King, Krebs & Jurgens: “A legislative change to partnership tax audit procedures enacted under the Obama administration is set to go into effect as of January 1, 2018. All tax partnerships need to be prepared to make certain amendments to their governance agreements, preferably prior to December 31, 2017. All partnership agreements and operating agreements of LLCs taxed as partnerships will need amendment.”
Bradley Arant Boult Cummings LLP: “the new federal partnership income tax audit rules, which are scheduled to take effect on January 1, 2018, will have significant implications for the taxation of partnerships and their partners. . . . Every partnership agreement must be reviewed–soon . . . . There are a number of items related to the new partnership audit rules that need to be addressed in any new or amended partnership agreement. . . . When should these amendments be made? Now.”
The CPA Journal: “The Bipartisan Budget Act of 2015 (BBA) replaced the existing rules for auditing large partnerships with a new set of streamlined rules that take effect January 1, 2018. The new audit rules also apply to any entity that elects to be treated as a partnership for income tax purposes (i.e., LLC). . . . .These changes are designed to streamline the audit of partnership returns. In general, the audit will take place at, and any adjustment will be taken into account only at, the partnership level; any taxes will be paid by the partnership—not the partners. The new partnership audit rules are examined in detail below.”
Lou Vlahos: “Beginning 2018, the IRS is authorized to collect from a partnership any tax deficiencies arising out of the partnership’s operations for a taxable year, even if the persons who were partners in the year to which the deficiency relates are no longer partners in the year that the deficiency is assessed. Stated differently, the current-year partners will bear the economic burden of the tax liability even though the tax adjustments relate to a prior year in which the composition of the partnership may have been different. How did we get to this, and what should [LLCs taxed as] partnerships and their partners be doing about it?“
Davis Brown Law Firm: “This blog post is intended to identify the most material aspects of the proposed regulations the IRS has introduced to implement the BBA partnership audit rules, and provide guidance on what actions a partnership should consider taking at this time. The proposed regulations (REG-136118-15) consists of a 157-page preamble and 120 pages of regulations; this blog post seeks only to highlight the regulations, rather than provide a comprehensive summary. . . . Congress enacted the Bipartisan Budget Act (the “BBA”) in 2015, which completely revamped the way partnerships (including LLCs taxed as partnerships) will be audited, beginning January 1, 2018. Since the introduction of the BBA, tax professionals have discovered a vast number of problems with the new audit regime and the administrative strain it will place on partnerships.
JD Supra: “Even though such audits [under the new rules] may not occur until years after the January 1 date, partners and their partnerships, ought to begin immediately to consider amendment of partnership [and operating] agreements to reflect the new audit regime. . . . advisors and partners [and members] ought to look to the amendment of partnership [and operating] agreements now in order to, at the very least, name a partnership representative and set forth the parameters of the authority of such person between the partners. January 1, 2018 is not far off.
Entrepreneur: “The IRS will begin a new way of auditing [LLCs taxed as] partnerships starting in the 2018 tax year. Partnerships need to develop a roadmap before venturing into this new frontier. . . . With these new rules comes the potential for a host of new disputes among partners. . . . Like going to the dentist, an update to the . . . [operating] agreement may be a dreaded but necessary task to provide for this roadmap. In this article, I outline the basics of the new rules, their impact on partnerships and actionable steps businesses can take now to prepare. . . . A revised partnership or member agreement is the only way to contractually address and diffuse these potential issues before they arise.”
McDonald Hopkins, a national law firm with offices in Chicago, Cleveland, Columbus, Detroit, Miami and West Palm Beach, announced that it is offering its clients two new services. The services are:
- Partnership and LLC Amendment Program
- Partnership Representative Specialists
This law firm is offering to be the partnership representative for clients for a fee. Since becoming aware of the new partnership tax audit rules and the requirement that entities taxed as partnerships appoint a partnership representative in 2016, I believed that accounting firms and law firms with partnership tax lawyers would offer their services as a partnership representative. It makes sense.
Few members of an LLC have any knowledge of partnership tax law. Which would you rather have be your LLC’s partnership representative who will be the only party that interacts with the IRS and fights a proposed tax assessment – a CPA or tax lawyer with experience representing clients before the IRS with respect to partnership tax law or a member of your LLC who knows nothing about partnership tax law or audits? Seems like a no brainer.
McDonald Hopkins says “Every partnership and LLC should amend their governing documents to:
- Designate a partnership representative who will have the sole authority to make binding decisions in audit proceedings. The IRS will designate a partnership representative if one is not appointed.
- Authorize selections regarding complex set of elections under the new audit rules.”
I agree. I don’t offer partnership representative services, but I do provide a state of the art “Tax Audit Agreement” for LLCs taxed as partnerships in which the members address the issues raised by the new partnership tax audit rules effective January 1, 2018. If your LLC is taxed as a partnership it will be a big mistake in my opinion as a tax lawyer for the members to fail to enter into an agreement with the LLC’s partnership representative that sets the ground rules for the partnership representative’s duties representing the LLC in a partnership tax audit.
How to Purchase a Tax Audit Agreement for Your LLC
I’ve made it very easy for LLCs taxed as partnerships to hire me to prepare a state of the art Tax Audit Agreement. All you need to do is complete and submit my “Tax Audit Agreement Questionnaire.” The fee is $497 unless you want to purchase the optional DocuSign digital signature for all the members for an additional $100. Divide the $497 by the number of members in your LLC and you will see that the per member cost is worth the risk to the LLC in being audited by the IRS and not being prepared for the audit.
DLA Piper, LLP: “The IRS recently issued proposed regulations implementing the BBA Rules. Because these new rules are likely to cause an increase in the number of partnership audits, we urge tax partnerships, and their partners or members, to consider the effect of the BBA Rules and amend their partnership/operating agreements as necessary before the rules become effective. This alert provides a high-level summary of the changes effectuated by the BBA Rules and outlines some of the implications of these changes for entities taxed as partnerships.”
von Briesen: “Significant changes to the way entities taxed as partnerships are audited by the Internal Revenue Service, and to the way any resulting tax is collected, will become effective January 1, 2018. The new rules will affect most businesses operated as general partnerships, limited partnerships, limited liability partnerships and limited liability companies. Such entities will need to consider changes to partnership agreements, operating agreements, buy-sell agreements and other documents.
JD Supra: “On November 2, 2015, Congress passed the new centralized partnership audit regime as part of the Bipartisan Budget Act of 2015 (BBA) which is set to take effect for the tax years beginning on or after January 1, 2018. The intent and purpose of the new regime is to allow the Internal Revenue Service (IRS) to more effectively and efficiently audit partnerships by (1) allowing the IRS to collect from the partnership any partnership tax adjustment; and (2) requiring the appointment of a “partnership representative” to act as the point-person and binding decision maker with respect to any IRS audit procedures and related matters.”
National Law Review: “The new federal partnership income tax audit rules, scheduled to take effect on January 1, 2018, will have significant implications for the state and local taxation of partnerships and their partners. Most, but not all, states that impose a net income-based tax adopt by reference the federal definition of taxable income, but those that do typically adjust that income to reflect differences between state and federal tax policies. Moreover, state revenue departments generally do not regard themselves as being bound by Internal Revenue Service interpretations of the Internal Revenue Code even when substantive Code provisions are incorporated into state law by reference. The federal statutory rules relating to partnership audits are procedural rules and not ones of substantive tax law, so they will not be automatically adopted by states that generally conform to Internal Revenue Code provisions relating to taxable income.”
by Elizabeth C. Crouse: “New partnership audit rules will be effective for audits of tax years beginning in 2018. Proposed Treasury Regulations have been released and are expected to be finalized in the next few months. These rules significantly change partners’ information and payment expectations upon audit of a partnership and should be considered sooner rather than later. . . . Partnership agreements should be reviewed and revised now to account for, at minimum, the new partnership representative requirements (appointment of any required designated individual would generally be better handled through internal processes of the partnership representative).”
