All About Member-Managed LLCs
A member-managed limited liability company (LLC) is a simple yet effective business structure often used by small businesses to provide robust liability protection for the owners. With a member-managed LLC, all of the owners, or members, share the responsibility of managing the company. In contrast, a manager-managed LLC is overseen by an appointed or designated manager or management group (the "manger") and not all of the members have a role in management.
Conceiving of an LLC as a general partnership provides a good angle from which to approach the LLC’s management structure. To manage a partnership, all of its partners must participate in the oversight of the company’s daily operations. But the partnership structure works best for smaller companies. Once a company expands, it may require the hiring of a manager. A member-managed LLC is a great option to accommodate that transition to increased oversight and control over company operations because it allows a business to choose whether to fill the manager role with one or more of its members or to hire an outside party, like a consultant or business manager. The members can always elect to transition to a manager-managed LLC by appointing an individual or management group to oversee its daily operations. So choosing member management at the LLC’s creation does not mean that members have to remain involved in management indefinitely.
A member-managed LLC has other advantages. One of the biggest benefits is that the members are not personally liable for the company’s debts or obligations. Members of a member-managed LLC are protected from creditors , except to the extent that they become personally liable through a separate agreement or through improper personal action. If a member of an LLC is sued, only the member’s stake in the company may be at risk in the lawsuit. However, the creditors of the LLC may pursue the assets of the company to satisfy any debts or obligations that the LLC may accrue.
And an LLC is generally less expensive to create than a corporation. Appreciating the distinction between the two becomes easier when we compare their respective "managerial" structures. The boards of directors of corporations have a high level of authority over company oversight, but the requirements for their appointment and operation are set out by state law. Members of an LLC take a seat on the "board" automatically, which means that there is no formal designation, appointment or registration required for them to start managing the company. There are no state-imposed rules that govern how a member-managed LLC must be run or when it can transition from a member-managed LLC to a manager-managed LLC. A member-managed LLC is freed from many of the financial and operational obligations required of a corporation.
Why You Need an Operating Agreement
While not legally required, an operating agreement for a member-managed LLC will amend the default rules that are contained in the state LLC statutes. If any of the default rules are not desirable to the members, the operating agreement can provide alternative rules. Further, without an operating agreement, the state statutes will provide rules on how the LLC will be managed, how profits will be distributed, how disputes will be resolved and how major decisions will be made. These rules can be fairly general and leave a good deal of uncertainty. For example, if management decisions need to be approved by the members, how do you address a situation where both members of the LLC voted against the same proposal? Is the proposal deemed to fail, or can you break the tie in some manner? By creating an operating agreement, you can eliminate this and other uncertainties.
Likewise, many state LLC statutes address disputes by requiring mediation and/or arbitration. While these methods can be effective in resolving disputes, it is unlikely that the parties to an LLC will want to be compelled to use them in many, if any situations. An operating agreement can specifically address the manner in which disputes should be resolved.
The default rules provided in the state LLC statutes will provide default rules for the management of the LLC. Unless an operating agreement provides otherwise, these rules will apply. For example, Utah’s default rule is that the managers are elected by the members, but managers will generally have control over LLC decision-making. Nevada’s default rule is similar, but gives management authority only to those managers who are in active control, meaning that they are performing management services for the LLC. Most states, however, also default to allowing members to manage the LLC. Some members may desire to have control over certain aspects of the LLC management (e.g., real estate activities or sales), while others may prefer to control financing activities. An operating agreement can allow some members to control one aspect of the management and others to control a different aspect of the management. Alternatively, the operating agreement can provide that no member will have management authority and that all management will be done by employees of the LLC.
The Most Critical Parts of an Operating Agreement for a Member-Managed LLC
A fundamental document for member-managed LLCs is the operating agreement (OA). Through the OA, the members define their roles, responsibilities, and relationships among themselves and in relation to the business. The OA also establishes the framework for how the LLC will be run, including its operational guidelines.
Several essential elements that should be included in an operating agreement for a member-managed LLC are:
Member roles and responsibilities. The OA should spell out the specific roles each member has in the daily operations of the business.
