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Investing in LLCs

Sometimes founders form LLCs as an easy way to get started.

Limited liability companies (or LLCs) can be simpler to form than corporations. LLCs also have the benefit of being pass-through entities for tax reasons by default. Meaning, the losses flow through to the personal tax returns of the owners, unless an election to be taxed as a corporation is made.

important The financial and tax consequences of your investment depend on how the LLC is taxed for federal income tax purposes. This is a legal and business due diligence point you will want to run down right away.

It is not uncommon for founders to have forgotten what their tax accountant did when they formed the company. If you are considering investing in a business organized as an LLC, you must confirm the tax classification of the LLC. It is preferable to do this sooner rather than later. Don’t assume that because the company is formed as an LLC that it is taxed as a partnership. For federal income tax purposes, an LLC can be classified as either:

  • a disregarded entity (if it is owned by one person)*;

  • a partnership;

  • an S corporation; or

  • a C corporation.

caution You will want to know the tax classification of the entity sooner rather than later in your investment process because investments in pass-through entities give rise to a number of issues that you might not want to spend time confronting.

If the LLC is taxed for federal income tax purposes as a partnership, but it intends to convert to a C corporation later, you may want to require the LLC to convert to a C corporation prior to your investment. If you invest in an LLC taxed as either a partnership or an S corporation, you will be taxed on the LLC’s income even if no cash is distributed to you to pay the tax. In other words, investing in an LLC can unnecessarily complicate your personal tax situation. See the tax issues section below.

You may, however, want to invest in an LLC taxed as a partnership that intends to stay an LLC taxed as a partnership. In addition to the single layer of taxation and its ability to pass through losses, other advantages of retaining the LLC form include the abilities to:

  • allocate income and losses in a manner disproportionate to ownership;

  • spin off or split up assets or businesses in a tax-efficient manner; and

  • consummate an asset sale and have the gain largely qualify as capital gain.

It is not always the case that investing in an LLC is the wrong choice. But be careful, because it frequently is. Below we will discuss some of the challenges with investing in LLCs and some things to watch out for.

Tax Issues With LLCs Taxed as Pass-Through Companies

LLCs with multiple owners who do not make any special elections are taxed as partnerships for federal income tax purposes. Under the federal tax law, partnerships do not themselves pay the federal income tax on their income. Instead, their owners pay the federal income tax on their share of the income allocated to them. This can be problematic for an angel investor for a number of reasons. See the discussion about investing in S corporations.

cautionIn this section we discuss the potential problems of investing in an LLC taxed as a pass-through company:

  • Pass-through taxation. If you invest in an LLC taxed as a pass-through company (meaning, either as an entity taxed as a partnership or as an S corporation), the LLC itself, as an entity, will not pay any federal income taxes. Instead, its owners will have to report on their tax returns and pay the tax on the income that the LLC generates—even if the LLC does not distribute any cash to its owners. Most angel investors do not want to invest in a company that will cause them to have to pay tax on the entity’s income, regardless of whether any cash is actually distributed to them.

    • Investors in LLCs should consider ensuring that the LLC agreement requires the LLC to distribute sufficient cash to owners so that you may pay the tax on the LLC’s income allocated to you. However, some LLC agreements do not mandate tax distributions.
  • State income taxes. LLCs are also problematic for state income tax purposes. If you invest in an LLC, you might become liable for state income taxes in states in which the LLC does business but in which you are neither a resident nor a visitor. For example, an investor who is a resident of a state such as Washington, which does not have income tax, may become subject to income taxation if they invest in an LLC doing business in a state with income tax, such as California. This could be a very unwelcome and expensive surprise.

  • No qualified small business stock benefit. Another negative aspect of investing in LLCs is that LLCs cannot issue qualified small business stock. Qualified small business stock is advantageous because it may qualify for special reductions in long-term capital gains tax treatment on sale (including up to 100% of the gain being excluded from tax entirely). This is not possible with LLCs.

  • Difficulty with understanding allocations. LLCs are also problematic because of the complex tax rules governing how income is allocated to the owners. You might receive a Form K-1 from an LLC, indicating your distributive share of the LLC’s income, loss, expense, credit, and other tax items—and not understand what it is you were allocated or why.

  • Delay in tax documents. If an LLC sends you a Form K-1 for your taxes, you may not receive that document until September following the end of the tax year.

Challenges As A Minority Investor In An LLC

Voting Rights

Another problem with LLCs is that the LLC agreement may contain a variety of provisions that are detrimental to the LLC’s minority owners. For example, because the LLC agreement is a contract in which the LLC members can essentially agree on anything (to waive fiduciary duties, for example), it has to include an amendment provision specifying how the agreement can be modified.

caution Companies are not going to want to have an amendment provision that requires unanimity, because that would hamstring the company and give any one member the right to hold the company up. As a result, if you are a minority investor in an LLC, you are probably going to be asked to sign an agreement that says it can be amended without your consent. This might make you uncomfortable.

