Understanding Restrictions on Transfers of Membership Units

By Shannon M. Bielski | January 10, 2008
Amendments to securities laws affecting transfer restrictions became effective after the submission of this article, and the article that follows has been updated by the author to reflect the changes. April 3, 2008

Despite disclosures that accompany the issuance of most membership units in limited liability companies, many investors are unaware of the strict limitations placed on transfers of LLC units by tax and securities laws. The truth of the matter is that LLC units are not freely tradable like shares of corporate stock.

Restrictions on transfer imposed by tax laws apply to all LLCs that wish to maintain pass-through taxation. Although restrictions on transferability are frustrating to many investors, the restrictions due to tax laws are actually advantageous to a company and its members. In order to be taxed as a partnership and circumvent the dreaded "double-tax" imposed on corporations, an LLC must take measures to avoid IRS classification as a publicly-traded partnership. These measures include limiting the number of transfers that can occur in a given year, which is often accomplished by establishing bulletin board trading systems on which a certain percentage of transfers may occur during a given year. The company will monitor and require approval of transfers in order to stay within the IRS limit. Most operating agreements contain detailed provisions regarding transfers in order to ensure that members stay within the confines of the tax laws.

The securities laws restrictions on transfers differ from the tax law restrictions, in that they depend on how units were originally acquired. All sales of securities must be registered with the U.S. Securities and Exchange Commission or qualify for an exemption from registration. In general, "restricted securities" are those that were acquired in a private offering exempt from registration with the SEC and any certificated securities likely bear a restrictive legend. "Control securities" are those units that were acquired by affiliates in any manner, including in a company's registered offering. In most cases, an affiliate is a director, executive officer or beneficial owner of more than 10 percent of the company's outstanding units. Often, affiliates acquire their units in private placement offerings that were exempt from registration with the SEC; as such, their securities qualify as restricted securities for a period of one year (six months in the case of an SEC reporting company) but remain control securities so long as they are an affiliate. Nonaffiliates who have held their units for longer than one year (six months in the case of an SEC reporting company) may sell their units free of the restrictions described below. Nonaffiliates of an SEC reporting company may sell their units between six months and one year of purchase so long as the company is current in its reporting obligations. Note, however, that the transfer will likely have to be approved by the company for tax purposes.

If an affiliate owns restricted securities or control securities, Rule 144 provides the most commonly used safe harbor from registering the resale of units. Under Rule 144, five conditions must be met before an affiliate may sell restricted or control securities to the public. First, there must be adequate public information available about the company.

This requirement is satisfied if the company is current in its reporting obligations with the SEC, but it is more difficult for non-reporting companies. The second condition of Rule 144 requires that units were held for at least one year (six months for an SEC reporting company). Third, there is a volume limitation on resales—during any three-month period, a member may not transfer units exceeding the greater of 1) 1 percent of the company's outstanding units or 2) the average trading volume of the units over the past four weeks. Further, Rule 144 resales of restricted or control securities must be made in unsolicited brokerage transactions. Finally, if a member intends to sell more than 5,000 units or expects to receive over $50,000 from the sale of units, a notice of the proposed sale must be filed with the SEC.

In conclusion, if you are considering a transfer of your LLC units and you own restricted or control securities, you should consider the availability of the safe harbor under Rule 144, which may be a useful tool for allowing you to sell your units to the public.

Shannon M. Bielski is an associate with BrownWinick, a Des Moines, Iowa-based law firm serving the renewable fuels industry. Reach her at bielski@brownwinick.com or (515) 242-2400.