How to fight for your investment in a small business

From time-to-time we answer questions related to business law -- and this one deals with lulling, equitable estoppel, breach of contract, and fraud. Right up our alley! The petitioner wrote:

I have an affidavit of trust signed with my employer for money that I gave him 100k cash. The Affidavit of trust states that I can ask for the money back only after 6 years after his business starts which would be in 2011. I have done that several times, but each time he comes up with the excuse that the business is not doing well etc... This time I am determined -- especially now that I heard he moved to Pennsylvania, sold his house in the area, and now he is not paying rent for the restaurant where I work (we received and eviction notice). Is he going to just declare bankruptcy? What are the ways for me to get my money back?

This is a great question! We just finished a multi-year LLC/corporate lawsuit covering just these questions last week -- a major jury victory in Washington, DC. There are actually three questions in what you wrote -- and so I'll cover each briefly.

First, you need address the problem of statute of limitations. You were a bit confusing in your time frames. Did you loan this fella money which was suppose to come due in 2011? If so, you need to move very quickly, as VA has stringent guidelines regarding statute of limitations. However, if you have been trying to collect from 2011, it is entirely likely you can win on a "lulling" -- a form of equitable estoppel that stops (or "tolls") the statute of limitation clock. You'll need to talk to us more about this, but the theory is alive and well, and we won a major law suit in 2014 based on lulling. This will also play-out in bankruptcy court (see below).

Second, you asked about the money. I'm not sure what you think you signed (an "affidavit of trust" sounds very squirrely), but if it was a contract of some kind, you can sue for breach. You may also be able to sue for material misrepresentation (fraud), and fraud in the inducement (also, well...fraud). We would need to see the contract, and determine how, if at all, you are constrained by the terms. This is a good time to kick yourself for not consulting with an attorney before entering a deal involving $100K. Always, always, always spend the couple of hundred it takes to make these deals work properly in the beginning. That's too much money to rely on the signer's "good faith."

Thirdly, as for bankruptcy, it depends on what type of experience he hires for a bankruptcy attorney (i.e. their understanding of the various form of exclusions/objections to discharge of debts). A mere breach of contract won't be excluded from discharge, however, equitable tolling and possibly fraud/misrepresentation certainly can, and should be argued (we've won those, too -- so I can assure you, it works!). Challenging his potential bankruptcy requires a fight in bankruptcy court - and that is different than a fight in state court (which you would also need to do for points 1 and 2 above). This are called "multi-dimensional cases" as they involve state law cases and strategies (state court) that then bleed into bankruptcy court (federal court).

A couple of important reminders here -- remember that you need to file -asap-. This is because (a) your time is running out under the statute of limitations (presumably), but more importantly, (b) your must have a state suit underway PRIOR to his filing bankruptcy or you are largely in trouble. Although you could technically do the entire state AND bankruptcy fight in bankruptcy court, this is not the preferred method, and you should not expect a very sympathetic bankruptcy judge.

If you need help with your state claim (breach of contract, and various forms of fraud), equitable estoppel (lulling), or the bankruptcy motions to object to this fellow's discharge, give us a ring at 703-402-2723 or email admin@hanoverlawpc.com. We'd be glad to help!

Hanover Law, PC
Offices in Fairfax, VA and Washington, DC
www.hanoverlawpc.com		Lili O'connell, Esq. Abby Archer, Esq.
888 16th St., NW Ste 800 Washington, DC 20006	2751 Prosperity Ave, Ste 150 Fairfax, VA 22031	Sean R. Hanover, Esq. Stephen Salwierak, Esq.
1-800-579-9864	admin@hanoverlawpc.com	Charles Hatley, Esq.

IRS Section 1244 - Claiming Worthless Shares

What happens when you invest in a company -- large or small investment -- and the company goes belly up? Usually, you are limited to claiming a max of $3,000 against regular income (unlimited against capital gains). But what if you invested much more?

Enter 1244!

