LLC Law Monitor

The IRS Again Loses in Attempt to Limit the Deductibility of LLC Losses

Doug Batey — Mon, 08 Mar 2010 16:36:57 -0800

The Tax Court has again ruled against the Internal Revenue Service in a case on the deductibility of a member’s LLC losses. Newell v. Commissioner, T.C.M. 2010-23 (Feb. 16, 2010). Last year I wrote about the three prior cases, here.

In these cases the IRS has taken the position that its regulations require a presumption that LLC losses are “passive activity losses” (passive losses). Under the regulations this presumption is difficult to overturn, so in many cases LLC losses are treated as passive losses. And for most taxpayers, passive losses are far less useful than active losses (losses not resulting from passive activities). Taxpayers generally prefer to use losses to offset taxable income, but passive losses can only be used to offset income from other passive activities, and not against income such as wages, interest, and dividends.

The Tax Court ruling in Newell is consistent with the prior cases in its interpretation of the IRS’s regulations. The regulations create a presumption that losses incurred by a limited partner in a limited partnership are passive losses, and make it difficult to overcome the presumption. The IRS has taken the position that a member of an LLC should be treated like a limited partner of a limited partnership for purposes of the regulation. The courts, including the Tax Court last month in Newell, have rejected the IRS’s argument.

This latest case should give additional comfort to LLC members, that they should be able to use LLC losses to offset “active” income such as wages. LLC members will still need to demonstrate that they materially participate in the LLC’s management, but they will be able to use the more flexible rules of the IRS’s regulations, without the need to overcome the presumption against material participation.

The IRS could of course change these regulations to explicitly treat LLCs in the same way that limited partnerships are treated. Because LLCs are relatively new, the IRS may still be trying to figure out how to deal with them while limiting the potential for abuse.

Deadlocked Manager and Deadlocked Members Plus Threatened Irreparable Harm Equals Judicial Dissolution of Solvent LLC

Doug Batey — Thu, 25 Feb 2010 08:14:53 -0800

The LLC in In re Metcalf Associates-2000, L.L.C. v. Chambers, 213 P.3d 751 (Kan. Ct. App. 2009), owned real estate encumbered by a loan that was coming due in the near future. The real estate needed to be sold or the loan refinanced, but the LLC’s manager could not act because it was deadlocked internally. The owners of the two 50% voting blocks in the LLC were deadlocked and could not agree on a course of action. Because the LLC was in effect frozen, one group of owners petitioned the court for the dissolution of the LLC and the sale of the real estate. The Kansas Court of Appeals upheld the trial court’s order for dissolution of the LLC.

Many state LLC statutes provide for judicially ordered dissolution if it is not reasonably practicable to carry on the LLC’s business in conformity with the LLC’s operating agreement. E.g., Del. Code Ann. tit. 6, § 18-802. Washington’s LLC Act is similar, but adds “or other circumstances render dissolution equitable.” Wash. Rev. Code § 25.15.275. These statutes emphasize the role of the operating agreement in evaluating whether judicially ordered dissolution is appropriate.

The Kansas statute, by contrast, uses an “irreparable injury” test. Any member owning at least 25% of the outstanding interests in the LLC’s capital or profits and losses may petition the court for dissolution and sale of the LLC’s assets

[i]f the business of the limited liability company is suffering or is threatened with irreparable injury because the members of a limited liability company, or the managers of a limited liability company having more than one manager, are so deadlocked respecting the management of the affairs of the limited liability company that the requisite vote for action cannot be obtained and the members are unable to terminate such deadlock ….

Kan. Stat. Ann. § 17-76,117(b). The approach of the Kansas statute, with its emphasis on deadlock and irreparable injury, comes straight out of the corporate statutes. E.g., Wash. Rev. Code § 23B.14.300(2)(a); Model Bus. Corp. Act § 14.30(2)(i) (2008).

The defendant Michael Chambers argued that a unanimity provision in the LLC’s operating agreement precluded a finding of deadlock. Chambers argued that (a) the LLC’s purpose was to buy office buildings and sell them for a profit; (b) the operating agreement required the unanimous agreement of the members to sell the LLC’s real estate; and (c) therefore there could not be a deadlock because the members had not fulfilled the requirement for unanimous agreement that it was time to sell.

The court, however, recognized that there was a fundamental dispute between Chambers and Patrick Hayes (who controlled the other 50% of the LLC). Hayes wanted to sell the building in a short period of time, and Chambers wanted to acquire the building for himself at a price substantially below its fair market value. The court opined that the LLC’s operating agreement could have been drafted to specifically limit the situations in which the court could declare a deadlock, but held that the unanimity requirement did not preclude a finding of deadlock and application of the statutory remedy for deadlock. Metcalf, 213 P.3d at 757-58.

Chambers also argued that the LLC was not facing irreparable harm because it was a solvent, profitable company with substantial rental income. But the court noted that the LLC had no management because its sole manager was itself deadlocked, and the LLC had no way to sell or refinance its real estate because of the members’ deadlock. The statute allows for judicial dissolution when the LLC is suffering or is threatened with irreparable injury. “By including both the actual suffering of irreparable injury and the mere threat of that injury, the legislature has implicitly rejected Chambers’ argument that a company can’t be dissolved so long as it’s still solvent.” Id. at 759.

So is there any difference in outcome between the approach of the Kansas statute (deadlock plus actual or threatened irreparable harm) and that of the Delaware statute (not reasonably practicable to carry on the LLC’s business in conformity with the LLC’s operating agreement)? The Delaware approach looks to the expectations of the parties under the LLC’s operating agreement, while the Kansas test is independent of the operating agreement. Also, the Delaware approach does not require either deadlock or irreparable harm in order for dissolution to result. All that Delaware requires is that it not be reasonably practicable to carry on the LLC’s business in conformity with the LLC’s operating agreement. The cause is not specified, although in many cases it is likely to be a deadlock between the members.

In Metcalf, the result would likely have been the same under the Delaware statute, since it’s hard to see how the LLC’s business could have been carried on in any manner, let alone in conformity with the operating agreement.

An LLC's Property Is Not the Members' Property

Doug Batey — Fri, 12 Feb 2010 11:05:35 -0800

A recent New York case dealt with one of the most fundamental characteristic of LLCs – the LLC as a legal entity. Sealy v. Clifton, LLC, 890 N.Y.S.2d 598, 2009 N.Y.App. Div. LEXIS 9020 (N.Y.App.Div. 2009). One of two LLC members, each owning a 50% interest, asked the trial court to partition the LLC’s real estate. In a partition action, real estate held by joint tenants or tenants in common is divided into portions so that each co-owner is awarded full, individual ownership of a portion of the real estate. The trial court refused to dismiss the partition action, but the Appellate Division reversed and required dismissal by the trial court.

Under state LLC laws, an LLC is a legal entity, in effect a legal person. An LLC can sue and be sued, own property, enter into contracts, and do many of the things that an individual human being can do. E.g. N.Y. Ltd. Liab. Co. Law §§ 203(d), 202.

Since an LLC is a legal person, the property it owns is the property of the LLC, not of the members. The New York LLC Act is clear: “A membership interest in the limited liability company is personal property. A member has no interest in specific property of the limited liability company.” N.Y. Ltd. Liab. Co. Law § 601. Other state LLC laws have similar provisions.

Relying on Section 601, the Sealy court held that the LLC, not its members, owned the real estate. Because the members were not co-owners of the real estate, the partition action had to be dismissed. Sealy, 2009 N.Y.App. Div. LEXIS 9020, at *1. Prior New York law allowed partition actions to be brought only by co-owners.

Perhaps the reasoning of the Sealy plaintiff was: “I am a part owner of the LLC; the LLC owns the real estate, therefore I am a part owner of the real estate.” In other words, something like “I own the box, ergo I own what’s inside the box.” The analogy is not apt, but perhaps it convinced the trial judge, since he refused to throw out the partition request.

That theory breaks down because an LLC is a legal entity, a legal person. The real estate in Sealy was owned by the LLC, not by the members. The only way a member could reach the real estate would be to cause the dissolution and winding up of the LLC. In that process either the real estate would be liquidated and its proceeds distributed to the members, or the real estate could be divided by the LLC and the individual parcels of the real estate distributed in kind to the members. But the member apparently had not pursued dissolution.

The legal personhood of LLCs, like that of corporations, partnerships and other entities, is a legal doctrine thoroughly woven into our legal, business, financial and political systems. It allows the law to treat LLCs as persons for many purposes – but not all. For example, LLCs cannot marry, adopt children, hold public office, or vote in public elections.

Some constitutional rights apply to legal entities. For example, the U.S. Supreme Court last month invalidated a federal ban on corporate expenditures for public communications intended to affect federal elections. The Court held that the First Amendment’s mandate that “Congress shall make no law … abridging the freedom of speech” applies to corporations. Citizens United v. Fed. Election Comm’n, 175 L. Ed. 2d 753 (2010). The Court’s opinion saw corporations as entitled to be heard in the political arena, like individuals. This was a controversial five-to-four decision that overruled prior Supreme Court precedent.

The boundaries of the legal doctrine that treats corporations and LLCs as persons will continue to be mapped and delineated. And as in Citizens United, the boundary may shift from time to time.

LLC's Creditors Have Standing to Sue Members for Unlawful Distributions

Doug Batey — Mon, 01 Feb 2010 16:19:34 -0800

The Colorado Court of Appeals held last month that creditors as a group have standing to sue members of an LLC who receive distributions knowing that the distributions were made when the LLC was insolvent. Colborne Corp. v. Weinstein, No. 09CA0724, 2010 Colo. App. LEXIS 58 (Colo. App. Jan. 21, 2010).

The Colorado LLC Act bars LLCs from making distributions to members if the LLC’s liabilities would exceed its assets after the distribution. Colo. Rev. Stat. § 7-80-606(1). The Act also provides that a member who receives a distribution in violation of the rule, with knowledge of the violation at the time of the distribution, is liable to the LLC to return the amount of the distribution. Colo. Rev. Stat. § 7-80-606(2).

