LLC operating agreements.

With the growing popularity and use of limited liability companies (LLCs), many taxpayers are (or should be) focusing their attention on these entities' operating agreements. Because LLCs are relatively new, they do not have the benefit of the extensive legislative and judicial guidelines that exist for other entities. Therefore, operating agreements may be critical, since their provisions will determine whether key issues are properly addressed and the desired tax treatment achieved.

Since the existence and availability of LLCs are based on state law, states have also determined rules for their operations. Often, however, LLCs may establish their own rules and procedures, and the state provisions go into effect only if the LLC does not otherwise specifically address a circumstance or situation.

Note: While an LLC's articles of organization can include most (if not all) of the basic provisions of the LLC's operations, there may be reasons to restrict the articles to the minimum information required by law.

CONTENTS OF AN OPERATING AGREEMENT

Formation and capital. The first issue is the types of contributions LLC members can make. Generally members contribute cash, but the LLC may permit contributions of property, services or loan guarantees. The agreement should indicate whether noncash contributions will be allowed, set any limits on the amount of such contributions and provide a valuation method. In addition, the agreement should address whether the LLC permits or requires additional capital contributions and how to deal with members who cannot (or will not) make them.

Member voting rights should also be considered. While state laws generally provide for voting based on contributions, an agreement can base it on other means, such as capital balances or capital contributions.

Operational issues. Operational issues include management and economic issues.

The most basic management issue is whether the LLC will be managed by members or outside managers. Once that is determined, an agreement should address the specifics of this management, such as the consent needed for daily operations; the number of individuals on the management team, their compensation and enumerated duties; limits on the authority of the manager or member to bind the LLC; meetings procedures; indemnification for liabilities arising from the performance of duties; and any limits on self-dealing.

Economic relations among LLC members may be critical. Absent a provision to the contrary, income and losses will be allocated based on capital contributions; if some other method of allocation is to be used, it must be specified. Also very important are provisions on the rights and timing of distributions before liquidation, noncash distributions and distributions after a triggering event (such as a sale of assets).

Member relations. An agreement should address the level of consent needed to admit new members. Because state laws generally require unanimous consent, failure to specify. a lower level of consent can severely restrict an LLC's ability to admit new members. Also, most state laws grant members the unrestricted right to assign an LLC interest; if this right is to be restricted, that fact must be included. Similarly, a member's ability to withdraw or sell part of his or her LLC interest should be addressed. Ira right of first refusal or mandatory purchase of an interest by the LLC is to be provided, the specifics (that is, terms, length of payout and valuation method) should also be included.

Dissolution issues. Generally, state laws provide that an LLC will dissolve on the death of a member or on some other triggering events, but they allow continuation of the LLC by unanimous consent of the remaining members. To maintain an LLC, the operating agreement should specifically address the events that will result in termination and the level of member consent needed to continue the business.

For a thorough discussion of the information that should be included in these agreements, see "The Importance of a Well-Drafted LLC Operating Agreement," by Michael Mares, Stephen Pascarella, II, and Albert White, III, in the August 1996 issue of The Tax Adviser.

-- Nicholas Fiore, editor

The Tax Adviser

Editor's Note 

The material discussed provides general information. Before you take any action in this area, the appropriate code sections, regulations, cases and rulings should be examined.