On October 9, 2012, Jerry Meek was one of five speakers at a day-long continuing education program, attended by approximately 150 CPAs and accountants from all over North Carolina.

Meek’s presentation highlighted some of the top tax law developments of 2012.  Among others, the list included the following:

1. Nat. Fed. of Independent Business v. Sebelius.  The U.S. Supreme Court upheld the constitutionality of the Patient Protection and Affordable Care Act.  The bill includes several tax-related features, including:  (1) a new 3.8% tax on net investment income for high income taxpayers; (2) a new 0.9% hospital insurance tax on high income taxpayers; (3) an increase (for most taxpayers) in the threshold for itemized deduction of medical expenses from 7.5% to 10%; and (4) codification of the economic substance doctrine, with new penalties.

2. Voss v. Commissioner.  The U.S. Tax Court rejected the argument of unmarried co-owners of two residences that each was entitled to a full $1.1 million mortgage interest deduction.  Instead, the $1.1 million limitation amounts must be allocated among them in some manner, such as by percentage of ownership.

3. U.S. v. Home Concrete & Supply.  Interpreting a provision which extends the statute of limitations for assessment of tax from 3 years to 6 years when then the taxpayer “omits” from income an amount greater than 25% of the income actually reported, the U.S. Supreme Court held that the overstatement of basis (and resulting underreporting of income) does not constitute an omission triggering the longer statute of limitations.

4. FATCA.  The Treasury issued 400 pages of regulation implementing FATCA (the “Foreign Account Tax Compliance Act”) and also announced its intent to enter into intergovernmental agreements with other nations to cooperatively implement the act.

5. In re Quality Stores, Inc.  Rejecting the exact argument previously adopted by the Federal Circuit, the Sixth Circuit held that severance payments are not subject to FICA tax, even when paid in a lump sum and regardless of whether the former employee is receiving unemployment compensation benefits.

6. Notice 2012-8.  The IRS announced a new, more flexible approach to granting § 6015(f) innocent spouse relief.  In particular, the IRS will no longer require that the application for relief be filed within 2 years of the first collection activity.  While other provisions of the Code permit innocent spouse relief when there has been an understatement of income on a tax return, only § 6015(f) permits relief in the case of an underpayment of tax (that is, when the tax due has been accurately reported but has not been paid).

7. Massachusetts v. DHHS.  The First Circuit held that the Defense of Marriage Act, which defines marriage as between a man and a woman for purposes of federal tax law (and for other purposes), was unconstitutional, but stayed its mandate pending appeal.  If ultimately affirmed by the Supreme Court, gay couples legally married under the laws of their State will be entitled to file joint returns.  Couples who have filed protective refund claims for past years will be also be entitled to receive those refunds.

by Jerry Meek

At the bottom of most lawyers’ emails, you’ll find an oddly worded tax disclaimer.  In its usual form, it cautions the recipient that “any tax advice contained in this communication was not intended or written to be used, and cannot be used, for the purpose of avoiding tax related penalties or promoting, marketing or recommending to another party any tax related matter addressed herein.”

Usually, it appears regardless of whether any tax advice is being offered.  Sometimes the attorney using it will not even know why it’s being used.  But when proposed amendments to Treasury Regulations become final at the end of this year, the disclaimer will become a thing of the past.

This so-called “Circular 230 disclaimer” finds its origin in Treasury Regulations governing practice before the IRS, codified at 31 CFR § 10 et. seq. and commonly known as Circular 230 regulations.  An attorney who renders “written advice” relating to an entity or transaction having a “potential for tax avoidance or evasion” is considered to be practicing before the IRS, even if he or she has no contact with the IRS.

Section 10.35 of the regulations establishes a category of written opinions, known as “covered opinions.”  The rules impose special requirements on any lawyer writing a covered opinion.  For example, the lawyer’s conclusions, and the presentation of those conclusions, must comply with a prescribed format.

