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Legal Update

Client Newsletter of Carr, Morris & Graeff, P.C.

June-July 2004
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In This Issue

• Business: Corporate Names, Trade Names and Trademarks
• Estate Planning: Discounts for Marketable Securities Partnership
• Electronic Mail: Reliable But Not Secure
• Contracts: Liquidated Damages Clause Enforced
• Staff Notes

Business
The Difference Between A Trademark, Trade Name And Corporate Name

Corporate names, trade names and trademarks are not interchangeable terms for the same thing. State and federal laws governing these issues serve different purposes and provide different protections.

State laws require businesses to be registered and, depending on the jurisdiction, this is accomplished by filing articles of incorporation with the appropriate state agency (e.g., the Virginia State Corporation Commission). While an owner has broad discretion in choosing a company name, state codes generally require that the word “corporation,” “incorporated” or “limited” or an abbreviation of these appear in the name. A business may not use the name of a company that is already registered in the state. Most states provide access to an online database of company names or will provide phone assistance in advance of filing so that there are no duplicates. The purpose of these laws requiring corporate registration is to protect the business owner(s) from liabilities due to business activities. The state of incorporation does not address whether the corporate name is in use elsewhere or whether it conflicts with an existing federally registered trademark.

Sometimes a company will also adopt a trade name or fictitious name. A trade name is commonly indicated by the “doing business as” prefix. A trade name is any name used to identify a business other than the owner’s legal name or the company’s registered name. Some states may take steps to prevent duplication; but, in many states, more than one company can use the same trade name. The purpose of filing a trade name is to allow the public to locate the true owner of a business.

A trademark is applied to goods and/or services. A trademark is a word, phrase and or design a company uses either on its product or to market its products. A corporate name or trade name can be a trademark if it is affixed to goods or used to advertise a service. Trademark rights arise from actual usage (common law trademark) and/or federal registration. The purpose of U.S. trademark law is to avoid confusion among consumers as to the source of goods and services.

Registering a corporate name does not guarantee rights to this name – and it certainly does not prevent someone outside the state of incorporation (or the states where the company is qualified to do business) from using it. Registration also does not prevent other companies in the same state from adopting confusingly similar names. Generally, state registration only guarantees that there is not another company in your state using the exact name. If there is a conflict, the first to use the company name or mark (not just by filing articles of incorporation) or obtain federal trademark registration has priority.

Before incorporating your business and spending time and money developing and marketing your brand, it is best to perform some basic name availability searches. Begin by contacting the Secretary of State in your jurisdiction(s) and researching registered corporate and fictitious names. Also conduct a trademark search by accessing the database on the U.S. Patent & Trademark website. While not exhaustive, the USPTO provides helpful information regarding registered and, in some cases, pending trademarks. Finally, perform a basic internet search. It is also important to repeat these steps periodically after incorporating your business to ensure others are not using your valuable mark.

Dana Theriot

Estate Planning
Tax Court Allows Large Discount For Marketable Securities Partnership

In what can only be described as an extraordinary taxpayer victory, the U.S. Tax Court has allowed a combined 29.5% discount for gifts of interests in a family limited partnership funded entirely with cash and marketable securities. In Peracchio v. Commissioner of Internal Revenue, T.C. Memo. 2003-280, the court allowed a 6% minority discount and a 25% lack of marketability discount, applied sequentially. The main reason this case is so unusual is that there is no valid business reason to place cash and marketable securities in a partnership. Put another way, the only reason a taxpayer would do so is to receive discounts, and such a structure can readily be attacked by the Internal Revenue Service (IRS) as exalting form over substance. Officially, Tax Court Memorandum decisions do not have any precedential value, but nevertheless they offer practitioners tantalizing insights into what actually happens in Tax Court when the IRS challenges a planning transaction. We do not yet know if this is a fluke, or if it presages a liberalization of family limited partnership planning opportunities.

