Former LLC Member: Why Does My K-1 Show All This Income?
An LLC member, Mr. Smith, sells his member interest and terminates all connections with the LLC. The sale agreement ends Smith’s rights in the LLC. Smith moves on and doesn’t think much more about the LLC. Many months later, Smith receives a Schedule K-1 from the LLC. >
Schedule K-1 is the form an LLC uses to inform each member of the member’s share of income, losses, deductions, credits and so on. Like almost all LLCs, Smith’s former LLC is taxed as a partnership for federal income tax purposes, and the LLC’s income and losses for each tax year are allocated to its members. The members then each pay taxes on their share of the LLC’s income for that year, or use the losses to shelter other income. (The ability to use losses to shelter other income is subject to various limitations. See my prior post on passive income loss limitations, here.)
Smith is shocked to see that the K-1 shows a whopping allocation of income to him for the last year of his membership in the LLC. He realizes that that income will have to be reported on his own personal tax return and will substantially increase his tax bill, and he didn’t receive any cash distribution from the LLC to cover those extra taxes. Based on what he knows about the LLC’s operations and finances towards the end of his involvement with it, he doesn’t understand how or why so much income was allocated to him. What does he do?
Naturally Smith starts asking questions. He requests copies of the LLC’s financial records so his CPA can evaluate the correctness of the LLC’s allocations. The LLC, however, points out that Smith is no longer a member, so its operating agreement gives him no right to see the records. The LLC also notes that the state LLC Act only allows members, not former members, to access LLC records. In short, he is politely told to go roll his hoop.
The plaintiffs in Abdalla v. Qadorh-Zidan, 913 N.E.2d 280 (Ind. Ct. App. Sept. 10, 2009), were faced with this situation. The Qadorh-Zidans (Zidans) and the Abdallas had formed five LLCs to own and operate apartment properties. Later the Abdallas filed a lawsuit against the Zidans alleging breach of fiduciary duty and usurpation of corporate opportunities. That suit was resolved through a settlement that included a buyout – the Zidans sold their membership interests in the LLCs to the Abdallas in August 2006.
In the fall of 2007 the Zidans received tax returns and K-1 Schedules from the LLCs for the tax year ending on the date of the buyout. The Zidans alleged discrepancies in the K-1s and requested accounting information and records from the LLCs for the time period when they were members. The Abdallas refused, so the Zidans filed a complaint alleging breach of fiduciary duty and seeking declaratory relief to inspect the books and records of the LLCs for the period when they were members. The Zidans sought discovery of the requested information, which was stayed pending a summary judgment motion by the Abdallas. The trial court’s denial of the Abdallas’ motion was appealed.
The Abdallas contended that any fiduciary duties owed to the Zidans terminated when they ceased being members of the LLCs, because the Zidans no longer had any rights under the operating agreements and because their settlement agreement in the first lawsuit included a relinquishment of all of the Zidans’ rights as members. The Zidans maintained that fiduciary duties should remain intact with respect to the resolution of pre-separation business, and that therefore the fiduciary relationship covered the preparation of the tax return which was completed after the Zidans sold out.
The court held that the Abdallas owed a fiduciary duty to the Zidans regarding the preparation of tax returns for the period during which the Zidans were members of the LLCs. Abdalla, 913 N.E.2d at 286. As the court said, “To hold otherwise would give the Abdallas the freedom to allocate tax burdens to the Zidans and retain tax benefits for themselves without allowing the Zidans any recourse to verify or rectify this allocation.” Id.
The court reached a similar result on the question of whether the Zidans had a right of access to the LLCs’ books. Although the Indiana LLC Act only gives members the right to access an LLC’s records, Ind. Code § 23-18-4-8(b), the court held that the Zidans, as former members, had a right to access the records covering the time period while they were still members of the LLCs. Abdalla, 913 N.E.2d at 287.
Many state LLC Acts, like Indiana’s, do not address what inspection rights former LLC members have. For example, the LLC Acts of Washington, Oregon and Delaware are silent on inspection rights for former members. There’s no reason why state statutes can’t address this issue, though. The Illinois LLC Act, for example, provides that former members have a right of access for a proper purpose to LLC records pertaining to the period when they were members. 805 Ill. Comp. Stat. 180/10-15. The Revised Uniform Limited Liability Company Act and the Uniform Limited Partnership Act also have comparable provisions giving former members limited access rights.
When the Zidans resolved their first dispute with the Abdallas through a buyout of the Zidans’ interests in the LLCs, they apparently did not consider the inevitable entanglement resulting from the tax flow-through treatment of the LLCs. In an LLC buyout there will usually be a time lag from the buyout to the computation and allocation of the LLC’s profits and losses, and the distribution of the Schedule K-1s.
