The limited liability company is a relatively new form of business entity, with most state statutes adopted in the 1990s. In just a few years, they overtook the corporation as the most common structure for new businesses. A reason for the LLC’s popularity is that the it combines some of the most desirable aspects of corporations with some of the most desirable aspects of partnerships, but that blending of characteristics can also be a source of confusion. For example, LLCs work much like partnerships when it comes to ownership rights, but people often incorrectly assume ownership that LLC interest is analogous to corporate stock and that LLC membership is analogous to being a corporate shareholder.
The owners of corporations are called shareholders and their ownership rights are embodied in shares of stock, a form of intangible personal property comprising a bundle of rights, some economic and some non-economic. The principal economic right is the right to receive dividends (usually cash) from the corporation, and the principal non-economic right is the right to vote in an election of directors and other matters that may be submitted to a vote of the shareholders. Although there can be restrictions (typically set out in the company’s articles of incorporation or bylaws, or a contract among shareholders or between a shareholder and the corporation), stock is generally transferable from one person to another. A person who acquires stock (thus becoming a shareholder) receives both sets of rights, economic (dividends) and non-economic (voting). It makes no difference how the person acquires the stock –by purchase, by gift, by inheritance, as compensation to an employee, or by court order (in a divorce or otherwise); a person who owns stock holds both economic and non-economic rights.
Limited liability companies also have economic and non-economic rights. The principal economic right is the right to receive distributions (usually cash) from the company, and the principal non-economic right is the right to participate in the management of the company’s business and affairs. A crucial distinction between LLCs and corporations is that the economic and non-economic rights associated with LLCs are not bundled together in a single package the way those rights in a corporation are bundled together in stock.
The economic rights in a limited liability company are known as interest, a form of intangible personal property that closely resembles interest in a partnership. As a property right, interest is generally transferable, although there can be, and often are, restrictions on transfer, typically imposed by the company’s articles of organization or operating agreement and sometimes by another contract.
Unlike a transfer of corporate stock, a transfer of LLC interest conveys no non-economic rights, which are held only by the LLC’s members, and merely acquiring interest does not (in most cases) make a person a member. A person becomes a member by being “admitted.” The non-economic rights are sometimes called “membership rights.”
The Indiana Business Flexibility Act provides that, with a few exceptions, a person becomes a member only with a unanimous vote or consent of the existing members or as otherwise established by the company’s articles of organization or operating agreement. The articles of organization or operating agreement can specify the conditions necessary for a person to be admitted, and they can even provide that anyone who acquires interest is automatically admitted as a member. Nonetheless, the sine qua non of membership is admission, not ownership of interest. In fact, it is entirely possible, and not uncommon, for a person who is not a member to hold interest. It is even possible, although unusual, for a person to be a member but hold no interest.
Although corporate stock and LLC interest are properly considered intangible personal property, it is not as clear how membership rights should be categorized. Because transferability is ordinarily considered one of the essential characteristics of property rights, membership rights are probably not properly categorized as property. Most likely membership rights should be considered as statutory rights or perhaps status rights. In any event, it is clear that membership rights are not within the bundle of property rights called “interest” and that (with certain exceptions) a person does not automatically become a member by acquiring interest. Business owners and lawyers who ignore that aspect of LLCs can be in for unpleasant surprises.*
*For an example, see our earlier blog post discussing the Alabama Supreme Court’s decision in L.B. Whitfield, III Family LLC v. Whitfield.