ARTICLE
30 April 2024

The Corporate Transparency Act – Case Law Update And Determining Beneficial Owners

As discussed in our prior two alerts (found here and here), effective as of January 1, 2024, the Corporate Transparency Act and rules issued thereunder by the Financial Crimes Enforcement Network...
United States Corporate/Commercial Law
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As discussed in our prior two alerts (found here and here), effective as of January 1, 2024, the Corporate Transparency Act and rules issued thereunder by the Financial Crimes Enforcement Network ("FinCEN") (collectively, the "CTA") require most U.S. entities and foreign entities registered to do business in the United States to file reports with FinCEN disclosing information about the entity and its beneficial owners ("BOI Reports"). This client alert provides an update on a recent case involving the CTA, a reminder on reporting deadlines, and information regarding the determination of a company's beneficial owners.

Federal District Court Case Rules the CTA Unconstitutional – But Most Companies Still Must Comply

On March 1, 2024, the U.S. District Court for the Northern District of Alabama ruled that the CTA is unconstitutional in response to a lawsuit brought by the National Small Business Association ("NSBA") and one of its individual members, Isaac Winkles. The lawsuit challenged the constitutionality of the CTA on various grounds, including allegations that the CTA's reporting requirements exceed Congressional authority under Article I of the U.S. Constitution, and violate the First, Fourth, Fifth, Ninth and Tenth Amendments. The court held that the CTA is unconstitutional because it exceeds Congress's enumerated powers, rejecting the government's arguments that the CTA is authorized under the foreign affairs powers, the Commerce Clause, and the taxing powers. However, the court remained silent regarding the plaintiffs' allegations that the CTA violates the specified Amendments. In connection with the ruling, the court also enjoined the federal government from enforcing the CTA as to the plaintiffs in the case. However, this injunction does not extend beyond those plaintiffs.

In response to the court's ruling, FinCEN issued a statement declaring that while the litigation is ongoing, FinCEN will continue to implement the CTA with reporting companies but will comply with the court's injunction as to Isaac Winkles, reporting companies for which Isaac Winkles is the beneficial owner or company applicant, the National Small Business Association, and members of the National Small Business Association as of March 1, 2024. FinCEN's statement acknowledges that those individuals are not required to report beneficial ownership information to FinCEN at this time; however, any other reporting companies are still required to comply with the CTA.

Companies should continue to monitor further proceedings in this case, which the government has appealed to the United States Court of Appeals for the Eleventh Circuit, as well as any similar lawsuits filed in other courts regarding the constitutionality of the CTA.

Deadlines For BOI Reports

In the meantime, the CTA filing deadlines remain in effect for most companies, and we recommend that companies prepare to meet these upcoming deadlines. Specifically, for entities formed on or after January 1, 2024, and before January 1, 2025, BOI Reports must be filed with FinCEN within 90 days of formation, unless one of the CTA's 23 exemptions applies. For entities formed on or after January 1, 2025, if required, BOI Reports must be filed with FinCEN within 30 days of formation. We recommend that any newly formed entities consider these short deadlines in connection with entity formation, and prepare in advance so they are able to meet the applicable deadlines.

With respect to entities formed before January 1, 2024, if required, BOI Reports must be filed with FinCEN by January 1, 2025. We recommend that companies subject to the January 1, 2025 deadline prepare in advance to allow sufficient time to analyze beneficial ownership, coordinate with beneficial owners, and prepare the required filings, particularly entities with complex capital structures, multiple entities, and/or large numbers of beneficial owners.

Assessing and Disclosing Beneficial Ownership Information

Unless a reporting exemption applies, the CTA requires each reporting entity to disclose specific personal information about all natural persons who, directly or indirectly:

  • Exercise substantial control over the entity; or
  • Own or control 25% or more of the ownership interests in the entity.
    • Note, however, that if a beneficial owner owns or controls their ownership interests in a reporting company exclusively through multiple exempt entities, then the names of all of those exempt entities may be reported to FinCEN instead of the individual beneficial owner's information.

Determining Substantial Control

An individual has "substantial control" over a reporting company if the individual:

  • serves as a senior officer;
  • has authority over appointment or removal of any senior officer or a majority of the board of directors (e.g., as a director);
  • directs, determines, or has substantial influence over important decisions of the company (such as decisions regarding the nature and scope of the company's business, the company's structure, major financial decisions, compensation of senior officers, significant contracts, governance documents, etc.); or
  • has any other form of substantial control.

An individual may exercise substantial control over a reporting company directly or indirectly through board representation, ownership or control of a majority of the voting power or voting rights of the reporting company, rights associated with a financing arrangement with the reporting company, control over one or more intermediary entities that individually or collectively exercise substantial control, arrangements or relationships (formal or informal) with other individuals or entities acting as nominees, or other contracts, arrangements or understandings.

