The Uniform Commercial Code, as enacted in most states, defines “Goods”  as “all things (including specially manufactured goods) which are movable at the time of identification to the contract for sale other than the money in which the price is to be paid, investment securities (Division eight) and things in action. “Goods” also includes the unborn young of animals and growing crops and other identified things attached to realty as described in section 2107 (relating to goods to be severed from realty; recording).[1]

In a typical transaction, a purchaser of manufactured goods, whether it is a manufacturer itself or a reseller, might for example transmit an order, via email, specifying the quantity and type of goods ordered, and a price.  The buyer might not specify any terms and conditions to be included with the order.  The seller might then acknowledge the order and include some “boilerplate” terms and conditions.  These conditions might for example disclaim all warranties and limit the buyer’s remedies for breach to repair or replacement of the goods.

Two questions arise: was a contract formed, and if so, what are its terms?  First, the UCC is very informal about the manner in which an offer can be accepted.  Any “definite and seasonable expression of acceptance or a written confirmation which is sent within a reasonable time operates as an acceptance”[2]  Therefore there is a contract, even though the seller’s acceptance contained terms and conditions never mentioned by the buyer.  The second question is, do any of the terms in the seller’s acknowledgment of the order become part of the contract? Under section 2207, different or additional terms can become part of the contract.  Since there was nothing in the buyer’s order limiting acceptance to the terms of the offer or objecting in advance to any different or additional terms, §2207(b) automatically includes additional terms (as opposed to different terms) unless the additional terms “materially alter” the offer.  Generally speaking, courts view a disclaimer of implied warranties as a material alteration so it does not become part of the contract.  On the other hand, a remedy limitation (repair or replacement, for example) is not considered material.  If additional terms do not cause “surprise or hardship” they are considered additional terms.

The treatment of different terms in the seller’s acknowledgment is a matter not directly addressed by Article 2 of the UCC in general, or §2207 in particular.  The courts in the several states have been left to come up with a rule for dealing with conflicting terms.  Most state courts have employed something called the “knockout rule” to resolve the impact of competing terms.[3]  The knockout rule removes express conflicting terms, leaving gaps to be filled with standard UCC terms.

Under the “knockout” rule, conflicting terms in the offer and acceptance cancel one another, i.e., are “knocked out.”  “Different” terms are not treated as “additional” terms for disposition under section 2207(b), and section 2207(b) is limited to its express language.  The offeree’s (the seller in this instance) form is treated only as an acceptance of the terms in the offeror’s form which did not conflict. The ultimate contract, then, includes those non-conflicting terms and any other terms supplied by the UCC, such as, for example, terms incorporated by course of performance (§ 2208), course of dealing (§ 1205), usage of trade (§ 1205), and other “gap fillers” or “off-the-rack” terms (e.g., implied warranty of fitness for particular purpose, § 2315).  One federal court explained the basis for this approach this way:

This approach recognizes the fundamental tenet behind U.C.C. § 2207: to repudiate the “mirror-image” rule of the common law. One should not be able to dictate the terms of the contract merely because one sent the offer. Indeed, the knockout rule recognizes that merchants are frequently willing to proceed with a transaction even though all terms have not been assented to. It would be inequitable to lend greater force to one party’s preferred terms than the other’s. As one court recently explained, “An approach other than the knock-out rule for conflicting terms would result in … [ ] any offeror … [ ] always prevailing on its terms solely because it sent the first form. That is not a desirable result, particularly when the parties have not negotiated for the challenged clause.”[4]

The result changes dramatically however if the order language states that acceptance means the seller is bound by the terms of the offer, or if there is language objecting in advance to any different or additional terms.  In that case, § 2207(b)(1) and (3) will preclude any additional terms in the seller’s acknowledgment of the order from inclusion in the contract.  §2207(b) incorporates a major theme of Article 2: the offeror is the master of the offer.

What then are the seller’s options if the buyer limits acceptance to the terms of its offer or objects in advance to any different or additional terms?  If the seller’s acknowledgment states that its acceptance of the order is conditioned in the buyer’s agreement to any different or additional terms or conditions in the seller’s acknowledgment, no contract is created.  However, the seller has made a counteroffer to the buyer, which the buyer can decide to accept, or to reject or ignore.  If the buyer ignores the seller’s new terms and conditions, there is no contract.  However, the parties could create one by their actions if the seller ships the goods and the buyer accepts them.[5]

The tax’s reach extends to the sales of the ownership interests in such entities, whether they are stock in a corporation, a partnership interest or a membership interest in a limited liability company.  Accordingly, the Tax Reform Code of 1971 defines a “Real estate company” as “[a] corporation or association which is primarily engaged in the business of holding, selling or leasing real estate ninety per cent or more of the ownership interest in which is held by thirty-five or fewer persons and which: (1) derives sixty per cent or more of its annual gross receipts from the ownership or disposition of real estate; or (2) holds real estate, the value of which comprises ninety per cent or more of the value of its entire tangible asset holdings exclusive of tangible assets which are freely transferable and actively traded on an established market.”[3]

The one percent tax is imposed on “Every person who makes, executes, delivers, accepts or presents for recording any document or in whose behalf any document is made, executed, delivered, accepted or presented for recording”.  Those persons “shall be subject to pay for and in respect to the transaction or any part thereof, or for or in respect of the vellum parchment or paper upon which such document is written or printed, a State tax at the rate of one per cent of the value of the real estate represented by such document, which State tax shall be payable at the earlier of the time the document is presented for recording or within thirty days of acceptance of such document or within thirty days of becoming an acquired company.”[4]

