How to Transfer an LLC Membership Interest

So you’ve formed an LLC with one other person and out of the blue, the other member says he wants out. Or perhaps your own situation has changed and you want to transfer your membership interest in the LLC to the other member. How do you do transfer the interest from one member of the LLC to another?

If there are only two members before the transfer and only one will remain, the process of one member giving up his interest is pretty simple. Although it could take several forms, the effect is that the member giving up his interest in the LLC is essentially transferring all of his rights to the remaining member. However, the mechanics of the transfer may differ under state law, as may the consequences.

Abandoning the LLC Membership Interest

One way to do get rid of an unwanted LLC interest is to simply abandon it, if that action is permitted under the applicable state law and the operating agreement of the LLC. Generally, in order to establish that the interest has been abandoned, the LLC member giving up the interest must take some affirmative step. Typically that take the form of a notice to the LLC and the other member that the membership interest is being abandoned.

The easy thing about abandonment is that it does not require the consent of the remaining member. The member giving up his LLC interest basically just walks away. Of course, abandoning the LLC interest does not relieve the departing member of any liabilities he may have personally incurred to third parties before his abandonment. FOr example, if he signed a personal guaranty of LLC debt, his merely giving up his interest in the LLC will not automatically negate his contractual obligation to the lender.

Assigning the LLC Membership Interest

Where the two members are in mutual agreement on the terms of the withdrawing member’s departure, a better alternative is to have the departing member assign his membership interest to the remaining member. Even if the departing member is not being paid for his interest in the LLC, there are several advantages to making an assignment of the LLC interest.

First, in many cases either state law or the LLC’s operating agreement may restrict the ability of a member to unilaterally withdraw. In that case, the attempted abandonment might either be ineffective or at least lead to a dispute and possible litigation. An assignment eliminates that potential problem.

Second, an assignment of an LLC interest is typically done in a written document signed by the parties that can often cover related issues by agreement. For example, an assignment agreement where compensation is being paid will usually contain a representation by the assigning member that the the membership interest is not encumbered by a lien or similar restriction.

Tax Issues Related to Transferring an LLC Membership Interest

A transfer of an LLC interest where compensation is being paid is treated as a sale or exchange. The selling member will usually have a taxable gain or loss on the sale.

Even where the two members agree that the departing member is getting nothing for his interest, if the LLC has liabilities if the transaction results in a decrease in the departing member’s share of liabilities under the Internal Revenue Code, he or she will be deemed to have received a cash distribution, and the relinquishment of his or her interest is considered a sale or exchange. Walking away from a partnership in this manner will result in a capital loss. Courts have ruled that even a de minimus amount determined in any way to be compensation for the partnership interest will cast the transaction as a sale.