The Problem With S-Corp LLCs

The Problem With S-Corp LLCs

While I do not disagree with Warren Kean that an S-Corp LLC may at times be a viable format based upon particular facts, I continue to view this structure as more often than not a “solution in search of a problem.”  See generally Rutledge,  S Corp LLCs – Planning Opportunity or Solution in Search of a Problem?, 15 J. Passthrough Entities 37 (July/Aug. 2012).

While is a highly-lawyered transaction the form may have a place, I see them in hugely unsophisticated deals and written by people who really do not understand what they are doing.

By way of example, I was recently sent for review an operating agreement which provides in part:

Section 4.4.  Counterpart of Code to Apply in Event of Subchapter S Election by Company

All references in this Operating Agreement to any provision found in Section 700 of the Code, including but not limited to references to same in Sections 4.2 and 4.3, supra and 5.7, infra, of this Operating Agreement shall be deemed references to the applicable Code provisions dealing with subchapter S corporations for such period of time as the Company is operated as a subchapter S corporation rather than as a partnership. 

My note as to this provision reads:

This section 4.4 should be deleted in its entirety. If this company is going to be governed by subchapter S rather than subchapter K, this agreement needs to be entirely rewritten. There is no general equivalency between subchapter S and subchapter K which could be carried over. Further, if this company were to elect to be an S corporation, there are provisions outside of 4.2, 4.3 and 5.7 which would in effect violate the S corporation rules, resulting in the LLC being classified, for tax purposes, as a C corporation.

Further, one of the original members to the LLC  is a corporation, and an S-corp with a corporation as one of several members will not be able to make an S-corp election.

That does not even get to “any provision found in Section 700 of the Code” – there is no such section.

Whose Attorney?

Whose Attorney?

      A lawyer for a business organization needs to be careful in identifying both who they serve and to make express who they do not serve.  Confusion as to these points has important implications in a variety of contexts including the related (albeit not co-extensive) realms of the attorney-client privilege and an attorneys obligation of confidentiality and who has standing to assert a malpractice claim against the attorney.

      These issues can be especially fraught in the area of small businesses, and the outcome of the analysis can turn on questions of organizational form.  Historically, the attorney for a corporation and the consequent obligations are owed to the corporation, that “person that exist in the mind of the law,” itself and not to any of the constituents thereof such as directors, officers, employees and shareholders.  While it is possible for an attorney to enter into an attorney-client relationship with both the corporation and a constituent thereof, proper disclosure and preferably written documentation of the existence and parameters of the parallel relationships is important.

      In contrast, while there has been law to the contrary, an attorney for a partnership has traditionally been deemed to be the attorney for every partner. 

      Between those two poles, what then is the treatment of the LLC; should the corporate model apply, should the partnership model apply, or should there be developed a model unique to this organizational form.  To date, most of the courts that have considered the question have applied the corporate model and deemed counsel for the LLC to not in consequence thereof be as well counsel for any of the constituent members or managers.  That apparent agreement has been brought into question by a recent decision from California. 

      Sprengel v. Zbylut, 194 Cal.Rptr.3d 407 (Ca. Ct. App. 2 Dist. Oct. 13, 2015; modified Oct. 29, 2015), arose out of the falling out between Jean Sprengel and Lanette Mohr, the two members in Purposeful Press, LLC.  Sprengel field an action for dissolution of the LLC, and Mohr hired counsel, including Zbylut, to represent the company; in retaining counsel she acted as a manager of the LLC.  After that suit was resolved Sprengel brought a malpractice action against Zbylut and the other attorneys:

“violated the duty of loyalty they owed to her under the Rules of Professional conduct by pursuing Mohr’s interests in the underlying dissolution and copyright actions.  Sprengel alleged she had an implied attorney-client relationship with each defendant based on her status as a 50 percent owner of Purposeful Press.”

            The attorneys sought dismissal of the suite based upon the California anti-SLAPP suit statute, it basing asserted that the representation of the LLC was “constitutionally protected petitioning activity.” and other law including the direct/derivative distinction.  Springel asserted as well that:

“several factors support[ed] a finding that there was an [implied] attorney client-relationship between [them],” including” (1) the limited “size of [Purposeful Press][, which] suggest[ed] an individual representation of the [company’s] members”; (2) the defendants’ legal services were paid with funds that belonged to Sprengel; (3) the subject matter of the representation involved Sprengel’s copyrights and her intellectually property rights; and (4) the district court’s order in the copyright action had specifically found that Purposeful Press had no interests independent of its two members.  Sprengel also argued that the litigation privilege did not provide a defense to her claims because the privilege was inapplicable where “a client has asserted claims against an attorney for breaches of duties…and conflict of interest.”

