Reverse piercing: a single member LLC paradox.

Author:Bishop, Carter G.
Position:Limited liability company
 
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  1. INTRODUCTION II. ENTITY TAX CLASSIFICATION & LLC LEGISLATION A. PARTNERSHIP VERSUS CORPORATE CLASSIFICATION B. SINGLE MEMBER LIMITED LIABILITY COMPANY TAX CLASSIFICATION III. OWNERSHIP INTEREST TRANSFER PARADIGM A. TRANSFER OF PARTNERSHIP & LLC INTERESTS B. TRANSFER OF SMLLC INTERESTS IV. ALTERNATIVE CREDITOR PATHWAYS A. BANKRUPTCY OF THE ONLY MEMBER OF A SMLLC B. FEDERAL TAX LIENS AGAINST THE MEMBER OF A SMLLC C. ARTICLE 9 SECURED CREDITOR OF THE MEMBER OF A SMLLC D. REVERSE PIERCING & FRAUDULENT TRANSFERS V. CONCLUSION I. INTRODUCTION

    A separate creditor of a corporate shareholder may reduce an obligation to judgment, foreclose on the corporate stock and purchase the stock at the foreclosure sale. Absent enforceable contractual limitations, the purchasing creditor steps into the shoes of the former shareholder and owns all the former shareholders rights represented by the shares. The transfer does not diminish or alter the nature of the shares. By contrast, when a foreclosing creditor purchases a partnership or limited liability company interest from a debtor partner or member, the creditor only acquires the rights of the debtor to receive future partnership or limited liability company distributions, when and if made. The creditor may not exercise the debtor partner or member's rights to participate in the management. This rule is largely historical and designed to protect the remaining partners or members from accepting services from a stranger. When the debtor is the only member in a single member limited liability company, these outcomes produce often bizarre and unexpected results. Namely, the creditor owns the rights to all future distributions but the authority to declare the distributions and operate or liquidate the entity is controlled by the member who no longer has any economic incentive to operate the business. This extraordinary result has encouraged asset protectionists to advise clients to transfer assets to a single member limited liability company with the hope that the creditor's untenable status will force the creditor to settle for less. The other result is more likely, as informed creditors will simply not extend credit without an alternate route to avoid this dilemma. This means the asset protection value of the plan truly affects only unsecured judgment creditors, normally unsuspecting tort creditors. From a policy perspective, the result seems unworthy. This Article explores these outcomes in various contexts in which the rights of the creditor depend upon the context. The evolution of the limited liability company and the unique single member limited liability company hold invaluable insights into both the problem and solutions.

    The limited liability company has a storied history traced in part to initial failed legislative attempts in Alaska followed by adoption in Wyoming in 1997. The limited liability company seemed almost too good to be true. The entity possessed a corporate styled limited liability shield where no member was personally liable for entity obligations but was nonetheless taxed like a partnership or sole proprietorship. At that time, federal tax regulations stated a corporate resemblance test that taxed an unincorporated entity as a corporation if it possessed more corporate characteristics than partnership characteristics. The Service was slow to confirm that the tax classification of an unincorporated Wyoming limited liability company would be classified and taxed as a partnership rather than as a corporation. A private letter ruling determination was finally obtained in 1980, but the victory was bittersweet because the Treasury released proposed regulations at the same time that, unlike the Wyoming ruling, required all unincorporated organizations with a corporate styled limited liability shield to be classified as corporations. The proposed regulations stalled most state enactments and only Florida adopted legislation in 1982. Due to heavy criticism, the proposed regulations were withdrawn in 1983 and the Service committed to a project to study the proper effect of limited liability in the classification scheme.

