Spring 2010 Edition

What Are The Chances of Being Audited By the IRS This Year?

By F. Stephen Glass

There are at least two approaches to preparing your income tax return this year. You can be a risk-taker and be aggressive regarding your credits and deduction claims. Or, you can be cautious, and be defensive as you prepare your tax returns. Let's look at some of the "odds" that YOU might be the subject of an income tax audit by the IRS this year.

Actually, the IRS also plays the odds. Because the IRS is unable to examine every return, it follows a policy of examining returns which, upon preliminary inspection, indicate the largest possible source of potential tax deficiency. Returns are rated for audit according to a mathematical formula called the discriminant function system (DIF). Various weights are assigned to separate items on each tax return, thus permitting the ranking of returns for the greatest potential error.

The odds are low that your return will be picked for an audit. However, the number has been increasing, particularly with respect to high-income taxpayers.

Audit odds vary depending on your income, profession, type of return, type of transactions reported , and where you live. Individual returns are classified by all income items on the return without regard to losses. Professional or business income reported on Schedule C is classified by total gross receipts, and corporate returns are classified by total assets.

Your return may receive special IRS scrutiny because of your profession, the type of transactions reported , or the deductions claimed. The chances of being audited are greater under the following circumstances:

• The information reported on your tax return does not match information received from third party documentation, such as Forms 1099 and W-2.
• Your itemized deductions exceed IRS targets.
• You claim tax-shelter losses.
• You report complex investment or business transactions without clear explanations.
• You receive cash payments in your work that the IRS thinks are easy to conceal, such as cash fees received by doctors or tips received by cab drivers and waiters.
• Business expenses are large in relation to income.
• Cash contributions to charity are large in relation to income.
• You are a shareholder of a closely held corporation whose return has been examined.
• A prior audit resulted in a tax deficiency.
• An informer gives the IRS grounds to believe that you are omitting income from your return.

Franchise Disclosure Document - Item by Item Analysis
(Part three of a series)

By M. Blen Gee, Jr.

The Franchise Disclosure Document (FDD) is required by federal law to be given to most prospective franchisees. A careful review of the FDD is an essential step in your review of any franchise opportunity.

Following up on our previous two articles on the subject, this article lists more things to look for in the FDD:

ITEM 8 - Restrictions on Sources of Products and Services. Franchisors, in order to maintain uniformity of appearance and quality within the franchise system, will exercise substantial control over products, advertising, equipment, sources of supplies, decor, and virtually every other aspect of a franchisee's business. This is normal and an important part of the franchise system. However, increasingly, restrictions on sources of products and services have become a major area of abuse. In all likelihood, somewhere in Item 8 of your FDD you will see a sentence or two indicating that the franchisor reserves the right to receive payments from suppliers as a result of dealings with you and other franchisees. In other words the franchisor is expressly reserving the right to receive "kickbacks" from the suppliers they choose. This creates an obvious conflict of interest and all too many franchisors are tempted to turn their legitimate right to oversee quality control and uniformity into a "profit center" at the expense of their franchisees. In extreme cases, a franchisee may find that its customers can purchase products at retail at the same price or cheaper than the franchisee is paying for the products at wholesale from the designated supplier.

ITEM 9 - Franchisee's Obligations. These items should be thoroughly studied and the corresponding provisions of the franchise agreement should be read carefully. Generally speaking, you must assume that the franchisor will rigorously insist on your performance of each of these requirements. Also, you can expect the court system to rigorously uphold the franchisor's right to enforce these provisions. In your due diligence investigation, you should ask current and former franchisees about each of these items and how the franchisor has dealt with them in the past.

ITEM 10 - Financing. Some franchisors offer startup financing. Claims of misrepresentation about financing were identified early on as a problem by the Federal Trade Commission. Typically, if you default under the financing offered by the franchisor, this will also be a default under the franchise agreement and vice versa. For this reason, a missed payment on your financing could result in the loss of your franchise. A loss of your franchise agreement would constitute a default under the financing, requiring the loan to be repaid in full. Great caution should be exercised in accepting financing from the franchisor. If you are not receiving financing from the franchisor but were referred to a lender by the franchisor, check Item 10 to see if the franchisor receives a referral fee.

Also, note that franchise brokers will sometimes encourage prospective franchisees to use their 401 (k) or IRA or other retirement savings to finance of the purchase of a franchise. Generally speaking, we believe that any new business opportunity is far too speculative and risky to jeopardize your retirement savings.

