Protect Your Business Interests with Anti-Raid and Anti-Disparagement Provisions
We’ve talked before about how South Carolina courts tend to favor employees over employers in regards to covenants not to compete. This means that employers must be very careful in wording covenants not to compete to ensure they’re not overly broad or too restrictive.
But this bias against employers doesn’t extend to all covenants employers use. South Carolina courts are more likely to enforce covenants that don’t have clauses and provisions limiting an employee or former employee from earning a living in their profession.
Two other provisions that can help protect an employer’s business interests and should be considered when drafting a covenant not to compete are anti-raid provisions and non-disparagement provisions. As with covenants not to compete, the purpose of these provisions is to protect the employer’s interests after an employee leaves the company. Let’s look at them in turn.
Anti-Raid Provisions
The anti-raid provision typically states that for a period of time after the employee is no longer with the company (and possibly during employment as well), they may not approach or attempt to solicit anyone working for the company to leave in order to compete with the company. This is intended to prevent an employee from leaving the company and taking along other employees, which is clearly detrimental to the company’s interests.
Like covenants not to compete, these provisions must be reasonable. In practice, that means limiting the provision to a restricted period of time, often a year after leaving employment. South Carolina courts are likely to interpret these more favorably for the employer rather than the employee, as they don’t harm the employee’s ability to make a living in their profession after leaving their employer.
Non-Disparagement Clauses
This clause prohibits an employee from disparaging, or making negative comments, about the company, its officers, and its employees, whether orally or in writing. This provision can be found in both employment agreements (often as a clause within the covenant not to compete) and in severance or settlement agreements at the end of the employee’s tenure. The purpose is to protect the company’s reputation. Again, South Carolina courts may be favorable towards these clauses because they don’t have anything to do with restricting the employee’s right to work. Employers should consider using this clause as a matter of course upon either hiring or dismissing employees.
Still, employers need to use caution with this clause. The agreement must be clear to both parties, as a lack of clarity can lead to unintended consequences. Great care is warranted with these clauses, in part because they are greatly disfavored by state and federal agencies.
Work with an Experienced Business Attorney in Mt. Pleasant, SC
As always, remember that issues like this depend very much on the state where business is being done and arbitrated.
If you need legal advice on business contracts, employment or severance agreements, business real estate transactions, corporate taxes, or other business matters in South Carolina, contact Gem McDowell Law Group in Mt. Pleasant, SC. Gem and his associatess help businesses of all sizes protect their interests so they can continue to grow. Call today to schedule an initial consultation at 843-284-1021.
Can Your Retirement Account Be Used to Settle Business Debts?
Let’s say you owe money in a judgment, yet you still want to continue contributing to your savings accounts. Can you do that, or can that money be used to settle your judgment?
First Citizens Bank v. Blue Ox
A case decided by the South Carolina Court of Appeals heard in late 2017 dealt with this exact issue. Here’s a little bit of the background.
J. Chris Lindgren was the sole member of Blue Ox, LLC. In 2013, he signed confessions of judgment totaling $113,000 on behalf of himself and Blue Ox after he defaulted on a loan from the Bank. Lindgren never paid the judgment, and in the meantime, Blue Ox went defunct. Since the time of the judgment, Lindgren made contributions to an IRA account and a 401(k) plan.
The Bank wanted the judgement settled and started supplemental proceedings against Lindgren. It argued that the contributions he made to those accounts were fraudulent and that money should be available to pay off the judgement.
Lindgren knew he owned money to the Bank. Yet he still made contributions to three separate savings accounts. Was that legal? Should the money have been or become available to pay off the judgment? Or are those accounts protected from such use?
The case was first heard and decided by the Master-In-Equity before the cross-appeal was heard by the Court of Appeals. The Master-In-Equity determined that the 401(k) contributions were exempt from execution but his IRA contributions were not. Here are some issues the Court considered when deciding the case, and what it means for you.
The Homestead Exemption Act: What’s Exempt Under the Law
The Bank argued that the 401(k) contributions Lindgren made were not subject to protection under the Homestead Exemption Act.
What is the Homestead Exemption Act? It’s probably best known to South Carolina homeowners because it exempts the first $50,000 in value in real property in from property taxes for homeowners over 65, totally and permanently disabled, or legally blind.
The Act goes much further than this, however, and spells out exactly how much property a debtor may have that is “exempt from attachment, levy, and sale.” That is, these particular assets are protected from being used to settle debts.
In addition to the $50,000 in real property that’s exempt, the Act also allows $5,000 of interest in one motor vehicle, $4,000 in personal property such as household goods and clothing, $1,000 in family jewelry, etc. It also protects income due to the debtor from things like social security benefits, veterans’ benefits, alimony, and pension plans.
In the case at hand, the Court of Appeals AFFIRMED the Master’s initial finding and DISAGREED with the Bank. It determined that that the contributions Lindgren made to his 401(k) accounts were clearly protected under Section 15-41-30(A)(14) of the Act as a matter of statute. The Court also noted that “the exemptions in the Homestead Act are to be construed in favor of the Debtor.”
The Statute of Elizabeth: What Constitutes Fraudulent Behavior
It is illegal under South Carolina law to intentionally transfer assets in order to avoid paying your debts. If you remember from a previous blog on this topic of fraudulent conveyances and the Statute of Elizabeth, Courts can look for “badges of fraud” to assess whether or not someone’s behavior was fraudulent in intent.
In this case, the Court stated that the Bank needed to demonstrate Lindgren’s “actual intent to defraud” in order to make his savings contributions available for settlement of the judgment. The Court determined that the following badges of fraud were present:
- Lindgren did not possess enough assets to pay the debt
- Lindgren reserved the benefit of the IRA contributions for himself
- Lindgren was aware of the outstanding judgment against him at the time of the contributions
However, the Court found that many other badges were missing:
- Contributions were limited in amount
- Contributions were not secretive
- Contributions were in line with his long-standing pattern of investing in retirement
This last point is important. Lindgren provided evidence that he had a pattern of contributing to his savings accounts for many years before he signed the confessions of judgment. The contributions he made after the judgment were a continuation of that pattern, which the Court said is “conduct that is encouraged by the very existence of the exemption.”
