Ron’s accountant was his biggest supporter. They had been friends forever. But his accountant was more than a friend. To Ron, his accountant felt more like a business partner, for all the advice and help he’d given him. And so when Ron decided to form an LLC to expand his storage business, he approached his accountant about joining him. In the end, Ron’s accountant agreed to take a 10% interest in the business in exchange for helping with the down payment on another facility and for providing accounting services for free.
Members
An LLC’s members own the LLC. In the case of a corporation, the corporation’s shareholders are the corporation’s owners. An LLC, though, has no stock shares and so no shareholders. Instead, an LLC has members who own the LLC by percentage interests. You may be your LLC’s only member. You don’t need multiple members. Just as in the case of a corporation in which you own all the stock shares, in the case of an LLC you may own 100% of the membership interests. But you may alternatively make yourself a 50% interest owner and a business acquaintance a 50% interest owner. Or you may make yourself a 51% owner and your friend a 49% owner. Or you can divide membership up equally among you and nine investors so that you each have a 10% interest. Members own the LLC by relative percentage interests.
Percentages
Percentage membership interests make good sense for LLC ownership. In the case of a corporation, a shareholder might own 100 shares, 1,000 shares, or 10,000 shares, without having any idea how much of the corporation they own. In the case of a corporation, ownership percentages depend on the number of outstanding stock shares. A corporation might have 50,000 outstanding shares, 500,000 outstanding shares, or 5 million outstanding shares. Apple, for instance, has over 15 billion shares outstanding. You don’t know what percentage of a corporation you own without comparing your shares to the outstanding shares. In the case of an LLC, ownership is much simpler. The LLC simply states the percentage interest of each member, in an exhibit attached to the operating agreement. With an LLC, you know exactly what percentage interest you own, without having to find out any other information about shares.
Dilution
Importantly, the LLC cannot dilute your membership interest by issuing additional interests. In the case of a corporation, the corporation may issue additional shares. Each additional share the corporation issues reduces the existing shareholders’ proportional interests. Issuing new shares dilutes the value of existing shares. But with an LLC, members own the percentage that they own. The LLC has no additional interests to issue, the members already holding 100% of the total membership interest. Bringing in new members involves gaining the agreement of other members to adjust their percentage interests. Members may agree or not, depending on their judgment of the value of bringing in new members. No dilution. Members own what they own.
Operation
Members determine the LLC’s operation. They do so by adopting the LLC’s operating agreement. The LLC’s organizer can form the LLC with only the organizer’s signature on the articles of organization. But the operating agreement requires the signatures of all members. To gain a member’s signature on the operating agreement, the organizer will need to draft and negotiate the terms of the operating agreement to each member’s satisfaction. The key to that negotiation is likely to include who the members are, what are their relative percentage interests, what they each must contribute to become a member, and who will manage the LLC. If prospective members don’t agree, they’re not going to sign the operating agreement. Members thus determine their percentage ownership interests, when negotiating and signing the operating agreement.
Control
Members also have continuing control over the LLC through the choice of the LLC’s manager. Initially, members choose a manager when signing the operating agreement. The manager has the authority that the operating agreement provides to manage the LLC. See the chapter below on LLC management. But under the operating agreement’s terms, members may generally vote their majority membership interests in favor of a new manager. Members could kick out a manager whose management they do not like. If you maintain more than 50% of the LLC membership interest, you can elect yourself as manager or choose and replace the manager at your will. You effectively control the LLC. But the moment you relinquish a majority of membership interest to others, those others control who manages the LLC. Keep 51% of the membership interests if you wish to maintain control over the choice of the LLC’s manager and, in effect, over the LLC’s operation. Be the LLC’s manager, if you prefer hands on, day-to-day control.
Benefit
Percentage membership interests are also important because they represent the relative rights of member owners to benefit from the LLC. An LLC can carry several owner benefits with it. Paid employment of the member manager or non-manager members is one benefit an LLC may offer. The LLC may pay out some, most, or all of its income in reasonable wages and employment benefits to a member manager and other member employees. The majority member or members who control the LLC effectively control employment and its reasonable compensation, as potential owner benefits.
Distributions
The other member financial benefit, after any employment that the LLC may offer its member manager or other member employees, is the right to distributions from the LLC. Distributions are out of the LLC’s net income, meaning the profit or earnings after the LLC pays all other obligations. For tax reasons (see a chapter below), LLCs do not generally retain earnings. LLCs instead generally pay out earnings in the form of employee bonuses or member distributions at the end of each year. Your operating agreement will likely provide for your LLC to make distributions based on member percentages. The larger your membership share, the larger your LLC distribution. That’s a primary way in which LLC members get a return on their investment, through periodic or year-end distributions.