            The anti-SLAPP defense was rejected, and this appeal followed.

            Ultimately, the denial of dismissal on the basis of the anti-SLAPP statute was upheld, so maybe (hopefully) all else is dicta, but it is disturbing that the court did not ab initio reject:

·                     the assertion that an implied attorney-client relationship exists between counsel to an LLC and its members, especially a member who is seeking the dissolution of that LLC (i.e., its legal death); or

·                     the suggestion that counsel engaged in malpractice “by accepting Sprengel’s funds to pay for their legal services without her consent.”

      As to the first point, if counsel to an LLC are as well counsel to each member, including a member who has already brought an action against the LLC, then no LLC can ever successfully hire counsel to defend itself.  Rather, counsel who considers the matter will never agree to accept the engagement without the plaintiff’s consent, and the plaintiff is never going to consent. The same outcome will result if the LLC is the plaintiff against a member.

      As to the second point, the funds the LLC used to pay its legal counsel was never Sprengel’s money.  Rather, it was the LLC’s money.  A member of an LLC has no ownership interest in the LLC’s property. Only if a distribution had been declar4ed and then those funds had been diverted to pay legal bills would “Sprengel’s money” have been used to pay for legal services.  But until a distribution was declared, it was the LLC’s money.

 

Maybe I Am a Nerd After All

      Rumors that I am a nerd have been challenged (SEE HERE), but at the same time on a recent flight I was writing an addition to a book chapter on fiduciary duties, and I was pretty excited to stumble upon an opportunity to cite Frank Herbert’s Dune and his God Emperor of Dune. 

      On second thought, as I have already cited both Star Wars and The Hitchhikers Guide to the Galaxy in other law review articles, maybe the nerd label has already been well earned.

The 2015 LLC Institute

The 2015 LLC Institute
Apparently I am a wonk, and not a nerd

      Last week the 2015 LLC Institute was held in Arlington Virginia.  Notwithstanding a few hiccups, the Institute was a success, that being attributable to great work of the program chairs.

      After the Institute, Professor Joan Heminway wrote an interesting post on it for the Business Law Professor Blog.  Based thereon, I'm glad to know that in fact I am not a “nerd,” but rather am a “wonk.”

     HERE IS A LINK to Professor Heminway’s post.

The Sad Passing of "Big" Lew Kaster

It is with beyond a heavy heart that I report to you the passing of our colleague, friend and mentor “Big” Lew Kaster.

Of late Lew was dealing with a number of health challenges, and we have missed his presence.  Still, last Thursday evening, at the Lubaroff Award Dinner, a glass was raised to him with the hope that he would soon rally and return to our merry band.  We did not then know that earlier that day had been his time to “shuffle off this mortal coil.” 

Lew was the 2010 recipient of the Martin I. Lubaroff Award.  Here is what was written in connection with that event:

The 2010 Martin I. Lubaroff Award to be Presented to Lewis R. Kaster

 

This year's recipient of the Martin I. Lubaroff Award is Lewis R. Kaster, of counsel in the New York office of Bryan Cave LLP.  Lew has been an active member of our committee for many years. Lew’s practice includes real estate joint venture negotiation; legal issues concerning partnerships; LLCs and other non-corporate business entities; and tax advice to pension plans and other exempt organizations investing in real estate. Lew is a member of the adjunct faculty of Columbia Law School, lecturing on partnerships, limited liability companies and other non-corporate entities—Lew has been lecturing on unincorporated entity issues since the early 1950’s. Lew has been a frequent writer on real estate issues for publications such as The Journal of Taxation, the Practicing Law Institute’s Issues and Answers, the ABA Real Property and Probate Trust Journal and the Real Estate Review, and was the editor of the Real Estate Department of The Journal of Taxation. He has served on the Board of Governors of the American College of Real Estate Lawyers and has been actively involved over the years in The Association of the Bar of the City of New York, the New York State Bar Association, the National Association of Real Estate Investment Managers, and numerous civic and charitable activities.

