“Under South Carolina law, can an employer be subject to liability for harm caused by the negligent selection of an independent contractor?”

This was the certified question posed to the Supreme Court of South Carolina by the US Court of Appeals for the Fourth Circuit in the recent case Ruh v. Metal Recycling Services, LLC (2023) (read it here).

The SC Supreme Court’s answer: YES.

If you’re an employer in South Carolina, this might sound concerning, but rest assured, the court insists that “the sky is not falling.” Here’s what this decision means for you.

Brief Background of Ruh v. Metal Recycling Services, LLC

Metal Recycling Services, LLC, hired an independent contractor, Norris Trucking, LLC, to transport scrap metal. A truck driver employed by Norris Trucking hit the car of Lucinda Ruh, who was injured in the accident.

Ruh sued. She later amended her complaint to claim that Metal Recycling Services was negligent in its selection of Norris Trucking as an independent contractor and thus had liability for the accident that injured her. The case ended up before the US Court of Appeals for the Fourth Circuit, a Federal Court, which sent the certified question to the SC Supreme Court.

Employers Have a Duty to Hire Competent Independent Contractors

It’s important to understand Ruh’s main argument. Ruh did not contend that Metal Recycling Services was liable because the independent contractor it hired, Norris Trucking, was negligent. She argued that Metal Recycling Services, the principal (the court’s term for “employer” throughout the opinion) was itself negligent in its selection of Norris Trucking as an independent contractor.

The Supreme Court of South Carolina says Yes, a principal can be held liable for its own negligence.

In its conclusion, the court states, “We answer the certified question ‘yes.’ The potential liability we recognize today is consistent with fundamental principles of tort law. It is based solely on a principal’s own negligence in hiring or selecting an independent contractor. It is not a form of vicarious liability nor is it an exception to the general rule that a principal is not liable for the negligence of an independent contractor.” (Emphasis added.)

This aligns with current South Carolina law, and, as noted by the Fourth Circuit in its certification order, “every other state in the Fourth Circuit has… recognized a duty to hire a competent independent contractor.”

What the Ruh Decision Means for South Carolina Employers

South Carolina employers may be understandably concerned about the effect this decision could have on its business and its vetting and contracting practices. Will this decision “open the floodgates” and “expand… the scope of liability” to every principal, as Metal Recycle Services argued? Will it adversely affect the business environment in the state, as others argued?

The SC Supreme Court goes into detail in its opinion about the possible ramifications of this decision, and says it wants to “assure those potentially affected by our decision that, in fact, the sky is not falling.” (Emphasis added.)

The court begins by affirming the general rule that a principal is not liable for the negligent act of any independent contractor it hires and that nothing in the Ruh opinion affects this general rule. This should come as a relief to South Carolina employers.

Four Factors Employers Should Consider When Hiring Independent Contractors

Next comes the most critical section of the decision for employers.

The court lists four factors that can guide principals (employers) when hiring independent contractors. Its analysis is based on section 411(a) of the Restatement (Second) of Torts.

Reasonable Care

An employer must use reasonable care when selecting an independent contractor.

This is not a very high standard, and the court even states that “most participants in the modern economy already act reasonably in selecting contractors,” meaning the Ruh decision will not add extra burden to the “vast majority of principals.”

If a plaintiff does bring a claim against a principal for negligence over the selection of a contractor, the plaintiff must use proof to establish a standard of care the principal should have used and also show that the principal breached that standard.

Risk of Harm

An employer must take into account the risk of harm associated with the work in question.

The standard of “reasonable care” varies depending on the degree to which the work involves risk of physical harm unless it is done “skillfully and carefully.” A riskier job requiring a higher level of competence and care on the part of the worker requires a “more thorough assessment” when hiring on the part of the principal.

Competent and Careful

An employer should take on a “competent and careful” contractor with the knowledge, skills, experience, and proper equipment to do the job at hand safely.

For a successful claim, a plaintiff must show that the principal breached the standard of care. The principal’s knowledge about the contractor’s competence and carefulness in previous work – or lack of it – “will always be relevant” in determining whether the principal breached the standard of care.

Proximate Cause

An employer’s negligence in selection of a contractor for the particular work must be a proximate cause of physical harm in order for a plaintiff to bring a successful claim.

Here, the court gives a good example to illuminate the nuance involved: “[…] if a principal hires a contractor unqualified to handle emergencies that may arise while hauling toxic chemicals, the principal is negligent in hiring the contractor. But if the contractor causes an accident by negligently failing to yield the right of way, and the dangerous quality of his cargo plays no part in the accident or injury, then the plaintiff will be unable to establish cause-in-fact and thus unable to establish proximate cause.”

Continuing: “In this example, the principal may be liable for his negligence in selecting the contractor only when the contractor’s lack of qualifications to handle an emergency involving toxic chemicals is the cause-in-fact of the plaintiff’s injury.”

The Takeaway

The court’s answer in Ruh does not set a very high bar for employers in South Carolina. If you’re an employer in South Carolina, you should hire independent contractors with care, ensuring that any contractor you engage has the appropriate qualifications and experience for the job. Be extra careful when hiring someone for a potentially risky or dangerous job. If you know or discover that the contractor performed poorly in the past, you might want to look for alternatives.

If you’re a business owner, you need to be proactive about protecting your interests and limiting your liability. For legal help and advice on business law and contracts, contact Gem McDowell of the Gem McDowell Law Group. Gem has over 30 years of experience helping South Carolina employers and business owners protect their interests, grow, and thrive. The Gem McDowell Law Group has offices in Mt. Pleasant, SC and Myrtle Beach. Call 843-284-1021 today to schedule a free consultation.

South Carolina Rejects the Mortgage Replacement Doctrine

The Supreme Court of South Carolina rejected the mortgage replacement doctrine in the 2023 case ArrowPointe Federal Credit Union v. Bailey (PDF), upholding the decision of the SC Court of Appeals.

Under the replacement mortgage doctrine, if an older (original) mortgage is released and replaced with a new mortgage in the same transaction, the newer mortgage maintains the same priority for repayment as the original.

But the replacement mortgage doctrine is not part of South Carolina law, and the SC Supreme Court rejected it. Here’s some brief background on the case and the court’s main points.

The Background of ArrowPointe Federal Credit Union v. Bailey (2023)

In late October 2009, Jimmy Eugene Bailey and Laura Jean Bailey took out a mortgage from Quicken Loans on their Winnsboro, SC home in the amount of $256,500. In early November, they took out an equity line of credit with ArrowPointe Federal Credit Union (ArrowPointe), secured by a mortgage, with a maximum principal amount of $99,000.

Less than three weeks later, in December 2009, the Baileys refinanced and got a new mortgage from Quicken Loans in the amount of $296,000. At closing, they signed a document saying the only lien on the property was the original Quicken Loans mortgage. Quicken didn’t have ArrowPointe sign a subordination agreement to ensure that it (Quicken Loans) would be paid back before ArrowPointe. It appears the ArrowPointe loan was not discovered during a title search, even though it had been properly recorded and Quicken Loans had constructive notice.