Blank Rome, LLC: “as a result of the new rules, careful consideration will have to be given in drafting the operative provisions of the governing documents, including but not limited to the expansion of the role and powers of the partnership representative, and the manner in which the various elections available to the entity will be dealt with . . . . the new rules present new challenges for [LLCs taxed as] partnerships. [LLCs taxed as] Partnerships should review their partnership agreements before the end of the year, and consider amending their agreements in anticipation of the new rules taking effect in 2018.”
Winston & Strawn LLP: “On June 13, 2017, the U.S. Treasury Department and Internal Revenue Service (“IRS”) re-released proposed regulations (the “Proposed Regulations”) governing the new centralized partnership audit regime that is scheduled to become effective for partnership taxable years beginning on or after January 1, 2018. . . . The Proposed Regulations provide, among other things, rules and procedures for (i) electing out of the centralized partnership audit regime, (ii) designating and replacing the partnership representative, (iii) determining amounts owed by the partnership or partners attributable to adjustments that arise out of a partnership audit, and (iv) “pushing out” partnership adjustments to the persons that were partners in the partnership in the taxable year under audit (the “review year”). . . . Partnerships . . . should be considering appropriate amendments to their partnership agreements to address a number of the issues discussed above, including
(i) the designation and removal of the partnership representative,
(ii) partners’ notice and participation rights in connection with audits,
(iii) appropriate indemnification protection for the partnership representative, and
(iv) how to ensure that imputed underpayments are economically borne by the appropriate partners (or former partners).
JD Supra: “many partnerships and limited liability companies (LLCs) have not yet delved into significant IRS audit rule changes that are certain to go into effect next year [January 1, 2018]. The changes, which will impact the 2018 tax year for partnerships and LLCs, will present owners with new decisions about how to handle IRS audits and any adjustments that may be required. . . . What Partnerships and LLCs need to do: Every partnership and LLC [taxed as a partnership] should consider revising their agreements to adapt to these new rules. For example, they must determine who will have decision-making authority over the elections that can be made, such as opting out of the new audit regime, or electing to push out adjustments to the partners. In addition, current partnership agreements do not provide for reserves for taxes, indemnifications, or holdbacks or clawbacks if there are any assessments. Failure to address these important issues may lead to disputes among partners, and could also impact buyers and sellers of partnership interests.”
JD Supra: “The updated IRS audit rules include new terminology, and will require such steps as new elections and changes to partnership agreements to account for a new audit landscape. The legislation driving the rule changes was passed two years ago. The new rules, embodied in proposed regulations re-issued last week, require changes in partnership agreements and LLC operating agreements. Starting with partnership returns for the 2018 tax year, partnerships will experience changes in how IRS audit adjustments are made to its partners’ returns.”
Bloomberg BNA: “There is good news for partnerships and their counsel who spent the last five months studying proposed centralized partnership audit regulations that the IRS issued on January 18 and withdrew on January 20: the proposed regulations reissued on June 14 (REG-136118-15) are essentially the same as those published in January. The proposed regulations implement the new centralized partnership audit regime enacted as part of the Bipartisan Budget Act of 2015 (BBA). The new regime and the proposed regulations generally apply to returns filed for partnership tax years beginning after December 31, 2017 . . . .
Preparing for the New Regime
Many partnerships (and limited liability companies taxed as partnerships) will find it necessary or desirable to amend the partnership (or operating) agreement in response to the new audit rules. For example, partnerships should carefully choose their representative and evaluate how the partnership agreement might be amended to provide guidance for the exercise of the representative’s broad statutory authority. Partnerships also should consider the ramifications of various partnership actions and elections, including the push out election, that affect both the partnership’s own financial condition and the tax attributes passed through to the partners. As well, the new rules provide that partners generally may not participate in or contest the results of an examination or other partnership proceeding without permission of the IRS. Therefore, the partnership should consider what safeguards might be appropriate to protect its own and its partners’ interests in the event of an audit.”
I have been saying for some time that LLCs that are taxed as partnerships must amend or adopt an Operating Agreement that contains well-drafted language that deals with the new partnership tax audit rules that become effective on January 1, 2017. Here are some pertinent quotations taken from an article written by Vidya Kauri of the firm Friedman, LLP:
“the need for robust and all-encompassing partnership agreements that can curtail representatives’ powers and hold them legally accountable.”
“Partnership agreements will have to be very specific about the decision-making powers of partnership representatives and the process for designating and terminating them”
“partnership representative might also require insurance coverage to defend against allegations of wrongdoing by disgruntled partners”
The bottom line is that LLCs taxed as partnerships MUST amend their Operating Agreements to include well-drafted provisions that deal designate an initial partnership representative and his or her replacement and that address other important issues that arise under the new tax audit rules. If your LLC is taxed as a partnership and it does not have an Operating Agreement, the members will be foolish if they don’t sign an Operating Agreement that appoints a partnership representative and deals with the new tax audit rules.
Hire the Keyts to Prepare or Amend an Operating Agreement
I have a masters degree in federal income tax law from New York University School of Law. I have also prepared 7,600+ LLC Operating Agreements. Since 2016 I have included partnership representative language in my multi-member LLC Operating Agreements.
We’ve made it very easy to hire us to amend an existing LLC Operating Agreement or prepare a new Operating Agreement with partnership tax audit provisions. The first step to hire us is to go to our Buy an Operating Agreement page.
If you have questions about adopting or amending an LLC Operating Agreement, call LLC attorney Richard Keyt at 480-664-7478 or send an email to Richard at firstname.lastname@example.org. You may also call Richard’s son LLC attorney and former CPA Richard C. Keyt at 480-664-7472 and email at email@example.com.
Thompson Coburn LLP wrote an excellent article on how life insurance can be a valuable asset for business owners and how it can be used to fund a purchase on death of a member of an LLC under a Buy Sell Agreement. The article starts with:
Life insurance is an effective tool that business owners can use to provide liquidity at their passing for both their businesses and their families. Having a properly drafted buy-sell agreement is key to avoiding conflict and memorializing how life insurance proceeds are to be used at the death of a business owner.
When life insurance is used to provide liquidity for the purchase of a deceased owner’s interest, such purchase can be structured as a redemption, a cross purchase by the surviving owners, or hybrid of the two. In addition, an insurance limited liability company can also be used to maximize creditor protection and other tax benefits.”
The article concludes by saying that a properly drafted buy-sell agreement “is critical in order to maximize the benefits of utilizing life insurance proceeds to purchase a deceased business owner’s interests.”
Question 1: My multi-member LLC is taxed as a partnership. Does it need to amend its Operating Agreement because of the new partnership tax rules that become effective on January 1, 2018?
Question 2: My multi-member LLC is taxed as a partnership. It does not have an Operating Agreement. Do the members of my LLC need to sign an Operating Agreement because of the new partnership tax rules that become effective on January 1, 2018?
Answer: Yes, yes and yes until I am blue in the face. All LLCs taxed as partnerships should amend their Operating Agreements or better yet adopt a stand alone Tax Audit Agreement drafted to deal with the new tax audit rules that take effect on January 1, 2018. The new partnership audit rules created by Section 1101 of the Bipartisan Budget Act of 2015, P.L. 114-74, and amended by the Protecting Americans From Tax Hikes Act of 2015, P.L. 114-113 affect all multi-member LLCs taxed as partnerships for federal income tax purposes.
I am an LLC attorney with a masters degree in federal income tax law from New York University School of Law who has prepared 7,600+ Operating Agreements. As a partnership tax law attorney I recommend:
- All LLCs taxed as partnerships amend their Operating Agreements to include language that deals with issues that may arise under the new partnership tax audit rules that take effect on January 1, 2018.
