Thursday, December 11, 2008

Selling An Interest In A Missouri LLC

Question: Can I sell my interest in a Missouri LLC that does not have a signed written operating agreement? I am an equal 1/3 member in the LLC. Do I need approval from the other members? Dan.
Below are relevant provisions from the Missouri LLC Act.
Mo. Stat. §347.115. Interest in company is personal property, assignability. 1. The interest of a member in a limited liability company is personal property and, except as provided in the operating agreement, may be assigned in whole or in part. An assignment of an interest does not entitle the assignee to participate in the management of the business and affairs of the limited liability company or to become or to exercise the rights of a member, except as provided in section 347.113. An assignee that has not become a member shall only be entitled to receive, to the extent assigned, the share of distributions and profits, including distributions representing the return of contributions, to which the assignor would otherwise be entitled with respect to the assigned interest. * * *

Mo. Stat. §347.113. Members--additional members. 1. A person is a member at the time the limited liability company is formed if such person is identified as a member in and signs, in person or by an attorney in fact, or otherwise becomes a party to the operating agreement.

2. A person may be admitted as an additional member by signing, in person or by an attorney in fact, or otherwise becoming a party to the operating agreement and by complying with the applicable terms and conditions of the operating agreement or, if the operating agreement does not so provide, upon the written consent of all members; or in the case of an assignee of the interest of a member who has the power, as provided in the operating agreement, to grant the assignee the right to become a member, upon the exercise of that power in compliance with any conditions limiting the exercise thereof.
Sorry Dan but it does not look good. Can you sell your LLC interest? This appears to be the case under Mo. Stat. §347.115. Note: a sale is within the meaning of the term assignment. The more important question is whether the buyer of your LLC interest can become a member of the LLC. As I read Section 347.113, unless the operating agreement states otherwise (and your LLC does not have an operating agreement), all members must agree to the admission of a new member.

Bottom line: you can sell your LLC interest to another party who gets all your rights to distributions from the LLC; however, the buyer cannot participate in the management of the LLC by becoming a member.

Monday, December 8, 2008

Documenting Member Withdrawal

Question: I need to know how to go about taking a member off of the LLC Operating Agreement. The members name is Sandra who is no longer going to be with the company. Any information you could give me to help us go about dropping a member would be very much appreciated. Phil.
I'll assume Sandra is voluntarily withdrawing from the LLC as a member or otherwise being bought out. The method by which a member withdraws should be set forth in the LLC operating agreement. If you purchased an LLC operating agreement form from®, it offers options for users to include member withdrawal provision in the agreement and, if you so elected, those terms would be found in paragraph 7.2. See sample LLC operating agreement. If you don't have an operating agreement that specifically sets forth how a member withdraws, seek counsel from a local lawyer with experienced in corporate / business law. The best course of action is to have a local lawyer handle the entire transaction regardless of whether or not you have a operating agreement. If a purchase of an LLC interest from a withdrawing member is involved, you need a sales contract. See the® asset sales contract and determine whether or not it fits your needs. Again, the advice is lawyer is encouraged.

The next step is amend the operating agreement to reflect to the new membership interests. Instructions on this topic can be found here. Do you need to file anything with the secretary of state's office to reflect the change in ownership? Normally, nothing is filed at the time of the withdrawal and the secretary of state's office becomes aware of the withdrawal of a member when the annual report is filed; however, this is not universally the case. Some states have specific forms for LLC member withdrawal that are filed at the time of the event. I suggest you contact the corporate division of the secretary of state's office and ask them. Links to the secretary of state office for each of the 50 states may be found here. State by state information.

Wednesday, December 3, 2008

Accounting Practice in Colorado Operating As LLC

Q. Hello, I am a CPA in Colorado, thinking about forming a single member LLC that provides tax, bookkeeping, payroll, etc. services (no independent audits). Am I required to form a PLLC? What are the differences between an LLC and a PLLC? Could you please explain the extent of the limited liability protection? (I had heard that the protection does not cover personal assets in the event of a lawsuit resulting from errors/mistakes, but rather only in instances of, for example, a client injured onsite.) Thank you!
In Colorado, and most states for that matter, there is not a separate legal entity type called 'PLLC' (professional limited liability company). See list of entity types from Colorado Secretary of State's office. Professionals form a standard LLC; however, the rules of the applicable state professional organization (bar association, medical board, board of accountancy, et cetera) mandate that the LLC carrying on a profession operate under certain additional rules not applicable to normal LLCs. These rules are not found in the state corporate code (i.e., Colorado Stat. § 7-90, et alia) but, rather, state laws specifically governing the profession in question.

The case of accountants, the application Colorado law is § 12-2-117. Of particular interest on the issue of liability is paragraph (3)(c) of this statute:
(c) All partners, shareholders of the corporation, or members of the limited liability company shall be jointly and severally liable for all acts, errors, and omissions of the employees of the partnership, corporation, or limited liability company except during periods of time when the partnership, corporation, or limited liability company maintains in good standing professional liability insurance, or designated or segregated moneys in lieu of such professional liability insurance, which meets the standards set forth in subparagraphs (I) to (V) of this paragraph (c) ... .
(Emphasis added.) What I take away from the above is that a member of an accounting LLC in Colorado is afforded the standard liability protection of LLCs EXCEPT for "errors and omissions of employees", for which they are personally liable. The Colorado law contains a further exception to the exception holding that members of accounting LLCs avoid personal liability for the errors and omissions of their employees by maintaining insurance that meets the standards set forth in the statute.

This earlier blog post discusses PLLCs further. I believe this form is used to qualify your PLLC with the Colorado Board of Accountancy after its formation. Further,® sells an operating agreement specifically designed for PLLCs.

Friday, November 14, 2008

Other Members Wish To Sell Their LLC Interests

Q. I am the managing member of a 4 member Delaware LLC. The other three members apparently are in discussion to sell their interest in the LLC. Can they do that? What happens to the loan we took out to purchase the business in 2006?
The place to start is your LLC operating agreement. Does it contain any restrictions upon the sale or transfer of LLC interests by members? If not (or you don't have an LLC operating agreement), then your LLC is covered by the default provisions of the Delaware LLC Act. In particular, § 18-702 has bearing on this issue. It provides, in pertinent part:
§ 18-702. Assignment of limited liability company interest.
(a) A limited liability company interest is assignable in whole or in part except as provided in a limited liability company agreement. The assignee of a member's limited liability company interest shall have no right to participate in the management of the business and affairs of a limited liability company except as provided in a limited liability company agreement and upon:
    (1) The approval of all of the members of the limited liability company other than the member assigning the limited liability company interest; or
    (2) Compliance with any procedure provided for in the limited liability company agreement.
(b) Unless otherwise provided in a limited liability company agreement:
    (1) An assignment of a limited liability company interest does not entitle the assignee to become or to exercise any rights or powers of a member;
    (2) An assignment of a limited liability company interest entitles the assignee to share in such profits and losses, to receive such distribution or distributions, and to receive such allocation of income, gain, loss, deduction, or credit or similar item to which the assignor was entitled, to the extent assigned;* * *
My reading of the above language is that the other members may sell their LLC interests; however, the purchaser does not become a member of the LLC unless the remaining LLC members vote unanimously to admit the purchaser as a member. What does the purchaser get if is blocked from becoming a member? The right to share in the LLC profits and losses and to receive any distributions otherwise allocated to the LLC interest purchased. Can the purchaser vote you out as managing member? I don't see how that happens without your consent to make the purchaser a member. Unless important facts are missing from your question, this transaction is highly unlikely to happen without your consent.

