LLC Archives - The National Law Forum

Unlike a Fine Wine, Tax Issues Do Not Get Better with Age

In a recent decision, the New York State Tax Appeals Tribunal (“Tribunal”) upheld notices of deficiency issued by the New York State Department of Taxation and Finance (the “Department”) totaling approximately $15 million in additional tax, plus interest and penalties for tax years dating as far back as 2002. In the Matter of the Petition of Cushlin Limited, DTA No. 829939 (TAT Oct. 10, 2024). The notices of deficiency came on the heels of an audit that lasted a decade and at the end of which the Department computed additional corporation franchise tax due “based on the information it had available” inasmuch as the information provided by the company over the 10-year audit was “incomplete and/or unsubstantiated.” This case is a cautionary tale for taxpayers and a reminder that tax issues do not get better with age, and delaying or putting off addressing known issues only makes the situation worse in the end.

The company was a corporation organized under the laws of The Isle of Man and was in the business of acquiring and refurbishing three- and four-star hotels. The company also owned equity interests in 13 limited liability companies (“LLCs”) that were doing business in New York. In 2008, the Department began an audit of one of the LLCs and discovered that it had sold real property in New York but did not file a New York State partnership tax return. As a result of its ownership interest in the LLCs, the Department determined that the company was required to file New York corporation franchise tax returns on which it was required to report the gains and losses of the LLCs. The audit of the company initially covered the tax years 2002 through 2006 and was later expanded to include 2007 through 2009.

From 2010 through 2013, the company and the Department communicated multiple times, and the company repeatedly stated that it was preparing tax returns for the audit years for the LLCs and the company and that it required more time to prepare those returns. In 2013, the company provided the Department with draft tax returns for the company and the LLCs. In May 2016, after another three years passed without final tax returns being filed, the Department informed the company that it was assessing additional corporation franchise tax computed based on the amounts in the draft returns plus interest and penalties. In June 2016, the company filed final tax returns for all of the audit years, and the final returns reflected income and deductions that were larger than the amounts previously included in the draft returns.

The Department then issued three information document requests over the next two years that requested information substantiating the deductions claimed on the filed returns. In response to these requests, the Tribunal found that the company “provided only partial responses that lacked any externally verifiable substantiation” and repeated Department requests were “met with partial, inconclusive responses.” Finally, in 2018, the Department issued the notices of deficiency that assessed the amount of additional corporation franchise tax that the Department had previously computed using the company’s draft returns plus updated additional interest and penalties. The company appealed and the Administrative Law Judge (“ALJ”) sustained the notices finding: (1) that the company had failed to meet its burden of proving that the notices were incorrect; and (2) that penalties were properly imposed as the company also failed to demonstrate that its failure to file timely returns was a result of reasonable cause and not willful neglect.

The Tribunal agreed with the ALJ, concluding that there was a rational basis for the notices because “[w]orking without returns or supporting documentation more than six years after it began, the [Department] used the available information provided by petitioner, verified by other information contained in the [Department’s] own database, to arrive at a computation of tax due from petitioner.” Moreover, the Tribunal reasoned, the Department provided the company with numerous opportunities to substantiate the amounts that the company reported on its filed returns and the company’s failure to provide substantiating information left the Department with “little choice” but to “use another method to arrive at a determination of tax liability.” Finally, the Tribunal concluded that the ALJ correctly determined that penalties were properly imposed as the company did not meet its burden to demonstrate reasonable cause.

Using an LLC to Protect the Family Vacation Home

Vacation homes offer a retreat from daily life, providing a sanctuary to relax and create cherished family memories. Many owners envision passing down their vacation home for future generations to enjoy, but the lack of proper planning can often lead to intra-family disputes. Leaving a vacation home outright to children or other family members may be the easiest option, but the potential for discord over the control and usage of the property only increases as ownership is passed from one generation to the next. A limited liability company (LLC) can mitigate the risk of conflict and provide a tailored solution to the meet the specific needs of a family.

When a vacation home is owned by an LLC, the membership interests in the LLC are passed down to younger generations, which allows for the continued use and enjoyment of the property by the family. The structure also provides a framework for management through an operating agreement, which governs the LLC. An operating agreement allows the original owner to create a plan for how the property will be used and managed as additional owners are added. The agreement can determine who is responsible for property management, how expenses should be proportioned and paid, how decisions should be made and provide guidelines for scheduling family usage. By establishing clear rules and procedures, an LLC can reduce the likelihood of disputes and encourage fairness among different generations.

Another benefit of an LLC is the ability to prevent unwanted transfers of ownership thus ensuring that the property stays in the family. A well-drafted operating agreement can prohibit membership interests from being transferred to third parties, protecting the family as a whole from an individual’s divorce or creditor problems. The LLC can also hold additional assets, including rental income and deposits of other funds earmarked for property expenditures, which facilitates the proper management and use of resources to cover expenses.

An LLC offers an efficient structure to avoid intra-family turmoil and preserves the spirit of the family vacation home for generations to come.

Amendments to New York LLC Transparency Act Delay Effective Date, Among Other Changes

New York Governor Kathy Hochul last month signed into law amendments to the recently enacted New York LLC Transparency Act (as amended, the “NYLTA”), extending the NYLTA’s effective date from December 21, 2024, to January 1, 2026 (the “Effective Date”).