- All multi-member LLCs taxed as a partnership that do not have an Operating Agreement signed by the members should adopt an Operating Agreement that includes language that deals with issues that may arise under the new partnership tax audit rules that take effect on January 1, 2018.
The members of an LLC taxed as a partnership risk substantial economic harm if the IRS audits their LLC and they have not adopted an agreement that properly addresses the issues that arise under the new tax audit rules that apply to tax years after December 31, 2017.
If you don’t believe me then read “LLCs Taxed as Partnerships Must Adopt a Tax Audit Agreement” in which 34 attorneys and CPAs recommend that LLCs taxed as partnerships amend their Operating Agreements for the new tax audit rules.
For more on this important topic see my tax audit agreement blog posts.
Hire Me to Prepare a Tax Audit Agreement for Your LLC that Has Partnership Tax Audit Provisions & Names a Partnership Representative
I’ve made it very easy to hire me for to prepare an agreement that contains the language your LLC taxed as a partnership needs for the new tax audit rules effective January 1, 2018. Complete my online Tax Audit Agreement Questionnaire.
If you have questions about the new tax audit rules or my Tax Audit Agreement, call me, partnership tax attorney Richard Keyt at 480-664-7478 or send an email to Richard at firstname.lastname@example.org.
KEYTLaw continues to use cutting edge technology that benefits our clients. We are now creating Operating Agreements and other contracts that use a state of the art digital signing service called “DocuSign.”
Digitally signed documents are legally binding. The United States has enacted laws that provide electronic contracts the same legal validity and enforce-ability as traditional pen-and-paper contracts. DocuSign is the trusted and secure solution for obtaining electronic signatures that fulfill key requirements of the Electronic Signatures in Global and National Commerce (E-SIGN) Act and the National Conference of Commissioners on Uniform State Laws’ Uniform Electronic Transactions Act (UETA). The world’s largest companies rely on DocuSign, and users have executed millions of contracts using DocuSign.
There is a significant movement toward signing legal documents electronically. You can sign legally binding contracts online and even from your phone. DocuSign allows LLC members to sign their LLC’s Operating Agreements faster, cheaper, and more securely than the old-fashioned method of signing paper documents.
DocuSign makes signing the Operating Agreement of a multi-member LLC a piece of cake compared to the old fashion way of signing contracts.
The Old Fashioned Method of Signing Contracts
Hopefully the LLC has at least one member who takes on the thankless task of getting all the members to sign the Operating Agreement. I’ll call that member the “Responsible Member or RM.” Unfortunately some multi-member LLCs do not have a responsible member, which means the LLC’s Operating Agreement will never be signed.
- The RM must take the ball and be in charge of getting members to sign the the Operating Agreement.
- The RM gets all other members together to sign the Operating Agreement or circulates the Operating Agreement among the members for their signature.
- The RM collects the fully signed Operating Agreement from the other members. Hopefully this happens, but sometimes it does not.
- The RM makes copies of the signed Operating Agreement and distributes a signed copy to all of the other members. Hopefully this happens, but sometimes it does not.
- The RM saves the fully signed Operating Agreement in a safe place for future reference. Hopefully this happens, but sometimes it does not.
I hope your multi-member LLC has a responsible member who accomplishes all of the tasks listed above. Unfortunately too many multi-member LLCs don’t have a responsible member or the responsible member does not complete all of the necessary steps to get the Operating Agreement fully signed and distributed.
KEYTLaw’s New Technology Digital Signature Method of Signing Contracts
- KEYTLaw emails to each member a DocuSign configured pdf version of the Operating Agreement.
- Each member digitally signs the Operating Agreement and sends the digitally signed agreement back to DocuSign. DocuSign makes it quick and easy to sign (you can even use your phone to sign) and once signed the document is automatically returned to DocuSign.
- If a member does not sign the Operating Agreement DocuSign bugs the heck out of the member until the member signs the Operating Agreement.
- When all members have signed and returned the Operating Agreement to DocuSign it automatically sends the fully signed Operating Agreement to all of the members.
Another Reason to Hire Us to Prepare Your LLC’s Operating Agreement or to Form Your Arizona LLC
The fact we use DocuSign for Operating Agreements of multi-member LLCs is another reason why you should hire us to prepare a custom Operating Agreement for your LLC or to form your LLC. If we prepare your Operating Agreement you have the option to have all members sign the Operating Agreement digitally using DocuSign. Members of multi-member LLCs (other than members of an LLC owned only by a married couple) that purchase our Silver ($597) or Gold ($997) LLC Formation Packages will be sent email messages that ask them to digitally sign their LLC’s Operating Agreement.
Question: I am the sole member of my Arizona limited liability company. Should I sign an Operating Agreement for my LLC?
Answer: Although Arizona LLC does not require that the members of an Arizona LLC sign an Operating Agreement, as an Arizona LLC attorney I highly recommend that all members of an Arizona LLC, including single member LLCs, sign a “good” Operating Agreement. A good Operating Agreement is a document that is drafted specifically to comply with Arizona’s LLC law and that contains provisions and language needed by most LLCs and their members. The fact the members of an LLC sign an Operating Agreement could actually be detrimental to the members if the Operating Agreement is poorly written or not written specifically to comply with Arizona LLC law.
There are several reasons why the sole member of an LLC should sign an Operating Agreement:
- Some banks require an Operating Agreement signed by the sole member before opening a bank account in the LLC’s name.
- If the LLC will ever buy or sell real property the title insurance / escrow company will require an Operating Agreement signed by the sole member.
- If the LLC were to borrow money the lender will require an Operating Agreement signed by the sole member
- When courts are asked to pierce the company veil and hold the sole member liable for the debts of the LLC one of the factors that counts against the member is the lack of an Operating Agreement. If you don’t have a signed Operating Agreement it tells the judge and jury that you are treating your LLC like a hobby rather than a business. Businesses have signed Operating Agreements signed by their owners.
- To set the rules that govern the operation of the company if the sole owner were to die and his or her interest is inherited by one or more loved ones.
A good Operating Agreement is a complex document that should cover a lot of important ground. It should be drafted by an experienced LLC attorney licensed to practice in the LLC’s state of formation. As a business lawyer who has practiced law in Arizona since 1980 I’ve prepared 7,600+ Operating Agreements and spent hundreds of hours researching and revising my Operating Agreement.
How to Hire Arizona LLC Attorney Richard Keyt to Prepare an Operating Agreement
To hire Richard Keyt to prepare an Operating Agreement for your sole member Arizona or California LLC for $297 complete and submit his online Operating Agreement Questionnaire.
McDonald Hopkins: “Section 6223 of the new partnership and LLC audit rules (the “Audit Rules”), . . . provides that ‘the partnership representative . . . shall have the sole authority to act on behalf of the [LLC taxed as a] partnership.’ Some of the more troubling aspects of this section include:
- The partnership representative has complete authority to act on behalf of the partnership . . . when dealing with the IRS. . . . [N]othing can change the partnership representative’s authority as far as the IRS is concerned. Of course, a partnership or operating agreement can require that the partnership representative receive the consent of the partners before agreeing with the IRS on a matter . . . .
- This authority includes the ability to bind the partnership and the partners in audits and other proceedings, including settlement authority and decisions on procedural issues, such as whether to proceed to litigation.
- Significantly, there is no legal obligation under the IRS rules for the partnership representative to keep the other partners updated on the status of an audit or even to notify the partners of the audit.
- The partnership representative does not need to be a partner in the partnership, raising the issue of naming a partnership representative permanently in a partnership or operating agreement, only to have that partner leave the partnership.
- Finally, if the partnership does not appoint a partnership representative, the IRS has the authority to appoint one for the partnership.”
Does Your LLC’s Operating Agreement Say What Happens if a Member or the LLC Gets a Judgment Against a Member?
Homer Simpson and Ned Flanders owned 60% and 40%, respectively, of World Wide Widgets, LLC, an Arizona limited liability company. WWW manufactures and sells widgets. Without WWW’s knowledge or consent Ned began working for Arizona Widgets, LLC, a competitor of World Wide Widgets, LLC.
