Forming a Limited Liability Partnership

A general partnership can reorganize as a limited liability partnership in two steps.

First, the partners vote to become a limited liability partnership. This vote requires the same level of approval that would be required to amend the partnership agreement (or, if the partnership agreement has special provisions that detail what partners must contribute, you need the same approval levels that would be required to amend those provisions). RUPA § 1001(b). So in a partnership following the default rules, changing from a general partnership to a limited liability partnership requires the approval of all the partners. RUPA § 401(j).

The second step is to file a statement of qualification with the state's secretary of state. RUPA § 1001(c). This document states the LLP's new name, the address of the CEO, the address of the LLP's office in the state (or if the LLP won't have an office in the state, the address of an agent that can receive service of process if the LLP gets sued), a statement that the partnership is electing to be a limited liability partnership and the effective date of the change. RUPA § 1001(c).

The LLP's new name should end with "Registered Limited Liability Partnership," "Limited Liability Partnership," "R.L.L.P.," "L.L.P.," "RLLP" or "LLP." RUPA § 1002.

There's often a fee associated with this initial filing that vary by state. In 2024, New York's fee was $50. Nebraska's was $110.

Pros and Cons

Changing from a general partnership to a limited liability partnership seems like an easy decision, and for most companies it's a better choice. But there are some downsides. Let's consider the pros and cons.

Personal Liability

The biggest advantage of a limited liability partnership is that the partners are no longer personally liable for the partnership's unpaid debts. RUPA § 306(c). However, this isn't a complete liability shield. Partners remain liable for their personal misconduct. RUPA § 306 cmt. 3. If I hit you with my car, I can't get out of it by saying I was just delivering bread for my LLP. But see RUPA § 306 cmts. 3, 7(e) (discussing LLP's obligation to indemnify partners operating in the ordinary course).

Timing

The limited liability protection applies only to obligations incurred while the partnership was a limited liability partnership. RUPA § 306 cmt. 3. It doesn't retroactively apply to the partnership's obligations incurred before the conversion or after the LLP dissolves. So you can't convert to an LLP to get out of current obligations.

When is an obligation considered "incurred"? That's defined by other bodies of law. For contracts, it's typically when the agreement is made. For torts, it's typically when the tortious conduct occurred (even if the injury happens later). RUPA § 306 cmt. 3. But this varies by state and case by case.

For example, in Evanston Ins. v. Dillard Dept. Stores, a law firm that was organized as an LLP set up a website to find clients for a class action lawsuit against a department store. 602 f..3d 610. The website illegally used the department store's trademark. The department store sued the law firm for trademark infringement, and while the litigation was pending the LLP dissolved. Judgment was issued later that year against the partnership, and the department store pursued the judgment against the partners personally. The partners claimed they weren't personally liable because the infringing website was set up while the partnership was an LLP. But the reviewing court held that the obligation incurred at the time of judgment, not at the time the website was created. The court reasoned that the department store may not have sued and may not have won. Because the partnership was not an LLP at the time of the judgment, the partners were personally liable even though the infringment occured while the LLP was in place, the partners were still liable. Be careful out there.

Contractual Exceptions

Finally, parties may contract around this liability shield. RUPA § 306 cmt. 7(h). Perhaps a supplier doesn't trust that the partnership has enough cash to make payments, so the supplier insists that the partners agree to be personally liable for any invoices.

More commonly the partners may contract around the liability shield for their personal claims. That is, the partners may agree that if the partnership can't afford to pay a partner's claim, then all the partners will be jointly and severally liable. So third parties could pursue a claim only against the partnership but the partners themselves could pursue a claim against the partnership and the partners personally.

Whatever approach the partnership takes, consider it in advance and consider documenting the decision clearly.

Taxes

Taxes are beyond the scope of the book, but at the federal level limited liability partnerships are treated like general partnerships, so there may not be a change in tax treatment.

Converting from a general partnership to a limited liability partnership doesn't typically trigger a taxable event because the conversion doesn't eliminate any current obligations. Again, this is a general statement of the law at the federal level, and your mileage may vary in specific cases or at the state level.

Annual Reporting & Fees

LLPs typically have reporting obligations, but these are generally limited. Each year the LLP must file a report with the secretary of state stating the LLP's name and the current address of the CEO and the business office (or if there isn't an office in the state, the address of an agent that will accept service of process for suits against the LLP). RUPA § 1003(a).

The report is typically due before April 1 of each year, and LLPs that don't file may have their statement of qualification revoked. RUPA § 1003(b), (c). 

LLPs typically pay an annual franchise fee at the same time as filing the annual report. These fees vary. For example, in 2024 the annual LLP franchise fee in New York was between $25 and $4,500, depending on the LLP's income. In Nebraska, the annual fee was $25 plus an extra $25 if the LLP is practicing law.

In General

Like all the business entities we study in this book, limited partnerships are governed by state law. Every state except Wyoming and Louisiana has adopted a version of the uniform limited partnership act. That act allows a partnership agreement to override most of the default rules. This section will present the default rules, but know that any given limited partnership may have adopted its own governance terms.

Formation & Nature

To form a limited partnership you first file a certificate of limited partnership with the state's secretary of state. ULPA § 201(a). This certificate says the name and address of: (i) the limited partnership, (ii) each general partner and (iii) the registered agent for service of process. ULPA § 201(b). You'll update this whenever that info changes, including whenever you add or remove a general partner. ULPA § 202(d), (e).

The name must indicate that it is a limited partnership. ULPA § 114(b). Most states, and the model act, reject older interpretations that said a limited partnership's name can't include the name of a limited partner, but check the state you're in. ULPA § 114(a).

Most states, and the most recent uniform act, allow limited partnerships to be organized for any lawful purpose, including nonprofit purposes. ULPA § 110(b). If you are forming a limited partnership as a nonprofit, you'll want to check whether the state has a separate nonprofit code and confirm you're complying with the internal revenue code.

Filing is only the first step. The limited partnership isn't formed until it has two partners, with at least one general partner and one limited partner. ULPA § 201(d). If at any point it doesn't meet this requirement, a 90-day countdown starts before the limited partnership is dissolved. ULPA § 801.

Once formed, a limited partnership is a separate legal entity from the partners. ULPA § 110(a). It can own property, sign contracts, sue or be sued. ULPA § 111. It has perpetual duration. ULPA § 110(c).

Governance & Control

At a high level, a limited partnership is governed by a certificate of limited partnership (which just has the most basic contact information) and a partnership agreement that often customizes the governance. The partnership is managed by general partners, with limited partners that don't do much other than receive distributions.

The Limited Partnership Agreement

A limited partnership is governed by a partnership agreement, which is treated as a contract and interpretted using contract law principles. ULPA § 102 cmt. 14. The partners and the limited partnership are considered parties to the agreement, and new partners are deemed to accept the terms of the partnership agreement when they join. ULPA § 106.

The partnership agreement can override most of the default rules in the statutes, but there are a few exceptions. See ULPA § 105. For example, a partnership agreement cannot authorize conduct that constitutes "bad faith, willful or intentional misconduct, or knowing violation of law." ULPA § 105(d)(2)(C).

Governance Structure

The defining feature of limited partnerships is that they have two classes of partners. Roughly speaking, limited partners have less control, fewer duties and narrower liability, while general partners have more control, more duties and broader liability.

Becoming a Limited or General Partner

There are a few ways to become a partner, but most typically it is by agreement of the partners ULPA § 301(a) (agreement prior to formation); ULPA § 301(b)(1) (named a limited partner in the partnership agreement); ULPA § 401(a) (agreement prior to formation); ULPA § 401(b)(1) (named a general partner in the partnership agreement).

The default rule is that adding new limited partners after formation requires unanimous consent of all the partners. ULPA § 301(b)(3); ULPA § 401(b)(3).

Management

Each general partner has authority to manage the ordinary course of business, and decisions are resolved by a majority vote of the general partners. ULPA § 406(a).

A general partner is an agent of the partnership by default. ULPA § 402(a). This means a general partner can contractually bind the partnership. ULPA § 402(a). But this power is limited to acts that are either (i) in the ordinary course of the partnership’s activities or (ii) of the kind carried on by the partnership. ULPA § 402(a). Actions outside that scope require approval by all of the partners. ULPA § 402(b).

An exception to this rule is that if the general partner lacks actual authority (say, because the partnership agreement has some limit) and the counterparty knows it, then the contract isn't binding regardless of the scope. ULPA § 402(a). If this reminds you of the rule for apparent authority, it's because early versions of limited partnerships were based on appparent authority and borrowed from those rules. See Stockwell v. U.S., 80 U.S. 531, 567 (1871).

Lingering apparent authority is a little more limited in limited partnerships. Recall that in normal agency relationships lingering apparent authority occurs when an agent is fired but the principal doesn't notify the agent's regular ounterparties. Those counterparties may believe that the agent still has authority based on past practice with the agent and principal, so there may be apparent authority after the agent has been fired. This is more limited in limited partnerships. When a general partner dissociates the limited partnership must file this information with the secretary of state. ULPA § 202. 90 days after that filing, counterparties are deemed to know the partner has been fired. ULPA § 103(d). Effectively, it cuts off lingering apparent authority 90 days after the filing. After two years lingering apparent authority ends even without a filing. ULPA § 606(a).

All the other typical rules of agency can apply to general partners---ratification, estoppel, apparent authority, etc.---so consider the facts of the case in front of you.

A limited partner isn't an agent of the partnership by default. ULPA § 302(a). So limited partners don't necessarily have authority to bind the partnership in contract. But normal agency rules still apply. So a limited partnership could give a limited partner actual authority to act as its agent. Or it could create a situation where the limited partner has apparent authority or it could ratify its actions. All the agency rules are still in play. So while the default is that they don't have authority, consider the fact pattern in front of you and apply the standard agency concepts.

Day-to-day management is done by the general partners and extraordinary matters require unanimous approval of every partner. These extraordinary matters include: 

• Amending the partnership agreement
• Becoming a limited liability limited partnership
• Sell all or substantially all of the limited partnership's assets

ULPA § 406(b).

Before the vote, the limited partnership must proactively provide the limited partners with "all information that is known to the partnership and is material to the limited partner’s decision." ULPA § 304(d).

Duties

General partners have fiduciary duties of care and loyalty to the partnership. ULPA § 409(a).

The duty of loyalty requires general partners to (i) protect the partnerships assets, including opportunities that come to the partnership; (ii) not act (or supporting others in acting) with adverse interests to the partnership; (iii) not compete with the limited partnership. ULPA § 409(b). This doesn't prohibit a general partner from acting in a way that benefits the general partner, as long as the act doesn't harm the limited partnership. ULPA § 409(e). A unanimous vote by the limited and general partners can ratify an act that would otherwise violate the duty of loyalty. ULPA § 409(f).

The duty of care prohibits "grossly negligent or reckless conduct, willful or intentional misconduct, or knowing violation of law." ULPA § 409(c). You may notice that some of these, like willful misconduct, would be treated as violations of the duty of loyalty in the corporate context.

Both general and limited partners have a duty of good faith and fair dealing. ULPA §§ 305, 409(d).

Liability

Each general partner is jointly and severably liable for the debts, obligations and liabilities of the limited partnership that are incurred while the general partner was a general partner. ULPA § 404(a). And the limited partnership is liable for the acts of its general partners when they are acting with authority or within the ordinary scope of the limited partnership. ULPA § 403. This includes torts. So, roughly speaking, each general partner is liable for their own acts, the acts of other general partners and the obligations of the partnership.

As a general rule, limited partners aren't liable for the debts, obligations or liabilities of the limited partnership. ULPA § 303(a). In most states, this limited liability is the rule even if the limited partner participated in management or control of the limited partnership and even if the limited partnership did not observe formalities. ULPA § 303(b).

Limited partners remain liable for their own conduct. ULPA § 302(b). So a limited partner is liable for the torts commited by that limited partner, but not for the torts of other limited partners, the general partners or the partnership.

Information Rights

General partners have a right to books and records reflecting "the partnership’s activities, affairs, financial condition, and other circumstances, to the extent the information is material to the general partner’s rights and duties . . . ." ULPA § 407(b). The limited partnership must affirmatively provide this info even without the general partner asking for it. ULPA § 407(c)(1).

A limited partner also has acess to the limited partnership's books and records. Specifically, they "may inspect and copy information regarding the activities, affairs, financial condition, and other circumstances of the limited partnership as is just and reasonable . . . for a purpose reasonably related to the partner’s interest as a limited partner [as long as] the information sought is directly connected to the limited partner’s purpose." ULPA § 304.

Dual Capacity

It's not obvious, but sometimes folks hold some interests as a general partner and some interests as a limited partner. ULPA § 109. In that case, their duties and obligations will conform to the role they are acting in at the time. ULPA § 109. The main reason you'd do this is to allow a person to act in their self interest in limited circumstances (like voting) or to limit their overall liability if things go wrong. So if a person holds some general partner interests and some limited partner interests, then when the person votes their limited partnership intersts the person is bound only by the duty of good faith and fair dealing, rather than all the fiduciary duties that go with being a general partner. ULPA §§ 109 cmt., 305(b).

