Your Co-Owner Died, Divorced or Filed Bankruptcy. What Happens to Their Share?

The call comes from a spouse, an estate lawyer or a bankruptcy trustee. Your co-owner has died, is divorcing, or has filed for bankruptcy, and the person on the phone wants to know what they now own in your company and when the next distribution is. Your question is the mirror image: who is about to be sitting across the table, and can they vote?

This post is for owners of LLCs and general partnerships in Arizona, California and Texas who want to know what passes to an heir, a former spouse or a bankruptcy trustee by default, and what a buy-sell clause changes. It explains the difference between membership and the economic interest, the three events one by one, the rights a judgment creditor of a co-owner has, and the terms owners can put in place before any of it happens. It is general information, not an opinion on any transfer. For the agreement that should answer most of these questions in advance, see our post on the buy-sell agreement.

The short answer

For an LLC in all three states, what passes to an heir or a former spouse under the default rules is the economic interest, meaning the right to receive distributions, and not membership. The person who receives it cannot vote or manage as a member unless the remaining owners admit them, which under the default rules takes the consent of every member. California adds an exception for a deceased member's estate: the executor or administrator may exercise all of the member's rights for the purpose of settling the estate, including any power the operating agreement gave the member to make a transferee a member. A general partnership works differently. Under the state partnership statutes, a partner's death ends that person's status as a partner; those statutes treat a partner's becoming a debtor in bankruptcy as the same kind of event, but whether that state consequence holds against a bankruptcy estate is a federal question addressed in the bankruptcy section below. Where the statutory buyout or redemption applies, the departed partner's interest is bought out (Arizona and California, where the partnership continues rather than winding up) or redeemed (Texas, where the redemption statute's condition is met, which for a death or bankruptcy withdrawal requires that no event requiring a winding up of the partnership business occur before the 61st day after the date of withdrawal), and in that situation what the estate holds is a claim to the statutory price rather than continuing ownership.²⁷

Under the Arizona and California LLC statutes, death dissociates the member, and so does becoming a debtor in bankruptcy, a rule California limits to member-managed LLCs. Because all three states are community-property states, a spouse may already hold a stake in the economic interest, and Texas says in its LLC statute that a membership interest "may be community property" while the right to manage "is not." A bankruptcy filing sweeps the co-owner's interest into the bankruptcy estate regardless of transfer restrictions; what the trustee may then do with the interest, including with the state dissociation rules and any voting or management rights, is decided under federal bankruptcy law applied to the state statute and the agreement, and this post does not answer that question. A buy-sell clause can replace many of these defaults with a purchase at an agreed price, and each state's LLC and partnership statutes give effect to transfer restrictions in a signed agreement; whether a particular trigger or purchase right can be enforced in a bankruptcy case is a separate question governed by federal law.

Two kinds of ownership: membership and the economic interest

The statutes split ownership in two. Arizona defines the "transferable interest" as "the right, as initially owned by a person in the person's capacity as a member, to receive distributions from a limited liability company, whether or not the person remains a member or continues to own any part of the right."¹ California's definition is substantially the same, and it defines the full "membership interest" as the member's rights "including the member’s transferable interest, any right to vote or participate in management, and any right to information."⁷ Texas says a "membership interest" includes the member's share of profits and losses and the right to receive distributions, and "does not include a member's right to participate in management."¹³

Under the default rules, a death, divorce or bankruptcy moves the first kind of ownership, subject to two exceptions covered in their sections below: California's rule for a deceased member's estate representative, and the questions federal law leaves open in bankruptcy. In Arizona and California a "transfer" expressly includes a "transfer by operation of law," which is how an inheritance, a divorce decree or a bankruptcy filing moves an interest without anyone signing an assignment.¹⁷ A transferee or assignee "has the right to receive, in accordance with the transfer, distributions to which the transferor would otherwise be entitled," but the transfer does not entitle them to participate in management (in Arizona's words, to "[p]articipate in the management or conduct of the company's activities and affairs"; in California's, to "[v]ote or otherwise participate in the management or conduct of the activities of a limited liability company") or, with limited exceptions, to company records.²⁸ Texas says an assignment "does not entitle the assignee to: (A) participate in the management and affairs of the company; (B) become a member of the company; or (C) exercise any rights of a member of the company," while the assignee receives the assigned allocations and distributions and may, "on written demand stating a proper purpose," examine records reasonably related to that purpose.¹⁴¹⁵

