Indiana Business Law Blog
On March 13, 2024, the Indiana Governor signed Senate Enrolled Act 18, which, among other things, amends the Indiana Business Flexibility Act with the goal of addressing problems that can arise from the death of the sole member of a limited liability company. The following article is based on our analysis and understanding of SEA 18, particularly Sections 2 and 3.
Basic LLC Principles: Interest versus Membership
Understanding SEA 18 requires an understanding of the difference between LLC interest and membership.
A good place to start is to compare the rights of owners of LLCs to the rights of owners of business corporations (called “shareholders” or “stockholders“). A share of corporate stock represents a bundle of both economic and noneconomic rights. The economic rights comprise the right to receive dividends, and the noneconomic rights comprise the right to vote in an election of corporate directors. A shareholder owns the entire bundle of rights. Because stock is a form of property, it can be freely transferred. When the shareholder sells her stock, the buyer receives the entire bundle, including economic and noneconomic rights.
Like corporations, LLCs also have both economic rights and noneconomic rights, but, unlike corporations, those rights are not bundled together. Instead, there are two separate bundles of rights. One bundle includes economic rights (called “interest,” consisting primarily of the right to receive distributions) that are separate from the noneconomic rights (such as the right to participate in management and the right of access to company information).
Like corporate stock, interest is a form of personal property. It is freely transferrable, subject to the Business Flexibility Act and the LLC s operating agreement (if there is one). As property, interest can be bought, sold, or given away. It can be transferred by the owner’s will or the rules of intestate succession, as transfer-on-death property, or by a joint tenant’s right of survivorship. Interest can be pledged as collateral to secure a debt, and it can form the basis of derivative rights, such as options and rights of first refusal.
Noneconomic LLC rights are different. They are personal rights, not property rights, and cannot be transferred. They are acquired only by being “admitted” as a “member.” Ordinarily, one does not become a member solely by acquiring interest. Instead, a person is admitted by satisfying the conditions for admission specified by an operating agreement or by the Business Flexibility Act. Unless the operating agreement establishes other conditions, new members may generally be admitted only with the unanimous consent of the other members.
Thus, it is possible, and relatively common, for a person to own interest in an LLC without being a member. Such a person is called an “assignee” by the Business Flexibility Act and sometimes, in other settings, a “bare naked assignee,” to emphasize the limited rights of a non-member who holds LLC interest. It is also possible, but less common, for a person to be a member but hold not interest, for example in the case of a “springing member,” a person who holds no interest but agrees to become a member when the LLC would otherwise have none. We will again touch on members with no interest when we discuss the powers of a personal representative near the end of this article.
The fundamental nature of noneconomic LLC rights as personal rights, separate from economic property rights comprised by interest, is one of the reasons LLCs are the entity of choice for most small businesses. Because noneconomic rights are personal, and because the acquisition of interest does not usually make one a member, business owners are protected from being forced into business with people they did not choose. For example, a member’s creditor may acquire the member’s right to receive distributions, but the creditor cannot acquire the right to participate in management except by obtaining the unanimous consent of all the other members or by satisfying conditions for admission specified by the LLC’s operating agreement. Similarly, a member’s spouse may acquire his interest in a divorce, but the spouse cannot participate in managing the business except with the unanimous consent of the other members or as authorized by the operating agreement.
The Death of a Sole Member
Unfortunately, the severability of interest and membership also creates the possibility of an LLC with no members and the LLC’s subsequent statutory dissolution under the Business Flexibility Act (and the LLC statutes of many other states). The most common situation in which that happens is the death of an LLC’s sole member. Upon the member’s death, the LLC interest passes to her heirs, but, unless the operating agreement provides for the admission of the heirs, they do not become members. Thus, the LLC will have no members and may be automatically dissolved by the Business Flexibility Act.
(Note: In this article, we use the term “heir” to designate anyone who receives a deceased member’s LLC interest by any mechanism, whether through a will, by intestate succession, as transfer-on-death property, through the survivorship rights of a joint tenant, or by any other mechanism. Similarly, we use the words “inherit” and “inheritance” to refer to the acquisition of a deceased member’s LLC interest by any mechanism.)