Distributions

A limited partnership may choose to pay out distributions to the partners, much like a corporation would pay out dividends. The distributions are based on the partnership agreement, but if the partnership agreement is silent, then they are paid out pro rata based on the contribution of each partner. ULPA § 503(a).

Suppose I contribute $5 and you contribute $95, then when there's a distribution, I would get 5% and you would get 95%. Partnership agreements commonly override this default rule.

But to apply the default rule, we need to figure out what counts as a "contribution." Contributions can be cash, assets, past service, future promises or anything else the partners agree to count. ULPA § 501. This gives the partnership flexibility to negotiate a solution that works for their situation.

Once a distribution is declared, the partners become creditors of the partnership for the amount due. ULPA § 503(d). You wouldn't be wrong to think this is weird. Typically equity gets paid after debt, and this would seem to allow equity to cut in line. To prevent partnerships from declaring distributions to cut in line of seniority, the ULPA prevents distributions that would leave the partnership insolvent and makes general partners personally liable for distributions that would violate these rules. ULPA § 504, 505(a).

Disassociation

Under the default rules, general and limited partners can voluntarily disassociate by giving notice to the partnership. ULPA §§ 601(a), (b)(1) (note that the right is more limited for a limited partner than a general partner), 603(a)(1), 604(a). General and limited partners are also disassociated as allowed or required by the partnership agreement, which could be based on some triggering event or some process adopted by the partnership. ULPA §§ 601(b)(2), (3); 603(a)(2), (3).

In a few specific circumstances a general or limited partner can be involuntarially disassociated (read: kicked out) by a unanimous vote of the other limited and general partners. ULPA § 601(b). While not required, we recommend doing this involuntary disassociation in an island ceremony where the partner's torch is dramatically extinguished.

You can't eject folks from the partnership without some reason, and the ULPA gives a long list of situations where involutarily disassociation is available. Conceptually they fall into three groups: (i) the partner no longer has an economic stake in the business, (ii) the partner dies or disolves (for artificial entities), or (iii) the partner is a willful, persistent bad actor. ULPA § 601(b); 603(4). General partners can also be disassociated by a unanimous vote of the the other partners if the general partner declares bankruptcy. ULPA § 603(7).

Dissolution

There are a few ways to dissolve a limited partnership. First, a limited partnership is dissolved if required by the partnership agreement, which could be because of some event or because the partnership agreement states a limited duration. ULPA § 801(a)(1).

Second, the general and limited partners can vote to dissolve the partnership. ULPA § 801(a)(2). This requires unanimous consent of the general partners and majority approval of the limited partnership interests. ULPA § 801(a)(2).

Third, a limited partnership can be dissolved if a partner leaves. This can happen in a few ways. Recall that a limited partnership must always have at least two members, with at least one general partner and at least one limited partner. ULPA § 201(d). If it doesn't because a partner dissassociated, then the partnership has 90 days to fix it or dissolve. ULPA § 801(a)(3)(B) (no general partner), ULPA § 801(a)(4) (no limited partner), ULPA § 801(a)(5) (only one partner).

Fourth, a limited partnership can be dissolved by a court order finding the limited partnership's activities are mostly just committing crimes or that it's not "reasonably practicable" to carry on in conformity with the partnership agreement. ULPA § 801(a)(6). It can also be dissolved by the secretary of state for failing to pay taxes, file regular reports or have a registered agent. ULPA §§ 801(a)(7), 811(a).

For the first three dissolution options above, the partners can rescind the dissolution by fixing whatever problem caused the dissolution and by unanimously agreeing to rescind. ULPA § 803.

Winding Up

Like other entities, dissolution doesn't immediately shut down a limited partnership. The limited partnership continues while it pays of debts, settles accounts and sells down assets. ULPA § 802(b). And like other entities, a limited partnership can time-bar claims against it by giving notice to creditors, publishing notice of dissolution in the newspaper and leaving a deposit with a court for contingent claims. ULPA §§ 806 (notifying creditors), 807 (newspaper notice), 808 (security left with court for contingent claims). After the time limits are met, creditors can't recover those claims from the partnership or its partners. ULPA § 807(d) (noting some claims that can be recovered from partners for their proportionate share).

If the limited partnership can't pay its debts, the general partners have to make up the difference. ULPA § 810(c). The amount that each general partner pays is proportional to the share of the total distributions they would have received as general partners. ULPA § 810(c)(1). If one doesn't pay, the others have to make up the difference, but they can try to recover that from the one that shirked. ULPA § 810(d).

If a limited partnership doesn't have a general partner during dissolution, a new one can be appointed with the approval of a majority of the limited partnership interests. ULPA § 802(c).

A limited liability limited partnership follows the rules of limited partnerships with a few minor variations. ULPA § 110(a). The two are so similar that they share a uniform act, the Uniform Limited Partnership Act.

Formation

A limited liability limited partnership is formed in the same way as a limited partnership, by filing a certificate of limited partnership with the state's secretary of state. ULPA § 201(b). A certificate of limited partnership must say whether it is a limited partnership or a limited liability limited partnership. ULPA § 201(b)(5).

A limited liability limited partnership's name must designate it as a limited liability limited partnership either by including either "Limited Liability Limited Partnership," "L.L.L.P." or "LLLP". ULPA § 114(c).

A limited liability limited partnership can also be formed by a limited partnership amending its certificate of limited partnership. ULPA § 203(a)(2). This amendment must be signed by all the entity's general and limited partners. ULPA §406(b)(2).

Liability

The defining feature of a limited liability limited partnership is that both classes of partners have limited liability. While the partnership is a limited liability limited partnership, only the limited liability limited partnership is liable for its debts, obligations and liabilities. ULPA § 404(c), (e).

This limited liability shield means only that a partner isn't liable for the debts, obligations and liabilities of the limited liability limited partnership. It doesn't prevent a partner from becoming liable for other acts related to the business. For example, if a partner guarantees a debt, the partner may be liable for the debt. Likewise, partners are alwyas liable for any torts they commit.

Courts may pierce the veil of a limited liability limited partnership. The analysis is the same as for piercing the veil of a corporation except that the court will not consider whether the limited liability limited partnership failed to observe formalities. ULPA § 404(d); § 404(d) cmt. subsection (d). 

Giles v. Giles Land Co., L.P.

47 Kan. App. 2d 744, 745

279 P.3d 139, 141

2012

Kelly Giles (Kelly), a general partner in a family farming partnership, filed suit against the partnership and his partners, arguing that he had not been provided access to partnership books and records. The remaining members of the partnership then filed a counterclaim requesting that Kelly be dissociated [some lawyers use "dissociation" instead of "disassociation"] from the partnership. The trial court held that Kelly was not denied access to the partnership books and records. Kelly does not appeal from this decision. Moreover, the trial court held that Kelly should be dissociated from the partnership. Kelly, however, contends that the trial court's ruling regarding his dissociated from the partnership was improper. We disagree. Accordingly, we affirm.

Check your understanding of this material using the following questions:

4.7.3.1. Ted and Anne form a partnership to sell baked goods to hungry customers. The form this partnership as a limited liability partnership wherein Ted is the general partner and Anne is a limited partner. Assuming there are no conflicting provisions in the partnership agreement, who has default control of Ted and Anne's partnership?

4.7.3.2. Same as above, but Ted and Anne's partnership sells a cookie that was baked with expired ingredients. The customer who purchased and ate this cookie became horribly ill and sued Ted and Anne's partnership. Could Ted be held personally liable here? What about Anne?

4.7.3.3. What is the difference between a Limited Liability Partnership and a Limited Liability Limited Partnership? Create a hypothetical in which it might be beneficial to use each of these alternative forms. *Hint: think limited partners, general partners, liability, and control!*

Limited liability companies ("LLCs") are the most common entity type. Because they are considered creatures of contract, they are the pinnacle of flexibility. So while this section will discuss the default rules, most limited liability companies will chart their own course.

All 50 states have some form of LLC statute. This section will focus on the 2013 Uniform Limited Liability Company Act ("ULLCA"). Some version of the uniform act has been adopted in 25 states, including California, Arizona, Utah, Nebraska, Illinois, Florida, Pennsylvannia and New Jersey. 

Nature & Formation

An LLC is a distinct legal entity and can have a perpetual existence. ULLCA § 108(a), (b). It has the capacity to sue and be sued, own property, and engage in any lawful activity. ULLCA §§ 108(c), 109.

To organize an LLC, you file a "certificate of organization" with the state secretary of state. ULLCA § 201(a). This is a fairly short document stating the name and addresses of the LLC and the registered agent for service of process. ULLCA § 201(b). As with other entities with limited liability, the LLC's name must indicate that it is a limited liability company, which can be done with abbreviations like LLC. ULLCA § 112.

The only other requirement is to have at least one member. ULLCA § 201(d). A "member" is just the word LLC's use for the equity holders, analogous to "shareholders" for a corporation or "partners" for a partnership. There's no requirement that this member be a natural person, so you could have an LLC with only one corporation as a member.

Similarly, equity interests are referred to as "interests." Interests are analogous to "stock" in the corporate context.

There are two main types of LLCs based on who is going to manage the business. In a member-managed LLC, the members manage the business. These LLCs look a lot like partnerships, and courts often look to partnership law to resolve disputes. 

The other type of LLC is a manager-managed LLC. Here, the managers run the day-to-day business of the LLC, and extraordinary items are raised to the shareholders for approval. The section below on governance has more detail on these two management structures.

When drafting the operating agreement, the folks organizing the LLC will choose which of these two management structures to use. ULLCA § 407(a). If they don't choose, it will be member-managed by default. ULLCA § 407(a). They can switch at any time by amending the operating agreement. ULLCA § 407(a). 

The final administrative note is that the LLC needs to file an annual or biennial report with the state's secretary of state. ULLCA § 212. The report contains barebones information about the company, like (i) the name and address of the LLC and the registered agent and (ii) the name of one manager (or one member, if it is member-managed). ULLCA § 212. There are also regular franchise taxes.

The Operating Agreement

The operating agreement is the primary governance document for an LLC. It governs the relationship among the members and LLC, the rights and duties of the managers and just about anything else the members decide to include in it. ULLCA § 105. The LLC is always a party to the operating agreement, and anyone that becomes a member of the LLC is deemed to assent to the operating agreement. ULLCA § 106.

The operating agreement usually overrides the rules in the ULLCA, but there are a few things can't be changed by the operating agreement. First, let's look at changes to the fiduciary duties of care and loyalty and the contractual obligation of good faith and fair dealing. Then we'll look at changes to the rights of third parties.

Limits on an Operating Agreement's Ability to Modify Fiduciary and Contractual Duties

State rules vary widely on how much an operating agreement may modify fiduciary duties. On one extreme, Delaware allows an operating agreement to expand, restrict or eliminate duties (including fiduciary duties) other than the obligation of good faith and fair dealing. Del. Code Ann., tit. 6, § 18-1101(c) (2010). In contrast, the Absolute Sports Cards case in the next section has broadly written statutory authority for reducing fiduciary duties, but the Minnesota court interprets them narrowly. In your practice you'll need to consult the applicable state law. This section will discuss the ULLCA rules. 

For the duty of care, the alterations can't be "manifestly unreasonable" and can't authorize conduct involving "bad faith, willful or intentional misconduct, or knowing vioaltions of law." ULLCA § 105(d)(3). But any changes to the duty of care that don't meet this standard and aren't "manifestly unreasonable" are allowed.

For the duty of loyalty, the operating agreement can modify the duty of loyalty as long as the alteration is not manifestly unreasonable. ULLCA § 105(d)(3). This includes changing the procedures for approving or ratifying conflicted transactions. ULLCA § 105(d). 

For the contractual obligation of good faith and fair dealing, the operating agreement can prescribe the standards to measure this duty as long as they are not "manifestly unreasonable." ULLCA § 105(c)(6).

One last protection among the members and the LLC, the operating agreement cannot unreasonably restrict books and records rights. ULLCA § 105(c)(8).

Limits on an Operating Agreement's Ability to Modify the Rights of and Obligations to Third Parties

Because the operating agreement is treated as a contract among the members, managers and LLC, it can't modify the rights of or obligations to third parties. This includes obvious things like modifying the ability of third parties to sue the LLC or of courts to dissolve the LLC. ULLCA §§ 105(c)(2) (being sued), 105(c)(9) (judicial dissolution).

It also protects obligations that benefit third parties, like the requirement to have a registered agent or to file forms with the secretary of state. ULLCA § 105(c)(3). Similarly, it can't modify the procedures for filing court documents or chose to be governed by the law of another jurisdiction. ULLCA § 105(c)(4) (filing procedures); ULLCA § 105(c)(1) (governing law). 

