Asset Protection in North Carolina - Part 1: The Basics

1. What is at risk for the professional, physician, or business owner?

If you face a lawsuit related to your profession, your business, or your ownership in property, the first question is usually - if they win a judgment, which of my assets are at risk? The lawsuit may be related to a promissory note, mortgage, contract, or negligence, or any other cause of action. State law provides certain protections for creditors under the North Carolina constitution and under certain statutes that are directly related to debtor protections.

2. North Carolina Constitutional Protections.

Something modern Americans have taken for granted, the first protection in the North Carolina constitution is the elimination of the English common law practice of prison for debtors. It states in section 28 of Article I, titled "Imprisonment for debt":

There shall be no imprisonment for debt in this State, except in cases of fraud.

The next set of protections is in Article X of the North Carolina Constitution. It contains 5 sections, 4 of which are effectively superceded by the North Carolina General Statutes. However, Section 5 provides protection for a life insurance policy and its proceeds, provided the policy is payable to your spouse, your children, or both. Generously it states at the end:

"...whether or not the policy reserves to the insured during his or her lifetime any or all rights provided for by the policy and whether or not the policy proceeds are payable to the estate of the insured in the event the beneficiary or beneficiaries predecease the insured."

That is, the insurance policy is still protected even if the insured enjoys benefits from the life insurance policy during his life and even if the policy proceeds eventually end up in his own estate. Although it is clear that this constitutional protection is probably available to term and whole life insurance policies, whether it also includes annuities is unresolved.

3. North Carolina Statutory Protections.

Article 16 of the North Carolina General Statutes cover exemptions from the collection of a judgment against a debtor. Before a judgment creditor is given a writ of execution, the creditor must send the judgment debtor a form to designate their exemptions. Covered by these statutory provisions are the homestead exemption up to $35,000, vehicle exemption up to $3500 in value, exemptions for alimony and child support, retirement benefits exemption, 529 plans for college tuition exemption, compensation for personal injury exemption, professionally prescribed health aids exemption, personal goods, apparel and furniture exemption up to $5000, professional tools and books exemption up to $2000. Rather than describing all of these exemptions in detail, I will address the largest ones.

4. Homestead Exemption.

A debtor may shield up to $35,000 in their personal residence, in a cooperative which owns their residence, or in a burial plot. The debtor may divide this exemption between his burial plot and personal residence as well. This exemption only covers the property in which the debtor lives and not, for example, vacant land or a vacation house. If the debtor was married and held the residence property as tenants by the entirety, and their spouse died leaving them the sole owner, the debtor may shield up to $60,000 in value from creditors.

The practical application of this exemption may not be apparent on its face. If a creditor attempts to collect a judgment and moves to have your personal residence sold, the debtor may collect the first $35,000 of the proceeds of the sale. So if the equity in a personal residence is less than $35,000, a judgment creditor would received nothing. Since many personal residences are held jointly by a husband and wife, or between two unmarried people, only half of the equity in the property is available at all, since the other half belongs to the significant other or spouse. Further complicating matters, husband and wives who own property by the entirities, cannot be forced to sell their personal residence by a judgment creditor.

4. Retirement Benefits.

Retirement benefits are covered but only to the extent that they are covered under Section 408(a), 408(b), 408A, or 408(c) of the Internal Revenue Code. These include Individual Retirement Accounts(IRA), Roth IRA, 401(k), and individual retirement annuities. Those plans not covered include inherited 403(b) plans, IRAs, SEP-IRAs, and SIMPLE-IRAs.

5. The Text of Chapter 1C-1601(a).

I have provided the entire list of statutory exemptions in N.C.G.S. 1C-1601(a):

(1) The debtor's aggregate interest, not to exceed thirty‑five thousand dollars ($35,000) in value, in real property or personal property that the debtor or a dependent of the debtor uses as a residence, in a cooperative that owns property that the debtor or a dependent of the debtor uses as a residence, or in a burial plot for the debtor or a dependent of the debtor; however, an unmarried debtor who is 65 years of age or older is entitled to retain an aggregate interest in the property not to exceed sixty thousand dollars ($60,000) in value so long as the property was previously owned by the debtor as a tenant by the entireties or as a joint tenant with rights of survivorship and the former co‑owner of the property is deceased.

(2) The debtor's aggregate interest in any property, not to exceed five thousand dollars ($5,000) in value of any unused exemption amount to which the debtor is entitled under subdivision (1) of this subsection.

