How to Force an LLC Member Out – Judicial Dissociation
What happens when you’re in business with someone whose behavior harms the LLC but who refuses to leave voluntarily?
Ideally, you have a well-drafted buy-sell agreement or operating agreement that addresses this exact situation and clearly lays out next steps. If not, you may be able to go to court to pursue judicial dissociation, the court-ordered removal of a member from an LLC.
South Carolina courts are typically reluctant to take such a drastic step, but it can be done. This blog will cover what it takes for a court to grant judicial dissociation in SC according to state statute and look at a case where the appeals court did not grant judicial dissociation, reversing the circuit court’s earlier decision. Note: We previously covered this case, The Boathouse v. Richard Stoney (2024) (read it here), on the issue of whether a single member “class of one” can bring a derivative action in SC.
South Carolina Statute on Judicial Dissociation
South Carolina Code Section 33-44-601 lays out the many ways in which a member of an LLC may be dissociated from the LLC, with subsection (6) specifically listing the circumstances under which a member may be expelled by judicial determination:
- If the member engaged in conduct that “adversely and materially” affected business;
- If the member committed a “material” breach “wilfully or persistently” of the operating agreement or duty owed to the company and other members, as described in Section 33-44-409 (covering General standards of member’s and manager’s conduct); OR
- If the member’s conduct relating to the business made it “not reasonably practicable” for the business to carry on with that member.
If a member’s conduct fits into one or more of the categories above, he or she may be removed from the LLC by the court.
Factors to Consider Whether Judicial Dissociation Is Warranted
That’s what the law says, but it’s up to the court to apply it on a case-by-case basis.
In the Boathouse opinion, the SC appeals court cited an “instructive” decision from the Supreme Court of New Jersey, IE Test, LLC v. Carroll (N.J. 2016), which laid out several factors to consider (while noting that it’s not binding on the South Carolina court):
- The nature of the LLC member’s conduct relating to the LLC’s business;
- Whether, with the LLC member remaining a member, the entity may be managed so as to promote the purposes for which it was formed;
- Whether the dispute among the LLC members precludes them from working with one another to pursue the LLC’s goals;
- Whether there is a deadlock among the members;
- Whether, despite that deadlock, members can make decisions on the management of the company, pursuant to the operating agreement or in accordance with applicable statutory provisions;
- Whether, due to the LLC’s financial position, there is still a business to operate; and
- Whether continuing the LLC, with the LLC member remaining a member is financially feasible.
The New Jersey Supreme Court states that mere conflict isn’t enough to warrant dissociation. Members seeking to expel another member through forcible dissociation must “clear a high bar” and prove that it’s not reasonably practicable to carry on the business with the member.
The Boathouse case: Judicial Dissociation in Practice
All of that sounds well and good, but it’s very theoretical. What does it look like in real life?
In the Boathouse case, the circuit court granted a motion for judicial dissociation of a member, which the appeals court later reversed.
For a more thorough look into the interesting background of this case, read our previous blog. Briefly: Cousins Laurence Stoney and Richard Stoney are both members, along with other individuals, of an LLC that runs the popular Charleston-area restaurant The Boathouse on Breach Inlet. Over the course of many years, Laurence alleged, Richard misspent company funds, taking money earned by the Boathouse and spending it in his other businesses and on personal expenses such as vacations and polo ponies. Richard, through a different but related LLC, ended up owing the Boathouse LLC $4 million.
But the motion for dissociation was not against Richard, it was against Laurence. Laurence sought to bring a derivative action as a “class of one” against Richard for his conduct. In turn, Richard and a few other third-party Intervenors filed a motion to dissociate Laurence from the company. The circuit court granted the motion to dissociate Laurence, based on:
- Laurence denigrating the company to vendors,
- Laurence’s efforts to change ownership and management during Richard’s divorce, and
- Laurence’s efforts to purchase land that Richard had an interest in without disclosing his efforts to Richard
The court of appeals looked at whether this behavior reached the high level required for forcible judicial dissociation.
Why the Appeals Court Reversed the Circuit Court
The South Carolina Court of Appeals found that “none of these incidents evidence conduct relating to the Company’s business that would warrant judicial dissociation.” In addition, the animosity between the members was not substantial enough to warrant judicial dissociation, as much of the animosity stemmed from disagreements over Richard’s use (or misuse) of company funds.
