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Bar Association

Legal Staff News & Views Newsletter
January 2003

Structuring an LLC Operating Agreement

Limited liability companies (LLC) have become a popular entity selection. Some of the reasons it is so appealing is the transferability, which often assists in estate planning, asset protection, the ability to maintain control of the underlying assets, protection from creditors, and valuation discounts. An LLC can be classified as a partnership for federal income tax purposes.

A traditional "C" or "S" corporation is governed by the by-laws and Articles of Incorporation, an LLC is governed by the terms of its operating agreement. The following is a summary of the major components of an effective operating agreement.

Definitions:
Various terms utilized throughout the operating agreement should be defined in the agreement. Examples of such terms include distributable cash, the manager and/or management structure of the organization, the membership interest, the net profits and losses, the percentage interest of each member, and the reserves.

Formation of Company:
This section of the agreement should specify the name of the company, the organizational structure, the principal place of business, and the registered office and registered agent. It is also appropriate to insert the LLC's length of existence in this section.

Business of Organization:
This section summaries the type of activities that the organization will be engaged in. The general provision of "engaging in any lawful business" is added to whatever specific purposes the LLC has authority to perform.

Members:
Names, addresses, phone numbers, e-mail addresses, and possible social security numbers of all of the members of the organization are set forth in this section.

Obligations of Managers:
This section sets forth the management of the company. The organization may either have its entire membership serve as managers or may elect to have one member serve as manager. The organization may have a non-member serve as manager. The limits and restraints on the authority of the manager(s) should be specified in detail in this section. The authority of the manager(s) to act without the consent of the members should be specified in detail within this section. The term of office of the manager(s), the removal from office of the manager(s), and the appointment of a successor, should all be specified.

The specific powers of the managers such as acquiring property, borrowing funds, maintaining insurance, maintain property, investment of company funds, execution of documents, employment of agents and counsel, should be listed. It is often recommended that a collar limit be inserted which the manager cannot exceed without the consent of the majority of the members and/or unanimous approval. Normally the manager is prohibited from being a surety and/or indemnitor on any obligations that could result in liability for the LLC without the prior written consent of all the members.

The manager(s) also will desire a provision protecting him/her from any individual liability provided that he/she is acting as an ordinary prudent business person. However, the company would want to be able to hold the manager(s) liable for an fraud, deceit, gross negligence, or intentional misconduct by manager(s).

Depending on the type of structure of the company, it may be appropriate to specify the amount of obligations and hours to be expected of the manager(s). The salary of the manager(s), if any, should be specified. Furthermore, a detailed procedure should be in place as to how a vacancy in the management provision is to be filled.

Obligations of Members:
In this section the responsibility and liability of the individual members is set forth. Normally the member liability is limited to that set forth in the operating agreement and under applicable law. Often, a provision is inserted requiring a super majority or a unanimous approval to dispose of substantially all of the company's assets. It is commonly provided that no member has priority over any other member as to the return of capital contributions or as to net profits.

Members Meetings:
This section details the procedures, notice requirements, and scheduling of the members meetings. Often it is provided that meetings can be held by telephone or other electronic means. Furthermore, flexibility is often inserted by allowing action to be taken upon written consent of all the members entitled to vote despite the lack of a meeting. As in most small corporations, a provision is also included to provide for waiver of formal notice.

Contributions to the Company & Capital Accounts:
This section sets forth, in detail, each member's initial capital contribution and further details under what requirements and circumstances each member can be required to commit additional capital to the LLC.

Usually this section requires that a separate capital account should be maintained for each member. The account is increased by the amount of money contributed by such member, the fair market value of the property, the allocations to the members of net profit and losses, and any allocations of income to the member. It also provides that the member's capital account can be decreased by the amount of money distributed to that member, the fair market value of property distributed to that member, the allocation of expenses to that member, and the allocation of losses and deductions to that member taking into account any adjustments to reflect book value. A provisions is also included regarding the treatment of the capital account if there is a permitted sale and/or exchange of the membership interest. Furthermore, all liabilities of the LLC have to be paid prior to the LLC paying any part of a member's capital account. A member has only the right to demand and receive cash in return for his/her capital contribution.