Under the Tax Reform Act, “[a] real estate company is an acquired company upon a change in the ownership interest in the company, however effected, if the change: (1) does not affect the continuity of the company; and (2) of itself or together with prior changes has the effect of transferring, directly or indirectly, ninety per cent or more of the total ownership interest in the company within a period of three years.[5]

A bill now pending in the Pennsylvania Senate would, if enacted, change the landscape significantly.[6]  The bill, introduced on January 26, 2012, was referred to the Finance Committee.  The bill would expand the definition of a real estate company to include one fifty percent of whose assets are real estate, instead of the current ninety percent.  At the same time, the bill would include, for the first time, real estate companies with real estate assets located outside Pennsylvania for purposes of determining the fifty percent threshold.

The bill reads in part as follows (new material is underlined, deleted language is bracketed):

The definition of “real estate company” in section 1101-C … is amended to read:

“Real estate company.”  Either of the following:

(1)  A corporation or association which is primarily engaged in the business of holding, selling or leasing real estate ninety per cent or more of the ownership interest in which is held by thirty-five or fewer persons and which:

[(1)] (i)  derives sixty per cent or more of its annual gross receipts from the ownership or disposition of real estate; or

[(2)] (ii)  holds real estate, the value of which comprises [ninety] fifty per cent or more of the value of its entire tangible asset holdings exclusive of tangible assets which are freely transferable and actively traded on an established market.

(2)  A corporation or association which holds, directly or indirectly, as ninety per cent or more of the value of its assets, an interest in a real estate company.  For purposes of this definition only, real estate shall not be limited to interests located within this Commonwealth.

The bill would also expand the definition of an “acquired company” to include any real estate company, ninety percent of whose ownership interests were transferred within the preceding three years, including interests which were the subject of a legally binding commitment executed during that time period.  The bill would make this change by adding the underlined text to the existing subsection (a) of the definition, as follows:

Section 1102-C.5.  Acquired Company.  (a)  A real estate company is an acquired company upon a change in the ownership interest in the company, however effected, if the change:

(1)  does not affect the continuity of the company; and

(2)  of itself or together with prior changes has the effect of transferring, directly or indirectly, ninety per cent or more of the total ownership interest in the company within a period of three years.

For purposes of this subsection, a transfer shall be deemed to have occurred within a period of three years of another transfer or transfers if a legally binding commitment to execute that transfer was made within that period. The tax shall be measured by the value of the cumulative percentage of change. 

Currently the Tax Reform Act defines “acquired companies” as those whose ownership changes have amounted to a transfer of ninety percent or more of the total ownership interest in the company within a period of three years.[7]

The bill will expand the transfer concept to include not only ownership changes which have in fact closed; presumably, those which have been transferred and for which consideration was paid.  It would now include “a legally binding commitment to execute that transfer” made during that time.  It is not clear from the language of the bill whether it was intended to include only executory agreements which were later actually consummated, and if so, when settlement should have occurred for purposes of defining that three-year period.

Finally, the bill provides that the “tax shall be measured by the value of the cumulative percentage of change.”  The bill does not indicate whether that change refers to the value of the real estate owned by the acquired company, how it was valued or when.  It also does not indicate whether “value” refers to the consideration actually paid for the transferred ownership interests.

As of March 7, 2012, the bill is in the Finance Committee.

For further information, contact Tom Barnes at (215) 886-6600.

February 6, 2012

Thomas J. Barnes, Esquire

1.         Introduction.

There would appear to be a growing trend toward government classification of construction workers as “employees”, even in cases where the general contractor or subcontractor paying for the work and the people performing the labor actually think otherwise. For a building contractor, the unintended result could be the imposition of significant additional cost when the state decides the workers are entitled to workers’ compensation, and the “employer” is obligated to buy workers’ compensation insurance or pay a substantial fine.

In February, 2011, Pennsylvania enacted the Pennsylvania Construction Workplace Misclassification Act.  This statute appears designed to enlarge the number of workers covered by both workers’ compensation and unemployment compensation.  It applies to all projects in Pennsylvania, whether privately or publicly funded.  This article is intended to provide a brief overview of the Act’s requirements as they apply to building and construction contractors.  Of course, we do not intend to provide specific legal advice for anyone here, and the reader is encouraged to consult counsel.

2.         What is an “Employee”?

The Pennsylvania Workers’ Compensation Act requires all Pennsylvania employers to insure their workers’ compensation liability.[1]  Most employers do so with insurance coverage.  A few large concerns are self-insured, and the rest use the State Workers’ Insurance Fund.  Problems arise when employers try to avoid this requirement by attempting to classify personnel as “independent contractors” when they are really employees.