Based on all this, the Court did not find “clear and convincing” evidence of fraudulent intent. It REVERSED the Master’s finding that Lindgren’s IRA contributions were fraudulent conveyances.
Ownership and Consideration
The Court failed to find Lindgren’s behavior demonstrated clear intent to defraud under the Statute of Elizabeth. Yet it also acknowledged that analysis under the Statute of Elizabeth was not mandated in this case for two reasons.
First, one of the hallmarks of fraudulent conveyance is that the asset changes ownership. However, money contributed to an IRA still belongs to the debtor; while it has now been transferred into a protected asset, ownership has not changed. (The Court also noted that in bankruptcy, the “conversion of a non-exempt asset into an exempt asset is not in and of itself a fraudulent act.”)
Second, there is the issue of consideration, which refers to the exchange of one thing for another. Typically, in instances of fraudulent conveyance, no consideration is being given for the assets transferred. For example, someone may transfer land into someone else’s name, but receive no money for it. This is one of the badges of fraud.
In this case, the Court stated that “in the specific case of IRAs, the contribution is never made for valuable consideration” (emphasis theirs). Therefore, it is not appropriate to consider Lindgren’s contributions his IRA in terms of the Statute of Elizabeth.
Your Savings Accounts May Be Safe from Debts
The South Carolina Court of Appeals looked at state statute, the intent of the law, and the Debtor’s behavior to come to the conclusions it did. It ultimately protected Lindgren’s contributions to his savings accounts from execution for settlement of the judgment he owed. This is a positive outcome for individuals who may be in debt but want to continue saving for the future.
However, don’t assume that any contributions made to savings accounts are always safe from execution. A lot depends on the particular facts of the case. In addition, this is a Court of Appeals decision, and may not be the final word on the issue. As of March 2018, there is a petition for rehearing pending, meaning that the South Carolina Supreme Court could reverse the decision.
Get Business and Estate Planning Advice
For legal advice from an experienced business and estate planning attorney, call Gem McDowell Law Group in Mt. Pleasant today at 843-284-1021. Gem has over 25 years of experience in solving legal problems and helping people planning for the future, and he is ready to help you do the same.
6 Common LLC Creation Mistakes
Starting a new business is exciting but also a little intimidating. There’s a lot you probably don’t know, and mistakes can end up costing you.
If you’ve decided to start a limited liability company (LLC), then you’ve already avoided the biggest mistake, which is not having a business entity at all. But you’ll also want to avoid these 6 other common mistakes people make when starting an LLC.
Mistake 1: Choosing to Become an LLC When It’s Not the Right Entity for Your Business
The first mistake people make when creating an LLC is choosing an LLC to begin with. The limited liability company is a great business structure for many business ventures, but it’s not suitable for all.
The main consideration is money. Do you plan on growing with capital from outside investors? If so, a corporation is likely a better choice for you. Investors are typically more comfortable investing in corporations than in LLCs. Corporations are also the only entities that can issue stock, so if you dream of a big IPO in the future, then the corporation is the entity for you.
Mistake 2: Incorporating Your Business in the Wrong State
Once you’ve determined that the LLC is the right entity for your business, your next step is to decide on where to incorporate it, i.e., where to register it.
Most of the time, incorporating in the state where you live and do business is the best solution. Some entrepreneurs want to incorporate in other states like Delaware, Wyoming, or Nevada for the supposed tax and legal benefits. This can make sense for larger companies, but it rarely makes sense for smaller LLCs.
Incorporating your business in a state your business isn’t based in means taking on hassles like maintaining a registered agent in both the state you live in and incorporate in, filing paperwork in both states, and paying fees to both states. After considering the time and money involved, it’s typically not a savvy move for most LLCs. It’s usually smarter to incorporate in your home state.
Mistake 3: Choosing the Wrong Type of LLC
There are actually four types of LLCs you can create in South Carolina, as we’ve covered before in a previous blog. Check out that blog for more information, but in short, know that an LLC can be either “term” or “at will” and “member managed” or “manager managed.” If you select the wrong type when setting up your LLC, it can be bad for the LLC and the members down the line.
Mistake 4: Choosing a Bad Name
What makes a “bad” name? One that’s already being used.
Before choosing a business name, do some research. You can search for existing business names in South Carolina here under “Existing Business,” which is a good start. (South Carolina does not allow a new business to register a name that’s not “grammatically distinguishable” from existing names.) You might also want to search the trademark database at the US Patent and Trademark Office here to see if the name you have in mind is being used somewhere else. Finally, a thorough Google search for your proposed name can turn up other uses of the name.
Your name matters because if you inadvertently violate someone else’s trademark, you can get in trouble. Disputes over names can end up being costly and time-consuming if someone sues you over the name and you want to defend your right to use it. But even if you decide to let go of the name, it will cost you time and money to rebrand your digital and physical presence. Worse, you will have lost the brand recognition and goodwill you’ve built up over the years in your community. So choose wisely.
Mistake 5: Not Having Corporate Governance Documents
This is probably the single biggest mistake you can make when you plan to start an LLC with business partners. Many people go into business with friends or family members, and at the start everything is copacetic. Everyone gets along and there are no major disagreements. But many an experienced business attorney will tell you that times change, and that’s when things can get ugly.
Imagine that you’re in a business with two friends and everything is going well at first. Then one friend unexpectedly dies, and you find you’re now in business with their spouse. Or the other friend starts slacking off, working fewer hours but taking the same profits as the hard-working partners. Or you become incapacitated and can no longer work. Or the three of you disagree on how to raise money for the company. What happens to you, your investment, and the business in these situations?
Corporate governance documents are intended to lay out the rules so that when a disagreement or unpleasant situation arises, what happens next is clear. These simple documents can preserve good relations between partners, protect the partners’ investments, and protect the business itself.
Two important documents that any business owner with partners should consider getting during the creation of their business:
An operating agreement. This spells out how the company should be managed, how profits and losses are handled, how much of the company each member owns, what each member’s responsibilities are, and more.
A buy-sell agreement. This document covers what happens to the business when a member dies, becomes incapacitated, stops working, etc. Read more about buy-sell agreements here.
By addressing future scenarios now, you can avoid major problems down the line. Just know that it’s vital to discuss these things before you and your partners start operating your business.
