Summer 2004

All of us have made donations to our favorite charities and, in most cases, received a letter from the donee organization acknowledging our gift. A recent case decided in the United States Tax Court puts taxpayers on notice that they should take great pains not only to retain these letters, but also to pursue charities who neglect to send them, because not only will substantial charitable deductions be disallowed without the requisite substantiation (whether or not the taxpayer can provide cancelled checks to prove payment), but taxpayers may also be subject to penalties for taking deductions of unsubstantiated charitable contributions. In Jerry L. Hill and Valerie J. Hill v. Commissioner, the Internal Revenue Service audited the 1999 joint personal income tax return filed by the Hills and, in particular, requested that the Hills produce cancelled checks to substantiate their deducted charitable contributions (which they did), but the Service also required that, for any deducted charitable contribution of $250 or more, the Hills produce contemporaneous written acknowledgments sent to the Hills by the recipient donee organizations.

Section 170(f)(8) of the Internal Revenue Code requires such written acknowledgements as substantiation and that they include:

Further, the written acknowledgment of the charity, in order to be “contemporaneous” and, therefore, compliant with the Code’s requirement, must be received by the taxpayer on or before the earlier to occur of (a) the filing date of the income tax return upon which the deduction is taken, or (b) the due date for filing that return (including extensions).

Of course, by the time the IRS auditors came calling, years later, it was too late for the Hills to go back to their charitable donees to obtain the required acknowledgments, as the Tax Court held that such after-acquired letters from the charities were not “contemporaneous” within the meaning of the Code. Not only did the Tax Court deny the deductions for the Hills’ charitable contributions of $250 or more, but the Court also assessed penalties for late payment and for a substantial understatement of the tax liability by reason of the Hills taking deductions to which they were not entitled.

The reason that Congress adopted Section 170(f)(8) was to curtail a perceived widespread abuse of charitable contribution deductions in which checks are written payable to a charity, and then deducted, but which were in fact payments for which the taxpayer received supermarket scrip, art or other property purchased at a charity auction, or meals and entertainment tickets provided at a charity event. In all of such cases, the law limits the amount of the deduction to the excess, if any, of the amount donated over the fair market value of the goods or services received by the donor; however, abusive taxpayers artificially inflated their deductions by failing to reduce their donations by the value of goods and services received.

The strict reading of the law by the Tax Court reminds us that some time before filing a personal income tax return, a taxpayer should determine (a) whether he or she has made any deductible charitable contributions of $250 or more and, if so, (b) whether he or she has received and can produce a contemporaneous, qualified written acknowledgment from each and every one. It also teaches each charity that it should be extremely vigilant about providing each donor of $250 or more with a timely letter of acknowledgment, since a donor whose contribution deduction is denied because he or she received no such contemporaneous letter is not likely to hold the donee organization in high regard for future donations.

Fiduciary Duties and Limited Liability Companies

The last several years have seen a boom in the popularity of the limited liability company as the form of choice for a new business entity. Everyone and their grand-mothers now know about the advantages of single taxation, the ability for a member to receive a profit interest or contribute appreciated property to a Limited Liability Company (LLC) without immediate income tax consequences, the ability to do tax-free dissolutions, divisions and mergers and relaxed requirements as to corporate formalities. But what about the fiduciary duties that members and managers owe to the LLC and to anyone else involved in the company?

The drafters of the California Limited Liability Company Act (LLC Act) did not list the fiduciary duties, so they simply incorporated by reference the fiduciary duty rules applicable to partnerships. These fiduciary duties are owed to the LLC and its members by the manager(s); if the LLC is member-managed, then the managing members are the ones with the fiduciary duties. These duties are, broadly, a duty of loyalty and a duty of care and include:

The LLC Act permits the fiduciary duties of a manager to be modified in the LLC’s operating agreement with the “informed consent” of the members. Since the term “informed consent” is not defined in the LLC Act, it is not entirely clear what kind of consent would be considered “informed.” Typically, where the member is a highly sophisticated investor or is represented by adequate counsel, “informed consent” may be presumed, but in other cases a company preparing its operating agreement may want to disclose the default levels of fiduciary duties under the LLC Act and explain how the default levels are being modified and the expected practical advantages and disadvantages to the LLC of these modifications.

