LLC Payment Classifications: Member Distributions vs. Compensation: Beware the Unintended Consequences

Those who do business through a closely-held limited liability company (LLC) often receive their share of business profits in the form of member distributions instead of guaranteed payments (compensation). [1] They may be advised, for example, that there are tax advantages to doing so.[2] What they may not realize, however, is that paying LLC members in the form of distributions instead of compensation may impair the limited liability protection otherwise afforded to LLC members and expose them to creditors’ claims, at least where the LLC engages in activities with a high risk of liability and/or becomes insolvent.

While there may be reasons for choosing to give members distributions instead of compensation, there are potential risks to the LLC’s members from a creditor standpoint. A.R.S. § 29-706 provides that a limited liability company “shall not make a distribution to its members to the extent that at the time of the distribution, after giving effect to the distribution, all liabilities of the limited liability company would exceed the fair value of the assets of the limited liability company….” Liability is imposed on each member who receives such distributions for the amount of such distributions.[3]

Take, for example, a medical practice that conducts its business as a professional limited liability company[4] and for which there has been a large malpractice claim. If the medical practice thereafter continues to pay its doctor members in the form of distributions instead of compensation, each member potentially can be personally liable for distributions received at any point after the company’s liabilities exceed its assets.

Other legal doctrines[5] can lead to the same result; and similar rules can apply in the context of corporations[6] and limited partnerships.[7] Thus, while there may be good reasons for classifying payments to members as distributions instead of compensation, beware the unintended consequences of doing so: it may adversely affect the limited liability protection otherwise afforded an LLC’s members.

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[1] Pursuant to IRS regulations, compensatory payments to LLC members are to be treated as guaranteed payments (similar to payments to an independent contractor) rather than salary.

[2] Whether or not there are actual tax advantages is beyond the scope of this discussion. For example, LLC members may still be liable for self-employment taxes at the personal level, whether they receive distributions or guaranteed payments or neither.

[3] Subsection D provides: "If a member receives a distribution with respect to his interest in a limited liability company in violation of this chapter or an operating agreement, he is liable to the limited liability company for a period of six years thereafter for the amount of the wrongful distribution."

[4] A.R.S. § 29-706 is made applicable to professional limited liability companies through A.R.S. § 29-843

[5] In Hullet v. Cousin, 32 P.3d 44 (Div. 1 2001), for example, the Arizona Court of Appeals applied fraudulent transfer law. There, after a limited partnership sold its only asset (an apartment complex), it distributed the net proceeds to its partners. A creditor later sued the limited partnership for claims related to the apartment complex. The creditor obtained a default judgment against the partnership, but the judgment was uncollectible because there were no assets remaining in the partnership. The creditor then sued the limited partners, arguing that the limited partnership's transfer of assets to them was voidable as fraudulent pursuant to Arizona Revised Statutes "A.R.S." sections 44-1004 and 44-1005. The Arizona Court of Appeals directed that judgment be entered in favor of the creditor on his fraudulent transfer claim against the limited partners. In so holding, the Court (citing to the functional equivalent of A.R.S. §29-706 as respects limited partnerships) recognized that a “limited partner is not entitled to distribution from a limited partnership to the extent that it would cause the liabilities of the limited partnership, other than those to partners on account of their partnership interests, to exceed the fair value of the limited partnership's assets. A.R.S. § 29-337 (1998).”

[6] A.R.S. §10-640(C).

[7] A.R.S. § 29-337.