Vincent Alfieri - In the late 1960’s, Lew Kaster joined what was then the firm of Robinson Silverman Pearce Aronsohn Sand & Berman as a young tax lawyer.  (In 2002, Robinson Silverman merged with Bryan Cave, where Lew continues to practice as Of Counsel.)  As a result of the firm’s significant real estate practice, Lew developed particular expertise in real estate tax law and structuring real estate transactions.  In structuring real estate transactions, the choice of appropriate entities was important, so Lew also became extremely knowledgeable with respect to the law regarding the formation, use, operation and tax consequences of general and limited partnerships and limited liability companies.  He became the “go to” attorney in the firm with respect to matters relating to these unincorporated entities.  He was also an enthusiastic mentor to younger attorneys.  He broadened his knowledge and reputation by reading cases, maintaining a dialogue with other attorneys serving on bar association committees, lecturing and writing.  He was well recognized for his intelligence, knowledge, creativity and practicality in resolving issues.  He became a valued resource not only for our firm but for lawyers and clients throughout the country.  We are proud of his achievements and his long association with the firm, and we congratulate him on the well-deserved recognition of being the 2010 recipient of the Martin I. Lubaroff Award from the ABA’s Committee on LLCs, Partnerships, and Unincorporated Entities.

Bill Callison - I was particularly pleased several years ago to notice that Lew edited an article I wrote for the same publication in early 1987.  Lew did this quite a few years before we knew one another and he became my friend.  It was pretty much a career starter for me in the affordable housing area (I was then into my 5th year as a lawyer).  I remain eternally grateful for life's favors, such as this one by Lew Kaster.  Bill Callison

Tom Rutledge – I must confess to not being able to identify the exact meeting at which I met Lew Kaster, but it is my impression that as long as I have been attending Committee meetings, he has been there.  Over the years, we have both spoken a panel together and co-authored a short piece that appeared in Corporate Counsel Weekly.  Of far greater importance, Lew has often been both a professional advisor helping me think through troubling problems and more importantly simply a great friend whose wealth of experience at life (in the broadest sense) has benefited me, probably more than he knows.  Lew Kaster is a master of partnership law, of the tax code, of the law of governing real estate and of the bankruptcy code; any of us should aspire to master any one of those subjects.  More importantly, Lew is a master of life, and we should certainly aspire to follow in his footsteps.

Lauris Rall - I have had the pleasure of knowing Lew for over a decade.  Although our paths did not cross frequently in the Big Apple, the center of the legal universe, I was well aware of his scholarship in the alternative entities field, particularly partnership taxation.  As the lawyer to many high net worth individuals and family firms, using a pass through entity for sophisticated tax planning was an art form under Lew's tutelage.  I am well aware that his reputation in our legal community has been that of an intellectual, but yet practically minded counselor, whose negotiating acumen is, how shall we say, persistence. 

For most of my career I have enjoyed being a "backroom" lawyer, as it never seemed useful to me to be out front with the paparazzi any more than absolutely necessary.  However, Lew asked me to help his partner as an expert witness in a New York partnership law case in federal court.  It was an opportunity to see a side of the practice that I had not seen before, and I am forever grateful for that experience.   

It has only been in recent years that I have had the pleasure to get to know Lew on a more personal level, and that has been rewarding many times over.  Lew has stories from every stage of his life and career, and I have been fortunate during dinners and other times to have heard at least a few of them.  Listening to these stories has instructed me well on one facet of Lew's character - he is a keen observer of the human experience.  Lew has learned from his life and Lew has and continues to teach us much about that broad subject AND about the law of alternative entities.  He is a classic and I am glad to call him my friend. 

Congratulations Lew on this wonderful honor, well deserved.