WWW sued Ned for breach of fiduciary duty and misappropriation of trade secrets by disclosing information to Arizona Widgets, LLC. The Arizona court awarded WWW a judgment for $100,000 and ordered that Ned transfer his entire membership interest in the LLC to the LLC.
WWW can use the collection process to collect the money from Ned’s non-WWW assets, but can WWW acquire Ned’s membership interest in the LLC if Ned does not voluntarily transfer his membership interest to the LLC? Arizona Revised Statutes Section 29-3503 states:
“On application by a judgment creditor of a member or transferee, a court may enter a charging order against the transferable interest of the judgment debtor for the unsatisfied amount of the judgment. A charging order requires the limited liability company to pay over to the person to which the charging order was issued any distribution that otherwise would be paid to the judgment debtor. . . . This Section provides the exclusive remedy by which a person seeking in the capacity of judgment creditor to enforce a judgment against a member or transferee may satisfy the judgment from the judgment debtor’s transferable interest..”
Section 29-3503 seems to prevent WWW from forcing Ned to transfer his membership interest to the LLC because the charging order is WWW’s sole remedy.
The WWW fact pattern is similar to the facts in a recent Texas LLC case called “Gillet v. ZUPT LLC,” Houston 14th Court of Appeals, Case No. 14-15-01033-CV, 2/23/17. In this case ZUPT, LLC, got a judgment that required its member Joel Gillet to transfer his entire membership interest to ZUPT, LLC. Like Arizona, Texas LLC law provides that the charging order is the sole remedy of a creditor who gets a judgment against a member of a Texas LLC.
The Texas Court of Appeals ruled that the charging order exclusive remedy statute did not prevent a court order that Gillet transfer his membership interest to the LLC. The Court stated:
“We hold that requiring turnover of a membership interest under these circumstances is proper for two reasons. First, the reasoning behind requiring a charging order as the exclusive remedy is inapposite when the judgment creditor seeking the membership interest is the entity from which the membership interest derives. Second, unlike a case in which a judgment creditor seeks to collect on its money judgment by forcing a sale of a membership interest, this case involves an explicit award of the membership interest itself from one party to the other as part of the judgment. For these reasons, we conclude that a charging order was not the exclusive remedy available to ZUPT, and the trial court did not abuse its discretion by ordering turnover of Gillet’s 45 percent interest in ZUPT.”
Unfortunately for Homer and World Wide Widgets, LLC, no Arizona appellate court has issued an opinion similar to the ZUPT, LLC, vs. Gillet opinion. WWW will be forced to litigate the issue and hope to get an order at the appellate level requiring transfer of the membership interest to WWW.
Warning for Multi-Member Arizona LLCs
The lesson to be learned from the ZUPT, LLC, vs Gillet case is that all multi-member LLCs should have provisions in their Operating Agreements that provide appropriate remedies if a member of the LLC or the LLC get a judgment against another member. The Operating Agreement should have language that creates remedies that allow the member or the LLC with the judgment to get around the exclusive remedy of Section 29-3503. The remedies include a requirement that money be distributed to the creditor from funds payable to the debtor member and a requirement that the debtor member forfeit the debtor member’s membership interest in the LLC.
In an article called “Yet Another Intra-Member Dispute in ZUPT” debt collection attorney Jay Adkisson wrote:
“The decision by the Texas Court of Appeals is, in my humble opinion, right on target, but it by no means reflects (yet) anything like a majority rule or a judicial re-writing of the cold, hard language of the charging order statutes.
Practitioners who are drafting LLC and partnership agreements need to recognize this issue, and confer with the members as to what they want the outcome to be. If one member becomes indebted to the other members or the LLC, do they want to be restricted by a charging order or not? It should be relatively easy to draft around this issue, but in my experience almost nobody does so.”
As a result of ZUPT, LLC, vs Gillet and Jay Adkisson’s advice I have amended my multi-member LLC Operating Agreement to provide special remedies if a member or the LLC get a judgment against another member.
Question: “Does a member of an Arizona limited liability company owe other members of the company any fiduciary duties?
Answer: A March 27, 2014, Arizona Court of Appeals opinion in the case of TM2008 Investments, Inc., vs. ProCon Capital Corp. says that the members of an Arizona limited liability company do not owe any fiduciary duties to the other members unless the members signed an Operating Agreement that creates and imposes contractual fiduciary duties on the members.
Since the TM2008 Investments case involves fiduciary duties we should first explain what the term means. The Cornell University Law School Legal Information Institute says the following about fiduciary duties:
“A fiduciary duty is a legal duty to act solely in another party’s interests. Parties owing this duty are called fiduciaries. The individuals to whom they owe a duty are called principals. Fiduciaries may not profit from their relationship with their principals unless they have the principals’ express informed consent. They also have a duty to avoid any conflicts of interest between themselves and their principals or between their principals and the fiduciaries’ other clients. A fiduciary duty is the strictest duty of care recognized by the US legal system.”
If a person owes a fiduciary duty to another person it also means it is much easier for the principal to sue the fiduciary for breach of a fiduciary duty and win a judgment because there is a higher standard of care associated with the fiduciary duty than would otherwise apply.
The TM2008 Investments, Inc., vs. ProCon Capital Corp. case arises from a dispute among the two members of Doveland Developments, LLC, a company formed to buy land and develop it into homes. Unfortunately the project was not successful. The lender threatened to foreclose and sell the land and go after the owners of the two members (Steve Tackett and Bonnie Vanzant) of Doveland Developments, LLC, because they had personally guaranteed the payment of the loan. The members of Doveland Developments, LLC, are TM2008 Investments, Inc., and ProCon Capital Corp.
When the lender notified the parties that the loan was in default Bonnie Vanzant paid the loan in full. She then sued Steve Tackett under an indemnification agreement they had signed to collect from Steve one half of the money Bonnie paid to the lender under her personal guaranty of the loan. TM2008 Investments filed a petition to dissolve and liquidate Doveland Developments due to the inability to conduct business in light of the members’ substantial disagreements. ProCon Capital filed counterclaims against TM2008 Investments for breach of the implied covenant of good faith and fair dealing (count 1) and breach of contract (count 3), and against TM2008 Investments and the Bonnie and James Vanzant personally for breach of fiduciary duty (count 2).
The lawsuits were consolidated. The trial court granted Bonnie Vanzant’s motion for summary judgment on the indemnification claim, but denied TM2008 Investments’ motion for summary judgment on the counterclaims. Just before trial, ProCon Capital voluntarily dismissed with prejudice counts 1 and 3. After jury trial on the claim for breach of fiduciary duty, the jury returned a verdict in favor of ProCon Capital and against TM2008 Investments and the Vanzants personally for $1,039,754. The losers appealed.
The primary issue before the Arizona Court of Appeals was whether or not Arizona’s limited liability company law provides that a member of an Arizona LLC owes a fiduciary duty to the other members of the LLC. ProCon Capital argued that because Arizona corporate and partnership law create fiduciary duties on shareholders and partners, respectively, Arizona law must therefor create fiduciary duties on members of an Arizona LLC. The appellate court disagreed. The court said:
“We decline in this case to mechanically apply fiduciary duty principles from the law of closely-held corporations or partnerships to a limited liability company created under Arizona law. The legislature did not explicitly outline any such duties for members of an LLC; instead, the LLC Act allows the members of an LLC to not only create an operating agreement, but also delineate in that agreement the duties members owe one another.”
Translation: The court said Arizona’s LLC statutes do not subject members of Arizona LLCs to any fiduciary duties and neither do any Arizona appellate court opinions.