A covered opinion includes, among other things, any opinion about a plan or arrangement “a significant purpose of which is the avoidance or evasion of any tax,” if the written advice is (among other types) a “reliance opinion” or a “marketed opinion.”  Generally, a reliance opinion is one in which the lawyer concludes that it is more likely than not that a federal tax issue will be resolved in favor of the taxpayer.  A marketed opinion is one which the lawyer knows, or has reason to know, will be used to promote or market the plan or arrangement to others.

But a lawyer’s opinion will avoid classification as a reliance opinion, and may avoid classification as a marketed opinion, if it is accompanied by a disclaimer “that it was not intended or written by the practitioner to be used, and that it cannot be used by the taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer.”  Hence the ubiquitous Circular 230 disclaimer.

Proposed amendments to the regulations, announced last week, will completely eliminate the category of “covered opinions.”  In its Notice of Proposed Rulemaking, Treasury noted the “unrestrained use of disclaimers on nearly every practitioner communication” and the tendency of clients to “ignore the disclaimers altogether.”  The elimination of covered opinions, according to Treasury, “will eliminate the use of a Circular 230 disclaimer in e-mail and other writings.”

Assuming the amendments become final, all written tax opinions will be subject to a single, streamlined standard.  Lawyers will still be required to base the advice solely on reasonable factual and legal assumptions and to use reasonable efforts to identify and ascertain all relevant facts.  Lawyers will also still be prohibited from considering the likelihood that a tax return will be audited or that a particular issue will be raised on audit.  But the Circular 230 disclaimer will become a thing of the past.

by Jerry Meek

In a stunning upset to the IRS and a sharp break with the Federal Circuit, the 6th Circuit has held that “supplemental unemployment compensation benefits” (or SUB benefits) are not taxable under FICA.

In In re Quality Stores, Inc. No. 10-1563 (6th Cir. September 7, 2012), the taxpayer, a Chapter 11 debtor, brought an adversary action in bankruptcy seeking a refund of approximately $1 million in taxes paid, on behalf of itself and certain employees, under FICA. The taxes arose out of severance payments made to employees pursuant to a plan to reduce the workforce and discontinue operations.

In Revenue Ruling 90-72, the IRS held that SUB payments would only be excluded from the definition of “wages” for FICA purposes if, among other things, the payments are: (1) linked to the receipt of state unemployment compensation benefits (and hence “supplemental” to those benefits); and (2) not provided in the form of a lump sum.

In CSX Corp. v. United States, 518 F.3d 1328 (Fed. Cir. 2008), CSX paid separation allowances, in connection with workforce reductions, in the form of lump-sum payments to some of its employees. The payments were made irrespective of whether the employee applied for or received unemployment compensation. Noting that the payments did not meet the requirements of Revenue Ruling 90-72, the Federal Circuit held that the payments constituted “wages” for purposes of FICA and were therefore taxable.

As in CSX Corp., the payments at issue in Quality Stores consisted of lump-sum payments, made to employees regardless of whether they applied for or received unemployment compensation. Adopting the exact same statutory interpretation earlier rejected by the Federal Circuit, the 6th Circuit held that the payments were not taxable under FICA.

I.R.C. § 3402(o) provides that, for withholding purposes, a SUB payment “shall be treated as if it were a payment of wages by an employer to an employee for a payroll period.” According to the 6th Circuit, the adoption of § 3402(o) is a recognition that Congress did not consider SUB payments to be “wages” for income tax purposes. (Otherwise, it would be unnecessary to specify that they should be treated as wages for income withholding purposes.) In Rowan Cos. V. United States, 452 U.S. 247 (1981), the Supreme Court held that Congress intended the term “wages” to carry the same meaning for purposes of both federal income tax withholding and FICA taxes, leading the 6th Circuit to conclude that, if Congress did not intend for SUB payments to be wages for income tax purposes, it must not have intended them to be wages for FICA purposes. Significantly, § 3402(o)(2)(A) defines SUB benefits without regard to whether the pay is linked to unemployment compensation or paid in a lump sum.

