We all know that some of the most difficult, emotional disputes can arise when the owners of a closely-held corporation, limited liability company (LLC), partnership or limited liability partnership (LLP), limited partnership or limited liability limited partnership (LLLP) part ways. These business disputes between the owners of a closely-held entity can arise at formation, or during operations, or when one or more of the owners desire to leave or exit the entity. Business disputes of this kind may also arise in estate and trust administration when there is a family business involved. These disputes may also arise in a family law or divorce setting as well, between husband and wife or other family members.
One of the issues often overlooked is the "negative capital account." For example, in a Tennessee state case, Dermon-Warner Properties, LLC v. Warner, 2017 WL 6502887 (Tenn. Ct. App. 12/19/2017), a 2-member LLC established to manage commercial and residential properties and consisting of 2 members, Dave Derman Co. and Steve Warner, each owning 50%, faced a situation where Mr. Warner withdrew from the LLC as a member on December 31, 2010. At the time, he had a negative capital account of $399,657. He did not pay back to the LLC this negative balance when he withdrew. In September, 2011, he gets his K-1 from the LLC. It describes how he now had "income" to report in the amount of this negative capital account balance. On February 8, 2012, the company sent a written demand to Mr. Warner demanding that he either pay the negative capital account balance or dispute the claim and provide documentation supporting the position. When Mr. Warner did not do either, the company sued him, asserting claims for unjust enrichment and breach of the operating agreement. After discovery, the company pursued summary judgment.
In pursuing summary judgment, the company admitted that the provisions of the operating agreement did not expressly require withdrawing members to reimburse the company for a capital account deficit, but asserted that it was only "logical and equitable" for such an obligation to exist because had there been a positive capital account balance at the time of withdrawal, the company would have been expressly required to pay that out to a withdrawing member. The trial court agreed. The issue became what was the effect, if any, of the K-1 that had been issued on the obligation. Mr. Warner claimed that the K-1 itself, in stating that "income" was produced in the amount of the negative capital account amounted to an admission that the deficit had been forgiven, giving rise to an affirmative defense including equitable estoppel and set-off. Mr. Warner looked to rely on cases involving IRS Form 1099-Cs issued with respect to the reporting of cancelled income for debtors. Noting that under a minority view, the filing of a Form 1099-C is prima facie evidence of a discharge which then forces the creditor to prove that the form was filed by mistake or pursuant to other IRS requirements, while a majority view conclude that issuance does not bar a creditor from collecting payment, the Tennessee court noted the "inherent differences that exist between" the Schedule K-1 and 1099-C. The LLC's CPA testified that the K-1 reflected a zero balance in Mr. Warner's capital account "for tax accounting purposes" only, and that there was nothing on the K-1 itself to indicate that the item was being "discharged" as there is on the Form 1099-C. For these reasons, the court refused to conclude that the mere issuance of the K-1 indicates that the LLC in any way forgave Mr. Warner's debt. The court also rejected Mr. Warner's equitable estoppel defense.
The Dermon-Warner Properties case is a reminder to all practitioners how important it is to expressly deal with the possibility of capital account deficits and withdrawal in the agreements, further distinguishing between the different manner in which capital accounts are maintained (i.e., tax, book, 704(b), GAAP, other).
In many of these disputes, client representation needs to be handled by legal practitioners who can combine the necessary tax and business entity expertise to assist the owners in working through these issues. The Tufts Law Firm aims to provide an owner with the expertise he or she or it may need to work through the issues that can arise in a business dispute of this kind.