While a limited liability company might share some common characteristics with a corporation, the process of exiting from an LLC is much more difficult than leaving a corporation. Since LLCs are privately held businesses, establishing the value of the departing member’s share in the business can be quite difficult. Since the owners of an LLC are responsible for paying taxes on their share of the business’s income, there are tax reporting issues that arise from a buyout as well.
Refer to the LLC’s operating agreement. An LLC operating agreement is the set of rules agreed to by the members at the outset of the business, and it defines how the organization is to operate and how the members interact with each other. If the operating agreement specifies how the LLC should act when a member leaves, that will govern how the transaction will take place.
Read More: How to Sell a Percentage of an LLC
See if a buyout agreement exists, if the operating agreement does not discuss what to do when a member leaves. A buyout agreement is a document separate from the operating agreement that dictates the rights and obligations of the LLC and its members when one person chooses to leave the business. If a buyout agreement exists and the operating agreement does not comment on buyouts, the buyout agreement will govern how the transaction takes place.
Balance the member’s capital account. A capital account keeps track of a member’s contributions to the LLC as well as any distributions made by the LLC to the member. It also tracks any loans the member made to the LLC as well as any loans given to the member by the LLC. If the either side owes the other money, make sure that those debts are settled before attempting to execute the buyout.
Calculate the value of the departing member’s interest in the business. Generally the operating agreement or buyout agreement will provide either a price or a means of arriving at a price for a member’s interest in the business. If there is no prior agreed-to means for valuing a member’s share, consider hiring a third-party professional to help you value the business and the member’s share of it.
Draft a purchase agreement. The purchase agreement is a legal contract stating the terms of the transaction. The purchase agreement should conform with any prior terms that are in the operating or buyout agreement. In addition, consider adding provisions such as a confidentiality or noncompete clause to protect your business’s competitive advantage.
Execute the purchase agreement. Have both parties review the document and sign it. The person who signs for the LLC must have the authority to do so. Depending on how the LLC is structured, either a member of the LLC or a person who was specifically chosen to represent the LLC in legal matters must sign the agreement.
Adjust capital accounts. Distribute the former member’s ownership percentage among the remaining owners subject to the terms of the operating agreement. If the operating agreement does not state how to distribute the departing member’s share, divide the amount equally among the remaining members’ capital accounts.
Deliver the final K-1 to the departing member. He is responsible to pay taxes on his share of the LLC’s income earned while he was still with the business. K-1s are reports prepared by the LLC that inform a member how much of the business's income and losses must be included on her personal tax return. Prepare a K-1 for the departing shareholder detailing his share of the business’s financial activity for her last year. Check the "Final K-1" box at the top of the form."
John Cromwell specializes in financial, legal and small business issues. Cromwell holds a bachelor's and master's degree in accounting, as well as a Juris Doctor. He is currently a co-founder of two businesses.