Top 7 Provisions to Understand in Your LLC Operating Agreement
As mentioned in other articles, LLC’s are governed by Operating Agreements. This article is based on the assumption that the LLC has two or more members and that it is treated as a partnership for federal income tax purposes (meaning that it has not elected to be taxed as a corporation). You should always read and understand all of the provisions of your Operating Agreement as well as your state’s LLC Act, but below is a list of some of the most important provisions:
- Authority of the Manager: The provision designating your LLC’s manager is critical as it specifies who will manage the day to day affairs of the LLC. It is also critical to understand whether there are any restrictions on the authority of the manager, such as provisions requiring that the manager be authorized by the members or specific combinations of members to do certain things (incur debt, make distributions, etc.).
- Voting: It is critical that you understand whether there are multiple classes of LLC interests and which classes have voting rights. Do the members have certain protective provisions limiting the manager’s authority? What vote is required to compel a distribution or to sell the assets of the LLC? You will want to understand the voting structure before investing in any LLC.
- Allocations of Profits and Losses. LLC’s are not necessarily owned equally by their members. One member may have a higher or lower percentage interest than another member. Profits and losses are generally allocated in accordance with these percentage interests, but there are variations. These allocations will determine the tax consequences of your ownership of the LLC and also impact your right to receive distributions in the future.
- Capital Accounts: Your percentage interest dictates what percent of future profits and losses you are entitled to, but your capital account is an indicator of your “equity” interest in the LLC. It is originally equal to your initial investment in the LLC and is subsequently adjusted to reflect allocations of profit and loss, distributions and additional contributions.
- Special Allocations: This is probably the most misunderstood aspect of LLC Operating Agreements and partnership taxation. Most LLC Operating Agreements provide for special allocations and their members (and their attorneys often) are not even aware of it. The full scope of special allocations are beyond the scope of this article, but the most common examples include situations where: (i) members have percentage interests disproportionate to their initial investment in the LLC; (ii) investors purchase an interest in an LLC and demand economic preferences such as preferred distributions or liquidation preferences; and (iii) members are not required to restore deficit (aka negative) capital accounts. For these special allocations to be upheld by the IRS, they must have substantial economic effect! The law on point is incredibly complex, but in layman terms, this means the tax obligations must follow the dollars! In other words, LLC’s can’t be used as tax shelters to allocate profit or loss one way and then distribute the cash elsewhere. The best way to ensure that your special allocations will be upheld by the IRS is to cause them to have substantial economic effect by including certain regulatory and curative allocations in your Operating Agreement. For this reason, you should never trust an attorney who does not specialize in partnership taxation to draft your LLC Operating Agreement!
- Transfer Restrictions: Most LLC Operating Agreements restrict the right of members to transfer their interests to third parties. There are often exceptions for bona fide estate planning transfers, such as gifts (or transfers at death) to a spouse or children. The primary reason for these restrictions is that LLC’s are typically small businesses and the members want to control who they are in business with. These restrictions are typically accomplished by rights of first refusal for the LLC and/or the other members.
- Liquidation: When a business has run its course and the members are ready to dissolve the legal entity, the final step is to liquidate. Operating Agreements typically provide for the assets of an LLC to be distributed as follows: (i) first to pay the LLC’s liabilities; (ii) second to set aside reserves for foreseeable liabilities such as final accounting and legal fees; (iii) to the members in accordance with their capital accounts; and (iv) to the members in accordance with their percentage interests. This means that members receive their capital account balance back before any funds are distributed in accordance with percentage interests. Keep in mind that LLC’s that purport not to liquidate first in accordance with capital accounts will generally be deemed to have allocations which lack substantial economic effect!