For most employers operating with Pennsylvania employees, some kind of coverage is mandatory. There are some exceptions in the Workers’ Compensation Act, such as for home and domestic workers.[2]

An “employe” (the Workers’ Compensation Act’s antiquated spelling) is a “servant”, and that term includes all natural persons who perform services for another for a valuable consideration.  It does not include people “whose employment is casual in character and not in the regular course of the business of the employer….”[3]

Independent contractors are not employees. The Workers’ Compensation Act does not contain a specific definition for an independent contractor, although it does define the term “contractor”.  A “contractor”, for purposes of the Workers’ Compensation Act, is any “employer who permits the entry upon premises occupied by him or under his control of a laborer or an assistant hired by an employe or contractor, for the performance upon such premises of a part of such employer’s regular business entrusted to that employe or contractor”.[4]  It does not include “a contractor engaged in an independent business … in which he serves persons other than the employer in whose service the injury occurs, but shall include a subcontractor to whom a principal contractor has sublet any part of the work which such principal contractor has undertaken.”[5]

3.         How is an “Employee” Different From an “Independent Contractor”?

Over time, the appellate courts have developed a method for analyzing when a worker is an employee or an independent contractor.  Most of these cases have decided workers’ compensation claims, so the courts have used the Workers’ Compensation Act’s definitions as a starting point.  The analysis is fact-specific and the results have not always been consistent.

The Workers’ Compensation Act does not specifically say that independent contractors are not required to be covered.  Instead, the Pennsylvania courts have developed and refined the concept over the years.  “Any employer who permits the entry upon premises occupied by him or under his control of a laborer or an assistant hired by an employe or contractor, for the performance upon such premises of a part of such employer’s regular business entrusted to that employe or contractor, shall be liable for the payment of compensation to such laborer or assistant unless such hiring employe or contractor, if primarily liable for the payment of such compensation, has secured the payment thereof as provided for in this act.”[6]

Courts in Pennsylvania examine the following factors in determining whether an employment relationship exists:

1. Control of the manner in which work is to be done;
2. Responsibility for the result, only;
3. The terms of the agreement between the parties;
4. The nature of the work or occupation;
5. The skill required for performance;
6. Whether one employed is engaged in a distinct occupation or business;
7. Which party supplies the tools;
8. Whether payment is by the time or by the job;
9. Whether work is part of the regular business of the employer, and also
10. The right to terminate the employment at any time.[7]

The most important factor is the first one: whether the alleged employer had the right to control the work to be done or the manner in which it is to be performed, regardless of whether that right is actually exercised. Universal Am-Cam, Ltd. v. WCAB (Minteer), 762 A.2d 328 (Pa. 2000).In an employment relationship, the employer controls the way work is performed, while in the independent contractor relationship, the person engaged in doing the work controls the manner in which the result is obtained. Feller v.New Amsterdam Casualty Co., 363 Pa. 483, 70 A.2d 299 (1950).

“[C]ontrol of the result only and not of the means of accomplishment” does not transform an independent contractor relationship into an employer-employee relationship.  C E Credits OnLine v. Unemployment Comp. Bd. of Review, 946 A.2d 1162, 1169 (Pa. Commw. Ct. 2008).

4.         The Impact of the Construction Workplace Misclassification Act.

The new Construction Workplace Misclassification Act applies to “construction”, which is the “[e]rection, reconstruction, demolition, alteration, modification, custom fabrication, building, assembling, site preparation and repair work done on any real property or premises under contract, whether or not the work is for a public body and paid for from public funds.”[8]  It borrows the definition of “employee” (the legislature uses the modern spelling of the word now) from the Workers’ Compensation Act and the Unemployment Compensation Law.[9]

This new Act defines “independent contractor”.  A construction worker is an independent contractor only if he is paid for the work, there is a written contract to perform the work, the worker is free from control or direction over the performance of the services both under the contract of service and “in fact” and, as to that work, the worker is customarily engaged in an “independently established trade, occupation, profession or business”.[10]

An individual is “customarily engaged in an independently established trade, occupation, profession or business” in the commercial or residential building construction industry only if each one of the following criteria is satisfied:[11]

(1) The individual possesses the essential tools, equipment and other assets necessary to perform the services in dependent of the person for whom the services are performed.

(2) The individual’s arrangement with the person for whom the services are performed is such that the individual shall realize a profit or suffer a loss as a result of performing the services.

(3) The individual performs the services through a business in which the individual has a proprietary interest.

(4) The individual maintains a business location that is separate from the location of the person for whom the services arebeing performed.

(5) The individual:(i) previously performed the same or similar services for another person in accordance with paragraphs (1), (2), (3) and (4) while free from direction or control over performance of the services, both under the contract of service and in fact; or(ii) holds himself out to other persons as available and able, and in fact is available and able, to perform the same or similar services in accordance with paragraphs (1), (2), (3) and (4) while free from direction or control over performance of the services.

(6) The individual maintains liability insurance during the term of this contract of at least $50,000.

The fact that taxes are not withheld is irrelevant[12].

These requirements raise the bar to independent contractor status quite a ways, so anyone who before was in between employee and independent contractor will now almost certainly fall into the employee category.

5.         The Consequences of Failing to Comply with the Construction Workplace Misclassification Act.

An employer who fails to properly classify an employee as such violates the Act.[13]  There is an array of powers granted to the Secretary of Labor and Industry to enforce it, ranging from investigations to money fines and referral to the State Attorney General for possible criminal prosecution[14].  There is some relief for the contractor for whom the services were performed: if they believed in good faith that the individual who performed the services qualified as an independent contractor at the time the services were performed, they will be excused.  However, proof of “good faith” is not an easy requirement to meet.  A proceeding before an administrative agency, as many business owners know, can be an expensive and time consuming process.

