LLC Does Not Distribute Clients on Dissolution

When a limited liability company dissolves, it pays its creditors and distributes the remaining assets in the winding-down process. Many professional practices are organized as LLCs, and their principal assets are the clients they serve.  That does not mean, however, that the professional limited liability company in dissolution has to divide up the clients.

This is an important holding for lawyers, accountants, doctors and other professionals that are practicing in New Jersey as a limited liability company. According to a New Jersey appeals court, the clients that the professionals, such as an accountant, bring to the LLC represent personal goodwill that belongs to the individual professional, rather than goodwill belonging to the enterprise.  Thus, clients of professional limited liability companies are not considered assets of the LLC and on dissolution are not subject to distribution.

Accountants Seek Dissolution of Firmdissolution2

The decision, Michael Gaines v. John Luongo (copy of opinion here) involved an accounting firm that was formed under the New Jersey Limited Liability Company Act, N.J.S.A. 42:2B-1. The Operating Agreement of the limited liability company gave Gaines a 70 percent majority but provided that the two members would share profits and losses equally.The Operating Agreement provided for dissolution of the limited liability company under various conditions, including any event that made it “impossible, unlawful or impractical” to continue operating the business of the limited liability company. The Operating Agreement also provided that in distributing assets to members at the time of dissolution, if the LLC’s assets could not be sold, they were to be valued on the company’s books for the purpose of distribution to the owners.

The Operating Agreement of the limited liability company also contained a restrictive covenant that prohibited Luongo, the defendant, from competing with the firm for one year and within a 10-mile radius. The relationship between the partners deteriorated within a few years of the formation of the LLC. The litigation arose out of the fact that the partners disagreed about whether they had agreed to dissolve or whether the majority had locked the plaintiff out of the business.

Dissolution of LLC Subject of Dispute

Defendant Luongo claimed that the two partners had decided that the LLC would be dissolved and that each would keep their own clients. Luongo claimed that he arranged for new office space and they divided up the furniture and agreed that each would keep their clients. Gaines denied any agreement to dissolve, said he had continued to operate the firm and that his partner had cleaned out the bank account and frozen him out of the business.

Although the firm was organized as a limited liability company, Gaines filed suit as an oppressed minority shareholder under N.J.S.A. 14A:2-7, seeking an injunction, appointment of a fiscal manager and an order determining the fair value of his interest – including the value of the clients of the firm as assets to be distributed on dissolution of the limited liability company. He sought to compel judicial resolution. He also sought to enforce the restrictive covenant.

The trial court held that the parties had, in fact, agreed to dissolve and that the clients were not part of the assets to be distributed. In affirming the lower court’s decision, the Appellate Division agreed with the trial court’s finding that the company’s clients were never carried on the books as an asset, no value was ever assigned to them on the company’s balance sheets, and that they were free to remain as clients of either partner, or neither.

Clients of Profession Are Personal Goodwill Not a Business Asset

Each of the accountants simply took their clients with them after the LLC had been dissolved. An in-kind distribution when the LLC was dissolved was “inconsistent wit the nature of professional clients, whose value is found in personal goodwill.” The court used the “working definition of personal goodwill” as the “part of increased earning capacity that results from the reputation, knowledge and skills of an individual person and is not transferable or marketable.” Which is simply to say that clients hire accountants (or lawyers or doctors) not firms.