JP Fernandes, Small Business Lawyer

Cybercrime is posing a rising threat to the private sector, particularly to small- and medium-size businesses, which are attractive targets because they tend to have fewer information security measures in place compared with larger enterprises.  The U.S. Sentencing Commission (Commission) has tried to crack down on identity theft and cybercrimes by increasing the penalties.  The Commission issued a final rule significantly enhancing the severity of punishment in the hopes of deterring potential cyber-criminals of computer and identity theft crimes.

Background

 As everyone knows, identity theft and cybercrimes are growing in size and sophistication. As businesses, large and small, become increasingly dependent on computer networks to store sensitive information, they are also increasing their risk for theft and loss.  In response to this trend, Congress passed a law strengthening prosecutors’ tools for penalizing identity theft and cyber criminals and expanding the possible avenues for victim restitution and looked to businesses and the Commission for guidance on these matters.  Business and the Commission recommended increasing penalties for five kinds of identity theft and computer crimes:

Fraud and Related Activity in Connection with Identification Documents, Authentication Features, and Information;

Aggravated Identity Theft;

Fraud and Related Activity in Connection With Computers;

Interception and Disclosure of Wire, Oral, or Electronic Communications Prohibited; and

Unlawful Access to Stored Communications.

Just a little background on what the sentencing guidelines do.  They are supposed to serve as a reference for federal judges when determining the level of penalties to impose for federal crimes.  The guidelines outline a range of 1 to 43 possible base offense levels that are assigned to various crimes.  The more serious the crime, the higher the offense level.  For each offense level, the Commission provides a range of months for which an offender can be imprisoned for committing a crime at that offense level.  And within each offense level, the range of imprisonment can also vary, depending on the person’s criminal history, which is rated from I to VI.

For example assigning the Range of Imprisonment at Each Offense Level.

A first-time offender (Criminal History Category I) whose crime is at a base offense level of 5 can be subject to anywhere from 0 to 6 months of imprisonment. A more experienced offender, in Criminal History Category IV, who commits a crime at the same offense level can be subject to 4 to 10 months of imprisonment.

Versus Increasing the Base Offense Level

When determining the base offense level of a crime, judges can increase or decrease the level based on various characteristics of the crime.  Theft, for example, often starts at a base offense level of 7 but can increase depending on the amount of monetary loss involved.

Criteria for Amending Penalties for Cyber and ID Theft Crimes

Business and the government identified 13 key factors including how sophisticated the crime is, whether the crime was intended to disrupt a critical infrastructure, whether the crime involved a computer associated with national security, among others.  These factors must be considered when increasing or decreasing the offense levels assigned to the five identity theft and cybercrimes.  The 13 criteria are as follows:

1. The level of sophistication and planning involved in the offense.

2. Whether the offense was committed for commercial advantage or private financial benefit.

3. The potential and actual loss resulting from the offense including a) the value of information obtained from a protected computer, regardless of whether the owner was deprived of use of the information; and b) where the information obtained constitutes a trade secret or other proprietary information, the cost to the victim incurred developing or compiling the information.

4. Whether the defendant acted with intent to cause either physical or property harm in committing the offense.

5. The extent to which the offense violated the privacy rights of individuals.

6. The effect of the offense upon the operations of a U.S. government agency or that of a state or local government.

7. Whether the offense involved a computer used by the U.S. government, state or local government in furtherance of national defense, national security or the administration of justice.

8. Whether the offense was intended to, or had the effect of, significantly interfering with or disrupting a critical infrastructure.

9. Whether the offense was intended to, or had the effect of, creating a threat to public health or safety, causing injury to any person, or causing death.

10. Whether the defendant purposefully involved a juvenile in the commission of the offense.

11. Whether the defendant’s intent to cause damage or intent to obtain personal information should be disaggregated and considered separately from the other factors set forth.

12. Whether the term “victim” should include individuals whose privacy was violated because of the offense in addition to those who suffered monetary harm as a result of the offense.

13. Whether the defendant disclosed personal information obtained during the commission of the offense.

As you can see many of the offenses are related to commercial activity or individual privacy.

The U.S. judiciary looked to the private sector for input on how to strengthen penalties for committing identity theft crimes and other computer related acts.  Small businesses, in particular, are becoming frequent targets for hackers and cyber criminals because they lack the information security defenses in which large enterprises have invested significant time and resources.  According to a Verizon study, 33 percent of all data breaches in 2008 were directed at businesses with 100 employees or less.  By comparison, large businesses with more than 10,000 employees sustained fewer data breaches in 2008, totaling 25 percent.  Furthermore, industry leaders conclude that almost 20 percent of small businesses do not even use antivirus software, more than half do not use encryption and two-thirds do not even have information security plans in place.

The U.S. Sentencing Commission’s request for input on sentencing guidelines provided an opportunity for businesses to review current penalties for such crimes and suggest increasing the severity of fines or prison sentences.  Whether or not greater penalties result in greater deterrence of identity theft and other computer crimes is yet to be seen.  However, the changes to the guidelines represented a significant opportunity for businesses to have their voices heard in an area typically dominated by the federal government.

After developing and adopting the company’s new testing policy, it is now time to examine the practical considerations of implementing the new policy.

It is Critical to Ensure the Accuracy of the Tests. 

