First, let’s define some important terms:
- Probate occurs when someone dies, and their assets are distributed to pay their liabilities and beneficiaries. Stated another way, probate is a court-led, legal process that begins after someone passes away. The court will distribute their estate to the proper heirs.
- An executor is someone assigned to follow the deceased person’s wishes when they’ve left a will. If there isn’t a will, the court distributes assets according to the state’s rules of succession.
- In an LLC, the business owners/shareholders are referred to as members. An LLC can have one member or multiple members.
- When an LLC is formed, the business may create an operating agreement to outline the rights and obligations of the members, as well as the distribution of the LLC’s income. You are normally not required to create an operating agreement, but it is strongly recommended that you do so.
Now that we provided a basis for the elements of this discussion, let’s move on to covering what really happens to a business when an LLC owner or member dies.
When No Operating Agreement is in Place
When the LLC owner (or members) does not have an operating agreement is not in place, or the operating agreement fails to address the death of the owner, the deceased LLC member’s survivors will be forced to default to the state laws. In this case, the state’s rules will be used to determine how the LLC ownership and membership interests are treated.
An Operating Agreement is Key
As stated above, an LLC operating agreement is a legal contract between the LLC’s owners that outlines the rights and obligations of the members, as well as the distribution of the LLC’s income. One important reason it’s essential to have an operating agreement is to protect the future of your company.
For Example: If a member of your LLC dies, their ownership could be transferred to their heirs as indicated in their will, which could cause problems if the LLC members don’t want to work with the heir/s. If an operating agreement was in place that indicates otherwise, this troubling situation would not occur.
Typically, the LLC operating agreement is created at the time of business formation and it includes the following information:
- Members’ ownership percentages
- How profits and losses will be distributed
- The LLC’s management structure and the members’ roles and responsibilities
- How you’ll make decisions
- Members’ voting rights
- What happens if a member wants to leave the company
- How can the LLC be dissolved
When an LLC has multiple members, all members must sign the document before it is considered effective and valid. That means all of the members would be able to weigh in on the outcome of a member’s death and would be in agreement on what happens next.
If an operating agreement is in place and it provides instructions for the death of a member, the operating agreement will be used for managing the death of a member.
Defining Your Asset Distribution
As noted above, the death of an LLC member results in their company shares (like their other assets) being passed on to their beneficiaries, per the instructions in their will or the state’s succession/inheritance laws. However, that’s not the only option. Nor likely the best one for your business.
If you don’t yet have an operating agreement or your agreement does not include this information, you can, and should, amend (update) your operating agreement as soon as possible. Remember that any procedural changes to an operating agreement must be voted on and agreed to by all members of the LLC.
Since an operating agreement is a legal document, you can delineate specifically what happens to a member’s shares in the event of their death, which will help you avoid probate.
Operating agreement options for managing the death of a member:
- Shares can be passed on to the deceased member’s beneficiary or beneficiaries. The operating agreement should contain a “Transfer of Membership” clause in which the recipients of the shares are named. This would likely also be noted in the deceased’s will.
- Shares can be purchased outright by the remaining LLC members, with the money going to the deceased member’s beneficiaries.
- The remaining LLC members can purchase shares over time, making regular payments to the deceased member’s beneficiaries.
- Shares can be bequeathed to a third party.
- The deceased beneficiaries can inherit shares, but they are not granted voting rights or any managerial authority.
Finally, the operating agreement could also dictate that the LLC be dissolved upon the death of a member. In this scenario, the remaining members may regroup and start another business or dissolve the LLC and distribute all the remaining assets.
Options for single-member LLCs:
- Typically, a single-member LLC is immediately dissolved when the sole member passes away, and the assets are distributed to their beneficiaries per their will or by state law.
- However, at startup, the operating agreement may be written to include a successor so the company can continue. The successor can be a person or organization.
Since the company’s home state regulates LLCs, checking your state’s LLC laws regarding succession is crucial.
The Revised Uniform Limited Liability Company Act (RULLCA)
Currently, 23 states have enacted some version of the Revised Uniform Limited Liability Company Act (RULLCA) or have legislation pending to do so. The RULLCA is an update of the 1996 act, which originally permitted the formation of LLCs, and provides consistent rules and procedures for LLC regulation.
Under the RULLCA, what can be transferred after the death of an LLC member is limited. For example, members can only transfer financial interests in the LLC. They cannot transfer managerial rights.
In addition, rights to actively participate in the LLC business are not granted without the approval and support of the other members.
These states who have enacted the RULLCA include:
- District of Columbia
- New Jersey
- New Mexico
- North Dakota
- South Dakota
Do You Need an Operating Agreement for Your LLC?
It’s never too soon to contemplate what will happen to your company in the event of the death of an LLC member and create a plan to address it. If you don’t have an operating agreement or your current one doesn’t cover this issue, it’s critical to create or update your LLC’s operating agreement. Don’t put this off; the future of your LLC could be at risk.