Llc Operating Agreement Buy Sell Provisions

Most limited liability company operating agreements contain provisions that address transfers of interests by the LLC members.[1] In the absence of specific provisions in an operating agreement, statutory defaults will apply. In privately held companies, transfers are often severely restricted by governing law, and sometimes prohibited altogether. LLC statutes commonly permit transfers of economic interests (i.e., the right to receive allocations and distributions), but not governance rights (e.g., voting, access to information). The bifurcation of LLC interests between economic rights and governance rights can, over time, tend to concentrate management authority in the person(s) who still possess governance rights, even though the person(s) represent only a minority of the economic interests in the LLC at present.

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Transaction Structure and Terms. Buy-sell transactions can be structured as cross-purchase transactions between or among equity owners, entity purchase transactions, or a combination of the two. The structure of the transaction not only has important tax implications, but it can also significantly impact ownership ratios and the resulting governance of the LLC. In certain circumstances, transactions can be funded with insurance. In others, a long-term payout may be required to ensure the soundness of the entity. The agreement must consider release from debt obligations and other liabilities (especially those taken into account in the valuation of the enterprise); and any cash waterfalls or profits interests (with corresponding value hurdles). Finally, the parties may want to address the possibility of a clawback in favor of the selling equity holder in the context of a future sale or other change in control transaction consummated within a defined window following the buy-sell transaction.

An LLC buy-sell agreement sample provides a framework for writing a legal contract that details how shares of your limited liability company (LLC) can be transferred in ownership. For example, will you permit shares to be sold to an outside entity if your business partner passes away, or will his or her estate inherit ownership? A buy-sell agreement provides the answers to these and related questions.

The buy-sell provisions can be detailed as part of your LLC operating agreement or in a separate agreement. Without having a buy-sell agreement in place, you may be subject to a costly legal battle if one owner wants to leave the LLC, gets divorced, retires, or dies. The buy-sell agreement details:

While a buy-sell agreement is useful for all small businesses, it's especially critical for LLCs with more than one owner. This prevents the LLC from dissolution if a member leaves while accounting for the rights of the member and his or her family. For a sole proprietor, a buy-sell agreement can arrange for an employee or a family member to take over if the original owner retires or passes away. For example, leaving the business to a successor can decrease the LLC's owed estate taxes.

Even if you don't think a co-owner will ever want to leave the business, statistics show that most multi-owner companies eventually part ways with at least one member. If this happens without a buy-sell agreement in place, the business will likely need to be dissolved and assets liquidated. Think of the buy-sell agreement as a prenuptial agreement for your business. Although you hope you never need it, it gives you a legally binding exit strategy should any of the members decide to part ways.

When drafting a buy-sell agreement, members can include virtually any type of event that they consider important and would affect the future of the company. These do not need to be standardized and can be customized to the members' needs and desires. However, there are several triggering events that are commonly included:

Calculating the fair market value of your LLC is one of the most important steps in creating a buy-sell agreement. The agreement is not enforceable unless it includes a purchase price, which can be derived through several methods.

If you need help with creating a buy-sell agreement for your LLC, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.

What is a buy-sell agreement?

Contrary to popular belief, a buy-sell agreement is not about buying and selling companies; rather, it is a binding contract between business owners. A buy-sell agreement is made up of several clauses in your written operating agreement (or it can be a separate agreement that stands on its own) that control the following business decisions:

A buy/sell agreement is a contract between the members of an LLC that provides for the sale (or offer to sell) of a member's interest in the business to the other members or to the LLC when a specified event or events occur. Common events triggering a buy/sell agreement include death, disability, retirement, and divorce. The sales price is determined under a valuation method specified in the agreement. Common valuation methods include a fixed price, an independent appraisal, a formula approach such as a multiple of earnings, or book value.

Establishing the value of an LLC interest prior to a client's death helps to identify and quantify the liquidity needs of the client's estate. A properly structured buy/sell agreement can help establish this value. However, if the valuation provisions in a buy/sell agreement are not recognized for estate tax purposes, the estate may face costly valuation disputes with the IRS, as well as potential liquidity problems.

