Legal Law

Elements of an LLC Operating Agreement

This article addresses entry-level to intermediate-level issues that need to be addressed in limited liability company (LLC) operating agreements with two or more members. The founding document of an LLC is the articles of organization filed with the state founding the LLC. Most US states do not require articles of organization to list all LLC members, and even if necessary, 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 do business with the LLC. Do single member LLCs have written operating agreements? Yes, precisely for the reason stated above (that is, to verify the identity of the members for third parties). The following are what I recommend as the most important issues that an LLC operating agreement should address.

  • Identify the members;
  • List the ownership interests of the members;
  • List members’ initial capital contributions (if any);
  • Indicate the method by which profits and losses will be distributed to members;
  • Indicate the method by which the voting of the members will take place; Y
  • If the LLC has managers (rather than being managed by all members), identify the manager and list the items reserved for voting by all members along with a mechanism for members to remove the manager.

Some of the above issues are self explanatory, but others require explanation. When a member contributes non-cash property to an LLC as part of the initial capital contributions, the LLC’s base in contributed assets is the same as each contributing member’s base in assets before contribution under Section 723 of the Internal Revenue Code. means that the value assigned to the contributed assets on the LLC’s books (and also listed as initial contributed capital in the LLC’s operating agreement) is the basis of that asset in the hands of the contributing member. Generally, the basis is the cost paid for the asset less any prior depreciation. Consult with a tax professional for more information on the subject. Ownership interests are generally expressed in LLC operating agreements as units (similar to participation in a corporation) or as percentages of the total. If the percentage interest is assigned to the members, make sure that the percentage interest of the members is 100%.

The two main types of voting by LLC members are by capital and on the basis of ownership interest. If an operating agreement establishes that the vote will be by capital, then the vote of each member will have the same weight. Members’ voting based on ownership interest means that each member’s vote is weighted to their ownership interest in the LLC. For example, suppose that XYZ, LLC has three members whose operating agreement states that they must vote on the basis of ownership interest 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 to a vote by the members, Z can then approve any measure with their 55 votes even if both X and Y vote against it.

The articles of organization of the LLC designate the LLC as being managed by all members or managed by a member-appointed manager or managers. To make matters more confusing, designated managers can be members themselves. Why would an LLC appoint managers? This most often happens when not all members need to be actively involved in the LLC. It can also occur when members who have majority ownership in the LLC can obtain an agreement from the minority members that the majority will retain management of the LLC to the exclusion of the minority. As the number of members increases, the practicality of all members managing the LLC decreases. In the case of a manager-run 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 include additional restrictions on the power of LLC managers in their operating agreement. Examples of such restrictions are loan transactions for a specified dollar amount, the execution of any real estate lease, the fixing of the salary of employees, etc.

The following is a list of additional topics 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 supermajority of the members for its approval;
  • Penalties for failing to provide the initial capital or agreed-upon services by the member;
  • Mandatory cash distributions to members;
  • Can the LLC require capital contributions from members after the formation of the LLC?
  • Member withdrawal;
  • Member removal;
  • Fiduciary duties that members owe to each other;
  • Limits on the sale or other transfer of membership interest; Y
  • whether any member will receive a salary in exchange for services rendered to the LLC.

Small businesses organized as LLCs are often found where members receive their share in the LLC in exchange for the promised future services rather than the capital contribution (or a combination of cash and promised future services). In such cases, it is important that the LLC’s operating agreement sets out in as much detail as possible the services that each member promises to provide to the LLC. Also, what are the penalties for not providing these services? When the LLC struggles, members frequently walk away in search of other business opportunities, leaving the remaining members to carry on in business. Planning in advance to address this issue will save LLC members a considerable headache down the road should the LLC be faced with this situation. Supermajority means a number above the majority and usually refers to 2/3 (or 66.7%). Matters where members may wish to impose a supermajority requirement for approval include the admission of new members, the decision to sell substantially all of the LLC’s assets, and the removal of the manager (if applicable).

LLC members who are unfamiliar with the tax intricacies of LLCs are often surprised to learn that all profits allocated to them by the LLC are taxed, regardless of whether the LLC actually makes cash distributions to them or not. The unfortunate LLC member may find himself incurring a tax bill that the LLC makes no distribution to cover. This can be especially burdensome for minority members who lack the ability to demand a cash outlay from the LLC to cover their personal tax liability from the LLC. This problem can be addressed by requiring in the operating agreement that, at a minimum, a certain portion of the annual profits (such as 40%) be distributed to the members each year when the LLC makes a 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 deadline for required tax distribution to members to be a certain number of days after it is finalize the LLC’s tax return (ie, 30 days).

Withdrawal of LLC members is a sensitive issue. In some states, such as Texas (see Section 101.107 of the Texas Business Organizations Code), members do not have the right to withdraw from an LLC unless this right is granted in the LLC’s operating agreement. In many ways, joining together to run a small business is like a marriage. Shouldn’t we expect divorces? All parties will be better off if members put some level of retirement planning in their LLC operating agreement. Another issue that is often overlooked in the drafting of operating agreements is the fiduciary duties that members owe to each other. Especially important within this topic is whether members will be allowed to conduct business outside of the LLC and, more particularly, whether they will be allowed to 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 imposition of fiduciary duties on the members or managers of LLCs, leaving the matter to the contractual arrangement between the parties. See Del. LLC Law Sect. 18-1101.

Hopefully, this will help those who are about to enter into an LLC operating agreement to detect problems for which they can seek legal advice.

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