What is an LLC Redemption Agreement?
An LLC Redemption Agreement is a contract entered into by and among the majority member(s) (often referred to as the "managing member" or "managing members") of an LLC and any minority member(s) of the LLC. This contract provides the terms by which the minority member(s) can sell their membership interest(s) back to the LLC. Specifically, an LLC Redemption Agreement dictates the price the minority member(s) will receive for their membership interest(s), when the purchase price will be paid, the business factors that will determine the price of the membership interest(s), the closing business day, the purchasing member(s) and the selling minority member(s) or the means by which the selling minority member(s) will be identified, an option for the purchasing members to purchase the membership interests, the source of funds for payment of the purchase price and the timetable for the redemption to occur .
It is important to note that an LLC Redemption Agreement is distinct from an LLC Purchase Agreement. The former form of agreement, i.e., an LLC Redemption Agreement, is one that is executed in situations wherein a minority member of the LLC seeks to sell their membership interest(s) back to the LLC, as opposed to a scenario where the minority member(s) are desirous of selling their membership interest(s) to an outside third party. In the event that the minority member(s) seek to sell their membership interests to an outside third party, the minority member(s) and/or the managing member(s) would typically enter into either a membership transfer consent agreement or a buy-sell agreement (both of which are discussed in greater detail below).
Key Terms of a Redemption Agreement
Redemption provisions typically provide the mechanism for redemption, the circumstances under which members can be redeemed, the procedure for redemption and certain post-redemption obligations.
First, redemption provisions often provide that the redemption must occur in accordance with an election procedure. For example, in one case, the redemption provision required at least 90 days’ prior written notice to the other member and at least 60 days’ prior written notice to the company, consistent with the procedures for a transfer of the member’s interest. Other provisions of the operating agreement may also be applicable, such as notice requirements or other procedures that may be applicable in the case of a redemption.
Second, redemption provisions typically provide that redemption can occur as a result of a triggering event. For example, a triggering event may occur when a member becomes permanently disabled, is determined to have a mental deficiency or has been convicted of a felony, any of which negatively impacts the company or is not in the best interests of the company. In addition, redemption provisions typically provide for redemption by the company of the membership interests held by a withdrawing member. A withdrawal triggers redemption. A withdrawing member is a member who has the right to require the company to purchase his or her membership interest. A withdrawing member’s right to redeem its interest may exist pursuant to a company event of dissolution or otherwise.
Third, redemption provisions in an operating agreement typically provide the company or the other members with the right of first refusal to purchase the membership interest before the withdrawing or transferring member can undertake to make a third-party transfer, including a redemption. A right of first refusal is a limiting provision. Limiting provisions are those that reduce or eliminate a member’s interest in the company, including, among other things, first rights, rights to compel redemption or other restrictions on the transfer of the members’ interests without the consent of the remaining members.
Fourth, redemption provisions typically provide for a process for the valuation of the membership interest being redeemed. The redemption provisions may set forth a formula to be applied to the membership interests subject to redemption based on the value of the company or some other component of value that reasonably effects the value of a membership interest. For example, the redemption provisions may state that the value of a membership interest is equal to the liquidation value of a member’s membership interest. A liquidation value is the amount that an intermediary would receive if it were to sell the membership interest in a distressed situation. If no valuation formula is provided, the redemption provisions may state that the fair market value of the membership interest shall be its stipulation by agreement between the member and the company or its appraisers.
Fifth, redemption provisions usually state a date by which the redemption must occur. The timing may differ from the notice requirement. A redemption date can be certain or diminish over time as the third party offer approaches. In addition, some redemption provisions provide that the redemption must occur within a certain number of months or years after a company or member event occurs. For example, in one case we reviewed, the redemption provision provided that redemption must occur no later than nine months after either the date of a third-party offer or the date on which the member ceases to meet the qualifications for membership.