Criminal sanctions are triggered when the violation is intentional.  A careless or negligent violation is punishable as summary offense, meaning a fine of up to $1,000[15].  Evidence of a first offense, however, can be used in connection with later offenses as proof of actual intent to violate the statute[16].

If the first offense is intentional and not negligent, it is a misdemeanor of the third degree.  Third degree misdemeanors are punishable by a term of imprisonment of up to one year[17].  A second or subsequent offense is classified as misdemeanor of the second degree.  Conviction carries a punishment of imprisonment of up to two years[18].

6.         Some Examples, by Industry.

Sales: documents and tax returns indicated that a worker changed from employee to independent contractor prior to his death.  The documents provided that worker was free to engage in business with other companies.[19]

Construction:  A “mason tender” who was injured while cleaning a cement machine which was used to mix mortar was not an independent contractor, but, rather, was an employee, because the contractor instructed the “mason tender” about how to clean the mixer at end of the workday, and the contractor supplied most of the tools.[20]

Construction:  A sign painter was determined to be an independent contractor and not an employee, for several reasons.  He did not specify an hourly charge for his labor, nor were his charges consistent with an hourly rate.  There was no agreement between the parties that the sign painter was to be the business owner’s handyman; there was no specific agreement as to the rate sign painter would receive for fixing the roof; the business owner did not have the right to control where the roof repair would be done by sign painter; the sign painter’s tax return for the year in which the accident occurred indicated that he was self-employed, the sign painter provided and used his own tools; and the business owner did not carry the sign painter on his payroll, deduct withholding tax, or pay social security benefits on the sign painter’s behalf.[21]

Construction:  A stone installer was engaged by a contractor to install stone as a small portion of the remodeling work being performed by several contractors.  The installer was paid by the job rather than by the hour, he used his own equipment, tools and vehicle, he paid and supervised his own workers on the job and the installation of the stone was a specialized job which very few men could perform.  Therefore, he was an “independent contractor” and not an “employee” of the contractors, who were not liable for injuries suffered when an automobile driven by a third party collided with the installer’s truck as installer was attempting to execute left turn into driveway of a home undergoing remodeling.[22]

Trucking and transporation:  A newspaper carrier was an “independent contractor” rather than an “employee” of the newspaper, and thus was not entitled to workmen’s compensation benefits for injuries sustained when hit by car while delivering papers.  The newspaper did not exercise sufficient control over the carrier’s work and the manner in which it was performed to create an employment relationship.  The newspaper did not prohibit the carrier from carrying a competing newspaper or to require the carrier to provide it with notice or get prior approval when he wished to substitute another person to deliver the papers.[23]  

Trucking and transporation:  The claimant was determined to be an independent contractor because he entered into a lease agreement in which he agreed to provide trucking services to the employer, but the employer did not direct claimant to use any particular route but, rather, advised the claimant of where the load was to be picked up and delivered.  Also, the claimant’s compensation was based on the load, and the claimant paid for the insurance.[24]

  7.       Conclusion: Be Careful.

Contractors in Pennsylvania are well advised to carry worker’s compensation insurance for everyone working for them.  The relationship with someone who is an independent contractor should be examined carefully, and the particulars of the relationship are often best put in writing, when the cost of such a contract makes sense in light of both its benefits, and of the substantial penalties for failing to comply with the Pennsylvania Construction Workplace Misclassification Act.

For further information, contact Tom Barnes or Jim Egbert at (215) 886-6600.

Written by Thomas Barnes, Esquire

Introduction.  Businesses operating in Pennsylvania, whether organized under Pennsylvania law and based here, or organized in another state and doing business here, are subject to the capital stock tax.  The tax’s name is somewhat misleading, because it applies not only to corporations, but also to limited liability companies and certain other entity types.  The taxed is assessed on a combination of the historical net income and net worth of the entity.  This is a general overview of how the tax is imposed, and on whom.  This is of course not intended as legal advice, and the reader is encouraged to consult counsel about any provision of the law he or she suspects may apply to their business.

General Rules.  Pennsylvania’s capital stock tax is imposed on corporations.  The statute defines the term “corporations” broadly.  Not only are regular business corporations with capital stock included in the definition, but it also defines “corporations” to include joint-stock associations, limited liability companies, business trusts, and other companies doing business within Pennsylvania. § 7601(a).[1]  Limited partnerships are not specifically included in the definition, nor are they specifically included in the list of excluded entities.  Nonprofit corporations are exempt.  Domestic corporations are subject to the capital stock tax while foreign corporations are subject to the foreign franchise tax on capital stock apportioned to Pennsylvania. § 7602.  In this brief summary, we will use the term “corporation” as a shortcut to refer to all these other entities, including corporations.

The capital stock tax for domestic firms is imposed on the corporation’s capital stock value, as derived by the application of a formula. §§ 7601(a), 7602.  Pennsylvania courts have held that the capital stock tax is in the nature of a property tax. [2]

The foreign franchise tax is imposed on out-of-state corporations, LLCs and other entities.  Pennsylvania courts classify it as a tax on the privilege of doing business in Pennsylvania, instead of a property tax. [3]

Computation of the Tax.  The tax is imposed on the capital stock value attributable to Pennsylvania; that is, the assets located in this state and the net income derived in Pennsylvania from the use of Pennsylvania assets.