Elizabeth Miller - On my bookshelf in my office are two out-of-print treatises, and these two old treatises are among my most prized possessions.  They are Crane and Bromberg on Partnership (1968) and Rowely on Partnership (2d ed. 1960).  Taped to the outside of each treatise when they unexpectedly arrived in my mail about five years ago were handwritten notes from Lew Kaster which I have tucked into each book and which evoke warm feelings in me each time I open the books and remember his kindness in passing along these treasures.   It seems that Lew was “cleaning out” as he prepared to phase out of his practice and thought I might make use of these reference works.  They have indeed been precious gifts in more than one sense.  I certainly did not foresee when I first encountered the learned Professor Kaster that I would one day receive such a touching gift from his library and that I would view him as such a gentle man as well as a gentleman.  The truth is I was quite intimidated by him after witnessing his passionate, booming argument on some bankruptcy issue that was under discussion at one of my first PUBO Committee meetings.  Sometime later I was tremendously flattered and a bit nervous when he contacted me and asked permission to use some of my materials for his class at Columbia.  Naturally, those feelings of intimidation and nervousness long ago gave way to great affection – what other outcome could possibly have resulted given Lew’s charm, wit, and kindness?  Admiration, of course, is a feeling that has transcended my entire acquaintance with Lew.  What a tireless student of the law of partnerships and unincorporated entities he is.  Since he sent me those books five years ago, I cannot tell that he has slowed down much.  I still regularly receive emails from him regarding a recent case or other development of interest.  I don’t think he knows how to stop contributing to this area of the law, and he certainly is a most deserving recipient of the Lubaroff Award.

Scott Ludwig - With respect to Lew, I can tell you that I first met Lew approximately 17 years ago--about the time I joined this committee.  Lew was then as he is now an imposing figure in the law.  Lew’s knowledge of real estate, tax, unincorporated entities and bankruptcy fascinated me and I knew immediately that Lew was one of those lawyers that you need to listen to carefully so that you absorb as much knowledge as possible while you were in his presence. 

     Shortly after joining the committee, I was asked to make a presentation and at the time I began preparing summaries on cases, rulings and other matters pertaining to the state taxation of LLCs and cases on professional unincorporated entities.  This combined effort was a daunting task for me and so when I made my first presentation and I saw Lew Kaster rise from his chair and move to the microphone I nearly swallowed my tongue.  I immediately jumped to the conclusion that I was about to receive the hardest question, one which was calculated to have no answer and one which was calculated to remind this poor dirt farmer that he was just that.  Instead of what I had imagined, Lew threw me a softball and then with a wink sat down.  In that single moment my impression of Lew Kaster changed from hardnosed stern New York lawyer, adjunct professor Columbia University and other scary monsters of the night to that of a gentle man who was attempting to help his peer.  After that experience, I began to know a different Lew Kaster than what I had imagined Lew to be.  I began to know the real Lew that everyone else knew and that I had, for whatever reason, placed on a pedestal and held at a distance out of fear. 

 

     What Lew taught me was that no matter how good you are or how preeminent you may be in your field, the practice of law is a profession in which we should extend courtesy and kindness to our fellow professionals and in which we should extend a hand to help guide those who may be less experienced or less knowledgeable then ourselves.

 

     I can think of no better legacy to leave in the practice of law than teaching fellow lawyers who aspire to be preeminent in their field to remain approachable and open to new lawyers in that field and to be willing to teach and educate those less experienced lawyers in order that the law and the legal profession is advanced.

 

In 2014 Dan Cullen of Bryan Cave presented at the LLC Institute.  While he was doing his final preparation in the lobby I interrupted to ask if he worked with Lew.  Dan put his materials aside and shared of his many experiences of working with Lew, including as to his expectations of precision in written product, whether it be a contract or an article, and his both ability and willingness to provide guidance to younger attorneys.

            Earlier today Scott Ludwig wrote

This is indeed sad news.  Lew was a wonderful person, lawyer and mentor – but more importantly, he was a devoted friend with an unbelievably big heart

 

The subject line of an email received earlier today from Bill Callison was simply “Tears.”

The obituary appears in today’s New York Times, and there is a guest book to which you can post any thoughts you may want to share.   http://www.legacy.com/obituaries/nytimes/obituary.aspx?n=LEWIS-KASTER&pid=176508763

 

            These words are far too little by way of acknowledgement of who was Lew Kaster to our shared area of interest and what his friendship meant to so many of us. I will close with the words that Ira Meislik wrote to me earlier today:

 

May his memory be for a blessing.

