Question: Can a law firm member avoid flow-through tax liability by giving up ownership in the law firm shortly before it files bankruptcy?
The answer is, “Yes.”
- That’s according to LeClair v. Tavenner, Case No. 23-1133 (4th Cir., decided 2/7/2025).
Facts
Law Firm operates successfully for several decades. But by 2019, Law Firm is in financial distress.
On July 26, 2019, one Partner gives notice of withdrawing as a member of the Firm, “effective immediately.”
On July 29, 2019, (after Partner’s withdrawal from ownership but before termination of Partner’s employment) the Law Firm’s other members (i) vote to dissolve the Law Firm, and (ii) establish a Dissolution Committee empowered to “assume all powers and functions” of Debtor’s leadership and “determine the Dissolution Effective Date.”
The Dissolution Committee never sets a Dissolution Effective Date.
Instead, the Dissolution Committee puts the Law Firm into a voluntary Chapter 11 bankruptcy on September 3, 2019. In the bankruptcy, the Law Firm files a list of its owners (the “List of Owners”), which list includes Partner.
The Law Firm’s bankruptcy then converts to Chapter 7, and Chapter 7 Trustee is appointed.
Since the Law Firm’s taxes flow-through to its owners, the Firm’s Chapter 7 Trustee sends K-1s for flow-through taxes to everyone identified on the List of Owners, including Partner. Partner objects, but the Chapter 7 Trustee refuses to budge, insisting on a right to rely on information in the List of Owners.
Partner persists in opposing the K-1, so Chapter 7 Trustee moves for Bankruptcy Court approval of the K-1. Partner objects to that motion.
After a notice and hearing process, the Bankruptcy Court sides with the Chapter 7 Trustee, finding;
- the effective date of the Law Firm’s dissolution was July 29, 2019, when the Law Firm’s other members voted to dissolve the firm;
- the Law Firm’s operating agreement, to which Partner is a party, prevents Partner from transferring shares back to the Law Firm after dissolution; and
- so, Partner is properly listed—and treated for flow-through tax purposes—as an owner.
Partner appeals to the U.S. District Court, which affirms. So, Partner appeals to the U.S. Circuit Court of Appeals for the Fourth Circuit.
Fourth Circuit Reversal
The Fourth Circuit reverses the Bankruptcy Court and District Court rulings. What follows is a summary of the Fourth Circuit’s reasoning.
–Standards of Review
“We review . . . findings of fact for clear error” and “conclusions of law de novo.” That means:
- “the bankruptcy court’s interpretation of a contract” is reviewed “de novo”; and
- “the bankruptcy court’s denial of a motion to amend the equity security holders list” is reviewed “for abuse of discretion”—a court abuses its discretion “by drawing an erroneous legal conclusion or making a clearly erroneous factual finding.”
–Operating Agreement
Under the Law Firm’s operating agreement, only lawyers are allowed to be owners in the Law Firm, and an owner is also a member of the Law Firm.
The operating agreement outlines the following effects of a member’s withdrawal from the Law Firm, according to the Bankruptcy Court’s appealed opinion:
- when a member departs, the Law Firm purchases and redeems all of that member’s ownership shares;
- those shares are “deemed sold and transferred” to the Law Firm as of the termination of member’s employment; and
- a member cannot withdraw from the Law Firm following a dissolution event.
In its appealed decision, however, the Bankruptcy Court asserts, incorrectly and in conclusory fashion, that Partner “could no longer withdraw or resign” from the Law Firm after the dissolution that “was effective on July 29, 2019.”
–Plain Meaning
The plain meaning of the operating agreement does not prevent Partner from withdrawing from the Law Firm after a dissolution event.
The operating agreement’s text does not prohibit a member from leaving the Law Firm’s membership generally—but only while retaining shares. The bankruptcy and district courts effectively and incorrectly read this condition out of the operating agreement.
Moreover, the bankruptcy and district courts “divined” a new limitation in the operating agreement that prohibits Partner from withdrawing after a dissolution event: that limitation is nowhere in the operating agreement.
To be sure, the operating agreement says that, while a member owns shares, any attempted withdrawal is ineffective “prior to the dissolution and winding up” of the Law Firm.
But the operating agreement does not prohibit Partner from withdrawing after dissolution. Rather, it bars withdrawal only when two conditions are met: (i) the Law Firm has not wound up, and (ii) the member holds shares.
The bankruptcy and district courts erred in concluding that the Law Firm’s operating agreement prohibited Partner from withdrawing from the Law Firm after a dissolution event; and
- it follows then that the Bankruptcy Court abused its discretion in denying Partner’s motion to amend the List of Owners.
Therefore, “we vacate and remand and leave it to the bankruptcy court to determine whether any equitable considerations warrant denial of the motion to amend,” despite Partner’s correct interpretation of the operating agreement.
Conclusion
While the LeClair v. Tavenner opinion is largely based on the construction of language in an operating agreement, it’s good to know that an owner can avoid pass-through tax liability, in appropriate circumstances, by giving up all ownership interests in the debtor that files bankruptcy soon thereafter.
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