owed on them and assures me there are many properties in my area I could get.  Numerous examples were shown of houses bought for only a few hundred dollars, but  worth far more.  And of course there's a money-back guarantee!!! 

TAKING A CLOSER LOOK.  Having long been an adherent of the “if it sounds too good to be true, it probably is” school of thought, I found it difficult to believe this “system” actually worked, but was nevertheless curious.  As an attorney with substantial experience in real estate and foreclosure law, it also just didn’t square with what I thought I knew about Ohio law in this area.  But I’m always willing to learn new things….

So I decided to investigate.  Google and the internet are a wonderful tool!!  It wasn’t long before I found a website called Infomercialscams.com with page after page of complaints about this very program.  Among the least of the issues with the “Free & Clear Real Estate System” was that the $39.95 apparently wasn’t a one-time fee as the program certainly implied, but instead was a recurring monthly charge.  There was also heart-wrenching story after story of people induced to part with thousands of dollars to "upgrade" to more intensive training and/or who vainly tried to cancel the entire transaction.  Well, if I had been inclined to shell out some money just to check it out, I certainly wasn’t going to do it anymore.  

But I was still confused about how this would work even in theory.  The idea is that because county governments need the tax money to provide necessary services to citizens, they have the power to sell property on which taxes have not been paid.  OK, so far so good – that’s all true and some Ohio counties do indeed have annual tax lien sales.  That, however, is where reality stops.    

A quick look at the Ohio Revised Code (See ORC 5721.30 through 5721.43) and a little more internet research.  I soon determined that while I suppose it’s possible (though I think unlikely) this “buy at tax sales” plan might work in other states, it CERTAINLY DOESN’T WORK IN OHIO!!!

OFFER NOT VALID IN OHIO. Here’s why:

1.  No Such Sales.  Perhaps the most important reason it won’t work here is that Ohio simply doesn’t do a retail “over-the-counter” business in tax lien sales.  Since 1997, only counties with more than 200,000 in population are even permitted to have tax lien sales AND all of them sell tax liens once annually solely to an institutional investor as a single lot costing more than a million dollars.

2.  The Long Wait.  Even if you could participate in a tax lien sale in Ohio, it isn’t the carefree and direct road to quick profits portrayed on the infomercial.  While it is true that if property taxes remain unpaid, the county will eventually offer a tax lien certificate for sale with respect to a particular parcel, that is only the beginning of a rather long journey towards making any money. 

The tax lien certificate does in fact carry an 18% interest rate plus penalties that are dangled before the uninitiated as the safe, secure, and amazingly large return on investment.  What is not disclosed is that having once purchased the tax lien certificate, probably at a discount (i.e. with an interest rate less than 18%), you CANNOT do anything with it for TWELVE MONTHS. 

What you hope happens is that the delinquent taxpayer somehow has an upturn in his financial fortunes and suddenly becomes able to pay off the taxes, plus interest and penalties – in the unlikely event this happens, then yes, you will make money.  However, you are not permitted to contact the delinquent taxpayer during this period and must just wait and see.  In at least some counties, payment plans are offered to those delinquent taxpayers wishing to redeeem their property, thus further delaying your ability to profit on the investment.   In addition, during this period, you may also find yourself dealing with zoning and nuisance issues associated with the property. 

3.  Working Through Foreclosure of the Lien.  If the property is not “redeemed” during this year following your purchase of the tax lien certificate, then you have the “opportunity” to foreclose on your tax lien certificate and finally get possession of the property.  However, you must do so within three years.  In addition,  Ohio is a “judicial” foreclosure state which means that you can’t just schedule a sale of the property and be done with it.  No, a foreclosure action requiring a court filing fee of probably at least $200, has to be filed in the local Court of Common Pleas and wind its way through the courts.  For a fee, generally around $3,500, you can use the services of the County Prosecutor to get this done; it’s also possible for you to engage the services of a lawyer in private practice although I rather doubt there would be any savings with this approach.  By this time you should be adding up the time and expense and wondering why anyone would want to do this.  But there's more......

4.  Minimum Bids Required.  So, assume that you finally get through the foreclosure litigation in a timely manner, perhaps in only a few months. Now what?  Can you still get real estate at a fraction of its true fair market value?  Nope.  Under Ohio law, property sold at foreclosure sale must be appraised (more court costs) and offered for a MINIMUM BID of TWO-THIRDS of its VALUE.  If no one is willing to pay the minimum bid, then the property will be reappraised and offered at a somewhat lower price, but probably not enough less to make it worthwhile.

