Six Clauses for Every LLC – Part 2

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The purpose of this post is to provide investors with some guidance in creating their LLCs. So far, I have covered three of six points that in my experience have created the most problems for LLC owners. These six in and of themselves are not an exhaustive list, but a good start toward creating an agreement that will meet your expectations.

Here are the remaining three clauses:

4. Restrictions of Transferability of Membership Interests
Your LLC operating agreement had better limit a member’s right to transfer his interest lest you end up in a partnership with someone you do not know. Your operating agreement should provide that transfers to anyone other than a spouse or living trust will require the unanimous approval of all members. In my operating agreements, I sometimes permit transfers to wholly owned business entities without membership approval. Furthermore, certain provisions can be included to protect the company in the event of a member’s bankruptcy, divorce or death. These provisions ensure your business remains in the hands of those whom you know and trust.

5. Tailor the LLC Operating Agreement to the Deal
Far too often I see operating agreements that are hardly more than photocopies of some form document with a few names and addresses inserted. These agreements show little or no awareness of the myriad of specific and unique issues that every LLC deal inevitably involves—for example, special issues regarding dissociation events, buy-sells, fiduciary duties or voting rights are often overlooked. Another area that should be addressed is taxes. Most form agreements provide for partnership taxation. This is fine provided there are at least two owners and they have agreed to have the company treated as a partnership for federal tax purposes. However, in my experience, LLCs are often established with only one owner in which case partnership tax status is unavailable to the LLC. As a result, business owners come to me with an operating agreement that is in conflict with federal tax law and/or their federal tax election. The result could be disastrous in an audit.

6. Outside Business Ventures
If you and your business associate set up a LLC to buy and sell real estate can each of you invest on the side? This question is rarely answered in operating agreements and can result in substantial legal bills down the road if not properly addressed at the outset. The problem is one of expectations. Must the LLC members be required to present every real estate deal he comes across to the LLC or will he be free to pick and choose. You can probably see the potential problem this creates without an operating agreement provision. One owner may decide to keep all of the best deals for himself and only present the mediocre deals to the LLC. A good operating agreement should provide that all deals must first be offered to the LLC for consideration before an owner be permitted to take the deal for himself. This ensures that each owner is working in the best interest of the company and not unfairly profiting from the LLC’s business and marketing

As you can gather from my post, LLC operating agreements can and should deal with many potential issues before they become problems. I have found that violated expectations are the primary cause for business disputes. Do yourself and your business a favor by spending some time at the outset to start your investing down the right path.

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5 Comments

  1. Hi,
    thanks for the valuable information in these 2 articles about LLC. I surely have one of those “online” operating agreements, and after reading these articles, I am thinking about updating it. Is it possible to simply “update” the operating agreement, with a help of lawyer? Or does it have to be done in certain time etc?
    I am the solely member of my LLC – so that should make things easier, since lot of the concerns you had, were for LLC with multiple members.

  2. Clint, thank you for all of the great advice. I have an existing rental unit and am planning to move it into an LLC as described for asset protection, do I need to have my tenants sign a new rental agreement? Is there any other “formal communication” needed to let them know that they will be dealing with a separate entity vs. me personally going forward?

  3. Rob,

    This can go either way. I find it preferable to have the tenant sign a new agreement with the LLC however, your existing agreement does bind the LLC. At a minimum, you should direct your tenants to start making payments to your LLC.

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