Avoiding New Jersey’s LLC Minority Oppression Statute through Domestication

Avoiding New Jersey’s LLC Minority Oppression Statute through Domestication
NJSBA Business Law Section Newsletter

New Jersey’s Revised Uniform Limited Liability Company Act (RULLCA),1 which applies to all New Jersey limited liability companies (LLCs) whenever formed, includes a minority oppression provision taken substantially from the New Jersey Business Corporation Act (BCA).2 It is one of the few provisions in RULLCA that cannot be overridden in an operating agreement. In some LLCs, the ability of a minority member to seek relief for oppression, real or imagined, may not be a desirable feature. For example, entrepreneurs who act as managing members (similar to the way a general partner functions in a limited partnership) may disdain the concept, and even participants in relatively small LLCs, where ownership is essentially equally divided among a few members, might prefer to eschew the concept.

For those who wish to have their carefully negotiated operating agreements control almost all future outcomes, but whose LLCs already are formed under New Jersey law, RULLCA offers a somewhat simple solution: move to another state. Thanks to the domestication provisions of RULLCA, by filing a few forms a New Jersey LLC can easily convert into a Delaware LLC, thereby escaping the reach of RULLCA’s oppression provisions. The conversion can be accomplished without forming a second company and engaging in a statutory merger that may be more likely to trigger change of control covenants, and usually can be done without adverse tax consequences.

The first part of this article briefly discusses the evolution of remedies for minority oppression in the context of New Jersey LLCs, and how RULLCA’s approach to the issue is more similar to the approach of traditional corporate law than to the ‘freedom of contract’ approach of the Delaware Limited Liability Company Act.3 The second part of the article reviews the domestication provisions of RULLCA and the conversion provisions of the Delaware act, and the mechanical requirements for converting a New Jersey LLC into a Delaware LLC. The article concludes by identifying the relevant U.S. federal income tax rules that assure tax-free treatment for most entities undergoing this conversion.

Minority Oppression under New Jersey and Delaware LLC Law 
Under RULLCA’s predecessor, the New Jersey Limited Liability Company Act,4 the New Jersey Superior Court was only permitted to order the dissolution of an LLC if it was “not reasonably practicable to carry on the business in conformity with an operating agreement.”5 For example, if the members or managers deadlocked on a major decision and the operating agreement did not provide an adequate mechanism to break the deadlock, the court could break the deadlock by decreeing the dissolution of the company, thereby forcing the company to wind down its business. 

In several instances, parties sought to have the courts intervene to remedy what they argued was unfair and oppressive conduct by those in control of New Jersey LLCs in which they were members.6 These parties argued that the court should apply the minority shareholder oppression rights and remedies available under the BCA to minority LLC members. Under certain circumstances under the BCA, one or more directors or shareholders may bring an action to have the superior court appoint a custodian or provisional director, force a sale of the corporation’s stock, or dissolve the corporation.7

One of the grounds for judicial intervention under the BCA is:

In the case of a corporation having 25 or less shareholders, the directors or those in control have acted fraudulently or illegally, mismanaged the corporation, or abused their authority as officers or directors or have acted oppressively or unfairly toward one or more minority shareholders in their capacities as shareholders, directors, officers, or employees.8 (emphasis added)

Thus, for example, if the directors of a closely held corporation offer employment to all but a small number of shareholders, forego paying dividends in favor of increasing salaries that not all shareholders receive, withhold information from some shareholders but not others, or enter into related party agreements that benefit some shareholders but not others, the aggrieved shareholders may seek the help of the courts. But the BCA applies to corporations, not LLCs. New Jersey courts have held that, in the absence of similar language in the LLC governing statutes, the remedies for oppression available to shareholders under the BCA are not available to members of LLCs.9

The landscape changed dramatically with the adoption of RULLCA, which took effect with respect to all existing New Jersey LLCs on March 1, 2014.10 Like the BCA, RULLCA provides that, at the request of an LLC member, the superior court may dissolve the LLC, appoint a custodian or provisional manager, order the sale of a member’s entire interest in the LLC, or grant other remedies.11 These remedies are available if the court finds that: the managers or those members in control of the company:

(a) have acted, are acting, or will act in a manner that is illegal or fraudulent; or (b)have acted or are acting in a manner that is oppressive and was, is, or will be directly harmful to the applicant.12 (emphasis added)

While the members of a New Jersey LLC may limit the courts’ available remedies by way of the operating agreement, RULLCA explicitly prohibits the members from denying the courts the power to dissolve an LLC in the case of oppression.13 Thus, even if members of a New Jersey LLC agree among themselves and provide in their operating agreement that particular acts or omissions will be permitted and will not be actionable, there remains a possibility that a court might find those acts or omissions to be oppressive and subject to the remedies available for oppressive conduct under RULLCA.

In contrast to RULLCA (but similar to its predecessor statute), the Delaware act only permits judicially imposed dissolution if “it is not reasonably practicable to carry on the business in conformity with a limited liability company agreement.”14 This approach is consistent with the Delaware act’s stated goal “to give the maximum effect to the principle of freedom of contract and to the enforceability of limited liability company agreements.”15 This is not to say that a court may never set aside a provision in a Delaware LLC’s operating agreement intended to avoid judicial dissolution,16 or that there are no equitable grounds on which a court may dissolve a Delaware LLC beyond what the Delaware act contemplates.17

The Delaware act states that traditional rules of law and equity still apply in cases not provided for under the act.18 In the words of the Delaware Court of Chancery, “equity backstops the LLC structure.”19 Nevertheless, where the parties to an operating agreement agreed to permit certain decisions to be made by the LLC’s members or managers, and it is reasonably practicable to carry on the business of the LLC after these decisions have been made, the decisions are far more likely to withstand judicial scrutiny if the LLC is subject to Delaware law, rather than New Jersey law with its LLC minority oppression statute.

Reverse Domestication into Delaware 
If the members of a New Jersey LLC consider the inability to prevent oppression litigation under RULLCA to be problematic, RULLCA’s domestication provisions may offer a solution. The same section of RULLCA that permits foreign LLCs to ‘domesticate’ and become New Jersey LLCs also permits New Jersey LLCs to become foreign LLCs—‘reverse domestication’—so long as the foreign jurisdiction’s law authorizes and permits the change and the law is complied with by the LLC.20 Thankfully, the Delaware act permits out-of-state LLCs to utilize its conversion provisions to become Delaware LLCs.21

Even before RULLCA, a New Jersey LLC could effectively migrate to Delaware. To do so, however, a new Delaware LLC had to be formed, and the New Jersey LLC then had to merge with and into that new Delaware LLC. The new Delaware LLC would hold all of the assets and assume all of the liabilities of the New Jersey LLC, but it would technically be a new entity.22 This could be a problem if, as is often the case, the New Jersey LLC was a party to agreements that prohibited mergers and similar transactions, granted rights to others upon the occurrence of these transactions, or subjected it to third-party consents.

However, in the case of a reverse domestication no new entity need be formed. Rather, under RULLCA “the domesticated company is for all purposes the company that existed before the domestication.”23 Likewise, under the Delaware act:

for all purposes of the laws of the State of Delaware, the limited liability company shall be deemed to be the same entity as the converting other entity and the conversion shall constitute a continuation of the existence of the converting other entity in the form of a domestic limited liability company.24

To effectuate a reverse domestication, the New Jersey LLC’s members must unanimously adopt a plan of domestication.25 The plan must set forth the name of the LLC before domestication; the name of the company after domestication and the state under whose laws it will be governed; and the terms and conditions of the domestication, including whether membership interests in the New Jersey LLC will be converted into membership interests in the post-domestication company (or how membership interests will be converted into a combination of money, membership interests and other consideration).26 The plan must include the organizational documents that will be effective upon domestication, which may be accomplished by attaching the certificate of formation and limited liability company agreement of the post-domestication company to the plan and providing in the plan itself that the attached documents are approved.27

The plan of domestication need not be filed with the state of New Jersey, but RULLCA does require several filings with the Division of Revenue and Enterprise Services to perfect the domestication. The first filing is the articles of domestication, setting forth:

