Fiduciary Income Tax Planning: Strategies for Minimizing Income Tax on Trusts and Estates

“Internal Affairs Doctrine, Asset Protection, and State of Formation for Legal Entities: Pt. 1 of 2,” that is the subject of today’s ACTEC Trust and Estate Talk.

Transcript/Show Notes

This is ACTEC Fellow Connie Tromble Eyster of Boulder, Colorado.

The internal affairs doctrine deals with the choice of jurisdiction-reforming entities and the ability to bind creditors to that choice. Typically, the internal affairs of an entity are controlled by the laws of the state of formation. For charging orders, the laws of the state enforcing the remedy may apply, and this leads to the question of whether there may be a reason to form entities in states with protective charging order statutes.

ACTEC Fellows Gray Edmondson of Oxford, Mississippi, and George Karibjanian of Boca Raton, Florida, join us today to help us understand this topic, which is beefy enough to require two sessions. In Part 1 of this two-part series, George and Gray will help us understand the nature of the internal affairs doctrine and some case law applying the doctrine. Welcome, Gray and George.

Overview of the Internal Affairs Doctrine

Gray Edmondson:  Thank you, Connie. And I guess where we’ll start is -where did this issue come up for us and, you know, the Asset Protection Committee where we discussed this originally? And it was sort of a series of cases that had come down where, sort of in a relatively short period of time, that addressed what state’s laws apply in enforcing remedies against an LLC member.

And really, I think the setup fact pattern to think about is you’ve got a situation where a judgment is obtained against a member of an LLC, and the creditor is seeking to enforce that judgment. But that creditor and its judgment is obtained in a state that allows, say, foreclosure against an LLC interest, but the LLC is formed or domesticated in a state that has a charging order as its sole remedy. The question then becomes -can that creditor enforce its judgment using the laws of the state where the LLC member is located, where they obtain their judgment, even if that’s different than the jurisdiction where the entity is formed, where their rights may be more limited? Where are they able to enforce that judgment, and what laws will apply to that?

That’s really what the question is. And it’s obviously very important because it affects the ability of these creditors to enforce their rights and constraints – or not – their remedies that are available to them. Where this also is important is at the formation stage. I think all of us have seen and read marketing materials and promotional materials to form an LLC in State X because it’s got superior creditor protection laws or form here because their charging order remedies are very limited.

But if, as a result of the internal affairs doctrine, which we’ll get into in a minute, those creditors aren’t going to be limited by the state of formation’s restrictive laws in that regard, whether that’s case law or statutory law, then is that all for nothing? Is that marketing purely that – marketing? Or is there really substance behind that? I think that’s sort of where we wanted to dive in and take a look at that and say, really, does it matter where I form an entity? Can I bind third parties to that? And that’s sort of the genesis of where we began our analysis and review.

Overview of the Limited Liability Company Act, Revised

And, from a statutory standpoint, where some of that comes up is under the Revised Uniform LLC Act. What we see in the Revised Uniform LLC Act are really two primary provisions at play in addressing this question as it relates to charging orders, which is where the action is here from the point of view we’re coming at it from. And it’s that the charging order statute – Section 503 of the Revised Uniform LLC Act – deals with the rights of a judgment creditor to an LLC. However, an LLC is defined for purposes of the Revised Uniform LLC Act under Section 102 as formed in that state, not any other state.

So if a judgment creditor is enforcing judgments in one state, but the LLC is formed in another, the statute that would apply is the statute in the state where the remedy is being enforced, not formed in another state. And so-or that could be one reading of that. And as George will get into in a minute, the case law isn’t exactly consistent in the application of that concept here. And really where the internal affairs doctrine broader than creditor protection or asset protection or charter order statutes is relevant, it’s really the corollary of the internal affairs doctrine that we’re looking at. Because what the internal affairs doctrine says is that the state of formation controls disputes regarding the internal affairs of the organization.

So the corollary of that could be that if it does not relate to the internal affairs of the organization, then the state of formation’s laws do not necessarily apply, right? That’s the flip side of that same coin. And the thought process from a policy standpoint that makes sense to me there is the members of an LLC, for example, have all voluntarily become members of that LLC and subjected themselves to the laws of the state of formation. Third parties have done nothing to limit themselves to the laws of Delaware, Nevada, Wyoming, orwherever that may be. If their harm or their debt is due as a result of the actions or inactions of someone in another state, why should they be limited to Delaware, Nevada, Wyoming, Alaska, orwherever the case may be,if they did nothing to limit themselves to that, versus what those who voluntarily became an owner of this entity did. And that’s sort of where sort of the concept comes up from here. And George, I’ll pass to you to discuss some of the case law that addressed some of these items.

Cases that Test the Internal Affairs Doctrine and the LLC Act

George Karibjanian: Thanks, Gray. And keep in mind, the issue here is that, as Gray pointed out, in the Revised Act in Section 104, it says, “[t]he law of this state governs (1) the internal affairs of a limited liability company,” but then you have the charging order provision in Model Section 503, which basically is trying to say – well, no, our rules govern attachments.