Voting rights. Each LLC member must be afforded the opportunity to vote on issues concerning the company.
Profit and loss sharing. The OA should include the distribution of profits and losses among the members.
Decision making. While frequently the decision-making process for many transactions can be handled by company officers, only certain decisions should typically be subject to a vote of the members as a whole. These include:
Meeting protocol. It’s important to have a mechanism for notifying members of general meetings and special emergency meetings.
Creating a Robust Operating Agreement
The process of drafting an effective operating agreement starts with the Members discussing their goals for the company and assessing the specific needs of the business, which will then inform the creation of a comprehensive document. The flexibility of the LLC arrangement allows Members to choose from templates or customize the operating agreement to meet their specific needs. A template may be helpful in that it provides a solid starting point to get to that specific customized agreement, but take care: failing to customize a template can be problematic if your business does not function as the template assumes. Importantly – and this goes for either templates or custom arrangements – a Members’ unwillingness to put their agreements in writing is usually a precursor for potential issues down the road. Even if there is only one Member at the outset, the Member should draft an operating agreement in the event future Members enter the LLC.
For example, it is not uncommon for an operating agreement to provide that Members of an LLC be paid by the company on a basis other than a fixed salary, which could include hourly compensation, commission, or even free rent in a residential property owned by the company. These types of compensation structures can promote entrepreneurial behavior on the part of the Members and can allow them to adjust their compensation packages as needed to reflect their economic circumstances. However, especially when there is only a single Member, the Member should structure the compensation arrangements in a manner that maintains the LLC’s pass-through status and that does not subject the Member to additional self-employment taxes (especially, high Medicare taxes).
Drafting the operating agreement can also involve sketching a simple table of contents of the agreement, listing the key elements to be addressed – e.g., the formation of the LLC, its name, the term, counsel, and the Members; etc. Members should also confer over the LLC’s start-up and operating costs, its proposed organizational structure, such as whether it will be a single- or multiple-Member LLC, its project or geographic scope, its economic and taxation structure, and the methods it will use to account for payments and distributions. Members should also weigh if, or when, they anticipate their use of the LLC will change, and them structure the agreement accordingly. If the LLC will have separate divisions or projects with differing needs, business plans, or financial resources, then those divisions might be treated as separate business enterprises under their own subdivision/sub-LLC agreements.
One common pitfall is when Members fail to consider what will happen to their business if a Member dies before the enterprise is up and running. Will the departing Member leave his or her share of the business to someone who has experience or expertise relevant to the business? Will there be any particular restrictions on transferring interests upon death? (e.g., a right of first refusal, or the establishment of a mandatory buy-sell agreement). Members need to consider how an unforeseen event, such as a death or divorce, can affect the stability of the business.
Another common pitfall is failing to address management issues satisfactorily, including the appointment and primary responsibilities of each Member and establishing means for resolving Member disputes in case of a deadlock. The Members also should consider setting forth guidelines for the development of new business projects and investments by the LLC, keeping in mind cash-flow requirements and the means for funding such expenditures. Other items that should be considered include the composition of the board of directors, designation of "officers" for day-to-day management, and appointment and rotation of "captive" directors (directors designated by specific, large equity holders) on an as-needed basis.
It is advisable to have an attorney draft and review the operating agreement (before the LLC is formed, if possible), as well as any amendments that may later be proposed.
Amending and Updating Your Operating Agreement
Even after taking the time to create a sensible and comprehensive operating agreement, members may find that they need to update or amend the document to suit their evolving business needs or if there are changes in ownership within the LLC. As opposed to other business entities, like corporations, with operating agreements are typically, yet not always, adaptable and the agreed to modifications are not usually dictated by statutory requirements. However, there are some instances when LLCs will be subject to state law concerning the amendment of their operating agreements. For example , Alaska adopted a statute in 2004 that went into effect in early 2005 and requires all Alaska limited liability companies that have not made an election to be governed by an operating agreement to have a written operating agreement. In order for an amendment to be legally binding, the members must unanimously agree to the proposed modification. It is advisable to put the amendment in writing and have all members sign it. If the amendment is accepted unanimously, it is a good idea to have it incorporated into the original operating agreement or placed in an addendum to that document to avoid confusion down the line – especially if the document requires one signature from each member to be considered valid.