Mistake 6: Not Getting Legal Assistance When You Need It
It’s very easy to go online and get the forms to start an LLC yourself, without the help of an attorney. Is that smart?
In some cases, doing so is fine and poses no future problems, particularly with single-member LLCs that operate within one state and are wholly self-funded. These business owners would likely benefit from speaking with a business attorney, but they may feel pretty confident that they can create their LLC on their own.
But other entrepreneurs should consider speaking with an attorney before and during the creation process of their LLC. This is especially true in any of the following situations:
- You have business partners
- You plan to take on money from outside investors
- You plan to do business in multiple states
The cost is usually the main reason that people don’t want to spend the money on an attorney at this stage, and that’s understandable. Business owners want to make money before they spend it. But the money you spend up front on corporate governance documents or advice from an experienced attorney can save you money and mistakes down the road. (Plus, don’t forget this expense is a business write-off when it comes to tax time.)
Questions About Your LLC? Speak with Business Attorney Gem McDowell
Gem McDowell is a business attorney with over 25 years of experience helping people start and run their businesses. He’s a problem solver who can help you start out right and avoid the many mistakes he’s seen in the past. Contact Gem at his Mt. Pleasant office today to schedule a free consultation by calling (843) 284-1021 or filling out this contact form.
Would Your Contract Hold Up in Court? Indemnification Clauses and Public Policy.
If you’re in business, you know that contracts are a must to protect yourself. But don’t make the mistake of assuming that simply having a contract is enough. If it’s worded incorrectly, it can cost you.
In previous blogs we’ve discussed what can happen when covenants not to compete and nondisclosure agreements overreach or violate public policy – they become unenforceable.
The same is true with other common clauses in business contracts. Today we’re looking at the indemnification clause, which was the subject in a recent case before the South Carolina Court of Appeals. The Court determined that the clause in question was worded in such a way as to violate state public policy and was therefore unenforceable.
Let’s look at what indemnification is first, then the case, and finally, what you as a business owner can do so you don’t find yourself in the same situation.
What is Indemnification?
In an indemnification clause, the indemnifying party (the indemnifier) agrees to – in standard contract language – “indemnify, hold harmless, and defend” the indemnified party (the indemnitee) against lawsuits and losses resulting from the actions or negligence of the indemnifying party.
In practice, indemnification serves to shift the costs of defending lawsuits and paying resulting damages, if any, from one party (the indemnitee) to the other (the indemnifier). It may also shift the actual defense litigation as well.
For example, say a construction company hires a subcontractor to do some work on a house. The subcontractor indemnifies the construction company against damages arising from lawsuits due to its (the subcontractor’s) work. Let’s say the subcontractor does a shoddy job and the homeowner later sues the construction company for damages. Because it was indemnified, the construction company can expect the subcontractor to cover the fees it spends defending itself and the damages it pays to settle the claim.
A Real-Life Example
This was the general situation in the case at hand, D.R. Horton v. Builders FirstSource v. Jamie Arreguin.
The builder D.R. Horton, Inc. (Horton) entered into a contract with Builders FirstSource (BFS) for BFS to do some construction work on a home. Several years after the work was completed, Horton was sued by Patricia Clark for damages related to multiple alleged construction defects in the home. Horton was ordered to pay Clark $150,000 in general damages after arbitration.
Horton then sought to recover those damages and legal fees from BFS under their contract’s indemnification clause. The case went to a circuit court, which sided with BFS. It then went to the South Carolina Court of Appeals, which affirmed the lower court’s decision.
(For more details about this case, read the PDF of the court’s opinion here.)
What happened? BFS and Horton had an indemnification clause in their contract; why was Horton not able to recover under it?
The Indemnification Clause Violated Public Policy
The main reason the Court decided in BFS’s favor was that the contract’s indemnification clause was written in such a way as to violate South Carolina public policy.
The Court of Appeals found that it was allowable under state statute for Horton and BFS to agree that BFS would indemnify Horton for damages caused by BFS. However, the Court also found that it was not allowable for Horton to have BFS indemnify Horton for damages caused by Horton, which is how the clause was worded. That violated Section 32-2-10 of the South Carolina code and went against public policy, making it illegal and therefore unenforceable.
Here is the relevant section of the Code, abridged for clarity:
“Notwithstanding any other provision of law, a promise or agreement in connection with the […] construction […] of a building […] purporting to indemnify the promisee […] against liability for damages […] proximately caused by or resulting from the sole negligence of the promisee […] is against public policy and unenforceable.”
In addition, the circuit court and Court of Appeals found that Horton failed to provide BFS written notice of the Clark matter, as per their contract, which acted as a waiver of Horton’s right to indemnification. Also, Horton and Clark requested that the arbitration award be general, which means there was no way to know what part, if any, of the $150,000 award was related to construction work completed by BFS.
What This Means for You
Time and again, businesses get in trouble when they try to get more than they fairly and lawfully deserve. Here, Horton wanted BFS to pay damages for what may have been Horton’s own negligence, which is not reasonably fair, and is also not legal. In the end, Horton got nothing.
As a business owner, here’s what you can do to avoid a similar situation:
- Be very intentional about the wording in the contracts you create. While you want to protect your company’s interests, if you go overboard, you could end up with a clause or contract that’s unenforceable.
- Be just as careful about the contracts you sign. Do you understand what every clause means, and is it fair?
- Work closely with an attorney who understands contract law. Have your attorney draft new contracts or review existing contracts and discuss them with you to ensure they’re worded correctly and align with your business interests.
Get Help with Your Contracts From the Business Attorneys at Gem McDowell Law Group
Gem McDowell is a problem solver and a business attorney with over 25 years of experience. He can help you with your legal needs including reviewing and drafting contracts. Call them at Gem McDowell Law Group in Mt. Pleasant, South Carolina to discuss your business matter at (843) 284-1021 today.
Law Is Not A DIY Field: When Not To Represent Yourself
Individuals have the right to represent themselves and “act as their own attorney,” but do businesses? Not necessarily. Try to DIY, and you may discover you’ve overstepped the bounds.
