Thinking About Chartering Your Boat? Consider Forming A Limited Liability Company

[vc_row][vc_column][vc_column_text]Copyright © 2017 Law Office of Alexander T Gruft

Overview:

Chartering is a term for the “hiring” out a boat.  Some owners charter their boat on an occasional basis to help with running costs.  Others make arrangements with a charter management company to arrange bareboat and crewed yacht charters for them.  Either way, if you are thinking about chartering your boat, you should be aware of the many applicable rules and regulations if you want to avoid getting yourself in deep water.

Whatever the type of charter arrangement, chartering can expose you to significant risk if you fail to plan and take sensible precautions.

With that in mind, one option to consider is to place your boat in a limited liability company.  This article is a basic overview of how to set up an LLC.  Before you make the decision to set up an LLC, consult with an attorney or a tax professional to determine if this scenario is suitable for your situation.

The following discussion provides a general overview of the steps in setting up the LLC and the implications of having ownership of a boat in an LLC.

  1. Chose a name for your LLC. The name of your LLC must comply with the rules of your state’s LLC division (typically found within the secretary of state’s office).  While requirements differ from state to state, generally:
  • The name cannot be the same as the name of another LLC on file with the LLC office;
  • The name must end with an LLC designator, such as “Limited Liability Company” or “Limited Company,” or an abbreviation of one of these phrases (such as “LLC,” L.L.C.,” or “Ltd. Liability Co.”); and
  • The name cannot include certain words prohibited by the state, such as Bank, Insurance, Corporation or City.

Besides following your state’s LLC naming rules, you must make sure your name will not violate another company’s trademark. Typically, the name of the LLC will be the name of the owner’s boat.

Once you have found a legal and available name, you generally do not need to register it with the state.  When you file your articles of organization, your business name will be automatically registered.

  1. Where to File. Some states offer LLCs more financial advantages than others, and that means you should carefully weigh your options before filing.  Filing in your home state may be a good option for owners who have a home, physical presence (i.e. work and/or slip), and conduct the vast majority or all of their business, i.e. chartering, in their home state.  If you meet these criteria, your best option may be to file in your home state to save money annually because the LLC will not have to register as a “foreign LLC” if it conducts business in that state.  Note that “doing business” generally requires an active business presence if not a physical office.  Also, an LLC that does business in its state of filing does not need to find and pay a registered agent to represent its interests within that state.  Another popular choice for those forming an LLC continues to be Delaware.  Delaware has a solid reputation as one of the most business-friendly jurisdictions in the country. Notably, Delaware does not tax out-of-state income, which can mean an enormous tax savings for Delaware LLCs that do little or no business in the state itself.  In addition, its initial filing fees and franchise taxes are quite low.  Other favorable jurisdictions are Nevada and Wyoming.

 

  1. Filed Articles of Organization. After settling on a name, you must prepare and file “articles of organization” with your state’s LLC filing office.  While most states use the term “articles of organization” to refer to the basic document required to create an LLC, some states call it a “certificate of formation” or “certificate of organization.”  One disadvantage of forming an LLC instead of a partnership or a sole proprietorship is that you will have to pay a filing fee when you submit your articles of organization.  In most states, the fees are modest—typically around $100.  A few other states cost more.  California, for example, charges an $800 annual tax on top of its filing fee.  You will likely have to list the name and address of a person, usually one of the LLC members, who will act as the LLC’s “registered agent,” or “agent for service of process.”  The agent is the person designated to receive legal papers in any future lawsuit involving the LLC.

 

  1. Creating an LLC Operating Agreement. Even though operating agreements need not be filed with the LLC filing office and are rarely required by state law, it is essential that you create one.  In an LLC operating agreement, you set out the rules for the ownership and operation of the business.  A typical operating agreement includes:
  • The members’ percentage interest in the business;
  • The members’ rights and responsibilities;
  • The members’ voting power;
  • How profits and losses will be allocated;
  • How the LLC with be managed;
  • Rules for holding meetings and taking votes; and
  • “Buy-sell” provisions, which determine what happens if a member wants to sell his or her interest, dies, or becomes disabled.

 

  1. Liability Protection. For the LLC to provide any special protection against legal liability, the LLC must exist for a legitimate business purpose rather than simply to hold ownership in a boat.  If the boat is the company’s sole asset and the company has no business purpose, a plaintiff’s attorney may be able to “pierce the corporate veil” and pursue the members personally as if the business entity did not exist.  If a legitimate business purpose for the company exists, the LLC can act as a shield to protect your personal assets from liabilities associated with the business conducted by the LLC.
  2. Single Member LLCs. Many boat owners will be setting up an LLC with themselves, or themselves and a spouse, as the sole owner (members).  An LLC with one owner, or in a community property state with a married couple as owners, is called a single-member LLC.  A single-member LLC will be treated as a “disregarded entity” for federal income tax purposes (unless it formally elects to be treated as a corporation), and thus its profits or loss will be reported on an individual member’s Schedule C as if it were a sole proprietorship.  This will save the member time and money in connection with the preparation of income tax returns because the separate LLC entity need not file tax return.  Note however, that the member will have to use his or her own social security number when registered a boat with the United States Coast Guard unless the LLC obtains a federal Employer Identification Number.

Although the single-member LLC may be more convenient, it may undercut liability protection and allow “piercing of the corporate veil” because it is not separate entity from its owner.  To avoid this issue, you can do one of two things: (i) create at least a two-member LLC with sufficient legal documentation (including an operating agreement and annual company minutes, etc.) to reflect that the two-member LLC is indeed a separate entity and has been treated as such; or (ii) set up a holding or parent company in a state that gives the single-member LLC the same protection as a multi-member LLC (Wyoming, Nevada and Delaware) to own the LLC and require a plaintiff to fight their way through another state before getting to the single-member LLC owned by the “parent.”