The Act only speaks of the member’s liability to the LLC – it says nothing about rights of the LLC’s creditors. Can an LLC’s creditor sue a member directly for knowingly receiving an improper distribution under Section 606 of the Act? That was the question in Colborne.

The Court of Appeals pointed out that a similar provision in the Colorado Business Corporation Act (CBCA) had been interpreted to give creditors standing to directly sue a corporation’s directors. See Paratransit Risk Retention Group Ins. Co. v. Kamins, 160 P.3d 307 (Colo. App. 2007). The CBCA holds corporate directors liable to the corporation for authorizing distributions if the corporation would be insolvent after the distribution. Colo. Rev. Stat. § 7-108-403. The Paratransit court held that the corporate creditors had standing to sue the directors directly for authorizing improper distributions.

The Colborne court found the reasons for extending standing to creditors to be as applicable to LLCs as they were to corporations. The purpose of Section 606 is to protect the LLC’s creditors, said the court, and to not allow creditors to sue members directly would “substantially undercut the purpose of a statute enacted to protect creditors from self-dealing managers and members.” Colborne, 2010 Colo. App. LEXIS, at *9.

The Court of Appeals had previously held that managers of an insolvent LLC owe the LLC’s creditors a limited fiduciary duty to abstain from favoring their own interests over those of the creditors. Sheffield Servs. Co. v. Trowbridge, 211 P.3d 714 (Colo. App. 2009). The Colborne court applied the Sheffield rule and held that Colborne Corp.’s complaint alleged sufficient facts to state a claim, even though the complaint did not explicitly allege that the managers favored their interests over Colborne’s.

The court held in conclusion that creditors of an insolvent LLC (a) have standing as a group to sue members of the LLC for knowingly receiving unlawful distributions, under Section 7-80-606 of Colorado’s LLC Act, and (b) are owed a limited fiduciary duty by the LLC’s managers to abstain from favoring their own interests over those of the creditors.

Many state LLC statutes have provisions similar to Section 606(2) of the Colorado Act. E.g., Del. Code Ann. tit. 6, § 18-607; Wash. Rev. Code § 25.15.235. But neither Delaware nor Washington has case law interpreting whether an LLC creditor has standing to sue a member for knowingly receiving an unlawful distribution, i.e., when the LLC was insolvent.

Colborne is interesting because the court found a remedy for LLC creditors based on the statute, even though the language of the statute only obligates the members to return unlawful distributions to the LLC. Section 606 says nothing about creating a cause of action for the LLC’s creditors. The court relied heavily on Section 606’s perceived policy of protecting creditors, and analogized to the similar result on the corporate side. Still, one might have thought that if the Colorado legislature wanted to allow creditors of an LLC to sue members directly for the return of distributions, it could have said so.

Ohio LLC Shields Privacy of Litigation Plaintiffs

Doug Batey — Fri, 22 Jan 2010 11:21:06 -0800

Parties to litigation normally cannot keep their identities out of the public eye--plaintiffs and defendants are named in the complaint that starts a lawsuit. Complaints are public documents that are filed with the court. But a group of allegedly defrauded investors in Ohio recently used a limited liability company to bring a securities fraud lawsuit while keeping their names out of the court records.

The events that led to this lawsuit are sadly reminiscent of the Bernie Madoff debacle. Fair Finance Co. is an Ohio loan company founded in 1934. The company was owned by the Fair family and sold investment certificates to Ohio residents for a generation, including to members of Ohio’s Amish community. In 2002 wealthy Indianapolis investor Timothy Durham took control of the company.

In November 2009 the FBI raided Fair Finance’s offices and seized computers and records. Federal investigators suspected that Fair Finance was being operated as a Ponzi scheme, according to court records. The ongoing investigation has not yet resulted in any charges or arrests, but the company and its eight Ohio offices have been closed since November 24, 2009.

On December 21, a lawsuit was filed by a group of Ohio residents against Fair Finance and several other defendants, including Timothy Durham. In their complaint the plaintiffs seek rescission and damages for breach of contract, securities fraud, and negligent misrepresentation.

The lawsuit was brought by 16 plaintiffs. Two are trusts, 13 are individuals, and one is Fair Recovery, LLC. Fair Recovery is an Ohio LLC that was formed on December 10, 2009. According to the complaint, Fair Recovery is pursing the claims of 20 individual investors, all of whom are members of the LLC. The LLC members invested a total of $1,360,000 in Fair Finance.

Under Ohio’s LLC Act, an LLC is formed by filing Articles of Organization, and according to Fair Recovery’s Articles of Organization, its purpose is “to engage in any lawful act or activity.” The Articles are not required to disclose the LLC’s members, and Fair Recovery did not disclose its members' identities.

According to local newspaper reports, some members of the local Amish community invested with Fair Finance and have claims against it. The articles point out that the Amish faith discourages its members from settling disputes in court, and speculate that Fair Recovery was formed to press the legal action on behalf of Amish investors and to keep their names out of the public record. The law firm representing Fair Recovery and the other plaintiffs declined to say whether any are Amish.

This is a rather novel use of an LLC. Apparently Fair Recovery has no other business, and was formed simply to press the claims of its members in the litigation against Fair Finance. Using such an entity would not normally confer any benefit in litigation, so it appears that the only added value it provides is protection of the privacy of its members.

It remains to be seen how well the LLC will hold up as a privacy shield. For one thing, the identity of Fair Recovery’s members will probably become the subject of pretrial discovery procedures. For example, the defendants will be entitled to depose the Fair Recovery members to investigate the details of their claims. But pretrial discovery information is not usually filed with the court, so the identity of the Fair Recovery claimants presumably will be kept out of the court records prior to trial. The trial itself should be open to the public, but it may or may not be necessary at trial for testimony to identify the Fair Recovery members. Fair Finance must know, of course, who its investors are. It can probably determine easily who the Fair Recovery plaintiffs are, and could disclose that information if it chose to do so.

A First -- New York Applies De Facto Corporation Doctrine to LLCs

Doug Batey — Mon, 11 Jan 2010 09:14:12 -0800

New York’s highest court, the Court of Appeals, held last month that the doctrine of de facto corporations applies to LLCs. In re Hausman, No. 08854, 2009 NY LEXIS 4145 (Dec. 1, 2009). “De facto corporations” is an equitable doctrine that can be applicable when founders have attempted to form a corporation but failed to fully comply with the statutory requirements. The New York court is apparently the first appellate court in the nation to resolve this issue (other than the Fifth Circuit in Western Sec. Corp., 303 F. App'x 173 (5th Cir. 2008), an opinion that the Fifth Circuit has determined should not be published and which for most purposes is not precedent.)

It sometimes happens that founders of a corporation or LLC to enter into contracts, incur debts or take other actions on behalf of the entity before its formation. But if an agent enters into a contract on behalf of a non-existent entity, under agency law the other party to the contract will usually be able to hold the agent personally liable. The de facto corporation doctrine can permit judicial recognition of the entity’s existence, thereby avoiding personal liability of the agent.

In most states, including New York, an LLC begins to exist when its articles of organization or certificate of formation are filed with the appropriate state agency. E.g., N.Y. Ltd. Liab. Co. Law § 203. But occasionally founders jump the gun and act on behalf of the LLC before the filing is made, sometimes by mistake and sometimes knowing that the articles were not yet filed.

When creditors later claim that the founders are personally liable for contracts entered into before the LLC existed, the founders may defend on the grounds that a de facto corporation existed. There are also other situations, such as in Hausman, where the effectiveness of a conveyance or some other action will depend on whether the LLC existed at the time of the action, and the de facto corporation doctrine may then come into play.

Hausman was a probate proceeding. Lena Hausman’s will left real estate to her son and daughter and to the children of two predeceased sons. Before her death, the son and daughter executed articles of organization and prepared an operating agreement for a New York LLC. Lena Hausman then deeded the real estate to the son and daughter’s LLC, but the articles of organization for the new LLC were not filed with the New York Department of State until 14 days later.

Lena Hausman died seven months later and her will was admitted to probate. In the probate proceedings, the children of the predeceased sons claimed that the real estate should pass by will because Lena’s deed did not convey the real estate to a valid LLC. They pointed out that the LLC did not exist at the time of the deed. The probate court concluded that the deed to the LLC was valid because the LLC was a de facto corporation when the deed was executed.

The Court of Appeals held that the de facto corporation doctrine is applicable to LLCs. “The statutory schemes of the Business Corporation Law and the Limited Liability Company Law are very similar, and we see no principled reason why the de facto corporation doctrine should not apply to both corporations and limited liability companies.” Hausman at *3. The court cited to no other authority, but implicitly recognized that the equitable considerations which support the doctrine for corporations apply to LLCs as well.

The Court of Appeals pointed out that the de facto corporation doctrine requires (1) a law under which the entity might be formed, (2) an attempt to form the entity, and (3) an exercise of the entity’s powers thereafter. Under the facts in Hausman, the court concluded that the second prong was not satisfied¾even though the doctrine was applicable, no de facto LLC existed because there had been no attempt to file the articles of organization until weeks after the deed conveying the real estate was executed.

It is worth noting that many other states have abolished the doctrine of de facto corporations. See, e.g., Equipto Div. Aurora Equip. Co. v. Yarmouth, 134 Wn.2d 356, 367, 950 P.2d 451 (1998). Many of those states have adopted variations of the Model Business Corporation Act, which is intended to abolish the de facto corporation doctrine. See Model Bus. Corp. Act §§ 2.03, 2.04 (2008). Presumably the states that have abolished the de facto corporation doctrine would not apply it to LLCs.

