Once you decide to form a corporation for your business entity, you will quickly be faced with another question. Should the corporation pay taxes as a “C” or “S” corporation?

There is a lot of confusion when it comes to the tax designation of a corporate entity. The first thing to understand is a corporation is a “C” designation by default. As a “C” entity, the corporation will file and pay its own taxes with profits and salaries being paid out to employees and shareholders. Since the employees and shareholders have to pay personal taxes on the distributions, “C” corporations are considered double taxation entities. This is generally viewed as a negative thing.

An “S” corporation is the government’s answer to the double taxation issue. The entity essentially acts as a pass through tax structure. The “S” corporation files a tax return with the IRS, but it is only an information tax return. This means no tax is paid. Instead, the finances of the company are passed through to the personal tax returns of the shareholders. The shareholders then report and pay tax to the IRS accordingly.

To gain “S” corporation status, you must take affirmative steps with the IRS. Specifically, you must file an application to be designated as an “S” corporation. The application in question is Form 2553. This form must be filed within 2 and ½ months of the creation of the entity or in the year prior to the year you wish the designation to be made. Prior to filing the designation, of course, you must have your employer identification number. This can be obtained with Form SS-4.

It is important to remember that there are restrictions on what corporations can file as “S” with the IRS. The designation is only available to small business corporations that are domestically formed. Further, the corporation can have no more than 100 shareholders and all must unanimously agree to the election. The shareholders cannot be other businesses, although there are some exceptions where business trusts are involved. A shareholder also may not be a non-resident alien. Finally, the corporation may only have one class of stock, although voting rights may differ.

One area where state law can cause problems with the s-election is in the field of community property. Certain states like California view marriage as conveying certain rights to both spouses whether they realize it or not. If you live in such a state, your non-involved spouse must also consent to the “S” election or it may be ruled invalid. Why? They essentially own part of your share position in the corporation.

Making the “S” designation for a corporation is not overly difficult, but many new entities run into problems because they fail to take care of the designation in a timely manner. Make sure you stay on top of the filing or you will have to wait for an additional year to make the designation.

By: Richard A. Chapo
California incorporation services via http://www.SanDiegoBusinessLawFirm.com.

Many of the most public and celebrated securities cases have been cases involving insider trading. The public's appetite for such cases is as endless as the cases themselves. Martha Stewart's case is notable only because it is recent--the past forty years have brought forth cases involving not only corporate insiders, but also attorneys, psychiatrists, football coaches, athletes, newspaper columnists, printers, golfing partners, and even professional escorts. The SEC repeatedly announces the elimination of insider trading to be one of its top enforcement priorities. Unfortunately, the law of insider trading is highly interpretive and it is difficult to distill a steadfast rule.

Readers are cautioned that the penalties for insider trading are extremely onerous, and one should rely upon this summary only as an informational starting point, and not as a definitive guideline for making trades.

The Source of the Prohibition

"Insider Trading" violations can be traced to Rule 10b-5, which prohibits any device, scheme, artifice, act, practice or course of business to defraud or to deceive in connection with the purchase or sale of any security.

Under the traditional view of insider trading, Rule 10b-5 is violated when a corporate insider trades in the securities of a corporation on the basis of material, nonpublic information. Trading on such information constitutes a "manipulative and deceptive device" under the Exchange Act because "a relationship of trust and confidence exists between the shareholders of a corporation and those insiders who have obtained confidential information by reason of their position with that corporation." This relationship implies a duty on the insider to either disclose information or refrain from trading on that information so that no unfair advantage is taken of the uninformed stockholders--familiarly called the "disclose or abstain" rule. In practice, disclosure is hardly practical, which leaves the "informed" insider with only one option: to abstain from trading. What Is "Material" Information?

The U.S. Supreme Court has broadly stated that a fact is material if it "would have taken on actual significance in an investor's deliberations." By way of example, the following nonpublic information has been found to be material when in the possession of insiders:


A company that was soon to receive a tender offer to be purchased.
A company that was soon to announce a merger.
A favorable earnings announcement.
A soon to be disclosed valuable mineral find.
A soon to be announced dividend payment.
An upcoming buy recommendation by a financial analyst.
An upcoming appearance in a financial news column.
An Expanded Definition of "Insiders"

In general terms, with respect to insider trading, corporate insiders may be defined as persons who, by virtue of their relationships with the issuer, are aware of material information about the entity that is not available to the public at large. Corporate Insiders would include all persons included in the Section 16 definition of "Insiders" (see Volume 5 of our newsletter), but would also include members of the immediate families of directors, officers and controlling persons. Also, underwriters, accountants, lawyers, and consultants "even if outside the Corporation" can be deemed insiders under some circumstances.

The Tipper/Tippee Problem; When Nonpublic Information is Passed

One of the most complex, fluid, and opaque topics in insider trading law is the problem of whether liability attaches to tippees--non-insiders who learn of nonpublic material information from insiders and then trade on that information. Recall that a condition of insider trading liability is the "breach of a duty of trust or confidence that is owed directly, indirectly, or derivatively, to the issuer or the shareholders or to any other person who is the source of the material nonpublic information." So, when is a tippee in a position of derivative trust or confidence? The Supreme Court has offered several pronouncements that help to answer this question.