Both the capital stock tax and the foreign franchise tax are based on two factors, the entity’s average net income and net worth.  For both taxes, the capital stock valuations are computed by using a mathematical formula, which is found in § 7601(a).  However, for the foreign franchise tax, there are reductions to average net income for business done out of state and certain other factors.  § 7401.  The formula is:

(0.5 X [Average Net Income/0.095 + (0.75 X Net Worth]) – $160,000.

The valuation deduction at the end of the formula, $160,000, will remain unchanged until 2014, when the tax expires.  §§ 7602(h), 7607.

Average net income is the average of the last five years’ income, but cannot be less than zero.  § 7601.  If there are less than five years of operating results available, the results that are available are averaged.

Net worth is net stockholders’ or owners’ equity as of the close of the tax year, either as shown on the federal tax return or determined in accordance with Generally Accepted Accounting Principles. § 7601.

Exemptions.  Companies engaged in manufacturing, processing, research or development plant are exempt from the capital stock tax to the extent their net worth is devoted to those activities.  § 7602(a).  For example, a distributor of equipment who also has fabrication operations can exempt that part of its asset base, net of liabilities, which is devoted strictly to fabrication.  § 7602(a).

Both foreign and domestic corporations can use either a single exempt assets factor or a three-factor apportionment to determine the portion of capital stock value attributable to Pennsylvania. Corporations use the exempt assets factor to exclude certain nontaxable assets.

The single-factor apportionment formula refers to one of two formulas utilized by domestic and foreign corporations to determine the taxable portion of their capital stock value under code.  Currently, it is: Taxable assets (total assets-exempt assets) / Total Assets x actual value x 1.89 mils = Tax Due. Both foreign and domestic corporations can use either the three-factor or the single fraction method.[4]

The three-factor apportionment is composed of property, payroll, and sales fractions. Under the three-factor apportionment method, the three factors taken into consideration in arriving at the apportionment factor are: (1) tangible property; (2) payroll, and (3) sales. 72 P.S. § 7401(3)2.(a)(9)-(18). The tax due is calculated by multiplying the apportionment factor by the capital stock value and the applicable tax rate, as follows:

The apportionment factor is the sum of three ratios[5]:

(i)                 Tangible property in PA / Total tangible property +

(ii)               Wages, salaries, etc. assignable in PA / Total Wages, salaries, etc. +

(iii)             Sales assignable in PA / Total sales

The result is divided by 3 to get the average, which is the apportionment factor.  To get the tax due, the apportionment factor is multiplied by the capital stock value and the tax rate:

Apportionment factor X capital stock value X tax rate = tax due.

The tax rate for 2012 will be 1.89 mills, and 0.89 mills in 2013, the last year of the tax.  § 7602(h).

For further information, contact Tom Barnes at (215) 886-6600.

The reader is asked to bear in mind that the legal principles cited in this article are not a complete exposition of the principles of limited liability company, corporate or tax law, and so may not apply to an individual’s particular situation.  This article is not intended as legal advice for anyone, and is simply intended as an illustration of certain aspects of the law.

Corporations, LLCs, limited partnerships and the other types of entities that can be created under Pennsylvania law, and in most states, all provide this essential protection from liability.   S-corporations have more non-tax related limitations than do LLCs.  For example, S-corporations are limited in the type and number of shareholders.  Classes of stock in a sub-S must be identical except for voting rights, and distributions of profit must be in proportion to each stockholder’s percentage share of ownership.

Most small businesses are organized as S-corporations, LLCs or limited partnerships because they all permit “pass through” taxation, meaning the net income or loss drops directly to the owner or owner’s tax returns.  No tax is paid at the corporate level, so the owners are only taxed once.  C-corporations, of course, are subject to double taxation: corporate income tax and then tax on dividends at ordinary rates.  S-corporations, LLCs, limited partnerships and the other variants of these entity types all allow the owners to elect to be taxed as a partnership, giving them the benefits of pass-through taxation.

LLCs, limited partnerships and even general partnerships (which do not protect the partners from individual liability) are automatically taxed as partnerships for federal and state income tax purposes.  Corporations, on the other hand, are presumed to be C-corporations when formed, unless the corporation makes an election at the federal level to be taxed as an S-corporation.  In this brief and limited discussion of pass through taxation, we will assume we are dealing with either an S-corporation or an LLC.

With both the LLC and the S-corporation, for tax purposes, income is passed through to the owners.  Losses are passed through also, subject to certain restrictions such as limitations on passive investment activity.  In addition, distributions of appreciated assets from an S-corporation are taxable events.

One significant limitation of an S-corporation compared to an LLC or partnership is that there is no method of equalizing the “inside” basis of an asset contributed by an owner to the entity with the “outside” basis.  The “inside basis” is the tax basis of the asset on the books of the entity.  The “outside basis” is the tax basis in the hands of the owner.  This difference can be an issue when there is a sale of all or part of the S-corporation’s stock or a membership interest.

In such a situation, the buyer of stock or a membership interest in an LLC will have a different tax basis than that of the entity, unless the entity is taxed as a disregarded entity, or as a partnership and a Section 754 election is made.  “Inside” basis can be adjusted to “outside” basis with a Section 754 election.   For example, if an LLC has as its only asset real estate with a basis of $100,000 and a fair market value of $5 million, a buyer of half the membership interest for $2.5 million would have a basis of that amount in the membership interest.  The LLC, on the other hand, would retain the $100,000 basis.

