Member Avoids Personal Liability for LLC's Withheld Taxes
An LLC member ordinarily is not liable for the debts and liabilities of an LLC simply by virtue of being a member. E.g., Wash. Rev. Code § 25.15.125; Or. Rev. Stat. § 63.165. Many states, however, impose personal liability for unpaid taxes on those within a business who have authority for paying taxes withheld from employee wages, or for paying sales taxes collected from customers. If one of those statutes applies, being a member of the LLC will not shield the employee, manager or officer from the statute’s reach.
Kelly Haugen, a 10% member of an Oregon LLC, was assessed liability by the Oregon Department of Revenue for the LLC’s failure to pay Oregon income taxes withheld from employee wages. Haugen v. Dep’t of Revenue, No. TC-MD 100052C, 2011 Ore. Tax LEXIS 187 (Or. T.C. Apr. 26, 2011). The LLC was manager-managed, and Haugen was not the LLC’s manager. Haugen occasionally signed checks for the LLC, and a form filed by the LLC with the state indicated that Haugen was responsible for hiring and firing employees. Id., at *2-3. The Department of Revenue asserted liability against Haugen because of his part ownership of the LLC and because he signed checks for the business. Id. at *6.
Oregon requires employers to withhold and pay Oregon income taxes from wages paid to employees. Or. Rev. Stat. § 316.167. Personal liability for unpaid tax withholdings is imposed on “[a]n officer or employee of a corporation, or a member or employee of a partnership, who as such officer, employee or member is under a duty to perform the acts required of employers by ORS 316.167 ….” Or. Rev. Stat. § 316.162(3)(b).
Finding a paucity of case law on the liability of LLC members, the Haugen court analogized Haugen’s status to that of a corporate officer for the purpose of determining liability. Haugen, 2011 Ore. Tax LEXIS 187, at *6. The court applied prior Oregon case law involving corporate officers, and found that Haugen would be liable if he had the actual authority and control to pay or direct payment of the tax withholdings. Id. at *7. The evidence indicated that Haugen did not have authority to unilaterally sign checks or make important financial decisions – he had authority to sign checks only under the direction of the 90% owner and manager, after obtaining specific consent to sign each check. Also, Haugen did not have general authority as a member, because the LLC was manager-managed, and Haugen was not a manager.
The court concluded that because Haugen “was not in a position to pay the withholdings or direct the payment of the withholdings at the time the duty arose to withhold or pay over the taxes,” he was not an “employer” under Or. Rev. Stat. § 316.162. Haugen, 2011 Ore. Tax LEXIS 187, at *11-12. The court therefore canceled the Department of Revenue’s Notice of Liability against Haugen.
Kelly Haugen escaped liability for the unpaid taxes because of his lack of authority. Had his been a member-managed LLC, or if he had had discretion to sign checks without prior approval, the court presumably would have upheld the tax assessment against him.
Many of the comparable statutes from other states are at least as strict in finding managers and check signers to be personally liable for failure to pay tax withholdings and sales taxes over to the state. The strict approach is not surprising, given that in these cases the business has in effect been a tax collector for the state and (at least in the state’s view) is holding the state’s money. The Haugen case should be a wake-up call for LLC managers and check signers to avoid the temptation of financing the business in troubled times by holding on to tax withholdings or sales taxes.
Manager Has Authority to Bind Oregon LLC Even With a Known Conflict of Interest
When an LLC manager signs a contract on behalf of the LLC there is usually no question whether the LLC is bound by the manager’s signature. But consider – what’s the result when the manager is an investor and an officer of the other party to the contract, and the LLC members disapprove of the contract and attempt to reject it on grounds that the manager lacked authority to enter into the contract because of the manager’s conflict of interest? The Oregon Court of Appeals was faced with this scenario in Synectic Ventures I, LLC v. EVI Corp., No. A139879, 2011 Ore. App. LEXIS 337 (Or. Ct. App. Mar. 16, 2011).