That’s what happened to Community Management Group, LLC, which manages HOAs and condo associations in the Charleston tri-county area, in a recent case. Beyond the typical duties of property management companies, such as property upkeep and enforcement of association rules, CMG also engaged in the practice of law without the help of an attorney. Specifically, CMG “prepared and recorded a notice of lien and related documents; brought an action in magistrate’s court to collect the debt; and after obtaining a judgment in magistrate’s court, filed the judgment in circuit court,” and advertised the fact that they did these things, according to the South Carolina Supreme Court decision.
The Supreme Court in South Carolina has the power to regulate the practice of law, and has made some allowances for non-lawyers to act in place of a lawyer in certain instances. In its decision, the Court clarifies instances where it’s not appropriate for non-lawyers to practice, including the things that CMG did.
Hire an attorney to look out for your interests instead
There’s a reason the South Carolina Bar gives out licenses to practice law. Despite the proliferation of information available on legal issues on the web, it doesn’t mean it’s a good idea – or even legal – to take legal matters into your own hands. Instead, work with an experienced attorney who can help with your business and estate planning needs, like Gem McDowell of Gem McDowell Law Group in Mt. Pleasant, SC. Gem has 25 years of experience in business law, tax law, commercial real estate, and estate planning. You can reach him by calling (843) 284-1021 or by filling out this contact form online.
When Covenants Not to Compete and NDAs Reach Too Far
South Carolina courts are clear in their general dislike of covenants not to compete and any provisions that restrict an individual’s ability to work. They are also clear in their tendency to rule in favor of the employee rather than the employer in related cases. This was the issue at hand in a recent case decided by the South Carolina Court of Appeals.
Covenants not to compete and non-disclosure agreements (NDA) were covered on this blog previously, because it’s so important for employers to be extremely careful in their wording on non-compete and non-disclosure agreements. If they try to restrict their employees’ actions too much, an employer may discover their agreement has reached too far and is invalid.
Fay vs. Total Quality Logistics
That’s essentially what happened in the case at hand, Fay vs. Total Quality Logistics. TQL, an Ohio-based transportation and logistics company, hired Joshua Fay in late 2012. As required by the company, Fay signed TQL’s Non-Compete, Confidentiality, and Non-Solicitation Agreement before commencing work. The Agreement was signed in Ohio and was to be enforced under Ohio law.
The following summer, Fay was fired. He then founded JF Progressions, LLC, in Mount Pleasant, SC, providing logistics services to another company. TQL found out and notified Fay that TQL intended to pursue legal action if he didn’t stop what he was doing. Fay then filed suit against TQL to seek a declaratory judgment that the Agreement he had signed was invalid and not enforceable. He argued that the Court must invalidate the Agreement if it is contrary to SC public policy, even if Ohio law applied to the interpretation of the Agreement.
The case made it to the South Carolina Court of Appeals which sided with Fay and found that, though it was to be enforced under Ohio law, the Agreement offended South Carolina public policy and was therefore not enforceable. The Court of Appeals found that the lower court (the Circuit Court) erred when it ruled against Fay, stating that the Agreement was enforceable under Ohio law and did not offend SC public policy.
When non-compete and non-disclosure agreements are too broad
To understand why the South Carolina Court of Appeals ruled as it did, it’s important to understand the basics of non-compete agreements. Two important clauses in a non-compete agreement are about time and geography; agreements place limits on the length of time and the geographical area in which an employee or former employee can work. An enforceable agreement strikes a balance between protecting the employer’s interests and giving the employee or former employee the freedom to earn a living in their profession.
South Carolina has determined that these limits must be “reasonable.” In the Agreement Fay signed, the limits were not reasonable under South Carolina’s standards. The non-disclosure agreement was worded so as to effectively be a non-compete agreement, which was to be in effect “at all times.” Under the Agreement, Fay was restricted from working with “Competing Businesses,” which was defined as “any person, firm, corporation, or entity that is engaged in the Business anywhere in the Continental United States.” If TQL’s Agreement were enforced, Fay would not be able to work in the field of transportation and logistics in the Continental U.S. “for an indefinite time, if not forever,” in the Court of Appeal’s wording. South Carolina determined that these restrictions were too broad and violated the state’s public policy, as they restrict an individual’s right to exercise their trade.
The Court of Appeal’s decision cited the Stonhard case, quoting “The agreement fails to limit the covenant to a particular geographical area. To add and enforce such a term requires this [c]ourt to bind these parties to a term that does not reflect the parties’ original intention. Therefore, we hold that the covenant, despite any reformation, is void and unenforceable as a matter of public policy.”</P
In addition, the Court of Appeal’s decisions reaffirmed the fact that South Carolina does not follow the “blue pencil” rule. In non-compete cases, this rule allows courts the discretion to invalidate certain portions of an agreement while maintaining others and to create terms the court believes the parties should have agreed on in the first place.
(It’s important to note that this discussion is about the March 2017 decision of the South Carolina Court of Appeals. It’s possible that the South Carolina Supreme Court may take up this issue at a future date, at which point this decision could be reversed or affirmed.)
Lesson for employers on covenants not to compete and NDAs
The lesson here for employers is to be extremely careful in the wording on covenants not to compete, NDAs, and other contracts that have any limiting effect on your employees’ current or future ability to work. As we can see from this case, strict wording of an NDA can effectively be interpreted as a non-compete agreement, even if that wasn’t the original intention.
Employers also need to be cognizant of these issues with regards to different states’ laws. Even if your state’s courts find your contracts “reasonable,” another state’s courts may not, depending on the state’s public policy. The internet cannot provide reliable guidance on this topic, which is why it’s important to discuss it with an attorney who’s well versed in this topic.
For guidance on how to craft your company’s covenants not to compete and NDAs, or for advice on one you’ve already signed, contact Mt. Pleasant business attorney Gem McDowell. He can be reached at Gem McDowell Law Group in Mount Pleasant at (843) 284-1021 or by filling out this contact form online. Contact them today.
Coming Soon to a Town Near You
For many years, South Carolina has limited the number of liquor stores an owner may have within the state to three. However, that law is no longer enforceable thanks to a recent South Carolina Supreme Court decision.
Total Wine & More, a large wine and liquor retailer that’s likely familiar to residents of Charleston, Greenville, and Columbia, was denied a fourth liquor license to open a new store in Aiken. In response, it brought an action seeking a declaratory judgment that the limitations in the law were unconstitutional.