The buyer of the LLC membership interest can make an election under section 754 of the Code and equalize the inside and outside basis.  Section 754 applies only to entities taxed as partnerships, such as LLCs, and not to C- or S-corporations.  It applies only upon the transfer of an interest in a partnership by sale or exchange, or upon the death of a partner, and it applies only to the buying partner.  The result is that the basis on the LLC’s books is increased to reflect the new owner’s basis.

Generally, no taxable event occurs upon formation.  At formation, the owners’ basis in the entity’s stock or in the LLC membership Interest is equal to the basis of the assets contributed when they were in the hands of the LLC owners.  There may be some adjustment for any gain recognized upon contribution.   After contribution, the entity’s basis in the assets is the contributing owners’ basis, adjusted for any gain recognized upon contribution.

During the course of entity operations, income and gains are passed through to each member or shareholder.  If there is income or gain, each owner’s basis in the stock or LLC Membership Interest is increased.   If there are losses, they are passed through to the owners.   Each dollar of loss reduces the basis in the stock or membership interest and is deductible to the extent permissible.

When the S-corporation or LLC distributes cash or other assets to the owners, there is a dollar-for-dollar reduction in basis in the stock of an S-corporation or LLC membership Interest.   This will cause the individual shareholder or membership interest holder’s basis to fluctuate.

Often real estate investors will ask their lender for a loan large enough to finance both the purchase of a property they intend to buy now, and also to finance the purchase of one or more properties in the future.  The loan might take the form of a line of credit.  The mortgage states that property X is covered, and the mortgage is filed in the county where property X is located.  The mortgage might also state that it covers any properties the borrower acquires in the future with the loan proceeds (the “after-acquired property clause”).  There is no trouble at this point.  The mortgage is completely effective against the collateral and there is no barrier to foreclosure if the loan becomes troubled.

It is important to be aware of the situation when the borrower buys another property using the loan proceeds, and no one files any documentation in the land records, either in the original county where property X is located or where new property is located.  The lender is still on solid ground, because the original mortgage is effective against the borrower and the new property (property Y).  This is so even if property Y is located in a different county, or even in a different state.  If the loan becomes troubled, the lender can take back both property X and property Y.

An issue may occur when the borrower conveys an interest in property Y to someone else.  If the borrower sells it outright, the lender will lose any mortgage interest it had in property Y.  The new purchaser would take title to property Y free and clear of the lender’s original mortgage with the after-acquired property clause, because he/she most likely did so without ever knowing it existed.  That new purchaser is innocent in the eyes of the law and the original mortgage is null and void as to him/her.  Similarly, if the borrower does not sell property Y, but does something such as borrow money from someone else without telling the original lender, and uses it as collateral, the original mortgage becomes junior to the new lien.

In Pennsylvania, a mortgage that goes unrecorded is effective between the parties, but is null and void as to someone who gives value for an interest in land and does so without actual or constructive notice of the mortgage.  With a recording statute like Pennsylvania’s, the lender/mortgagee’s lien in after-acquired property (Y, for example) will be subordinate to the interest of someone who pays value and lacks notice of it.  In our scenario, an outright sale of property Y would make the mortgage on property X meaningless.  It would be treated as unrecorded.  If, instead of selling it, the borrower mortgaged property Y to another lender, the original lender’s lien would become junior to the interests of the new mortgagee.

The idea is to protect the person acquiring the land, who probably would not have discovered it until after a reasonably diligent search of the records.  The mortgage is not in the “chain of title”. The original mortgage will only refer to property X.  Forcing a title searcher to check every entry in the grantor-grantee index is considered to be too much to require.  The title searcher for the innocent purchaser of property Y would have to check all the land records in every surrounding county to look for the lender’s original mortgage.  It would be impractical and unfair to require the title searcher checking the chain of title for property Y to research every conveyance ever made to the borrower.  If the borrower is an active land speculator with holdings in several states, the job would be astronomically expensive, time-consuming, and nearly impossible.

To avoid this result, the lender must record a notice in the county where property Y is located that specifically identifies property Y, refers to the mortgage containing the after-acquired property provision, and is in a form that provides record notice under local law.  Of course, this must be done before the new purchaser records the deed.  Recording such a notice has the effect of making the after-acquired property clause part of the chain of title.  Interests in the property that arise after recording will be junior to the lien of the after-acquired property clause.

Under this rule, an after-acquired property clause does not add much value and holds real potential for trouble unless the lender keeps a close eye on associated transactions.  At a minimum, that means setting up systems and procedures designed to make sure loan proceeds are released to the borrower only if the lender gets a description of the new property.  The lender should also make sure that if and when property is acquired, the correct form of notice is filed in the land records in the county in which the after-acquired property is located so that anyone researching the title will be aware of the lender’s original lien.

Thomas J. Barnes is a lawyer who concentrates his practice in commercial real estate finance, commercial transactions, and general corporate and business law.  Mr. Barnes is a partner of the Jenkintown, Pennsylvania firm of Egbert & Barnes, P.C.

How do I protect my business entity?

You can either file directly with the State of Pennsylvania or by contacting our office. Either James Egbert or Tom Barnes will fill out the appropriate paperwork to ensure that your business entity is protected. We will charge you a flat fee of $200, which includes the $70 Department of State filing fee. Please call us immediately if you would like us to help. You can call us at 215-886-6600 or email Jim Egbert at jegbert@egbertbarnes.com or Tom Barnes at tbarnes@egbertbarnes.com.