Conflicting Views as to the Unfinished Business Doctrine

Conflicting Views as to the Unfinished Business Doctrine

I, along with Tara McGuire, an associate here at Stoll Keenon Ogden, have recently published in the Texas Journal of Business Law an article titled Conflicting Views as to the Unfinished Business Doctrine.  In this article we consider a pair of recent decisions from New York and Colorado that come to opposite conclusions as to the application of the Unfinished Business Doctrine.  We address as well the validity of the Doctrine as a means of protecting partnership creditors, including retired partners, and explain why the Doctrine does not raise ethical issues as to the capacity of clients to select the attorney(s) of their choice.

The article can be accessed AT THIS LINK.

 

Crowdfunding

Crowdfunding

      On October 30 (the eve of Halloween), the SEC approved the long awaited Crowdfunding rules.

 

      Several of my law partners and I who practice in the area of securities regulation have prepared a short review of the Crowdfunding rules.  HERE IS A LINK to that document.

 

       Hopefully you will find this review of interest.

Hoist on the Petard of a General Purpose Clause

Hoist on the Petard of a General Purpose Clause

 

In a recent decision out of New Jersey, an LLC, itself taxed as a disregarded entity and wholly-owned by a 501(c)(3) corporation, was denied a property tax exemption with respect to improved real property it leased to another charitable organization because the LLC’s articles of organization provided that it could engage in any lawful activity permitted an LLC. 1785 Swarthmore, LLC v. Township of Lakewood, No. A-4701-13C 4 (N. J. App. Div. Oct. 28, 2015).

Oorah, Inc., a New Jersey non-profit corporation, was classified by the IRS as a “public charity” under section 501(c)(3). After acquiring a piece of improved real property, Oorah formed 1785 Swarthmore, LLC and re-deeded the property to it. As such, Swarthmore was wholly-owned by a 501(c)(3) corporation; Swarthmore was, for federal income tax purposes, classified as a disregarded entity. Swarthmore’s operating agreement provided that its purpose was “for conducting any legal business enterprise.” Thereafter, Oorah leased a portion of the property to Lakewood Chedar School. Regardless, after the lease was entered into, Oorah, in its capacity as the sole member of Swarthmore, applied for a property tax exemption with respect to at least that portion of the property being leased to the school. That application would be denied by the municipal tax assessor, reasoning that Swarthmore, being the “organization claiming the exemption,” was “not recognized by the State of New Jersey as a nonprofit organization.”  That denial would be upheld by both the Tax Court and the Court of Appeals.

Under New Jersey law, a property tax exemption is available for property that is:

(1) “actually owned and exclusively used for [a] tax-exempt purpose”;

 

(2) the “operation and use of the property is not conducted for profit”; and

 

(3) where the property “owner” is “organized exclusively for tax-exempt purpose”.

 

N.J.S.A. § 54:4-3.6.

Even while the court recognized that, under the Internal Revenue Code, Swarthmore’s activities as a disregarded entity are treated as those of its parent, under New Jersey law, federal income tax standards do not govern state law as to property tax exemptions. In this case, it was necessary that the landowner be organized for the nonprofit purpose, and:

 

Swarthmore did not specifically limit its stated purposes to any extent in its Certificate of Formation. In that certificate, as we have already noted, Swarthmore’s stated purpose was very broad: “to engage in any activity within the purposes for which Limited Liability Companies may be formed pursuant to the New Jersey Limited Liability Company Act.” (emphasis in original). Hence, Swarthmore could have been formed and operated for any number of non-exempt purposes and thus has not satisfied the organizational purpose requirement under the statute.

 

Slip op. at 21.

 

The careful crafting of the purpose clause for any business entity is important. For example, the purpose clause can impact upon the scope of the fiduciary duties binding the members/managers of an LLC. This case is another illustration of the need to carefully consider that provision and, often, if not always, forgo the use of the simple “any lawful purpose” formula.

 

Thanks to Stuart Pachman for the lead on this decision.

 

“Equitable” Forced Buyout

“Equitable” Forced Buyout

      Peter Mahler, at New York Business Divorce, has reviewed the second decision by the New Jersey Court of Appeals in All Saints University of Medicine Aruba v. Chilana, No. A-2425-13T1 (N.J. Super. Ct. App. Oct. 27, 2015).  In this decision, notwithstanding the absence of a mandatory buyout upon dissociation provision in the then controlling New Jersey LLC Act, the Court of Appeals directed the lower court to consider ordering a buyout as a “common-law equitable remedy.”

       HERE IS A LINK to Peter’s review of this decision