The highest concern an employer  involved in drug or alcohol testing programs has to be in ensuring the accuracy of the selected tests.  There is a growing body of medical literature on this subject showing that certain tests are highly accurate for specific substances, while others have more dubious validity. Again, a basic decision must be made as to the substances for which an employer will be testing. Expert assistance should be sought to determine the tests that are most reliable and cost-efficient for those substances.

We should not forget the employee perspective here either.  If you were an employee that was subjected to, what you already considered embarrassing testing procedures, imagine the humiliation that the employee would feel if he were tagged a false positive finding based on a test of “dubious validity?”  Even if the employee is “cleared” by subsequent re-testing he will always have that stigma.  Again, just an example of “Blow Back” that could arise in this type environment the angrier a wronged employee is the likely he will sue you.

Use Correct Test Procedures.

Of equal concern to selecting the proper tests is ensuring that appropriate test procedures are used.  For example, most knowledgeable commentators believe that more than one test should be performed before an employer concludes that an individual has ingested a particular drug.  In addition, there are varying levels of accuracy with respect to confirmation tests.  Employers should strive to achieve the highest degree of reliability in the manner in which samples are obtained and tested.  Of course, before any testing is performed, the employer is best advised to obtain a signed consent and release form from each employee.  The form should also advise the employee of:

• What tests which will be required, and
• The purpose of the tests.

The consent form should also include language assuring the employee that appropriate procedures will be used in handling and analyzing samples.  The form should also provide a space for the employee to identify legal prescription medications that may show up in the test results.

Many employers obtain an applicant’s consent to drug testing by including appropriate language on their application forms.  However, I believe that while this is helpful, applicants should still sign a more detailed consent form at the time they are tested.  The employer’s written drug/alcohol testing policy should provide that failure to execute such a form will be cause for termination.

The Need for a Defined Chain of Custody.

 Another practical concern with significant legal consequences is the maintenance of a delineated chain of custody in order to avoid claims of tampering, mistake, etc.

General Checklist for a Successful Drug and Alcohol Program.

The following checklist should be consulted in drafting and implementing any drug and alcohol program:

Pre-Implementation Checklist. Before implementing a drug and alcohol program, an employer should:

•  Identify problem areas.
•  General community concerns.
•  Specific plant/industry concerns.
•  Anecdotal evidence of problems.
•  Determine means of addressing the concerns.
•  Employee assistance programs and/or  discipline/discharge policies
•  Develop policy implementation guidelines consistent with general corporate policy.
•  Develop a general policy statement addressing:
•  The drugs with which the employer is concerned.
•  The role of the employee assistance plan.
•  The role of the disciplinary system.
•  Develop and promulgate a policy on testing:
•  A policy on testing of applicants.
•  A policy on testing of employees.
•  Develop and promulgate revisions to the company’s disciplinary policy consistent with the aforementioned policy statements.
• Advise employees of the disciplinary consequences of:
•  Failing or refusing to participate in testing procedures.
•  Possession or sale of drugs on company premises.
•  Continued use or abuse of drugs.

Document each step of the process outlined above.

The Americans with Disabilities Act does not consider a test to detect the illegal use of drugs to be a medical examination, and therefore an applicant can be required to take such a test before a conditional offer of employment is made. This is not so of a test to detect the use of alcohol.

Employers should be wary of using the phrase ‘‘abuse’’ when they mean ‘‘abuse and/or use’’.  Similarly, avoid use of the phrase ‘‘under the influence of,’’ particularly when referring to drug usage.  Unlike alcohol, there are no generally accepted or legally recognized standards for ascertaining when a recreational user steps over the line and becomes an abuser of a particular drug or when an individual is under the influence of a drug as opposed to having that drug within his bodily system.  Accordingly, using or misusing the phrases ‘‘abuse’’ and ‘‘under the influence of,’’ employers may assume a burden that they cannot satisfy (i.e., proving the applicability of those terms in a particular case.)

Implementation-Phase Checklist. 

While implementing the drug and alcohol program an employer should:

• Establish chain-of-custody procedures for the urine/blood sample from clinic to lab, and within the lab.
• Develop appropriate consent forms.
• Choose state-of-the-art testing procedures and facilities, particularly if discipline or discharge is anticipated.

Program-Monitoring Checklist.

To successfully monitor the drug and alcohol program, an employer should:

• Apply standards appropriate to forensic drug/alcohol issues.
• Test the testers.
• Testing laboratories ought to be subject to rigid checking procedures including various tests for false negatives as well as false positives.
• Ensure that specimens are retained in case of potential legal challenges.

Should an employer advise an individual that he or she failed a drug or alcohol test?  If so, should an employer permit an individual to have a portion of the tested specimen examined by a laboratory of the employee’s choice?

In most instances, employees who are disciplined or discharged after a drug and alcohol test are going to relate the two events, and no purpose is served in attempting to disguise the correlation. Employers who choose not to take action after receiving positive tests and then later discipline or discharge the tested individual for some other makeweight reason increase the potential for an adverse result if and when the discipline or discharge decision is challenged.

While some employers have taken the approach of not advising job applicants that they failed drug and alcohol tests, on the assumption that the applicant will not necessarily correlate the failure to be hired with the results of medical tests, again, in the authors’ view, general principles of fairness and equity dictate that persons who failed tests and are not hired for that reason be advised of this. Such notice allows an individual to challenge the test and allows the employer to reconsider his actions before a lawsuit is filed.  Be aware that some states require an employer to notify an applicant or employee of a positive test result, provide additional information, and allow the individual to have an independent test done of the sample to verify the test results.