5.  Dealing with Lenders "Bidding It In".  Maybe you think buying property at two-thirds of its value still sounds like a good deal, especially if you can immediately “flip” it.  Unfortunately, the likelihood of getting the property for that little is not particularly good in practice.  Usually, there will be at least one mortgage on the property as well as possibly some judgment liens.  The bank or financial institution holding the mortgage will not infrequently “bid it in”, meaning that until it bids more than is owed on the mortgage, the lender is essentially playing with “house” money and will not have to come out of pocket to take title to the property.  If the property IS worth having, chances are the lender will have figured that out and bid accordingly.

6.  If You Don't Believe Me...  For the "official" version of what I've just explained, visit the explanations of tax lien sales provided by the Franklin County Treasurer, Hamilton County Treasurer, Cuyahoga County Treasurer, and Lucas County Treasurer.

Look Before You Leap.  Every state is different so the strategy might be more viable elsewhere, but there are bound to be some important procedures you should be sure you’re aware of that must be followed before you can realize any profits.  Some of those may be similar to what I've pointed out above.  In particular, at a minimum, I would suggest determining if the state is a “judicial” foreclosure state like Ohio.  If it is, then it will probably take longer and cost more to get to the point where you can sell or take possession of the property.  Make sure you really understand ALL the steps that need to be taken for you to get from putting money out to supposedly getting more money back.        

My point in going into some detail here is that it’s important to understand fully the process by which you are supposed to get rich before investing even a little hard-earned cash into the deal.  Whether it's this "system" or some other way to invest in real estate, or some other "plan" to make lost of money quickly with almost no risk and little effort, it really is BUYER BEWARE out there.  If there really was a foolproof method of turning real estate into cash, many more people would be financially independent.

Soo.. now you know how I spent part of my Sunday… Scary, huh?

• Email This
• Print
• Comments
• Trackbacks

As I was doing my usual lunchtime surfing and Google Reader review, I came across an interesting quiz presented by Ben Blanquera at the Columbus Tech blog which is supposed to help you decide if you have what it takes to really be an entreprenuer.  It asks the usual sorts of questions about being willing to work hard and make sacrifices, but it also asks questions like your birth order and whether you had chores around the house before you were 10.  I took the test - my score indicates that I have the "necessary characteristics to be an entreprenuer". 

The Small Business Administration's webpage also explores "Is Entreprenuership for You?" and has a checklist to help aspiring entreprenuers answer the question, "Do You Have What It Takes?"

I've also been reading the Napoleon Hill classic, THINK AND GROW RICH which purports to contain the secret needed to identify your goals,  obtain whatever you want in life, and join the ranks of the super-successful.  Early on he says:

desiring riches with a state of mind that becomes an obsession, then planning definte ways and means to acquire riches, and backing those plans with persistence which does not recognize failure, will bring riches 

Do not wait for a definite plan through which you intend to exchange services or merchandise for the money you are visualizing.  Begin at once to see yourself in possession of the money, demanding and expecting meanwhile that your subconscious mind will hand over the plan, or plans, you need.  Be on the alert for these plans, sand when they appear, put them into action immediately.  They will probably "flash" into your mind through the sixth sense, in the form of an "inspiration.  

All of which got me to thinking about what it actually DOES take to be an entrprenuer.  It almost goes without saying that you must be willing to work incredibly hard and have enormous faith in yourself even when no one else really does.  But being a successful entreprenuer has to be more than that.

Some years ago when I was moving my law practice from a large firm to a much smaller one and became more responsible for finding my own work, I asked an attorney I knew from a smaller firm what the biggest difference would be.  "The highs are higher and the lows are lower," he said.  And I think that is also true for entreprenuers of any kind.        

Entreprenuers must have both a dreamer and and hard-headed realist within them.  Having the courage and fortitude to endure the uncertainties any new business will face and know the difference between when to forge ahead and when to change course is a special set of talents. 

Without a dream and vision, there's really no reason to be out on your own instead of working for someone else.  Seeing that dream and vision come true is a feeling unlike any other.  However, without the ability to adapt to events and circumstances as they occur and perhaps even modify the vision a bit, the project may stall or fail entirely.  

So you have to REALLY WANT IT to stay out there.  If you don't, the pain and difficulty of the journey could never be worth the effort and sometime even heartbreak along the way. 