Utah's Conflicting Remedies - LLC Statute vs. Common Law

Doug Batey — Thu, 17 Dec 2009 13:30:47 -0800

Members of an LLC are at loggerheads and one sues the other. The plaintiff decides that the remedies in the state LLC Act are inadequate. The plaintiff instead asks the court for damages under the common law, for repudiation of the LLC’s operating agreement and for breach of contract rather than for dissolution and an accounting under the LLC Act. That was the situation in OLP, L.L.C. v. Burningham, 2009 UT 75, 2009 WL 4406148 (Utah Dec. 4, 2009). The defendant in turn claimed that the plaintiff’s claims for repudiation and breach of contract were not allowable because the remedies under Utah’s LLC Act are exclusive. The court found otherwise and allowed the plaintiff’s contract claims.

Richard Wilson and Wayne Burningham formed OLP, L.L.C. as a Utah limited liability company, to purchase and operate an anti-reflective optical lens coating machine. They agreed to share equal control and ownership of OLP, and initially contributed equal amounts of capital. They agreed that Intermountain Coatings, a company owned by Burningham, would use the lens coating machine.

Acrimony between Wilson and Burningham soon reared its ugly head. They disagreed over how profits should be divided between OLP and Intermountain Coatings, and over whether the funds provided by Intermountain Coatings to OLP should be classified as a loan or as a capital contribution from Burningham.

Wilson eventually filed suit against Burningham and Intermountain Coatings for breach of fiduciary duty, repudiation of the contract, and breach of contract, and for an accounting of OLP’s expenses, revenues, profits, and losses. Burningham counterclaimed for dissolution of OLP. Burningham argued that in winding up OLP’s business, the members’ ownership interests should be determined and distributed according to each member’s capital account as provided in the LLC Act. Burningham’s theory was that Wilson’s claims should be resolved under the LLC Act’s dissolution procedures because those procedures are the exclusive remedy for claims between members.

The court pointed out that the LLC Act does not contain any explicit authorization or denial of common law claims, and examined a number of provisions in the LLC Act which imply that common law claims between members continue to apply. The court found that analogous partnership law allows common law claims between partners, without limiting remedies to equitable remedies. The court held that Utah’s LLC Act does not preclude common law claims between LLC members, such as claims for breach of contract, and that the remedies for such claims include equitable relief such as an accounting as well as damages.

The court rejected Burningham’s argument that dissolution is the sole remedy for wrongdoing between the members as being inconsistent with the jury’s finding that he had repudiated and abandoned the operating agreement. As the court said: “When one party effectively extinguishes a business agreement, whether it be a partnership agreement or a limited liability agreement, that party cannot rely on the agreement (or the default provisions of the LLC Act that supplement the agreement) to protect itself from the harm its actions have occasioned.” OLP, 2009 UT 75, ¶ 21.

The OLP decision is consistent with the approach of many courts to the rights and remedies of LLC members. For example, earlier this year I blogged on a New York decision which found that LLC members have a common law right to an equitable accounting, even though not explicitly authorized in the statute, here. I also described Idaho’s first case on fiduciary duties of LLC members, which found that fiduciary duties existed between managing members even though no such right was described in Idaho’s LLC Act, here. Courts generally seem to be reluctant to rule out common law rights of recovery or to exclude equitable remedies, in the absence of an explicit bar in their state’s LLC Act.

Confusion Over LLC Units

Doug Batey — Fri, 04 Dec 2009 16:51:13 -0800

LLC operating agreements often use the term “units” to describe member rights in the LLC. It is convenient to have a word like “units” to label the members’ rights, and “units” is widely used. But “units” has no uniform definition or generally accepted meaning when applied to LLCs.

Andrew Immerman recently authored an article that examines the inherent ambiguity and the confusion that often results from using units to describe LLC member rights. L. Andrew Immerman, Is There Any Such Thing as an LLC Unit?, 11 No. 4 Bus. Entities 20 (July/Aug. 2009), 2009 WL 2563091. The article is a good review of how and why the units terminology is used and misunderstood. It provides examples of the mistaken conclusions that business people can reach when they ignore the differences between shares of stock in a corporation and the rights of a member in an LLC.

Immerman ascribes this confusion to three principal causes. First, business people and sometimes lawyers often think of an LLC as essentially similar to a corporation. Second, the state laws that authorize LLCs do not expressly authorize the issuance of LLC units or define an LLC unit. Third, LLC members are taxed differently than shareholders. LLC taxation can cause units in the same LLC to unexpectedly provide different benefits to their owners, unlike shares of stock, which are usually interchangeable.

There is no concept of “units” in the various state LLC statutes. For example, Washington’s LLC Act makes no reference to units, and simply defines a member’s LLC interest as personal property comprising the member’s share of the profits and losses of an LLC, and the right to receive distributions of the LLC’s assets. Wash. Rev. Code §§ 25.15.005(6), 25.15.245(1).

Delaware’s LLC Act likewise makes no reference to units, and has an almost identical definition of a member’s LLC interest. Del. Code Ann. tit. 6, §§ 18-101(8), 18-701. And neither NCCUSL’s Revised Uniform Limited Liability Act nor the Revised Prototype Limited Liability Company Act from the American Bar Association uses that terminology.

LLCs are distinct from corporations in a number of ways. One major difference is that an LLC is much more a creature of contract than is a corporation. LLC member rights are normally defined by the members’ operating agreement, and only secondarily by the LLC Act. Members are parties to the operating agreement, whereas corporate shareholders hold shares of stock but need not be parties to any contract. Most of a shareholder’s rights will generally be defined by the applicable corporate statute, while an LLC member’s rights will be defined by the terms of the operating agreement. A potential investor in an LLC cannot know what rights the holder of a unit will have without a careful examination of the operating agreement.

Another difference between LLCs and corporations is that the rights associated with ownership of a share of stock are not normally divided. If a share of stock is sold, the rights to receive dividends, to vote, and to receive corporate information will usually all go with the share of stock. Transfer of a member’s interest in an LLC, on the other hand, will convey the right to receive profits, losses and distributions, but it will not necessarily carry with it the right to vote and participate in management of the LLC. All the members must approve the transferee’s admission as a member and participation in management, or the operating agreement may provide for the transferee’s admission as a member. E.g., Wash. Rev. Code §§ 25.15.250, 25.15.260; Del. Code Ann. tit. 6, §§ 18-702, 18-703.

LLCs are taxed as partnerships (absent an election to be taxed as a corporation), so items of profit and loss are allocated directly to the members. The LLC is not a taxpayer. Corporations, in contrast, are taxpaying entities and do not pass profits or losses through to shareholders. (One exception: a corporation can make a Subchapter S election, in which case its shareholders will each be allocated their proportionate share of the corporation’s profits and losses. An S corporation, however, can have only one class of stock and cannot have nonresident aliens or certain types of entities as shareholders.)

LLC members generally want the LLC’s allocations to be respected for tax purposes. This is a matter of predictability and being able to accurately assess and plan for the economic benefits and tax consequences of their LLC investment. For the LLC’s allocations of profit and loss to be respected for federal income tax purposes, the allocations in the operating agreement must comply with a set of complicated Treasury regulations intended to ensure that the allocations have “substantial economic effect.” I.R.C. § 704(b)(2). One of those requirements is that a capital account be maintained for each member. A member’s capital account is increased by the member’s contributions to the LLC’s capital, by profits allocated to the member, and by LLC liabilities assumed by the member, and decreased by distributions paid and losses allocated to the member, and by liabilities of the member assumed by the LLC.

The regulations also require, when the LLC is dissolved and its assets liquidated, that liquidating distributions be made to the members in accordance with the positive balances in their capital accounts. This is a key requirement of the allocation regulations, and has the effect of truing up the final, liquidating distributions with the effects of the LLC’s history. All the prior member capital contributions, distributions to members, and allocations of profits and losses would have impacted each member’s capital account in ways that may have varied from member to member.

Assuming the LLC’s operating agreement complies with these rules, the result is that on liquidation one member may receive substantially more or less per unit than another member receives per unit. A corollary is that at any point in the life of the LLC, one member’s unit may be worth more or less than a different member’s unit. One might try to define “unit” in the operating agreement to take capital account variations into effect, but then the definition would likely not work well for attributes such as voting and establishing percentages for profit and loss allocations.

In corporations it’s different and much simpler. At any given time the corporation’s capital per share is the same amount for all outstanding shares of common stock. If a corporation is dissolved and liquidated, the liquidating distributions per share of common stock will be the same amount for all the shares. “Holders of corporate stock need not worry about capital accounts, and the superficial resemblance of LLC units to corporate stock may create the impression that LLC members can safely ignore the concept as well. It can be perilous, however, to ignore LLC capital accounts.” Immerman, supra, at 62.

In all states LLCs now lead corporations in formations of new business entities. For many business people LLCs are relatively new and sometimes perplexing. Their lawyer or the other parties may present them with operating agreements that describe their interests as “units.” They may be familiar with corporations, but should not be misled by the surface similarities and assume that those units are comparable to shares of stock. The operating agreement should be read and analyzed carefully. The ways in which units are handled in the agreement needs to be thoroughly understood. Because many of the results of a member’s investment will depend on the tax treatment of allocations and capital accounts, an experienced tax advisor should usually be consulted.

The Beneficial Ownership Bill Just Won't Go Away

Doug Batey — Sat, 21 Nov 2009 08:57:31 -0800

The Incorporation Transparency and Law Enforcement Assistance Act, S. 569 (the Bill), is still alive. Two weeks ago the Senate Committee on Homeland Security and Governmental Affairs held a hearing on the Bill, on November 5 (the Hearing). The list of witnesses and their prepared testimonies are available, here. The Committee’s previous hearing on the Bill was on June 18, 2009.

The principal purpose of the Bill is to require the states to change their laws to mandate that organizers of LLCs and corporations provide each state with lists of the “beneficial owners” of the entity being formed, during the formation process and annually thereafter. Each beneficial owner must be identified by name and address. For more details, see my previous blog on this Bill, Big Brother Wants to Crack Open Your LLC.

The Bill’s definition of “beneficial owner” is awe inspiring in its scope and ambiguity. A beneficial owner is defined as an individual “who has a level of control that, as a practical matter, enables the individual, directly or indirectly, to control, manage, or direct the corporation or limited liability company.”