An earlier article, Family Businesses: Succession Planning for LLCs, discusses an Alabama case, L.B. Whitfield, III Family LLC v. Virginia Ann Whitfield, et al., involving the unintended dissolution of a family LLC after its sole member died, leaving the LLC with no members. Because it had no members, it was automatically dissolved in accordance with the the Alabama statute. (When Whitfied was decided, the Alabama statute was, for this purpose, similar to the Business Flexibility Act. Alabama has since replaced the statute by adopting the Revised Uniform Limited Liability Company Act.) For simplicity, we refer to the unintended, automatic dissolution of an LLC for lack of members upon the death of a sole or last remaining member as the “Whitfield problem.”
The Whitfield problem can be avoided if at least one new member is admitted to succeed the deceased member. Under the Business Flexibility Act, that can happen in two ways. The first and best way is through an LLC operating agreement that provides for the automatic admission of one or more members. Unfortunately, many single-member LLCs have no operating agreement or have an operating agreement that is silent with respect admission of new members after the death of the sole member.
Another way is for the personal representative of a deceased sole member to elect to become a member or to designate another person who agrees to become a member, thus avoiding the LLC’s automatic dissolution. The personal representative must make the election in writing, within 90 days of the death of the sole member. If not, the opportunity is lost. Unfortunately, a personal representative or even a probate lawyer can easily overlook that requirement until it is too late. If so, the LLC is automatically dissolved, and its business and affairs must be wound up, with the proceeds of the liquidation distributed to the appropriate heirs. (Another question, but one we do not address here: Who has the power to control the winding up and dissolution of a memberless LLC? See What to Do with an LLC with No Members?)
SEA 18 and Avoiding Dissolution: Too Much and Not Enough
SEA 18 attempts to solve the Whitfield problem with amendments to the Business Flexibility Act that address both the inheritance of the deceased sole member’s interest and the admission of new members to avoid automatic dissolution. It succeeds only in part.
To begin with, the provisions of Sections 2 and 3 of SEA 18 that deal with the inheritance of interest do nothing to solve or avoid the Whitfield problem. Indeed, there is no reason for the Business Flexibility Act to address the inheritance of any deceased member’s interest at all. Other laws, including the probate laws that govern the estate of the deceased member, deal with that issue quite adequately, just as they deal with the inheritance of the rest of the deceased member’s personal property. In fact, as far as we can tell, SEA 18 and the Indiana Probate Code produce identical results for the inheritance of a deceased sole member’s interest. Thus, SEA 18 Sections 2 and 3 are both unnecessary and redundant, or, in other words, superfluous.
Is SEA 18’s unnecessary, redundant statutory language a problem? Not if that’s how courts interpret it, but courts generally try to construe a statute to give effect to all its sections, avoiding interpretations that render some language superfluous. That principle, if applied to SEA 18 Sections 2 and 3, could produce unintended and unpredictable consequences.
(Note: SEA 18 is not the first bill to create superfluous provisions dealing with the transfer of interest after the death of a member. The 2013 amendment to the Business Flexibility Act that added Ind. Code Section 23-18-6-2.5 also created unnecessary and redundant statutory language, in that case related to the transfer of LLC interest under Indiana’s Transfer on Death Act.)
Where SEA 18 tries to do too much with respect to inheritance of interest, it does too little to correct the true root cause of the Whitfield problem, an impractical mechanism to admit new members if the operating agreement doesn’t include one. SEA 18 solves that problem by providing for the automatic admission of the heirs of a deceased sole member without action by the personal representative, but only if the interest passes under a will admitted to probate under Indiana law or under the Indiana rules of intestate succession. That leaves two categories of interest entirely unaddressed.
The first category not addressed by SEA 18 is interest in an Indiana LLC held by a sole member whose estate is subject to the probate laws of any jurisdiction other than Indiana. In that situation, Sections 2 and 3 of SEA 18 are inapplicable on their face, and automatic dissolution of the LLC can be avoided only if an operating agreement saves it from dissolution or if the personal representative elects to become a member (or designates another person to become a member) within 90 days after the sole member’s death.
Second, SEA 18 does not address interest inherited outside probate, for example interest that passes to a transfer-on-death beneficiary or to a non-member joint tenant of a deceased sole member. Because the interest is not part of a probate estate (and certainly if no estate is opened in probate), there is no personal representative who can become a member or designate another person to become a member, leaving an operating agreement as the only way to avoid the Whitfield problem.