1. A statement that the company has been domesticated into another jurisdiction.
2. The name of the pre-domestication company (and other identifying information) and the jurisdiction of its governing statute.
3. The name of the post-domestication company and the jurisdiction of its governing statute. 4. The effective date of the domestication.
5. A statement that the domestication was approved as required by RULLCA.
6. If the post-domestication company will not be authorized to transact business in New Jersey, the street and mailing addresses to which the division may forward process that is served on the division as agent for service of process of the company under N.J.S.A. 42:2C-85(b).28

The second required filing is a statement surrendering the company’s certificate of formation, which must set forth:
1. The name of the company (and other identifying information).
2. A statement that the certificate of formation is being surrendered in connection with its domestication in a foreign jurisdiction.
3. A statement that the domestication was approved as required by RULLCA.
4. The jurisdiction of formation of the post-domestication company.29

Finally, if the post-domestication company will continue to conduct business in New Jersey, it should apply for a certificate of authority.30 The application must state the name of the company, the state whose law it is formed under (post-domestication), the street and mailing addresses of its principal office and of its registered office in the state of formation, and the name and street and mailing addresses of its registered agent in New Jersey going forward.31

The New Jersey Division of Revenue has consolidated the above filings into a single form, Form L-102D Certificate of Domestication, which is available on its website and may be submitted electronically.32 In creating the form, the division availed itself of certain language in N.J.S.A. 42:2C-85(c)(1) to add a requirement that a business purpose for the transaction be stated.

Down in Delaware, two certificates must be filed with the Delaware secretary of state: a certificate of conversion and a certificate of formation.33 The certificate of conversion must set forth: 

1. The date on which and the jurisdiction where the company was first formed (and, if not the same, its jurisdiction immediately prior to the conversion).
2. The company’s name and entity type (i.e., limited liability company) immediately prior to the conversion.
3. The post-conversion name of the company.
4. If the conversion will not be effective upon filing in Delaware, the future effective date or time.34

The certificate of formation only needs to state the name of the company and identify the registered office and registered agent in Delaware.35 Although this initial formation document technically is required, as if the post-domestication entity were a new company, the Delaware act makes clear that “the existence of the limited liability company shall be deemed to have commenced on the date the [pre-domestication] entity commenced its existence in the jurisdiction in which [it] was first created, formed, incorporated or otherwise came into being.”36

Relevant Tax Provisions
As with any corporate or other business entity transaction, federal income tax consequences should always be considered. Thankfully, where the ownership of an LLC is not altered through a domestication or conversion, the transaction is likely to be tax free.

Most multi-member LLCs are taxed as partnerships, their default classification.37 Under Section 708 of the Internal Revenue Code of 1986, as amended, a partnership “shall be considered as continuing if it is not terminated.” Section 708 goes on to state that a partnership is considered to have terminated only if it stops doing business or if 50 percent or more of its ownership interests are sold or exchanged within a 12-month period. Thus, a mere change of jurisdiction without any change in business or ownership does not result in any entity change for federal income tax purposes if an LLC is taxed as a partnership.

Single-member LLCs generally are disregarded as separate from their owners for federal income tax purposes; they are not treated as separate entities.38 If an LLC has the same single member before and after domestication, there never is a separate entity for federal income tax purposes, and there is no change in ownership to be taxed.

LLCs may elect to be taxed as corporations—C corporations or, if they meet the relevant criteria, S corporations.39 Corporations are governed by a separate set of tax rules from those described above. Nevertheless, even if the members of an LLC that is taxed as a corporation are treated as having exchanged ownership interests in the pre-domestication LLC for equivalent interests in the post-domestication LLC, the exchanges are not taxable if done in the context of a ‘reorganization.’40 One of the definitions of the term ‘reorganization’ (that of an ‘F reorganization’) is “a mere change in identity, form, or place of organization of one corporation, however effected.”41 Certainly that is what a domestication is; therefore, the transaction is not taxable even for LLCs taxed as corporations.