However, the court said that an Operating Agreement can contain language that creates one or more fiduciary duties on members. The Operating Agreement of Doveland Developments, LLC, contained this clause that ProCon Capital aruged created a fiduciary duty on TM2008 Investments, Inc, and Bonnie and James Vanzant:
It is agreed any Member shall not be liable to the Company or any other Member for any damages or the like relating to any vote, decision, action, inaction or the like taken on behalf of the Company in accordance with these provisions and other provisions of this Agreement if such is done in good faith and with reasonable business judgment including the duty to make management decisions with the care of an ordinarily prudent person in a like position and similar circumstances and in a manner believed to be in the best interests of the Company.
The appellate court found that the above quoted language did not create a fiduciary duty on the members.
The court reversed the trial court and sent the case back to the trial court.
Lessons to Be Learned
The TM2008 Investments, Inc., vs. ProCon Capital Corp. case stands for the following:
- Arizona’s statutes that govern Arizona limited liability companies do not create fiduciary duties on members.
- Members of an Arizona LLC can create one or more fiduciary duties by inserting appropriate language in the LLC’s Operating Agreement.
The issue of whether the Operating Agreement of a multimember Arizona LLC should or should not contain fiduciary duty provisions is a topic for another article. Hint: A member in control of an Arizona LLC would not want any fiduciary duties in the Operating Agreement, but the minority member would want the opposite.
McDonald Hopkins: This article is an excellent summary of issues that arise under the new partnership tax audit rules. “partners (which for purposes of this alert include members in a limited liability company) need to start discussing the implementation of the new rules now and amend their partnership/operating agreements appropriately before” the rules become effective on January 1, 2018. The article states:
“Key Changes to Prepare For
- In most cases the IRS will be able to assess any additional tax resulting from an audit against the partnership itself – eliminating the need to proceed against individual partners. . . .
- Every partnership will have to appoint a partnership representative who will have exclusive authority to represent the partnership before the IRS and to make every decision relating to certain elections, audits, and settlements with the IRS.
The implementation of these seemingly simple concepts is complex – evident by the nearly 280 pages of regulations and explanation the IRS . . . that only begin to address the issues raised by the new audit rules. This white paper describes . . . the practical impact the rules will have on partnership/operating agreements, and how these agreements will need to be amended.”
The IRS recently issued proposed regulations (REG-136118-15) that will, if implemented, govern the new partnership audit rules created by Section 1101 of the Bipartisan Budget Act of 2015, P.L. 114-74, and amended by the Protecting Americans From Tax Hikes Act of 2015, P.L. 114-113. These new rules apply to partnerships and limited liability companies that are taxed as a partnership for federal income tax purposes beginning January 1, 2018.
The new partnership audit rules allow the IRS to assess and collect income tax at the partnership level rather than from individual partners. The new audit rules replace the partnership audit procedures created under the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA). The new audit rules apply to tax years beginning January 1, 2018.
The Bipartisan Budget Act of 2015 replaced the TEFRA tax matters partner with a partnership representative that must be a person or entity that has a “substantial presence” in the United States. If the partnership or LLC taxed as a partnership fails to designate a partnership representative the IRS may name the partnership representative. This is one of the reasons LLCs taxed as partnerships must amend their Operating Agreement or adopt an Operating Agreement, i.e., to name a partnership representative in the Operating Agreement to prevent the IRS from doing so. The LLC taxed as a partnership cannot change its designated partnership representative without the IRS’s consent.
The partnership representative can be an entity or a person. The partnership representative does not have to be a member of the LLC. After being appointed by the partnership or LLC, the partnership representative must then be designated on the partnership’s or LLC’s tax return.
Take care when appointing a partnership representative because the partnership representative has the sole authority to deal with the IRS on behalf of the partnership or LLC and all of its partners or members with respect to the following matters: (i) settling a tax audit, (ii) agreeing to a final partnership tax adjustment, (iii) making an Internal Revenue Code Section 6226 election to pay a partnership liability at the partner level, and (iv) agreeing to a Section 6235 extension of the period for making partnership adjustments.
The new audit rules take effect January 1, 2018. There are three important take a-ways to be learned from the new partnership audit rules:
- All existing partnerships and limited liability companies taxed as partnerships that have an Operating Agreement need to amend their Operating Agreements to add provisions dealing with the new partnership audit rules and to designate a partnership representative.
- All existing partnerships and limited liability companies taxed as partnerships that do not have an Operating Agreement need to adopt an Operating Agreement that contains provisions dealing with the new partnership audit rules and that designates a partnership representative.
- All new partnerships and limited liability companies taxed as partnerships should adopt an Operating Agreement with the new partnership audit provisions and should designate a partnership representative.
Hire Us to Amend or Prepare an Operating Agreement for Your LLC that Has Partnership Tax Audit Provisions & Names a Partnership Representative
We’ve made it very easy to hire us to amend an existing LLC Operating Agreement or prepare a new Operating Agreement. The first step to hire us is to go to our Buy an Operating Agreement page.
If you have questions about adopting or amending an LLC Operating Agreement, call LLC attorney Richard Keyt at 480-664-7478 or send an email to Richard at email@example.com. You may also call Richard’s son LLC attorney and former CPA Richard C. Keyt at 480-664-7472 and email at firstname.lastname@example.org.
For the umpteen time today a client told me about the client’s discussion with a person who does not understand the difference between the type of entity formed under the law of one of the fifty states vs. the method of income tax applied to the entity by the Internal Revenue Code of 1986, as amended. The ignoramus said, “My company insists that it enter into a contract with your company, but only if your company is an S corp.” My client’s company is an LLC, but the ignorant person thinks his company cannot enter into a contract with the LLC because the LLC is not an “S corporation.”
Too many people, including CPAs and lawyers, do not understand that when they say the entity must be an S corporation they are mixing two concepts: (i) the type of entity formed under state law, and (ii) the income tax method applicable to the entity under the Internal Revenue Code. Just today I downloaded the materials to a webinar I will watch later today. The lawyer who is teaching the webinar created reference materials that constantly use the phrase “limited liability companies vs. ‘S’ corporation.” The lawyer knows better, but falls into the trap of loose talk about S corporations.
Not one single state in the United States allows people to create an S corporation. The states allow people to create, sole proprietorships, general partnerships, limited partnerships, limited liability partnerships, limited liability limited partnerships, for profit corporations, nonprofit corporations, benefit corporations, and limited liability companies. The term “S corporation” refers to a method of federal income tax applicable to an entity under the Internal Revenue Code. After forming your entity under state law you must then decide the federal income tax method you want to apply to your entity. If Homer Simpson forms a for profit corporation in Arizona and an Arizona LLC, he can cause both entities to be taxed under Subchapter S of the Internal Revenue Code by timely filing an IRS form 2553. The federal income tax law applies exactly the same to the corporation and the LLC taxed as S corporations.
P.S. Timely filing the IRS Form 2553 means filing the form with the IRS within the first two and one half months of the entity’s existence or within the first two and one half months after the beginning of a calendar year.
For more on this topic see my article called “LLCs vs. Corporations: Which Type of Arizona Entity Should You Form?“
I formed my first Arizona LLC the day the Arizona LLC law became effective in October of 1992. Since then I have formed 7,600+ Arizona LLCs. In practicing LLC law since 1992 I have seen the same LLC operational problems over and over. When I learn about an operational problem I add new language to my LLC Operating Agreement to “fix” or prevent the problem.
For example, one of the most common LLC operational problems occurs when members cannot agree and need a company divorce. When members have major disagreements over running the LLC it is very common for a member without any authority or basis to file an amendment to the LLC’s Articles of Organization that removes one or more members as members of the LLC. The culprit may also open a new bank account and misrepresent to the bank who the members of the LLC are.
People who file false documents with the Arizona Corporation Commission are usually unaware that they could be committing a felony. Arizona Revised Statutes Section 29-613.A states:
“A person who . . . signs any articles . . . or other document filed with the [Arizona Corporation] commission that is known to the person as false in any material respect is guilty of a class 4 felony.”
