Failure to Issue K-1s May Impact Whether LLC Meets Diversity of Citizenship Test k1-legal-sm.png09 / 26 / 2020
Salameno v. Rawlings, 2020 U.S. Dist. LEXIS 171552 (S.D.N.Y. 9/17/2020)
When litigating in Federal Court, and seeking to establish diversity of citizenship, litigants learn that the Federal court will look through any LLC and focus on the citizenship of the LLC members. This can then raise a factual issue, as to whether or not a person is, in fact, a member. When examining the issue, courts will distinguish a person having merely an economic interest, from someone who has been duly admitted as a member, and whether under the applicable LLC Act, what are the statutory requirements for admission.
In Salameno, the NY federal court looked to apply Florida's LLC Act, and the standards in place for admission of a member. Interestingly enough, the court discussed how the Florida LLC Act had changed, from Chapter 608 (the Florida Limited Liability Company Act) to the Florida Revised Limited Liability Company Act (Chapter 605), effective January 1, 2014. That change which impacted the analysis of admission of a member meant that instead of Section 608.4232 being applied (by which consent to admit a member had to be in writing), Section 605.0401(3)(c) applied, by which consent to become a member need NOT be in writing.
The facts of Salameno at issue in the jurisdictional analysis were focused on the suggestion that a 49% interest had been "purchased" such that the buyer had become a de facto member. The original founder of a LLC and corporation, Ms. Rawlings, was alleged to have conned the Plaintiffs out of $561,000, and were sued for fraud, breach of contract, and an accounting. In bringing the case in the New York Federal court, the plaintiffs had to establish that the defendant entities they sued (a LLC and corporation) were citizens of another state distinct from the Plaintiffs, upon which diversity of citizenship would exist. While the state of incorporation establishes the citizenship of corporations, this is not true for LLCs. Thus, when it came to testing the LLC defendant, the analysis turned to establishing the citizenship of the members of that LLC defendant. Ms. Rawlings contended that diversity of citizenship was lacking, based on the allegation that a 49% interest in the LLC had been purchased by a buyer whose citizenship was in the same state as the plaintiffs. However, in looking at this 49% interest holder, the Federal court took the added step of suggesting that even if the 49% interest holder had a legal right to the economic interest, there was still the issue of membership. Florida's LLC laws require that the interest holder be duly admitted, with the consent of the other members. When conducting the limited evidentiary hearing for diversity of jurisdiction, the Federal court noted that there was no proffering of a written consent to admit the purchaser of the interest. That did not end the analysis, however. The Fedreal court then determined that because the Florida LLC law had been changed, to where consent to become a member need not be in writing, further factual development on this particular issue was important.
In conducting that analysis, the Federal court took note that no Schedule K-1 had been issued for the year in which the interest had been purchased. Accordingly, the Federal court determined that the purchaser of the interest did not qualify as a member, with respect to whose citizenship then needed to be evaluated for subject matter jurisdiction.
K-1 disputes, especially in the partnership context, involve some of the most complicated issues, and often involve intersection of Federal and state substantive laws. Resolving the disputes requires examination of underlying agreements, state laws, and the processes and procedures employed by the partnership entity in transmitting financial and tax information (inclusive of Schedules K-1) to the partner/member/owners. If the K-1 is in error, there is the requirement to take action promptly, first by adhering to IRS instructions and requesting correction, and then, if the K-1 is not corrected, taking action to contest the positions set forth within the four corners of the form (partnership items), by and through the filing of Form 8082, Notice of Inconsistent Treatment. Further consideration must be given to the possible application of the Bipartisan Budget Act of 2015 (the "BBA") and whether the centralized audit procedures are applicable, because of the presence of a pass-thru partner/member not otherwise exempt from its application.
If you have any need for assistance in this area, advising with respect to K-1 processes and procedures, or the BBA, Mr. Tufts at CPLS, P.A. can be reached at 407-647-7887.