June 15, 2021
Top 10 LLC Operating Agreement Mistakes
Largely as a result of their flexibility, Limited Liability Companies (“LLCs”) account for the vast majority of newly formed business entities. The Operating Agreement of an LLC is the governing document and often only memorialization of LLC ownership. A well drafted and thought out Operating Agreement is worth its weight in gold. Not only can an Operating Agreement head off and resolve potential membership disputes, it can also protect the members from various tax and transfer issues.
#1 – Failing to draft one
All too frequently this document is ignored or parroted from an internet repository to disastrous effect. Much like fences make good neighbors, Operating Agreements make good partners and the lack of one can drive an LLC into the ground. Similar to a Will, if you fail to draft one, the state will dictate the terms of your business relationship, likely to everyone’s displeasure.
#2 – Failing to adequately address Management and deadlocks
Unlike a corporation, LLCs by default have no Board of Directors or Officers. Rather, much like a partnership, the default provisions in Georgia grant members the right to bind and manage the LLC. However, members may wish to appoint “Managers” of the LLC. A well drafted Operating Agreement will address who these Managers are, how they can be elected, removed and replaced and their duties, powers and compensation. Inherent in any LLC governed by an even number of Managers or Members (or where Members have veto authority over certain Manager actions) is the possibility for deadlock. The possibilities for breaking such a deadlock are endless but they will not be found in the default provisions of Georgia law and must be drafted into an Operating Agreement.
#3 - Failing to consider the resultant fiduciary duties and need for restrictive covenants
Closely related to Item 2, all parties must be aware that members in a Manager-managed LLC generally owe no fiduciary duties to the LLC or their fellow members. This can arise as a rude awakening in the form of members taking actions that are not in the best interest of the LLC. If this is a concern, an Operating Agreement must include restrictive covenants and other provisions which protect the LLC’s business interests.
#4 - Failing to adequately protect member rights in a Manager-Managed LLC
Typically arising in Manager-managed LLCs, it is imperative that any non-Manager member or minority owner take the time to ensure their interests are adequately protected by an Operating Agreement. Otherwise, a member can easily fall subject to various “minority squeeze out” techniques by controlling members or managers. These can range from the seemingly benign (lack of full rights to LLC records) to the patently unfair (oppressive actions resulting in ownership dilution).
#5 - Failing to address mandatory distributions
Closely related to Item 4 is the necessity for an Operating Agreement to set a formula for mandatory distributions to members. A failure to do so can be compounded if one member or his family is on the LLC payroll, to the exclusion of other members. Further, an LLC taxed as a partnership results in partners being subject to tax as income is earned by the partnership even in the absence of any distributions (referred to as “phantom income”). Accordingly, requiring mandatory tax distributions made on a regular basis can ensure members will not be holding a phantom tax bill with no cash to pay it.
#6 - Failing to adequately provide for transfer restrictions
Most people know that they want a “Buy-Sell” agreement. Broadly speaking, transfer restrictions are typically included in an Operating Agreement. They encompass both prohibitions on or requirements for transferring LLC ownership to third parties and triggers for buyout rights for other members and/or the LLC itself (eg: death, disability, retirement, etc.). These provisions can get complicated quickly and are highly dependent on the unique dynamic between any given LLC’s members. Perhaps more than any other type of provision found in an Operating Agreement, there is no “one size fits all” approach with transfer restrictions, as is often claimed by legal websites or form repositories.
#7 - Failing to draft the Operating Agreement to conform with tax elections
While a full discussion of the various tax elections and implications of operating an LLC is beyond the scope of this article, any Operating Agreement must be drafted taking into account the current and potential future tax elections of an LLC. With more than one member, LLCs are taxed by default as partnerships, requiring the filing of a Partnership Tax Return (Form 1065). However, many LLCs elect to be taxed as an S-Corporation (Form 1120S). The S-Corp tax election, in particular, is susceptible to being lost as a result of language contained in an Operating Agreement, with very negative effects for the LLC and its members.
#8 – Failing to Address Member Voting Power
Because LLCs are most akin to partnerships, the default Georgia law provides that each member (or, if management is vested in managers, each manager) shall have one vote, with decisions made by majority vote with respect to most matters. This can be a devastating outcome for a member who thought by being 51% owner of an LLC, they were in a position of power. In fact, a 1% owner of an LLC has an equal membership vote to a 99% owner if an Operating Agreement fails to properly address membership voting rights.
#9 - Failing to address distributions upon dissolution
Members may bring different contributions to an LLC in the nature of cash and “sweat,” resulting in equal capital accounts as memorialized in an Operating Agreement. Unless addressed properly, however, in the event of a dissolution these members may receive an equal distribution of the company assets, even if those assets consist entirely of the cash contributed by one member.
#10 - Failing to address BBA tax elections
A well drafted Operating Agreement must include language to address the new partnership audit regime introduced by the Bipartisan Budget Act of 2015, effective as of 2018. This Act imposes liability for federal income taxes directly on the partnership, regardless of any changes in ownership between the taxable year in which the partnership items arose and the taxable year in which the partnership items are adjusted. In short, unless the Operating Agreement is drafted appropriately, a member who was not in the LLC in a year under audit could be liable for the partnership’s previous tax liability.