The importance of a well-drafted LLC operating agreement.

Editor's note: Mr. Mares is currently vice chair of the AICPA Tax Division Tax Executive Committee. Mr. Pascarella chairs the Tax Division Tax Practice Management Committee. Mr. Mares and Mr. Pascarella are co-authors of Guide to Limited Liability Companies (Practitioners' Publishing Co., 1996).

Now that the business has elected to be a limited liability company (LLC), what happens next? The document that governs the day-to-day operation of LLCs, the Operating Agreement, controls such items as income and loss allocation, cash distributions, ability to make elections, and transferability of member interests. This article examines the range of subissues this instrument should also consider.

The increasing popularity of limited liability companies (LLCs) has focused attention on the importance of the LLC's Operating Agreement. Unlike corporations and partnerships, which both have extensive legislative and judicial guidelines, LLC case law is virtually nonexistent. Because an LLC must function in this uncertain environment, it is critical to draft an Operating Agreement that addresses key issues. Further, most state statutes provide significant flexibility in structuring an LLC, requiring the Operating Agreement to flesh out the statutory skeleton not only to meet the members' needs and desires, but also to ensure the desired tax treatment. Finally, the Operating Agreement must specifically address issues such as the admission of new members, dissolution and income allocation if the members want to avoid state law default provisions. While the creation of an Operating Agreement falls to the LLC's attorney, CPAs should not hesitate to provide input, because many of the provisions will affect both the members' tax liabilities and their economic relationships. For example, the Operating Agreement will control:

* Income and loss allocations.

* Cash distributions.

* Ability to make accounting and tax elections.

* Ability to sell or dispose of LLC interests.

Further, the CPA is often much more familiar with the business and can provide a better perspective on how the arrangement should be structured.

Contents of the Operating Agreement

While the Articles of Organization (Articles) can include most (if not all) of the basic provisions governing the LLC's operations, there are several reasons to restrict the Articles to the minimum information required by statute. The most obvious is that the Articles are public information, while the Operating Agreement is not. Including the various provisions in the Operating Agreement thus affords the members more privacy than if the terms were set out in the Articles. Amending the Articles may also be more difficult and expensive, because an additional recordation fee is normally charged.

Another problem arises if the LLC will conduct business in more than one state. Lengthy Articles may provide creditors and others with information not otherwise available under the laws of the state(s) in which the LLC will operate. Finally, most practitioners agree that the rapidly changing business environment in general, and the LLC area in particular, require constant monitoring and an ability to quickly and frequently change basic relationships among the members, a difficult task if the Articles must constantly be amended or restated.

Generally, the Operating Agreement should address four major areas:

1. Formation and capital.

2. Operations.

3. Member relations.

4. Dissolution.

Of course, each of these categories contains a number of subissues, but it is helpful to keep these four major areas in mind in developing or reviewing an Operating Agreement. Normally, the overriding consideration in drafting the Operating Agreement is to ensure that the LLC will be accorded partnership status; to achieve this, the LLC must lack at least two of the Regs. Sec. 301.7701 corporate characteristics of limited liability, centralized management, free transferability of interests and continuity of life. While a discussion of how to fail these tests is beyond the scope of this article, Rev. Proc. 95-10(1) sets forth the criteria the IRS uses in ruling on whether a particular LLC will be classified as a partnership for Federal tax purposes. Most state statutes have default provisions that generally provide that the LLC lacks all corporate characteristics except limited liability. Because the LLC must lack only two of the four corporate characteristics, the members can decide which corporate characteristics the LLC should have, and the Operating Agreement can then be tailored to meet these requirements.

Hopefully, the final "check-the-box" regulations will eliminate these often confusing requirements. Essentially, the proposed regulations(2) provide partnership tax treatment to noncorporate business entities, a simple and welcome set of rules.

Formation Issues

At first blush, formation issues appear to be the easiest to address. However, capital requirements, the types of capital contributions permitted, the need for additional capital and members' voting rights can prove to be very thorny issues, which, if overlooked, can lead to expensive controversy later. Not all of these issues may be present in every LLC, but each should be considered in drafting the Operating Agreement.

