Do it Yourself Pitfalls

The limited liability company (LLC) generates a great deal of interest because it offers some significant benefits. First, like a corporation, liability is limited to the business in most cases, leaving individual members immune from suit. But, unlike a corporation, an LLC can be run relatively informally in the sense that there are fewer bureaucratic requirements for hierarchy, meetings, and recordkeeping. Also, whereas a corporation contends with double taxation—the corporation pays taxes, and the shareholders pay income taxes—an LLC can select pass-through taxation; that is, the company does not pay taxes, only the members do on their income. No wonder, then, that many business owners are eager to select an LLC structure.

However, they may be too eager if they choose to file with the Secretary of State on their own. There is a difference between satisfying legal requirements and satisfying practical requirements for optimal company functioning. The heart of an LLC is the operating agreement. The more contingencies addressed by the agreement the better it is for preventing conflicts within the organization. The agreement should address such concerns as the duties of management, the percentage of ownership interest, and procedures for and limitations on transferring interest. It may be easy to simply file with the state but correctly setting up a business is still complicated. A case in point is Sohani v. Sunesara, 546 S.W.3d 393 (Tex.App. 2018).

The main issue in this case was whether one of three LLC members was indeed a member and thus was entitled to a third of the profits. The jury said “Yes,” but the appeals court said, “No.” The conflict was due in part to a discrepancy between the certificates of formation and the operating agreements.

The business associates were Manisch Sohani, Anis Virani, and Nizar Sunesara. Sunesara and Virani first worked together selling smoking accessories at flea markets, with Sunesara buying the inventory and Virani contributing his time. Sohani owned a “general merchandise wholesale” business, Mike’s Worldwide Imports (MWI), and was one of their vendors. When Sunesara and Virani opened a brick-and-mortar retail shop, they offered Sohani a third of the ownership, to which he agreed. They split the profits of Zig Zag Smoke Shop in thirds.

In 2012, Zig Zag was doing so well that Sunesara and Virani decided to expand with a second retail location, which they called Burn Smoke Shop (“Burn I”). In 2007, Sunesara set up SSV Corporation, and it owned the assets of Zig Zag and Burn I. Sunesara testified that he gave Virani $10,000 in cash to start the business but presented no records of the contribution. Virani denied that Sunesara had given him any startup money. He said that the fixtures had been acquired on credit, and that Sohani had provided the inventory. Toward the end of 2012, the three men bought an existing smoke shop, which they called Burn Smoke Shop Two (“Burn II”). Sunesara claimed to have given Virani $10,000 in cash to acquire the business, but again no records exist of the transaction. Later they acquired another smoke shop from a customer of Sohani’s MWI company. Sohani supported Virani’s statements that Sunesara had not contributed anything to the three shops.

Before acquiring Burn II, Virani and Sohani asked Sunesara to file paperwork for three LLCs, one for each smoke shop. Neither Sohani nor Virani knew anything about setting up entities. Apparently, they asked Sunesara if he would do the paperwork because of his experience in forming SSV Corporation. Sunesara set up three LLCs, and each of the Certificates of Formation listed Virani, Sohani, and Sunesara as governing persons. Sunesara testified that he showed the certificates to Virani, who authorized filing, as did Sohani, though he did not see the certificates. Sunesara’s signature is on each of certificates, but Virani and Sohani did not sign. However, each of their signatures appears on the bank accounts for the three LLCs as members of each company.

Virani disputed that he had seen the certificates prior to filing, and he stated that though Sohani had authorized filing the certificates, Sunesara’s name should not have been on any of the certificates. Virani and Sohani were supposed to have been the only members of the LLCs. This testimony is consistent with franchise tax documents for 2014 in which only Virani and Sohani are listed as members. Also, income tax returns for 2013 and 2014 show that Virani and Sohani each owned 50% of the LLCs.

Prior to the filing of these financial documents, however, relations between the parties soured. In 2007 or 2008, Sunesara shifted focus to handling sales and marketing for MWI, Sohani’s import business. Eventually, he became MWI’s chief financial officer. In June of 2012, federal law enforcement officers began targeting sellers of synthetic marijuana, which MWI and the smoke shops were selling. Sunesara testified that he told Sohani that he would quit MWI if they continued to sell the product. He said that he never told Virani or Sohani that he wanted to give up his share of the ownership of the retail shops.

In June of 2013, federal law enforcement raided MWI. Sunesara was not charged with anything, but he took a leave of absence from MWI, which displeased Sohani. In July of 2012, Virani and Sohani realized the LLCs were missing important documentation, such as operating agreements. After some internet searching, they drafted agreements for each LLC. The agreements were signed only by Virani and Sohani, who are listed as having made 50% contributions to and owning 50% of each LLC. Sunesara’s name does not appear on any of the agreements, and he had no part in drafting them. Sunesara testified that he received profit distributions for the first five months of 2013, but they stopped in June, after the raid.

In November 2014, Sunehara sent a letter through his attorney claiming ownership interest in the LLCs. Virani and Sohani tried to open an account at a new bank, but they could not do so without Sunehara’s signature. Neither could they obtain a loan without Sunehara’s authorization and signature because he was listed as a member on the Certificates of Formation. In February 2015, Virani and Sohani filed suit against Sunesara for fraudulently listing himself as an LLC member on the Certificates of Formation. Sunesara filed counterclaims including fraud and breach of fiduciary duty and seeking a declaratory judgment that he was a member of the LLCs.

The jury found that Sunesara was a member of the LLCs, which is understandable given that his name was on the Certificates of Formation. And, apparently based on his membership, it decided that Sunesara was entitled to one-third of the profits. Also, the jury may have sympathized with Sunesara’s decision to distance himself from MWI after the raid.

Virani and Sohani appealed, pointing out that Sunesara did not provide any evidence of a written or oral agreement that he was member entitled to a one-third share of the profits. According to Business Organizations Code Section 101.201, “[t]he profits and losses of a limited liability company shall be allocated to each member of the company on the basis of the agreed value of the contributions made by each member, as stated in the company’s records required under Section 101.501.” (emphasis added). According to Section 101.501, a limited liability company must keep certain records at the principal place of business, including a written statement of “the amount of a cash contribution and a description of and statement of the agreed value of any other contribution made or agreed to be made by each member.”

Sunesara did present records indicating that he was one of the owners of the corporations that spawned the LLCs. But the appeals court stuck to the letter of the law regarding LLCs. It emphasized that that there was no LLC agreement establishing his alleged monetary contributions or his entitlement to profits. So, it found that Sunesara was not entitled to a one-third share of the profits. Sohani and Virani did not appeal the ruling that Sunehara was a member of the LLCs. Thus, it appears that one may be a member of an LLC and yet not be entitled to profits if there is no operating agreement clearly specifying that right.

Sohani v. Sunesara, 546 S.W.3d 393 (Tex.App. 2018)