Monica Lin, Esq. MBA
Where Is The Money - LLC Members' Failure To Pay Initial Capital
(Written by Monica Lin, Esq., originally published by California Lawyers Association’s Partnerships and Limited Liability Companies Committee, Business Law Section, on October 4, 2019)
Having a partner who has not put in his share of the required initial capital is a common but distressing problem for people who go into business by forming an LLC (limited liability company) together. It puts a strain on the company’s financial resources, and jeopardizes the company’s ability to operate profitably.
To make the problem worse, often LLC members sign boilerplate operating agreements at the inception of business without obtaining legal advice. The language of these form agreements usually assume all members have paid or will promptly pay the required initial capital in exchange of their percentage interests stated in the agreements. As a result, an LLC member who has not paid the required capital would continue to be identified and listed as a member in the operating agreement with full voting and economic rights (at least on paper). After a period of operation or when it comes time to share profits, such failure to contribute, coupled with improper documentation, will almost certainly lead to a fallout between partners which can lead to lengthy lawsuits, business disruptions, and even dissolution of the LLC.
For example: Two partners started three LLCs as 50/50 owners. After a couple 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 non-contributing 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). (See Blue Water Sunset, LLC v. Markowitz, 2017 Cal. App. Unpub. LEXIS 486.)
Note that these types of cases can be very fact-specific. An LLC member’s failure to make the initial capital contribution does not necessarily always result in reduction of his interest in the company.
As demonstrated in the case above, having a clearly drafted and well-thought-out LLC operating agreement is vital to an LLC’s continued success. Timely and accurate documentation of LLC members’ capital contributions and any failure to contribute is also crucial.
First and foremost, LLC members must take care to clearly define the required amount and form of the initial capital contribution in the operating agreement. A due date must also be specified. Provisions should be made in the operating agreements to penalize non-contributing members, in the event that a member fails to contribute in full or timely. To cover the deficiency caused by a non-contributing member, a contributing member can elect 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 should be provided for in the LLC operating agreement, so that a chosen remedy can be enforced when needed. Any failure to make initial or additional capital contribution must be promptly documented and notices should be sent, so that potential claims against the non-contributing member can be readily proven by LLC records.
Lastly but most importantly, LLC members should always retain legal counsel when planning, drafting and enforcing remedies for a member’s failure to contribute required capital. The implementation of these remedies can 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.
This eBulletin was prepared by Monica Lin at CEO Law (lin@CEOFirm.com),
Chair of Publications, Partnerships and LLCs Committee, California Lawyers Association.