The trial court found the provisions constitutional because they presume laws are constitutional, but when the issue was appealed, the Supreme Court found the reverse.
Now that the law has been declared unconstitutional, expect to see some bigger name stores dominate the alcohol landscape across the state, perhaps starting with Total Wine in Aiken.
Business guidance from an experienced corporate attorney
For legal and strategic advice, contact Gem McDowell of Gem McDowell Law Group. Gem has 25 years of experience in business law, including business creation; contracts, NDAs, covenants not to compete, buy-sell agreements and more; handling large commercial real estate transactions; tax law; and estate planning. You can reach him at (843) 284-1021 or by filling out this contact form online.
Are You Protected? What You May Not Know About “Piercing the Corporate Veil.”
One of the first things to do when going into business is to select the appropriate business structure for your venture and set it up correctly. A primary advantage of doing so is gaining the protection of the entity so that your personal finances are safe from being used to settle company debts or pay the company’s bills. Having the right business structure also allows for the business to be considered a separate entity, with its own income and debts separate from other businesses that you may also own.
But don’t assume that just because you’ve set up a legal structure that you and your business are fully protected; that protection is only valid if you follow all the rules. In other words, you are not guaranteed liability protection just because you have created a limited liability company or a corporation. (Note that sole proprietorships and partnerships do not offer the same liability protection and so are excluded from this discussion.)
Today we’ll look at the concept of “piercing the corporate veil” (PCV), which is when a court suspends the liability protection your business entity gives you, what it means, and how you can avoid it.
What Can Happen When You Fail to Keep Business and Personal Accounts Separate
One of most important ways to maintain your personal liability protection is to be scrupulous about keeping business and personal finances separate. Maintain separate checking and savings accounts and use different credit cards for your business and for yourself. The key idea is not to “commingle” your personal finances with your company’s finances. You pay your own bills from your personal account and you make sure to pay the company’s bills from the company’s account.
Let’s say you aren’t meticulous about keeping finances separate. Then your business hits a rough patch and is unable to pay a debt it owes. Since your finances aren’t separate, it may look like you and your business are essentially the same, and you personally may be on the hook. Your assets – including investments, cash, your car, and your house – could be taken to satisfy your company’s debt. That’s why it’s crucial to keep separate accounts.
What Can Happen When You Fail to Keep Individual Businesses Separate
PCV isn’t just an issue of separate business from personal accounts. It’s also a matter of keeping businesses distinct from each other.
Imagine a scenario like this. Alpha Corp. and Bravo Corp. are run by the same management group. About 60% of the shareholders are the same between the two, as well. Alpha Corp. runs into trouble and needs to pay a creditor immediately, but has no money. No problem, because Bravo Corp. has plenty of money. Bravo Corp. writes a check directly to pay Alpha Corp.’s debt.
The companies have now commingled funds. When this happens, they may be considered “alter egos” of one another under the alter ego doctrine, a.k.a. the instrumentality rule. Here are two examples of what can happen next:
- Three shareholders of Bravo Corp. who are not also shareholders of Alpha Corp. are, understandably, not happy that Bravo’s funds are being used to pay off Alpha’s debts. They bring a type of lawsuit called a derivative action against the management group arguing that there’s one giant pool of money, and the companies are in fact not separate.
- Another creditor sues Alpha Corp. for not paying its debt. During discovery, it’s determined that Alpha and Bravo have commingled funds. Now Bravo Corp. can be compelled to pay Alpha Corp.’s debts, as the two are alter egos.
It’s not just about money, either. Even seemingly simple things as sharing the same mailing address, office space, and letterhead may lead to trouble, as the “blurred identity theory” addresses situations where individual businesses don’t have individual identities. The two companies may be confused with each other as their identities are “blurred” into one another.
Proving PCV in Court
The concept of piercing the corporate veil (also known as “lifting the corporate veil”) was put to the test in the 1976 case that originated in South Carolina, DeWitt Truck Brokers v. W. Ray Flemming Fruit Co. The U.S. Court of Appeals for the Fourth Circuit upheld the District Court’s decision to pierce the corporate veil and impose individual liability on the owner. Flemming was found personally liable for debts owed by his company after it was discovered the business did not follow basic corporate protocols and that he, as the dominant shareholder, had drawn a salary, leaving the company undercapitalized and in debt.
In its decision, the court reiterated that while it recognizes a corporation is a separate entity that’s distinct from its owners and officers, it can “decline” to recognize that autonomy when doing so would “produce injustices or inequitable consequences.” Still, it will do so “reluctantly” and “cautiously.”
Bases for PCV noted in the DeWitt decision include:
- Fraud
- Inadequacy of capital
- Complete domination of the corporate entity
- Instrumentality theory (discussed above)
- Failure to observe corporate formalities
- Non-payment of dividends
- Insolvency of the debtor corporation at the time
- Siphoning of funds by the dominant shareholder
- Non-functioning of the other officers and directors
- Absence of corporate records
- Existence of the corporation as a façade for the operations of the dominant stockholder(s)
Ultimately, the court may pierce the corporate veil when “a number” of the above factors exist in order to right an injustice or unfairness.
How to Avoid PCV
You can make it less likely for a plaintiff/complainant to win (and less likely to sue in the first place) over this issue if you follow proper procedures.
- Keep finances separate between individual and company or company and company
- Move funds between entities through loans or other above-the-board methods
- Keep distinct business identities through separate addresses, trademarks, letterheads, etc. for each company
- *Hold regular shareholder meetings
- *Keep minutes
- *Pay dividends if applicable
*Applicable to corporations, not LLCs.
It’s not difficult to follow protocols to avoid PCV, it just takes discipline. When people get lazy and let basic things slip, that’s when problems arise.
Speak with a corporate attorney about your business
This is a very general overview of some elements of PCV; the topic is extensive and can become very complex. Maintaining the liability protection your business entity gives you is one of the most important things you can do. Make sure you’ve got your bases covered by speaking with a corporate attorney like Gem McDowell.
Gem handles a wide range of corporate law issues and advises on business matters. Contact Gem at their Mount Pleasant office today by calling (843) 284-1021 or filling out this contact form online. They are ready to help you with your business.
