Unlike the shares in a corporation that are easily exchanged, the transfer of a membership interest in an LLC has more restrictions. State laws do not allow for the transfer of a member’s right to engage in management activities. However, a member can sell or exchange a financial interest in the LLC. The transferee of the interest receives a legal claim to the portion of assets and profits that the transferring member has. If the operating agreement of the LLC allows for the transfer of management rights, then the state prohibition is inapplicable.
Becoming a Member
An investor can become a member of an LLC at the time of formation if he is included in the certificate of organization. A person may later join the LLC only with the unanimous consent of all current members or by a method the operating agreement stipulates. Although an operating agreement may require it, most jurisdictions do not require a prospective member to make a contribution of money or property to the LLC as a condition to acquiring an interest. In contrast to a corporation, more barriers to entry exist with an LLC.
Most of the jurisdictions do not require an LLC to distribute its profits to members. However, in the absence of an alternate profit allocation in the operating agreement, members have equal rights to the earnings of the company whether they are distributed or not. Regardless of what the operating agreement stipulates, a distribution is never allowable if it will prevent the LLC from paying its debts or meeting other obligations in the normal course of business. Additionally, the distribution may not cause the company’s liabilities to exceed assets. If a member with authority to declare a distribution does so in violation of a state prohibition, that member is personally liable to the LLC for the improper amount of the distribution. A profit distribution is similar to a shareholder’s entitlement to a dividend; however, shareholders have no claim on the company’s earnings as members of an LLC do.
Just as shareholders must pay personal income tax on a corporate dividend, members of an LLC must pay tax on profit distributions if the LLC elects corporate tax treatment. However, the Internal Revenue Service automatically designates an LLC as a partnership for tax purposes if more than one member exists. Partnership taxation imposes pass-through principles that require each member to report their allocable share of business profits on a personal tax return, irrespective of whether there is a distribution or LLC retention of its earnings.