• Email This
• Print
• Comments
• Trackbacks

Suppose you’ve decided that you’ve learned all you can from where you work now and want to put it to use by opening your own company.  Or the grass is looking mighty greener at another company in your industry and you’d like to make a move.  Hold on a minute!  Before you turn in your resignation, you need to consider whether you are subject to a noncompetition agreement, and if so, how that will affect your ability to move on.

What Noncompetes Do

Noncompetition agreements, or noncompetes as they are often called, may be a separate agreement, but are frequently part of an employment agreement.  Their purpose is to protect an employer from unfair competition by restricting the ability of an employee to compete with his or her former employer immediately following termination of employment.  Sometimes employees are asked to sign such an agreement after they have already been employed for quite a while.

Essentially, an employee signing a noncompete promises not to start, work in, own, or otherwise be involved with another company competing for the same business for a specified period of time after that employee stops working for the original company.  The idea is that in the course of doing his or her job, an employee learns valuable nonpublic information about how the company operates. In addition, an employer may have invested time and money in training the employee.

General Enforceability

Usually, employees asked to sign a noncompete have little choice but to agree if they want to work or continue to work for the employer.  Not infrequently, the question comes up as to whether this sort of agreement can be enforced.  Perhaps predictably, the answer depends on many things, including what state you are in and how stringent the restrictions are.

A few states such as California, Montana, and Oklahoma tend to view enforcement of noncompetes as against public policy and severely limit their enforceability.  Others have specific statutes governing use of noncompetes. Several states apply a “reasonableness” test, with some making an up or down decision based on the noncompete as written and others modifying the restrictions as they deem necessary.  Wikipedia has a very detailed Non-compete clause entry which focuses specifically on enforceability in California, Massachusetts, Ohio, and Virginia.

In Ohio, so long as the employer hasn’t gotten greedy, noncompetes are generally enforceable, even if they aren’t signed until long after employment originally began.  The Ohio State Bar Association’s News You Can Use feature offers a concise FAQ regarding “Are Noncompetition Agreements Enforceable in Ohio?”    In determining enforceability, Ohio courts look at three main factors enunciated in Raimonde v. Van Vlerah, 42 Ohio St.2d 21, 325 N.E. 2d 544 (1975):

• Whether the restriction is no greater than is necessary to protect the employer’s legitimate interests
• Whether the restrictions impose undue hardship on the former employee
• Whether the restrictions are injurious to the public

How Reasonableness Plays Out

How do these factors work in “real life”?  Of course, every case is different, but there are some general principles. The duration, geographic range, and scope of the prohibition are especially important.  Thus, noncompetes of one year or less are often found enforceable while longer periods become progressively less enforceable. 

Geographic range is related to the nature of the business; if it has a single location and serves only a local clientele, a noncompete prohibiting employment anywhere in the world is unlikely to be enforced.  If there are multiple locations, the prohibited proximity becomes important; restrictions forcing the former employee to work in the next county may be enforceable in these cases.   

Noncompetes which have the effect of preventing any sort of employment by the former employee will generally be found overly broad.  The prohibited activity must be related to the company’s existing or perhaps realistically potential business or industry.

One recent case involving a hairstylist with an eight month noncompete (Charles Penzone, Inc. v. Koster, 2008 Ohio 327 (10th App. Dist.) illustrates how subjective the factors for determining enforceability of noncompetes really are.  It also clearly demonstrates the predominant employer-friendly perspective on the issue which seems to be held by many Ohio courts. 

• The trial court, in part because there was no evidence the hairstylist had done anything other than service former customers who sought her out, refused to enforce the noncompete.  It also felt that forcing the hairstylist to “scrutinize every potential client who walked through the salon door” was an undue hardship and preventing members of the public from utilizing their preferred stylist was injurious to the public.
• The Franklin County Court of Appeals reversed, finding that the hairstylist could easily tell which customers were “off-limits” and that the restriction did not prevent those customers from having other hairstylists service them during the restricted period.  

In another case involving a rival title company hiring away a key employee with a five year noncompete, the United States Sixth Circuit analyzed the issues this way in Chicago Title Ins. Co. v. Magnuson, 487 F.3d 985 ( 2007):

Overall, because Chicago Ttle had critical customer and employee relationships to protect, because these relationships directly affected Chicago Ttle’s ability to compete in the market, because Magnuson could influence the continuity of these relationships, because the [noncompete] Covenant contained appropriate geographic and temporal limits, because Magnuson had other means to support himself (his law degree), and because at least some of Magnuson’s relationships were established or strengthened during his employment with Chicago Title, we find that the district court properly concluded that the Covenant was reasonable for at least two years following Magnuson’s departure from Chicago Title.