California residents may avoid these fiduciary duty rules by forming an LLC in Delaware. In contrast to the LLC Act, the Delaware Limited Liability Company Act (Delaware Act) has a much simpler formulation that gives greater flexibility to the drafter of an operating agreement to limit a manager’s fiduciary duties to the LLC and its members. The Delaware Act simply states that the duties of a member or manager to any other person, including fiduciary duties, may be expanded or limited by the provisions of the LLC’s operating agreement. There is no “informed consent” requirement, and the Delaware Act protects a member or manager acting under the operating agreement from liability if he or she acted in good faith reliance on the operating agreement’s provisions. Fiduciary duties under the Delaware Act may not be entirely eliminated; at the very least, a manager owes a general duty of loyalty and care to the LLC as well as a duty to make good faith efforts to ensure that an LLC fulfills its contractual duty to its members. Metro Communication Corp. BVI v. Advanced Mobilecomm Technologies, Inc., 2004 Del. Ch. LEXIS 57 (April 30, 2004). Nonetheless, the formulation under the Delaware Act statute does give greater flexibility to a company to create its own fiduciary duty standards.

Marvin H. Lewis Retirement

Our esteemed partner, Marvin H. Lewis, is retiring from the practice of law after 43 years of dedicated service. While we are saddened by the departure of one of our senior partners, we wish Marvin well in his new personal endeavors.

For the past quarter century, Marvin has worked closely with our partner, Reeve Chudd. At Marvin’s direction, we ask that our clients, whom he has served so well for so many years, now contact Reeve, who can be reached directly at 310.281.6308 or rchudd@ecjlaw.com.

The firm continues to practice in the areas of Real Estate, Litigation, Employment, Estate Planning, Bankruptcy, Intellectual Property, Business and Securities, Tax and Health Care.

Thank you, Marvin, for your marvelous service to ECJ. You have been a model of professionalism and expertise for us.

Estate Planning Bits and Pieces

One planning opportunity often overlooked by those who wish to make charitable bequests from their estates upon death is the selection of the optimum asset for donation. Typically, we find that a person’s main estate planning document (will or trust) will have a specific charitable bequest in a dollar amount or percentage or formula format. Yet such a simple approach may result in the charitable bequest being funded by the general estate of the person, instead of the more advisable use of an Individual Retirement Account (IRA) or pension plan.

When the participant of an IRA or pension plan dies, normally a designated beneficiary receives a distribution of the deceased participant’s remaining IRA or account. Unfortunately, since the deceased participant deferred recognition, for income taxes, of the amount in his or her IRA or pension plan account, the designated beneficiary will have to report this distribution, for his own income taxes, as ordinary income received. While a designated beneficiary recipient may have alternatives that will permit him or her to further delay income tax recognition, sooner or later a recipient will pay income taxes on that distribution.

For example, suppose that a widow, Mrs. Gold, has a $100,000 spousal rollover IRA from her late husband and she designates her only child, Lisa, as the sole beneficiary to receive the IRA at Mrs. Gold’s subsequent death. Suppose also that Mrs. Gold’s estate, other than the IRA, is $800,000, and her will gives her favorite charity a $100,000 bequest at her death, with the rest of her estate going to Lisa. Upon Mrs. Gold’s death, Mrs. Gold’s estate will be distributed $100,000 to the charity and $700,000 to Lisa. The IRA will be distributed to Lisa, and Lisa will pay income taxes of, say, $40,000 on the IRA distribution. Lisa ends up with $760,000 and the charity will receive $100,000.

