Treatment of Members Upon Their Death and Withdrawal from a Limited Liability Company: The Case for a Uniform Paradigm

Continuing an international trend, Wyoming initiated a national movement in 1977 by adopting the first limited liability company act in the United States. The movement began slowly, as the Internal Revenue Service (Service) took more than ten years to announce that a Wyoming limited liability company would be taxed like a partnership. [FN4] Since that time, a total of forty-seven states and the District of Columbia adopted limited liability company legislation and the National Conference of Commissioners on Uniform State Laws (Conference) adopted the Uniform Limited Liability Company Act (ULLCA). The allure of the limited liability company is a unique statutory structure that combines the two most critical features of all of the other business organizations in a single business organization -- a corporate-styled liability shield and the pass-through tax benefits of a partnership. General and limited partnerships do not extend their partners a corporate-styled liability shield. Corporations, including those having made a Subchapter S election, do not provide their shareholders all the pass-through tax benefits of a partnership. All state limited liability company acts contain provisions to assure the presence of a corporate-like liability shield and partnership tax status. Generally, a limited liability company will be taxed like a partnership unless it possesses three or more of the four corporate characteristics including continuity of life, centralized management, limited liability, and free transferability of interests. Since most limited liability companies possess limited liability, they are classified as partnerships because they lack at least two of the remaining three characteristics -- generally, continuity of life and free transferability of interests. Despite the commonality of the liability shield and partnership tax themes, state acts reflect a dazzling array of diversity. Unfortunately, this lack of uniformity manifests itself in basic but fundamentally important questions. Arguably, the most important issue relates to the treatment of dissociated members. State laws accord vastly different treatment to the effect of member dissociation on the dissociating member (purchase of interest and management rights) and its separate effect on the business continuity of the limited liability company (dissolution). Because each state act is an amalgam of general and limited partnership and corporate laws, the results are far from uniform. Shareholder events such as death, bankruptcy, retirement or resignation of employment, incapacity, and share transfers generally do not require the company to purchase the dissociated shareholder's interest absent an agreement to the contrary. Also, these events do not affect the corporation's perpetual business continuity. Partnership law is different. A dissociating partner is usually entitled to either force the partnership to liquidate or to purchase that partner's interest. Most state limited liability company acts are designed to have the entity taxed like a partnership because it lacks the corporate characteristics of continuity of life and free transferability of interests. Therefore, in most respects the acts adopt the partnership rather than the corporate paradigm regarding the effect of member dissociation on that member's right to be bought out by the company and to cause a liquidation of the entity. Unfortunately, because of the Service's view on specific aspects of its tax classification regulations, important details of these state laws are extremely varied and inconsistent as state legislatures cope with how much uncertainty their limited liability law should tolerate. The Service itself has publicly recognized these limitations and endorses radical change in its tax classification regulations that should ultimately stabilize state legislation. Widely divergent rules on the effects of member dissociation will ultimately create confusion and inhibit the development of uniform case law. As a result, case law will have little precedential value from state to state.