The Loan. Three LLC investment funds (Synectic) loaned $3 million to EVI Corporation pursuant to a 2003 loan agreement. The loan agreement called for repayment by December 31, 2004, but EVI had the right to convert the debt into equity in the form of EVI stock if it received additional investments of at least $1 million before the December 31 deadline.
Conflict of Interest. The Synectic LLCs were managed by Craig Berkman, at first directly and later through management firms he controlled. Berkman was involved with both parties to the loan. In addition to being Synectic’s manager, Berkman was also the board chairman and treasurer of EVI, and held EVI warrants and stock options.
Amendment. In September 2004, as the year-end due date of the loan approached, Berkman executed an amendment to the loan agreement on behalf of Synectic that extended EVI’s repayment date one year, to December 31, 2005. Berkman also approved the amendment in his capacity as an EVI board member. The Synectic members were unaware of the amendment at the time it was made. Berkman was removed as manager in December 2004, and in 2005 Synectic learned of the amendment and notified EVI that the amendment was not authorized and that EVI was in default on the loan.
EVI raised $1 million in additional investment before December 31, 2005 and converted the loan into equity, thereby avoiding default (if the amendment was binding on Synectic).
Synectic sued EVI to collect on the loan, and EVI defended on grounds that it was not in default under the amended loan. The trial court concluded that the amendment was valid and binding on Synectic and that EVI was therefore not in default.
Authority. The Court of Appeals began with a look at Or. Rev. Stat. § 63.140(2)(a), which provides in part:
Each manager is an agent of the limited liability company for the purpose of its business, and an act of a manager, including the signing of an instrument in the limited liability company's name, for apparently carrying on in the ordinary course the business of the limited liability company, or business of the kind carried on by the limited liability company, binds the limited liability company unless the manager had no authority to act for the limited liability company in the particular matter and the person with whom the manager was dealing knew or had notice that the manager lacked authority.
This section provides for the manager’s apparent authority in the ordinary course of the LLC’s business. Many state LLC acts have similar provisions for managers and members (if the LLC is member managed), e.g., Washington, Utah, and New York. Both the Uniform Partnership Act and the Uniform Limited Partnership Act have similar provisions for the apparent authority of general partners.
Under Or. Rev. Stat. § 63.140(2)(a), if the manager has no authority and the third party has knowledge of the lack of authority, the principal will not be bound. The court therefore reviewed Synectic’s operating agreements to determine Berkman’s authority, and concluded that the agreements gave Berkman the exclusive authority to manage the business of the LLCs and to take action without the consent of the members. The operating agreements also provided that third parties could rely on Berkman’s authority to bind the LLCs without further inquiry. Synectic, 2011 Ore. App. LEXIS 337, at *12-13. Under these provisions it appeared to the court that the amendment was within the authority granted to Berkman in the operating agreements: “As such, at first blush it would appear that Berkman’s act of executing the amendment was within the express authority granted to him in the operating agreements.” Id.
Synectic argued that Berkman’s actual authority was limited by letter agreements Berkman had entered into with some of Synectic’s investors, and by his acts of self-dealing and breach of fiduciary duties. Id. at *13.
The court held that the letter agreements did not limit Berkman’s authority because they were between Berkman and some of the Synectic members, but not with Synectic. If the letter agreements obligated Berkman to those members, any breach was between him and them and did not affect his authority to act for Synectic. Id. at *17.
Fiduciary Duties. Synectic’s operating agreements obligated Berkman to carry out his duties in accordance with the standard of conduct specified for LLC managers in the Oregon LLC Act, which includes the duty of care and the duty of loyalty. Or. Rev. Stat. § 63.155. Synectic contended that Berkman’s breaches of those duties without member approval invalidated his execution of the amendment. But before the court considered whether Berkman had breached his fiduciary duties, it examined whether the remedy requested by Synectic would be available even if Berkman had breached his duty.