What about the loan used to purchase the business? The selling members are not relieved or any LLC debt they guaranteed merely by selling their LLC interest. Any deal to replace the purchaser as guarantor on this debt for the sellers is matter to be negotiated privately with the lender. It may be that the sales price is assumption of the debt.

As always, the best advice is to address restrictions on transfer of LLC interests in the LLC Operating Agreement at the initial formation of the LLC.

Thursday, November 13, 2008

The Quirky Tennessee LLC Act

In all states except one, LLCs are divided into two categories--those managed by the members and those managed by managers appointed by the members (aka "manager-managed"). In a quest to offer LLCs the face of a corporation, Tennessee goes a different route. Their LLCs are either member managed or governor managed. Further, in a LLC with governors, the governors may appoint managers who serve under them in much the same capacity as officers server under a corporate board of directors. For more information on the particulars, see "New Management Structures" section of this article.

I don't really see what this statutory frameworks adds to Tennessee LLCs; however, the novel framework does create traps for the unwary. The managers of LLCs in other jurisdictions act like officers of a corporation. Further, in a manager-managed LLC, the members have a roll very similar to the board of directors of a corporation. So what's the point to LLC governors Tennessee? In the grand scheme of things, it's not that big of a deal. Governor-managed Tennessee LLCs operate exactly the same as member-managed LLCs in the other 49 states (except for the fact that they can named managers who report to them). For Tennessee LLCs wishing managers, they are required by statute to create an intermediate body of "governors" in addition to naming managers. This necessitates additional complexity in the operating agreement. However, one option to simplify governance for Tennessee LLCs with managers is to name all governors additionally as managers. The net effect of such an arrangement is that the body of LLC governors = the body of LLC managers. Although the operating agreement still requires extra provisions to address the issue of governors, I believe it's a relatively easy drafting issue to handle.

Here is a link to the Tennessee statutes. Go to Title 48 (Corporations and Associations) and see Chapter 201, et alia for the Tennessee LLC Act.

Sunday, October 26, 2008

Division of Power, LLC Managers v. Members

LLCs come in two basic flavors: member-managed and those managed by managers. Conflating the distinction between the two types is the fact that members may also serve as managers in an LLC that elects to be managed by managers. See Section 101(10) of the Uniform Limited Liability Company Act. Member-managed LLCs operate much as traditional partners in that management of the entity's business affairs is conducted by all the members. A manager-managed LLC operates more like a corporation with the members in the roll of shareholders / board of directors and managers as officers. Here is the general rule for business operations of a manager-managed LLC:
[A]ny matter relating to the business of the company may be exclusively decided by the manager or, if there is more than one manager, by a majority of the managers ... .
See Section 404 of the Uniform Limited Liability Company Act. I can't think of a broader formulation of manager power.

However, certain matters are reserved by the default provision of the Uniform LLC Act for decision by the members such as the admission of a new member and the consent to dissolve the company. See Section 404(c). Remember that most of the LLC Act provisions can be altered by the operating agreement. A common feature of manager-managed LLC operating agreements is to reserve for member approval purchases or contract obligations (such as leases) above a certain dollar amount. I personally advocate putting such a check on the power of the managers. For a sample, see Section 4.3 of this manager-managed operating agreement.

Friday, October 24, 2008

Admission of New LLC Members

In today's economic environment, small business is looking for additional capital. With the credit markets in turmoil, bringing in additional owners is option many shall look at. For an existing LLC, the operating agreement should address the preconditions for admission of new members. Typically, there are three drafting options for member vote necessary to admit a new memeber: (a) simple majority, (b) super majority (67%), or (c) unanimous vote. Further, it is standard for operating agreement to state that new members must consent to the terms of the existing operating agreement upon admission. What if your operating agreement fails to address the issue? Then your LLC is governed by the default LLC act provisions of the state where you were organized. Below are examples from various state laws on the admission of new LLC members where the membership interest is purchased from the LLC: What if a member wishes to sell his membership interest to a third party not currently a member of the LLC? Can this stranger walk in off the street to become a member of your LLC? This case is the sale of the member interest by an existing LLC member as opposed to the sale by the LLC itself. If we were talking about S corporations, the answer would be that only a buy-sell agreement among the shareholders could prevent the sale of stock to an outside party. In the case of LLCs, the member operating agreement can restrict the purchaser (also referred to as an assignee) from becoming a member absent consent of the other LLC members. If the LLC agreement is silent about the purchaser of an LLC interest becoming an LLC member, the default provisions of the state LLC act apply. The states are generally split between requiring unanimous or majority in interest consent of the existing LLC members.

Wednesday, October 22, 2008

LLC Member Voting

The default rule under Uniform Limited Liability Company Act Section 404 is that each member gets an equal vote. Not every state follows the uniform act on this point. California, for example, mandates that members "shall vote in proportion to their interests in current profits of the limited liability company" unless otherwise stated in the articles of organization or operating agreement. See California Corporations Code Section 17103. Florida and New York (NY LLC Act §402) also have proportional member voting. Those state I randomly checked which followed the uniform act by defaulting to per capita voting (i.e., one vote for each member) are Colorado, Illinois, and Missouri. If your state was not mentioned and wish me to look it up for you, please leave a comment.

The member voting rules given above can be modified by the LLC operating agreement. In a multi-member LLC where the member own disproportionate shares of the LLC, I have yet to find a situation where the member holding a larger share is OK with per capita voting (i.e., one person, one vote). I recommend as the best course of action to lay out the manner and power of each member in the LLC voting process. For an example, see Section 3.5 of this sample LLC operating agreement.

A final issue: Do the members have to actually meet to vote? No according to the Uniform LLC Act. See Section 401(d). However, at least one state requires unanimous written consent of the members to take action without a meeting. See Missouri Stat. Section 347.083. I suggest you check the LLC rules for your state to see what requirements there are for member voting on the issue of member action without a meeting.

Tuesday, October 21, 2008

Personal Liability for LLC Debts

It's a common question from LLC members and, in these troubled financial times, the issue shall become even bigger. The general rule for member liability upon LLC debt is set forth in the LLC act of the state where your LLC was organized. California's Corporate Code Section 17101 is typical of what one finds in other states.
Except as otherwise provided in Section 17254 or in subdivision (e), no member of a limited liability company shall be personally liable under any judgment of a court, or in any other manner, for any debt, obligation, or liability of the limited liability company, whether that liability or obligation arises in contract, tort, or otherwise, solely by reason of being a member of the limited liability company.
I've reproduced just subdivision (a) of section 17101. Subdivision (e) basically states that the general rule of no member personal liability found in (a) is inapplicable where the member cosigns or guarantees an LLC debt. A new small business entity, whether it be an LLC or Sub S corporation, has by its nature zero credit history. As such, the owners invariably are asked to cosign business contracts such real estate leases, bank lines of credit, credit card accounts, equipment leases, and phone service contracts. Even if your LLC has been in business for a number of years, you as a founding member could still be liable for LLC debts from these sorts of accounts that were set up years ago but for which you cosigned. If your LLC is in danger of going under and you are concerned about personal liability, check the contracts with the lenders / suppliers. I've seen instances where the members cosigned on a contract exposing themselves to personal liability without even realizing they had done so.

Sections 17254 and 17255
California does not give titles to their statutes. If they did, Section 17254 would be named "Liability for unlawful distributions". See Section 407 of the Uniform Limited Liability Act. Essentially, Sections 17254 and 17255 make a member who votes for distributions to the members personally liable where said distribution will leave the LLC unable to pay its debts or with liabilities in excess of assets. The comments to Uniform LLC Section 407 state: "The recovery remedy under this section extends only to the company, not the company's creditors." California section 17254 is close to the model provision but not exactly the same. I'm uncertain whether a creditor may attempt to use Section 17254 to force personal liability upon members who have violated its provisions. Under the model act, only the LLC could make a claim against a member for violation of Section 407. Be that as it may, creditors also have resort to the Uniform Fraudulent Conveyances Act for transfers made at a time when a debtor is insolvent for less than full and fair consideration.