  1. LLC Benefits When Selling a Boat. In California, the purchase of a corporation or an LLC that owns a boat as its sole asset is not subject to the assessment of sales or use tax.  This is because sales and use tax are not assessed on the purchase of corporate securities or the purchase of part or all of a business entity.  Also, when the business entity is sold, there is no change in the title or ownership of the company’s assets.  Since the boat is still owned by the LLC, there was no purchase or sale of the boat and nothing to assess sales or use tax against.

The owner should be aware of the step transaction doctrine.  The basic idea behind this judicially created doctrine is that the tax results of a series of steps in a transaction should be determined based on the overall transaction.  A taxing authority (the Board of Equalization in California) will scrutinize a transaction under this doctrine to determine whether an owner set up an LLC with a boat as its sole asset simply to sell the LLC a short time later to a buyer wishing to avoid sales or use tax.  To avoid this, the LLC should already have been established for a significant amount of time before the entity is sold and the entity must have a legitimate business purpose.

Owners should also be aware that the sale of an entity, as opposed to the boat itself, adds a layer of complexity to the transaction.  Many buyers are not familiar with LLC or corporations and may be hesitant to buy one with its attendant risks and potential liabilities.

  1. Transfer the Boat to the LLC. If the LLC did not purchase the boat, you will need to transfer the boat to the LLC and register it in the LLC’s name.  If the owner financed the purchase of the boat, the transfer of title from the individual owner to the LLC may trigger an acceleration clause in a promissory note or preferred mortgage.  Most notes have language stating that if any or all of the interest in the boat is transferred without the lender’s prior approval, the lender has the right to require immediate payment of the entire note balance.  In most cases, the lender has no incentive to consent to the transfer into an LLC because it would limit their recourse if you stopped paying on the loan.  Nevertheless, you should advise your lender of the transfer to avoid a default on the loan.  The lender may accept a guarantee from the individual owner to protect against the risk of having to pursue the LLC.  There is also a possible tax implication in the transfer to the LLC even though you are the sole owner of the LLC because the LLC is a separate legal entity from the owner.  This will depend on a myriad of different factors and is a good reason to have an attorney or tax professional assist with the transfer.
  2. While an LLC may provide some liability protection, there is no substitute for adequate insurance on the boat to protect your assets.  There are many forms of insurance applicable to the marine industry.  Hull insurance is written with the expectation of insuring the hull of the vessel.  One provision of a hull insurance policy, dealing with “constructive total loss”, is of particular interest. In the event of a total loss of the vessel, the hull insurance will pay off either the “stipulated value” if it is an agreed or stipulated value policy, or the “fair market value” of the vessel as determined according to proof.  However, if the vessel is not totally destroyed but the cost of repair or restoration would exceed some specified percentage of the agreed or stipulated value of the vessel at the time of loss, then it is deemed a constructive total loss and the entire proceeds of the policy are payable.  Some policies provide that payoff in the event of constructive total loss is an option at the discretion of the underwriter and that the underwriter may elect to repair.  That provision can create a conflict between the insured and the underwriter particularly if there is major damage which will require substantial time to repair.

The protection and indemnity insurance form, or “P & I” as it is more commonly called, is equivalent to the general liability form of policy on automobiles. Like the hull policy, the P & I policy should be read carefully and any question about its contents or the meaning of its paragraphs should be addressed to competent insurance brokers.  Like the hull policy form, the P & I form is interpreted through a great deal of history and therefore should be carefully read and understood since some of its clauses do not necessarily mean what they appear to say on their face.  If the yacht owner employs crew or is engaged in passenger carrying operations, the yacht owner must be careful to ensure that there are adequate liability insurance coverages for passengers and crew members. Because of the high cost of seaman injury claims, employing crew members will undoubtedly adjust premiums rates considerably.  Passenger carrying activity will also adjust insurance rates.  The vessel owner should be certain that all conditions of the policy are met.  Any unsatisfied condition may give rise to a policy which is not of any force and effect or may be voidable at the election of the underwriter.  Insurance forms and terminology can be confusing so it is important that a yacht owner consult with a broker and/or attorney to ensure a clear understanding of the risks that are covered by the particular policy.[/vc_column_text][/vc_column][/vc_row]

5 Things To Know Before Buying A Boat

[vc_row][vc_column][vc_column_text]Copyright © 2016 Law Office of Alexander T Gruft

Many boaters have years of experience on the water and even the most novice boater has some practical experience with boating. But just like the language of boats and boating is different from that of the land and landsmen, so is the legal landscape of buying a boat different from the practical realities of being a boatman. There is no doubt that being an excellent boater should be of primary consideration for boat owners.  But no matter how skilled a boater is, he or she must understand the technicalities of buying a pleasure craft in order to fully appreciate boat ownership.

Use A Yacht Broker

When buying a boat, the right broker can reduce stress and make the transaction go
smoothly and painlessly.  Yacht brokers play a major role in facilitating the transactions between seller and purchaser in a yacht transaction.  Brokers obtain the listings for the vessel or represent the manufacturer, advertise the listing, solicit the buyers, assist in the financing of the yacht and guide the parties through the closing.  Often the broker’s services go beyond these charges and he or she may aid the buyer in repair or maintenance or adding equipment and may locate berthing or other services.  Brokers are usually the most knowledgeable in a given area for understanding yachting activities and practices.

California law requires the licensing of brokers selling yachts 16 feet or more in length and under 300 gross tons.  However, licensing does not insure that the person with whom you are dealing is either honest or well qualified.  Before engaging the services of a yacht brokers and salesperson, a seller or prospective purchaser should contact the California Division of Boating and Waterways, Yacht and Ship Broker Licensing to determine whether the particular broker or salesperson has been the subject of any complaints or discipline proceedings. Information regarding licensing can be found here: http://dbw.ca.gov/Yns/Yacht.aspx.