How to Determine 1099 or W-2 Status According to the IRS
Update, 02/15/2023: The Department of Labor’s Wage and Hour Division published a notice of proposed rulemaking on the subject of worker misclassification and how to correctly classify workers as employees or independent contractors; read more about this on our blog here. This rule would be in addition to the approach the IRS takes to worker classification described below.
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In business, the term “1099” usually refers to someone in an independent contractor position. The term comes from the IRS; at the end of the tax year, a 1099 worker receives a 1099 form from their employer rather than a W-2 that employees receive.
Employers may prefer to hire independent contractors rather than employees whenever possible for the main reason that they often cost less to employ. That’s because for employees, employers have to pay Social Security taxes, Medicare taxes, unemployment taxes, and withheld income taxes to the IRS, and carry workers’ compensation insurance to cover them. Also, employers often provide benefits such as health insurance and retirement plans to employees, but not to independent contractors.
How does an employer know how the worker they’re hiring should be classified? While in many cases it’s clear, in others it’s complicated. Here’s how to determine whether a worker in South Carolina is an employee who should receive a W-2 or an independent contractor who should receive a 1099.
Federal Versus State Definitions Of 1099 Independent Contractors
To illustrate the difference between a 1099 and W-2 workers, imagine two plumbing companies hire two plumbers, Jack and Jane. By the terms of employment, Jack must come to the office every day from 9-1, use the company’s truck and tools, and is told which jobs to do and when. By contract, Jill may show up at the office if and when she wants, drives her own truck and uses her own tools, and is told about jobs but not told when she must complete them or how. In this scenario, Jack would be classified as an employee, and Jill an independent contractor.
How workers are classified is of interest to both the federal and state government. The federal government – more specifically, the IRS – cares because it wants to know who will pay the withheld income taxes, Social Security taxes, Medicare taxes, and unemployment taxes for each worker. The state government cares because it runs the state’s workers’ compensation program and needs to know who is responsible for paying for a worker’s injury sustained on the job – the employer (for an injured employee) or the worker themselves (for an injured independent contractor)?
Because the federal and state government have different reasons for wanting to know a worker’s status, they use different standards to determine whether someone is an employee (W-2) or independent contractor (1099).
The IRS’s Definition of 1099 Independent Contractors
The IRS proposes three common law rules for employers to consider when classifying a worker:
- Behavioral: Does the employer control, or have the right to determine, how the worker does their job?
- Financial: Does the employer control the business aspects of the worker’s job? How is the work paid? Are expenses reimbursed? Does the worker provide their own tools, or do they use the employer’s?
- Type of Relationship: Are there written contracts or benefits? What is the nature of the relationship? Was the expectation upon hiring that the relationship would continue indefinitely?
If you’re still uncertain as to how to classify an employee, the IRS can make that determination for you. Fill out Form SS-8 (PDF) and the IRS will review it and make a determination in six months or more.
The Changing Definition of 1099 Independent Contractors in South Carolina
In South Carolina, the approach to worker classification relies on a four-factor model, which you can read more about on our blog here.
A 2015 South Carolina Supreme Court case, Lewis v. L. B. Dynasty (read it here), changed the standard for classifying a worker as an independent contractor, making it stricter in favor of the employee. As a result of this case, workers that previously had been classified as independent contractors may need to be reclassified as employees.
The background: An exotic dancer named LeAndra Lewis was injured when she was accidentally shot while working at the Boom Boom Room Studio 54 in Columbia, SC. She filed a claim for workers’ compensation for coverage of the medical costs of her injuries (which included the loss of a kidney) as well as temporary total disability.
Her claim was denied at first, as she was determined to be an independent contractor by both the single commissioner and the Workers’ Compensation Commission appellate panel. (Independent contractors do not have a right to workers’ comp benefits in South Carolina and employers do not need to carry workers’ comp insurance for them.) The Court of Appeals also affirmed this decision. The South Carolina Supreme Court, however, did not.
Taking the viewpoint that the law should be interpreted to be advantageous to the worker, the Court stated, “The question before the Court is a simple, fact-based consideration—did the Club exercise sufficient control over Lewis to create an employee relationship?” The Court looked at a variety of factors, including the right to, or exercise of, control; furnishing of equipment; method of payment; and right to fire to determine whether the worker should be an employee or independent contractor. Ultimately, the relationship was found to be of an employee nature. That meant Lewis was entitled to workers’ compensation for her injuries.
What The Supreme Court’s Decision Means For South Carolina Employers
South Carolina employers must be sure that their independent contractors meet the high standards the SC Supreme Court has set. The Court has said “we construe workers’ compensation law liberally in favor of coverage to further the beneficent purpose of the Workers’ Compensation Act.” In other words, it will tend to side with the worker and act in their favor rather than in the employer’s.
What happens if you’ve been treating a worker as a 1099 independent contractor when you should have been treating them as a W-2 employee? You may find an unwanted notice from the IRS stating that you owe back taxes for employees. Or your worker may become injured while on the job and sue you, leading to a long and expensive lawsuit. In short, it could cause a big headache and cost a lot of money. For many companies, either one of these scenarios could be devastating. It’s a good idea to review the nature of your independent contractors’ work and make sure they are truly independent contractors according to federal and state law.
Contact Mount Pleasant Corporate Attorney Gem McDowell for Advice
For advice on classifying employees, hiring and firing, contracts, and other aspects of starting or running a business, contact attorney Gem McDowell. He and his team at the Gem McDowell Law Group in Mount Pleasant, SC help businesses make smart and informed decisions in day-to-day and exceptional circumstances. Get in touch by calling (843) 284-1021 or by filling out this contact form online. Schedule your free initial consultation today.
Why You Need to Read the Fine Print: A Cautionary Tale
You know you should read “the fine print” of every contract and agreement you sign, but do you? We sometimes assume that there’s nothing truly important happening in the fine print, the section of a contract that’s characterized by small type and is often full of mind-numbing legalese , and so we don’t read it. We tend to trust that the person who wrote the contract is treating us fairly.
But that’s a mistake. Here’s a quick story that shows why you should always read the fine print.