In light of these provisions, members need to be very careful about making distributions from the LLC to themselves when the LLC could be considered insolvent or otherwise unable to pay its debts.

Monday, October 20, 2008

Removal of Member From A Texas LLC

I answer questions on business law and estate planning topics over at my commercial web site and thought I would post some of those Q&As here to give them wider circulation.

"I read Sec 101.107 of TX LLC Act, however one of the members deserted (literally walked out one night and has not returned) the business almost a year ago, and actually has worked with competitors as an advisor... What applies here? Cathy."

Section 101.107 prevents the withdrawal or expulsion of a member in a Texas LLC. However, as explained in this prior post, I believe the Texas LLC Act allows the members to modify Section 101.107 through their operating agreement. I assume you wish to kick out the member now working for a competitor. If your operating agreement contains a mechanism for terminating or removing a member, then then it overrides § 101.107. As your question makes no mention of an operating agreement, I assume your LLC either does not have one or it is silent on removal of a member.

Question: what is the legal consequence of a member working for a competitor of the LLC absent any bar to such activity in the LLC operating agreement? I'm not sure because the Texas LLC Act does not spell out what if any duty of loyalty LLC members owe to each other. At least one Texas lawyer believes it is likely that members of a member-managed LLC owe a fiduciary duty of loyalty to the LLC and to the other members of the LLCs. I concur with that view. See also prior blog post on this topic. Thus, under this view, the member who went AWOL then consulted with the competition has violated this duty of loyalty to the other members. This may give rise to a cause of action for damages and/or injunctive relief. The best course of action would be to retain a local attorney for assistance in this matter. A claim against the departed LLC member for violation of the fiduciary duty of loyalty may bring him or her to the bargaining table to negotiate a withdrawal from the LLC (which is probably what you desire).

Wednesday, October 15, 2008

Planning for bankruptcy of an LLC member

These are tough economic times. Entering into a business relationship with another individual is much like a marriage, for better or for worse. However, in the business relationship, one is allowed to take precautions against "the worse". What happens when one member of a multi-member LLC goes bankrupt? Absent some provision in the operating agreement to the contrary, the member's LLC ownership interest becomes the property of the debtor's bankruptcy estate. Does the debtor still have the authority to act on behalf of the LLC as a member? Unless the operating agreement addresses this issue, the answer depends on which state your LLC is organized in. Some states such as Florida have a specific statute in their LLC code stating that a person ceases to be a member upon filing for bankruptcy. See Florida Stat. § 608.4237 and Uniform Limited Liability Company Act § 601(7).

How does this effect drafting of LLC operating agreements? As not all state LLC acts, to my knowledge, automatically terminate a member's right to vote and participate in the management of an LLC when filing a petition in bankruptcy, it is prudent to write such a provision into the operating agreement. But see below caveat. If the member becomes disassociate, the next issue is what does that member receive in return for his or her membership interest upon disassociation? One turns first to the operating agreement to see if this is spelled out and, if not, then the default provision of the state LLC act control. Using Florida as an example again, I believe Florida Stat. § 608.427 speaks to this situation even though it uses the words "withdraw" of a member rather than ceasing to be a member by operation of law. Section 608.427 states that the withdrawing member receives "the fair value of the withdrawing member's interest". Trust me, that's nearly impossible to calculate in closely held, small business LLCs. There is no market for small business LLC interests so basically one is left with hiring accountants to pull numbers out of their ass, which often leads to litigation. Thus, the smart move is to set forth in the operating agreement exactly what the disassociated member receive upon filing for bankruptcy. Examples include the member's capital account, some multiple of past earnings of the LLC then multiplied by the member's ownership percentage, book value of the LLC multiplied by the member's ownership interest, or naming a specific outside expert to value the departing member's interest if agreement cannot be reached. These examples require the LLC to come up with capital to pay off the departing member in a reasonably short time frame. That may place a burden on the LLC. Another option is for the disassociate member to be stripped of management and voting power within the LLC but to retain all rights to distributions otherwise payable to his or her ownership interest.

As with everything in the law, exception apply. What about a professional service LLC or one whether a significant chunk of the LLC is tied to specific members? It may not be in the best interest of the LLC as a whole to automatically expel a member generating significant revenue for the LLC upon the filing a petition for bankruptcy. In such case, perhaps the prudent course is to suspend the member's voting rights during bankruptcy and, further, limit the bankrupt member's ownership rights to those of an assign (i.e., retains right receive distributions otherwise payable to the LLC ownership interest).

Sunday, October 12, 2008

Do I need a lawyer to set up my LLC?

The correct answer is "that depends". Everyone prefers a straight up 'yes' or 'no', unfortunately, our laws come in shades of gray. Legal formation of an LLC is a relatively simple matter. The steps are outlined here. Or, if you prefer, there are services with reasonable prices that do LLC formation. Check out the ads on this Google query for a sample of incorporation companies. (One cavaet for Arizona, this state requires publication of notice of formation of the LLC.) For single member LLCs, one small but important item to keep in mind for single member LLCs comes when filling out IRS Form SS4 to obtain your federal employer identification number. For question 9a entitled "Type of Entity", check the first box "Sole Proprietorship" and give your personal Social Security Number. Why? This allows your LLC to be disregarded for federal tax purposes and, thus, removes the need to file a separate federal tax return for the LLC. Instead, the single owner of the LLC reports income / loss from the LLC on Schedule C of his or her personal IRS form 1040. If you don't know what I'm talking about, please consult with your tax accountant.

So you formed the LLC through the state and obtained an IRS tax identification number, what is left? For single member LLCs, maybe nothing. The last step is execution of an operating agreement. To my knowledge, only the state of Missouri requires all LLCs to have an operating agreement. See Mo. Stat. § 347.081. 1. Even outside of Missouri, it is common for single member LLCs to have operating agreements. Why should the sole member of an LLC have an agreement with himself? Typically banks and other financial institutions require LLCs to supply an operating agreement before they will allow the LLC to open an account. In the majority of states, this is the only document which positively lists all the current member of the LLC and their voting power within the LLC. If you are a single member LLC and the bank wants an operating agreement, any standard vanilla operating agreement form shall suffice IMHO. It's not necessary to pay an attorney $500, $1000 or more in these cases. Here is a link to the® LLC operating agreement. This document is created online by filling out a relatively simple questionnaire.

All LLCs with more than one member absolutely should have an LLC operating agreement. Don't rely on an oral agreement to delineate ownership interest, how the profits are to be split, what work each members shall perform for the LLC, capital contributions, the right to withdraw from the LLC, etc. Take the time to reach agreement on all of these issues among the members prior to launching your LLC. Is it necessary to get a lawyer to draft an LLC operating agreement? These can be complicated documents so it is recommended. Using a lawyer means you get a document that a lawyer is willing to stand behind as something suited to your needs containing language that has been explained to you. Downloading a legal form from the internet is quicker and much cheaper but comes with the risk that the document purchased does not do all you desire, that you don't really understand the provisions of the contract, or that there was some error in drafting. If your choice is download an LLC operating agreement from the internet or fail to have one at all, I would go with the online document. Check to make sure the company has been in operation for more than a few years, that the form templates were drafted by lawyers, and also whether any complaints have been filed against the seller with the BBB.

