The Advisor: Helping You Manage Your Life and Legacy in Today's Complex World

This quarterly newsletter provides articles of interest, insights, and recent developments involving interdisciplinary legal topics affecting high-net worth individuals as well as family offices, trust companies, financial advisors, and similar private client service providers. We hope you find this publication informative, and we welcome your feedback on topics you'd like to read about in future publications.

Home Sweet Home—Best Practices for Hiring Household Workers

By Joshua F. Alloy, Mary Cassidy

So you and your family are planning to hire someone to work in or around your home? Whether that person is a housekeeper, nanny, gardener, chef, driver, caretaker, estate manager, or someone in any other household position, you and your family need to make sure you have done your due diligence and are properly following all relevant local, state and federal employment and tax laws. We have set forth below some general guidelines and best practices to consider—while they are by no means meant to be exhaustive, they should provide you, your accountant and your legal counsel plenty to plan for and think about.

1. Determine the Proper Relationship: Do you plan to engage a third-party company to perform the work; hire an employee through a staffing agency; retain an independent contractor; or hire an employee directly? Keep in mind that while most household workers are your employees or co-employees, if a staffing or other third-party company provides the worker and controls what work is performed and how it is performed, that worker is likely not your employee. Similarly, a worker may be an independent contractor—and not your employee—if you do not control how the work is done, and the worker provides their own tools and equipment and offers services to the general public as an independent business. Before engaging anyone as an independent contractor you should carefully consider the various independent contractor tests under tax, wage/hour and state law and consult with legal counsel.
2. Decide Whether to Use an LLC or Other Entity to Employ the Workers: Another consideration for families when hiring household workers is whether to employ those workers personally or through a family office, LLC or other entity. While there may not be significant tax benefits and the employees may remain common law employees of the family, using a corporate entity could provide important privacy protections, administrative and recordkeeping efficiencies, and greater protection against liability for injuries or property damage in certain circumstances. Make sure to discuss the pros and cons of forming a separate entity with a tax or financial advisor and your legal counsel before making any decision.
3. Proceed with Caution when Conducting Background Checks: It is a good idea to request a background check from a reputable third-party company when hiring anyone to work in or around your home. Keep in mind that a background check performed by a third party is subject to the Fair Credit Reporting Act which requires specific disclosures and authorizations. In addition, many cities and states have enacted restrictions and limitations on criminal background checks and even credit checks in some places, including whether and when such checks can be performed (e.g., only after a conditional offer of employment has been made), and when they can be relied upon to rescind an offer.
4. Document the Relationship: Make sure to put in place written offer letters or employment contracts with each worker. At a minimum, these letters should document the proper wage rate, expected hours to be worked each week, whether the employee is entitled to overtime, what employee benefits (if any) the employee is entitled to, and the at-will nature of the relationship and how it can be terminated by either party. If the contract is with a third-party staffing agency or company, carefully review the contract to ensure that the third party is responsible for complying with all laws, including with respect to wages, overtime, taxes, and other employee benefits and that there is an adequate indemnification provision in favor of you and your family.
5. Require Employees to Sign a Non-Disclosure/Confidentiality Agreement: Because household employees will be working in and around your home(s), they may learn personal and private details about you, your family members and friends, and your finances. It is critical to require each employee—at the outset of employment—to sign a Non-Disclosure/Confidentiality Agreement in which they agree to keep all such confidential and personal information private and not to disclose it to anyone else except as part of their work (with limited exceptions required by law).
6. Keep Track of Hours and Overtime: First, you will need to determine if each employee is entitled to overtime under the Fair Labor Standards Act and applicable state law. Most domestic workers are entitled to overtime when they work more than 40 hours in a week, unless they are managing part of the household or closely supervising other employees; in addition, certain live-in domestic workers may also be exempt from overtime, depending on the state. Second, make sure that all employees are paid at least the federal and local minimum wage, or the minimum salary threshold if they are exempt from overtime. Third, develop a mechanism to accurately record and track hours worked each week—some localities, like Washington, DC, require a record of the precise hours worked each day by non-exempt employees, not just the daily total.
7. Follow State and Local Law: Depending on where you live, your household employees may be entitled to a variety of additional employee benefits, including paid sick leave, payout of accrued but unused vacation, paid family or parental leave, short term disability, or daily overtime. In addition, federal as well as many state and local laws require employers to post a number of employment law notices and provide employees with a variety of additional notices and pamphlets describing their rights as workers. These notices and posters can be found online, or can be purchased through various third party providers.
8. Report Wages and Pay Federal Payroll Taxes: For each employee to whom you pay cash wages of at least (i) $2,100 in 2019, you must withhold and pay Social Security/Medicare taxes, or (ii) $1,000 in any calendar quarter in 2019, you must pay federal unemployment taxes (FUTA). You are not required to withhold federal income taxes from your employee's pay, but if you do so, you must obtain a completed Form W-4 from your employee. Social Security/Medicare taxes (employee and employer portions), federal income tax withholding and FUTA are reported each year on your Form 1040, Schedule H and are paid to the IRS when you file your Form 1040. In addition, if you are required to withhold Social Security/Medicare taxes, or you choose to withhold federal income taxes, from your employee's pay, you must issue a Form W-2 to your employee and file a copy with the Social Security Administration. In order to file Form 1040, Schedule H and issue a Form W-2, you must obtain a federal employer identification number. Many families contract with a payroll provider to handle both payroll and taxes, but you should discuss this with your financial/tax advisor.
9. Follow State Wage and Payroll Tax Rules and Obtain Workers' Compensation Insurance: You should consult with your financial/tax advisor to determine if you are required to withhold state and local income taxes and/or pay state unemployment insurance. Although workers compensation rules vary from state to state on what is required, if you employ a worker in or around the house, you should purchase workers' compensation insurance or determine if your homeowners insurance policy provides adequate coverage.

