Considerations for When an LLC Member Dies
Nobody enjoys talking about what happens to an LLC when a member dies. It’s not a happy subject, nor is it easily brought up. However, as a limited liability owner, you need to know what happens to your business when you die. Also, what would happen to your business if one of your business partners dies? However, death isn’t the only issue that can affect a limited liability owner. What happens if someone retires? Or becomes disabled? Or gets divorced?
Controlling the Rights of Assignee upon Death of a Member
Transfers to a Trust
If the Operating Agreement allows transfers to a trust, we need to consider whether or not the member will be the designated trustee, and, if so, whether or not the trustee acquires an economic interest only.
Moreover, if that member or Trustee dies, will the successor trustee continue to hold the same interests as the decedent? In other words, will the death of the member trustee be considered an “assignment” and what are the effects of any such assignment?
We need to consider the Member’s rights to amend the operating agreement as to adversely affect the rights of an assignee. For example, if a member dies and the remaining members amend the operating agreement to increase one or more of the remaining members’ share in the profits and decrease the share of the deceased member’s estate, would the assignee have any recourse? Even if the Operating Agreement requires unanimous consent, the estate, being merely an assignee, would have no ability to block the contemplated amendment if all other Members were in agreement. These types of scenarios should be discussed and proper contractual provisions should be built into the Operating Agreement to effectuate the intent of the Members.
One example might be to draft language granting any assignee the same rights as the assigning member on the limited issue of amending the Operating Agreement to adversely impact the assignee’s rights. Conversely, you may want to build in a provision that makes it clear that an assignee has no rights to object to any amendments made to the Operating Agreement, even if such amendments may potentially or actually adversely impact the assignee’s rights. In certain instances, this may be a fair provision, particularly where the deceased member was also an operational manager of the LLC and is no longer contributing his efforts on a day to day basis.
Further restrictions on assignees
Right to transfer
Because most statutes relegate a trustee, executor or heir in possession of transferred member interest, to the status of an assignee, they have no rights to dispose of or otherwise transfer the membership units without the consent of the other members. For the same reason, the assignee does not possess a right of redemption.
Involuntary withdrawal (death, incapacity) – triggering mandatory payments?
Depending on where your LLC is formed we would need to research that state’s statutory default provisions to ascertain whether or not it includes a definition for the “withdrawal” of a member, since certain state statutes mandate payment be made to the “withdrawing” member at “fair value,” if the withdrawing member withdraws pursuant to the protocols set forth in the LLC’s governing documents.
When drafting those portions of the Operating Agreement dealing with the death, incapacity, retirement, and withdrawal of a member, the practitioner is advised to carefully identify and define what constitutes a “withdrawing member” and distinguish it from the involuntary withdrawal of a member due to death, incapacity, expulsion, etc., and then decide what rights are triggered upon “withdrawal.”
When addressing issues of transfers triggered by retirement, death, incapacity or expulsion, the following issues, among others, should be explored:
- What will be the incapacitated or deceased member’s withdrawal and redemption rights?
- Will there be a buy-sell option allowed, and if so, under what circumstances and for what price?
- Will transferring units to the surviving spouse or heirs be a permitted transfer? And if so, which rights are being transferred? Economic only? Voting/Managing rights, (restricted or otherwise), as well?
Buy out Provisions and Valuation of Interests: Do’s and Don’ts
A common method of valuing ownership interests that look at “comps” in the industry with similar metrics, to determine the value of the LLC. Fair Market Value is the price that would be accepted if both parties had reasonable knowledge of the facts and no force or coercion was present during the transaction.
Value is based on the income of the LLC. Typically, you look at the last 24 to 36 months to ascertain the average monthly income, take out the company’s debts, and then add any cash on hand. This amount is then multiplied by a factor mutually agreed to by the partners which result in the value of the member’s units. Typically, a discount will be applied if the selling member holds only a minority interest in the LLC and/or if there is a lack of marketability for membership units. Is important to note that the IRS may recalculate the FMV if it believes that the ownership interests are being undervalued. Under this method, the multiplier should be specified in the Operating Agreement.
The members may agree to a set determined price of the membership interests and buy members out at that stated price. The Operating Agreement could set the value to be equivalent to whatever the amount is that the member originally contributed in capital to be a member. For instance, if an employee buys a 3% interest in the LLC for $5,000.00, and then is later terminated or quits, the members could buy those units back at the same price.
Alternatively, the members can meet annually to, among other things, set forth the stated value of the company such that any member selling her interest within that next calendar year would be bound to that price. In determining the value of an LLC using this method, the members should also decide how they will arrive at this annual figure. If an appraiser will be used, then the setting forth the method by which the appraiser will be selected and perhaps even what type of valuation will be applied, should be delineated in the Operating Agreement.
The stated value could also be based on an agreed upon formulae, such as two times book value or the average of net profits over a set period of time, multiplied by an agreed upon number.
The method of arriving at the value of any member’s shares should be clearly set forth in the operating agreement. If the partners would like to rely on the professional services of an appraisal expert, then the method by which the appraiser will be selected should also be clearly stated. It may be that the remaining members put forth 3 appraisal options and the departing member select one.
You will want to specify which events will trigger either an optional or compulsory buy out of the affected member. Some triggering events might include:
- Death. Note that the buyout of a deceased member can be financed through life insurance. You and the other members need to decide if you would like to obtain life insurance policies with the LLC being designated as the primary beneficiary. This finance method is fairly common, particularly when it comes to “key persons” in the LLC.
- A default under or breach of Operating Agreement. In the event of a default, the Operating Agreement may set forth triggering buy out provisions whereby the defaulting member’s interests are sold for less than the actual or full value.
- Selling a majority interest in the LLC. This will often trigger what’s commonly known as “drag along” provisions whereby the sale of a majority member’s interest, triggers an option in favor of the majority member to require the minority members to sell their interests in the LLC on the same terms and conditions as the sale of the majority member’s interests. Conversely, a “tag along” provision gives rights to the minority members to insist that the sale of the majority member’s interest, trigger an option for the minority member to demand that their interests also be sold under the same terms and conditions as the sale of majority member’s interest.
- Loss of licensing. For LLC’s where the managing members must be licensed to carry on the operational functions of the LLC, like doctors/physicians, then the Operating Agreement should contain a provision that triggers an automatic sale of the member’s ownership interests upon being unlicensed for any reason.
- Conviction of a felony
Other provisions that should be considered with respect to buy-outs:
Make sure to divide the triggering events leading to the purchase of a member’s units, into “mandatory” sales and “optional” sales. Decide on the actual mechanism and procedure for triggering any buy-sale options including, how demand for purchase must be made, (typically made in writing within 30 to 60 days following the triggering event), decide what a right of refusal will look like, how the purchase of the divested member’s shares will be purchased, e.g. can it be financed over time? When will purchase payments be due? Will the balance of the purchase price owed be memorialized and evidenced in a promissory note? If so, with our without the need for another member to be a personal guarantor? Will there be any collateral requirement, perhaps in the purchasing member’s ownership interests? Will the balance be subject to interest accrual? If so, in what percentage? Will there be a pre-payment penalty? What are the remedies if the purchaser stops making payments to acquire the member’s interest?
We are not only well versed in what happens when an LLC member dies, but we take the extra step of consulting with you to understand exactly what you have in mind for your LLC and what will be best for your unique interests. That way you can be assured of a strong and smoothly-functioning enterprise come what may. For a consultation call 305-921-0440 or email Romy@jflawfirm.com.