Friday, September 26, 2008

Walking Away From Your LLC & Taking the Customers

Every lawyer will say plan up front in the member operating agreement for LLC breakups. Be that as it may, I know the majority of LLCs with more than one member do not have operating agreements that plan for member withdrawal or removal of a member who fails to perform promised services. Typically, I hear from an unhappy LLC member who feels he/she is doing all the work and the other member is free-loading. However, the operating agreement provides for an equal distribution of LLC income regardless of the level of work put in by each member on behalf of the LLC. The first step, of course, is to attempt to reach agreement with the other member for their withdrawal. What happens when no agreement between the members can be reached?

One option is for the unhappy member to leave the LLC and allow it to fail. That's a drastic step with some down-side risk. Let's first look at potential benefits of walking. This approach can be attractive where the LLC is a service business. The main issue in service businesses is who controls the bulk of the customer contacts and new business leads? If it is the same member who is disgruntled and wishes to bolt the LLC, then it may make sense to walk and take the business with you. If the LLC owns equipment that is vital to providing the service, this becomes problematic. A member cannot walk away with key assets. That's theft.

Risks In Walking Away From LLC While Talking Lion's Share of LLC Business
  1. Up top has to be dealing with LLC debts for which the departing member is personally liable. Does the LLC have a lease for office space that is personally guaranteed by the members? What about equipment leases? Bank loans? Credit cards?
  2. As stated above, a departing member cannot bring with him or her any assets of the LLC. The LLC customer list is an asset. You should leave it with the LLC records. If the LLC has a small number of key customers, no big deal. But if the list if voluminous, you may have a difficult time recreating the customer list from secondary sources such as the Yellow Pages.
  3. Stealing key employees. If the LLC has employees with a written contract, legal issues arise when a former member steals an employee from the LLC (i.e., tortious interference with a contractual relationship).
  4. Fiduciary duties LLC members owe to one another. The extent of fiduciary duties owed by LLC members to each other varies from state to state and can often be modified by the operating agreement. A common fiduciary duty owed by LLC members to each other is one of loyalty. That means the LLC member never acts against the interest of the LLC. If a member plans on bolting the LLC and scooping up key customers / employees in the process, overt actions to further than plan should not occur while the individual is still an active member of the LLC. By "overt", I mean don't contact the customers / key employees asking them to join you in the new venture until you are already out the door. Why? Recruiting away customers and employees from the LLC to the new business could violate the duty of loyalty. See blog post from my commercial site for more info on topic.

Tuesday, September 16, 2008

Dividing LLC Profits and Losses On Other Than A Straight Percentage Basis

Question from Ali: "I want to form an LLC and I'll own 95% and a friend 5%. However when we take a contract - Profit won't be split like that. In fact, it'll fluctuate depending on time contributed. We want to avoid doing payroll taxes but will get a EIN for the purpose of getting a bank account, etc.

1) Can an LLC (Delaware) pay "members" who do work through a 1099?

2) Can profit be taken in and split on an arbitrary basis?

What's the best way to outsource work (if we cannot use a 1099) to a "member" and what about a non-member?

Thanks - it'd be a big help!"

I generally eschew blogging about tax issues but I'll make a few comments here. In responding, I'll assume your LLC plans to elect partnership tax treatment (as opposed to the rare election to be treated as a corporation). The term "payroll taxes" generally refers to both federal income tax withholding done by employers and FICA taxes reported on IRS form 941 along with the state / local equivalents of the 941. When an LLC pays members, it is generally treated as one of two things: (a) a capital withdrawal or (b) a member loan (or repayment of a loan). Put another way, payments to members are not wages. At the end of the year, the LLC files a federal form 1065. Each member of the LLC receives a K-1 from the LLC as part of the LLC form 1065 that allocates LLC income-loss between the two members. Each member, in turn, reports that income or loss on his (or her) individual income tax return (IRS form 1040). As part of the individual 1040 return, income allocated to the member from the LLC is subject to self-employment tax which equals FICA paid by employers. The members are required to pay estimated tax to the federal government upon the expected income from the LLC.

"Can (LLC) profit be taken in and split on an arbitrary basis?"

I think arbitrary is not the word you meant here. I assume you are asking whether LLC income-loss can be allocated between the members in other than a straight percentage arrangement. The answer is "yes", formulas are allowed. LLCs are allowed to allocated the profits between the members in any fashion they desire so long as the formula has "substantial economic effect" (or at least this was the case when I last studied partnership taxation almost 20 years ago). A discussion of what that means is well beyond the scope of a short blog post. Getting back to the division of profits and losses, you can have a formula or I have even seen agreements that delegated division of profits and losses to a compensation committee. These sorts of arrangements are most often found in professional services LLCs. The operating agreements for PLLCs are a complicated matter. What you have described is not an easy thing to draft.

I think you would be well advised to sit down with a tax accountant to get a thorough understanding of how the LLC you envision will work from a tax standpoint. Also, the agreement on division of profits will, by necessity, be difficult to draft. Advice of legal counsel is highly recommended.

Saturday, July 26, 2008

Creditor Collection Action Against Member LLC Interest

I shy away from debtor-creditor conflicts as they are messy affairs; however, a corporate lawyer needs to have a basic understanding of collection fundamentals when creating business entities. One of the main reasons for forming an LLC is liability protection of the members from the debts of the LLC. But what about the reverse, a claim by a creditor of a member against the assets of the LLC?

The Uniform Limited Liability Company Act (upon which the LLC laws of all states are based), provides the following in Section 504 entitled "Rights of Creditors":
(a) On application by a judgment creditor of a member of a limited liability company or of a member's transferee, a court having jurisdiction may charge the distributional interest of the judgment debtor to satisfy the judgment. The court may appoint a receiver of the share of the distributions due or to become due to the judgment debtor and make all other orders, directions, accounts, and inquiries the judgment debtor might have made or which the circumstances may require to give effect to the charging order.
The comments to Section 504 further state that "A charging order is the only remedy by which a judgment creditor of a member or a member's transferee may reach the distributional interest of a member or member's transferee."

Why is this important? Two reasons: (a) it means a creditor of an LLC member cannot vote a member's LLC interest nor otherwise attempt to manage the LLC and (b) the creditor cannot force liquidation of the LLC assets to satisfy a judgment it holds against a member. Basically, once a judgment creditor seizes an LLC membership interest through a judicial charging order, the creditor is left to sit on its hands waiting for the LLC members to vote a member asset distribution. Only then does the creditor collect anything from the LLC.

A bankruptcy court in Colorado carved out an exception to the above rule in the case of single-member LLCs. In the 2003 case of In re Ashley Albright, the sole member of an LLC went into bankruptcy. The bankruptcy trustee asserted that he as trustee now controlled the LLC and could cause the LLC to liquidate its property for the benefit of the bankruptcy estate. The court held that a charging order remedy given in the state LLC statute only acts to protect other members of the LLC. With no other members to protect in this case, the court granted the bankruptcy trustee complete control of the LLC and its property. See also In re Modanlo, 2008 U.S. App. LEXIS 3685 (4th Cir.), affirming In re Modanlo, 2006 Bankr. LEXIS 4524 (Bankr. D. Md); But see In re KRSM Properties, LLC, 318 B.R. 712 (9th Cir. Bank App. 2004) rejecting the Ashley Albright holding.