The 6th Circuit’s decision is only binding in that circuit. As a result, the IRS will continue to assert that taxpayers domiciled outside of Kentucky, Ohio, Michigan, and Tennessee must pay FICA taxes on any severance payment that does not meet the requirements of Revenue Ruling 90-72. Taxpayers in other circuits should file protective refund claims, using Form 941-X, within the statute of limitations (generally 3 years from the April 15th following the year the original Form 941 was filed). If the claim is denied, taxpayers should either timely file a refund suit or enter into an agreement with the IRS extending the time for such a suit, allowing time for the issue to be resolved by either the Supreme Court or other Circuit Courts.

by Jerry Meek

It has happened to many lawyers.  After countless hours of negotiations, the parties believe they’ve reached a settlement agreement.  But instead of rejoicing in the resolution, they find themselves locked in renewed conflict after the “deal” falls through.

Usually this happens for one of three reasons.  Sometimes the parties fail to recognize the importance of details that could doom the agreement.  Some agreements, for example, have significant zero-sum tax consequences for the parties, which must be addressed in the final agreement but may not be apparent to the clients at the time the agreement is being negotiated.  Other times, the lawyers fail to appreciate how their clients will react to the inclusion or exclusion of some particular provision.  Many lawyers, for example, incorrectly assume that their clients will have no objection to the insertion of a confidentiality clause.  When the lawyers make incorrect assumptions about what their clients will agree to, the result is often not only a “deal” that falls through but also a strained lawyer-client relationship.

Sometimes, after an agreement is reached, a dispute arises as to whether one or more parties to the agreement are fulfilling their end of the deal.  Believing that one party is not in compliance, another party may refuse to comply.  Obviously, this is more likely to happen when the parties’ obligations under the agreement are complex or when those obligations are to be performed over a long period of time.  It is particularly likely to happen if any party’s performance under the agreement is to be measured by what would be “reasonable” or by what is “in good faith.”

Finally, sometimes a client simply has a change of mind.  It is the unusual case when, as in Estate of Gilbert Barber v. Guilford County Sheriff’s Dept., 161 N.C. App. 658, 589 S.E.2d 433 (2003), a party to a settlement agreement brazenly repudiates the agreement, proclaiming,  “Psyche!  I lied.  I will not honor it.”  More commonly, the client has post-settlement remorse – often because of newly acquired information – which prompts him to find an excuse for either not executing the written document or for not complying with the agreement as executed.

When the opposing party refuses to comply with a settlement agreement, two tools are available.  The aggrieved party can either file a Motion to Enforce Settlement Agreement or file a separate action for breach of contract, seeking specific performance of the agreement.  Currituck Assocs. v. Hollowell, 166 N.C. App. 17, 24, 601 S.E.2d 256, 261 (2004).  Generally, when the underlying action is still pending, a Motion to Enforce is the easiest and quickest method of obtaining relief.  But if the underlying action has already been dismissed, this option won’t be available.  There may then be no choice but to file a separate action for breach of contract.

Regardless of which tool you employ, two sets of issues can emerge.  First, did the parties agree on all of the material terms of the settlement, so as to give rise to an enforceable agreement?  Or were essential terms left open, such that there was no “meeting of the minds”?  Second, even if an enforceable settlement agreement was reached, are there grounds for rescission of that agreement?

It is an often repeated mantra that Courts favor compromises and settlements of controversies.  Despite this, the Courts’ approach to enforcing settlement agreements is no different than its approach to enforcing any agreement.  Since a Motion to Enforce is nothing more than a motion for specific performance of a contract, a Court will apply general principles of contract law to decide whether the settlement agreement should be enforced.  It will treat a Motion to Enforce as a motion for summary judgment, granting it only when there is no genuine issue of material fact.  Hardin v. KCS International, Inc., 199 N.C. App. 687, 682 S.E.2d 726 (2009).