In sum, reverse domestication from a New Jersey LLC into a Delaware LLC is an attractive, relatively simple, usually tax-free method for LLC members who are concerned the provisions of their operating agreements might be deemed overruled by the oppression provisions of RULLCA. By taking advantage of the domestication provisions of RULLCA, these members can obtain much greater certainty that the courts will enforce the operating agreement provisions they agreed upon to address their business relations.

1. N.J.S.A. 42:2C-1 et seq.
2. N.J.S.A. 14A:1-1 et seq.
3. 6 Del. Code § 18-101 et seq.
4. N.J.S.A. 42:2B-1 et seq., repealed by L. 2012, c. 50.
5. N.J.S.A. 42:2B-49, repealed by L. 2012, c. 50.
6. See, e.g., Casella v. Home Depot USA, Inc., 2010 WL 3001919 (D.N.J. 2010); Tutunikov v. Markov, 2013 WL 3940889 (App. Div. 2013).
7. N.J.S.A. 14A:12-7.
8. N.J.S.A. 14A:12-7(1)(c). New Jersey State Bar Association Business Law Section 26 Go to Index
9. Casella, 2010 WL 3001919 *4; Tutunikov, 2013 WL 3940889 *9; see also DeNike v. Cupo, 394 N.J. Super. 357, 378 (App. Div. 2007), rev’d on other grounds, 196 N.J. 502 (2008).
10. N.J.S.A. 42:2C-91.
11. N.J.S.A. 42:2C-48.
12. N.J.S.A. 42:2C-48(a)(5).
13. N.J.S.A. 42:2C-11(c)(7).
14. 6 Del. Code § 18-802.
15. 6 Del. Code § 18-1101(b).
16. See, e.g., Haley v. Talcott, 864 A.2d 86 (Del. Ch. 2004) (ordering dissolution where exit mechanism provided for in operating agreement was “not sufficient to provide an adequate remedy”).
17. See, e.g., In re Carlisle Etcetera LLC, 114 A.3d 592 (Del. Ch. 2015) (permitting dissolution on equitable grounds where statutory-based judicial dissolution was unavailable).
18. 6 Del. Code § 18-1104.
19. Carlisle, 114 A.3d at 601.
20. N.J.S.A. 42:2C-82.
21. 6 Del. Code § 18-214. While Delaware uses the term ‘conversion’ to describe this transaction, RULLCA reserves the term ‘conversion’ for when an LLC becomes a different type of business entity, such as a corporation. See N.J.S.A. 42:2C-78. Out-of-state conversions are possible, such as a New Jersey LLC’s becoming a Delaware corporation. Unfortunately, New Jersey has yet to amend its corporate and partnership statutes to permit LLCs to convert to these types of entities or vice versa.
22. See N.J.S.A. 42:2B-20(g), repealed by L. 2012, c. 50; 6 Del. Code § 18-209(g); see also N.J.S.A. 42:2C-77.
23. N.J.S.A. 42:2C-85(a)(1).
24. 6 Del. Code § 18-214(g).
25. N.J.S.A. 42:2C-83(a).
26. N.J.S.A. 42:2C-82(c).
27. N.J.S.A. 42:2C-73 and -82(c)(4).
28. N.J.S.A. 42:2C-84(a).
29. N.J.S.A. 42:2C-85(c).
30. N.J.S.A. 42:2C-58.
31. N.J.S.A. 42:2C-58(a).
32. https://cform.mwg.nj.gov/Download/DownLoadForm.aspx?AGENCY_DOCUMENT_ID=36last downloaded on June 17, 2016.
33. 6 Del. Code § 18-214(b).
34. 6 Del. Code § 18-214(c).
35. 6 Del. Code § 18-201(a).
36. 6 Del. Code § 18-214(d).
37. See Treas. Reg. § 301.7701-2(c)(1) and -3(b)(1)(i).
38. See Treas. Reg. § 301.7701-2(c)(2) and -3(b)(1)(ii).
39. See Treas. Reg. § 301.7701-3(a)
40. I.R.C. § 354(a)(1).
41. I.R.C. § 368(a)(1)(F).