LLC Member Disputes
In recent years, one commonly used corporate entity is the limited liability company or LLC. The LLC provides many of the same benefits as a corporation does. The LLC’s members, just like the shareholders of a corporation, are not personally liable for the entity’s debts. An LLC can elect to be taxed as a partnership or as a corporation. Most LLCs elect passthrough taxation. Passthrough taxation means that the LLC itself does not pay taxes. Instead, the gains and losses are distributed to its members who pay the taxes on their personal tax returns. As an example, a member owns 30% of an LLC. At the end of the tax year, the LLC has a profit of $10. The LLC does not pay tax. Instead, it distributes $3 to the 30% owner so that he or she can pay tax on the $3 of income. This is similar to the manner in which an “S” Corporation would pay taxes. The “S” means that the corporation has made an election under subchapter S of the Internal Revenue Code.
By contrast, a “C” corporation is just like a person. (The C corporation is taxed under subchapter C of the Internal Revenue Code). It pays tax on its income.An LLC is Not a Corporation
The LLC can be very different than a corporation. First, the LLC is governed by an Operating Agreement. That Agreement sets the rules for how the LLC operates, how the profits or losses are divided amongst the members. In many cases, the Operating Agreement can change customary Illinois law. The statute defines an “Operating Agreement” in this way:
"Operating agreement" means the agreement under Section 15-5, whether or not referred to as an operating agreement and whether oral, in a record, implied, or in any combination thereof, of all of the members of a limited liability company, including a sole member, concerning the relations among the members, managers, and limited liability company. The term "operating agreement" includes amendments to the agreement. 805 ILCS 180 Section 1.5.
The Illinois Limited Liability Company Act, 805 ILCS §180, governs any LLC situated in Illinois. Prior to 2017, the LLC Act contained a provision that allowed a member of any Illinois LLC to request that the company purchase his or her shares. This provision, commonly known as a buy-out provision, was removed from the Act in 2017. There were significant changes to the LLC Act in 2017. Those changes, in general, made it more difficult for a minority member to seek a buyout or commence litigation with the LLC.
One of the most common sources of litigation with an LLC was that one member would fail to sign the Operating Agreement. The business would commence operations and that member would regard himself as immune to any of the rules of the business. Or, worse, he would wait until the business was worth something and then sue for his interest. This created huge problems and litigation for LLCs. The 2017 Amendment solved this problem in this way:
Sec. 1-46. Applicability of statute of frauds. An operating agreement is enforceable whether or not there is a writing signed or record authenticated by a party against whom enforcement is sought, even if the agreement is not capable of performance within one year of its making.
(Source: P.A. 99-637, eff. 7-1-17.) (805 ILCS 180/1-46).
The Clinton Law Firm has handled cases where one member of an LLC refused to sign the operating agreement. This has caused difficulty for all the members. The Amendment of Section 1-46 was an excellent one that will reduce the potential for further litigation.
An LLC can be managed directly by the members or by a manager. The manager need not be a member of the LLC.
A member owes a fiduciary duty of loyalty to the LLC. Because this duty was a source of litigation, the Act was recently amended to make the nature and extent of those duties more clear. Section 15-3 now reads as follows:
(a) The fiduciary duties a member owes to a member-managed company and its other members include the duty of loyalty and the duty of care referred to in subsections (b) and (c) of this Section.
(b) A member's duty of loyalty to a member-managed company and its other members includes the following:
(1) to account to the company and to hold as trustee for it any property, profit, or benefit derived by the member in the conduct or winding up of the company's business or derived from a use by the member of the company's property, including the appropriation of a company's opportunity;
(2) to act fairly when a member deals with the company in the conduct or winding up of the company's business as or on behalf of a party having an interest adverse to the company; and
(3) to refrain from competing with the company in the conduct of the company's business before the dissolution of the company.
(c) A member's duty of care to a member-managed company and its other members in the conduct of and winding up of the company's business is limited to refraining from engaging in grossly negligent or reckless conduct, intentional misconduct, or a knowing violation of law.
(d) A member shall discharge his or her duties to a member-managed company and its other members under this Act or under the operating agreement and exercise any rights consistent with the obligation of good faith and fair dealing.
(e) A member of a member-managed company does not violate a duty or obligation under this Act or under the operating agreement merely because the member's conduct furthers the member's own interest.
(f) This Section applies to a person winding up the limited liability company's business as the personal or legal representative of the last surviving member as if the person were a member.
Section (f) was inserted because the prior version of the Act did not govern the conduct of an administrator or executor of a deceased member. The duties set forth in Section (b)(1)-(3) are more explicit than prior law and are, hopefully, easier to understand.We can Assist You in Preventing or Resolving any Disputes
First, we can offer our best assistance if you contact us before you sign the Operating Agreement. We may be able to negotiate changes or clarify expectations.
Second, if you are a member of an LLC and you run into problems after the LLC has been formed and after you signed the Operating Agreement, we may be able to offer assistance.
Section 35-1 allows a member to petition a court to dissolve an LLC in certain circumstances. This is the most important statutory remedy that a minority or dissociated (ousted) member has.
(4) On application by a member or a dissociated member, upon entry of a judicial decree that:
(A) the economic purpose of the company has been or is likely to be unreasonably frustrated;
(B) the conduct of all or substantially all of the company's activities is unlawful;
(C) it is not otherwise reasonably practicable to carry on the company's business in conformity with the articles of organization and the operating agreement.
(5) On application by a member or transferee of a distributional interest, upon entry of a judicial decree that the managers or those members in control of the company:
(A) have acted, are acting, or will act in a manner that is illegal or fraudulent; or
(B) have acted or are acting in a manner that is oppressive and was, is, or will be directly harmful to the applicant.
A member may also be able to bring other actions against the LLC or fellow members for fraud or other business torts. Please see the following webpages for further information on those topics.
If you are about to become a member of an LLC, we can help you. Please call us for a consultation. If you are already a member of an LLC and believe that you are not being treated fairly or appropriately, please let us know.