Be Careful if you Withdraw from an LLC | Business Transaction Newsletter

In the case of Dermon-Warner Properties, LLC v. Steve Warner, the Court dealt with the issue of whether a Member leaving an LLC with a negative capital account has a debt owed to the LLC for the amount of the negative capital account.

The Court reached which seemed like a very tough decision against the withdrawing Member finding that he was liable to the LLC for the full amount of the negative balance in his capital account.

The Operating Agreement for the LLC explained that when a Member withdrew, if the Member had a positive capital account, the Company was required to pay the withdrawing Member an amount equal to his positive capital account. The Operating Agreement did not address what happens if a Member withdraws and has a negative capital account. Mr. Warner withdrew from the LLC with a negative capital account of $399,657.00. The Company issued a K-1 to him showing income in the amount of $399,657.00 (being the amount of his negative capital account). Mr. Warner reported the income and paid income tax on that amount. Warner then sought to have the Court determine that the debt had been extinguished by the LLC issuing a K-1 and the fact that he recognized and paid income tax on the negative capital account balance.

The Court went through and discussed differing documents under the Internal Revenue Code that are issued by companies regarding debt forgiveness. The Court described the “minority view” in some states that a creditor is estopped from pursuing collection of the “debt” because it is inequitable to require a debtor to claim cancellation of debt as income as a component of his gross income and subsequently have to pay income taxes on that “debt” while still allowing the creditor then to collect it from the debtor (i.e. the withdrawing member).

The Court instead followed the “majority view” in other states which concluded that the issuance of the K-1 is simply a method for complying with the IRS reporting requirements and does not, alone, bar creditors from collecting payments of a debt. Therefore, the Court concluded that even though Mr. Warner paid income tax on a negative capital account balance of $399,657, he was still liable to the LLC for that amount of money as an outstanding debt to the LLC.

MY COMMENTS: The Warner decision seems like a very tough decision for Mr. Warner. He got hit twice having to pay income tax on $399,657 on the negative capital account and then still having liability to the LLC for the $399,675 negative capital account.

Members of an LLC need to stay cognizant of the status of their capital account and be especially cautious when withdrawing from an LLC. A withdrawing Member should confer with his/her lawyer and accountant prior to taking such action.

Yours very truly,
RAINEY, KIZER, REVIERE & BELL, P.L.C.
William C. Bell, Jr., Attorney at Law

This letter is intended to provide you with ideas for consideration in commercial transactions.  It is not intended to give a general solution applicable to all apparently similar individual problems, since slight changes in facts may require variance in legal advice.  Please contact legal counsel with specific questions.