ITEM 11 - Franchisor's Assistance, Advertising, Computer Systems, and Training. The Federal Trade Commission franchise rule requires that each franchisor include in Item 11 the following statement in bold type:

"Except as listed below, we are not required to provide you with any assistance."

That about says it all. What you see is what you get. What you see is ALL you get.

One of the most frequent complaints from franchisees, especially concerning small or startup franchise systems, is that the franchisor is not giving them any support. Unfortunately, the typical franchise agreement does not require the franchisor to give you ongoing support or much of anything. If the franchise agreement does not require the franchisor to give ongoing support and spell that support out in some detail, a court or arbitrator will not require the franchisor to give ongoing support. Also, courts and arbitrators will not enforce the oral promises made to you by brokers and salesmen.

If you do decide to proceed with the franchise opportunity, we recommend that you take full advantage of all assistance that the franchisor offers. After all this is what you are paying for. You should take advantage of site location assistance, initial training, ongoing training, advertising assistance, telephone support, etc.

>> Read part four of our Franchise Disclosure Document series

In the News

George G. Hearn, Member-Manager of our firm, was one of the presenters at the March 4, 2010 Administrative Law Seminar sponsored by the Administrative Law Section of the N.C. Bar Association Foundation. Hearn joined four other attorneys presenting a panel discussion about occupational licensing boards . There are over 50 such boards in North Carolina, including those regulating the practice of medicine, law, architecture, nursing, real estate brokerage and certified public accounting. Hearn and our firm have been privileged since December, 1989 to represent the North Carolina Veterinary Medical Board, which licenses veterinarians and registers veterinary technicians and regulates the practice of veterinary medicine .. Each attorney on the panel prepared written materials for the seminar participants explaining the role and function of their respective client board.

F. Stephen Glass recently presented his manuscripts: Mechanics of Drafting Trusts, Understanding of Ethics in Trusts and How to Administer a Trust Appropriately at a seminar for lawyers and CPAs sponsored by the National Business Institute.

The Computer Fraud and Abuse Act - A New Remedy for Employers

by F. Stephen Glass

The federal Computer Fraud and Abuse Act (CFAA) provides a legal remedy for a host of computer-related activities in which a disloyal employee might engage at an employer's expense.

CFAA states "[a]ny person who suffers damage or loss by reason of a violation of this section may maintain a civil action against the violator to obtain compensatory damages and injunctive relief or other equitable relief."

One section of CFAA makes it illegal for an individual to intentionally access a computer without authorization or to exceed authorized access and thereby obtain information from any employer's protected computer.

Another section prohibits an individual from knowingly and with intent to defraud, accessing a protected computer without authorization, or by exceeding authorized access, and thus further any intended fraud and obtain anything of value, unless the object of the fraud and the thing obtained consists only of the computer and the value of such use is not more than $5,000 in anyone-year period.

Yet another section prohibits a number of activities, which include unauthorized to access a computer, that cause damage to a "protected" computer.

While there is no consensus about federal circuit, the middle approach in interpreting the CFAA is to rely heavily upon express agreements entered into between the employer or computer system operator and the employee or computer system user. In each case, these courts found that under express terms of the agreements the users accessed the computer without or in excess of their authorization in violation of the CFAA.

The leading case using this approach is Hewlett-Packard v. BydSign, Inc. , 2007 WL 275476 (E.D. Tex. 2007) ("HP"). In HP, the district court found that HP "actually alleged that the defendants had agreed not only to refrain from disclosing information but also to refrain from sending or accessing messages on HP's computer systems for personal gain.

In Erin Smith Advertising and Public Relations, Inc. v. Erin, 2009 WL 249998 (D. Neb.) the court found that the confidentiality agreement in the employee handbook supported the employer's argument that the defendant employees were only authorized access to protected information as long as they abided by the handbook's terms. Employers should develop and enforce computer access policies that explicitly define the authorized use of the company's computers.

Business Tax Law - What is All This About Income Tax Basis??

by F. Stephen Glass

Basis is the original cost of property, adjusted for factors such as depreciation. When property is sold, the taxpayer pays taxes on a capital gain that equals the amount realized on the sale of the property, minus the sold property's basis. IRS Publication 551 states that "Basis is the amount of your investment in property for tax purposes. Use the basis of property to figure depreciation, amortization, depletion, and casualty losses." For federal income taxation purposes, determining basis depends on how the asset in question was acquired.

Assets acquired by purchase or contract: For assets purchased or acquired contractually, the basis equals the purchase price.

Assets acquired by gift or trust: The general rule is that assets acquired by gift or trust receive transferred basis (also called carryover basis). Put simply, gifted assets retain the donor's basis.