Friday, July 18, 2008

Forced Member Capital Contributions

Your LLC has been formed and competing in the business world. Oops, things have not gone as smoothly as the business plan predicted. The LLC needs an additional infusion of capital to survive. Perhaps your LLC has been wildly successful and needs an additional capital infusion to grow. You basically have two options at this point for equity investment in the LLC: (a) sell an LLC ownership interest to a new member (or existing member) that dilutes all other members or (b) require all existing LLC members to kick in new capital in amounts proportionate to their ownership interest. It's often difficult to bring new members into an existing LLC. There's a limited market for closely held small business interests. The problem with option (b) above is what happens when less than all members vote for new capital contributions. Unless the operating agreement provides for forced member contributions with a less than unanimous vote, many state LLC statutes prohibit the practice. Below are a few sample statutes.
  • California Corporate Code Section 17200(b): "Unless the articles of organization or operating agreement provide otherwise, no member shall be required to make any additional contribution to the limited liability company." Link.
  • Florida Business Code Section 608.4211: "(2)A promise by a member to contribute to the limited liability company is not enforceable unless it is set out in writing signed by the member. * * * (4) Unless otherwise provided in the articles of organization or the operating agreement, the obligation of a member to make a contribution or return money or other property paid or distributed in violation of this chapter may be compromised only by consent of all the members." Link.
  • New York LLC Act Section 502(b): "Unless otherwise provided in the operating agreement and except as provided in section six hundred five of this chapter, the obligation of a member to make a contribution or to return money or other property paid or distributed in violation of this chapter may be compromised only by consent of all the members." Link.
Thus, when forming an LLC, remember that in most states an LLC member cannot be required to make capital contributions absent the member's consent unless a written operating agreement sets out such a right on the part of the LLC. If your operating agreement will allow the majority of the LLC members to force a minority of members to make additional capital contributions after formation, then you should also address what remedies are to be available to the LLC in the event of a breach of this duty (i.e., penalties? attorney fees? forced sale of LLC interest?).

Tuesday, July 15, 2008

Initial LLC Member Contributions

Many an LLC operating agreement merely lists dollar values that members are to make as an initial capital contribution. But what happens if one member never makes the agreed contribution? Planning is required to put the aggrieved members in a solid position should this situation come to pass. Here are a few basic drafting points for inclusion in an operating agreement that can tighten up this area:
  • Delineate initial capital contributions between cash and non-cash contributions;
  • For contributions of property other than cash, make a specific list of the items to be contributed (i.e., HP copier, Dell desktop computer, conference table, etc.);
  • State a specific deadline by which initial capital contributions are to be made;
  • Provide for interest to accrue on any unpaid balance of the initial capital contribution (perhaps also provide for a penalty when a delinquency occurs);
  • Provide for attorneys fees to the party collecting upon a member's failure to make the required capital contribution.
Here is sample language of the foregoing:

Section 7 Capital Contributions.
  1. Each Member shall contribute or shall have contributed, as an initial capital contribution ("Initial Capital Contribution") to the LLC the amounts set forth below. Any non-cash contributions to be made by the Members and their valuations are set forth in Attachment 1 hereto. Below are the cash contributions.

    Member NameInitial Capital Contribution
    Stan Jordan$ 30,000
    Bob Lobe$ 30,000
    Tom Stroud$ 20,000

  2. The Members shall complete their initial capital contributions to the LLC within 10 days of the date of this agreement unless another date is agreed upon in writing by all LLC Members.
  3. Interest shall accrue against a member upon any unpaid capital contribution at a rate of 6% per annum, compounded annually, commencing from the due date of the initial capital contribution.
  4. Indemnification of Attorneys Fees and out-of-pocket costs. Should a member breach Section 5.3 of this agreement, any other member may sue for enforcement and shall be indemnified by the breaching member for its reasonable attorneys fees and out-of-pocket costs which in any way relate to, or were precipitated by, the breach of Section 5.3 of this agreement.

Language for attorneys fees can be much more detailed than the above sample but it should give you an idea of the minimum specificity one desires in operating agreement on the topic of initial member contributions.

Friday, July 11, 2008

Passive Investors In An LLC

I received a user question from my commercial site yesterday regarding how to structure the admittance of passive investors into an existing single person LLC. In a basic, member-managed LLC, the members serve three rolls when compared to corporations: shareholder, board director, and corporate officer. In order to curtain the authority of certain members (and enhance the authority of others), I have seen LLCs adopt corporate style bylaws then name certain of its members as "officers" of the LLC. That muddies the waters IMHO. This situation can be handled within the framework of the operating agreement.

The first step is to switch the LLC from one managed by all members to one that has managers. For an existing LLC, this quite often entails amendment of the LLC articles of organization which is not a complicated task. Most states have pre-printed forms for amending the articles. Remember that LLC managers can also be members. The operating agreement is then amended allowing the members to name managers (or one manager if that be your desire). The passive members are not named as managers. The tricky part comes with spelling out the level of authority of the manager and those acts for which a vote of the LLC members is required. The amount of authority that can be delegated to the managers by the members in an operating agreement is quite extensive. Section 404 of the Uniform Limited Liability Company Act (upon which all states have modeled their LLC acts) sets forth 10 acts which require unanimous consent of all members. The comments to Section 404 give further insight into the relationship between managers and members:
In a manager-managed company, the members, unless also managers, have no rights in the management and conduct of the company's business unless otherwise provided in an operating agreement. If there is more than one manager, manager disputes as to any matter relating to the company's business may be resolved by a majority of the managers unless the matter relates to a matter specified in subsection (c) (unanimous member consent required). Managers must be designated, appointed, or elected by a majority of the members. A manager need not be a member and is an agent of the company with the apparent authority to bind the company in the ordinary course of its business.
Here is a sample member-managed LLC operating agreement setting up boundaries of manager authority by reserving certain decisions for the members. As you might expect, there are tax implications to being a passive LLC member. For example, here is an article discussing the deductibility of LLC losses by a passive member.

Wednesday, July 9, 2008

LLC Articles of Organization

I've noticed occasional confusion between two LLC forms: (a) Articles of Organization and (b) the Operating Agreement. Here are two sample LLC articles of organization from the states of California and Florida. The articles of organization is the document filed with the state (usually in the office of the secretary of state) that initiates the legal existence of your LLC (usually the same day the articles are filed). Almost every state has a pre-printed form for articles of organization. They ask for rather basic information: LLC name, registered agent, location of headquarters, location of business, the LLC managers, and some ask for the LLC members. For links to articles of organization forms for all 50 states (that have forms), click on your state from this page. In two or three states (Arizona being the most notable), those who form an LLC are required to publish this fact in a newspaper in general circulation in the state shortly after the LLC is formed. In other states, the filing of the articles of organization is all that is legally required to legally bring an LLC into being.

Then what is the purpose of the operating agreement? This is the contract between members recording agreement upon such issues as ownership, voting, admission of new members, division of profits and losses, et alia. It is analogous to a partnership agreement. In single members LLCs, it is not uncommon for there to be no operating agreement. Why have an operating agreement in a single member LLC? In most states, a list of members is only filed with the state annually. An LLC operating agreement definitely sets out who are the members and who has the authority to act on behalf of the LLC. It is standard procedure for banks and other lenders / suppliers doing new business with an LLC to ask for a copy of the operating agreement regardless of the number of members.

Friday, June 20, 2008

Professional Services LLCs

Every state except California allows licensed professionals to run their professional services practice through an LLC. The two main differences between a professional services LLC and a standard LLC is that only professionals licensed by the state may be members of a professional services LLC and, in many states, there is not complete personal liability protection to professional from the LLC (as is the case with professional services corporations). An example of state law on personal liability for a professional rendering services through an LLC is found in Arizona's LLC Act:
§ 29-846. Professional relationship and responsibility.
This chapter shall not alter any law applicable to the relationship between a person performing professional services and a person receiving those services, including liability arising out of those professional services. Each member, manager or employee performing professional services shall remain personally liable for any results of the negligent or wrongful acts, omissions or misconduct committed by him or by any person under his direct supervision and control while performing professional services on behalf of the limited liability company. * * *
Another strange quirk of the LLC laws of the various states regards use of the "PLLC" versus "LLC" to designate professional services LLCs. In the 49 states and District of Columbia that allow licensed professionals to practice their profession in the LLC form, some mandate use of PLLC in the name, some mandate use of LLC (or LC) while still other allow either PLLC or LLC. Go figure.