Insider Trading's Personal Benefit Test One Year After Martoma

By Andrew Bauer, Ryan White

On Monday, June 3, 2019, the Supreme Court declined to review former SAC Capital Advisors portfolio manager Mathew Martoma's 2014 conviction for insider trading. The news comes as the one-year anniversary approaches of the Second Circuit's revised opinion in Martoma's case. Martoma's conviction was part of what many have called the biggest insider trading scheme in history—spawning TV shows such as Showtime's Billions, and best-selling books such as Black Edge, by Sheelah Kolhatkar—stemming from activity in 2008 when he paid a doctor from the University of Michigan for tips about clinical trials of a potential Alzheimer's medication. Before the results of the clinical trial were announced, Martoma caused SAC Capital to enter into substantial short-sale and options trades that resulted in approximately $275 million in gains and losses avoided. Martoma's appeal is one of several recent insider trading cases attempting to provide guidance on what type of "personal benefit" an insider or tipper must receive in order to trigger insider trading liability.

The Personal Benefit Test

According to the SEC, illegal insider trading is "buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, on the basis of material, nonpublic information about the security."¹ Therefore, any successful prosecution for insider trading requires, among other things, proof that an insider/tipper breached a duty in disseminating the information to the tippee. The issue of what constitutes a breach, which was first established decades ago, has been the subject of significant litigation in recent years.

According to the Supreme Court, a breach of duty occurs when, based on objective criteria, "the insider personally will benefit, directly or indirectly, from his disclosure."² In other words, that the insider engaged in self-dealing by trading on the information or sharing it with others. For almost thirty years, courts deemed the personal benefit requirement to be satisfied if the government proved that the tipper received a benefit that was either tangible (e.g., money) or intangible (e.g., friendship).

Then, in 2014, a Court of Appeals sitting in New York sparked a new debate in U.S. v. Newman when it narrowed the definition of a personal benefit, making it harder for prosecutors to prove insider trading. The court added a requirement that there be a "meaningfully close personal relationship that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature."³ The two instances of tipping at issue in Newman—casual career advice between colleagues and a conversation between church acquaintances—did not meet that standard. Without such a benefit, the court reasoned, the insider-tippers had not breached a fiduciary duty, and the tippees could not be held liable.

Two years later, however, the Supreme Court at least partially rejected heightened burden,⁴holding that the additional requirements were inconsistent with Supreme Court precedent when information is shared with the intent to benefit a "trading relative or friend."

Then, in July 2018, the same New York Court of Appeals that shook things up in Newman upheld Martoma's conviction and, in the process, attempted to clarify the personal benefit test. The court provided a slightly more nuanced version of the test, which it said could be satisfied in one of two ways: (1) if the tipper and tippee share a quid pro quo relationship (akin to the "meaningfully close personal relationship" test in Newman), or (2) if the tipper simply intended to benefit the tippee.⁵ Regarding the latter test, the "intent to benefit" the tippee, the Martoma court likened the sharing of inside information to a tip you might give your doorman during the holidays. You and the doorman may not have a meaningful relationship (kudos if you do), but if you give him inside information for him to trade on, you clearly intended that he benefit from the information, just as you would if you had given him a cash tip. Critics, on the other hand, have argued that this new emphasis on the tipper's "intent" will all but eviscerate the personal benefit requirement entirely.