Becoming a member is a separate step. After formation, a person becomes a member of an Arizona LLC "[a]s provided in the operating agreement" or "with the affirmative vote or consent of all the members"; of a California LLC as the operating agreement provides or "[w]ith the consent of all the members"; and of a Texas LLC "on approval or consent of all of the company's members."³⁹¹⁶ Unless the agreement says otherwise, the remaining owners decide whether the heir or the former spouse ever gets a vote. Whether the same is true of a bankruptcy trustee is reserved: owner consent and the agreement are not the whole of the federal analysis, and the bankruptcy section below leaves that question open.

When a co-owner dies

Arizona. An individual member "is dissociated as a member if and when" the individual dies;⁴ dissociation is the statute's word for ceasing to be a member while the economic interest continues in other hands. On dissociation the person's management rights terminate and the transferable interest "is owned by the person solely as a transferee."⁵ The deceased member's "legal representative" may exercise the transferee's right to an accounting on winding up and, "[f]or the purposes of settling the estate, the rights the deceased member had" to information.⁶ Arizona's statute also addresses interests held by a married couple: a transferable interest "may be held ... by a married couple as community property with right of survivorship," and a co-owner holding an interest as community property "shall have only the rights of a transferee ... both during the lifetime and following the death of any other co-owner, unless and until the co-owner becomes a member."³ Where the interest was held with right of survivorship, the surviving spouse "shall succeed to the ownership of the decedent's interest in the transferable interest without further action" but still "shall have only the rights of a transferee" until admitted.³

California. Death dissociates the member,¹⁰ with the same result: voting and management rights end and the interest is held "solely as a transferee."¹¹ The personal representative may exercise a transferee's accounting right and, "for the purposes of settling the estate, the rights of a current member" to information.¹² California's statute then grants an express authority that Arizona's § 29-3504 and Texas's § 101.1115 do not: the member's executor, administrator or other legal representative "may exercise all of the member’s rights for the purpose of settling the member’s estate or administering the member’s property, including any power the member had under the articles of organization or an operating agreement to give a transferee the right to become a member."¹¹ If the operating agreement gave the member a power to make a transferee a member, the estate can exercise it for that purpose. Arizona and Texas owners can write a succession mechanism into their own agreements; the difference is that California's statute supplies this authority itself.

Texas. Texas's LLC statute takes a different route. It provides that a member "may not withdraw or be expelled from the company,"⁴⁰ and it addresses death by naming who holds the interest afterward: "on the death of a member, the member's surviving spouse, if any, and an heir, devisee, personal representative, or other successor of the member, to the extent of their respective membership interest, are assignees of the membership interest."¹⁷ An assignee has the economic and records rights described above and "is entitled to become a member of the company on the approval of all of the company's members."¹⁵

General partnerships. An individual partner's death is a dissociation event in Arizona and California and an "event of withdrawal" in Texas.¹⁹²³²⁶ In Texas "[a] partnership continues after an event of withdrawal"; in Arizona and California, if the partnership continues rather than winding up, it "shall cause the dissociated partner's interest ... to be purchased for a buyout price."²⁰²⁴²⁷ In Texas the withdrawn partner's interest "automatically is redeemed by the partnership as of the date of withdrawal" at "the fair value of the interest on the date of withdrawal," on the statutory condition that "an event requiring a winding up of partnership business does not occur before the 61st day after the date of the withdrawal," and when the statutory redemption applies, the surviving spouse and heirs "are creditors of the partnership until the redemption price is paid"; otherwise they are transferees.²⁷²⁸ Our post on what the default rules say when there is no written partnership agreement explains why many two-person businesses are partnerships without knowing it.

