Storm Clouds For Certain Business Succession Planning

A 2021 Maryland Court of Special Appeals decision questioned whether a common provision in an LLC operating agreement is enforceable or whether such a provision must conform to the Statute of Wills.  The decision has important implications for the owners of small, closely held businesses and their advisors.

The Broader Context of the Decision

Those owners need to coordinate the pattern of permitted succession negotiated in the operating agreement (for LLC) or partnership agreement (for limited or general partnerships) with the dispositional pattern of their estate planning. The problem is, of course, that Wills and revocable trusts are “ambulatory” meaning they can be changed anytime before death, assuming competency. The other owners may wish to guard against unanticipated changes that may adversely affect the business governance.

The provision in the Court of Special Appeals case mimicked a “pay-on-death” provision. At the death of each member, the successor to the interest was named in the LLC operating agreement. The case does not address other, and more prevalent, approaches to controlling the composition of the business. Not addressed by the case are provisions describing permissive transferees who can become members without the consent of other members. Those provisions generally are paired with a right of first refusal back to the company or the other members if the membership interest is left to a person not on the approved transferee list. Nevertheless, the case needs to be considered when drafting any LLC operating agreements provisions related to the succession of interests. As discussed below, the 2021 Session of the Maryland General Assembly is considering a Bill to effectively reverse this decision and give primacy to the succession provisions contained in the agreements which should obviate any issues.

The Case

The recent Court of Special Appeals case held that a provision in a Maryland LLC operating agreement directing the transfer of a membership interest at the member’s death was inoperable because such an interest is a probate asset controlled by the decedent’s Will or, in the absence of a Will, the rules of intestacy. The specific provision at issue named the individual who would succeed to a deceased member’s membership interest, much like a pay-on-death provision for financial accounts. Obviously, this ruling raises concerns about the efficacy of the provisions of many LLCs and partnerships agreements that seek to control the composition of the entity after the death of one of the initial members/partners.  Potter v. Potter, 250 Md. App. 569, 252 A.3d 17 (2021).

The Potter case reversed a decision of the Circuit Court of Anne Arundel County that held that the provision of the LLC operating agreement was dispositive. After the reversal by the Court of Special Appeals, the appellee was granted certiorari to the Court of Appeals 476 Md. 238 (9/13/21), but the case was settled by the agreement of the parties thereafter and the appeal dismissed. [In full disclosure, Franke Beckett LLC represented the party who prevailed in the Circuit Court, who then was appellee in the Court of Special Appeals and finally who was the petitioner for certiorari.]

What Is “Probate” Property?

ET § 1-301 establishes that “all property of a decedent shall be subject to the estates of decedents law.” (Emphasis added.) This section comes from the Henderson Commission Report (1968) and was enacted into Maryland law in 1969. It dramatically altered the then existing common law. Prior to the change, real estate was treated differently than personal property: it automatically devolved independent of the probate estate to the heirs (a vestige of primogeniture).

As the Potter Court discussed, the “all” never literally meant “all”. ET § 1-101(r)(1), also derived from the Henderson Commission, excludes from the definition of property “any right or interest therein which does not pass, at the time of the decedent’s death, to another person by the terms of the instrument under which it is held, or by operation of law.”  Looking to the legislative history of that section, the Court of Special Appeals recognized that the definition was only intended to include “assets which have traditionally constituted” the probate estate expanded by the inclusion, however, of real estate.  Thus, “property” (again per the Henderson Commission) was not meant to include such assets as “property held in an inter vivos trust,” other identified contractual relationships, “and the like.”

How Extensive Is the Carve-Out From Probate Property

On a conceptual level, the acknowledgement by the Potter Court that inter vivos trusts were never intended to be swept into the probate system is somewhat ironic. An influential article that traces the development of the trust at common law holds that it only came into being because the law at that time was insufficiently developed (“too primitive”) to recognize third party beneficiaries to contracts, but: “the deal between settlor and trustee is functionally indistinguishable from the modem third-party-beneficiary contract.”  John H. Langbein, The Contractarian Basis of the Law of Trusts., 105 Yale L. J. 625, 627 (1995). LLCs, of course, did not come into existence until after 1969 but under Professor Langbein’s formulation, one might suppose that, as a substitute to the third party beneficiary contract, a provision in an LLC operating agreement directing the successor in interest at a member’s death ought to qualify “as the like” relative to inter vivos trusts.