Capital Contributions

The first issue is the types of contributions the members can make. Generally, members will contribute cash, but the LLC can permit contributions of property, services or loan guarantees. The Operating Agreement should indicate whether a member will be permitted to make noncash contributions, establish any limits on the amount of such contributions and provide a method of valuing those contributions. While an independent appraisal is probably the simplest way to establish value, it is also the most expensive; thus, the LLC may want to adopt alternative valuation methods, including a simple provision that the members may establish a value with all of the members' consent. This may be very useful when services are to be contributed, because the valuation of services is often difficult. Valuation controversies can be problematic because the "fair market value" of any property (other than cash and listed securities) can often be difficult to determine. In fact, it is common to have appraisers for different sides of a controversy with substantially different opinions on what the disputed value should be. A clearly stated process for valuing property contributed to the LLC can eliminate these problems.

Valuation of contributed property is particularly important when there is unrecognized gain at the time the property is contributed. Under Sec. 704(c), the pre-contribution gain must be allocated to the contributing partner. There can also be a tax cost to certain distributions of contributed property. If the LLC permits noncash contributions, provision also needs to be made for assumption of related liabilities; alternatively, the LLC can also require that all contributions be in cash.

Other capital issues that should be addressed by the Operating Agreement are whether the LLC should permit or require additional capital contributions and how to deal with members who cannot or will not make required additional contributions. Because most state statutes permit great flexibility in an LLC's capital structure, the penalty for failing to make a required contribution can range from interest on the deficiency to a loss of distributions to a loss of the member's LLC interest. The Operating Agreement should also provide any time limits (e.g., 90 days) on making capital contributions, and address whether any right to make additional contributions is cumulative.

Voting Rights

A second issue is member voting rights. While state statutes generally provide for voting based on contributions, the Operating Agreement can provide for voting based on capital balances, contributions or other means. However, if the method of voting is based on capital contributions or the capital balance, the Operating Agreement should provide a date for determining the contributions made or the capital balance. This prevents a member from making a large contribution shortly before a vote, thereby increasing his voting power. Many LLCs have elected to establish voting rights based on outstanding capital at the beginning of the year; this eliminates the effect of contributions, distributions and extraordinary events occurring during the year.

A final formation issue is whether there are any statutory default provisions that need to be modified to meet the members' needs. If so, those provisions should be considered in drafting the Operating Agreement.

Operational Issues

Many operational issues need to be considered in drafting the LLC's Operating Agreement. These can be roughly divided into two main areas: management issues and economic issues. Management issues deal with how the members (or managers) handle daily operations; economic issues deal with the LLC's income, cash flow and business aspects.

The most fundamental management issue is whether the LLC will be managed by managers or by members. If the LLC is to have managers, the first consideration is the limits (if any) to place on the manager's authority and the penalties that will be imposed if that authority is exceeded. Can managers (without member consent) sell assets outside the ordinary course of business, incur large debts, merge or consolidate the LLC or engage in similar transactions? Additional considerations include whether nonmembers can be managers, the number of managers, their terms and the initial designation of managers. Provisions must also be included for removing managers (whether for cause or otherwise) and for replacing them by election. The procedural aspects of management by managers must also be considered, including meeting notice requirements, content and frequency of meetings, how decisions are made (e.g., majority rule) and whether greater levels of consent (e.g., two-thirds majority) are needed for extraordinary transactions. The Operating Agreement should also authorize manager compensation and fringe benefits, if the managers are to be paid annual compensation, as well as providing a process for determining annual compensation. Enumerated duties of the managers to the members should also be included, such as the requirement to maintain adequate books and records, limits on self-dealing, the requirement to keep members informed about LLC affairs and the standard of care owed to the LLC.

The Operating Agreement should address whether managers will be indemnified for any liability arising out of the performance of their duties, and the limits (if any) that will be placed on such indemnification. The members should also consider providing the managers with a power of attorney to execute documents on the LLC's behalf, provided that the managers do so within the scope of their authority. Clearly, the members and their advisers need a good understanding of how the LLC will operate to draft this part of the Operating Agreement.

Many of these same issues need to be addressed if the LLC will be member-managed. Issues include the consent needed for daily operations, the need for special consent (e.g., two-thirds majority) for extraordinary events, members' compensation, limits on individual members' authority to bind the LLC, notice of meetings and other meeting procedures, indemnification of member actions and limits (if any) on self-dealing. In addition, the Operating Agreement needs to provide specific guidance on member relations, including any requirement for good-faith dealing by majority members toward minority members, as well as rules for member admission, termination and assignments of interest. This is often a controversial section, because the members' personal wishes can be contradictory.

