Evidence of ownership. Necessary in business divorce. Not always so easy to prove.

Today’s case— Xiaoyan Lu v Sagewood SFF III LLC, 2024 NY Slip Op 05895 (1st Dept 2024)—gives an example of how far (or not) the doctrines of equitable estoppel, tax estoppel, and collateral estoppel can take a plaintiff in answering that threshold question, “Am I a member of the LLC?” (a topic we’ve previously covered in the partnership context)

Spoiler alert: The “torrent of admissions” by defendants in this case left the court little choice but to find that plaintiffs were, indeed, members of the defendant LLC.

As Justice Cohen notes, “[T]he facts, the good, the bad and the ugly are all pretty much agreed.” Good, bad, and ugly facts, they are. Let’s dive in.

Sagewood KT II, LLC (“Fund II”) & Sagewood SFF III LLC (“Fund III”)

The plaintiffs in this case are four friends who, in 2017, invested $200,000 each into a real estate investment fund (Fund II)—in the business of flipping residential properties—managed by defendant Jingying Wu. Fund II was also co-managed by non-party Kenneth Tse.

At some point in mid-2018, Ms. Wu discovered that Mr. Tse apparently defrauded Fund II and absconded with the funds. Ms. Wu undertook efforts, as manager of Fund II, to recover the losses and eventually commenced litigation against Mr. Tse.

BUT, instead of advising Plaintiffs right away of the issues with Fund II (i.e., that someone stole all its money), in August 2018, Ms. Wu instead presented Plaintiffs with the “opportunity” to roll over their full $200,000 investment into a different but similar fund, Fund III, also managed by Ms. Wu.

Unaware of any specific issue with Fund II, but with some knowledge that Ms. Wu wanted to wind up Fund II, Plaintiffs accepted the rollover into Fund III and signed subscription agreements.

Then came a series of actions and representations by Ms. Wu and by Fund III acknowledging Plaintiffs’ membership in Fund III that, remarkably, defendants later admit to, albeit under the cover of “mistake.” We’ll get to those in a moment.

In November 2019, Ms. Wu, for the first time notified Plaintiffs that, actually, Plaintiffs had no membership interest in Fund III because they had not made the required capital contribution to Fund III; that they were solely investors in Fund II; and that, surprise, Fund II experienced a total loss of funds.

A few weeks later, no doubt sensing litigation in the wind, Ms. Wu shifted her posture, now claiming that Plaintiffs were in breach of the Fund III Operating Agreement and Subscription Agreements they signed for failing to fund their respective $200,000 capital contribution to Fund III.

The Lawsuits

Plaintiffs commenced a books and records proceeding for the books and records of both Fund II and Fund III. Defendants objected on the grounds that Plaintiffs were not members of Fund III. The court granted the petition for both Fund II and Fund III.

Plaintiffs, then, commenced this lawsuit in November 2020, for, among other things: declaratory judgment that plaintiffs are full members of Fund III who have made the required $200,000 capital contribution, and a pair of accounting claims.

Defendants asserted a counterclaim for the $200,000 they claim is owed by Plaintiffs to Fund III for their capital contribution, or, in the alternative, the return of $23,454.79 “erroneously” distributed to Plaintiffs out of Fund III.

The parties filed competing summary judgment motions.

The Myriad of Representations, Turned Admissions

On the record before Manhattan Commercial Division Justice Joel M. Cohen were numerous unchallenged representations by Ms. Wu and Fund III indicating Plaintiffs’ membership in Fund III, including:

• Subscription Agreements for Fund III, executed by Plaintiffs in August 2018
• Schedule A to Fund III’s Operating Agreement, listing each Plaintiff as holding an approx. 2% interest in Fund III.
• Capital Call Notice, dated October 25, 2018, calling for a capital contribution on behalf of Fund III
• Text messages from Ms. Wu to Plaintiffs a few days later: “We have not distributed, but we have added the amount to your capital account, because of the rollover we want to make sure everything is recorded and reported correctly,” and, “you are all 100% rollover so there won’t be additional funding liabilities from you guys. No need to worry about funding Fund III. You will still get notices as it is a uniform email that goes out to all the investors.”
• Net Capital Demand Notice from Fund III for $100,000, dated March 6, 2019, stating: “Your contribution will be rolled over from Fund II and this letter is for information only” with a notation that the previous capital contribution call was “Rolled over from Fund II” with an unpaid capital obligation of $0
• Text message from Ms. Wu on May 13, 2019: “[T]he principal amount of this group has been rolled into Fund III, technically it is guaranteed.”