On the valuation day the taxpayer as grantor and his wife as trustee created a trust. Although the opinion does not so state, we assume the trust was irrevocable so that gifts to it were completed. On the same day the taxpayer, the trust, and the taxpayer’s son organized a limited partnership. The taxpayer transferred to the partnership about $2,000,000 in cash and marketable securities. Most of the value was in money market funds and publicly traded stock. The taxpayer received a 0.5% general partner interest and a 99.4% limited partner interest. The son contributed $1,000 to the partnership in exchange for a 0.05% general partner interest; and, the trust also contributed $1,000 to the partnership in exchange for a 0.05% general partner interest. Also on the valuation day, the taxpayer made three transfers of partnership interests. He gifted a 0.45% general partner interest to his son and a 45.47% limited partner interest to the trust. He also transferred a 53.48% limited partner interest to the trust in exchange for a promissory note in the amount of approximately $650,000. After all transfers percentage ownership of the partnership was follows:

General Partners
Taxpayer 0.05%
Son 0.50%

Limited Partners
Taxpayer 0.45%
Trust 99.00%

The partnership agreement provided that no limited partner was allowed to withdraw his capital from the partnership prior to the termination date in the year 2047 without the written consent of the general partners. Partners were allowed to transfer their interests only to certain family members or charities. Partners wishing to transfer interests to someone other than permitted transferees first had to offer the interests to the partnership on the same terms and conditions. No transferee was allowed to attain the legal status of partner without the unanimous consent of the general partners. Limited partners had no right to participate in management and distributions were at the discretion of the general partner.

The taxpayer filed timely gift tax returns and reported the gift to his son at full value. With respect to the gift to the trust, taxpayer applied a combined discount of 40% for lack of control and lack of marketability. The Service assessed deficiencies and argued that, since the partnership lacked any economic substance, it should be disregarded and the discounts disallowed. Later the IRS modified its position to allow for a 4.4% discount for lack of control and a 15% discount for lack of marketability. The Service applied the discounts serially so they amounted to 18.74%. The fact that before the Tax Court the IRS withdrew its lack of economic substance argument and conceded combined discounts of nearly 20% is in itself quite remarkable. The sole issue before the Tax Court was the magnitude of the discounts, since the parties had agreed that both types of discounts were applicable.

In its opinion the court carefully reviewed the positions of the expert witnesses for both sides. Nevertheless, in its reasoning the court simply concluded that a 29.5% discount was appropriate without elaborating on why that was so. It is not a leap of imagination to reach the conclusion that the court decided to split the difference. The average of the 40% proposed by the taxpayer and the 18.74% proposed by the government is precisely 29.37%, almost identical to the 29.5% allowed by the court. In any event, a discount of almost 30% for a partnership interest with 100% of its assets invested in cash and marketable securities is quite generous. For example, discounts allowed for interests in entities that operate active businesses are usually around 35% and rarely exceed 45%.

Two simple examples will illustrate the marvelous estate or gift tax savings that can be obtained by placing cash and marketable securities inside a limited partnership and arranging for minority holdings.

Assume a couple with a combined estate of $2.8 million. For the sake of simplicity, also assume that all their wealth is in cash and marketable securities. First, the couple creates a limited partnership, puts appropriate transferability prohibitions in the partnership agreement, and transfers their assets to the partnership. Second, they sever joint tenancies and title half of the partnership interests to each spouse’s bypass trust. Third, each spouse gifts small amounts of his or her limited partner interests to their children so that each spouse ends up with, say, a 1% general partner interest and a 48% limited partner interest. Given this fact situation each spouse would be entitled to marketability and minority discounts of approximately 30%, in line with the case under discussion. Each spouse had wealth totaling $1.4 million before the three transactions described previously. Afterwards, by virtue of the 30% discount, the wealth of each spouse is reduced to $980,000, enough to fund bypass trusts and reduce estate taxes to zero. Creation of the partnership saved each spouse $103,000 in estate taxes, for a combined savings of $206,000. This, of course, is in addition to the $435,000 estate tax savings attained with the bypass trusts.

