Real Estate Interests

Real Estate Interests

Legal interests in real estate seem simple upon first consideration – someone may own a home, and when they sell it, the buyer owns it. However, even such “simple” purchase and sale arrangements are often layered with other forms of legal interests being retained or changing hands, such as mortgage lien rights, easements, tenant rights and restrictive covenants. Holding an interest in property does not mean just one thing and even the descriptor of “ownership” fails to identify important differences among ownership types. Financial, tax and estate planning goals often are best accomplished by using forms of property transfers outside of traditional sale and purchase agreements and understanding such mechanisms is important to making efficient decisions about your real estate.

It is helpful to first present a framework for which to analyze the differences between types of interests. The classic real estate analogy to help frame the various rights and obligations of land ownership is the “bundle of sticks” thought exercise. First, imagine a bundle of sticks, where each stick represents a right or obligation regarding a particular piece of real property. One stick, for example, is the right to occupy the property, another may be the right to build or destroy structures on the property. When someone has all of the sticks, representing every conceivable right to the land, they are the “owner” in the truest sense of the word for the land associated with the sticks. However, individual sticks are often removed from the bundle and given to others – thus the rights to the property are divided among different people and entities. In fact, no individual holds all the sticks to any given bundle because certain property rights are held by the government. Some examples of this are: the right to tax, to prevent certain uses of the property through zoning and permitting requirements, and to forcibly acquire property through eminent domain. The remainder of the rights are typically divided in one of the following classifications of interest in real estate:

Fee Simple Interest. An owner in “Fee Simple” holds the most rights to real estate any individual can enjoy. They can occupy and use the property as they see fit, exclude anyone they do not want to be there, sell or rent to whomever they like, and build or tear down any structures so long as they comply with the governmental limits to such powers. Their use of the property exists currently and there is no time limit on such use.

Leasehold Interest. The first interest in real estate most people acquire is the leasehold to their first apartment. This interest is also referred to as a “Lessee” or “Tenant” interest. Lease rights vary tremendously based on the terms of the lease contract, but in general, ownership is retained by the landlord and the right to occupancy, use, and enjoyment for a set length of time is sold to the tenant for the price of rent. While the ownership of the property is retained by the Landlord, those occupancy rights are temporarily transferred away from them. This transfer of rights is what separates a “tenant” from a “guest.”  For example, despite being the “owner” of the property, Landlords generally do not have the right to sleep or live in the rented space, invite guests over or tell their tenants who is and is not allowed on the premises – these rights are retained by the Tenant for the duration of the lease.

Landlord Interest. The opposite of the leasehold interest, the Landlord, also known as the “Lessor,” retains the rights not traded for rental payments to the Tenant. This typically includes the rights to make decisions regarding the improvements on the property (although some leases allow Tenants wide discretion to remodel or even build improvements), the right to sell the property to others, or encumber it with a mortgage to finance other projects, and to have the property returned to them at the end of the lease.

Life Estate Interest. Life estate arrangements transfer the “sticks” associated with a property after the owner’s death to another party, often as a gift but sometimes as a sale, but keep the “sticks” for use during one’s life with the owner. The rights to use the property during life is called the “Life Estate Interest.” This typically involves the holder being able to live in the property rent free for the duration of their life. In theory, the “Life Estate interest” can be sold to a third party, but because it terminates on the death of the original holder (it does not reset to the lifespan of the buyer), few people are interested in purchasing such rights. Life Estate interest holders are usually required to pay the property taxes and keep the improvements in good repair to protect the value of the remainder interest holder’s rights. Granting a Life Estate is fundamentally different than naming someone in a will, as the legal ownership of the right to use the property after the grantor’s death irrevocably transfers to that individual and cannot be rescinded.

Remainder Interest. The opposite of the Life Estate Interest, the holder of the remainder interest has no current use or occupancy rights but will assume full ownership of the property when the Life Estate interest holder dies. They also have certain rights to ensure the Life Estate Interest holder keeps the taxes paid and the property in good condition, as failure to maintain the property damages their future rights. A remainder interest holder can sell their remainder interest to other parties. The value of such interests is typically determined by the life expectancy of the Life Estate interest holder.