(3) The debtor's interest, not to exceed three thousand five hundred dollars ($3,500) in value, in one motor vehicle.

(4) The debtor's aggregate interest, not to exceed five thousand dollars ($5,000) in value for the debtor plus one thousand dollars ($1,000) for each dependent of the debtor, not to exceed four thousand dollars ($4,000) total for dependents, in household furnishings, household goods, wearing apparel, appliances, books, animals, crops, or musical instruments, that are held primarily for the personal, family, or household use of the debtor or a dependent of the debtor.

(5) The debtor's aggregate interest, not to exceed two thousand dollars ($2,000) in value, in any implements, professional books, or tools of the trade of the debtor or the trade of a dependent of the debtor.

(6) Life insurance as provided in Article X, Section 5 of the Constitution of North Carolina.

(7) Professionally prescribed health aids for the debtor or a dependent of the debtor.

(8) Compensation for personal injury, including compensation from private disability policies or annuities, or compensation for the death of a person upon whom the debtor was dependent for support, but such compensation is not exempt from claims for funeral, legal, medical, dental, hospital, and health care charges related to the accident or injury giving rise to the compensation.

(9) Individual retirement plans as defined in the Internal Revenue Code and any plan treated in the same manner as an individual retirement plan under the Internal Revenue Code, including individual retirement accounts and Roth retirement accounts as described in section 408(a) and section 408A of the Internal Revenue Code, individual retirement annuities as described in section 408(b) of the Internal Revenue Code, and accounts established as part of a trust described in section 408(c) of the Internal Revenue Code.

(10) Funds in a college savings plan qualified under section 529 of the Internal Revenue Code, not to exceed a cumulative limit of twenty‑five thousand dollars ($25,000), but excluding any funds placed in a college savings plan account within the preceding 12 months (except to the extent any of the contributions were made in the ordinary course of the debtor's financial affairs and were consistent with the debtor's past pattern of contributions) and only to the extent that the funds are for a child of the debtor and will actually be used for the child's college or university expenses.

(11) Retirement benefits under the retirement plans of other states and governmental units of other states, to the extent that these benefits are exempt under the laws of the state or governmental unit under which the benefit plan is established.

(12) Alimony, support, separate maintenance, and child support payments or funds that have been received or to which the debtor is entitled, to the extent the payments or funds are reasonably necessary for the support of the debtor or any dependent of the debtor.

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Employment Law Basics - For the Small Business Owner - Part 2

2. ERISA - Employment Retirement Income Security Act.

The Employee Retirement Income Security Act of 1974 (ERISA) (Pub.L. 93-406, 88 Stat. 829, enacted September 2, 1974) is a federal statute that establishes minimum standards for pension plans in private industry and provides for extensive rules on the federal income tax effects of transactions associated with employee benefit plans. ERISA was enacted to protect the interests of employee benefit plan participants and their beneficiaries by requiring the disclosure to them of financial and other information concerning the plan; by establishing standards of conduct for plan fiduciaries; and by providing for appropriate remedies and access to the federal courts.

Most employers are aware of the common “discrimination” claims brought by employees or former employees like gender, race, disability, and age. However, there is another not so well-known anti-discrimination/retaliation claim under the Employee Retirement Income Security Act (ERISA) that is becoming more and more prevalent.

ERISA §510 states that “It shall be unlawful for any person to discharge, fine, suspend, expel, discipline, or discriminate against a participant or beneficiary for exercising any right to which he is entitled under the provisions of an employee benefit plan . . . or for the purpose of interfering with the attainment of any right to which such participant may become entitled under the plan”. This provision provides protection to employees from adverse action by an employer in order to interfere with the attainment of rights under ERISA or in order to stop a participant from availing himself/herself of rights under ERISA.

Historically, ERISA §510 claims have been most often asserted in relation to retirement/pension plans. However, recent cases have been brought under ERISA §510 in relation to health and welfare plans. Claims for ERISA §510 violations occur most often when an employer has terminated an employee, and the employee claims that the termination was in anticipation of the employee making a claim under a benefit plan or becoming eligible for benefits under a benefits plan.

A recent case, Rodrigues v. The Scotts Co., LLC., involved an employer who had a company policy that prohibited its employees from smoking at any time. One employee was terminated shortly after being hired after he tested positive for nicotine. The employee brought several causes of action against the employer, one of which was a claim of an ERISA §510 violation. The employer moved to dismiss the claim, but the district court denied the motion and allowed the case to proceed, stating that the key inquiry is whether the employment action was taken with the specific intent of interference with the right to a benefit.