When a co-owner divorces

Arizona, California and Texas are community-property states. In Arizona, "[a]ll property acquired by either husband or wife during the marriage is the community property of the husband and wife" except property acquired by gift, devise or descent or after service of a petition that results in a decree.²⁹ In California, "[e]xcept as otherwise provided by statute, all property, real or personal, wherever situated, acquired by a married person during the marriage while domiciled in this state is community property," each spouse's interest in it is "present, existing, and equal," and on divorce the court "shall ... divide the community estate of the parties equally" absent agreement.³⁰³⁹³¹ In Texas, community property "consists of the property, other than separate property, acquired by either spouse during marriage," and "[p]roperty possessed by either spouse during or on dissolution of marriage is presumed to be community property," rebuttable only by clear and convincing evidence.³² Each statute has exceptions, so acquisition during the marriage is the starting point of the analysis, not the end of it. Each state's separate-property statute places property owned before the marriage outside the community: Arizona's covers property "owned by that spouse before marriage" together with "the increase, rents, issues and profits of that property,"⁴⁴ California's includes "[a]ll property owned by the person before marriage" and "[t]he rents, issues, and profits of the property described in this section,"⁴⁵ and Texas's covers "the property owned or claimed by the spouse before marriage."⁴⁶ A valid agreement between the spouses can also change the characterization: Arizona enforces a premarital agreement "in writing and signed by both parties," while providing that it "is not enforceable" where the person against whom enforcement is sought proves the grounds the statute lists;⁴⁷ California allows married persons, "[s]ubject to Sections 851 to 853, inclusive," to "[t]ransmute community property to separate property of either spouse" or the reverse;⁴⁸ and Texas allows spouses to "partition or exchange between themselves all or part of their community property," after which the transferred property "becomes that spouse's separate property."⁴⁹ An agreement that is not valid or enforceable does not change the characterization, and how the source of the funds used to acquire an interest affects the analysis is not settled by the statutes quoted here.

An ownership interest acquired during the marriage is therefore likely to be community property, in whole or in part. Two distinctions matter for the company. First, dividing the property is not the same as admitting a member. The divorce concerns whatever interest is subject to division, and the decree may award the business interest to the owner-spouse and balance the division with other property or a money award, in which case no ownership interest in the company changes hands. Arizona's dissolution statute directs the court to "divide the community, joint tenancy and other property held in common equitably, though not necessarily in kind, without regard to marital misconduct,"⁴² and California's permits the court, "[w]here economic circumstances warrant," to "award an asset of the community estate to one party on such conditions as the court deems proper to effect a substantially equal division of the community estate."⁴³ Second, if the decree does award some or all of the interest to the other spouse, what passes is the economic interest, not control: the award does not by itself admit a spouse who was not already a member, and admission still follows the entity's rules. A spouse who was already a member in their own right is in a different position, because that membership did not come from the decree.

Texas. The LLC statute says it directly: "A membership interest may be community property under applicable law," and "[a] member's right to participate in the management and conduct of the business of the limited liability company is not community property."¹⁸ On divorce, "the member's spouse, to the extent of the spouse's membership interest, if any, is an assignee of the membership interest," and in a partnership the former spouse "is a transferee of the partnership interest."¹⁷²⁵

Arizona. The LLC statute states the entity rule directly: each co-owner of a transferable interest held as community property "shall have only the rights of a transferee with respect to the interest" and holds those rights "unless and until the co-owner becomes a member" by the route the statute provides.³ A decree that awards the interest changes who holds the economic interest; it does not change that rule.

California. The entity rule is in the LLC statute: a transfer, which includes a transfer by operation of law, "does not entitle the transferee" to "[v]ote or otherwise participate in the management or conduct of the activities of a limited liability company," and a person becomes a member only as the operating agreement provides or with the consent of all the members.⁷⁸⁹ The Family Code provision that gives the spouse "who is operating or managing a business or an interest in a business that is all or substantially all community personal property" the "primary management and control of the business or interest" governs management between the spouses during the marriage; it is not the rule that decides whether a former spouse becomes a member.³³

For the remaining owners, a co-owner's divorce rarely changes who manages the company, but it can create a new economic owner with a right to distributions and, in Texas, records on a proper-purpose demand. A buy-sell clause that gives the member or the company the right to purchase an interest awarded to a former spouse is the usual answer, and Texas confirms that its LLC and partnership statutes do "not impair an agreement for the purchase or sale" of an interest "on the death or divorce of an owner."¹⁷²⁵