Amending the Operating Agreement

The default rule is that amending the operating agreement requires unanimous approval of the members. But perhaps more interestingly, the operating agreement can allow non-members a veto right on any amendment to the operating agreement. ULLCA § 107(a).

Management

As noted above, LLCs select whether to managed by their members (kind of like a partnership) or by designated managers (like a board of directors).

Becoming a Member or Manager

There are a few ways to become a member, but most typically it is by the unanimous consent of the other members. ULLCA § 401(a), (b) (agreement prior to formation); ULLCA § 401(c)(1) (named a limited partner in the partnership agreement); ULLCA § 401(c)(3) (unanimous consent of the other members).

A manager can be chosen at any time by the majority of the members. ULLCA § 407(c)(4). A manager doesn't need to be a member. ULLCA § 407(c)(5).

Unlike other entities, managers don't have a fixed term; they serve until they a replaced, resign or die. ULLCA § 407(c)(4). They can be replaced by a majority of the members without notice and without cause. ULLCA § 407(c)(4). If you're a member as well as a manager, then if you dissociate as a member, you stop being a manager as well. ULLCA § 407(c)(5). 

Like in partnerships, the default LLC rules do not entitle members or managers to be paid for their services to the LLC, but this can be amended in the operating agreement or through employment contracts. ULLCA § 407(h).

Management of Member-Managed LLCs

Most state laws make a member in a member-managed LLC is an agent of the LLC. But under the ULLCA, merely being a member doesn't make you an agent of the LLC, even in a member-managed LLC. ULLCA § 301(a). That doesn't mean they can't become agents through actual authority or any other agency principle, but membership alone isn't sufficient to create agency. 

This poses a couple challenges. If no one is necessarily an agent of a member-managed LLC, how is the LLC able to act? How will a creditor know who has authority to sign a contract on behalf of the LLC?

The easiest way is to detail who has authority in the operating agreement.

A more interesting solution is the statement of limited liability company authority. Member-managed and manager-managed LLCs can file a form with the secretary of state that says who has authority to bind the company. The form can designate authority to specific individuals ("Eduardo has authority to bind the company in real estate transactions") or to anyone holding a specific title ("Each person holding the office of vice president has authority to buy and sell hamster wheels, but only during the month of July.") ULLCA § 302(a).

Statements of limited liability company authority give authority to a person only when they are interacting with non-members; the operating agreement is controlling for relationships between members. ULLCA § 302(c). Also, if the counterparty knows the certificate of limited liability company authority is inaccurate, the counterparty can't rely on it. ULLCA § 302(e)(1). And if the statement would give authority or place limits on real estate transactions, then it should also be filed with the county recorder or whichever office records real estate deeds. ULLCA § 302(f), (g). These statements automatically expire after five years. ULLCA § 302(j).

If authority isn't granted in the operating agreement or through a statement of limited liability company authority, then a few background rules apply.

For ordinary course items, each member has equal, but limited management rights. ULLCA § 407(b)(1). Specifically, each member has actual authority to bind the LLC in ordinary course matters, with two exceptions. ULLCA § 407(b)(2); cmt. subsection (b). The first exception is when the member has "reason to know that other members might disagree." Id. The second exception is when the member has "some other reason to know that consultation with fellow members is appropriate. " Id. The reasoning behind these exceptions is that every member has equal rights to management, so a member shouldn't knowingly act against the wishes of another member.

For ordinary course items that meet these two exceptions, the action can be authorized only by a majority of the members. ULLCA § 407(b)(3).

For extraordinary course items, the members must all consent to the action. ULLCA §§ 407(b)(4); cmt. subsection (b). This includes amending the operating agreement. Id.

Members can approve things either by holding a meeeting to vote, collecting proxies for a vote or through writen consent. ULLCA § 407(d).

Manager-Managed LLCs

It will not come as a shock that in manager-managed LLCs the managers manage the LLC. Management mirrors the member-managed LLC, but with the managers replacing the members.

So for ordinary items each individual manager can bind the LLC unless the manager (i) knows the other managers may disagree with the action or (ii) knows (for some other reason) consulting with the other managers is required. ULLCA § 407(c) cmt. subsection (c). In those situations, a majority of managers is required to approve the decision. ULLCA § 407(c)(1), (2). Note that the default rules don't define "majority," so it's not clear how to count when there are vacant seats.

For extraordinary items, the members (not the managers) must unanimously consent to the action. ULLCA § 407(c)(3). Again, this includes amending the operating agreement. ULLCA § 407(c)(3).

Fiduciary Duties & Contractual Obligations

Whoever is managing the LLC (whether members or managers) owes a fiduciary duty of care and a fiduciary duty loyalty. Everyone (both members and managers) owes a contractual obligation of good faith and fair dealing. So that's two fiduciary duties for whoever is managing and one contractual obligation for everyone.

When courts review LLC disputes, they often look to partnership law for guidance when dealing with member-managed LLCs and often to corporate law when dealing with manager managed LLCs.

Member-Managed LLCs

Members of a member-managed LLC owe a fiduciary duty of care and a fiduciary duty of loyalty to the LLC and to the other members. ULLCA § 409(a).

Fiduciary Duty of Loyalty

This section will discuss the requirements of the default duty of loyalty. Note that most LLCs modify this, as noted above, so in any individual LLC, read the operating agreement.

By default, the duty of loyalty prevents members from:

• Using the LLC's assets to benefit themselves. ULLCA § 409(b)(1).
• Taking opportunities that belong to the LLC. ULLCA § 409(b)(1)(C).
• Act with an adverse interest to the LLC. ULLCA § 409(b)(2).
  • That just means you can't be on the other side of a transaction. ULLCA § 409 cmt. subsection (b)(2). 
• Competing with the LLC. ULLCA § 409(b)(3).

Not every self-interested act violates the duty of loyalty. ULLCA § 409(e). For example, shareholders can consider their own self interest when voting.

If a memmber engages in a transaction or agreement that would violate the duty of loyalty, that doesn't mean they're liable for two reasons.

First, the members can ratify or approve any transaction or agreement. ULLCA § 409(f). Before the vote, the members must be given all material information about the transaction or agreement. ULLCA § 409(f).

Second, before declaring a member liable the court will consider whether the act was fair to the LLC. If so, the member won't be held liable despite taking one of the actions listed above. ULLCA § 409(g) (note that this is not the full entire fairness standard for Delaware corporate law).

Fiduciary Duty of Care

By default, the duty of care prohibits members from acting in a way that is grossly negligent, reckless, involves willful or intentional misconduct or knowingly violates the law. ULLCA § 409(c) (note that the duty of care under the ULLCA is broader than the Delaware General Corporate Law, which is limited to gross negligence). Like the duty of loyalty and as detailed above, this can be modifed by the operating agreement.

Contractual Obligation of Good Faith and Fair Dealing

Members also owe a contractual obligation of good faith and fair dealing when acting under the ULLCA or the operating agreement. ULLCA § 409(d). This isn't a fiduciary duty, and the ULLCA drafters advised that it "should be used only to protect agreed-upon arrangements from conduct that is manifestly beyond what a reasonable person could have contemplated when the arrangements were made." ULLCA § 409 cmt. subsection (d). It cannot be 

Manager-Manged LLCs

The duties owed in manager-managed LLCs are generally the same as the duties owed in member-managed LLCs, but the duties are owed by the managers, rather than the members. ULLCA § 409(i)(1). This makes sense. In a member-managed LLC, the members are the managers. The duties derive from their ability to control the LLC. So someone else is controling the LLC, that person should bear the fiduciary duties.

There are two differences in the duty structure worth noting. In a manager-managed LLC, managers (unlike members) are not authorized to pursue their own self interest. ULLCA § 409(i)(4). And in a manager-managed LLC, only the members can ratify or pre-approve a transaction or agreement. ULLCA § 409(i)(5).

Because the obligation of good faith and fair dealing arises from contract (rather than a fiduciary relationship), both members and managers continue to bear this obligation in a manager-managed LLC. ULLCA § 409(i)(3).

Liability

Members and managers are not personally liable for the debts, obligations or liabilities of the LLC. ULLCA § 304(a). But they'll still be liable for acts in their own name (e.g., guaranteeing a contract) and for their own torts (e.g., a member of an LLC fights a customer).

Courts may pierce the corporate veil against an LLC, and though it varies by state, courts typically consider the same factors used for piercing the veil against a corporation, except that they will not consider whether the LLC complied with corporate formalities. ULLCA § 304(b); see also Murphy v. Jewell, 213 N.Y.S.3d 370, 373 (N.Y. 2024); Thomas & Thomas Ct. Reps., L.L.C. v. Switzer, 283 Neb. 19, 27, 810 N.W.2d 677, 685 (2012). 

Information Rights

An LLC must proactively (that is, without waiting for a request) provide information to whoever is managing it, whether that's the members or managers. ULLCA §§ 410(a)(2)(A); (b)(1).

In a manager-managed LLC, the members still have access to books and records upon request by showing the information is "directly connected" to a purpose that is "reasonably related to the member's interest as a member." ULLCA § 410(b)(2).

Distributions

Distributions are determined by the LLC agreement. If it doesn't specify a method, the default rule is that distributions are made on a per capita basis, so each member gets the same amount. ULLCA § 404. This is regardless of how much each member contributed.

As with most entities, distributions for an LLC are discretionary unless there are assets leftover when the company winds up. ULLCA § 404(b).

Once a distribution is declared, the members become creditors of the LLC for the amount due. ULLCA §§ 404(d); 405(d). Typically equity gets paid only after the debt is paid, so giving equity holders a debt claim may seem like it allows equity holder to jump forward in the line. To prevent this line cutting, the ULLCA prevents distributions that would leave the LLC insolvent and makes members personally liable for distributions that would violate these rules. ULLCA §§ 405, 406(c). 

Transferability

A member can typically transfer the economic rights, but not the management rights, of their membership interest. ULLCA § 502(a). This means the person who recieves the interests gets any future distributions but can't bind the partnership or vote. The operating agreement can override the default rules and prohibit transfers. ULLCA § 502(f).

Dissociation

Under the default rules, members can disassociate at any time. ULLCA § 601(a). Members are also dissociated as allowed or required by the operating agreement, which could be based on some triggering event or some process adopted by the partnership. ULLCA § 602(2).

In a few specific circumstances a member can be involuntarially dissociated by a unanimous vote of the other members. ULLCA § 602(5). But like in other entities, you can't eject folks from the partnership without some reason, and the ULLCA gives a long list of situations where involutarily dissociation is available. Conceptually these fall into three buckets: (i) the member no longer has an economic stake in the business, (ii) the member dies or disolves (for artificial entities), or (iii) the member is a willful, persistent bad actor. ULLCA § 602.

Dissociating terminates management rights but not economic rights. ULLCA § 603(a). The dissociated party can continue to receive distributions, when declared, but they no longer have control and their fiduciary duties (if any) terminate. ULLCA § 603(a).

Dissolution

There are a few ways to dissolve an LLC. First, an LLC dissolves if required by the operating agreement, which could be because of some event or because the agreement states a limited duration. ULLCA § 701(a)(1).

Second, the members can vote to dissolve the LLC. ULLCA § 701(a)(2). This must be unanimous, and it is the members voting regardless of the management structure. Id.

Third, an LLC dissolves if it doesn't have any members for 90 days (with a few minor exceptions). ULLCA § 701(a)(3).

Fourth, an LLC can be dissolved if a court finds that (i) the LLC's activities are mostly illegal activity, (ii) the managers are mostly just breaking laws or oppressing members, or (iii) it's not "reasonably practicable" to carry on in conformity with the operating agreement. ULLCA § 701(a)(4). It can also be dissolved by the secretary of state for failing to pay taxes, file regular reports or have a registered agent. ULLCA §§ 701(a)(5), 708(a).

For the all but the fourth dissolution paragraph above, the members can rescind the dissolution by reversing whatever led to the dissolution and by unanimously agreeing to rescind. ULPA § 703.

Winding Up

Like other entities, dissolution doesn't immediately shut down an LLC. The LLC continues while it pays of debts, settles accounts and sells down assets. ULLCA § 702. And like other entities, a LLC can time-bar claims against it by giving notice to creditors, publishing notice of dissolution in the newspaper and leaving a deposit with a court for contingent claims. ULLCA §§ 704 (notifying creditors), 705 (newspaper notice), 706 (security left with court for contingent claims). After the time limits are met, creditors can't recover those claims from the LLC.

If the LLC can't pay its debts, they just go unpaid. ULLCA § 304(a). That's limited liability for you.

Absolute Sports Cards, LLC, Respondent, v. Matthew Thornton, Appellant.

09-23-2024

Adam Y. Galili, Metro Law &Mediation, Minneapolis, Minnesota (for respondent) Rodd Tschida, Minneapolis, Minnesota (for appellant)

This opinion is nonprecedential except as provided by Minn. R. Civ. App. P. 136.01, subd. 1(c).