Sometime later, the Baileys defaulted on their ArrowPointe loan, which stood at $187,201.60 in March 2017.

Who Gets Paid First?

In 2017, ArrowPointe filed this action seeking a declaration that its line of credit had priority over the second Quicken Loans mortgage – now held by U.S. Bank – and should be paid first.

U.S. Bank argued it was entitled to priority over ArrowPointe under the replacement mortgage doctrine. ArrowPointe argued that it was entitled to priority, as Quicken Loans had recorded notice of the ArrowPointe line of credit at the time the second mortgage was signed.

A special referee agreed with ArrowPointe, finding that South Carolina does not recognize the replacement mortgage doctrine and that ArrowPointe had priority over U.S. Bank under South Carolina’s race-notice statute (discussed below). The referee ordered the foreclosure of the mortgage and the sale of the Bailey home. The SC Court of Appeals affirmed the special referee’s decision. The matter then went to the Supreme Court in May 2022.

The SC Supreme Court Rejects the Mortgage Replacement Doctrine

The SC Supreme Court affirmed the lower court’s decision. Here are some takeaways from its opinion.

South Carolina Statute is Clear, and the Court is Not a “Superlegislature”

U.S. Bank’s argument for priority was based on the replacement mortgage doctrine, but that is not part of current South Carolina law. The Supreme Court agrees with the SC Court of Appeals that whether South Carolina should adopt the replacement mortgage doctrine is an issue for the General Assembly, not the court, saying, “We do not sit as a superlegislature to second-guess the General Assembly’s decisions.”

Current law is clear. South Carolina has a race-notice recording statute, which is one way of determining the lawful owner of a piece of property when more than one party makes a claim to it. In states with a race statute, the party that records the sale with the recording office first is the legal owner. In states with a notice statute, a subsequent buyer who is not aware of a previous sale of the property, through actual or constructive notice, is considered the owner. The buyer may be made aware of a prior conveyance either through actual notice or constructive notice, such as the recording of a deed which is public record.

In a race-notice statute state like South Carolina, a subsequent buyer must have no actual or constructive notice of a prior conveyance and must record the purchase before the prior buyer. Under this statute, ArrowPointe has priority over U.S. Bank.

Equitable Subrogation Doctrine and Replacement Mortgage Doctrine Are Not the Same

U.S. Bank also argued that because the South Carolina Supreme Court has adopted the equitable subrogation doctrine as an exception to the race-notice statute in the past, it may also adopt the replacement mortgage doctrine.

But the two are different, says the court. With equitable subrogation doctrine, a new party essentially “steps into the shoes” of the existing mortgagee, to use the court’s analogy. The party has changed, but the loan itself has not. With the mortgage replacement doctrine, however, the old mortgage is satisfied and replaced with a wholly new mortgage that may or may not have similar terms. In the present case, the second mortgage the Baileys took out was substantially more than the first – $39,500 more – so the two mortgages were significantly different. The second mortgage was not an exact replacement for the first.

A Thorough Title Search is a Better Solution

A thorough title examination is “inherent” in our state’s race-notice statute, says the court. Quicken Loans should have discovered the ArrowPointe line of credit in a title search and addressed it during refinancing, but it didn’t.

“We conclude the replacement mortgage doctrine invites needless litigation that could be avoided by a simple examination of the title to the real property,” says the SC Supreme Court. “We see no reason to adopt a doctrine that excuses the failure to conduct such a title examination—or, when a title examination is conducted, the failure to ascertain the existence of an intervening lien.” (Emphasis added by Gem McDowell Law Group.)

Don’t take chances or shortcuts when it comes to real estate deals. Work with an attorney who can help you cover all your legal bases so there are no surprises in the future.

Call South Carolina Attorney Gem McDowell

For help with contracts, commercial real estate transactions, and other estate planning and business law needs, call Gem and his team at his Mt. Pleasant office. Gem has over 30 years of experience helping individuals and businesses in South Carolina to protect their interests and avoid potentially costly mistakes. Call 843-284-1021 today to schedule your free consultation.

What is a Lady Bird Deed? Are Lady Bird Deeds Legal in South Carolina?

A lady bird deed, like other kinds of deeds, determines how ownership of a property is transferred and to whom. It’s similar to a life estate deed in that it allows the transfer of property outside of probate. But the big difference is that a lady bird deed gives the life tenant rights to the property that are restricted by a traditional life estate deed, such as the right to mortgage or sell the property.

A lady bird deed – also known as a ladybird deed or an enhanced life estate deed – can be a useful tool in the right estate plan. But it’s not right for everyone, and using a lady bird deed can lead to serious unintended consequences.

Let’s look at what a lady bird deed is and what it does, the advantages and disadvantages of the lady bird deed, and lady bird deeds in South Carolina.

What Is a Lady Bird Deed? What Does a Lady Bird Deed Do?

The lady bird deed was created by Florida attorney Jerome Ira Solkoff in the early 1980s; the name comes from Solkoff’s book and is not a reference to First Lady “Lady Bird” Johnson. Solkoff started using the lady bird deed to address an issue with the traditional life estate.

In a typical life estate, a piece of property (often but not always real estate) is owned by a “life tenant” for the duration of their life only. When the life tenant dies, the property automatically passes to a “remainderman” or “remaindermen.” The life tenant may be the grantor (the original owner of the property), the grantor’s spouse or child, or someone else.

One big advantage of a life estate deed is that the property is not subject to probate. But one big disadvantage – to the life tenant, at least – of the traditional life estate is that the life tenant does not have full rights to the property during their lifetime. The life tenant cannot, for example, sell or take out a mortgage on the property without the permission of the remainderman. Understandably, selling or mortgaging the property goes against the best interests of the remainderman, who would prefer for the property to remain intact with its full value. This clash of interests between the life tenant and the remainderman effectively means that, in most cases, the life tenant is unable to sell or mortgage the property, even if it is legally theirs.

Enter the lady bird deed. With a lady bird deed, the life tenant has full rights to the property during their lifetime, including the right to mortgage, sell, or otherwise dispose of the property without the permission of the remainderman. This is why the term “enhanced life estate” is also used for a lady bird deed, since it’s essentially a life estate deed that gives the life tenant additional rights to the property. Upon the death of the life tenant, the property, or what remains of it, automatically goes to the remainderman (or remaindermen).

Another important difference between a lady bird deed and a life estate deed is that a lady bird deed can be revoked or changed by the grantor alone. By contrast, a life estate deed can only be revoked or changed by the grantor with the permission of the life tenant and the remainderman.

Benefits of a Lady Bird Deed

As covered above, the main benefits of a lady bird deed over a life estate deed include:

Full property rights to the life tenant including the right to sell or mortgage the property without the remainderman’s permission.
Ability for grantor to revoke or change the lady bird deed without the remainderman’s permission.

