Incorporator The Journal of U.S. Formation
Start Free Quiz
Editorial 6 MIN READ

Preparing a member-to-member LLC buyout without wrecking the tax outcome

Seven steps from the operating agreement to the BOI update, and where the money actually moves

The Editors
Staff, Incorporator.org
6 min read Updated
Contents 8 sections
  1. Step 1: read the operating agreement before anything else
  2. Step 2: pick a valuation method and document it
  3. Step 3: choose the tax structure, because the two paths diverge
  4. Step 4: paper the deal, then refresh the corporate record
  5. Step 5: decide how the deal gets funded
  6. Step 6: check the state traps
  7. Step 7: do the cleanup the week after closing
  8. Sources

n LLC member-to-member buyout is almost always cheaper to model than to paper. The tax structure, the operating agreement, and the post-closing cleanup are where deals lose money nobody priced in.

What follows is the sequence to run before the wire goes out, for a closely held multi-member LLC taxed as a partnership.

Step 1: read the operating agreement before anything else

The operating agreement controls. Three clauses matter.

Valuation method: many OAs fix it in advance (book value, an EBITDA multiple, an appraisal procedure, or a revenue formula). If the OA specifies a method, you cannot negotiate around it without a written amendment signed by the required percentage of members.

Trigger events: a voluntary buyout differs from a mandatory buyout on death, disability, divorce, bankruptcy, or termination. Triggered buyouts often carry a 10 to 25 percent minority or marketability discount that a voluntary sale does not bear.

Payment term: OAs frequently permit installments over three to seven years at the applicable federal rate. If the seller expects a lump-sum wire and the OA says five-year note, surface that now.

If the OA is silent, state defaults fill the gap. Delaware (6 Del. C. § 18-604) makes distribution on resignation a matter of contract with a statutory fallback.

Step 2: pick a valuation method and document it

Four methods dominate closely held LLC buyouts.

Book value (capital accounts or GAAP equity split by interest) is fast, cheap, and usually wrong for a business with goodwill, trained staff, or recurring revenue.

Fixed multiple of EBITDA is the working compromise for small operating businesses with clean books. Services firms often trade at 3x to 5x trailing twelve-month EBITDA. Agree on the multiple, the EBITDA definition (adjusted for owner compensation and nonrecurring items), and the measurement period before either side pulls numbers.

Appraisal is right when stakes justify a five-figure fee or the parties distrust each other's inputs. Credentialed appraisers (ASA, NACVA, AICPA) produce a defensible fair market value under Rev. Rul. 59-60 factors. It is also the safest path when the IRS, a divorce court, or an estate examiner may scrutinize the transaction.

Formula valuation is common in professional-services LLCs: a multiple of trailing billings, plus work in progress, minus capital withdrawals. Predictable, but it drifts from economic reality as the firm grows.

Document the method in a member resolution and keep the workpapers.

Step 3: choose the tax structure, because the two paths diverge

A member-to-member buyout can be structured two ways for federal tax purposes.

Path one is a direct sale of the seller's interest to the buying member. Under IRC § 741, the seller recognizes capital gain or loss, except to the extent of § 751 hot assets (unrealized receivables and inventory items), which become ordinary income. The buyer takes a cost basis under § 742. If a § 754 election is in effect, the buyer gets a § 743(b) special basis adjustment equal to the cost of the interest minus the buyer's share of inside basis. That adjustment flows to the buyer alone, as added depreciation or amortization, and is often what turns a good deal into a great one.

Path two is a liquidation of the seller's interest by the LLC under IRC § 736. The LLC writes the check. § 736(a) payments are amounts in excess of the seller's share of partnership property: typically payments for unstated goodwill (in service partnerships where capital is not a material income-producing factor) or for services rendered. § 736(a) amounts are ordinary income to the seller and deductible to the LLC. § 736(b) payments are made in exchange for the seller's interest in partnership property: capital gain to the seller (subject to § 751), nondeductible to the LLC.

A § 754 election is a one-time filing with the partnership return for the year of transfer, per Treas. Reg. § 1.754-1. Once made, it binds the LLC until revoked. Run both paths with a CPA before drafting.

Step 4: paper the deal, then refresh the corporate record

Three documents carry the transaction. The Membership Interest Purchase Agreement sets the price, the agreed tax characterization (§ 741 sale or § 736 redemption), the reps and warranties, the indemnity, and closing conditions. The amended operating agreement updates the membership schedule, capital accounts, allocations, and any shifted management provisions. A member or manager resolution authorizes the deal and directs any state filings.

The 2024 overlay is the Corporate Transparency Act. A reporting company whose beneficial ownership changes must file an updated BOI report with FinCEN within 30 days, under 31 CFR 1010.380(a)(2). A buyout that crosses the 25 percent ownership threshold or alters the senior-officer list is a reporting event. Filing is free through FinCEN's BOI E-Filing portal. Calendar the 30-day clock at signing.

Step 5: decide how the deal gets funded

Cash is cleanest: wire the price, pay the tax, close in one motion.

A seller note is the common workaround when the buyer lacks liquidity. Part of the price is paid at closing; the balance runs on a promissory note at the applicable federal rate or above, over three to seven years, often secured by the acquired interest. The seller reports gain on the installment method under IRC § 453, except that § 751 hot-asset gain is recognized in the year of sale.

An earnout shifts part of the price into contingent payments keyed to post-closing performance. Earnouts can be structured as § 736(a) payments if crafted for services. They also invite litigation, so the contingency formula needs derivative-contract precision.

Step 6: check the state traps

California's Proposition 13 reassessment trap hits any LLC owning California real property. Under Cal. Rev. & Tax. Code § 64(c), a change in ownership (triggering reassessment to current fair market value for property-tax purposes) occurs when any person obtains a cumulative more-than-50 percent interest in the entity. The LLC must file Form BOE-100-B with the State Board of Equalization within 90 days. On property held since the 1990s, the tax increase is permanent and large.

New York's controlling-interest transfer tax hits LLCs owning New York real estate. Under N.Y. Tax Law § 1401(f) and § 1402, a transfer of a controlling interest (50 percent or more) is treated as a transfer of the underlying real property. The state rate is 0.4 percent of consideration, plus NYC's Real Property Transfer Tax (1 to 2.625 percent) on city property.

Some states also require a licensing authority (liquor, cannabis, professional services) to approve the transfer.

Step 7: do the cleanup the week after closing

Remove the seller from bank signature cards, ACH origination, and wire authority. Revoke email, VPN, payroll, accounting software, and card access. Rotate shared passwords. Transfer super-admin roles on Google Workspace or Microsoft 365 before revoking the seller's account. Update vendor, customer, insurance, and tax-agency records. File any state change-of-member or change-of-manager amendments. Save the FinCEN BOI confirmation number with the deal file. Book the capital account rebalance under Treas. Reg. § 1.704-1(b)(2)(iv), record any § 743(b) adjustment, and feed the new allocations into the K-1 workpapers.

Rule of thumb: the tax structure and the BOI update cost more to fix after closing than to plan before it.

Sources

Keep reading

More from the journal.