GPSolo Magazine - September 2005
LLC Operating Agreements: Drafting Tips and Traps for the Unwary
Most law firms have a basic “form” operating agreement that was either acquired from a form manual or that one of the partners painstakingly drafted from scratch back when LLCs were first authorized under state law. But has anyone taken the time to update the form? In several states there have been significant changes in statutory law during the last several years in the LLC arena.
Ownership defined. Many “form” operating agreements define ownership in terms of relative capital account balances. Although this may be an acceptable method in some circumstances, structuring ownership as a definition of capital accounts should generally be avoided. Consider the following example. A and B form an LLC, each contributing $10,000 for a 50 percent interest. The LLC buys an asset for $20,000. Assume it produces little or no income and has generated few expenses. After five years, the asset has appreciated to $100,000. A and B now wish to admit C for a one-third interest, perhaps to help develop the land, with A and B each retaining a one-third interest. (Remember, assume A and B still have capital account balances of $10,000 each.) What amount should C contribute? If C contributes $10,000, then A, B, and C each will have a $10,000 capital account balance and each will own a one-third interest. The result is incredibly good for C: He has contributed only $10,000 and received a one-third interest in a $100,000 asset.
This problem can usually be remedied by defining ownership in terms of percentage ownership, largely ignoring capital accounts for ownership purposes. So long as allocations and distributions are made in accordance with ownership interests and liquidating distributions are made first in accordance with positive capital account balances, the allocations should still have “substantial economic effect,” a requirement under the Code § 704 regulations.
Quorum and voting. Quorum is an issue that should be given more than mere passing consideration, especially if the LLC operating agreement involves a number of individuals with minority interests. All too often the basic form provision requires a quorum of 100 percent of the members. What happens when there is a dispute? A disgruntled member who is quick-witted and realizes what the provision does will simply not allow a quorum to be established, effectively locking down the operation of the company and perhaps forcing a judicial dissolution. At the same time, a quorum of too few members can be equally problematic, unless the “manner of acting” provisions are also tightly drawn to prohibit a minority of owners from establishing quorum and then acting on behalf of the company.
One alternative is to provide for a quorum at some amount between 51 percent and 80 percent. In that case, the “manner of acting” provision should provide for action by members holding at least 51 percent of all membership (voting) interests.
Buyouts: Right of first refusal and put provisions. Most LLC operating agreements have a basic “right of first refusal” (ROFR) provision. It is often advisable to add a “put” provision that guarantees that a severance of ownership can and will occur if an irreconcilable dispute arises.
The ROFR provision provides that if any member receives an offer from a prospective third-party purchaser to buy any portion of his or her membership interest, he or she must first offer that interest to the remaining members on the same terms and conditions as received from the third-party purchaser. The remaining members then have a set time period in which to determine whether to exercise their right of first refusal and purchase the selling member’s interest or allow the sale to go through to a third party.
The “put” is a fallback provision when a member has not received an offer from a third party yet wishes to either (1) sell his or her interest to the remaining members or (2) purchase all of the remaining members’ interests. A put provision is merely a fallback provision when no other agreement can be reached to settle a severance of ownership amicably. In a forced-out provision, any member of an LLC may be bought out by affirmative vote of some percentage of the remaining members.
What happens at the death of a member? One option is to provide for authorized transfers to defined “permitted transferees.” Under this option, a member has an absolute right to transfer his or her interest to the permitted transferees without triggering the ROFR provisions. A second option is to give the LLC itself or the other members a limited window of opportunity in which to elect to exercise a right of first refusal. If not exercised, the transferee could either become a substitute member or merely an economic interest holder. Another option is to require repurchase at the death of a member.
Day-to-day management, authority, limitations. An LLC can be either (1) member-managed or (2) manager-managed, reserving to the members collectively only certain decision-making rights. If a management committee is appointed, care should be taken to provide for appointment of successors, terms of office, and procedures for resignation and removal. In addition, a properly drafted operating agreement should clearly set forth both quorum and voting procedures not only for members but also for managers. Any limitations on the authority of the managers and the members should be both addressed in the operating agreement and recited in the articles to be effective against third parties.
LLCs used for estate planning — drafting around Hackl concerns. Beware Hackl. In 2002, the Tax Court issued the opinion Hackl v. Commissioner, which has caused much concern among estate planners. In Hackl, the family patriarch established an LLC with significant amounts of timberland. He subsequently made numerous annual exclusion gifts over several years. The IRS challenged the gifts and their valuations, resulting in significant tax. Some key provisions of the operating agreement, as focused on by the IRS, included:
- a family patriarch appointed manager for life, with 80 percent vote required for removal;
- a manager who had no fiduciary duty to the other members;
- distributions that were in the sole discretion of the manager; and
- very limited transferability without manager approval.
In addition, the LLC had significant losses and was expected to continue in the red for several years. The IRS determined the provisions of the operating agreement, coupled with the losses, meant that there was no “present interest.” The Tax Court agreed.
How does one avoid a Hackl-type argument? Several steps can be taken:
1. Do not appoint a manager for life. If sole authority has to be vested in a senior generation family member, provide a reasonable mechanism whereby the other members may remove the manager, preferably by majority vote.
2. Include recitals of fiduciary duties to the other members.
3. Ideally, provide members with an unrestricted right to withdraw, although this runs contrary to many estate-planning goals. Alternatively, consider requiring distributions quarterly or annually, at least in an amount sufficient to cover tax liabilities for pass-through income on the members’ K-1s.
4. Provide for some transferability of interests.
Notwithstanding the foregoing, it is important to bear in mind the client’s specific estate-planning purposes while drafting the agreement.
Bradley R. Coppedge is a member of Hatcher, Stubbs, Land, Hollis & Rothschild, LLP, in Columbus, Georgia. He can be reached at email@example.com.
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