What Was Buried in the Fine Print
This happened several years ago. Joe owned a piece of property that ran alongside a major road. Sam owned a billboard company and approached Joe about putting a billboard on the property. Sam would pay to construct it and would secure the advertisers; Joe didn’t have to do anything except let Sam put up the billboard and then collect a small amount of rent each month.
This arrangement worked perfectly for both parties – until Joe sold the property.
Joe sold the property to Harry, which included in it the lease for the billboard. What Harry and Joe didn’t realize was that the lease contained the following provision: Sam had the right of first refusal for any sale of the property by Joe. That is, Joe should have approached Sam first about the sale of the property rather than immediately selling it to Harry.
Sam seized the opportunity to demand that someone buy his right of first refusal for an astronomical fee. He sued both Joe and Harry for the money. He didn’t care who paid it, as long as he got paid.
Eventually the matter was settled out of court. Joe and Harry ended up paying a large amount of money to Sam. And Sam made a tidy sum for doing absolutely nothing.
How the Story Should Have Gone Instead
Here’s what should have happened to avoid this troubling situation:
Joe should have never signed the lease with the right of first refusal. He should have had an experienced commercial real estate attorney review the lease for him, or at the very least he should have read every word of it before signing.
Then Harry should have never bought the property with the billboard lease agreement as-is. He should have had an experienced commercial real estate attorney review the contracts for him, or at the very least he should have read every word of them before signing.
The solution is the same both times: read the fine print!
What You Can Do To Prevent Unwelcome Surprises
First of all, don’t assume that the contract you’re about to sign is written in a way that treats you fairly. People can be sneaky, and when it comes to contracts, you’ve got to look out for your own interests.
Then do what Joe and Harry should have done – read the fine print. If the print is literally too small for you to read, request that the contract be reprinted in a more legible font size and refuse to sign it until you are able to read every word. Once you’re able to read it, make sure you understand what it actually means, and what the consequences could be.
Even better than reading it yourself is having a lawyer review it for you.
If you need an experienced commercial real estate attorney to review contracts or give advice on a purchase or sale, contact Gem McDowell of Gem McDowell Law Group. He can help. Send us a message today at our Mount Pleasant office or call (843) 284-1021.
How South Carolina Courts View Covenants Not to Compete
On the surface, covenants not to compete look simple. One party agrees not to compete against another party – either by working for a competing company, or by starting their own competing company – for a specified amount of time and within a specified location. But as simple as they seem, covenants not to compete aren’t so straightforward.
When two parties end up disagreeing over a covenant not to compete, the matter sometimes ends up in the South Carolina Court of Appeals. That happened recently, in a matter called Palmetto Mortuary Transport, Inc. v. Knight Systems, Inc., as recorded in the May 4, 2016 Advance Sheets (pdf). This case shows how the courts of South Carolina view and enforce covenants not to compete, and why, as a business owner, it’s important to do everything you can to draw up covenants not to compete that are enforceable.
The Background: Seller’s Remorse
In 2007, Seller sold its mortuary transportation business to Buyer. Among other things, the two parties agreed that 1) Seller would not provide mortuary transportation services within 150 miles of the business for a period of ten years after the sale, and 2) Buyer would buy certain types of body bags exclusively from Seller (at discounted prices) for ten years.
The terms of the sale worked well for several years, but then two things happened.
First, in 2011, Richland County sent out an RFP (request for proposal) for mortuary services. As part of the sale, Buyer had bought an existing contract for mortuary transportation services with Richland County. The covenant not to compete would bar Seller from providing mortuary services to Richland County for 10 years from the date of sale, because it was located within the agreed upon 150-mile radius. However, Seller was interested in submitting an RFP.
Second, Seller accused Buyer of breaking their agreement by purchasing body bags from someone other than Seller. It was found that Buyer had purchased over $45,000’s worth of body bags from Seller since 2007, but had also purchased $478.50’s worth of body bags from a third party. Because Buyer was in breach of contract, Seller said, Seller was no longer bound by the rules of the covenant not to compete.
Seller ended up winning the contract with Richland County. Buyer wasn’t happy.
The case was tried in late 2013, and the judge (actually a court-appointed special referee) found in favor of Buyer. Seller appealed and the decision by the South Carolina Court of Appeals is recorded in the May 4th Advance Sheets.
The Court of Appeals’ Verdict: Throw out the Baby With the Bathwater
The Court of Appeals did not agree with the lower court.
The lower court held that the terms of the covenant not to compete were “reasonably limited” in time and geographic scope. The Court of Appeals disagreed, stating, “In our view, the 150-mile restriction was overly broad and did not protect the rights and interests of [Buyer] in a reasonable manner.”
The Court also wrote that “In South Carolina, our courts will generally uphold and enforce a covenant not to compete arising out of the sale of a business if it is (1) reasonably limited as to time and territory, (2) supported by valuable consideration, and (3) not detrimental to the public interest.”
So for a covenant not to compete to be enforceable in South Carolina, it must meet all three requirements. If it fails one of the requirements, the entire agreement becomes void. Some other states allow courts to “blue pencil,” which means a court can say something like “150 miles is too much, but 50 miles is acceptable, so the rest of the agreement remains intact except for this part.” Not South Carolina. It throws the baby out with the bathwater.
Because the covenant not to compete in question failed to satisfy requirement #1, the entire covenant is not enforceable.
What it means for the parties: Seller is free to provide mortuary services in South Carolina without the restrictions originally laid out in the terms of the sale. Buyer lost a valuable contract as well as a competitive advantage because the covenant not to compete wasn’t enforceable. What Buyer thought was a smart move – restricting business activities of Seller in the manner it did – didn’t end up working out.
Why 150 Miles Wasn’t “Reasonable”
The United States is a large country. From Washington, D.C. to San Francisco, it’s over 2,400 miles. So restricting a business within a 150-mile radius doesn’t seem like a large area. How could that be “unreasonable”?
But consider the State of South Carolina. If you buy a business in Columbia, is it reasonable to expect the seller to abstain from business within a 150-mile radius? Columbia to Hilton Head is 125 miles as the crow flies. Columbia to Myrtle Beach is also 125 miles. And it’s just shy of 100 miles to Greenville. The seller would effectively be barred from conducting business in the entire state.
Also consider that the State of South Carolina is just over 30,000 square miles. The area in a circle with a 150-mile radius (πrr) is over 70,000 square miles – more than twice the area of the State of South Carolina.