So what happens if you violate a noncompete?  Your former employer can sue you for damages which may be lost business because of your actions – this could result in very expensive attorney fees -- and the pending lawsuit will often have the effect of lengthening your noncompete period. 

Clients sometimes ask me whether it matters that they signed the noncompete years ago, apparently in the hope that there is some sort of automatic expiration period.  No it does not matter how long ago or how recently you signed the noncompete.   

What if other people have left and the employer has never really enforced the noncompete before?  Well, maybe you might have something here.  This is, by the way, why you should expect to be sued if you violate a noncompete; failing to come after you might make it more difficult for the employer to enforce the noncompete later against someone else.

What if the company gets sold to a new owner?  Read my post on "Can a New Owner Enforce a Noncompete Made by an Employee with the Prior Owner?"

Drafting Tips for Employers

From an employer perspective, the key is to be realistic about the restrictions placed upon former employees.  A 2006 article in HR Magazine by Stephen L. Richey entitled “Tailor Non-competes to a T: a One-Size-Fits-All Non-compete Agreement Won’t Pass a Judge’s Inspection” provides several helpful hints about what to think about.  Employers can also take some comfort in the fact that Ohio courts will usually modify noncompetes that go too far rather than simply refusing to enforce them at all.  

• Email This
• Print
• Comments
• Trackbacks

Anita Campbell of the Small Business Trends blog has recently offered an interesting post inviting small business owners an opportunity to Monetize Your Website or Blog by Offering Trade Magazines.  Check out both the publications available that you might like  and how you can participate if it seems like a good fit to you.

Anita explains that TradePub.com is a way to get B-to-B trade publications for free and links to the TradePub.com feature on her site.  According to Anita, TradePub.com is now looking for additional blogs and websites interested in affiliating with TradePub.com to offer a trade publication storefront on their website.  In addition to offering an additional service to visitors to your site, you will get paid a fee, varying by publication, for each new subscription your readers make through your storefront.  The fee may be as little as a dollar per subscription, but can also be as much as $5 or $10, or in a few cases, even $20.

I took a look at the publications available and was surprised at the range.  Virtually every industry seems to be represented.  Within minutes, I found two that seemed like they'd be useful to me, including one called The Deal which is described as "the indispensable newsweekly for all dealmakers covering M&A, bankruptcy, private equity, venture capital, law & tax, corporate."  The confirming e-mail said it might take up to 12 weeks for the subscription to kick in, which was a little disappointing, but then I suppose you shouldn't expect too much for free.

As far as signing up to be an affiliate, I'm still thinking about that.  It certainly sounds like a good program.  From what Anita says, it also appears to be low maintenance from the site owner perspective.  Anita also points out that once you sign up, you get stats about which publications are of the most interest to your readers and that can give you useful information about topics your readers are interested in.

To become an affiliate, you must sign-up with RevResponse.

• for more information on how the program works, click here or here.

• Email This
• Print
• Comments
• Trackbacks

 I've often said that I consider TAX a four-letter word.  So I was most pleased when CPA Karen deLaubenfels accepted my invitation to make a guest post on this very subject. 

>>>>>>>>>> So, without further ado, KAREN DELAUBENFELS on TAX:....

A business tax issue that is somewhat neglected is owner tax basis, which is, roughly speaking, the owner’s stake in the business. Tax basis of business ownership is a topic of interest regardless of entity choice because it can affect the amount (and whether)  you may owe the government for taxes.  However, we focus here on the tax basis of a corporate shareholder.   

Many entities aside from actual corporations, such as LLCs, may wish to be taxed as a corporation under the “check-the-box” regulations, which allow the non-corporate entity to choose whether to be taxed as a “flow-through” partnership/sole proprietorship or a C (regular) corporation. The C corporation can then elect to be taxed as a “flow-through” S corporation, as Teri Rasmussen mentions in her article, "Taking the Plunge - How to Choose the Right Business Entity for Your Business." In a “flow-through” entity, the owners are taxed on their share of the company’s income, regardless of whether they receive any actual distributions of cash or property. Many of these non-corporate entities choose to be taxed as S corporations to maintain the flow-through aspect of the business, while avoiding possible ambiguity about whether owners may be treated as employees, allowing for withholding and tax-free fringe benefits available only to employees. Regardless of the entity choice, though, basis is a key player in determining taxability of any distributions to owners.