Spouses
Including your spouse as a member of your LLC with a percentage interest may make sense. Giving a spouse a membership percentage may reassure the spouse of participation in the LLC’s business and earnings. Your state’s LLC act may alternatively permit you and your spouse to hold your membership interest as a joint tenancy with rights of survivorship. You may not need, though, to give your spouse a membership interest or hold your membership interest in joint tenancy, to ensure your spouse receives appropriate value in the event of death or divorce. If created during the marriage with current earnings or marital property, your LLC membership interest may well already be a marital asset, without having to put anything in your spouse’s name. Your LLC membership interest would likely become part of your probate estate in the event of your demise, the value from which your spouse or other beneficiaries could then receive. You and your spouse may prefer not to involve your spouse directly in the LLC’s affairs through employment or membership, in which case family law and probate rights may protect your spouse’s financial interest.
Family
The same would be true for a parent, sibling, child, or other relative, that you may have reasons to offer a family member an LLC membership interest or reasons not to do so. Family members may contribute capital, labor, or other resources. An LLC may be a good way to recognize specific interests in a family business. But hesitate to give membership interests to non-participating, non-contributing family members. You can always give away the LLC’s earnings without giving away membership interests. Gifting family members interests in an LLC that you intend to grow and manage could also complicate growth goals and management opportunities.
Assigning
Your LLC’s operating agreement should address whether a member may assign the member’s right to distributions to another individual. Assigning a right to distributions does not transfer the membership interest. Members do not have the unilateral right to sell, give away, or otherwise transfer their membership interests. In that respect, LLC membership interests are unlike corporation stock shares, which one may generally sell without other shareholders having to consent. Your LLC operating agreement may deny transfer of membership interests or may provide for transfer of a membership interest only on consent of all or a majority of remaining membership interests. Assigning a member interest, though, does not transfer the interest. It instead transfers the benefit from the interest. In the typical assignment, the assignee (the one receiving the assignment) gets the assigning member’s distributions. That’s it. Assignments may be in exchange for anything, whether for loans, cash, services, or relief from loans, among other exchanges.
Contributions
Your LLC’s operating agreement should indicate, typically on an attached schedule, the initial capital contributions each member makes to receive that member’s percentage interest. Initial capital contributions may be in the form of money, real property, personal property, intellectual property, or promised services. The schedule should assign a value to non-cash contributions so that the value of each member’s cash or non-cash contribution reflects the relative membership interests of all members. If no member is contributing cash, and all members are instead contributing services, consider assigning any modest cash values that enable equating of membership interests. Put some figures down. Don’t leave the contribution amounts blank.
Calls
Your LLC’s operating agreement may provide for the manager to make a call for members to contribute additional capital. If, for instance, the LLC runs short of operating funds, or the LLC would benefit from the purchase of land or equipment for which it lacks the current capital, the LLC’s manager may call on each member to contribute their fair share of the needed capital based on percentage interests, if the operating agreement permits capital calls. If a member refuses or is unable, the operating agreement may permit the other members to loan the funds, which the non-contributing member would then owe, presumably payable by reducing that member’s distributions. Or the operating agreement may permit the other members to make the non-contributing member’s contribution and to dilute that member’s percentage interest accordingly.
Withdrawing
Your LLC’s operating agreement should address whether members may withdraw from the LLC and, if so, the terms for withdrawal. If the member who wishes to withdraw was to have contributed services or resources and simply refuses to do so, then the remaining members could treat the refusal under the operating agreement’s terms, for instance, either to enforce the promise or dilute or dissolve the non-contributing member’s interest. You can’t generally force a person to continue to do something they no longer wish to do. The operating agreement should provide thoughtfully for the possibility that a member will simply cease participating. Simply continuing on without the member’s participation or dissolving the LLC and starting over with a new LLC may be other options, besides enforcement of the obligation or dilution of the interest.
Rights
LLC members have other rights beyond adopting an operating agreement, choosing or replacing a manager, and receiving distributions. Members may vote a majority of their interests to require that the LLC wind up its affairs and dissolve. Members may also vote any time the LLC’s manager proposes to sell or transfer any substantial part of the LLC’s assets, as the operating agreement provides. Members may also vote on whether to merge the LLC with another entity or amend the LLC’s articles of organization or operating agreement. The operating agreement may require an annual meeting of members and permit members to call special meetings at which they can hold such votes. A majority of members in effect control the LLC, at least at the higher level of governance if not at the manager’s lower level of daily operation. Members have ways to participate in the LLC’s governance, even if holding minority membership interests.
Key Points
An LLC’s members own the LLC.
Owners become members by signing the LLC’s operating agreement.
Members contribute capital to fund the LLC’s operation.
The operating agreement reflects the member’s percentage interests.
A majority of member interests controls the LLC through its manager.
Members have rights to distributions based on percentage interests.
Members elect and replace the manager by a majority of interests.
A majority of member interests determine merger or dissolution.