In prior postings, I have discussed how membership has its privileges, but how does a person know if they are in fact a member? Washington’s LLC Act provides two different standards for membership depending on the time period a member is admitted. For the admission of “the initial member” a person becomes a member upon the later occurrence of 1) the formation of the LLC or 2) when the person’s “admission is reflected in the records” of the LLC. For admission of other members after the “initial member,” the default rule in the Act is for admission to occur “upon the consent of all members and when the person’s admission is reflected in the record” of the LLC. RCW 25.15.116.
What if the sole “records” of the LLC are the tax return? A recent case out of New York gives an answer (while the case involves an LLP as opposed to an LLC, it is still instructive).
Barrison v. D’Amato & Lynch LLP
D’Amato & Lynch LLP (the “LLP”) was founded in the 1970s with two founding partners. Around 1995, the LLP began issuing Barrison with annual K-1 statements indicating he was a General Partner with a capital account. Barrison was never informed as to whether he had an equity interest at the firm, nor was he asked to make a capital contribution to the Firm, nor did he enter into a written partnership agreement. In 1999, one of the two founding partners passed away. In April 2002, D’Amato and Lynch Jr. executed documentation stating that they were the only General Partners at the Firm. D’Amato died in 2007, leaving Lynch Jr. as the sole general partner.
After significant difficulties in the relationship between Barrison and Lynch Jr., Barrison brought litigation alleging he was a general partner on the basis that he received a K-1 since his employment began. Furthermore, Barrison sought dissolution of the firm since, as a general partner (in his eyes), he held the right to request such dissolution.
The New York trial court determined Barrison was not a general partner stating, “[t]ax returns, without any other indicia of partnership are insufficient” to establish a person as a partner. Additionally, the court stated Barrison “[h]aving failed to make any inquiries, despite indications that he was not an equity partner, plaintiff’s reliance on the K-1’s was unreasonable as a matter of law.”
While receiving tax documents in the form of a K-1 can serve as an indication of partnership or membership status, such evidence alone is insufficient to establish partner status. Additional factors such as sharing in profits and losses, exercising joint control over the business, making capital investment, and possessing an ownership interest in the partnership may help substantiate partnership status. The existence of such factors will almost certainly go farther than merely receiving a K-1.
So what are we to make of the “I’m a partner because I have a K-1” argument? Do not rely on it. Rather, a fully executed agreement with the consent of all the members or partners is your best practice.
For more Washington business entity law considerations, refer to this blog every Wednesday at 12 PM, noon.