Only human beings are included in the definition of beneficial owner, so multiple levels of ownership will have to be traced. If an LLC or corporation is a member of an LLC, for example, the ownership will have to be followed up to the individuals at the top of the ownership structure.

In many cases it will be unclear which individuals have the ability, as a practical matter, directly or indirectly, to direct the affairs of an LLC with multiple levels of ownership. And if an organizer knowingly omits the name of an individual that is later determined to somehow have the practical ability to directly or indirectly control the entity, that organizer may be fined up to $10,000 and sent to jail for up to three years.

This is a bad bill. It is one more example of the federal government attempting to federalize an area of commerce traditionally handled by the states. It would be an invasion of the privacy of millions of legitimate business people. The bureaucrats promoting this Bill disregard the legitimate commercial interests many business people have in not disclosing their ownership of a business.

The Bill is justified by organizations such as the Treasury Department, the Justice Department, and the Federal Law Enforcement Officers Association as being helpful in investigations of crimes such as money laundering and wire fraud. The testimony skates briefly over the fact that LLCs and corporations can act only through their human agents, officers, and employees. For example, to open a bank account an LLC must have a person appear on its behalf at the bank and identify himself or herself to the bank’s satisfaction. LLCs and corporations are required to have registered agents in their state of formation and every state in which they do business. The records of an LLC, including its ownership records, may be searched if a judge issues a search warrant on probable cause.

The Bill appears to be driven in large part by law enforcement’s desire to peer into business records without a warrant and without any need to alert the business that the government is looking at its records.

The proponents of the Bill deprecate its impact on the states. For example, it was asserted in John Ramsey’s prepared testimony at the Hearing, on behalf of the Federal Law Enforcement Officers Association, that “this Bill does not require any state to enact any law with respect to corporations; it merely requires the states to add one more question to their existing incorporation forms and to make the information provided available to law enforcement upon presentation of a legally authorized subpoena or summons.” That is incorrect; the Bill does not contemplate a voluntary process. For the states to make it mandatory on an LLC to disclose its beneficial owners, the states will have to pass laws or adopt regulations.

Mr. Ramsey dismissed the costs on the states, saying “beneficial ownership information can be collected via existing electronic incorporation methods and stored in existing electronic databases.” He should talk to those who would be responsible for complying with the Bill’s requirements. Senator John Ensign testified at the Hearing that the Nevada Secretary of State estimates that its costs for implementing the required systems could reach as high as $10 million, with ongoing annual costs of approximately $1 million.

Kevin Shepherd represented the American Bar Association at the Hearing. He testified:

In our view, the imposition of a federal regulatory regime focused on beneficial ownership information is not workable, would be extremely costly, would impose onerous burdens on state authorities and legitimate businesses, would run counter to formation practices of major countries (including Canada, Mexico, Japan, and China), and will not achieve the laudable goal of assisting federal law enforcement authorities with pursuing and prosecuting criminal activity.

Mr. Shepherd pointed out in his remarks that the United Kingdom has studied and considered this issue. The UK authorities concluded that there were significant disadvantages and no clear benefits to adopting a system requiring up-front disclosure of beneficial ownership of entities, especially since it was unlikely that those engaged in criminal activities would provide true information. Financial Action Task Force Third Mutual Evaluation Report, Anti-Money Laundering and Combating the Financing of Terrorism, The United Kingdom of Great Britain and Northern Ireland at 234.

Jack Blum, a Washington attorney who testified at the Hearing in support of the Bill, conceded that criminals would be able to conceal the identity of the beneficial owners of entities formed for nefarious purposes. It does seem rather unlikely that criminals and fraudsters would worry about complying with a law intended to make it easy to catch them.

American businesses form approximately two million LLCs and corporations each year. These range from small, mom-and-pop businesses to entrepreneurial, venture-capital-funded start-ups to joint ventures between large organizations with complex ownership structures. This Bill would burden all of them with confusing and difficult-to-understand reporting requirements that will provide little or no benefit to law enforcement. The Bill should be rejected.

New York Court Holds Distribution Was Not a Misappropriation

Doug Batey — Wed, 11 Nov 2009 08:58:20 -0800

Is it a distribution or a misappropriation when a managing member of an LLC withdraws funds from the LLC for his own use? That was the dispositive issue in Mostel v. Petrycki, 885 N.Y.S.2d 397 (N.Y. Sup. Ct. Sept. 2, 2009). It was dispositive because the answer to that question determined which of two different statutes of limitations applied.

Mostel had a judgment against Fulcrum Global Partners, LLC, a Delaware LLC (Fulcrum), from a prior lawsuit. Fulcrum went out of business and Mostel was unable to recover from Fulcrum on his judgment, so he brought a lawsuit against Petrycki, the founding member and CEO of Fulcrum. Mostel claimed that a $300,000 withdrawal from Fulcrum by Petrycki was a fraudulent conveyance under New York’s Debtor and Creditor Law, N.Y. Debt. & Cred. Law §§ 273, 273-a, 276 and 276-a.

According to Mostel, Petrycki’s withdrawal was a fraudulent conveyance because it was without consideration, and rendered Fulcrum insolvent and without assets to satisfy the judgment against it. If the withdrawal was a fraudulent conveyance, Mostel’s judgment against Fulcrum could reach the $300,000 in Petrycki’s hands.

Petrycki, however, asked for Mostel’s suit against him to be dismissed on grounds that his $300,000 withdrawal was a distribution to him by Fulcrum, and the lawsuit was therefore barred by the three-year statute of limitations in the New York Limited Liability Company Act and the Delaware Limited Liability Company Act.

Mostel riposted that the six-year statute of limitations applicable to the fraudulent conveyance claim should apply. (Mostel’s suit was filed more than three years and less than six years after the withdrawal.) Mostel argued that the $300,000 withdrawal was not a distribution because Petrycki did not have authority to withdraw the funds and had applied them for his personal use.

Since Fulcrum was a Delaware LLC, the court examined both the Delaware and New York LLC Acts. Both statutes provide that if a member receives a distribution that causes the liabilities of the LLC to exceed its assets, and if the member knew of the resulting insolvency at the time of the distribution, then the member is liable to the LLC for return of the distribution. Both statutes also provide that a member’s liability for receiving a wrongful distribution will end three years after the distribution, unless a lawsuit is brought on the claim before the end of the three years. N.Y. Ltd. Liab. Co. Law § 508; Del. Code Ann. tit. 6, § 18-607. Finding no difference between the two states’ laws, the court said it need not decide which state’s law governed – the result would be the same in either case. Mostel, 885 N.Y.S.2d at 399 n.1.

The New York courts had previously determined that in the case of an LLC distribution which is both wrongful under Section 508 of the LLC Act and a fraudulent conveyance under the Debtor and Creditor Law, the three-year limitations period of the LLC Act overrides the six-year limitations period of the Debtor and Creditor Law. O’Connell v. Shallo, 323 B.R. 101 (S.D.N.Y. 2005). So if the $300,000 withdrawal was a distribution, the three-year limitations period of the LLC Act would apply, and Mostel’s claim would be barred. If it was a misappropriation and therefore not a distribution, Mostel’s suit could go forward.

The New York LLC Act defines “distribution” as “the transfer of property by a limited liability company to one or more of its members in his or her capacity as a member.” N.Y. Ltd. Liab. Co. Law § 102(i). Fulcrum’s Operating Agreement gave all members the right to request a return of their invested capital, subject to the approval of the managing member. The agreement did not provide for any additional procedures when a managing member seeks a return of its own invested capital.

Mostel’s complaint conceded that Petrycki was the managing member and that his $300,000 withdrawal was a return of his capital contribution, so the court rather straightforwardly concluded that the withdrawal was an authorized distribution to Petrycki. The three-year limitations period applied and Mostel’s claim was time-barred. Mostel’s complaint was dismissed.

The lessons from this case? Apart from the obvious, of course – don’t delay filing a lawsuit for so long that a statute of limitations bars the claim – the case underscores the importance of written LLC agreements. It also shows the need for the members to consider carefully the distribution provisions in their agreement. Interim distributions should be authorized by the agreement, and the parties should think about what procedures or approvals will be necessary for different types of distributions. For example, in Fulcrum’s agreement, distributions on request of a member for return of its invested capital were allowed if approved by the managing member, and that provision validated Petrycki’s withdrawal as a distribution.

SEC Limits the Use of Series LLCs for Broker-Dealers

Doug Batey — Thu, 29 Oct 2009 15:27:40 -0800

The SEC recently took the wind out of the sails of broker-dealers hoping to use series LLCs for multiple broker-dealers within one LLC. In a letter dated September 1, 2009, the SEC staff advised the Financial Industry Regulatory Authority (FINRA) that the proposed series LLC structure would not pass muster under the SEC’s net capital rule, its customer protection rule, and its financial reporting rule.

FINRA proposed, for example, that an LLC would have two series, one to operate a retail broker-dealer and one to operate an institutional broker-dealer. The LLC, and not either series, would register with the LLC.

The LLC itself would have no business operations. Instead, each series would operate a separate brokerage and would have separate assets and liabilities. The liabilities of one series would not be enforceable against the assets of the other series or the overall LLC, but the assets and liabilities of the two series would be aggregated on the LLC’s consolidated financial statement, which is filed periodically with the SEC. (For a description of how series LLCs work, see my previous post, here.)

The SEC’s staff pointed out that partitioning each series’ assets and liabilities within the LLC would be inconsistent with applying the net capital rule at the LLC level. Reporting the LLC’s financials on a consolidated basis would greatly impair the SEC’s and FINRA’s ability to supervise the LLC’s financial position, since the SEC would not be able to determine the financial position of the LLC and each series without substantial effort.

The staff pointed out other problems regarding customer reserve accounts and equal treatment of customers in the event of a liquidation proceeding. The bottom line was that the idea of having the LLC be the regulated entity while yet having each series be treated as separate, independent entities for purposes of their assets and liabilities, is inconsistent with the SEC’s regulations.