In order for an employee to prevail under a claim of an ERISA §510 violation, he/she must prove that the employer’s adverse employment action was taken with the specific intent to interfere with the employee’s rights or benefits under an ERISA plan. This means that the loss of benefits was the motivating factor behind the adverse employment action, not merely a consequence of the action. As with other employment discrimination causes of action, if the employee can make an initial showing of a prima facie case for intentional interference, then the employer must prove that there was a legitimate, non-discriminatory basis for their action. If the employer succeeds, then the employee is then required to offer proof that the employer’s legitimate, non-discriminatory reason is a mere pretext. Because the requirements to maintain an ERISA §510 action mirror many other employment discrimination causes of action, they are often brought in conjunction with other causes of action.

As companies continue to explore ways to decrease their operational expenses, benefit costs may seem to be an easy area in which to realize cost savings. However, employers need to be cautious in the criteria used for making benefit reduction decisions. ERISA § 510 claims seem to go hand-in-hand with employment discrimination claims such as age discrimination. Before making any decisions about reducing benefits costs, employer should consult with benefits counsel to ensure that any actions taken aren’t in violation of ERISA.

Employment Law Basics - For the Small Business Owner

1. The Big Bad Wolf - Employee Lawsuits.


The biggest fear of the business owner, other than losing money hand over fist, is being sued. And to make matters worse, the largest source of discontent in the business owner's company is likely to be a current or former employee. This, the employer reasons, is really adding insult to injury, rubbing salt in the wounds, adding fuel to the fire, twisting the knife, and is a slap in the face - why? because the owner hired this litigant, invited them into their family, paid them to stay, work - and to eventually, inadvertently, sue them.

But how afraid should the business owner be? Well, it depends on their size, to a certain extent. Some laws apply only to large or medium size employers based on the intent of the law.

2. Discrimination Laws

The first type of laws that I will describe are the employment anti-discrimination laws. Broadly, these provide that certain classes of people, those historically subject to improper treatment in hiring, promotion, and termination, are protected by law and given a cause of action to sue their employer for mistreatment due solely or partially because of their class status. For example, the employer that lays off his pregnant female employee, because, he reasons, she will take valuable company time for maternity leave and childcare. This employee is given the right to sue her employer under federal law.

Federal Anti-Discrimination Laws

 

Law	Description	Threshold
Title VII of the Civil Rights Act of 1964	Prohibits discrimination in employment based on race, religion, or national origin.	15 or more employees.
Equal Pay Act of 1963	Women must be paid the same wages as men for similar work.	Most employees.
Americans with Disabilities Act	Prohibits discrimination in employment based on disability	15 or more employees.
Age Discrimination in Employment Act	Prohibits discrimination based on age.	20 or more employees.
Pregnancy Discrimination Act	Prohibits discrimination in employment based on pregnancy or against new mothers.	15 or more employees.
Veterans Reemployment Rights Act	Prohibits discrimination based on military service.	All employers.

In addition, federal contractors have additional obligations (please call for details). Moreover, North Carolina has wage-hour and labor laws which dictate rules with regard to child labor, wage-hour issues, minimum wage, over-time pay, and right-to-work laws. Here is a list of the applicable state anti-discrimination laws.

 

State Anti-Discrimination Laws

 

Law	Description	Threshold
N.C. Equal Employment Practices Act	Forbids discrimination based on race, religion, sex, national origin, color, age, or handicap.	15 or more employees.
Persons with Disabilities Protection Act	Prohibits discrimination in employment based on physical or mental handicap.	15 or more employees.

Finally, employers are required to hang posters on a variety of labor issues for the purpose of informing employees of their rights

Partnerships - Easy, But Limited and Potentially Risky

1. What are Partnerships? How are partnerships formed?

Why should the small business owner or start-up company care about S-Corporations, when a general partnership is so easy. Very little is needed to start a general partnership, aside from the intention of the partners to form a partnership for a business and to share profits. NCGS 59-36(a) states that a partnership is an association of two or more persons to carry on as co-owners a business for profit. Partners can agree in writing or can agree to a partnership orally. In the absense of a written agreement, Article 59 of the North Carolina General Statutes provides certain terms that are universal to any partnership formed in the state of North Carolina. Among them, that partners' share profits and losses equally and have an equal say in the management of the partnership. In addition, partners have equal rights in the partnership property, regardless of who contributed the property. Finally, upon dissolution, partners receive back an amount equal to their contribution, and any excess was divided equally among the partners.