Unfortunately the Arizona Attorney General does not prosecute people who file false documents with the Arizona Corporation Commission.
The purpose of Arizona Revised Statutes Section 29-858 is to reduce false filings with the Arizona Corporation Commission and give aggrieved members a remedy. This statute states:
“any person that authorizes or signs a report, certificate, notice or other document with respect to a limited liability company that is delivered for filing with the commission pursuant to this chapter and that has knowledge at the time of delivery to the commission for filing that the information contained in that report, certificate, notice or other document is materially false or misleading is liable to the limited liability company and its creditors and members for all damages resulting.”
The problems with this statute are: (i) proving damages for a false filing is very difficult, and (ii) the cost to sue coupled with the risk of winning and collecting a judgment makes this remedy very risky. Few members will actually use this statute to sue another member.
After seeing the false amendment to the Articles of Organization too many times I added a clause to my Operating Agreements that provides that a member who files a false document with the Arizona Corporation Commission is liable to all other members for liquidated damages of $10,000 and if the damages are not paid in full within sixty days the member who filed the false document ceases to be a member.
Why Your Existing or New Arizona LLC Needs Richard Keyt’s State of the Art Operating Agreement
I have prepared 7,600+ LLC Operating Agreements. My Operating Agreement is unlike any Operating Agreement prepared by anybody else including attorneys because it contains provisions I created to prevent or solve common LLC operational problems I have seen representing thousands of LLCs. For a partial list of common LLC operational problems see my article called “Common LLC Disasters a Good Operating Agreement Prevents.”
To hire me to prepare an Operating Agreement for an LLC that does not have one or to amend an Operating Agreement for an LLC whose members signed an Operating Agreement complete my comprehensive Operating Agreement Questionnaire.
P.S. To see Operating Agreement provisions in my Operating Agreements that you will not get any where else scroll to the bottom of my Operating Agreement Questionnaire.
Married Arizona residents can own property as: (i) separate property, (ii) community property or (iii) community property with right of survivorship, sometimes referred to as “CPWROS.” Arizona law provides that if a married Arizona resident acquires property from any source, the property is automatically the community property (not community property with right of survivorship) of the couple unless the property was a gift or inherited property.
When a married Arizona resident acquires property from a gift or by inheriting the property that person owns the property as his or her separate property. Separate property also includes property of a spouse acquired before the marriage. The non-owner spouse has no interest in or claim to his or her spouse’s separate property.
When property is owned as community property or community property with right of survivorship then each spouse owns an undivided one half of the property and if they divorce, each spouse is entitled to one half the value of the property.
Community Property Does Not Transfer to Heirs Automatically
The only difference between community property and community property with right of survivorship is what happens to the interest of the first spouse to die. When an Arizona married couple owns property as community property and one of them dies, the interest of the deceased spouse in the property does not transfer automatically to the other spouse. The interest of the deceased spouse in the property goes to the heir(s) named in the deceased spouse’s will or trust, but if there is no will or trust then the interest of the deceased spouse passes according to the law of intestate succession of the deceased spouse’s state of resident at the time of death. A probate may be required to complete the transfer to the property heir(s) unless the value of the interest of the deceased Arizona resident is less than $75,000 for personal property and $100,000 for real property.
Community Property with Right of Survivorship Transfers to Spouse Automatically
When an Arizona couple owns property as community property with right of survivorship then if one spouse dies, the interest of the deceased spouse transfers automatically to the surviving spouse without the need for a probate. If a married Arizona couple wants the community property interest of a deceased spouse to pass automatically to the surviving spouse on the death of the first spouse they must own the property as community property with right of survivoship.
How to Own an Interest in an Arizona LLC as Community Property with Right of Survivorship
Warning: If a married couple who are Arizona residents form an Arizona LLC or acquire a membership interest in an existing LLC they automatically own their interest in the LLC as community property, not community property with right of survivorship. If they want to own their interest in the LLC as community property with right of survivorship they must sign an Operating Agreement that expressly declares that the married couple holds their interest in the limited liability company as community property with right of survivorship. See Arizona Revised Statutes Section 29-3401.G.
When people hire me to form their Arizona LLC and tell me they want to own their interest in the LLC as community property with right of survivorship then we insert language in the LLC’s Operating Agreement hat expressly declares that the married couple holds their interest in the limited liability company as community property with right of survivorship.
Question: My husband and I acquired a 50% membership interest in an Arizona LLC as community property with right of survivorship. Homer & Marge Simpson own the other 50% of the LLC. My husband died and my husband’s interest in the LLC passed to me automatically per Arizona Revised Statutes Section 29-3401.G.
Homer Simpson says that he and Marge now have control of the LLC because the 25% interest I acquired from my husband is a mere assignment of his interest and is not a membership interest with voting rights. The Simpsons say that I own a 25% membership interest in the LLC and the 25 votes associated with that membership interest and an economic right to 25% of the profits of the LLC without any voting rights. Homer says that since my husband’s death members have 75 total votes instead of 100, the Simpsons have 50 votes and I have 25 votes How many votes do I have?
Answer: The interest in the LLC that you inherited from your husband is a membership interest with voting rights rather than an assignment of an economic interest without voting rights if the members of your LLC signed an Operating Agreement that provides that when a married couple own their interest in the LLC as community property with right of survivorship and one of them dies, the interest of the deceased inherited by the survivor is a membership interest. Section 29-3401.G. If the members of your LLC did not sign such an Operating Agreement then what you inherited from your husband was a 25% economic interest in the LLC without any voting rights.
Lesson to Be Learned: If your Arizona LLC has members who own their membership interests as community property with right of survivorship, joint tenancy with right of survivorship or tenants in common and the members want the heirs who inherit an interest to inherit membership interests with voting rights vs. economic interests without voting rights then the members of the LLC must sign an Operating Agreement that provides that inherited interests are membership interests with voting rights.
Note: My standard Operating Agreement contains this automatic membership interest with respect to inherited interests clause.
How to Hire Richard Keyt to Fix Your LLC’s Operating Agreement
To hire Arizona LLC attorney Richard Keyt to amend your existing Operating Agreement or prepare a new Operating Agreement complete our online Operating Agreement Preparation Questionnaire.
Question: Can a single member limited liability company be taxed as a partnership for federal income tax purposes?
Answer: No. The following text from the IRS’ website answers the question:
“Over the years, there has been confusion regarding Single Member Limited Liability Companies in general and specifically, how they can report and pay employment taxes.
An LLC is an entity created by state statute. The IRS uses tax entity classification, which allows the LLC to be taxed as a corporation, partnership, or sole proprietor, depending on elections made by the LLC and the number of members. An LLC is always classified under federal law as one of these types of taxable entities.
A multi-member LLC can be either a partnership or a corporation, including an S corporation. To be treated as a corporation, an LLC has to file Form Form 8832, Entity Classification Election (PDF), and elect to be taxed as a corporation. A multi-member LLC that does not so elect will be classified under federal law as a partnership.
A single member LLC (SMLLC) can be either a corporation or a single member “disregarded entity.” Again, to be treated under federal law as a corporation, the SMLLC has to file Form 8832 and elect to be classified as a corporation. An SMLLC that does not elect to be a corporation will be classified by the existing federal guidance as a “disregarded entity” which is taxed as a sole proprietor for income tax purposes.”
IRS Form 8832 is the form used by an entity to elect a method of federal income taxation that is different from the IRS’ default method (sole proprietorship or disregarded entity for single members LLCs and partnership for multi-member LLCs). This form is also known as the “check the box” form because an entity can elect a tax method by checking the box on the form. IRS Form 8832, question 3 reads:
“Does the eligible entity have more than one owner?
Yes. You can elect to be classified as a partnership or an association taxable as a corporation.
No. You can elect to be classified as an association taxable as a corporation or to be disregarded as a separate entity.”
