Confusion Over LLC Units
LLC operating agreements often use the term “units” to describe member rights in the LLC. It is convenient to have a word like “units” to label the members’ rights, and “units” is widely used. But “units” has no uniform definition or generally accepted meaning when applied to LLCs.
Andrew Immerman recently authored an article that examines the inherent ambiguity and the confusion that often results from using units to describe LLC member rights. L. Andrew Immerman, Is There Any Such Thing as an LLC Unit?, 11 No. 4 Bus. Entities 20 (July/Aug. 2009), 2009 WL 2563091. The article is a good review of how and why the units terminology is used and misunderstood. It provides examples of the mistaken conclusions that business people can reach when they ignore the differences between shares of stock in a corporation and the rights of a member in an LLC.
Immerman ascribes this confusion to three principal causes. First, business people and sometimes lawyers often think of an LLC as essentially similar to a corporation. Second, the state laws that authorize LLCs do not expressly authorize the issuance of LLC units or define an LLC unit. Third, LLC members are taxed differently than shareholders. LLC taxation can cause units in the same LLC to unexpectedly provide different benefits to their owners, unlike shares of stock, which are usually interchangeable.
There is no concept of “units” in the various state LLC statutes. For example, Washington’s LLC Act makes no reference to units, and simply defines a member’s LLC interest as personal property comprising the member’s share of the profits and losses of an LLC, and the right to receive distributions of the LLC’s assets. Wash. Rev. Code §§ 25.15.005(6), 25.15.245(1).
Delaware’s LLC Act likewise makes no reference to units, and has an almost identical definition of a member’s LLC interest. Del. Code Ann. tit. 6, §§ 18-101(8), 18-701. And neither NCCUSL’s Revised Uniform Limited Liability Act nor the Revised Prototype Limited Liability Company Act from the American Bar Association uses that terminology.
LLCs are distinct from corporations in a number of ways. One major difference is that an LLC is much more a creature of contract than is a corporation. LLC member rights are normally defined by the members’ operating agreement, and only secondarily by the LLC Act. Members are parties to the operating agreement, whereas corporate shareholders hold shares of stock but need not be parties to any contract. Most of a shareholder’s rights will generally be defined by the applicable corporate statute, while an LLC member’s rights will be defined by the terms of the operating agreement. A potential investor in an LLC cannot know what rights the holder of a unit will have without a careful examination of the operating agreement.
Another difference between LLCs and corporations is that the rights associated with ownership of a share of stock are not normally divided. If a share of stock is sold, the rights to receive dividends, to vote, and to receive corporate information will usually all go with the share of stock. Transfer of a member’s interest in an LLC, on the other hand, will convey the right to receive profits, losses and distributions, but it will not necessarily carry with it the right to vote and participate in management of the LLC. All the members must approve the transferee’s admission as a member and participation in management, or the operating agreement may provide for the transferee’s admission as a member. E.g., Wash. Rev. Code §§ 25.15.250, 25.15.260; Del. Code Ann. tit. 6, §§ 18-702, 18-703.
LLCs are taxed as partnerships (absent an election to be taxed as a corporation), so items of profit and loss are allocated directly to the members. The LLC is not a taxpayer. Corporations, in contrast, are taxpaying entities and do not pass profits or losses through to shareholders. (One exception: a corporation can make a Subchapter S election, in which case its shareholders will each be allocated their proportionate share of the corporation’s profits and losses. An S corporation, however, can have only one class of stock and cannot have nonresident aliens or certain types of entities as shareholders.)
LLC members generally want the LLC’s allocations to be respected for tax purposes. This is a matter of predictability and being able to accurately assess and plan for the economic benefits and tax consequences of their LLC investment. For the LLC’s allocations of profit and loss to be respected for federal income tax purposes, the allocations in the operating agreement must comply with a set of complicated Treasury regulations intended to ensure that the allocations have “substantial economic effect.” I.R.C. § 704(b)(2). One of those requirements is that a capital account be maintained for each member. A member’s capital account is increased by the member’s contributions to the LLC’s capital, by profits allocated to the member, and by LLC liabilities assumed by the member, and decreased by distributions paid and losses allocated to the member, and by liabilities of the member assumed by the LLC.
The regulations also require, when the LLC is dissolved and its assets liquidated, that liquidating distributions be made to the members in accordance with the positive balances in their capital accounts. This is a key requirement of the allocation regulations, and has the effect of truing up the final, liquidating distributions with the effects of the LLC’s history. All the prior member capital contributions, distributions to members, and allocations of profits and losses would have impacted each member’s capital account in ways that may have varied from member to member.
Assuming the LLC’s operating agreement complies with these rules, the result is that on liquidation one member may receive substantially more or less per unit than another member receives per unit. A corollary is that at any point in the life of the LLC, one member’s unit may be worth more or less than a different member’s unit. One might try to define “unit” in the operating agreement to take capital account variations into effect, but then the definition would likely not work well for attributes such as voting and establishing percentages for profit and loss allocations.
In corporations it’s different and much simpler. At any given time the corporation’s capital per share is the same amount for all outstanding shares of common stock. If a corporation is dissolved and liquidated, the liquidating distributions per share of common stock will be the same amount for all the shares. “Holders of corporate stock need not worry about capital accounts, and the superficial resemblance of LLC units to corporate stock may create the impression that LLC members can safely ignore the concept as well. It can be perilous, however, to ignore LLC capital accounts.” Immerman, supra, at 62.
In all states LLCs now lead corporations in formations of new business entities. For many business people LLCs are relatively new and sometimes perplexing. Their lawyer or the other parties may present them with operating agreements that describe their interests as “units.” They may be familiar with corporations, but should not be misled by the surface similarities and assume that those units are comparable to shares of stock. The operating agreement should be read and analyzed carefully. The ways in which units are handled in the agreement needs to be thoroughly understood. Because many of the results of a member’s investment will depend on the tax treatment of allocations and capital accounts, an experienced tax advisor should usually be consulted.
