LLC Buyout Agreement

At some point, most LLCs will undergo a change in membership because a member (owner) wants to leave. When that happens, the business needs an LLC buyout agreement.

But you can’t just download a buyout agreement off your state’s website. You’ll have to create one customized for your LLC. In this guide, we’ll cover the essentials to creating a buyout agreement: what it is, what it includes, and how to create your own.

Understanding LLC Buyout Agreements

LLC buyout agreements can be a bit complicated and overwhelming. So let’s answer some of the essential questions about these agreements.

One quick note before we dive in: this guide covers a buyout agreement for a partial sale of an LLC. If you’re curious about buying and selling a full LLC, check out our guide to buying an LLC.

What is a buyout agreement?

A buyout agreement, sometimes called a buy-sell agreement, is a document that describes what happens when a member wants to sell their membership interest in a limited liability company. It’s a legally binding contract. Ideally, an LLC has a buyout agreement article included in its operating agreement. Alternatively, members can draft a separate buyout agreement together.

Typically, a buyout agreement describes how the member’s ownership interest will be valued, who can — or must — buy it, and how the payment will be made. Some LLCs might even include non-compete clauses or confidentiality provisions to protect the business’s intellectual property.

Why is it important to have a buyout agreement?

There are two primary reasons an LLC should create a buyout agreement. First, if you don’t have one, your LLC sale will be governed by your state’s default provisions. In some states, if you don’t have an agreement in place and a member leaves, the LLC has to dissolve completely and start over. Other states require a unanimous vote of the members. 

Additionally, a buyout agreement helps protect all the members from emotionally charged disputes. It’s not uncommon for members to leave a business on less-than-good terms. Discussing a sale when the relationship is sour can be tense (and expensive if you have to get a lawyer involved). But if an LLC defines the process at the start, that tension can be mostly avoided.

When is an LLC buyout agreement needed?

An agreement is needed prior to the sale of a member’s ownership interest. But it’s best to create a buyout agreement in advance — ideally when the business is just starting out. It’s much like creating a prenup agreement; the buyout agreement protects your interests should things turn sour. 

Establishing this procedure at the outset can save your LLC’s members from costly litigation down the road. It’s especially important for multi-member LLCs, but single-member LLCs can benefit from planning ahead, too. 

What are the different types of buyout agreements?

There are two primary categories of buyout agreements: a cross-purchase agreement and an entity-purchase agreement. When a cross-purchase agreement occurs, the remaining members agree to purchase the departing member’s ownership interest. In an entity-purchase agreement, the LLC itself purchases the member’s interest. Some LLCs also agree on a wait-and-see approach, where the entity or the fellow members will make the purchase, deciding when the time comes.

There are also different agreements you can create to allow external parties to purchase a member’s interest. If you’re not sure what agreement would be best for your LLC, we recommend getting legal counsel.

Buying Out a Partner in a Limited Liability Company

Every buyout process looks a bit different, but there are four basic steps that most buyouts will follow.

Step 1: Determining the Value of the Partner’s Interest in the LLC

How much an LLC member’s ownership interest is worth depends on several factors. First, the LLC as a whole needs to be valued. An LLC’s members might even agree to have a third-party assessor value the business. Depending on the financial statements, cash assets, and tangible capital the business has, this can be very straightforward or complicated.

After the LLC’s value is estimated, the member’s ownership interest can be valued based on the percent ownership they have in the business. Typically, this information is described in the LLC’s operating agreement. Based on the value of the member’s ownership interest, the members can set a buyout price.

Step 2: Negotiating the Terms of the Buyout Agreement

Who will be buying the departing member’s ownership interest? Do the other members have preferential rights to purchase the ownership interest before a third party? How will the purchase price be paid? When is the sale effective? How do responsibilities change for remaining members? How will their member titles change? Will management rights change? 

Will the departing member leave or take physical property investments they brought to the LLC? Is a non-compete agreement or confidentiality statement important? Are you going to place a limitation on liability for any of the members?

