Having a partner who has not put in his/her share of the required initial capital is a common LLC problem. The problem is often exacerbated when members sign a boilerplate operating agreement at the inception of business without first obtaining legal advice. The language of these form agreements ordinarily assumes all members have paid the required initial capital in exchange for their percentage interests stated in the agreements. Consequently, an LLC member who has not paid the required capital would be identified and listed as a member in the operating agreement with full voting and economic rights. When it comes time to distribute profits, such failure to contribute frequently results in discord between members and, in many cases, lawsuits, business disruptions, and potentially dissolution of the LLC.
One example of what can happen was discussed in the case of Blue Water Sunset, LLC v. Markowitz, an unpublished 2017 California Court of Appeals case. In Blue Water Sunset, LLC two partners started three LLCs as 50/50 owners. After a few years, one member alleged that the other member never paid the $1,000 initial capital to each LLC as required by the LLC operating agreements, and therefore was not a member. The allegedly noncontributing member contended that it had
transferred properties worth millions of dollars to the three LLCs, which should suffice as its initial capital contribution. The court held that the non-contributing member did not make the required initial capital contribution, and therefore was never a member. The court found that, pursuant to the operating agreement, the initial contribution is required for membership to the LLC, and the $1,000 initial contribution must be made in the form of cash (or check).
Unlike in Blue Water Sunset, LLC an LLC member’s failure to make the initial capital contribution does not necessarily result in reduction of his interest in the company.
A clearly drafted and well-thought-out LLC operating agreement is vital to an LLC’s continued success. LLC members should clearly define the required amount and form of the initial capital contribution in the operating agreement. A due date should also be specified. Provisions may be made in the operating agreements to penalize non-contributing members.
If properly structured in the operating agreements to cover the deficiency caused by a non-contributing member, a contributing member can elect among proscribed remedies in a well-drafted operating agreement to do any or some of the following:
- Withdraw the capital contribution
- Advance the fund as a loan to the non-contributing member
- Advance the fund as a loan to the LLC
- Advance the fund as a preferred contribution and receive preferential distributions
- Advance the fund and reduce the non-contributing member’s percentage interests in accordance with a predetermined adjustment formula.
These types of remedies may only be able to be enforced if set forth in the LLC operating agreement.\
A failure to make initial or additional capital contributions should be promptly documented and notices sent so that potential claims against the noncontributing member can be readily proven by LLC records.
Ultimately, LLC members should retain legal counsel when planning, drafting and enforcing remedies for a member’s failure to contribute required capital.
Implementation of many of these remedies involve complex income tax issues and can also lead to unintended consequences such as a “change in ownership” that triggers a reassessment of the real property owned by an LLC.
The information presented is not intended to be, and does not constitute, “legal advice.” Because each situation varies, and only brief summary information is provided here, you should not use this information as a basis for action unless you have independently verified with your own counsel that it applies to your particular situation.
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