CONSENT PROVISIONS IN THE OPERATING AGREEMENTS OF MULTI-MEMBER LLCs—CONSERVATIVE VS. MODERATE VS. AGGRESSIVE
EXECUTIVE SUMMARY. The liability of New Hampshire LLC members for the New Hampshire Interest and Dividends Tax on distributions to them from their LLC depends on their meeting a “who” test under RSA 77:3 and a “what” test under RSA 77:4. If these members want to minimize their I&D Tax audit risk and if their operating agreement contains a “consent” test within the meaning of the New Hampshire Department of Revenue Administration regulations, a conservative provision ought to require the consent of at least a majority in interest of the non-transferring members in order to minimize this risk. But “moderate” and “aggressive” provisions may be appropriate in certain situations.
DISCUSSION. Under RSA 77-3, the New Hampshire Interest and Dividends Tax statute, distributions from a LLC to its members residing in New Hampshire are not subject to the Interest and Dividends Tax (the “I&D Tax”) if the LLC’s “shares” are “nontransferable.”
Under the relevant New Hampshire Department of Revenue Administration (“DRA”) regulations, the shares of an LLC are nontransferable if, under the governing LLC act or LLC operating agreement, the LLC meets either a “consent” test or a “dissolution” test.
An LLC will meet the consent test if its members may not transfer the LLC’s shares except with member consent. It will meet the dissolution test if a member’s transfer of his or her shares of shares will cause the LLC’s dissolution.
The three relevant New Hampshire DRA regulations that define the nature of the member consent required for I&D Tax purposes are as follows:
- Rev 901.02, which applies to RSA 77:3, I(b) (“Who Taxable”), requires “prior member approval.”
- Rev 901.03, which applies to RSA 77:4,III (“What Taxable”), also requires “prior member approval.”
- However, Rev 901.19, which, like Rev 901.02, applies to RSA 77:3,I(b) (“Who Taxable”), requires approval “by another beneficiary.”
RSA 77:3, I (“Who Taxable”) provides as set forth below. The terms below specifically applicable to consent provisions are in italics.
- Taxable income [i.e., income subject to the I&D Tax] is that income received from interest and dividends during the tax year prior to the assessment date by:
(a) Individuals who are inhabitants or residents of this state for any part of the taxable year whose gross interest and dividend income from all sources, including income from a qualified investment company pursuant to RSA 77:4, V, exceeds $2,400 during that taxable period.
(b) Partnerships, limited liability companies, and associations, the beneficial interest in which is not represented by transferable shares, whose gross interest and dividend income from all sources exceeds $2,400 during the taxable year, but not including a qualified investment company as defined in RSA 77-A:1, XXI, or a trust comprising a part of an employee benefit plan, as defined in the Employee Retirement Income Security Act of 1974, section 3.
(c) Executors deriving their appointment from a court of this state whose gross interest and dividend income from all sources exceeds $2,400 during the taxable year.
RSA 77:4,III (“What Taxable”) provides as set forth below. The terms in the section that are relevant to members of LLCs are in italics.
77:4 What Taxable. – Income of the following described classes is taxable:
I. Interest from bonds, notes, money at interest, and from all debts due the person to be taxed, except interest from notes or bonds of this state and notes or bonds of any political subdivision of this state.
II. Dividends, other than stock dividends paid in new stock of the company issuing the same, on shares in all corporations and joint stock companies organized under the laws of any state, territory, or nation.
III. Dividends, other than stock dividends paid in new stock of the partnership, limited liability company, or association issuing the same, on shares in partnerships, limited liability companies, or associations the beneficial interest in which is represented by transferable shares.
IV. Dividends, other than that portion of a dividend declared by corporations to be a return of capital and considered by the federal internal revenue service to be such, the exemption of which is permitted by RSA 77:7.
V. Amounts reported and taxed federally as dividends or interest to a holder of an ownership interest in a qualified investment company as defined in RSA 77-A:1, XXI, a mutual fund, or a unit investment trust.
In its Lyme Timber decision, the New Hampshire Supreme Court stated that the above regs may only be applied in construing the specific provisions of the I&D Tax statute to which they specifically refer.
Assume that Mary Doe is a New Hampshire resident during 2014, that she is a member of XYZ, LLC, and that during 2014 she receives dividends from XYZ exceeding $2,400. XYZ’s operating agreement contains a consent provision.
Under RSA 77:3, I(a), Mary is one clearly one of the types of taxpayers who are potentially subject to the I&D Tax on her interest and dividend income. But are her distributions from XYZ one of the types of income defined under RSA 77:4,III as income subject to the I&D Tax.
As noted, the only reg that we may consult on this issue is Rev 901.03. We may not consult Revs 901.02 or 901.19.
However, the determinative phrase on the above question in Rev 901.03 is the phrase “prior member approval.” Since the regulations under RSA 77:3 do not specify that only a single other member must consent in order to for an LLC operating agreement consent provision to be valid, while the regulations under RSA 77:4,I(b) do not so specify, the DRA may argue that in order for an LLC operating agreement consent provision to be valid under RSA 77:4,I(b), this provision must require the consent of at least a majority in interest of the other members or even of all of the other members.
CONCLUSION. If clients of yours who are New Hampshire members of LLCs want to minimize their I&D Tax audit risk:
- If they want to be conservative, the consent provision in their LLC operating agreement should require a transfer consent by all of the other members;
- If they want to be moderate, the provision should provide for consent by a majority in interest of the other members;
- If they want to be aggressive, it should provide for consent by at least one other member.