Considered and decided by Worke, Presiding Judge; Bjorkman, Judge; and Larson, Judge.

OPINION

BJORKMAN, Judge

Appellant challenges the judgment entered following a court trial regarding his dispute with respondent, a limited liability company that appellant and two other members formed. Appellant argues that the district court (1) erred by concluding that a section of respondent's operating agreement is void as "manifestly unreasonable" under Minn. Stat.  § 322C.0110, subd. 4 (2022); (2) erred in expelling him as a member of respondent under Minn. Stat. § 322C.0602 (2022), effective before the date of its order; (3) abused its discretion by awarding respondent lost profits for appellant's competition with respondent in breach of the operating agreement; and (4) abused its discretion in determining the value of appellant's share in respondent at the time of his expulsion. We affirm.

FACTS

In October 2016, appellant Matthew Lawson Thornton and two other men who traded sports cards and other sports collectibles, Michael Hanson and Clint Wolcyn, formed respondent Absolute Sports Cards LLC (ASC) for the purpose of doing so together. They executed an operating agreement that establishes certain rights and obligations of the members of ASC and provides that those not established in the operating agreement are "as provided in" the Minnesota Revised Uniform Limited Liability Company Act, Minn. Stat. §§ 322C.0101-.1205 (2022) (the Act). Among those obligations specified in the operating agreement, Section 11 prohibits the members from competing with ASC during their tenure as members and for two years after their membership ends, detailing numerous categories of prohibited competitive conduct. But Section 11.5 of the operating agreement provides: "Unless subsequently unanimously agreed to in writing by Members, the provisions of Section 11 shall not apply to or be binding upon any Member's same or similar business in existence at the time of the execution of this Agreement."

Following execution of the operating agreement, Hanson and Wolcyn wrapped up their individual sports-collectibles businesses, transferring both their inventory and the proceeds from final sales to ASC. But Thornton did not transfer any of his inventory to ASC and continued operating his individual business, real651. Between ASC's founding and August 2018, Thornton received $67,198.48 from real651 sales and did not transfer any of it to ASC. Hanson and Wolcyn spoke with Thornton several times about their concerns that he was continuing to operate his competing business and not putting full time and effort into ASC; Thornton did not change his conduct.

At a company meeting on August 25, 2018, Hanson and Wolcyn voted to remove Thornton from ASC, principally because of his continued operation of a competing business, and offered to buy him out. Thornton objected on the ground that Section 11.5 of the operating agreement permits him to continue real651 as the business existed when they executed the agreement. After that meeting, Thornton no longer participated in ASC's activities but continued to operate real651.

The following spring, ASC initiated this action against Thornton, alleging that he competed with the company in violation of the operating agreement and seeking (1) Thornton's expulsion from ASC under Minn. Stat. § 322C.0602, subd. 5; (2) damages incurred as a result of his competition with ASC; and (3) an order prohibiting him from competing with ASC for two years. Thornton asserted counterclaims, alleging, in relevant part, that the other members of ASC forced him out in violation of the operating agreement,  denied him his rightful compensation, and improperly withdrew cash from the company for their own benefit. He requested relief in the form of ASC's dissolution and damages.

ASC moved for partial summary judgment, seeking a determination that Section 11.5's noncompetition waiver is void as "manifestly unreasonable" under Minn. Stat. § 322C.0110, subd. 4(1)(iii), and that Thornton's undisputed ongoing competition breached his duty of loyalty to the company, which warrants his expulsion from the company. ASC also sought dismissal of Thornton's dissolution counterclaim. In February 2022, the district court partially granted the motion, determining that Section 11.5 is void but concluding that material issues of fact remained as to whether Thornton breached his duty of loyalty to the company or whether dissolution of the company is warranted.

Following a three-day trial in April 2023, the district court determined that Thornton engaged in "persistent and uninterrupted" competition with ASC from the time of the company's establishment through trial, warranting his expulsion from ASC effective August 25, 2018. And it ordered ASC to pay Thornton the value of his share in the company as of that date, which it found to be $25,000. The district court also determined that Thornton breached the operating agreement by competing with ASC, specifically by selling collectibles through real651 that he otherwise "would have sold . . . through [ASC] as his partners did with their inventories," and awarded ASC damages of $67,198.48-the amount that Thornton netted from his real651 sales through August 25, 2018. The district court rejected Thornton's breach-of-contract claim, finding that even if ASC breached the operating agreement by "expelling him as a member," he "defaulted first by competing against it," and his breach "has continued uninterrupted" since execution of the operating  agreement. The district court also determined that the company's dissolution was not warranted.

Thornton moved for amended findings or a new trial. ASC opposed the motions and moved for attorney fees under the operating agreement, which provides for attorney fees to the prevailing party in an action to enforce or interpret the agreement. The district court denied Thornton's posttrial motions and awarded ASC attorney fees.

Thornton appeals.

DECISION

A district court's factual findings "shall not be set aside unless clearly erroneous, and due regard shall be given to the opportunity of the [district] court to judge the credibility of the witnesses." Minn. R. Civ. P. 52.01. We will not disturb the court's findings unless they are "manifestly contrary to the weight of the evidence or not reasonably supported by the evidence as a whole." Tonka Tours, Inc. v. Chadima, 372 N.W.2d 723, 726 (Minn. 1985). But we apply a de novo standard of review to questions of law, including interpretation of a statute or an unambiguous contract, Horodenski v. Lyndale Green Townhome Ass'n, Inc., 804 N.W.2d 366, 371 (Minn.App. 2011), and application of a statute to established facts, State Farm Mut. Auto. Ins. Co. v. Metro. Council, 854 N.W.2d 249, 255 (Minn.App. 2014), rev. denied (Minn. Dec. 16, 2014).

I. Section 11.5 of the operating agreement is void as "manifestly unreasonable" under Minn. Stat. § 322C.0110, subd. 4.

Under the Act, each member of a member-managed limited liability company-like ASC-owes fiduciary duties of loyalty and care to the company and the other members.  Minn. Stat. § 322C.0409, subd. 1. The duty of loyalty includes a duty "to refrain from competing with the company in the conduct of the company's activities." Id., subd. 2(3). An operating agreement generally may not "eliminate" the duty of loyalty or any other fiduciary duty. Minn. Stat. § 322C.0110, subd. 3(4). But "[i]f not manifestly unreasonable," an operating agreement may "restrict or eliminate" the duty "to refrain from competing with the company in the conduct of the company's business." Id., subd. 4(1)(iii). In determining whether any term of an operating agreement is manifestly unreasonable, a court

(1) shall make its determination as of the time the challenged term became part of the operating agreement and by considering only circumstances existing at that time; and

(2) may invalidate the term only if, in light of the purposes and activities of the limited liability company, it is readily apparent that:

(i) the objective of the term is unreasonable; or

(ii) the term is an unreasonable means to achieve the provision's objective.

Id., subd. 8.

Thornton argues that the waiver of the duty not to compete in Section 11.5 cannot be manifestly unreasonable because Minn. Stat. § 322C.0110, subd. 4(1)(iii), expressly permits such waivers. And he points to Lamme v. Client Instant Access, LLC, which addressed New Jersey's parallel uniform-law provision, as authority for the proposition that "such waivers . . . are commonplace and widely accepted." No. A-2689-20, 2022 WL 1276123, at *2 ( N.J.Super.Ct.App.Div. Apr. 29, 2022). We agree that Minn. Stat. § 322C.0110, subd. 4(1)(iii), expressly permits members to, as part of the operating agreement, "restrict" or even "eliminate" the duty not to compete with the company. But  members may do so only if this term is "not manifestly unreasonable." Id. In other words, inclusion of a term in an operating agreement that waives the duty not to compete is not inherently unreasonable; there must be something else in the circumstances existing at the time the operating agreement was executed that makes the waiver manifestly unreasonable. After careful review, we are convinced that Section 11 of the operating agreement is that something else.

Section 11 exhaustively prohibits the members from engaging in any form of competition with ASC, not only during their membership but for two years thereafter. It provides that the members will not: "compete" with ASC in "the same sales business," which it defines to include not only the sale of sports cards and other sports collectibles but also "non-sports-related valuables"; "carry on" or "engage in" any business "similar" to ASC; "take any action" that is "designed to" or actually "compete[s]" for ASC customers, suppliers, or other ASC business contacts; or "own" or otherwise "engage in" any business "similar" to ASC. And it applies in Minnesota, North Dakota, South Dakota, Iowa, Wisconsin, and "any other states [ASC] solicits business or prospects in the future."

In light of the comprehensive scope of this prohibition, Section 11.5 can only mean one of two things, neither of which is reasonable. First, Section 11.5 could mean that the members, while generally committing not to compete with ASC, have some temporary latitude to continue operating their existing individual businesses as they wind them down and transfer inventories to ASC. If so, Section 11.5 is an unreasonable means to achieving that objective because it contains no temporal or other scope restriction. Second, Section 11.5 could mean that the members may continue operating their individual businesses in  direct competition with ASC, indefinitely. If so, Section 11.5 is unreasonable in its objective and wholly undermines and creates an irreconcilable conflict with Section 11.

Because neither interpretation of Section 11.5 is reasonable, the purported agreement to eliminate the members' duty not to compete with ASC is manifestly unreasonable and, therefore, void.

II. The district court did not err by expelling Thornton as a member of ASC, effective August 25, 2018.

The Act provides 14 events that dissociate a member from a limited liability company, including

when . . . on application by the company, the person is expelled as a member by judicial order because the person . . . has willfully or persistently committed, or is willfully and persistently committing, a material breach of the operating agreement or the person's duties or obligations under section 322C.0409.

Minn. Stat. § 322C.0602(5).

The district court granted ASC's request to expel Thornton based on its determination that he engaged in direct and uninterrupted competition with ASC from the date of its inception through the date of trial in a manner that was both persistent and willful, constituting material breaches of both Section 11 of the operating agreement and his duty of loyalty to the company under Minn. Stat. § 322C.0409. Thornton argues that the district court erred by (1) determining that he engaged in conduct warranting his  judicial expulsion from ASC, and (2) making his expulsion effective August 25, 2018, the date on which the other members voted to remove him.

Grounds for Judicial Expulsion

Thornton argues that he could not have "willfully" breached either Section 11 of the operating agreement or his duty of loyalty because he acted in reliance on Section 11.5. This argument is unavailing for two reasons. First, as the district court noted, Thornton continued to operate real651 not only in spite of his fellow members' objections but also after the court decided that Section 11.5 is void through the time of trial, a span of 14 additional months. Such conduct amply demonstrates "willful" competition in contravention of Section 11 and his duty of loyalty.

Second, a court may order expulsion of a member who "willfully or persistently" breaches their duties. Minn. Stat. § 322C.0602(5) (emphasis added). The term "or" generally indicates a disjunctive. Broadway Child Care Ctr., Inc. v. Minn. Dep't of Hum. Servs., 955 N.W.2d 626, 634 (Minn.App. 2021). As such, the unchallenged and amply supported finding that Thornton "persistently" breached Section 11 and his duty of loyalty independently justifies the decision to expel him under Minn. Stat. § 322C.0602(5). Because the record supports the district court's determination that Thornton breached  Section 11 and his duty of loyalty to the company, both willfully and persistently, we discern no error in its decision to order his expulsion.

Effective Date of Expulsion

Thornton also assigns error in the district court's decision to make the expulsion effective as of the date the other members voted to remove him from the company. He notes that the Act provides that a person is dissociated "when . . . the person is expelled as a member by judicial order." Minn. Stat. § 322C.0602(5). And he argues that the term "when" indicates a temporal limitation, meaning that a judicial expulsion is effective at the time the court enters the order for expulsion. We are not persuaded for two reasons.

First, the term "when" is not categorically temporal. It often refers to a point in time. See The American Heritage Dictionary of the English Language 1971 (5th ed. 2018) (providing several definitions of "when" related to time). But the term "when" also commonly indicates the existence of a particular circumstance, much like the term "if." See Webster's Third New International Dictionary 2602 (1993) (defining "when," in part, as "in the event that" or "on condition that"). Because Minn. Stat. § 322C.0602 defines the circumstances under which a member is dissociated, the term "when" naturally operates as a conditional limitation rather than a temporal one.

Second, even if we read "when" as a temporal limitation, the language of the statute does not support the limited view that Thornton urges. The statute identifies 14 different circumstances that trigger a member's dissociation from a company. Minn. Stat. § 322C.0602. Most of them involve a single event, such as "an event stated in the operating agreement as causing the person's dissociation," an individual member's death, or the  company's termination. E.g., id. (2), (6)(i), (14). By contrast, dissociation because of a judicial order expelling the member involves two events: (1) the commission of the underlying conduct that leads the company to apply for the member's expulsion, which conduct may be past ("committed") or ongoing ("committing"); and (2) the district court's entry of an order granting that application. See id. (5). Tying the timing of the dissociation to the conduct at issue-rather than the court's order-makes this provision effectively most like the other provisions in Minn. Stat. § 322C.0602. And it prevents the member whose conduct warrants expulsion from benefiting from any delay between the conduct and the entry of the order.