Mortgage Liens. Banks and other financial institutions own interests in a huge number of properties in the form of mortgage liens. Individual lenders may also acquire such rights. When a bank lends you money to purchase a home, or sometimes for other reasons, they may “secure” that debt by placing a mortgage lien on the property. This grants a “conditional right,” meaning that if certain events happen, the right comes into effect. The main conditional right with a mortgage lien is the right to seize the property from the borrower if payments are not made or if the borrower attempts to transfer the property without their consent, which is frequently called the “due on sale clause.” Lenders require these liens be granted to them to ensure that they will receive their money back from the sale of the seized home in the event the borrower stops paying the loan.

Land Contract Vendor. The Vendor of a land contract makes a contract with a purchaser or “Vendee” to sell specific land in exchange for a promissory note which is paid over time. In a traditional mortgage financed transaction, the seller is fully paid at closing from the money the borrower got from the bank and transfers the full interest at that time. In a land contract however, the payments are made directly to the Vendor over a number of years, and the title is retained until it is paid in full, at which point the Vendor is required under the contract to transfer the property by deed to the Vendee. Although title remains with the Vendor until the note is paid, for most practical purposes, the use and occupancy rights to the property transfer to the Vendee upon signing the Land Contract, at least for so long as the Vendee stays current on their payments.

Land Contract Vendee. The Vendee of a land contract agrees to purchase the property from the seller, or “Vendor.” The Vendee has a right to acquire the property when they have completed the payment schedule called for in the Land Contract. They typically have broad rights to use the property while paying off the debt, but also are typically required to maintain insurance and maintenance to protect the security of the Vendor. If they fail to make the payments, the Vendor may be able to seize the property back from them, as the legal title to the ownership never changed hands.

Easements. The owner of an easement right does not own the property it pertains to, but rather has specific rights to use that property for specific purposes. The most common form of easement is for access, also known as “ingress and egress easements.” If a lot is created that has no access to a public road because it is surrounded by other lots, it is common for the owner of that lot to negotiate for the purchase of an easement on someone else’s property for the right to travel across it to get to the road. Other common easements are for hunting or recreational use. Easements are presumed to be “appurtenant” to the land, meaning future owners automatically get the rights and obligations transferred to them when they buy the property. However, some easements are “in gross” meaning an individual owns the easement right (common with hunting easements). If an easement is vital to the use of a property, buyers should carefully ensure the rights will continue after the property changes hands.

Restrictive Covenants/Deed Restrictions. Where an easement is a right of another to use someone else’s property for a specific purpose, a restrictive covenant or deed restriction is the right of another to prohibit certain uses of a property by its owner. For example, the owner of a house on a hill may decide to sell some of their land at the bottom of the hill. Because they are worried about their view being blocked if the new owner builds a tall structure, they retain for themselves the “stick in the bundle” that represents the right to build structures over a certain height. The new owners take title to the land, but never obtain the right to build any structure that would block the view. The most common type of restrictive covenants are found in property developments, where the developer, to increase the value of the land or houses they are selling, puts use restrictions on all of the lots. While the value of a single property may be decreased if it comes with rules about what the owner cannot do with it i.e., “no barking dogs on the property” and “no non-running cars in the driveway,” the value may increase significantly if all the neighboring properties also are prohibited from owning barking dogs or leaving junk cars out front as buyers get the peace of mind in knowing their neighbors cannot do these things.

Option to Purchase. An option to purchase grants the legal right, but not the obligation, to acquire a property at a set price during a window of time. If exercised by the option holder, the owner is legally required to sell them the property. The owner may still occupy and enjoy the property during the interim and the option holder has no rights to the property unless they exercise the option. Options become more valuable if the land value increases, as the right to buy a property for $100,000 that has doubled in value since the option was granted obviously is quite valuable. Option rights are typically sold to purchasers when they express interest in a property they cannot currently acquire and want to secure their right to buy it in the future.

Right of First Refusal. A right of first refusal is a contractual right to have a property offered to be sold to the holder for a set price and terms before the owner can sell to anyone else. The right holder does not own the property or have any ability to force the sale, but if the seller wishes to sell, the right holder will be guaranteed a chance to buy the property themselves. The price is sometimes set to match the offer made by another party, requiring the right holder to match the outside offer to acquire the interest. Sometimes the terms call for a formula or appraisal-based price determination instead. Rights of First Refusal are often utilized in family land transactions when the real estate is sentimental in some way. For example, if two siblings inherit their family home, one sibling may wish to purchase it from the other to live in. That sibling may agree to the sale but only on the condition that before they could sell it to someone else, they would have to first offer it back to them.

