Ward on Iowa Limited Liability Company Law

Converting an S Corporation to an LLC - The IRS Lays Out the Rules

In Private Letter Ruling 200839017 (Released Sept. 26, 2008) the IRS recognizes as an "F" reorganization the conversion an S corporation incorporated as a corporation under state law to a limited liability company organized under state law, so long as the entity remains an S corporation for tax purposes.

The taxpayer (corporation) made 16 representations in connection with the ruling.  You can read all 16 here, but in sum it was a plain vanilla transaction.  The units received were equal in value to the shares converted, no other consideration was paid, there were no plans by the shareholders to dispose of the units or by the company to sell any assets, no plans to redeem. 

Interestingly, the company represented there would be no dissenting shareholders.  If that continues to be a key to a conversion it might prove problematic and limit conversions to transactions in which all of the shareholders agree to the conversion in advance.  This does not appear to be a requirement in the more traditional F reorganization.

Finally, the taxpayer represented that under state law Newco would be considered the same entity after the conversion as before.  Under current Iowa law, a corporation could not make that representation.  Under the new Iowa LLC Act Section 489.1009(1) does provide that an organization converted to an LLC is the same entity as before.

Based on these representations, the Service ruled that the conversion would be an F reorganization, no gain or loss would be recognized by any of the participants, the tax basis would be unchanged and the holding periods would tack.  Also, the S election would not terminate and the taxpayer would keep its EIN.  The Service also noted that the operating agreement would not create different classes of stock because "it does not create different rights to current distributions or liquidation proceeds."  There is no way to know if these means that distributions were mandated to be pro rata, like a corporate dividend, or the IRS was recognizing the discretion inherent in LLC distributions.  Be cautious here.

-Marc Ward

Professional Plaintiffs Beware

Judge Cote of the Southern District of New York recently entered an order that should be of some relief to the beleaguered investment banks, such as there are.  It seems that whenever a financial crisis strikes sleazy law firms and equally contemptible professional plaintiffs slither from under the rocks to bring derivative claims against financial institutions.  That is not to say there are not legitimate derivative claims, there are, but there are far too many involving professional plaintiffs looking for a fast buck.

In re JPMorgan Chase & Co. Derivative Litigation, 2008 U.S. Dist.. LEXIS 71353 (September 19, 2008) is case arising out of the subprime mortgage fiasco.  The outcome of this case revolves around Federal Rule of Civil Procedure 23.1(a) requires a plaintiff in a derivative action to "fairly and adequately represent the interests of shareholders."

In this case, the plaintiff, Robert L. Garber, clearly did not.  He alleged that officers and directors of JPMorgan had violated the Securities Exchange Act of 1934, breached their fiduciary duties to JPMorgan, wasted corporate assets , and unjustly enriched themselves at the expense of the shareholders.  As it turned out, Garber is a professional plaintiff in about 25 similar lawsuits, he had never met his lawyers until the day before his court-ordered deposition, never signed a retainer agreement with one firm and with the other firm only the day of his deposition.  He was "appallingly ignorant of the many derivative actions that were filed in his name.  And the court noted "this litigation has been controlled by counsel with absentee plaintiffs."  Garber never provided the court with information that would allow it to conclude that he could fulfill his responsibilities to the shareholders and the corporation.

Based upon this record, the court dismissed the case.

Who Has the Right to Bring Derivative Claims?

A recent New York Supreme Court case, Billings v. Bridgeport Partners, LLC, 2008 N.Y. Misc. LEXIS 5506 (September 19, 2008) (remember, that a NY supreme court is the equivalent to our district courts) highlights an issue that can vex members who think they have been harmed by the actions of the other members.

The New York Court of Appeals (the highest court in the state) ruled earlier this year that although the New York LLC statute was silent members of New York LLCs had a common law right to bring derivative claims (Tzolis v. Wolff, 10 NY 3d 100(2008)).  Tzolis did not decide whether a plaintiff had to be a member of the LLC at the time of the alleged wrongdoing and when the lawsuit was brought or whether a demand first had to be made on the LLC management to bring action on behalf of the LLC.

The Billings case gave the lower court an opportunity to rule on these open issues.  Billings was not a member when he brought the lawsuit and had not made demand on the company to bring the action in its name.  The defendants moved to dismiss 5 of the 7 counts on this basis.

The court ruled that based on Tzolis and a 1904 case, Hanna v. Lyon, 179 NY 107 (1904)) (old law is good law!) a member of an LLC must have been a member of the LLC at the time of the offending conduct and at the time he or she brings the lawsuit.  The judge did not rule directly on whether a demand had to be made first, but in dicta didn't see why not.

So what does Iowa law say about this?  Its mixed.