The NYLTA will require all limited liability companies (“LLCs”) either formed under New York law or foreign LLCs that seek to be authorized to do business in New York to submit certain beneficial ownership information to the New York Department of State. LLCs will be required to disclose their beneficial owners unless the LLC qualifies for an exemption from the requirements. New York LLCs and foreign LLCs registered to do business in New York should evaluate their structure with counsel that is familiar with the NYLTA (and the federal Corporate Transparency Act (the “CTA”)) to determine whether they will have a filing obligation under the new law.

For New York LLCs formed on or prior to the Effective Date, and foreign LLCs authorized to do business in New York on or prior to the Effective Date, the deadline to file the required beneficial ownership report or the statement specifying the applicable exemptions(s) from the filing requirement is January 1, 2027. For New York LLCs formed after the Effective Date, and foreign LLCs authorized in New York after the Effective Date, the NYLTA will require that beneficial ownership information be submitted within thirty days of filing the articles of organization for an LLC formed under New York law or the initial application for registration filed by a foreign LLC. Thereafter, the NYLTA (as amended) imposes an ongoing requirement to file an annual statement with the New York Department of State confirming or updating (1) the beneficial ownership disclosure information; (2) the street address of the entity’s principal executive office; (3) status as an exempt company, if applicable; and (4) such other information as may be designated by the New York Department of State.

The definitions of important terms such as “exempt company,” “reporting company,” “applicant,” and “beneficial owner” used in the NYLTA refer to the equivalent definitions in the CTA but are limited in application only to LLCs. Correspondingly, the NYLTA shares the same 23 exemptions from the reporting requirements as the CTA. If an LLC falls within one or more of the available exemptions, however, in a departure from the CTA, the NYLTA requires the entity to submit a statement attested to under penalty of perjury indicating the specific exemption(s) for which the LLC qualifies.

Potential penalties for failing to comply with the NYLTA include monetary penalties of $500 for every day that a required filing under the NYLTA is past due, as well as a potential suspension or cancellation of an LLC.

The amendments to the NYLTA also provide that the beneficial ownership information relating to natural persons will be deemed confidential except (1) by written consent of or request by the beneficial owner of the LLC; (2) by court order; (3) to federal, state, or local government agencies performing official duties as required by statute; or (4) for a valid law enforcement purpose. This is in contrast to the original New York statute, which provided for beneficial ownership information to be made publicly available in a searchable database.

Profits Interest as Equity-Based Incentive: Keeping Your Team Motivated

Say you own one-half of an LLC that is taxed as a partnership. You and your partner invested the initial capital that was necessary to get the business up and running, and you both built the business with the help of a few key employees. With the business still in the growth phase, you want to make sure that you motivate and retain these key employees who are helping you grow your company. What should you do? You and your partner might want to consider causing the LLC to issue the key employees a profits interest in the LLC.

What is a Profits Interest?

From a tax-standpoint, an LLC can issue two basic types of membership interests: capital interests and profits interests. A capital interest is an interest in a partnership or LLC taxed as a partnership that entitles the recipient to share immediately in the proceeds of liquidation. A capital interest normally results from a capital investment and provides recipients with participation in current and future equity value, a share of income, and distributions. When someone receives a capital interest in an LLC in exchange for a corresponding capital contribution, this is typically a tax-free event. When someone receives a capital interest in exchange for services, this is taxable compensation to the service provider.

Profits interests are distinct from capital interests, providing no current right to share in the proceeds of liquidation as of the date of grant. Instead, they typically only provide a holder with the right to share in those profits of the business that arise after the recipient acquires the interest. The primary goal of issuing profits interests is typically to give a service provider the ability to participate in the growth of the enterprise without incurring tax on the receipt of the interest, and to enjoy at least some long-term capital gain treatment (instead of ordinary income treatment) on proceeds they receive on a sale of the LLC or similar liquidity event.

Structuring a Profits Interests

Usually, as long as the profits interest is structured properly and capital accounts are booked up on entrance of the profits interest member, the IRS should not treat the grant of a vested or unvested profits interest as a taxable event. Most practitioners design profits interests so that they meet IRS safe harbor standards for ensuring profits interest treatment. These standards include:

The profits interest must not relate to a substantially certain and predictable stream of income from the entity’s assets, such as income from high quality debt securities or a net lease,
The recipient of the profits interest must not dispose of it within two years of receipt, and
The profits interest may not be a limited partnership interest in a publically traded partnership.

The issuing entity’s partnership or operating agreement should be closely examined upon the issuance of a profits interest. Things to consider with respect to newly issued profits interests include whether such recipients should have voting rights similar to that of members who contributed capital to the enterprise. Additionally, the agreement should be updated to clearly define how the profits interests will be valued relative to capital interests under current buy-out or redemption provisions. Oftentimes, practitioners ensure that a profits interest has no right to share in liquidation proceeds on the grant date by valuing the company as of that date, and providing that a profits interest holder will not share in distributions except to the extent a threshold established based on the value is exceeded. Also, booking up capital accounts is generally critical to ensuring that the profits interest does not entitle the recipient to any proceeds of liquidation if the entity was liquidated on the grant date.