All these questions (and more) should be answered by the members. You might decide to have a lawyer present at these negotiations to help ensure that you cover all of your bases.

Step 3: Drafting and Executing the Buyout Agreement

Once you’ve verbally agreed on the terms of the agreement, it’s time to put everything in writing. You can use a buyout agreement template to complete this task, or you might have a business attorney draw this up. Since it’s a contract, it’s imperative that you don’t gloss over the terms of the agreement.

Once the agreement is written, all participating parties should sign it. Executing the document makes the sale official and legally binding.

Step 4: Paying for the Partner’s Interest in the LLC

The buyout agreement will clearly delineate how the purchasing party should pay for the member’s ownership interest. For example, the agreement might require the balance to be paid in full right away in cash. Another agreement might set out a suitable payment plan.

In some circumstances, LLCs might even have insurance policies for each member, to be claimed when a member dies or is incapacitated. The insurance money can be used to buy back the member’s ownership interest from the heir. Not every business goes this route, but it’s an option. The important thing: the purchasing party should pay in accordance with the terms of the purchase agreement.

What to Include in a Buyout Agreement

A good buyout agreement is customized to an LLC’s unique needs. But most will include these core elements:

• Purchase price and payment terms: The agreement should put in writing how much the member’s ownership interest costs and how the purchasing party will pay that amount.
• Timeframe for the buyout: The agreement should clearly set out exactly when the buyout will occur and how long the process will take.
• Rights and obligations of the remaining members and the departing member: The responsibilities of members usually change when one member leaves. Voting rights often change, too. The agreement should clearly delineate how these change. Additionally, if the departing member has any responsibilities, such as transferring a title for physical property or a company car, the agreement should describe those.
• Non-compete clauses and confidentiality statements: In many cases, when a member leaves, they agree to keep the LLC’s information, practices, products, and intellectual property secret. They also often agree not to compete directly with the LLC they’re leaving. If your limited liability company wants these protections, you should include this in the agreement.
• Process to resolve disputes: Even with a well-written agreement, disputes can arise. In case that happens, the buyout agreement should describe how the affected parties can reach a resolution.

If there are any unique provisions your LLC needs, you should include those, too.

Tax Implications of Buying Out a Partner

Selling membership interest in an LLC is usually a taxable event. But the impact it has on taxes varies depending on the circumstances surrounding the sale. A membership interest in an LLC is a capital asset, and selling it can generate profit or loss.

Tax Implications for a Departing Member

Let’s say, for example, that a business owner who joined an LLC in 2019 had 25% ownership of the business when it was valued at $100,000. They paid $25,000 to buy in. But the economy proved difficult for the business, and the value of the LLC dropped to $75,000 over time. Now the member wants to pursue a different career, so they sell their ownership interest to their fellow members for $18,750.

That creates a loss that the departing member can report on their taxes. But if the circumstances were reversed, they’d be taxed on the profits.

Tax Implications for Remaining Members

If members of an LLC buy out the ownership interest of a departing member, their distributive share of the LLC’s profits will probably change, too. For example, let’s say a member of an evenly split three-member LLC sells their ownership interest to their fellow members. The remaining members decide to take an even split of that stake, and now both have a 50-50 split.

Before they received about a third of the profits, and now they’ll receive half. Their income will change, and so will their income taxes (unless the LLC operating agreement calls for something different). 

And that’s just one way their taxes could change. We highly recommend consulting with a tax attorney to discuss tax implications for your entire LLC.

We can help!

Starting and running an LLC doesn’t have to feel like a chore. Here at ZenBusiness, we handle the paperwork and red tape so you can focus on what makes your business shine. Whether you need help creating an operating agreement, managing your business’s money, or staying compliant year over year, we can help.

Disclaimer: The content on this page is for informational purposes only, and does not constitute legal, tax, or accounting advice. If you have specific questions about any of these topics, seek the counsel of a licensed professional.