ASK CHERI S HILL

FACT: Sooner or later the ownership interest of your business will change hands.

- Owners leave for a variety of reasons
- Owners become disabled and can’t work
- Owners get divorced
- Owners become incompatible (business or personal conflicts)
- Owners die
- Owners go bankrupt
- Owners who hold their interest in another entity sometimes terminate that entity

It’s a huge mistake to ignore this fact since often the result is major conflicts that literally destroy a company. The same is true for family owned businesses. To think that families are always harmonious and that severe discords never arise among parents, siblings and children is foolish. In truth they fight, in some cases, with a savagery that makes most business battles look like petty squabbles.

Reality is that things change, people change, we get restless or we’re just not on the same page anymore. Sage International, Inc. deals a lot with these issues and has helped many of our clients get through the transition easily.

Whether you are admitting a new member, selling an ownership interest to an outsider; or a member wants to withdraw from the LLC, there are certain steps you need to take so it’s done right and everyone is protected.

Admitting a new LLC member

1. You have to like the person.
2. They need to show up with some form of capital contribution – cash, property or services. Be careful with services. If the new member receives an interest for the performance of services, that member could owe taxes on their membership interest. Verify with your CPA before admitting a member for “sweat equity.”
3. All members must consent and approve the admission of a new member. This requires a discussion and a vote and needs to be documented either through a regular or special meeting of the LLC with a resolution to admit a new LLC member.
4. The Operating Agreement spells out the rights, responsibilities, and interests (capital, profits, and voting) of the members. The new member must consent to the terms of the operating agreement. This can be done by having the new member sign a statement agreeing to be bound by the terms of the operating agreement or if there are other changes that affect the other members regarding capital, profits, and voting interests (which is often the case), a new operating agreement can be prepared and signed by all the members – new and existing.

Example: Happiness LLC currently has two members, Bill and Mary. Their friend, Jason an online marketing wizard is eager to join their company. He will be given a one-third capital interest in exchange for his contribution of $10,000 and will also receive a one-third profits interest in the business for building up the online presence of the company and increasing their online product sales. So that means that the capital and profit interests of Bill and Mary will change too. Instead of 50/50 they are now 33 1/3% each. They are excited to have Jason join the company and have approved his admission. A new operating agreement is prepared showing everyone’s new capital and profit interests in the company.
5. If you are selling interest to an investor (passive-inactive in the business) member please consult with a Securities Attorney so you don’t violate any SEC laws.
6. If the LLC is Manager-Managed and the new member is also going to be a Manager, often times an amended annual report or list should be filed with the state showing the new member has authority to transact business on behalf of the LLC.

Transferring an ownership interest

Typically the sale of a membership interest to an outsider includes all the departing owners’ responsibilities and rights: economic - profits & capital, managerial, and voting to the Transferee. There are some additional issues to be aware of with regards to tax consequences, so I would highly recommend consulting with your tax advisor well in advance to figure out how to handle the transaction (on the books) to minimize the tax consequences for both the selling member and the Transferee.

1. Members still need to approve the sale (Meeting/Resolutions). If they do not, the buyer may end up with only an economic interest (profits and capital distributions), but not voting or management rights. Usually, the member who receives the transferred LLC interest attains noneconomic rights, such as management and participation, only with the agreement of the nontransferring members. The Articles and the Operating Agreement often dictate the terms under which noneconomic membership interests are acquired.
2. Selling your interest does not transfer any liabilities or obligations you may have incurred while you were a member. You should have a written agreement prepared and signed designating that the purchaser of the interest and/or the remaining members indemnify (agree to be responsible) for these liabilities upon your departure.

Withdrawal of an LLC member

1. A withdrawing member must give notice; at least six months in advance that they wish to withdraw from the LLC. Check your operating agreement for exact details.
2. Determine who is purchasing the withdrawing members’ interest. The LLC or the other members?
3. Check the LLC articles and operating agreement for any buy-sell provisions (can the LLC or the other members buy it?) or any other restrictions related to a member cashing out before the liquidation or sale of the LLC. If nothing is stated, then you will have to check your state’s LLC statutes to find out how to legally handle the departure of an LLC member. Every state is different in its treatment of a withdrawing member. (NOTE: Now would be a good time to review your operating agreement to make sure it has those provisions and if it doesn’t get it updated to avoid future hassles).
4. This is a taxable event to the withdrawing member. Consult with your tax advisor before the sale to determine the amount of capital gains (sold at a profit) or if sold at a loss, any issues related to the passive loss limitations for the withdrawing member, and how the withdrawing member is to be paid.
5. The remaining members of the LLC should hold a meeting to approve the purchase of interest (whether by the LLC or another member) and to also consent in writing that the remaining members wish to continue the business after a member withdraws. This should be done within 90 days after a member leaves.
6. If you are a two member LLC (partnership taxation) and a member leaves, you are now a one person LLC which is disregarded for tax purposes. This completely changes the tax structure of your LLC. If you are taxed as an S corp there could be additional tax related issues. I highly recommend you consult with a tax advisor before any change in ownership occurs!

As you can see there are many ways out: some easy, some difficult, some voluntary, some involuntary. The Articles of Organization and the Operating Agreement need to have clear language related to the transfer of membership interest, however contemplated. State laws are specific and proper procedures must be followed to protect the rights of all members, coming and going. If you need help contact Sage International, Inc. for additional insight and guidance as determined by your specific situation.