If you have any questions about these types of interest in real estate, please do not hesitate to reach out to one of our experiences real estate attorneys.

How do Gift Taxes and Annual Exclusion Gifts Work?

How do Gift Taxes and Annual Exclusion Gifts Work?

Many people are aware that gift taxation rules exist, but do not understand the actual process for determining when reporting or payment is required. Fortunately, the types of gifts most people make each year fall under broad exclusions to the gift tax rules such as charitable giving, interspousal gifts, or annual exclusion amount gifting. This article focuses on annual exclusion amount gifting. Most individuals in the United States regularly rely on annual exclusion amounts to avoid filing burdens, for things like buying Christmas presents or treating someone to lunch, without ever realizing the exception is operating. However, relying on the annual exclusion amount without understanding it can lead to negative tax ramifications.

Before discussing the exception, we need to begin with the general rule. Internal Revenue Code Section 2503(a) provides that “taxable gifts” means the total amount of gifts made during the calendar year. A “gift” is a transfer of any type of property from one person to another for no or less than full fair market value. For example, if a person sells property with a fair market value of $100,000 to another for $100,000, no gift has occurred because the property was transferred for full value. If the property is instead given away for no payment, a gift of $100,000 has occurred. You may also be making a gift by allowing use of property without fair payment, even if the property itself is not outright transferred or is set to return to you. An example could be, residing in a property without rent or making an interest free loan. Determining “fair market value” can sometimes be difficult, but generally is the price which the property would trade hands for between unrelated individuals, both of which are fully informed about the characteristics of the property and under no compulsion to buy or sell it. Between unrelated parties, the presumption is that the transfer price is the fair market value. Between related parties, higher scrutiny is applied as it is more likely the transfer price was determined not by market value, but instead by charitable motivations.

IRC Section 2503(b) provides the annual exclusion rule. This rule exempts from “taxable gifts” an inflation adjusted at $10,000 (adjusted to $16,000 in 2022) annually made by any person to any other person. This annual amount prevents routine transfers like Christmas presents, birthday cards and paying for meals from requiring any special tax filings. Using up to the maximum amount each year for cash or security transfers is a common tool used by wealthy estate planning clients seeking to shift money out of their estates whose value may otherwise incur estate taxes at death. While $16,000 may not seem like much in the context of multi-million dollar estates, the multiplying force of “per donor” and “per recipient” can allow significant annual transfers. Consider a wealthy married couple with three children, each of whom are married with two children of their own. By using annual exclusion limits, each spouse can give to each child $16,000. They can give $16,000 to the spouse of their child plus additional $16,000 gifts from each grandparent to each grandchild. In this example, $384,000 a year could be transferred gift and estate tax free. The “annual” nature of the exclusion is measured by the calendar year, so it is common for transfers that may otherwise not qualify for the exemption to be split into separate smaller gifts on a December-of-one-year then January-of-the-next schedule.

Making annual exclusion gifts needs to be weighed against other options for the assets. Highly appreciated assets in estates without estate tax exposure would typically be better off being held until death to benefit from tax basis adjustment rules. Gifted assets generally have a “carryover” tax basis from the donor. Conversely, newly acquired stock expected to rise in value makes for a powerful transfer option, as the growth in value will occur under the new owner and has been removed from the donor’s estate at a relative discount compared to its anticipated future value.

To count as a gift completed in any given year, the gift must be of a “present interest” and “complete”. These requirements can become quite complex in certain types of advanced planning – such as Crummey withdrawal notices for gifts made with the intention to fund trusts or the ownership interests in highly restricted Family Investment LLCs. Generally, the requirements mean that the value and use of the property needs to have changed hands in an irrevocable manner and without contingencies. For example, telling a child in college “If you get all A’s this semester, I will give you $1,000” does not constitute a gift, but once the funds have changed hands, the gift would be complete. The same would apply to naming someone a beneficiary on a bank account as the designation is both revocable and payment is contingent on the grantor’s death. This differs from naming someone as a joint owner on an account, as that conveys an ownership interest at the time it is made. Failing to satisfy this requirement can create problems if large gifts are made in consecutive years. For example, if in 2022 a father gifts to their son a car worth $15,000 and then in 2023 gifts $15,000 worth of stock in their family business, then the gifts each year were under the annual exclusion limits. Conversely, if in 2022 the father tells his son, “Consider the car yours, I will get the title transferred soon”, then in 2023 the car is actually transferred and the gift of stock is made, then, because the gift of the car was not complete in 2022, both gifts took place in 2023 and the exemption is not large enough for both 2023 asset transfers.