When a co-owner files for bankruptcy

Federal law decides what enters the bankruptcy estate. Filing a case "creates an estate" comprising "all legal or equitable interests of the debtor in property as of the commencement of the case," together with the debtor's and the debtor's spouse's interests in community property that is under the debtor's "sole, equal, or joint management and control" or liable for claims against the debtor.³⁴ The interest enters the estate "notwithstanding any provision in an agreement, transfer instrument, or applicable nonbankruptcy law" that "restricts or conditions transfer of such interest by the debtor" or that is "conditioned on the insolvency or financial condition of the debtor" and effects "a forfeiture, modification, or termination of the debtor's interest."³⁵ Under § 541(c)(1), a transfer restriction in the operating agreement does not keep the co-owner's interest out of the estate, and neither does a clause that strips or modifies the interest because of the filing; what the trustee can do with the interest afterward is a separate question, discussed below. Property the debtor "acquires or becomes entitled to acquire within 180 days after" filing "by bequest, devise, or inheritance" or "as a result of a property settlement agreement with the debtor's spouse, or of an interlocutory or final divorce decree" joins the estate as well.³⁴

The state statutes supply the rules the interest is held under, but they do not settle what the estate holds. Section 541(c)(1) reaches restrictions in "applicable nonbankruptcy law" as well as in agreements, so a state rule that dissociates a member or ends rights because of a bankruptcy filing is itself subject to federal-law analysis in the case. The state rules are these.

Arizona. The LLC statute provides that a member is dissociated when the person "[b]ecomes a debtor in bankruptcy," a term defined by reference to an order for relief under title 11 or a comparable insolvency order, and that a dissociated person's interest is thereafter held solely as a transferee.⁴⁵ Whether that state rule operates against the bankruptcy estate is decided under federal law in the case.

California. The statute lists becoming a debtor in bankruptcy as a dissociation event only "[i]n a member-managed limited liability company,"¹⁰ with the same federal-law reservation.

Texas. Texas's Chapter 101 does not impose the same express bankruptcy-dissociation rule; its statute provides that a member "may not withdraw or be expelled from the company."⁴⁰ The membership interest enters the bankruptcy estate under § 541, and which rights the trustee can exercise is decided under federal bankruptcy law applied to the Texas statute and the company agreement, not by the fact of entry alone.

General partnerships. A partner's becoming a debtor in bankruptcy is a dissociation or withdrawal event under all three state partnership statutes, and under those statutes it leads to the partnership buyout or redemption described above.¹⁹²³²⁶ Whether that consequence stands in a particular bankruptcy case is again a federal question.

Federal law also has its own framework for contracts, and an operating or partnership agreement may be analyzed under it. Each of the provisions below operates subject to the limits the section itself states. The trustee, "subject to the court's approval, may assume or reject any executory contract" of the debtor, "[e]xcept as provided in sections 765 and 766 of this title and in subsections (b), (c), and (d) of this section." The trustee "may not assume or assign" a contract where "applicable law excuses a party, other than the debtor," from "accepting performance from or rendering performance to an entity other than the debtor or the debtor in possession" and "such party does not consent to such assumption or assignment." And as a general rule, "[n]otwithstanding a provision in an executory contract or unexpired lease, or in applicable law," a contract of the debtor "may not be terminated or modified" after the filing "solely because of a provision in such contract or lease that is conditioned on" the debtor's insolvency, the bankruptcy filing or the appointment of a trustee. That general rule is itself subject to statutory exceptions: it "does not apply" where "applicable law excuses a party, other than the debtor," from "accepting performance from or rendering performance to the trustee or to an assignee of such contract or lease" and "such party does not consent to such assumption or assignment," or where the contract is "a contract to make a loan, or extend other debt financing or financial accommodations, to or for the benefit of the debtor, or to issue a security of the debtor."⁴¹ Whether a particular agreement is an executory contract, and what these provisions mean for a trustee's exercise of a member's voting or management rights, is decided in the bankruptcy case under federal law applied to the state statute and the agreement. This post does not answer that question for any company.

