It has been over three years since Congress enacted the federal Corporate Transparency Act (“CTA”), the groundbreaking legislation that obligates small business owners, among others, to file beneficial ownership information (“BOI”) reports with U.S. Treasury’s Financial Crimes Enforcement Network (“FinCEN”). The reporting of beneficial ownership information officially kicked-off on January 1, 2024, and in the six months since then a number of developments—and challenges—have arisen. This article will summarize a few of them.
Just 60 days after the CTA’s effective date, the U.S. District Court for the Northern District of Alabama ruled on March 1, 2024 that the CTA is unconstitutional. The plaintiffs, National Small Business United (d/b/a National Small Business Association) (“NSBA”) and Isaac Winkles, an NSBA member and small business owner, filed suit in November 2022, alleging the CTA’s mandatory beneficial ownership disclosure requirements exceed Congress’s authority under Article I of the Constitution and violate the First, Fourth, Fifth, Ninth, and Tenth Amendments. The trial court ruled in favor of the plaintiffs and declared the CTA unconstitutional because it cannot be justified by any of Congress’s enumerated powers. Accordingly, the court granted the plaintiffs’ summary judgment motion and permanently enjoined the defendants from enforcing the CTA against the plaintiffs.
The federal government promptly appealed the decision to the federal Court of Appeals for the Eleventh Circuit. To date, numerous amici curiae have filed briefs in the appeal. Amici include Congressional members seeking a ruling to reverse the district court’s ruling, while 22 states filed a brief in support of the district court’s decision. Oral arguments are scheduled for September 27, 2024. This litigation will not be resolved before January 1, 2025, the CTA filing deadline for entities in existence prior to January 1, 2024. Even if the Eleventh Circuit issues a ruling in 2024, it’s all but certain the losing party will appeal.
Although FinCEN stated it will comply with the injunction not to enforce the CTA “for as long as it remains in effect[],” FinCEN was crystal clear that non-enforcement applies only to the plaintiffs in that case. This means only Isaac Winkles, reporting companies for which Isaac Winkles is the beneficial owner or applicant, the NSBA, and members of the NSBA (as of March 1, 2024). Note that FinCEN included only NSBA members as of March 1, 2024, so an entity seeking to join the NSBA in hopes of shielding itself from CTA enforcement may not succeed. By implication, all other entities must still comply with the CTA and are required to submit beneficial ownership and company applicant information to FinCEN.
Since FinCEN will continue to enforce the CTA against all other parties, reporting companies should continue to comply with the CTA unless additional guidance is provided.
Business groups and others have filed at least six other lawsuits in federal district court challenging the constitutionality of the CTA. The National Small Business United court did not issue a nationwide injunction against the enforcement of the CTA, but a lawsuit filed on December 29, 2023 in the United States District Court for the Northern District of Ohio seeks such a nationwide injunction. That court has stayed proceedings pending the outcome of the Eleventh Circuit appeal. Robert J. Gargasz, Co., LPA et al. v. Yellen et al., 1:23-cv-02468 (D. Ohio). The first federal case challenging the constitutionality of the CTA to be filed after the National Small Business United court decision was filed on March 15, 2024 in the United States District Court for the District of Maine. Boyle v. Yellen et al., 2:24-cv00081-LEW (D. Me.). Less than two weeks later, the Small Business Organization of Michigan, along with other plaintiffs, filed a complaint on March 26, 2024 in the United States District Court for the Western District of Michigan (Southern Division) challenging the constitutionality of the CTA. Small Business Ass’n of Michigan v. Yellen et al., 1:24-cv-00314 ECF (D. Mi.). On May 28, 2024, a complaint was filed in the United States District Court for the Eastern District of Texas (Sherman Division) seeking the invalidation of the CTA and a nationwide injunction prohibiting the federal government from enforcing the CTA and its reporting regulations. Texas Top Cop Shop, Inc. et al. v. Garland et al. 4:24-cv-00478 (D. Tex.). The following day, May 29, 2024, a complaint was filed in the United States District Court for the District of Massachusetts, alleging, among other things, that the CTA infringes on the privacy rights of business owners in violation of the Fourth Amendment to the federal Constitution. Black Economic Council of Massachusetts, Inc. v. Yellen et al., 1:24-CV-11411. The most recent case is one brought on June 27, 2024 in the United States District Court for the District of Oregon. Firestone et al. v. Yellen et al., 3:24-cv01034-SI. These cases will need to be closely monitored to see if the trial courts reach the same conclusion as the National Small Business United court on the merits and seek to go further in their relief.
