Whether as a result of the expiration of compliance periods (extended-use agreements, tax credit compliance periods, or otherwise), deal failures, or completion of purpose, knowing how to properly wind up and conclude the affairs of a limited company can avoid potential pitfalls and personal liability.

L. Dolan Jr.
L. Dolan Jr.

Just as careful planning and consideration go into formation and operational issues, thoughtful consideration should be given to the proper way to dissolve, wind up, and cancel limited liability companies and the events that can trigger dissolution. It is not sufficient to simply close up shop and walk away.

Properly handled, foresight into issues such as who is responsible for completing the affairs of the entity, what assets are available for distribution, preservation of assets during distribution, the method of liquidating and distribution of assets, and the order of priority in liquidating assets, can avoid internal disputes and creditor claims.

There are generally three stages in the death of a limited liability company: dissolution, winding up, and, ultimately, cancellation.

Although a common misperception is that dissolution is the last step in the process, it is actually the first. Dissolution is merely a change in the relationship of the members: from conducting the entity’s ongoing business to beginning the process of concluding it.

Dissolution usually comes about as a result of express terms in the agreement that govern the limited liability company—its operating agreement—or as a requirement under the law of the state in which the entity was formed.

A common reason for dissolution is the completion of business purpose—such as the sale of real property or receipt of all anticipated tax benefits. Another is the death of one or more key members. However, there are instances in which dissolution becomes necessary, even though the business purpose for the entity’s existence has not been satisfied. One example is where the business purpose of the entity has been frustrated by the owners or can no longer be achieved. In some circumstances, where the members cannot agree as to whether dissolution is permitted or required, or a managing member has become non-responsive, court intervention may be necessary in order to obtain a judicial declaration for dissolution and winding up. In this event, it is often helpful to obtain a very broad order of dissolution, identifying who has the authority to conduct the dissolution, winding up, and cancellation; whether they are to be reimbursed for expenses incurred; the scope of their authority with respect to disposing of assets; and limitations on liability, if these items are not spelled out in the operating agreement. A bit of foresight in crafting such an order can save substantial litigation costs and headache down the road. Dissolution by itself does not affect the limited liability of the entity’s members.

Once an event of dissolution has occurred, the next step is the winding up of the affairs of the entity. Winding up includes the collection and liquidation of assets and the determination of liabilities and claims; it is often completed in conjunction with a final accounting by the company’s accountants. During this process there is either an express or implied obligation not to waste the company’s assets.

Winding up is typically completed under the terms set out in the operating agreement, although state law can alter the order of distribution of assets. For example, the Delaware Limited Liability Company Act requires that creditors of the limited liability company be paid first, to the extent of assets, regardless of whether the operating agreement requires otherwise.

Creditors would include third-party debt, such as mortgages and trade debt, but could also include debts owed to members and managers if they have loaned the company money. Of course, disputes arise where there are insufficient assets to pay all creditors. Delaware law provides in that circumstance that creditors are to be paid in order of priority, i.e., secured creditors first, then unsecured creditors, and within those classes, ratably, to the extent of available assets.

Many states require that a notice of dissolution and winding up be provided to known creditors, so that creditors may bring claims in potential satisfaction of their debt. Additionally, some states require that a liquidating member or trustee certify that either a notice to known creditors was provided or that there are no known creditors before a limited liability company’s existence may be canceled formally.

Some states also require a dissolved limited liability company to make provisions for the

later payment of certain pending claims known to the company. During the dissolution and winding up period, the company, acting under the authority of the member responsible for winding up the affairs, may prosecute and defend claims, dispose of and convey the company’s property, discharge or make reasonable provision for liabilities, and distribute any remaining assets of the limited liability company to members, all without affecting the liability of members and managers for conducting those acts.

There are, however, ways to incur liability. For example, a member who knowingly receives an improper distribution in the course of winding up may be held accountable for the amount of the distribution for up to three years. Under Delaware law, if a company or liquidating member has reason to know of a claim that may arise at any time in the next 10 years, the company and liquidating member may also be responsible for making reasonable provisions for that claim.

Upon completion of the dissolution and winding up, a certificate of cancellation should be filed with the appropriate Secretary of State, memorializing the termination of the entity.

After such a certificate is filed, it is generally difficult to recover any further assets from the entity. Although sometimes more convenient, simply allowing an entity’s existence to lapse or be forfeited (as, for example, by not paying the annual franchise tax or filing the required annual reports) runs the risk that the entity will be disregarded in the event of future litigation with the possibility of future personal liability on the members.

In addition, where an entity has been allowed to lapse or fall into forfeited status, states will generally require restoration of the entity before it may subsequently be wound up and formally canceled. This can often come at a cost of preparing and filing the annual reports for the lapsed years, paying the applicable taxes, obtaining a registered agent, and sometimes significant reinstatement fees. Notwithstanding the extra cost, some prefer to formally revive and cancel the entity rather than allow it to linger in forfeited status forever.

Louis E. Dolan Jr. is a partner with Nixon Peabody, LLP, and based in the firm’s Washington, D.C., office. He heads the firm’s Tax Credit/Affordable Housing Litigation and Workout team and the Government Contracts team.