Other benefits of a lady bird deed are the same as a typical life estate deed, which include:

Avoiding probate. Because the lady bird deed (or life estate deed) directs where the property should go after death, the property passes automatically to the heir without needing to go through probate.
Help with Medicaid eligibility. If the grantor is also the life tenant, then the property is not considered an asset when the grantor applies for Medicaid. Lady bird deeds aren’t considered a transfer for Medicaid eligibility purposes.
Prevent property from being used to repay Medicaid. Lady bird deeds (and life estate deeds) prevent the property from being used to repay the state for Medicaid costs related to long-term care after the individual’s death.
Avoid federal gift tax. Importantly, it does not help you avoid applicable estate taxes.

This list is not exhaustive. Depending on your specific circumstances, you may derive other benefits from a lady bird deed or life estate deed.

Drawbacks of a Lady Bird Deed and Potential Consequences

Lady bird deeds sound great. They provide all the benefits of a life estate deed but without the major drawback of restricting the life tenant’s rights. Plus, they can be changed or revoked by the grantor at will.

But there are two major drawbacks specific to lady bird deeds that can create unintended consequences. These are:

Drawback 1: Lack of widespread recognition

Lady bird deeds are not as common and widespread as life estate deeds and many other estate planning tools. As of now, only five states fully recognize lady bird deeds (usually called enhanced life estate deeds): Florida, Michigan, Texas, Vermont, and West Virginia.

While this doesn’t mean you are prohibited from having a lady bird deed if you live in one of the other forty-five states, it does mean that doing so is taking a risk. Your wishes may not be carried out as you want, because the law still isn’t clear on how to handle lady bird deeds in most states.

Drawback 2: Difficulty obtaining title insurance

One of the great benefits of a lady bird deed is that the life tenant does not require permission from the remainderman to mortgage, sell, or otherwise encumber or dispose of the property. But this can cause a problem when it comes to title insurance if the life tenant ever decides to sell or take out a mortgage on the property.

A title insurance company in a state where lady bird deeds are not routinely recognized may refuse to issue title insurance unless it has the “joinder of the remainder,” that is, the agreement of the remainderman or remaindermen to the sale or mortgage. Since, as discussed above, doing so goes against the remainderman’s best interests, it may be impossible to obtain the joinder of the remainder. At that point, the enhanced life estate created by the lady bird deed is no different than a typical life estate.

What if you simply don’t get title insurance and go ahead with the sale? It’s true that title insurance is not required for every sale. But skipping the title insurance doesn’t address the underlying problem, which is that the remainderman has a vested interest in the property and can bring a claim in the future. Fighting such claims in and out of court can be costly and time consuming, and they can irreparably damage relationships among heirs.

Are Lady Bird Deeds Legal in South Carolina?

Lady bird deeds are not codified into law in South Carolina, nor have they been officially recognized by the courts.

However, in at least two instances, South Carolina higher courts have agreed with the intention of an enhanced life estate, or, in its words, a “life estate with the power of disposition,” as far back as 1971. That is, it recognized the right of a life tenant to dispose of the property as they wish without the consent of the remaindermen when this wish was explicitly expressed in the original property owner’s last will. See Blackmon v. Weaver (2005) (here) and Johnson v. Waldrop (1971) (here).

This may be reassuring to those who wish to take advantage of the benefits of a lady bird deed in South Carolina, but it’s still a long way from being widely used and recognized here. Plus, it still doesn’t change the fact that title insurance companies may refuse to issue title insurance without the joinder of the remainder, which could hamper real estate deals. Finally, it’s worth noting that both of the “life estates with the power of disposition” recognized by the courts were created in last wills, not through deeds, meaning that the properties in question were subject to probate.

Alternatives to Lady Bird Deeds in South Carolina

At this time, the most prudent thing to do may be to find an alternative to the lady bird deed if you live in South Carolina or another state where enhanced life estate deeds are not routinely recognized. Some possible alternatives to a lady bird deed, depending on your objectives, include a life estate deed, a transfer-upon-death deed, or a revocable living trust.

If you have questions about your estate plan and are concerned about avoiding probate or ensuring that your property is inherited according to your wishes, call estate planning attorney Gem McDowell at the Gem McDowell Law Group. He and his team can help you create, review, or update your estate plan so it reflects your current life circumstances and future wishes. He can also help you understand the possible consequences of how your estate plan will play out and how that can affect your family members and heirs and prevent friction in the future.

Call Gem today at his office in Mount Pleasant, SC, at 843-284-1021 to schedule your free consultation today.

What Is the Legal Rate of Interest in South Carolina in 2024?

Update: Read about the 2025 legal rate of interest here on the blog.

On January 4, 2024, the Supreme Court of South Carolina issued an order regarding interest rates on money decrees and judgments for the next twelve months. The legal rate of interest for money decrees and judgments is 12.50% compounded annually for the period between January 15, 2024 and January 14, 2025. (Read the original order in PDF format.)

The rate “is equal to the prime rate as listed in the first edition of the Wall Street Journal published for each calendar year for which the damages are awarded, plus four percentage points, compounded annually,” according to South Carolina Code § 34-31-20 (B). The law also provides that the SC Supreme Court updates the interest rate every year, no later than January 15^th, for the upcoming year.

Are You Responsible for Your Spouse’s Debts?

Are you responsible for your spouse’s debts? It depends. Generally, you are not responsible for any debts your spouse brings into the marriage.

As for debts incurred during the marriage, it depends on the state you live in and the type of debt. In an equitable division state such as South Carolina, both spouses are responsible for debt taken on jointly and for debt that benefits the marriage. In South Carolina and many other states, you would not be liable for debts incurred only by your spouse that don’t benefit the marriage.

There’s one important exception – the doctrine of necessaries.

The Doctrine of Necessaries in South Carolina

The doctrine of necessaries (also called the necessaries doctrine or sometimes the doctrine of necessities) comes from common law and is still valid in many states today, including South Carolina. It makes an individual liable for a spouse’s debts if the debts are related to medical care, food, shelter, or other “necessaries” for life. It also applies to parents who are liable for their minor children’s debts including medical bills.

The necessaries doctrine has been affirmed a number of times in South Carolina courts, including in the case Richland Memorial Hospital v Burton (1984) in the Supreme Court of South Carolina (here). Richland Memorial Hospital brought a collection action against Cary Burton, the husband of a deceased patient of the hospital, for debts incurred by his wife during her medical care. The trial court found Burton liable for the debts, and the SC Supreme Court ultimately affirmed.

This case is important because it brought equality to a common law that originally applied only to men and not to women.

Historical Inequality in the Doctrine of Necessaries

Originally, only husbands had the legal duty to support their wives and take on their debt. The necessaries doctrine comes from common law during a time when women did not have all the rights they do today, including property rights and the right to enter into contracts. A husband had a duty to support his wife, even taking on the debts she incurred before the marriage, and he also had the authority to use her property to satisfy her debts. Common law did not require a woman to take on her husband’s debts, because it didn’t make sense at the time.

