An operating agreement is the basic document for a limited liability company, or LLC. The agreement should spell out how owners, called members, deal with each other and make decisions for the company; how new members may be brought into the company; how profits and losses are allocated and distributed among the members; and what happens when a member wants out, or when the company winds down. These matters may sound simple, but they are often fraught with perils.
I would like to describe some of the most common pitfalls I see in reviewing operating agreements in my practice. There are certainly others, but these are the problems that come up most often.
Big income tax bills for “sweat equity.” A client, who has worked hard over the past five years, is offered a 10% stake in his company, which is an LLC taxed as a partnership. He doesn’t have to pay anything in; the boss just wants to give a 10% interest to him so he can share in the company’s success. The draft operating agreement says that he gets 10% of everything; capital, profits, losses, voting. Sounds great, right?
Not so fast. As far as the IRS is concerned, he’s not being given anything. Because he is getting an interest in a business in return for performing services for it, the value of the interest in the company he is getting is considered income. Unless the agreement is drafted carefully, he could end up with “income” in the year he receives the interest equal to 10% of the value of the company! If it’s a $1 million company, he’s suddenly facing taxes on $100,000 in income he had not planned on and for which he didn’t receive any cash with which to pay the taxes. There are ways to address this problem, but they require careful drafting and an understanding of the tax laws governing receipt of interests in a company in return for services.
Phantom income. This issue is similar to the first one, but can happen at any time, not just when a member joins the company. Under the partnership income tax laws, which are the most common way for LLCs to be taxed, the company itself does not pay any income taxes. Rather, it passes through all of its income, losses, deductions, credits, and the like to the members on a Schedule K-1, and the members include all these on their own tax returns.
Just because a company has income on paper to pass through, though, does not mean that it has distributed any cash to its members. This phenomenon is called “phantom income;” the members owe taxes on income the company made, but did not get any cash to use to pay the taxes. A well-drafted operating agreement will, in cases where phantom income could be a significant problem, include a provision to ensure that the members receive at least some percentage of the profits each year, so that they are not caught short at tax time.
Incomplete buy-sell arrangements. An operating agreement needs to have a clear scheme for what to do when a member (owner) leaves the company, whether voluntarily or because of bankruptcy, death, disability, or some other reason. These are often called “buy-sell provisions.” If these provisions are not clear, disagreements about how to implement them can easily lead to lawsuits and the related delays, lawyers’ fees, and costs.
Common issues with buy-sell arrangements include: Can a member transfer his interest to a family member by will without consent of the other members? Put it in a trust or family partnership? Will the company or the other members have a right of first offer or of first refusal to buy the interest of a member who wants to sell? Is there a clear and fair process for how that will be done? If a member dies or becomes disabled, is there a clear and fair process for liquidating the member’s interest to provide cash for her and her family? How will the price be determined? Can the members use life or disability insurance to fund such purchases? All these issues call for review and drafting by a competent lawyer.
Hidden ways for members to be pushed out of the company. A client, excited that her boss wants to make her a part-owner of the company, may come to me with a draft operating agreement prepared by their business-partner-to-be’s lawyer, asking me to review it to be sure she is “protected.” I will ask her questions about what she wants protection from, but I know she means certain basic things. One of those is protection from being forced out of the company.
Many operating agreements allow a majority of the members to vote to require the members to put in additional capital. This sounds convenient, but what happens if one member doesn’t have any more capital to contribute? Often, the agreement will have penalties for not contributing, including dilution of interests, forced loans, suspension of distribution of profits, or even forced buyout of the defaulting member’s interests.
An LLC owned 50-50 by two friends may seem like a great, straightforward business that does not need legal help, but often that simply isn’t the case. Even a brief consultation with a lawyer, just to go over some issues which the owners may never have thought of, is worthwhile. It will usually turn out to be money well spent, which can save many times the amount in taxes and expenses later on.
Seth W. Whitaker, Ltd. Co. is a personalized trusts and estates and business law firm for individuals, families, professionals, and entrepreneurs, with offices in Charleston and Raleigh and serving clients throughout the Carolinas. This article is not legal advice, and no attorney-client relationship is formed by reading it. We hope you will contact us at (843) 202-4472 or info@whitakerltdco.com if you would like to discuss your specific situation.