Along the same lines, an employer should not be reluctant to provide an authorized laboratory of the employee’s own choosing a sample of the specimen that tested positive, as long as the employer has confidence in the testing procedures of its own laboratory. Doing this is more likely to discourage legal complaints than it is to encourage them. Should the employer provide an individual with a portion of the sample for testing by another laboratory, care should be taken to preserve a sufficient portion of the specimen for validating the employer’s laboratory’s tests.

Lastly, when dealing with a present employee who has tested positive, the employer, before advising the employee of the result, may want to require a surprise re-test, and take disciplinary action only if both specimens are positive for controlled substances. This procedure would eliminate many potential employee claims of lab mix-ups, poor chain of custody, improper specimen handling, etc.

It is obvious, but often overlooked—formulate your policy. 

The first step in developing a comprehensive program on employee use and abuse of drugs and alcohol is to create a clear policy that advises employees of the company’s new approach that the employer will take in identifying, treating and disciplining employees who were found to have possessed, ingested or worked with alcohol or drugs in their systems.  Employers should build in a lag time between notice of the new policy and when any actual testing for drug or alcohol use will begin.  The notice period allows any hardened users to quietly leave the work force without any further employer action or records of the employee.  It is also wise to give employees notice to minimize morale problems and claims of unfair treatment.

 Give Notice of the Company’s Testing Standards.  The next aspect of a drug and alcohol use program are the specific rules for making employees to submit to drug and alcohol tests and deciding which individuals will be tested.

Testing options include:

•  Testing based on specific impaired employee behavior.
•  Testing of employees who are performing high risk duties or are responsible for the safety of others (e.g., drivers of vehicles, persons involved in the manufacture of critical components, etc.).
•  Testing of the whole work force, often on a random basis.
•  After accident tests.
•  Applicant testing.

Employers usually test employees that fall into two or more of the above categories, depending upon that employer’s perception of the nature of the problem.

 Notify employees of the breaches of the policy and/or refusing to submit to drug and alcohol tests.

 The third step in a typical drug and alcohol use program informs the employees how the company will react to those employees who breach the company’s drug and alcohol rules as well as the consequences of their refusing to submit to drug and alcohol tests.

Before implementing a drug and alcohol testing policy, employers must determine if their state has a drug testing statute and what it requires.  In some states drug testing must follow very specific procedures and that certain information be provided to employees or applicants whose test comes back positive.

Often employees bring actions for defamation and/or invasion of privacy actions against their employer in connection with drug and alcohol testing.  Some of the ways employers can take to prevent defamation claims include:

•  Using only reliable information regarding possible drug and alcohol issues.
• Maintaining the utmost confidentiality throughout the entire process when dealing with drug and alcohol issues, only those individuals who have an absolute need to know about them should be involved in the process.

Private employers are subject to common law invasion of privacy tort claims.  For example, employers and counselors can be found liable for invasion of privacy where a counselor releases confidential information.

Consider this:  Bill W, a supervisor for a fast food chain, has a falling out with top management that leads to his termination.  Bill W claims that he was terminated for failing to promote an individual who was the son of one of his superiors.  His employer contends he was terminated because of poor performance and for violating company policy prohibiting employees from using illegal drugs.  Confronted with the drug charge, Bill W takes a polygraph test that he later claimed he did only because he was coerced to do so.  Bill W was terminated upon his employer’s receipt of the polygraph examination.  Bill W claims that his employer violated his privacy rights by offensively or objectionably prying into something that was a private matter.  In some jurisdictions, those that recognize the tort of invasion of privacy, Bill W has probably stated a valid cause of action.

Employers can minimize their exposure to common law privacy actions by:

•  Avoiding enforceable ‘‘expectations of privacy’’ by advising employees and applicants of the extent of their privacy rights in the employment environment and, most importantly, of the nature of the inquiries the employer may make with respect to usage of drugs and alcohol.
•  Obtaining consent to inquiries about otherwise private matters through appropriate waiver forms.
•  Using the least obnoxious methods to obtain the most relevant information, by the most credible means, and thereafter maintaining all information related to this process in the most confidential manner.

There is going to be some blowback from a drug/alcohol testing/policy; that is, such a policy can erode employee morale by creating a sense of distrust and authoritarianism from the employee perspective including the perception that the employer is trying to control employee behavior outside of the workplace.

In our next discussion the practical implementation of a drug and alcohol policy.

Today’s employers have to be aware of the economic costs of employee alcoholism.  Statics are starting to show that those costs, however, may be small in comparison to the expenses associated with the generation of new employees that are as likely to use and/or abuse drugs as they are alcohol.  In stark contrast to the popular misconception that drug users typically are unemployed, approximately 75 percent of adult illicit drug users, some 8.5 million people, are employed.  Some estimated the problem is as bad as at least one employee in ten having a problem with alcohol or drugs.  No matter what size your company, large or small, is immune from this problem.  In response to these alarming statistics or to unpleasant first-hand experiences, an increasing number of businesses are developing programs to identify, rehabilitate and, if necessary, discipline and discharge employees who have used or abused drugs and/or alcohol while working.

A properly structured drug/alcohol program may increase employee productivity, reduce employee turnover, reduce health insurance costs, reduce accidents and poor decision making.  On the other hand, a poorly drafted or administered program will not only fail to achieve these goals, but is virtually guaranteed to increase costs, create severe morale problems at best and subject an employer to expensive litigation at worst.