Each business owner has a tax basis in that ownership, unique to that individual. This basis is often, roughly speaking, the owner’s investment, plus earnings of the business, minus distributions to the owners and losses of the business, although the calculation differs somewhat depending on the type of business entity. We’ll focus on an entity that comprises 61.9% of the total number of corporations in the U.S. according to 2003 IRS statistics: the S corporation.

So what happens when the owner of an S corporation takes a distribution of cash or property? The short answer is that it’s generally not taxable, since the owner has already been taxed on the flow-through income; however, the exceptions to this general situation can have serious tax consequences for the business owner, and deserve a look.

An S corporation has a different set-up than other business entities, and is distinct even from other flow-through entities. The owner’s basis in shares of stock generally begins as just their cost, as with any other corporate shares; however, whereas the C corporation owner’s stock basis doesn’t change, the S corporation shareholder’s basis in the shares is a moving target, changing with corporate earnings and the owner’s contributions and distributions. In addition, if the owner makes any loans to the S corporation, there’s an additional quirk of the S corporation, loan basis. Although loan basis is beyond the scope of this post, it should be noted that it can affect the deductibility of corporate flow-through losses, and is thus worthy of consideration by the S corporation shareholder as well. 

Whether a distribution to the shareholder is taxable or not depends on whether the corporation has sufficient AAA, PTI, AEP, and OAA, and then on whether the shareholder has any tax basis in his/her shares.

This jumble of letters deserves some explanation. 

• AAA (the Accumulated Adjustments Account) tracks the corporation’s contributions, taxable earnings/losses, and distributions. A positive balance in this account represents corporate earnings that have been taxed as flow-through income, but not yet distributed to owners.

• PTI (Previously Taxed Income) is an “old-school” analog of AAA, which is only (possibly) relevant for S corporations that were in existence before 1983.

• AEP (Accumulated Earnings and Profits) is only (possibly) relevant for S corporations that were formerly C corporations. AEP is a topic in itself, and deserves its own separate discussion. For now, let’s note that any distributions from AEP are taxable as corporate dividends.

• Finally, OAA (the Other Adjustments Account) tracks the corporation’s non-taxable items affecting shareholder basis. This would include such items as tax-exempt municipal bond interest and “key person” life insurance proceeds, along with their associated non-deductible expenses.

Every time a cash or property distribution is made to shareholders, it reduces the balances in these accounts, in the order given above. As long as distributions do not use up AAA and PTI, they are not taxable. If AAA and PTI are gone, any distributions are next deemed to come from AEP, and are taxable as regular corporation dividends, subject to lower tax rates at present. When AEP is gone, distributions are deemed to come from OAA, and are again not taxable.

Next, though, we have the situation to watch out for, as it’s generally avoidable with good tax planning: If AAA, PTI, AEP, and OAA are consumed, the distributions are a return of the shareholder’s capital, lowering his basis in his shares. Once basis is used up by distributions, any additional distributions are taxable gain to the shareholder. 

Do you need to know your AAA, PTI, AEP, and OAA?  If your corporation has ever been a C corporation, you need to look at all four. If not, you need at least AAA; if you sell your ownership interest, your taxable gain may be reduced by your share of any positive balance in the AAA account.

Do you need to know your tax basis in your corporate ownership?  Absolutely. How else will you know whether your distributions have crossed the line from tax-free to taxable gain? 

Karen L. deLaubenfels, CPA offers accounting advice, including a full line of tax consulting and preparation service, to clients in Central Ohio.  She also offers Quickbooks consulting and bookeeping services.   For more information, you can visit her website at www.karendcpa.com,  

• Email This
• Print
• Comments
• Trackbacks

In recent years, the concept of having an "advisory board" has grown in popularity.  Should your business have one and, if so, how do you get one set up?

An advisory board is similar to a board of directors in some respects, but there are some important differences.  An advisory board is a small group of hand-picked professsionals offering advice to a privately held business in areas the owners may feel they lack skills or experience.  It differs from a board of directors because members of a board of directors make decisions on behalf of the company while an advisory board simply offers suggestions and ideas which may or may not be acted upon.  In addition, those serving on a board of directors have fiduciary duties to all of the company's owners, and in some cases to creditors and other third parties.  