It was also undisputed that in September 2019, Plaintiffs each received a $20,000 partial capital return from Fund III and a $3,454.79 profit distribution check from Fund III’s bank account and signed by Ms. Wu. The distribution was accompanied by a Capital Account Statement through September 30, 2019, providing: “Your original commitments to the Fund [Fund III] include $200,000 of committed capital due as equity rollover from Sagewood KT II, LLC (“Fund II”). Your contributions owed for these commitments will be adjusted from previous and future distributions from Fund II.”

Finally, Plaintiffs received 2018 K-1s for Fund III that reflected an approx. 2% membership interest.

Defendants, for their part, largely acknowledged and admitted to these representations, but relied on two additional facts they contend militated against a declaration that Plaintiffs were members of Fund III:

• No funds were ever rolled over from Fund II to Fund III
• Plaintiffs’ 2019 K-1s for Fund III reflected a 0% membership interest, a “correction” of the “mistake” contained in the 2018 returns reflecting a capital contribution by Plaintiffs.

The Trial Court Grants Declaratory Relief

Judge Cohen granted summary judgment in favor of Plaintiffs on equitable estoppel and tax estoppel grounds (but rejected collateral estoppel), finding that Plaintiffs were members of Fund III as repeatedly represented to them by Defendants.

The trial court credited the “torrent of representations and omissions that the rollover had occurred,” further noting, “[it] is difficult to imagine a more compelling record of admissions than that.” While the court did state that the record was somewhat “murky” as to whether any of the money was actually rolled over, “[b]ut even assuming that is true, I still think that the defendants cannot get past the – again, the torrent of admissions that the rollover did occur. I think plaintiffs relied on it to their detriment.”

Further impacting the court’s decision was the undisputed fact that the “only party who could have known the behind-the-scenes accounting between Fund II and Fund III was Ms. Wu who was the co-manager of one and the sole manager of the other.”

As for tax estoppel, the Court distinguished United Hay v Harounian, which rejected tax estoppel where an amendment to the tax returns materially impacted the parties’ positions. But here, the fact that the 2019 K-1 contained “different numbers” did not serve to “amend” the 2018 returns.

Finally, the Court declined to rely on collateral estoppel (based on the books and records proceeding), pointing out that while it is arguable “that by granting books and records to the plaintiff in that case which is the plaintiff here, [Judge Rakower] had to have concluded that they were in fact members of Fund III, [] her actual ruling does not come across to me anyway as her making a final factual finding on that point.”

The Court concluded that Plaintiffs are members of Fund III, and because they did not participate in distributions that have been made since, there must be an accounting of what they are owed.

First Department Affirms

The First Department unanimously affirmed Judge Cohen’s decision on the same grounds.

The Appellate Court held:

Plaintiffs established equitable estoppel by showing defendants’ admitted concealment of the fact that plaintiffs’ investments had been embezzled by the co-manager of [Fund II], and defendants’ repeated and varied statements and actions confirming that their investment was rolled over into defendant Fund III, despite there not being any money to roll over.

As for tax estoppel, the Appellate Court held that Defendants represented to the IRS that Plaintiffs were members in Fund III by attaching their K-1s to a signed tax return, citing Tradesman Program Mgrs, LLC v Doyle, 202 AD3d 456, 457 (1st Dept 2022) and PH-105 Realty Corp v Elayaan, 183 AD3d 792 (1^st Dept 2020) (covered here).

The Appellate Court was unpersuaded by Defendants’ “explanation” for filing false K-1s as “meritless and unreasonable” given that Defendants were aware of the facts when they made the false filings.

A Parting Thought:

Beware the Orphan K-1 as an Evidentiary Basis for Tax Estoppel

Plaintiffs were nearly tripped up in their reliance on the K-1s as the evidentiary basis for tax estoppel. One way to attack tax estoppel is to show that the tax filing was not signed or sworn by the party or on its behalf (see here for Frank McRoberts’ deep dive on the doctrine of tax estoppel). A K-1, standing alone, is not a signed document and arguably (at least according to Judge Cohen) might support a representation by the company to the plaintiff, but perhaps not a representation by the company to the government.

Here, Judge Cohen ultimately accepted the K-1s together with the accountant’s cover page representing that the K-1 “has been provided to the Internal Revenue Service with the U.S. Partnership return of income, Form 1065,” even absent a copy of the complete Form 1065.

As best as I am aware, the only tax estoppel cases featuring orphan K-1s (i.e. K-1s submitted as evidence of tax estoppel, absent the Form 1065) are Tradesman and United Hays, both of which cases rejected the movant’s reliance on those K-1s because they were “unsigned.” Practitioner should exercise caution and ensure submission of the entire signed return in support of tax estoppel.