Assets acquired by inheritance: Prior to 2010, assets acquired by inheritance received stepped-up basis, meaning the fair market value of the asset at the time of the decedent's death. Stepped-up basis shields the appreciation in value of the asset during the life of the decedent from any income taxation whatsoever. During 2010, assets acquired by inheritance receive a carry-over basis instead of stepped-up basis [see article regarding Estate Tax Repeal in Special Edition insert for discussion of exceptions to this rule] .

Adjusted basis: An asset's basis can increase or decrease depending on changes that occur throughout its lifetime. Computing gain requires determining the amount realized from the sale or disposition of property minus the adjusted basis.

2010 ESTATE TAX REPEAL- MANY SURVIVING SPOUSES MAY BE LEFT OUT

by F. Stephen Glass

We need to turn the calendar back to the year 2001 to understand how 2010 might be affecting your estate plan. What we find there is the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) -- a sweeping piece of legislation that made significant changes in several areas of tax law. There was a built-in flaw which would "sunset" important provisions of the tax law. It was universally assumed that sometime before 2010, Congress would fix that flaw.

It hasn't. So, EGTRRA makes it prudent to review closely your estate plan early this year. For reasons discussed below, your perfectly good estate plan that was in good order for the last year or last several years, could in 2010 and possibly thereafter, produce unintended results.

For 2010, the most important changes to the federal transfer tax system include:

• The estate tax is repealed.
• The generation-skipping transfer ("GST") tax is repealed .
• The gift tax is retained , but the highest effective tax rate is capped at 35 %.

Each decedent will be allowed to step up the basis in her assets by $1 .3 million. A deceased spouse can provide a "step up" in basis of another $3 million for qualifying transfers to or in trust for the surviving spouse. In other words, the beneficiaries or heirs of an estate will "carry over" the decedent's income tax basis except for those limited basis amounts. This may be responsible for capital gains taxes on any appreciated property when they sell it, forcing them to go back through decades of records or brokerage statements to calculate the difference between the value of something on the date of sale compared with its original price. [See article "What's All This About Tax Basis"]

These changes apply only for 2010. EGTRRA provides that the federal estate tax system will revert to the laws that were in effect prior to the enactment in 2001 of EGTRRA, namely:

• The estate tax will return and each person will have a $1 million exemption
• The GST tax will return and each person will have a $1.3 million exemption (adjusted for inflation).
• The estate, GST and gift taxes will impose a maximum tax rate of 55 percent, with an additional five percent surtax on estates between $10,000,000 and $17,184,000.

Estates subject to federal estate taxes will receive a credit against the federal estate tax for any estate taxes paid to a state, subject to a maximum allowable credit tied to the size of the estate.

In addition to the present uncertainty of whether Congress will enact estate tax reform this year, there is also the uncertainty as to whether reform legislation would be retroactively effective to January 1, 2010. The issue of constitutionality of retroactive tax laws could be tied up in the court system.

It is very important to review all existing estate planning documents to identify any provisions that should be changed to reflect the situation in 2010. Below is a list of common drafting terms that may be present in older estate planning documents and cause problems under 2010 law.

Your Old Trust Formula Clauses.

It was the standard practice for estate planning documents to refer to specific elements of the federal estate and GST taxes. Formula clauses were blessed in authoritative texts and form books. These formula references do not make sense in 2010 when there are no federal estate or GST taxes. Examples of common formula references include:

• The smallest amount that would reduce estate tax to zero.
• The largest amount that can pass free from estate tax.
• The maximum amount that can pass free from GST tax. References to federal estate and GST terminology can also be nonsensical in absence of federal estate and GST taxes.
• "Unified credit," "estate tax exemption," "applicable exemption amount" and similar references to the estate tax credit or exemption
• Marital deduction, unlimited marital deduction and similar references to the federal estate tax marital deduction.
• GST tax exemption or then available GST tax exemption

These previously approved formula clauses and now outdated language could cause some intended beneficiaries to be disinherited and other beneficiaries to receive windfalls unless corrected.

Don't delay the review and update of your estate plans.

Employment Law Briefs

by F. Stephen Glass

Sexual Comments, Conduct May Have Created Hostile Workplace Environment

A female employee offered sufficient evidence to create triable issues as to whether her male supervisor's conduct created a sexually abusive work environment. The employee put forth evidence that the supervisor frequently made sexual comments about female employees, frequently stared at her, inappropriately touched her, described his erection and simulated masturbation in front of her. The supervisor's offensive conduct occurred on a consistent basis. As a consequence, the federal court found the supervisor's conduct was of a type that a reasonable jury could determine would make a reasonable woman in the employee's situation feel as though her working conditions were altered. Triable issues also existed as to whether the employer took corrective action in response to the employee's allegations. Mitchel v Holder, N D. CA, March 9, 2010.

