Documenting LLC Ownership Interests

Q. How can I show evidence of a sale or transfer of an LLC in MO? My son and I own 50% of a family LLC and my husband has either given or sold the LLC to his brother in KS who did own only 1%. Sandra, Mo

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A. I am a little confused by the question; however, I read the situation as one where your husband has attempted to sell an LLC ownership interest to his brother that you believe you and your son have an ownership interest in. Further, your issue is how to prove or document that you and your son own a 50% interest in an LLC now claimed by your brother-in-law.

This is a good question as the ownership interests of the respective members is not (to my knowledge) recorded in the annual report filed with the Missouri Secretary of State. However, the ownership interest of each member should be recorded in the LLC operating agreement. If your company does not have an operating agreement (or the ownership interests have changed and the new percentages not documented) then the next best document source is probably the LLC's annual federal income tax report (which is most likely an IRS form 1065 although an LLC can file another form depending on its tax status). If the LLC is taxed as a partnership (which is the most common form of taxation for LLC's with more than one member), each member is supposed to receive a form K-1 when the tax return for each year is filed. The form K-1 contains the ownership interest in the LLC for the member.

Other than that, the LLC should maintain internal books and records that record the ownership interest of each member. RSMO § 347.091 sets out the documents each LLC is required to maintain and the right of a member to inspect said documents.

Articles of Organization versus LLC Operating Agreement

Question: Is this document sold on your web site filed with the state of Florida? Is it what I use to start my LLC? Stan, Orlando.

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I often receive this question. No, the document you linked to is an LLC operating agreement. That is an agreement between the members setting forth such things as ownership percentages, method of allocation of profits and losses, voting procedures, et cetera. The document filed with the state (usually the corporate division of the secretary of state) is generally called "articles of organization". Here is a link to the version of this form used in Florida. The articles of organization are brief and something that a non-lawyer should be able to fill out on his or her own without professional assistance.

"Qualified Income Offset" Under Trea. Reg. 1.704

LLC's taxed as partnerships must meet the "substantial economic effect" test of Treasury Reg. § 1.704-1(b)(2) for the allocation of income, losses and other items. This is an especially important point in regard to pass-through LLC losses as a deduction could be denied by the IRS if it finds the allocation lacks substantial economic effect. There are two alternative tests for providing that allocations by an LLC have substantial economic effect.

Under the first test, the LLC operating agreement must unconditionally obligate all members with a negative capital account to restore the amount of such deficit balance to the LLC by the end of the taxable year during which liquidation occurs (or, if later, within 90 days after the date of such liquidation). Treas. Reg. § 1.704-1(b)(2)(ii)(b)(3). One of the main reasons people find the LLC form attractive for business is it's limited liability feature. If the operating agreement requires all members to repay capital account deficits upon the liquidation of the LLC, this could make them liable to some degree for LLC debts. For obvious reasons, this is not an attractive option for complying with the substantial economic effect requirement.

The alternate test for substantial economic effect is less draconian. It requires the LLC operating agreement to contain a "qualified income offset" (in addition to other requirements). In laymans terms (to the best of my reading of the regulations), a qualified income offset merely suspends any special allocations to an LLC member that would increase a capital deficit and requires the LLC to allocate income or gain to the member to eliminate any the negative capital account as quickly as possible. For an example of such a provision, see this operating agreement at Section 6.2(c). Another common way one sees for addressing "qualified income offset" requirement in LLC operating agreement is including the following short phrase: "To the extent a Member shall have a negative capital account balance, there shall be a qualified income offset, as set forth in Treasury Regulation 1.704-l(b)(2)(ii)(d)." I personally prefer more of an explanation of what the offset entails but I have seen no ruling for the IRS indicating that this phrase is inadequate. For more extensive sample language, click here and language contained in PLR 145623-04.

For more on this topic, see Federal Income Taxation of LLC Members By Charles R. Beaudrot.

Fudging Loan Application Of LLC

Question: I'm a 1/3 partner in an LLC - we are having credit problems getting a loan because of my credit - not too bad, just not good enough. We need this $65,000 loan for biz improvements - the broker suggested taking me off the LLC paperwork just until the loan is approved then putting me back on. Your thoughts or suggestions would be greatly appreciated. thank you. Barry, CA

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Answer: My reaction is that the broker is suggesting you commit banking fraud. Stop and think about what it means to "take me off the LLC paperwork just until the loan is approved". If I understand the suggestion correctly, at all times you will be the true beneficial owner of a 1/3rd interest in the LLC; however, the broker recommends submitting loan applications to banks showing just two LLC members each having a 50% interest. It is a federal crime to lie on a loan application to a federally insured bank. See Lying on mortgage application can lead to a fine and even jail time.

I'm not sure what problem a bank has with your bad credit if the other two members have good credit. Normally, all owners "jointly and severally" guaranty small business loans. That means the bank can recover the full amount of the loan to the LLC from any member. If the issue is that the bank does not wish one with bad credit to have control over the money loaned, then perhaps there is another way to deal with the situation. The LLC could be converted to a manager-managed LLC. Then the two members with good credit are made the managers. You are left a member but not a manager. For good measure, the LLC operating agreement could state that only managers may have signature authority over LLC financial accounts. Not sure if this will calm the loan officer's fears but it never hurts to inquire. Lying is not an option.