The court concluded that the language of Or. Rev. Stat. § 63.140(2)(a) controlled: the act of a manager binds the LLC “unless the manager had no authority to act for the limited liability company in the particular matter and the person with whom the manager was dealing knew or had notice that the manager lacked authority.” Berkman had the express authority under the operating agreements to enter into the amendment. Synectic took no action to limit his authority, and the loan extension was within the ordinary course of the LLC’s business. Even if knowledge of Berkman’s self-dealing were imputed to EVI, any inquiry by EVI would only have led to the conclusion that Berkman had authority to execute the amendment. Synectic, 2011 Ore. App. LEXIS 337, at *23-24.
In short, Berkman had actual, unqualified authority under the operating agreements, and his act of executing the amendment therefore was binding on Synectic even if it was a breach of his fiduciary duties.
Conflict of Interest. Synectic also pointed out that under Or. Rev. Stat. § 130(2)-(4), a transaction involving an actual or a potential conflict of interest between a member or a manager and the LLC requires the consent of a majority of the members, unless the operating agreement provides otherwise. The Synectic operating agreements clearly allowed members to have conflicts of interest, but said nothing about actual or potential manager conflicts.
Strangely enough, the court found that Berkman’s alleged conflict between his role as Synectic’s LLC manager and his role as EVI’s board member and treasurer was excused by the Synectic operating agreements. While it is correct that Berkman was a member, Synectic’s allegation was that Berkman had a conflict because of his status as a manager, not as a member.
The court’s opinion says not a word about why the operating agreements’ waivers of member conflicts should apply to Berkman in his capacity as manager. Berkman was acting as Synectic’s manager when he signed the amendment, not as a member. For an operating agreement to allow members to have a conflict of interest is a far cry from allowing a manager to have a conflict of interest – non-managing members are passive and don’t make the management decisions that could be affected by a conflict of interest. Synectic may still be trying to puzzle this one out.
More States Are Considering Low-Profit LLCs
At least 10 state legislatures are considering bills to authorize low-profit limited liability companies (L3Cs) – all introduced in the last two and a half months:
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Arizona; Senate Bill No. 1503 |
Arkansas; Senate Bill No. 5 |
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Hawaii; Senate Bill No. 674 |
Indiana; Senate Bill No. 501 |
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Kentucky; House Bill No. 110 |
Maryland; House Bill No. 552 |
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Montana; House Bill No. 415 |
New York; Senate Bill No. 3011 |
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Oregon; House Bill No. 2745 |
Rhode Island; Senate Bill No. 353 |
These have the potential to more than double the number of states that authorize L3Cs. Currently eight states have authorized L3Cs: Illinois, Louisiana, Maine (effective July 1, 2011), Michigan, North Carolina, Utah, Vermont, and Wyoming.
The L3C is a relatively new type of limited liability company, a hybrid which attempts to combine a charitable purpose with a profit-making motive. An L3C is not a nonprofit and is taxed on its profits like any other LLC. I have previously written about L3Cs, here.
Advocates of L3Cs suggest they will encourage investment by private foundations in L3C enterprises. Typical program-related investments (PRIs) made by private foundations in either for-profit or tax-exempt enterprises include equity investments and loans, on terms more favorable to the recipient than a market rate investment. The purpose of the investment must be to support the foundation’s charitable purpose. L3Cs are promoted as facilitating increased investment by private foundations, because the state statutes apply to L3Cs the Internal Revenue Code requirements for the recipient of a PRI made by a private foundation. IRC § 4944(c). The idea is that because L3Cs automatically apply those standards to L3Cs, private foundations will be more willing to invest in L3Cs.
