Under New York state law, business owners who form a limited liability company are required to create an operating agreement which details the procedures by which the LLC will operate.
Despite the requirement, many companies don’t have an agreement in place, or have created a document using boilerplate language without advice from an attorney.
Owners who don’t have an agreement probably shouldn’t worry about the state coming after them: New York has no penalties for failure to comply with this aspect of the LLC law.
But just because there is no need to fear penalties does not mean business owners should ignore the operating agreement requirement – by doing so, owners will miss a prime opportunity to strengthen their business at its birth. The operating agreement can help ensure that all of the owners of an LLC are on the same page about how the business will operate. An operating agreement is drafted at perhaps the best moment to set those rules: when a business is being formed and all of the parties involved are usually in agreement (and agreeable).
A thorough operating agreement, created and vetted by an experienced small business attorney, may serve as springboard for a successful business venture. It can help avoid future disagreements by spelling out a business’s guiding principles and by specifying how and when things are going to happen.
An operating agreement will specify when and where an LLC’s members will have their annual meeting to review the performance of the business and make necessary decisions, and also specify when, how and by whom special meetings can be called to address issues which may arise. The operating agreement also sets out the purpose of the business and allows owners to determine who will manage operations, where financial and other business records will be kept, and how changes to the agreement should be made in the future. The limited liability of members, the rights of members to access LLC records, and certain tax matters are among other standard operating issues addressed in the agreement.
Some items require contemplation and decision-making among the LLC’s members. Those decisions should be clearly reflected in the agreement, so everyone understands how the company will run in good times and in bad.
Among the other significant issues that should be addressed include:
- Management. Who will run the business? Will all or some of the LLC’s members serve as managers? Will an outside manager be hired to run the operation? How will the manager be compensated?
- Decision-making. What happens in the case of a deadlock among members over a matter? Will the issue proceed to arbitration? Or will it trigger the end of the business?
- Capital calls. Will members need to contribute funds to the LLC beyond an initial investment? How is the need for additional capital determined? How is a capital call communicated? What happens if a member fails to make a contribution? If one member contributes more during a capital call than other members, does that person receive a greater percentage of the business?
- Taxes. Which LLC member will be responsible for handling tax issues? One person should be selected to avoiding having multiple members dealing with state and federal taxing authorities, and so it is clear that one individual is responsible to ensure all flings and payments are properly made on a timely basis.
- Distributions. If the LLC generates a great deal of capital, how much of it will be distributed? Can it build a reserve? If so, how much and for what purposes? Because the members of an LLC pay taxes on the LLC’s profits, members may be forced to pay income taxes on money which is held in reserve and not actually distributed (known as “phantom income”). Will the operating agreement address this concern by including language requiring minimum distributions to offset the members’ tax liability?
- Sale of shares. The operating agreement can also address what rules will apply if members want to sell their share of the enterprise. It should spell out whether the other members of the LLC have the right of first refusal to buy the shares, and on what terms. It should also specify if there should be any exceptions, such as for transfers to family members or estate planning transfers to a trust.
- Competition issues. Will members be asked to refrain from competing with the business? How exacting will a non-compete agreement be? While a member has a fiduciary duty to work in the best interests of the LLC, the business may also be a side venture, and not a member’s primary source of income. In the member’s primary job, they may even compete with the LLC. In that scenario, it’s unlikely that a member will quit the job that provides their main source of income in favor of the LLC. The operating agreement can address such a situation in advance and help avoid future conflicts over competitive concerns.
- Dissolution. Finally, an operating agreement should determine when an LLC may be dissolved or ended. It should spell out what happens when a member wants to withdraw or passes away. It can also define certain events that will trigger dissolution, such as a deadlock among members that can’t be resolved or if profits drop below a certain level. Those provisions are particularly useful in New York, where the standards for dissolution of an LLC are very strict and limited. Dissolution can occur through a judicial proceeding, but the members must show that the LLC can no longer function. An operating agreement can ease the process by clearly defining certain events that will trigger the members’ right to dissolve the LLC. Having an operating agreement in place at the beginning of the business allows for a smoother ending.
A modest investment in a thorough, professionally drafted operating agreement can avoid lengthy, ugly and expensive disputes down the road.
This post does not constitute legal advice or establish an attorney-client relationship.