Fred Witt PLC, Phoenix Federal Tax Attorney
   

August 2014

LLC Alert: Is Your LLC Compliant with Federal Law?

A thoughtful, well-drafted LLC operating agreement can address federal partnership tax, bankruptcy and diversity jurisdiction issues.

Fred Witt

 

Fred Witt

 

Generally, where state law intersects and conflicts with federal law, state law must give way to the supremacy of applicable federal law. This does not bode well for any LLC that has not carefully considered the impact of federal tax, bankruptcy and diversity jurisdiction laws. Complexity and uncertainty await.

As I discussed in prior LLC Alerts, an LLC is treated as a partnership for federal, state and local income tax purposes and for determining the existence of federal district court diversity jurisdiction, among others. While an LLC has some characteristics of a corporation, there are many differences. For example, a member's interest is not treated in the same/identical manner as a share of stock - and, it seems, the courts have had little trouble concluding the LLC (or a member interest) was on the losing end of the continuum.

The problems with federal law are not academic. There is case authority for the following:

  • An Arizona bankruptcy court bulldozed conventional wisdom that a chapter 7 trustee is a mere "transferee," concluding a trustee may have extraordinary powers to take over and appoint a receiver to operate the LLC and even liquidate and dissolve the entity. This is about as far from being stock-like as one could imagine.

  • The U.S. District Court for Arizona recently refused removal in a dispute between a limited liability company and a trust, finding no diversity jurisdiction and remanding back to the Superior Court of Arizona (the State court).

  • Failure to appreciate the diversity jurisdiction rules for LLCs may prove costly. A recent ruling may have the effect of moving future litigants closer to an award of attorneys' fees in favor of the prevailing party if an improper removal is sought. See 28 U.S.C. 1447(c).

What to do? Are solutions possible?

A thoughtful, well-drafted LLC operating agreement can address the partnership tax, bankruptcy and diversity jurisdiction issues. It may be time to engage in a diagnostic review and update to reflect these new developments. Make sure federal law is embedded in your document. An ounce of prevention