The prospect of a FinCEN computer crash was not out of the question in light of the estimated 32+ million filings projected by FinCEN to be made in 2024. The initial rollout has been smooth from all appearances and there has been no public reports of system crashes or malfunctions. The robust nature of FinCEN’s BO IT system will continue to be tested as more initial filings and updated filings are made this year. The request for, and issuance of, FinCEN Identifiers has also not been the subject of any public reports of system crashes or malfunctions. As of April 30, 2024, however, fewer than 2 million BOI Reports haven been filed with FinCEN, which is dramatically lower than the number of filings that were projected to be filed by that date. BOI Reports will need to be filed at a far more rapid rate to achieve full compliance before the end of 2024.
The CTA contains 23 exemptions for reporting companies. FinCEN has sought to clarify the scope of certain of these exemptions in its Small Entity Compliance Guide and periodic FAQ releases, but there are numerous unanswered questions concerning the precise scope of these exemptions and their availability in a myriad of factual scenarios. Set forth below are a couple of examples highlighting this uncertainty.
The Subsidiary Exemption focuses on subsidiaries, not parents or other affiliates, of exempt entities. To qualify for the Subsidiary Exemption, the entity’s ownership interests must be controlled or wholly owned, directly or indirectly, by any of the enumerated 18 exempt entities. Note that “wholly” modifies “owned,” but does not modify “controlled.” The question thus arises whether a subsidiary whose ownership interests are partially controlled by an exempt entity qualifies for the Subsidiary Exemption. FinCEN answered this question in the negative in its January 12, 2024 FAQ update (Question L.6): “If an exempt entity controls some but not all of the ownership interests of the subsidiary, the subsidiary does not qualify. To qualify, a subsidiary’s ownership interests must be fully, 100 percent owned or controlled by an exempt entity.” FinCEN explained that “control of ownership interests means that the exempt entity entirely controls all of the ownership interests in the reporting company, in the same way that an exempt entity must wholly own all of a subsidiary’s ownership interests for the exemption to apply.”
An entity qualifies for the Tax-Exempt Entity Exemption if, among other things, it is described in section 501(c) of the Internal Revenue Code (“IRC”) (determined without regard to IRC section 508(a)) and exempt from tax under IRC section 501(a). At issue is whether a newly formed section 501(c)(3) entity is “exempt from tax” under IRC section 501(a) if it has not yet received an IRS determination letter. There appears to be a lack of consensus among lawyers on whether a potential 501(c)(3) charity can claim the Tax-Exempt Entity Exemption while awaiting the determination letter. The preamble to the BOI reporting rule did not address this specific issue, thus the conservative approach would be for a potential 501(c)(3) charity to file its initial BOI Report with FinCEN and, once the entity receives the IRS determination letter, file an amended BOI Report with FinCEN stating that the reporting company is now exempt.
A statutory and regulatory regime as complex and wide reaching as the CTA could not—despite efforts by legislators and regulators—address every conceivable permutation arising from countless corporate transactions and entities. To take just one example, assume that a corporation formed before January 1, 2024 ceases to exist because it failed to maintain its good standing in its state of creation and its corporate charter is forfeited. Assume further that in April 2024 the corporation files for reinstatement after paying any applicable fees and penalties and filing the required reinstatement documentation with the state secretary of state. Based on these assumed facts, does the filing of the articles of reinstatement constitute the creation of a new entity and thus trigger the company applicant provisions of the CTA or, rather, does the reinstatement relate back to the corporation’s original date of creation? Most states have reinstatement statutes that are expressly designed to allow a corporation that was forfeited to address the issue that caused the forfeiture and be reinstated and, once reinstated, to be treated as the same corporation. On that basis, because the company was created before January 1, 2024, it would appear that a company applicant would not have to be identified when the reinstated corporation files its initial BOI Report before the January 1, 2025 reporting deadline.
While common law trusts are not reporting companies, they often own reporting companies. The proper way to attribute reporting companies owned by a trust is far from clear. Anyone with the power to “dispose of trust property” will be attributed ownership. This could include not only the trustee, but a beneficiary with an inter-vivos power of appointment, a grantor with the right to exchange assets of equal value with the trust, as well as investment or distribution advisors if the trust is structured as a directed trust.
Where a corporate trustee is serving, employees of the corporate trust company (e.g., trust officers, members of an investment committee, or members of a distribution committee) may be treated as beneficial owners of reporting companies. Recently issued FAQ D.16 says the owners of a corporate trustee will also be treated as owning a pro-rata amount of any reporting companies held by trusts under the control of the corporate trustee. In other words, if someone owns 25% of a corporate trustee they will be deemed to own 25% of every LLC, limited partnership, corporation, or other form of reporting company under the supervision of that corporate trustee.
If an individual has the right to remove the current trustee and name a successor it’s unclear if that person will be treated as having indirect control over interests in a reporting company owned by the trust.
