Your LLC: What You Don’t Know About Operating Agreements Can Hurt You

Short story: If you are a member of a multi-member LLC, make sure you and the other owners or members have an operating agreement to protect your interests.

Longer story: It’s complicated.

A lot of truth in the title of this post, a truth many owners of limited liability companies (“LLCs”) are unaware of, particularly those who share ownership with other members. After all, many assume, LLCs are easy peasy to set up: Reserve a name for the LLC, secure an EIN (if necessary), register the LLC with the Secretary of State (in Wyoming) or with the Department of Commerce’s Division of Corporations & Commercial Code (in Utah)–all for peanuts–and you’re off and running, organizational certificate in hand and all the liability protection that represents. Or if you’re short on time, any number of online service providers will do all that for you for a few additional peanuts. In either case, after literally minutes, your newly minted LLC will be ready to go. And you can get back to the real business of selling software or buying real estate or whatever else sits behind the liability shield you just set up.

Well, maybe, but again, maybe not. It depends, as they say.

I know; that’s not a very satisfying answer, but here’s the deal: If your LLC is a single-member LLC, that is, if you are the only owner, then maybe you’ve taken all the steps necessary to the formation of your LLC (more on this in another post). But if you’re just one of two or more members, you still have at least one more very important step to take: You and the other owners (aka “members”) of the LLC almost surely need what’s referred to as an Operating Agreement, an agreement between all the members of the LLC.

The operating agreement does what its name implies. It governs the operations, the daily ins and outs of the LLC, its ups and downs, its beginning and timely (or untimely) end. For example, the operating agreement can control if, when, and how new members can be admitted into the LLC. It can contain provisions that govern who manages the LLC and what powers they have or don’t have. Need power to make all decisions that involve less than $10,000.00? If the operating agreement says you’ve got it, well, you’ve got it. Power to sell the company to a suitor? Not without the consent of all the members, again, if the operating agreement says so. And so on. That’s the stuff an operating agreement is made of.

What? I Already Have an Operating Agreement?

Now it may come as a surprise to you that you already have an operating agreement, at least you do if you organized your LLC in Utah or Wyoming (and virtually every other state). The Limited Liability Company Acts of both states are essentially operating agreements. In fact, both acts say that “to the extent that [your own] operating agreement does not provide for a matter described in . . . this [act]. the [act] governs the matter.” Thus, the LLC Acts of both states are a sort of default operating agreement for those who never get around to having an attorney draft an actual operating agreement.

The target group of both states’s Limited Liability Company Acts was supposed to be small “entrepreneurs who organize their businesses without the benefit of [legal] counsel,” says Donald J. Weidner in his article LLC Default Rules Are Hazardous to Member Liquidity. At least that had been the objective of previous iterations of both Acts. The newest iterations? Not so much–and very much to the detriment of the unwary members of multi-member LLCs (“MMLLCs”).

So long and thanks for all the fish

As Weidner makes clear at the beginning of his article, the newest version of the Acts, versions that Utah and Wyoming enacted said so long to some protections tailored to the target group of small entrepreneurs. Instead, the new version,

(1) declared LLCs to be perpetual entities, and . . . (2) denied dissociated members both the right to dissolve and the right to be bought out. (3) It also took away their easy access to judicial remedies . . . (numbers added)

Let’s put some hypothetical meat on those abstract bones. Suppose you and your two best buddies form an LLC for the sole purpose of purchasing and managing a 4-plex in West Valley City, Utah, or Laramie, Wyoming. And suppose that things go great for a while. Real estate prices soar. Rents increase. Equity builds. But then, things change, at least for you. You and your family moved to another state. Your spouse is diagnosed with cancer. And right now, you’re just not that interested in part ownership of a 4-plex located in another state. You have other things on your mind.

So you ask your buddies to buy you out. Guess what: they have no obligation to do so, at least under the default “operating agreement” provided by the state’s LLC Act. In fact, you may have to wait until your buddies decide it’s time to dissolve the LLC and wind up its affairs–a time that could be years down the road, years after you really needed the money. Remember, that the life of your LLC is perpetual under the state’s LLC Act–unless your operating agreement says otherwise. Unfortunately, you and your buddies never drafted an operating agreement. In short, you’re kind of stuck.

Now, you’re not without any remedies. You might be able to sell your interest to an outside party. Of course, the person would have to buy knowing that she is buying only the rights to any distributions from the LLC and not necessarily for any voting rights or management rights. Good luck selling that.

