The Emporer Has No Clothes: The LLC Without an Operating Agreement

In an earlier post, I discussed the pitfalls of using a one-size-fits-all operating agreement, especially for real estate investing. What about when an LLC has no operating agreement at all? 

This is a common scenario when someone files the articles of organization with their state's secretary of state and declares the job well done. Usually, it's the do-it-yourselfer who either (a) isn't really fully informed of how the law treats LLCs and corporations or (b) is a bit optimistic about what might happen in the future. Like love and marriage, quite a few real estate investors jump into contract and partnership arrangements with an exceptionally bright view of the future, with little consideration of what might happen if everything goes south. Like insurance, the value an attorney adds to the enterprise is that backstop against ruinous loss.

If you have an LLC with no operating agreement, you are operating under default rules provided by your state's LLC statute. These rules range from innocuous to ridiculous to the disastrous for estate planning. In this short article, I'll hit upon the most important points. 

In this article, I speak in general terms of what is typically found in most states' LLC statutes. Please note that your rules may vary by state. To be certain you are covered, please consult an attorney who is licensed in your LLC's state.

1. If you are the only member of your LLC and you die, your LLC may dissolve and your LLC's assets will end up in probate court.

This requires discussion of another rule: that a member who dies, becomes disabled, withdraws, or assigns his interest in the LLC to another without consent of other members ceases to be a member of the LLC. In the case of an LLC with a single member, what happens when that member dies? You guessed it--the LLC has no members and gets dissolved. That means that the executor of your estate will be required wind up the affairs of the company by distributing all the assets (or selling them for cash) and returning all the proceeds to the probate estate. Most people here are aware of how much a pain probate can be, and there are easy strategies for avoiding this result, but only if you have an operating agreement.

2. You may be restricted from competing with your partners.

Many states have a default rule that implements a non-competition agreement and a "business opportunity" requirement -- that you cannot appropriate a business opportunity from the LLC without presenting it. This creates big problems in real estate investment, as many people invest on their own account as well as with several joint ventures.

3. You may be required to buy out your partner if he disagrees with the company's actions.

Some states, by default, provide statutory relief for a dissenting member when converting or merging an LLC, and still others require the LLC to buy out a withdrawing member within a certain timeframe. If that's the case, you might have only a few months to pay off that member the fair cash value of the member's LLC interest. In most cases, these statutory defaults can be waived in an operating agreement.

4. A partner may be able to get out of a promise to contribute capital to an LLC.

If you and your "money partner" don't have a written agreement regarding the money partner putting up capital, depending on your state that partner might have the ability to pull the plug without notice and force the company to dissolve. Get it in writing!

5. By default, profits and losses are typically distributed according to contributions.

If you have an understanding between your partners that you'll split profits 50/50, it's possible that this isn't enforceable without an operating agreement if you haven't contributed equal amounts to the enterprise.

6. Voting is typically on a per-capita basis.

Unlike the profit-sharing rules above, the voting rules are often different, and done on a one-vote-per-person basis. In order to escape this rule, you may have to lay down some pretty specific voting procedures in your operating agreement.

Conclusion

These are just a few typical statutory default rules that often can be modified or waived altogether in the operating agreement. It's important to translate your partners' understandings as to how the business will run onto a paper document. In the course of negotiating the document, you might just discover that your partners' ideas are significantly different than your own -- and this is what causes legal disputes among unhappy operators. Get it in writing!