Usefulness of Advisory Boards.  Advisory boards may be particularly useful for more recently formed companies or companies in transitioning to a larger presence in the marketplace, but more established companies can also benefit.  For small businesses with only one or two owners, advisory boards can be a useful resource giving more structure to decisionmaking.  Among the ways an advisory board can be useful are:

• Strategic Planning.  For companies in transition, having advisory board members who may have "been there, done that" can be helpful in mapping out where a company may want to go next and in providing a reality check as to what may be needed to get there. 
• Practical Advice and Evaluation.  Advisory board members can fill gaps in business knowledge and be a good sounding board in making ordinary business decisions about personnel policies, prospective business partners and opportunities, marketing and pricing strategy and tactics, etc.
• Leverage and Influence.   The knowledge, contacts and experience of advisory board members can sometimes lend credibility and clout to the company in its marketplace.  

Putting an Adviosry Board Together.  So how do you get an advisory board put together?  Various nonprofit groups offer advisory board programs.  For example, the Womens Presidents' Organization offers peer advisory boards for its chapter members  In addition, in Columbus, the Advisory Board Exchange - an initative of Business First - offers an ongoing program open to applicants averaging at least $3 million in revenue annually over the past three years and which are headquartered in Central Ohio. 

Another possible organized advisory board alternative  is the Athena PowerLink program sponsored by the Columbus National Association of Women Business Owners (NAWBO) chapter.  One woman-owned business is selected as a recipient each year and provided a custom-tailored group of advisors for a year.  Applicants must have been in business for at least two years, have at least two employees, and generate annual revenues of at least $250,000 for manfacturing concerns or $100,000 for service companies.

Business owners can also put together an advisory board on their own, perhaps starting by asking an attorney, CPA, or financial advisor to serve on the advisory board.  Retired executives may also be good  prospects.  In addition to having a genuine desire to help a business grow and mature, these professionals enjoy the opportunity to meet and become acquainted with other like-minded professionals. 

  .

• Email This
• Print
• Comments
• Trackbacks

When considering an exit strategy for leaving the ownership of a business, don't forget to factor in the rights and input on the subject to which your fellow owners may be entitled. In many cases, finding a buyer for your equity stake is only part of the process.

Whether it's a closely held corporation or LLC whose equity holders are owner-operators or an investment vehicle LLC with sophisticated equity holders, the Operating Agreement or Close Corporation Agreement is quite likely to contain some restrictions on the manner in which ownership interests can be transferred to nonowners. Often one such restriction will be a "right of first refusal" which requires that one's fellow owners, and/or the company itself, be given an opportunity to purchase the ownership interest before any sale or transfer to a third party is permitted.

The typical "right of first refusal" generally follows the following sort of sequence:

1.  Getting the Purchase Offer in Writing. The equity holder wishing to sell to someone outside the existing ownernship must obtain a WRITTEN bona fide offer from the propsective purchaser setting forth the material terms and conditions of the offer and the amount of consideration offered.

• YES, it really does need to be written. It doesn't necessarily have to be in the form of a formal purchase agreement, but a few notes on the back of an envelope or business card will probably not be adequate. 
• Bona fide just means it needs to be something that the prospective purchaser really will follow through on and there are not any questionable side transactions (e.g., part of the purchase price is immediately refunded to the purchaser) required to support the proposed transaction. 
• Yes, it does need to be specific. If, for example, payment is going to be made over time, that needs to be explicitly stated.

2. Notifying the Remaining Owners. A copy of the written bona fide offer, together with some sort of written notice setting forth the desire to sell, must be provided to all of the remaining equity holders.

• NO, an e-mail to the remaining equity holders from the owner wishing to sell out which summarizes the terms of a verbal offer is probably not good enough. 
• The precise form of the notice required is generally not spelled out in the Operating Agreement. However, nothing more complicated than indicating it is a notice of the desire/intent to sell is necessary. Some Operating Agreements do require the notice to contain a summary of the terms and conditions of the offer.

3. Waiting for a Response. The company and the remaining equity holders are given a period of time to consider whether they wish to "meet" the offer made and buy back the equity interest. Usually, but not always, the company is given the first "right of refusal" with the remaining equity holders being given a chance to purchase if and only if the company decides not to exercise its right of refusal.

