June 2003 Vol

Kelo v. City of New London: The U.S. Supreme Court and the Eminent Domain Controversy

The U.S. Supreme Court recently accomplished what elected officials thought impossible - unite the far left and right of the political spectrum. In the case of Kelo v. City of New London, the Court held that a city’s exercise of its eminent domain power in the furtherance of an “economic development” plan utilizing private developers satisfied the “public use” requirement of the 5^th Amendment of the U.S. Constitution, permitting the taking of private property for just compensation. In so doing, the court aroused the ire of both liberal and conservative commentators, as well as of a public fearful that their houses could be seized and turned into the next Wal-Mart. In the past weeks since the Court handed down its now famous decision, I have been a guest on radio talk shows catering to both liberal and conservative audiences, and have fielded numerous questions and outraged comments from listeners from all ends of the body politic, none of whom voiced support for the Supreme Court’s decision. Is the alarm justified? Has the Court opened the door for wholesale governmental abuse? Or has the Court made a limited decision that does not create an unreasonable threat to personal property rights? As with most issues of public policy and complex court decisions, the answer to both questions at this point is “maybe.”

The Kelo case is significant in two important ways. First, it involved the taking by the City of New London, Connecticut, of private homes that by the City’s own admission were not blighted. The City had in general undergone a significant economic downturn and had been designated a “distressed municipality,” primarily because of the decision of the federal government to close the New London submarine base. As a result the City had developed a comprehensive economic redevelopment plan designed not only to restore vacant properties to active (taxpaying) status, but also to attempt to create jobs for the area. It just so happened, however, that the lower-middle-class homes of Susette Kelo and eight of her neighbors (including one who had lived in the same house since being born there in 1918) lay within the proposed development area. The Supreme Court recognized that the houses were not “blighted or otherwise in poor condition.” Nevertheless, after a protracted legal battle, the U.S. Supreme Court did what almost every other federal and state court dealing with eminent domain cases has done over the years. It refused to second-guess the City’s determination that the property was “necessary” for a public use and permitted the condemnation to proceed.

Second, unlike the “classic” use of eminent domain, the property that was the subject of the Kelo case was ultimately to be conveyed by the city to private developers and owners. While this had happened before, Kelo validated the practice, which while viewed as suspect, had never expressly been either upheld or ruled unlawful by the Supreme Court.

The Kelo decision is thus noteworthy both for what it permitted as well as for what it did not do. Like many Supreme Court cases, this case presented facts that were an extension, perhaps an extreme one, of the Court’s long line of eminent domain decisions. While eminent domain is typically viewed as a mechanism to enable cities to take property for such public facilities as roads and schools, courts recently have wrestled with the issue of permitting the taking of private land for redevelopment and subsequent re-ownership by other private enterprises. This practice began decades ago when the Michigan Supreme Court upheld the taking of hundreds of private homes to permit the construction of a Ford automobile plant (ironically, that court recently reversed itself, in essence holding the opposite of the Kelo decision). In so doing, the courts have strayed from the requirement that a taking be justified by a “public use,” as stated in the 5^th Amendment, culminating in 1954, when the U.S. Supreme Court ruled a taking lawful if it serves a “public purpose” - a nuance, but a significant one. Commentators of all political stripes have jumped on that phrase to charge that the Supreme Court has created a situation whereby even the nicest homes, or even commercial properties, can be condemned to permit the building of newer and bigger structures that will bring in more real estate taxes, create more employment, etc. On the other hand, city planners and economic development officials have breathed a sigh of relief, seeing in the decision a tool to combat economic distress without having to wait until an area is blighted beyond recovery.

Why then are many public officials downplaying the decision and assuring the public that it will not be abused in their jurisdictions? Largely for three reasons. First, as noted, the decision has been wildly unpopular, arousing an editorial outcry from all corners. Second, the Supreme Court very clearly stated that its decision was based only on the U.S. Constitution and that local governments were free to address the issue as they saw fit. City officials no doubt realize that an overzealous use of the eminent domain power could result in state legislation taking away the club before they have a chance to wield it.

But the biggest reason city officials downplay the use of eminent domain is that they don’t have to actually use it for it to be effective. Eminent domain is the equivalent in governmental action circles of the nuclear bomb in a military arsenal. Merely knowing it is there and can be used is enough. Thus when a landowner is approached by the city with a “request” to sell property to make way for, say, a massive redevelopment project aimed at improving the entry corridor to a major state university, the landowner, mindful of the city’s power, will not waste time arguing over whether the city really “needs” the property, but will focus on obtaining favorable appraisals to get the best price for the land.

