The ease of forming an LLC has been a mixed blessing, as its simplicity and relative informality has allowed for many risky shortcuts – mostly notably with respect to the entity’s operating agreement. Many organizers used a “boilerplate” agreement that was inadequate to the situation, or they skipped the operating agreement altogether (Arizona’s original 1992 LLC law did not require one).
Those shortcuts became a real issue in 2020, when the current Arizona Limited Liability Company Act went into effect. Literally overnight, on September 1, 2020, LLCs that did not have an operating agreement suddenly had one imposed upon them, via a litany of controversial default provisions contained in the Act. Similarly, if an operating agreement did exist but did not address one or more default provisions, the Act filled the vacuum, often to the detriment of the LLC’s members.
Two default provisions in particular created problems for multi-member LLCs. The Act:
- imposed fiduciary duties on LLC members and managers, creating legal grounds for inter-member lawsuits, in instances where there was no operating agreement or the operating agreement did not address that issue; and
- required that all distributions made by an LLC before its dissolution and winding up must be equal among members, regardless of ownership percentages.
If those issues inspire you to take a fresh look at your operating agreement (or to create one), let us suggest a few additional issues that, while you are under the hood, you can address to align your agreement with your estate planning objectives.
Planning Questions for Your LLC Operating Agreement
- If your LLC has multiple members, will all members’ ownership shares and contributions be equal, or will ownership shares vary with the contribution amounts?
- How will voting power relate to ownership shares or contributions?
- How will new members be admitted, and what will be their contribution amount?
- How will living members be removed or allowed to withdraw, and what will happen to their capital contributions?
- If a member dies, what will happen to their ownership interest and capital contributions? Will there be a buy-sell agreement? Will the surviving members be allowed (or required) to purchase the decedent’s interest? Can the decedent’s interest be inherited by, or transferred to, a third party without the other members' approval? Will a surviving spouse be forced to sell their interest to the members?
- If there is a buy-sell agreement, how will the purchase of a member’s ownership interest be funded (e.g., cash on hand, member contributions, life insurance)?
- How will decisions be made? Does approval of major issues, such as a business sale or a modification of the operating agreement, require a simple majority, a super majority, or a unanimous vote?
- How will the business be managed day to day? If there will be a managing member, what will be the limits on their authority? Will they be compensated for serving as managing member?
- How will management authority be transferred if the managing member resigns or cannot serve?
- How and when will profits and losses be distributed or allocated among the members? What events will trigger a distribution?
- How will the LLC’s taxable profits and deductible losses be allocated among the members?
- If the LLC is dissolved, how will its assets and liabilities be distributed?
Answering these questions in the context of your overall estate planning is an opportunity to kill two birds with one stone: maximizing the business and personal benefits of your LLC’s operating agreement, and resolving any conflicts between your business planning and your personal estate planning.