Legal Issues Associated with Redemption Agreements
LLCs are usually governed by state law (the applicable state limited liability company act) and the operating agreement of the LLC. When a redemption occurs, in many states the applicable state limited liability company act will generally provide that members have a fiduciary duty to the LLC and every other member as well as a duty of care and duty of loyalty. Likewise, in some states, the applicable state limited liability company act might very well require that the redemption be made in good faith, and/or require the payment of "fair value". In addition, if the operating agreement is silent about redemption of a member in an LLC, the applicable state limited liability company act might (as previously alluded to) govern the redemption without any flexibility if there are multiple classes of members with different rights.
But if the redemption is made in compliance with the applicable provisions of the state laws, the redemption agreement of the LLC member, and applicable case law interpreting the redemption agreement, there may not be a problem with the redemption agreement. If, however, the redemption agreement violates the state’s requirements, causes injury to others, is against public policy, etc., then the redemption agreement may very well be void. A good example of this may be where the redemption agreement for a member in an LLC is done at a depressed price, in violation of the state’s limited liability company contractual agreement laws and/or its case law, and the redemption was done with fraudulent intent, thereby causing injury to others or in violation of public policy.
Tax Issues As They Relate to LLC Redemptions
In the prior background section of this blog post, we looked at what an LLC redemption is, how it works and the basic structure of a redemption agreement. In this section, we will look at the tax implications of an LLC redemption for both the LLC itself and the redeeming member (the redeemer).
LLC Tax Considerations
If an LLC is taxed as a sole proprietorship, there is no special tax consequence to the LLC from the redemption. However, if the LLC is treated as a partnership for tax purposes, then the LLC will recognize gain or loss from the redemption to the extent the distribution to the redeemer exceeds that redeemer’s basis in his or her LLC interest. The amount of any gain or loss allocable to the redeemer’s interest would theoretically then be passed through to the owner to be taxed on the owner’s personal tax return.
Redeeming Member Tax Considerations
If a LLC is taxed as a sole proprietorship, there is no special tax consequence to the redeemer from the redemption. However, if the LLC is treated as a partnership for income tax purposes, then the redeemer will recognize a gain if any cash or other property (other than a share in the LLC’s income) is received that exceeds the "investing tax basis" of the interest redeemed. (For an explanation of "investing tax basis" or tax basis, see this post.) Any gain recognized by the redeemer will be treated as income from the interest so redeemed, and the amount of any such gain not covered by any such income should be treated as gain from the sale or exchange of a capital asset. The treatment of the redemption will be capital gain or ordinary income depending on the nature of the property redeemed, the character of the gain realized and the length of time the redeemer has held his or her interest in the LLC. If a redeemer has a loss from the redemption, it may only be deducted against gain of the same character and cannot be used to offset other income.
What to Negotiate in a Redemption Agreement
Considerations in Negotiating the Purchase Price
The purchase price to be paid for transferring the LLC interest is a matter of negotiation, which will be influenced by the individual circumstances of the parties. Potential factors to consider in determining the fairness of the purchase price include: If the redemption is triggered by the death of a member, the value of the deceased member’s interest may need to be discounted to account for events subsequent to the death which adversely affect the LLC’s value. For example, the remaining members may elect to liquidate the LLC’s assets and distribute them in kind to themselves and cease the LLC operations. If that is the case, the deceased member’s interest in the LLC is colaterized by the LLC’s assets and the purchase price is fair. Alternatively, if the LLC is seeking to wind down operations, the LLC likely has a negative going concern value; however, a positive liquidation value. In that case, the deceased member’s interest in the LLC is not easily monetized, and the price offered should be correspondingly discounted. In either case it is important to know the value and status of the LLC assets if the LLC or its representative is providing the valuation information .