As to the other factors laid out by the New Jersey court, cited above, the South Carolina appeals court notes that Laurence was not in a position to create a deadlock or interfere with the running of the business, owning just a 5% stake; the Boathouse restaurant still brought in money and was projected to continue with strong sales; and the LLC would not be prevented from continuing to operate if Laurence remained a member.
The appeals court ultimately held that the circuit court erred when it found Laurence “engaged in conduct relating to the company’s business which makes it not reasonably practicable to carry on the business with the member” and reversed the grant of the motion for dissociation.
A Better Option: Solid Corporate Governance Documents
You don’t know what the future holds for your LLC, but you can be sure that it won’t always be smooth sailing. So figure out what to do in advance, instead of deciding how to handle the storm only after it strikes. When a situation does arise in the future, you can turn to your corporate governance documents instead of the courts.
At the least, when you are going into business with another person you should have:
An Operating Agreement. An operating agreement lays out the roles and responsibilities of each party so everyone is clear on what his or her job is and knows when a member is not living up to his or her duties. An operating agreement often includes provisions for removing or dissociating a member in certain situations such as misconduct or breach of duty.
A Buy-Sell Agreement. A buy-sell agreement sets the rules for how and when changes in ownership occur due to things like death, disability, divorce, or dispute. Members can agree in advance on what to do if one member does not live up to his or her duties as outlined in the operating agreement, which could include buying him or her out. Read more about buy-sell agreements here on our blog.
It’s best to have these drawn up when you start up your business, while all members are still on good terms. However, if you’ve been in business for a while and still don’t have anything in place, you can do it now – it’s never too late.
For Corporate Governance Documents and Strategic Legal Advice, Call Gem McDowell
To draw up or review operating agreements, buy-sell agreements, and other corporate governance documents, or for strategic business advice, call Gem at the Gem McDowell Law Group. Gem and his team help South Carolina businesses and business owners with starting, buying, selling, and more. With over thirty years in practice in the state, Gem has the experience to help you grow, avoid mistakes, and protect your interests.
The Gem McDowell Law Group has offices in Myrtle Beach and Mt. Pleasant, SC. Call 843-284-1021 today to schedule your free, no-obligation consultation.
Partnership Representatives: What Partners and LLC Members Need to Know Now
Are you a member of a partnership or a multi-member LLC that’s taxed like a partnership? If so, you need to know about partnership representatives.
A partnership representative is an individual or entity that represents a partnership in front of the IRS in all matters including audits.
The term and role are relatively new. Partnership representatives (PR) went into effect in 2018 after being created in the Bipartisan Budget Act of 2015 (BBA), which repealed and replaced the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA). It replaces the role of the “tax matters partner” in TEFRA, though the two are not exactly the same (more on that below).
Importantly, the BBA also changed the way that the IRS can assess and collect taxes from a partnership due after an audit. Previously, those taxes were collected from the individual partners; now, they are collected at the partnership level – unless the partnership has opted out (more on that below, too). This process is more streamlined for the benefit of the IRS and may benefit partnerships, too.
All partnerships that file US tax returns and multi-member LLCs that are taxed as partnerships are affected. (For the sake of expediency, we’ll just use the term “partnership” throughout the rest of this blog as a shorthand for “partnerships and multi-member LLCs that are taxed as partnerships.”)
If your business is affected, here’s what you need to know.
Partnership Representatives
What is the role of the partnership representative?
In the IRS’s own words: “The partnership representative has the sole authority to act on behalf of the partnership for purposes of Bipartisan Budget Act (BBA) partnership audit procedures. The partnership and the partners are bound by the actions of the partnership representative under the BBA.” (Emphasis added.)
The IRS lists the following actions as things that a PR can do, noting that this list is not exhaustive:
- Entering into a settlement agreement
- Agreeing to a notice of final partnership adjustment (FPA)
- Requesting modification of an imputed underpayment
- Extending the modification period by agreement
- Waiving the modification period
- Agreeing do adjustments and waiving the FPA
- Extending the statutory periods for making adjustments by agreement
- Making a push out election
Ideally, the PR will have nothing to do, because as a business owner you want to have as little to do with the IRS as possible. But if your partnership is audited by the IRS, you want to be sure your PR is competent, honest, and trustworthy, because they have a lot of power to make binding decisions for the partnership and its partners.
Who can be a partnership representative?
A PR can be any individual or entity (including the partnership itself) that has a “substantial presence” in the US. An entity that’s a PR must appoint a designated individual to act on the entity’s behalf.
A “substantial presence,” as defined by the IRS for these purposes, is an individual or entity that has a US taxpayer identification number, a US street address, and a phone number with a US area code, and who is able to meet with the IRS in person in the US “at a reasonable time and place as determined by the IRS.”