L3Cs have generated a lot of interest in the non-profit and social enterprise community, and a fair amount of commentary is becoming available. The Vermont Law Review sponsored a symposium on L3Cs and other developments in social entrepreneurship in February 2010. (Vermont was the first state to authorize L3Cs.) Articles related to the Symposium were published in a symposium edition of the Vermont Law Review, Symposium, Corporate Creativity: The Vermont L3C and Other Developments in Social Entrepreneurship, 35 Vt. L. Rev. 1 (2010).
Two articles in the symposium edition caught my eye. The first was Program-Related Investments in Practice, 35 Vt. L. Rev. 53 (2010), by Luther M. Ragin, Jr., Chief Investment officer of the F. B. Heron Foundation. Heron has been an active PRI maker since 1997, and at the end of 2009 had $21 million in outstanding PRIs, in 38 separate transactions. Heron’s PRIs were made to a variety of organizations. Most were to non-profits, but 10 were equity or subordinated debt investments in limited partnerships, LLCs, and corporations.
The critical driver for Heron is not the legal form of the organization seeking capital. Heron has found that it can apply the PRI rules and reach positive decisions on PRIs to various types of for-profit entities as well as non-profits, provided the PRI serves a charitable purpose. (The two other PRI tests – no lobbying, and income from the PRI not being a significant purpose of the foundation’s decision to make the investment – must also be satisfied.)
The other article in the Symposium edition that jumped out was The L3C Illusion: Why Low-Profit Limited Liability Companies Will Not Stimulate Socially Optimal Private Foundation Investment in Entrepreneurial Ventures, 35 Vt. L. Rev. 275 (2010), by J. William Callison and Allan W. Vestal. The article nicely reviews the law of private foundations and PRIs. It then examines the L3C requirements of the state LLC laws and how they attempt to match the PRI requirements. The article concludes that the statutory form does not match well with the PRI requirements and that private foundations will still need to conduct the same due diligence they would conduct before making a PRI to a non-L3C entity.
The experience of the F. B. Heron Foundation buttresses Callison and Vestal’s analysis. The type of entity, and whether it is a for-profit or a non-profit, play little part in Heron’s decisions about making PRIs.
The article concludes with a discussion of why L3Cs are considered harmful. First, smaller, less well-advised foundations may unduly rely on the L3C status of the recipient when making a PRI rather than on their usual due diligence, resulting in non-compliance with tax requirements and possibly endangering the foundation’s charitable status. Second, in an L3C with profit-seeking participants, where the foundation makes a high-risk, low-return investment vis-à-vis the other investors, there is risk that the foundation may run afoul of the “private benefit” doctrine, which is intended to prevent tax-exempt organizations from conferring private benefit on private participants.
Callison and Vestal’s conclusion is succinct: without changes to federal PRI rules there is little or no value to the L3C structure, the existence of the L3C form is a dangerous trap for the unwary, and the form should be shelved.
The article makes a strong case for the states to stop adopting the L3C form, and for the states that currently authorize the L3C form to revise their LLC laws to delete the L3C authorizations.
Will careful legal analysis and commentary take the wind out of the sails of the L3C movement? It’s hard to say. Popular enthusiasms and fads take on a life of their own. And one of the drivers of the L3C movement is the laudable goal of increasing the flow of private foundation money to ventures with charitable purposes. But that goal appears to be blinding the L3C promoters and some state legislators to the legal realities – L3Cs don’t and won’t accomplish that goal unless and until the federal tax rules are changed, which appears unlikely.
Oregon Clarifies LLC Derivative Suit Requirements
The Oregon Court of Appeals has clarified when and how members of an Oregon LLC can maintain a derivative suit in the name of the LLC. Bernards v. Summit Real Estate Mgmt., 229 Or.App. 357, 213 P.3d 1 (July 1, 2009). Oregon’s LLC Act allows member derivative suits, but the court imposed additional pleading requirements on the complaint. The court also found that a requirement in the LLC’s operating agreement of unanimous member approval before commencing any suit in the name of the LLC was subject to the agreement’s standard of care and to the implied duty of good faith and fair dealing.