Series LLCs have a place in the business world. But at least in this case, asking regulators to ignore the inherent inconsistency between regulating only the overall LLC, while disregarding the separate liability shield of each series within the LLC, was simply a bridge too far.

Former LLC Member: Why Does My K-1 Show All This Income?

Doug Batey — Mon, 19 Oct 2009 10:59:42 -0800

An LLC member, Mr. Smith, sells his member interest and terminates all connections with the LLC. The sale agreement ends Smith’s rights in the LLC. Smith moves on and doesn’t think much more about the LLC. Many months later, Smith receives a Schedule K-1 from the LLC. >

Schedule K-1 is the form an LLC uses to inform each member of the member’s share of income, losses, deductions, credits and so on. Like almost all LLCs, Smith’s former LLC is taxed as a partnership for federal income tax purposes, and the LLC’s income and losses for each tax year are allocated to its members. The members then each pay taxes on their share of the LLC’s income for that year, or use the losses to shelter other income. (The ability to use losses to shelter other income is subject to various limitations. See my prior post on passive income loss limitations, here.)

Smith is shocked to see that the K-1 shows a whopping allocation of income to him for the last year of his membership in the LLC. He realizes that that income will have to be reported on his own personal tax return and will substantially increase his tax bill, and he didn’t receive any cash distribution from the LLC to cover those extra taxes. Based on what he knows about the LLC’s operations and finances towards the end of his involvement with it, he doesn’t understand how or why so much income was allocated to him. What does he do?

Naturally Smith starts asking questions. He requests copies of the LLC’s financial records so his CPA can evaluate the correctness of the LLC’s allocations. The LLC, however, points out that Smith is no longer a member, so its operating agreement gives him no right to see the records. The LLC also notes that the state LLC Act only allows members, not former members, to access LLC records. In short, he is politely told to go roll his hoop.

The plaintiffs in Abdalla v. Qadorh-Zidan, 913 N.E.2d 280 (Ind. Ct. App. Sept. 10, 2009), were faced with this situation. The Qadorh-Zidans (Zidans) and the Abdallas had formed five LLCs to own and operate apartment properties. Later the Abdallas filed a lawsuit against the Zidans alleging breach of fiduciary duty and usurpation of corporate opportunities. That suit was resolved through a settlement that included a buyout – the Zidans sold their membership interests in the LLCs to the Abdallas in August 2006.

In the fall of 2007 the Zidans received tax returns and K-1 Schedules from the LLCs for the tax year ending on the date of the buyout. The Zidans alleged discrepancies in the K-1s and requested accounting information and records from the LLCs for the time period when they were members. The Abdallas refused, so the Zidans filed a complaint alleging breach of fiduciary duty and seeking declaratory relief to inspect the books and records of the LLCs for the period when they were members. The Zidans sought discovery of the requested information, which was stayed pending a summary judgment motion by the Abdallas. The trial court’s denial of the Abdallas’ motion was appealed.

The Abdallas contended that any fiduciary duties owed to the Zidans terminated when they ceased being members of the LLCs, because the Zidans no longer had any rights under the operating agreements and because their settlement agreement in the first lawsuit included a relinquishment of all of the Zidans’ rights as members. The Zidans maintained that fiduciary duties should remain intact with respect to the resolution of pre-separation business, and that therefore the fiduciary relationship covered the preparation of the tax return which was completed after the Zidans sold out.

The court held that the Abdallas owed a fiduciary duty to the Zidans regarding the preparation of tax returns for the period during which the Zidans were members of the LLCs. Abdalla, 913 N.E.2d at 286. As the court said, “To hold otherwise would give the Abdallas the freedom to allocate tax burdens to the Zidans and retain tax benefits for themselves without allowing the Zidans any recourse to verify or rectify this allocation.” Id.

The court reached a similar result on the question of whether the Zidans had a right of access to the LLCs’ books. Although the Indiana LLC Act only gives members the right to access an LLC’s records, Ind. Code § 23-18-4-8(b), the court held that the Zidans, as former members, had a right to access the records covering the time period while they were still members of the LLCs. Abdalla, 913 N.E.2d at 287.

Many state LLC Acts, like Indiana’s, do not address what inspection rights former LLC members have. For example, the LLC Acts of Washington, Oregon and Delaware are silent on inspection rights for former members. There’s no reason why state statutes can’t address this issue, though. The Illinois LLC Act, for example, provides that former members have a right of access for a proper purpose to LLC records pertaining to the period when they were members. 805 Ill. Comp. Stat. 180/10-15. The Revised Uniform Limited Liability Company Act and the Uniform Limited Partnership Act also have comparable provisions giving former members limited access rights.

When the Zidans resolved their first dispute with the Abdallas through a buyout of the Zidans’ interests in the LLCs, they apparently did not consider the inevitable entanglement resulting from the tax flow-through treatment of the LLCs. In an LLC buyout there will usually be a time lag from the buyout to the computation and allocation of the LLC’s profits and losses, and the distribution of the Schedule K-1s.

There’s a moral here. A member selling its interest in an LLC should consider adding provisions to the buyout agreement for later access to the LLC’s accounting records and for consultation with the LLC’s manager or CPA over the tax allocations and the preparation of tax returns, for the period when the seller was a member. The seller should also consider provisions for notice, access to records and consultation regarding any later amendment to the LLC’s previously filed tax returns, or any IRS contact with the LLC or tax audit for the period before the buyout. These provisions can help the former member avoid unpleasant tax-related surprises, and can give the former member the tools necessary to investigate unexpected tax allocations.

Connecticut Orders LLC Dissolution and Winding Up - Member Acrimony Prevents LLC from Carrying On Its Business

Doug Batey — Wed, 14 Oct 2009 09:23:09 -0800

It’s a classic fact pattern that is all too familiar to many business lawyers. Two good friends decide to start a business. In their enthusiasm they create a 50/50 ownership structure and launch the business. Later, things change. One starts devoting more time to the business. Or maybe the business develops a commercial relationship with a separate company owned by one of the friends, which benefits only that one. Their business relationship becomes asymmetrical. Their views of how each should be compensated or how the business should be conducted diverge.

That’s essentially what happened in Saunders v. Firtel, 978 A.2d 487 (Conn. Sept. 22, 2009). Saunders and Firtel were friends who began a business relationship in the mid-1980s. Saunders joined Firtel as an employee and shareholder in Adco Medical Supplies, Inc. (Adco) in 1986. Saunders held 49% of the stock, Firtel held 51%. Firtel was President and Saunders Vice President, and they agreed that each would receive the same annual salary. In 1999, when things were still going well, Saunders and Firtel formed Barbur Associates, LLC (Barbur), a Connecticut LLC in which each owned a 50% interest. Barbur acquired real estate and leased it to Adco on an oral month-to-month lease.

The stage was now set. By 2004, Saunders had become dissatisfied because he perceived that he was doing most of the work but receiving the same compensation as Firtel. Saunders advised Firtel that the 1986 agreement for equal compensation was no longer acceptable. Firtel responded by firing Saunders from Adco in July 2004, lowering the rent charged by Barbur to Adco, unilaterally authorizing repairs by Barbur to the building Adco rented, and arranging a $5,000 loan from Barbur to Adco. Adco refused to pay Saunders his salary for 2004. Shortly thereafter, Saunders and Firtel ceased having any business or personal relationship, and made accusations against each other of theft, breach of fiduciary duty, self-dealing and other “improper and felonious conduct.” Saunders, 978 A.2d at 500 n.22.

Saunders sued Adco for his unpaid 2004 compensation, and for a decree ordering the dissolution and winding up of Barbur. The trial court found for Saunders on his wage claim and ordered double damages pursuant to Conn. Gen. Stat. § 31-72. The trial court also ordered a dissolution and winding up of Barbur, under Conn. Gen. Stat. §§ 34-207 and 34-208.

The Connecticut LLC Act authorizes the superior court to order dissolution “whenever it is not reasonably practicable to carry on the business in conformity with the articles of organization or operating agreement.” Conn. Gen. Stat. § 34-207. The LLC Acts of Washington, Delaware, New York and many other states have similar provisions, as does NCCUSL’s Revised Uniform LLC Act. The essence of this test is whether or not the business of the LLC can be carried on in a reasonable way. The court has discretion; this is an equitable proceeding in which factors such as oppression, wrong-doing or deadlock are considered.

The court concluded that “the trial court’s order of dissolution is well supported by the evidence.” Saunders, 978 A.2d at 500. In reaching its conclusion, however, the court simply recited the facts identified above. The court did not examine Barbur’s articles of organization or operating agreement to see if the business was being carried out in conformity with the articles or the operating agreement, or refer to any such examination by the trial court. The two Connecticut cases cited by the court don’t seem particularly relevant, since both involved dissolutions of corporations for deadlock under prior corporate statutes. Those statutes, unlike Connecticut’s LLC Act, allowed dissolution for deadlock or other good and sufficient reasons. The court may have concluded that the various abuses by Firtel and the hostility and lack of cooperation between Firtel and Saunders simply made it impossible for the LLC to carry on any business, but the court’s analysis is conclusory and opaque.

Contract provisions don’t necessarily make disagreements between members go away, but sometimes they can provide helpful mechanisms to mitigate disputes and keep the parties out of court. For example, Saunders and Firtel apparently had no provisions in Barbur’s operating agreement to deal with deadlock. If their operating agreement had had a provision that allowed either party to initiate a buy-out process, they might have avoided litigation. A business person may assume that the initially cordial relationship with a potential business partner will continue indefinitely, but his or her lawyer should ask the hard-edged questions to challenge that assumption and help the parties build some safety nets into their agreement.

