The Lobb Report – August 2023 Business and Business Owner Updates

Authored by Mark Lobb

The August edition of the Lobb Report covers a wide range of topics for business owners from employment law to tax to asset protection.  I hope you are having a profitable summer.

The content this month is focused heavily on new employment laws in California.  A few years back I polled my clients and in order of their concerns in doing business in California were (1) employee liabilities, (2) taxation, and (3) regulatory issues.  I thought taxes would be number one, but I was wrong.  The Unions continue to dominate Sacramento legislation and it is forcing employers to automate or leave the state.  Below are discussions regarding succession planning, caste discrimination, employee onboarding, employee arbitration agreements, I-9 changes, and monetized installment sales.

Succession Planning/Taxation

ESOPs:  There was some panic over the past month about the viability of Employee Stock Ownership Plans (ESOPs) and the use of Incomplete Non-Grantor Trusts (INGs).  It is good to be concerned, but do not abandon ship.

The News Release (IR 2023-144) issued on August 9, 2023, from the IRS is not a cause to avoid consideration of implementing an ESOP or fretting because you have already sold to an ESOP.  I received some panic driven e-mail after the News Release. The IRS is going after improper valuations, abusive loans and other misdeeds which have nothing to do with legitimate ESOPs.

In the news release the Service states concerns about:

1. Valuation issues with employee stock.
2. Prohibited allocation of shares to disqualified persons.
3. Failure to follow tax law requirements for ESOP loans causing the loan to be a prohibited transaction.
4. Schemes where a business creates a “management” S corporation whose stock is wholly owned by an ESOP for the sole purpose of diverting taxable business income to the ESOP. The S corporation then provides loans to the business owners in the amount of the business income to avoid taxation of that income.

The Biden Administration and Congress are not against ESOP’s.  For instance, Congress encouraged more ESOPs last year when it passed the broad retirement plan overhaul package dubbed SECURE Act 2.0.  Under the Secure Act, the Department of Labor has launched an initiative to promote worker-owned businesses and has created the Division of Employee Ownership to support employee ownership.  The IRS is simply  trying to eliminate abuse and that is what is addressed in the News Release referenced above.

INGs: A great tool used by residents of some high tax states is the Incomplete Non-Grantor Trust.  For instance, a business owner in California would fund stock in a Nevada ING and have the ING sell the stock to a third party.  With this structure, California would not tax the proceeds from the sale of the stock.  However, in July California passed a new law (SB 131) to eliminate this tax mitigation.

Is the use of Incomplete Non-Grantor Trusts for California residents dead?  In my opinion, the answer is “no.”   Although the new law seeks to substantially limit the use of INGs, I am not convinced the text of the new law accomplishes the intent of the legislators who voted for it or the governor who signed it into law.

As written, the new statute violates the due process clause.  Taken literally, the state can tax a trust which is established by a non-resident, with a non-resident trustee and with discretionary resident beneficiaries or non-resident beneficiaries.  The United States Supreme Court in Kaestner ruled in 2019 that such a law to violates the due process protections in the Constitution.

Provisions of SB 131 relating to INGs are set forth in California Revenue and Taxation Code 17082.  The law imposes tax on INGs of a “qualified taxpayer” which is defined as “a grantor of an incomplete gift non-grantor trust.”  What if the grantor was a non-resident at the time the gifting was completed, and the trust has an independent non-resident trustee, and the distributions are discretionary?  What protections or benefits are being provided to the grantor relative to the trust or the trust itself?  Take Connecticut as a contrast.  Connecticut taxes resident trusts or estates which would exclude taxing of the trust structure described above.  I am not suggesting California would seek to tax the example trust structure set forth above, but the language in the statute seems to allow it.

Next, the plain language of the statue states that it will not tax the trust income if the trust donates 90% of its distributable net income (DNI) to a charity.  If there is nominal DNI and 90% of the nominal DNI is distributed to a charity in a year in which there is a large capital gains event, the capital gains will not be taxed by California.

