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.

Renowned Sports Law Attorney Travis Leach Joins the Phoenix Office of Jennings, Strouss & Salmon

PHOENIX, Ariz. (January 18, 2012) – Jennings, Strouss & Salmon, PLC, a leading Phoenix-based law firm, is pleased to announce that Travis J. Leach has joined the firm as a Member in the Phoenix office.

“Travis is a talented attorney with extensive experience in the areas of securities, mergers and acquisitions, and corporate governance,” states Richard Lieberman, Chair of the firm’s corporate, securities and finance department. “As a certified contract advisor by the NFL, he also brings a substantial professional sports practice, which will enhance the firm’s growing sports and entertainment group.”

Leach will focus his practice in the area of securities, including public offerings, private placements, corporate governance matters (including Sarbanes-Oxley compliance), SEC reporting obligations, and mergers and acquisitions. He will also help lead the firm's Sports and Entertainment practice. As such, he will counsel professional athletes, coaches and ownership groups in contract and licensing negotiations and a variety of other individual and collaborative business ventures. His experience supplements the firm’s ability to advise professional athletes and entertainers in all their personal and business legal matters.

“It is an honor to join such a dynamic team of attorneys and I look forward to helping the firm grow its footprint in the sports industry,” said Leach. “Jennings Strouss is a firm with creative and talented attorneys who have solid reputations for delivering great client service; characteristics that provide positive synergies with clients in the sports and entertainment industry.”

Leach is certified as a Contract Advisor by the National Football League Players’ Association and the Canadian Football Players’ Association. He earned a J.D. from University of Miami Law School and a B.S. from Arizona State University.

Jennings, Strouss & Salmon Elects Bradley V. Martorana as a New Member

PHOENIX, Ariz. (January 12, 2012) – Jennings, Strouss & Salmon, P.L.C., a leading Phoenix-based law firm, is pleased to announce that Bradley V. Martorana has been elected a Member (Partner) of the firm, effective January 1, 2012.

“Brad’s success with clients in a wide-range of industries has been impressive and we are proud to have him join us as a Member of the firm,” said Richard Lieberman, Chair of Jennings, Strouss & Salmon’s Corporate, Securities and Finance department.

Mr. Martorana focuses his practice on advising businesses and their owners in structuring, negotiating and documenting a wide range of business transactions and relationships. Mr. Martorana has previously practiced at a large firm in Baltimore, Maryland, and is a certified public accountant (CPA) with experience at a “big four” accounting firm. He has earned a B.S. in Accounting and Finance from Georgetown University’s McDonough School of Business, a J.D. from The University of Maryland School of Law, and an M.B.A. from Arizona State University. Mr. Martorana is licensed in Arizona, California, Maryland and Washington, D.C.

Arizona Court of Appeals Expands Arizona Anti-Deficiency Protection to Unfinished Homes with Intent to Occupy Upon Completion

The Arizona Court of Appeals in M&I Marshall & Ilsley Bank v Mueller, 1 CA-CV 10-0804 (December 27, 2011), has expanded the scope of the Arizona anti-deficiency statute to include: (i) trust properties of two and one-half acres or less; (ii) which are limited to a single one-family or a single two-family dwelling; (iii) where construction of the house has not been completed; and (iv) the property was purchased by the borrower with the purpose of occupying the dwelling upon its completion (emphasis added).

A.R.S. § 33-814(G) (the “Statute”) provides and Arizona case law has held that the property must be “utilized” as a dwelling unit in order for the Statute to apply and preclude a deficiency action by a lender against a borrower after a non-judicial foreclosure of the property.

The Court of Appeals distinguished the Mueller facts from the Arizona Supreme Court case of Mid Kansas Federal Savings & Loan Association of Wichita v. Dynamic Development Corp., 167 Ariz. 122, 804 P. 2d 1310, in that the borrower in Mueller intended to live in the single-family home upon its completion, whereas in Mid Kansas, the borrower was a corporation that never intended to occupy the property. The Court of Appeals further stated that the primary purpose of the Arizona anti-deficiency statutes is to protect “homeowners” from deficiency judgments – not to afford protection to commercial homebuilders and that its interpretation of Mid Kansas was consistent with the intent of the Arizona legislature to protect homeowners.

Thus, the Court of Appeals in dismissing the lender’s deficiency claim against the borrowers held that the borrowers were entitled to anti-deficiency protection under the Statute even when the construction of the house is not completed and unoccupied where the borrower has the intent to occupy the house upon its completion.

Each case a business or individual may face is unique and may require legal advice. If you would like additional information regarding the content of this article, please contact the author, David Elston, or the Chair of our Real Estate Department, Lee Esch.