This article addresses the basic to intermediate level issues that need to be addressed in limited liability company (LLC) operating arrangements with two or more members. The founding document of an LLC is the articles of organization filed with the state that forms the LLC. Most US states do not require articles of organization to include all members of the LLC, and even if it is required, the identity of the members may change over time. Therefore, the most basic function of an LLC operating agreement is to identify members to third parties who transact business with the LLC. Do Single Member LLCs Have Written Operating Agreements? Yes, precisely for the reason stated above (ie to verify for third parties the identity of the member(s). The following are what I recommend as the most important issues to address in an LLC operating agreement.
- Identify members;
- List members’ ownership interests;
- List members’ initial capital contributions (if applicable);
- Indicate the method by which profits and losses will be distributed among the partners;
- Indicate the method by which the members will vote; Y
- If the LLC has managers (rather than being managed by all members), identify the manager and set the issues reserved for all members to vote on along with a mechanism for members to remove the manager.
Some of the above issues are self explanatory, but others require an explanation. When a member contributes non-cash property to an LLC as part of the initial capital contributions, the LLC’s basis in contributed assets is the same as each contributing member’s basis in assets before contribution under the Section 723 of the Internal Revenue Code. means that the value assigned to contributed assets on the LLC’s books (and also listed as contributed initial capital in the LLC’s operating agreement) is the basis of such assets held by the contributing partner. Basis is generally the cost paid for the asset less any prior depreciation. Consult with a tax professional for more information on the subject. Ownership interests are usually expressed in LLC operating agreements as units (similar to a share in a corporation) or percentages of the whole. If your percentage interests are allocated to members, make sure that the members’ percentage interests total 100%.
The two main types of voting by LLC members are by equity and by ownership interest. If an operating agreement states that voting will be per capita, then each member’s vote will carry equal weight. Member voting based on ownership interest means that each member’s vote is weighted by his or her share of the LLC. For example, suppose XYZ, LLC has three members whose operating agreement states that they must vote on an ownership share basis, and the members have the following ownership interests: Member x–15%, Member Y–30%, and Member Z –55%. In this case, it is as if X had 15 votes, Y 30 votes, and Z 55 votes out of a total of 100 votes cast. If XYZ, LLC’s operating agreement requires a simple majority to pass any resolution voted on by the members, Z may approve any measure with his 55 votes even if both X and Y vote against such measure.
The LLC’s articles of organization designate the LLC as managed by all the members or managed by a manager or managers appointed by the members. To make things more confusing, designated managers can be members. Why would an LLC appoint managers? This most often happens when not all members are required to actively participate in the LLC. It can also occur when members who have majority ownership in the LLC can obtain an agreement from minority members that the majority will retain management of the LLC to the exclusion of the minority. As the number of members grows, the practicality of having all members manage the LLC decreases. In the case of a manager-managed LLC, there are very few issues left for the members to decide. Two examples are the admission of new members and the voluntary dissolution of the LLC. However, members can write additional restrictions on the power of LLC managers in their operating agreement. Examples of such restrictions are loan transactions above a certain dollar amount, the execution of any real estate lease, the fixing of the salary of employees, etc.
The following is a list of additional items that those who form an LLC may wish to include in their operating agreement. Many issues beyond these could potentially be addressed in an operating agreement.
- Services required to be provided to the LLC by any member;
- Any matter that requires the vote of the qualified majority of the members for its approval;
- Penalties for failure of the member to provide the agreed initial capital or services;
- Mandatory cash distributions to members;
- Can the LLC require capital contributions from members after the formation of the LLC?
- Withdrawal of members;
- Elimination of members;
- Fiduciary duties that members owe each other;
- Limits on the sale or other transfer of membership interests; Y
- whether any of the members will receive a salary in exchange for services rendered to the LLC.
Small businesses organized as LLCs are often found where members receive their membership interest in the LLC in exchange for promised future services rather than capital contribution (or a combination of cash and promised future services). In such cases, it is important that the LLC’s operating agreement set out in as much detail as possible the services that each member agrees to provide to the LLC. Also, what are the penalties for not providing these services? When the LLC runs into difficulties, the members often walk away to pursue other business opportunities, leaving the remaining members to carry on the business. Planning ahead to deal with this problem will save LLC members from considerable headache down the road if the LLC is faced with this situation. Supermajority means a number above the majority and generally refers to 2/3 (or 66.7%). Matters on which members may wish to impose a supermajority requirement for approval include the admission of new members, the decision to sell substantially all of the assets of the LLC, and the removal of the manager (if applicable).
LLC members who are not versed in the tax intricacies of LLCs are often surprised to learn that they pay taxes on all profits allocated to them by the LLC, regardless of whether or not the LLC makes cash distributions to them. The unlucky LLC member may find themselves incurring a tax bill for which the LLC makes no distribution to cover. This can be especially burdensome for minority members who lack the ability to demand disbursement of cash from the LLC to cover their personal tax liability from the LLC. This issue can be addressed by requiring in the operating agreement that, at a minimum, a certain portion of annual profits (such as 40%) be distributed to members each year the LLC is in profit. As the amount of earnings allocated to each member is not known until the LLC’s tax return is finalized, it is common for the required tax distribution deadline to members to be a certain number of days after the LLC’s tax return is finalized. the LLC’s tax return (ie 30 days).
Retirement of LLC members is a complicated subject. In some states, such as Texas (see Texas Business Organizations Code, Sec. 101.107), members do not have the right to withdraw from an LLC unless this right is provided in the LLC’s operating agreement. In many ways, members coming together to run a small business is like a marriage. Shouldn’t we expect divorces? All parties are better off if members put some level of member retirement planning into their LLC operating agreement. Another issue often overlooked in drafting an operating agreement is the fiduciary duties that members owe each other. Especially important within this issue is whether members can conduct business outside of the LLC and, more particularly, whether members can engage in the same business sector as the LLC that can potentially compete with the LLC. It is not uncommon for state LLC laws to be silent or vague on the subject. For example, the Delaware Limited Liability Company Law does not mention the application of fiduciary duties to the members or managers of limited liability companies, leaving the matter in the hands of the contractual agreement between the parties. See Del. LLC Law Section. 18-1101.
Hopefully the above will help those who are about to enter into an LLC operating agreement spot problems for which they can seek legal advice.