The Potter Court found “no direct answer” to the question of whether an LLC would have been treated as a probate asset if it had existed at the time that the Henderson Commission provisions were enacted into law. Trusts are not, of course, contracts. Trusts are defined by, indeed coterminous with, the fiduciary duty owed by the trustee to the beneficiary. Even Professor Langbein rejected treating trusts as the equivalent of contracts: “[I]t was not my wish to fold the law of trusts into the law of contracts. Maitland was surely right to speak of trusts as perhaps ‘the most distinctive achievement’ of Anglo-American legal tradition.” Langbein at 671.

Revocable Contracts Without A Present Obligation Deemed Not Carved Out

The Potter Court folded LLCs into the general law of contracts. It held that only certain kinds of transfers at death by contract will escape the probate system: “[T]he Court of Appeals has consistently interpreted Maryland’s statute of wills to mean that a contract that attempts to transfer title to property upon the death of an individual is testamentary in nature unless it is both irrevocable and based on a present legal obligation whose performance is deferred during his or her lifetime.”  Potter, 252 A.3d at 34. The Potter Court determined that the succession provisions of an LLC operating agreement failed that test.

LLC Statutory Provisions Tilting The Other Way

In so holding, the Potter Court did not see various provisions of the LLC statute itself as permitting operating agreements to provide for the succession of those LLC interests independent of the probate process.  See Corps. & Ass’ns § 4A-402(a) (members “may enter into an operating agreement to regulate or establish any aspect of the affairs of the limited liability company or the relationship of its members.”); § 4A-402(a)(3) (operating agreements may grant “the rights of members to assign all or a portion of their membership interest.”); § 4A-402(a)(4) (“the circumstances in which a person may be admitted as a member of the limited liability company may be regulated by the operating agreement.”).  The Court determined that these provisions were not sufficient to pull the LLC operating agreement out of the “all” dictate of the statute.

The Potential Legislative Fix

Because the parties settled the case after certiorari was granted but before any decision by the Court of Appeals, the decision of the Court of Special Appeals is the last (and only) reported decision addressing the issue of whether LLC operating agreements are subservient to the statute of wills and thus controlled by probate. Although Potter only addressed the issue in the LLC context, there are obvious implications for partnerships as well.

The MSBA Estates & Trusts Law Section and the Business Law Section jointly have proposed legislation to legislatively reverse the Potter decision. The proposed amendment to ET § 1-401(c) would add the following language:

Transfers on death pursuant to an operating agreement of a limited liability company or a partnership agreement of a general or limited partnership are effective according to the operating agreement or partnership agreement and are not considered testamentary.

Hopefully, the proposed legislation will be enacted.  Otherwise, thoughtful, and creative lawyering may be needed protect the terms of the succession pattern in the LLC operating agreement or partnership agreement. If, for example, the business owners wish to specifically name individuals to succeed to deceased members’ interests, they may wish to consider overlying contracts requiring all of the owners to make Wills in conformance with the succession pattern in the business agreements. This work-around would then permit the surviving owners to bring an action against a deceased owner’s estate as a contract action if the Will or revocable trust provides otherwise. Contracts to make a Will have a rich case law history that needs to guide such an approach.

Contact Us For Your Planning Needs

For over 35 years, our law firm has concentrated on the law of estates and trusts – including addressing a wide variety of estate and closely-held business planning challenges brought about by .tax, regulatory, and common law caselaw changes.  The firm, Franke Beckett LLC., engages in estate and business planning within the context of a larger estates and trusts practice of law. We engage in estate planning, closely held business succession planning, estate/trust administration, and a broad range of fiduciary litigation. Because of the range of our practice within a concentrated practice area, we develop a deep experience in, and knowledge of, the Maryland law of estates and trusts. To schedule a consultation with an experienced Maryland estate, trusts, and closely-held business structuring lawyer for planning, administration, or litigation, call 410-263-4876 or use the “contact” tab on our website for an appointment.