To the extent the profits interest issued is unvested at the time of issuance, most practitioners opt to make an 83(b) election to ensure tax-free treatment upon receipt. When a profits interest is issued, it has no value. If the profits interest is vested, there is no question that it is taxed at the time of receipt, at $0. Unvested property is taxed at the time of vesting, on the property’s value at the time of vesting. Hence, if the profits interest has appreciated in value since the time of grant, then there would be ordinary income at the time of vesting. To avoid this treatment, recipients of profits interests can make an 83(b) election, which is an election to treat the profits interest as vested for tax purposes at the time of grant and to be taxed on the value of the profits interest at the time of grant. There is some IRS guidance that states that an 83(b) election is not necessary. However, that issue is beyond the scope of this article and a so-called “protective 83(b) election” is usually still made to assist in easing the minds of profits interest holders who want to ensure that the interest is not taxable when it vests.

Tax Consequences of a Profits Interest

The recipient of a properly structured profits interest is not taxed on receipt because the IRS views the profits interest’s value as $0. Because the profits interest is treated as having no value, there is no deduction that corresponds to the issuance of the profits interest for the entity. The profits interest will be treated as having a $0 basis, and no capital account. Going forward, the recipient should be treated as an equity owner under the terms of the governing partnership or operating agreement for the entity starting on the date on which the profits interest was granted. The recipient should receive a K-1 and pay taxes on income that is passed through from the entity. Capital accounts should be adjusted accordingly, just as is the case for any other member.

The Future of Profits Interests

The history of how profits interests are taxed is riddled with controversy. In addition, politicians continue to discuss the desirability of profits interests (also sometimes called “carried interests”), in the context of private equity and hedge funds. However, the foregoing analysis reflects the IRS’ stated position on profits interests based on several Revenue Procedures that were issued to address the topic pending additional guidance. Until the IRS or Department of Treasury issues additional guidance, the current rules will generally remain applicable to small businesses and startups who are issuing profits interests.

Overall, profits interests are a unique and creative way to give people who are rendering services to the LLC or partnership a stake in the enterprise. They can generally be viewed as similar to options, except that they also provide the holder with a stake in the losses of the entity. With the increasing use of LLCs for startup operations, the use of profits interests as an incentive compensation mechanism has grown in the past years.

ARTICLE BY Katie K. Wilbur of Varnum LLP

Tax Talk: When Reporting Gifts at Discounted Values, a Qualified Appraisal is Crucial

A common method for transferring wealth from one generation to the next involves contributing assets to a partnership or limited liability company, then transferring minority interests in the partnership or LLC to descendants or other family members. Done correctly, the technique allows donors to reduce their taxable estates by making gifts at reduced values, because of discounts for lack of control and lack of marketability. In so doing, the donor also effectively shifts the tax on any appreciation of the underlying assets to the younger generation.

In order to benefit from this estate planning technique, however, it is crucial that the gift is adequately disclosed on a gift tax return and its value backed by a qualified appraisal or a detailed description of the method used to determine the fair market value of the transferred partnership or LLC interest. Unfortunately, we have encountered situations recently in which a gift was not supported by a qualified appraisal, leading the Internal Revenue Service to challenge the value claimed by the donor and to propose additional gift tax, penalties and interest. Such challenges can lead to significant uncertainty, stress and legal expense—even if the donor’s valuation ultimately is sustained.

This article describes what constitutes a qualified appraisal and the information that is necessary if no appraisal is provided, and offers some practical advice for donors based on our recent experiences dealing with the IRS in audits and administrative appeals involving disputed gift tax valuations.

IRS Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return, requires donors to disclose whether the value of any gift reflects a valuation discount and, if so, to attach an explanation. If the discount is for “lack of marketability, a minority interest, a fractional interest in real estate, blockage, market absorption, or for any other reason,” the explanation must show the amount of, and the basis for, the claimed discounts. Moreover, in order for the statute of limitations to begin running with respect to a gift, the gift must be adequately disclosed on a return or statement for the year of the gift that includes all of the following:

A complete Form 709;
A description of the transferred property and the consideration, if any, received by the donor;
The identify of, and relationship between, the donor and each donee;
If the property is transferred in trust, the employer identification number of the trust and a brief description of its terms (or a copy of the trust);
A statement describing any position taken on the gift tax return that is contrary to any proposed, temporary or final Treasury regulations or IRS revenue rulings; and
Either a qualified appraisal or a detailed description of the method used to determine the fair market value of the gift.

While most of these requirements are straightforward, the last generally requires the donor to provide a more complete explanation. Fortunately, the IRS has published regulations that describe what constitutes a qualified appraisal and what information must be provided in lieu of an appraisal.