In sum, because Minn. Stat. § 322C.0602 lists the circumstances that precipitate a member's dissociation, and the relevant circumstance for dissociation based on judicial expulsion is the misconduct of the member being expelled, the district court did not err by setting the effective date of Thornton's expulsion based on his misconduct.

III. The district court did not abuse its discretion by awarding ASC lost profits.

Generally, damages for breach of a covenant not to compete "are measured by the business loss suffered as a consequence of the breach," meaning the profits lost "as a direct result of" the competition. Faust v. Parrott, 270 N.W.2d 117, 120 (Minn. 1978). "The district court has broad discretion in determining damages, and we do not reverse absent an abuse of discretion." Fontaine v. Steen, 759 N.W.2d 672, 679 (Minn.App. 2009).

Thornton argues that the district court abused its discretion by awarding ASC $67,198.48 as lost profits attributable to his breach of the operating agreement. He contends the award is improper because (1) ASC did not plead a claim for lost profits, and (2) the record contains insufficient evidence of causation. Neither contention convinces us to reverse.

Pleading

Minnesota is a "notice-pleading state," requiring only that a pleading contain "information sufficient to fairly notify the opposing party of the claim against it." Halva v. Minn. State Colls. &Univs., 953 N.W.2d 496, 500 (Minn. 2021) (quotation omitted); see Minn. R. Civ. P. 8.01. In its complaint, ASC alleged that Thornton breached Section 11 of the operating agreement by selling sports collectibles through real651 in direct competition with ASC, and sought "judgment against [Thornton] in an amount equal to the amount [he] derived by competing with the Company," expected to exceed $25,000. This pleading may not have used the phrase "lost profits," but it provided ample notice that ASC sought to recover profits it lost because of Thornton's breach of the operating agreement.

Causation

The district court awarded $67,198.48 in lost profits because that is the amount Thornton netted through real651 from the time of ASC's establishment through August 25,  2018. Thornton contends this award is improper because "ASC's damages cannot be based on real651 'sales' in general," without a causal link. But the district court identified that link, finding that if Thornton had not made those sales through real651, he otherwise "would have sold . . . through [ASC] as his partners did with their inventories." The record amply supports that finding. Section 11 of the operating agreement broadly prohibits members from engaging in the trade of sports collectibles in competition with ASC. Had Thornton complied with it, his only way to sell sports collectibles would have been through ASC and the proceeds of all those sales would have gone to the company. Both Hanson and Wolcyn did exactly that, transferring their inventories to ASC and selling them through the company, or transferring the proceeds of any final individual sales to the company. On this record, the district court did not abuse its discretion by awarding $67,198.48 in damages for lost profits.

IV. The district court did not abuse its discretion in determining and awarding to Thornton the value of his share in ASC on the effective date of his expulsion.

Thornton challenges the district court's finding that the fair value of his share of the company on the effective date of his expulsion was $25,000, as well as the district court's approach to determining this amount. Nothing in the Act expressly addresses how to value a member's share of a company in the context of a court-ordered buy-out. But generally, a district court has "broad discretion" to determine the date and method of valuing a company. Lund v. Lund, 924 N.W.2d 274, 282-83 (Minn.App. 2019) (quoting Advanced Commc'n Design, Inc. v. Follett, 615 N.W.2d 285, 290 (Minn. 2000)), rev. denied (Minn. Mar. 27, 2019). This discretion extends to determining the weight and credibility of expert  opinions regarding fair value. Rainforest Cafe, Inc. v. State of Wis. Inv. Bd., 677 N.W.2d 443, 451 (Minn.App. 2004). A district court abuses its discretion when it makes clearly erroneous findings of fact or misapplies the law. In re Otto Bremer Tr., 2 N.W.3d 308, 319 (Minn. 2024).

Thornton contends the district court abused its discretion in setting August 25, 2018, as the valuation date because he was technically still a member of the company from then until the date the district court ordered his expulsion. But the district court's expulsion order negated that membership. And more importantly, the court selected August 25, 2018, as the valuation date because Thornton undisputedly did not contribute anything to the company's growth after that date, the other members "acted promptly" to seek his judicial expulsion, and Thornton "should not be able to capitalize upon gains and value realized during this lawsuit." Thornton identifies no flaw in this reasoning, and we discern none.

Thornton also challenges the district court's rejection of his expert's opinion that his one-third share of ACS was worth $343,700. But that opinion valued the company as of December 31, 2021-more than three years after the court-adopted valuation date. Because setting the valuation date was well within the district court's discretion, the court was equally entitled to exercise its discretion to reject an expert opinion that has no relation to that date. Using that date as a reference, the court noted that a schedule attached to, and executed simultaneously with, the operating agreement provides that the value of each member's interest in the company is $25,000, and that the members never updated or revised that schedule. And the court found that a $25,000 per-member value "corresponds reasonably" with ASC's financial information around August 2018.

Moreover, the district court made more than six pages of findings evaluating the expert's valuation and detailing its numerous reasons for rejecting it. In particular, the court noted that Thornton was the sole source of the expert's information about ASC, which led the expert to mischaracterize cash withdrawals that Hanson and Wolcyn used for purchasing inventory and disregard the impact of real651's competition on ASC. The court also observed that the valuation was prepared in January 2023 but focused on December 2021, omitting ASC's losses in 2022 even though it purported to give greater weight to more recent years' performance. Because the district court made robust findings in support of its decision to reject the expert's valuation, and Thornton has identified no clear error in those findings, he has not demonstrated any abuse of discretion in that decision.

Finally, within this same section of his brief, Thornton also appears to argue that the district court abused its discretion by (1) not awarding him member distributions after August 2018 and other amounts he claimed as damages in connection with his breach-of-contract claim against ASC; and (2) awarding ASC attorney fees as the prevailing party. As to the first argument, Thornton fails to acknowledge that the district court rejected his breach-of-contract claim, let alone present any legal analysis or authority demonstrating that the district court erred in doing so. Accordingly, he has forfeited any such argument. See Ward v. El Rancho Manana, Inc., 945 N.W.2d 439, 448 (Minn.App. 2020), rev. denied (Minn. Sept. 29, 2020). And Thornton's attorney-fees argument is similarly flawed because he does not dispute that ASC is the prevailing party, that the prevailing party is entitled to attorney fees under the operating agreement, or the amount of attorney fees awarded. Indeed, he argues only that he should prevail in this appeal and therefore ASC  is not the prevailing party. But as discussed above, his arguments for reversal fail, leaving ASC as the prevailing party.

Affirmed.

1. Peter Pan and Wendy are the only two members of Neverland LLC, a member-managed limited liability company. Peter signs a contract for six pints of pixie dust on behalf of the LLC, signing "Peter Pan, as a member of Neverland LLC." Assume the default rules are in place. Is the LLC bound by the contract? Is Peter?
2. Same facts. Assume that Neverland pays for the order after delivery. The next month, Peter orders again and Neverland pays. This goes on for six months until Wendy realizes what's going on and refuses to let the LLC pay. Is the LLC bound by Peter's latest, unpaid order?
3. Same facts. How would you advise Neverland LLC to avoid this issue?
4. Wendy puts out a press release saying, "Neverland LLC denounces Tinkerbell. She's a thief and a terrible fairy." Assuming the press release meets the requirements for a defamation claim, is Wendy liable? Suppose the LLC had a statement of LLC authority authorizing Wendy to make the claim. What liability?
5. Tom and Jean-Ralphio file a remarkably complete certificate of organization to create an LLC to run their entertainment company. They never get around to drafting an operating agreement, but they have a few late night talks where they agree on how it will be managed. Specifically, Tom will hire the musicians, and Jean-Ralphio will do the accounting. Tom contracts on behalf of the LLC to hire a saxophonist named Duke Silver. After the performance, who is liable for the payment to Duke?

Answers

1. Without more, members aren't agents of an LLC. The facts don't indicate Peter getting authority some other wa. So the LLC wouldn't be liable. Peter, on the other hand, warranted his authority as an agent. So he would be liable.
2. This situation would likely create apparent authority, and the LLC would be liable. We can trace the apparent authority to the LLC's actions, namely, paying the bill for so long.
3. Adopting authority rules into the operating agreement would be a strong start. They could also use statements of LLC authority. And probably fire Peter. Every time his name pops up here there's a problem. Kid needs to grow up.
4. Agents are liable for their own torts, so Wendy would be liable whether or not the LLC is. If she acted with authority, then the LLC would also be liable. But note that in either case Wendy would be liable only if sued directly; she wouldn't be liable if the judgment was solely against the LLC. Members are not liable for the debts of the LLC.
5. They have an LLC because they filed the certificate of organization. It's a member-managed LLC because they didn't specify otherwise. That means neither of these guys has authority to sign, absent some other facts. And we have those facts here. The understanding they reached in the late night discussions is an operating agreement, and it gave Tom authority to hire musicians. Duke Silver is a musician, so Tom acted within the scope of his authority, and so the LLC is liable. 

Often folks will talk about charities, 501(c)(3)s or tax exempt organizations as if they are synonyms. As lawyers, we've never met a synonym, so here's some more precise definitions.

A tax exempt organization is an organization that is exempted from paying taxes, though typically it refers to organizations exempt from federal income tax. This could include a church, a pension fund or an ERISA plan. As long as some statute exempts the organization from paying taxes, it's proper to refer to it as a tax exempt organization.

A nonprofit is an organization that derives its tax exemption from 26 U.S.C. 501(c). So nonprofits are a subset of tax exempt organizations; it's a narrower list and includes things like churches, cemetaries, the Elks Lodge, some insurance co-operatives, veteran's organizations, labor unions and the chamber of commerce. § 501(c) has 28 categories of nonprofits, all of which are properly called nonprofits.

Charity is a more narrow subset of nonprofits. A charity is an organization that derives its tax exemption from 26 U.S.C. 501(c)(3). This section reads: 

Corporations, and any community chest, fund, or foundation, organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, or educational purposes, or to foster national or international amateur sports competition (but only if no part of its activities involve the provision of athletic facilities or equipment), or for the prevention of cruelty to children or animals, no part of the net earnings of which inures to the benefit of any private shareholder or individual, no substantial part of the activities of which is carrying on propaganda, or otherwise attempting, to influence legislation (except as otherwise provided in subsection (h)), and which does not participate in, or intervene in (including the publishing or distributing of statements), any political campaign on behalf of (or in opposition to) any candidate for public office.

Charities include mosques, universities, soup kitchens, some hospitals, the Red Cross and shelters. This chapter will focus on charities. Charities are sometimes referred to as 501(c)(3)'s. We'll discuss the things a charity must do (education, charity, religion, etc.) and the things it can't do (pay dividends, too much politics).

Every charity is a nonprofit, and every nonprofit is a tax exempt organization. But not every tax exempt organization is a nonprofit, and not every nonprofit is a charity.

One other quick note. The term "church" is a defined term that the IRS uses to refer to churches, synagogues, mosques and other worship communities. We're using it in this technical sense here, so it should not be considered exclusive of any religious practices or beliefs.

Internal Revenue Code § 501(c)(3) exempts charities from federal income tax, subject to some exceptions. For example, charities still pay federal taxes on income derived from unrelated business. So if your soup kitchen is also running a cryptocurrency trading platform, you’re going to pay some taxes.

States typically exempt churches and charities from income taxes, property taxes and sales taxes. They often defer to the federal definitions when determining what is a charity, so an organization that qualifies for federal income tax deduction typically qualifies for state tax deductions, though this can vary state by state.

The most heated issues arise with property taxes. When a charity gets a property tax deduction, it reduces the budget for local officials, so local officials have an incentive to define charity narrowly. This can turn into cases where local officials dispute whether a preschool really advances a church’s religious mission or whether the art at a museum is so bad that displaying it can't be considered charity.

Donations to charities (but not all nonprofits) are also deductible for the donor. 26 U.S.C. § 170. That means if you give $10 to a food pantry, you can deduct that $10 from your taxable income. So if your tax rate is 20%, then you’ll pay $2 less in taxes ($10 * 20% = $2; but you’re still poorer because you gave away $10 and saved only $2 in taxes). There are limits on how much you can deduct, but that’s beyond the scope of this introduction.

Tax Expenditures

A tax expenditure refers to a reduction in tax revenue due to tax deductions, exclusions, exemptions, credits or similar policies that reduce a taxpayer's burden. There are a few ways of thinking about this.

Suppose the government wants to subsidize archery. It could give money to folks running archery schools. Or it could reduce the taxes of folks running archery schools. Giving cash to archery schools is clearly an expenditure. But decreasing the schools' tax burden has the same effect--more money for the schools, less money for the government. Because a cash payment is economically equivalent to a reduction in taxes owed, we can treat a reduction in taxes as a government expenditure.