Oregon Clarifies LLC Derivative Suit Requirements

Doug Batey — Mon, 05 Oct 2009 09:41:12 -0800

The Oregon Court of Appeals has clarified when and how members of an Oregon LLC can maintain a derivative suit in the name of the LLC. Bernards v. Summit Real Estate Mgmt., 229 Or.App. 357, 213 P.3d 1 (July 1, 2009). Oregon’s LLC Act allows member derivative suits, but the court imposed additional pleading requirements on the complaint. The court also found that a requirement in the LLC’s operating agreement of unanimous member approval before commencing any suit in the name of the LLC was subject to the agreement’s standard of care and to the implied duty of good faith and fair dealing.

The plaintiffs (Bernards) were minority members of two member-managed LLCs. Each of the LLCs owned apartment buildings and entered into management contracts with the defendant management company (Summit). Bernards claimed that Summit and one of its officers (McKenna) had embezzled the LLCs’ funds, and demanded that the other members approve lawsuits by the LLCs against Summit and McKenna to recover the funds. (The operating agreements for the LLCs required the unanimous approval of the members to bring legal action in the name of the LLCs.)

The other members refused to approve a lawsuit without giving any reasons for their refusal, even though McKenna had admitted embezzling substantial amounts from the LLCs. Bernards then brought derivative suits against Summit, McKenna and the other members, alleging that the other members had breached their duty to the LLCs by refusing to approve the lawsuits against Summit and McKenna.

Oregon’s LLC Act authorizes derivative proceedings by a member in the name of an LLC. Or. Rev. Stat. § 63.801(1). The statute requires that the complaint allege with particularity either that a demand to file the suit was made of the managers (or members in the case of a member-managed LLC), or why a demand was not made. Or. Rev. Stat. § 63.801(2).

The statute does not explicitly refer to any requirement of wrongdoing by the members that refused to approve the lawsuits. The court nonetheless held that when the members have refused the demand for litigation, the complaint must allege facts showing wrongdoing by the refusing members. Bernards, 229 Or. App. at 364.

The court analogized LLC derivative suits to corporate derivative suits. The court had previously held that Oregon’s almost identical corporate statute required, albeit in a demand-futility case, that the complaint in a shareholder derivative suit plead facts showing wrongful conduct by the directors. The court in Bernards applied the corporate rule, holding that in order to rebut the presumption that the members were exercising their business judgment, the complaint must allege facts showing wrongful conduct by the members.

Section 63.801(2) of Oregon’s LLC Act allows the LLC’s operating agreement to vary the statutory pleading requirements. The court therefore looked to the operating agreements and applied their standard of care as the definition of wrongful conduct—gross negligence, fraud or willful or wanton misconduct.

The other members argued that the operating agreements’ requirement of unanimous member consent trumped the pleading requirements of Or. Rev. Stat. § 63.801(2). The court disagreed and held that the requirement of consent was not equivalent to giving every member the unfettered authority to withhold consent. The right to consent was subject to the express standard of care in the operating agreement and the implied duty of good faith and fair dealing. The court noted that the requirement of unanimous member consent meant that the plaintiffs had to allege facts demonstrating that all of the member defendants refused wrongfully. “[I]f even one of them refused to proceed and had a valid business reason for doing so, the LLCs could not bring legal action against McKenna and Summit.” Bernards, 229 Or. App. at 367-68.

The court concluded that the facts alleged by the plaintiffs were not adequate to demonstrate wrongdoing. Yes, there was a clear right to recover the embezzled funds (one defendant had admitted the embezzlement). Yes, the other members refused to sue when a demand was made. Yes, the other members had not provided an explanation for their refusal. Yes, one member had stated that he would not authorize legal action against McKenna and Summit “no matter how much money they had embezzled.” Bernards, 229 Or. App. at 362. But, said the court, it was not alleged, for example, that the members had refused to provide an explanation, or that they had a personal financial interest in McKenna or Summit, or that they were driven by some personal animus against the plaintiffs. The result was that the court affirmed the trial court’s dismissal of the complaints.

The Bernards opinion is noteworthy not only because it answered an open question under Oregon law, but also because it reasoned by analogy and applied Oregon’s corporate law of derivative actions to LLCs. And the result here was clearly right--why should a minority member be able to sue in the name of the LLC to initiate litigation when the other members have decided that the LLC should abstain, without alleging some facts showing that that there was something wrong with the other members’ decision, such as a conflict of interest? Also noteworthy is that the court applied the business judgment rule, while implicitly recognizing that an LLC’s operating agreement could change the rule for that LLC.

Upcoming Event - Seminar for Washington Condominium Developers on Dissolution and Cancellation of Limited Liability Companies

Doug Batey — Fri, 25 Sep 2009 10:21:45 -0800

Stoel Rives LLP is hosting a complimentary breakfast seminar in Seattle on Thursday, October 8, 2009, entitled “A Law Update for Condominium Developers: Practical Advice for Dissolution and Cancellation of Limited Liability Companies.” The seminar topics will include:

The life cycle of a condominium LLC
The recent Washington Supreme Court ruling in Chadwick Farms Owners Association v. FHC LLC
Dissolution and cancellation of LLCs
Limitations on liability protection afforded by an LLC
How to “wind up” the business of the LLC
How to avoid personal liability for the obligations of an LLC

The Chadwick Farms case was discussed in my prior blog post, here. Chadwick Farms is especially relevant to condo developers because of the project-oriented nature of the condo development business, and because of the strong Washington law on the implied warranty given to new condo buyers. The process of dissolving, winding up and cancelling a condo developer’s LLC will often present the developer with some difficult choices—this seminar will discuss the pros and cons of the alternatives.

Registration and breakfast begin at 7:30 a.m., and the presentation runs from 8:00 to 9:30 a.m. Limited space is still available, so if you're interested in attending you can see the location and other details and register here.

Court of Federal Claims Upholds Deductibility of LLC Losses

Doug Batey — Wed, 23 Sep 2009 15:19:11 -0800

Most business people who are familiar with the tax treatment of LLCs understand that LLCs are tax-efficient. LLCs are taxed as partnerships (except in the rare event that they elect to be taxed as corporations). Since they are taxed as partnerships, LLC profits and losses are passed through to the members. The pass-through of LLC profits avoids double taxation—profits are not taxed to the LLC and are only taxed to the members. The pass-through of LLC losses allows members to use the losses to offset against their other income, reducing their tax bills.

What is less well known, except by tax lawyers and CPAs, is that the IRS has interpreted its regulations so that LLC losses are presumed to be “passive activity losses” (passive losses). Furthermore, the presumption is difficult to overturn. The result is that under the IRS’s interpretation of its regulations, LLC losses are often treated as passive losses.

For most taxpayers, passive losses are much less useful than active losses (losses not resulting from passive activities). The reason is that passive losses may only be used to offset income from other passive activities, and not to offset “active” income such as wages, interest, dividends, etc. Internal Revenue Code (IRC) § 469. Instead, any passive losses that exceed “passive” income must be carried over to subsequent tax years until the taxpayer either has enough passive income to use the losses or disposes of the activity that generated the passive losses. Active losses, on the other hand, can be used to offset either active income or passive income. The IRS’s position greatly limits the income-sheltering benefits of losses for LLC members.

There are three reported opinions in which courts have ruled on this issue. The IRS lost in all three courts, most recently in Thompson v. United States, 87 Fed. Cl. 728 (July 20, 2009). (The IRS also lost in Garnett v. Commissioner, 132 T.C. No. 19 (June 30, 2009), and in Gregg v. United States, 186 F. Supp. 2d 1123 (D. Or. 2000).)

The plaintiff in Thompson had formed Mountain Air Charter, LLC to operate an on-demand air charter business. Thompson held 99% of the member interests in Mountain Air directly, and 1% through a subchapter S corporation. On his 2002 and 2003 individual income tax returns, Thompson claimed a total of $2.1 million of losses from Mountain Air and used those losses to offset against other income. The IRS disallowed all but $156,000 of those losses, contending that they were passive activity losses and could not be offset against non-passive activity income. Thompson paid the taxes assessed by the IRS and sought a refund, and when it was denied he brought suit, seeking a tax refund of $781,241 plus interest.

The Thompson case turned on the interpretation of IRS regulations that were adopted under the authority of IRC § 469. Section 469 was adopted as part of the Tax Reform Act of 1986 to address the growth in the 1980s of perceived abusive tax shelters. Many of those tax shelters were formed as limited partnerships that allowed investors to use partnership tax losses to shelter their income from wages or self-employment.

Section 469 establishes limitations on passive activity losses and defines a “passive activity” as a business activity in which the taxpayer does not “materially participate.” It also requires, in the case of limited partnerships, that a limited partner’s participation not be treated as “material participation,” except as provided in IRS regulations. IRC § 469(h)(2). Following the passage of IRC § 469, the IRS adopted temporary regulations that define how an investor can demonstrate material participation in an activity, but that also greatly restrict the ways in which a limited partner can demonstrate material participation in a limited partnership. Treas. Reg. § 1.469-5T. Limited liability companies were new and were used very little at that time, so the temporary regulation did not explicitly address LLCs.

The key regulatory provision that was at issue in Thompson provides:

(i) In general. Except as provided in paragraph (e)(3)(ii) of this section, for purposes of section 469(h)(2) and this paragraph (e), a partnership interest shall be treated as a limited partnership interest if—

(A) Such interest is designated a limited partnership interest in the limited partnership agreement or the certificate of limited partnership, without regard to whether the liability of the holder of such interest for obligations of the partnership is limited under the applicable State law; or

(B) The liability of the holder of such interest for obligations of the partnership is limited, under the law of the State in which the partnership is organized, to a determinable fixed amount (for example, the sum of the holder’s capital contributions to the partnership and contractual obligations to make additional capital contributions to the partnership).

Treas. Reg. § 1.469-5T(e)(3)(i).

