A recent decision by Vice Chancellor Donald F. Parsons, Jr. of the Delaware Chancery Court in Duff v. Innovative Discovery LLC, C.A. No. 7599-VCP (Del Ch Dec. 7, 2012), garnered much attention primarily for its holding that Section 18-111 of the Delaware LLC Act (“Interpretation and Enforcement of Limited Liability Company Agreement”) gives Chancery Court, which generally functions as a court of equity jurisdiction, subject matter jurisdiction even over lawsuits essentially seeking money damages arising from the alleged breach of a Delaware LLC operating agreement.

But that’s not what I want to talk about. What caught my eye was the underlying dispute over a tax-related provision in a February 2012 redemption agreement under which two members of a Delaware LLC sold their membership interests back to the company. At issue was the former members’ personal income tax liability for that portion of the LLC’s 2011 net income allocated to the former members on their form K-1’s but not distributed to them.

This is not the first time I’ve written about how the issue of taxes on “phantom” income can bedevil owners of interests in pass-through entities who sell their interests without ascertaining and negotiating protection against subsequent net income allocation on their K-1 in excess of amounts actually received by them. In August 2011 I wrote about a New York case where the selling 25% shareholder under a buy-out agreement involving an S corporation unsuccessfully sued for reimbursement of his personal income taxes on $75,000 phantom income. The buy-out agreement included no provision for indemnification of such taxes and no buyer warranty that the seller’s future K-1 would exclude phantom income.

Unlike that case, in Duff the parties thought about the issue and included in the LLC membership redemption agreement a provision addressing the selling members’ future K-1’s. The problem — at least according to the sellers in their subsequent lawsuit — was that the provision as drafted did not jibe with the parties’ intent to protect the sellers against taxes on phantom income for the prior and current tax years.

Until the redemption of their interests in February 2012 for $1.3 million each, the two plaintiffs in Duff each owned 17.5% of the LLC. Section 8(i) of the redemption agreement, entitled “Distributions for 2011 and 2012,” stated as follows:

The Company hereby covenants and agrees that the total dollars (including value of all kind) distributed or paid to Seller from the Company and/or IDNY in calendar year 2011 was $105,000. The Company hereby covenants and agrees that the total dollars (including value of all kind) distributed or paid to Seller from the Company and/or IDNY in calendar year 2012 was $0. The company shall file, or cause to be filed, all tax filings, disclosures and returns of the Company and IDNY consistent with those amounts. [Emphases added.]

In April 2012, the LLC issued a K-1 to each of the sellers that reflected the stipulated $105,000 distribution but also reflected pass-through, taxable, net income allocation to each of $231,354 for 2011, i.e., approximately $126,000 more than was actually distributed to them in 2011 as stated in Section 8(i). The additional allocation required the sellers to incur over $40,000 each in additional federal and state taxes.

The sellers thereafter sued in Delaware Chancery Court seeking, among other claims, to recover the additional taxes based on Section 8(i). The LLC moved pre-answer to dismiss the claim, contending that the plain meaning of Section 8(i)’s reference to amounts “distributed or paid to Seller” could not be interpreted to cover phantom income “allocated” to them on their K-1’s. The sellers argued that Section 8(i) as drafted did not reflect the true intent of the parties which, based on alleged verbal communications, was to protect the sellers against tax liability for having income allocated to them above $105,000 in 2011. The sellers urged the court to reform the redemption agreement based on the doctrine of mutual mistake, to achieve the “real agreement” of the parties.

In his decision, Vice Chancellor Parsons examined closely the complaint’s allegations and ultimately concluded that they sufficiently pleaded a valid cause of action for reformation based on mutual mistake. Specifically, the complaint alleged conversations among the parties including a conference call in January 2012 during which the company representative assured the sellers that he shared their understanding that Section 8(i) capped their taxable income for 2011 at $105,000. “Thus,” Vice Chancellor Parsons explained,

while the parties conceivably intended Section 8(i) of the Redemption Agreements to limit the tax liability of Duff and Carp, as Plaintiffs allege, the Agreements failed to accomplish that purpose because they refer to an amount that was “distributed” as opposed to “allocated” as income. Thus, the facts alleged conceivably could support a finding of mutual mistake.

The case presumably now proceeds to expensive discovery and a trial at which likely the court will have to sort through and weigh conflicting accounts of oral communications bearing on the parties’ subjective intent, i.e., it may boil down to a credibility contest.

As I see it, the takeaways from Duff for business owners and their counsel in buy-out transactions involving pass-through entities are as follows:

  • When an owner of an interest in a pass-through entity sells the interest before company returns and K-1’s have been filed for any period prior to the transaction, the seller is at risk of incurring taxes on phantom income, the accounting for which normally is left under the exclusive control of the ongoing owners.
  • The allocation of phantom income to a former owner, the tax liability for which is not assumed by the company, represents a transfer of wealth to the ongoing owners no less real than the dollars exchanged at the closing.
  • Unless both (a) the termination of the ownership interest being redeemed or transferred is coincident with the end of the company’s tax year and (b) a K-1 already has been issued for such completed tax year, the seller and his or her counsel must analyze the potential tax consequences to the seller for the unfiled year(s) with particular attention paid to possible phantom income. Of course, it also is possible the company is generating pass-through losses, in which case the ongoing owners may want to capture all the losses for themselves.
  • There are two commonly used drafting techniques that protect the seller against taxes on phantom income. They are not mutually exclusive. First, there can be a provision requiring the company to indemnify the seller for such taxes. This ought to be done on a grossed-up basis since the indemnity payment will also be taxable. Second, there can be a provision in the nature of a representation, covenant or warranty that the seller’s allocable pass-through income for the defined tax year(s) will not exceed a fixed amount, in tandem with a remedial provision for breach of such representation, covenant or warranty. The latter technique by its nature may not be available unless the company’s tax accounting period is at or near an end as of the effective date of the redemption or transfer of the ownership interest.
  • Finally, use of the term “allocation” in the context of a provision addressing pass-through income has a special meaning that is different from monies “distributed” or “paid.” Allocation refers to the owner’s pro rata share of the company’s reported net income whether distributed or not. Monies “distributed” or “paid” are monies actually received by the owner. Look at any form K-1 and you’ll see different boxes to enter figures for sums allocated and distributed. The different meanings of these terms must be appreciated by counsel involved in the drafting of redemption or cross-purchase agreements, otherwise their clients may end up with an unexpected tax bill and possibly litigation.