What is a Legal Partnership?
A legal partnership is a type of business structure where two or more individuals share ownership. Each partner contributes to all aspects of the business, including money, property, labor, or skill. In return, each partner shares in the profits and losses of the business. There are a number of type of partnership under North Carolina law: a general partnership, a limited partnership, a limited liability partnership, and – most commonly – a limited liability company (LLC), which is typically treated as a partnership. This article focuses on LLCs, but it applies equally to most other forms of partnership.
LLCs as a Form of Partnership
A LLC is a business structure that combines the pass-through taxation of a partnership or sole proprietorship with the limited liability of a corporation. This means that owners (usually called “members”) are protected from personal liability for company debts and obligations, a feature that partnerships typically lack. The IRS reports that LLCs account for nearly 72% of all partnership tax returns, which indicates the predominance of the LLC as form of partnership that most businesses choose.
The LLC Operating Agreement as a Partnership Agreement
An LLC’s “operating agreement” is a legal document that outlines the ownership and member duties. Generally speaking, there are two types of rights that can be allocated in an operating agreement: economic rights, and management rights. The economic rights set forth in an operating agreement determine a member’s right to a share of the profits and losses. The management rights determine the member’s ability to control the actions of the company.
Common provisions in an LLC operating agreement include:
Percentage of Ownership: Each member’s percentage of ownership in the LLC, usually in proportion to their investment.
Voting Rights and Responsibilities: The rights and responsibilities of each member in terms of voting on company decisions.
Profit and Loss Allocation: How the company’s profits and losses are divided among members.
Management and Voting Structure: Whether the LLC is managed by its members, or by hired managers, or whether different aspects of the company’s management will be shared among the members and managers.
The Importance of a Buy-Sell Agreement
A buy-sell agreement, also known as a buyout agreement, is a legally binding agreement between co-owners of an LLC that governs the situation if a co-owner dies or is otherwise forced to leave the business, or chooses to leave the business. It stipulates when members can sell their interest, who can buy an owner’s interest, and what price will be paid.
Death, Disability, or Divorce
A buy-sell agreement, and other rights related to transfer of an interest in an LLC, are crucial to have in an operating agreement so that the members know in advance what will happen to the company, and to their interests in it, if one of the members dies, becomes permanently disabled, or gets divorced. These provisions can include:
Death: The agreement might specify that the deceased member’s interest is to be purchased by the LLC itself (called “redemption”) or by the members themselves.
Disability: The agreement might define what constitutes a disability and how the member’s interest will be handled in such cases. Where the members themselves are managing the LLC, and are expected to contribute to the day-to-day operations, the permanent disability of one of the members will cause the disabled member to be unable to perform their duties. To continue the business of the company, it may be necessary to force that member to sell his or her interest back to the company.
Divorce: The agreement might prevent the transfer of a member’s interest to a spouse upon divorce. It is unlikely that members, especially ones in a closely owned company, will want to find themselves suddenly in business with one of their partners’ ex-spouses as a result of a divorce settlement.
Including these provisions in an operating agreement prevents disputes among surviving members, the deceased members’ heirs, and ensure the smooth transition of ownership and control.
Most operating agreements will contain a formula for how the LLC interest of the departing member will be valued. It is common, for instance, to have the LLC’s accountants provide a valuation at the fair market value, and then to pay the departing member or their heirs for their portion of their ownership interest. Sometimes there will be multiple ways to value the departing member’s interest – for example, if a member has to be forced out due to some misconduct, that member’s interest may be valued at a lower amount than if the member departed due to no fault of their own.
Conclusion
If the foregoing provisions are not included, the LLC is likely to face significant legal and financial challenges. For instance, without a proper buy-sell agreement, the deceased member’s heirs or exes could become unintended partners, or the business may even need to be sold to pay estate taxes. The primary goal with all of these provisions is to keep the LLC in business with a minimum of interruption. After all, if the company is no longer able to operate due to an unexpected personal tragedy of one of the members, everyone’s hopes and expectations for the LLC will have been thwarted.
A well-drafted LLC operating agreement is the roadmap for the members to deal with changes in ownership and help ensure the continuity of the business. It’s always advisable to consult with a legal professional when drafting these agreements to ensure all potential scenarios are covered.
Dye Culik is a law firm based in Charlotte, North Carolina. Our attorneys represent businesses, franchises, and business owners in drafting operating agreements and partnership agreements that best protect the interests of all. Connect with us to set up a consultation regarding your business. We're here to help.