LLC Operating Agreement FAQ
- What is a Limited Liability Company and what is an Operating Agreement
- Unanimous Consent of Members
Q. What is a Limited Liability Company (LLC)?
A. A limited liability company (LLC) is a business entity that enjoys the attractive features of both a partnership and a corporation. It is similar to a corporation in that the liability exposure of individual members is limited to what each member has invested in the business. In addition, an LLC can be structured to be taxed only at one level, similar to a partnership. Like a partnership, income passes through and is taxed against individual members as personal income. The exact tax implications of an LLC will vary between jurisdictions. You should consult a tax professional if you are uncertain how to proceed. An LLC can be managed by members or by a management team.
Q. What is an Operating Agreement?
A. An Operating Agreement is an agreement between the Members (owners) of a Limited Liability Company. The Operating Agreement governs the operation of the LLC and defines the rights and obligations of the Members to each other and to the LLC. It is similar in function to a Partnership Agreement. The LLC Operating Agreement is not the document you file when creating an LLC. The filing document for an LLC is called the Articles of Organization.
Q. Why should I choose an LLC Operating Agreement instead of a Partnership Agreement for my LLC?
A. In a General Partnership, each Partner is liable for all debts and obligations of the Partnership. If one or more of the remaining Partners are unable to meet their obligations to the Partnership then a single Partner could be liable for the full debts of the Partnership. In the case of an LLC, each Member has limited liability and is protected in a similar manner to the shareholders in a corporation. In general, an LLC would not want to create and distribute ambiguous or misleading documents (such as a General Partnership Agreement) that could potentially be used to defeat the limited liability characteristics of the LLC.
Q. What is the difference between a Partnership and an LLC?
A. An LLC can be structured to be taxed in the same manner as a partnership however the owners or partners of a partnership are jointly and severally liable for the debts and obligations of the partnership. This means that if the other partners are unable to meet their obligations to the partnership then each partner could be potentially responsible for the full amount of the debts and obligations of the partnership. In contrast to a partnership, the liability of the owners or members of an LLC is limited to the amount of capital investment each member has contributed.
Q. How are Limited Liability Companies created?
A. A limited liability company must be registered in the relevant jurisdiction. This is accomplished by preparing and filing a document called the Articles of Organization. The Articles of Organization must conform with the reporting requirements of the jurisdiction. The operating agreement is a separate document and is an agreement between the owners of the LLC. The operating agreement outlines the terms under which the owners will interact as members of the LLC. The operating agreement does not have to be filed with the governing jurisdiction.
Q. How does a Limited Liability Company end?
A. The parties can expressly agree that a LLC will end at a specified date, or upon completion of certain tasks. Absent an agreement to the contrary, members of an LLC can make a written submission to the other members to have themselves withdrawn from the LLC. An operating agreement should protect the LLC and the remaining members from the withdrawal of an essential member. If the voluntary withdrawal of a member offends a term of the operating agreement then the withdrawing Member may be liable for any damages suffered by the LLC or remaining members.
Q. How is an LLC managed?
A. An LLC can be managed by the Members (the owners) or by one or more managers hired for that purpose. The type of management will be identified in the Operating Agreement.
Q. Who are the "Members" of the LLC?
A. The Members are the actual owners of the LLC. They will provide capital, assets or a primary service to the LLC and in exchange will receive an ownership interest in the company.
Q. Why would the LLC want an initial period of prohibition on withdrawal?
A. Members of the LLC have a duty to function in the best interest of the LLC and of each other. By enforcing a prohibition on withdrawal, individuals will be motivated to take their responsibility as a member seriously and commit to at least a minimum period with the LLC. The other Members can then feel comfortable relying on the commitment of their fellow Members to the purpose and goals of the LLC.
Q. What is the "Cash" method of accounting?
A. The "Cash" method of accounting is a method of recording earnings and expenses only upon receipt or payment without regard to when they occurred or were incurred.
Q. What is the "Accrual" method of accounting?
A. The "Accrual" method of accounting is a method of recording earnings and expenses as they occur or are incurred, without regard to the actual date of collection or payment.