Older Worker Benefits Protection Act (OWBPA) Invalidated Release That Barred Challenges To Its Validity

A discharged employee who signed a Separation Agreement and Release of Claims in exchange for a salary continuation and other benefits could still proceed with his Age Discrimination in Employment Act claims because the release at issue was invalid under the Older Worker Benefits Protection Act (OWBPA). The federal court adopted the view that a waiver is invalid if it contains provisions that could reasonably be interpreted to prohibit challenges to the validity of the waiver. Such a waiver does not meet the OWBPA requirement that it be written in a manner calculated to be understood by the individual employee. The court found that it is clear under the law that an employer must comply with all eight OWBPA requirements regardless of the employee's subjective knowledge. Bogacz v MTD Products, Inc, W.D. PA. March 9, 2010.

Monitoring Employee's Keystrokes May Have Been Unlawful

A federal trial court found that an employee who alleged that his employer unlawfully monitored his computer keystrokes in order to obtain the password to the employee's personal email account can proceed with his claim under the Electronic Communications Privacy Act. The court found that the Act is implicated when electronic communications are "intercepted" during transmission. Brahmana v. Lembo, N.D. CA, May 20,2009.

Americans with Disabilities Act (ADA) Did Not Protect Unlawful Conduct of Police Chief Fired for DUI

A police chief for an Illinois county failed to comply with workplace rules when he chose to drive while intoxicated and caused a crash that sent two people to the hospital, and thus, was not a qualified individual with a disability afforded protection under the ADA. Following the collision, he was discharged. He claimed that the district violated the ADA by firing him due to his disability (alcoholism). The federal court found that because of the accident, which constituted a violation of the county's standard operating procedure, and the resulting suspension of his driver's license, he was no longer qualified to perform his job as police chief. Due to his suspended driver's license, he could not legally operate a motor vehicle, which was an essential function of his police chief position. Thus, he was fired as a consequence of his misconduct, not discrimination. Budde v Kane County Forest Preserve, 7th Cir. COA, March 4,2010.

Former Employees Enjoined After Removing Trade Secrets

Three former employees of Agilent Company breached their employment contracts by removing property from the company's premises without permission and taking proprietary information, including trade secrets, to set up a competing company. Each of the employees had signed a confidentiality agreement requiring that they only use trade secrets and confidential information in the performance of their duties. Instead, they pursued processes and products that Agilent had researched or produced, and had taken documents related to those products. The court concluded the three employees took a great deal of confidential information in clear breach of their contractual duties and then used that information to compete against their former employer. The employees and their company were enjoined from using Agilent confidential information and were required to return all Agilent property to its possession. Agilent Technologies, Inc v Kirkland, DelChanCt: February 22, 2010.

About our authors:

M. Blen Gee, Jr. is an honors graduate of the University of North Carolina School of Law. His areas of concentration include business and corporate law, including sales of businesses; business litigation, including arbitration and mediation; franchise law; automobile dealer law; and insurance company insolvency. Mr. Gee has earned the highest peer-review rating for professional excellence and ethical standards by the national publication Martindale Hubbell.

F. Stephen Glass is the author of numerous publications on business and business entities as well as estate planning. He is a frequent presenter for the National Business Institute. His practice is concentrated in the areas of business and corporate law, business succession planning and estate planning. He serves on the Cary board of Capital Bank. Mr. Glass has earned the highest peer-review rating for professional excellence and ethical standards by the national publication Martindale Hubbell. He serves on the American Bar Association Business Law Committee on Corporate Governance.

DISCLAIMER: Johnson, Hearn, Vinegar, Gee & Glass, PLLC, provides this newsletter for general information only. The materials contained herein may not reflect the most current legal developments. Such material does not constitute legal advice, and no person should act or refrain from acting on the basis of any information contained In this newsletter without seeking appropriate legal or other professional advice on their particular circumstances. Johnson, Hearn, Vinegar, Gee & Glass, PLLC and all contributing authors expressly disclaim all liability to any person with respect to the contents of this newsletter, and with respect to any act or failure to act made in reliance on any material contained herein. Distribution of this newsletter does not create or constitute an attorney-client relationship between the firm and any reader or user of such information.