Member Issues

The member relations provisions in the Operating Agreement should address the level of consent needed to admit a new member. Because state statutes generally require unanimous consent, failure to provide a lower level of consent (e.g., a simple majority) can severely restrict the LLC's ability to admit new members. Also, most state statutes grant a member an unrestricted right to assign an LLC interest, absent a prohibition in the Operating Agreement. If a restriction is desired, it must be so included. Other issues should also be considered, such as the LLC's right to withold distributions from the assignee to fund future capital calls or the assignor's unpaid capital contributions, any limits on the rights of assignee creditors, and any limits on the assignee's management rights.

Can a member withdraw or sell part or all of his LLC interest? Many small LLCs want to preclude or severely restrict a member's ability to sell or otherwise transfer an interest in the business. Again, most state statutes permit unrestricted transfers, so that any prohibitions must be included in the Operating Agreement. If a right of first refusal or a mandatory purchase of an LLC interest is provided for, the Operating Agreement should specify the terms and length of payout, a method for valuing the interest and procedures to determine what a "bona fide offer" is.

Economic Issues

While management and formation provisions are certainly crucial, neither can create as many problems as the provisions governing economic relations among members. Thus, provisions governing the allocations of income and loss, distributions and sales of member interests should be thoroughly discussed and included in the Operating Agreement. Because state law varies on the members' rights to distributions prior to liquidation, this is probably one of the first issues to be discussed; the next issue should be the allocation of income and loss to members. Most state statutes provide that, absent a different provision in the Operating Agreement, income and losses will be allocated based on capital contributions. Both the allocation of income or loss and the rights and timing of distributions must be addressed in the Operating Agreement to avoid application of the statutory default provisions and some other significant member problems. Of course, the allocations must meet the requirements of Sec. 704(b) to be valid for income tax purposes. The Operating Agreement should also address whether noncash distributions will be made after a triggering event (e.g., a sale of assets).

The Operating Agreement should also cover member economic issues, such as whether interest is to be paid on capital contributions, whether members have the status as creditors after a distribution has been declared, the responsibility (if any) of a member to return a distribution that renders the LLC insolvent and the compensation that can be paid to members for providing services to the LLC.

In addition to ensuring that the LLC is classified as a partnership, the Operating Agreement can include other economic provisions that create great tax flexibility for the LLC and its members. First, and most importantly, the LLC should be given the authority to make any appropriate tax election, such as an optional step-up in basis under Sec. 754. The LLC should also be able to make any tax election with less-than-unanimous consent, which may not be the case absent a specific provision in the Operating Agreement. Further, the LLC should consider restricting a member's ability to transfer an interest if such transfer would result in termination of the LLC under Sec. 708(b). Of course, the Operating Agreement should appoint a Tax Matters Partner, if appropriate.

Dissolution

Dissolution is the final phase of an LLC's life. Because continuity of life is a concern, the LLC should have an expiration date, if not already included in the Articles; however, an expiration date alone does not mean that the LLC has failed the continuity-of-life test. Generally, state statutes provide that the LLC will dissolve on the death of a member and on the happening of various other events, but the LLC may continue by unanimous consent of the members. The Operating Agreement should specifically address the events that will result in termination, and the level of member consent necessary to continue the business. A requirement for unanimous consent to continue the LLC may make it very difficult to operate after one of the dissolution events occurs, and provides an opportunity for a minority member to block continuance until special concessions are made. If continuity of life is one of the tests the LLC must fail to be classified as a partnership, steps must be taken to include enough dissolution events to meet the IRS requirements. The Operating Agreement should also provide dissolution procedures and priority of distributions on liquidation, including a requirement for a full accounting of the dissolution.

Conclusion

Various other issues should be considered in drafting an Operating Agreement. These deal with a variety of potential problems, and include the consent needed to amend the Operating Agreement; the extent of a member's right to inspect the LLC's books and records; required recordkeeping; a member's right to demand a full accounting and how the costs of such accounting are to be allocated; whether controversies arising out of the agreement should be settled by binding arbitration and which state's law will control the interpretation of the Operating Agreement. It is also useful to specify which court will decide a controversy arising from the Operating Agreement.

A carefully thought-out and well-drafted Operating Agreement can significantly reduce the risk that the LLC will have to rely on the default provisions of the state LLC statute. The Operating Agreement also clearly sets out the agreement among the members, which reduces the likelihood of a time-consuming and expensive misunderstanding. All in all, a well-written Operating Agreement is worth a pound of cure.

(1) Rev. Proc. 95-10, 1995-1 CB 501.

(2) PS-43-95 (5/9/96).