Limited liability companies can offer better asset protection than ordinary stock corporations, but there are potential adverse economic and tax results if investors are not alert.
Investors increasingly use LLCs to operate a trade or business, to hold real estate or to hold other investment assets, as opposed to state law corporations. But when investors transfer LLC interests to a spouse, children, trust or others, as opposed to ordinary corporate stock, they can risk losing control of the business or decreasing the basis for heirs — with a corresponding increase in the beneficiary’s income tax.
An LLC owner or “member” has two types of rights: economic and management. Economic rights allow them to receive property from the LLC both during existence and upon liquidation, along with tax attributes and profits/losses. Management rights allow them the right to vote, participate in management or the conduct of company affairs and have access to company reports, records and accountings.
It is the latter category that can cause problems when transferring LLC interests by gift or at death, and the division of these two bundles of rights are important in distinguishing LLCs from ordinary stock (although S corporations may have voting/non-voting shares and C corporations may have preferred stock).
Problems occur when an LLC member transfers a portion of his or her ownership interest in the LLC to another person, either during his or her lifetime or at death. Unlike when you transfer corporation stock and get the same rights as the previous owner, if an LLC member transfers the transferee may become a mere assignee of the LLC interest, and not a full substitute member. Under the laws of most states, unless the operating agreement provides or parties otherwise agree, an assignee only receives the transferor’s economic rights in the LLC, not the management rights.
Laws governing this were enacted to protect business owners from unwillingly becoming partners with someone they never intended to be partners with. But they can wreak havoc on your business and tax planning if you are not careful.
To protect yourself against these hazards, work with a legal professional to arrange for certain transferees or assignees — such as a guardian/conservator, spouse, children or trust — to be full substitute members while keeping other transferees — such as creditors or ex-spouses — as mere assignees with no management rights. This can be set forth in the LLC’s written operating agreement.