A fundamental purpose of a buy/sell agreement for a family LLC is to restrict the owners' ability to freely transfer their interests, to avoid unwanted owners. This is usually accomplished by limiting the situations in which an owner can dispose of his or her interest to the identifiable events specified in the agreement. Accordingly, the buy/sell agreement facilitates the creation of a market for the ownership interests at times when an owner may need liquid assets.

When a triggering event occurs, the buy/sell agreement will provide the entity or the other owners with certain requirements or options (e.g., a mandatory obligation to purchase the selling owner's interest or a right of first refusal), depending on the client's objectives. In a sense, it establishes an exit strategy for the owners at the inception of the entity, which reduces the potential for conflict later, when a triggering event occurs.

Buy/sell agreements and restrictions on transferability are useful in determining how a member's interest will be valued for transfer-tax purposes, and the owners will be bound by the terms of the agreement. Possible methods for determining the value of an ownership interest (i.e., purchase/sale price) under a buy/sell agreement include (1) a fixed price per unit; (2) requiring an independent appraisal; or (3) using a formula approach. The authors recommend that the chosen method establish the fair market value (FMV) of the interest at the date of sale, net of any applicable discounts. A fixed price as of the date the agreement is drafted is not appropriate for transfer-tax purposes (Bommer Revocable Trust, T.C. Memo. 1997-380).

Warning: If the IRS determines that the buy/sell agreement is a device to transfer property to family members for less than full and adequate consideration, it can redetermine the value of the transferred interest for gift, estate, and generation-skipping transfer (GST) tax purposes. The IRS may also challenge the value established in a buy/sell agreement when it appears the decedent was attempting to transfer property for less than full consideration (a partial disguised gift) to a nonfamily member (Gloeckner, 152 F.3d 208 (2d Cir. 1998)).

The value of a closely held business (or other property) is determined without regard to any option, agreement, or other right to acquire or use the property at a price less than the FMV of the property, or any restriction on the right to sell or use the property (Sec. 2703(a)).

The general rule does not apply if certain requirements are met. Careful adherence to these requirements will allow the buy/sell agreement to be used to value the closely held business for transfer-tax purposes. The general rule does not apply to any option, agreement, right, or restriction that meets all of the following requirements (Sec. 2703(b)):

Caution: The unilateral ability to modify a buy/sell agreement renders it ineffective in establishing the value of a business (Estate of Blount, T.C. Memo. 2004-116, aff'd, 428 F.3d 1338 (11th Cir. 2005)). A careful analysis should be performed on any proposed modification to a buy/sell agreement before the change is formally adopted.

The statute and regulations are silent as to the specifics of this requirement. It appears the requirement is met if it can be shown that the purpose of the buy/sell agreement is to maintain continuity of management and family control (Estate of Lauder, T.C. Memo. 1992-736). The business reason(s) for executing the agreement should be well documented (e.g., in written correspondence between the practitioner and the client). In addition, the Tax Court has held that planning for future liquidity needs of the decedent's estate is considered a bona fide purpose (Estate of Amlie, T.C. Memo. 2006-76). However, the Tax Court (affirmed by the Eighth Circuit) held that an entity consisting entirely of marketable securities was not a bona fide business arrangement (Holman, 130 T.C. 170 (2008), aff'd, 601 F.3d 763 (8th Cir. 2010)).

In Estate of Lauder, however, the Tax Court provided insights into how this test is applied. The Tax Court found that a buy/sell agreement was merely a device to reduce estate taxes when (1) testamentary considerations influenced the parties involved, and (2) the formula in the agreement did not reflect full and adequate consideration because it did not set a fair price for the interest. The formula used was an adjusted book value formula, which the court may have found arbitrary in nature. Because the agreement did not pass the nondevice test, the terms of the agreement did not control the estate tax value of the interest.

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