Things began to change in the mid-1800s when Married Women’s Property Acts and similar acts were passed, state by state, across the country, giving women more legal authority and property rights. South Carolina later enacted Code 20-5-60 which relieved husbands of liability for their wives’ debts, except for her necessary support: “A husband shall not be liable for the debts his wife contracted prior to or after their marriage, except for her necessary support and that of their minor children residing with her.”

Still, while women gained more rights, the necessaries doctrine remained unchanged in many places for a long time, including South Carolina.

An Old Common Law in Modern Times

In Richland Memorial Hospital v Burton, Burton argued that the necessaries doctrine and SC Code Section 20-5-60 were unconstitutional because they violated the equal protection clauses of the South Carolina Constitution and the United States Constitution. The appellant and respondent conceded that the necessaries doctrine denied equal protection because it imposed an obligation on husbands it did not impose on wives. The court agreed.

But the court also agreed with Richland Hospital that the doctrine of necessaries remains a viable common law doctrine. The court determined that both husbands and wives were subject to the necessaries doctrine. From the court’s opinion: “We accordingly hold that the necessaries doctrine allows third parties providing necessaries to a husband or wife to bring an action against the individual’s spouse.”

In short, yes, in South Carolina you can be responsible for necessaries-related debts your spouse alone incurs – whether you’re a husband or a wife.

Estate Planning with Gem McDowell

For help with estate planning, call estate planning attorney Gem McDowell at the Gem McDowell Law Group. He and his team can help you with estate planning documents like wills, living wills, and trusts, and help make sure your estate plan is up to date and reflects your wishes and current laws. Call 843-284-1021 to schedule your free initial consultation today.

What is a Right of First Refusal and When Is It Enforceable?

The right of first refusal sounds simple on the surface. A right of first refusal (ROFR) gives the right-holder the opportunity to enter into a business transaction with another party before anyone else. It’s most commonly seen in real estate contracts, such as when a lessor signs a contract giving them the ROFR to put in an offer to purchase the property if it ever comes up for sale.

But as straightforward as it sounds on paper, it’s not always so straightforward in the real world. Contracts that include an ROFR must be clear and detailed in order to be enforceable.

The Supreme Court of South Carolina addressed this issue in the 2023 case Clarke v. Fine Housing, Inc. (here). We’ll look at the factors required for an enforceable right of first refusal in South Carolina and how they played out in this recent case.

The Pros and Cons of a Right of First Refusal

An ROFR can benefit both parties. In the example of a lessor with the ROFR to purchase the property, if and when it comes up for sale, they can be sure not to miss out on the opportunity to put in an offer. There’s no downside for the potential buyer; if they don’t want to buy the property, they simply refuse.

The property owner can benefit by having a potential buyer already lined up when it’s time to sell, which may help them in negotiations with other potential buyers. However, the downside for the property owner is that a ROFR can restrict their power of alienation, which is their ability to dispose of property.

“South Carolina law prohibits enforcement of unreasonable restraints on alienation of real property,” the court says in the Clarke opinion. The key word here is “unreasonable.” Whether a particular ROFR is enforceable depends on whether the restraints on alienation are considered unreasonable.

Unreasonable Restraints on Alienation of Property: What is Unreasonable?

In the Clarke opinion, the SC Supreme Court turns to the Restatement (Third) of Property. The Restatements of the Law (Third) are a comprehensive set of legal treatises widely referenced and relied upon by courts, judges, lawyers, and others across the U.S. On the subject of the ROFR, it says, “Reasonableness is determined by weighing the utility of the restraint against the injurious consequences of enforcing the restraint.”

The Supreme Court of South Carolina uses the factors listed in the Restatement (Third) of Property (Comment f) to determine, on a case-by-case basis, whether a right of first refusal is enforceable. The factors are:

The legitimacy of the purpose of the right,
The price at which the right may be exercised, and
The procedures for exercising the right

These factors are not exclusive.

Let’s look at each one of the factors and how they figure into the Clarke case.

Background of Clarke v Fine Housing (2023)

First, the pertinent background of 2023 Supreme Court of South Carolina case Clarke v. Fine Housing, Inc.: Barry Clarke owned a strip club in Charleston. In 1999, he entered into a lease agreement with the owners of another strip club across the street to use part of their unimproved land for parking. The lease contained the following language:

Section 5.2. Right of First Refusal: Lessor grants the Lessee the right of first refusal should it wish to sell.

Note that there’s no mention of price, timing, how to exercise the right, or any other specifics – not even which property this right of first refusal applies to.

In 2013, then-owner RRJR conveyed the property in question to Fine Housing, Inc. Clarke learned of the sale in 2014 after it was a done deal, having had no opportunity to exercise what he believed to be his enforceable right of first refusal (Right).

In 2015, Clarke brought this action for specific performance against Fine Housing and RRJR. The case eventually came before the Supreme Court of South Carolina, which agreed with the SC Court of Appeals that the Right was not enforceable because it constituted an unreasonable restraint on alienation.

Factors for an Enforceable Right of First Refusal

Here are the three factors the Supreme Court of South Carolina uses to determine enforceability of a right of first refusal on a case-by-case basis and how they show up in Clarke.

Factor 1: Legitimacy

In Clarke, Fine Housing didn’t challenge the legitimacy of the purpose of the Right, so the court didn’t address the issue.

Factor 2: Price

Price may or may not be an unreasonable restraint on alienation. If, for example, the ROFR were dependent on a fixed price, that could restrain alienation. If the price were to be matched to a third party’s offer, there would be less restraint.

In Clarke, Clarke argued that the Right left the price to be determined entirely by RRJR and required him to match any offer from a third party. He also argued that exercising the Right would have started a bidding war that would have benefitted RRJR.

The court agreed with Fine Housing that the absence of any method for determining the purchase price in the lease constituted an unreasonable restraint on alienation. Absence of specifics on how to determine price may not be as restraining as a fixed price, says the court, but it is still a restraint, and “a right of first refusal should contain some method for determining the price at which it may be exercised.” The lease Clarke signed had no method, and therefore this factor worked against him.

Factor 3: Procedures governing the exercise of the right

Comment f to the Restatement stresses the importance of provisions governing the exercise of the right, stating, “Lack of clarity may cause substantial harm by making it difficult to obtain financing and exposing potential buyers to threats of litigation. Lengthy periods for exercise of rights of first refusal will also substantially affect alienability of the property.”

Time is also an important consideration. How soon after the owner decides to sell does the right holder have to exercise their right? An extended period of time can be a restraint on the property owner, while a “reasonable” time frame does not impose unreasonable restraint and is generally enforceable.

In Clarke, Clarke argued that a ROFR does not require detailed instructions on how to exercise it to be valid, but this directly contradicts the Restatement (Third) of Property. He also argued that the lease provided satisfactory procedures regarding the exercise of the right. The court disagreed “because the Right contains no such procedures whatsoever.”

