LLC Operating Agreement

What Is a Multi-Member LLC Operating Agreement?

A multi-member LLC operating agreement is a legal business document that lays out the ownership and operation of a multi-member LLC. The agreement outlines the financial and working relationships between the members of the LLC and between the managers and the members of the LLC.

A multi-member LLC operating agreement should be signed by all of the members of the LLC in front of a notary, and each member should be given a copy of the document. A copy of the signed multi-member LLC operating agreement should also be kept at the company's physical address.

Elements to Include in a Multi-Member LLC Operating Agreement

A multi-member LLC operating agreement is a contract between the members of the LLC. What's in the contract is mainly determined by the members of the LLC, so exact content varies. However, in general, the operating agreement determines how an LLC is run and how to solve any disputes that arise between the members. Because of this, creating and upholding an operating agreement is extremely important to multi-member LLCs.

Core elements of a multi-member LLC operating agreement include the following:

• Structure of equity: There are many sub-sections to the structure of equity section of a multi-member LLC operating agreement.

  • Membership interest: The membership interest is typically represented as a percentage interest in the business. The membership interest is broken down into two components, economic interest and management interest.

  • Classes of membership interests: This is the opportunity for an LLC to set up equity structures similar to that of partnerships and corporations. The LLC can have non-voting interests, common interests, preferred interests, convertible interests, profits interests, and others.

  • Contributions and capital accounts: A member's initial capital contribution decides the initial percentage of interests he's entitled to. A capital contribution can be cash, property, services rendered, or any combination of these things. It should also be decided whether members will make ongoing contributions or only an initial contribution.

  • Allocation of profits, losses, and distributions: The multi-member LLC operating agreement should decide how profits, losses, and distributions are divided among the members. The division doesn't have to be equal or even equal across classes.

• Management: A multi-member LLC may be managed by members or managers. This section should lay out the specifics of how the LLC should be managed. If the multi-member LLC is manager-managed, this section should lay out how to select managers, the frequency of manager meetings, voting procedures, duties and responsibilities of managers, the term of services, and procedures for removing and replacing managers. This section should also describe how the multi-member LLC will be managed on a day-to-day basis.

• Voting: Traditionally, members vote in proportion to their percentage of capital interest invested in the LLC. The multi-member LLC operating agreement can set the terms for voting. This section can also withhold the right for certain members or a certain class of members to vote. Voting rights can be determined by capital contributions, capital commitments, or capital accounts. Some members can even have veto rights or supermajority votes.

• Limitations on liability and indemnification: This section has to do with the duties and obligations that managers have to the members and to the multi-member LLC.

• Books and records: This section lays out how the LLC's records should be kept. It also states what rights the members have to examine corporate and accounting records of the multi-member LLC.

• Anti-dilution protections: This protects current members in allowing them to maintain their percentage of interest in the business when the LLC offers membership interests to a new member. There are numerous ways to do this, current members may be allowed to veto new members or to purchase a new class of membership status to maintain their current percentage of interest.

• Restrictions: There are a few important sections within the restriction of transfer.

  • Assignability of interests: A membership interest can be assigned without including management rights. Any restrictions are set that must be complied with if a member wants to transfer economic and management rights of a membership interest in the multi-member LLC. The management rights include the following:

    • Veto and approval rights: A transfer may require the approval of a certain percentage of all members.

    • Right of first approval: The LLC or other members receive the right, within a period of time, to match the third party's offer to buy the other member's membership interest.

    • Permitted transfers: This provision allows for certain transfers, such as transfers to affiliates or estate planning.

  • Buyout: This section sets up the events that can lead to the buyout of another member. Those events might include death, disability, bankruptcy, or termination of employment. This should also include the process through which the buyout will take place. Two very important sections here are the "put" provision and the death provision.

    • Put provision: This is a fallback provision. It kicks in when a member has not received an offer from a third party but wants to sell his interest to remaining members or purchase the interests of the remaining members. The put provision is used when no other agreement can be reached to settle the severance of ownership. This provision might set a percentage of affirmative votes needed to force out another member.

