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George F. Bearup, J.D. Senior Legal Trust Advisor

9-Feb-22

LLC Inheritance Agreement

Take-Away: It may be possible, through an LLC Operating Agreement, to direct who inherits a deceased Member’s interest in the LLC.

Background: The use of LLCs has grown dramatically over the years by families with closely held business interests and investments, including commercial real estate. The LLC is a popular form of entity to hold business and income producing assets due to its flexibility with regard to limitations on ownership, limitations and restrictions expressed in an LLC Operating Agreement. In some instances, an LLC can be looked at as a surrogate for an irrevocable trust, where the LLC Manager acts in the role of a trustee, with duties of loyalty and care to the LLC Member and with regard to decisions to the timing and amount of distributions from the LLC to its Members.

Restrictive Operating Agreements: However, many restrictive LLC Operating Agreements exist to prevent the transfer of a Member’s interest in the LLC to ex-spouses, in bankruptcy, to judgement creditors, or to others who are not members of the family or involved with the family business. The restrictions in the LLC Operating Agreement often come in the form of a right of redemption held by the LLC, or the right of first refusal to purchase a Member’s interest that would otherwise be transferred, either voluntarily or involuntarily. The ‘problem’ with these restrictions is that they often impose a financial burden on the redeeming LLC entity, or its other Members who exercise their right of first refusal to purchase the withdrawing or deceased Member’s interest in the LLC.  While the remaining Members want to control the identity of the ‘new’ Member, they would prefer to not have to scramble to raise cash to facilitate the redemption or purchase of the Member’s interest. This is especially the case when a Member dies and the other Members want to control the identity of the inheriting Member. A couple of Florida court decisions seem to suggest that it may be possible in an LLC Operating Agreement to compel Members to name an inheriting Member of the LLC, and effectively override the deceased Member’s Will or revocable trust provision to the contrary.

Blechman v. Estate of Blechman, 160 So.3d 152 (Florida Court of Appeals, Fourth District, 2015): This case dealt with whether the decedent’s membership interest in the LLC was part of his probate estate.

Facts: The LLC was owned by a brother and sister, each owning a 50% membership interest. Their LLC Operating Agreement contained restrictions on the transfer of membership interests without the prior unanimous written consent of the other Member. One exception to this unanimous written consent requirement allowed the a transfer to the Member’s living children and the issue of a deceased child, but not to parents, spouses, stepchildren or paramours. On the death of a Member, unless his/her interest passed to one of these identified individuals, the decedent’s membership interest was directed to pass to the deceased Member’s then living children and issue of a deceased child, per stirpes, i.e. a default disposition. Despite this provision in the LLC Operating Agreement, the deceased brother by his revocable trust (which was funded with probate assets via his pour-over Will) directed that his LLC membership interest, and distributions from the LLC, pass to his girlfriend.

Dispute: The deceased Member’s children refused to give the LLC membership unit to the girlfriend along with the specified distributions. The decedent’s children argued that the LLC membership interest passed according to the LLC Operating Agreement, and accordingly it was not a probate asset that passed to the revocable trust to be subject to the trust’s terms. The children argued that the testamentary gift to the girlfriend was void.

Court Decision: The court found that New Jersey law governed the LLC Operating Agreement. It found that under New Jersey law, contracts transferring property on death, and supported by adequate consideration are evaluated using contract law, and not the law that governs Wills. The Florida court found that the LLC Operating Agreement was a contract that validly directed the disposition of the decedent’s membership interest despite the terms of his revocable trust to the contrary. In effect the court found that the LLC Operating Agreement could be used to ensure who will inherit a membership interest on the death of a Member without the need to have a separate ‘contract to make a Will’ or the need to redeem or purchase the decedent’s membership interest from a prohibited transferee.

The court relied on Murray Van & Storage v. Murray, 364 So. 2d 68 (1978) in which that court held that an entity buy-sell agreement ‘trumped’ a conflicting provision in a Will.

Finlaw v Finlaw, 2D19-3108 (Florida Court of Appeals, April 16, 2021):

Facts: This case dealt with an Ohio partnership in which the partnership agreement contained a provision where the partners agreed to:

“Have prepared and to execute a last will and testament so as to ensure that his or her interest in this Partnership will, upon his or her death, pass to and vest in his or her surviving spouse. Each partner, who shall ultimately become a surviving spouse further agrees to have prepared and execute a last will and testament so as to vest his or her interest in this Partnership in his or her children (lineal descendants.)”

One of the 50% partners died in 2014 who executed a Will that divides the remainder of her estate on her death to her grandson. She subsequently died a resident of Florida.

Dispute: The decedent’s son filed a claim in the Florida probate court asserting an entitlement to the partnership interest of his mother according to the terms of the Partnership Agreement.

Court Decision: The court, applying contract principles, found that the decedent’s son was entitled to the ownership of his mother’s interest in the partnership. Thus, the Partnership Agreement was in effect an inheritance agreement, an entity ‘governing instrument’. The court found:

“[U]nder both Ohio and Florida law, where contracting parties expressly agree on the disposition of property on death, that agreement generally controls over a testamentary disposition of property.”

The court seemed to ignore the fact that the mother failed to execute a last will and testament consistent with the terms of the Partnership Agreement. Nor did the court address whether the Partnership Agreement actually constituted a proper ‘contract to make a Will’.

Michigan Law: Michigan’s law on a contract-to-make-a Will is very short and to the point:

  • If executed after July 1, 1979, a contract to make a will or devise, not to revoke a will or devise, or to die intestate may be established only by 1 or more of the following:

(a) Provisions of a will stating the material provisions of the contract;

(b) An express reference in a will to a contract and extrinsic evidence proving the terms of the contract;

(c) a writing signed by the decedent evidencing the contract.

  • The execution of a joint will or mutual wills does not create a presumption of a contract not to revoke the will or wills. [MCL 700.2514.]

Conceivably a provision in a partnership agreement or an LLC Operating Agreement, if signed by a partner or a Member, would satisfy the requirement of (1)(c) of the statute and thus become a contract-to-make-a-Will.

Conclusion: It may be possible to control in an entity restrictive agreement the disposition of a membership or partnership interest on the death of a partner or Member, perhaps without the need for a purchase or redemption of the decedent’s interest in the LLC or the partnership. Such a provision might be appropriate in a family owned and controlled entity. However, if such a provision is contemplated consider giving the member/partner some latitude as to who they might leave their interest to on their death to avoid a completed gift of the remainder interest in the entity.