With respect to the latter, the description of the method used to determine fair market value must include the financial data used to determine the value of the interest, any restrictions on the transferred property that were considered in determining its value, and a description of any discounts claimed in valuing the property. If the transfer involves an interest in a non-publicly traded partnership (including an LLC), a description must be provided of any discount claimed in valuing the entity or any assets owned by the entity. Further, if the value of the entity is based on the net value of its assets, a statement must be provided regarding the fair market value of 100% of the entity (determined without regard to any discounts in valuing the entity or any assets owned by the entity), the portion of the entity subject to the transfer, and the fair market value of the transferred interest as reported on the return.^[1]

Donors and their counsel will rarely have the expertise needed to provide such a description. While it may be relatively simple to provide some of the factual information, determining the appropriate actuarial factors and discount rates is a highly complex and specialized field. Moreover, even if a donor or his or her counsel happened to have the relevant expertise, a description that is not prepared by an independent expert may be viewed suspiciously by the IRS because of a lack of impartiality. Moreover, if the description (or the appraisal, for that matter) is prepared by the donor’s counsel, it may negate the attorney-client privilege, at least with respect to any work papers prepared by the attorney in connection with the description or appraisal.

For these reasons and others, we strongly recommend that donors obtain an appraisal from an independent, reputable valuation firm before claiming discounts with respect to a gift of a partnership or LLC interest. The applicable Treasury regulations provide that the requirement described above will be satisfied if, in lieu of submitting a detailed description of the method used to determine the fair market value of the transferred interest, the donor submits an appraisal of the transferred property prepared by an appraiser who meets all of the following requirements:

The appraiser holds himself or herself out to the public as an appraiser or performs appraisals on a regular basis;
Because of the appraiser’s qualifications, as described in the appraisal that details the appraiser’s background, experience, education, and membership, if any, in professional appraisal associations, the appraiser is qualified to make appraisals of the type of property being valued; and
The appraiser is not the donor or the donee of the property or a member of the family of the donor or donee or any person employed by the donor, the donee or a member of the family of either.

Further, the appraisal itself must contain all of the following:

The date of the transfer, the date on which the transferred property was appraised, and the purpose of the appraisal;
A description of the property;
A description of the appraisal process employed;
A description of the assumptions, hypothetical conditions, and any limiting conditions and restrictions on the transferred property that affect the analyses, opinions and conclusions;
The information considered in determining the appraised value, including, in the case of an ownership interest in a business, all financial data used in determining the value of the interest that is sufficiently detailed to allow another person to replicate the process and arrive at the appraised value;
The appraisal procedures followed, and the reasoning that supports the analyses, opinions, and conclusions;
The valuation method used, the rationale for the valuation method and the procedure used in determining the fair market value of the asset transferred; and
The specific basis for the valuation, such as specific comparable sales or transactions, sales of similar interests, asset-based approaches, merger-acquisition transactions and the like.^[2]

While there is no firm rule on when or how often appraisals must be obtained, appraisals that are more than a year old may be less reliable—particularly if there is good reason to believe that the value of the underlying assets has changed—and thus more vulnerable to challenge.

An appraisal that meets all of the requirements described above is not unassailable, of course, but if the IRS does choose to challenge a gift tax valuation that is supported by such an appraisal, the donor will be in a significantly stronger position in the resulting examination or proceeding than a donor who failed to obtain a qualified appraisal or opted to rely on a stale appraisal.

In sum, obtaining a qualified appraisal is a crucial step in any estate planning or gifting strategy that involves making gifts of assets valued at a discount. Although donors may occasionally balk at the time and expense of preparing a reliable appraisal, it is almost certainly less time-consuming and costly than battling the IRS in an examination, administrative appeal or in litigation and should give donors confidence that their gifts are unlikely to be successfully challenged by the IRS.

Article By Ivan H. Gold of Schiff Hardin LLP

_{[1] Treas. Reg. § 301.6501(c)-1(f)(2)(iv).}

_{[2] Treas. Reg. § 301.6501(c)-1(f)(3).}

Jumpstart Your Startup: Entity Selection and Formation

When starting a business, you must decide what form of business entity to establish. The “choice of entity” decision is one of the most important decisions facing new business owners. There are several forms of business to choose from, each of which generates different legal and tax consequences. That said, there is no single form of entity that is appropriate for every type of business owner.

The most common forms of business are the sole proprietorship, partnership, C corporation, S corporation, and limited liability company.

Sole Proprietorship

A sole proprietorship is the simplest business structure. It is an unincorporated entity owned and run by one individual with no distinction between the business and the individual owner. The owner is entitled to all profits and is personally responsible for all the business’ debts, losses, and liabilities.

A sole proprietorship needs to obtain the necessary licenses and permits for the industry in which the sole proprietorship does business. If the business operates under a name different than the individual, registering that name (e.g., DBA name, short for “doing business as”) with a state agency may be required.

Because the business and the owner are one and the same, the business itself is not taxed separately. The owner is responsible for and reports income, losses and expenses for income tax purposes.

Partnership

A partnership is the relationship between two or more persons who join to carry on a trade or business. Each partner may contribute money, property, labor, and/or skill, and, in return, each partner shares in the profits and losses of the business.