Allocations of Tax, Distributions, & Elections:
This section sets forth a percentage ownership of each member and the allocation of net profits and net losses. This section also normally provides for limitations upon distribution. These limitations would be imposed if any distribution would cause the company to become insolvent or decrease the net asset of the company below zero.

The method of accounting and the adherence to generally accepted accounting principals would be provided for in this section. Additionally, the document would provide that no member is entitled automatically to interest or return of its capital contribution. A section could be provided allowing members or preventing members from making secured or unsecured loans to the company upon agreement. This fiscal year of the company should be specified.

Transferability of Interest:
This section of the operating agreement would govern the ability of a member to sell or otherwise transfer that member's interest in the LLC. Often the remaining members are given a right of first refusal upon written notice of that member's intent to transfer that member's interest. The time period for the notification and action and right of first refusal is to be specified. Also, the determination as to how the value is to be determined would also need to be specified.

Often it is provided that all of the remaining members do not approve by a super majority or unanimous written consent of a proposed transferee, then the proposed transferee gains no right to participate in the management of the LLC.

Additional Memberships:
This section sets for the procedural requirements for admitting an individual or other entity into membership of the LLC.

Dissolution & Termination:
This section governs dissolution of the LLC. The dissolution may be caused by a fixed period that has been specified upon the organization of the company. It may also be caused by unanimous written agreement by all members, or the death of a member(s), disability for over ninety (90) days, retirement, resignation, expulsion, bankruptcy, or dissolution of a member or occurrence of any act which terminates membership of a member in the LLC. Oftentimes the LLC retains the right by the consent of the remaining members after the event causing the withdrawal to continue the organization. A detailed procedure is normally set forth governing as to the valuation and purchase of the member whose interest is being terminated.

A provision for the winding up liquidated and distribution of the assets should be included. A procedure would need to be set forth for liquidating the assets and allocating any profits or losses and discharging all liabilities of the company. Furthermore, a provision would be required for the filing of the articles of dissolution with the Secretary of State and the possible return of any capital contribution of any individual member.

Miscellaneous Items:
A comprehensive operating agreement would also contain the standard contract language regarding notice provisions, provisions requiring the keeping of the books, accounts, and records, and the applicable governing law of the organization. A provision whereby each member would irrevocably waive their right to maintain an action for partition of the LLC's property is also beneficial.

Other standard provisions such as the method of amending the operating agreement, requiring execution of any documents necessary to comply with laws, rules, regulations, and the operation agreement itself, and that remedies contained in the agreement are cumulative should be provided. A standard provision regarding severability of any provision of the agreement not rendering the remainder of the agreement invalid should also be included. Binding the heirs, successors and assigns of the members is also recommended. A provision that the benefits of the agreement are not attachable by the creditors of any member should be provided.

By paying attention to detail and crafting a comprehensive efficient operating agreement, the chance of ambiguity and dispute arising in the LLC can be minimized.

Reprint authorized by Herbert J. Klein, Law Offices of Walter J. Zukowski, Peru, IL

F.Y.I. ...

Many times I have suggested photocopying your credit cards, social security card, and driver's license so that you would have a record in the event of a lost or stolen wallet. I recently received an e-mail with some additional good advice.

1. Call the toll free number on your credit card records and report it lost or stolen.
2. Make a police report in local where it was lost or stolen.
3. Call the three national credit reporting organizations immediately to place a fraud alert on your name and social security number. (This is especially important since you can apply for credit cards over the Internet!) Those organizations are:

Equifax: 1-800-525-6285
Experian (formerly TRW): 1-888-397-3742
Trans Union: 1-800-680-7289
Social Security Admin. Fraud line: 1-800-269-0271

The alert means any company that checks your credit knows your information was stolen and they have to contact you by telephone to authorize new credit. There are records of all credit checks initiated by thieves' purchases. This will pretty much stop thieves in their tracks before they can do a lot of damage.

For information contact Gloria Norton at DuPage County Bar Association, 126 S. County Farm Road, Wheaton, IL 60187-4597, Telephone 630-653-7779, Fax to 630-653-7870 or E-Mail to: gnorton@dcba.org.