You might also sue to force the dissolution of the LLC (thereby triggering distribution of your capital contribution) by proving that your buddies are “acting in a manner that is oppressive.” That, too, is a long shot unless they really are twisting the knife and not just exercising good business judgment under the circumstances. But if they’re simply not agreeing to buy you out because such a buyout would be a financial burden to them or the company, then oppression will be hard to prove.

So pick up the darn dollars.

There’s an old saying, don’t step over dollars to pick up dimes. Going bare, that is, setting up a multi-member LLC without an operating agreement that provides more flexible liquidity rights is picking up pennies. Just know that if you choose that route, down the road, you may find yourself battling for dollars with your former buddies because they don’t want to buy you out.

A well-drafted operating agreement can limit the life of the LLC if appropriate; it can provide for buyouts in the event of death, disability, or myriad other reasons; it can provide for judicial remedies not allowed under the default “operating agreement.” In fact, the operating can cover all kinds of bases, all sorts of contingencies that the state’s default agreement doesn’t even begin to address. In other words, a well-drafted operating agreement is a must have for multi-member LLCs.

And now you know how to avoid a world of hurt.

Your LLC Up and Running in 6 Steps

One of the first decisions to make when starting a business is what type of business entity to form. The limited liability company (LLC) is one of the most popular business structures because it offers a level of flexibility and legal protection that is attractive to many people who are starting their own businesses. The following six steps will help you get started if you are interested in forming an LLC.

  1. Choose a name. To form an LLC, you must select a business name that complies with state regulations. The name you select cannot be the same as or even too similar to any other LLC’s name; it must be unique to avoid consumer confusion. Next, states often require that the name of your LLC include one of the following at the end: “limited liability company,” “LLC,” or “Limited.” This requirement gives the public notice of your business structure. As simplistic as this step may seem, it is critical to successfully establishing an LLC and being able to take advantage of the legal protections this business structure provides.
  2. Select a registered agent. In addition to selecting an appropriate name, you must select a registered agent. A registered agent, also known as a statutory agent, is the party appointed to receive service of process and communication from your state’s secretary of state. If you live in the state where you form your LLC, you may be your own registered agent. Registered agents must provide an address where important correspondence can be sent. Typically, post office boxes are not acceptable places for a registered agent to receive these communications—rather, a physical address is usually required so the agent can receive service of process. When deciding who should serve as the registered agent, keep in mind that the registered agent will typically be the first person to whom the state reaches out if any issues arise with your LLC. As a result, it is important to ensure that your registered agent consistently checks incoming correspondence and relays that information to you as the business owner. If you are not interested in being your own registered agent, consider using one or more commercial registered agents in your state to do the job. Generally, they perform their services fairly inexpensively.
  3. File documents. Perhaps the most important step in creating your LLC is filing the required documents. The articles of organization (referred to in some states as the certificate of formation or certificate of organization) are usually filed with the secretary of state and include such information as the company’s name, the registered agent’s name and address, and the business’s purpose. This information becomes public record, so be mindful of what information you are comfortable sharing with the world. Keep in mind that there is a fee to file these documents; however, any start-up costs and filing fees you incur are tax-deductible. 
  4. Get a tax identification number. Another essential step in starting an LLC is obtaining a Tax Identification Number. Your LLC’s Tax Identification Number, also known as an Employer Identification Number or EIN, is provided by the Internal Revenue Service (IRS). After completing a successful application, the IRS assigns a unique number that links the identity of the responsible party to the business for income tax purposes. 
  5. Open a business bank account. After you have filed your LLC’s formation documents with the state and obtained a Tax Identification Number, you will be ready to open a business checking account. This step must not be overlooked in order to enjoy the benefits of an LLC. Maintaining this separate business checking account prevents you from commingling your personal funds with the business’s funds. Failure to maintain this separate business account could result in losing the business’s limited liability status because of a legal concept called “piercing the veil.” If this happens, you could be held personally liable for the LLC’s debts and liabilities.
  6. Draft an operating agreement. Finally, to form an LLC, you must create an operating agreement. This document outlines the rules and regulations governing the LLC. Think of it as a contract or agreement between you and the other members of the LLC or between you and the LLC if you form a single-member LLC. In some states, business owners are required to file this document with the articles of organization. 

Once your LLC is formed, it is critical to remember and adhere to the compliance requirements to keep your LLC in good standing. These requirements vary by state but often involve some form of annual reporting. In most states, for example, Utah and Wyoming, you may also be required to pay an annual fee. Failure to comply with these requirements will result in the suspension of your LLC and put your personal assets at risk.

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