Another way of thinking about it is that assuming all our government debt will eventually be paid and inflation kept constant, long-term taxes must cover expenses. So if taxes from one source are reduced, taxes from another source must increase. Tax credits, deductions and exclusions don't reduce the amount of taxes collected in the long-term under our assumptions. Instead they shift the burden onto others.

An opposing way to think of it is that taxation is theft. The government can't claim to be doing me a favor by not taking my money. I don't owe gratitude to the mugger who passes me by for another victim. It was never the government's money, so it wasn't some noble sacrifice for the government not to take it. Under this view, a deduction isn't a government expenditure, it's a bypassed theft.

You may sympathize with some of these arguments more than others. But where you set the baseline (is the default to be taxed or is the default to be left alone?) will likely shape how you view the policy arguments around tax benefits for charities.

Policy Arguments

First, is the historical argument. Churches have been exempt from taxation since the Egyptian pharaohs. This tradition continued for thousands of years, bolstered by claims that God was sovereign, so earthly sovereigns lacked authority to tax the church. Tax exemption is part of our legal heritage.

There are two common responses. First, so what? Lots of old laws were bad and history alone isn’t a sufficient justification. Second, respect aside, a deity is unlikely to be harmed by any taxes. To paraphrase Captain Kirk, “What does God need with a [tax exemption]?”

Second, is the public benefit subsidy theory, which says charities are exempt from taxes because they provide services that would otherwise the government would have to provide. Soup kitchens reduce welfare needs. Universities reduce educational needs. Civic societies create unified communities. Because charities create benefits that reduce costs of government, the government should subsidize them.

A counterargument is that not all charities provide services that the government would otherwise have to provide. Churches provide charitable services, but they also teach dogmas that are at odds with each other. New York’s Metropolitan Opera mostly provides entertainment for wealthy patrons. It’s not clear the government would need to provide this if charities did not. (How would you respond to these arguments?)

One common response to this is pluralism. Pluralism is a system that supports diverse and even opposing objectives. For example, our first amendment doesn't review speech in advance to see if it is good and only then offer protection. The first amendment protects all speech for a wide range of ideas and views. It also protects a variety of religious traditions. Pluralism allows ideas to compete for donors and disciples. The opposite system would be that the majority chooses the correct answer, and minority views are suppressed. Pluralism protects minority views and minority religions from majority oppression. Everyone holds some minority view, the argument goes, so pluralism protects everyone.

The income measurement theory argues that standard taxation policies don’t make sense in the charitable context. Returning to our example above, if I donate $10 to someone in need, I don’t have that $10. It didn’t benefit me. So is it right to count that as my income? Why should I pay tax on soup someone else eats?

More technically, accounting defintions aren't equipped to deal with charities. Assume a charity raises $100, spends $20 on staff and $80 to feed the hungry. How much is the charity's income? What if it spent only $70 to feed the hungry and retained $10 for the following year. Is that income? If it uses that to create an endowment, is that a capital expense? Accounting and taxation systems don’t map easily onto charitable models.

Charities can be organized as corporations, LLCs, trusts or unincorporated associations.

Corporations

Corporations are a useful form because they are flexible, they can hold property and they can act as a legal person. The downsides of the corporate form are that corporations take longer to form than other entity types and require more maintenance, for example, regular board meetings and other time consuming formalities.

Still, most large charities are organized as corporations. Nonprofit corporations are formed by filing a charter with the secretary of state. The primary difference is that the charter doesn’t authorize shares with economic interests and the charter has a few special clauses, for example, that none of the charity’s assets can be used for private benefit or inurement.

Charitable corporations are managed by a board of directors. The board will typically appoint officers to do the day-to-day work of the charity, and the chief executive is typically called the executive director (which can be confusing, because it is an officer position, not a board position).

Directors and officers owe fiduciary duties to the charity, which typically can be enforced by the state attorney general. This includes a duty of care and a duty of loyalty, though check your state law, as some states spell out these concepts differently. In a fiduciary duty suit, managers are typically entitled to the best judgment rule. This rule operates like the business judgment rule in the for-profit context and typically shields managers from liability absent a showing of bad faith or conflicted dealing.

Charitable corporations don’t have shareholders. In some charitable corporations the role of shareholders is filled by “members” and in others it is filled by the board of directors. It will depend on the state law and the charter. Unlike for-profit corporations, non-profit corporations are not predominately organized in Delaware.

Trusts

Trusts are the second most common entity form. A trust is essentially just a document appointing someone (the “trustee”) to manage some asset and laying out the rules to manage it. In a typical trust, the beneficiary might have rights to enforce the trust against the trustee. Because charitable trusts lack a specific beneficiary, the state attorney general is typically empowered to bring suit against a wayward trustee. Other state trust laws are often softened for charitable trusts; for example, unlike other trusts a charitable trust won’t fail for vagueness.

The advantages of a trust is that it is quick to create, it has low formalities and it doesn’t require any government approvals before it becomes effective. The downsides are that the governance structure is more rigid than corporate governance. It is typically used by private foundations and other charities that limit their work to issuing grants.

Limited Liability Companies

Limited liability companies are a rare entity type for a charitable organization. That’s because the IRS requires that all members of a charitable LLC also qualify as charities. In other words, LLCs can be used only as subsidiaries of another charity. Because of this LLCs are primarily used to cordon liability or potential tax issues. For example, a museum may run a bookstore through an LLC so that if the IRS determines the bookstore isn’t tax exempt it won’t affect the rest of the museum. Similarly, a charity formed to teach children to work with animals may use a separate LLC for the team using lions. This allows the charity to cordon off liability. But check with your client first. It is not uncommon for charities to forgo legally beneficial structures in order to promote the charity’s mission. You should know your client’s priorities before structuring a liability-free lion feeding program. Nonprofit LLCs typically have the same flexible governance as for-profit LLCs.

Unincorporated Associations

Finally, unincorporated associations can be approved nonprofits under § 501(c). This might be a local tennis club. These organizations are governed by agency law principles. The advantages are that they require no setup and no formalities. The downsides are unlimited liability and that the association can’t own property. This is usually not the optimal organizational form and is suited best for temporary projects or casual organizations.

There are a few things charities are required to do and a few things they are prohibited from doing. Let's review the positive mandates, which are bolded in the reprint of § 501(c)(3) below:

Corporations, and any community chest, fund, or foundation, organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, or educational purposes, or to foster national or international amateur sports competition (but only if no part of its activities involve the provision of athletic facilities or equipment), or for the prevention of cruelty to children or animals, no part of the net earnings of which inures to the benefit of any private shareholder or individual, no substantial part of the activities of which is carrying on propaganda, or otherwise attempting, to influence legislation (except as otherwise provided in subsection (h)), and which does not participate in, or intervene in (including the publishing or distributing of statements), any political campaign on behalf of (or in opposition to) any candidate for public office.

The affirmative duties are to be exclusively 1) organized for its charitable purpose and 2) operated for its charitable purpose. The IRS interprets "exclusively" to mean "predominantly," so insubstantial diversions are unlikley to risk the organizations tax exempt status.

An entity is organized for its charitable purpose if the governance documents limit it to its charitable purpose. Recall that for-profit corporations typically have a purpose statement that allows the corporation to "engage in any lawful business." This wouldn't work for charities because there is plenty of "lawful business" that wouldn't meet the definitions of § 501(c)(3). Instead, a charity's organizational documents will typically have a purpose clause that limits it to "operate exclusively for religious purposes" or "operate exclusively for charitable and educational purposes," or something similar.

An entity is operated exclusively for its charitable purpose if its actions promote its charitable purpose. So while the organizational test can be resolved by just reading the governance documents, the operational test looks at what the charity actually does. For example, consider a group that claims to be a charity benefiting the environment. It's charter may limit it to environmental protection. But if the charity's only activity is purchasing land behind the director's home to maintain his view, that's going to fail the operational test.

It's easy to see that this is going to create some judgment calls. What does it mean to operate charitably? Why is preserving land in the director’s backyard less charitable than preserving land farther away? What makes something "charitable"?

And what does it mean to be educational? Would a course on alchemy be educational? Does it matter if the education is one-sided, for example a charity organized to teach only the social benefits of gun ownership? Would your view change if it was teaching only the social costs of gun ownership? What if the education is in illegal activity, like pickpocketing? How about a charity that educates dogs, like an obedience school? Should that count as educational?

And what does it mean to operate for a religious purpose? What makes something religious? Is that code for Christian? For theism more broadly? What about religions that do not believe in any supreme being(s)? In Nebraska, folks often talk of watching football religiously. Is that an exempt activity? What beliefs or practices are required to be a good and proper religion in the eyes of IRS bureaucrats?

The following case looks at how the IRS determines whether something counts as a religion.

General Counsel Memorandum 36993

February 3, 1977

ALVIN D. LURIE

Assistant Commissioner (Employee Plans & Organizations)

Attention: Director, Exempt Organizations Division

This responds to your memorandum (T:MS:EO:R:2-5) dated November 5, 1974, referring a proposed ruling letter addressed to the above-captioned organization for our concurrence or comment.

ISSUES

1. Whether an organization formed for and engaged in the practice of witchcraft may be considered a ‘religious' organization within the meaning of Int. Rev. Code of 1954 § 501(c)(3) [hereinafter cited as Code].

2. Whether the organization qualifies as a ‘church’ for purposes of Code § 170(b)(1)(A)(i).

CONCLUSIONS

1. We agree with your proposed position that the organization and its subordinates may be recognized as exempt from Federal income tax under Code § 501(a) as religious organizations within the ambit of Code § 501(c)(3).

2. We also agree that the organization qualifies as a ‘church’ for purposes of Code § 170(b)(1)(A)(i).

FACTS

The *** was incorporated under the laws of *** on *** as a nonprofit religious organization. The purpose of the organization is to promote the *** religion and the worship of deities recognized by the *** to train priests, priestesses and other leaders of the *** religion and to instruct members of the religious association in the history, philosophy and all other components of the stated religion. Members of the organization consider themselves of be pagans engaged in the practice of witchcraft. The organization has published a pagan manifesto, which sets forth standards of behavior for its followers. In the manifesto the members are urged to live according to the laws of nature. Judging by the available information these beliefs are sincerely held and there is no evidence in the file that the organization engages in activities that violate any laws or contravene any clearly defined public policy or policies.

The organization holds weekly services following a set ritual. There are also seasonal festivals and marriage ceremonies. The file does not show whether these ceremonies are recognized as valid marriages under applicable state laws. The organization's members worship ‘the horned god’, but it is specifically alleged that this horned god is not the devil. Magic, healing and clairvoyance are practiced and certain animals and plants are sacred to the organization's members.

ANALYSIS

1. Code § 501(c)(3) provides that organizations organized and operated exclusively for religious, charitable and educational purposes, no part of the net earnings of which inure to the benefit of any private shareholder or individuals, are exempt under Code § 501(a).

The First Amendment to the United States Constitution provides that Congress is forbidden from enacting any ‘law respecting an establishment of religion, or prohibiting the free exercise thereof . . ..’

There are various definitions of ‘pagan’ and ‘paganism’ to be found in dictionaries. One definition of a ‘pagan’ is ‘an irreligious person.’ A more frequently found definition, perhaps, is that a ‘pagan’ is a ‘follower of a polytheistic religion.’ In the instant case the primary issue is whether the organization, whose members consider themselves to be ‘pagans engaged in the practice of witchcraft,’ may be said to be ‘religious' as that term is used in Code § 501(c)(3). By the preponderance of dictionary definitions, the beliefs professed by the *** would qualify as ‘religious beliefs.’

An analysis of the First Amendment to the Constitution of the United States indicates that it is logically impossible to define ‘religion’. It appears that the two religious clauses of the First Amendment define' religious freedom' but do not establish a definition of ‘religion’ within recognized parameters. An attempt to define religion, even for purposes of statutory construction, violates the ‘establishment’ clause since it necessarily delineates and, therefore, limits what can and cannot be a religion. The judicial system has struggled with this philosophic problem throughout the years in a variety of contexts.

In Reynolds v. United States, 98 U.S. 145 (1878), the issue of the constitutionality of a law passed by Congress making the practice of polygamy by persons residing in United States Territories a criminal act was before the Supreme Court. The Court interpreted the constitutional prohibition in this way: ‘Congress was deprived of all legislative power over mere opinion, but was left free to reach actions which were in violation of social duties or subversive of good order.’ 98 U.S. at 164. Thus, finding that for some 100 years polygamy had been considered an offense against society in all the states of the union, the Court held that the statute under consideration was constitutional and valid as prescribing a rule of action for all those residing in the territories. In holding that religious belief did not except persons from operation of the statute, the Court said: ‘. . . while they [laws] cannot interfere with mere religious belief and opinions, they may with practices.’ Id. at 166. In Cantwell v. Connecticut, 310 U.S. 296 (1940), the Court endorsed Reynolds, stating ‘. . . the [First] Amendment embraces two concepts, freedom to believe and freedom to act. The first is absolute but, in the nature of things, the second cannot be.’ 310 U.S. at 303-4. See also Davis v. Beason, 133 U.S. 133 (1890) and Mormon Church v. United States, 136 U.S. 1 (1890) where the Court grappled with the same issue. While continuing to affirm the right of freedom of religious belief, the Court nevertheless held that legislation for the punishment of acts ‘inimical to the peace, good order and morals of society’ did not violate the First Amendment.