For subsequent tippees to be liable, the insider (tipper) must breach his or her duty of trust or confidence to the issuer's shareholders.
In order for a tippee to be held liable, there must have been some benefit to the tipper in making the tip. The tipper's benefit need not be tangible, a gift of information to a friend or relative is sufficient.
The tipper need not be a "true" insider such as a director, officer, or lawyer. Liability can be extended to "temporary insiders" such as financial printers.
The tipper need not have a belief that the tippee (or subsequent tippee) will trade, wrongfulness is presumed merely from the divulgence of confidential information.
In most cases, for liability to attach to the tippee, the tippee must know that the information received is tainted in breach of a duty of trust or confidence.
Subsequent tippees can create a "chain" of liability, if the breach of trust and confidence is passed down the line. One example of liability involved the passing of information from husband to wife, then from the wife to a third party.
There is a recent trend in the case law narrowing the breadth of tippee liability.
The Timing of Insider Trades

At what point after public disclosure of material information may insiders trade in their company's securities depends on how quickly the information makes its way through newswire services and on the nature of the information. In an important case, a court ruled that an insider should not have placed an order to purchase securities until the information could reasonably have been expected to appear over the news service with the widest circulation. The SEC typically has adopted a sterner position, requiring that in addition to dissemination through recognized channels of distribution, public investors must be afforded a reasonable waiting period to react to the information. The American Exchange recommends that insiders wait from 24 to 48 hours after general publication of information.

The SEC Likes Tattle-Tales

In order to increase the likelihood of discovering insider violations, the Commission is permitted to make bounty awards from the civil penalties that are actually recovered from violators. With minor exceptions, any person who provides information leading to the imposition of a civil penalty upon an insider may be paid a bounty.

The Bad News: Liabilities and Punishment for Insider Trading

The penalties, both civil and criminal, for insider trading are severe. First, there are private civil remedies, as found in Section 20A of the Exchange Act of 1934. Persons who are harmed by insider trading can bring actions in most circumstances to recover the illegal profits (or avoided losses) enjoyed by wrongful traders in contemporaneous trading.

Furthermore, the SEC has the authority to impose criminal penalties, civil penalties, and punitive civil awards against wrongful traders. Congress passed the Insider Trading Sanctions Act in 1984 to toughen penalties for illegal traders. The civil penalty in such a suit can include disgorgement of profits and a penalty of up to three times the ill-gotten profits. The 1984 law also increased the criminal penalty from $10,000 to $100,000.

And, in 1988 Congress went even farther by passing the Insider Trading and Securities Fraud Enforcement Act in 1988. ITSFEA impacts an issuer's controlling persons. ITSFEA made clear that tippers and tippees are both primary violators and are thus jointly and severally liable. Under ITSFEA, a court can impose sanctions equaling up to three times the illegal profits made by inside traders. These recent laws have led the SEC to adopt a very aggressive enforcement posture and have yielded tremendously large settlements.

The Good News: Protecting Legitimate Insider Transactions

The term "insider trading" is a misnomer; not all insider trades are unlawful. Executives may in good faith make purchases of their company's stock. Rule 10b-2 of the Exchange Act outlines a compliance program that can protect insider transactions. 10b-2 dictates that a purchase or sale is deemed not made on the basis of material nonpublic information if the trader adopts a regular, periodic and written plan for the acquisition or sale of securities. The written plan can be a "formula or algorithm, or computer program, for determining the amount of securities to be purchased or sold and the price at which and the date on which the securities were to be purchased or sold." The development (and faithful observance) of such a plan can be a powerful device in defeating a charge of insider trading.

By: Michael Spadaccini
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Lock Realty Corp. v. U.S. Health LP, which was the backdrop of my December 14, 2006 article, continues to be a lawyer’s dream in terms of complexity and challenges. The case also continues to be educational for creditors that need to protect their rights in deals gone bad. The lawsuit, which is pending in the Northern District of Indiana under case number 3:06-cv-487, involves six different law firms, as well as the U.S. Attorney’s Office, and nine parties. The February 27, 2007 opinion from Judge Robert L. Miller, Jr., 2007 U.S. Dist. LEXIS 14578, addresses a priority dispute over accounts receivable, specifically Medicare receivables.

The parties. In this piece of the case, secured creditors National City Bank (“Nat City”) and Health Care Services (“HCS”) battled judgment creditor Lock Realty. The secured creditors sought an order directing AdminiStar Federal, the entity responsible for processing the Medicare claims of Americare (a nursing home business), to pay them funds that represent their secured interests in the A/R of Americare. HCS provided housekeeping services for Americare nursing homes and, in lieu of immediate payment, took a secured interest in Americare’s A/R. Nat City took an interest in Americare’s A/R to secure payment under a loan agreement with an affiliate of Americare. In November of 2005, before Lock Realty became a judgment creditor, Nat City and HCS perfected their security interests through the filing of appropriate financing statements with the Indiana Secretary of State.

