Are Former Contributions Considered in an LLC Buyout?

by John Cromwell

When an owner, known as a member, of a limited liability company wants to leave the business, he is generally bought out. This means that other members compensate the departing member in exchange for his ownership in the business. The key issue in a buyout scenario is how much the departing member gets for his stake, and how that price is determined. Generally, the contributions of a member to the LLC are considered. Which contributions are considered and how much weight those contributions carry in determining the buyout price will vary based on the circumstances.

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Buyout Agreement

Prior to starting the business, the members may create a buyout agreement. This agreement is either included in the operating agreement or drafted separately. The agreement establishes who can buy a member’s interest, as well as a way to set the price for a member's share of the business. You can structure a buyout agreement so that the buyout price reflects the departing member’s financial contributions to the business. A buyout agreement is generally a good idea because it can help your business avoid a lot of problems when you do need to buy someone out.

State Law

If there is no agreement concerning the buyout price for departing members, the LLC may be forced to rely on state law, as LLCs operate under state law. There is no common set of standards to which all states adhere. Many state statutes have been amended throughout the years on a patchwork basis. Further, individual states have not always kept up with LLC cases and other legal developments. At the time of publication, five states have adopted, while four more are considering, the current version of the Revised Uniform Limited Liability Company Act, or RULLCA. The advantage of the RULLCA, created in 2006, is that it takes into account two decades of legal developments concerning LLCs.

Buyout Under the RULLCA

Under the RULLCA, if there is no agreement regarding the buyout, the buyout price is based on the market value of the business as of the day the member decides to leave the LLC; the value is not based on prior contributions. In this case, fair value has a broad definition, which depends largely on the circumstances. If a court is asked to value an interest in an LLC, it can use the business’s fair market value, the total value of its individual assets, or another scheme that it believes fits the circumstances. The RULLCA assumes that every member has an equal share unless the operating agreement states otherwise. If the members’ shares in the business are unequal, the contributions of the members may affect the size of each individual’s interest, which would in turn determine his buyout price.

Tax Implications

The financial contribution that a member has made to the LLC does have an effect on how a buyout is taxed for the exiting member. LLCs are generally taxed as partnerships. When an interest in an LLC is sold, it is treated as a capital transaction. Basis is the tax law term that refers to the amount of investment a taxpayer has in business assets. The capital gain or loss is calculated by subtracting the taxpayer’s adjusted basis in the LLC, which takes into effect factors like improvements and depreciation, from the amount of proceeds he receives.