The Pitfalls of Limited Liability Companies – Part I

The Pitfalls of Limited L…

The limited liability company has become immensely popular as a corporate structure for businesses. Many are drawn to the lack of complexity in tax matters and the protection of members from liability, among other features. However, membership in a limited liability company can also become a trap. Often, entrepreneurs about to embark on a new business venture with others neglect to acknowledge the possibility of failure or, more often, of discord among the members. As a result, these entrepreneurs don’t execute a thoughtful, appropriate operating agreement and instead use a sample downloaded from the internet, without understanding many of the terms. This series of blogs provides examples of what can go wrong – or right – with LLCs and operating agreements.

In one of our recently concluded cases, our client, a local medical professional with his own group of clinics, had allowed another doctor to buy into his limited liability company several years ago. The new doctor borrowed the buy-in amount from our client and the two agreed that repayment would be made from the business’s distributions. The operating agreement made the two equal owners of the LLC.

Things were great – until they weren’t. A staff member accused the doctor of misconduct, and the doctor’s personal financial problems began to affect the workplace. In addition, repayment of the buy-in amount was not on schedule. Our client wanted to sever ties with the doctor. After attempts to settle failed, our client faced the time and expense of an action to foreclose on his security interest in the membership shares.

Then, the other doctor filed for chapter 7 bankruptcy protection. The doctor’s membership interests became assets of the bankruptcy estate and quickly drew the attention of the chapter 7 trustee and other creditors. This is when our client turned to us for help.

As it turned out, this client had been smart and consulted an attorney for advice before jumping into business with his new partner. Even though the two were 50-50 owners of the business, our client had reserved for himself a controlling voting interest until the buy-in debt was paid in full. Furthermore, any sale of the LLC membership interests required a vote of a majority of the members. In other words, our client controlled the salability of the debtor doctor’s membership interests, making their value to the bankruptcy estate practically zero.

Iurillo Law Group convinced the bankruptcy trustee that the contractual relationship rendered the membership interests worthless to the estate. The trustee agreed to sell the membership interests back to our client for what amounted to a convenience value – far less than what a foreclosure action would have cost.

Iurillo Law Group advises individuals and businesses on both ends of this kind of situation. We can help you devise deadlock-breaking mechanisms and other protections to put in place at the outset – before they are needed. We also help businesses resolve internal conflict through methods ranging from informal settlement discussions through litigation. Our attorneys look forward to helping you with your business questions. 

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