Brokers are compensated by commissions.  A percentage of the sale price is paid to
the broker after the successful completion of the sale transaction.  Brokerage commissions vary somewhat among the major boating regions in the U.S.  For the most part, commissions tend to range from 6 percent to 10 percent of the selling price depending on the size of the vessel.

A broker has a duty to disclose known conditions of the vessel.  A yacht broker who
willfully fails to disclose a known defect or condition of a vessel to a prospective purchaser may be just as liable as the owner of the vessel for restitution or repair.

Check The Title and Get Seller’s Assurance Regarding Liens and Encumbrances

There are many issues that a purchaser should be aware of regarding the title to a vessel. Specifically, that a purchaser of a vessel takes that vessel with all maritime liens and encumbrances whether known or unknown. A lien is a cloud on title and may restrict the free transferability of recreational vessels.  Liens are generally burdens on the vessel. That is, they represent amounts owed to others which may arise out of contract or tort such as the repairs of vessels, provisioning of vessels, salvaging of vessels or maritime collision or maritime personal injury. A lien can arise by operation of law without any formal writing and most maritime liens are secret in that there is no recording required.  In some cases, the vessel owner may not know of their existence. An encumbrance, on the other hand, generally refers to mortgages or security interests created by written agreements. A preferred maritime mortgage may be an
encumbrance on a documented vessel.  A state registered vessel may be encumbered by a security interest.

Before purchasing a vessel, the prospective purchaser should obtain an Abstract of Title from the U.S. Coast Guard National Vessel Documentation Center. The Abstract of Title should identify any mortgages or claims of lien recorded with the Coast Guard. However, because some liens are secret, the Abstract of Title may not accurately represent all existing liens on the vessel.  A purchaser should require, and almost all boat transactions include, a representation from the sell that the vessel is free and clear of all liens and encumbrances.

For the most part, there is no way to assure the purchaser that the vessel is being purchased lien free.  Unlike real property there are no title insurance companies nor are there mandatory requirements for recording maritime liens.  Therefore, the only means by which a purchaser is assured of a lien free vessel is by the representation of the seller that the vessel is free and clear of all known liens and encumbrances.  A purchaser should, to the extent possible, check with those who may have performed work or provided services to the vessel or with whom the vessel’s owner was dealing in the months preceding the sale.  Additionally, the purchase should demand written assurance that the seller will indemnify the buyer against all claims that may be brought against the purchaser for liens that prior to the sale.

You May Not Have to Pay Sales Tax

“Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the treasury. There is not even a patriotic duty to increase one’s taxes. Over and over again the Courts have said that there is nothing sinister in so arranging affairs as to keep taxes as low as possible. Everyone does it, rich and poor alike and all do right, for nobody owes any public duty to pay more than the law demands.” Judge Learned Hand, Gregory v. Helvering, 69 F.2d 809, 810 (2d Cir. 1934).

California imposes two types of taxes on the sale and purchase of property, including vessels – sales and use tax. The distinction between the two is often confusing. Sales tax is imposed on the sale of property, whereas use tax is imposed on the use or storage of property in California. Generally, California will not impose both taxes on the same transaction. That is, for example, purchasing a vessel in California may require the imposition of a sales tax, but the purchaser’s continued use of the vessel in California does not require a use tax.

Property purchased for use outside of California is not considered purchased in California. California imposes a presumption that property purchased outside of California, which is first functionally used outside of California, and then remains outside of California for the first 12 months is purchased with the intent not to use the property in California. Stated differently, if the vessel is purchased out of California and is brought into California within 12 months from the date of its purchase, it is rebuttably presumed that the vessel was acquired for use in California and thus subject to use tax. The 12 months excludes any period the vessel is in California exclusively for warranty or repair service and is California for that purpose for 30 days or less.

In order to take advantage of the tax exemption, the buyer must follow very specific rules and not appear to intend to bring the vessel back to California, or appear to be keeping it out of California specifically to avoid the sales tax.  A crucial first step is to perform an offshore delivery.

A yacht broker should be able to assist with this and the offshore delivery should be specifically provided for in the purchase agreement. Generally, the vessel will be taken at least three miles off shore into international waters. The location of the vessel at the time of delivery will be documented by taking pictures of the GPS location, the day’s newspaper to verify the date and execution of the closing documents. The vessel will then be brought back into California for provisioning before it is taken outside of California shortly thereafter. The owner should keep all records of usage out of state to verify the vessel was used out of state and not simply stored. If a boat purchaser can follow these guideline he or she may be able to successfully avoid use tax in California.  We strongly recommend using an attorney to insure compliance with California and federal tax laws.

Insuring Your Purchase

There are many forms of insurance applicable to the marine industry. Hull insurance is written with the expectation of insuring the hulls of the vessel. One provision of a hull insurance policy, dealing with “constructive total loss”, is of particular interest. In the event of a total loss of the vessel, the hull insurance will pay off either the “stipulated value” if it is an agreed or stipulated value policy, or the “fair market value” of the vessel as determined according to proof. However, if the vessel is not totally destroyed but the cost of repair or restoration would exceed fifty percent of the agreed or stipulated value of the vessel at the time of loss, then it is deemed a constructive total loss and the entire proceeds of the policy are payable. Some policies provide that payoff in the event of constructive total loss is an option at the discretion of the underwriter and that the underwriter may elect to repair. That provision can create a conflict between the insured and the underwriter particularly if there is major damage which will require substantial time to repair.