150 miles doesn’t seem quite so reasonable now.
How to Determine “Reasonable” Geographic Restriction
It would be helpful to business owners if the courts would give a firm number that’s reasonable. But it doesn’t work that way. Among other things, the nature of the individual business determines what’s reasonable.
One way to think of it is how far a customer would travel to patronize a business. Would a customer drive 20 miles to go to a convenience store? Unlikely. That’s like driving all the way from Isle of Palms to Avondale in West Ashley. The vast majority of people are not going to drive that far for a soda and a lottery ticket. So in this example, even a 20-mile radius would be too large.
Or think of it from the salesperson’s point of view. Could a company that installs pools expect to serve customers in both Summerville and Folly Beach (a distance of 35 miles)? Possibly, yes. In this example, a 20-mile radius might be perfectly reasonable.
What You Should Do
Before drawing up or signing any covenant not to compete in South Carolina, take time to see if it will satisfy the three requirements listed above. In particular, look at restrictions on time and geographic scope. Consider the nature of the business you’re selling or buying to determine what seems reasonable. Don’t be greedy; that’s often the underlying case of such disputes. Rather, be conservative. You stand a better chance of having an enforceable agreement if you do.
You should also seek out the advice of an experienced business attorney like Gem McDowell. Contact Gem at their Mount Pleasant office at (843) 284-1021 today.
What You Need to Know About Section 1031 “Like-Kind Exchanges”
Under Section 1031 of the US Code, you can sell a qualifying property, take the money from that sale, and buy new qualifying property of a “like-kind” without paying any federal income tax on the first sale. This is what’s known as a “1031 Exchange” or a “Like-Kind Exchange.”
For example, let’s say you own an investment property that you bought for $15,000 in 1965, which is now worth $250,000. You want to sell that property and buy a new investment property. If you simply sold the property, you’d need to pay income taxes on the gain of $235,000. At around 33% for combined federal and state taxes, you’d pay approximately $77,550 in taxes – a substantial amount of money.
But, under 1031, you’re allowed to exchange that property for “like-kind” property and defer paying taxes on the gain. (Note that you are deferring taxes, not eliminating them altogether.) It’s a great tool for businesses and individuals to use to reduce tax bills and manage cash flow during the year.
How Like-Kind or 1031 Exchanges Work
How does an exchange of like-kind property work under Section 1031?
Using the example above, you’d sell your property (the “Relinquished Property”) and the money would go into an account controlled by a neutral third-party agent (the “Qualified Intermediary”), often an attorney or CPA, someone who has not done any work for you in the past two years. You cannot touch the money from that sale, and neither can your lawyer or CPA. Otherwise, the money is disqualified and subject to taxation.
Generally, you have 45 days to find a Replacement Property from the date of sale of the Relinquished Property and 180 days to close on that Replacement Property. The Qualified Intermediary purchases the like-kind property (the “Replacement Property”) with the money from the account you never touched, puts the Replacement Property in your name, and the process is complete.
What does “like-kind” mean?
It means that the property that’s being exchanged is of the same character. You can trade livestock for livestock or investment property for investment property, for example. You cannot trade livestock for investment property under Section 1031. However, you may exchange property that “differ[s] in grade or quality,” meaning that you may essentially “upgrade” your property or assets. Determining what qualifies as Replacement Property is done on a case-by-case basis.
What type of property is eligible for like-kind exchange under Section 1031?
Most property that is solely for business use is eligible, including investment property, livestock, vehicles, machinery, equipment, and other items of tangible property. Intangible property such as copyrights and patents qualify, too.
What type of property is not eligible?
According to the IRS, “inventory, stocks, bonds, notes, other securities or evidence of indebtedness, or certain other assets” are not eligible. Real property for personal use, i.e., a personal residence, is not eligible. It must be used for trade or business only.
What if you do not spend all the money you made from the sale within 180 days?
Money left over at the end of the 180-day period is commonly known as “boot.” If you cannot locate property that costs as much as the property you sold, or you are unable to close within 180 days, you will need to pay taxes on the boot.
What if you receive money or other types of property that are not like-kind in the exchange?
“Boot” can also refer to the value of goods received in the exchange that are not qualifying. If your exchange results in boot, you’ll need to pay taxes on it. (Though if the exchange results in a loss, it won’t be recognized.)
What about property that has debt attached to it?
Let’s say in the example above, you don’t own the house free and clear but have borrowed $100,000 against it. You sell the house and now have $250,000. In the exchange, you need to buy a Replacement Property that has as much equity and as much debt as the Relinquished Property. Otherwise, the IRS sees that you’re better off after the transaction, which is not the intent of the code, and you’ll need to pay tax. You need to “roll” what you made and what you owe to your new property.
What about state taxes?
The laws on how states handle taxes vary from state to state. In South Carolina, the law recognizes like-kind exchanges and will defer taxes on exchanges as long as the Relinquished Property and the Replacement Property are both located within the state of South Carolina. If you sell Relinquished Property in South Carolina and buy Replacement Property in North Carolina, for example, you can defer your federal taxes on the sale under 1031, but you will be responsible for the gain earned on the sale of the Replacement Property to South Carolina.
Who is eligible to do a 1031 Exchange?
Any entity that is exchanging qualifying property used solely for business. A corporation, partnership, LLC, individual, or trust may take advantage of Section 1031 as long as the property qualifies. A business may exchange equipment, or an individual may exchange investment rental property, for example. Dealers are not eligible for Section 1031 treatment.
How much does it cost to execute a 1031 Exchange?
Some businesses shy away from 1031 Exchanges because they believe it will cost a lot of money. In South Carolina, you can carry out a Like-Kind or 1031 Exchange for around $1,500 or $2,000. This small amount of money could end up saving you or your business thousands or tens of thousands of dollars in taxes. In a large majority of cases, it’s a worthwhile investment.
Could your business benefit from tax deferral from a Like-Kind Exchange?
This is just the start; there are more nuances to exchanges under 1031. If you want to know whether a 1031 Exchange could be a good tool for your company, contact Mount Pleasant corporate attorney at Gem McDowell Law Group. Send us a message or call us today at (843) 284-1021 today.
