• Court Recasts Advances as Capital Contributions in Determining LLC Members' Ownership Percentages
  • September 14, 2012 | Author: Peter A. Mahler
  • Law Firm: Farrell Fritz, P.C. - New York Office
  • Here we go again.

    Another limited liability company (LLC) without a written operating agreement or regularly maintained books and records memorializing the ownership interests of the members. Another lawsuit in which no one agrees who owns what if any percentage interest in the LLC. Another court decision that struggles to reconcile conflicting evidence surrounding the litigants' relative contributions to the LLC in arriving at a decision that satisfies neither side and is likely to be appealed by both.

    About three months ago I wrote about the Eight of Swords case involving a tattoo parlor, in which the appellate court affirmed a lower court's assessment of the non-cash contributions in the form of services provided by LLC members who had no operating agreement and who disagreed over the petitioner's claimed 50% membership interest. The petitioner lost that case.

    Now comes a decision late last month in a much higher stakes case involving a real estate holding company, in which the trial court had to resolve a dispute between two brothers, one of whom claimed 100% ownership of the LLC and the other who claimed a 75%/25% split, where there was no operating agreement, no tax returns after the first two years, and where each side contested the other's financial contributions, withdrawals and liabilities. At issue was: (1) whether the brother claiming the 25% interest had no membership interest, a 25% interest, or something in between; (2) depending on what if any interest the brother had, whether his withdrawal from the LLC entitled him to be paid the fair value of his interest; and (3) assuming he had a membership interest and the right to withdraw, determining the LLC's value and whether to apply a discount for lack of marketability.

    In a 21-page Memorandum Decision following a lengthy bench trial in Chiu v. Chiu, Index No. 21905/07 (Sup Ct Queens County Aug. 30, 2102), Queens County Supreme Court Justice Allan B. Weiss determined, essentially based on the LLC's initial tax returns showing a 75%/25% membership split and subsequent property renovation expenses paid by the majority member which the court deemed to be capital contributions, that the minority member held a 10% interest as of the date he withdrew, and that he therefore was entitled to be paid 10% of the approximately $10.5 million net asset value of the LLC without any discount for lack of marketability. This post discusses the court's determination of the brothers' membership percentages. Next week I'll examine the valuation decision.

    Background

    Chiu arises from a bitter family dispute between older brother Winston Chiu (WC) and younger brother Man Choi Chiu (MCC) over a company called 42-52 Northern Blvd., LLC which was formed in 1999 to acquire a warehouse to be renovated and occupied by MCC's separate business. MCC and WC made initial investments in a 3:1 ratio of $581,562 and $193,854 resulting in a 75%/25% membership split as reported in their Schedule K-1s included with the LLC's 1999 and 2000 tax returns. The rest of the approximately $5.5 million paid for the building was financed by a $3.5 million mortgage which the brothers personally guaranteed, and a $1.1 million loan from MCC which he raised by refinancing another property indirectly owned by MCC.

    WC and MCC never had a written operating agreement. No LLC tax returns were filed after 2000, apparently because the following year a dispute erupted either leading to or resulting from WC's purported deed conveyance of the warehouse property to his personal trust. In the first of multiple lawsuits stretching over the next decade, MCC successfully sued to set aside the conveyance as fraudulent. In that same suit, however, MCC's request for a declaration that he was the LLC's sole member was rejected based largely on the 1999-2000 tax returns.

    The Expulsion Litigation

    In one of the subsequent suits MCC sought a judgment removing WC as a member of the LLC based upon his conduct surrounding the previously adjudicated fraudulent conveyance. In 2008, the lower court dismissed the removal claim on the ground that the LLC Law does not empower a court to expel an LLC member absent authorization in the operating agreement. This ruling was affirmed on appeal in 2010.

    WC's Withdrawal and Demand for Fair Value

    MCC's suit also sought a judgment declaring the extent of WC's ownership interest in the LLC, if any. In February 2008, in the form of counterclaims, WC gave notice of his withdrawal as an LLC member pursuant to the governing, pre-amendment version of LLC Law §606 (the amendment reversed the original default rule allowing member withdrawal unless barred by the operating agreement) and demanded payment for the fair value of his claimed 25% interest pursuant to LLC Law §509.

    The Parties' Positions on Membership Percentage

    Between October 2011 and April 2012, Justice Weiss held 22 days of hearing on the issues of WC's disputed membership interest in the LLC and on the LLC's valuation assuming WC held a membership interest as of the date of his withdrawal in February 2008.