The protection and indemnity insurance form or “P & I” as it is more commonly called is equivalent to the general liability form of policy on automobiles. Like the hull policy, the P & I policy should be read carefully and any question about its contents or the meaning of its paragraphs should be addressed to competent insurance brokers. Like the hull policy form, the P & I form is interpreted through a great deal of history and therefore should be carefully read and understood since some of its clauses do not necessarily mean what they purport to say on their face. If the yacht owner employs crew or is engaged in passenger carrying operations, the yacht owner must be careful to ensure that there are adequate insurance coverages for passengers and crew members. Because of the high cost of seaman injury claims, employing crew members will undoubtedly adjust premiums rates considerably. Additionally, passenger carrying activity will also adjust insurance rates. The vessel owner should be certain that all conditions of the policy are met. Any unsatisfied condition may give rise to a policy which is not of any force and effect or may be voidable at the election of the underwriter. Insurance forms and terminology can be confusing so it is important that a yacht owner consult with a broker and/or attorney to ensure a clear understanding of the risks that are covered by the particular policy.

Making It Official

Recreational boat owners in the U.S. are required to either register their vessels with their respective state governments or document their vessels with the U.S. Coast Guard. Under current federal law any vessel over five tons net is eligible to be documented as a pleasure with the United States Coast Guard. These same vessels, and vessels under five tons net, may be registered in accordance with the laws of the state in which the owner resides.

Assuming a vessel is eligible for federal documentation, there are several reasons why an owner may chose documentation over state registration. If an owner travels to foreign waters, the Coast Guard issued Certificate of Documentation facilitates clearance with foreign governments and provides certain protection by the U.S. flag. It may be easier to obtain a bank loan to finance a vessel if it is documented. The lender will generally want to record a preferred ship mortgage with the Coast Guard to perfect its lien. The mortgage is enforceable throughout the U.S., its territories and some foreign countries. Once documented, the vessel stays documented for the life of the vessel. Thus, if the vessel is sold the new owner needs simply to update the documentation information by filling out paperwork for the Coast Guard and paying a fee. The vessel’s documentation number will remain the same. There is an annual documentation update form required by the Coast Guard, but this is automatically sent to the owner 45 days in advance of annual expiration and there are no further fees involved.

Generally, the Coast Guard standard Bill of Sale is sufficient to pass title if properly
completed and executed. The Bill of Sale is not effective until filed with the Coast Guard National Vessel Documentation Center (“NVDC”). A standard Bill of Sale and other forms related to documentation are available from the NVDC here:
http://www.uscg.mil/nvdc/nvdcforms.asp.

This is a very general discussion of purchasing a vessel and vessel ownership. Each
section has a multitude of variations, specific requirements and hidden pitfalls. We always suggest that anyone interested in purchasing a vessel seeks the advice of counsel to help navigate through this complex, yet rewarding, process.[/vc_column_text][/vc_column][/vc_row]

Horiike v. Coldwell Banker (Cal. Ct. App. – April 9, 2014) And Its Implications On A Yacht Broker’s Fiduciary Duties

[vc_row][vc_column][vc_column_text]Copyright © 2014 Law Office of Alexander T Gruft

California cases have often analogized between yacht brokers and real estate brokers with respect to the fiduciary duties they owe to their respective clients.  As such, yacht brokers and salespersons should take note of a recent California Court of Appeal decision which held that where two real estate agents who work for the same broker represent the seller and buyer, respectively, the broker is the dual agent of both the seller and buyer.  As the dual agent, the broker, and its salespersons, owe a fiduciary duty to both the seller and buyer.  Horiike v. Colwell Banker Residential Brokerage Company (Cal. Ct. App. – April 9, 2014).

The case arose out of a real estate transaction involving a home in Malibu, California.  The buyer claimed that the listing agent, an employee of Coldwell Banker, misrepresented the square footage of the home.  The buyer was represented by a licensed associate also of Coldwell Banker.  After discovering the discrepancy in the square footage, the buyer sued Coldwell Banker and the listing agent for breach of fiduciary duty and intentional and negligent misrepresentation.

The Court of Appeal held that because the listing agent and the buyer’s agent were both Coldwell Banker employees, Coldwell Banker was the dual agent for the both the buyer and the seller and owed both a fiduciary duty of “the highest good faith and undivided service and loyalty.”  The court further held that the listing agent owed an equivalent duty to the buyer because he acted on behalf of Coldwell Banker.

Yacht brokers who represent the buyer and seller in a transaction are legally obligated to fully disclose the dual agency to both clients and obtain their written consent.  Therefore, Horiike has important implications for yacht brokers whose salespersons represent both the buyer and seller.   The case makes it clear that if two different agents represent the buyer and seller, there is a dual agency when both agents work for the same broker.  As such, full disclosure and informed written consent is a must in such situations.[/vc_column_text][/vc_column][/vc_row]

Vessel Owners Beware – You May Not Have To Pay That Property Tax Bill

[vc_row][vc_column][vc_column_text]Copyright © 2013 Law Office of Alexander T Gruft

In these troubled economic times, counties are becoming more aggressive in their assessments of personal property.  This is particularly true with respect to unsecured tax assessments of vessels.  Vessel owners may receive tax bills based on a county assessor’s erroneous information regarding the vessel’s location or because the vessel was in California only temporarily.  The purpose of this article is to discuss one ground for cancelling an unsecured tax assessment against a vessel – lack of tax situs.

Unless otherwise exempt under California or federal law, all property, including vessels, is taxable.  Cal. Constit., Art. 13, § 1; Cal. Rev. & Tax. Code § 401.3.  All property subject to tax shall be assessed in the jurisdiction in which it is situated.  Cal. Constit., Art. 13, § 14.  According to the Assessor’s Handbook, published by the California Board of Equalization, “situated” connotes a more or less permanent location or situs.  Thus, a vessel will earn tax situs when it is kept or maintained in the county on more than a casual or transitory basis.  This includes habitual moorage at a California location, or regularly plying California waters.

