SHAREHOLDER AGREEMENTS AND OPERATING AGREEMENTS
By Attorney Randall J. Andersen
April, 2014
By Attorney Randall J. Andersen
April, 2014
Disclaimer: The information contained on this page is not legal advice. The information provided on this website is for general informational purposes and is not necessarily updated to account for changes in the law. You should consult with an attorney for legal advice regarding your individual circumstances.
Closely held businesses in Wisconsin are typically organized as either a corporation or a limited liability company. The owners of a limited liability company are referred to as members; the owners of a corporation are shareholders.
If the closely held business is owned by more than one person, it is usually advisable to enter into an agreement imposing restrictions on the sale and transfer of ownership interests, and providing what will happen to ownership interests upon the retirement or death of a member/ shareholder. With a limited liability company this type of agreement is referred to as an operating agreement. With a corporation, it is referred to either as a shareholder agreement, buy-sell agreement or cross-purchase agreement.
There are many reasons for entering into an operating agreement or shareholder agreement. The existence of an operating agreement/shareholder agreement may provide assurances to the owners and outsiders that the business will continue in the event of the death or departure of one of the owners. The existence of procedures for the acquisition of the shares/units of an owner who dies or departs from the business can be of great value in facilitating the continuation of the business following the death, retirement or departure from employment of an owner.
In the event an owner divorces, there may be a concern that an ownership interest in the company could be awarded to the owner’s spouse in the divorce proceeding. Operating agreements and shareholder agreements often include provisions to deal with these circumstances.
One of the more important issues to address in an operating agreement or shareholder agreement is the manner in which the membership unit or stock will be valued for the buy-out of a deceased or departing owner’s membership units or shares. Will an appraisal be performed? Who will perform the appraisal? How and when will the purchase price be paid? When will the closing occur following a triggering event? If the purchase is to be pursuant to a promissory note, will there be collateral to secure the note? Will there be restrictions on the operation of the business until the note is paid?
Closely held businesses are often organized as S corporations. LLC’s can also elect to be taxed as an S corporation. Under the Internal Revenue Code, there are limitations on who can hold an ownership interest in the shares of an S corporation or an LLC which elects to be taxed as an S corporation. For example, corporations and other business entities and certain types of trusts cannot own S corporation stock or membership units in an LLC electing S corporation tax status. Violation of these rules can cause the termination of the entity’s S corporation election, which can have significant adverse tax consequences. A shareholder agreement or operating agreement can include provisions to help avoid the inadvertent termination of an S corporation tax election.
It is important for owners to review their operating agreement/shareholder agreement periodically to make sure that it continues to match their intentions for the business, and to update the agreement as needed by way of a signed amendment to reflect changes in the business. Shareholder agreements and operating agreements normally include provisions for determining the method of valuation of the business upon retirement or in the event of death or a divorce. It is especially important to review these provisions from time to time to make sure that they continue to be appropriate for the business structure.
If the closely held business is owned by more than one person, it is usually advisable to enter into an agreement imposing restrictions on the sale and transfer of ownership interests, and providing what will happen to ownership interests upon the retirement or death of a member/ shareholder. With a limited liability company this type of agreement is referred to as an operating agreement. With a corporation, it is referred to either as a shareholder agreement, buy-sell agreement or cross-purchase agreement.
There are many reasons for entering into an operating agreement or shareholder agreement. The existence of an operating agreement/shareholder agreement may provide assurances to the owners and outsiders that the business will continue in the event of the death or departure of one of the owners. The existence of procedures for the acquisition of the shares/units of an owner who dies or departs from the business can be of great value in facilitating the continuation of the business following the death, retirement or departure from employment of an owner.
In the event an owner divorces, there may be a concern that an ownership interest in the company could be awarded to the owner’s spouse in the divorce proceeding. Operating agreements and shareholder agreements often include provisions to deal with these circumstances.
One of the more important issues to address in an operating agreement or shareholder agreement is the manner in which the membership unit or stock will be valued for the buy-out of a deceased or departing owner’s membership units or shares. Will an appraisal be performed? Who will perform the appraisal? How and when will the purchase price be paid? When will the closing occur following a triggering event? If the purchase is to be pursuant to a promissory note, will there be collateral to secure the note? Will there be restrictions on the operation of the business until the note is paid?
Closely held businesses are often organized as S corporations. LLC’s can also elect to be taxed as an S corporation. Under the Internal Revenue Code, there are limitations on who can hold an ownership interest in the shares of an S corporation or an LLC which elects to be taxed as an S corporation. For example, corporations and other business entities and certain types of trusts cannot own S corporation stock or membership units in an LLC electing S corporation tax status. Violation of these rules can cause the termination of the entity’s S corporation election, which can have significant adverse tax consequences. A shareholder agreement or operating agreement can include provisions to help avoid the inadvertent termination of an S corporation tax election.
It is important for owners to review their operating agreement/shareholder agreement periodically to make sure that it continues to match their intentions for the business, and to update the agreement as needed by way of a signed amendment to reflect changes in the business. Shareholder agreements and operating agreements normally include provisions for determining the method of valuation of the business upon retirement or in the event of death or a divorce. It is especially important to review these provisions from time to time to make sure that they continue to be appropriate for the business structure.