Compliance, Regulation, and the Law
When it comes to operating agreements, member-managed LLCs need to take into account certain legal requirements and compliance issues. While the specifics may vary from state to state, the general requirement is that LLCs must have an operating agreement that complies with state law. Most states do not expressly require member-managed LLCs to have written operating agreements, but it is generally recommended that they do so for the protection it affords members.
An operating agreement is a contract among members that sets forth the LLC’s management structure and the financial rights of the members. Many states require, if not encourage, LLCs to have written operating agreements. However, even if not expressly required, a written operating agreement may be necessary under the terms of your state’s LLC statute in order to meet formation requirements and maintain legal compliance. An operating agreement also becomes increasingly necessary when creditors of the LLC attempt to hold members liable for the debts of the LLC.
If you have members with diverse skills, interests, or opinions, a written operating agreement can be helpful to resolving any conflict that may arise among members. If members disagree on major business decisions, an operating agreement can provide a means for resolving such conflicts while avoiding costly litigation.
A properly drafted operating agreement can also help to establish liability limits for managers and members alike. In fact, LLC members are limited in personal liability in most jurisdictions. In general terms, this means that members and managers of an LLC typically are not personally liable for the obligations of the LLC. But if a member manages the business directly, he or she may be held liable for the debts or misconduct of the LLC while acting in that capacity. In addition, individuals can be personally liable for crimes and torts they commit while acting on behalf of an LLC.
State laws typically provide statutory protections for managers and employees. However, those protections may not extend to unpaid managers, which can lead to liability risks. A properly drafted operating agreement can limit management liability. But without a written agreement, such liability risks are increased and may even include claims arising from the breach of fiduciary duties, such as the duty of loyalty, the duty of care, and the duty of good faith.
Operating agreements for member-managed LLCs are entirely customizable, and as such they can be tailored to fit the individual needs of the LLC. Consequently, an agreement addressing management authority and liability will be different for every member-managed LLC. It is essential for members to work with legal counsel to determine what protections should be included in your operating agreement, and what limitations may be necessary to maximize the protections of the LLC.
Operating Agreement Clauses: Real World Examples
One of the most effective operating agreement clauses for a member-managed LLC is that the unanimous consent of all members is required for certain important decisions. Here is a summary of what common types of decisions most often require unanimous member consent: Every LLC should contain terms similar to the above clause because members are the ultimate owners of the LLC. Any important decision that could affect the value of the members’ ownership interest should be made only with the consent of each member. The above clause would prevent a minority member from being outvoted or ignored by the majority.
Another very useful operating agreement clause is that upon the death of a member, his or her ownership interest will be bought out by the surviving members rather than being inherited by that person’s heirs. This purchase can be implemented at the same time as the purchase price is being determined. In this way, the members can avoid having a stranger inherit an interest and become a member in their LLC. This clause also helps establish the value of an ownership interest for heirs who may be heirs of a non-member who has an interest in the LLC.
A common operating agreement clause that is advantageous for tax purposes is the addition of a "qualified income offset" clause , which provides that any special allocations will not cause any member to have an adjusted capital account deficit. Similar language can also be used to provide that allocations will be made in a manner that will cause no member to have an adjusted capital account deficit.
The above clause stems from the Internal Revenue Code, which provides that "special allocations" of partnership income and gain that would cause a partner’s capital account to become negative within the taxable year must be allocated back to the remaining partners so as to prevent a capital account deficit.
Many member-managed LLCs also contain provisions terms relating to the commencement of business. These provisions usually provide that the members will file paperwork with the appropriate state or local government agencies in order to legally form the LLC as soon as possible after signing their operating agreements. These provisions typically state that the date of formation will be retroactive to the date the LLC has filed its paperwork.