Situs, the place where property is legally situated, is, therefore, one of the essential factors for a valid assessment.  Generally, because of its movable nature, vessels do not have a fixed situs.  It is the county assessor’s obligation to determine that  a vessel has established a situs in the county for the tax year before assessing property tax.

For property tax purposes, a vessel’s taxable situs is established on the January 1 lien date.  Cal. Rev. & Tax. Code §§ 401.3, 2192.  If the vessel is in the county on January 1, it will be considered to have a taxable situs in the county and it will be assessed for the tax year.  If the vessel is outside of the county on January 1 it will not be assessable unless it has otherwise established a more or less permanent presence in the county.

Unfortunately, counties tend to base the determination of situs on inaccurate information resulting in the burden shifting to the taxpayer to establish a lack of situs.   Counties rely on information from the California Department of Motor Vehicles or the United States Coast Guard.  These agencies are backlogged in their paperwork and recent sale information or amendments to a vessel’s Certificate of Documentation may not be readily available.  Marinas are also a source of information.  But slip rental does not necessarily equate with the vessel’s presence in the county.  Further, a vessel may be only temporarily moored in a “Port of Convenience” on the first of the year for refueling or minor maintenance before continuing its cruise elsewhere.  A deputy assessor may also physically search marinas asking questions of persons on or around vessels.  An erroneous assessment could , therefore, be based on a thin discussion between the deputy assessor and a novice crew member who has little understanding of “lien dates” or the vessel’s itinerary.

Clearly, vessel assessments are not black and white and a vessel owner must know how to avoid an assessment and his or her rights when faced with an assessment.  Remaining outside of California waters on January 1 is a prerequisite.  Although a vessel’s home port, identified on a Certificate of Documentation, is not determinative of situs, a location outside of California should be listed.  Stops in California should be kept to a minimum.  Visiting a California county to refuel, restock provisions and undergo repairs and maintenance will not result in tax situs if the length of the visit is only for as long as necessary to complete the vessel’s mission and all other indicia do not point to “habitual moorage” in California.  It is also persuasive if the vessel has established a situs in an alternative jurisdiction even if the alternative jurisdiction does not have a property tax.

Maintaining a vessel log with regular entries showing the vessel’s itinerary is crucial.  It is also advisable to maintain receipts for gas, repairs and maintenance, lodging and moorings, and evidence of customs importation permits.  The owner should be proactive upon receipt of a tax bill.  Contacting the assessor’s office to determine the basis of the assessment and offering to provide the assessor with evidence of an alternative situs will result in a quicker cancellation and possibly eliminate the need to pay the tax before the payment deadline.

If informal discussions with the assessor’s office do not result in cancellation of the tax bill, the taxpayer must file an appeal with the county.  The appeal is initiated by the taxpayer filing an Application for Changed Assessment.  For regular assessments, the Application must be filed between July 2 and September 15.   Appeals of supplemental assessments and escape assessments must be filed with the county within sixty days of the mailing date shown on the tax bill.

Filing an appeal does not excuse the taxpayer’s obligation to pay the tax by the deadline stated in the tax bill.  The taxpayer is still responsible for timely payment of the tax.  See Cal. Constit., article XIII, § 32; Pacific Gas & Electric Co. v. State Bd. of Equalization (1980) 27 Cal.3d 277.  Failure to pay the tax on time will result in a 10% penalty, additional late fees and a tax lien.

One last point bears mentioning.  Many owners wonder whether they are liable for property tax if they sell the vessel during the year.  They are unless other arrangements are made with the buyer.  The owner of personal property as of January 1st is responsible for the unsecured tax bill.  Sale of the property after the January 1st lien date will not affect the tax bill and taxes will not be prorated due to the sale of the vessel after the lien date.  Therefore any vessel sale agreement should include, among other things, a provision providing for the proration of property tax between the seller and buyer.  It would be unsettling, to say the least, for a former owner to receive a tax bill mid-year and to realize he alone is responsible for the taxes for the coming fiscal year.

Taxes are a fact of life.  But as Judge Learned Hand stated, “Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the treasury.  There is not even a patriotic duty to increase one’s taxes.”  Gregory v. Helvering 69 F.2d 809, 810 (2d Cir. 1934).  Attention to these key elements regarding situs can help a vessel owner keep his or her taxes as low as possible.

IRS CIRCULAR 230 DISCLOSURE: To ensure compliance with IRS requirements, we inform you that any tax advice contained in this communication was not intended or rendered, and cannot be used to: (i) avoid penalties under the Internal Revenue Code; and/or (ii) promote, market or recommend to anyone else anything the communication addresses.

This article is distributed with the understanding that Wright & L’Estrange is not providing legal, or other professional advice. Facts and circumstances differ among taxpayers and you should contact our firm to discuss the specifics of your situation and how they may apply to information presented here.[/vc_column_text][/vc_column][/vc_row]

Foreclosing On Mixed Collateral In Federal Court: Tips For Lenders Foreclosing On Vessels and Real Property In A Single Action

[vc_row][vc_column][vc_column_text]Copyright © 2013 Law Office of Alexander T Gruft

Overview:

Despite tough economic times, U.S. boat sales are on the rise.  According to Soldboats.com, between January and August 2013, 23,488 boats have been sold throughout the U.S.  This is an increase of 4 percent from the same period in 2012.  For the year through August the aggregate price of all boats sold was 25 percent higher than in 2012, with $2.8 billion changing hands.[1]

Many, if not most, of these purchases are facilitated with a single loan secured by a preferred mortgage[2] covering the vessel.  Additionally, the lender may require other collateral to secure the loan such as a trust deed covering real estate owned by the borrower.  This article explores the “mixed collateral” situation where a borrower defaults on a loan secured by both a vessel and real property and the lender wishes to foreclose on both collateral while preserving its rights to a deficiency judgment against the borrower.  This article discusses California’s one-action/security-first rule and the pitfalls and procedures lenders must be aware of when it pursues mixed collateral in federal court.[3]