What does the future hold? Expect municipalities to react conservatively, using eminent domain sparingly lest state legislatives impose legislatively what the Supreme Court refused judicially. Also look for cities, with limited resources and growing redevelopment needs, to form alliances with private companies with both the means and the profit motive to facilitate major projects. For now, government has won, at least on paper. Whether the public reaps the benefits remains to be seen.

Brent D. Rosenthal is a Shareholder in the Business Law and Real Estate & Construction Practice Groups of Buckingham, Doolittle & Burroughs, LLP. He can be reached at brosenthal@bdblaw.com or 614.227.4266.

The benefits of a qualified retirement plan are certainly well known. Contributions to such a plan are deductible when made, the trust into which the contributions are made is tax-exempt, and the benefits are not taxed to the employees until distributed.

With recent changes in the tax laws, defined benefit pension plans have become more popular. These plans are governed by benefit limits rather than by contribution limits. Therefore, the contribution needed to fund a substantial benefit for an employee nearing retirement age can be substantially greater than the maximum contribution available in a defined contribution plan. Improperly structured plans, however, are now considered non-compliant by the IRS and will be treated as abusive tax shelters.

Of course, taxpayers and their advisors are always looking for “better ways” to maximize the deductible contributions made to a qualified retirement plan. In this regard, the Internal Revenue Code gives us a type of defined benefit pension plan that in the right circumstances may very well outperform the traditional defined benefit pension plan. This plan is commonly referred to as a “412(i) Plan.” The unique feature of a 412(i) plan is that it is funded not with cash, but with insurance contracts and annuities. Because the insurance contracts typically offer a fairly low guaranteed rate of return, achieving a specific annual retirement benefit requires higher funding levels as compared to a traditional plan. If the 412(i) plan is structured properly, the amounts contributed to the plan to purchase the life insurance and annuities will be tax deductible.

Over the past several years, retirement plans created under the provisions of Section 412(i) of the Internal Revenue Code have been designed utilizing methods that are questionable, at best. The most common “abusive” structure entails the purchase of life insurance on a participant’s life in excess of the participant’s death benefit provided under the terms of the plan. Further, the life insurance contract purchased is a “springing cash value” type of policy. If the program works as advertised, the employer heavily funds the life insurance policy in its early years with large tax-deductible premiums while the participant pays annual income tax only on the value of the pure death benefit protection, which is a very small portion of the premium. After making these purported tax-deductible premium payments (say for five years) the plan distributes the life insurance policy to the insured/employee when the cash surrender value is substantially lower than the premiums paid. The insured/employee pays tax on the low cash surrender value even though the policy is worth substantially more. Following the distribution, the cash value springs or balloons in value. With the policy in hand, the participant can then elect to take income-tax-free loans for retirement.

The structure of the above described purported 412(i) plan has been on the IRS hit list for quite some time. Although there are many legitimate Section 412(i) plans, the plans structured this way are not. Simply put, the claimed tax results for employees and employers do not reflect the underlying economics of the arrangements.

With recent rulings and the passage of final regulations in August of 2005, the IRS has sent a message that they want to shut down these abusive plans. They have done so by declaring that premiums paid for life insurance in excess of the death benefit provided by the plan will be non-deductible and subject to a 10% excise tax penalty. Further, it is no longer possible to value life insurance (in a qualified plan or otherwise) solely on the basis of the purported cash surrender value. To add fuel to the fire, the IRS has announced that these non-compliant 412(i) plans will be treated as abusive tax shelters. As such, these plans can lead to additional penalties being assessed against the taxpayer.

Certainly, taxpayers who are involved with one of these abusive 412(i) plans need to respond to the IRS directives and plan to modify their programs accordingly. Unfortunately, this is likely to result in substantial out-of-pocket expenses that could not have been anticipated. On the other hand, these developments should not dissuade taxpayers who are in a legitimate 412(i) plan from continuing their program or from pursuing a legitimate program.

The foregoing is a statement of the bad news (for some). The good news is that most pension practitioners were already aware of the abusive plans and have avoided them. Therefore, these practitioners are operating as usual. Although a few promoters have spoiled the appearance of a 412(i) plan and as a result have received much negative publicity, 412(i) plans sponsored by the vast majority of the administrators and practitioners that work in this area are still legitimate.

Thomas J. Sigmund is a Shareholder in the Business Law and Trusts & Estates Practice Groups of Buckingham, Doolittle & Burroughs, LLP. He can be reached at tsigmund@bdblaw.com or 614.221.1222.

