Ward on Iowa Limited Liability Company Law

Tax Court Recognizes Single Member LLCs for Valuation Discounts

Joe Kristan writes: "In a rare decision by the full court, the Tax Court yesterday ruled that single-member limited liability companies, which are ignored for income tax purposes under the "check-the-box" rules, are to be respected under the gift tax rules. This opens up the door to using single-member LLCs to obtain estate and gift tax valuation discounts."

Read more about this important case at Joe Kristan's Tax Blog: 

http://www.rothcpa.com/taxupdates.php

McGinnis v. Iowa Clinic: Fiduciary Duties in Closely-Held Corporations

The Iowa Court of Appeals addressed whether shareholders in a closely-held corporation, in this case a professional corporation of physicians, owed fiduciary duties to one another and whether the claims for breach of those duties could be brought directly rather than derivatively.  On both points the Iowa Court of Appeals said no.  McGinnis v. Iowa Clinic, P.C., 2009 WL 2424643 (Iowa App., August 6, 2009).

Senate File 413 Must be Defeated

I know it seems early to be concerned with the 2010 Iowa Legislature, but there is a bill carried over from last year that the Bar Association and others have been told will certainly become law if something isn't done about it.  And it is a bill that should not become law.

Why am I so concerned with SF 413?  Because by creating a new Iowa Code Section 91A.15 it imposes personal liability on officers of corporations, members and managers of LLCs and partners in partnerships "for a judgment obtained against an employer for failure to pay wages dues pursuant to Iowa Code Chapters 91A or 91D (Wage Payment Collection and Minimum Wage, respectively).  It is such a poorly written bill that it excludes corporate directors and shareholders, but includes LLC managers and members, the drafter apparently not realizing that they are practically interchangeable concepts.  It is also unclear whether it applies to LLPs and LLLPs.

Subsection 2 of this proposed new 91A.15 attempts to soften the liability exposure of subsection 1 by limiting it to persons (a) who control, supervise or have authority over wages and (b) who have a controlling interest or ownership in the entity and knowingly violate 91A or 91D.

This is not as limiting as it might seem because none of the terms are defined.  What is "control"?  Is being a manager having "authority for"?  What does it mean to "knowingly" violate?

If this law is passed you can kiss LLCs in Iowa good-bye.  The Legislature will also make it very difficult for out-of-state businesses organized as LLCs to do business in this state.  In other words, the preferred business entity, chosen by 77% of all new businesses in the State of Iowa, will be persona non grata.  Don't let any legislator who votes for this bill try to tell you they are pro-business or an advocate of business development in Iowa because they are not.

I appreciate what the sponsors of this bill are trying to do, but there is a better way to do it: Codify the elements of piercing the corporate veil.  Doing so will give clear guidance to owners and courts alike and see that people are punished for their conduct, not merely their ownership.

-Marc Ward

The Duty of Loyalty in the Context of a Law Firm Break-Up

It is not often you run across a RUPA case and a rare find when it is a duty of loyalty case to boot.  What makes In re Brobeck, Phleger & Harrison LLP, 2009 Bankr. LEXIS 2076 (July 2, 2009) particularly interesting is the RUPA provision in the case is nearly identical to the duty of loyalty provision found in the new Iowa LLC Act.

Brobeck, Phleger & Harrison LLP was a prominent law firm with over 900 attorneys.  The law firm fell into economic trouble causing the partners to take steps to ensure an orderly dissolution and winding up of its affairs.  Just prior to dissolution, the partners agreed upon a Final Partnership Agreement that addressed the "unfinished business rule" and the results of Jewel v. Boxer, 156 Cal. App. 3d 171 (1984).

The unfinished business rule says that unless the partners have agreed otherwise, they have a duty to account to the dissolved partnership and their former partners for the profits they earn on the dissolved firm's "unfinished business."  Jewel added emphasis to the UBR by making it clear that the partners can and should agree in advance to waive their rights to unfinished business (a "Jewel Waiver").

This unfinished business agreement/Jewel Waiver waived any claims the firm would have against its partners or that the partners would have against each other to account for the profits from unfinished business at the time of the dissolution of the partnership. In other words, it guided what happens between partners qua partners and between partners and the partnership.

The court did not end its analysis with the UBR and Jewel Waiver, but went on to determine whether the modifications to the partnership agreement (i.e. identifying the activities that did not violate the duty of loyalty) were manifestly unreasonable.

When I first saw the reference to "manifestly unreasonable" I was hoping I had finally come across the definitive definition.  No such luck.  The judge noted that no cases defined the term and not even a dictionary had one, so he concluded he must rely on his own common sense.  Great.  The good news is he found the law firm's Jewel Waiver not to be manifestly unreasonable.

You would think the opinion would end at this point, but the UBR and Jewel Waiver only affected the partners and the partnership.  There were other actors in this play, the creditors.  The bankruptcy trustee, on behalf of these creditors, asserted that the Jewel Waiver was an actual or constructive fraudulent transfer.

As to actual fraud, the court found none in light of the fact that the California courts encouraged partners to enter into Jewel Waivers.  Constructive fraud was another matter.  The court found that the partnership received nothing of value in exchange for the unfinished business it gave up to the partners.  The activities the partners listed as consideration for the unfinished business were either pre-existing duties or ethical obligations under the California Rules of Professional Conduct. 

Accordingly, the transfer of the unfinished law firm business was effective among the partners, but because nothing of reasonably equivalent value was given up by the partners in exchange for the partnership giving up its property right in the unfinished business, that exchange was a fraudulent transfer, albeit a constructive one, and the creditors were entitled to judgment against the partners and their new law firms.

 

-Marc Ward

IRS Dealt a 1-2 Punch on Applicability of Passive Loss Rules to LLCs

Two cases decided three weeks apart have made it very clear that LLC membership interests are not limited partnership interests under the passive activity loss rules of IRC Section 469.  This determination is important because if an LLC interest is treated as a limited partnership interest the member would be limited in his or her ability to claim material participation in the business operations.  Material participation is critical to ordinary loss treatment for tax purposes.  Ordinary loss treatment is better than passive activity loss treatment because the latter can only offset passive activity income.

In Garnett v Commissioner, 2009 U.S. Tax Court LEXIS 18, 132 T.C. 19 (June 30, 2009) the Tax Court ruled that the LLP and LLC interests of the petitioners (it just so happens they entities in question were Iowa LLPs and LLCs) were entitled to be treated as general partnership interests and not subject to the special rule of IRC Section 469(h)(2).  Instead, the seven factor test of Temp. Reg. Sec. 1.469-5T(a) would be used to determine whether the taxpayer materially participated in the business operations.

The Federal Court of Claims went further in Thompson v. US, No: 06-211 T (July 20, 2009).  Garnett was unwilling to simply conclude that LLCs are not partnerships therefore LLC interests are not limited partnership interests.  Instead, the opinion relies on the general partnership exception found in the regulations to hold an LLC interest to be a general partnership interest.  Thompson shared no such reluctance.  The IRS regulations say that "a partnership interest shall be treated as a limited partnership interest if...[t]he 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." Treas. Reg. Sec. 1.469-5T(e)(3)(i)(B) (emphasis added by the court).  The court was compelled to enforce the "plain meaning" of the regulation.  An LLC is not a limited partnership.  Therefore an LLC interest could not be a limited partnership interest.  QED.

The Thompson opinion goes on for six more pages with a rather anticlimactic discussion about whether limited liability or participation in management was more important to the determination of limited partnership status.  Didn't the court just conclude that it didn't matter?

-Marc Ward