The Year Since Martoma

Earlier this year, the Second Circuit issued another decision that appears to further distance the personal benefit test from the heightened standard that was suggested in Newman almost five years ago. Rajat Gupta, a board member at Goldman Sachs who shared material, nonpublic information to a friend and business colleague Raj Rajaratnam, founder of the hedge fund family Galleon Group, appealed his conviction arguing that that the jury instructions were improper as to how personal benefit was defined and whether he had received such a benefit. The Second Circuit rejected Gupta's argument, reiterating its decision in Martoma that the personal benefit need not be pecuniary, and held that the "good relationship with a frequent business partner was consistent" within the personal benefit requirement established by the Supreme Court long ago.⁶

Prosecutors appear to have taken advantage of the relaxed requirements for satisfying the personal benefit burden. For instance, in a recent case in Florida, Brian Fettner gained access to material, non-public information regarding a potential acquisition of G&K Services by Cintas. Using that information, Fettner placed several trades on behalf of his ex-wife and a former girlfriend and persuaded his father and another friend to make trades. The SEC's complaint explicitly stated that "Fettner did not purchase G&K stock in any account of his own. He did not receive proceeds from any of the G&K trades he placed or from any of the G&K trades he persuaded others to place." While Fettner himself had no pecuniary gain from the trades, the intent to benefit the other four individuals was sufficient to satisfy the personal benefit test and establish liability.⁷

Other cases suggest that prosecutors may choose to avoid the challenges posed by the personal benefit test altogether. In March, the Court of Appeals in New York heard oral arguments in the appeal of another set of high-profile insider trading convictions in U.S. v. Blaszczak.⁸ Blaszczak and three others were convicted last year for trading on information leaked from the Center for Medicaid and Medicare Services (CMS) about how certain medical treatments would be reimbursed. In addition to those standard insider trading charges, prosecutors charged the Blaszczak defendants with Securities and Commodities Fraud, which had been enacted as part of the Sarbanes-Oxley Act of 2002 but had been seldom used to charge insider trading prior to Blaszczak. Significantly, the defendants were convicted under the new theory but acquitted on the more traditional insider trading charges. Unlike traditional insider trading, the new theory included no discussion of any breach of duty or personal benefit as an element of the crime. The Court of Appeals may choose to address this disparity between the two legal standards, so securities lawyers are staying tuned awaiting the court's decision.

Looking Forward

The 2014 decision in Newman may have created the impression that passing tips to friends and family would not create any risk of insider trading liability so long as there was no quid pro quo or financial gain. The past year has made clear, however, that is not the case. Last summer, Martoma brought some needed clarity to what triggers insider trading liability for a tipper. Since then, several court decisions have solidified (at least for the time being) that the "intent to benefit" standard will control moving forward. Thus, family and friends cannot hide behind the personal benefit test and insiders need to avoid even the appearance that they have shared material, nonpublic information with family, friends, or business associates.

In the meantime, if the Blaszczak convictions stand up on appeal, prosecutors may have an even simpler path forward that enables them to obtain convictions while side-stepping the burdens imposed by the personal benefit test. Regardless of which path prosecutors choose, all eyes remain on the that case for the next development in insider trading law.

The Other Side of the Bitcoin: Estate Planning Opportunities with Cryptocurrency

By Cara M. Koss, Corey W. Glass

Virtual currency, such as Bitcoin and other cryptocurrencies, is a relatively modern asset class with unique characteristics that present novel tax issues and potentially unfavorable tax consequences. On the other side of the Bitcoin, however, these characteristics can also present unique estate planning opportunities. This article will highlight several distinguishing features of Bitcoin, and explain how these features can be leveraged under current tax law to maximize wealth transfer planning opportunities.

Understanding Volatility

As brief background, cryptocurrencies represent a digital form of currency with no physical counterpart. Bitcoin, the most well-known cryptocurrency, has an equivalent value in "real" currency and can be digitally traded between users or converted into legal tender. The technology underlying Bitcoin, known as blockchain, allows financial transactions to be verified and recorded through a public network of participants rather than through authentication from a central banking authority. While the decentralization of information may have its benefits, the lack of government oversight or regulation may be one factor in Bitcoin's extreme volatility. In 2011, when Bitcoin was still considered to be in its early days, the price plummeted 94% in about five months, from $32 down to $2,  taking almost two years to regain those losses. In 2017, the value of one Bitcoin grew from $998 to $14,156, famously producing an investment return of 1,318%. The volatility continued, with an 85% decline over 2018, ending the year around $3,200. 2019 has seen robust gains, and is still climbing. As of the date of this article, the price is around $8,000. There are myriad other factors that may contribute to Bitcoin's wild volatility (and which are beyond the scope of this article). But we know that, at least for the foreseeable future, such volatility is a mainstay feature of Bitcoin. Understanding this volatility is critical in order to avoid any tax surprises and, in some cases, can even be used to leverage gift and estate planning opportunities. 