Because partnerships involve more than one person, it is important to develop a partnership agreement. The partnership agreement should document how future business decisions will be made, including how the partners will divide profits, resolve disputes, change ownership (i.e., bring in new partners or buy out current partners) and under what circumstances the partnership would be dissolved. In addition, owners of a partnership should determine which type of partnership to establish. The three most common types of partnership arrangements are:

General Partnership: Profits, liability, and management duties are presumed to be divided equally among all partners. If an unequal ownership distribution is preferred, the partnership agreement must document that preference. A general partnership ordinarily owns its assets and is responsible for its debts. It is important to note that in a general partnership, the individual partners are personally liable for all partnership debt, obligations and liabilities. No formal state registration and/or filing is required to form a general partnership.
Limited Partnership: A limited partnership requires at least one general partner and one limited partner. Limited partners are generally not liable for the debts and obligations of the limited partnership (though the general partners will be liable), but they must have restricted participation in management decisions. Limited partnerships ordinarily must be filed with a state.
Limited Liability Partnership: A limited liability partnership generally operates and is governed by the same rules as a general partnership, except: (1) its partners have limited liability for partnership debt, (2) it can choose to be taxed as a corporation or a partnership, and (3) it is formed by filing the appropriate documentation with a state.

Generally, a partnership must file an annual information return to report income, deductions, gains, and losses from its operations, but it does not pay income tax. Instead, it “passes through” any profits or losses to its partners. Each partner includes his or her share of the partnership income or loss on his or her individual tax return.

C Corporation

A C corporation is an independent legal entity incorporated in a single state, although it may do business in other states. Because a corporation is an independent legal entity, its existence continues until formally dissolved under the laws of the state in which it is incorporated. Ownership of a corporation is in the form of shares of stock, there is no limit to the number of stockholders, and there is no limit on the number of classes of stock a C corporation can issue. Additionally, the corporation itself, not the stockholders, is generally liable for the debts and obligations of the business.

For corporate governance, a corporation generally has a board of directors and bylaws. The initial directors may be named in the articles of incorporation or elected shortly after filing the articles of incorporation. Thereafter, directors are elected as set out in the articles of incorporation or bylaws.

For federal income tax purposes, a C corporation is recognized as a separate taxpaying entity. The profit of a C corporation is taxed to the corporation when earned, and then is taxed to the stockholders if and when distributed as dividends. This creates a double tax. The corporation does not receive a tax deduction when it distributes dividends to stockholders and stockholders cannot deduct any loss of the corporation.

S Corporation

An S corporation is similar to a C corporation, except that an S corporation passes income, losses, deductions, and credits through to its stockholders for federal tax purposes. Stockholders of an S corporation report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates. Thus, an S corporation generally avoids double taxation on corporate income.

In order to become an S corporation, the corporation must make appropriate filings with the IRS. To qualify for S corporation status, the corporation must meet the following requirements:

Be a domestic corporation;
Have only allowable stockholders, which are individuals, certain trusts and estates, and may not include partnerships, corporations (unless owned as a qualified subchapter S subsidiary), or non-resident aliens;
Have no more than 100 stockholders;
Have only one class of stock; and
Not be an ineligible corporation (e.g., certain financial institutions and insurance companies).

S corporations file specific tax returns and tax forms with the IRS.

Limited Liability Company

A limited liability company (“LLC”) is a hybrid entity that is treated like a corporation for limited liability purposes, but for tax purposes can choose to be taxed either as a corporation, partnership, or, in some cases, a disregarded entity (i.e., single-member LLC). A limited liability company is created under state law by filing articles of organization with a state. The owners of an LLC are referred to as “members” and generally may include individuals, corporations, other LLCs and other types of entities. There typically is no maximum number of members.

LLCs with more than one owner should have an operating agreement. An operating agreement usually includes provisions that address ownership interests, allocation of profits and losses, and members’ rights and responsibilities, among others.

Since the federal government does not consider an LLC a separate legal entity, an LLC with at least two members is, by default, classified as a partnership for federal tax purposes unless it files with the IRS and affirmatively elects to be treated as a corporation for tax purposes. An LLC with only one member is referred to as a single-member LLC and is treated as one and the same as its owner for income tax purposes (but as a separate entity for purposes of employment tax and certain excise taxes), unless it affirmatively elects to be treated as a corporation. An LLC may also elect to be taxed as an S corporation.

The business structure you choose will have significant legal and tax implications. In order to identify the best structure for you, it is important to understand your business goals and how the characteristics of each type of business entity can help you achieve those goals.

Article By:

Patrick J. Cannon

Of:

von Briesen & Roper, S.C.

Three Provisions You Cannot Operate Without In Your Operating Agreement

Thomas D. Flanigan of McBrayer, McGinnis, Leslie and Kirkland, PLLC recently had an article featured in The National Law Review titled, Three Provisions You Cannot Operate Without In Your Operating Agreement:

Deciding on the entity form to use for your business depends on a number of factors, but for many entrepreneurs, an LLC is the best fit. An LLC is a hybrid entity as it provides liability protection similar to a corporation and favorable income tax treatment similar to a partnership. If you are starting or currently operating a business through an LLC, your most important organizational document is the agreement between you and your partners: the Operating Agreement. An operating agreement establishes the internal operations of the business in a way that suits the specific needs of the business owners. Once signed by the members of the LLC, it is an official binding contract.