As for timing, Clarke argued that if there’s no mention of a timeline in the language of the agreement, then it must be done within a “reasonable time.” The court disagreed, saying that the point of the Restatement is to include a predetermined time limit so as to protect the property owner’s power of alienation, rather than having the owner rely on a “judicially implied ‘reasonable time.’”

Because of the total lack of provisions regarding timing and procedures on how to exercise the Right, the court found again in favor of restraint on alienation.

Additionally: Which Property?

The court also addressed a matter specific to Clarke: to which property did the Right ostensibly apply? The entire property that includes the unimproved land Clarke leased for parking, or the unimproved land only?

Clarke argued that the Right applied to the entire property, but the court disagreed because the language in the lease was not clear. That uncertainty constitutes an additional unreasonable restraint on alienation.

Takeaway: Rely on Clear, Specific Contracts

The SC Supreme Court affirmed the appeals court’s decision, finding in favor of Fine Housing and against Clarke, stating “The Right does not identify the property it encumbers, contain price provisions, or contain procedures governing the exercise of the Right. We conclude the Right is an unreasonable restraint on alienation. We therefore affirm the court of appeals’ holding that the Right is unenforceable.”

An important takeaway for anyone entering into a contract with a right of first refusal in South Carolina: Make sure the language in your contact is clear and specific and that it addresses the three factors discussed above. It must contain language on how the price should be determined and how the right should be exercised. Language that unreasonably restrains the property owner’s power of alienation may render it unenforceable, so the right cannot be construed too favorably to the would-be buyer.

Call Gem McDowell for Contracts, Strategic Business Advice, and Commercial Real Estate

Many legal disputes come down to the language in a contract. Is it clear? Is it enforceable? Would the courts side with you if the matter were ultimately litigated? It’s critical to get the contract right before signing it, so you lessen the chances of complications and litigation down the road.

For help with business contracts and commercial real estate, call business attorney Gem McDowell at the Gem McDowell Law Group. Gem has over 30 years of experience working with business owners to help them start, grow, and protect their businesses. He and his team can help you with contracts, corporate governance documents, strategic advice, and more. He also has extensive experience in commercial real estate transactions in South Carolina. Call the Gem McDowell Law Group today to schedule a free consultation at 843-284-1021.

What is Family Malpractice™, and Have You Committed It?

Have you committed Family Malpractice™?

If you’ve neglected your legal responsibilities regarding your family, then yes, you have.

What is Family Malpractice™?

You’ve heard of attorney malpractice, where an attorney’s misconduct causes problems for a client, and you’ve heard of medical malpractice, where a doctor’s error or negligence causes problems for a patient. Similarly, Family Malpractice™ is when an individual causes problems for his/her family members, usually because of failure to take action on a legal matter.

Problems that are created can be legal, financial, and/or familial in nature. I’ve seen a decedent’s heirs have to go through years of expensive and stressful legal battles over how to divide up assets. I’ve seen people take a huge financial hit because of how property was handled after the owner’s death. I’ve seen families torn apart and relationships permanently ruined due to Family Malpractice™.

While it’s not something you can be prosecuted for, Family Malpractice™ is something to avoid. You can easily do so by knowing some of the common pitfalls that put your family in peril legally and financially, and how to avoid these easily avoidable situations yourself.

When You Have Children but Have No Will, That’s Family Malpractice™

Do you know what happens in South Carolina if you die without a will, leaving behind a spouse and children? When I ask this question in consultations or at live, in-person seminars, most people believe that 100% of the deceased’s probate estate goes to the spouse. This is incorrect. By state statute, the deceased’s probate estate is divided evenly between the spouse, who gets 50%, and the children, who share the remaining 50% among themselves.

This sounds reasonable and fair. But, as straightforward as it sounds, this simple arrangement can cause a lot of problems, usually for the spouse. For instance, if a husband and father dies intestate (without a will), his half of the house is divided equally between his surviving wife and children. So his wife now owns 75% of the house and the children own the other 25%. If she’s not able to keep up with the house payments and wants to downsize, she can’t sell unless her children agree. They then have leverage and can demand more than the 25% of the sales price of the home, or else simply refuse to sell.

Who would do this to their own mother, you ask? Plenty of people, unfortunately. I’ve seen scenarios like these play out many times in my 30+ years of being an attorney. Situations like these can ruin a person financially in their later years and destroy family relationships irrevocably.

The situation becomes even more complicated in blended families where one or both spouses have children from a previous marriage. Imagine then, the surviving spouse may own 75% of the house and the children from a previous marriage own the other 25%. The children from the previous marriage are not required to cooperate with the surviving spouse. They can veto a sale, refinance, etc. They essentially control the property. That is not what the decedent wanted, and that decedent committed Family Malpractice™ with regards to the surviving spouse.

In short, the way an estate is passed along and divided up according to South Carolina law may not be what an individual wants, but if they die intestate, they don’t get a choice – and their heirs have to live with the consequences.

The solution: Have a will drawn up. This is vital if you have a family and especially if you have anything other than a small estate. Dying without a will can potentially create a lot of problems for your heirs that could have been avoided with a current estate plan.

When You Don’t Probate Your Deceased Mom or Dad’s Estate, That’s Family Malpractice™

The idea of a family home being passed down from generation to generation is something many people aspire to. Passing on wealth in the form of real property to your children, and to their children in turn, and so on, is a wonderful gift.

At least, it can be. It’s not uncommon for property passed on after death to become “heirs property,” which can cause a lot of problems for the heirs. This can happen when the surviving children of the original, now-deceased homeowner continue to live in the home but don’t go through the proper legal process to put the property in the new owners’ names. That is going through the probate process. If the same situation repeats for a few generations in a row, you can end up with literally dozens of people (typically, the grandchildren or great-grandchildren of the original owner) who all have legal claims to the property, all while the property is still technically in the original owner’s name.

Why is this such a problem? Because it’s very difficult to sell a house like this, when there are so many owners and a cloudy title. A buyer interested in the property risks having the deal fall through if one of the many owners decides they want more than their proportional share of the sales price or refuses to sell altogether. Getting the title cleared takes extra time and money. Meanwhile, the family members who own the house cannot sell and take the equity in the house, and they may be barred from accessing things that require clear title of ownership, like mortgages, loans, and government programs.

The solution: Ensure your deceased parent’s estate goes through probate. The probate process does not happen automatically; it’s something the executor named in the will must carry out. If there is no will, the probate court names an executor, usually a child or close relative of the deceased.

