Key Provisions in an LLC's Operating Agreement
- Created: Thursday, 10 August 2017 11:40
"Key provisions in an LLC's operating agreement" by Kelli Madigan
A limited liability company (LLC) should have an operating agreement to govern its internal management and the relationship among the members. Since an LLC’s operating agreement is a contract among the owners, it can be tailored to suit the owners’ needs.
The following should be addressed in an operating agreement.
A. Informational Provisions
The operating agreement should contain basic information regarding the names and addresses of members, managers and the registered agent.
B. Type of Management
An LLC may be managed by its members, or the members may delegate various degrees of managerial authority to one or more managers. Managers may be, but are not required to be, members. When members are primarily responsible for the conduct of the business, they function in a manner similar to general partners in a partnership. If all of the managerial powers of an LLC are vested in managers, then the management structure is more similar to a corporation.
One of the advantages of an LLC is the flexibility of the members; they determine what level of management responsibilities are delegated to a manager while still retaining other managerial powers and authorities to themselves. When members delegate only limited responsibility to managers while retaining substantial managerial powers to themselves, the management structure is a hybrid―combining elements of the corporate form with those of a general partnership. Your choice of management structure would be implemented in the operating agreement.
C. Contributions, Capital Accounts and Loans
Capital accounts reflect a member’s economic interest in the LLC. This begins with a member’s initial contribution to the LLC, which adjusted on an ongoing basis to reflect the member’s allocations of profits and losses, distributions of cash or property, and assumption of liabilities. Proper maintenance of capital accounts is critical to the taxation of an LLC as a partnership for federal tax purposes. The operating agreement should reflect the form and value of each member’s initial capital contribution. Additionally, it should indicate whether members are obligated to make additional capital contributions (also known as capital calls).
D. Profit and Loss Allocations
The allocation of profits and losses is purely an accounting procedure in which members are allocated a share of the LLC’s profits and losses for federal income tax purposes. In the simplest of forms, these allocations will be in accordance with the members’ percentage interests in the LLC. You could also consider whether profit or loss allocations should be different depending on the source of the profit or loss, income from operations, capital transactions or liquidation proceeds. These types of special allocations are most often used in LLCs set up with multiple classes of membership interests, such as where one class is set up like “preferred stock” with minimal voting rights but greater investment risk.
Distributions, unlike allocations of profits and losses, are actual disbursements of cash or property to a member. There are many options available regarding the amount and timing of distributions of cash or property from the company. Distributions of cash or property could be based on the following:
- percentage of membership interests;
- an agreed upon percentage (other than percentage of membership interests);
- per capita;
- pro rata in accordance with capital contributions; or
- any “priority” or “special” returns of capital.
The timing of distributions will likely depend on the productivity of the LLC and the cash flow needs of the LLC throughout its calendar year. Minimum distributions to cover each member’s income tax liability arise from the allocation of income to that member.
Each member’s interest is simply the member’s ownership in the LLC including both managerial and economic rights. An operating agreement should address the transfer of a member’s interests. For example, a transfer may be necessary in the event of the member’s death, disability or retirement, or an outright sale to a third party. The most restrictive position is that no interests may be sold or passed on without the unanimous consent of all of the members. The most flexible position is that interest may be freely transferred to any other person or entity. There can be any number of variations of restrictions on the transfer.
Typically an LLC is formed with a “perpetual life” under the articles of organization. However, the articles may certainly provide for dissolution as of a certain date or upon the occurrence of certain events. Dissolution provisions may also be overridden by the vote of a percentage of member interests as stated in the operating agreement. It can provide for a percentage of majority vote, super majority vote or unanimous consent.
LLCs are created under state statutes that provide default rules to govern operational and management issues if an operating agreement does not address them. Thus, if a dispute or issue arises which is not governed by the terms of your operating agreement, then the provisions of the Illinois Limited Liability Company Act (805 ILCS 180/1-5, et seq.) will govern.
Kelli Madigan is a shareholder at Mathis, Marifian & Richter, Ltd. in Belleville, Illinois. Kelli focuses her law practice in business law, estate planning, taxation, real estate and banking.
Professional Services Disclaimer: Please note that the information presented here is as an educational service, and while it contains information about legal issues, it is not legal advice. No warranty is made regarding the applicability of the information presented to a particular client situation, and the information set forth is not a substitute for original legal research, analysis and drafting for a particular client situation.