Another benefit of using an LLC to operate your business is the flexibility LLC owners have to structure their operations and business relations with their partners. While the Kentucky Limited Liability Company Act contains default provisions for many of the organizational issues that may arise, members of an LLC may agree to operate under provisions other than the Act’s default provisions. No matter the nature of your business, your LLC should have an operating agreement that includes details such as voting rights and responsibilities, powers and duties of members and managers, allocation of profits and losses, and distribution of capital, whether the members agree to use the LLC Act’s default provisions or alternatives to the default language.

As an example of the flexibility of the Act, and also of the importance of carefully considering the effects of each section of your operating agreement, consider the following three provisions that will help your business run smoothly.

1. Transfer provisions.

An operating agreement typically contains some language about the circumstances under which a member may or must transfer his ownership interest in the LLC to another person or entity. Under the Act, a member may freely transfer membership interest to anyone. There are a number of provisions in the Act that tell us how the transferring member and the new owner are to be treated, one of which is that the new owner will not be a full member with the right to vote unless a majority of the other members vote to make the new owner a full member. If members are allowed to freely transfer their interests however, founding members may find themselves faced with new business partners they did not approve. Moreover, a member’s interest could be transferred involuntarily, such as by death, divorce, or bankruptcy. For these and other reasons, you and your business partners may decide on a transfer provision that would limit uncertainty in these situations. Terms in the operating agreement may require a majority of members to vote to allow a proposed transfer before it can occur, or give the company or the members a right of first refusal to purchase the membership interest subject to a proposed transfer. The members might agree to purchase life insurance policies to provide the funds to purchase the membership interest of a member at death. The operating agreement may also prohibit members from pledging (granting a lien on) membership interest. Putting restrictions on transferability gives members control over when, how, and why membership interests are transferable.

2. Deadlock provisions.

Management or member deadlock occurs when a company’s decision makers are evenly split on a matter and neither side will relent. It is a potentially fatal problem and, thus, should always be addressed within the operating agreement. Under the Act, the remedy for deadlock is judicial dissolution. A court “may dissolve a limited liability company in a proceeding by a member if it is established that it is not reasonably practicable to carry on the business of the limited liability company in conformity with the operating agreement.” Once the LLC is dissolved, it cannot carry on business, but must wind up and liquidate its business. There are, however, many strategies that can be put into your operating agreement to avoid this problem:

· The opposing member may be allowed to withdraw from the LLC.

· The operating agreement may require that a deadlock at the manager level be subject to a vote of the members.

· The members may agree to be bound by a coin flip.

· The members may be required to take the issue to binding arbitration.

· The members may incorporate a buy-sell provision that would require one member to provide a purchase price to the other member and then require that other member to purchase or sell the membership interest in the LLC at that purchase price such that the selling member ceases to be a member of the LLC.

With each of these strategies, the common feature is that the LLC is likely to continue as a functioning business after the deadlock is resolved.

3. Additional Capital Contributions.

A company operating agreement will usually state the amount of money or the value of property each member initially contributes to the company for operations, known as initial capital contributions. As an example, three people may decide to start a business and agree that each of them will give the company $3,000 so the company has $9,000 in start-up capital. Most operating agreements also have language about additional money from the members, known as additional capital contributions. Because the Act allows flexibility here as well, that language may state that members are not required to make additional capital contributions, or it may require additional capital contributions and allow for one member to make an additional capital contribution for another member that fails to make that contribution when due in exchange for a portion of that member’s membership interest. There are many possibilities. But frequently, when considering these possibilities, members fail to consider the effect of the additional capital contribution language on the limited liability feature of the LLC.

One important function of an LLC is that the members are not individually liable for the debts of the LLC if the LLC cannot pay its creditors. That protection from individual liability is not absolute, however. Among other things that may cause a court to ignore limited liability protection, including fraud, intentional misconduct, or the failure to maintain a real distinction between the LLC and its members, the additional capital contribution language can be read to require the members to pay LLC debt that the LLC cannot pay itself. The members may avoid this by affirmatively stating in the operating agreement that additional capital contributions are never required and the members have no personal liability for the debts of the LLC, but that may cause problems later if the LLC needs additional capital. The members may instead decide to have additional capital contribution language, but to have it drafted carefully so as to avoid unintentionally negating the limited liability protection generally afforded by the LLC. The important thing is to consider and plan for the potential needs of the LLC, and to do so in a way that doesn’t result in unintended consequences for the LLC or its members.

Every successful business encounters bumps in the roads. An operating agreement is a road map, a tool to navigate through the difficult obstacles.

The Debate Rages On Regarding Whether Default Fiduciary Duties Apply to LLC Managers Under Delaware Law

Michael C. Hefter and Ryan M. Philp of Bracewell & Giuliani LLP recently had an article, The Debate Rages On Regarding Whether Default Fiduciary Duties Apply to LLC Managers Under Delaware Law, featured in The National Law Review:

Earlier this year, we reported on the Delaware Court of Chancery’s decision in Auriga Capital Corp. v. Gatz Properties, LLC, wherein Chancellor Strine held that traditional fiduciary principles apply to LLC managers or members by default. See Delaware Chancery Court Clarifies that Default Fiduciary Duties Apply to LLC Managers, March 15, 2012 available here (discussing Auriga Capital Corp. v. Gatz Properties, LLC, No. C.A. 4390-CS, 2012 WL 361677 (Del. Ch. Jan. 27, 2012)). We emphasized that “until the Delaware Supreme Court or General Assembly state otherwise, Chancellor Strine has definitively established that LLC managers are governed by the same well-established fiduciary duties applicable to corporate fiduciaries, unless explicitly stated otherwise in the LLC Agreement.”