Who is required to file?

All domestic and foreign profit and nonprofit corporations, limited liability companies, limited liability partnerships that are not also limited partnerships, business trusts, insignias and “marks used with articles and supplies” that have not made a new or amended filing with the Corporation Bureau from January 1, 2002 through December 31, 2011 shall during the year 2011, file in the Department of State a report that they continue to exist. 54 Pa.C.S. § 503(b)(1), § 1314(b), § 1515(b). Fictitious names and trademarks are not required to make decennial filings.

What if I’ve missed the December 31, 2011 deadline?

If you’ve missed the December 31, 2011 deadline, you still need to file. Contact us and we will help.  You can call us at 215-886-6600 or email Jim Egbert at jegbert@egbertbarnes.com or Tom Barnes at tbarnes@egbertbarnes.com.

1.      What is the legal definition of a partnership?

The general rule in Pennsylvania is that a partnership is an association of two or more persons to carry on as co-owners a business for profit.[1]  Many of the rules applicable to partnerships also apply to registered limited liability partnerships, limited partnerships and limited liability companies.[2]

This discussion is intended to apply to a general partnership in which the partners have no partnership agreement (or a very limited one), and have made no provision for the unexpected death of one of the partners.  In these situations, the law governing partnerships fills in the blanks by providing rules for paying the partnership creditors and distributing the remaining assets to the partners.  In the case of a deceased partner, the executor of his estate or other legal representative stands in the shoes of the deceased partner.

The reader is asked to bear in mind that the legal principles cited in this article are not a complete exposition of the principles of general partnership law, and so may not apply to an individual’s particular situation.  This article is not intended as legal advice for anyone, and is simply intended as an illustration of certain aspects of the law.

2.      Determining whether a partnership exists

As a general rule, where two or more people are sharing gross revenue or profits, there is a strong inference they are a partnership.  Without any formal partnership agreement, oral or written, real estate can be owned by two or more people as a joint tenancy, a tenancy in common, tenancy by the entireties (married persons).

However, joint ownership by itself does not establish a partnership, even if the co-owners share profits made by the use of the property.[3]  Likewise, the sharing of gross returns does not of itself establish a partnership whether or not the persons sharing them have a joint or common right or interest in any property from which the returns are derived.[4] For example, there is no partnership where profits are received in payment for a debt, by installments or otherwise, as wages of an employee or rent to a landlord, as an annuity to a surviving spouse or representative of a deceased partner, as interest on a loan though the amount of payment varies with the profits of the business, or as the consideration for the sale of the goodwill of a business or other property, such as by installment payments.

The intention of the parties is the determining factor.  Obviously, the best way to eliminate uncertainty is to have a written agreement between the participants, stating clearly whether or not the relationship is a partnership.

3.      Identifying the partnership’s property

All property originally brought into the partnership stock or subsequently acquired, by purchase or otherwise, on account of the partnership is partnership property.[5]  Unless the contrary intention appears, property acquired with partnership funds is partnership property.[6]  Title to real property may be acquired in the partnership name, but title so acquired can be conveyed only in the partnership name.[7]   A conveyance to a partnership in the partnership name, though without words of inheritance, passes the entire estate of the grantor unless a contrary intent appears.[8]

4.      The Relationships of the Partners to One Another

 a.      Determining rights and obligations of partners

Absent a written agreement, the rights and duties of the partners in relation to the partnership are subject to certain rules.  The following is an oversimplification, but, generally, each partner is entitled to be repaid his contributions of capital, and to share equally in the profits and surplus remaining after all liabilities, including those to partners, are satisfied.  On the other hand, a partner is obligated to contribute towards the losses, whether of capital or otherwise, sustained by the partnership, according to his share in the profits.[9]

b.      The partners’ duty to render information to each other

Partners are obligated to report, on demand, true and full information of all things affecting the partnership to any partner, or the legal representative of any deceased partner, or of a partner under a legal disability.[10]  In the proper circumstances, a partner has the right to a formal accounting as to the partnership affairs.  For example, if he is wrongfully excluded from the partnership business or possession of its property by his copartners, or whenever other circumstances render it just and reasonable.[11]

c.       The Property Rights of a Partner

The property rights of a partner are (1) his rights in specific partnership property, (2) his interest in the partnership and (3) his right to participate in the management of the partnership.[12]  A partner is a co-owner with his partners of specific partnership property, holding as a tenant in partnership.[13]  Absent a written agreement, the features of this tenancy are as follows:

(1) A partner has an equal right with his partners to possess specific partnership property for partnership purposes, but he has no right to possess the property for any other purpose without the consent of his partners.[14]

(2) The right of a partner in specific partnership property is not assignable except in connection with the assignment of the rights of all partners in the same property.[15]

(3) The right of a partner in specific partnership property is not subject to attachment by creditors or execution except on a claim against the partnership.[16]

(4) On the death of a partner, his right in specific partnership property vests in the surviving partner or partners, except where the deceased was the last surviving partner, when his right in the property vests in his legal representative. The surviving partner or partners, or the legal representative of the last surviving partner, has no right to possess the partnership property for any but a partnership purpose.[17]  The interest of a partner in the partnership is his share of the profits and surplus and that interest is personal property.[18]

According to the Supreme Court of Pennsylvania, “At the death of a partner, not only does his estate acquire no greater right in specific partnership property than the decedent had during his lifetime, but the above limited right which the partner had in such property during his lifetime is vested at his death in his surviving partners and not in his estate.  Further, where a partner dies and the business is continued without a settlement of accounts, … the [Uniform Partnership] Act specifically limits the estate to (1) ascertainment of the ‘value of [decedent's] interest at the date of dissolution’ and (2) receipt ‘as an ordinary creditor [of] an amount equal to the value of [decedent's] interest.’” [19]

5.      Partnership dissolution (termination)

A partnership is dissolved by six kinds of events.