If one spouse in a community property state holds legal title to 25% of a reporting company, it’s unclear how that interest should be reported. At a recent American Bar Association conference a representative of the Treasury Department was asked about this issue and was unable to offer any guidance. Arguments could be made for reporting this interest as being owned entirely by one spouse, as entirely owned by both spouses (meaning 25% each), or as being owned equally by the spouses (meaning 12.5% each).
A question that continues to arise is whether a lawyer or reporting company should outsource the population and completion of a BOI Report to a third party service provider. Lawyers will certainly provide guidance of which individuals should be reported as beneficial owners, but lawyers have differing views on whether they should recommend that clients use the services of third party service provider that provide a platform or service for populating the BOI Report. From a cost efficiency standpoint, that approach may appear attractive. On the other hand, would the attorney have any exposure if the third party service provider’s system is hacked or has a security breach? At a minimum, before recommending the services of a third party service provider, it may be prudent for the lawyer to first inquire into the data security provided by the third party to determine whether it meets industry standards.
Rather than submit the personally identifiable information (“PII”) for a beneficial owner or company applicant to the reporting company, FinCEN permits a beneficial owner and company applicant to submit their FinCEN Identifier to the reporting company. The reporting company would then include the FinCEN Identifiers for the beneficial owners and company applicants in the BOI Report to be submitted to FinCEN. By obtaining a FinCEN Identifier from FinCEN and providing that number to the reporting company, the beneficial owner and company applicant can reduce the risk their PII will be compromised. Those obtaining a FinCEN Identifier should understand, however, that they will have an obligation to update their PII on file with FinCEN should any changes occur, such as a change in their address or name. Currently, there is no process to deactivate a FinCEN Identifier. Once FinCEN issues a FinCEN Identifier, the individual (and not the reporting company) has an ongoing obligation to notify FinCEN within thirty days of any changes in the PII on file with FinCEN.
The BOI disclosed under the CTA includes an identifying document, which must be either a non-expired passport, a non-expired identification document issued for by a government for the purpose of identifying the individual, or a non-expired driver’s license. We have learned that many elderly people don’t have any such document, making compliance impossible. It has also been noted that some identifying documents are reissued with the same identifying number while others, including a U.S. passport, provide a different number with each renewal. It is generally simpler to use an identifying document like a driver’s license whose number does not change, since that avoids the need to update your BOI with FinCEN when the document is renewed. On the other hand, a passport often has less BOI than a driver’s license.
A complication may arise when lead counsel engages local counsel on a transaction involving the creation of one or more entities in the local jurisdiction. If lead counsel instructs local counsel to prepare and file a certificate of formation to create an LLC in the local jurisdiction, local counsel will instruct his or her paralegal to directly file the creation document with the state Secretary of State’s office. The paralegal will thus be a company applicant. As between lead counsel and local counsel, which one is “primarily responsible” for creating the LLC and thus assuming the role as the other company applicant? In any event, lead counsel and local counsel should agree on who will be the second company applicant in this scenario.
Reporting companies subject to the CTA will need to monitor and timely report changes in beneficial ownership. Beneficial owners may change their names through marriage or divorce, moving from one residence to another, or obtaining a new drivers license in another state if such owners move. Someone within an organization, who may assume the role of “CTA Compliance Officer,” needs to implement an effective process to monitor and timely report these changes to FinCEN. The reporting company should determine who will maintain the BOI (and how) at the entity level, and identify the protective measures that should be employed to ensure the confidentiality and privacy of that PII. The reporting company should exercise care in both maintaining and transmitting the BOI to FinCEN.
Because of the severe civil and criminal penalties for non-compliance with the CTA and its implementing regulations and notwithstanding the willful violation standard, reporting companies may err on the side of being overly inclusive in identifying those who are beneficial owners by virtue of exercising “substantial control” over the reporting company. One obvious risk of overreporting is that changes in the identified beneficial owners will need to be timely updated with FinCEN as changes occur.
Some states have embarked on an effort to adopt a state-level variation of the CTA. These “mini-CTAs” are generally not as broad as the federal CTA, but they present potential compliance burdens and costs that will further complicate compliance with another BOI reporting regime. New York enacted its “LLC Transparency Act” that is limited to LLCs (both domestic and foreign) and, initially, contained a public database feature. The final version of the LLC Transparency Act removed the public database provision and limited access to government agencies and law enforcement. The California Senate recently passed S.B. 1201, which would require corporations and LLCs to reveal their beneficial ownership information in a publicly available database. This bill was withdrawn when it reached the California Assembly.
Law enforcement and others consider the CTA a key breakthrough in bringing a level of entity transparency to the United States. The benefits and burdens of beneficial ownership disclosure—perceived or actual—remain to be seen, but lawyers and their clients now have to deal with the reality of complying with a complex reporting regime that continues to pose nuanced compliance issues.
