By Lane V. Erickson, Idaho Business Attorney
Whenever a person is creating a new Limited Liability Company or LLC business, a good business plan will also contemplate how that business may come to an end. In other words, a good business plan is thorough and goes from the beginning all the way through the potential end that could occur for that business.
This is not to say that a business owner should be pessimistic. Rather, a business owner should be realistic and should create a good plan that will help them and the other owners even when bad things happen. For example, it’s possible that at some point during the operation of a business, one of the business owners may die unexpectedly. Because this is a possibility, a good business plan will contemplate this and create a mechanism that will take care of this problem. One of the solutions for this type of a problem is using life insurance as part of a succession plan.
At the Racine law office, we have assisted business owners in both the creation and operation of their businesses in Idaho for more than 70 years. We have also helped owners of LLCs do these things since LLCs were allowed in Idaho during the last 30 or so years. In doing this, we have assisted in the transitioning of business operations from an owner who dies to the surviving owners. Our team of Idaho business attorneys include partners Lane Erickson and TJ Budge, and attorneys Nate Palmer and Dave Bagley. Each of our attorneys is skilled and experienced with business transactions and in helping our business clients especially when it comes to transitioning ownership interests after an owner passes away.
The purpose of this article is to describe how life insurance can be used in this process. We begin by talking about how succession is controlled by the operating agreement. We then describe the options and rights of first refusal when it comes to purchasing the deceased member’s ownership interest in the LLC. Finally, we describe how life insurance can be used as a way of purchasing that ownership interest.
Succession Controlled by Operating AgreementWhen it comes to an LLC, it’s true that the operating agreement controls everything. This is because the operating agreement acts as a contract between the owners of the business. As a contract, each of the owners is bound to follow whatever it is the operating agreement says. This is especially true when it comes to succession of an ownership interest in the LLC.
An ownership interest in an LLC can end for a number of reasons. One of those reasons is that the person simply doesn’t want to be part of the business anymore. Other reasons could include that the owner has become disabled, or entered into bankruptcy, or been divorced. The focus of this article is to talk about an additional reason, which is the death of the owner.
When an owner dies, the ownership interest they have in the LLC is their personal property. Because it is their property it becomes property of the estate that belongs to that individual. As a result, if there is nothing in the operating agreement about how the LLC ownership interest will be transitioned, then that person’s written last will and testament, or if they have no written will, the laws of intestacy will control who ends up owning that ownership interest.
Rights of First RefusalThe purpose of the operating agreement is to provide a contractual right for either the LLC business itself or the other owners to keep that ownership interest from ending up in the hands of a third party.
For example, if the operating agreement is silent, then when an owner dies, their spouse would likely have a right to take over that ownership interest in the business. In this instance, most of the remaining business owners likely didn’t contemplate being in business with their partner’s spouse. Most business owners in this situation wouldn’t be happy if a third party, such as a spouse, could suddenly exercise voting rights, or management rights, or other rights that could control the operation of the business.
To keep this from happening, most operating agreements for an LLC contain a right or multiple rights of first refusal. These rights give either the LLC business itself, or any of the surviving owners of the LLC, the first right to purchase the ownership interest from the estate of the owner who passed away. By having this written into an operating agreement, the remaining owners can control whether or not an ownership interest goes to a third party rather than to the business or its remaining owners.
Life Insurance for Buying Owner’s Interest in LLCThe problem is, in many instances, neither the owners nor the business itself has the funds necessary to purchase the deceased owner’s ownership interest in the LLC. This is where life insurance comes in.
When the business is created, the owners of the business could elect to have the business purchase a life insurance policy on each of the owners of the business. That life insurance policy could name the business as the beneficiary. As a result, if one of the owners does pass away, the life insurance would pay the policy amounts to the business. The business could then use the life insurance money to purchase the ownership interest from the heirs of the deceased owner.
When this is coupled with a right of first refusal, the heirs do not have any ability to demand more money for the payment of the ownership interest. Rather, the amount of money that will be paid to purchase that ownership interest is controlled by the operating agreement.
This article describes just one of the numerous ways that an operating agreement can be used to help control the ownership interest in an LLC. This article also illustrates how life insurance can be used as part of this process. There are many other techniques and options that owners of an LLC have available to them when it comes to the operation and ownership interest in an LLC business. If you have questions, we encourage you to contact us so that we can answer your questions and help you to better understand the options and rights that are available to you.
Enlist an Idaho Business Attorney to Help YouOur team of Idaho lawyers can help you with any of your estate planning or probate needs. Whether you are seeking to create or review an estate plan for yourself or would like to help a loved one, we are available to discuss your options and answer your questions at an initial free 30-minute consultation. Call us toll free at 877.232.6101 or 208.232.6101 for a free consultation. You can also email us directly at lane@racineolson.com or stop by our office at 201 East Center Street, Pocatello, Idaho 83201. We will answer your questions and help you solve your Idaho Estate Planning problems.