    MCC contended that he allowed WC to participate in the warehouse purchase solely to assist him in deferring taxes as part of a "Section 1031 exchange"; that it was never intended that WC would hold a beneficial interest in the LLC; and that in any event, in May 2001, WC withdrew all of his capital in the LLC consisting of his initial $193,854 contribution. MCC also argued that the 75%/25% split recorded in the 1999 and 2000 K-1s incorrectly reflected the parties' capital contributions because they omitted nearly $2 million contributed by MCC toward the purchase of the property and another $1.23 million contributed by MCC for capital improvements to the property. Accordingly, MCC contended, if WC had an interest as of February 2008 it was not more than 9% based on their respective capital contributions.

    WC argued that the 1999 and 2000 tax returns, which MCC signed, together with other financial records estopped him from denying WC's 25% membership interest; that the brothers had "agreed" that WC would be a 25% member regardless of any imbalance in cash contributions; that the fact that his investment in the LLC was part of a 1031 exchange was immaterial to the acquisition of his membership interest; that WC never withdrew his initial capital contribution; that monies loaned by MCC for the warehouse acquisition retroactively could not be recharacterized as capital contributions; and that MCC could not characterize mortgage, tax and renovation expenses paid by his other companies as capital contributions because those companies occupied the warehouse since 1999 under triple net leases at below-market rents.

    The Court's Ruling

    Justice Weiss's decision initially addresses the impact of the 1999 and 2000 tax returns, agreeing with WC that they estop MCC from taking a contrary position "but," he quickly qualifies, "the estoppel cannot be taken as far as WC would like." Instead, Justice Weiss writes, "the estoppel merely pertains to the years 1999 and 2000, and it does not bar the admission of evidence showing that the relative interests of the parties changed in subsequent years."

    Next, Justice Weiss observes that, upon his withdrawal from the LLC, pursuant to LLC Law §504 and 509,

    WC became entitled to receive the fair value of his ownership interest in the company, and the determination of the fair value of that interest depends on his right to share in the distributions of the company. WC's right to share in the distributions of the LLC, in turn, depends on the relative value of the parties' contributions to the LLC.

    Justice Weiss then sets forth the guiding legal principles for examining the claimed post-2000 contributions, as follows:

    • Although there are some "old cases" involving partnerships that consider any monies voluntarily provided for the use of the partnership over and above the amount required by the partnership agreement to be a loan to the company, "[m]ore recent cases show that courts will consider the circumstances surrounding the infusion of money in classifying it as a loan or capital contribution."
    • A loan to a company "does not, of course, amount to a capital contribution" (citing the above-mentioned Eight of Swords case).
    • Whether the transaction "bears the earmarks of an arm's length negotiation" is the "primary factor" to consider in distinguishing whether funds advanced by an owner constitute a capital contribution or a loan.
    • Justice Weiss lists the 11 distinguishing factors identified in Roth Steel Tube Co. v. Comm'r, 800 F.2d 625 (6th Cir. 1986), a tax case involving a taxpayer's disputed treatment of advances as losses, including the presence or absence of traditional characteristics of loans (e.g. fixed maturity date, payment schedule, interest rate, security), adequacy or inadequacy of the company's capitalization, and identity of interest between the creditor and the company owner.

    Based on these principles, Justice Weiss concludes that the parties "had no agreement concerning how the [$1.23 million] spent by MCC on major renovations would be characterized," that "[t]here was no arm's length transaction between a creditor and a debtor," and that "the Roth Steel Tube factors indicate that the advances made by MCC to the LLC for renovations should be characterized as capital contributions rather than as loans." Justice Weiss also notes that the court's "concern," that MCC's unilateral contributions "had a dilutive effect on WC's interest," is "lessened by WC's failure to prove that he expressed opposition to the renovations made by MCC or offered to share in their expense" and that the renovations increased the property's value to WC's benefit. Justice Weiss also rejects WC's argument that the renovation expenses were incurred as substitute for rent from MCC's companies that occupied the building, stating that triple net lease tenants normally are not obligated to pay for major renovations but only for "ordinary" repair and maintenance.

    MCC does not fare as well with his expenditures totaling about $3.8 million for mortgage payments, real estate taxes, insurance and other building operating expenses, which Justice Weiss finds "were not capital contributions, but merely payments made as a substitute for rent" due from MCC's companies that occupied the building.

    Based on his findings Justice Weiss computes that, as of WC's withdrawal in February 2008, MCC has a 90% membership based on the ratio of his total capital contributions ($581,562 initial capital contribution plus $1,233,014 for renovations) versus WC's 10% interest based on his sole, initial capital contribution of $193,854.

    As mentioned above, next week's post will look at the court's valuation of WC's 10% interest and, in particular, the court's determination not to apply a marketability discount.