Elements of An LLC Operating Agreement

This article addresses the basic to intermediate level issues that should be addressed in limited liability company (LLC) operating agreements with two or more members. The founding document of an LLC are the articles of organization filed with the state that charters the LLC. The majority of US states do not require the articles of organization to list all LLC members and, even if required, the identity of the members can change over time. Thus, the most basic function of an LLC operating agreement is to identify the member(s) to third parties who transact business with the LLC. Do single member LLC’s have written operating agreements? Yes, precisely for the reason state above (i.e., verifying for the third parties the identity of the member(s)). The following are what I recommend as the most important issues for an LLC operating agreement to address.

  • Identify the members;
  • List member ownership interests;
  • List initial capital contributions of members (if any);
  • State the method by which profits and losses shall be allocated to the members;
  • State the method by which member voting shall occur; and
  • If the LLC has managers (as opposed to being managed by all members), identify the manager and state those issues reserved for vote by all members together with a mechanism for the members to remove the manager.

Some of the above issues are self-explanatory but others requires explanation. When property other than cash is contributed to an LLC by a member as part of initial capital contributions, the LLC’s basis in the contributed assets is the same as each contributing member’s basis in the assets prior to the contribution under Internal Revenue Code Section 723. This means that the value assigned to contributed assets on the books of the LLC (and also listed as initial contributed capital in the LLC operating agreement) is the basis of said asset in the hands of the contributing member. Generally, basis is the cost paid for the asset less any prior depreciation. Please check with a tax professional for further information on the topic. Ownership interests are typically expressed in LLC operating agreements as either units (akin to share in a corporation) or percentages of the whole. If you percentage interests are assigned to the members, ensure that the members percentage interests total to 100%.

The two main types of LLC member voting are per capital and on the basis of ownership interest. If an operating agreement states that voting shall be on a per capital basis then the vote of each member shall have equal weight. Member voting on the basis of ownership interest means that the vote of each member is weighted to his or her ownership interest in the LLC. For example, assume XYZ, LLC has three members whose operating agreement states that they are to vote on the basis of ownership interest and the members have following ownership interests: Member x–15%, Member Y–%30, and Member Z–55%. In this case, it is as if X possessed 15 votes, Y 30 votes and Z 55 votes out of a total 100 votes cast. If the operating agreement of XYZ, LLC requires a simple majority to pass any resolution up for vote by the members, Z may then pass any measure with his 55 votes even though both X and Y vote against said measure.

The LLC articles of organization designate the LLC as either managed by all member or managed by manager or managers who are designed by the members. To make matters more confusing, designated managers may themselves be members. Why would an LLC designate managers? This most often happens when not all the members are to be actively involved in the LLC. It can also occur where the member(s) holding majority ownership in the LLC are able to extract an agreement from the minority member(s) that the majority shall 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 an LLC managed by managers there are very few matters left for decision by the members. Two examples are admission of new members and voluntary dissolution of the LLC. However, the members may write additional restraints upon the power of LLC managers into their operating agreement. Examples of such restraints are loan transactions over a certain dollar amount, the execution of any real estate lease, setting the salary of employees, et cetera.

The following is a list of additional issues those forming an LLC may wish to include into their operating agreement. Many issues beyond these could potentially be addressed in an operating agreement.

  • Required services to be provided to the LLC by any member;
  • Any matter requiring supermajority vote of members for passage;
  • Penalties for failure of member to provide initial capital or agreed services;
  • Mandated cash distributions to members;
  • May the LLC require capital contributions from members after formation of LLC?
  • Withdrawal of members;
  • Removal of members;
  • Fiduciary duties members owe to one another;
  • Limits upon the sale or other transfer of membership interests; and
  • whether any members shall receive a salary in exchange for services rendered to the LLC.

One often finds small businesses organized as LLC’s where the members receive their membership interest in the LLC in exchange for promised future services as opposed to the contribution of capital (or a combination of cash and promised future services). In such cases, it is important for the LLC operating agreement to set forth in as much detail as possible the services each member promises to provide the LLC. Also, what are the penalties for failure to provide these services? When the LLC struggles members not infrequently wander off to pursue other business opportunities leaving the remaining members to carry on the business. Planning done up front to deal with this issue shall save the LLC members considerable headache down the road should the LLC be confronted with this situation. Supermajority means a number above a majority and typically refers to 2/3rds (or 66.7%). Issues members may wish to place a supermajority requirement upon for passage include admission of new members, the decision to sell substantially all the assets of the LLC, and removal of the manager (if any).

LLC members not versed in the tax intricacies of LLC’s are often shocked to learn that are taxed on all profits allocated to them by the LLC regardless of whether or not the LLC actually makes cash distributions to them. The hapless LLC member may find himself incurring a tax bill for which the LLC makes no distribution to cover. This can be especially burdensome on minority members who lack the ability to demand disbursement of LLC cash to cover the tax liability flowing through to them personally 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 the members each year where the LLC has a profit. As the amount of profit allocated to each member is not known until the LLC tax return is finalized, it is common for the deadline for the required tax distribution to members to be a certain number of days after the LLC tax return is finalized (i.e., 30 days).

Withdrawal of LLC members is a sticky subject. In some states, such as Texas (see Texas Business Organizations Code Sec. 101.107), members have no right to withdraw from an LLC unless this right is granted in the LLC operating agreement. In many respects, the coming together of members to run a small business is like a marriage. Should not we expect there to be divorces? All parties are better off if the members put some level of planning for member withdrawal into their LLC operating agreement. Another issue often overlooked in operating agreement drafting is fiduciary duties owed by members to one another. Especially important within this topic is whether the members shall be allowed to conduct business activities outside of the LLC and, more particularly, whether the members may be allowed to participate in the same business sector as the LLC that may potentially compete with the LLC. It is not uncommon for state LLC acts to be silent or vague on the issue. For instance, Delaware’s Limited Liability Company Act makes no mention of enforcing fiduciary duties upon members or managers of LLCs leaving the matter to the contractual arrangement between the parties. See Del. LLC Act Sect. 18-1101.

Hopefully the foregoing helps those about to enter into an LLC operating agreement spot issues for which they may seek legal advice.

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