But this describes only general partnerships, and doesn't include limited partnerships and limited liability partnerships. In a limited partnership, only the general partners are personally liable for the actions or debts of the partnership, while the limited partners only risk their investment in the limited partnership. In limited liability partnerships, none of the partners are personally at risk for more than their investment in the limited liability partnership. Of course, many times partners are required to personally guaranty loans or other obligations undertaken by the partnership by those loaning money or leasing equipment.

2. Partnership Taxation.

Partnerships file one entity level tax form with the IRS - form 1065. However, no tax is paid at the entity level and the form is merely informational. Instead, the partnership files form K-1 with the IRS when it files its IRS Form 1065 which allocates to each partner a share of the profits, losses, and/or deductions of the partnership in proportion to the ownership interests of the partners. For example, a partnership with $100,000 in partnership profit would allocate $65,000 to its partner who owns 65% of the partnership interests and 35% to the partner with 35% of the partnership interests.

3. Asset Protection.

Partnerships offer intermediate asset protection. Unless the partner is a limited partner, or a limited liability partner, the general partner's assets are personally at risk for debts or liabilities of the partnership. On the other end, if a debtor comes against the partner, are the partnership's assets at risk? A creditor who attaches the partnership interest of a partner/debtor is only entitled to a "charging order" entitling that creditor to receive the distribution that would normally accrue to the partner alone. So when distributions are alloted, the share of the partner/debtor is given to the creditor. However, the partnership, provided their partnership agreement provides so, can withhold the distribution of the partner so that the debtor will not receive it, meanwhile, the debtor must pay taxes on the amount of distribution that would have been paid.

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S-Corporations: What are they and why care? - Part 3

Part 3 - Transfer Restrictions - Buy-Sell Agreements

Typical for any S-corporation, C-corporation, limited liability company, or partnership, owned by more than one person, are certain provisions that govern who can be an owner and under what circumstances. For example, although your partner and you chose to work together, in the event of the death of one of the other owners, many business owners would not chose to work with the decedent-owner's inheritors. For this reason, legal restrictions called buy-sell provisions are typical in owner agreements. Partnership agreements are the easiest example, since there is broad discretion to restrict transfers, either voluntary or involuntary.

The shares of a corporation may be restricted for any reasonable purpose as long as it is not unconscionable. However, the type of restrictions are limited in their remedies to (1) obligate the shareholder first to offer the shares to the corporation or other persons; (2) obligate the corporation or other persons to acquire the shares; (3) require consent to the assignment if not manifestly unreasonable; (4) prohibit transfer to designated persons or classes of persons, if not manifestly unreasonable; or (5) contain any other provision reasonably related to an authorized purpose. In contrast, a LLC membership interest is freely assignable except as provided in the articles of organization or a written operating agreement. The assignee only becomes a member of the LLC if the other members unanimously agree or if the articles of organization or operating agreement otherwise provide.

A buy-sell agreement or provisions, whether it is contained in a shareholders agreement or operating agreement, provides transfer restrictions if a triggering event occurs. These triggering events typically include the death of an owner, the firing of an employee-owner, the retirement or disability of an owner, or the attempted sale or transfer by an owner. These buy-sell provisions often require the triggering event owner to sell to the remaining owners or the company itself at a set price or a price deduced by an accountant or using a formula. Typical valuation formulas for small or large companies include (1) books value, (2) some factor or multiple of gross or net revenue, or (3) liquidation values.

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S-Corporations: What are they and why care? - Part 2

Part 2: Saving on Employment Taxes? How?

1. Introduction.

As described in the previous post, an "S-Corporation" is a unique tax designation created by the IRS that is neither a corporate tax status, nor a partnership tax designation. It is designated as a "Small Business Election" by the IRS. Under the IRS's check the box regulations, any qualified business entity can be designated as an S-Corporation by the IRS, be it a partnership, corporation, LLC, or sole proprietor. To form an S-Corporation, the business entity, files a form 2553 with the IRS asking for the designation and will receive a reply letter acknowledging its acceptance. Not every business entity may become an S-Corporation. All members of the business entity must be U.S. residents or citizens, natural persons, and there can be no more than one hundred (100) owners of one class of stock. Below, I will further describe some of the advantages and restrictions on S-Corporations.