    The Service concluded the study in 1988 and released the watershed Revenue Ruling 88-76. (1) That ruling classified a Wyoming limited liability company as a partnership because, under the resemblance regulations, it lacked the corporate characteristics of continuity of life and free transferability of interests. Specifically, a Wyoming limited liability company lacked corporate perpetual life because the dissociation of any member for any reason caused the dissolution of the entity. Similarly, it lacked corporate free transferability of interests because no member could transfer their interest to a third person and make that person a member without the consent of all the remaining members ("pick-your-partner" rule). By 1996 all states had adopted specific limited liability company legislation and the burden of ruling determinations under those statutes was crushing. Consequently, the Service released the so-called check-the-box (CTB) tax classification regulations effective for entities formed after January 1, 1997. The CTB regulations classified most unincorporated entities with two or more members as partnerships unless the entity elected to be classified as a corporation. (2)

    Importantly, the CTB regulations clarified an important but as of then unresolved controversy concerning the proper tax classification of a limited liability company formed and operated with only one member (SMLLC). The absence of at least two members meant that such entities could not be classified as partnerships because there were no "partners" to share income and loss. Consequently, the classification of a SMLLC as either a sole proprietorship or a corporation was in doubt. The first state to permit a limited liability company to be formed and operated with only one member was Texas in 1992, but legislative amendments were slow before the CTB regulations determined that the SMLLC is classified as a sole proprietorship rather than a corporation unless it elects to be taxed like a corporation. Every state now permits a limited liability company to be formed and operated with only one member. Oddly, because of the limited liability company historical partnership connections, the transfer of the only member's interest to a third party still requires that the "remaining" transferring member consent to admit the transferee as a member. While such consent can be implied in a voluntary transfer, the implication deteriorates when the transfer is involuntary. In involuntary transfer cases, the structure of the SMLLC laws permits the transferring member to retain the member status and the right to control the entity even though that person no longer has any continuing economic interest in the entity. This perverse result permits the transferring member to prefer its own non-ownership economic position through salaries and other payments at the expense of the only true economic owner. Because the creditor is a mere transferee, the member owes no fiduciary duty of fairness to the creditor who is isolated by the statutes. This article explores this plight and offers some suggestions.

    Part II explores the tax classification evolution of the limited liability company and later the SMLLC. The tax classification regulations were in large part responsible for the modern structure of the limited liability company. Part III explores the ownership transfer paradigm under state law. In particular, the nature of the obscure judgment creditor charging order limitation is examined. Finally, using the base of information from Parts II and III, Part IV explores various creditor pathways a member creditor may press its claim against a member and, if unsatisfied, the assets of a SMLLC. This journey travels through the enviable rights of a secured party, the acceptable rights of a bankruptcy trustee, and the little understood federal tax lien and levy process. Finally, the section explores the residual creditor, often a tort victim holding a judgment as a general unsecured creditor. That section considers unsatisfactory fraudulent transfer and conveyance rules with the backstop of the reverse piercing doctrine. Ultimately, the creditor problem created by awkward SMLLC statutes can only be cured by ad hoc equitable judicial remedies or amending the statutory law to create a more sensible result.

  2. ENTITY TAX CLASSIFICATION & LLC LEGISLATION

    The consequences involving the transfer of a limited liability company membership interest generally, and a single member limited liability company specifically, implicate partnership law and the development of the limited liability company. An important factor in the prominence of a limited liability company with two or more members is its federal tax classification as a partnership rather than a corporation. A single member limited liability company depends upon federal tax classification as a sole proprietorship rather than a corporation.

    Under tax regulations existing prior to 1997, unincorporated entities with two or more owners were classified either as partnerships or corporations. (3) The classification outcome depended upon whether the entity more closely resembled a general partnership or a corporation (4) based upon four critical criteria stated in the regulations. (5) One of the criteria related to whether the ownership interests in the entity were freely transferable like corporate stock or not like a partnership interest. (6) A single member limited liability company could not be classified as a partnership because it has only one member. Therefore, the tax regulations did not address this classification issue that devolved to obscure rulings.

    In 1997, the check-the-box (CTB) regulations were released classifying all unincorporated entities as partnerships, if two or more members, or as disregarded entities, if only one member. Since...

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