As with any contract, there must be a “meeting of the minds as to all essential terms of the agreement.”  Northington v. Michelotti, 121 N.C. App. 180, 184, 464 S.E.2d 711, 714 (1995).  To be enforceable, the agreement cannot leave “material portions open for future agreement.”  Boyce v. McMahan, 285 N.C. 730, 734, 208 S.E.2d 692, 695 (1974).  But what terms are essential?  And what portions are material?

Unfortunately, there is no magic formula to help us answer this question.  Nor is it a question that can be answered in the abstract.  In Chappell v. Roth, 353 N.C. 690, 548 S.E.2d 499 (2001), the parties reached an agreement at mediation, pursuant to which the defendant would pay the $20,000 in exchange for a voluntary dismissal of the action and a “full and complete release, mutually agreeable to both parties.”  When the parties were unable to agree on the language of the release, the plaintiff moved to enforce the settlement agreement.  Reversing the Court of Appeals, our Supreme Court held that the “mutually agreeable” release provision was “part of the consideration, and hence, material to the settlement agreement.”  As a result, “no meeting of the minds occurred between the parties as to a material term; and the settlement agreement did not constitute a valid, enforceable contract.”  Id.  Deciding whether any particular term is material or essential is therefore a fact-specific inquiry that defies generalizations.

Two things, however, are clearly not required for a settlement agreement to be enforceable.

First, there’s no requirement that your client personally agree to the settlement.  That’s because there is a strong presumption under the law that an attorney has authority to bind her client.  In Harris v. Ray Johnson Construction Co., Inc., 139 N.C. App. 827, 534 S.E.2d 653 (2000), the client authorized her attorney to settle her case for $2000, net of attorney’s fees and other costs.  Her attorney thought that he was authorized to settle for a gross amount of $2000.  Noting that the attorney-client relationship is based upon principles of agency, the Court of Appeals affirmed the trial court’s decision to enforce the settlement.  “Actual authority is that authority which the agent reasonably thinks he possesses, conferred either intentionally or by want of ordinary care by the principal.”  Id.  Since the attorney reasonably thoughtthat he had authority to settle the case for $2000, he in fact had that authority.  In practice, the presumption that an attorney has authority to act for her client (in settlement negotiations and elsewhere) is so strong that it will seldom be rebutted.  See Harmon v. Frangis, 2009 N.C. App. LEXIS 778 (2009) (client bound by settlement even though her attorney negotiated the settlement after filing a motion to withdraw from the case).

Second, there’s generally no requirement that the settlement agreement be in writing.  Except where the Statute of Frauds requires otherwise, an oral settlement agreement is binding, even when it is understood that the agreement would later be memorialized.  In fact, even when the Statute of Frauds applies, Courts have eagerly found that a written agreement existed.  In Bass v. Siloam Baptist Church, 204 N.C. App. LEXIS 207 (2004), for example, the Court of Appeals concluded that a letter signed by an attorney conveying the terms of an agreed settlement was sufficient to satisfy the Statute of Frauds.  Similarly, in Currituck Assocs. v. Hollowell, supra., a string of emails between opposing counsel was held sufficient to satisfy the Statute’s requirements that the agreement be in writing and signed by the person to be charged.

Even when there has been a “meeting of the minds” sufficient to give rise to an enforceable contract, a settlement agreement can be rescinded for all the same reasons that any contract can be rescinded.  Of the many possible grounds for rescission, a party to a settlement agreement is most likely to seek rescission on the grounds that another party has materially breached the agreement.

But, as in any contract dispute, whether a breach is material (therefore justifying nonperformance and rescission) or an independent promise (entitling the non-breaching party merely to damages) is critical.  In Hardin v. KCS International, Inc., supra., the settlement agreement at issue required the plaintiff to release the defendants, but further provided that this release was not intended to bar any future action to enforce the agreement.  The Court of Appeals held that, where the settlement agreement authorizes further litigation arising out of disputes regarding compliance with the agreement, a party cannot show that failure to fully comply with the agreement is a material breach.  Ironically, by including language obviously intended to protect his rights, the plaintiff lost his right to rescind the agreement and sue on the underlying claim.

