In the world of entrepreneurship, change comes in many forms and it is inevitable. People who were once robustly passionate about their business endeavors may find new opportunities or face life situations that lead them to focus on other priorities. What can you do if that happens to members of a Limited Liability Company (LLC)?
LLC members might decide to transfer the ownership interests in their company for a variety of reasons. Ownership transfer can occur when new LLC members are added, one or more existing LLC members want to sell their shares of ownership, or an LLC member dies or divorces. Let’s review a few factors that will impact this process.
Basically, there are two ways that LLC ownership gets transferred:
Partial transfers tend to be less complicated than full transfers, which have more complex legal and tax consequences.
An LLC operating agreement typically lays out the rules and procedures for transferring a company’s ownership interests. Ideally, the agreement will describe what must happen when a member dies, retires, leaves the company for other reasons, or is involuntarily removed.
Some operating agreements require that departing members must first offer their interests to other members before they may sell them to an outside party. An operating agreement might also have requirements for handling the valuation of a member’s ownership interests.
What if there are no provisions in the LLC operating agreement for transferring ownership? In that case, business owners should check their state’s laws for any rules related to selling ownership shares of an LLC.
Many multi-member LLCs have a buy-sell agreement within their operating agreement. A buy-sell agreement is a standalone document that addresses the transferability of LLC membership interests. A buy-sell agreement is a contract between the LLC owners that defines various conditions related to selling LLC ownership interests.
These documented conditions might include:
LLCs that don’t have a buy-sell agreement can add one by drafting an amendment to their operating agreement and voting to approve it. Alternatively, they can follow their state’s rules or enter into an agreement with the buyer at the time of sale.
Note that in some states, LLC members must dissolve their entity and form a new one when changing ownership if there are no buy-sell provisions in the operating agreement.
Usually, the LLC operating agreement or buy-sell agreement will state how to determine the value of the ownership percentage being sold. Valuation steps might include having a third party assess the net worth of the company so the price for ownership interests can be calculated.
The sum of all members’ ownership percentages in the LLC must equal 100%. The percentage of ownership might be determined by the members’ initial financial and property investments in the LLC, their degree of involvement in managing the LLC, or other factors.
An example scenario where a multi-member LLC with three members might have ownership allocated as follows:
Suppose the three members agree to bring on a fourth member. In that case, they would need to transfer a percentage of their ownership interests to the new member so that the total percentage does not exceed 100%.
Transferring ownership of an LLC has tax consequences, which may be confusing and complicated. Therefore, it’s important to talk with legal counsel and a trusted tax expert for guidance.
Whether an LLC is taxed as a Sole Proprietorship, Partnership, S Corporation, or C Corporation will affect the tax liability when transferring LLC ownership interests. Some members might be subject to capital gains taxes, depending on how long they have held an interest in the company. Also, some income from transferring ownership might be taxed as ordinary income instead (e.g., if the LLC owns unrealized receivables, appreciated inventory, or certain types of depreciable real property). In the case of an LLC taxed as a C Corporation, the entity pays the tax rather than the individual owners.
The type of sale (entity sale or asset sale) affects taxes, too. Entity sale (known as a stock sale for LLCs taxed as C Corps), which involves the transfer of ownership shares, is what we’ve been talking about in this article. An asset sale is when the LLC members are selling the LLC’s tangible and intangible assets but not the legal entity.
As we’ve discussed, there’s no universal formula for transferring ownership of an LLC because every scenario is unique. However, the steps below represent the tasks and responsibilities typically involved.
There may also be other tasks depending on the LLC operating agreement, buy-sell provisions, state laws, and circumstances triggering the transfer of ownership.
With so many moving parts potentially involved in transferring an LLC’s ownership interests, be diligent about paying attention to every detail. Remember that the transfer is a legal transaction with tax consequences, so consider seeking the advice of a lawyer and tax professional with experience in helping LLCs through ownership transfers.
Nellie Akalp is an entrepreneur, small business expert, speaker, and mother of four amazing kids. As CEO of CorpNet.com, she has helped more than half a million entrepreneurs launch their businesses. Akalp is nationally recognized as one of the most prominent experts on small business legal matters, contributing frequently to outlets like Entrepreneur, Forbes, Huffington Post, Mashable, and Fox Small Business. A passionate entrepreneur herself, Akalp is committed to helping others take the reigns and dive into small business ownership. Through her public speaking, media appearances, and frequent blogging, she has developed a strong following within the small business community and has been honored as a Small Business Influencer Champion three years in a row.