On multiple occasions, I have reviewed or updated a limited liability company’s (“LLC”) operating agreement and come across what is known as a deficit restoration obligation (“DRO”) provision. These provisions are likely the result of an uninformed attorney modifying a partnership agreement and turning it into an LLC operating agreement. Since the majority of LLCs in the U.S. are taxed as partnerships, many if not most of the tax provisions of a partnership agreement can be used in an operating agreement for an LLC taxed as a partnership. However, that is not the case when it comes to DROs, which can result in unlimited liability to the members of the LLC.
A company that is taxed as a partnership files a Form 1065 and reports all the income and loss for the year. Once aggregated, the income and loss is divided among the partners and each partner receives an allocated share, which is reported to each partner on a Schedule K-1. A partnership agreement or operating agreement defines how the division of income and profits of a company taxed as a partnership should occur. Under the partnership tax rules of Internal Revenue Code (“IRC”) Section 704(b) and Treas. Reg. Section 1.704-1(b), the allocation of profits and losses between partners or members of a company taxed as a partnership must have “substantial economic effect.” Essentially, this means that the tax liability has to follow economics. If one partner will ultimately receive the cash reported as income by a partnership, that partner must also pay the associated tax. Alternatively, if a partner will ultimately bear the burden of the loss or expense, that partner should also be allocated the tax deduction. The partnership tax law allows significant flexibility as long as the rules of substantial economic effect are followed. This may seem simple on the surface but can get a little confusing since not all income or loss is immediately distributed to the partners. For this reason, another requirement for allocations among partners to have “substantial economic effect” is that the partnership maintains a capital account for each partner. Basically, these capital accounts reflect what each partner would receive if the company liquidated. At the end of a tax period, the income and loss from the partnership is calculated, allocated among the partners and added or subtracted to the balance in each partner’s capital account. Contributions and distributions also affect a partner’s capital account. The concept is very similar to a bank account that earns interest, pays bank fees, receives contributions and makes distributions.
Sometimes the economics of a partnership arrangement is not as simple as each partner receiving income or loss based on a partner’s membership interest percentage. For example, two partners may decide that one of the partners will be allocated the first $100,000 of earnings and the other partner gets nothing until the company’s earnings exceed $100,000, at which time they will share the profits 20/80. Maybe it’s the reverse and one partner assumes all the company losses so that his or her capital is depleted down to zero before the other partners lose anything. Going even further, the partners can agree in a partnership or operating agreement to have one partner be allocated enough losses or receive a large enough distribution to incur a negative capital account; and it is in this situation where a DROs may come into the picture. The partnership tax laws and substantial economic effect only permit a partner to have a negative capital account in limited circumstances. One of those circumstances is when a partnership or operating agreement includes a DRO. A DRO is a promise by a partner to restore the negative capital account in the future either by a contribution to the partnership or by a later allocation of company income designed to bring the partner’s capital account balance back to zero or positive. Theoretically, this makes sense because if a partner is going to be allocated a tax loss he or she has to bear the economic burden of that loss and therefore must contribute cash or be allocated a future tax liability (with no cash distributed by the partnership to help cover the tax). For example, if a partner has a negative $5,000 capital account and the partnership has a deficit restoration obligation, the partner is obligated to contribute $5,000 to the partnership at some time prior to liquidation of the company in order to bring the partner’s capital account balance to zero. If the partnership liquidated the day after the partner made the $5,000 contribution, the partner would get nothing from the partnership because that partner’s capital account would be a zero balance.
When an LLC includes a deficit restoration provision in its operating agreement, the result can be an unlimited liability for its members. Having unlimited liability is expected in a general partnership or by a general partner in a limited partnership, but not to members of an LLC. A DRO in an LLC results in unlimited liability because a large legal judgment against the LLC could wipe out all the LLC assets, with any remaining amounts owed becoming an unfunded liability. The offsetting balance sheet item would be negative capital accounts.
For example, suppose a company had $200 of assets and those assets were financed with $50 debt and $150 equity (capital accounts). The balance sheet would look like this:
$200 Assets = $50 debt + $150 equity (capital accounts)
If the LLC incurred a judgment against it in the amount of $500 and the creditors took the available assets the balance sheet of the company would be as follows:
$0 Assets = $350 debt – $350 equity (capital accounts)
A DRO would require the partners to restore their capital accounts prior to any liquidation of the company. If the partners attempted to amend the operating agreement to eliminate this issue at a point that is too close to a judgment or at a point subsequent to judgment there is a reasonable likelihood that the amendment could be seen as a fraudulent transfer of rights between the company and its partners.