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. LLC formation services
- 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.