I see other problems with SB 131, but the two items above are reasons why planners and clients should not completely ignore the use of INGs.  INGs also still provide tax mitigation when selling certain subchapter C corporation stock as well as asset protection.

Employment Law/Discrimination Issues

You may not think “caste” discrimination is an issue with your company.  Think again.  There is a bill which will likely become law that claims to be focused on “caste,” but goes much further and has the potential of creating a new avenue for extensive employee lawsuits for all businesses in California.

In July the California Senate approved SB 403 making “caste” a protected class within the state’s anti-discrimination statutes.  The bill was amended and approved by the California Assembly on August 10, 2023.  The bill will likely be signed into law by Governor Newsom.

Under the law, “caste” is defined as an “individual’s perceived position in a system of social stratification on the basis of inherited status,” which may be characterized by the following factors:

• The inability to alter inherited status.
• Socially enforced restrictions on marriage.
• Public and private segregation, and discrimination.
• Social exclusion on the basis of perceived status.

What does the bill mean to California employers?  Technically, under current laws including the Fair Employment and Housing Act, provisions in the Education Code, and provisions in the Civil Code, discrimination on the basis of enumerated “protected characteristics” are prohibited.  The people the bill seeks to protect are already protected.

The scope of the law seems to go far beyond caste-based discrimination.  For instance, the concept of “social exclusion on the basis of perceived status” could mean almost anything in the context of someone not socially engaging with another.  What does “perceived status” mean?  What is “social exclusion?”  There likely will be a fair amount of litigation brought as the result of the ambiguity of such terms.

California employers will need to revise their policy manuals and training programs to incorporate provisions and information regarding caste-based discrimination if and when this bill becomes law.

Employment Law/Arbitration Agreements

A recent California Court of Appeals decision (Alberto v. Cambrian Homecare) invalidated an employee arbitration agreement which an employee signed during the onboarding process.

In Alberto, the employee was required to sign a confidentiality agreement during the onboarding process along with a mandatory arbitration agreement.  The court found that the separate arbitration agreement should be read together with the confidentiality agreement in determining conscionability.  The court then held that because the confidentiality agreement was unconscionable, so too was the arbitration agreement.

What was wrong with the confidentiality agreement?  The confidentiality agreement required the following:

• The employee was required to consent to an injunction, without bond, from any court of competent jurisdiction for any violation or threatened violation of the agreement.
• The agreement also allowed the employer to receive attorneys’ fees and costs if it prevailed on an injunction, which would exclusively benefit the employer.
• The confidentiality agreement prohibited the employee from discussing wages and salary information, which is a violation of California law.
• The agreement contained a blanket waiver of Private Attorneys General Act (PAGA) claims which consisted of class and representative action waivers. The court ruled that blanket waivers of PAGA claims are unconscionable.

Employers should review all onboarding documents to ensure reasonableness and enforceability.  If one document used in the onboarding process is deemed unconscionable, the courts may well hold all documents in the onboarding process to be unenforceable.  Importantly, many employers are still requiring employees to sign non-compete agreements which are not in compliance with California law.  Such an agreement could cause the employee arbitration agreement to be invalidated.

Tax Planning: Monetized Installment Sales

IRS Proposed regulations released on August 3, 2023, identify monetized installment sale transactions and substantially similar transactions as listed transactions. A listed transaction is one in which the IRS requires to be separately disclosed because it has the potential to be a tax avoidance transaction.  Material advisors and participants in these listed transactions are required to file disclosures with the IRS and will be subject to penalties for failure to disclose.

A transaction is “substantially similar” if it is expected to obtain the same or similar type of tax consequence and is either factually similar or based on the same or similar tax strategy.

I have written about monetized instalment sales in the past as they have been listed as a part of the IRS Dirty Dozen for the past three years.  If you participated in a monetized installment sale or a transaction which may be deemed “substantially similar,” you need to consult with your tax advisors and monitor the status of the proposed regulations.