Second, assume a couple wishes to gift the maximum tax-free amount of $11,000 per year per donor per donee (adjusted for inflation) to their children and grandchildren. If the couple gifts interests in a partnership holding the securities instead of gifting the actual securities, they can gift interests actually worth $15,000.

This sounds too good to be true, and it might be. Until this case was decided conservative estate planners thought that such a result would never pass muster, although many aggressive estate planners have been using the technique for some time. At this point, however, we do not know if this case is just a fluke or the start of a new trend. For example, it is possible that the IRS took the position it did before the Tax Court because it thought it might lose the case and might be waiting for another more appropriate vehicle to fight this battle again, perhaps in Federal district court and eventually at the Federal court of appeals level.

It just seems very unlike the Service to switch positions on such an important issue without a greater effort to enforce the law as it sees it. Irrevocable life insurance trusts (ILIT) come to mind. Even though the IRS has been defeated on various ILIT issues in several venues on numerous occasions, it was not until recently that it grudgingly conceded defeat; nonetheless, the IRS is still actively scrutinizing ILIT’s that come its way. With respect to the issue under discussion, as recently as 1998 the Service held in Technical Advice Memorandum 1998-42-003 (July 2, 1998) that the formation of a family limited partnership with personal assets such as taxpayer’s home, cash and marketable securities has no apparent purpose other than tax avoidance and, is, therefore, a sham transaction. Keep tuned to this station as we keep our eyes and ears open for new developments on this front.

Néstor Cruz

Electronic Mail:
Be Careful

In this age of rapid communication, email is the medium of choice for many. Quick, accurate and reasonably reliable, email fills the gap between formal written correspondence and informal phone calls and voice messages.

We caution clients to be wary of email for substantive communication. Although easy and informal are positive attributes of email, it is perhaps the least secure of all media. Re-publication and broadcast publication of what was intended as a privatecommunication is all too common. The wildfire spread of internet humor is evidence enough of how quickly and randomly electronic communications can spread. Who hasn’t been the unintended recipient of a reply electronic message when the sender inadvertently hit “reply all” rather than “reply?” It is truly remarkable how often emails become litigation evidence—particularly in employment-related disputes.

Email is generally not the best medium for substantive dialogue or, certainly, for emotional exchanges. Perhaps the instant message system has engendered a feeling of conversational intimacy. Participants in email exchanges, though, must remember that they are creating an indelible record—a record to be revisited, dissected and republished if the recipient so desires but never taken back or erased. Whit and sarcasm—even vulgarity—are common in emails. While we don’t advocate abandoning email, we do urge clients to treat email like an open phone line. If you would not be comfortable letting non-targeted recipients read your email, you should reconsider it.

While we’re on the topic of communications, the same caution should apply to voice mail. Keep it short, keep it simple, keep it vanilla. If you feel a need to rant, a simple “please call” message is preferable. You canrant later in person if you wish—unless the urge has passed.

Contracts
Court Favors, Enforces Liquidated Damages Provisions

“Liquidated damages” is a term often used but frequently misunderstood by clients in the negotiation of contract provisions. “Liquidated damages” are an amount of money agreed upon by both parties to a contract which one will pay to the other upon breaching the agreement. Liquidated damages provisions typically are upheld if, at the time of contract, the actual damages would have been extremely difficult to ascertain and the amount of designated liquidated damages is reasonable.

A recent case decided by the District of Columbia Court of Appeals is helpful in understanding when it is appropriate to include a liquated damages provision in a contract and how that provision will be interpreted if a contractual dispute should arise. The Court of Appeals case, S.Brooke Prull, Inc. v. Vailes, D.C. App. No. 02-CV-1016 (May 27, 2004), involved a dispute between a building contractor and a homeowner who had contracted for home renovation. The salient background information is as follows. For reasons not articulated in the decision, the disgruntled owner filed suit in Small Claims Court for return of his $5,000 deposit under the construction contract. The contractor counter-claimed for liquated damages of approximately $36,000 plus attorney fees, citing the liquated damagesclause in the construction contract. The total contract price was approximately $103,000.