 The Purpose of Drug or Alcohol Testing.

While a number of employers have policies governing situations in which employees have actually been observed consuming alcohol or using narcotics while on duty, such policies often do not satisfactorily address the difficult problem of detection where an individual is suspected of alcohol or illegal drug use, but is not ‘‘caught in the act.’’ Or before they are employed at all.  Due to increased awareness of the costs and risks of employee drug and alcohol usage, a number of employers have adopted requirements that employees and/or applicants submit to urinalysis and/or blood tests for the purposes of detecting narcotics or alcohol.

Factors That Should Be Considered Before Starting on a Drug or Alcohol Testing Program.

One of the first concerns that an employer should review before it implements a drug or alcohol testing program is in identifying the specific problems which the employer wishes to address.

That involves considering the following questions:

• Is the employer concerned with alcohol, drugs or both of these problems?
• With respect to drugs, what substances pose the greatest concerns and/or risks?
• Are there particular regional problems that are unique to a specific operation?
• Is the employer concerned exclusively with on-duty/on-premises use, or is off-duty/weekend use also subject to the discipline policy?  Remember there are laws against discipline of legal substances while not on duty.
• Does the employer wish to treat drug/alcohol issues exclusively through its disciplinary system or does it wish to develop a policy that is designed to prevent and resolve employee abuse of drugs/alcohol, relying on discipline as a last resort?

Typically employers concerned with employee use or abuse of drugs/alcohol may want to rethink considering discipline and discharge policies as the primary tool for changing employee behavior.  The disciplinary approach often leads to costly litigation and potentially troublesome morale problems, but it is also generally recognized that a broad multifaceted programs that include rehabilitation alternatives are the most effective—but also the most costly often out of reach of the typical small business.  On the other hand many believe that rehabilitative programs are preferred for financial reasons in that the costs of rehabilitating an employee experiencing a drug or alcohol problem are often substantially less than the costs of releasing that employee and rehiring and training his or her successor.  Thus the employer is left with a Hobson’s choice:   either the employer pays the costs of alcohol/substance abuse through low productivity, increased workplace accidents, high turnover and potential litigation or they pay the costs of designing and implementing a drug and alcohol abuse program hoping to make up the costs in part by increasing an employer’s litigation defense posture if, prior to discharge, the employee has been afforded an opportunity to enroll in a program but has declined, or if the employee has enrolled in the program but failed to solve the problem.

Part 2 of our look at drugs and alcohol in the work place: The Three Aspects of a Well-Defined Drug and Alcohol Program.

On November 1, Wisconsin’s new concealed carry law went into effect, making it legal for individuals who have a concealed carry license to carry concealed firearms in public (with certain exceptions – for example, even with a concealed carry license, it is still not legal to carry a firearm within 1,000 feet of a school).

Several of my small business clients have phoned me with questions about the possibility that someone might carry a concealed firearm into their place of business.  Some business owners are concerned about their possible liability if a firearm were to be discharged on the premises of their businesses, causing damages or injury, while others, for ethical or philosophical reasons, simply don’t like the idea of having guns carried onto their property.  Despite the new law, can you, as a business owner, prohibit firearms on your own property?

The answer is yes, you can prohibit guns on your own property, and many businesses are doing exactly that. Wisconsin law does not require you to allow your customers and clients to carry weapons into your business place. If you want to prohibit guns on your business property, I recommend that you start with the following two steps:

1. Put up a sign that clearly states your policy.  In the photos accompanying this blog post, you can see several possible sign formats.  For example, the sign I found at Sears reads: “No Firearms or Weapons Allowed on This Property.”  Your sign could use the same words or other words to that effect, as long as the language you choose is clear.  Depending on the business, you may prefer a smaller, more tasteful sign.  You might put a sign in the window of your business rather than right on the street.  Either option is acceptable as long as the sign is clearly visible and leaves no doubt as to your business policy.

Why do you need a sign? Well, first of all, your clients and customers may not be clairvoyant. They won’t know what your policy is unless you state it. Secondly, however, if you do see a customer carrying a weapon, having a clear policy posted in a location that is plainly visible to any person entering the business puts you, the business owner, in a better position if you choose to phone the authorities. You can then report that a firearm was carried into your business in defiance of your stated policy, and you can request assistance.

2. Take a few minutes to check with your insurance carrier. Ask your insurance agent specifically whether your insurance will cover your liability if you are sued for an injury or damage that might be caused if a gun were to be fired in your place of business. In addition, you will want to ask whether your insurance will cover any damages to your business place that might be caused by the discharge of a firearm. Get your answer in writing, or write to your agent afterward with a thank you letter that notes your appreciation of his or her time and that you are glad to know that your insurance will cover you (if that is what you were told) in the event that you ever are sued for damages related to the discharge of a firearm.

If you have further questions related to your particular type of business, please do not hesitate to contact me. You may also wish to read the Wisconsin Department of Justice’s FAQ on this issue: http://www.doj.state.wi.us/dles/cib/ConcealedCarry/ccw-faq-20111020.pdf.

One of the most profitable sub-industries in the credit card industry is what is known as “Zombie” debt collection.  Zombie debt is old and uncollected debt purchased for pennies on the dollar and then collect on debt for which they couldn’t otherwise sue.  The Fair Debt Collection Practices Act provides only a minimal deterrent to consumer rights abuses that are often engaged in by many of these debt collectors.