Attorney Tanya Simpson’s article in the Florida State University Law Review entitled “How Restrictions on Dissolution have Crippled the LLC” is a detailed discussion of issues that face all multi-member LLCs. The article is an in depth look at LLC dissolutions, aka LLC divorces. She makes several points about multi-member LLCs that are worth reiterating:
- Many multi-member LLCs do not have an Operating Agreement.
- Many multi-member LLCs that have Operating Agreements do not have a good well drafted Operating Agreement.
- Multi-member LLCs need a state of the art comprehensive Operating Agreement.
As an LLC attorney who has drafted 7,600+ Operating Agreements and has seen the nightmares that arise when multi-member LLCs need a company divorce, I recommend that all multi-member LLCs have an Operating Agreement written by an experienced Operating Agreement attorney.
Tanya Simpson says,
With the chaotic state of judicial dissolution provisions and the commensurate uncertainty as to how they will be interpreted, both from state to state and within the same state, a carefully drafted LLC operating agreement appears at present to be an LLC member’s best protection.
The very factors that make the LLC most attractive to small business entrepreneurs – simplicity of organization and flexibility of contract – likely also create an environment that is ripe for problematic operating agreements. Because many small businesses are composed of family members and close friends, agreements may not always be negotiated at arm’s length. In addition, because of the few required formalities, many LLCs may have unsophisticated or boilerplate operating agreements, or may not have any operating agreement at all. Thus the very nature of the LLC may preclude it from protecting itself against the events of a bad break-up.
The freedom and flexibility to contractually organize the LLC grants members an opportunity to fashion a kind of prenuptial agreement to plan for the challenges of a potential business divorce. That same freedom and flexibility, however, may lull members into drafting incomplete or unsophisticated operating agreements that, consequentially, will be of little use – or worse – in the event of dissolution litigation. In the absence of an adequate operating agreement or in the likely event that even sophisticated drafters will not have considered every eventuality, courts will look to the default judicial dissolution provisions in the states’ LLC statutes to fill in the gaps.
The article concludes with this statement:
“A final warning: Anyone that is either (1) contemplating a new . . . business that will be classified as a partnership for federal tax purposes (including an LLC or joint venture) or (2) needing to amend an existing agreement should strongly consider incorporating these changes into the new or revised agreement immediately“
The New York case of Duff v.Curto, 2012 NY Slip Op 30264(U) (Sup Ct Suffolk County Jan. 25, 2012), by Suffolk County New York Justice Emily Pines involved a claim by one LLC member that the other member failed to contribute money to the company. Duff claimed he contributed $523,000 to the capital of Fairlea Court Holding, LLC, of which Gary Duff and Peter Curto, Jr., were the only two members. Duff claimed that Curto breached the Operating Agreement because he did not contribute any money to the company and that Curto was unjustly enriched.
They signed an Operating Agreement that said:
“[u]pon the execution of this Agreement, each Member shall contribute cash and/or property to the Company as set forth opposite their names in Exhibit A”
Exhibit A stated that each member had a 50% interest in the company, but it did not show that either member was to contribute any capital to the company. The Court said:
“The Court finds that the documentary evidence provided raises an issue of the parties intent in placing the 50% figure in the Agreement and does not definitively dispose of the plaintiff’s claim”
The Court found that Duff reported on his tax returns that he loaned $309,000 to the LLC and that Curto never agreed to contribute any money to the company.
Lesson for Members of LLCs
Arizona LLC law provides that no member of an Arizona limited liability company is liable to contribute money or property or services to the LLC unless the member agrees to do so in writing. Arizona Revised Statutes Section 29-702.A states:
“A promise by a member to make a capital contribution to the limited liability company is not enforceable unless set out in writing and signed by the member.”
California LLC law provides that a contribution is “in accordance with an agreement” with the initial members when forming the LLC, the company after forming the LLC or existing members after forming the LLC. See California RULLCA Section 17701.02(c).
If you have an Arizona or a California LLC and want to create a legal obligation on the part of one or more members then the LLC must obtain a written document signed by the member(s) that states the amount of money or the description of the property or the nature and extent of the services and when the money or property or services must be contributed. The best way to obligate members of an LLC to contribute money or property to the LLC is in an Operating Agreement signed by all of the members.
The Journal of Passthrough Entities (CCH): “This column has three focal points: S corporations (of course!), the new partnership audit procedures”
The author of this article makes three predictions. His prediction number 2 deals with partnership agreements and operating agreements of LLCs taxed as partnerships. He predicts:
Some partnership agreements will be revised and some new ones drafted to require S corporation partners to provide annually to the partnership an accurate list of the names and TINs of the S corporation’s shareholders (i.e., the persons to whom the S corporation is required to issue Schedules K-1 for the year).
Corollary: Some partnership agreements will provide that S corporation partners must indemnify the partnership and its other partners against either: (i) partnership-level income taxes the partnership is required to pay but could have avoided had the S corporation provided the information necessary for the partnership to elect out of the entity-level audit provisions on a timely basis, or (ii) the costs to the partnership of making an election under new Code Sec. 6226.”
Paul Hastings LLP, Thomas S. Wisialowski, Erika Mayshar and Noah Metz: “Hedge funds, private equity firms, real estate companies, and other businesses structured as partnerships or limited liability companies are paying close attention to recent changes in IRS audit procedures. . . . This means that under the rules described above, if a partnership filed a tax return and paid its taxes in year 1 (the year 1 tax return), partner X sold its interest in the partnership to new partner Y in year 2, and the partnership was audited in year 3 in respect of its year 1 tax return, then partner Y would bear its share of any additional tax liability assessed on the partnership in year 3 in respect of the year 1 tax return, despite that partner X, and not partner Y, was a partner in the partnership in year 1.”
The article states one of the most important reason that operating agreement of all LLCs taxed as partnerships must be amended to deal with the new audit rules:
“Partnership and LLC agreements should generally be revised to provide for who will act as the ‘partnership representative’ because in the absence of an appointed person, the IRS has the discretion to pick a ‘partnership representative.’
New Jersey business litigator Jay McDaniel wrote an article about the five biggest mistakes people make when they form an LLC. The mistakes are the same mistakes I caution people against constantly when I form LLCs and advise the owners of existing LLCs.
Jay McDaniel is a business litigator whose opinions are based on years of experience representing business owners in disputes that arise from the ownership of businesses. Jay wrote:
“Having litigated many of these matters over the years, I see the same mistakes made early in the life of the business surfacing again and again as the source of litigation.”
McDaniel’s point is that the failure to plan when companies are created can be a very expensive blunder when a dispute among owners arises. Even though I am not a litigator (I never personally represent anybody in litigation), my experience as an LLC attorney who has formed 7,600+ LLCs is the same as McDaniel’s.
The list omits the mistake of not having an Operating Agreement. The following is what McDaniel says about the lack of an Operating Agreement:
“If a business does not have one, sooner or later, it will have problems and without any point of reference whatsoever, the probability of litigation is high. When that happens and the business is successful, the chances are that you will spend the price of a college education – at a nice private school – on the lawsuit.
Bottom Line: All multi-member LLCs must have a well-drafted Operating Agreement. Note I said “well-drafted” because a poorly worded Operating Agreement drafted by somebody who lacks LLC experience can be a bigger problem than no Operating Agreement.
Here’s Jay McDaniel’s list of the five biggest LLC formation mistakes (read the article to get the reasoning behind each mistake:
- No operational planning
- No contingency planning
- No valuation planning
- No succession planning
- No planning for amendments to the Operating Agreement.
Taft Stettinius & Hollister LLP, Todd C. Lady and Lourdes E. Perrino: “On Nov. 2, 2015, President Obama signed into law the Bipartisan Budget Act of 2015 (the “Act”). The Act dramatically changes the way the IRS will conduct partnership audits going forward and, in turn, likely will have far reaching implications on how partnerships, including funds, conduct operations in the future. . . . Although these rules have not yet taken effect, they should be taken into account when drafting new operating agreements or engaging in acquisitive transactions involving partnerships. Operating agreements should include procedures that address the option to elect to pass any adjustment on to the reviewed-year partners. Additionally, partners should clearly define their respective rights to notice and participation during an audit and carefully select the partnership representative that will have the authority to bind the partnership.”
