The tax lawyers mess up LLCs

I'm working on one of the semi-annual supplements to Ribstein & Keatinge on LLCs, and so I'm thinking about LLCs lately. Today's lesson: dissolution, and a recent New York case.

Here's some background: One of the main advantages of the partnership form is that it allows cash-out of member interests. This is important in closely held firms that have no developed market for their shares. I've even argued, e.g., here, that some form of cash-out rights can be useful in publicly held firms.

So one would think that an important advantage LLCs would have over corporations, since they're based on the partnership form, would be a statutory default rule that provides for partnership-type exit at will. Then the courts wouldn't have to provide exit through the cumbersome corporate "oppression" rules that are vague and unpredictable and sometimes trump the parties' express agreements.

Of course some firms might like to prevent exit at will because members can abuse this right.  Where this is a risk, the parties can draft around the exit provision in the statute, or incorporate. But it's safe to assume that the owners of the sort of very small and informal firms that don't have agreements would want to be able to exit at will. So the statute should give them this right by default.

This simple logic doesn't reckon with tax lawyers or the Internal Revenue Code. The latter provides (I won't bore you with the details) that an interest in a business (usually this applies to family owned businesses) can be transferred at a discounted value for estate tax purposes only if the business association statute under which the business was organized restricts transfer. In other words, it's not enough under the IRC that the business does so by agreement.

Once this tax rule became clear, the tax lawyers promoted changes in both limited partnership and LLC statutes that provided the default rules the tax lawyers needed for the discount. Then all firms, including very closely held firms, that neglected to contract around the statute were left with locked-in interests, and at the mercy of the courts, just like corporations.

Lots of writers have noted this problem and argued against eliminating default exit, most recently Moll, Minority Oppression & The Limited Liability Company: Learning (Or Not) From Close Corporation History, 70 Wake Forest L.Rev. 883 (2005).  And, and back in 1995, me, in Statutory Forms for Closely Held Firms: Theories and Evidence from LLCs, 73 Wash. U. L. Q. 369, 427-28 and The Emergence of the Limited Liability Company, 51 Business Lawyer 1, 28, where I said:

The problem with the statutes that eliminate default withdrawal rights is that, while solving the tax problem, they also may create costs for the informal firms in which a default put is an important benefit of the LLC form.

Ironically, I can take some blame for this because, back in 1988, I worked with the Georgia bar to make the Georgia limited partnership statute the first to eliminate default exit rights (GA. CODE ANN. § 14 9 603). Although this provision was not added for estate tax purposes, it later was used for that when lawyers discovered the estate tax problem.

In my defense, the limited partnership is a specialized entity, often used for publicly held firms, especially back in the 1980's when the Georgia statute was being drafted. The LLC, by contrast, is increasingly used for small, informal firms and therefore needs different default rules. So it makes sense to have the tax-friendly rule in the limited partnership statute, and keep the LLC default-rule friendly. Nevertheless, as I said, the tax lawyers got hold of the LLC statutes too.

All of this is a prelude to the case decided last week in New York, Horning v. Horning Const., LLC, 2006 WL 738716 (N.Y.Sup., Mar 21, 2006). The court refused to order judicial dissolution in order to let a locked-in member exit. The plaintiff tried to get the court to give him the exit the NY LLC act, like many others, denies him. The court held that dissolution on this ground would be inconsistent with the statute's intent to bar exit in exactly this situation for estate tax reasons. Here's an excerpt (footnotes omitted, slip at 7-8):

One certainly can sympathize with petitioner's plight. In 2001, he had a thriving corporation and wished to reduce his work schedule. Whether for estate and gift tax reasons, or otherwise, he brought in two trusted men and gave them each one third ownership of a new venture set up as a LLC. But he did this without prior or contemporaneous execution of an operating agreement giving him fair exit rights in the event of future disharmony. . . . . Despite petitioner's stated frustration with the failure of the members to reach terms on an operating agreement, he was happy to keep doing business through the LLC until he unsuccessfully proposed a buyout to respondents in 2005, the company's most successful year. Only then did he seek dissolution. The company continues to thrive in the ups and downs of the construction business. Even in the corporate context, with the more liberal involuntary dissolution standards designed to protect minority interests, courts have rejected dissolution petitions in similar circumstances (or even worse scenarios from petitioner's perspective). . . .A fortiori, petitioner's showing under the more stringent standard of [NY] LLCL § 702 is insufficient here.

So it's going to be up to legislatures to fix the problem.  But they'll have to contend with the tax lawyers.

Comments

[josh]

It has been my experience that permitting LLC members to cash out creates problems. This is not just a tax/estate planning issue. Most small companies simply do not have the financial ability to cash out a member. It creates a hardship on the LLC.

[Robert Schwartz]

Another good reason to repeal the Estate Tax.

[Larry E. Ribstein]

Yes, we should repeal the estate tax. But unfortunately we would still have tax lawyers, so the underlying problem would remain.

As for the problems with cash-out--I address that point in my post. The question is what should be the default rule.

[CompanyCounselor]

Interested studies on LLCs. What are your thoughts of Northwest Energetics Services LLC v. FTB, SF Super. Ct. #CGC-05-437721, a San Francisco trial court decision involving a Washington organized LLC that had qualified to do business in California, but never actually had any business activities in California? The court rendered a notice of intended decision that the failure to apportion the LLC fee renders the fee unconstitutional under the US Constitution’s due process and commerce clauses because it is an unapportioned tax on income.