Ultimately, in determining whether a provision is material, a Court is forced to divine the intent of the parties.  In the end, its conclusion on this issue is likely to determine whether the plaintiff can pursue its original claim or is limited to recovering under the settlement agreement.  Under the election of remedies doctrine, in the event of breach, the non-breaching party must choose between enforcing the settlement agreement or recovering on the original claim.  Keyzer v. Amerlink, Ltd., 2008 N.C. App. LEXIS 11 (2008) (“To allow plaintiff to pursue both actions is repugnant to the whole purpose behind the settlement and release.”)  Obviously, unless the agreement is rescinded, an action on the underlying claim will be barred.

As a lawyer, there’s no fun in either pursuing a Motion to Enforce or defending against one.  While most Motions to Enforce are without controversy, many can be as thorny as the underlying claim that was just settled.  The best way to avoid them is by fully understanding your client and your client’s expectations, by anticipating and negotiating critical issues, and by clarifying which provisions of the agreement your client considers essential or material.

[This article originally appeared in the Campbell Law Observer, March 28, 2012.]

by Jerry Meek

A New Jersey landlord whose tenant had failed to properly exercise an option was obligated to tell the tenant of his mistake prior to the option’s expiration. In Massachusetts, a beverage supplier was liable to its distributor for terminating their agreement after the supplier learned that the distributor was attempting to form an association of the supplier’s distributors, even though the agreement allowed for termination at will. A New York law firm could pursue a claim against its client after the client rejected two settlement agreements in order to prevent the firm from getting its contingent fee.

Underlying each of these decisions is the “implied covenant of good faith and fair dealing” – a doctrine recognized in North Carolina but largely underused, despite its potential as a powerful litigation tool. Its standard formulation is pretty unassuming: “In every contract there is an implied covenant of good faith and fair dealing that neither party will do anything which injures the right of the other to receive the benefits of the agreement.” In other words, it’s not enough to do what the contract says you must do; you’ve got to do it in good faith. And sometimes good faith requires you to do things not expressly required by the contract.

In some states, the implied covenant gives rise to a separate cause of action in tort, with all of the damages customarily available in tort. But in North Carolina, rather than permitting an independent claim for relief in tort, the doctrine sounds in contract, giving rise to an affirmative claim for breach of contract even when the adverse party has complied with the express terms of an agreement. In addition, the doctrine can be used as a defense to a breach of contract claim, by arguing that the adverse party’s breach of an implied covenant eliminates the need to perform.

The doctrine is usually described as a “gap-filler.” In this view, parties are either unable to anticipate all of the possibilities which may arise after the contract’s execution or unwilling to incur the transaction costs of safeguarding against all such possibilities. The implied covenant, therefore, upholds the parties’ intent by enforcing the agreement in the way that they would want it to be enforced had they had the prescience or resources to anticipate the dispute. Under these circumstances, it is presumed, the parties had to have intended that all would act in good faith.

In theory, therefore, the implied covenant purports to bolster the written contract. In reality the doctrine has a strong anti-formalist and counter-textualist strain, coexisting uncomfortably with other established areas of contract law.

Take, for example, the notion of “efficient breach.” While no appellate court in North Carolina has ever used this term, it is well accepted that certain breaches are to be encouraged because they maximize economic efficiency. This amoral view of contracts was captured most famously by Oliver Holmes’ remark that “the duty to keep a contract at common law means a prediction that you must pay damages if you do not keep it – and nothing else.” In a world in which certain breaches are not only tolerated, but encouraged, the concept of a breach for lack of “good faith” seems odd.