• The amount of time given for consideration of the offer varies, although 15, 30, or 60 days are common choices. Generally the length of consideration time is the same for all parties having a rights of first refusal, i.e. both the company and the remaining owners will each be given 30 days.
• The consideration time is usually cumulative, i.e. the company has 30 days to decide and then the remaining owners get 30 more days after that to make their decision.
  o Occasionally, Operating Agreements provide that the presentation of a bona fide offer permits the remaing equity holders to purchase the subject equity interest at predetermined price, perhaps "fair market value", as determined by an agreed upon formula or method.
• The purchase by the company or remaining equity holders in the aggregate must be for the entire portion of ownership interest being offered for sale - no partial purchases are permitted, although it is often possible for the equity interest to be divided among the remaining owners.

4. Exercising the Right of First Refusal. If the parties holding "rights of refusal" wish to exercise them, they must provide the party wishing to sell with written notice of that intent within the time required. The transaction must then be closed within the time specified by the Operating Agreement which can vary considerably from one Operating Agreement to another. Some Operating Agreements may even prevent a closing prior to the expiration of at least some period of time, i.e. 30 or 60 days.

5. Right of First Refusal NOT Exercised. If the parties holding the rights of refusal choose not to exercise them, the party wishing to sell may proceed to consummate the offer under the terms and conditions disclosed. Generally, if the transaction is not consummated within a certain period of time, perhaps as short as 30 or 60 days, the party wishing to sell will have to go through the entire right of first refusal process again.

Make sure you understand the "big picture" once you've decided it's time to move on and want to transfer your ownership interest in a business to ensure you don't lose valuable time.

• Email This
• Print
• Comments (1)
• Trackbacks

If you've been in business long at all, somewhere along the line there may well have been some sort of dispute about the amount a customer owes.  And if you've had any contact at all with an attorney, you have undoubtedly been told to watch out for "payment in full"  situations in which you receive checks purporting to be "in full satisfaction" or containing some similar endorsement indicating that the customer intends this payment to be it.  In fact, if you're in Ohio, you have probably been admonished (and maybe even established as policy) that any check accompanied by a such a restrictive endorsement, or any cover correspondence using this language, MUST be returned to the customer. 

Simple enough.  But suppose you receive a cover letter enclosing a check for less than the amount owed which doesn't use these "magic" terms of art?  What if the letter specifically states that it is not placing any restrictive endorsement on the check to you, but hastens to add something to the effect that this is all the money we believe is owed to you?

In Ohio, the answer has changed over the years.   Prior to the 1989 Ohio Supreme Court case of AFC Interiors v. DiCello, 46 Ohio St.3d 1, 544 N.E.2d 869 (1989), creditors faced the dilemma of having to choose between  accepting the lesser amount offered and writing off the balance or rejecting the partial payment being offered in favor of pursuing the debtor for the entire amount due.  If a check offered "in full payment" or "in full satisfaction" was cashed by the creditor, the remaining amount owed simply could not be recovered.

From 1989 through 1994, there followed a glorious period for creditors in which they could rely upon Ohio Rev. Code 1301.13 to take the partial payment AND still pursue the debtor for the balance if they did so while make a "reservation of rights".  Thus if the creditor endorsed the check by writing words such as "under protest" or "without prejudice" just above their endorsement before cashing the check, the creditor had managed to have its cake and eat it too.  In this way, creditors accepted the partial payment, applied it against the balance owing and then were permittred to continue further collection efforts.  

All this changed in 1994 when Ohio adopted the revised version of Uniform Commercial Code Articles 3 and 4.  As a result of the change in the law, making a reservation of rights was no longer possible.  In addition, if the partical payment was accompanied by correspondence indicating that the payment was ended to satisfy the obligation in full. cashing the check meant that the creditor could not pursue the trmaining ballance.  New Ohio Rev. Code 1303.40 (A), which remains in effect today, provided that

the claim is discharged if the person against whom the claim is asserted proves that the instrument or an accompanying written communication contained a conspicuous statement to the effect that the instrument was tendered as full satisfaction of the claim.

 This had the effect of returning Ohio to the pre-1989 common law era.

So, today, do not be fooled if receiving a partial payment check.  In addition to the obvious situation in which it is clearly marked as "payment in full", you must also pay attention to the correspondence accompanying the payment.  If that correspondence indicates that the sender does not intend to pay the balance, then you are cashing the check at your own risk, even if there is no restrictive endorsement placed  on the check.  

• Email This
• Print
• Comments
• Trackbacks