A limited liability company is as easy to set up as it is to screw up. Though it is justifiably advisors’ favored business structure due to its simplicity, flexibility and liability protections, there are still a select few “corporate formalities” that should be observed. The primary such formality is what’s known as the operating agreement, and it is just as important to keep it updated as it is to draft it in the first place.
Wyoming created the first limited liability company act in 1977, and other states followed suit in due course. LLCs are thus governed by state law, and each state imposes slightly different requirements on the creation, structure and ongoing business of LLCs formed pursuant to its laws. No state requires the LLC to file its operating agreement with the state, and almost no states even require an LLC to have an operating agreement in the first place.
(That is, with a few notable exceptions like California and New York, because they’re California and New York and think they’re better than everyone else and always have to do things the hard way. I actually had a law school professor tell me that advising a client to form a California LLC should be considered legal malpractice because the state is so business-unfriendly. I suspect he was only half-joking. But I digress.).
So if most LLC owners aren’t required to create an operating agreement, why go through the trouble at all? Three reasons: personal asset protection, governance and preventing transition disruption.
1. Personal Asset Protection
One of the primary reasons for creating an LLC instead of operating as a sole proprietor or partnership is fairly obvious: limiting liability. More specifically, an LLC is designed to shield an LLC member’s personal assets from creditors of the LLC. The fundamental concept is that the LLC is a separate legal person, with the ability to earn revenue, incur liabilities, enter into contracts, etc. Importantly, LLCs can sue and also be sued. If a judgment is entered against an LLC, the assets used to satisfy the judgment are generally the assets of the LLC (i.e., not the separate personal assets of the LLC member(s)).
I say “generally” because it is easy to lose the liability protections afforded by the LLC structure if its members do not treat the LLC as a legally distinct entity separate from personal affairs. This can happen by co-mingling LLC and personal funds, signing documents personally rather than as an agent of the LLC, and – you guessed it – failing to maintain certain records like an operating agreement.
Basically a court will look to see if the LLC is merely a member’s “alter ego” with the member and the LLC being one in the same. If so, the “corporate veil” of liability protection can be “pierced” and the member’s personal assets exposed. Let me put it another way: Clark Kent can’t escape personal liability for all the property damage he causes to Metropolis just because he operates as Superman LLC.
A well-drafted and up-to-date operating agreement will help demonstrate to a court that the LLC is indeed separate and worthy of liability protection. Don’t let the lack of an operating agreement be your kryptonite.
2. Governance
In its most basic form, the operating agreement should be just that – an agreement among its members about how the LLC is to operate. Think of it as an instruction manual of sorts.
There is no single prescribed set of contents, but an operating agreement should generally include:
- A list of the members and their respective rights and obligations
- How capital is contributed and how it is withdrawn
- Allocation of membership units, ownership percentages and/or voting rights
- Admission of new members and withdrawal of existing members (voluntary and involuntary)
- Management by members or by managers
- Authority of members/managers and restrictions imposed on that authority
- Accounting, bookkeeping and tax matters
- Transfer or sale of ownership interests
- Dissolution and wind-up procedures
Depending on the size and complexity of the LLC, additional sections may be needed and some may not be necessary. A single-member LLC that exists as a solo advisory practice will be much more straightforward than an LLC comprised of multiple members with varying degrees of capital contributions, control and authority.
The goal is to draft the operating agreement to prevent or quickly resolve disputes among members and to serve as the definitive handbook for day-to-day governance. To avoid some of the potential pitfalls of the single-member LLC structure, check out my prior article here.
3. Preventing Transition Disruption
Personal asset protection and governance should be reason enough to draft and maintain an operating agreement that accurately reflects the intent of the members, but perhaps the most salient reason should sound familiar to the advisory community: continuity and succession planning.
Business transitions – whether voluntary or involuntary – are inevitable. In the best case scenario, an advisor reaches retirement age and exits the business, receives a distribution from the LLC for her ownership stake, and hands her clients over to her other business owners pursuant to the buy-sell provisions in the operating agreement. In the worst case, an advisor unexpectedly becomes incapacitated or dies without an operating agreement in place, and the remaining business owners (and heirs) are left trying to figure out what to do with his share of the business. Somewhere in the middle is a potential acquisition or merger of the LLC into another advisory practice, and the various LLC members can’t agree whether to go forward with the deal or not because their operating agreement doesn’t address voting or decision-making authority.
The point is that businesses evolve over time, and it’s important for the operating agreement to evolve lockstep (and exist in the first place). Building buy-sell provisions into an operating agreement sets expectations up front, avoids unanticipated controversy down the line, and insulates long-term enterprise value by eliminating uncertainty.
Just in case you don’t have enough New Year’s resolutions for 2016, dust off your LLC’s operating agreement and confirm it accurately and comprehensively represents your intentions. If you don’t have one yet… well, you know what I’m going to say.
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This article originally appeared on January 8, 2015 in ThinkAdvisor.