2. Saving Money on Payroll Taxes: Dividends are Not Payroll.

Closely held C-corporations often distribute substantial salaries to the owners, and avoid double taxation on corporate earnings by insuring that salary deductions match remaining unspent income to the corporation. In constrast S-corporations shareholders may be paid salaries but any remaining amounts of S-corporation income are taxed to them at ordinary individual rates without any payroll taxes deducted.

In order to appreciate the significance of this tax savings, it is important to understand how much payroll taxes cost the owner of a business on his own salaried income. Under the IRS Code, Social Security and Medicare (FICA) taxes are assessed on both the employer and the employee at the rate of 7.65% of wages paid to the employee during the year (15.3% total). The FICA tax consists of Social Security tax at the rate of 12.4% on the first $XX of wages paid (increase each year) with 6.2% paid by the employer and 6.2% paid by the employee. Also, the hospital insurance (Medicare) tax is assessed at the rate of 2.9% on all wages paid to the employee during the year, with 1.45% paid by the employer and 1.45% paid by the employee. There is no wage base cap on the Medicare portion of the FICA tax. By example, on $100,000.00 of income, the typical owner-employee would pay $15,300.00 in payroll taxes, both employer and employee shares. The S-corporation employee-owner avoids this by paying only "reasonable compensation" as salary and the remainder as dividends.

3. Asset Protection Issues.

Asset protection is important to professionals and high-wealth individuals as well as ordinary individual business owners with good credit and a desire to avoid debt collectors. Often the regular business owner is asked to guaranty a loan or other form of indebtedness. If the purpose for the loan or the overall business enterprise is unsuccessful, the individual owner may become liable to the maker of the promisssory note. Under these circumstances, the business owner looks to his business attorney to best advise him on these issues and which business entity best protects him and his business. If the business owner has personally guaranteed a debt, his personal assets are at risk. With regard to his ownership in the business enterprise itself, the business owners' assets are best protected by the LLC, rather than a corporation, partnership or sole proprietorship. This is because his debtors cannot attach or have ownership in the LLC, but instead may obtain only a charging order instead. The creditor cannot obtain distributions from the LLC and the debt will likely remain unpaid. In contrast, the debtor can obtain the stock of the debtor's ownership in any corporations, and can force dividends to be paid to shareholders. This is also true of sole proprietorships.

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S-Corporations: What are they and why care?

Overview of S-Corporations and C-Corporations

There are two types of corporations for purposes of federal taxation. C-Corporations and S-Corporations. C-Corporations are your grandfather's traditional corporation. C-Corporations, like Intel, Dupont or Exxon, pay tax at the entity level with graduated tax rates up to 35%. Then, in addition, any employees of the C-Corporation pay taxes on their wages and shareholders pay taxes on their dividends. S-Corporations are different. S-Corporations are pass-through tax entities like partnerships. What is pass-through taxation? The S-Corporation pays no tax at the entity level. Rather, the S-Corporation shareholder pays taxes on their share of the income as reported on their K-1s. The S-Corporation shareholder/employee also pays income taxes and employment taxes on wages received. Finally, the S-Corporation shareholder pays taxes on any dividends. Thus, S-Corporations are said to avoid the double taxation of C-Corporations, although the matter is more complex than that.

Benefits and Limitations of S-Corporations vs. C-Corporations

1. Double Taxation.

One of the big benefits of S-Corporations is the avoidance of double taxation of the C-Corporation shareholder/employee. As referenced above, the C-Corporation pays taxes, then the shareholder/employee pays their income taxes and employment taxes on payroll received. In contrast, the S-Corporation shareholder pays their share of the S-Corporation's taxable income, but deducts any salary or dividends paid to the shareholder, thus avoiding double taxation. Although this is generally true, S-Corporation shareholders who own 2% or more of the corporation's stock will be taxed on some of the benefits received, which would normally be non-taxable to C-Corporation shareholders, thus incurring a double taxation to the extent of these benefits. These benefits taxed to the S-corporation shareholder include:

• (a) Group term life insurance;



• (b) Accident and health insurance plans;



• (c) Meals and lodging;



• (d) Employee death benefits;

In addition, S-Corporation shareholder(>2%)/employees cannot participate in "cafeteria plans".

Next article, the Triangle Business Matters Blog will address additional S-Corporation limitations and benefits, including the exclusion from employment taxes of dividends paid to S-Corporation shareholder/employees.

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