How Operating Agreements Can Prevent Disputes Over Owner Contributions

Many privately held businesses rely on infusions of cash from their owners in order to start a business and, in many cases, fund its expansion. The infusions can be small, such as amounts needed to fund a payroll period while awaiting payment of a customer receivable, or can be large, such as funds required to purchase equipment to enable long-term growth.

When cash (or other forms of value) is infused into a privately held company, such as a multi-member LLC, the transfer can be structured as either a loan or a capital contribution. The distinction between loans and capital contributions—for the business, its owners, and its creditors—is significant.

Is it a Loan or a Capital Contribution?

Capital contributions are equity investments an owner makes in his or her business. The Michigan Limited Liability Act (MCL 450.4102(2)(d)) defines a “contribution” as “anything of value that a person contributes to the limited liability company as a prerequisite for, or in connection with, membership, including cash, property, services performed, or a promissory note or other binding obligation to contribute cash or property, or to perform services.”

A loan, on the other hand, is a debt owed by the company.

The classification of a transfer—as a loan or a capital contribution—has important implications. For example, the classification dictates how the repayment is treated for tax purposes for the owner. If it is a loan, then the repayment is tax free. If it is a contribution to capital, then the repayment may be treated as a taxable dividend to the shareholder.

The classification also affects whether the business can deduct interest payments on the advances. It can if it’s a loan, but cannot if it’s a contribution to capital.

Because classification has important implications, courts are often asked to characterize the nature of a cash transfer to a business as either a loan or a contribution.

A common framework which courts use to determine whether a transaction should be characterized as either debt or equity was established by the U.S. Court of Appeals for the Sixth Circuit (commonly referred to as the “Roth Steel Factors”).

The Roth Steel Factors look beyond the intent of the parties and require an analysis of a series of factors such as (but not limited to): (i) names given to the instruments, if any, evidencing the indebtedness; (ii) presence or absence of a fixed rate of interest and interest payments; (iii) source of repayment; and (iv) adequacy or inadequacy of capitalization.

In short, the loan versus capital contribution question requires a fact-intensive analysis.

Practical Implications for Business Owners

The manner in which transfers of value from owners to their business are characterized can have tax consequences. It can lead to disputes with creditors if the business is forced into bankruptcy, because loans/debts are entitled to a higher priority in bankruptcy than equity. And it can result in disputes between owners, themselves, when a business relationship sours (as many do).

In our practice, we have seen many instances where business relationships break down and the owners end up squabbling over issues such as:

– Whether a transfer was a loan or capital contribution
– Whether one owner’s “sweat equity” was the equivalent of another’s cash transfer
– Whether an operating agreement obligated one owner to make a contribution but not another

An example of how these issues play out in the real world is described in a case between two business partners in the State of New York, Gary Duff and Peter Curto, who were each 50-percent members in an LLC. Their business failed and Duff initiated a lawsuit against his partner, Curto, alleging that he (Duff) made over $500,000 in capital contributions to the business and Curto made none. Duff asserted claims including breach of contract and unjust enrichment against Curto.

The LLC’s operating agreement provided that “[u]pon the execution of this Agreement, each Member shall contribute cash and/or property to the Company as set forth opposite their names in Exhibit A” to the agreement.

The problem was that the column on Exhibit A with the header “Initial Cash Contribution” was left blank. Accordingly, the court found that the operating agreement was ambiguous as to whether an initial cash contribution was required by both parties. Because of the ambiguity, and the fact that Duff reported a recourse loan to the LLC on his tax return, the court ruled in favor of Curto on summary judgment.

There are many other examples of cases between business owners involving disputes over contributions to privately held businesses. In 2016, the Michigan Court of Appeals, in Copacia v Ginzinger, analyzed a dispute between two 50/50 owners in an LLC formed in 1998. One of the owners contributed funds when the financing for a project had to be restructured, and later sued the other owner for 50 percent of the operating expenses and costs pursuant to a purported oral agreement between the parties.

The court ruled in favor of the non-contributing party because, among other factors, the Michigan Limited Liability Act (MCL 450.4302) states that “a promise by a member to contribute to the [LLC] is not enforceable unless…in writing and signed by the member.” Moreover, the parties’ operating agreement, itself, provided that to be valid, any change in the LLC operating agreement must be “in writing and signed by all of the parties to” the LLC operating agreement.

Accordingly, the court rejected the plaintiff’s breach of contract claim, which it characterized as an “attempt to circumvent the plain language of the LLC operating agreement, which restricted plaintiff’s remedy to reallocation of the member’s sharing ratios.”

The Solution: A Clear, Thorough, and Enforceable Operating Agreement

What these cases and others make clear is that the best way to avoid disputes, and the possibility of protracted and costly litigation is to have an effective operating agreement in place.

To avoid disputes between owners, an operating agreement should address issues such as how ownership interests are allocated, the amount and manner in which initial and additional capital contributions will be made, and how unexpected events which may impact ownership interests (or the very existence of the business), such as death, withdrawal from the business, bankruptcy, or failure to make capital contributions, will be handled.

Without a clear operating agreement in place, it is often left to courts to decide the outcome, which rarely results in a positive outcome for anyone. At Dalton & Tomich, we help Michigan small and medium-sized businesses and their owners create effective operating agreements. If you require helping in incorporating a business, creating an operating agreement, or have questions about your existing operating agreement, please contact Zana Tomich.