If It Walks Like a Duck …

“If I don’t know I don’t know, I think I know.  If I don’t know I know, I think I don’t know.” – R. D. Laing

Here’s a fun fact: A membership interest in a limited liability company isn’t always a “security”.

Everyone knows that a share of stock in a corporation is a security.  Many business owners take it for granted that a membership interest in a limited liability company is the same as a share of stock in a corporation.  For the purposes of corporate ownership and governance, that is a good working assumption.  It’s also a good assumption under the federal and state laws governing the issuance and transfer of securities, like the Securities Act of 1933 and the Texas Securities Act.  But it’s not true in every case.  Some traps for the unwary:

● Pledge of a membership interest:  The last step in creating a security interest or lien on property under the Uniform Commercial Code is called “perfection”.  For most property, the security interest is perfected by filing a financing statement.  But there are other ways to perfect a security interest and it isn’t uncommon for a lender to take delivery of stock certificates as a way of perfection a security interest.  For “certificated securities” a lender may perfect a security interest by taking delivery of the certificate (UCC § 9.313(a)).  So it sounds like a lender could perfect the security interest in a limited liability company that issued membership certificates by taking delivery of the certificate.  Not so fast.  The Uniform Commercial Code provides that “an interest in a partnership or limited liability company is not a security unless it is dealt in or traded on securities exchanges or in securities markets, its terms expressly provide that it is a security governed by [the UCC], or it is an investment company security.” (UCC § 8.103)  Since a membership interest in a limited liability company isn’t a security under the UCC, taking possession of the certificate does not perfect the security interest.

● Sale of a membership interest:  You may understand that a gain (or loss) on the sale of stock is treated as a capital gain (or loss) – either short term or long term depending on how long you held the stock.  It would seem only logical that the same treatment would be afforded to the sale of a membership interest in a limited liability company.  It isn’t.  The sale of an interest in a limited liability company usually is taxed like the sale of a partnership interest.  Any gain or loss attributable to the company’s “hot assets” like inventory, depreciation recapture, and accounts receivable may be treated as ordinary income of the seller.  Only the balance, if any, would be treated as a capital gain or loss.

Limited liability companies are great business entities but they aren’t for everyone every time.  It’s important to realize the differences between corporations, limited liability companies, limited partnerships and other forms of entities whether you are starting a business, or contracting with a business (for another curious quirk relating to limited liability companies in Texas click HERE).  It really is a case of you don’t know what you don’t know.