In the last three decades the Court continued to struggle for a definition of ‘religion.’

In West Virginia State Board of Education v. Barnett, 319 U.S . 624 (1943) the Court stated:

. . . If there is any fixed star in our Constitutional constellation, it is that no official, high or petty, can prescribe what shall be orthodox in politics, nationalism, religion, or in other matters of opinion or force citizens to confess by word or act their faith therein. 319 U.S. 642.

Mr. Justice Frankfurter, dissenting, succinctly posed the dilemma then facing the Court and now facing the Service. He noted that in dealing with religious scruples the Court was dealing with almost numberless varieties of doctrines and beliefs entertained with equal sincerity by particular groups for which they satisfied man's needs in his relation to the mystery of the universe. He stated: ‘. . . This court cannot be called upon to determine what claims of conscience should be recognized and which should be rejected as satisfying the ‘religion’ which the Constitution protects. That would indeed resurrect the very discriminatory treatment of the religion which the Constitution sought forever to forbid.' 319 U.S. 658.

The following year in United States v. Ballard, 322 U.S. 78 (1944), the Court held that the truth or verity of the Ballards' religious doctrines and beliefs could not be submitted to a jury. With respect to Constitutional freedom of religious beliefs the Court said:

It embraces the right to maintain theories of life and death and of the hereafter which are rank heresy to the followers of the orthodox faith. . . . Man can believe what he cannot prove. They may not be put to the proof of their religious doctrines or beliefs.

More recently the Court has been concerned with ‘religious beliefs' as utilized in the Military Selective Service Acts. In United States v. Seeger, 380 U.S. 163 (1965) the Court enunciated a proposition that a sincere and meaningful belief that occupies a place in the lives of its possessor parallel to that filled by orthodox beliefs in God is, in effect, a religious belief.

The Court reaffirmed Seeger in Welsh v. United States, 398 U.S. 408 (1970), where originally the claim for military exemption was not based on a ‘religious' ground. Notwithstanding the ‘nonreligious' claim for exemption, the Court found that the strong beliefs of the defendant in the case were ‘religious'. See also United States v. Craft, 423 F.2d 829, 833 (9th Cir. 1970) and United States v. Spears, 443 F.2d 895 (5th Cir. 1971) and other cases therein cited.

We have concluded that the proper rule as reflected by the above cases is that in the absence of a clear showing that the beliefs or doctrines under consideration are not sincerely held by those professing or claiming them as a religion, the Service cannot question the ‘religious' nature of those beliefs. This rule has been uniformly followed by the Tax Court in examining organizations claiming tax exemption as religious organizations.

In the early case of Unity School of Christianity, 4 B.T.A. 61 (1926), the Board set the tenor for later Tax Court cases when it stated:

Religion is not confined to a sect or ritual. The symbols of religion to one are anathema to another. What one may regard as charity another may scorn as foolish waste. . . . Congress left open the door of tax exemption to all corporations meeting the test, the restrictions not being as to the specie of religion, charity, science or education under which they might operate, but as to the use of its profits and the exclusive purpose of its existence.

Some twelve years after the Supreme Court looked at the ‘I AM’ movement in United States v. Ballard, supra, the movement was before the Tax Court. In Saint Germain Foundation, 26 T.C. 648 (1956), the Commissioner had revoked the exemption of taxpayer on the basis of inurement. With respect to the characterization of the organization as religious, the court noted that the Commissioner's revocation of exemption was not on the ground that taxpayer lacked the necessary religious character. The court then quoted the above excerpt from Unity School and concluded that the evidence established that the organization was organized exclusively for religious purposes.

The rule was again followed in A. A. Allen Revivals, Inc., 22 CCH Tax Ct. Mem. 1435 (1963) where the Tax Court held that under the First Amendment to the Constitution, the decisions of the Supreme Court of the United States and prior decisions of the Tax Court, it was ‘not free to distinguish between or to approve or disapprove of one form or expression of religious faith.’

Thus, when examining an organization claiming a religious character such as the organization in the instant case, the primary rule as to religiousity is whether the organization's adherents are sincere in their beliefs. If that question is resolved affirmatively, the rule of Unity School becomes applicable to test the use of the profits of the organization and the exclusive purposes of its existence.

In addition to the foregoing tests, an organization must conform to basic principles of charity law to qualify for recognition of exemption under Code § 501(c)(3). Thus, for example, its organizational documents cannot authorize it to engage, nor can it engage, in activities that are illegal or contrary to clearly defined public policy. See Restatement (Second), Trusts § 377 (1959); IV A. Scott, The Law of Trusts § 377 (3d ed. 1967).

Applying the above rules to this case, we have concluded on the basis of the evidence available in the administrative file that the organization's members are sincere in their beliefs, the organization is organized and operated exclusively for the claimed purposes, and there is no evidence that its organizational documents authorize it to engage in, or that it in fact engages in, activities that are illegal or contrary to any clearly defined public policy. Accordingly, and on the assumption that it otherwise qualifies, we see no reason to disagree with your proposed conclusion that the organization qualifies for recognition of exemption under Code § 501(c)(3) as a religious organization.

2. The Service has previously considered whether a particular organization constituted a ‘church.’ In Rev. Rul. 59-129, 1959-1 C.B. 58 *** A-617682 (Sept. 8, 1955)), the *** was held to be a church within the meaning of Code § 170(b)(1)(A). In connection with this ruling, it was observed that the *** had (1) a distinct legal existence; (2) a recognized creed and form of worship; (3) a definite and distinct ecclesiastical government; (4) a formal code of doctrine and discipline; (5) a distinct religious history; (6) a membership not associated with any church or denomination; (7) a complete organization of ordained ministers ministering to their congregations; (8) ordained ministers selected after completing prescribed courses of study; (9) a literature of its own; (10) established places of worship; (11) regular congregations; (12) regular religious services; (13) Sunday Schools for the religious instruction of the young; and (14) schools for the preparation of its ministers. Rev. Rul. 59-129 was published in digest form and did not set forth these characteristics. These characteristics normally would be attributed to a ‘church’ in the commonly accepted meaning of that term. In view of the fact that ‘church’ is not defined in the Code or regulations, the above criteria are useful in determining whether, on balance, a particular religious organization, if tax-exempt, constitutes a ‘church.’ The determination is necessarily one of fact and must be made on a case by case basis.

Since it is doubtful that an organization need have all of the above characteristics in order to constitute a ‘church’, it is helpful to examine the few court decisions relevant to this issue in order to ascertain which characteristics have been emphasized.

In Vaughn v. Chapman, 48 T.C. 358 (1967), the court was called upon to determine, inter alia, whether a religious and charitable organization was a ‘church’ within the meaning of Code § 170(b)(1)(A)(i). The organization was interdenominational and was not affiliated with any church group or denomination. The purpose of the organization was two fold: (1) to perform dental work for missionaries, religious workers, and natives, and (2) to promote ‘* * * the Gospel of the Lord Jesus Christ, around the world, and the evangelization of the world on the basis of the principles of the Protestant Faith.’

The organization conducted regular services in the United literature. The members of the organization were all trained in the Bible and church work. While many of its members were ordained ministers, the organization did not conduct a seminary or Bible School. All members were required to be licensed dentists.

The court, after examining the legislative history of Code § 170(b), determined that a more limited concept was intended for the term ‘church’ than that denoted by the term ‘religious organization.’ The court stated that Congress did not intend ‘church’ to be used in a generic or universal sense but rather in the sense of a ‘denomination’ or ‘sect’. The court added that a group need not necessarily have an organizational hierarchy or maintain church buildings to constitute a ‘church.’

In holding that the organization was not a church, the court emphasized that (1) the organization's individual members maintained their affiliation with various churches; (2) the organization was interdenominational and did not seek converts than to the principles of christianity generally; (3) the organization did not ordain its own ministers; and (4) the conducting of religious services by its members was not conclusive per se that the organization was a church.

In Christian Echoes National Ministry, Inc. v. United States, 470 F.2d 849 (10th Cir. 1972) rev'g D.C. unreported, 28 A.F.T.R. 2d 71-5934 (N.D. Okla. 1971), cert. den. 414 U.S. 864 (1973), the United States sought to revoke the Code § 501(c)(3) exempt status of a religious organization. The organization was founded and administered by an ordained minister of the Gospel of Jesus Christ. Other ordained ministers staffed the organization and were emplowered to perform all sacerdotal functions on its behalf. The organization conducted numerous religious revivals in various churches throughout the United States sponsored by local congregations, and it also held regular Sunday services in Tulsa, Oklahoma. It conducted annual conventions, leadership schools, and summer sessions for the young. In upholding the organization's tax-exempt status, the court concluded that

[p]aintiff's organization and structure, its practices and precepts, and activities provide all the necessary elements of a ‘church’ in the ordinary acceptance of the term and as used in the Internal Revenue Code of 1954, its amendments and applicable regulations. Plaintiff's followers together with its ordained pastors clearly constitute a congregation the same as any local church.

In De La Salle Institute v. United States, 195 F. Supp. 891 (N.D. Cal. 1961), the court employed a ‘common sense’ approach in determining whether a particular organization constituted a church for purposes of Code § 511:

To exempt churches, one must know what a church is. Congress must either define ‘church’ or leave the definition to the common meaning and usage of the word; otherwise, Congress would be unable to exempt churches.

The court held in that case that an incorporated religious teaching order that performs no sacerdotal functions is not a church, and the income derived by the order from the owership and operation of a separately incorporated winery is not the income of a church, notwithstanding that both corporations were formed under church auspices.

In comparing the rationale of Chapman, Christian Echoes, and De La Salle to the Salvation Army characteristics underlying Rev . Rul. 59-129, it is evident that some of these characteristics have been considered more significant than others. Thus, Chapman, in equating ‘church’ with denomination, stresses both the fact that the organization did not seek to attract individuals into the ranks of its membership and the fact that its members were also members of other church denominations. The court did not, on the other hand, believe that it was necessary to have a church hierarchy or church building. Christian Echoes, in a similar approach, emphasized that the religious organization in question had an established congregation ministered to by ordained ministers. The De La Salle court, rather than commenting on what a church is, analyzed the issue from the opposite point of view: what a church is not, i.e., it is not a separately incorporated teaching order that performs no sacerdotal functions, or the order's separately incorporated winery.

In the instant case the organization seeks to attract individuals into its ranks and to be accepted such individuals need not abandon their affiliation with other churches. Notwithstanding the nonabandonment factor, we have concluded that it represents a ‘denomination’ within the Chapman rationale. Under the facts presented, it has trained priests and priestesses to minister to an established congregation and thus satisfies the Christian Echoes requirements.

Application of the other criteria underlying Rev. Rul. 59-129 to the *** shows the following:

(1) It has incorporated and has a distinct legal existence.

(2) It has a recognized creed entitled ‘pagan manifesto’ and a distinct form of worship, both unique.

(3) It has a definite ecclesiastical government headed by an individual entitled ‘elder.’

(4) It has a code of doctrine and discipline.

(5) It has adopted the history relating to Welsh mythology.

(6) It alleges it has a complete organization with trained priests who have completed prescribed courses of study.

(7) It has a vast bulk of literature relating to paganism.

(8) It at the present time neither owns or leases property, however it alleges it carries on regular services.

(9) It has no separate organization for the religious instruction of the young.

In addition to the above criteria it may be helpful to evaluate this organization in the light of a draft of proposed regulations defining a church for purposes of Code § 170(b)(1)(A) that was prepared, (but never issued as a notice of proposed rule-making), in 1974 (CC:LR-124-74 dated November 14, 1974).

The draft provides in part:

(a) Church or a convention or association of churches. A church or convention or association of churches as described in section 170(b)(1)(A)(i) if it is an organization of individuals having commonly held religious beliefs, engaged solely in religious activities in furtherance of such beliefs. The activities of the organization must include the conduct of religious worship and the celebration of life cycle events such as births, deaths and marriage . The individuals engaged in the religious activities of a church are generally not regular participants in activities of another church, except when such other church is a parent or subsidiary organization of their church. . . .

Available information indicates that the *** meets the above tests other than the ‘abandonment of other church’ criterion, evidently adopted from Chapman.

Based on an overall weighing of the ‘normal characteristics' of churches we believe that the *** may qualify as a church for purposes of Code § 170.