Although Mountain Air Charter, LLC was formed as an LLC under Texas state law, the IRS contended that the regulation applied to Thompson’s LLC member interests because Mountain Air was taxed as a partnership for income tax purposes and because the liability of the members of Mountain Air was limited under Texas law. Thompson’s response was simply that Mountain Air was not a limited partnership so his member interest could not be that of a limited partner. In short, the IRS wanted the LLC to be treated as a limited partnership for purposes of the regulation, and Thompson wanted the text of the regulation to be applied literally.

The court began its analysis by pointing out that an LLC is not a partnership. After a lengthy analysis of the language and purpose of the regulation, the court concluded that “[o]nce [the regulation] is read in context and with due regard to its text, structure, and purpose, it becomes abundantly clear that it is simply inapplicable to a membership interest in an LLC.” Thompson, 87 Fed. Cl. at 738.

Since the court ruled that the regulation did not apply, Thompson’s member interests were not presumed to be interests in a limited partnership. Thompson still needed to demonstrate that he was a “material participant” in the activities of the LLC, but in his case the IRS had already stipulated that if he did not hold a limited partnership interest under the regulation, his losses from Mountain Air would not be limited by the passive loss rules of Section 469. The upshot was that the court entered a judgment in Thompson’s favor in the amount of $781,241 on July 21, 2009, plus interest until paid.

The court’s holding in Thompson does not mean that all owners of LLCs will be out from under the passive loss rules. Instead, what Thompson stands for is that losses passed through to LLC owners will not be treated as per se passive. Owners of LLCs must still prove to the IRS that they materially participate in the LLC’s activity in order to use losses and credits from that activity against active income, but they can use the more flexible rules of Treas. Reg. § 1.469-5T(a).

For example, assume that one spouse owns a restaurant in an LLC while the other spouse works at a separate job as an employee. The LLC structure was chosen because it offered limited liability to the owner while not requiring the use of a corporation. The spouse who owns the LLC works full time managing the restaurant, including supervision of employees. The owner spouse should have little difficulty establishing that they materially participate in the restaurant business. Therefore, if the restaurant in any year incurs a tax loss, that tax loss should be available to offset the wage income of the employee spouse, assuming the husband and wife file a joint return.

Thompson enhances the flexibility that LLCs offer to entrepreneurs and small businesses. Their use will still require advance tax planning to ensure that owners will be treated as materially participating. Clarification that the per se passive rule does not apply to LLCs, however, means that owners who do materially participate need no longer fear that tax losses cannot be used to offset “active” income.

One last word of caution. The Thompson, Garnett and Gregg cases are not the last word on this issue, even though the IRS is apparently not appealing Garnett or Thompson. All three courts were trial courts, not appellate courts, so their decisions are not binding on the IRS in other taxpayer disputes. Nonetheless, after three at-bats and three strikeouts, it seems unlikely that the IRS would continue to attempt to apply Treasury Regulation § 1.469-5T to LLCs in the same restrictive manner as in Thompson. The Service might, however, continue to assert the same loss-limiting position that it did in these cases, against other taxpayers on audit in order to leverage higher settlements. Or, the Service could change its regulations to explicitly require that LLC losses be presumed to be passive losses. Watch for future developments.

Bankruptcy Court--Dissolution of an Idaho LLC Does Not Transfer the LLC's Assets or Terminate the LLC

Doug Batey — Mon, 14 Sep 2009 15:00:02 -0800

The debtor corporation, Aldape Telford Glazier, Inc. (ATG), was the sole member and manager of two Idaho LLCs. ATG filed a Chapter 7 bankruptcy case, listed a number of assets of its two subsidiary LLCs in the schedule of ATG’s personal property, and did not list its member interests in the two LLCs. The two LLCs had been previously dissolved, and each had filed articles of dissolution which recited that “[a]ll assets revert to sole member.” In re Aldape Telford Glazier, Inc., No. 09-00834-TLM, slip op. at 3, 2009 WL 2216594 (Bankr. D. Idaho July 23, 2009).

The trustee sought dismissal of the bankruptcy case on the grounds that ATG was attempting to impermissibly combine the financial affairs of separate legal entities, thus creating in effect a “joint petition” of ATG and the two LLCs. (Joint filings of a bankruptcy case are not allowed except in the case of spouses. Fitzgerald v. Hudson (In re Clem), 29 B.R. 3 (Bankr. D. Idaho 1982).)

The bankruptcy court applied Idaho state LLC law and determined that LLC property belongs to the LLC and not its members (Idaho Code § 53-633(1)), that on dissolution an Idaho LLC continues to exist and to own its property until it has wound up its business and affairs and distributed its property (Idaho Code §§ 53-644, 53-646), and that the statements in the articles of dissolution that the LLCs’ assets reverted to their members were ineffective. In re Aldape, slip op. at 7-9.

ATG argued that the trustee could “handle the process of identifying and segregating the physical assets and accomplishing the wind up process for both LLCs,” or that the trustee could file Chapter 7 petitions for the LLCs. The court rejected those suggestions as unreasonable and inconsistent with the Bankruptcy Code. Id. at 11-12.

ATG’s approach, i.e., the statements in the LLCs’ articles of dissolution about assets reverting to the sole member and the inclusion of the LLCs’ assets in ATG’s asset schedule in the Chapter 7 filing, shows some confusion over the effects of dissolution. Under Idaho’s LLC Act, dissolution of an LLC is simply a change of its status, not a termination of its existence. ATG attempted unsuccessfully to treat the dissolution as a termination of the LLCs’ existence and as a conveyance of the LLCs’ assets to their member.

The approach of the Idaho statute—LLC dissolution as a change of status requiring that the business be wound up, debts paid and liabilities provided for, and any remaining assets distributed to members—is widely used by the states. E.g., Washington, Delaware. The Revised Uniform Limited Liability Company Act uses the same approach.

Should State Laws Require LLC Operating Agreements to Be inWriting?

Doug Batey — Tue, 01 Sep 2009 14:43:21 -0800

A committee of the Washington State Bar Association is currently reviewing the Washington Limited Liability Company Act, RCW ch. 25.15, with an eye toward recommendations for changes to the statute. One of the issues the committee is considering is whether Washington’s LLC Act should continue to require LLC agreements to be in writing. The Washington Act defines a “limited liability company agreement” as a written agreement (or a written statement of a sole member) concerning the affairs or business of the LLC. RCW 25.15.005(5). The result is that only written agreements of the members will control over the default provisions of Washington’s LLC Act.

The state LLC laws vary. Some require that member agreements (often called operating agreements) be in writing, while some allow oral agreements as well as written. Under Delaware’s LLC Act, for example, a limited liability company agreement can be “written, oral or implied.” In contrast, the New York LLC Act defines an operating agreement as a written agreement of the members, much like the Washington definition.

Business lawyers usually have an emphatic answer if asked about oral LLC agreements: “Of course they should be in writing.” That’s generally the right advice to give to a client considering any kind of business investment or transaction more complicated than getting one’s shoes shined at the shoe-shine stand. But some people inevitably will choose to form LLCs with only an oral agreement about matters such as capitalization, profit and loss allocations, distributions, voting control and so on. Should their oral agreement be disregarded if it would yield results different from the default rules under the statute?

Corporations, of course, are in the “put it in writing” camp. All state corporation statutes require that articles of incorporation, the basic charter document, be in writing and be filed with the appropriate state agency to create a corporation. Many state corporate statutes allow shareholder agreements to vary some of the statutory default rules, but those statutes require that the shareholder agreements be in writing and be executed by all the shareholders. E.g., RCW 23B.07.320. The Model Business Corporation Act, which has been adopted in 24 states, takes the same approach by requiring that shareholder agreements be in writing to override statutory default rules. Model Bus. Corp. Act § 7.32 (2002).

Partnership law approaches the issue differently. Partnerships are based on the agreement of the partners, and both the Uniform Partnership Act (UPA), Section 101(7), and the Uniform Limited Partnership Act (ULPA), Section 102(13), provide that partnership agreements can be written, oral or implied. Thirty-six states have adopted the UPA and 15 have adopted the ULPA, including Washington.

The common law concept of a partnership – an association of two or more persons to carry on as co-owners a business for profit – recognizes that partnerships can be formed informally and by oral agreements. Although the formation of a limited partnership also requires the filing of a written certificate with a state agency, the certificate of formation need contain only limited information such as the name and address of the limited partnership, and the name and address of each general partner. The certificate of formation is simply a notice filing and is not usually used to define the rights of the partners.

Even if a state’s LLC Act allows oral LLC agreements, the state’s statute of frauds will apply. A statute of frauds invalidates certain types of agreements unless they are in writing and signed, such as a guaranty of another’s debt or an agreement that by its terms is not to be performed in one year. E.g., RCW 19.36.010.

For example, last year the Delaware Chancery Court ruled that the Delaware statute of frauds applied to the oral limited liability company agreement of a Delaware LLC. Olson v. Halvorsen, No. 1884-VCL, 2008 WL 4661831 (Del. Ch. Oct. 22, 2008). The court accordingly dismissed a claim under the agreement that called for a multiyear earn-out after a member’s retirement, since by its terms that provision of the agreement could not be performed in a year.

Washington’s and New York’s LLC Acts do not invalidate an oral LLC agreement. Instead they simply define the LLC agreement as a written agreement. Many of their statutory rules may be waived or modified by the members’ agreement, if it is in writing. The New York court has held that if the member agreement is not in writing, the LLC exists but the default rules in the statute govern the LLC, rather than conflicting terms in the oral member agreement. Spires v. Casterline, 4 Misc.3d 428, 778 N.Y.S.2d 259 (Sup. Ct. 2004). Presumably an oral agreement that supplements but does not purport to override the defaults of the LLC Act would still be enforceable.

To return to the question, should state law require LLC agreements to be in writing? The policy in favor of requiring written agreements is similar to that behind the statute of frauds – experience teaches that certain types of agreements are so significant that the higher degree of certainty inherent in a writing should be required. In the event of a dispute, permitting oral LLC agreements will increase litigation costs because of the difficulty of proving the oral terms. It will also be more difficult for new members of an LLC to determine the oral terms governing the LLC.

