LLC Operating Agreement Drafting – Minority Member Tips

Limited liability companies (LLL’s) are hybrid business entities created under state law. In the case of corporations, there are three layers of structure to the ownership and management–shareholders (owners), board of directors, officers. Most closely held LLCs have only one layer. The LLC members hold all positions analogous to corporate shareholders, directors and officers. On its face, the LLC structure appears simpler; however, looks can be deceiving. The LLC Acts of most states are rather vague regarding the rights and duties of LLC members vis-a-vis each other. The statutes leave a vast range of discretion to the LLC members in fashioning their LLC operating agreement to control how the enterprise operates in practice and the remedies afforded to aggrieved members when the operating agreement has been breached. LLC services

Required Capital Contributions
In many states, the promise of a member to make contributions of capital to the LLC is not enforceable unless the promise is put in writing (usually the operating agreement) signed by the member against who enforcement is sought. See Florida Stat. Section 608.4211(2) and California Corporate Code Section 17200. Every operating agreement should state the amount of capital each member is to make to the LLC, when the contributions is to be made by, and what form the contributions is to be made in (i.e., cash or other property). If a member is to contribute property in lieu of cash, attach a list of the property to be contributed and its agreed value to the operating agreement. What happens if a member does not make capital contributions as required by the LLC operating agreement? A simple and effective remember is to reduce the offending member’s ownership interest in the LLC in proportion to the capital contribution not made. However, to my knowledge, LLC members lack the authority to unilaterally reduce the ownership percentage of a member for failure to make required capital contributions unless this remedy is found in the operating agreement.

Another hidden issue that comes back to bite minority LLC members is secondary required capital contributions called for after the LLC begins operations. Let’s assume your LLC loses money in the early years of operation and creating a need for additional capital. Minority shareholders should read carefully the terms of the agreement regarding whether minority members can be forced to make secondary capital contributions, otherwise, it may come as a nasty surprise when a capital call comes from the majority member. If secondary capital calls require unanimous approval by all members, then minority members are protected against involuntary capital calls.

Distributions of Capital
LLC’s are flow-through entities for federal tax purposes. That means all LLC income is annually allocated to the members regardless of whether or not the members actually receive capital distributions from the LLC equal to the income allocation. It comes as a shock to some minority LLC members that they can be taxed on LLC income allocations in cases where the LLC decides to retain capital and not distribute all or a portion of the income to the members. One way to protect minority LLC members is to require a certain percentage of allocated income be distributed to LLC members no less than annually unless all members unanimously agree otherwise. Forty percent is a safe percentage assuring every member receive a distribution from the LLC sufficient to cover his or her tax liability generated by the LLC income allocation. For instance, assume LLC X has $200,000 of income in 2010 resulting in Member 1 holding a 20% ownership interest being allocated $40,000 of income from the LLC ($200,000 x 20%) for that year. If the LLC operating agreement provides that members must be distributed 40% of their annual income allocation, then Member 1 will receive a check of at least $16,000 ($40,000 x 40%) from the LLC as his required capital distribution. This protects minority LLC members from incurring tax liability for which they do not receive capital distributions from the LLC to cover.

Penalties For Member Failure To Provide Promised Services
It is common for LLC members to be given sweat equity, i.e., an ownership interest in return for the promise to perform services. All promises by LLC members to provide services should be documented in the operating agreement. Oral promises of this nature are very difficult to enforce unless the promise is recorded in the operating agreement. Often the agreement contains an integration clause, which states that any promise or agreement between the parties not recorded in document is unenforceable. Recording the promise is only half the battle. What is the penalty for failure of a member to perform promised services? I often receive inquiries from LLC members asking whether they can kick a non-performing LLC member out of the business and take it over. The answer is “no” unless your operating agreement specifically provides this remember. If the agreement is silent on the issue of seizing a member’s LLC ownership interest for failure to perform services, then an aggrieved member’s remember is to sue the non-performing LLC member for damages. A lawsuit is an expense and lengthy means to seek compensation.

Member Right of Disassociation
As a minority member, control of the operations of the LLC is usually in the hands of the majority member(s). What if you disagree with the operational or strategic direction the LLC takes after operations begin? In most states, a member of an LLC may not withdraw unless this right is specified in the LLC operating agreement. See Florida Stat. Section 608.427. Like a bad marriage, an minority member can become trapped in a LLC. Securing a right of withdrawal in the LLC operating is helpful but the terms upon which withdrawal is allowed are also very important to the practicality of exercising that right. When an LLC member has a significant capital account at the time of withdrawal, how much, when and if that capital account is paid to the withdrawing member by the LLC is an important element that should be addressed in the operating agreement.