Topics included in this issue:
New Accounting Rule Applies to
Any Arrangement for Mandatory
Redemption of Stock
On May 15, 2003, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 150 – Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity (the “Statement”). The Statement established standards for how companies must classify and measure certain financial instruments in their financial statements.
Of particular concern is how the Statement classifies outstanding shares that are subject to mandatory redemption rights. According to the Statement, if a company is required to redeem shares from a shareholder upon the occurrence of some event that is “certain” to occur then the value of the redemption price must be shifted from the equity section of the company’s balance sheet to the liability section. One example of such a situation provided by the Statement is the mandatory redemption of stock upon the death of a shareholder. Because the eventual death of the shareholder is certain, the company must recognize the redemption price as a liability. Mandatory redemption of stock held by an employee upon termination of employment is another situation that will be covered by the new rule.
For example, suppose a company has three shareholders and its only asset is a piece of commercial real estate purchased 20 years ago. There is a buy and sell agreement between the company and one of the shareholders that requires the company to buy her shares upon her death (not an option). The buy and sell agreement states that the redemption price is equal to 1/3 of the value of the company. The company’s balance sheet, prepared in accordance with GAAP before the Statement, is as follows:
|
Assets |
|
Liabilities & Equity |
|
Real Estate
(at cost) |
$200,000 |
|
Mortgage Liability |
$100,000 |
|
________ |
|
Equity |
100,000 |
|
Total Assets |
$200,000 |
|
Total Liability &
Equity |
$200,000 |
After 20 years, the property is currently valued at $1,000,000. The value of the company would be approximately $900,000 (the fair value of the real estate, less the mortgage). Thus, the redemption price would be $300,000 if the shareholder died today. After applying the rules of the Statement, the balance sheet would be changed to the following:
|
Assets |
|
Liabilities & Equity |
|
Real Estate
(at cost) |
$200,000 |
|
Mortgage Liability |
$100,000 |
|
|
|
Redemption Liability |
300,000 |
|
________ |
|
Equity |
(200,000) |
|
Total Assets |
$200,000 |
|
Total Liability &
Equity |
$200,000 |
The company now shows negative equity (or negative net worth) of $200,000. This can create problems for the company if it has any agreements with banks or other third-parties that contain covenants requiring the company to maintain certain ratios. After applying the Statement, the company may be in breach of those covenants.
One solution to prevent the reclassification of mandatorily redeemable shares is to replace the mandatory redemption with a “put option” and a “call option.” Upon death, the company would have the right, but not the obligation, to call the shares and purchase them from the shareholder (or the shareholder’s estate). Likewise, upon death, the shareholder (or the shareholder’s estate) would have the right to put the shares and sell them to the company. Although probable, it is not certain that either party would exercise their respective options. Therefore, no reclassification would be required pursuant to the Statement.
The Statement is effective for public companies at the beginning of the first interim period beginning after June 15, 2003, and for nonpublic companies for the first fiscal period beginning after December 15, 2003.
Additional statements are expected from FASB regarding the classification of equity and liability. FASB expects to modify the definition of “liabilities” and address other equity characteristics, including puttable shares. The impact that these statements will have is not clear, but they could affect the put/call solution suggested in this article. Contact your WN&J attorney with questions or for assistance.
Michigan Income Tax Withholding Required by
LLCs and Other “Flow-Through Entities” On
Distributions to Non-residents
By Stephen R. Kretschman
The Michigan Legislature has passed and the Governor has signed a package of bills modifying various state tax laws. Referred to as “loophole closers,” the bills seek to raise $18.8 million, primarily by more effectively taxing non-residents. Under the legislation, “flow-through entities” will be required to withhold Michigan income tax on distributions to non-residents, effective for distributions made on or after October 1, 2003. Withholding is to be at the current rate of tax (currently 4.0%) reduced by the amount of personal and dependency exemptions of the individual allowed under the Income Tax Act, prorated based on the amount of time covered by the distribution. Flow-through entities are defined as S corporations, partnerships, limited partnerships, limited liability partnerships and limited liability companies. Non-residents can elect to be included in composite returns filed by flow-through entities. Under the legislation, withholding is required on lottery and race track winnings of non-residents. Contact Stephen Kretschman at 616.752.2124 or your WN&J attorney with questions or for assistance.
Corporate Governance Update
By Jeffrey S. Battershall
The Sarbanes-Oxley Act and the new rules adopted by the NYSE and NASDAQ stock exchanges have substantially changed corporate governance rules and practices for publicly traded companies. These new rules are also impacting the corporate governance practices of privately-owned companies. Many private companies are reviewing and adopting new or updated corporate governance items such as corporate governance policies, employee or officer codes of conduct, ethics policies, records retention policies, written indemnification arrangements, and updated bylaws. Enhanced corporate governance will be increasingly important for private companies in many respects, including raising capital, obtaining bank loans, expediting audits, securing director and officer insurance and defending government or litigation claims. If you have any questions concerning current corporate governance practices or if you have any interest in reviewing or adopting upgraded corporate governance documents, please contact us. We have assisted numerous clients in this area and would like to assist you also. Contact Jeffrey Battershall at 616.752.2169 or your WN&J attorney with questions or for assistance.
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Business Law Update is published by Warner Norcross & Judd to inform clients and friends of new developments. It is not intended as legal advice. If you need additional information on the topics in this issue, please contact your Warner Norcross attorney at 616.752.2000.