Under the current LLC law (Iowa Code 490A.1001) demand must be made (no futility exception) and the member must be a member of the LLC at the time of the bringing of the action and at the time of the challenged transaction or, and here is language I had a hand in writing but am not sure what it means, "the plaintiff's status as a member of the limited liability company thereafter devolved upon the plaintiff pursuant to the terms of the articles of organization or an operating agreement from a person who was a member at such time."

The new Iowa LLC law (Iowa Code 489.902 and 903) says a member may maintain a derivative action if demand is first made (futility and irreparable injury exceptions) and it is rejected or 90 days go by without rejection and the plaintiff is a member at the time the action is commenced.  There is no requirement that the person have been a member at the time of the alleged misconduct.

Compare this to the Iowa Business Corporation Act (Iowa Code 490.741 and 742).  A demand must be first made upon the corporation (no futility exception, but one for irreparable injury) and it is rejected or 90 days go by without rejection. A plaintiff must have been a shareholder at the time of the act or omission complained of or became a shareholder by operation of law from one who was a shareholder at such time, but not at the time the action is filed.

Under the Iowa Uniform Limited Partnership Act (Iowa Code 488) the demand test is the same as under the new Iowa LLC Act but the plaintiff must have been a partner at the time of the alleged misconduct (or his or her status as a partner devolved by operation of law from such a person meeting this test) and when the action is commenced.

So, if you define the Demand Test as "A", the Owner at the Time Test as "B" and the Owner When the Suit is Filed Test as "C" you get the following:

Current Iowa LLC Law: Tests A (no exceptions), B and C must be met.

New Iowa LLC Law:  Tests A (futility and injury exceptions) and C must be met.

IBCA:  Tests A (injury exception) and B must be met.

ULPA: Tests A (futility and injury exceptions), B and C must be met.

This makes a lot of sense!

-Marc Ward

A Tax Levy will Attach to the Property Rights of Sole Member

In Chief Counsel Memorandum GL-101770-08 (No. 200836002; released 9/5/2008) the Service ruled that a levy served on an LLC will attach to the property rights of the sole owner of the LLC.  In this case it was a lawyer receiving income from the LLC as a result of contingent fee agreements between the LLC and the clients.

The lawyer owed income tax to the government.  Notices of tax liens were filed by the IRS.  The only asset available to satisfy these liens was the income generated by the LLC.  The Chief Counsel concluded that the right to receive a return of a member's capital contribution and to share in the LLC's profits is a property right subject to the levy. Accordingly, the LLC would be required to turn over the income in its possession to the IRS.  However, the contingent rights represented by the contingent fee agreements belonged to the LLC and were not subject to the levy.

-Marc Ward

Del. Case Looks at the Bad Faith Test for Breach of the Duty of Loyalty

In re Walt Disney Co. Derivative Litigation, 900 A. 2d 27, 66 (Del. 2006) created bad faith conduct as a breach of the duty of loyalty.  The court made clear that there is a distinction between bad faith and gross negligence.  Id. at 64.65.

The Chancery Court recently had an opportunity to test this distinction in McPadden v. Sidu, et al., 2008 Del Ch. LEXIS 123 (August 29, 2008).  The facts are extraordinary and require a reading of the entire case, but to summarize briefly, the board of directors of i2 sold a subsidiary (TSC) to the management of TSC for $3 million who not too long after flipped it for $25 million.  There were a lot of facts that should have caused the board to know that the $3 million price tag was woefully inadequate, as the subsequent sale revealed.

The court concluded that this was a case of gross negligence, not bad faith, thus the portion of the case alleging breach of the directors' fiduciary duties was thrown out because Section 102(b)(7) of the Delaware Corporation Act exculpated directors for breach of the duty of care (gross negligence).

The distinction between gross negligence and bad faith seems like a rather thin one, but appears to rest on whether there is evidence of bad intent, that is intentional dereliction of duty.  Read the case!

-Marc Ward

IRS Allows Another S Corporation to Avoid Inadvertent Termination

In PLR 200834007 (released August 22, 2008) the Service concluded that an S Corporation's election to be treated as an S corporation was terminated inadvertently.  Here are the facts.

The corporation was formed on "a" and elected S corporation treatment.  At the time the shareholder was "A" who owned the stock directly and indirectly through a wholly-owned LLC (a disregarded entity for tax purposes).

On a later date ("b") "A" sold his LLC interest to "B" and "C" which caused the LLC to no longer be a disregarded entity and an ineligible shareholder.

The corporation represented to the IRS that the S election termination was inadvertent and not motivated by tax avoidance or retroactive tax planning.  The corporation and its shareholders agreed to make such adjustments as required by the Service to treat the company as an S corporation.

The IRS ruled the termination was inadvertent and the corporation would continue to be treated as an S corporation from date "b."  The ruling is contingent on A, B, and C being treated as owning the corporation's stock held by the LLC in proportion to their ownership interests in the LLC on "b."

-Marc Ward