Cozen O’Connor, Richard J. Silpe”If you are a partner of a partnership or a member of a limited liability company (LLC) taxed as a partnership, or are entering into a new partnership or LLC, you may have some important decisions to make in light of impending changes to the rules governing federal tax audits. . . . These new rules will lead to new provisions in partnership and LLC agreements and amendments of existing agreements to, among other things, designate a method for selecting a partnership representative and its rights and obligations of the partners, address whether certain tax elections will be made, and provide for indemnification and other contractual provisions (e.g., in the case of a withdrawing partner).
Kilpatrick Townsend & Stockton LLP, James E. Brown, Heather L. Preston, Lynn E. Fowler and Charles E. Hodges II “Congress has recently scrapped the existing procedures for IRS audits of partnerships. The new rules (the “BBA Audit Rules”1) are effective for partnership taxable years beginning on or after January 1, 2018. A partnership that fails to address key concepts of the BBA Audit Rules could make a partner indirectly liable for federal income tax of the partners assessed for a year prior to becoming a partner. Almost all partnership (and LLC operating) agreements will need to be amended at a minimum to clarify which partners will be liable with respect to audit adjustments asserted by the IRS.”
Holland & Knight LLP, William B. Sherman and Daniel L. Janovitz: “The Bipartisan Budget Act of 2015 (P.L. 114-74) includes a complete overhaul of the procedures that apply to Internal Revenue Service (IRS) audits of partnerships, including limited liability companies (LLCs) taxed as partnerships and their partners. . . . . Issues that Partnerships Need to Address . . . . 1. Existing partnership and LLC operating agreements should be reviewed, and amendments will need to be drafted to address aspects of the new rules, including:
- designating the partnership representative in place of the TMP
- determining the partner(s) that will control the decision to opt out of the new regime
- preventing assignments of partner interests to persons that would preclude the ability to opt-out
- addressing the payment of entity-level tax
- committing to making certain elections in the event of an audit adjustment
- addressing circumstances where partners agree to “adjusted information returns” in lieu of entity-level tax
2. Negotiations will be necessary to determine the appropriate partnership representative and the contractual limitations on the authority of such representative.
Dykema Gossett PLLC, Jeffrey A. Goldman, Steven E. Grob, Anthony Ilardi, Jr., William C. Lentine and Robert W. Nelson: “On November 2, President Obama signed the Bipartisan Budget Act of 2015 (the “Act”), which significantly changes the procedures for tax audits of partnerships. . . . The sweeping changes in the realm of partnership tax audits will likely require revisions to most partnership agreements and new considerations when entering or leaving a partnership.”
See the end of the article for a list of changes to make to operating agreements and partnership agreements.
Venable LLP, Brian J. O’Connor, Norman Lencz, Michael A. Bloom and Christopher S. Davidson: “On November 2, 2015, President Obama signed into law the Bipartisan Budget Act of 2015 (the Act). The Act significantly changes how partnerships (including LLCs taxed as partnerships) are audited by the IRS. . . . As a result of changes made to the Internal Revenue Code by the Act, partnerships may now be directly liable for any tax deficiency resulting from an adjustment to partnership items (e.g., income, gain, loss deduction and/or credit). Thus, the current partners in a partnership could bear economic responsibility for improper tax reporting in prior years, even if one or more of such partners was not a partner in the year in which the improper reporting occurred.”
This article includes the following statement:
“existing partnership agreements should be reviewed to account for these new audit procedures”
I agree. I recommend without exception that all existing LLCs taxed as partnerships amend their Operating Agreements to cover the issues created by the Bipartisan Budget Act of 2015. LLCs that are taxed as partnerships that do not have an Operating Agreement should adopt an Operating Agreement that contains language that deals with the issues created by the BBA.
Akerman LLP, Donald K. Duffy: “Effective for partnership tax years beginning after 2017, the Bipartisan Budget Act of 2015 repealed the current partnership audit rules and replaced them with rules described in general terms below. Partnerships can also elect to apply the new rules sooner to partnership tax years beginning after the date of the Act’s enactment. In brief, the major change is that the partnership itself can be liable for federal income tax in the tax year the audit adjustments become final. The partners in that year bear the economic burden of the tax and not the partners in the earlier tax year under audit and with respect to which the adjustments are made. Since partnerships can elect to apply these new rules earlier than 2018, some extra diligence is needed now in the acquisition of partnership and LLC interests.”
This article lists eight partnership tax issues that should be addressed in partnership agreements and operating agreements of LLCs taxed as partnerships. Bottom line: If your existing or new LLC is or will be taxed as a partnership it must have an operating agreement that includes language that addresses the issues created by the Bipartisan Budget Act of 2015.
Drinker Biddle & Reath LLP, Stephen D.D. Hamilton, David Shechtman and Jonathan D. Grossberg: “Although the new rules under the Budget Act will first apply to returns filed during 2019 ( i.e., for a partnership’s 2018 taxable year), partnerships and their advisors need to plan now for these eventual changes. Anyone entering into a new partnership agreement or acquiring an interest in an existing partnership should focus on what tax audit rights, and what tax representations and covenants, to seek. Partners of “small partnerships” should consider whether to bind themselves to the election-out procedures and whether to adopt transfer restrictions that will insure that the election-out remains available. Existing partnerships should begin consideration of the procedures for designating the PR and whether to utilize the alternative regime for allocation of assessed tax liability back to the partners in the Audit Year.”
Kaye Scholer LLP, David A. Sausen, Willys H. Schneider and Zeno Houston: “The Bipartisan Budget Act of 2015 (the Budget Act), which was signed into law on November 2, 2015, has dramatically reformed how the U.S. Internal Revenue Service (IRS) will assess and collect taxes from partnerships, including limited liability companies (LLCs) treated as partnerships for tax purposes. . . . Accordingly, absent the exercise of an election as described below, the New Audit Rules can result in the imposition of an entity-level tax on the partnership as a result of audit adjustments. This heralds a significant change from the existing partnership audit procedures”
The authors state:
“All partnerships will need to consider appropriate revisions to existing partnership agreements—preferably, long in advance of the Effective Date
Ropes & Gray LLP: “On Monday, November 2, President Obama signed the Bipartisan Budget Act of 2015 (the “BBA”) into law, effecting sweeping changes to the rules governing audits of entities treated as partnerships for U.S. federal income tax purposes. The new rules can be expected to increase partnership audit rates by making audits and related tax assessments more efficient for the IRS, including by imposing an entity-level tax on the partnership on audit adjustments, absent an election (described below) to shift tax liability to partners. The new rules constitute a stark change from existing law“
The authors said the partners of a partnership and the members of an LLC taxed as a partnership should take the following action:
“Revision of partnership agreement provisions addressing the sharing among the partners of any partnership-level tax and related items.”
The authors described six other issues that partnerships and LLCs taxed as partnerships must consider.
Shearman & Sterling LLP, David S. Raab, Julie M. Marion and Thomas H. Halpern: “Existing partnerships should review operating agreements before new rules take effect. The Bipartisan Budget Act of 2015 (the Act), which President Obama signed on November 2, upends the way the Internal Revenue Service (IRS) conducts partnership audits, with potentially far-reaching effects. . . . Small partnerships will have to decide whether they want to elect out of the new regime, thereby weakening the ability to control consistent partner reporting. Partnerships that do not elect out or that are ineligible to elect out will need to ensure their operating agreements address the new procedural requirements, such as addressing whether the partnership is required to elect to pass-through audit adjustments to the partners or who will have the authority to make that decision.