Court Looks to Partnership Law in Ruling Against Petitioner’s Status as LLC Member
August 26, 2019
What makes someone a member of an LLC?
It’s a question that frequently arises in business divorce cases involving LLCs that have no written operating agreement much less certificated membership interests. On the answer hangs the fate of the complainant’s standing to seek judicial dissolution, or to demand access to LLC books and records, or to assert derivative claims, or to enforce any other rights arising from member status.
It’s also a question the answer to which turns on an endless array of case-specific facts and circumstances, which may be why I haven’t seen any New York case law purporting to establish a uniform test for establishing one’s undocumented membership in an LLC.
In a recent decision by a Brooklyn judge involving a petition for judicial dissolution of an LLC, however, the court borrowed from partnership law its multi-factor test for determining the existence of a partnership in concluding that the petitioner was not a member of the subject LLC and therefore lacked standing to seek dissolution.
The case is Matter of Shiel (CoolFrames, LLC), in which I represented the prevailing company and the respondent members.
The LLC in CoolFrames is an online retailer of designer eyewear formed in 2014 by the respondents — two brothers — who already had an established eyewear business. At the time, the respondents engaged in discussions with the petitioner about his financing the purchase of the CoolFrames domain name from a third party and managing the LLC’s online marketing in exchange for a percentage of profits. They also discussed including him as a member of the LLC and sent him an off-the-shelf form of operating agreement with the petitioner’s name filled in as a member.
The petitioner’s financing of the domain name purchase, his engagement to manage online marketing, and his commission for doing so in the form of a profit participation all went forward over the next four years.
However, the initial discussions concerning petitioner’s LLC membership never came to fruition. They never signed the operating agreement. The petitioner, a citizen and resident of Canada, never applied for a tax ID number which would have been required for purposes of issuing him a Form K-1 as a member of the LLC. The LLC’s initial and subsequent tax returns identified the two respondents as the sole members. In its second tax year, the LLC elected to be taxed as an S corporation which precluded foreign ownership.
In 2016, for purposes of a mortgage application, the petitioner wrote to the respondents asking for documentation for the lender identifying him as an “equal partner” in the LLC, stating, “This is needed ASAP for mortgage approval so [must] look super legit and top notch. If we have to could we quickly, temporarily, put me on the corporation [sic] for a week?”
In response, the company’s accountant drafted and sent the petitioner a letter identifying him as a “subcontractor,” adding “Sorry, we cannot say you are an equal partner because you are not. We can say you get 33% of profits in form of commission.” The petitioner did not object and, for the next year and a half, continued his involvement with the company’s online marketing and continued to receive his profit share.
That is, until early 2019 when the company terminated him after allegedly discovering that he had diverted hundreds of thousands of dollars of company funds to himself, to his girlfriend, and to promote his separate online businesses.
After the company demanded that he account for the allegedly diverted funds and threatened him with legal action, the petitioner preemptively filed a petition in the Commercial Division of the Brooklyn Supreme Court seeking judicial dissolution of the LLC and asserting claims for fiduciary breach and accounting.
The company and the individual members-respondents, in addition to counterclaiming for petitioner’s alleged diversions, contended that the petitioner was not a member of the LLC and, on that basis, moved to dismiss the petition on the ground that the petitioner lacked standing to seek dissolution and was owed no fiduciary duty.
The Court’s Decision
The court’s decision, by Brooklyn Supreme Court Justice Leon Ruchelsman, began its legal analysis with fundamental rule found in the statute itself, that “only a member may seek dissolution pursuant to Limited Liability Company Law § 702.”
But the court then quickly framed its analysis with principles and a nine-factor test drawn from partnership case law where the existence of a partnership is in dispute, writing,
when there is no written partnership agreement between the parties, the court must determine whether a partnership in fact existed from the conduct, intention, and relationship between the parties. There are nine factors the courts consider when deciding whether a partnership exists and they include (1) sharing of profits, (2) sharing of losses, (3) ownership of partnership assets, (4) joint management and control, (5) joint liability to creditors, (6) intention of the parties, (7) compensation, (8) contribution of capital, and (9) loans to the organization. [Citation omitted.]
Applying these principles and factors, the court noted that, while there were initial discussions among the parties and “an initial intent to include the petitioner as an owner, . . . considering the remaining factors, the petitioner has failed to demonstrate any ownership interest.” The remaining factors highlighted by the court included:
- The evidence showed that the purchase price for the domain name paid by the petitioner “was intended to be paid back to the petitioner who would be entitled to a third of all profits while working as an online marketing specialist.”
- The online marketing tasks performed by the petitioner “are not in any way connected to the overall control and management of the partnership. . . . Indeed, the petitioner cannot point to any other management decision where he provided any input, including the selection of the partnership’s accountant or any other operation of the partnership’s business.”
- The petitioner “did not share in the partnership’s profits or losses.”
- The company’s tax returns including K-1s “never included [petitioner] as a member of the partnership” as required by Internal Revenue Code § 6031(b). On the contrary, the company’s accountant averred that “all payments to [petitioner] were properly recorded in CoolFrames’ books and records, and properly reported in its tax returns, as ordinary business expenses and not as member distributions.”
- The petitioner never demanded a Form K-1, never filed a Form 8082 Notice of Inconsistent Treatment concerning a K-1, and never submitted to the IRS a Form W-8 required of foreign owners of domestic partnerships.
- The petitioner “never adequately explained why he requested of the respondents to be added as an owner to satisfy mortgage requirements if he was already an owner.”
Based on these and other factors addressed in the opinion, Justice Ruchelsman concluded that the petitioner failed to demonstrate that he was a member of the LLC and, “[c]onsequently, he does not maintain standing to initiate this dissolution proceeding. Therefore, the motion seeking to dismiss the petition in full is granted.”
The Takeaway. The petitioner in the CoolFrames case sought unsuccessfully to take advantage of the absence of any definitive, contemporaneous, written statement evidencing the parties’ intent not to admit the petitioner to membership in the LLC in the immediate aftermath of their initial discussions about doing so and sending him an unsigned operating agreement naming him as a member. In the end, the undisputed evidence that the petitioner did not exercise the attributes of member status, his omission from the K-1s, and his explicit admission of his non-member status in connection with his mortgage application, put the kibosh on his petition to dissolve the LLC.
The obvious lesson and advice for founders of closely held business entities is to document ownership interests by way of written agreement, certificated ownership interests, and consistent tax reporting.
Is such advice likely to fall on some deaf ears? Of course! Trust, optimism, and expediency often trump self-protection. Or, as one judge wisely observed ten years ago in Matter of Pappas, “In the real world, particularly that in which close corporations operate, clear evidence of share ownership is often not found in the corporate books and records, for any number of reasons.”