There are a few roadblocks keeping people from ensuring a deceased parent’s estate goes through probate. One is simply not knowing that it’s needed; they may incorrectly assume that the ownership of the house legally passes from the parent to the child(ren) without having to do anything. Another reason is an aversion to having to pay a lot to probate the estate. But in SC, probate fees are not very high. For instance, probate fees on an estate worth $1 million is just $1,845, which is paid out of the estate, as are attorney’s fees. Finally, some people want to avoid dealing with the government altogether. While this may be understandable, it’s not a good reason to avoid probate. Working with an experienced probate attorney you trust can help you and ensure that your estate is handled legally and fairly.

Read more about probate here on our blog.

When You Don’t Take the 1014(e) Step-Up in Basis, That’s Family Malpractice™

A step-up in basis occurs when the cost basis of an asset, like a home, is adjusted from the original cost basis to the current fair market value upon the death of the owner.

Let’s say your parents bought a house 20 years ago for $150,000, and when you inherited it upon their deaths, it was worth $350,000. If you don’t take the step-up in basis and proceed to sell it, you’ll have to pay capital gains tax on the difference, which is $200,000. If instead you do take the step-up in basis, and have the cost basis of the house increased to $350,000 (the fair market value at the time of your parents’ deaths), then you’ll only pay capital gains tax on the difference between $350,000 and whatever you sell it for in the future.

Depending on the value of the house, and how much that value has grown over time, that can mean saving a lot of money in taxes. When someone does not take this step-up in basis, it can lead to very large tax bills when the time comes to sell the property. There are a few reasons a person may fail to do so; they may not even know that the option exists, or they may mistakenly assume that it happens automatically.

The solution: Take the step-up in basis on property in an estate that you are executor of, or ensure that the executor of your parents’ estate does so. The probate attorney handling the estate can help you. As a probate attorney, my goal is to get the largest step-up in basis possible for my clients in order to reduce their tax liability in the future.

Work with Estate Planning Attorney Gem McDowell

Wills, probate, and step-up in basis are things that most people don’t think about because it’s outside the scope of daily life. But failing to take care of these matters is what I call Family Malpractice™, and it can lead to major legal and financial hassles in the future. Even more devastating, it can cause rifts between family members as they fight over assets in and out of court. Fortunately, these issues are completely avoidable. Work with an estate planning attorney and probate attorney to ensure your estate plan is solid and current and that you’re handling your deceased relatives’ estates correctly.

If you have questions about creating or revising your own estate plan in South Carolina, or you want advice or assistance handling the estate of a deceased relative, contact Gem McDowell at the Gem McDowell Law Group today. Gem has over 30 years of experience as an attorney and has helped countless families in South Carolina create estate plans, avoid mistakes, and fix problems. He and his team can help you understand and avoid committing Family Malpractice™ that can harm your family. Call him at his Mount Pleasant office today at 843-284-1021 to schedule a free consultation.

What Happens to Your Estate If You Die During a Divorce in South Carolina? Spousal Elective Share

Imagine this scenario:

Husband and Wife have been married for many years. One day, Wife files for divorce. At a hearing a few months later, the divorce is granted.

Husband dies about a week later.

A few days after that, the final divorce decree is signed by the judge, then filed with the clerk.

The tragic and unlikely timing of Husband’s death brings up some important questions.

Were Husband and Wife still married when he died because the decree wasn’t yet signed and filed?
Or were they already divorced because the divorce had been officially granted by the court?
Would Wife be entitled to part of Husband’s estate as a surviving spouse?

This exact situation happened in South Carolina in the late 90s and ended up before the South Carolina Court of Appeals in the 2000 case Hatchell-Freeman v Freeman. It’s an interesting case to know for anyone contemplating or going through a divorce in South Carolina as it answers the questions above.

Dying Before Divorce Is Finalized: Hatchell-Freeman v. Freeman (2000)

In the Hatchell-Freeman case (read it here), Angela Hatchell-Freeman filed for divorce on June 21, 1996. The divorce was granted at a hearing on September 27, 1996, and ten days later, on October 7, Husband died. The final order granting the divorce was signed on October 10, and the following day the order was filed.

In December, father of the decedent Gilbert Freeman filed a petition to be appointed personal representative of his late son’s estate, which the court granted. He did not list Hatchell-Freeman as an intestate heir or as “a person having a prior or equal right of appointment.”

In January, Hatchell-Freeman filed a notice of election by surviving spouse for her intestate share – aka “elective share,” which is a portion of the decedent’s estate the surviving spouse is entitled to by statute. The probate court ruled that she was entitled to elective share.

She also filed a petition to be appointed personal representative, which would mean removing Gilbert Freeman from the role. The probate court ruled that she had had “adequate” time to file – over three months since her husband’s death – and so denied her petition.

Both parties appealed.

The Circuit Court’s Findings

The circuit court affirmed the probate court’s finding that Hatchell-Freeman was the wife of the decedent at the time of his death and therefore entitled to her elective share.

However, it found that she had a superior right to serve as personal representative. Gilbert Freeman was removed from the role and replaced by Hatchell-Freeman.

Gilbert Freeman then appealed.

The SC Court of Appeals

The appeals court affirmed the circuit court’s findings.

It found that the couple was indeed married at the time of Husband’s death, making Hatchell-Freeman eligible to receive her elective share of the estate. The fact that the divorce had been granted at the final hearing before Husband’s death was irrelevant, as South Carolina Code 62-2-802(c) (1987) is clear: “A divorce or annulment is not final until signed by the court and filed in the office of the clerk of court.”

The court also affirmed the lower court’s decision to replace Gilbert Freeman with Hatchell-Freeman as personal representative. SC Code 62-3-203(a) (1999) lists in order which individual should be given priority for the role of personal representative, and when there is no will naming a personal representative (as in this case, since Husband died intestate), a surviving spouse has priority over other heirs.

Although it may not have been Husband’s intention for the woman he was divorcing to inherit any portion of his estate, that’s what happened. But was there something he could have done to prevent it?

(Technically) Married at Time of Death: Spousal Elective Share in South Carolina

As stated above, a surviving spouse is entitled to spousal elective share, which is a portion of the deceased spouse’s estate. The concept of elective share originates from English common law and is widespread across the US, with different laws governing elective share in different states.

In South Carolina, a surviving spouse may claim one third of the decedent’s probate estate. (“Probate estate” is defined in SC Code Section 62-2-202 as “the decedent’s property passing under the decedent’s will plus the decedent’s property passing by intestacy, reduced by funeral and administration expenses and enforceable claims.”) This is a minimum; the testator or testatrix can of course leave more than one third of their estate to their spouse in their will.

It doesn’t matter whether the decedent had a will or not; whether the couple was separated at the time of decedent’s death, divorce pending; or even whether the decedent had purposely left the surviving spouse out of the will in an attempt to disinherit them. The surviving spouse is legally entitled to their elective share.

In short, if you die before your divorce is signed and filed, your spouse is entitled to claim a portion of your estate under South Carolina law even if that’s not what you want. The only exception is if your spouse has waived their right to elective share, typically via a prenuptial or postnuptial agreement.