Payments of Deferred Compensation on an Instalment Basis
In lieu of a lump sum payment, the redemption can be structured to provide for deferred compensation if the purchase price exceeds a member’s basis in his or her LLC interest. (IRC §731(a) provides for the nonrecognition of gain on the redemption of the LLC interest although depreciation recapture may be triggered.) Typically, the redemption agreement will provide for annual payments of principal and interest; however, the parties have flexibility in determining the payment schedule and terms as long as both parties agree, as cash flow and tax considerations dictate. As the deferred compensation is treated as a dividend distribution under IRC §736(a)(2), the LLC can deduct the interest component as ordinary business expense.
Redemptions Between Unrelated Parties
Under IRC §707(b)(1) the IRS may disallow a full deduction for ordinary losses and IRC §731(a) does not apply to the extent a redemption gives rise to ordinary income. Thus, related party losses are limited under the tax redistribution rules. In the context of a liquidation, a redemption from an unrelated party, unlike a distribution from a partnership, can be treated as a sale or exchange. As such, for federal income tax purposes, a sale or exchange should be considered when identifying redemptions tax treatment.
Common Pitfalls of Redemption Agreements
One of the most common mistakes in an LLC redemption agreement is when the agreement lacks an arbitrator to make a decision on who should be able to exercise their rights. The LLC manager, and majority of members, will often want to have as much power as they can when trying to buyout a member, as it’s costly if the member is still digging their heels when it comes to getting their ownership share out. With the limited liability company, and especially with a redemption agreement, a court can easily side with the group in charge of the business. Any language that gives too much control over the situation and would allow maybe the majority holder to say an equal amount of shares of the overall business is worth more than their percentage of the business in profits. Or perhaps the LLC incurs additional costs that the person being redeemed owes. That could be anything from any recent business loss to just a hefty accounting fee. In this case, you could lose the buyer and also lose the person making the majority of the revenue.
If your redemption agreement does not lay out how the distribution of assets following the buyout is to be handled, then it probably isn’t going to contain them in a way that’s fair and beneficial to protect your interests.
Another mistake is not explicitly laying out the economic interests of the LLC, either financially or otherwise, that are allowed to be redeemed. Also, the redemption agreement may not contain the LLC interests and rights from the agreement, but only if the party looking to be redeemed is a minority holder, which they should not be.
If you do not have these things specified in the agreement, the redemption agreement is simply invalid, and it will almost certainly lead to a legal dispute, which is anything but good for business.
Any limitations that apply to the redemption plan cannot be under the control of the LLC, and in most cases, the one seeking the redemption should be the one with control of the process. The party who is redeeming their interest should not be bound by any of the terms of the redemption unless they voluntarily accept them.
Missed deadlines for compliance for the agreement, whether it’s in the claim for withdrawing or renegotiating the terms, is another common and costly mistake that should be avoided at all costs. Unless it was in the contract from the start, the agreement will stand, and the future of the business will be uncertain.
Sample Scenarios for Redemption Agreements
While every LLC will have specific circumstances that apply to utilizing a redemption agreement, there are several hypothetical situations where a redemption agreement is commonly used and/or needed:
Going through a divorce. An individual (or couple) owns an LLC (or is married to the owner). In order to properly account for division of property in a divorce settlement, it may make sense for one party to buy out the other’s ownership interest in the LLC.
Death of an owner. An LLC owner dies, or a number of years has passed since the last operating agreement was created, and the terms for the buyout of the deceased owner’s interest are not addressed in an existing agreement.
A key member is leaving the business. An LLC owner is becoming a partner in a larger company and wishes to cash out their interest in the current LLC .
The terms of the LLC membership are changing. A majority owner wishes to change the percentage of ownership and control in the company. The redemption agreement allows for a pre-agreed upon valuation for the departing owner, and allows the majority owner to replace that energy with someone else they choose.
When an investor wants to leave. For example, an investor (other than a manager or member) may have invested $100,000 in the LLC at its formation. As the business has begun generating profits, the investor’s ownership interest has grown over time, and the investor may want to leave with a higher payout than they originally invested. An LLC redemption agreement can cover this situation in advance and provide a fair settlement to the leaving investor.