Another common issue with professional service LLCs is exactly what professions are covered by the law. Most states, if their statutes distinguish between professionals service and regular LLCs, do not give a specific list of those professions included within the definition of "professional services". Florida is one of the fews states whose LLC statute does give us a list of covered professions.
§ 621.03 Definitions.--As used in this act the following words shall have the meaning indicated:
(1) The term "professional service" means any type of personal service to the public which requires as a condition precedent to the rendering of such service the obtaining of a license or other legal authorization. By way of example and without limiting the generality thereof, the personal services which come within the provisions of this act are the personal services rendered by certified public accountants, public accountants, chiropractic physicians, dentists, osteopathic physicians, physicians and surgeons, doctors of medicine, doctors of dentistry, podiatric physicians, chiropodists, architects, veterinarians, attorneys at law, and life insurance agents.
This list is not exhaustive but give one an idea of the breadth of the covered professions.

Operating agreements for PLLCs are generally more difficult to draft than for standard LLCs. PLLCs, by their nature, rely heavily upon the delivery of services for generating revenue and less on capital invested by its members. Thus, compensation formulas are the norm in PLLC operating agreements. Here is a link to a PLLC operating agreement template from my commercial web site.

Monday, June 16, 2008

List of Secretary of States, Corporate Divisions

In the United States, LLCs are formed by filing a form document usually called articles of organization with a state office. This office is most often the secretary of state, corporate division. I thought it would be handy for myself and the public to have links to the web sites for the secretary of state, corporate division (or equivalent office) of all 50 US states and the District of Columbia. Without further adieu, here is the list:As of the date of publication of this post, all the above links are good. However, I have found the secretary of state offices for the various states change around their URLs over time for whatever reason. If you find a bad link, please post a comment and I'll correct the link.

What Happens When An LLC Member Dies?

Got an email today from an individual who is a member of an LLC with two members and no operating agreement. The LLC operates a bar / restaurant and the other member died suddenly. Guess what? Without an operating agreement, the deceased member's LLC interest goes into his estate and, most likely, the spouse of the deceased member ends up as your new partner. Not all written operating agreements deal with the death or withdrawal of a member. They are somewhat complicated for one unsophisticated in business to plan for but, should the worst come to pass, you end up so much farther ahead and avoid mucho aggravation if the situation is properly planned for on the front end. The LLC operating agreement should contain a buy-sell agreement covering the death of a member.

Article VII of this sample operating agreement contains a buy-sell agreement with transfer restrictions. Section 7.3 specifically deals with the death of a member.

Thursday, May 15, 2008

Tax Advantages of LLCs

You desire limited liability protection for your business and, also, the single level of taxation afforded to LLCs and S corporations. From a tax standpoint, which is best? If you are the sole owner of the business, one advantage of a single member LLC is the option to disregard it for tax purposes allowing you to report the income and expenses from your LLC on Schedule C of your individual income tax return (IRS form 1040). It's one less tax return to file and, perhaps, lowers the reporting complexity enough to allow you to do your own tax return as opposed to taking it to an accountant. All 50 states allow single member LLCs. How about LLC versus S Corporation? There are subtle yet significant tax differences between LLC and S corporations.

Additional Basis For Entity Loans
If your LLC is to be highly leveraged (i.e., the LLC will borrow substantial sums) and you anticipate losses in the early years of the business, an LLC possesses one additional advantage over an S corporation. Members of an LLC allocate to their basis a portion of all LLC debt pursuant to IRC Section 752. FN1. Not so for S corporation shareholders. Even if an S corporation shareholder guarantees the corporation debt, the shareholder does not gain basis from the debt. Pursuant to IRC Section 1366, S Corporation shareholders obtain basis only for contributions of capital. This means an S corporation shareholder, to obtain a basis increase for debt, must take out the loan him or herself as the primary debtor then contribute the loan proceeds to the corporation. Link. Why is this important? LLC and S corporation owners are limited in the deduction of entity losses to the amount of basis. Thus, members of a leveraged LLC are allowed to deduct greater losses than similarly leveraged S corporation shareholders.

Contribution of Appreciated Property
LLC members, whether majority or minority members, can contribute substantially appreciated property to the LLC without tax consequences. Even tax free distributions of appreciated property from LLCs is allowed under IRC Section 731. Not so with S corporations. Only where the shareholder is in control of the S corporation immediately before and after the transaction is a contribution of appreciated property by an S corporation shareholder a non-recognition event (i.e., tax free). See IRC Section 351. When contributing assets other than cash to an LLC, it is important for the operating agreement to list the assets to be contributed by each member and, also, the agreed value of each asset. See LLC Operating Agreement examples linked here.

Pluses for C corporations
Corporations can offer a greater range of deductible fringe benefits to employees as opposed to LLCs. Please speak with your tax accountants about the specifics. Also, a corporation which has significant assets or non-owner employees may be able to pay out a certain percentage of its profits in dividends as opposed to straight compensation. That could save you the 15+% FICA tax on wages. It can add up to a significant savings for a small business. The IRS is sensitive to inappropriate small owner-officer salaries to circumvent this problem so be prepared to justify any salary chosen.

See also Why Real Estate Businesses Chose the LLC Form

Footnote 1: "Any increase in a partner’s share of liabilities of the partnership is considered a contribution by such partner to the partnership, and, consequently, increases the basis of the partner’s interest in the partnership. Sec. 752(a); sec. 1.752-1(b), Income Tax Regs.; see HGA Cinema Trust v. Commissioner, 950 F.2d 1357, 1362 (7th Cir. 1991), affg. T.C. Memo. 1989-370; Callahan v. Commissioner, 98 T.C. 276, 280 (1992)." IPO II v. Commissioner, 122 T.C. No. 17 (2004), Slip Op. at page 9. Partnership liabilities are allocated in two different methods depending on whether the partnership debt is recourse or nonrecourse. For recourse liabilities, partners are allocated partnership debt based on their economic risk of loss (EROL). EROL is determined by determing a partner’s liability for the debt in question upon constructive partnership liquidation. "Section 1.752-3(a)(2) provides that the partner's share of the nonrecourse liabilities of the partnership includes the amount of any taxable gain that would be allocated to the partner under section 704(c) (or in the same manner as section 704(c) in connection with a revaluation of partnership property) if the partnership disposed of (in a taxable transaction) all partnership property subject to one or more nonrecourse liabilities of the partnership in full satisfaction of liabilities and for no other consideration. The gain a partner would be allocated under the hypothetical sale in section 1.752- 3(a)(2) is referred to as section 704(c) minimum gain." LTR 200120020. See more detailed discussion of issue; See also at-risk rules of IRC § 465. IRC Section 752 applies equally to partnerships and LLCs in cases where the LLC is taxed as a partnership.

Friday, May 9, 2008

Personal Liability of LLC Members

LLC stands for "limited liability company". I am often asked by those forming LLCs, how much protection do I get from an LLC for my personal assets? Section 303 of the Uniform Limited Liability Company Act (upon which all state LLC acts are based) reads, in pertinent part, as follows:
(a) [T]he debts, obligations, and liabilities of a limited liability company, whether arising in contract, tort, or otherwise, are solely the debts, obligations, and liabilities of the company. A member or manager is not personally liable for a debt, obligation, or liability of the company solely by reason of being or acting as a member or manager.
* * *
(c) All or specified members of a limited liability company are liable in their capacity as members for all or specified debts, obligations, or liabilities of the company if:
     (1) a provision to that effect is contained in the articles of organization; and
     (2) a member so liable has consented in writing to the adoption of the provision or to be bound by the provision.
Bottom line: an LLC member has no personal liability for LLC debts unless "a member so liable has consented in writing to the adoption of the provision or to be bound by the provision."

