The single member limited liability company (SMLLC) is highly useful but hardly simple. State law and tax treatment render it sometimes “regarded” (but not always) and sometimes disregarded (but not always), all of which lead to some unusual results.
When first authorized about 30 years ago, LLCs, like partnerships, were designed to have two or more members. The “pick your partner” principle of partnership law became part of an LLC’s DNA. This prevents a member, either during lifetime or at death, from forcing an unadmitted and perhaps undesirable member on those who remain or survive. When state statutes were subsequently amended to authorize SMLLCs, followed by the “check the box” regulations, the “pick-your-partner” principle adhered. As noted in the dissent in Olmsted v. FTC, a case involving the rights of a creditor of a sole member, when legislatures amended their LLC statutes to permit SMLLCs, they did not contemplate issues that would arise from application to SMLLCs of statutory sections designed for those with more than one member. The default rule when a sole member dies without providing for that inevitable event is another place where “pick-your-partner” protection is inappropriate.
In both a multimember and SMLLC, when a (or the) member dies, the deceased is dissociated. Without provision in an operating agreement addressing death, the decedent’s interest divides. In a multimember LLC, the economic rights pass to the decedent’s estate, but the decedent’s management rights devolve on the surviving members who are thereby protected from unadmitted heirs participating in management.
Absent provision in an operating agreement, when a sole (or last surviving) member dies, the membership rights also divide with the economic rights passing to the decedent’s estate. Although there are no surviving members to protect, the authority to manage goes into what might be described as a “suspended state.” Uncertainty ensues. The governing statute may provide for a 90 day or other period within which the decedent’s estate may designate a successor member who must then agree to assume that role. If no designation is made and the statutory period expires, the LLC “automatically” dissolves, which may not be a desirable outcome. Meanwhile, the business is like a rudderless ship. Who has the authority to collect the receivables, carry out the LLCs contracts, and deal with employee issues?
Is it reasonable to assume that the decedent’s estate will timely designate a successor to manage the business? The Will must be found, submitted to probate, and perhaps be subject to a Will contest. If there is no Will, uncertainties inherent in the law of intestate succession may arise. In either case, an executor or administrator may not be timely appointed, may not know or be advised of the need to make the designation, or may fail to act timely to designate a person or entity willing to accept the responsibility of a successor member.
The importance of a timely election was illustrated by a case involving a multimember LLC where the operating agreement provided that unless the surviving members elected to continue the LLC within 90 days of a member’s death, the LLC would dissolve. The issue was whether the alleged election to continue had been made timely. If the LLC had dissolved, a member’s judgment creditor would be able to collect from the member or member’s estate, but if the LLC has been timely continued, the judgment creditor would be limited to a charging order against the LLC.
Contrast these issues with what follows the death of a sole shareholder. The shareholder’s entire bundle of rights in the shares pass to the estate. The corporation does not dissolve automatically after a fixed time. There is no doubt what becomes the immediate successor shareholder. If the sole shareholder had been a sole director, the estate can “elect” a new director. If the corporation is governed by a board of directors, the board continues to operate the business subject to the estate’s rights as shareholder.
Some business people form SMLLCs without the benefit of counsel; some engage counsel who are not business lawyers; and some, when advised to adopt an operating agreement to avoid the default rule, are pennywise and pound foolish. Whether the member’s failure to provide for succession results from ignorance or refusal to follow sound advice, there appears to be no reason why the entire bundle of rights in the 100-percent LLC interest held by a sole member, like the entire bundle of rights in all of the corporation’s issued and outstanding shares held by a sole shareholder, should not pass to the estate. The distinction between economic and management rights in the SMLLC is an unnecessary trap for the unwary.