The plaintiffs (Bernards) were minority members of two member-managed LLCs. Each of the LLCs owned apartment buildings and entered into management contracts with the defendant management company (Summit). Bernards claimed that Summit and one of its officers (McKenna) had embezzled the LLCs’ funds, and demanded that the other members approve lawsuits by the LLCs against Summit and McKenna to recover the funds. (The operating agreements for the LLCs required the unanimous approval of the members to bring legal action in the name of the LLCs.)
The other members refused to approve a lawsuit without giving any reasons for their refusal, even though McKenna had admitted embezzling substantial amounts from the LLCs. Bernards then brought derivative suits against Summit, McKenna and the other members, alleging that the other members had breached their duty to the LLCs by refusing to approve the lawsuits against Summit and McKenna.
Oregon’s LLC Act authorizes derivative proceedings by a member in the name of an LLC. Or. Rev. Stat. § 63.801(1). The statute requires that the complaint allege with particularity either that a demand to file the suit was made of the managers (or members in the case of a member-managed LLC), or why a demand was not made. Or. Rev. Stat. § 63.801(2).
The statute does not explicitly refer to any requirement of wrongdoing by the members that refused to approve the lawsuits. The court nonetheless held that when the members have refused the demand for litigation, the complaint must allege facts showing wrongdoing by the refusing members. Bernards, 229 Or. App. at 364.
The court analogized LLC derivative suits to corporate derivative suits. The court had previously held that Oregon’s almost identical corporate statute required, albeit in a demand-futility case, that the complaint in a shareholder derivative suit plead facts showing wrongful conduct by the directors. The court in Bernards applied the corporate rule, holding that in order to rebut the presumption that the members were exercising their business judgment, the complaint must allege facts showing wrongful conduct by the members.
Section 63.801(2) of Oregon’s LLC Act allows the LLC’s operating agreement to vary the statutory pleading requirements. The court therefore looked to the operating agreements and applied their standard of care as the definition of wrongful conduct—gross negligence, fraud or willful or wanton misconduct.
The other members argued that the operating agreements’ requirement of unanimous member consent trumped the pleading requirements of Or. Rev. Stat. § 63.801(2). The court disagreed and held that the requirement of consent was not equivalent to giving every member the unfettered authority to withhold consent. The right to consent was subject to the express standard of care in the operating agreement and the implied duty of good faith and fair dealing. The court noted that the requirement of unanimous member consent meant that the plaintiffs had to allege facts demonstrating that all of the member defendants refused wrongfully. “[I]f even one of them refused to proceed and had a valid business reason for doing so, the LLCs could not bring legal action against McKenna and Summit.” Bernards, 229 Or. App. at 367-68.
The court concluded that the facts alleged by the plaintiffs were not adequate to demonstrate wrongdoing. Yes, there was a clear right to recover the embezzled funds (one defendant had admitted the embezzlement). Yes, the other members refused to sue when a demand was made. Yes, the other members had not provided an explanation for their refusal. Yes, one member had stated that he would not authorize legal action against McKenna and Summit “no matter how much money they had embezzled.” Bernards, 229 Or. App. at 362. But, said the court, it was not alleged, for example, that the members had refused to provide an explanation, or that they had a personal financial interest in McKenna or Summit, or that they were driven by some personal animus against the plaintiffs. The result was that the court affirmed the trial court’s dismissal of the complaints.
The Bernards opinion is noteworthy not only because it answered an open question under Oregon law, but also because it reasoned by analogy and applied Oregon’s corporate law of derivative actions to LLCs. And the result here was clearly right--why should a minority member be able to sue in the name of the LLC to initiate litigation when the other members have decided that the LLC should abstain, without alleging some facts showing that that there was something wrong with the other members’ decision, such as a conflict of interest? Also noteworthy is that the court applied the business judgment rule, while implicitly recognizing that an LLC’s operating agreement could change the rule for that LLC.