Reviewing and Revising Your Estate Plan During or After Life Events – Call Attorney Gem McDowell

If you’ve recently undergone a major life event like divorce, marriage, or birth of a child, you should consider contacting an estate planning attorney to review your last will, powers of attorney, and other estate planning documents. It’s a good opportunity to ensure that your estate plan is in line with your current wishes and life situation.

For help with estate planning, asset protection, and contracts including prenuptial agreements and postnuptial agreements, contact attorney Gem McDowell. He and his team at the Gem McDowell Law Group can help you with your estate planning needs before, during, and after a divorce. Call him at his Mt. Pleasant office at 843-284-1021 today to schedule a free consultation.

Employee or Independent Contractor? Employers Need to Know DOL’s Proposed Rule

This blog will be updated with relevant developments

Misclassification of workers by employers is a big problem, according to the Department of Labor (DOL).

“The misclassification of employees as independent contractors remains one of the most serious problems facing workers, businesses, and the broader economy,” it says in a 10/13/2022 notice of proposed rulemaking (NPRM) from the Wage and Hour Division of the DOL, discussed below.

To combat worker misclassification, the NPRM proposes modifications to regulations regarding how workers should be classified. This is a big deal because if the proposal is adopted – which it almost certainly will be – it would make it more difficult for workers to be classified as independent contracts and easier to be classified as employees, compared to current regulations.

Further, the DOL and the Internal Revenue Service (IRS) entered into a Memorandum of Understanding (MOU) in mid-2022, replacing a similar MOU from 2011, that lays out how the two agencies will work together to combat worker misclassification. More on this below, too.

These developments are of great importance to employers in South Carolina and across the country. It could mean reclassifying some workers that are currently independent contractors as employees, with all that entails.

Here’s what to know.

Proposed Rule by the DOL on Worker Classification

On October 13, 2022, the Wage and Hour Division of the DOL published a notice of proposed rulemaking (NPRM), Employee or Independent Contractor Classification Under the Fair Labor Standards Act (FLSA). You can read the NPRM in its entirety here on the Federal Register.

The rule would provide clear guidance on how to classify workers, making it “more consistent with judicial precedent” and with the FLSA’s “text and purpose,” says the DOL. Workers classified as employees have protections and benefits at the federal level under the FLSA, such as minimum wage and overtime pay, which independent contractors do not have.

The practical effect would most likely be that many workers who are now currently classified as independent contractors would need to be reclassified as employees. An article from the Small Business Administration on the topic notes that “In its Initial Regulatory Analysis, DOL estimates that millions of small businesses could hire and/or be independent contractors,” so this rule could affect a large number of people.

The Six Factors of the Economic Reality Test for Worker Classification

Classification would involve a totality-of-the-circumstances analysis using a multifactor economic reality test comprised of six specific factors and one additional, nonspecific factor. They are:

Opportunity for profit or loss depending on managerial skill
Investments by the worker and the employer
Degree of permanence of the work relationship
Nature and degree of control
Extent to which the work performed is an integral part of the employer’s business
Skill and initiative
Additional factors

In this blog we won’t go into too much detail about each of these factors, but here’s a little bit of explanation for each one. (For more discussion on the history and application of these tests, follow this link to go straight to factor #1 in the NPRM, which goes into great detail about all the factors.)

Opportunity for profit or loss depending on managerial skill. This considers several factors such as whether the worker determines their own pay, can accept or decline jobs at will, engages in marketing or advertising to secure more work, and has an opportunity for loss.
Investments by the worker and the employer. This should also consider how the worker’s investment (if any) compares to the employer’s investment in the business.
Degree of permanence of the work relationship. This should also consider whether the worker works for the employer exclusively or works for others, too.
Nature and degree of control. This considers factors such as scheduling, supervision over the performance of work, setting rates, and the worker’s ability to work for others.
Extent to which the work performed is an integral part of the employer’s business. This is not the same as the degree of contribution a worker makes; for example, one person in a call center of hundreds is still performing work that is essential to the business, even if that individual worker’s contribution is minimal.
Skill and initiative. Specialized skills and business-like initiative are factors that favor independent contractor status, while work that’s unskilled, requires no training, or requires training from the employer favors employee status.
Additional factors. Other factors, not enumerated here, may be considered if relevant to determining a worker’s classification.

No one factor is more important than the other, and no single factor is determinative on its own. Rather, this is a totality-of-the-circumstances approach to determine worker classification.

How is this rule different from current rule?

If finalized, which is very likely, this rule would rescind and replace the 2021 Independent Contractor Rule (2021 IC Rule). That rule was finalized in January 2021 shortly before President Trump left office and President Biden was inaugurated, and it was scheduled to take effect in March 2021.

The 2021 IC Rule focuses on two core factors to determine classification: 1, the nature and degree of control over the work, and 2, the worker’s opportunity for profit or loss. Additional factors may be considered if the first two are not clearly determinative. The purpose of this streamlined approach is to “promote certainty for stakeholders, reduce litigation, and encourage innovation in the economy,” according to the final rule published by the DOL.

The current NPRM notes that the approach of the 2021 IR is not in keeping with past approaches, which have included multifactor economic reality tests that looked at the totality of the circumstances, it does not “fully comport” with the FLSA’s text and purpose, and it goes against long standing case law.

In practice, the 2021 IC Rule makes it easier for workers to be classified as independent contractors rather than employees. The rule that’s currently being proposed would make it harder for workers to be classified as independent contractors.

DOL and IRS working together to identify employers misclassifying workers

The interest in codifying and enforcing rules on worker classification is not new.

The DOL and the IRS entered into a Memorandum of Understanding (MOU) in 2022, replacing a similar one from 2011, in which the agencies agree to collaborate and share information. This is less in the pursuit of protecting workers and ensuring they are afforded the protections under the FLSA due to them and more about collecting revenue.

The point of the collaboration is to “promote employer compliance with obligations to properly pay employees and to pay employment taxes.” The MOU outlines, among other things, how the DOL can evaluate businesses to refer to the IRS to look into whether workers have been misclassified. In addition, in reference to whether the DOL should refer a particular case to the IRS, it says “Given scarce IRS resources, the focus is where there is a likely source of collection.”

In short, the IRS appears to be looking for sources of revenue. (Another recent initiative announced by the IRS is a “proposed revenue procedure” called the Service Industry Tip Compliance Agreement program, a voluntary program for employers that would improve reporting of tips to the IRS.)

What this means for employers

Employers need to pay attention to if and when the DOL finalizes the rule proposed in October 2022 and ensure that they are correctly classifying their workers under the new rule once it takes effect. Some employers may be able to easily reclassify existing independent contractors as employees, if needed. Others may not have the resources to do so, because of the associated costs of employment taxes, workers’ compensation insurance, additional benefits, and so forth for employees. Employers may have to significantly change their relationship with their workers in order to meet the qualifications of being an independent contractor, or possibly let these workers go entirely.