So the first time we see this come up is in a case, VantagePoint Venture Partners 1996 v. Examine, Inc., 871 Atlantic 2d 1108. And that, again, involved a Delaware Limited Liability Company- Limited Partnership, I’m sorry. And what you try to have is – this whole issue is, what is internal affairs? And does that govern? Now, the court cited other opinions and basically went to say the internal affairs doctrine applies to those matters pertaining to the relationships among or between the corporation and its officers, directors, and shareholders. It’s trying to keep it internally. The court then went on to say in an opinion, it doesn’t apply to the rights of third parties outside of the corporation. So, therefore, that statute – the charging order provision – isn’t going to apply.

So now we move on. And now the question became, well, you don’t have jurisdiction over me. I’m not in that governing jurisdiction. So, I mean, you can’t bring the action against me. Well, that’s AVT-New York LP v. Olivet University. It was a Utah case from 2022. And basically, what they were trying to argue here is, again -no, you can’t get the underlying assets because you don’t have jurisdiction over that. Well, the court came in and said -you want to know something? You own the interest. We’ve got jurisdiction. Personal jurisdiction is enough for this point.

All of that leads into what we will call the seminal case, which is called Earthgrains Baking Companies v. Sycamore Family Bakery, Inc., from a district court out of Utah, it went to the appellate court in the 10th Circuit in February of 2022. So the issue here was that they were trying to get Sycamore’s assets and take them, which underlying assets were other LLC entities. One of the things that wasn’t raised at the trial court was the issue of should the laws of formation have applied. For some reason, it was not brought up. And the lower court, then the 10th Circuit, basically came in and said – “Gang, where you’re living, where the claim was brought, that’s the laws we’re going to apply. We’re not going; we don’t care about the formation. It wasn’t brought up. Therefore, you’re in Utah. The claim is in Utah. We’re taking the interest.”

Now, bringing that further, you had SEC v. Brogdon, a 2021 case where they did raise the governing law issue of the laws of formation. And the court there acknowledged that there is an issue. There is this issue regarding state law versus, what they were arguing, was there’s a glitch in the statute in that the statute says charging order – can’t touch it. But there was this other internal affairs provision within the Limited Liability Act. The court acknowledged the glitch, but said – “You want to know something? The Kansas legislature in adopting the Kansas LLC Act didn’t intend the result that basically this would be outside. Kansas legislature would have wanted this interest to be subject to reachability by creditors.” That is a very big deal.

Now, that is not, however, the law throughout the land. There are two big cases that we would cite that go to the opposite. So these two cases where the courts have gone the other way, one is Sutton 58 Associates v. Beninati, which is a New York case unpublished from 2017. In that case, they said – “We get it. However, the statute is pretty clear that the charging order from the laws of the state of formation would not allow this.” And what’s the real issue here? Who cares? Most states that have adopted the Act have what we call charging order protection. Well, there’s a difference. In some jurisdictions, charging orders are not the exclusive remedy, meaning they can foreclose. In certain states like Delaware or Nevada, it specifically says a charging order is the exclusive remedy. Here in Sutton 58 Associates, they held firm to that.

And that also leads into another case, which is McElroy v. Sumrall, which involved Alabama. And the court there said they tried to limit the use. They said, our act only applies to domestic LLCs. If an LLC is formed in another jurisdiction, it’s foreign. Therefore, it’s outside of the realm of our act. You have to go look to that state’s act or that jurisdiction’s act.

So, therefore, you can see that it’s not clear what the uniform law is, but we want to at least raise the issue. Many jurisdictions are arguing – we don’t care that you have charging order protection. If you don’t have it in the state where you’re residing, where the claim is brought, that’s going to be problematic in terms of you trying to protect your interests from creditors.

Gray Edmondson:  And so with that, you know, we can see that we have statutes, we have cases around the country that are different, right? We’ve got the Revised Uniform LLC Act. We’ve got that charging order protections in some states as the exclusive remedy.; In other states, we allow foreclosure. And courts have analyzed that differently around the country in terms of whether they’re going to hold creditors to the laws of the state of formation or the law in the state where the debtor arises or where the judgment is granted.

In Part 2 of this podcast, we’ll discuss how that plays out in sort of more different fact patterns where you have, say, single-member LLCs, multi-jurisdictional LLCs, property, and other jurisdictions, and whether we believe that’s the right analysis and how that may overlay with at least one or two trust law cases that have addressed similar concepts.

Connie Eyster: Thank you, Gray and George, for this interesting discussion of the internal affairs doctrine. And we look forward to Part 2 of this podcast series.

Additional Resources:

• The Administration of a Closely Held Entity (Pt. 3 of 4) (Jan 2023)
• Internal Affairs Doctrine
• Uniform LLC Act, Revised