ONE ACTION RULE

California Code of Civil Procedure § 726, commonly referred to as either the security first rule or One Action Rule, requires a secured creditor to first exhaust all of its security in a single foreclosure action before it can obtain a monetary deficiency judgment against the debtor personally.[4]

Section 726 mandates that a secured creditor (1) foreclose on its security and obtain a judgment before proceeding directly on the note, (2) include all of the security in a single judicial foreclosure action, and (3) refrain from exercising self-help remedies after a debtor’s default.[5]

The borrower can raise the rule as a defense thereby requiring the creditor to amend its complaint to include all of its security in the action before it can obtain a money judgment against the debtor.  But even if not raised as a defense, the rule will still act as a sanction: once the creditor obtains a judgment, it will be precluded from foreclosing on any security not included in the foreclosure action.[6]

The One Action Rule does not prohibit a creditor from pursuing nonjudicial foreclosure before resorting to additional security because a nonjudicial foreclosure is not considered an “action” within the meaning of section 726 of the Code of Civil Procedure.[7]  In fact, a creditor may pursue its remedies of a judicial and trustee’s sale alternatively or concurrently.[8]  But by pursuing a trustee’s sale to conclusion, the creditor forfeits its right to a deficiency judgment against the borrower.[9]

MIXED COLLATERAL

Prior to California’s adoption of the mixed collateral statute[10], section 726 applied to any debt secured by a mortgage on real or personal property so that there could only be one form of action for the recovery of debt whether the debt was secured solely by real property, solely by personal property, or by both real and personal property.[11]

Pursuant to the Mixed Collateral Statute, where a single debt is secured by both real and personal property, special “mixed collateral” rules apply.[12]  California Commercial Code section 9604 provides two methods for selling mixed collateral – a nonunified sale and a unified sale.  In a nonunified sale, a lender holding both real and personal property collateral may elect to proceed, in any sequence, to either: (a) foreclose on the real property in accordance with the rights and remedies respecting foreclosure of real property; or (b) foreclose on the personal property in accordance with the rights and remedies under the Commercial Code.[13]  The One Action Rule does not apply to the personal property component where the personal property is foreclosed separate from the real property.[14]

Alternatively, the lender may sell closely-related real and personal property as a single unit in a “unified sale.”[15]  In a unified sale, the foreclosure is governed entirely by statutes applicable to real property collateral.[16]

Given the Mixed Collateral Statute, what are the lender’s options? There is no indication that section 9604 applies in situations other than those covered by the Commercial Code.  And Division 9 of the Commercial Code does not apply to the extent that a statute of the United States preempts it, and federal courts have exclusive jurisdiction to enforce a ship mortgage.[17]  But even if section 9604 was applicable, the lender would still be required to pursue both forms of collateral in a federal action – the lender is thrust into federal court by virtue of the federal court’s exclusive admiralty jurisdiction, and the lender’s desire for a deficiency judgment bars resort to a nonjudicial sale of the real property.[18]   To exclude the real property in the federal action would run afoul of the One Action Rule.

PROCEEDING IN FEDERAL COURT

It is against this background that the lender must navigate when foreclosing on a vessel.  The lender must proceed with caution to preserve its security in the real property and its right to a deficiency judgment against the borrower.  It is beyond the scope of this article to discuss the advantages and disadvantages of a judicial foreclosure of a vessel.[19]

We will assume that a judicial foreclosure is the best (and only) option for the lender because the vessel is in the judicial district and thus subject to federal jurisdiction, the value of the vessel exceeds the likely return from a distressed sale, and the lender desires to maximize the sale price by extinguishing other valid maritime liens against the vessel.[20]

Federal courts have exclusive jurisdiction to enforce maritime liens, including preferred mortgages.[21]  Under the federal Commercial Instrument and Maritime Liens Act, the lien holder has the right to arrest the vessel, have it sold, and be repaid the debt from the proceeds.[22]

Thus, the lender’s only option for judicial foreclosure on the vessel is to proceed in federal court.  Once a decision is made to arrest the vessel, counsel must prepare a complaint “in rem”, i.e., against the vessel.[23]   Drafting the complaint requires careful attention to the One Action Rule.  The lender must foreclose all of its security in a single action.  Therefore, the complaint must include separate claims for relief for foreclosure of the vessel and foreclosure of the real property.[24]  The lender cannot obtain a money judgment against the borrower individually except for a deficiency judgment following foreclosure.

Because of the expenses inherent in keeping a vessel under the custody of the court and the inevitable deterioration of the vessel as it sits during the litigation, the federal rules permit an interlocutory sale of the vessel.[25]  An interlocutory sale is a sale before the completion of the litigation and the entering of a judgment.  The sale typically occurs three to five months after the filing of the complaint.  Any sale proceeds, less expenses incurred for the keeping of the vessel and fees to the U.S. Marshal, are substituted for the vessel and deposited into the registry of the court pending final outcome of the litigation.[26]

Once the vessel is sold, the lender should consider moving for summary judgment on the foreclosure claims to reduce litigation costs and to conclude the action.[27]  If money is deposited with the court, a judgment of foreclosure may be necessary before the court orders a release of the funds.[28]

PREPARING THE JUDGMENT

The form of judgment in the federal court should include a judgment for foreclosure against the vessel and the lender’s entitlement to any sale proceeds.  It should also include a decree of foreclosure of a mortgage under Code of Civil Procedure section 726(b) as to the real property.[29]  The decree of foreclosure should direct the sale of the real property, determine the amount to be paid to the lender, determine the personal liability of any defendants, name the defendants against whom a deficiency judgment may be ordered, provide that the property is subject to a right of redemption, and that the court retains jurisdiction to determine the amount of any deficiency.[30]