If gifts are made in excess of the annual exclusion limit and no other exemption applies, then under the general rule of IRC Section 2503(a), the gift is a “taxable gift” and needs to be reported on IRS Form 709 – the gift tax return. However, this does not necessarily mean that any tax is owed – in fact it rarely does. Taxable gifts made during life reduce the amount of exemption available for the donor to use to protect assets from the estate tax at their death. To summarize, estate taxes operate by valuing the assets a person owned at their death, then applying a heavy tax on the value of assets over their exemption amount ($12,060,000 per person in 2022 – a historically high figure). So taxable gifts made during life reduce that exemption amount at death. If a person dies without owing estate taxes under the reduced amount, then no tax is collected at any point for the gifts made during their life. If the exemption is entirely used up, either during life or at death, then a tax is owed.

This combined system of gift and estate taxation makes sense when the legislative objectives are understood. Gifts and inheritances share the common trait of passing assets without compensation, usually to younger family members. Without the unified credit, large near-death or deathbed gifts could be used to avoid estate taxes, which are important for both revenue generation and curbing wealth inequality. However, without the annual exclusion exemption, the general rule of taxability would mean that every small routine gift would be a reportable gift. This would create a paperwork nightmare, both for average citizens whose tax filing burdens would substantially increase and for the IRS who would need to review and process these submissions. Further, because no tax is owed as long as there is available exemption, this massive paperwork burden would generate very little tax revenue as the vast majority of people do not have estates large enough to trigger the estate tax (at least under current exemption limits).

As a final note, it is important to understand that the annual exclusion gift exemption only applies for purposes of calculating taxable gifts – the exclusion does not apply for determining Medicaid eligibility and reportable transfers during the look back period, which are governed by entirely separate and far stricter rules. This article is meant to provide a basic overview of the gift tax system and annual exclusion gifting. As always, professional advice from an attorney or accountant should be sought when determining the effects of any specific course of action.

Can I Disclaim an Interest in an Estate?

Can I Disclaim an Interest in an Estate?

When someone dies and leaves you property in their will, by beneficiary designation, or through the intestate beneficiary laws of their state, it is possible, and sometimes wise, to reject the would-be inheritance by “disclaiming” your legal interest to it. However, there are certain procedural rules and mechanics necessary to effectively complete the disclaimer.

Someone may choose to disclaim their interest in an inheritance for a variety of reasons. They may simply not need it or would prefer another person to receive it. Disclaiming in these circumstances may be preferable to accepting the asset, then gifting it to the recipient. Disclaiming may also be warranted if receipt of the asset could lead to it being seized by creditors, impacting the person’s tax planning, or affecting their eligibility for certain government programs. For very wealthy individuals, receipt of additional assets through inheritance may prove problematic for purpose of the estate tax and later cause taxation at the recipient’s death that could have been avoided by a timely disclaimer. In fact, some types of trusts, commonly known as Disclaimer Trusts, anticipate the disclaimer process being utilized for estate tax purposes and create mechanisms to take advantage of the disclaimer process to minimize the repeated taxation of assets as they move through a family tree.

Wisconsin Statute § 854.13 governs the rules for disclaiming assets in Wisconsin. To be a valid disclaimer under the statute, the disclaimer must meet certain technical requirements. It must contain a description of the asset to be disclaimed, declare the intent to disclaim, the extent to which the disclaimer applies, and must be signed by the disclaimant. The disclaimer must be delivered within nine months after the effective date of the transfer, although extensions are sometimes possible “for cause” with court permission. The disclaimer must be delivered to the party identified under WI. Statute §854.13(5), which is typically the personal representative of an estate or the trustee of a trust holding the relevant asset. The delivered disclaimer must then be filed with the probate court with jurisdiction over the estate and, for real estate, recorded with the Register of Deeds of the county the real estate is located in. When the individual disclaiming the interest is a minor or incapacitated, the statute includes special rules which apply to ensure their guardian or agent acting under power of attorney is acting in the best interest of the disclaimant.