Tax code 26 USC §1244 deals with the deduction for worthless stock -- either because of mismanagement or simple bad luck. Known as "1244 stock", qualified deductions under this regulation are not limited to the capital gains deduction cap ($3K outlined above), but rather have a much higher deduction of $50,000 for individuals, and $100,000 for married couples.

To qualify for "1244" status, a company, whose stock is now worthless, must meet the following requirements:

1) The taxpayer has to be the original holder of the stock (can't inherit it, or buy it from someone else).

2) Taxpayer must be a real person (i.e., not a trust, estate, company, etc.)

3) The stock must originate from a company whose gross value (based on the value of the shares themselves) does not exceed $1 million ("small business" test). There are some qualifiers here -- stock issued for amounts invested over the $1 million threshold do not qualify for 1244 stock status (In the easiest example, if each share is worth $1, the first million shares would qualify for 1244 status; each share purchased thereafter would NOT qualify for 1244 status. If investor X held 600,000 shares (at $1), and investor Y held 500,000 shares (at $1), some portion of each set of shares would not qualify for 1244 treatment. The code states that which shares are 1244 shares should be declared if the gross investment is above $1 million; there is a formula if that fails, but it is beyond the scope of this article); also, there are computation differences when more money is put into the company, but no new shares are issued.

4) The company issuing the stock must be "largely an operating company." This is defined variously in the code, but the controlling cases are Bates v. United States, 581 F.2d 575 (6th Cir. Ohio 1978) and Crigler v. Comm'r, T.C. Memo 2003-93 (Tax Court 2003).

Most companies/taxpayors will pass the first three tests, and the last one will be a complete miss.

In Bates, the Court explains the "largely an operating company" concept. There, the plaintiffs attempted to claim $100,000 in "worthless" stock losses. BIC, the company in Bates, had never sold any product, although it worked closely with another company, National Cleveland, to develop a machine tool business, and had even sent an "employee" (who was actually the son of the owner and was never paid) to work with the other company. There was considerable development work done on ideas and prototypes. However, nothing was ever finished or produced. The Court held:

Congress created a significant tax advantage in enacting § 1244, but it was intended to have narrow application. It was not intended to provide a vehicle for favorable tax treatment of losses suffered on passive investments or investments in large enterprises. Its purpose was to offer an incentive for investment of new funds in small businesses. Other provisions limit the size of corporations which may issue section 1244 stock. The purpose of § 1244(c) (1)(E) was to prevent a mere investment entity or holding company from qualifying.

and further:

The second issue presents little difficulty. BIC never engaged in any business operations. It invested most of its resources in National Cleveland. This investment resulted in the employment of Arthur Bates by National Cleveland. Nevertheless BIC was nothing more than a holding company or vehicle for investment. (Bates at 580)

There are many ways to show that the company was largely operating, even without sales. The Court did explain that:

If National Cleveland had paid BIC for the services of either Alfred or Arthur Bates or if there had been some agreement specifying that the services were performed for National Cleveland on behalf of BIC the case would be much stronger for the taxpayers. (Bates, 580)

Other examples might be a business plan, investment in marketing and actual marketing leads, prototype deliveries and actual test deployments. In a receipt tax case Hanover Law handled, none of these factors occurred. In fact, it appears that while a few sales calls were made, and some material was produced, the thrust of the sales and marketing was fabricated (a great deal of fraud and misdirection). The moving of funds overseas further obfuscated the playing field and suggested this company was nothing more than a "holding company." The IRS is very very strick on when stock may be claimed as a 1244 writeoff. Our company did not qualify.

How do you claim "1244 shares" status on your tax return?

Complete Form 4797. 1244 losses are claimed at line 10. See: Form 4797 instructions.
Complete Form 8949 if your loss exceeded $50K (individuals) or $100K (married filing jointly). See Instructions for Form 8949

Do you have a tax question? Give us a ring or send us a note! We'll be glad to review your question and see how we can help. 703-402-2723.

Sean Hanover, Esq.
Hanover Law
www.hanoverlawpc.com
Offices in Fairfax and DC
888 16th St. NW
Washington, DC 20006