Powers of a Personal Representative
Under both SEA 18 and existing law, the member’s estate holds the economic rights, or interest, until the interest is liquidated or distributed in kind to the member’s heirs. What about noneconomic rights?
SEA 18 provides that the deceased member’s heirs are admitted upon the sole member’s death, but it also grants to the personal representative the power to exercise all noneconomic rights previously held by the deceased member. To our knowledge, there are no other situations in which the Business Flexibility Act affords to a non-member the right to participate in management.
That leads naturally to the next question, what rights do the heirs hold while the estate holds the interest? Probably none, other than future rights. It appears that the heirs are admitted upon the sole member’s death in name only, solely for the purpose of avoiding a memberless LLC. Until the personal representative distributes the interest to the heirs, all the economic rights are in the estate, and all noneconomic rights rest with the personal representative.
The General Assembly could have followed the example of Ind. Code Sections 23-18-9-1(c) and -1.1(c) by admitting the personal representative or the personal representative’s designee, postponing the addmission of the heirs until distribution of the interest from the estate. If the operating agreement does not contain a procedure for admitting the heirs, their admission could be handled in one of two ways: The personal representative or designee could take action to admit them (which is how Sections 23-18-9-1(c) and -1.1(c) work), or the Business Flexibility Act could admit them automatically. That approach would target the true root cause of the Whitfield problem: It would eliminate the easily overlooked deadline for the personal representative to take action within 90 days of the deceased member’s death.
Perhaps the General Assembly chose not to admit the personal representative to avoid creating a member who holds no interest in his own name. If that was the logic, it was flawed. As mentioned earlier, a member who holds no interest, while relatively unusual, does not offend the Business Flexibility Act. In fact, many operating agreements avoid dissolution for the lack of members by the automatic admission of a person who holds no interest as a “springing member” when the LLC would otherwise become memberless.
Moreover, SEA 18’s grant of noneconomic membership rights to the non-member personal representative departs from the established paradigm in which only LLC members hold noneconomic rights. Admission of a personal representative, with the attendant bestowing of noneconomic rights, would address the Whitfield problem, but would do so within the familiar structure that only members hold noneconomic rights, particularly rights to participate in management. Nonetheless, for reasons we cannot discern, the General Assembly chose to blaze a new path to (we hope) the same destination.
A Better Solution
The purpose of SEA 18 Sections 2 and 3, as well as the purpose of Ind. Code Section 23-18-6-2.5 dealing with the inheritance of LLC interest as transfer-on-death property, could be accomplished better by statutory provisions similar to the following:
Except to the extent a written operating agreement provides otherwise, upon the death of the sole or last remaining member of an LLC:
1. If the deceased member’s interest is held in an estate opened under applicable probate law:
a. The personal representative (or a person with similar powers under applicable law, regardless of title) is automatically admitted as a member.
b. A personal representative may designate another person to replace the personal representative as a member.
c. To the extent the rights of a member in the LLC depend on the amount of interest held, the membership rights of the personal representative or designee are determined by the interest held in the estate.
d. A person to whom interest is distributed from the estate is automatically admitted as a member upon distribution, with rights determined by amount of interest distributed and a corresponding reduction in rights held by the personal representative.
e. The personal representative or designee automatically ceases to be a member when the last interest held by the estate is distributed.2. A person who acquires interest outside probate (for example, as transfer-on-death property or by a joint tenant’s right of survivorship) is automatically admitted as a member with rights determined by the amount of interest distributed to that person.
A Final Word to Business Owners
None of this matters to the owners of LLCs with written operating agreements that sort out the Whitfield issue as they wish it to be sorted, rather than leaving it to the General Assembly to sort it for them. Be one of those owners.
Note: This article describes our ideas for possible revisions to the Business Flexibility Act. Others may have better ideas. For various reasons, we do not take comments to our blog articles on line, but you are welcome to send comments or corrections to us by email. If we revise our article based on your comments, we will be happy to give you credit for the idea when we do. Please send comments on this article to Michael Smith, msmith@hpindiana.law.