Membership and interests of an LLC are two different things. Understanding the differences between membership and interests in an LLC makes you better equipped to optimally design economic and management relationships for your LLC.
Membership belongs to those who have ultimate authority to manage the business and affairs of the LLC. By statute, decisions on LLC matters are decided by members, or classes of members, subject to governing provisions of the LLC agreement. The LLC agreement may contain provisions by which the members delegate authority to manage the business and affairs of the LLC to certain individuals or entities, who may not be members.
Regardless of whether the members hold or delegate authority to manage the LLC’s business, members are the sole individuals who have the ultimate authority to determine who manages the affairs of the LLC.
In addition, members have apparent authority to bind the LLC. Managers of an LLC, if any, may also have apparent authority. An interest holder, as such, does not have apparent authority to bind the company.
Members also have certain exclusive rights, including access the LLC’s books and records. They have the power, in some cases, to bring derivative actions in the name of the LLC. These rights and powers are exclusively the rights and powers of the members.
Members are also subject to duties, sometimes fiduciary duties, to the members and to the company. Mere interest holders are not subject to those duties.
Interests represent contractual rights to distributions from the LLC. Interests do not include rights to receive service payments or interest payments on loans, however, they are rights to receive returns that are subject to entrepreneurial risk. That is, those returns must be subject to the financial fortunes of the LLC.
As mentioned above, persons holding interests do not, by holding those interests, have the rights, powers, authority, or duties of a member.
Membership and interests are not linked – a person can be a member without holding an interest. An individual who is not a member can hold an interest. Additionally, an interest can be transferred; it’s the personal property of the interest holder. Membership cannot be transferred and does not technically belong to anyone. Membership is more-so viewed as the “property” of the company. The members as a group control who is admitted to membership and who remains in the membership. The concept of transferring a membership interest, therefore, does not make sense.
Perhaps the best reason to reject the linkage is that it limits your thinking. If you understand that the membership and interests are separate items, you can imagine more flexible business and financial arrangements in your LLC. You realize that you can grant economic interests to someone you do not want to have rights to (i) access books and records of the LLC, (ii) bring derivative claims on the Company’s behalf, or (iii) default powers under the LLC Act, each of which is a member right. Additionally, you might want to grant a person a right as a member without requiring that person to contribute capital or share in profits. The person may be an affiliate of one of someone who holds an interest but does not want to be directly involved in management.
Separating the concepts helps to break out of the corporate mindset where most everything is defined with reference to shares of stock. Voting, shares of profits and capital, contributions, distribution priorities are all determined on class and per share basis in a corporation. If you apply a corporate mindset to an LLC, you’ll miss some great opportunities to fashion the optimal LLC deal.
As you probably know, a taxpayer realizes gain when the taxpayer transfers appreciated property in exchange for other property. There are exceptions to this general rule. One of those exceptions is defined in Internal Revenue Code Section 721. Section 721 governs when a taxpayer contributes property to a partnership in exchange for a partnership interest. As usual in tax law, this exception is defined to eliminate transactions that don’t fit the intent of the provision. As a consequence, some taxpayers will realize gain when they contribute property to a partnership in exchange for a partnership interest.
Partners in partnerships are allowed to deduct operating losses in partnerships that their shareholder counterparts in S corporations cannot deduct. The difference results from a difference between partners and shareholders as to entity-level debt. That debt increases a partner’s tax basis in her partnership interest. That debt will not increase a shareholder’s tax basis in her corporate shares (unless she is the lender).
Congress most likely believed it was doing real estate professionals and their advisors a favor when it enacted Section 469(c)(7). That section excepts real estate professionals from limits on losses (and tax credits) generated on real estate rental activity. Those limits generally apply to passive activities. Under passive activity rules, taxpayers can deduct net passive activity losses only in certain cases. One of those cases applies when a taxpayer materially participates in an activity. This material participation case generally does not apply to losses generated from rental activities, though. Rental activity is per se “passive” under passive activity rules of Section 469. In other words, generally, no matter how much time a taxpayer spends on a real estate rental activity, all losses from that activity will be passive losses.
“Choice of entity” may be the most mercilessly beaten dead horse of all. There are many varieties of the presentation. All of them have merit. Criteria used vary widely. No matter which criteria folks emphasize, all agree that there is a choice to be made. No business entity is clearly superior in all cases or circumstances.
Business and tax attorneys draft partnership agreements, including LLC agreements. These agreements often contain cash waterfall provisions that are designed to cause cash to be distributed a certain way until certain investors achieve a designated internal rate of return. For example, partnership waterfall provisions may provide that available cash is distributed as follows:
First, to A until A has achieved an 8% internal rate of return (IRR);
Second, 10% to B and 90% to A until A has achieved a 15% IRR;
The balance, 20% to B and 80% to A.
Partnerships do not pay federal income tax. Instead, the partners of the partnership pay income tax on their distributive shares of the partnership’s income. Their distributive shares of income are determined under the partnership agreement, if the partnership agreement properly allocates the partnership’s income.