The judgment is not a money judgment or a judgment for damages.  Only after the court determines that a deficiency remains on the obligation will the court render a deficiency judgment against the borrower.[31]  Although counsel should be aware of the fair market value deficiency rules applicable to nonjudicial foreclosures[32] and judicial foreclosures,[33] those rules likely will not apply in the admiralty proceeding.  Under the Mixed Collateral Statute, the “fair value” limitation applies to deficiency judgments only where the mixed collateral is sold as a unit and the sale is governed by real property law and not the Commercial Code.[34]  Further, the federal court will have already made a fair value determination as part of the sale confirmation immediately after the interlocutory sale.[35]

CONCLUSION

Given the surge in vessel sales and vessel prices, there is likely to be an increase in loans secured by both a vessel and real property.  Unfortunately, it is only when the borrower defaults that the lender realizes the potential minefield involved with foreclosing on mixed collateral.  In practice, lenders and their counsel will have to act fast to initiate a federal court action against the vessel and secure its arrest.  They also must be wary of the One Action Rule and the Mixed Collateral Statute or risk forfeiting their real property security and a potential deficiency judgment against the borrower.[36]

[1] John Burnham, Brokerage Sales Exceed 3,000 for Fifth Month In Row (Sept. 30, 2013), http://www.tradeonlytoday.com.

[2] A preferred mortgage is a mortgage recorded against a vessel documented with the United States Coast Guard.  It is protected under the Commercial Instruments and Maritime Liens Act (formally the Ship’s Mortgage Act of 1920) (46 U.S.C. §§31301-31343), and takes precedence over all liens other than preferred maritime liens.  46 U.S.C. §§ 31301(6), 31322, 31326; Maryland Nat’l. Bank v. Vessel Madam Chapel, 46 F.3d 895, 898-899 (9th Cir. 1995).

[3] This article focuses on proceedings in federal court because the federal court’s jurisdiction over foreclosure of preferred ship mortgages is exclusive of state courts.  See, supra, note 20.

[4] Bank of America, N.A. v. Roberts, 217 Cal.App.4th 1386, 1396 (2013); In re Kearns, 314 B.R. 819, 822 (2004).

[5] Walker v. Community Bank, 10 Cal.3d 729, 733-734 (1974).

[6] Security Pacific National Bank v. Wozab, 51 Cal.3d 991, 1004-1005 (1990); Shin v. Superior Court, 26 Cal.App.4th 542, 547 (1994) (Korean action including a writ of attachment on unencumbered property violates the “multiplicity of actions” aspect of the “one form of action” rule).

[7] Western Security Bank v. Superior Court, 15 Cal.4th 232, 252 (1997) (stating that a creditor that resorts to additional security nonjudicially “does no more than call on all the security pledged for the debt”); Coppola v. Superior Court, 211 Cal.App.3d 848, 866 (1989) (creditor secured by a trust deed on real property may recover full amount of debt upon default through three mutually exclusive remedies: suit for a personal judgment on the full amount of the debt; private trustee sale; or action for judicial foreclosure).

[8] Oxford Street Properties, LLC v. Rehabilitation Associates, LLC, 206 Cal.App.4th 296, 304 n. 3 (2012).

[9] Cal. Civ. Proc. Code § 580d; Oxford Street Properties, LLC, 206 Cal.App.4th at 304 n. 3; Coppola, 211 Cal.App.3d at 866.

[10] Cal. Com. Code § 9604 (formerly Cal. Com. Code § 9501(4)).

[11] Walker, 10 Cal.3d at 734; O’Neil v. General Security Corp., 4 Cal.App.4th 587, 597 (1992).

[12] Cal. Com. Code § 9604; Florio v. Lau, 68 Cal.App.4th 637, 644-645 (1989).

[13] Cal. Com. Code § 9604(a)(1)(A).

[14] Cal. Com. Code § 9604(a)(2)(A); Cal. Civ. Proc. Code § 726; Oxford Street Properties, LLC, 206 Cal.App.4th at 304 n. 4.

[15] Cal. Com. Code § 9604(a)(1)(B); Aspen Enterprises, Inc. v. Bodge, 37 Cal.App.4th 1811, 1818-1819 (1995) (interpreting “unified foreclosure” under predecessor statute as applying “only where a debt is secured by collateral which consists of closely related elements of real property and personal property, such as business premises plus the fixtures and inventory of the business located on the premises.”).

[16] Cal. Com. Code § 9604(a)(1)(B); Florio, 68 Cal.App.4th at 642.

[17] Cal. Com. Code § 9109(c)(1); Detroit Trust Co. v. The Thomas Barlum, 293 U.S. 21, 42 (1934) (“If a mortgage is within the [ship mortgage] Act, there can be no suit to foreclose it in a state court; if the mortgage is not within the Act, there can be no suit for foreclosure in the admiralty.”); Crimson Yachts, et al. v. Betty Lyn II Motor Yacht, et al., 2010 A.M.C. 1414, 1417, 603 F.3d 864 (11th Cir. 2010) (“[a]n in rem suit against a vessel is…distinctively an admiralty proceeding, and is hence within the exclusive province of the federal courts.”).

[18] Cal. Civ. Proc. Code § 580d; Coppola, 211 Cal.App.3d at 866.

