By William Bronchick Real Estate Mentor
Most “DIY” startups will form an LLC by filing articles of organization with the state and obtaining an EIN number. While these two steps are the start of a company, it is the MINIMUM that one should do when forming an LLC. If you have two or more owners (“members”) in your LLC, it is IMPERATIVE that you draft a good LLC operating agreement. In Real Estate Investing, asset protection is paramount.
What is an Operating Agreement?
An operating agreement sets forth the rules and regulations for the owners (“members”) and managers of the company, similar to the By-Laws of a corporation. In another sense, it is also like a partnership agreement amongst the members of the company. Some DIY-ers will find a generic operating agreement online or use a service like Legalzoom.com to draft their operating agreement. However, these agreements are often vague and general in nature, and may not address the specific concerns of the owners of the company.
10 Clauses that Your Operating Agreement Should Contain
- Maintenance of Capital Accounts. If you are electing to have your LLC taxed as a partnership, then you should have provisions that call for the creation and maintenance of “capital accounts”. What are the capital accounts? They are an essential cornerstone of partnership taxation; capital accounts keep track of each member’s equity in the company. They measure contributions and distribution of members’ capital and allocations of profit and loss to each member’s equity account. While capital accounts are beyond the comprehension of the average business owner and are generally handled by the LLC’s accountant, the operating agreement should lay out how capital accounts are maintained.
- Voting. By default, a member’s vote is generally equal to his membership share, which is in turn determined by his capital contributions. But the members may want more than a majority vote required for certain company actions, such as dissolution or bringing in new members. You may want to require a unanimous vote for such actions. The point is that you will want to discuss these issues with your co-owners, and decide which actions of the company require majority vote vs. a more stringent standard.
- Managers’ Authority. If your LLC is managed by one or more managers, you will want to define what the managers’ authority is, and what a manager can do without a vote of the rest of the members of the company.
- Transfers of Membership Interest. Can a member transfer his ownership share to a third party without the consent of the other members? If so, do the other members get a right of first refusal to purchase those shares? This should all be spelled out in the operating agreement.
- “Triggering Events”. There are certain events that could trigger the right of other members to purchase a member’s share. For example, if a member dies, files bankruptcy, or gets divorced, what happens to his share of the company? Do the shares go to someone else, and if so, does the assignee of the shares (children, bankruptcy court, or ex-spouse) receive voting rights or just a right to receive income? This should all be clearly spelled out in the operating agreement.
- Resignation of a Member. What if one of the members wants out of the business? Can he retire and still receive the same share of profit? Can he sell his shares to another or demand that the LLC cash him out? This should all be spelled out in the operating agreement.
- Disputes. How are disputes between the members handled? Is mediation and/or arbitration required instead of going to court? This should all be spelled out in the operating agreement.
- Dissolution of the LLC. If there are two members of the company filing as a partnership for tax purposes and one partner dies or retires, the company ceases to exist in the eyes of the IRS, because it is no longer a partnership. But, the remaining member can have the right to continue the company as a single-member LLC. This should all be spelled out in the operating agreement.
- Indemnification of Members/Managers. If a manager or member of the LLC is sued for activities that he engaged in on behalf of the company, will the company (and the other members) pay to defend him? Should there be exceptions if the manager or member engages in gross or unlawful misconduct? This should all be spelled out in the operating agreement.
- Amendments to the Operating Agreement. What if the members want to change the rules; should this require a majority vote or unanimous vote of the members? Again, this should all be spelled out in the operating agreement.
While the foregoing is a good start of items to address in an LLC operating agreement, it is highly recommended that you speak with a qualified attorney to discuss these and other issues related to your LLC’s business to make sure your operating agreement covers the many contingencies that you never considered when forming your company. It goes without saying that having a good Real Estate Attorney, Real Estate Coach or Real Estate Mentor as part of your Real Estate INvesting Team is of utmost importance!
Please contact us for a quote to review, revise, or draft a new operating agreement for your LLC.