SHOULD YOUR LLC HAVE AN OPERATING AGREEMENT?
Many people form limited liability companies (“LLCs”) for the purpose of shielding their personal assets from the claims of certain creditors. For example, by placing rental properties in one or more LLCs and conducting all of the activities relating to the rental properties through the LLC, creditors of the LLC can make a claim against the assets of the LLC, but generally not the owners’ personal assets. LLCs are the entity of choice for many business owners because of the ease with which they can be formed and because the owners do not need to follow many of the formalities that are required of corporations. Moreover, even if the owners do not have an operating agreement, default statutes in the state where the LLC is domiciled will guide how the LLC will function and the relationship between the members. Because LLCs are so easy to form and do not necessitate an operating agreement, many owners don’t bother to draft an operating agreement- often without knowing what the default statutes actually provide. Foregoing the time and attention to drafting an operating agreement can be a mistake for a number of reasons, including:
- Limitations on Transferrability of Membership Interest. If a member of an LLC with more than one member wants to transfer his or her membership interest and the LLC does not have an operating agreement, then under Idaho Code 30-6-401(3), the transferee will not be admitted as a “member” unless all of the members consent to the transfer. If the other members don’t consent to the transfer, then the member can still transfer his interest, but the transferee will only have a right to a distribution of profits when made, no right to participate in management of the entity, no right to vote and limited access to records of the LLC. This significantly reduces the price at which the member could sell his interest and significantly reduces the value of the interest to any transferee. Because an owner of an LLC may have a large portion of his or her wealth tied up in the LLC, it is preferable that the owner be able to extract his or her wealth from the LLC if the members do not get along or to transfer that value to his or her heirs upon his death. Owners typically want to restrict the transfer of membership interests so that strangers or competitors do not obtain an ownership interest. With careful drafting, this objective can be achieved and still enable a withdrawing member to extract value from the LLC by transferring his or her membership interest.
- The LLC may be in Limbo for 90 Days following the Death of a Sole Member. If an LLC has only one member and there is no operating agreement, then, under Idaho Code 30-6-401(3)(d), the personal representative may designate a person to become a member 90 consecutive days after the death of the last member. Because of the 90 day delay in appointment of the new member, the LLC is essentially left without anyone with authority to continue operations of the business during this 90 day period. This may result not only in lost business opportunities, but can also expose the LLC to penalties, fines and liability for failing to file tax returns, renew permits, and perform existing contracts. In contrast, an operating agreement can provide that the member may transfer his membership interests to his or her heirs on his or her death and that, subject only to certain requirements (including signing the operating agreement), they can become a member immediately.
- Non-differentiation between Members. In the absence of an operating agreement, Idaho Code 30-6-404 provides that any distributions made by an LLC before its dissolution and winding up must be in equal shares among members and dissociated members (according to their ownership percentages), except in limited circumstances. An operating agreement, in contrast, can be drafted not only to create different classes of members, but also to differentiate the amount of control various members have over the business activities of the LLC.
LLCs are one of the most flexible business entity forms available, but much of that flexibility may be lost if the members do not take the time to negotiate the terms of the operating agreement.
Mathieu, Ranum & Allaire, PLLC is a boutique law firm with offices in Boise and Sun Valley, Idaho focusing exclusively in the areas of estate and trust planning, probate and trust administration, asset protection, business law and charitable organization laws. We represent individuals, families, trustees, heirs and beneficiaries, entrepreneurs and closely held businesses, tax-exempt organizations, and family offices, as well as professionals and business owners potentially exposed to future creditor claims.
The foregoing is NOT legal advice. We have prepared these materials to inform and educate. They are not, and should not be considered, legal opinions or advice to anyone, nor do they create an attorney client relationship by your reading them. These materials may not reflect the most current legal developments in the applicable area of law. Furthermore, this information should in no way be taken as an indication of future results.
© Mathieu, Ranum & Allaire, PLLC. 2015