Friday, September 26, 2008

Walking Away From Your LLC & Taking the Customers

Every lawyer will say plan up front in the member operating agreement for LLC breakups. Be that as it may, I know the majority of LLCs with more than one member do not have operating agreements that plan for member withdrawal or removal of a member who fails to perform promised services. Typically, I hear from an unhappy LLC member who feels he/she is doing all the work and the other member is free-loading. However, the operating agreement provides for an equal distribution of LLC income regardless of the level of work put in by each member on behalf of the LLC. The first step, of course, is to attempt to reach agreement with the other member for their withdrawal. What happens when no agreement between the members can be reached?

One option is for the unhappy member to leave the LLC and allow it to fail. That's a drastic step with some down-side risk. Let's first look at potential benefits of walking. This approach can be attractive where the LLC is a service business. The main issue in service businesses is who controls the bulk of the customer contacts and new business leads? If it is the same member who is disgruntled and wishes to bolt the LLC, then it may make sense to walk and take the business with you. If the LLC owns equipment that is vital to providing the service, this becomes problematic. A member cannot walk away with key assets. That's theft.

Risks In Walking Away From LLC While Talking Lion's Share of LLC Business
  1. Up top has to be dealing with LLC debts for which the departing member is personally liable. Does the LLC have a lease for office space that is personally guaranteed by the members? What about equipment leases? Bank loans? Credit cards?
  2. As stated above, a departing member cannot bring with him or her any assets of the LLC. The LLC customer list is an asset. You should leave it with the LLC records. If the LLC has a small number of key customers, no big deal. But if the list if voluminous, you may have a difficult time recreating the customer list from secondary sources such as the Yellow Pages.
  3. Stealing key employees. If the LLC has employees with a written contract, legal issues arise when a former member steals an employee from the LLC (i.e., tortious interference with a contractual relationship).
  4. Fiduciary duties LLC members owe to one another. The extent of fiduciary duties owed by LLC members to each other varies from state to state and can often be modified by the operating agreement. A common fiduciary duty owed by LLC members to each other is one of loyalty. That means the LLC member never acts against the interest of the LLC. If a member plans on bolting the LLC and scooping up key customers / employees in the process, overt actions to further than plan should not occur while the individual is still an active member of the LLC. By "overt", I mean don't contact the customers / key employees asking them to join you in the new venture until you are already out the door. Why? Recruiting away customers and employees from the LLC to the new business could violate the duty of loyalty. See blog post from my commercial site for more info on topic.

Tuesday, September 16, 2008

Dividing LLC Profits and Losses On Other Than A Straight Percentage Basis

Question from Ali: "I want to form an LLC and I'll own 95% and a friend 5%. However when we take a contract - Profit won't be split like that. In fact, it'll fluctuate depending on time contributed. We want to avoid doing payroll taxes but will get a EIN for the purpose of getting a bank account, etc.

1) Can an LLC (Delaware) pay "members" who do work through a 1099?

2) Can profit be taken in and split on an arbitrary basis?

What's the best way to outsource work (if we cannot use a 1099) to a "member" and what about a non-member?

Thanks - it'd be a big help!"

I generally eschew blogging about tax issues but I'll make a few comments here. In responding, I'll assume your LLC plans to elect partnership tax treatment (as opposed to the rare election to be treated as a corporation). The term "payroll taxes" generally refers to both federal income tax withholding done by employers and FICA taxes reported on IRS form 941 along with the state / local equivalents of the 941. When an LLC pays members, it is generally treated as one of two things: (a) a capital withdrawal or (b) a member loan (or repayment of a loan). Put another way, payments to members are not wages. At the end of the year, the LLC files a federal form 1065. Each member of the LLC receives a K-1 from the LLC as part of the LLC form 1065 that allocates LLC income-loss between the two members. Each member, in turn, reports that income or loss on his (or her) individual income tax return (IRS form 1040). As part of the individual 1040 return, income allocated to the member from the LLC is subject to self-employment tax which equals FICA paid by employers. The members are required to pay estimated tax to the federal government upon the expected income from the LLC.

"Can (LLC) profit be taken in and split on an arbitrary basis?"

I think arbitrary is not the word you meant here. I assume you are asking whether LLC income-loss can be allocated between the members in other than a straight percentage arrangement. The answer is "yes", formulas are allowed. LLCs are allowed to allocated the profits between the members in any fashion they desire so long as the formula has "substantial economic effect" (or at least this was the case when I last studied partnership taxation almost 20 years ago). A discussion of what that means is well beyond the scope of a short blog post. Getting back to the division of profits and losses, you can have a formula or I have even seen agreements that delegated division of profits and losses to a compensation committee. These sorts of arrangements are most often found in professional services LLCs. The operating agreements for PLLCs are a complicated matter. What you have described is not an easy thing to draft.

I think you would be well advised to sit down with a tax accountant to get a thorough understanding of how the LLC you envision will work from a tax standpoint. Also, the agreement on division of profits will, by necessity, be difficult to draft. Advice of legal counsel is highly recommended.