Moreover, like virtually all states, North Carolina applies the parol evidence rule to contract interpretation. Where there’s a final integrated agreement – usually an agreement containing a merger or integration clause – evidence of prior or contemporaneous negotiations is not permitted, except to clarify an ambiguity in the agreement. But the implied covenant does more than clarify ambiguities. It imposes obligations over and above the obligations expressly agreed to by the parties as embodied in the contractual language chosen by the parties. As a result, an implied covenant which purports to be a doctrine of contract law can scarcely be reconciled with the parol evidence rule.

None of this, of course, makes the implied covenant a necessarily bad principle of law (in fact, the North Carolina Court of Appeals has observed that the implied covenant has been “wisely and justly” imposed). But it does, I think, explain the rarity with which the doctrine rears its head in business litigation. The doctrine runs so counter to the conception of contracts as products of mutual assent through negotiations embodied in a written document that it is often overlooked as a viable claim for, or defense to, breach of contract. In fact, all too often the implied covenant has been a tool of last resort, employed only when the prospects of succeeding on the express terms of the contract are dim.

But as lawyers, we ignore the implied covenant at our clients’ peril.

First, the possibilities for invoking the implied covenant – both as an affirmative claim for breach and as a defense – are wide-ranging, largely because the contours of the doctrine are remarkably undefined. This is perhaps by design. After all, the doctrine’s usefulness as a “gap-filler” is diminished as it becomes more clearly defined, as the gap to be filled will forever vary. But even the broad description of the doctrine presents more questions than answers. When Courts refer to the implied covenant of “good faith” and that of “fair dealing,” are they describing the same thing? Or, as the words suggest, is the former a subjective assessment of a party’s conduct while the latter is an objective assessment measured against industry standards or even the parties’ prior course of dealing? Moreover, what is good faith? What seems like a relatively straightforward concept led the drafters of § 205 of the Restatement (Second) of Contracts to define it by defining “bad faith” and leaving its opposite to inference.

In fact, in North Carolina, there are only two obvious limitations on the doctrine: courts have declined to apply the implied covenant of good faith and fair dealing to at-will employment contracts or so as to impose obligations contrary to the express provisions of the contract. Outside of these two areas, the implied covenant’s possibilities represent a treasure trove for successful advocacy.

Second, a credible implied covenant claim or defense will dramatically increase the chance of surviving summary judgment. Often, actions for breach of contract based upon the express language of the agreement are resolved by the Court at summary judgment. If there’s a trial, damages may be the only issue. But whether there has been a breach of the implied covenant is an inherently fact-intensive inquiry, often ill-suited to disposition at the summary judgment stage. At least one North Carolina Court has noted that the implied covenant requires “wrongful intent,” the type of determination for which the jury is believed to be well suited. For the same reason, a jury’s favorable determination of the issue is more likely to be upheld on appeal than a Judge’s legal determination of breach of an express provision.

Third, as a claim arising in contract, breach of the implied covenant gives rise to characteristically breach of contract damages (generally, expectation or reliance damages). The typically more generous damages in tort are unavailable. But by emphasizing the bad faith conduct of the other party, the implied covenant lends itself naturally in the human mind to award extra-contractual damages, however inappropriate it may be to do so. And when – as is often the case – a claim for breach of an express provision is coupled with an implied covenant claim, the opportunity exists to present potentially damning evidence to the jury which could have a powerful impact on the jury’s deliberations as to damages.

The potential power of the implied covenant as a litigation tool should also be of interest to non-litigators who negotiate and draft contracts. Because under North Carolina law the implied covenant cannot impose an obligation contrary to the contract’s express provisions, there is an incentive to draft agreements with careful attention to the most common disputes for which the implied covenant is invoked. While a court likely will not uphold a mutual agreement by the parties to reject all obligations to act in good faith, it should respect the expressly established rights of the parties, even when principals of good faith and fair dealing might counsel otherwise.

[This article originally appeared in the Campbell Law Observer, February 2011.]