You may want to ask for protective provisions, meaning special voting rights of just the investors, just as you can when investing in a corporation. It is possible to negotiate for just about any type of special voting rights you want in an LLC.

At the very least in these situations, you should ask that the amendment provision be written such that no amendment can single out or treat any member differently from the group, or require any one member but not others to put in additional capital, guarantee any debt, or otherwise cause any member to have a personal liability. Additionally, you may want to specify what types of amendments require your consent—such as requiring the members to contribute additional capital.

Potential For Capital Calls

importantAs alluded to above, an LLC agreement could specify that a manager or a majority of the members can require capital contributions from all members. Review the agreements carefully to insure that you will not be on the hook to make a larger financial commitment than you had intended. Make sure your investment documents don’t obligate you to put more money into the company. This is not an uncommon provision in an LLC agreement.

exampleJoe knew an investor who invested in a bar, and the LLC agreement obligated all of the members of the LLC to put additional capital in upon the majority consent of the members. This was basically a blank check the investor was signing up for!

Investor Protective Covenants

You can ask for all of the same investor protective covenants in the LLC context that you can ask for in the corporate context. Those might include:

  • Information rights. For example, the rights to receive regular accounting reports, and have access to accounting information.

  • Disclosure and approval of conflicted transactions. In other words, the investors must approve insider transactions* after disclosure of all material facts related to the insider transaction.

  • Right of first refusal. Meaning, the right to be the first to purchase shares other members are selling.

  • Co-sale rights. The right to sell your shares alongside the founders, if the founders are selling some or all of their shares.

  • Participation rights. The right to buy more shares if the company sells more in an equity financing.

Withdrawal

caution If the managers can indebt the LLC or require capital contributions, you may want to exit the LLC immediately. But frequently, LLC agreements preclude an owner from exiting or withdrawing.

If you invest in an LLC, you might want to negotiate for the right to withdraw from the LLC and convert your interest into the right to receive an amount of cash upon written notice from you under certain circumstances, such as:

  • The LLC fails to give you the information you need to file your taxes in a timely manner.

  • The LLC fails to observe your information rights or other rights you’ve negotiated.

Another approach is to invest through an LLC that you create and own specifically for making investments. With this approach, if your LLC becomes liable somehow to the portfolio company, then at least that liability will not become your personal liability, but will only be the liability of the LLC you formed to make the investment.

Non-Compete, Non-Solicitation Agreements

Frequently, LLC agreements will include non-compete and non-solicitation (of customers and potentially employees) provisions that attempt to:

  • bind all owners regardless of whether the owner provides services to the company (this doesn’t make sense, but is common), and

  • broadly apply to any and all businesses whatsoever that the LLC is currently engaged with or becomes engaged with.

caution These provisions can be problematic if you have investments across the industry. If you are not a service provider to the company, or if you were once but are no longer a service provider to the company, you should not be bound by a non-compete or non-solicitation agreement.

LLC Agreements Are Complex

LLCs are also problematic because LLC agreements can be long and difficult to understand. The statutes under which LLCs are created typically allow the parties to contractually agree on anything. This means LLC agreements wind up covering a lot of different subjects. To give you a short list, your average LLC agreement will contain provisions addressing the following:

  • economics

  • governance

  • tax allocations

  • cash distribution

  • new member admission

  • transferability of units (more specifically, restrictions on transfers)

  • amendment of the agreements

  • withdrawal provisions.

LLC agreements may also contain buyout provisions.

Shortlist of Questions for Consideration in Becoming a Minority Member of an LLC

important If you’re considering becoming a minority member of an LLC, make sure you’ve asked and have received satisfactory answers to the following questions:

  1. Are you on the hook for anything personally, or could you be on the hook for anything personally?

  2. Do you have the right to withdraw from the LLC, or are you stuck?

  3. Can the majority members amend the LLC agreement without your consent?

  4. Does the LLC agreement bind you to a non-compete, or a non-solicit?

  5. Have you confirmed the LLC’s tax status? Did it check the box to be taxed as an S corporation?

  6. If the LLC is taxed as a pass-through company, does the LLC have to distribute cash to you so that you can pay the taxes on the LLC’s income?

  7. Do you have voting rights? Are they meaningful or are you such a minority that it won’t matter?

  8. Does the LLC agreement say that conflicted interest transactions have to be approved by at least two independent managers or owners (members) who are not conflicted?

  9. Do you have good information rights?

  10. Are there transfer restrictions on your units? Can you sell your units? Can others sell theirs despite the fact that you can’t sell yours?

  11. Do you have co-sale rights?

  12. Are your units subject to rights of first refusal?

  13. Do you have participation rights in the company’s next financing?

  14. Are you subject to a drag-along agreement? Is it suitably drafted?

  15. Have you confirmed that you will not be taxed as a result of your admission to the company?*

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