    • Death: In the event of a death of one of the members, the other members should know how to distribute that member's capital interest and interest in the LLC. A member has the right to transfer his interest to a permitted transferee without triggering the right of first refusal provision. Or, the LLC itself might get a set amount of time to have right of first refusal. The transferee could become a member or just an economic interest holder. The LLC might also require the repurchase of the member's capital interest in the LLC upon their death.

  • Tag-along and drag-along rights: This section offers protection for minority members. If a majority member sells their interest, these tag-along rights give minority members a chance to join the deal. It also ensures that minority members' interests are protected during a sale. A majority member might be able to force minority members to join a deal (via drag-along rights), but they are guaranteed identical terms.

• Confidentiality: This includes non-compete and non-solicit clauses.

• Liquidation and Dissolution: This section lays out who may decide that the LLC should be dissolved. It also lays out how the multi-member LLC should be dissolved and how assets should be distributed.

• General provisions: This section should include how members of the LLC solve disputes, preferably through non-binding mediation, followed by binding arbitration. There should also be a section on what is necessary to make an amendment to the multi-member LLC operating agreement. This should include an "adverse effect" provision that empowers members who might be affected by the decision to amend the operating agreement.

The Hackl Problem within Multi-Member LLCs Operating Agreement

Some LLCs are used for estate planning, but there's a new legal challenge to this type of agreement. In 2002, a tax court heard Hackl v. Commissioner. The decision caused concern for estate planners.

Hackl, a family patriarch, had set up an LLC and made numerous exclusion gifts over several years. The IRS challenged these gifts and their valuation, which resulted in a high tax burden. The operating agreement contained these provisions:

• The family patriarch is appointed manager for life.

  • The manager can only be removed with 80-percent vote.

• The manager has no fiduciary responsibility to the other members.

• Distributions are at the sole discretion of the manager.

• There is very limited transferability without the approval of the manager.

• The LLC has significant losses and won't be profitable for many years in the future.

The IRS decided that the LLC's operating agreement and significant losses meant that there was no "present interest." The court agreed with the IRS.

How To Avoid a Hackl Situation

One simple way to avoid a Hackl situation is to not appoint a manager for life. The sole authority shouldn't reside in a senior family member with no power for other members to remove the manager. Removal of the manager should likely be by majority vote of the members.

Members should also ideally have responsibility and obligation to the other members. This wasn't present in the Hackl case. This is known as fiduciary duties.

Members should have the unrestricted right to withdraw from the LLC. This idea is contrary to estate-planning goals. If this doesn't work for your LLC, consider requiring annual or quarterly distributions in amounts that are sufficient to cover the LLC's tax liabilities.

The multi-member LLC operating agreement should also provide for some transferability of interests.

If some or all of these provisions are included in your multi-member LLC operating agreement, you should be able to avoid the problems of the Hackl case.

Single Versus Multi-Member LLC Operating Agreement

An LLC can be established as a single-member or a multi-member LLC, and the operating agreement will reflect whether that. Each type of LLC has different objectives and concerns to address in the operating agreement.

A multi-member LLC typically focuses on solving issues and disputes between the members. This isn't an issue in a single-member LLC, as there's only one member. In contrast, a single-member LLC must focus on differentiating the single member's business interests and assets from his personal interests and assets.

When deciding whether your LLC should be a multi-member or single member LLC, you should consider more than just the number of owners. There are advantages and disadvantages to both options, so the best interests of the LLC should be the deciding factor.

For instance, no federal tax return is required for a single-member LLC, making this a slightly easier arrangement when tax season comes. The income from a single-member LLC is reported on the member's personal tax return. In a multi-member LLC, each member is given a K-1 to file with their taxes.

How Does Equity Work in a Multi-Member LLC Operating Agreement?

There are multiple types of equity in a multi-member LLC that must be considered when creating an operating agreement.