The policy that supports allowing oral LLC agreements is that of not frustrating the expectations of the parties. LLCs are popular for smaller businesses with few members, who often form an LLC with minimal legal formalities. Many states, including Washington and Delaware, have recognized in their statutes the goal of maximizing the enforceability of agreements between members: “It is the policy of this chapter to give the maximum effect to the principle of freedom of contract and to the enforceability of limited liability company agreements.” RCW 25.15.800(2). That policy is undermined by not enforcing oral member agreements. Also, it seems anomalous to have a different rule on this point for LLCs than for limited partnerships, since in Washington and most other states the limited partnership agreement can be written or oral. RCW 25.10.010(9).

LLCs are used for a wide range of types and sizes of businesses. Large enterprises normally have legal counsel, accountants and written LLC agreements. Smaller, closely held enterprises sometimes don’t have written agreements. An efficient and flexible LLC statute should work well for the widest range of individuals and groups forming an LLC. To do that it should recognize that some LLCs will be based on oral agreements. The need to prove the terms of an oral agreement in the event of a dispute seems an inadequate reason for automatically disqualifying all oral LLC agreements. On balance, the policy reasons seem to tilt in favor of allowing LLC agreements to be oral as well as written.

When I started writing this post I was on the fence on this issue, but I’ve come to the conclusion that the best approach for the Washington LLC Act is to allow LLC agreements to be oral as well as written. But I recognize that people may differ on this point, and I would welcome any comments or input on this issue. Feel free to comment by clicking on the "Comment" link below.

Low-Profit LLCs - The Newest Limited Liability Company Structure

Doug Batey — Fri, 21 Aug 2009 15:54:32 -0800

This month Illinois became the latest state to pass enabling legislation for low-profit limited liability companies, or L3Cs, joining Vermont, Michigan, Utah and Wyoming. The new Illinois law becomes effective on January 1, 2010. According to the Nonprofit Law Blog several other states are considering adopting L3C laws.

An L3C is a limited liability company whose primary purpose is not to earn a profit but to “significantly further the accomplishment of one or more charitable or educational purposes.” E.g., Ill. Pub. Act 096-0126 (SB 0239). An L3C is not a nonprofit and is not precluded from earning a profit, but income or property appreciation may not be a significant purpose of the company. An L3C is a hybrid, a business entity formed to carry out charitable or educational purposes, and designed to attract philanthropic as well as private investment. In almost all respects other than its purpose, an L3C is treated like any other LLC, including income taxes.

To qualify as an L3C under the state laws, the LLC:

● must significantly further the accomplishment of one or more charitable or educational purposes within the meaning of IRC section 170(c)(2)(B);

● would not have been formed but for the accomplishment of the charitable or educational purposes;

● does not have as a significant purpose the production of income or the appreciation of property, although the fact that the company produces significant income or capital appreciation is not conclusive evidence of a profit motive; and

● does not have as a purpose the accomplishment of any political or legislative purpose.

These state law requirements parallel the Internal Revenue Code requirements for the target of a “program-related investment” by a private foundation. IRC § 4944(c). In addition, each of the five states requires that the name of the L3C contain either the abbreviation “L3C” or the words “Low-Profit Limited Liability Company.”

Vermont was the first state to pass legislation to authorize L3Cs, in April 2008. As of August 20, 2009 there were over 60 L3Cs formed in Vermont. In a little over a year four more states have amended their LLC Acts to authorize L3Cs. Illinois, the latest of the four, is a heavyweight in terms of its industry and commerce. L3Cs are here to stay and are growing in use and in public recognition.

There are two principal reasons why L3Cs are taking off. The first is the hope that L3Cs will attract program-related investments (PRIs) by private foundations. By combining philanthropic investment with private capital, L3Cs can offer the possibility of major social impact.

If an investment by a private foundation meets the Internal Revenue Code’s requirements for a PRI, the investment will count towards the foundation’s annual distribution requirements and will not jeopardize the foundation’s charitable purpose. IRC § 4944(c). PRIs by private foundations are not common occurrences today, in part because of the high transaction costs to the foundation in verifying that the target of the investment will meet the PRI requirements. The promoters of state laws authorizing L3Cs expect that foundations will be more willing to invest in companies organized as L3Cs.

A company’s status as an L3C under state law, however, is not adequate to qualify the L3C for a PRI. And if a private foundation makes an investment with an L3C and the investment turns out not to qualify as a PRI, the foundation can be assessed substantial taxes and penalties. The result is that unless and until the IRS issues guidance about qualifying L3Cs for PRIs, private foundations will likely conclude that they must continue to incur the transaction costs involved in determining the correctness of a specific PRI. Those costs often include expensive private letter ruling requests to the IRS.

These tax issues are well described in Allison Evans, Christine Petrovits & Glenn Walberg, L3C: Will New Business Entity Attract Foundation Investment?, 63 The Exempt Organization Tax Review 457 (2009). It appears that without regulatory guidance from the IRS or changes to the tax laws, private foundations will continue to be reluctant to make program-related investments in LLCs, whether or not they are structured as L3Cs.

Branding is the second reason why L3Cs appear to be attractive for companies with social missions. By being labeled as an L3C, companies send a signal to their customers, employees, vendors and communities that they have a charitable or educational purpose, even though they are not a nonprofit. The L3C movement appears to have tapped into this vein of entrepreneurial desire to provide public benefit.

We can expect continued growth in the number of states that authorize L3Cs and in the number of L3Cs being formed. That should increase the pressure for the IRS and federal regulators to come up with a more economically efficient way for L3Cs to qualify for program-related investments, so that private foundations will not be deterred from making investments in L3Cs compatible with the foundation’s mission.

Big Brother Wants to Crack Open Your LLC

Doug Batey — Fri, 07 Aug 2009 08:40:32 -0800

Congress is considering a bill that would require organizers of LLCs to disclose the LLC’s members on formation and periodically thereafter. (The bill also applies to corporations and corporate shareholders.) On June 18, 2009 the U.S. Senate Committee on Homeland Security and Governmental Affairs held a hearing on the Incorporation Transparency and Law Enforcement Assistance Act, S. 569. This bill was introduced in 2008 and re-introduced in 2009. One of the co-sponsors in 2008 was then-Senator Barack Obama. Gary Rosin has reported on the hearing here.

This bill would require all the states to change their laws so that organizers of LLCs would be required to provide the state at the time of formation with the names and addresses of the LLC’s “beneficial owners”. Each LLC would have to update its list of beneficial owners in an annual filing, or if the state does not require annual filings, each time a change is made in the ownership. S. 569 § 3. “Beneficial owner” is defined broadly as an individual who has “a level of control over, or entitlement to, the funds or assets of a corporation or limited liability company that, as a practical matter, enables the individual, directly or indirectly, to control, manage, or direct” the corporation or LLC. Id. Since a beneficial owner has to be an individual and not an entity, any multiple levels of ownership would have to be traced to find the individuals who are the beneficial owners.

This definition is breathtakingly broad. For a variety of investor requirements and legitimate financing and tax efficiency reasons, many businesses involve complex structures with multiple entities, various ownership and voting rights, and contractual relationships with nonmembers. The terms “control” and “as a practical matter” are undefined and will be difficult to interpret in some contexts. In many cases individuals who are not members of an LLC could nonetheless fall within the definition of beneficial owner, requiring that their names and addresses be reported to the state.

The information that the states must collect is to be given to the federal government or other states in response to:

· subpoenas from any state or federal agency or congressional committee;

· written requests by a federal agency on behalf of another country under an international treaty, agreement or convention; or

· orders from a federal court responding to a request by a foreign or international tribunal or litigant.

This bill has so many things wrong with it that a critic can view it as a target-rich opportunity. Professors Ribstein, Bainbridge and Verret have criticized the bill’s weak justification, lack of clarity, high costs and low benefits, ineffectiveness, unconstitutionality, and lack of wisdom in federalizing an area of law that has traditionally been a matter of state control.

S. 569 would be a radical change because in this country members of LLCs (and shareholders of corporations) are not generally required to be identified when the entity is formed or at any later time. There are some specific occasions when members and shareholders must be identified, such as in response to discovery requests in litigation, in response to law enforcement subpoenas, or when a shareholder or member makes a request in compliance with the applicable state LLC or corporate statute, but those are event-driven and relatively infrequent.

There is one case where some states require that members of an LLC be routinely identified, and that is when the LLC is member-managed. Many states require that the identity of corporate directors and LLC managers be provided to the state, and make that information publicly available. But if there are no managers other than the members, then all members are managers, and some states require in that case that all the members be identified. Washington and California, for example, require that all members of a member-managed LLC be periodically identified in a statement filed with the state. RCW 25.15.105(1)(e); Cal. Corp. Code § 17060(a)(4). Oregon requires that at least one member of a member-managed LLC be identified in an annual report to the state. ORS 63.787(1)(d).

S. 569 does not require public disclosure of the member and shareholder information that it would require the states to collect, but it does not bar disclosure by the states. It’s likely that over time this member and shareholder information would be made publicly available by at least some states, under the combined pressure of the feel-good label “transparency” and the usual legislative and bureaucratic mission creep.

All of this information would be collected to further the goals stated in the bill of preventing wrongdoing by U.S. corporations and LLCs with unknown owners. Since LLCs and corporations cannot act except through human agents, i.e., directors, managers, and officers, the ownership of a wrongdoing LLC can be investigated through application of the existing law enforcement tools to the agents of LLC. The testimony in the hearing on the need for this information to be collected is not compelling.

But even assuming that there is a law enforcement need for uniform collection of ownership information, it seems unlikely that a criminal who forms an LLC for an illegal enterprise will dutifully use his correct name. An alias or a straw man can easily be used, or the wrongdoer can use an entity not covered by the bill. Meanwhile, the nearly two million new LLCs and corporations formed in this country each year, and all ongoing LLCs and corporations, will be attempting to comply with the new filing requirements. Only law-abiding businesses would be burdened by these requirements.