A Loan Is a Loan Is a Loan, Except When It’s Equity

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Disputes over capital accounts and equity percentages are frequent fodder for business divorce litigation — especially in LLCs without operating agreements. Exemplars previously treated on this blog include Chiu v Chiu, an LLC appraisal case in which the court found that the 75% member improperly accounted for monies it loaned to the company as capital contribution in an attempt to eliminate or at least diminish the withdrawing 25% member’s ownership percentage, and YMSF Family Partnership LP v Beitel where the court rejected a claim designed to de-equitize a 49.9% LLC member based on an allegation that its capital contribution was a disguised loan.

A pair of recent decisions, in two cases involving disputes between members of realty-holding LLCs, addressed the loan vs. capital contribution conundrum in unusual circumstances:

  • In Moskowitz v Fischer, decided by Suffolk County Commercial Division Justice Elizabeth H. Emerson, a 50% member of a defunct realty-holding LLC (Member #1) sued the LLC’s accounting firm for fraud and malpractice alleging that, in cahoots with the other 50% member who also served as tax partner (Member #2), and without advising Member #1, it amended the LLC’s tax return to convert to equity Member #1’s non-performing $1 million loan made to the LLC many years earlier, for which Member #2 had given his personal guarantee, for the purpose of defeating Member #1’s separate, derivative lawsuit against Member #2 seeking to enforce the loan guarantee.
  • In JDS Fourth Avenue JV LLC v Largo 613 Baltic Street Partners LLC, decided by Manhattan Commercial Division Justice Andrew Borrok, the 51% member of a realty-holding LLC sued the 49% member alleging default on an approximate $1 million, undocumented, demand-loan obligation which, in its defense and the subject of its motion to dismiss based on documentary evidence, the 49% member contended was an equity distribution.

Moskowitz v Fischer

Moskowitz involves an LLC formed by plaintiff Moskowitz and defendant Stevens in 2007 to acquire and develop a parcel of real property in Quogue, New York. After failing to develop the property as planned, it was sold at auction in early 2016 for about $5.5 million. Moskowitz, a 50% member, allegedly received none of the sale proceeds. Moskowitz soon afterward filed suit asserting direct and derivative claims against Stevens including a derivative claim to enforce a personal loan guarantee Stevens gave in connection with an approximate $1 million loan made to the LLC by Moskowitz in 2007.

Later in 2016, Moskowitz received the LLC’s 2015 K-1 showing an approximate $1 million increase in his capital account. Moskowitz emailed the LLC’s outside tax accountant, Fischer, asking “Why did my equity number increase by over a million,” to which Fischer replied, “Is exactly the same as last years K-1.” Moskowitz allegedly took Fischer “at his word.” In 2017, Fischer filed the LLC’s final return for 2016 and issued a K-1 carrying forward Moskowitz’s increased capital account, which Moskowitz reported as a loss on his personal 2016 return.

Moskowitz allegedly learned in the subsequent course of the litigation against Stevens that, in consultation with Stevens and Stevens’ litigation counsel, in 2016, without advising Moskowitz, Fischer amended the LLC’s 2014 tax return by converting Moskowitz’s loan to equity. In other words, as alleged by Moskowitz, whereas Fischer’s email reply stating that Moskowitz’s 2015 K-1 was “exactly the same” as his 2014 K-1, although literally true because of the amendment, it nonetheless was deceptive due to Fischer’s failure to advise Moskowitz of the amended 2014 return.

In 2019, Moskowitz learned that the IRS was auditing the LLC’s 2016 final return, and that Fischer and his accounting firm were representing the LLC in meetings with the IRS in an attempt to convince the IRS that the change to Moskowitz’s capital account was proper.

With his lawsuit against Stevens still pending, in 2021 Moskowitz filed a separate suit against Fischer and his accounting firm. The complaint (read here) asserted causes of action for fraud, accounting malpractice, aiding and abetting breach of fiduciary duty by Stevens, and negligent misrepresentation. The complaint’s gravamen is that the accountants acted in concert with Stevens to wipe out Moskowitz’s loan, and thereby undermine Moskowitz’s prior, pending action against Stevens to enforce the latter’s loan guarantee, by amending the LLC’s 2014 tax return without his knowledge and later convincing the IRS to ratify it.

The defendants moved to dismiss the complaint as untimely and for failure to state a valid claim. In her decision handed down last month, Justice Emerson agreed with the defendants and dismissed each of the claims:

  • Fraud — Justice Emerson found that Moskowitz was on inquiry notice of the alleged fraud when he received his 2015 K-1 in July 2016. “Although his suspicions were aroused,” she wrote, “the plaintiff took Fischer’s reply, which was not false, at face value and made no further inquiry into or attempt to investigate the matter.” Referring to Moskowitz as a “sophisticated businessman who employed his own accountant to prepare his personal tax returns,” and “having the means to verify Fischer’s statement,” Justice Emerson concluded that Moskowitz’s reliance on Fischer’s statement “was unreasonable as a matter of law” and thus fatal to his fraud claim.
  • Negligent Misrepresentation — Justice Emerson dismissed this cause of action for the same reason she dismissed the fraud claim, namely, Moskowitz’s inability to establish reasonable reliance.
  • Aiding and Abetting Fiduciary Breach — Justice Emerson dismissed this claim primarily on the ground that it was barred by the three-year statute of limitations applicable to fiduciary breach claims when the remedy sought is purely monetary. In so ruling Justice Emerson found that Moskowitz’s claim accrued when the accountants filed the amended return in 2016, and that their subsequent filing of returns in 2017 and representation of the LLC in the IRS audit did not cause Moskowitz any additional damages and therefore did not extend the accrual date. The court’s dismissal of the fraud claim likewise precluded application of the six-year limitations period for fraud-based breach of fiduciary duty.
  • Accounting Malpractice — Justice Emerson dismissed this claim on the dual grounds, first, that the LLC and not Moskowitz was the defendants’ client and Moskowitz therefore lacked the requisite privity to sue for malpractice and, second, that the claim was barred by the three-year limitations period applicable to professional malpractice claims. Justice Emerson rejected Moskowitz’s arguments to extend the limitations period based on the continuous representation and equitable tolling doctrines.

All is not lost for Moskowitz, whose separate lawsuit against Stevens for direct and derivative damages and seeking enforcement of the latter’s loan guarantee, are headed to a jury trial along with Stevens’ counterclaims against Moskowitz.

JDS Fourth Avenue JV LLC v Largo 613 Baltic Street Partners LLC

The dispute in JDS involves the parties’ acquisition and development of a property in Brooklyn’s Park Slope neighborhood for the construction of an 11-story apartment building. The plaintiff, JDS, as 51% member and the defendant, Largo, as 49% member formed an LLC which held a 50% interest in the property-owning entity. The LLC’s operating agreement designated JDS the sole manager and gave Largo limited rights including the right to receive distributions of profits to the extent such profits existed.

In 2020, JDS sued Largo alleging a number of claims including one for fraudulent inducement regarding a purported $925,000 undocumented demand loan by JDS to Largo which Largo contended, rather than being a loan, was an equity distribution. In support of its motion to dismiss the claim based on “conclusive” documentary evidence, Largo offered the following email exchange between the parties’ two principals:

  • On 5/16/18, JDS sent Largo an email concerning “Inventory Loan Distributions” from a third party stating, “we can touch base middle of the day and talk distribution” and attaching a copy of the current capital account pre-distribution.
  • On 5/17/18, Largo emailed JDS outlining adjustments to be made to the LLC’s capital accounts associated with a distribution.
  • Later in the day on 5/17/18, JDS replied, “We received your wire instructions and request for a distribution of $925,119.39 of returned equity, which we accept as your acknowledgment and confirmation of your agreement with the distribution calculations distributed yesterday. Please confirm and upon receipt we will initiate the distribution,” followed some minutes later by a wire transfer to Largo in the stated amount identified as “Fourth Ave LLC Equity Distr.”

JDS’s opposition to the motion told a different story, alleging oral conversations in which Largo demanded a share of development fees that JDS had recently received, explaining it was in “desperate need” of the funding to satisfy an imminent debt obligation; that JDS proposed loaning the $925,000 to Largo; and that Largo promised that any funds paid to it would be paid back on demand either in the form of cash or deductions from future equity distributions.

JDS further argued that the email correspondence upon which Largo relied did not “utterly refute” JDS’s allegation that it loaned the funds to Largo, and that any discussion of repayment concerned future distributions. It also argued that under the LLC’s operating agreement Largo had no contractual right to receipt of the funds and that even if the funds were remitted as a return of equity, a return of equity when not entitled to a distribution is the equivalent of a loan.

Justice Borrok’s decision denied Largo’s motion under the plaintiff-friendly standard for pre-answer dismissal motions founded on documentary evidence. Here’s what he wrote:

In the instant matter, the emails attached to Mr. Ben-Nun’s affirmation [on behalf of Largo] (NYSCEF Docs. No 82-84) do not conclusively refute, as a matter of law, the plaintiffs’ allegations that this distribution was intended to be a loan. There is simply not enough context in the emails for the court to determine whether there were additional oral terms agreed upon by the parties for this “distribution” to be paid back by Largo at some future point, as alleged in the amended complaint (NYSCEF Doc. No. 69, ¶ 57). Perhaps the only thing that is clear from the emails is the urgency with which Largo needed the funds from JDS Fourth. Accordingly, Largo’s motion to dismiss the breach of contract claim (third) is denied.

Largo recently filed a notice of appeal from Justice Borrok’s decision, contending that the court “failed to consider and/or erred in ruling that the provided documentary evidence did not utterly refute the Plaintiffs’ allegations supporting their breach of contract claim.”

The Takeaway

As Moskowitz and JDS demonstrate, characterizing funds, on the one hand, as capital contribution or distribution to equity or, on the other hand, as loan to or by the company, can have drastic financial and tax consequences, including the possibility of lengthy and expensive litigation. These two cases also demonstrate that there is no immunity for sophisticated business owners with access to experienced legal counsel and accounting acumen.

When parties enter into operating, shareholder, or partnership agreements, it is incumbent upon them to document any such funds transfer in strict accordance with the agreement’s terms, and to amend the agreement if necessary to ensure that a funds transfer is recognized as between themselves and for tax purposes as consistent with the parties’ meeting of the minds, whether as a capital or loan transaction. The temptation to achieve instant results via oral agreement and/or spontaneous, informal email correspondence can backfire badly, as we see all too often.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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