[19]  Bank of America National Trust & Savings Association v. Fogle, 637 F.Supp. 305 (N.D. Cal. 1985) (barring lender from seeking a deficiency against borrowers after private, nonjudicial sale because federal law provides exclusive means to foreclose ship mortgage).  But see, Dietrich v. Key Bank, N.A., 72 F.3d 1509 (11th Cir. 1996) (holding that parties to a ship’s mortgage could agree to incorporate self-help provisions in mortgage) and comments in the Congressional Record related to the 1996 amendment to 46 U.S.C. § 31325(b)(3) stating, “Section 1124(a) of the Senate bill adds a new paragraph (3) to section 31325(b) … to clarify that the remedies currently available under section 31325(b) do not preclude the exercise of other lawful rights and remedies available to mortgagees, including extrajudicial, “self-help” remedies.”  142 Cong. Rec. H.11485-02, 11522.

[20] 46 U.S.C. 31326(a) (“When a vessel is sold by order of a district court in a civil action in rem brought to enforce a preferred mortgage lien or a maritime lien, any claim in the vessel existing on the date of sale is terminated….”); HGN Corp. v. Vessel Coinseco Alfa, 1985 A.M.C. 1083, 1087 (S.D. Cal. 1984).

[21] Detroit Trust Co., 293 U.S. at 42 (“If a mortgage is within the [ship mortgage] Act, there can be no suit to foreclose it in a state court; if the mortgage is not within the Act, there can be no suit for foreclosure in the admiralty.”);Crimson Yachts, et al., 2010 A.M.C. at 1417, 603 F.3d 864 (“[a]n in rem suit against a vessel is…distinctively an admiralty proceeding, and is hence within the exclusive province of the federal courts.”).

[22] 46 U.S.C. § 31342(a); Trans-Tec Asia v. M/V Harmony Container, 518 F.3d 1120, 1128 (9th Cir. 2008); Capital Bank PLC v. M/Y Birgitta, 2010 WL 2902740 (C.D. Cal. 2010) (“[A] court may order the sale of a vessel to enforce a preferred mortgage on that vessel.”).

[23] Supplemental Admiralty Rule C(2).

[24] Federal subject matter jurisdiction over the real property foreclosure exists either based on diversity of citizenship and a principal indebtedness of more than $75,000, or supplemental jurisdiction by virtue of the admiralty claims.  28 U.S.C. §§ 1331, 1332 and 1367(a).

[25] Rule (E)(9)(a) of the Federal Rules of Civil Procedure, Supplemental Rules for Admiralty or Maritime Claims permits interlocutory sale of vessels if the vessel (1) is perishable, or liable to deterioration, decay, or injury; or (2) if the expense of keeping the property is excessive or disproportionate; or (3) if there is an unreasonable delay in securing the release of the vessel.

[26] 46 U.S.C. § 31326(b) (upon the vessel’s sale the maritime lien created by the preferred mortgage transfers to the sale proceeds in rem).  If the lender credit bids at the auction and is the high and successful bidder, there will be no sale proceeds to deposit in the court registry.  In other words, no money will change hands.  This is the ideal outcome because it eliminates the need to obtain a judgment before the court will order the court registry to release the funds to the claimant.  C.f. United States District Court, Southern District of California, Local Rules, Civil Rule 67.1.

[27] Fed. R. Civ. P. 56.

[28] Fed. R. Civ. P. 67(b); 28 U.S.C. § 2042; United States District Court, Southern District of California, Local Rules, Civil Rule 67.1.

[29] It is beyond the scope of this article to discuss whether recovery of attorneys’ fees and costs constitutes a money judgment on the debt resulting in a waiver of security under the One Action Rule.  The Mixed Collateral Statute gives some guidance in California Commercial Code section 9604(a)(6):

“Monetary judgment on the debt” does not include a judgment which provides only for other relief (whether or not that other relief is secured by the collateral), such as one or more forms of nonmonetary relief, and monetary relief ancillary to any of the foregoing, such as attorneys’ fees and costs incurred in seeking the relief.

[30] Coppola, 211 Cal.App.3d at 867-868.

[31] Cal. Civ. Proc. Code §726(b); Kinsmith Financial Corp. v. Gilroy, 105 Cal.App.4th 447, 453-454 (2003) (holding that foreclosure decree is not the only final judgment in an action for judicial foreclosure; thus, only a deficiency money judgment must be renewed within ten years).

[32] Cal. Civ. Proc. Code § 580a.

[33] Cal. Civ. Proc. Code § 726.

[34] Cal. Com. Code § 9604(a)(2)(A), (8); Florio, 68 Cal.App.4th at 644-645.  Counsel would be hard pressed to argue that the vessel and real property are so closely related as to constitute a single unit.  This designation is typically reserved for situations where real and personal property comprise a single package, such as a hotel, and a unified sale of the real property, fixtures and inventory would enhance the “going concern” value.  Aspen Enterprises, Inc., 37 Cal.App.4th at 1818-1819.

[35] The local admiralty rules for the Southern, Central and Northern Districts of California contain provisions for confirmation of the vessel sale.  The provisions provide for a short period of time (e.g., 3 days in the Southern District) after which, if no written objection to the sale is filed, the sale will stand confirmed as a matter of course.  See also, Bank of Am., NT & SA v. Pengwin, 175 F.3d 1109, 1118 (9th Cir. 1999) (sale may be set aside on a showing of (1) fraud on the part of the purchaser, the officer conducting the sale, or any other person connected with the sale; (2) collusion; or (3) inadequacy of price, provided the inadequacy is gross and is such as amounts to either fraud or unfairness.”).

[36] For additional discussion of the interplay between section 726 and the Mixed Collateral Statute, see John R. Hetland and Charles A. Hansen, The ‘Mixed Collateral’ Amendments to California’s Commercial Code – Covert Repeal of California’s Real Property Foreclosure and Antideficiency Provisions or Exercise in Futility?, 75 Cal. L. Rev. 185 (1987) and Morris W. Hirsch et al., The U.C.C. Mixed Collateral Statute – Has Paradise Really Been Lost?, 36 UCLA L. Rev. 1 (1988).[/vc_column_text][/vc_column][/vc_row]