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.
Key Considerations to Review
Partial Transfer vs. Full Transfer
Basically, there are two ways that LLC ownership gets transferred:
- Partial transfer of ownership interest – This is when only a portion of the ownership is being transferred. In other words, one or more LLC members sell their ownership interests, but other LLC members retain theirs.
- Full Transfer of ownership interest – If the LLC member(s) decide to transfer all ownership interests in the company to someone else, they are essentially selling the LLC.
Partial transfers tend to be less complicated than full transfers, which have more complex legal and tax consequences.
Existing vs. No Operating Agreement
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:
- What events or circumstances trigger the sale of membership shares
- Who may purchase LLC membership interests and whether approval of the LLC membership is required
- How to determine the selling price of the interests
- How to fund the sale (if other LLC members are buying the ownership interests)
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.
Valuation and Purchase Price
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.
Transferring Ownership When Adding New LLC Members
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:
- Member 1 – 30%
- Member 2 – 40%
- Member 3 – 30%
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%.
Tax Implications of Selling an LLC
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.
Steps for Transferring LLC Ownership
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.
- Reach out to an attorney and tax advisor for guidance through the process to help ensure you execute the transfer legally and understand its tax implications.
- Review the LLC operating agreement and buy-sell agreement to determine the terms and conditions for selling ownership interests in the business. If no provisions for the transfer of ownership exist, check the state’s laws.
- Determine the asking price for the ownership interests. This may require the help of a business valuation expert to determine the market value of the business.
- Create a sales agreement to record the terms, conditions, price, and other details about the transaction.
- Obtain the required approval of LLC members and execute the sale.
- File Articles of Amendment to update the LLC’s articles of organization on file with the state. This will ensure the state has an accurate account of who owns the entity.
- Update the LLC operating agreement to remove members who have sold their ownership interests and document new members’ rights, contributions, and ownership percentages.
- Issue a new LLC membership certificate to the new member(s).
- File IRS Form 8822-B (Change of Address or Responsible Party) to notify the IRS if the LLC’s responsible party for the entity has changed — i.e. if a member who transferred their ownership interests and left the LLC was serving in that role. The IRS requires this within 60 days of the membership change.
- If the LLC’s communication contact on file with its registered agent is leaving the company, appoint a new one and notify the registered agent. Failing to do so could result in important notices falling through the cracks!
- Notify your bank and other financial institutions about changes to the individuals authorized to access the LLC’s accounts and make transactions on the company’s behalf. I recommend researching your financial institution’s policies and procedures before the ownership transfer takes place.
There may also be other tasks depending on the LLC operating agreement, buy-sell provisions, state laws, and circumstances triggering the transfer of ownership.
The Details Matters
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.