Bitcoin as Property

The Internal Revenue Service (IRS) has declared that for federal tax purposes, virtual currency is not treated as currency at all; rather, it is characterized as property and taxed according to the general tax principles applicable to property transactions. Like other capital assets, taxpayers acquire a cost basis when investing in Bitcoin, and the sale or exchange (e.g., as payment for goods or services) of Bitcoin will generate capital gains or losses. If the Bitcoin that was sold or exchanged was held for less than one year, any capital gain is short term capital gain and taxable at ordinary income tax rates. For example, assume you purchased a single Bitcoin in 2018 when the price was $3,200 and decided to purchase a new sofa with that Bitcoin today when the trading price is $8,000. For income tax purposes, you would be taxed as though you first sold the Bitcoin and then used the sale proceeds to purchase the sofa, realizing $4,800 of short-term capital gain, subject to federal income tax at rates imposed up to 37% and potential state tax rates up to 13.3% (California). 

Planning with Volatile Property

Generally speaking, the goal of any good estate plan is to transfer appreciating assets out of the estate so that the asset themselves—as well as all future appreciation—are outside the transfer tax system. Is Bitcoin an appropriate asset from this perspective? The volatility poses a potential opportunity if the value skyrockets again in the future. Granted, it also poses a potential risk that the value could plummet, meaning exemption has been wasted. To hedge this risk, one might consider utilizing a Grantor Retained Annuity Trust (GRAT), which is a wealth transfer strategy in which you transfer assets to the GRAT and retain the right to receive annual annuity payments equal to the present value of the assets transferred, plus an assumed rate of return set by the IRS (currently 2.8%). At the end of the term, any assets remaining in the GRAT pass to the remainder beneficiaries free of gift tax. In other words, if the contributed assets appreciate more than the assumed rate of return over the GRAT term, that amount passes to the beneficiaries free of tax; if the assets fail to appreciate by the assumed rate of return (or if they depreciate), then the GRAT simply terminates and returns the assets to you. Furthermore, if Bitcoin's value spikes during the GRAT term, Bitcoin can be "swapped" out of the GRAT in exchange for cash or other stable assets of equivalent value, thereby locking in the gains and ensuring the GRAT's success.

As discussed above, treating Bitcoin as property rather than currency can produce unfavorable income tax results. From an estate planning perspective, however, this characterization presents unique estate planning opportunities due to the way property is valued for tax purposes. Since transactions using virtual currency must be reported in US dollars, the IRS has instructed taxpayers to perform an exchange rate conversion "in a reasonable manner that is consistently applied." For gift tax purposes, the value of property traded on a public exchange (e.g., stock) is the average of the high and low quoted trading prices on the transfer date. Similar to public equities and other marketable securities, Bitcoin and many other cryptocurrencies are openly traded on public exchanges. It would therefore be reasonable to apply the same method used to value stocks to determine the fair market value of Bitcoin and other publicly traded cryptocurrencies. Given the big swings in trading prices throughout the day, this valuation approach could be leveraged to transfer the difference between the gift tax value and the actual Bitcoin price free of gift tax. For example, on April 2, 2019, trading prices for Bitcoin ranged between $4,147.70 and $5,104.42, yielding an average trading price of $4,626.06 for the day. For gift tax reporting purposes, the value of any gift of Bitcoin made on that day would be $4,626.06. Thus, if you transferred a Bitcoin to your child on April 2 at the moment when the price was $5,000, you would have transferred $373.94 free and clear of gift tax.

Until the IRS issues further guidance concerning virtual currency taxation, understanding how the tax principles governing property transactions apply to the unique characteristics of this modern asset class is crucial not only to avoid unfavorable income tax treatment, but also to identify potential wealth transfer opportunities. If you would like to learn more about tax and estate planning with your cryptocurrency investment, please contact a member of the Private Client Services group at Arnold & Porter.

© Arnold & Porter Kaye Scholer LLP 2019 All Rights Reserved. This newsletter is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.