Judgment creditors of a co-owner

Short of bankruptcy, a co-owner's personal judgment creditor reaches the interest through a charging order, a court order that directs the company to pay the creditor whatever distributions would otherwise go to the debtor-owner.

Arizona. "[O]n application by a judgment creditor of a member or transferee, a court may enter a charging order against the transferable interest," which "requires the limited liability company to pay over to the person to which the charging order was issued any distribution that otherwise would be paid to the judgment debtor"; the section "provides the exclusive remedy" for a judgment creditor against the interest.³⁶

California. The charging order is a lien on the interest and the exclusive remedy; a court may foreclose the lien and sell the interest, but "[t]he purchaser at the foreclosure sale obtains only the transferable interest, does not thereby become a member."³⁷

Texas. The charging order gives the creditor "only the right to receive any distribution to which the judgment debtor would otherwise be entitled," the lien "may not be foreclosed on under this code or any other law," the order is the exclusive remedy, and the rule applies to single-member LLCs too.³⁸

General partnerships. A court in Arizona or California "may order a foreclosure of the interest subject to the charging order," and the purchaser "has the rights of a transferee."²¹²²

Our post on whether an LLC protects your personal assets covers the other direction, a creditor of the company reaching the owner.

What a buy-sell clause changes

Many of the rules above are defaults that the owners' agreement can replace with a purchase, and each state's statute gives effect to a transfer restriction in the agreement. Arizona and California make a transfer "in violation of a restriction on transfer" ineffective against a transferee with notice of the restriction, with Arizona adding that a restriction "set forth in an operating agreement embodied in a signed record" binds regardless of notice.²⁸ Texas, as noted, preserves agreements for the purchase or sale of an interest "on the death or divorce of an owner."¹⁷²⁵ Two limits apply. A transfer restriction is not the same as an enforceable purchase right: whether a particular trigger, price formula or purchase obligation can be enforced against an estate, a former spouse or a bankruptcy trustee depends on the terms, the facts and, in bankruptcy, federal law. And some rules are not the owners' to change, including the federal bankruptcy provisions discussed above and, for a licensed professional, the rules of that profession. Terms that do the work:

1. Triggers. Death, disability, divorce, bankruptcy, a charging order, a transfer attempt, and loss of a professional license, each with a defined effective date. Listing bankruptcy as a trigger does not establish that the trigger is enforceable: § 541(c)(1) brings the interest into the estate despite a clause conditioned on the filing, and § 365(e)(1) limits the termination or modification of an executory contract because of the filing, subject to the exceptions § 365(e)(2) states, so a bankruptcy trigger has to be drafted with that federal overlay in mind and may not operate as written.³⁵⁴¹
2. Who buys. The company, the other owners pro rata, or both in sequence, with a right of first refusal on any transfer.
3. Price. An agreed value updated annually, a formula, or an appraisal process, and whether the price is discounted for a minority or non-controlling interest.
4. Funding and payment. Life or disability insurance on each owner, and installment terms secured by the interest for the rest; our post on the buy-sell agreement explains the cross-purchase and entity-redemption structures and why the choice has tax consequences.
5. Spousal acknowledgment. A signed acknowledgment from each owner's spouse that the agreement governs any community-property interest, which reduces the risk that the purchase terms are contested in a later divorce.
6. Rights in the meantime. Whether a transferee or assignee receives distributions, information and tax reporting until the purchase closes.

Our posts on ten ways to protect yourself in a 50/50 partnership, the founders' agreement and why your LLC needs an operating agreement cover where these terms live.

