LLCsOperating agreements

LLC Timebombs: Have you read your Operating Agreement lately?

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Potential clients often ask me, “why do I need a lawyer if an LLC is so easy to form?” Sure, it doesn’t take much effort to log on to the Secretary of State’s website, but there is much more to LLC formation than just putting your name into a form and paying $125. An LLC operating agreement is supposed to be a nuanced document that reflects the agreement of the members doing business together. An operating agreement is a contract between partners that describes the nature of their relationship, their duties to each other, and what happens when the LLC folds up. These issues don’t seem important when the LLC is started, but they can become very big problems when the partners’ relationship gets contentious.

Related: The Emporer Has No Clothes: The LLC Without an Operating Agreement

My advice is this: a business partnership is like a marriage. Prepare for divorce, because it happens often. Think of the operating agreement like a prenuptial agreement, with detailed statements as to what will happen in certain situations.

I see the same mistakes made in operating agreements over and over again. Most of the time, they’re not appropriate for the relationship the partners intend.

Let me stress that if you do not have an operating agreement, the state’s statutory defaults will apply to you. These defaults might cause just the same problems as are detailed below. I will say that it is common in Ohio.

Here are just a few fatal flaws that I often see:

1. Does the agreement accurately state your ownership percentage?

Most form operating agreements state that ownership percentages should be in proportion to capital accounts or contributions. This becomes a big problem when a money partner and a service partner decide to do a 50/50 split, but the service partner contributes nothing. In order to make the books work properly, one has to assume that the partners agreed that the service partner’s contribution is services, and the services are worth the same amount as the money partner’s contribution. You just created an unpaid tax liability for the service partner – as a contribution of services is counted as income to that partner.

2. Does your agreement require distributions for tax payments?

Most form agreements require the LLC to distribute enough money to cover the members’ federal and state taxes, taxable at the highest marginal rate. This can be significantly higher than the members’ actual tax payment and account for more than 40% of the LLC’s income for that year. If you are required to make the distribution but you didn’t, a disgruntled member may be able to sue you or the LLC for breach of duty.

3. Do you owe a duty not to compete with the LLC or your partners?
This is a big one that I see often. Statutory default rules in Ohio for LLCs require that a member (1) not to compete with the LLC, and (2) to present business opportunities to the LLC before acting upon them personally. This can create huge problems for the real estate JV¬†LLC, where most partners actively “compete” in the real estate market by buying property on their own. Don’t inadvertently tie yourself to your new partner by failing to address this issue.

4. Does your LLC dissolve when all the members resign, die or become disabled?

Many form agreements provide for the dissolution of an LLC with no members. They also provide for the automatic removal of dead or disabled members, as this is a safeguard against having an “unwanted” party take control of the LLC contrary to the agreement. The peculiar result of failing to plan for this contingency is the dissolution of an LLC, since many state statutes prohibit an LLC from existing with no members. There has to be some kind of check or safeguard for the continuing existence of the LLC.

5. Do you have a way to buy out a partner or sell your interest?

There is usually no statutory default rule for splitting up an LLC aside from court action. I always recommend that any multi-member LLC execute a buy-sell agreement alongside the operating agreement. This document provides for a mechanism for buying out, or selling to, the other partner or partners in case one partner wants to cash out. Several methods are available, namely, the appraisal method, the three-appraisal method, the “Texas Shoot-out”, “Dutch Auction,” “Russian Roulette,” or the second-price auction method.