Why Well Drafted Partnership Documents Matter: Court Holds that Funds Paid to LLC By Members After Initial Capital Contributions are Loans by Default

Why Well Drafted Partnership Documents Matter:  Court Holds that Funds Paid to LLC By Members After Initial Capital Contributions are Loans by Default

The following illustrates why well drafted operating, partnership, or shareholder agreements among business partners (the type of agreement is related to the type of entity) are essential.  And it is substantially more cost effective to pay a professional to properly draft these documents up front as opposed to litigating the matter later.

As the New York Law Journal wrote recently, on February 18, 2015, the Second Department issued a decision in Chiu v. Chiu, 2015 NY Slip Op. 01427, holding that funds paid by a member to an LLC should be treated as loans, rather than contributions to capital, in the absence of evidence that the parties intended them to be capital contributions.  This matters because capital contributions dictate equity and initial payments of cash to an LLC are generally treated as capital contributions.  After that, however, things can get murky as occurred in this case because subsequent payments typically will be assumed to be loans unless a specific intention that the payment should be treated as a capital contribution is set out in the operating agreement.

In Chiu, two members of an LLC litigated their respective ownership shares and the value of those shares. Reversing a trial court decision after trial that one of the members had only a 10 percent ownership interest, the Second Department explained:

“After a joint nonjury trial, the Supreme Court issued a decision finding that although Winston Chiu initially had a 25% membership interest in the LLC, subsequent capital contributions by Man Choi Chiu had the effect of reducing Winston Chiu’s membership interest to 10% and increasing Man Choi Chiu’s membership interest to 90%. . . . Here, the Supreme Court properly determined that the LLC’s records, which included the LLC’s tax returns for the years 1999 and 2000, established that Winston Chiu’s initial membership interest was 25%. Although Man Choi Chiu contends that the LLC’s records were incorrect, he cannot subsequently take a position contrary to that taken in the income tax returns which he admitted that he signed. However, the Supreme Court incorrectly determined that the subsequent contributions by Man Choi Chiu should be treated as capital contributions, and not as loans, as the record was bereft of any evidence of an agreement between the members to such treatment. Accordingly, on the date of his withdrawal, Winston Chiu’s membership interest remained at 25%.”

(Internal quotations and citations omitted) (emphasis added).

Had these individuals simply added a provision to their operating agreement stating how subsequent contributions or payments to the LLC would be treated, they would not have had any confusion about the effect of the additional payments by one partner.

Portions of this post were taken from “Recent New York Decisions Regarding Defamation and Business Divorce”, NYLJ, 3/23/15

This blog post is not intended to consist of legal advice and you should always consult with a lawyer before acting on anything you find on the Internet.  If you have questions or comments about this post, about the topic, or if you need legal assistance, you should feel free to give us a call or send us an email.