When a member passes away, his economic rights associated with membership pass to his estate. However, in Delaware LLCs the operating agreement typically takes precedence over any non-mandatory provisions in the Delaware LLC Act.
Delaware law gives members virtually complete autonomy when it comes to contracting the terms of ownership and operation, such as whether to bring derivative lawsuits. One key feature is this right.
Distribution of Shares
Delaware LLCs are an increasingly popular choice for business, as they give owners flexibility in contracting between themselves on virtually any terms while offering protection from liability like corporations do. Furthermore, Delaware LLCs can be considered tax pass-through entities and treated either as partnerships or corporations for tax purposes.
When creating an LLC, it is vitally important to create an operating agreement which provides for smooth ownership and management transition, including how shares will pass to heirs upon death.
Without an operating agreement in place, state law will dictate how membership interests should be distributed among members. This can be a difficult and expensive process that may lead to litigation; recently the Delaware Chancery Court provided its initial ruling on this topic when dealing with an expelled member seeking his fair value of his ownership interest in an LLC.
Taxes on Distributions
If an operating agreement doesn’t specify terms for transferring interest/membership upon death, state law dictates their rights – which can often not be in the best interests of their heirs.
Delaware allows LLC members the option of choosing whether their LLC will be taxed like a C corporation (with corporate tax rates in effect) or as an “Financially Transparent Entity”, meaning any profits accruing to it can instead be distributed among members who pay personal income taxes at their individual rates.
The Delaware Act contains many mandatory and permissive provisions that offer both flexibility and protection to participants in high-stakes private equity deals, who want to limit investor members from challenging management initiatives or actions. This can easily be addressed with proper structuring of an LLC agreement.
Transfers to Heirs
As LLCs become an increasingly popular alternative to corporations, lawyers and clients often ask about how best to transfer ownership. Unlike corporations which must adhere to specific formalities for transferring shares, LLCs allow members to freely transfer membership interests.
Heirs of deceased members can inherit their membership rights according to an LLC’s operating agreement and state laws on intestate succession. Furthermore, an LLC may opt to include a “transfer on death clause” within their operating agreement or plan.
The Delaware Act permits three arrangements that are unique to this statute: transfers, domestications and series LLCs. Domestications and transfer allow non-Delaware LLCs to become Delaware entities while series LLCs permit an entity to form multiple “series” of members, managers or assets that can be protected against claims against each other. It’s unlikely any of these arrangements would be utilized during high-stakes private equity deals.
Distributions to Managers
An individual who serves both as member and manager in a Delaware limited liability company can transfer their ownership interests to someone else; however, this requires the consent of all of its managers as well as possibly including a transfer of management rights. Detaching themselves as managers does not free them from any debts, liabilities or obligations they incurred while serving on those roles.
The Estate contends that, absent an LLC agreement which prohibits it, state law will govern how financial and governing rights of deceased members are transferred posthumously. They point to the absence of “unless otherwise provided” in Section 18-705 as evidence of this. The court disagrees; rather, noting its purpose as protecting third-party successors in interest; in this instance it would protect heirs who could continue exercising the deceased member’s governing rights while the legal representative takes over his financial interests.