Beware the Zombie Debt Collectors

Against the backdrop of the passage of the new credit card legislation and President Obama’s desire to create a Federal Consumer Protection Agency, a small spotlight was shown on one of the most profitable sub-industries within the credit card industry: what the industry calls “Zombie” debt collectors. “Debt buyers” or “re-purchasers” as they are known, buy old and uncollected debt. These uncollected debts are known as “Zombie” debts.  The Zombie moniker comes from the fact that virtually all of this debt remains uncollected beyond a State’s statute of limitations, has either previously been discharged in bankruptcy or actually paid off as part of a prior settlement by the “so-called debtor.”

Zombie Debt Originated in the Savings and Loan Crisis

The Zombie debt industry arose during the 1980’s as an unintended side effect from the savings and loan crisis when the government auctioned off the failed S&L’s receivables.  Since its beginning, there has been unprecedented growth.  Large companies like Asset Acceptance Capital Group has a glossy website marketed to businesses, often with promises that they can collect and deliver. And deliver they do.  The company reported millions in revenues.

Like the fictional “zombies,” the once-dead debt rises from the dead to live again upon purchase for pennies on the dollar, making this a very simple risk/benefit analysis for these industry executives.  The Zombie debt collectors often successfully collect on debt for which they couldn’t otherwise sue, and they are notorious for engaging in some of the most vicious behavior against consumers.  Unfortunately, the Fair Debt Collection Practices Act (“FDCPA”) does not provide a deterrent to these repugnant actions.  As to be expected, the lack of specific regulation of the Zombie debt collectors’ practices has spawned several scam companies that have taken their practices to an even lower level.

Collection Agencies Shut Down in New York

Recently, New York State Attorney General Andrew M. Cuomo’s office obtained a court order to shut down debt several collection agencies run by Tobias Boyland. “This case is one of the more egregious cases we have found,” said Mr. Cuomo. According to the lawsuit filed by Mr. Cuomo’s office, Boyland operated out of Buffalo, New York, which is widely recognized as the collection capital of the United States due to its concentration of collection agencies and attendant employment opportunities. The lawsuit alleged that thanks mainly to the increased internet accessibility to information, Boyland’s agencies would use lists of people whose debts were successfully discharged in bankruptcy, many of which were at least ten years old or more, and attempt to collect these no longer valid debts.

Attorney General Cuomo followed up the Boyland case by suing thirty-five law firms and two debt collectors in New York State in an attempt to have the court throw out an estimated 100,000 default judgments against New York consumers. According to the suit, the law firms and debt collectors used false affidavits to obtain these judgments over a nineteen-month period. Many of the defendants did not know anything about the judgments until they learned that their wages were garnished or their bank accounts frozen.

FDCPA Penalties Deficient

Although this is an extreme example of how Zombie debt collection can go awry, it does serve to illustrate how open it is to the type of abusive practice that the FDCPA was designed to prevent. The problem with the FDCPA is that the penalties were legislated in 1978 and have not changed since. Although, the attorney’s fees are a mandatory award and the aggrieved party can sue for actual damages, meaning out of pocket losses, and emotional distress, the statutory penalty is still, as it was then, a meager $1,000.

Considering how much less the dollar is now worth compared to 1978 when the statute was written and the advent of the profitable Zombie debt collection industry, this statutory penalty is hardly a deterrent.  Moreover, the penalties are not imposed per violation, but per each consumer case.  Therefore, in many cases, where the collector has violated the FDCPA by making phone calls to a debtor’s neighbors and employers or by making umpteen harassing and abusive calls to the debtor and the debtor’s family, the statutory penalty is still only $1,000.

Although some states, such as Pennsylvania, have criminal statutes forbidding debt collectors from collecting debts absent the original agreement and any assignment thereof, these statutes are rarely enforced, so the abuses continue with little incentive to do otherwise.

FTC Findings

The FTC has concluded that “the debt collection legal system needs to be reformed and modernized to reflect changes in consumer debt, the debt collection industry, and technology.” In light of its conclusions, the FTC has made several recommendations ranging from mandating debt collectors to transmit better information to consumers about their rights to modernizing debt collection laws minimizing the consumer costs when being contacted via cell phones. The FTC also recommends that it be given the authority to create regulations to employ the FDCPA prior to congressional action.

The FTC recognizes that collection agencies, collection lawyers, and debt buyers need better information in order to prevent collections from the wrong people or for the wrong amounts. More to the point, the FTC report raises concerns over “certain debt collection litigation and arbitration practices,” an area that has been particularly ripe for consumer rights violations. Although the FTC expressly recognized that aggressive law enforcement is needed to deter collection abuses and that the FTC will step up its efforts in doing so, it also emphasized that the consumer, through their filing of lawsuits, should be the “main means of promoting industry compliance.”

Here is part II of our look at LLC’s and their use in business continuity and succession planning.

III. Non-Tax Benefits of Forming an LLC.

There a number of non-tax benefits that stem from formation of an LLC. Chief among these non-tax benefits are the following:

• . LLC members are shielded from personal liability. This is an advantage enjoyed by corporate shareholders and limited partners in a limited partnership. However, unlike in a limited partnership, where one general partner has to be designated to be personally liable for partnership debts and obligations, no such restriction exists in an LLC.
• . LLCs may be managed and directed in their day-to-day operations by their members or owners. This provides great governance and control flexibility and eliminates the need for a board of directors. Management may be concentrated or decentralized.
• . LLCs are not as formal as corporations. For example, LLCs are allowed to dispense with annual meetings which are often required for corporations.
• . LLCs may have an unlimited number of members. For example, S corporations may have no more than seventy-five shareholders. Further, an S corporation may not have any foreign shareholders or investors. Additionally, shareholders in S corporations may only be individuals or certain types of trusts. LLC members may be individuals, trusts, corporations, or partnerships.
• . LLCs may issue multiple classes and series of stock and equity. S corporations are limited to the issuance of a single class or series of stock.
• . In a number of states one person may form an LLC. This is much like a sole proprietorship, but with limited liability. A partnership requires two or more individuals.
• . Employee benefits programs otherwise unavailable to a sole proprietor or partnership may be available to the LLC to attract and retain the services of key employees.

IV. Tax Treatment.

State law plays a large role in determining how an LLC will be taxed. In the 1990s, the Internal Revenue Service (IRS) adopted so-called check-the-box regulations that govern the tax treatment of LLCs. If state law does not require classification and treatment like a corporation, an LLC with two or more members may elect to be treated as either a corporation or a partnership. Where corporate status is chosen, the LLC prepares a separate entity tax return and is taxed like a corporation. If partnership status is chosen, the LLC is treated like a pass-through entity and taxes are reported on the individual owners tax returns. In states that allow single member LLCs, the LLC may be treated as a corporation or a pass-through entity and taxed like a sole proprietorship. As a default rule, if the LLC does not elect how it wants to be taxed (as a corporation or partnership) IRS regulations mandate tax treatment as a partnership.

The ability to elect partnership taxation is a great benefit to LLCs. Corporations are subject to double taxation. The corporation pays separate entity taxes. Shareholders pay individual taxes on dividends and distributions. However, when taxed as a partnership, with pass-through treatment, the LLC avoids the double taxation problem corporations present.

V. Tax Benefits Associated with LLCs.

A number of tax benefits are associated with the formation and operation of an LLC. Chief among these tax benefits are the following:

• . LLCs may allocate profits and losses on a basis other than ownership percentages.
• . According to § 754 of the Internal Revenue Code (IRC) an LLC may make an election to adjust the tax basis of assets after a change in ownership. Further, § 754 allows for the use of debt to increase the basis in determining an owners share of ownership.
• . Where restrictions are placed on LLC membership alienability, marketability discounts may be available to offset the basis of member ownership. Marketability discounts are based on the availability, or lack thereof, of a market in which to liquidate the assets and interests of the LLC.
• . Key person discounts may be available for estate planning purposes in order to account for the lack of performance of services of a key member of the LLC who has been rendered disabled, incapacitated, or dead.
• . Minority discounts may be available for LLCs where the minority-interest holding members, if any exist, lack the ability to manage the LLC.

VI. Family and Estate Planning Guidance: Using LLCs to Benefit the Small Business Owner.

Due to their flexibility and non-tax and tax advantages, LLCs can be useful tools in the hands of wise estate planners to assist in answering business continuity and succession planning issues long before they become problematic and potentially catastrophic. In general, LLCs are useful in diminishing family dramas and rivalries if care is taken in their formation and structuring. The LLCs Articles of Organization or Bylaws hold the key in merging family and estate planning into business planning. The Articles of Organization should and must definitively speak to the issues of disability, incapacity, resignation, retirement, death, divorce or other domestic disturbance, debt, and creditors and bankruptcy. In terms of planning guidance, the Articles of Organization should outline and provide procedures and protocol to address the following issues as they arise:

• . Resignation or retirement of members or key employees;
• . The distribution of LLC assets upon the settlement of a legal separation, divorce or dissolution;
• . The effect of a foreclosure of debt and the personal bankruptcy of a member;
• . Qualifications to hold LLC offices; and
• . The disability, incapacity, retirement, and death of an LLC member.

Finally, with an LLC in place, the small business owner is wise to consider the stand-alone adoption of a Buy-Sell agreement. Legally, a Buy-Sell agreement is a contractual agreement that would speak to the sale of LLC membership interests upon the happening of a specified condition or event. In essence, it would bind the LLC interest holder and the LLC itself to repurchase interests in the LLC upon the occurrence of a triggering event. This triggering event could be the disability, incapacity, resignation, retirement, or death of an LLC member. Offers by outsiders or others to purchase assets or interests in the LLC could very well trigger such an agreement. The Buy-Sell agreement would assure that all LLC interests are accounted for and are being used properly. The Buy-Sell agreement provides a further crutch to ensure that the LLC is not crippled further by the disability, incapacity, resignation, retirement, and death of a member or other specified events.

Disability, incapacity, retirement, and death most certainly make business continuity and succession planning difficult or impossible. Families are often faced with the seminal question: Is it worth keeping this business in the family, or should we just let it go? The next question is often the following: If we decide to keep the business going who is going to manage the business? Establishment of an LLC long before these issues arise gives the small business owner time to groom and train replacements within the family. If this effort fails, the LLC may serve as a useful vehicle to look outside the family to attract and retain key leaders to carry on the business and legacy. Employee benefits and opportunities to own equity in the LLC may go a long way towards attracting the leaders to guide the business beyond the capabilities or earthly limitations (i.e., sickness and death) of the founding member(s).