Importantly, the disclaimer must also be made before the individual accepts the asset or any benefit from the disclaimed asset. For example, if the contents of an investment account are liquidated and transferred to the beneficiary’s account, those funds have been accepted and the person can no longer disclaim them. Similarly, if someone is to inherit a vehicle and drives in it, they have accepted the benefit of the asset and can no longer disclaim it. Accidental acceptance of an asset can sometimes be disastrous, so if you are considering disclaiming your interest, make sure to be mindful of the management and use of the asset so you do not accidentally bar yourself from disclaiming it by accepting the asset or its benefit. The possibility of accidental acceptance is also a limitation of the Disclaimer Trust described previously, and some estate planning attorneys choose to avoid it in favor of other methods – like formula funded trusts – to avoid this risk.

To be valid for federal tax purposes, the IRS also imposes requirements for a “Qualified Disclaimer” in Section 2518 of the Internal Revenue Code, which are similar, but distinct from the Wisconsin rules.

A properly executed disclaimer is irrevocable and causes the asset to be treated as if it never vested in or transferred to the disclaimant. Assuming a divestment is effectively made, the asset passes under the rules set forth in WI. Statute §854.13(7) through (10). The general effect of the disclaimer is that the asset would pass as if the disclaimant has died before the decedent. For example, if a person dies without a will and the laws of intestacy direct that the asset would pass to the decedent’s surviving parent, who then disclaims, the asset passes as if the parent has predeceased and it passes to any living siblings of the decedent. As another example, if an individual dies with a will providing all assets would pass to their surviving spouse, and to their children if the spouse predeceases them, a disclaimer by the surviving spouse would cause the assets to pass to the children.

Despite the “general rule” outlined above, the statutes contain many exceptions and special rules for certain scenarios. Because a disclaimer is irrevocable once made, it is important to fully understand where the asset will pass before completing the disclaimer. If you have any questions about disclaiming assets from an estate, please do not hesitate to reach out to one of our attorneys.

 

Legal Considerations for Running a Business from Home

Legal Considerations for Running a Business from Home

The past decade has seen a steady increase of businesses being run from individual’s homes and the changes brought about by the Covid-19 pandemic have only increased this trend. Whether a “side-hustle” or primary source of income, business owners should carefully consider the legal and tax rules at play before opening their homes for business.

In addition to aspects relevant to all businesses, those operating a business from home must consider: (1) relevant property restrictions, (2) home business tax deductions, and (3) special liability and insurance considerations.

Property Restrictions

Property restrictions should be among the earliest factors analyzed, ideally before expenses are invested into the venture, as municipal zoning or private land restrictions may flatly prohibit the at-home business altogether.

Counties and municipalities enforce zoning restrictions which classify large swaths of land under different rules for use. These zoning programs are intended to organize land use in a planned and practical manner. For example, zoning codes may protect the interests of quiet suburbs by prohibiting the construction of multi-unit apartments or noisy factories in the area. While every local government unit has their own approach to zoning, generally, larger communities have more specific, restrictive, and regularly enforced zoning programs than smaller ones. Depending on your local rules, your home may be in an area which prohibits commercial activity. Whether your planned business falls under the relevant rules can only be determined by checking to see how the local codes define and restrict commercial use. Faced with an adverse zoning designation, you may be able to apply for a variance – a special exception to the zoning rule applied for and reviewed on a case-by-case basis.

Your use of the home may also be subject to private land-use restrictions. Most obviously if you rent your home, your lease may restrict your ability to operate a business from the property. If you have a good relationship with your landlord, they may be willing to amend the lease, as the inclusion of commercial use restrictions in the lease is often the result of a landlord using a form document, not their particular objection to you using the property that way.

Homeowners are not necessarily free from private party restrictions, as many properties are subject to restrictive covenants. These documents are essentially private contracts that were put into place by former owners and whose terms automatically pass on to new owners of the property. Some neighborhoods form Homeowner Associations to enforce these covenants. Others do not, but still allow any property owner, also subject to the covenants, to sue for their enforcement. Make sure to read your restrictive covenants carefully before opening a business. In addition to restrictions on business operations, check the rules for signage restrictions and parking and guest vehicle restrictions if clients will be visiting your home office. If the covenants restrict the type of activity you plan to perform, check to see what process is available for amending them.

Taxes

Assuming no land use restrictions prevent you from operating the business from your home, you will want to ensure you are taking maximum advantage of any available tax saving options. When considered during the onset of a new business, these tax rules may influence how you choose to organize running the business from your home.

