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Can Your Partners Give Away Their Interest in Your LLC? - February 2012

February 24, 2012

A limited liability company (“LLC”) is a flexible and relatively simple business entity and as such, has become the heavily favored choice for entrepreneurs. The Virginia Limited Liability Act, enacted in 1991 (the “Act”), created the option of an entity which combines the more attractive characteristics of a corporation and a traditional partnership.  Members of an LLC enjoy the protection of limited liability as well as pass-through treatment of income for tax purposes. Perhaps because of the hybrid nature of an LLC, confusion frequently arises over the ability to transfer or assign a member’s interests, and the rights that go with it.

While a corporation’s shareholders may often transfer their shares—and all of the rights that go with them—the transferability of an LLC member’s interest is more analogous to the transferability of a partnership interest. An LLC member holds two components to his interest:  the right to participate in control of the company, and the right to share in profits, losses and distributions of the company.  The Limited Liability Company Act allows for members to assign their interests in profits, losses and distributions to third parties, however, members cannot assign the right to participate in control of the company.

Members of a new venture typically establish a comfort level with one another, yet frequently express concern over the prospect of dealing with their partner’s spouses, offspring or outside colleagues. Simply put, they are prepared to deal with a chosen business partner, but not necessarily his wife or son.  Such concerns are generally unfounded. 

In November of 2011, the Virginia Supreme Court addressed this very issue.  In the case of Ott v. Monroe, 282 Va. 403 (2011), a majority member of an LLC bequeathed his entire estate to his daughter, which included his majority control of the company.  The daughter who inherited the interest then sought to remove the remaining minority LLC member as managing member of the company, and elected herself as the new managing member.  The remaining minority member claimed that the inheriting daughter could only receive the right to share in profits, losses and distributions of the company, and that control of the company could not be inherited.  The Court agreed and held that it was not within the deceased majority member’s ability to convey unilaterally his control interest and make his daughter a member of the company.

The practical effect of this decision is that neither inheritance nor assignment is the proper means to convey one’s participation in control of an LLC.  To participate in control of an LLC, an individual must become an actual member of that company through the terms of the Act or the company’s operating agreement.  In most cases, your control cannot be taken away by beneficiaries and creditors of other members.

Written by David L. Arnold.