After a bench trial the judge found that the owner had in fact breached the contract; however, she ruled that the liquidated damages clause was a penalty provision and refused to award either the $36,000 or counsel’s fees to the contractor. The judge awarded the contractor just $2,937. The contractor appealed, arguing that the trial court erred in striking down the liquidated damages provision. The Court of Appeals reversed the trial judge’s decision and sent the case back to the trial court for further proceedings consistent with the Court of Appeals opinion.

The Court of Appeals in S.Brooke Prullexplained that “as long as a liquidated sum bears a reasonable relation to the damages foreseeable at the time of contracting the clause is enforceable.” The Court noted that in recent times liquidated damages have been more often than not found to be reasonable and that contracts between competent parties should be viewed in light of general principles of freedom of contract. The Court noted the fading distinction between liquidated damages and penalties and recognized the trend favoring approval of stipulated damages provisions.

The Court of Appeals reasoned that the homeowner had the burden of proving that the agreed upon liquidated damages were disproportionate to the foreseeable harm, thus constituting an improper penalty. The Court ruled that the homeowner had not sustained that burden of proof in that the full contract price was approximately $103,000 with one-third of that amount representing the contractor’s profit. In reversing the trial judge’s denial of liquidated damages in this case, the Court of Appeals cited language from a 1984 decision it had rendered concerning the utility of liquidated damages:

Upholding the liquidated damages provision in the present case is consistent with one of the main purposes of such a clause: to simplify the resolution of a breach of contract dispute. In addition to giving the parties an opportunity to resolve the damages question without resorting to litigation,…a liquidated damages clause allows the parties to fix the measure of damages at the outset, before a breach even occurs. Such a provision is particularly appropriate when the parties enter into a contract like the one at bar, where the damages to be ascertained are uncertain in amount and cannot be easily ascertained.

Clearly, this ruling of the D.C. Court of Appeals is consistent with earlier decisions and confirms the Court’s favorable view of liquidated damages clauses in contracts. Parties crafting agreements including such provisions should pay heed. Far more than mere boilerplate, liquidated damages clauses will be enforced in the District of Columbia unless one party can prove that the damages he or she had agreed upon are in fact disproportionate under the circumstances—and that is a very high hurdle to clear.

Stephen Graeff

Staff Notes

Farewell. After seven years of excellent legal work, mediocre sports prognostication and an admirable effort to populate Loudoun County with children, Tim Feely has moved on. Tim has taken the reins as General Counsel of the Carmen Group, Inc., a major lobbying and public relations firm headquartered in Washington.

* * *

Vacation update. There are those who vacation well…and there are those who, well, just vacation. CMG lawyers’ holiday choices this year are, as usual, diverse:

• Roy and Marie Morris, semi-empty nesters, once again set the standard for originality. Ten days of motorcycle touring through Yellowstone National Park is planned for early September.
• Steve and Carla Graeff are notgoing to Italy this year—bad news for the Italian tourist industry. They will, however, enjoy lobsters in Maine, then kick back for a quiet patio Summer in D.C.
• After graduation season, the Carr family will hit the beach, as usual; and, there is also a family reunion (sans Larry) in South Carolina.
• The Schwartz clan plans a family get-together in Chicago and a week in Jamaica. Hurricane season discount.
• Margarita and Néstor Cruz will spend their obligatory two weeks in Boca Ratón, Florida this summer. Margarita and Néstor are aiming for the vacation version of a Ripken-like streak of consistency…like Yogi said, “It’s déjà vu all over again.”
• Ray and Monica Jones will squeeze mini-vacations to Newport, Rhode Island, and the Hamptons into busy schedules.
• Dana and Bart Theriot will pack up young Aidan and head to a kid-friendly beach TBD.
• Brenda Hankins is building her vacation plans around her sister’s wedding in California. Later, she’s off to New York for the Republican National Convention, where she’ll be a volunteer with RightNOW!

The articles in this publication are designed to give general information on the matters covered. Space limitations prevent exhaustive treatment or analysis of any topic. The articles are not intended to substitute for advice on specific legal problems.