What Is an LLC Operating Agreement With Multiple Classes?
An LLC operating agreement with multiple classes is a business structure that involves multiple owners, also called members.3 min read
Updated November 4, 2020:
An LLC operating agreement with multiple classes is a business structure that involves multiple owners, also called members. To create one, you file articles of organization with the secretary of state where you plan to operate. In most jurisdictions, the initial documentation must include the names and addresses of the members.
The Operating Agreement
Though not always required by law, operating agreements are highly recommended to prevent lawsuits and protect against liability. This document is the LLC's bylaws, shareholder agreement, and equity purchase agreement all rolled into one. It is entered into by the members when the LLC's certificate of organization (also known as a certificate of formation or articles of organization) is filed or possibly just before.
Unlike corporations, LLCs don't have many statutory requirements on how to operate the business and how to manage equity interests. Instead, those things are covered in the operating agreement, which should include:
- How many classes of membership interest there are and the rights and responsibilities of each one.
- A description of ownership rights to prevent confusion and tension among members.
- A system of checks and balances. This is sometimes required by state law.
- A description of voting rights, member responsibilities, financial topics, how the agreement can be changed, how members can withdraw, and how the company can be dissolved or sold.
In addition to information about the members, you may also have to submit details on how you will manage the company when you file your articles of organization.
- You can choose to operate as a member-managed LLC, meaning that you and the other members run it yourselves.
- You can also have a member-managed LLC that is run by professional managers.
- Some LLCs prefer a hybrid of the first two options where the members choose a set of board members to run the company.
Taxes for Multi-Member LLCs
The United States Treasury Department has a set of rules for classifying businesses. Known as the Check-the-Box Regulations, they allow multi-member LLCs to choose how they will be taxed. The options are as a C corporation, an S corporation, or as a partnership under Internal Revenue Code Subchapter K. If no selection is made, the tax status defaults to a partnership.
Prop. Reg. §1.1402(a)-2 is an IRS guideline for determining the tax liability of members in a multi-member LLC that is being taxed as a partnership. Generally, members must pay SET on distributive shares of income from the LLC unless:
- They are not personally liable for the obligations of the LLC.
- They work for 500 hours or less for the LLC during the tax year.
- They have no LLC agency authority and cannot sign contracts for the LLC.
If the LLC elects to be taxable as an S corporation, the members don't have to pay Social Security taxes on their distributive shares of income. The net income of an S corporation is not subject to these taxes.
Ownership interest in an LLC, also known as equity, is called membership interest. Unlike shares of stock, you don't have certificates that reflect your membership interest. Instead, the LLC has an operating agreement that outlines who owns what percentage and the associated distribution rights. For example, four members with equal ownership in the LLC would each have a 25 percent membership interest. You cannot freely transfer ownership of your interest in an LLC. Sometimes membership interests are expressed as units rather than percentages.
Capital Interests and Profit Interests
As a member of an LLC, you are allowed to have capital interests or profit interests. Capital interests give you ownership of the equity and the profits of the business. What you receive is in proportion to your share of the ownership. So if you own 25 percent interest, then you get 25 percent of profits distributed, 25 percent of equity if the LLC is sold, or 25 percent of the liquidation proceeds if the company goes out of business. This is the most common arrangement and involves only one class of membership.
It is possible to have multiple classes of equity in an LLC. In a real estate LLC, for example, you may have an actively managing member and other passive participants. The managing member may have more voting rights than the passive members. The managing member might only own 25.5 percent of the equity but control 51 percent of the vote.
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