Employment Law/Prospective Employee Criminal Background Issues

On July 24, 2023, the Office of Administrative Law approved the California Civil Rights Council’s proposed modifications to the regulations applicable to employer use of criminal history.  The modifications will be effective October 1, 2023.

The regulations apply to employers.  The new regulations expand the definition of “employer” to include “any entity that evaluates an applicant’s conviction history on behalf of an employer, or acts as an agent of an employer, directly or indirectly.”

California employers should note the following:

• Employers are prohibited from requesting and using criminal history information until after a conditional offer of employment is made.
• A prohibition on requesting and using criminal history information also applies to current employees in the context of decisions regarding promotion, training, discipline, lay-off, or termination. The definition of “applicant” now includes “an existing employee who is subject to a review and consideration of criminal history because of a change in ownership, management, policy or practice.”
• Employers cannot put anything in a job advertisement or posting that indicting a person with a criminal history will not be considered.
• If information is provided by an individual about their criminal history before receiving a conditional offer, the employer may not consider the information until after deciding to make a conditional employment offer.
• The regulations exempt employers required by any state, federal, or local law to conduct criminal background checks or to restrict employment based on criminal history. The new regulations clarify the exemption applies only if the employer is required by law to conduct the background check.  The exemption does not cover an employer if a state, federal, or local law requires another entity, such as an occupational licensing board, to conduct the background check.
• Employers cannot mandate certain information and may not refuse to receive and consider any information the applicant or employee presents.
• Employers may not require individuals to disclose their status as a survivor of domestic or dating violence, sexual assault, or stalking and may not mandate that an individual produce medical records or disclose the existence of a disability or diagnosis.
• The regulations require an employer’s assessment to include consideration of the nature and gravity of the offense or conduct, the time that has passed since the offense or conduct, and the nature of the job held or sought.
• The regulations require an employer to conduct an “initial” individualized assessment before sending notice of preliminary decision.  The preliminary decision must identify the criminal history that is potentially disqualifying, include a copy of the conviction history report and any other documents that include information about the conviction and notice of the right to respond before the employer makes a final decision.
• The regulations provide examples of the types of rehabilitation or mitigating evidence an applicant or employee may provide, and that an employer must consider. An employer must consider whether “trauma, domestic or dating violence, sexual assault, stalking, human trafficking, duress, or other similar factors contributed to the offense or conduct” and whether “a disability, including but not limited to past drug addiction or mental impairment, contributed to the offense or conduct, and, if so, whether the likelihood of harm arising from similar conduct could be sufficiently mitigated or eliminated by a reasonable accommodation, or whether the disability has been mitigated or eliminated by treatment or otherwise.”
• The regulations require an employer to conduct a “reassessment” if an individual provides rehabilitation or mitigating evidence in response to the preliminary decision notice, but now includes additional factors an employer may want to consider as part of this reassessment.

The regulations continue to require an employer to advise in the final decision letter of the individual’s “right to contest the decision by filing a complaint with the Civil Rights Department.”  The regulations still do not require an employer to disclose to the applicant or employee its specific analysis of the criminal history, although an employer can choose to do so.

As an addendum to this, on August 21, 2023, the California Supreme Court ruled that an employer’s business entity agents can be held directly liable under FEHA for employment discrimination when the business entity agent has at least five employees and carries out FEHA regulated activities on behalf of an employer.  This means professional screening companies can be held liable as the employer of the person being screened.  The case is Raines v. U.S. Healthworks Medical Group.   The Raines court reiterated that under FEHA, the term “employer” includes “any person regularly employing five or more persons, or any person acting as an agent of an employer, directly or indirectly…”

The reach of employee liabilities continues to expand.  The scope of laws creating employer liability seems to grow monthly.  The definition of “employer” continues to expand beyond the immediate employer making the class of “defendants” much larger and more enticing for plaintiff lawyers to bring actions.

I hope you have a great September.  If there are certain topics you would like discussed, please let me know.