A partnership must designate a PR on its tax return (IRS Form 1065 or 1066) each taxable year, as the PR does not carry over year to year. The designated PR can be changed in between tax returns by filling out IRS Form 8979.
Alternatively, eligible partnerships may opt out; more on that below.
Is a Partnership Representative the Same as a Tax Matters Partner?
A partnership representative is similar to a tax matters partner (TMP), but the two are not exactly the same.
What are the differences between a partnership representative and a tax matters partner?
Both a TMP and a PR represent a partnership in audits and other matters with the IRS. However, there are some important differences.
A TMP was required to be a partner of the partnership (or member of the LLC), while a PR can be any individual or entity that meets the requirements listed above. This is the most obvious difference between the two. This change allows partnerships to choose a different party, like a tax attorney or accountant, as their PR.
Also, a TMP represented the partnership to the IRS, but they did not have exclusive authority to do so; other partners could take part, too. A PR, on the other hand, has the sole and exclusive authority to do so.
Finally, the partnership and the partners are bound by the actions and decisions of the PR, as mentioned above. Previously, a TMP could bind the partnership but not the individual partners.
What this means for you, as a partner or member in LLC
If you’re a partner in a partnership or a member in a multi-member LLC that’s taxed as a partnership, here are some things to know and to consider.
You (may) have the option to elect out
Some partnerships are eligible to “elect out of the centralized partnership audit regime for a tax year,” to use the IRS’s words. By making the election to opt out, it means that any adjustments found during an audit will be processed at the partner level. By not electing to opt out, these adjustments will happen at the partnership level, which is now the default state.
To be eligible, a partnership cannot have more than 100 partners, each of which must be an individual, C corporation, foreign entity that would be treated as a C corporation if it were domestic, S corporation, or estate of a deceased partner.
A partnership that has opted out and then is notified of an audit may revoke their decision with the approval of the IRS.
Some advantages and disadvantages of opting out
The advantage of taking part in the BBA centralized partnership audit regime, i.e., not opting out, is that the situation is more streamlined for both the IRS and the partnership. Because an audit (or other matter) happens at the partnership level, individual partners do not have to (and cannot) deal with the IRS directly and do not have to amend their individual tax returns.
One disadvantage is that, depending on the nature of your partnership and your partners’ individual financial situations, it’s possible that assessing additional taxes at the partnership level could cost more than if it were done at the partner level.
Another disadvantage was mentioned before: the PR has a lot of power. In their role, they are authorized to make binding decisions unilaterally, which could lead to a situation that’s unfavorable to the partnership or some or all of the partners. The PR’s decision is binding, and individual partners do not have a right to appeal the PR’s decision(s) to the IRS.
Furthermore, under the BBA, the IRS only has to notify the partnership and partnership representative when initiating an administrative proceeding and thereafter only notify the PR. So it’s possible for an audit to occur without individual partners being aware it happened, even if in the past under TEFRA they would have known. (You can read more about the IRS’s BBA partnership audit process here.)
Discuss with the other partners/members and ensure your partnership agreement/operating agreement is updated
Some of the issues mentioned above can easily be handled by updating the partnership’s governance documents. This would allow your partnership to take part in the centralized partnership audit regime and designate a PR while providing more protections to the individual partners via your partnership agreement/operating agreement. For example, you could include a provision that the PR must notify all individual partners of audit proceedings, even if the IRS doesn’t require it.
Some issues to discuss:
- Whether the partnership (if eligible) will opt out or how that will be decided each year
- How the partnership will choose a PR each tax year
- Whether the PR must inform individual partners of audit proceedings, findings, decisions, etc., and how
- Whether and how partners have any say on decisions relating to an audit or other matter
- What to do if disputes between partners arise during or after an audit or other matter
Discuss these issues with your business attorney and make changes, as needed, to your partnership agreement or operating agreement.
Choose your partnership representative wisely
If your partnership accepts the default and does not opt out (or is not eligible to), then be very judicious about whom you designate as your PR. Hopefully, you will never need one, but if that day comes, you’ll want someone you can trust with the future of your business.
Call Business Attorney Gem McDowell for Help and Legal Advice
Gem has over 30 years of legal experience in South Carolina and he is ready to help you and your business. He can advise you on how to handle the issue of partnership representatives in your partnership or LLC and help you think through potential difficult situations that you may not have thought of.