On November 7, 2012, the Delaware Supreme Court issued its decision on appeal. In an en banc opinion, the Supreme Court affirmed the Court of Chancery decision, but declined to reach the issue whether default fiduciary duties exist for LLC managers. See Gatz Properties, LLC v. Auriga Capital Corp., No. 148, 2012 (Nov. 7, 2012). The Supreme Court instead affirmed on the ground that the defendants breached their fiduciary duties arising from an express contractual provision in the operating agreement of the LLC. The Supreme Court’s analysis focused on Section 15 of the LLC Agreement. Section 15 provided, in pertinent part, that no member or manager was permitted to cause the company to “enter into any additional agreements with affiliates on terms and conditions which [were] less favorable to the Company than the terms and conditions of similar agreements which could then be entered into with arms-length third parties . . . .” Emphasizing that “there is no requirement in Delaware that an LLC agreement use magic words, such as ‘entire fairness’ or ‘fiduciary duties[,]'” the Supreme Court construed Section 15 as an explicit contractual assumption by the contracting parties of a fiduciary duty to obtain a fair price for the LLC in transactions between the LLC and affiliated persons. Viewing Section 15 functionally, the Supreme Court treated it as the contractual equivalent of the entire fairness standard of conduct and judicial review. Thus, because there was no approving vote by the majority of the Company’s minority members, the Supreme Court held that the defendant – the LLC’s manager – had the burden of establishing the entire fairness of the transaction. Referencing the defendant’s trial testimony and the evidentiary record, the Supreme Court held that he failed to meet this burden, and thus affirmed the Court of Chancery’s holding that he had breached his contractually adopted fiduciary duties.¹

While the Supreme Court’s contractual analysis is instructive, the decision has garnered far more attention based on the Supreme Court’s analysis of Chancellor Strine’s holding that default fiduciary duties apply to LLC managers, which it characterized as “dictum without any precedential value.” The Supreme Court reasoned that “[w]here, as here, the dispute over whether fiduciary standards apply could be decided solely by reference to the LLC Agreement, it was improvident and unnecessary for the trial court to reach out and decide, sua sponte, the default fiduciary duty issue as a matter of statutory construction.” The Supreme Court thus intentionally left unresolved the question whether default fiduciary duties apply to managers of an LLC.

However, the debate regarding default fiduciary duties did not end there. Just a few weeks later, Vice Chancellor Laster revisited the issue in Feeley v. NJAOCG, C.A. No. 7304-VCL (Del. Ch. Nov. 28, 2012), a case that, unlike Auriga, put the question of default fiduciary duties squarely before the court. Though he acknowledged that the Auriga decision could not be relied upon as precedent, Vice Chancellor Laster nonetheless adopted Chancellor Strine’s analysis, “afford[ing] his views the same weight as a law review article, a form of authority the Delaware Supreme Court often cites.” Based on Chancellor Strine’s reasoning and “the long line of Chancery precedents holding that default fiduciary duties apply to the managers of an LLC[,]” the Court held that default fiduciary duties apply to LLC managers. Vice Chancellor Laster recognized, however, that “[t]he Delaware Supreme Court is of course the final arbiter on matters of Delaware law.”

Thus, in many ways these two decisions bring things full circle. Until the Delaware Supreme Court or General Assembly address the question whether default fiduciary duties exist for managers of Delaware LLCs, Delaware Chancery precedent provides that they do. However, while this may suggest extra caution be used when drafting an LLC agreement, the Supreme Court’s contractual analysis in the Auriga decision suggests that the question of default fiduciary duties may often be beside the point. Even in the absence of magic language regarding “fiduciary duties” or “entire fairness,” imprecise language in an LLC agreement may be construed as a contractual assumption by the LLC manager to abide by traditional fiduciary duties. Thus, while we do not expect that Chancellor Strine’s Feeley decision represents the last word in the default fiduciary duty debate, the lesson is the same: LLC agreements should be drafted to expressly address the nature and scope of the LLC managers’ fiduciary duties, or to specifically eliminate fiduciary duties altogether.

