Generally, where state law intersects and conflicts with
federal law, state law must give way to the supremacy of applicable federal law.
This does not bode well for any LLC that has not carefully considered the impact
of federal tax, bankruptcy and diversity jurisdiction laws. Complexity and
As I discussed in prior LLC Alerts, an LLC is treated as a partnership for federal, state and local income
tax purposes and for determining the existence of federal district court
diversity jurisdiction, among others. While an LLC has some characteristics of a
corporation, there are many differences. For example, a member's interest is not
treated in the same/identical manner as a share of stock - and, it seems, the
courts have had little trouble concluding the LLC (or a member interest)
was on the losing end of the continuum.
The problems with federal law are not academic. There is
case authority for the following:
An Arizona bankruptcy court bulldozed conventional wisdom
that a chapter 7 trustee is a mere "transferee," concluding a trustee may
have extraordinary powers to take over and appoint a receiver to operate the
LLC and even liquidate and dissolve the entity. This is about as far from
being stock-like as one could imagine.
The U.S. District Court for Arizona recently refused removal in a
dispute between a limited liability company and a trust, finding no
diversity jurisdiction and remanding back to the Superior Court of Arizona
(the State court).
Failure to appreciate the diversity jurisdiction rules for
LLCs may prove costly. A recent ruling may have the effect of moving
future litigants closer to an award of attorneys' fees in favor of the
prevailing party if an improper removal is sought. See 28 U.S.C. § 1447(c).
What to do? Are solutions possible?
A thoughtful, well-drafted LLC operating agreement can
address the partnership tax, bankruptcy and diversity jurisdiction issues. It
may be time to engage in a diagnostic review and update to reflect these new
developments. Make sure federal law is embedded in your document. An ounce of
Article © Fred Witt 2014. All Rights Reserved.
Disclaimer: This alert is
provided for general information only and is not intended to constitute legal
advice. Please consult with your own legal advisor before making any decisions.