Gem and his team not only help business owners with corporate governance documents like partnership agreements and operating agreements, they can help your business grow and thrive, all while keeping your assets protected. Call Gem and his team at the Mt. Pleasant office at 843-284-1021 today to schedule a free consultation.
Choosing the Right Business Entity at the Federal and State Level
As a business owner, it’s important to understand the differences between various business entities. Some of the differences include how the entity is structured, how it’s taxed, and what kind of liability protection if offers its owners.
Another difference that’s often overlooked is whether the entity is defined at the federal level or the state level. For instance, the corporation, partnership, and sole proprietorship are defined by the IRS at the federal level. The limited liability company, on the other hand, exists because of state statute. It’s treated as a corporation, partnership, or disregarded entity by the IRS for federal tax purposes.
Some entities look so similar at first glance, it can be hard to see the distinction between a business entity defined at the federal level and one at the state level. One example of this is the S-Corp versus the statutory close corporation.
Case in Point: Pertuis vs Front Roe (2018)
Even the Supreme Court of South Carolina failed to make the distinction between state and federal statute in a recent decision filed in July, 2018, Pertuis vs. Front Roe Restaurants, Inc. (find it here).
In short, Kyle Pertuis was the manager of three restaurants owned by three separate S-Corporations: Lake Point and Beachfront, both in North Carolina, and Front Roe, in South Carolina. All three S-Corporations were owned by Mark and Larkin Hammond. After working with the Hammonds for several years, Pertuis decided to leave, and this case is primarily about his ownership in the three restaurants and their valuation.
That’s not relevant to our discussion here, but what is relevant is the South Carolina Supreme Court’s assessment of whether the three S-Corporations should be amalgamated into a single entity or not. If yes, that means the three would be considered together as if they were one company. If no, the three should continue to be considered as three distinct businesses.
The Trial Court said yes, the three should be amalgamated, citing in part the fact that the Hammonds had “disregarded corporate formalities” including shareholder and board of director meetings. The Supreme Court said the trial court erred, because it overlooked the fact that all three companies were S-Corporations, which are statutorily permitted to disregard various corporate formalities including those of having shareholder and board of director meetings. The Court cites SC Code Section 33 Chapter 18, -200, -210, -220, and -230 to make these points.
But here’s where the Supreme Court erred: it failed to make a distinction between an S-Corporation (federal) and a statutory close corporation (state). The SC Code it cited is about statutory close corporations, not about S-Corporations.
S-Corporation Versus Statutory Close Corporation
An S-Corporation is a business entity that is defined by the IRS. A statutory close corporation is a business entity allowed by some states, including South Carolina.
S-Corporation
An S-Corporation is a business entity with shares and shareholders, just like a C-Corporation. Certain entities may elect to become an S-Corp by filing Form 2553 with the IRS. Unlike a C-Corp, S-Corp income, losses, deductions, and credits “pass through” to shareholders, who pay taxes on the income (or deduct the losses) on their individual federal income tax returns. This is the biggest advantage of the S-Corp and why many businesses elect to become one – to avoid the “double taxation” of the C-Corp. (Read more on C-Corp versus S-Corp here on this blog.)
Statutory Close Corporation
A statutory close corporation is a type of corporation that is defined by state statute. A “close” corporation is typically one where the shareholders are actively involved in managing the business. Not all states allow for statutory close corporations, but South Carolina does. Any corporation in South Carolina with one or more shareholder may elect statutory close corporation status by filing with the South Carolina Secretary of State.
The main reason corporations in the state elect statutory close corporation status is because it offers business owners greater freedom from corporate formalities and greater organizational flexibility than does a standard corporation.
Some provisions to ease the formalities are automatically put in place for your business once the election is made to statutory close corporation status. Other provisions are only put in place if those incorporating make an affirmative selection. These may be made by checking the appropriate boxes on the form articles. Lastly, business owners also have the option to have documents laying out management, elimination of by-laws, dissolution rights, and buy-sell provisions.
The election of filing for a statutory close corporation at the state level does not affect how the corporation is taxed at the federal level. An important thing to note is that the statutory close corporation is automatically taxed as a C-Corp unless it makes the election to be taxed as an S-Corp.
Corporations that elect statutory close corporation status find that under these less rigid rules, they can operate more like a partnership, with greater organizational flexibility and freedom from standard corporate formalities.
Understand How the Law Affects Your Business: Work with Business Attorney Gem McDowell
Choosing the right entity and structure for your business may be more complex than simply deciding on LLC or corporation or partnership. By not understanding the difference between federal and state levels of business entities, and what options are available to you, you could be missing out on some great advantages in your business.
