Ward on Iowa Limited Liability Company Law

LLC Charging Orders and Their Priority

As readers of this blog should know, a charging order is the exclusive remedy with regard to a debtor’s membership interest in an LLC.  This is true even if a creditor has a security agreement signed by the debtor that assigns all right, title and interest in a membership interest in an LLC to the creditor (courts have found that absent the consents required by the operating agreement the assignment is ineffective).

This does not mean that creditors can’t take steps to improve their position with respect to claims they have on an LLC membership interest. In First Mid-Illinois Bank & Trust v. Parker, 2010 WL 3179734 (Ill. App. 2010) Bank A argued that its charging order should take priority over Bank B’s charging order even though Bank B’s charging order was entered first because Bank A had an attachment lien entered four months earlier. The court agreed finding that because the charging order and attachment lien of Bank A related to the same claim the attachment merged with the charging order and the charging order related back to the date of the earlier attachment filing based on the “relation back” doctrine.

-Marc Ward

Covenants Not to Compete and the Allocation of Goodwill in the Sale of a Professional Business

It is something to ponder during these dog days of August, why would a sole shareholder/dentist enter into an employment agreement containing a covenant not to compete with the PC?  In essence, he agreed not to compete with himself.  Howard v. U.S., (USDT, Eastern District of Washington, July 30, 2010).

That is exactly what Dr. Larry Howard did in 1980.  In 2002, when he sold his practice to a competitor the Asset Purchase Agreement allocated $549,900 to Dr. Howard for his personal goodwill.  On his tax return for 2002, Howard reported $320,358 as long-term capital gain resulting from the sale of the goodwill.  As a result of an audit, the IRS recharacterized the sale of the goodwill as a corporate asset and treated the amount Howard received as a dividend.  This resulted in a $60,129 tax deficiency plus $14,792 in interest.

As the court points out, the case law makes it quite clear that an employee working for a corporation without a covenant not to compete owns the goodwill.  See Martin Ice Cream v. Commissioner, 110TC 189 (1998).  But when an employee works for a corporation under an employment agreement with a covenant not to compete, it is the corporation and not the professional owns the goodwill generated by the professional. Norwalk v. Commissioner, TC Memo. 1998-279.

Now explain to me again, why did he agree not to compete with himself?  I smell another victim to form practice.

-Marc Ward

LLC Operating Agreements Must be Drafted with Care

An opinion from the Superior Court of Vermont indicates once again why LLC operating agreements need to be drafted with care.  In Casella Waste Systems, Inc. v. GR TEchnology, Inc., 2009 Vt. Super. LEXIS 10, the question before the court was whether it had subject matter jurisdiction to dissolve two LLCs organized under Delaware law.  The plaintiff sought to have two LLCs judicially dissolved by the Vermont court because the management of the companies was so divided that the members’ business relationship was “irretrievably broken.”

 

The operating agreements of both LLCs permitted dissolution by “the entry of a decree of judicial dissolution pursuant to the Delaware LLC Act.”  Section 18-802 of the Delaware LLC Act provides that “on application by or for a member or manager the Court of Chancery may decree dissolution of a limited liability company whenever it is not reasonably practicable to carry on the business in conformity with a limited liability company agreement.”

 

The Vermont court concluded that because the operating agreements specifically referred to the Delaware LLC Act and that act specified the Delaware Court of Chancery as the court with jurisdiction over judicial dissolutions of Delaware LLCs, the Vermont court could not exert subject matter jurisdiction over the dissolution of the LLCs even though the LLCs presumably were owned by Vermont residents and did business in Vermont.

 

This case raises two points.  First, if you choose to form a Delaware LLC, consider whether Section 18-109(d) and Section 18-111, when read together, permits an operating agreement to designate another jurisdiction other than Delaware to have authority over the LLC, its members and managers.  Section 18-109(d) clearly permits the members and managers to choose another jurisdiction, but it just as clearly omits LLCs.  Unless it can be read that the members or managers may choose on behalf of the LLC to choose another jurisdiction.  Section 18-111 uses the word “may” instead of “shall” when stating that the Court of Chancery has authority to “to interpret, apply or enforce the provisions of” an operating agreement.

 

Second, if you are not going to do business in Delaware, why choose to organize a Delaware LLC?  Like all LLC acts, the Delaware LLC Act is nuanced and littered with traps for those unfamiliar with its terms.  When in doubt, stay home.

 

-Marc Ward

Single Member LLCs are Not Always Disregarded for Tax Purposes

For federal income tax purposes, single member LLCs are disregarded.  That is not the case with respect to gift taxes.  In Pierre v. Commissioner, 133 T.C. 24 (2009) the Tax Court held that a single member LLC would not be disregarded for gift tax valuation purposes under the IRS "Check the Box" regulations.  What this meant in Pierre was that the taxpayer's transfer of an interest in a single member LLC was treated as just that, a transfer of an interest in an LLC, and not a transfer of a proportionate share of the assets owned by the LLC.  Thus, the transfer was subject to discounts for marketability and for lack of control.