Businesses are entitled under the tax code to deduct necessary and ordinary business expenses from their taxes. For example, if a business purchases a couch for their waiting room and hires a cleaning service to maintain it, this will typically be deductible as a business expense. If an individual purchases that same couch for personal use and hires the same cleaning crew to clean their home, this expense is not entitled to deduction. Because of a home business’s inherent melding of business and personal use expenses, the rules for home office deductions are somewhat complex. This article will review in broad strokes how these rules operate, but a qualified tax accountant or attorney can help guide you through the nuance of your particular situation. While no substitute to qualified professional advice, Reviewing IRS Publication 587 may also be a good start to understanding the basic rules at play.

The first step towards taking advantage of these tax benefits is to qualify for the deduction. Generally to qualify, a part of your home must be used exclusively and regularly for business purposes. As an example, using your living room couch as a place to sit when you check email is unlikely to qualify. Special variations of the general rules exist for unattached separate structures, space used for storage of inventory, daycare facilities or property used for rental purposes. Like most areas of law, the qualification tests are deceptively simple, and careful attention must be paid to how the rules define each word in a given test.

Assuming you qualify to take the deduction, the next step is to calculate the amount of the deduction. Here, you have a choice for each year you claim the deduction, either use a calculation for actual expenses or elect to use the simplified method offered by the IRS. Whatever your method of accounting for the deduction, make sure to keep adequate records to support your claims if you are challenged by the IRS. Your records should be maintained as long as the facts they support may still be challenged. For tax purposes, this usually is three years following the date that year’s tax return was filed.

Liability and Insurance

A lawsuit can wipe out years worth of income if proper precautions are not taken by a business owner and running a business from the home introduces unique risks. These risks are compounded if you have business clients or employees of the business meet or work at your home.

Like all business owners, a home business operator should consider forming a Limited Liability Company (LLC), Corporation or other form of limited liability business entity to operate their business out of to shield their personal assets from any suits made against their business.

To the extent possible, anyone entering your home for business purposes should remain in the portion of the property used for the business, as an injury occurring in another part of the home may blur lines between a business contact of your LLC and a house guest to whom you are personally liable for. It may be difficult to argue a personal injury lawsuit should be limited to your LLC when the injury was a result of tripping over a toy left in the living room by your child.

Even with proper limited liability entity planning, the assets of the business inside the entity are still subject to the suit and may be a devasting loss if liquidated to pay a settlement or judgement. Thus, insurance on the business is the first line of defense to maintain your assets, with the limited liability entity planning serving as an emergency flood wall against a disastrous lawsuit wiping out your entire estate. Most homeowner’s carry homeowner’s insurance, but these policies may not cover damages flowing from business use of the property. You should consult with your insurance provider to make sure you are appropriately covered and whether you need a supplemental business insurance policy. In addition to liability coverage, if your business owns expensive equipment or large amounts of inventory stored in your home, consider loss coverage to fund the replacement of those assets in the event of a flood, theft, or fire. Like with liability coverage, homeowner’s coverage for your personal assets will be unlikely to cover the garage full of business inventory that is damaged, destroyed or stolen without additional coverage options. If you have questions, do not hesitate to reach out to one of our business or tax law attorneys.

 

What Does the Indemnification Clause in My Contract Mean?

What Does the Indemnification Clause in My Contract Mean?

Indemnification provisions provide an important tool to parties seeking to allocate the risk of third-party damages and liabilities when contracting. When reviewing a contract, most people understandably first consider things like deadlines, pricing information, and the description of the assets to be transferred or the services to be performed. While these things are of course important, a well drafted contract can do much more. Frequently overlooked as “boiler plate” language, the exact structure and wording of an indemnification clause can become vitally important to protect your interests and limit the impact of creditor claims for actions you had little control over or means to prevent. These clauses should be fully understood and carefully considered before signing an agreement. Some contracts may not use the word “indemnification,” rather phrases like “hold harmless” or agreements to “defend” the other party and are a red flag that something like an indemnification clause may be at play. For such reasons you should always look beyond the heading of a section when interpreting the text at issue.