What to do when it happens

1. Find the agreement and read the transfer and buy-sell sections first. They may set the price, the timeline and who has the right to buy.
2. Identify what the other person holds. An economic interest, a claim to a redemption price, or a right to be admitted as a member under the agreement.
3. Keep paying what is owed, to the person entitled to it. Distributions do not stop because of the event, but do not redirect them to whoever called first. Confirm who is legally entitled to receive them (the estate's representative, a former spouse under the decree, a trustee, or still the co-owner), that the transfer has actually taken effect, that the company has proper notice of it, and whether any court order directs payment; then pay. Withholding what is owed invites a claim, and so does paying the wrong person.
4. Do not admit anyone by accident. Admission takes the consent the statute or the agreement requires, through one of the routes those sources provide: an operating or partnership agreement can itself provide for admission, and in California a deceased member's representative may exercise a power the agreement gave the member to make a transferee a member. Outside those routes, do not sign a consent, issue a membership certificate or record the person as a member unless the owners have decided to admit them. A signed consent that is properly authorized and sufficient under the statute or the agreement can itself be the required consent; a membership certificate or a record entry does not necessarily constitute that consent, although either may be evidence in a later dispute over whether consent was given.
5. Respond to information requests according to who is asking. The rights differ, and they are not the same in each state. In Arizona a transferee has the rights to information under § 29-3410(B) "[s]olely for a purpose that is reasonably related to the transferee's right to receive distributions," and on a dissolution and winding up "is entitled to an account of the company's transactions only from the date of dissolution."² California does not supply that same express distributions-purpose right: its statute withholds from a transferee access "to records or other information concerning the activities of a limited liability company" except "as otherwise provided in subdivision (c) and Section 17704.10," and subdivision (c) entitles a transferee, in a dissolution and winding up, to "an account of the limited liability company's transactions only from the date of dissolution."⁸ A deceased member's representative has the member's information rights for settling the estate, and in California all of the member's rights for that purpose;⁶¹¹¹² a Texas assignee may examine records on a written demand stating a proper purpose.¹⁵ Not every economic owner has a member's inspection rights, and a flat refusal to a person who does have them invites a claim the company would have to answer.
6. Ask about tax before the purchase closes. Tax treatment of the buyout is handled with our of-counsel tax attorney.
7. Talk to the counterparty early. An estate or former spouse may prefer a prompt purchase at a fair price to an open-ended position as an economic owner; the only way to know is to ask. Our post on what happens when a co-founder leaves covers the mechanics of a negotiated exit.

Questions to settle before it happens

1. Does the operating or partnership agreement say what happens on an owner's death, divorce or bankruptcy, or does it leave those events to the statutory defaults?
2. Is any owner's interest community property, and has that owner's spouse acknowledged the agreement?
3. Who has the right to buy a departing owner's interest, at what price, and how is the purchase funded?
4. Is the company member-managed or manager-managed, which in California decides whether the statute lists a member's bankruptcy as a dissociation event?
5. For a partnership, is it at will or for a term, and do the owners understand the buyout or redemption that the statute requires?
6. What does a transferee or assignee receive while a purchase is pending: distributions, information, tax allocations?
7. Does each owner's estate plan match the agreement, so that the designated successor is someone the other owners have agreed to admit?

What this post does not cover

This post does not cover corporations and their shareholders, limited partnerships, the probate or divorce process itself, how a divorce court values a business interest, bankruptcy procedure or a trustee's powers beyond the statutory text quoted, or the tax consequences of a transfer or buyout, which are handled with our of-counsel tax attorney. It does not say what any particular heir, spouse or trustee holds. For the structural choices behind these rules, see our posts on partnership versus LLC and how co-owners handle disputes.

How we can help

Accord & Shield Legal drafts buy-sell, operating and partnership agreements that address in advance what happens to an owner's interest on death, divorce or bankruptcy, within the limits described above, and helps companies in Arizona, California and Texas respond when one of those events has happened, from identifying what the other party holds to documenting a purchase. To better understand the scope of your matter, you can schedule an initial consultation. The consultation is evaluation-only; no legal advice is provided. Representation begins only after an engagement agreement is signed and any required retainer is received. Please do not send confidential or sensitive documents before we confirm that we can assist.

This article is general information, not legal advice. Reading it does not create an attorney-client relationship. What passes on a co-owner's death, divorce or bankruptcy depends on the entity, the agreement, the property involved and the governing law; consult an attorney about your situation.

Book an Initial Consultation

Schedule an initial consultation to discuss the scope of buy-sell terms for your company or a transfer that has already happened. Bring a short, nonconfidential description of the situation and any deadline.

Please do not send contracts, documents or confidential information until the firm has agreed in writing to represent you.

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