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What Happens When a Corporation’s Shareholder or an LLC Member Dies or Leaves?

Among the numerous issues LLCs might face, one that can't be forgotten is the death of a shareholder. What happens to the business when this occurs? Nellie Akalp of CorpNet outlines various scenarios and discusses how each one affects the company.

Sep 18th 2020
CEO and Founder CorpNet
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Incentives for S corps converting to C corps

When an owner of a corporation or limited liability company decides to leave the company or passes away, it potentially can affect the business in numerous ways. If you haven’t already faced these sorts of situations with your business clients, you may eventually. Therefore, it’s good to have a basic understanding of what clients should be prepared for under those circumstances. You, of course, can offer your clients the accounting and tax guidance you’re legally authorized to provide to them. Your clients should also consider contacting a business attorney for legal advice on how to proceed.

Right now, let’s talk about what generally occurs when shareholders or LLC members leave a company and what the other business’s owners might do to ensure a smooth transition.

Loss of Key Shareholder at a Corporation

Because a corporation is a separate legal entity from its owners (shareholders), the business has perpetual life (referred to as “perpetual existence”). Its existence goes on even after an owner dies or otherwise leaves the company. Unless a corporation’s shareholders' agreement, buy-sell agreement, or its bylaws state otherwise, the company continues to operate unless it is officially ended by filing Articles of Dissolution (or administratively dissolved by the state due to noncompliance).

One of the attractive features of operating as a corporation is that there are various options for handling ownership shares if a shareholder leaves, dies, or becomes incapacitated. Shareholders can sell, bequeath, or otherwise give their ownership shares of the business to someone else. The key to ensuring everyone is on the same page is to have the rules and process documented formally. Without proper documentation of how things should be handled, disagreements may arise, creating stress and potential legal issues.

When a Key Shareholder Dies

If no provisions in the company’s shareholder agreement or other corporate paperwork specifically spell out what must happen with a deceased or incapacitated shareholder’s shares of ownership, then the shares are generally passed to that shareholder’s heirs. Under some circumstances, this might not be an ideal situation because the person(s) inheriting the shares may lack the business acumen and well intentions of a key stakeholder. And if the shareholder also served as a director or officer, the scenario can get even more challenging.

A buy-sell agreement (sometimes referred to as a “buyout” agreement) or buy-sell section in a corporation’s shareholder agreement can help guarantee the ownership and control of the company will remain with other key shareholders. Buy-sell provisions detail what should happen if a key shareholder dies or leaves under other scenarios. For instance, a buy-sell agreement could dictate that remaining shareholders have first rights to purchase all of the deceased shareholder's ownership shares.

Another way a corporation can protect itself is by buying a key person insurance policy. Your clients may want to explore this if they have one or more shareholders who are critical to their business’s operations. Key person insurance can provide funds to cover lost revenue due to the loss of the shareholder’s presence, the costs of finding a new person to take on the shareholder’s role, and, if necessary, settle debts, pay severance to employees, or distribute funds to investors.

When a Shareholder Withdraws from the Business

One of the benefits of the corporate structure is that transferring ownership interests does not have to disrupt operations. Unless corporate documents state otherwise, all stockholders may need to do to leave the business is to sell their shares, which typically involves recording the transfer and capturing the new owner’s information in the corporation’s stock ledger. This allows for operations to continue seamlessly when a shareholder decides to leave a corporation. Unless shareholders are also employees, directors, or officers of the company, they don’t participate in—nor do they have rights to engage in—management of the business. 

A corporation’s owners can have control over share transfers by drawing up buy-sell agreement or adding provisions in the company's bylaws or shareholder agreement. For example, they might consider adding restrictions to require shareholders who leave to sell their shares back to one of the other shareholders or back to the company.

Potential Issues Corporations Might Face

In a small corporation in which all shareholders are actively involved in managing the business, the withdrawal or death of any stockholder could leave a void in the company’s operations.

Moreover, if no buy-sell provision is in place, there could be misunderstandings and arguments about how much the departed shareholder’s interest is worth. If disagreements about how much a stockholder’s ownership interests are worth cannot be resolved among the shareholders, it may be necessary to hire a third party to perform a business valuation to move the process along.