Determining 25% Ownership Interest

Beneficial ownership information is also required from any natural person who, directly or indirectly, owns or controls 25% or more of the ownership interests in the entity. "Ownership interests" are not limited to traditional shares of stock, membership interests, or partnership interests and may include:

  • equity, stock or similar instruments;
  • capital or profits interests;
  • instruments convertible into any share or instrument described above, futures on any such instrument, or warrants or rights to purchase, sell, or subscribe to any such instrument;
  • puts, calls, straddles or other options to buy or sell any of the items described above; and
  • other instruments, contracts, arrangements, understandings, relationships or other mechanisms used to establish ownership.

"Ownership or control" may be direct or indirect, including control through any contract, arrangement or understanding, including:

  • joint ownership;
  • ownership through another individual acting as a nominee, custodian or agent;
  • ownership or control of one or more intermediaries that individually or collectively own or control ownership interests of the reporting company; and
  • for trusts holding ownership in a reporting company: a trustee, beneficiary, or grantor.

Ownership is calculated on a fully-diluted basis, as if all options, warrants and similar instruments are fully exercised, and calculations are performed on the ownership interests as they stand at the time of the calculation. For entities treated as partnerships for federal income tax purposes and any other entities that issue capital or profit interests, an individual's percentage ownership is calculated as a percentage of the total outstanding capital and profit interests of the entity (the "Capital Rule"). For corporations, entities taxed as corporations and those that issue stock, an individual's percentage ownership is calculated by taking the greater of (i) the total combined voting power of all classes of ownership interests of the individual as a percentage of total outstanding voting power of all classes of ownership interests entitled to vote (the "Voting Rule") or (2) the total combined value of the ownership interests of the individual as a percentage of the total outstanding value of all classes of ownership interests (the "Value Rule").

If any these calculations cannot be performed with reasonable certainty, then the individual is deemed to hold 25% or more of the total ownership interests in the reporting company if the individual owns or controls 25% or more of any class or type of ownership interests (the "Catch-All Rule").

Reporting companies with a complex capital structure (i.e., one utilizing SAFEs, convertible debt instruments, waterfall provisions, liquidation preferences attached to preferred stock, profits interests, etc.) will likely need to rely on the Catch-All Rule because they will not be able to calculate beneficial ownership "with reasonable certainty" under either the Capital Rule (for entities taxes as partnerships for federal income tax purposes) or the Voting Rule or the Value Rule (for entities taxed as corporations and those that issue stock) because, for example, (i) the conversion ratio into the underlying security of certain convertible interests, such as SAFEs and/or convertible notes, is not determinable at the time the calculation is performed or (ii) the entity's ownership interests, such as preferred stock, membership interests or profits interests, may have multi-tiered distribution arrangements or liquidation preferences and no reliable aggregate valuation is available to be used to calculate ultimate percentage ownership.

To apply the Catch-All Rule, a reporting company must identify each "class or type of ownership interests" that exists within a reporting company's capital structure. FinCEN has not yet provided detailed guidance on identifying and segregating each "class or type of ownership interest." Aggregating or over-generalizing "classes" or "types" of securities for purposes of this analysis may reduce the number of beneficial owners required to be reported (thus resulting in a less-burdensome disclosure), but may also subject reporting companies to the risk of noncompliance and penalties due to under-inclusive reporting. We recommend that reporting companies work with their advisors to conduct this analysis and continue to monitor CTA guidance and market practice as it evolves.

For individuals who have an indirect interest in a reporting company through an ownership interest in a holding company that has an ownership interest in the reporting company, the individual's ownership percentage in the reporting company is calculated by multiplying the individual's ownership percentage in the holding company by the holding company's ownership percentage in the reporting company.

Use of FinCEN Identifiers to Streamline Reporting Obligations

As discussed in our prior alert, a reporting company may provide a FinCEN identifier ("FinCEN ID") in lieu of a company applicant's and/or beneficial owner's personal information at the time of filing. The use of FinCEN IDs allows the reporting company to reduce its handling of potentially sensitive personal information. In addition, providing a FinCEN ID in lieu of the individual's personal information eliminates the need for a reporting company to file an updated BOI Report when the personal information of a beneficial owner changes (for example, a change in the beneficial owner's name, address, driver's license number, etc.), as the individual is obligated to keep such information updated directly with FinCEN.

This client alert is based on the CTA and FinCEN guidance in effect as of the date hereof, and we plan to provide periodic updates as FinCEN provides additional information and market practice regarding CTA filings and requirements becomes more settled.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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