The DOL notes in its NPRM that businesses that are already in compliance and are correctly classifying workers will benefit from this new rule, as businesses that misclassify employees as independent contractors gain a competitive advantage. This advantage will be eliminated or reduced if and when the new rule is finalized.

Additionally, an increase in the number of employers could mean an increase in unions and labor organizing. Labor unions generally are not allowed to organize independent contractors, but they can organize employees. The connection between worker classification and the drive to increase organizing and unions was made explicit on Joe Biden’s campaign website page for “Strengthening worker organizing, collective bargaining, and unions.” One of the promises was to “drive an aggressive, all-hands-on-deck enforcement effort that will dramatically reduce worker misclassification.”

Employers should also be aware that even if/when this rule from the DOL is passed, this is not the one and only way to determine whether a worker is an employee. The IRS has its own guidance on determining whether to provide a 1099 or a W-2 (read more on that here), and individual states may have their own rules or precedents, too; in South Carolina, the four-factor model is the standard (read more on that here).

Contact Business Attorney Gem McDowell for Advice and Guidance

If you’re an employer in South Carolina and are seeking legal advice, call Gem McDowell. He has over thirty years of experience helping South Carolina business owners start, grow, and thrive in their businesses. Changing classifications of workers could have a large impact on your business, as could noncompliance, and Gem can advise you on how to navigate this change.

Call Gem and his team at the Gem McDowell Law Group at the Mount Pleasant office at 843-284-1021. In addition to an office in Mount Pleasant near Charleston, Gem also has an office in Myrtle Beach for your convenience.

Involved in Real Estate or Passive Activities? Passive Activity Loss Rules to Know

Let’s say you’ve dipped your toe into the real estate game and flipped a house. Instead of making a killing on it, you took a big financial hit. When tax time comes around, can you take that loss against your regular income to reduce your taxes?

Generally, no. That’s because of passive activity loss rules.

In short, passive activity loss rules are anti-tax shelter rules. They prohibit taxpayers from using financial losses from passive activity to offset active income and thereby reduce their taxable income and pay less in taxes.

If you own rental property or are otherwise involved in any passive activity trade or business, you need to know about passive activity loss rules. We’ll look at these rules more closely along with the important definitions and exceptions you should know.

Passive Activity Loss Rules: Definitions and Overview

Below is a summary of some key points of the passive activity loss rules along with definition of terms (in bold). Note that this blog is not intended to be exhaustive, but just to familiarize you with the topic. We’ll be discussing rules from the IRS, specifically Topic No. 425 and Publication 925 (2021), which are derived from 26 U.S. Code § 469. The IRS rules are detailed and contain multiple exceptions, which we won’t go into here, as this is an overview. If you believe you’re subject to passive activity loss rules, speak with an accountant to help you with your taxes.

Passive activity loss rules prohibit a taxpayer from taking a deduction of losses incurred from passive activity to offset active (ordinary/earned) income.

While passive activity losses can’t be used to offset active income, they can be used to offset passive activity income. Losses that exceed passive activity gains in the same year can be carried over to the following tax year.

Passive activity rules apply to:

Individuals
Estates
Trusts (other than grantor trusts)
Personal service corporations, and
Closely held corporations

The IRS notes that grantor trusts, partnerships, and S corporations are not directly subject to these rules, but the individuals who own them are.

Active income includes wages, salaries, commissions, and any other income “that comes from performing a service.” This is the money you make from your job or business, whether you’re a W2 employee, 1099 contractor, or business owner actively involved in your business.

In contrast, passive income is income from a passive activity in which you’re not “materially” involved. The IRS defines two kinds of passive activity: 1) rental activities, and 2) trade or business activities the taxpayer did not actively contribute to.

Material participation means being involved in the business activity on a “regular, continuous, and substantial basis.” The IRS lays out seven “material participation tests” to help determine whether involvement is passive or active. The taxpayer only needs to satisfy one of the seven for their participation to be considered material and thus not have the activity considered “passive.”

To see all seven tests, go to IRS Publication 925, linked above; here are three:

Participation in the activity for more than 500 hours in the tax year
Participation in the activity for more than 100 hours in the tax year, and at least as much as any other individual (including individuals who don’t own any interest in the activity)
“Based on all the facts and circumstances, you participated in the activity on a regular, continuous, and substantial basis during the year”

These material participation tests do not apply to rental activity (discussed below) or to working interests in oil and gas property, which have separate rules.

Active participation is a lower standard to meet than “material” participation. For example, taking decisions with regard to management of the business activity would qualify as active participation.

Passive Activity and Rental Activities

If you earn income from a rental property, then you know that it only takes a few major repairs or renovations or a couple months without tenants to put you in the red for the year.

That’s where passive activity loss rule comes in. These rules apply to you because the income from your rental property is considered passive activity, even if you are “materially” involved in the activity, as described above – unless you are a real estate professional.

To be considered real estate professional by the IRS, you must meet both of the following requirements:

“More than half of the personal services you performed in all trades or businesses during the tax year were performed in real property trades or businesses in which you materially participated.”
“You performed more than 750 hours of services during the tax year in real property trades or businesses in which you materially participated.”

Under the IRS’s definition, you do not need to be a licensed real estate agent, contractor, or other certified real estate professional to meet these requirements. Conversely, the IRS definition means that some people who are licensed in the field, like a part-time real estate agent, would not be considered a real estate professional, and their rental activity would be considered passive.

Real property trades or businesses include not only renting out a real property, but development, construction, acquisition, management, and more.

Special $25,000 allowance

If you are not a real estate professional, then your income is considered passive. Any loss you derive from rental activities may be “trapped” (meaning, you can’t take the loss on your taxes) unless you can offset gains from other passive activities – most of the time.

But there is one big exception to know about. The IRS allows up to $25,000 in passive losses to be used to offset ordinary income such as salary or wages as long as you are “actively participating.” In this specific context, active participation may include things like determining rental terms, approving new tenants, and making repairs or hiring someone to do them.

The full amount up to $25,000 is available for taxpayers whose modified adjusted gross income (MAGI) is $100,000 or less. It begins to phase out above a MAGI of $100,000 and is completely phased out at a MAGI of $150,000, meaning that you cannot offset any ordinary income from passive losses if your MAGI is over $150,000.

There are several facets to this special allowance that we won’t go into here, including different allowance amounts depending on filing status and exceptions to the phaseout rules; again, read more on IRS.gov for more detail.

Estate Planning and Trusts

Passive activity loss rules apply to trusts and estates, too. Remember to work with an accountant if you have questions about how passive activity loss rules affect your taxes. If you have questions about trusts and estate planning, or are the personal representative of someone who recently died and need advice, call estate planning attorney Gem McDowell.

Gem and his team at the Gem McDowell Law Group help individuals and families in South Carolina with trusts, wills, powers of attorney, and other estate planning documents to ensure they’re in control of their assets now and in the future. Call Gem and his team at his Mt. Pleasant office at 843-284-1021 today to schedule your free consultation.

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