Membership Interests

A membership interest or equity is the owner's interest in an LLC. The membership interest isn't recorded in certificates but instead in percentages. The operating agreement defines the percentage that each member owns and what that translates into in terms of distribution rights. As an LLC member, you can't transfer your interests without consulting with the other members of the LLC.

Interests

Each member in an LLC has capital interests or profit interests in addition to the membership interests. Capital interests give a member interest in the equity and the profits of the LLC. This is the standard used in most multi-member LLC operating agreements.

Classes

An LLC can be split into multiple classes so that different members receive different rights, such as voting and distribution. For example, a member who does the majority of the management of the LLC may only own 25 percent but could have 51 percent voting control.

The operating agreement is very important to a multi-member LLC because, unlike corporations, there are very few statutory requirements regarding how an LLC must be governed.

The operating agreement should clearly define the classes of membership and how the equity will be distributed among the members. The clearer the multi-member LLC operating agreement, the less likely members are to have problems and disagreements in the future.

How to Write a Multi-Member LLC Operating Agreement

Writing a multi-member LLC operating agreement is no easy task. It's possible to use sample forms found online to be the basis of your LLC's operating agreement, but it might be the best for the company if you consider hiring a knowledgeable lawyer to help create the document. UpCounsel has many lawyers who have experience creating multi-member LLC operating agreements.

Whichever option you choose, the basic steps used to draft the operating agreement will be as follows:

1. Start with the company name, the names of the LLC members, and the date.

2. The second section of your multi-member LLC operating agreement should include the following:

   • Formation: the date that the LLC was formed, the company name, the state where the LLC resides, and the section number of the law that governs the LLC.

   • Name: the name of the company.

   • Purpose: the purpose of the company.

   • Office: address of the LLC's main office.

   • Registered agent: the name and address of the third party who will receive communications on the LLC's behalf.

   • Term: the date on which the company began doing business.

3. Enter the state's name to say under which laws the LLC will be governed.

4. Have the owners sign and print their names to ratify the operating agreement.

5. List each owner's capital investment and ownership percentage. Include the owner's signatures here, as well.

6. Record each owner's valuation, which will link to their ownership percentages.

7. Have a notary complete the final page to prove the document is genuine.

Reasons to Use a Multi-Member LLC Operating Agreement

An operating agreement is important to an LLC because it determines the structure, working relationship, and financial agreement of the LLC. This prevents and gives guidance for solving any potential problems the LLC might have.

Protect Your LLC Status

A formal, written operating agreement gives the LLC status as a true LLC. Having an operating agreement helps to ensure that the courts will respect a company's limited liability status.

Defines the Management and Financial Structure of the LLC

The protocols and procedures laid out in the multi-member LLC operating agreement help the LLC to make decisions, handle finances, and settle misunderstandings. It also includes provisions to make sure that the members of the LLC can resolve any potential conflicts that might come up with the way shares or percentages are distributed or if a member dies.

Override Default Rules of the State

Each state has laws on how to operate an LLC. If your LLC has a multi-member LLC operating agreement, those rules supersede or override your state's default rules.

Without a multi-member LLC operating agreement, your LLC is subject to the default rules set out by the state. State rules generally aren't written to benefit and protect an LLC, so it's in an LLC's best interest to create its own operating agreement.

FAQs

• Is an operating agreement required for a multi-member LLC?

Legally, no. A multi-member LLC doesn't have to file an operating agreement with any government agencies. That being said, a multi-member LLC operating agreement can save an LLC a lot of problems in the future.

• Why does a multi-member LLC need an operating agreement?

An operating agreement for a multi-member LLC establishes the expectations that are held for the members of the LLC. Multi-member LLCs are prone to disputes and an operating agreement tries to prevent and solve these disputes.

A multi-member LLC operating agreement also protects the LLC financially, operationally, and structurally should a member decide to leave.

If you're ready to create a multi-member LLC operating agreement, you can consult with one of UpCounsel's highly trained attorneys who are ready to help at any time.