But here's the rub: an entrepreneur starting a new business is universally required to guaranty everything to get credit for the new LLC--suppliers, utilities, commercial real estate lease, bank loan, etc. What about the credit card offer that is sure to come in the mail a few months after you open an LLC bank account? On its face, the credit card offer appears in the name of the business but you the owner invariably guaranty the account (check the fine print on the back of the offer). So if the owners of a new LLC are required to guaranty every element of credit, is the promise of limited protection just an illusion? No, I think not. As the new LLC gains its legs over years of operation, suppliers and other will begin to offer credit terms to the LLC without guaranty based upon the LLC's own credit history. Secondly, above we have been discussing contractual liability for loans.

But businesses also face tort liability for such things as personal injury claims. Let's say your LLC runs a coffee shop and an elderly female patron falls breaking her hip. The hip surgery goes poorly causing the old woman to spend months in the hospital. The hospital bills and claimed pain and suffering in the suit brought by the patron against the coffee shop exceed its liability insurance coverage. This is the type of liability situation that the LLC form of business affords protection to business owners regardless of personal guaranty. What if you are one-person computer programming consulting operating out of your house? Where tort liability exposure is low, the incentives for the small business owner to utilize the LLC structure diminish for asset protect purposes. There may be tax reasons for forming an LLC even in a low tort business but please consult your tax account for insight on that issue.

Thursday, April 17, 2008

Restrictive Covenants Among LLC Members

You've heard of buy-sell agreements among shareholders of closely held corporations. In the case of LLCs, the operating agreement is typically the place one finds restrictions upon transfer of LLC member interests. But why have them? A small business is much like a marriage. And one carefully chooses a spouse. If a member of your LLC is allowed to sell out to anyone of the member's choosing making the buyer of a member of your ownership group, that's a problem for the remaining members. They may be stuck to continue the business with a stranger or, worse, a disruptive individual they never would have freely chose to hook up with. This problem is magnified for LLCs that are managed collectively by the managers as opposed to having named managers who control the operation of the LLC. Any new member automatically becomes a member of the management team.

When a group of entrepreneurs trust each other implicitly at the start of a new business venture, they may think restrictive covenants among the members are unnecessary as one of their fellow members is not going to screw the LLC over by selling out. But consider the following: divorce, death, and bankruptcy. Forces beyond the control of a member may force him or her to sell. Best to plan for these eventualities on the front end so that the LLC may continue in business with the least disruption as possible should one of these events befall a member.

Another difference between corporate shareholder buy-sells and LLC restrictive covenants found in LLC operating agreements. For tax reasons, the LLC is typically the buyer of the LLC units of the departing member. Link. In shareholder buy-sell agreements, the shareholders typically purchase the stock of the departing shareholder individually.

Middle ground option. You the LLC members wish to prevent any individual LLC member from transferring his or her membership in the LLC outside of the current ownership group but you are reluctant to bind the LLC to mandatory purchase of an LLC interest upon the withdrawal, death, financial insolvency of a member. It's a legitimate concern. For an LLC whose business is thinly capitalized, the extra burden of buying out a departing member may well force the LLC into liquidation. Is there another option? Yes, forbid withdrawal or other transfer of member LLC interests. What happens upon the insolvency or death of the member? In these cases, the creditor or heirs of deceased member (as the case may be) only take the right to distributions held by the member but may not vote the LLC membership interest or otherwise exercise any rights of members. Here is a sample LLC operating agreement with restrictive covenants (see article VII). See also Online LLC Operating Agreement Form.

Wednesday, April 16, 2008

Fiduciary Duties of LLC Members

At common law, partners owe each other a fiduciary duty of loyalty and good faith. "A fiduciary has a duty to act primarily for the client's benefit in matters connected with the undertaking and not for the fiduciary's own personal interest." Link. "Loyalty" can be a nebulous concept to pin down but, with certainty, one can say that a partner is forbidden from competing against the partnership through an outside business venture and from converting partnership business opportunities to the partner's individual benefit. But limited liability companies are hybrids, not exactly partnerships nor corporations. What fiduciary duties, if any, do LLC members owe to each other? Can these be modified in a written operating agreement.

This variance from state to state on the topic but my general sense of the law prevailing in most states is that managers (be they members or not) owe a fiduciary duty of loyalty to the LLC; however, non-managing members owe no such duty. Further, the fiduciary duty of managers to the LLC can be altered by the operating agreement. The following is an overview of selected state LLC statutes on this subjective to present a better feel for how this shakes out.

California. Section 17153 of the California Corporations Code provides: "The fiduciary duties a manager owes to the limited liability company and to its members are those of a partner to a partnership and to the partners of the partnership." Link. See Section 16404(b) of the California Corporations Code for the specifics of fiduciary duties of partners under California law. "The fiduciary duties of a manager to the limited liability company and to the members of the limited liability company may only be modified in a written operating agreement with the informed consent of the members." Link.

Florida. "[E]ach manager and managing member shall owe a duty of loyalty and a duty of care to the limited liability company and all of the members of the limited liability company." Florida Stat. Section 608.4225(1). Section 608.4225 goes on in great detail relative to the specifics of the "duty of loyalty and duty of care". Under Section 608.423(2)(b), the LLC operating agreement may not "Eliminate the duty of loyalty under s. 608.4225, but the agreement may" change a few other elements of other duties owed by managers to the LLC.

Texas. " Texas law governing LLCs does not specifically address whether manager or member fiduciary duties exist or expressly define them. Therefore the existence of such a duty may be a question of fact dependent upon the unique circumstances of each case and determined by case law. The relationships of managers and members to a limited liability company are generally assumed to be fiduciary in nature." Web site of Tipton Jones, a Texas law firm. Although the Texas LLC Act punts on the issue of defining fiduciary duties for managers, it clearly states that any such duty can be modified by the LLC operating agreement: "The company agreement of a limited liability company may expand or restrict any duties, including fiduciary duties, and related liabilities that a member, manager, officer, or other person has to the company or to a member or manager of the company." Texas Business Organizations Code, Section 101.401.

Saturday, April 12, 2008

LLC Managers

Limited Liability Companies (LLCs) come in two basic varieties: (a) those managed collectively by the LLC members and (b) those managed by "managers" who are appointed by the LLC members. To complicate matters, LLC members can also be LLC managers. Let's take the common example of an LLC set up to own and operate an apartment complex. The owners of the LLC (i.e., the members) do not wish to handle leasing, maintenance, rent collection and all the other details that go with operating an apartment complex. Thus, they will hire a management company to run the operations of the LLC that owns the apartment complex. This post will walk through the legal paperwork necessary to set up this arrangement.

First step is filing articles of organization with the state of your choice. See California LLC articles of organization (scroll down to page 3) and Florida articles of organization. This page has links to the articles of organization for most states. You'll notice that in Florida, the managers must be named in the articles of organization. In California, as with most states, the LLC organizer merely checks a box indicating whether the LLC shall be managed collectively by the LLC members or by managers. In most states your LLC charter is issued the same day that it is filed with the appropriate state office. OK, now you have an official legal entity--an LLC. The next step is an LLC operating agreement. Prior posts on this blog discuss its contents so I'll not belabor the point. But in relation to managers, one issue is important to cover in the operating agreement: the division of responsibility between the LLC members and the managers. Is there a dollar cutoff for transactions the members must approve? Are there certain sorts of contracts that the members wish to reserve for approval (i.e., any contract with a duration over one year)? Without any boundaries set forth in the operating agreement, the power of managers to bind the LLC to transactions is theoretically limitless. I also think it is important for the operating agreement, in the case of managers, to set forth the grounds and mechanism for firing the managers.