VII. Conclusion.

Some people say that sometimes business and family do not mix. Sometimes this is true. Business and family can mix quite well if thought and planning take place on the business side of the equation. LLCs as outlined above hold special appeal to small business owners concerned about business continuity and succession planning. LLCs offer many non-tax and tax advantages over other forms of business that small business owners and their advisors alike should strongly consider. LLCs are excellent entity choices to address the recurring issues of risk and liability, capital formation and financing, governance and control, and business continuity and succession planning. Finally, the tax benefits and impact of LLC ownership, due to the hybrid nature of an LLC, are tremendous.

Here is Part II of  my answers to top ten questions I get asked by a clients or a colleagues.

6. I understand that if I organize my business as an LLC, I will not be able to provide my employees with options or some other form of equity participation. Is that correct?

No. LLCs and partnerships can offer equity-based compensation plans. Indeed, the flexibility associated with LLCs and partnerships permits tailoring of compensation plans that can reduce or eliminate current income tax at the time of a grant.

7. If I am setting up an LLC, is there any reason to form it under the laws of one state rather than another?

In most instances there is no reason for a business to organize in another state rather than the one in which is operates.

8. Should you ever form a general partnership?

Not in today’s world, no.

The general rule is that all partners in a partnership are liable jointly and severally for all obligations of the partnership.  Limited liability partnerships are a type of general partnership that provides its general partners with limited liability for certain obligations of the partnership.  It has the benefits of a partnership and limitations on liabilities.  For example, partners in LLPs are not liable for the debts caused by the negligence of other partners.

9. I have heard about LLCs and LLPs, but what in the world is an LLLP?

Investment vehicles have traditionally been structured as limited partnerships. A limited partnership must have at least one general partner. Promoters have often minimized liability exposure by using an adequately (but not robustly) capitalized corporation as the general partner. Some states, such as Delaware, now expressly authorize limited partnerships to file a statement of qualification and become “limited liability limited partnerships,” or LLLPs. In these states, even the general partner is shielded from partnership liabilities.

10. If the Secretary of State allows me to reserve a name for a new entity, do I need to worry about any further name searches?

Maybe. Typically, Secretaries of State will reserve a name for anyone who wishes to form a new business entity. By reserving the name prior to organizing the entity, one can be assured that the Secretary of State’s office has checked its database and determined that the name is available for use.

The Secretary of State’s office, however, usually does not determine whether the chosen name may infringe upon federally registered or common law trademarks. If a new business anticipates building a broad identity around its entity name (think, for example, about Ben & Jerry’s Homemade, Inc., or Amazon.com, Inc.), then it should consider performing trademark searches before committing to a name. It may be cheaper to analyze the trademark issues now than to adopt a new corporate identity later.

Naturally, I have heard many more questions all over the map.  The ones we’ve just discussed are the ones I hear the most often.

Limited Liability Companies present unique opportunities not available in partnerships and corporations for business continuity and succession planning here are some of the key advantages and distinctions.

I.          Introduction.

For small business owners, a number of factors come into play in deciding what type of entity to choose for conducting their business. Entity choice is often one of the key initial decisions a business owner must make. Often, this is a critical decision that must be made before the first goods are manufactured and sold, or the first services are provided to patrons or clients. In order to make the proper entity choice, the business owner must consider a number of non-tax and tax factors. In terms of the non-tax considerations that come to mind, four primary considerations affect the calculus of entity choice: (1) risk and liability issues; (2) capital formation and financing options; (3) governance and control of the entity; and (4) continuity and succession planning.

There are primarily four main choices to pick from in operating a business and choosing an entity: (1) a sole proprietorship; (2) a partnership (whether general or with limited liability); (3) a corporation (whether a subchapter C or S corporation); and (4) a limited liability company. The decision to choose one of these types of entities over another creates a whole host of considerations geared around liability and risk aversion, capital formation, governance and control, and continuity and succession. Especially, for small business owners, these core considerations are highly magnified and take on great significance. As their small businesses succeed and grow, becoming large businesses, business owners and key executives/employees become most worried and concerned about disability and incapacity planning, retirement, and death. Certainly, where business owners and key executives/employees are concerned, disability, incapacity, retirement, and death can ravage and destroy even the best businesses virtually overnight.

II. Limited Liability Companies.

Sole proprietorships, partnerships, and corporations all address the issues of risk and liability, capital formation and financing, governance and control, and continuity and succession in varying ways. Indeed, sole proprietorships and partnerships (particularly general partnerships) generally are not the best choices where business owners run a high risk of being sued as they do not shield their owners from personal liability. Corporations are excellent in high-risk situations where owners seek limited liability. Sole proprietorships and general partnerships are limited in capital formation and financing by their owners creditworthiness. Corporations allow greater options for capital formation through the sale of shares of stock and other equity. Sole proprietorships and general partnerships allow for direct control and management by owners. Corporations are formal and bureaucratic in that officers and agents have to answer to shareholders and boards of directors. Sole proprietorships and general partnerships die and cease to exist when their owners die. Corporations are advantageous in that they have perpetual life and existence.

In the not so distant past, those wishing to start a business essentially had only three options for the form of that business sole proprietorship, general partnership, or corporation. As demonstrated, each of these business types brought with it a number of factors to be weighed and considered when viewing risk and liability, ease of capital formation, internal control and governance, and continuity. There existed very little room for the proverbial happy medium. However, in the 1970s, this changed when Wyoming enacted the first limited liability company (LLC) statute, creating a business form that blended features of sole proprietorships, general partnerships, and corporations. Essentially, LLCs are hybrid entities that limit personal liability, have equity features like corporations that assist in capital formation, provide flexibility in governance and control structure, and exhibit almost unlimited life and duration. Currently, all fifty states and the District of Columbia have LLC statutes in place. LLCs are formed quite easily through filings of forms with the appropriate state official, usually the Secretary of State.

