The Business Divorce Law Report
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There is no statutory right to receive a distribution of profits from a limited liability company before it dissolves and winds up its affairs. Distributions before then are discretionary.
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Profit distributions are in the discretion of the majority members or commonly in the discretion of the managers of the limited liability company.
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A minority member who is not receiving distributions may have a claim under the operating agreement or as an oppressed minority member if the majority refuses to make profit distributions.
Profit distributions are a frequent source of dispute among the members of a limited liability company. The fundamental question of who decides when distributions are made, how much is made, and how to deal with the tax issues related to distributions, profits and losses can all be the source of conflict.
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The short answer to the question of when a limited liability company must distribute profits is that ‘it depends.’ And many minority owners of LLC interests are frustrated to learn that they have less control over the process than they anticipated.
Limited Liability Companies Often Do Not Have Operating Agreements
Entrepreneurs choose limited liability companies as the form of a new business far more often than corporations or partnerships. They are cheap and easy to form and do not require the type of documentation and formalities that you generally see associated with other entities, corporations in particular.
But a limited liability company does not have the same kind of statutory framework as does a corporation. In many ways, the LLC affords the owners of minority interests much less protection from overreaching and oppressive behavior by the majority owners or managers than other forms of business.
Here we will take a look at how that happens and why contractual protections are important in forming a new limited liability company. In the process, we will compare the statutory protections that exist when the business is a corporation or a general partnership.
Operating Agreements Determine When Profits Must Be Distributed
The inescapable fact is that the time to deal with the payment of dividends or distribution of profits is when the business is formed using contracts between the owners. Once a dispute arises over these financial issues, it is often difficult to resolve the conflict without litigation.
For example, imagine the startup of a software company as a limited liability company. The founders chose to form a limited liability company. The simplicity, flexibility, and ease of organization make it easy. Many will not bother with an operating agreement or even a lawyer. This is fertile ground for a dispute.
The Uniform Limited Liability Company Act adopted in just less than half the states, including New Jersey, where I practice, makes it clear that distributions before the company dissolves and winds up its affairs, which is the legal process for closing, are not required.
The statute in New Jersey provides that “person has a right to a distribution before the dissolution and winding up of a limited liability company only if the company decides to make an interim distribution.” N.J.S.A. 42:C-34. This language comes right from the uniform act. Quitting and withdrawing from the business will not compel a distribution.
The only real requirement is that the distribution has to be in “equal shares,” which you cannot interpret to mean in the same amount, but rather that all members participate equally. In other words, if there’s $100,000 to distribute, it cannot be made to some members and not others. All members must participate according to their interest in the business.
Delaware and New York, which are states that are often seen as models for business law, say nothing about when a member is entitled to receive a distribution from an operating limited liability company, except to refer to the requirements of the operating agreements and to require, if there is no operating agreement, that the amounts be in proportion to the capital contributed.
Distribution of LLC Profits is Discretionary
Ultimately, there must be separate authority to compel a limited liability company to distribute profits. That authority can be in a binding decision of the members or managers of the limited liability company or in the terms of the operating agreement.
Without such authority, a limited liability company may choose to retain profits for reinvestment or future business needs. The distribution of profits is typically determined by the operating agreement, which outlines the rights and responsibilities of the members and managers in relation to profit allocation.
In much the same way, a corporation’s board of directors may elect not to pay dividends. The directors run the business for the benefit of the shareholders, and the decision of whether or not to distribute a dividend is entitled to a great deal of deference from a court. A difference that may apply to a corporation is that it operates under the majority model of corporate governance, meaning that it operates under the direction of a majority of its board of directors. Thus, unless there is some contractual agreement to the contrary, If the shareholders are unhappy with the dividend policy, they will have an opportunity at the next annual meeting to vote out the shareholders.
In many limited liability companies, that is not the case because the owners frequently have already agreed to concentrate authority in one or more managers.
Because many closely held businesses, whether organized as a corporation or as a limited liability company, elect to be taxed as a partnership, the failure to pay dividends implicates the prospect of phantom income for the owners. Income tax is payable on profits, whether or not there has been a distribution. When the distributions in cash are insufficient to cover the income tax liability of the members, the members pay taxes on the phantom income from their own pockets.
The founders of a closely held business should address the distribution of profits in the formation agreements of the business, be it a limited liability company, a corporation, or a partnership. Most do at some level, but there are many startups that operate without corporate governance documents like by-laws or an operating agreement, and others in which the agreements do not adequately address the topic.
The provisions that are commonly found in the operating agreement of an LLC may give discretion to the managers to distribute cash in their discretion. In other cases, it may make distributions mandatory on some predetermined schedule — often annually. Sometimes the operating agreement allows for the withholding of reserves. Very commonly, and this is important, the operating agreement requires the distribution of enough cash to cover the members’ income tax liability.
However, as the business grows, the majority owners or managers with control over distributions may make decisions that prioritize their own interests over those of the minority owners. Since there is no strong legal framework in place to protect the minority owners within an LLC, they have limited recourse to address this oppressive behavior and may suffer financial losses as a result.
Refusal to Distribute Profits In Breach of Contract
If refusal to distribute cash, whether in the form of profit or corporate dividends, is in breach of some contractual agreement, the first remedy is to pursue a claim under the terms of that contract. The other, and more difficult, approach is to pursue a claim for oppression or breach of a fiduciary duty to the minority.
For example, let’s say that in an LLC with three owners, two majority owners consistently make decisions that benefit themselves financially, such as awarding lucrative contracts to their own companies instead of paying dividends or profits. The minority owner, who holds a smaller stake in the company, may feel powerless to address this unfair behavior due to the lack of legal protection for minority owners within an LLC. As a result, the minority owner may suffer financial losses as they are not receiving their fair share of profits or dividends.
Even if the majority has discretion to make those decisions under the operating agreement or other contract, their control of the business creates the obligation to treat the minority fairly. They cannot elevate their own interests over those of the minority owners.
In many circumstances, minority owners will have a cause of action for minority oppression. Minority oppression occurs when the majority owners abuse their control and power to unfairly prejudice the rights and interests of the minority owners. This can include actions such as excluding the minority from important business decisions, misappropriating company funds, or engaging in self-dealing transactions. In such cases, the minority owners may have legal recourse to seek remedies, such as a court order to rectify the oppressive conduct or even the dissolution of the company.
Some states, such as New Jersey, will consider the failure to pay dividends as minority oppression. The touchstone of minority oppression in many states is that it frustrates the reasonable expectations of the minority members when they joined the business—for employment or regular income , for example—that the conduct is illegal, fraudulent, or simply unfair.
When Is The Refusal To Distribute Profits Or Pay Dividends Minority Oppression?
In a closely held corporation where the majority shareholder consistently withholds dividends from the minority owners, it could be considered as a form of minority oppression. If the minority owners can prove that this action prejudiced their rights and interests, they may be able to seek legal remedies like a court order to compel the payment of dividends or even dissolve the company if necessary.
Nearly all states have some form of recourse for the minority shareholders of a corporation that are the subject of oppressive conduct. That is not the case in many states in disputes over limited liability companies. Approximately half of the states have adopted the Uniform Limited Liability Company Act, which allows minority members to sue for oppression.
However, those states that have adopted statutes based on the Delaware or New York LLC laws will not provide such a remedy. The recourse of the minority members in those jurisdictions must generally be found in the contracts among the members.
The takeaway from this discussion is that minority members always have some exposure to abuse by the majority in control when it comes to the payment of dividends and distributions of profit. The best approach is to address these issues with contracts at the formation of the business. By the time a dispute arises, the vested interests of the parties will make compromise difficult, if not impossible.