(1) Without violation of the (oral or written) agreement between the partners:

(i) By the termination of the definite term or particular undertaking specified in the agreement.

(ii) By the express will of any partner when no definite term or particular undertaking is specified.

(iii) By the express will of all the partners.

(iv) By the expulsion of any partner from the business bona fide in accordance with such a power conferred by the agreement between the partners.

(2) In contravention of the agreement between the partners, where the circumstances do not permit a dissolution under any other provision of this section, by the express will of any partner at any time.

(3) By any event which makes it unlawful for the business of the partnership to be carried on or for the members to carry it on in partnership.

(4) By the death of any partner.

(5) By the bankruptcy of any partner or the partnership.

(6) By court-ordered dissolution. [20]

6.      The effect of the death of a partner: dissolution of the partnership

The dissolution of a partnership is the change in the relation of the partners caused by any partner ceasing to be associated in the carrying on, as distinguished from the winding up, of the business.[21] Death is one cause of dissolution, but there are several other causes.

On dissolution, the partnership is not terminated but continues until the winding up of partnership affairs is completed.[22]

7.      The winding up process: the distribution of its assets

The partners may agree in a partnership agreement that on the death of a partner, the surviving partner or partners, if there are any, can buy out the deceased partner and continue the partnership without dissolving it and starting over.  There are many ways to set the value and price of the buyout, and many mechanisms for making sure it takes place smoothly and fairly.

Without such an agreement, the surviving partners or the legal representative of the last surviving partner, not bankrupt, have the right to wind up the partnership affairs.[23]  In the case of the death of a partner, the surviving partner or partners have the right to wind up the partnership.  They also have a fiduciary obligation to the estate of the deceased partner.  Since the death of one partner leaves the survivor in a position of absolute control with only the duty to account, the survivor must proceed with utmost caution and use the highest degree of care in the liquidation of the partnership.[24]

In settling accounts between the partners after dissolution, the following rules are observed, subject to anything contained in the partnership agreement to the contrary:

The assets of the partnership are the partnership property itself, and any contributions the partners that are necessary for the payment of all the liabilities.

The liabilities of the partnership rank, in order of payment, as follows: (i) those owing to creditors other than partners; (ii) those owing to partners other than for capital and profits; (iii) those owing to partners in respect of capital; and (iv) those owing to partners in respect of profits.  The assets shall be applied, in the preceding order, to the satisfaction of the liabilities.

The partners are obligated to contribute the amount necessary to satisfy the liabilities in the relative proportions in which they share the profits.  The individual property of a deceased partner is liable for these contributions.

Where a partner has become bankrupt or his estate is insolvent, the claims against his separate property shall rank in the following order: (i) those owing to separate creditors, then (ii) those owing to partnership creditors, then (iii) those owing to partners by way of contribution.

A&B has designed several highly successful drilling equipment components, but none of them are protected by patents.  The know-how that went into the products is captured in a library of engineering drawings.  None of the testing results are documented, and the rest of the company’s knowledge resides between the ears of the two men.

Arthur and Bob have enjoyed a strong personal and business relationship over the years, with no stresses or conflicts between them.  Arthur owns 70% of the business, and Bob owns the remaining 30%.  The business is an S-corporation.  The corporate records sit in a binder on the shelf in Arthur’s office, never touched.  There are bylaws, but they say nothing about when and how each shareholder’s stock can be sold by the shareholder.

Both Arthur and Bob are married with children.  Two of Arthur’s four children are actively involved in the business.  Neither of Bob’s two children has indicated any interest in the business, preferring to pursue other careers.  Neither Arthur nor Bob’s wife is employed by the business or takes any active role in it.

Arthur and Bob both have wills.  Each will gives all their assets to their wives.  The wills give nothing to the children unless their wives die before the husbands, or die at the same time.

This fall, Bob went on a hunting trip in mid-state Pennsylvania, where he collapsed and died of a heart attack.  His widow now is a 30% owner of the business!  She needs money and wants to liquidate her husband’s stock in A&B Corporation, but Arthur has told her that is impossible because he cannot personally afford to buy her out.  Bob’s widow does not receive his salary and has no idea as to what is going on in the business.  She feels isolated and neglected, and is worried that Arthur will not pay her anything.

Arthur and Bob did not take the time to consider what would happen if one of them dies, became incapacitate, ill, bankrupt or simply wished to retire.  They had no buy-sell arrangement between them, so there is no specified series of steps to take to buy Bob’s widow’s interest, or to fund the purchase price on Arthur’s behalf.

This scenario outlines several issues that commonly plague business owners. In upcoming articles we will elaborate on this case and discuss alternatives and solutions that may be available. Please contact Thomas Barnes for more information.