As I have practiced over the years, I have heard some of the same questions over and over again from both colleagues and clients relating to business entities; that is, how do they differ and why when to use one type of entity over another.  Here are some answers to top ten questions I get asked by a clients or a colleagues.

1.  I understand the difference between an S and a regular C corporation, but what is a close corporation and how is it different?

There is a distinction between the classifying a business entity for state law purposes (which deals with issues like limited liability and requirements for running and maintaining the business) and the company’s federal tax classification.  Virtually all states permit the formation of “close corporations.” A close corporation has a limited number of shareholders typically no more than thirty-five, can operate without a board of directors, does not need to adopt bylaws, and generally operated with less formality than a “regular” corporation—without loosing any of the liability protection offered by “regular corporations.”  If you ran a entity without a board of directors, bylaws or failed to follow any of the required “corporate formalities,” you may be subject to personal liability.  By statue, statutory close corporations are exempted from taking such factors into account if the question of piercing the corporate veil ever arises.

For tax purposes, a close corporation’s status is an independent question.  A close corporation will be treated as a C corporation unless it qualifies for treatment as an S corporation and timely elects the “pass-through” treatment available under Subchapter S of the Internal Revenue Code (“IRC”).

2. With the drop in individual income tax rates does it make sense to organize my business as a regular C corporation?

When the top marginal rate for individuals was 39.6% and the top marginal rate for corporations was 35%, it was frequently advantageous to organize a business as a C corporation as long as the entity did not hold assets expected to appreciate in value and the business plan called for retaining earnings for capital investment. When the top tax bracket was reduced to 35% in 2006 many of the reasons were lost.  There are, however, still some attributes of a C corporation that are attractive, such as the availability of tax-advantaged fringe benefits for owners of the business and the potential 50% capital gains exclusion. The reduction in individual tax rates, however, makes entities that offer pass-through taxation more attractive than ever.

3. Why do the venture capital providers prefer funding C corporations?

I hear this one a lot.  For start-up businesses generating losses, a flow-through entity such as an LLC generally provides tax benefits that make it preferable to a C corporation.  A profitable C corporation may distribute after-tax earnings to shareholders in the form of dividends. In computing their tax liability, however, shareholders must generally include C corporation distributions in income, and cannot use C corporation losses as deductions.  Since LLCs can have multiple classes of equity interests and it is possible to fashion an LLC membership interest comparable to convertible preferred stock, one might think that the LLC form would be attractive to investors.

Nonetheless, venture capital providers generally make conversion to a C corporation a condition for providing funding. One reason is the non-recognition treatment available to C corporations for mergers and other kinds of reorganizations under IRC § 368.  This non-recognition treatment is not available to LLCs–or to corporations that have converted to C corporations in anticipation of a re-organization. Second, only C corporations can take advantage of the 50% capital gains exclusion under IRC § 1202. Venture capital providers seem willing to sacrifice short term tax benefits in hopes of maximizing the after-tax return to investors when a liquidity event occurs.

The preference for C corporations also appears to be driven by non-tax reasons. Investors, familiar with the structure of corporations, find it easier to get deals closed and manage their investments if all their portfolio companies are organized as corporations.

4. I sometimes get told that it is too expensive to form an LLC as a vehicle to operate hier sole proprietorship. Are they right?

No way! If an LLC is taxed as a partnership under the Internal Revenue Code, then the LLC does not pay any federal income taxes. The LLC, however, would generally be subject to a nominal fee to the state of filing.  If the LLC is a single member LLC, it is a disregarded entity for federal income tax purposes; it is not taxed as a partnership but as a sole proprietor is.

If an individual forms an LLC as a vehicle to operate what would otherwise be a sole proprietor-ship, the activities of the LLC are reported on Schedule C to the individual’s IRS Form 1040. There is no need to prepare and file a separate federal or state tax return for the LLC, or obtain a separate employer identification number.  The benefits of operating through a limited liability entity far outweigh the small formation costs.

5. What is the deal with self-employment tax and LLCs?

This one is murky. Once a determination has been made that a pass-through entity is an appropriate choice advisors have steered clients away from LLCs to S corporations in order to minimize federal payroll taxes.  A shareholder of an S corporation can be an employee of the S corporation, so the shareholder may report some of their share of business income as a shareholder distribution and some as compensation for services as an employee. Only that portion deemed to be compensation is subject to FICA (the contributions for old age, survivors and disability insurance, and hospitalization insurance) and unemployment taxes.

In an LLC taxed as a partnership, a member is considered self-employed rather than employed by the LLC. A member who performs services for the LLC is subject to SECA (the self-employment counterpart of FICA) on “net earnings from self-employment,” which includes (with certain exclusions) the member’s distributive shares of income or loss from any trade or business carried on by the LLC.  Thus, there is no question that a shareholder of an S corporation can shelter some income from employment taxes by taking some of the business income as a shareholder distribution rather than compensation for employment. In contrast, except as noted below, a member’s share of LLC profits will be subject to self employment taxes regardless of whether the member considers herself an “employee” of the LLC.