The assignment of responsibilities for liabilities is often a large part of agreements for commercial transactions. While the parties to a contract have broad discretion to transfer property, obligations and liability between themselves, they are limited in their ability to dictate that third parties – who have not joined into the contract – respect the terms of an agreement they had no say in. This conforms to the broader legal principle that “no one gives what they do not have.” For the same reason you cannot contract to sell something that belongs to another without their consent, you cannot contract to limit the rights of others to make claims they are otherwise entitled to make. Because the allocation of liability for certain causes of action is such an important part of many contractual matters, parties sometimes instead use indemnification provisions to essentially refund, or “indemnify,” the other party if they suffer damages resulting from certain types of issues.

To illustrate this principle, consider the following situation. A business owner rents a storefront from a landlord and agrees in the lease that they can only sue the landlord under certain circumstances. The business owner accepts certain risks or faults with the property they are renting.  For this example, assume the landlord discloses the radiator is not up to code and could cause a burn, so the tenant will take on the responsibility to get it fixed and agrees not to sue the landlord if they get burned by it before it is fixed. On its face, this arrangement seems a valid contractual exchange – the landlord gives up the right to use the property for a set time in exchange for: (1) rent and (2) the tenant’s agreement to limit suit against them from injuries over certain disclosed problems and (3) the agreement by tenant to fix the radiator.

In contrast, the landlord cannot effectively include a provision saying that “none of your customers can sue me if they are injured on the property, because you are responsible for keeping it in good and safe condition.” Despite the landlord shifting responsibility to keep the property in good condition to the tenant, they cannot prohibit third parties from making claims against the landlord if they are injured on the property. If the business owner fails to have the radiator replaced and a customer burns themselves while shopping, the burned customer would be fully within their rights to sue the landlord, despite the landlord’s arrangement with the tenant to fix the issue.

To better protect themselves, the landlord should have included an indemnification provision. Since the parties cannot limit who third parties claim damages from, they instead say “If I am forced to pay a certain type of claim, you agree to pay me back.” Here, the lease could apply indemnification to liabilities arising from the tenant’s negligent maintenance or actions with respect to the rented space, perhaps with specific reference to damages from the radiator if they fail to replace it. If the injured customer sues the landlord, the landlord would pay the claim and then seek to enforce the indemnification provision to recover the costs from their tenant who had agreed to indemnify them under these circumstances.

Far from being the “standard provision” they are often dismissed for, indemnification provisions can vary widely in scope, application and duration. Depending on the bargaining power of the parties, all such points may be negotiated.

The scope of an indemnity governs what circumstances are covered under it. A common scope provision might provide damages fall under the indemnity if they are a result of a breach of the agreement, inaccuracy of any representations or warranties made by the indemnifying party. Before agreeing to indemnify another party, consider what type of actions would fall under the described scope, whether any ambiguities exist regarding the scope of coverage and whether you have any control over preventing or reducing the risk of those types of claims. Ideally, you should not be agreeing to indemnify a party for liability resulting from the actions, errors, or omissions of their own or of a third party you have no control over. Wisconsin law permits broad indemnification clauses, but Wisconsin courts tend to strictly construe them, meaning they will not generally stretch the interpretation of the clause to bring an ambiguous situation under the indemnity. Wisconsin also has special rules for the scope of indemnification in construction contracts.

The application of an indemnity relates to how an indemnity will mechanically be triggered, calculated, and resolved. This includes important provisions on the required notices and timelines associated with various aspects of the indemnification procedure. A party seeking to rely on the clause should carefully comply with these technical requirements as the party obligated to pay under it will likely be looking for ways to get out of it if it is triggered. The provision may also place limits on the amounts required to be paid under the clause, or require certain steps are taken to ensure damages are mitigated or funds are available to comply with the indemnification requirements. The parties may require each other to carry insurance policies designed to cover these costs during the term of the indemnity to ensure it is effective. This is important because an indemnification right against a party with no collectible assets does not offer much protection. In the example used earlier of the landlord and tenant, the landlord’s indemnity will not be useful if the tenant has no assets from which to recover or if all of the assets are separated from the limited liability entity which granted the indemnity and thus very difficult to reach.

The duration of the indemnity governs how long the agreement to provide indemnity lasts. Contracts for purchase and sale transactions often have the bulk of the agreement terms end following the transfer of goods and payment, but indemnification provisions are often among the terms separated out and assigned a longer period of “survival.” These terms usually are tied to the statute of limitations for the claims they are being applied against but may still vary.

If you have questions on how an indemnification clause in a contract you are considering will operate, you should speak to a business law attorney to help you review, understand and potentially negotiate alterations to the agreement.

 

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