Q. What is a disregarded entity?
A. For tax purposes Disregarded Entity status is available to an LLC where there is only one Member. An LLC that is classified as Disregarded Entity will be taxed in the same manner as a sole proprietorship. If an LLC has a single Member they will be treated as a Disregarded Entity by default. If an LLC has two or more Members it will be treated as a Partnership by default. In order to change the classification of the LLC for tax purposes, form 8832 will need to be filed along with the federal income tax return. Note: Statutes and Regulations change frequently. Consult Internal Revenue Services for the most current requirement. For specific information on the benefits and detriments of each system of taxation, it is recommended you contact a tax lawyer in your area or qualified tax accountant.
Q. Why would the LLC require unanimous consent on some conditions but not others?
A. In general, business decisions will be resolved by a majority vote of the members. However where the impact on individual members will be significant, the company may wish to resolve these decisions through a unanimous vote in order to protect the interests of individual members. The members may want to require unanimous consent for areas that are deemed critical to the success of the LLC, such as hiring/firing of employees or things that will affect the interests of all existing members and their stake in the enterprise such as bringing on a new member or acquiring or selling company assets or assuming substantial company debt.
Q. Under the section "Actions that require Unanimous Consent of the Members", what is meant by the option "Assignment of ownership rights of Company Property"?
A. In order to protect the interests of all members from unauthorized behavior involving company property, the members may want to enhance the control over the use and disposition of company property by requiring unanimous consent on issues involving the use and assignment of property rights in company property.
Q. Under the section "Actions Requiring Unanimous Consent of the Members", what is meant by the option "Incurring Company liabilities over a fixed dollar amount"?
A. Where expansion of the LLC requires a significant financial investment involving a large debt load, the interests of all members must be considered before proceeding with that risk. Where the risk is great, the company may wish to protect the interests of individual members in the operating agreement. Within the operating agreement the members can agree what level of liability (dollar amount) is acceptable. Any liability over that amount would require the unanimous consent of all members. Any liability under that amount would only require the consent of a majority of the members.
Q. Under the section "Actions Requiring Unanimous Consent of the Members", what is meant by the option "Incurring single transaction expenditures over a fixed amount"?
A. To protect the interests of all members, the unanimous consent of all members may be required when making substantial purchases.
Q. Under the section "Actions Requiring Unanimous Consent of the Members", what is meant by the option "Sale of any Company asset with fair market value greater than a fixed amount"?
A. Sale of significant Company assets should require the unanimous consent of all members so that the interests of all members are protected. An individual member cannot sell or otherwise dispose of Company property. This option includes the situation where an individual member cannot use Company property as collateral for a loan (either a personal loan or a Company loan) without the majority or unanimous consent of the remaining Members where the property could be subject to seizure if the loan was in default. Ensure the fixed amount selected is practical for the size of the Company. It may be an unnecessary administrative burden to require unanimous approval for the sale of nominal assets.
Q. Under the section "Actions Requiring Unanimous Consent of the Members", what is meant by the option "Releasing any Company claim except for full consideration"?
A. Where the Company has a claim against another person or business entity or where a debt is owed to the Company it is in the best interest of the Company and the individual members if these obligations owed to the Company are paid in full. Whenever an obligation is to be released for less than full consideration it is important that the interests of each member is represented and each member is allowed to provide or reasonably withhold consent to the transaction.
Q. Under the section "Actions Requiring Unanimous Consent of the Members", what is meant by the option "Endangering the ownership or possession of Company property"?
A. Individual members do not have property rights in Company property. Where Company assets are put at risk, either by loaning to a third party or by placing the asset in an environment where the asset is subjected to theft or loss, the interest of all Members is affected. In these situations the Company may wish to require the unanimous consent of all members.
Q. What is the Principal Office Address?
A. The principal office is where the main office of the Company. The Principal Office does not have to be located in the same state as the state that the Company is being formed in. The principal office address is also not required to be the same as the Registered Office. The principal office address is not necessarily the same as the Place of Business, which is the location where the Company's commercial transactions mostly occur.
Q. Are witnesses required to sign the Operating Agreement?
A. Most documents and contracts do NOT require a witness for them to be legally valid. Many banks and other institutions have their own policies about signing requirements, and may refuse to accept documents that are not notarized regardless of their legal sufficiency. If you want to avoid bureaucratic hold-ups, it may be a good idea to take your document to a Notary Public or have it witnessed.
Q. Why should I use mediation and arbitration instead of going to court?
A. Mediation and arbitration are superior processes when there is a long term relationship involved and the survival of the LLC is desirable. They focus on creating a mutually agreeable solution to a problem instead of the adversarial environment of a court confrontation. In addition to this, the process can be less expensive, and more expedient and efficient than the court process.