What Happens to an LLC in Divorce? Part 2
So, what happens to an LLC interest when the spouses divorce? There is very little case law that deals with divorce and limited liability company interests. Based on current Texas statutory law the only interest that can be owned by “the member’s spouse, to the extent of the spouse’s membership interest, if any, is an assignee of the membership interest.” (Texas Business Organization Code, §101.1115. “Effect of Death or Divorce on Membership Interest” (hereafter TBOC)).
As skilled Dallas divorce lawyers, we will tell you an assignee does not have the right to participate in the management or affairs of the LLC. An assignee does not have the right to become a member of the LLC. An assignee does not have the right to exercise any rights of a member. All that an assignee has is the right to be allocated income, gain, loss, deduction, credit or similar items, and to receive distributions to which its assignor (the owner spouse) was entitled, to the extent those items are assigned. In addition, the assignee acquires the right for any proper purpose to require reasonable information or account of transactions of the LLC and to make reasonable inspection of the LLC’s books and records.
Since there is so little case law regarding Limited Liability Company in a divorce, the most likely place to find analogous situations is in closely held corporations and in partnership law. The statutory scheme for partnership interests is very similar to that of limited liability interest. Texas case law regarding partnerships is quite clear – a divorce court can only award the non-partner spouse the rights of an assignee. If the analysis was that of a closely held corporation, perhaps the situation would be different – in Earthman’s Inc. v. Earthman, 526 S.W.2d 192 (Tex. App. Houston [1st Dist] 1975 the non-shareholder wife was awarded shareholder husband’s stock in a family corporation. The corporation, pursuant to their shareholders agreement, redeemed the stock awarded to the wife and offered to pay, pursuant to the shareholder’s agreement actually signed previous to the divorce by the now ex-wife, the book value of the stock (book value of an asset is seldom any indication of actual value and is most likely greatly less than actual market value). The appellate court decided that since the corporation was formed in a community property state and the stock was community property, that the wife could own the stock subject to the provisions of the shareholder’s agreement – basically meaning that she could own the stock but if she wanted to sell it, she had to comply with the shareholder’s agreement.
Dangers of ownership of an assignee’s interest – since the limited liability is a “pass through entity”, what happens if the entity has taxable income but does not make a distribution? What happens is that the assignee gets to report taxable income without receiving any funds to pay the income taxes. Typically partnerships and limited liability companies make distributions to cover income taxes, but there is no guaranty that this will happen. And if one is in a family business situation, or a entity where the other owners would rather reinvest the income of the entity rather than distribute it out, the assignee has little or no recourse (unless the refusal to make a distribution was not for legitimate business purposes). As far as the IRS is concerned, the taxes attributable to the undistributed income will be due in the next year.
The fight to determine the legitimacy of a failure to make a distribution could take years to resolve. In a somewhat different situation, but one that has implications of the danger of suing the business entity during divorce, the case of Lifshutz v. Lifshutz, 199 S. W. 3d 9 (Tex. App. San Antonio 2006, pets denied) is informative. In that case, in the middle of a divorce action, the wife sued the husband’s family businesses claiming that she had been defrauded by her husband and his family. During the discovery in the case, the other family members learned that the husband and wife had taken monies out of the partnerships and corporations without authority. The case was tried three times and appealed twice over a 9 year period. The final results were that the husband and wife each owed the partnership considerable money and the wife did not appear to gain any appreciable amount of assets.
Another strategy depends on how the LLC is managed. In extreme situations one can attempt to collapse the LLC in a process called reverse piercing the veil. There is a line of cases that permit a creditor to collapse the corporate veil so that the creditor can collect against the shareholders of a corporation. These cases have been used by courts to also collapse the LLC. The reverse piercing allows the spouse to claim that the assets of the LLC are not shielded by the LLC and belong to the member spouse. The normal reason for this type of result is where an LLC is claimed by the owner spouse as his or her separate property. As of the writing of this paper, no reported case has been successful in Texas (that does not mean that they have not been tried without appeal or settled and subject to confidentiality agreements). These cases are very complex, time consuming and expensive to litigate.
A different strategy would be to simply value the limited liability interest even with discounts for lack of marketability and lack of control, and suggest to the court either (1) the whole interest be awarded to the owner spouse with the non-owner spouse receiving other assets or (2) order the owner spouse to modify the company agreement to allow for two or more owners or simply be an assignee for half or some other percentage of the LLC. The suggestion to the court should also make clear that any income tax obligation resulting from the ownership of the asset also be allocated to the owner spouse irrespective of whose income tax return the taxable income is reported. For icing on the cake, if any tax losses have accumulated, determine the amount and how the IRS Code allocates them – many times they have to be allocated equally to each party depending on the type of loss. Sometimes the loss follows the asset, so it is another valuable asset being “divided”.
Most property cases are settled. The most obvious reason for settlement is that in settlement one can carefully construct a division of property (including LLC’s) that is creative and doable. In settlement everyone is purportedly in agreement so obtaining concessions from other owners of the business entity or using devices such as a liquidating partnership or trust can make the division of property a more positive experience.
Documents to Request
At the beginning of any divorce proceeding in which a spouse owns an interest in a limited liability company, our Dallas divorce attorneys recommend that you get copies of the LLC’s tax returns, K-1’s and the company agreement. If necessary, agree to a confidentiality order to protect the privacy rights of other members (and subsequently your privacy rights if the asset is allocated to you). Also determine how and when the interest was acquired. Then determine if the interest can be transferred so that the non-owner spouse can be accepted as a member into the LLC. The final step is to determine if one should attempt to value the LLC with the assistance of a qualified business appraiser. With this information, one can then determine what strategy works best within the framework of a division of property that is “just and right”. As you can see, the process can be quite complex. At GoransonBain Ausley, our divorce lawyers have the knowledge and experience necessary to assist you throughout this process.
This post was written by Thomas P. Goranson.
“In my experience, seeking to destroy the other side simply does not garner the best results. The wisest and most productive approach is to help clients find the best solutions, while keeping matters under control.” – Tom Goranson