_{1 The Supreme Court also affirmed the Court of Chancery’s determination that the LLC Agreement did not exculpate or indemnify the LLC’s manager due to his bad faith and willful misrepresentations, as well as its awards of damages and attorneys’ fees.}

Beware of Ohio LLCs: New law changes the game for LLC members

The National Law Review recently published an article by Jason B. Sims of Dinsmore & Shohl LLP regarding Ohio LLC’s:

If you are thinking about forming an LLC in Ohio for your new business, you may want to think again. And if you are a member of an existing Ohio LLC, the Ohio legislature just signed you up for a non-compete agreement with that LLC. On May 4th, the provisions of House Bill 48 related to Ohio LLCs went into effect. House Bill 48 was a legislative initiative that made several changes to the Ohio corporate statute and LLC statute. While the Bill made many positive changes, the Ohio legislature made some changes to the LLC statute that seriously bring into question if an Ohio LLC is a viable option any more for selecting what type of entity that a new business will operate under. Here is a brief summary of the important changes that House Bill 48 made to Ohio’s LLC statute:

Members have fiduciary duties of loyalty and care to other members. Members also have an obligation of good faith and fair dealing when discharging the member’s duties to the LLC or the other members. The statute already set out the fiduciary duties of managers that were similar to the standard for directors of a corporation. However, if a member is a manager these manager specific fiduciary duties only apply if the member was appointed in writing and the member has agreed in writing to serve as a manager; otherwise the member’s fiduciary duties are the same as those of the members (duty of loyalty, care and the obligation of good faith and fair dealing).

The duty of loyalty for a member is defined as: (1) accounting to the LLC and hold in trust for the LLC any profit or benefit the member derives in the conduct of the LLC’s business or the member’s use of the LLC’s property (which includes appropriating a company opportunity of the LLC); (2) refraining from dealing with the LLC on behalf of a party having an interest adverse to the LLC; and (3) refraining from competing with the LLC. This last obligation is troubling.
The duty of care for a member is defined as refraining from gross negligence, intentional misconduct or knowingly violating the law, all when acting on behalf of the LLC.
An operating agreement cannot eliminate the members’ duties of loyalty, care and good faith and fair dealing. However, the operating agreement may identify specific categories of activities that do not violate the duty of loyalty so long as they are not manifestly unreasonable.
Members can authorize or ratify an action that would otherwise be a breach of a duty of loyalty after full disclosure of all material facts related to the action.

While Ohio courts have adopted many of these duties for members, they have never included an express obligation to refrain from competing with the LLC. With these changes, Ohio now goes in the opposite direction of Delaware, which expressly permits the elimination of fiduciary duties for managers and members.

These additional duties would not provide any significant problems if the members of an LLC could opt out or alter them to meet the particular needs of the members and the LLC. However, the new provisions of the statute prohibit members of an Ohio LLC from eliminating the duties of care, loyalty and good faith and fair dealing in the LLC’s operating agreement. Also, these express duties apply to all members regardless of the size of their equity interest or involvement in the operation of the LLC. In many instances, an operating agreement for an LLC will expressly permit competition as there is a recognition that members may come together to invest in a specific opportunity but otherwise want to be free to pursue their other interests without any restrictions.

As to the idea that you can carve out some items from the duty of loyalty that are not “manifestly unreasonable”, in my nearly 20 years of practice I have never figured out exactly what manifestly unreasonable means. It is one of those legal terms that sounds important and fair, but in practice makes it nearly impossible for lawyers to provide concrete guidance to their clients. So, while businesses look for certainty, they are left with a “I know it when I see it” standard. Members of LLC’s will be able to carve out certain items from the duty of loyalty, but as to exactly what items, who knows?

The concept of an LLC was founded on the basic principal of freedom of contract. As a result, LLC’s provide great flexibility to its members on how to conduct their affairs in operating the business of the LLC. While I am sure the Ohio legislature did not intend to do this, one result of these changes is to restrict this flexibility. So, if you are in Ohio and want to form an LLC with multiple members for your new business, you should consider forming a Delaware LLC or an LLC in some other state and qualify to do business in Ohio as a foreign company.

What is an LLC and How Does an LLC Work?

Featured recently in The National Law Review an article by Christopher J. Caldwell and Laura E. Radle of Varnum LLP regarding LLCs:

Varnum LLP

Many cottage owners have heard of others who have established a “Cottage LLC”. But what exactly does this mean? What is an LLC? How does an LLC which owns a cottage work and why would someone use an LLC to own his or her cottage?

Simply put, an LLC is a “limited liability company,” which has some features of both partnerships and traditional corporations. It provides greater liability protection than individual ownership and may have perpetual existence. However, an LLC is also somewhat simpler to manage than a traditional corporation.

In an LLC the owners are called members. The LLC can be controlled either by its members or by managers who are selected by the members. In family cottage situations, selecting one or two managers (who may be members) typically works best.

The rules and regulations of an LLC are set forth in the LLC’s operating agreement. The operating agreement can be as basic or as detailed as the members wish. At a minimum, when created for cottage ownership, the operating agreement should discuss the potential sale or transfer of the cottage, management responsibilities, contributions for expenses, potential for renting, scheduling of time, liability of the owners, and an exit strategy if one owner wants to end the relationship. The primary goal of the LLC – as addressed by the operating agreement – is to provide clear rules, rights and obligations for all of the members.

Cottage owners often need to use an entity that will provide a liability shelter (for example, if the cottage is rented to third parties). But the owners also need an entity that does not require a lot of time to maintain. And, most importantly, because cottage owners want to be able to tailor the operating agreement to fit their lifestyles, they need an entity that is flexible. The LLC has all of these attributes, making it a great match for cottage owners. And once an LLC is established, cottage owners will be able to focus on the fun part of their ownership, spending carefree and conflict-free time at the cottage.

Tag: LLC

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