Accordingly, we agree with your proposed conclusions on the basis of the information that is in your file. We recognize as you do, however, that in a case like this where the applicant is an unusual, even controversial, organization, the Service's judgment in issuing a favorable exemption ruling to it may be called into question. Prior to issuing a ruling, therefore, you may wish to consider whether it would be helpful to you to try to develop any further information from independent sources to augment the usual ex parte representations of the applicant.

CHARLES L. SAUNDERS, JR.

Acting Chief Counsel

By:

SARAH W. GARRETT

Chief, Branch No. 5

Interpretative Division

Attachment:

Admin. file

This document is not to be relied upon or otherwise cited as precedent by taxpayers.

Let's return to IRC § 501(c)(3), with emphasis added to three prohibitions on charities that we'll discuss further:

Corporations, and any community chest, fund, or foundation, organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, or educational purposes, or to foster national or international amateur sports competition (but only if no part of its activities involve the provision of athletic facilities or equipment), or for the prevention of cruelty to children or animals, no part of the net earnings of which inures to the benefit of any private shareholder or individual, no substantial part of the activities of which is carrying on propaganda, or otherwise attempting, to influence legislation (except as otherwise provided in subsection (h)), and which does not participate in, or intervene in (including the publishing or distributing of statements), any political campaign on behalf of (or in opposition to) any candidate for public office.

Inurement

"No part of the net earnings" of a charity can "inure[] to the benefit of any private shareholder or individual." There are a lot of traps here. For example, the whole point of many charities is to give away their assets to other individuals. Shouldn't the soup at a soup kitchen should inure to the benefit of a private individual?

The prohibition on inurement is aimed at insiders, not the charitable beneficiaries of the organization. So a soup kitchen doesn't cross the line by giving away soup. But if the soup kitchen gave all the soup to its founder, who resold it for a profit, that would be a problem. "Net earnings" encompasses all of the charity's assets, and diverting assets to insiders can risk the exemption.

This doesn't mean the insiders have to work for free. Reasonable salaries are permitted. But what is "reasonable" is not always clear. The average salary for a CEO at a nonprofit hospital is around $600,000 per year. Should charities be paying someone to be in the top 1% of earners? Between 2010 and 2018 average nonprofit hospital CEO salaries doubled while nuring salaries increased only 3%. Is that reasonable?

On the other hand, do we want charities to be staffed only by folks who either can't command a higher salary elsewhere or by people who don't need the money? A logistics expert can stretch a food pantry's budget by orders of magnitude, which more than offsets a high salary. If we can do more good by paying for a pricey expert, must we choose between doing the most good and doing what feels good?

This is more controversial in the realm of religion. It's easy to criticize religous leaders that own a fleet of private jets, but the criticism only lands if you reject their claims of divine authority. Said differently, assuming the authors were still alive, what would be a fair market value for producing another surah of the Quran, Paul's letter to the Romans or the book of Isaiah? Scientology has frequently gotten in trouble for their compensation to the religion's founder, L. Ron Hubbard, but what is the market rate for divine truth? And even absent a gift of prophecy, would society really be worse off if we subsidize the production of more moral philosophers?

There is more detail than can be covered in this introductory survey, but best practices are to have all insider benefits approved by an independent board and for larger charities to engage compensation consultants.

Legislation & Lobbying

"[N]o substantial part of the activities" of a charity can be "carrying on propaganda, or otherwise attempting, to influence legislation . . . ." IRC § 501(c)(3).

This may strike you as bizarre. Shouldn't we want the Red Cross to provide its views on war? Or the Sierra Club to  speak out on forest preservation? Why do we allow Nabisco to speak on a childhood obesity bill, but not the American Diabetes Association?

The Treasury Regulations limit this restriction to pending, identifiable legislation. Treasury Regulation § 1.513-1(c)(3). So a church sermon condemning abortion generally or urging the need to welcome refugees probably won't cross any lines. But if the same sermon metions House Bill 138 (or even "the bill pending before our legislature"), that is lobbying. Charities that contact legislators (or urge others to contact legislators) to support or oppose legislation or advocate the adoption or rejection of any legislation are engaged in lobbying.

So let's define legislation. Legislation is limited to actions by legislatures. This includes laws, but also confirmations of nominations. The public is the legislator in public referendums and ballot initiatives, so advocacy on a public referendum would be lobbying. But legislation does not include any judicial or executive actions, so it won't cover agency rule making, executive orders or judicial opinions.

Some charitable activities around legislation are expressly permitted. For example, charities are permitted to create nonpartisan analysis and reports of specific legislation, and they can even provide it to legislators as long as the analysis doesn't support a position. Rev. Rul 70-79, 1970-1 C.B. 127. Charities officials can give technical or expert advice to a legislative body when invited to speak, but an unsolicitied appearance at a congressional committee to oppose a bill is lobbying.

Finally, note that this probibits substantial lobbying. Insubstantial lobbying isn't going to risk the charity's exemption. There's no clear rule here on what is substantial, but one rule of thumb is to keep lobbying at less than 10% of the charity's revenue. A charity can opt-in to bright line rules and penalties under IRC § 501(h), but that's beyond the scope of this introduction.

Policital Campaigns

In 1954 then-Texas Senator Lyndon B. Johnson faced a primary challenge by a young upstart backed by two tax-exempt organizations. Months later he introduced the restriction on charities participating in political campaigns for public office. The Johnson Amendment passed without committee review, discussion or debate.

A charity may not "participate in, or intervene in (including the publishing or distributing of statements), any political campaign on behalf of (or in opposition to) any candidate for public office." IRC § 501(c)(3). Unlike the lobbying prohibition, which allows insubstantial activity, the prohibition on candidate campaign intereference is absolute. 

A candidate is anyone offering to be a contestant for public office. Treasury Regulations § 1.513-1(c)(3). This includes candidates for congress, city council or state legislature, but excludes nominated positions, like an appointment for secretary of state.

Campaign donations are clearly prohibited, but more subtle activities are also prohibited. For example, a charity can't distribute flyers rating candidates even if the criteria are objective. And a charity can't invite a candidate to speak in a way that favors that candidate over others. This gets tricky. Can the ACLU invite a candidate to speak on civil liberties? If a pastor decides to run for office, can the pastor continue to give sermons leading up to election day? Can the Humane Society allow a governor facing re-election to cut the ribbon at its new headquarters?

The IRS produces detailed guides that can help you and your clients with these issues. The general guidance is that you must treat candidates equally when they are acting in their role as candidates. So a pastor can continue giving sermons; a governor can continue cutting ribbons; and if you invite a candidate to speak, you should probably invite the others as well.

Is This Constitutional?

Maybe? Can you condition benefits and tax breaks on an organization waiving a fundamental right? The prohibitions have withstood challenges for seven decades. We'll address the issue in more depth when we read Citizens United.

(a) A “public benefit corporation” is a for-profit corporation organized under and subject to the requirements of this chapter that is intended to produce a public benefit or public benefits and to operate in a responsible and sustainable manner. To that end, a public benefit corporation shall be managed in a manner that balances the stockholders’ pecuniary interests, the best interests of those materially affected by the corporation’s conduct, and the public benefit or public benefits identified in its certificate of incorporation. In the certificate of incorporation, a public benefit corporation shall:

(1) Identify within its statement of business or purpose pursuant to § 102(a)(3) of this title one or more specific public benefits to be promoted by the corporation; and

(2) State within its heading that it is a public benefit corporation.

(b) “Public benefit” means a positive effect (or reduction of negative effects) on 1 or more categories of persons, entities, communities or interests (other than stockholders in their capacities as stockholders) including, but not limited to, effects of an artistic, charitable, cultural, economic, educational, environmental, literary, medical, religious, scientific or technological nature. “Public benefit provisions” means the provisions of a certificate of incorporation contemplated by this subchapter.

(c) The name of the public benefit corporation may contain the words “public benefit corporation,” or the abbreviation “P.B.C.,” or the designation “PBC,” which shall be deemed to satisfy the requirements of § 102(a)(1)(i) of this title. If the name does not contain such language, the corporation shall, prior to issuing unissued shares of stock or disposing of treasury shares, provide notice to any person to whom such stock is issued or who acquires such treasury shares that it is a public benefit corporation; provided that such notice need not be provided if the issuance or disposal is pursuant to an offering registered under the Securities Act of 1933 [15 U.S.C. § 77r et seq.] or if, at the time of issuance or disposal, the corporation has a class of securities that is registered under the Securities Exchange Act of 1934 [15 U.S.C. § 78a et seq.].

(a) The board of directors shall manage or direct the business and affairs of the public benefit corporation in a manner that balances the pecuniary interests of the stockholders, the best interests of those materially affected by the corporation’s conduct, and the specific public benefit or public benefits identified in its certificate of incorporation.

(b) A director of a public benefit corporation shall not, by virtue of the public benefit provisions or § 362(a) of this title, have any duty to any person on account of any interest of such person in the public benefit or public benefits identified in the certificate of incorporation or on account of any interest materially affected by the corporation’s conduct and, with respect to a decision implicating the balance requirement in subsection (a) of this section, will be deemed to satisfy such director’s fiduciary duties to stockholders and the corporation if such director’s decision is both informed and disinterested and not such that no person of ordinary, sound judgment would approve.

(c) A director’s ownership of or other interest in the stock of the public benefit corporation shall not alone, for the purposes of this section, create a conflict of interest on the part of the director with respect to the director’s decision implicating the balancing requirement in subsection (a) of this section, except to the extent that such ownership or interest would create a conflict of interest if the corporation were not a public benefit corporation. In the absence of a conflict of interest, no failure to satisfy that balancing requirement shall, for the purposes of § 102(b)(7) or § 145 of this title, constitute an act or omission not in good faith, or a breach of the duty of loyalty, unless the certificate of incorporation so provides.

Any action to enforce the balancing requirement of § 365(a) of this title, including any individual, derivative or any other type of action, may not be brought unless the plaintiffs in such action own individually or collectively, as of the date of instituting such action, at least 2% of the corporation’s outstanding shares or, in the case of a corporation with shares listed on a national securities exchange, the lesser of such percentage or shares of the corporation with a market value of at least $2,000,000 as of the date the action is instituted. This section shall not relieve the plaintiffs from complying with any other conditions applicable to filing a derivative action including § 327 of this title and any rules of the court in which the action is filed.

(a) A public benefit corporation shall include in every notice of a meeting of stockholders a statement to the effect that it is a public benefit corporation formed pursuant to this subchapter.

(b) A public benefit corporation shall no less than biennially provide its stockholders with a statement as to the corporation’s promotion of the public benefit or public benefits identified in the certificate of incorporation and of the best interests of those materially affected by the corporation’s conduct. The statement shall include:

(1) The objectives the board of directors has established to promote such public benefit or public benefits and interests;

(2) The standards the board of directors has adopted to measure the corporation’s progress in promoting such public benefit or public benefits and interests;

(3) Objective factual information based on those standards regarding the corporation’s success in meeting the objectives for promoting such public benefit or public benefits and interests; and

(4) An assessment of the corporation’s success in meeting the objectives and promoting such public benefit or public benefits and interests.

(c) The certificate of incorporation or bylaws of a public benefit corporation may require that the corporation:

(1) Provide the statement described in subsection (b) of this section more frequently than biennially;

(2) Make the statement described in subsection (b) of this section available to the public; and/or

(3) Use a third-party standard in connection with and/or attain a periodic third-party certification addressing the corporation’s promotion of the public benefit or public benefits identified in the certificate of incorporation and/or the best interests of those materially affected by the corporation’s conduct.

With the rise of blockchain technology, some are hoping to move beyond standard legal entity structures. Distributed Autonomous Organizations (DAOs) are groups designed to run autonomously on a blockchain.

A blockchain is essentially a ledger that stores information and is difficult for any one person to tamper with. Think of an Excel spreadsheet that everyone can access but that requires consensus to edit. Now imagine the spreadsheet doesn't just say who owns what, but also includes formulas and if-then statements that change the ledger when certain conditions are met. They might change who owns what asset or they might change who has authority to act. In a typical contract, the parties would argue about whether conditions are met. In a DAO, the goal is for the code to determine whether the conditions are met and automatically implement the consequences. When these "smart contracts" are built around forming an entity, you have a DAO.

You form a DAO by writing all the rules into some code that typically runs on a blockchain. The code functions like a charter, bylaws or operating agreement---all written in a programming language. The DAO automatically executes predefined actions when specific conditions are met (which the DAO determines autonomously).

DAOs typically kick off by selling "tokens," which are like shares. Tokens give token holders rights within the DAO, like the ability to vote on proposals or share in any economic profits. But because they are just a bunch of code, they operate without any filings with the secretary of state and do not confer limited liability.

DAOs usually aren't recognized as legal entities. Given what you've learned so far, how is a court likely to treat them? If you guessed "general partnership," you're right. This means tokenholders may be held liable for any fool activity undertaken by another tokenholder.

DAOs are an interesting, underdeveloped entity type that may get its day while you're practicing.