The death of an owner is almost always a challenging event for a business. And what happens to that business depends on its structure, the statute it was organized under, and any controlling or governing documents (such as an LLC’s operating agreement or an owner’s will). Do you know what would happen to your business?
The Default Situation Under Colorado Law:
Under the Colorado LLC Act, voting and control rights are separated by default from economic rights. Generally, this separation is beneficial for LLC owners (“members”). But it can create a unique trap for the unwary that jeopardizes the survival of a business after the death of its last member.FN1
Unless otherwise provided in an operating agreement, when a member of an LLC passes away, his or her economic rights in the business are transferred to their estate – ultimately ending up with either heirs or devisees depending on whether the departed had a will that controlled the transfer of the membership interest.
The voting and control rights, on the other hand, do not pass to the estate but are shared pro rata by the LLC’s remaining members.
Understanding the Kinds of Ownership Rights in Limited Liability Companies:
Voting and Control Rights allow LLC members (and only members) to participate in the determination how key company decisions are made. Exactly which decisions are reserved to members is generally specified in an LLC’s operating agreement, but typically these decisions include at least decisions related to dissolution, merger or acquisition, the admission of new members, and whether to sell substantially all of the businesses assets or engage in other activities outside of the normal course of ordinary business.
Economic Rights allow the rights holder to share in company profits and losses as well as to receive distributions from the company. Generally, these rights are held by members, but they can be assigned or transferred (depending on the terms of the operating agreement) to others. In an LLC, these rights do not themselves automatically grant any corresponding right to vote on member decisions or to manage the company. Economic rights holders, who are not admitted as members, may also be forbidden from inspecting company books or records.
In an LLC with more than one member – also called a multimember LLC – separating control and voting rights from the economic rights prevents any of the remaining members from having to co-manage or operate the business with someone who they did not choose to have as a business partner (such as a child or spouse of the departed member). This is an offshoot of partnership law’s “pick your partner” principle and it is generally desirable in situations where a business still has remaining members.
"Upon the death of a single-member LLC’s member... the economic rights pass to the departed member’s estate... but there is no remaining member in the business to receive the departed member’s voting and control rights."
The Default Situation Applied to Single-Member LLCs:
However, while partnerships cannot exist with only a single owner, LLCs can and often do have a only single member. Whether they were formed that way or ended up that way through the departure of previous members, many businesses these days operate as single-member LLCs.
Under the CLLCA, as is generally the case in other states, single-member LLCs are treated the same as multimember LLCs by default. Accordingly, upon the death of a single-member LLC’s member, the member is disassociated from the LLC and their voting and control rights are divorced from their economic rights. While the economic rights pass to the departed member’s estate (as would be the case in a multimember LLC), there is no remaining member in the business to receive the departed member’s voting and control rights.
The result is an LLC with no member and, as a result, no one who can make those business decisions reserved to members. What those decisions are will depend both on the terms of any operating agreement as well as whether the LLC was organized as member managed or manager managed under the Colorado LLC Act. For a more detail discussion of the difference between a member-managed and a manager-managed LLC, please see LLC Talk: Management Structure - Member or Manager Managed?.
The situation is generally worse in a member-managed LLC, which now has no one in charge of day-to-day operations and decision making. In this situation, the business has not simply lost its only member, but also its manager. Who will make sure that rent and other bills are paid? Who will oversee the employees of the business, if any? And if there aren’t any employees, who will make sure that the (literal or metaphorical) doors are open each morning? Who will ensure that customers or clients are making required payments? Not knowing the answers to these questions places a business is a perilous situation.
When an LLC’s sole member is also designated as the manager of a manager-managed LLC, the result is effectively the same as a memberless member-managed LLC: not only is there no individual with voting and control rights, but there is no one with the right or power to manage the business. The ship is lost at sea without its captain, headed into uncharted waters.
To make matters worse, an LLC without any members will be automatically dissolved after 90 days unless a new member is admitted in the meantime by the deceased’s estate (which holds the economic rights in the business).FN2 While the estate is still being settled, an administrator or executor can appoint a new member before 90 days passes. But there is no guarantee that they will act quickly or competently enough to prevent the automatic dissolution of the business.FN3
Many things can go wrong when administering an estate. Just to name a few: there may be a will contest, uncertainties may arise regarding possible heirs, or the administrator may not realize among all the other matters they are handling that they need to appoint a new member to the deceased’s LLC.
"To make matters worse, an LLC without any members will be automatically dissolved after 90 days unless a new member is appointed in the meantime by the deceased’s estate (which holds the economic rights in the business)."
Obviously, it would be better to simply avoid this situation with a bit of careful planning before an LLC ends up without any members. And the good news is that effective, efficient solutions are available!
How an Operating Agreement Can Help:
Before explaining further, it is helpful to understand how the situation is handled in the corporate context. Both LLCs and corporations are entities that provide liability protection and are capable of having only a single owner.
But unlike LLCs, when the last owner (“shareholder”) of a corporation dies, voting and control rights and economic rights are not separated, but are transferred together. As a result, the situation does not arise where there is no one with the deceased shareholder’s voting and control rights; those rights belong to the person (or persons) who has the economic rights in the business.
Why can’t a single-member LLC simply follow this corporate model? Fortunately, it can! LLCs, unlike corporations, are incredibly flexible business structures. Their operating agreement or other governing documents are generally permitted to replace the default rules of the Colorado LLC Act (or similar statutes for LLCs organized in other states).
In fact, under the Colorado LLC Act, the terms of an LLC’s operating agreement are to be given “maximum effect,” except for a few instances of nonwaivable provisions, so as to respect the “principle of freedom of contract.”FN4 For more information about operating-agreement enforceability, please see Giving ‘Maximum Effect’ to Operating Agreement Terms.
As a result, a well-drafted operating agreement can make use of several different tools to avoid the situation where an LLC ends up memberless and without its captain. One option is to simply permit the sole member (or last remaining member) of an LLC to designate an individual, usually a spouse or another adult heir, who will be automatically admitted as a member upon the current owner’s death. This designated member will receive the voting and control rights of a member and can, but does not have to, also receive any economic rights in the LLC.
By having a new member automatically admitted upon the death of the sole (or last remaining) member, the membership interest in the LLC passes to the designated person by contract and never becomes part of the current owner’s estate. As a result, the LLC never ends up memberless and headed towards dissolution. Moreover, the administrator of the estate need not worry about making a timely appointment of a new member since the LLC is never without a member.
Other succession strategies are also available and, in any case, exactly which provisions to include in an operating agreement and how to draft them will depend upon the particular circumstances of the business and its owner. A knowledgeable business attorney can help you develop an agreement that will get the right result for you.
"One option is to simply permit the sole member (or last remaining member) of an LLC to designate an individual, usually a spouse or another adult heir, who will be automatically admitted as a member upon the current owner’s death..."
If you need assistance developing an operating agreement for your business, or revising an existing one, please Reach out, Today!
This article provides only general information and is not intended to be a substitute for legal advice.