Business owners conducting business through a Subchapter S corporation may have an unwelcome visitor soon - Uncle Sam. The IRS recently announced a new initiative aimed at putting Subchapter S corporations under the microscope of the dreaded tax audit. This is not the first time this has been done. In the 1990s, for example, every Subchapter S corporation return filed in the IRS's Kansas City office was pulled for scrutiny. The new initiative shows the IRS's renewed interest in cracking down on those who use the veil of the Subchapter S corporation for illegitimate tax benefits. Perhaps the single most important weapon in the Subchapter S corporation shareholder's anti-IRS arsenal is a detailed, complete, and up-to-date minute book. Our attorneys who assist clients in IRS audits routinely find that corporate expenditures that are properly authorized in detailed corporate minutes generally pass the auditor's scrutiny, while those reflected only in financial records often fail. If your corporate records are not up-to date, or you are not sure, contact your BDB business lawyer before the IRS calls you.

As 2005 comes to an end, it is prudent to start the new year with a review of both the accomplishments of the past year and the tasks to be performed during 2006. Besides corporate, financial and tax issues, the following list offers items for you to consider when planning for the upcoming year. Consider whether an item should be updated, amended, or modified to meet the present and future needs of your company or organization.

v Business advisors: List your accountant, insurance representative, business manager, bank or banker, and legal counsel. Does your company work well with each of these business advisors? Do the business advisors timely respond to your questions and other matters? Do you have the correct contact information for each business advisor listed?

v Corporate record concerns: Determine whether the corporate record or minute book is up-to-date. Must any actions be taken to bring the record or minute book up-to-date? Have all major company actions been recorded in the record or minute book? Are all documents on the record or minute book signed by the appropriate parties? Are there any matters that have not yet been completed?

v Employee matters: What is the date of last review for the Employee Handbook? Does the Employee Handbook need to be revised to include new policies?

Is the company in compliance with federal, state, county and city governmental law regarding payroll and withholding tax (including workers’ compensation and unemployment compensation)? Is the company in compliance with minimum wage laws?

Do any employees need a new or modified employment agreement? Are there any negotiations or plans for negotiation of any employment agreements?

Review bonus and incentive arrangements for the upcoming year. Review employee benefit plans for the upcoming year. Do the benefits plans meet the needs of your employees?

v Loss of key employees: What effect would the death, disability, retirement or resignation of a key employee have on company operations? What provisions or plans are in place to maintain operations if the company loses one or more key employees?

v Litigation: Are there any lawsuits pending against the company? If so, what is the status of the litigation? Is there any litigation initiated or to be initiated by the company? If so, what is the time table and who needs to be involved?

v Audits: Are there any audits, financial or governmental, planned for the upcoming year? If so, when will the audits take place? Who needs to be involved?

v Intellectual property: Are there any trademarks, service marks, patents, fictitious names or trade name registrations required?

v Business agreements: List all contracts and agreements currently executed. Which contracts and agreements will expire in the upcoming year? Which contracts and agreements will automatically renew? Does the company wish to terminate, renew or modify any contracts or agreements? Does the company have any leases that need to be reviewed?

v Record retention and disposition: Does your agency have a policy concerning record retention and disposition? If so, does the policy need to be updated?

After reviewing these items, prioritize which matters the company needs to address, and contact the appropriate business advisor for any necessary assistance. Because this list is not complete, always consult with the company’s business advisors to ensure successful business operations in the upcoming year.

This article was adapted from a Business Review Checklist developed by Thomas W. Hess, Esq., Buckingham Columbus.

Thomas Hess is a Shareholder in the Health & Medicine Practice Group of Buckingham, Doolittle & Burroughs, LLP. He can be reached at thess@bdblaw.com or 614.227.4260.

Thomas W. Hess (Buckingham Columbus^SM) was elected to the Board of Directors of the Northeastern Ohio Universities College of Medicine (NEOUCOM).

Donald B. Leach (Buckingham Columbus^SM) was elected to the Upper Arlington City Council. Don has been involved with the electoral/political process for many years. Prior to receiving his legal degree, Don was a legislative assistant to the President of the Ohio Senate, and he has been the long time Treasurer for both the Columbus and Upper Arlington School Levy Campaigns.

Priya J. Bathija and Peter W. Hahn (Buckingham Columbus^SM) wrote articles for Briefs, which is a quarterly publication of the Columbus Bar Association. Priya’s article is entitled, "An Overview of Attorney Trust Accounts," and Peter’s article is entitled, "Personal Technology for Lawyers." Peter also wrote an article for the October issue of Journal of the American Geriatrics Society called, "Long-Term Care Liability for Pressure Ulcers."