For a better understanding of your options, or for help drafting contracts and corporate governance documents, call Gem and his associatess at Gem McDowell Law Group in Mt. Pleasant, SC. Schedule an initial consultation by calling 843-284-1021 today.
Did You Choose the Wrong Business Type?
Picking what kind of business you’re going to be – “choice of entity” – is one of the first and most important things you do when you start a business. It’s an area where many business owners can get into trouble because they don’t know what they don’t know. Beyond basic issues of personal liability and how many people are in your company, there are subtleties you may miss if you don’t know the law.
Here are some common business types, and why they may be the wrong choice for your business. (If you think you’ve already set up your business as the wrong entity, don’t worry; Gem and his associates can help you.)
Sole proprietors and partnerships
The benefits of sole proprietorship and partnerships
Many businesses default to these business types because they don’t require any formal federal or state paperwork to set up. (You should still look into whether you need licenses and permits, though.) If you start selling baby blankets online and making money, you’re automatically a sole proprietor. If you and your buddies start roasting coffee and selling it, you’re in a partnership. It’s very easy, which is why these are still very common business structures.
What to watch out for
The major drawback – and it’s a big one – of being one of these two types of business entity is that you have no liability protection. Your personal assets are not protected in case your business is sued or goes into debt. That means that you can lose your money, your home, your car, and any other assets you have if the business gets into trouble. For partnerships, you take even more risk, because you’re not just reliable for your own actions and debts you incur, you’re liable for those of your partners, too.
The bottom line
It’s better to choose a different business structure altogether than to accept the risk of putting your personal assets on the line.
Limited liability companies (LLCs)
The benefits of LLCs
The big benefit is liability protection. With an LLC, as long as you maintain a separation between business and personal accounts, you will be (in most cases) protected from being held personally liable for the debts of your business. An LLC is flexible because you can have a single-person LLC or an LLC with multiple people. For taxes, the income (or loss) “passes through” to the owners to include on their personal tax returns.
For all these reasons, the LLC is an ideal business structure for many companies.
What to watch out for
With LLCs, there’s more than meets the eye. Did you know that there are four ways to establish a limited liability company in South Carolina? Most people don’t. And when most people set up the business themselves, they inadvertently set it up as the wrong type of LLC.
An LLC can either be “term” or “at will” and can be “member managed” or “manager managed.” Let’s say you and your friend are in an LLC together and you don’t yet have a buy-sell agreement. If your friend dies, and your LLC is set up as “at will” instead of “term,” you have only a limited time to buy out their portion of the business, or the business dissolves.
Or let’s say you’re in an LLC with your business partner and your LLC is set up as “member managed.” Even if that person owns just 1% of the business, they can go to the bank and take out money in your company’s name, which you’re now on the hook for.
The bottom line
The LLC is a great business structure, but you need to make sure it’s set up as the correct type of LLC. There are four possible types of LLC, and only one is ideal.
Corporations
The benefits of corporations
As a business entity, the corporation is great because it’s robust and can grow easily with capital from investors. Most of the brand name companies you know are corporations. You can choose to be a C-Corp or an S-Corp depending on how you want to be taxed. This is a great choice for a company looking to grow with outside investors and shareholders.
What to watch out for
If you’re a regular corporation, you’ll be required to have a board of directors, hold regular meetings, keep meeting minutes, and have those minutes available to shareholders to review. Failure to do these things can lead to a Plaintiff’s lawyer asking a court to “pierce the corporate veil” when the company is sued. That is, blurring the line between what’s business and what’s personal. In the worst-case scenario, you could be personally liable and find yourself paying off the company’s debts with your own assets.
But you can sidestep these problems entirely by electing to become a “statutory close corporation” by filing with the State of South Carolina. Every corporation in South Carolina is eligible. You get the benefits of being a corporation, but you won’t be required to have a board of directors and hold meetings if you don’t want to.
The bottom line
If you’re already a corporation but your company is not meticulous about holding board meetings and maintaining minutes, look into becoming a statutory close corporation. And even if you are meticulous, it’s just one more layer of protection for you.
Get Help Setting Up Your Business
The majority of companies are not set up in a way that’s optimal for the business owner, says Mount Pleasant business attorney Gem McDowell. If you want to discuss choice of entity for a new or existing business, call Gem and his associates at (843) 284-1021 today. They can help you evaluate your options and choose the entity that’s right for your business.
