The Basics on Operating Agreements
Operating Agreements structure the internal financial and functional operations of a limited liability company (LLC).
An LLC is an independent legal entity that acts as a hybrid between a partnership and a corporation with many of the management and tax options of a partnership and the limited liability of a corporation. The owners of an LLC are called “members” and the LLC can either be member-managed similar to a partnership, in which all of the members contribute to the management of the LLC, or manager-managed, similar to a limited partnership or corporation in which only certain members or outside entities manage the LLC. Under California’s Revised Uniform Limited Liability Company (RULLCA), the default management structure, unless otherwise specified in the articles of organization, is member-managed. Unlike a partnership, an LLC cannot be formed without official state action—the organizer(s) of the LLC must file articles of organization on the form provided by and to the California Secretary of State.
Most LLCs can opt to be taxed by the IRS either as a partnership or corporation, depending on the number of members and the elections that the LLC makes. A sole-member LLC can even elect to be taxed as part of the owner’s own personal tax return as a “disregarded entity”.
Unlike a general partnership, creditors of an LLC generally cannot reach the personal assets of its members to satisfy the debts of the LLC, and an LLC can declare bankruptcy independent of its members. However, members may lose the benefit of limited liability if the LLC’s legal form have not been respected, such as by members 1) treating the LLC assets as their personal property, 2) failing to respect and adhere to legal formalities, 3) commingling their funds with those of the LLC, 4) committing fraud by intentionally undercapitalizing the LLC, 5) making sizeable monetary distributions to themselves rather than paying off creditors, and 6) otherwise treating the LLC as an alterego for its members.
The primary disadvantages of an LLC over other business forms are (1) California LLCs must pay an annual minimum franchise tax of $800 and LLCs with more than $250,000 in gross revenue must pay an additional gross receipts tax of at least $900, (2) sometimes the LLC structure’s relative informality and flexibility as compared to corporations encourages members to disregard the formal separation required to maintain the protection of limited liability and (3) there is less case law applying law to LLCs as opposed to corporations, which can increase uncertainty and the possibility of litigation between members. This final disadvantage makes it especially important for members of an LLC to execute an Operating Agreement, so that they can define their own rights vis-á-vis the LLC and do not rely upon the RULLCA to set the internal rules of their LLC for them.
Protect your LLC with an operating agreement
The internet abounds with countless instances in which business arrangements have come to an end as the result of disagreements, particularly when friends or family members are both owners of a business, whether it is a partnership, a limited liability company, or a corporation. Even when all parties have the best intentions, owning and/or managing a business with a friend or family member can become unexpectedly complicated and lead to disagreements that can be exceedingly difficult to resolve without the proper framework in place.
For instance, let’s say you start an LLC with a close friend in which you both own 50% of the company and agree to split distributions 50/50 because each of you plan to work an equal number of hours on behalf of the business. Due to unforeseen circumstances, your friend only performs minimal work for the business and decides that he has no interest in working any additional hours in the foreseeable future but still asserts his entitlement to his share of the distributions, which you both agreed, in writing or verbally, to split 50/50. Given your friend’s reduced hours commitment, you may feel unsatisfied and seek a change, which could put a strain on the non-business side of your relationship.
All of the potential stress and damage to the friendship caused by the above scenario can be solved in large part by executing an operating agreement that directly ties how much time and effort each person contributes to working in the business to the distribution allocation. A well-conceived operating agreement will also address each owner’s responsibilities, how much capital each person contributes, what happens when an owner leaves the business or dies, and what happens if the business needs additional capital, among other factors.
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