Adding a member is 2 events on the same day, and the bank account the money lands in decides the second one

A founder asked me last spring how to add her co-founder to their single member LLC, and I told her it was a signature on the operating agreement and an update to the cap table. That was bad advice by omission. Adding a member is 2 separate events, one legal and one tax, they happen on the same day whether or not anybody notices, and the way the new person pays decides what the second event looks like on paper long after everybody has forgotten which account the money went into.

So how to add a member to an llc has a Delaware answer and a federal tax answer, and I only knew a blurred version of each. I went looking for both texts afterwards, which took most of an afternoon: section 18-301 of the Delaware Limited Liability Company Act, and an IRS revenue ruling from 1999 that still decides what happens to a single member company the day a second person arrives. One state checked here, not fifty.

I had assumed the legal side was a formality and the tax side took care of itself. Both assumptions were wrong in ways that only show up months later.

Event 1: becoming a member is a legal act with a default rule

I would read this section before drafting anything. Section 18-301 splits admission by timing. At formation, a person becomes a member at the later of the formation itself or the time the company agreement provides, and if the agreement is silent, when the admission is reflected in the company’s records.

After formation, which is the case for a co-founder joining later, the rule for anyone who is not an assignee is short. The person is admitted “at the time provided in and upon compliance with the limited liability company agreement or, if the limited liability company agreement does not so provide, upon the consent of all members”.

I put this sentence in every onboarding pack now. Read the fallback carefully. If your operating agreement says nothing about admitting new members, the default is unanimous consent. In a single member company that is 1 signature and easy. In a company that already has 3 members, the agreement’s silence gives each of the 3 a veto over the fourth, which is a strange thing to discover at the moment you most need the new person, usually because the investor has a closing date and one of the 3 existing members has stopped answering email.

There is a second route, and it stayed outside this file. Somebody who acquires an existing member’s interest by assignment is admitted under a different section, 18-704, and the admission rules there are not the ones quoted above. If the new person is buying an existing member’s interest rather than a new one from the company, that section is the one to read next.

Event 2: the tax classification changes on the same day

I told her none of this, and I should have. A single member LLC is, by default, disregarded for federal tax purposes: the company’s assets are treated as owned directly by its owner. The moment a second member arrives, that stops being true, and Revenue Ruling 99-5 describes exactly how it happens in 2 situations that differ only in where the money goes.

The ruling states the first fact pattern in one line: “B, who is not related to A, purchases 50% of A’s ownership interest in the LLC for $5,000. A does not contribute any portion of the $5,000 to the LLC.” Its conclusion is equally short. The LLC “is converted to a partnership when the new member, B, purchases an interest in the disregarded entity from the owner, A.”

In Situation 1, then, B buys half of A’s interest for 5,000 dollars, and A keeps the money rather than putting it into the LLC. The ruling treats this as B buying “a 50% interest in each of the LLC’s assets, which are treated as held directly by A for federal tax purposes”. Immediately afterwards, A and B are treated as contributing their shares of those assets to a new partnership.

The second fact pattern differs in 1 detail, and the ruling spells it out: B “contributes $10,000 to the LLC in exchange for a 50% ownership interest in the LLC. The LLC uses all of the contributed cash in its business.” So in Situation 2 the money goes to the company and stays there. Here the money goes to the company, not to A, and the ruling reaches for section 721(a), which “generally provides that no gain or loss shall be recognized to a partnership or to any of its partners in the case of a contribution of property to the partnership in exchange for an interest in the partnership”.

What happened to the founder who asked

Her co-founder paid 25,000 dollars for half the company, and he paid it to her personal account, because that is where she told him to send it. Nobody thought of it as a decision. It was a bank transfer between 2 people who trusted each other, sent on a Friday afternoon so the paperwork could be done on Monday.

Read against the ruling, that transfer looks like Situation 1 rather than Situation 2: money to the owner, not to the company. I cannot tell you what their accountant concluded, because they did not share it, and I have not found a way to say anything about their tax position without their numbers. What I can say is that the route was chosen by the payment details on an invoice, and that the same 25,000 dollars paid to the company account would have matched the other situation in the ruling.

My guess is that this is the ordinary way it happens. The legal step gets a document, the tax step gets nothing, and the payment instruction quietly decides the second one.

Why the route matters more than the price

I use a 2 column sheet for this. Put the 2 situations side by side and the economics look similar: a new person owns half. The tax picture is not similar at all. In the first, A has sold half of his interest in every asset for cash that went into his own pocket, which is a sale by A. In the second, the cash went into the company and the transaction is framed as a contribution, and the 721(a) language is about contributions.

That is my plain reading of the 2 situations, not tax advice, and I would put the choice of route in front of an accountant before any money moves, because the structure is set by where the cheque is paid and cannot easily be rewritten afterwards. I suspect most founders never make the choice consciously. The co-founder transfers money to whoever asks for it, and the route is decided by a bank transfer rather than by a decision.

I find that uncomfortable, because it is the one moment in the whole process where 10 minutes of thought changes the tax description of the entire deal.

What I would do, in order

Here is the order I would insist on. Start with the operating agreement. If it sets a process for admitting members, follow it to the letter, because Delaware admits the person “upon compliance with” that process. If it says nothing, get the written consent of every existing member, since that is the statutory default.

Then the step I would never skip. Decide the route before the money moves: a purchase from an existing member, or a contribution to the company. Write down which one it is, with the amount and the percentage, and have the accountant confirm the tax consequence of that specific route for your facts.

Then record the admission in the company’s own records and amend the operating agreement to reflect 2 members, their interests and how decisions are made. A single member agreement usually has no voting rules at all. The first disagreement will expose that within a year.

Questions we get

These come from founders adding a co-founder, an early employee or an investor. I answer them the same way every time.

What does admission of a new member require in Delaware? Compliance with whatever the LLC agreement provides, and if the agreement is silent on the point, the consent of all members, which in a company with more than 1 existing member turns an ordinary hire of a co-founder into a unanimous vote that nobody planned for. Assignees follow section 18-704 instead.

Is the consent of all members always required? No. It is the statutory default. A well drafted agreement can set a different rule, such as a majority vote or a manager’s decision, and Delaware follows the agreement where it speaks.

When does a disregarded entity become a partnership? When a second member arrives. Revenue Ruling 99-5 describes the conversion both where the new member buys part of the owner’s interest and where the new member contributes cash to the company.

How do you buy into an llc without triggering a sale by the owner? The ruling’s second situation, a contribution of cash to the company in exchange for an interest, is the one framed under section 721(a). Whether that fits your facts is a question for an accountant, not for this file.

What is a contribution for a membership interest? Money or property paid to the company itself, rather than to an existing member, in exchange for a new interest. In the ruling it is 10,000 dollars for 50 per cent, spent by the LLC in its business.

A short digression about the word member

I dislike this word more than most. Member sounds like a club and behaves like a vote. The moment a second one exists, every decision the founder used to make alone has an owner the statute recognises, and the agreement that governed 1 person now has to govern 2 who may disagree. I still find it strange how casually that word gets used in cap table conversations. Anyway, back to the order of steps.

What is not settled here

Section 18-704 on admitting assignees. It is the route for buying an existing member’s interest, and it stayed outside this file on purpose, to keep the scope honest.

The partnership filing that follows the conversion is the next gap. The ruling describes a change of classification and says nothing about the return that follows it, the forms that return needs, or the date it falls due, and those details belong to whoever prepares your filings rather than to a file about admission.

I do not know your filing calendar either, and I would rather say so than guess at it.

Every state other than Delaware. One was checked here, and nothing above describes the rest.