Another potential point of contention is if the corporation has not kept accurate records of when shareholders have deferred salary or wages owed to them by the corporation or loaned money personally to the corporation. And, if the company doesn’t have adequate funds to pay a departing shareholder, a payment plan may need to be negotiated. 

Business Entity Compliance Tasks After Loss of a Shareholder

When a shareholder leaves the corporation, whether through death or withdrawal, clients will need to update their official business documents and submit required filings with the state. This may include updating the stock ledger and bylaws, filing articles of amendment to update the formation documents (articles of incorporation), and reflecting the change in other corporate records.

Loss of an LLC Member

Because a limited liability company is considered a legal entity separate from its owners (“members”), usually it can remain intact after a member of a multi-member LLC leaves, dies, or becomes incapacitated. If the entity is a single-member LLC (only one owner), the ownership becomes part of the member’s estate and is transferred through the individual’s will (or, if there is no will, according to the state’s intestacy laws).

For the purposes of this article, I’ll focus on what might occur with a multi-member LLC. As is the case with a corporation losing a key shareholder, having official documentation of what should happen in the event of losing an LLC member will help alleviate disagreements and ensure a seamless adjustment.

When an LLC Member Dies

Ideally, an LLC will have an operating agreement with provisions that explain what must happen when a member passes away. Several of the possible options that LLCs might include in their LLC operating agreements are:

  • Surviving LLC members must buy the deceased member’s ownership share from the departed heirs.
  • The deceased’s heirs may inherit only the financial interests (i.e., profits, losses, assets) but not management rights in the business.
  • The LLC must dissolve if a member dies and that deceased member’s share of the LLC’s assets must be distributed to the departed’s heirs. 

As you can see, the various alternatives can have vastly different effects on the company, remaining members, and the beneficiaries of the deceased member. That’s why it’s critical for an operating agreement to detail what the LLC members have reached a consensus on.

What if the LLC doesn’t have an operating agreement or the one in place doesn’t include what should happen when a member dies? The state’s law will determine how to handle matters.  Some states require that an LLC must dissolve and file to start anew upon a member’s death (although that’s not usually the case with a multiple-member LLC), some require that the deceased member’s financial interests (sometimes management interests, too) go to the beneficiaries in the individual’s will, and some states may have other rules.

Just as a corporation may find itself at a disadvantage competitively and financially when a highly involved owner dies, the same can happen to an LLC. Therefore, LLC members may consider getting a key person insurance policy to help the company get through that time of loss without experiencing devastating financial hardship.

When a Member Withdraws from an LLC

Unless the LLC wants to be at the mercy of the state’s default rules, its operating agreement should set forth specific provisions for how to handle matters if a member withdraws from the company.

LLCs sometimes state in their operating agreements that other members must purchase the resigning member’s ownership stake in the company. And sometimes members agree that members do not receive compensation if they leave the LLC.

If there is no operating agreement or the LLC operating agreement doesn’t include provisions for a succession plan if a member leaves, then the state might require a member’s ownership interest to be divided equally between the remaining LLC members or transferred to a new member. Alternately, some states require that the LLC follow a process to dissolve the company when a member leaves.

Potential Issues LLCs Might Face

The valuation of what a member’s share of the LLC’s ownership is worth could get messy. An LLC’s profits can be distributed according to considerations (e.g. time spent working in the company, professional expertise, etc.) other than the amount a member invested in the company. For example, LLC members might have agreed that a member who only invested 30 percent in the company is entitled to 50 of the profits. Therefore, upon a member’s departure, the LLC may need to bring an expert third-party to evaluate the situation and assess the dollar amount of that individual’s share.

Business Entity Compliance Tasks After Loss of an LLC Member

Like a corporation, an LLC must make sure it notifies the state about any changes to its ownership. This might include filing articles of amendment to update the LLC’s articles of organization and updating other business records.

The Power of Preparation

As with all things business-related, planning how the exit of a corporation’s key shareholder or an LLC member should be handled can go miles toward avoiding conflict and carrying on business activities. By thinking through and formally documenting the provisions and processes for their companies, your clients will be more prepared to navigate those challenges should they arise.

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