On the other hand, if Mrs. Gold instead changes her will to give her entire estate to Lisa and changes the beneficiary designation on the IRA to the charity, Lisa will receive the entire $800,000 estate and the charity will still receive $100,000, because the charity, being exempt from income taxes, will not have to pay income taxes on the distributed IRA. It goes without saying that, as part of any comprehensive estate planning process, a person inclined to provide for a charitable bequest in his or her estate plan should consult a tax professional to explore the most advantageous method of funding the charitable bequest.

Many of our clients make regular annual gifts to their children and grandchildren using the federal gift tax annual exclusion (currently $11,000 per donor for each donee per calendar year) as a method of reducing the donor’s eventual taxable estate. In general, if a taxpayer makes only annual exclusion gifts in a calendar year, i.e. only gives $11,000 per donee, then the taxpayer is not required to file a gift tax return or pay a gift tax.

Normally we advise clients making annual exclusion gifts to do so with cash or marketable securities, all of which can easily be valued to target the $11,000 figure. On the other hand, we have, on occasion, seen cases where individuals make gifts of property, such as fractional shares of real estate, closely-held corporations or partnerships, and take the position that the value of these small fractional gifts is less than or equal to the annual exclusion amount. Based upon this position, they do not file a gift tax return to report their gifts, nor do they expend additional funds to obtain an annual appraisal of their fractional share gifts. Further, in order to make such fractional gifts each year, one must make annual assumptions regarding the value of the entity or parcel for which a fractional share is given.

We do not recommend that our clients pursue this latter practice, simply because of the exposure to challenge on the value of their annual gifts. First, if one files no gift tax return reporting such gifts of property, then the normal three-year statute of limitations on gift tax returns does not run, meaning that the Internal Revenue Service may challenge the value of a gift at any future time (and sometimes does so, as part of the estate tax return audit after a donor has died). Second, because the cost of obtaining a timely appraisal for each year of such gifts is probably prohibitive, defending against such a challenge by the IRS without qualified, contemporaneous appraisals will be extremely difficult.

ECJ Welcomes Three New Associates

The firm is pleased to welcome three new associates: David S. Hochman, John M. Houkom and Patricia M. Kosich.

David S. Hochman received his J.D. from Loyola University. He is an associate in the Business and Securities Law and the Intellectual Property Law Departments, where his areas of practice include corporate law, general business transactions, corporate structuring, licensing, trademark and copyright.

John M. Houkom received his J.D. from the University of California at Berkeley. He is an associate in the Litigation and the Intellectual Property Law Departments, where his areas of practice include business litigation, real estate litigation, intellectual property and unfair competition litigation.

Patricia M. Kosich received her J.D. from the University of California, Los Angeles School of Law. She is an associate in the Business and Securities Law and Health Care Law Departments, where her areas of practice include health care and corporate law.

Todd Pipe & Supply Is Sold

ECJ represented Karl B. McMillen, Jr. and his family trusts in the negotiation and sale of Todd Pipe & Supply - Hawthorne, Inc. and all of its subsidiaries to Hughes Supply, Inc. Todd Pipe is the largest independent wholesale plumbing supplier in Southern California. Hughes, a NYSE company, is the second largest distributor of plumbing material, construction, repair and maintenance products.

Legal Update is published by the law firm of Ervin, Cohen & Jessup LLP as a service to clients and friends of the Firm. Articles are intended as summaries of the law and should not be relied upon as substitutes for legal consultation. Authors will, on request, be pleased to discuss in greater detail the information contained in their articles.

Correspondence regarding information contained in this issue or address corrections should be addressed to Cynthia Kaiser, c/o Ervin, Cohen & Jessup LLP, 9401 Wilshire Boulevard, Ninth Floor, Beverly Hills, California 90212-2974 or ckaiser@ecjlaw.com.

If you would like to receive a complimentary copy of ECJ's Legal Update, please e-mail Cynthia Kaiser at ckaiser@ecjlaw.com.

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