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I Know I Need An Operating Agreement, Now What?

In my last post, The Limited Liability Company Operating Agreement Part 1; The LLC Business Plan & Owners Manaual, I explained how filing the articles of organization with the appropriate state agency to activate your LLC is just the beginning.

Business owners form LLCs to take advantage of statutorily prescribed protections and tax benefits. Whether or not the protections and benefits will be applied to your LLC when it comes before a judge, is a question of operation. If the LLC was operated consistent with the requirements in the state’s LLC Act, and the provisions of the LLC operating agreement, the LLC will receive all potential protections.
Understanding that you need an operating agreement is the first step to running your LLC, understanding the operating agreement is the next step.  For most people, the idea of understanding either the provisions of a large legal document such as an operating agreement or a state’s LLC Act seems overwhelming.  The thought of perusing all the “thereins” and “heretofores” makes them feel like they are shrinking dizzily under a mass of words.  It does not, however, have to be this overwhelming.  If we understand a few critical concepts the LLC turns out to be quite easy to own and operate.

The LLC is Not Governed By Hidden Laws About Fiduciary Duties

As I mention in the History of the LLC, the LLC is different from a partnership and corporation in that it is a purely contract and statute derived business structure.  Both partnerships and corporations have decades of case law where judges added little bits and pieces to the laws that govern these entities.  Businesses have to rely heavily on attorneys to stay on track and comply with all the hidden fiduciary duties that are not in state statutes and somehow override their partnership agreements and corporate bylaws.  The LLC is different however.  It does not have the long legal history in the courts where judges made up additional rules, and when the LLC has been judged in courts, judges have been forced to leave it alone because the state LLC Acts are clear that judges should not add to what is already in the act.

The Four Divisions Of LLC Act Provisions; It Isn’t Hard To Understand

The fact that judges have not added to the law governing LLCs for the most part means that LLC owners have to worry about two things, 1) knowing in basic terms the main issues addressed in the state LLC Act, and 2) having an operating agreement that customizes the LLC to fit the owners business model.   A New Hampshire attorney named John Cunningham is the nations foremost expert on LLC law, and has done an amazing job at reducing the complexity of LLC statutes.  To cut to the chase, the provisions of an LLC Act address issues affecting the LLC, its operation and members.  A provision is an individual section. It contains a title and one or more paragraphs addressing one or more issues.  Cunningham sorts the LLC Act provisions into the following four areas.

1. Definitional provisions: These provisions define the parts and terms of an LLC. An example of this is the “LLC interest” definition in most statutes. In most LLC statutes, the LLC interest is defined as “personal property”.  This is important because it affects how one can transfer or sell the interest, and also affects how the property is treated in bankruptcy.
   
2. Mandatory provisions: All state LLC Acts have a few “thou shalts!” or mandatory provisions.  The way the provision is written is the way the law is and will be applied in court.  An example of a mandatory provision in some states is the requirement that managers refrain from taking a “business opportunity” that the LLC is in the business of.  The manager must make the members of the LLC aware of the opportunity and give the LLC rights to the opportunity.  In some states however, this same issue of whether a manager may act on a business opportunity in the LLC’s line of business, is a default provision and members may override the provision in the state statute by writing a different course of conduct for such situation in the operating agreement.
3. Default provisions: As just discussed, default provisions prescribe a course of conduct for certain issues, but leave it open for LLC members to write a different course of conduct concerning the issue into their operating agreement.  An example of this is the New Hampshire statute RSA 304-C:40 which essentially prohibits interim distributions (or the distributions of money to LLC members at times other than the disolution of the LLC) unless they are provided for in the LLC operating agreement.  Thus, members cannot distribute LLC income to themselves to pay taxes or for other needs under the statute provision, but they can override this provision in their operating agreement.  Arizona takes the oposite approach and makes such interim distributions at the discretion of the members, but allows them to prohibit such distributions if they wish by writing such a provision in the LLC’s operating agreement.
4. Permissive provisions: Permissive provisions are basically suggestions that are put in the LLC Act to bring attention to a certain issue.  These provisions generally explain an issue such as whether or not an LLC may indemnify its managers from legal liability for certain actions, and then says — if you want to do so, you may, but you must write it into the LLC operating agreement.

If you understand these four basic categories, you are way ahead in understanding the LLC.  In my next post I will explain how STARTright assembles an operating agreement for its users and how they can use the digital editor to better understand and customize their agreement.

Tags: Limited Liability Company, LLC, llc act, Operating Agreement