Priority. A prior perfected security interest is superior to a judgment lien. See, Ind. Code 26-1-9.1-317 and 322. HCS and Nat City filed appropriate financing statements with the Secretary of State. They perfected their security interests in Americare’s A/R before Lock Realty became a judgment creditor. As such, HCA and Nat City had superior claims to the funds.

Validity: the anti-assignment statute. The more meaty issue related to the validity of the security interests in the first place. Lock Realty argued that the funds at issue were Medicare payments and that the federal “anti-assignment” statute rendered the interests in the A/R unenforceable. The opinion gets into an involved and technical discussion of the anti-assignment statute, 42 U.S.C. 1395g(c). Generally, the statute prohibits Medicare funds from being paid directly to someone other than the provider. The statute does not, however, prohibit someone other than the provider from receiving the funds if they first flow through the provider. As a fundamental proposition, therefore, lenders can secure loans by Medicare receivables. In Lock, neither secured party had a right to file a claim for direct payment of Medicare funds. The rights flowed through the medical provider. “[N]either [HCS nor Nat City] could receive Medicare funds pursuant to their arrangement without subsequent judicial enforcement of the security agreement.”

Lien enforcement. Whether and how the subject security interests could be enforced was a critical question in Lock. Judge Miller held that, although federal law preempts non-judicial enforcement of the such security interests under the UCC, HCS and Nat City ultimately could receive direct payment by court order. The financing arrangements of HCS and Nat City were valid and in accord with the anti-assignment statute. Judge Miller merely enforced the security agreements. His court-ordered assignment, which directed payment from AdminiStar to the secured parties, did not violate the anti-assignment statute.

Cliff notes. Judge Miller’s February 27 opinion teaches us that (1) a prior security interest is superior to a judgment lien, (2) a lender can take a valid security interest in the Medicare A/R of a medical provider and (3) the enforcement of the security interest – the right to directly receive the money – requires a court order.

If you’re a commercial lending institution with loans secured by governmental Medicare payments, you or your lawyer should study Judge Miller’s opinion further. Also, stay tuned for additional court commentary that may arise out of this fairly complex lawsuit. Lenders who deal with nursing home borrowers and related entities will continue to learn from the issues being litigated in Lock Realty.

By: John Waller
John D. Waller is a partner at the Indianapolis law firm of Wooden & McLaughlin LLP. He publishes the blog Indiana Commercial Foreclosure Law at http://commercialforeclosureblog.typepad.com John’s phone number is 317-639-6151, and his e-mail address is jwaller@woodmclaw.com.

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Purchasing an existing business can be a very rewarding endeavor. The first thing that comes to mind about purchasing an existing business is the avoidance of “start-up” costs. The initial costs of creating a new business can be staggering, in addition to the costs for advertising that new business, with no guarantee of a return on your investment. The existing business, however, will have a track record that you can look at as far as income and expenses. While previous performance is no guarantee, it at least gives you a ballpark reference as to what you can expect.

There are many legal considerations when purchasing an existing business. First and foremost is to know exactly what you are purchasing. Are you purchasing the entire business and all of its components, or are you merely purchasing the assets of the business? This is an important issue because you want to make sure that you are not purchasing another person’s mistakes. If you are purchasing the entirety of another business, you may be assuming responsibility for all of that business’ debts and liabilities, known or unknown. For that reason, we usually recommend that the purchase only include the assets of the existing business. There are exceptions to this rule which are based upon the size, goodwill and standing of the existing business, but that is to be considered on a case by case basis.

When making an Asset purchase, it is extremely important to set forth in writing exactly what the assets are, so there is no confusion after the transaction closes. Make a list of the physically identifiable assets, i.e. the copy machine, the customer list, the desks and chairs, etc... You should also make a list of the intangible assets, i.e. the phone number of the existing business. The failure to consider the exact assets included in the purchase account for many of the business transaction claims that are brought into my office.

The next legal consideration regards the type of business that you are purchasing. Whether it’s a Pizza shop or an Insurance business, you want to make sure that the Seller will not open up a similar business right next door to the business that you are purchasing. This is where a Covenant Not to Compete is essential. Almost every type of business purchase transaction should include such a covenant. The Covenant Not to Compete should prevent the Seller from doing many things, including opening a similar establishment, using client or customer lists of the established business, hiring employees of the existing business or advising others to use a competing business. These Covenants are typically limited in time and location. If the Seller is unwilling to enter into such an agreement, the business may not be worth purchasing.

Take the time and effort to consult with your local attorney if you are considering purchasing an existing business. It may save you thousand of dollars and hours of time in the long run.

By: Greg Artim
Greg Artim is an Attorney based in Pittsburgh Pennsylvania. For more information on related legal issues, please visit his website at http://www.gregartim.com.

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