There’s a moral here. A member selling its interest in an LLC should consider adding provisions to the buyout agreement for later access to the LLC’s accounting records and for consultation with the LLC’s manager or CPA over the tax allocations and the preparation of tax returns, for the period when the seller was a member. The seller should also consider provisions for notice, access to records and consultation regarding any later amendment to the LLC’s previously filed tax returns, or any IRS contact with the LLC or tax audit for the period before the buyout. These provisions can help the former member avoid unpleasant tax-related surprises, and can give the former member the tools necessary to investigate unexpected tax allocations.
Courts Continue to Find an Accounting Remedy
A recent decision of the New York Appellate Division, Gottlieb v. Northriver Trading Co. LLC (Jan. 27, 2009), garnered some controversy when it recognized that members of an LLC may seek an equitable accounting under common law. The New York LLC Law does not explicitly authorize an accounting remedy, and the court’s decision has been characterized by Professor Larry Ribstein as an example of the unpredictability of New York’s LLC law and as a contribution to the “impenetrable murk” of New York’s LLC Law.
The Gottlieb opinion relied on the reasoning of New York’s highest court in Tzolis v. Wolff. The court in Tzolis had to decide whether members of an LLC may bring a derivative suit on the LLC’s behalf, even though there were no provisions authorizing or governing derivative suites in New York’s LLC Law. The Tzolis court reasoned by analogy to both corporations and limited partnerships. The New York courts had in the past found an equitable right to a derivative suit for shareholders of a corporation and for limited partners in a limited partnership. In neither of those prior cases, at the times of their holdings, was there a statutory authorization of derivative suits for shareholders or limited partners.
Two recent cases from other states have dealt with this issue, both handed down just a month after publication of the New York court’s opinion in Gottlieb. One state had statutory language explicitly authorizing an accounting, one did not. Both upheld the availability of an accounting.
In February the Indiana Court of Appeals concluded in Perkins v. Brown that the trial court erred when it failed to order an accounting of an LLC’s finances in connection with the dissolution of the two-member LLC. Without discussing or analyzing whether Indiana’s LLC Act authorizes an accounting, the court simply concluded that an accounting was necessary to determine the LLC’s creditors and expenses and whether any improper distributions had been made. Indiana’s LLC Act does not expressly authorize an accounting, but it does provide that “[a] court may enforce an operating agreement by injunction or by granting other relief that the court in its discretion determines to be fair and appropriate in the circumstances.” Section 23-18-4-7(a). That section was also not discussed by the court.
In another February decision, the South Carolina Supreme Court recognized that its courts have “broad judicial discretion in fashioning remedies in actions by a member of an LLC against the LLC and/or other members,” including the remedy of an accounting. Historic Charleston Holdings, LLC v. Mallon. The court proceeded to reverse the trial court’s order for an accounting, but only because “a full financial accounting would unnecessarily prolong this otherwise simple matter.” The court’s conclusion about the authority for an accounting was based on South Carolina’s LLC Act. South Carolina has enacted the ULLCA, and Section 33-44-410(a)of South Carolina’s Act states that “[a] member or manager may maintain an action against a limited liability company or another member or manager for legal or equitable relief, with or without an accounting as to the company’s business . . . .”
In contrast to the explicit ULLCA language, the Revised Uniform Limited Liability Company Act (RULLCA), currently recommended by the National Conference of Commissioners on Uniform State Laws, states that “[u]nless displaced by particular provisions of this Act, the principles of law and equity supplement this Act.” Section 107. Many courts would likely see that as an implicit statutory approval of the accounting remedy for LLCs. RULLCA has been adopted by Idaho and Iowa.
The right to seek an accounting has long been recognized by U.S. courts as an equitable remedy with origins in England’s Chancery Courts. 1 Dan B. Dobbs, Law of Remedies 609-14 (2d ed. 1993). An accounting is generally available when there is a claim of breach of fiduciary duty or other wrongdoing, and is often used in partnership dissolution cases.
Washington, the state where I practice, danced around the issue of an LLC accounting in 2007, but concluded that it need not reach that issue on the facts of the case. Noble v. A&R Envtl. Services, LLC, 140 Wn. App. 29, 164 P.3d 519 (2007). One party appealed the trial Court’s refusal to order an accounting. The Court of Appeals decided that the trial court had not made sufficient findings of fact, remanded the case for adequate findings, and concluded that it need not reach the accounting argument.
The three opinions handed down this year (in New York, Indiana and South Carolina) all recognized that on request of a member of an LLC, an accounting may be ordered in appropriate situations. In none of the three was an accounting to be automatically granted – the analysis is fact-specific and will likely depend on whether there was fraud, breach of fiduciary duty or other wrongdoing, and whether the facts are complex enough to warrant the accounting process. The courts find the authority either in their LLC statute (explicitly or implicitly), by analogy to partnership and corporate law, or under general principles of equity.
These three opinions seem to reflect an unspoken reluctance to rule out the accounting remedy unless the applicable LLC Act expressly bars it, and I’m not aware of any LLC Act that does so. It seems likely that in the absence of such a statutory prohibition, most courts, when first presented with the issue and on request of a member of an LLC, will order an accounting in appropriate situations.