The next step is appointment of the managers and setting compensation. This can be done in the operating agreement or a separate resolution of the LLC members. Either way, the specific management contract that is to be entered into between the management company (or individuals) and the LLC should be included and approved by the members. I'd attach the management contract as an exhibit. Here is an extensive LLC property management contract from the ABA. Make sure the management contract tracks any restrictions on the authority of the managers to bind the LLC contained in the operating agreement. Third parties dealing the LLC managers for any sizable transaction will certainly ask for a copy of the management contract but might neglect to ask for the LLC operating agreement. Putting restrictions on manager authority both places does the best job of putting third parties on notice of these restrictions. Other things to go in the management contract include the duties of the managers, compensation for services, and grounds for termination. Although it would be unusual in a property management contract, confidentiality agreements for business information of the LLC (such as customer lists) are often found in management contracts.

The last formality is execution of the LLC management agreement. One other potential requirement occurs for an LLC organized under the laws of one state (say California) but owning property or otherwise operating in another state (say Nevada). In this example, the California LLC would need to register as a foreign LLC in Nevada.

Thursday, April 10, 2008

Removal of LLC member

Single member LLCs are really sole proprietorships for which the law gives limited liability protection traditionally enjoyed by corporations. An LLC with two or more members is, at its core, a business marriage. And we know marriages can, and often do, go bad. The best course of action is to plan for a potential breakup. Amicable LLC breakups are easy enough to draft for in an LLC operating agreement. Either one member withdraws (see below article on member withdraw) or the members mutually agree to dissolve their LLC. What if there is no agreement between the members? Then we are faced with a contested business divorce and it can get ugly. When there are just two members, each with 50% ownership interest, there really is no way to resolve the issue. There is no majority owner with voting power to oust the minority. Dissolution based upon management deadlock is the ultimate resolution of the impasse unless the two members can agree on a course of action.

The most common situation I encounter involving a desire to remove a member is one where a member does not live up to his or her commitments to provide money or services to the LLC. See post on the topic. It is common for state LLC laws to prohibit removal of a member unless there is a written LLC operating agreement that specifically provides for removal. I should back up and emphasize the importance of your operating agreement specifically detailing what cash payments and services are to be provided by each member. A written operating agreement that leaves out these provisions is fatally defective.

You're first option, assuming the operating agreement plainly states that the member is to provide money or a service, is to sue the member for breach of contract. It's difficult to continue in business with a person who you had to sue in order to force him or her to live up to their commitments. The logical resolution of the problem is removal of the deadbeat member. And that is a sticky wicket to negotiate. First, the operating agreement must provide for removal under these circumstances. Second issue, can the moving members gather sufficient votes to remove the member? Here is the rub. Operating agreements commonly provide for removal of a member only upon a supermajority vote is required. Supermajority is generally anywhere from 60 to 90 percent. If the member you are trying to remove holds at least 41% of the ownership in the LLC, under some LLC operating agreements, you cannot remove him or her even if they have failed to provide the required capital contribution or services.

An alternative way to draft the operating agreement is that the member up for removal is barred from voting on the motion. Thus, if it takes supermajority for removal, this is determined without inclusion of the ownership interest of the member up for removal. For example, assume ABC LLC has three owners, two of whom (A & B) own 40% and last (C) holding 20%. Further assume ABC LLC has a provision in the operating agreement for removal of an LLC member who fails to provide services upon a 66% vote of members in interest. If the operating agreement excludes the ownership interest of the member up for removal from the calculation, then A and C members could vote to remove member B for failure to pay the required capital contribution. Although A & C together own only 60% of the interest in the LLC, they own 100% when the interest of B (the member up for removal) is not taken into consideration.

The downside of excluding the ownership interest of the member up for removal from the calculation of supermajority? A majority own is likely not to agree to such a provision. By doing so, he or she has agreed to summary mechanism for the majority member's removal from the LLC. Bottom line: if your LLC has more than one member, deal with the issue of removal of a member up front in your LLC operating agreement. The operating agreement should detail (a) the grounds for removal, (b) the actual mechanism for removal, and (c) compensation to the member upon removal for his or her LLC interest.

Friday, April 4, 2008

Planning For Withdrawal of a Member

One of the most important, but often overlooked, elements of an LLC operating agreement is provision for withdrawal of a member. In some states, an LLC member is not allowed to withdraw absent a provision in a written operating agreement specifically allowing for withdrawal. See Texas LLC law and Florida LLC law. In providing for withdrawal of a member from your LLC, two matters should be addressed: (a) the mechanics of withdrawal (when, where, and how notice of withdrawal is given) and (b) compensation to the withdrawing member. Of the two, compensation is the more difficult question. In Florida, if the LLC operating agreement does not specify the amount a withdrawing member is to receive, the withdrawing member is to receive "fair value" for his or her LLC interest. Florida Stat. Section 608.427(2). Sounds nice, the member who leaves gets what's "fair". The problem is that "fair value" is a nebulous term and difficult to arrive at precise calculation for assets that are not publicly traded. Hire five experts to determine fair value of a closely held business interest and you probably will be handed five different valuations. One option is to return the withdrawing member's capital account. Other options are formula's that can work either off of the capital account or the ownership interest. For example, member capital account multiplied by 110%. Or, LLC profits for the prior year multiplied by six and, then, by the member's ownership percentage. Formulas are hard to arrive at but they surely save much headache on the backend.

Thursday, April 3, 2008

What Goes Into An LLC Operating Agreement?

A limited liability company (LLC) is formed by filing articles of organization with a state that issues the charter. The articles are very basic. An LLC operating agreement is an agreement between the members (i.e., owners) of the LLC giving the operational details of the organization. Here is a survey for each state listing whether an operating agreement is required and, also, whether the LLC operating agreement must be in writing.

So your LLC has been formed. You've decided you wish to have a written operating agreement and, now, are faced with determining exactly what goes into the agreement. Let's start with the basic elements.
  • Name all the members.
  • List the initial capital contribution required by each member.
  • List what services, if any, are to be provided by each member
  • Allocation of profits and losses.
As to the initial capital contribution, the best course of action is to state specifically when the contribution must be made by the members and the penalty for failure to make the payment. Same with services: what is the penalty if a member fails to deliver the promised services? Lastly, the all important issue of profits and losses. Most LLC operating agreements state percentages of ownership for each member (sometimes expressed in units) with profits and losses divided according to ownership interest. But this is not required. When profits and losses of an LLC are not allocated based upon the ownership percentage, it is called a "special allocation". Corporations may not make special allocations of profits and losses while partnerships and LLCs can. However, special allocations must meet the substantial economic effect test set forth in IRS regulations. Get advice from a tax professional before attempting a special allocation.

Other recommended topics to be covered in an LLC operating include the following:
  • Expulsion of a member.
  • Admission of a new member.
  • Withdrawal of a member.
  • Death of a member.
  • How LLC member voting is conducted.
  • When the LLC is managed by managers, what matters are reserved for decision by the members.
  • Restrictions upon sale of LLC interests to persons outside of the current ownership group.
  • Restrictions upon LLC members participating in competing business ventures.
The list of topics that can go into an LLC operating agreement is quite expansive but, hopefully, the foregoing has covered the most common topics.

Sample LLC operating agreements: