Real Estate Law | October 2011
Operating Agreement Is a Vital Document for an LLC
In the absence of an operating agreement, the LLC will be governed by the rules set forth in Arizona’s statutes, which are silent on what will happen in many situations
Because of its simplicity and low cost
(compared to incorporation) and its ability to protect owners from
legal liability, the limited liability company (LLC) is the legal
entity of choice for many business owners.
In Arizona, an LLC is formed by
filing articles of organization with the Arizona Corporation
Commission. While the articles are necessary in the creation of an
LLC, when it comes to protecting the company and its owners from
expensive litigation, the most important document in an LLC’s legal arsenal is its operating agreement.
An operating agreement governs how the LLC will be run. In the
absence of an operating agreement, the LLC will be governed by the
rules set forth in Arizona’s statutes. Because the statutes are
silent on what will happen in many situations, having an
operating agreement from the outset is an important tool for
avoiding legal confusion and exposure later on.
Here are some examples of key issues usually governed by an operating
The Members. An operating agreement
should identify the "members" (the LLC equivalent of
percentage of the company each member owns, and how each member will
be paid for his share. It may allow the company to have members with
and without voting rights. It governs whether the LLC can call on
its members for additional capital contributions. It also defines
how profits will be shared, how decisions will be made, and how
disputes will be settled.
Changes in Membership. An operating agreement
should define whether and how members may be added, whether a member can transfer his
interest, and under what circumstances a member can be terminated.
The agreement can give the LLC a right of first refusal if a member
dies or chooses to sell his share. The agreement can restrict a
member's ability to transfer his shares and can protect the business
from having to accept someone as a member, even if that person buys
an existing member’s share.
Keeping Outsiders Out of Your Business. An operating agreement can
provide that, if a member becomes insolvent or is threatened with a
divorce action, the member must sell his interest back to the
business for a predetermined, reduced price. This protects the
company from being forced to open up its records to the courts and
other outside parties and keeps creditors and ex-spouses out of the
Protecting Your Assets. The main reason for creating an LLC is to
protect the members’ assets – home, car, cash, etc. – from the
risks of doing business. The LLC can shield individual members from
personal liability for the company’s debts. However, if the LLC has
not carefully kept its affairs separate from the affairs of its
members, a creditor may be able to "pierce the corporate veil”
and reach the assets of individual
members. A written operating agreement and other
written records of actions taken by the LLC go a long way toward
proving that the LLC has observed “corporate formalities” in
conducting its business, such that the court should respect the
shield the LLC provides its members.
Member LLCs. Though many people do not realize it, an operating agreement may be
even more important to an LLC with only one member (a "single-member LLC") than it is to an LLC with
many members. Because a sole owner may tend to conduct business
without using many formal documents, a single-member LLC can look a
lot like a sole proprietorship – therefore exposing the owner to
possible personal liability. An operating agreement may be important
proof that a single-member LLC has observed “corporate formalities”
such that the LLC’s separate existence, and the shield it provides
its members, should be respected. In addition, a simple operating
agreement may allow a sole owner to protect the longevity of his
business, by specifying a person authorized to make business
decisions in the event of the owner’s incapacity or death. Without a
written agreement of this type, the LLC may not have authority to
continue business and may terminate after the death or disability of
its only member.
Situations. There are a few situations
in which an operating agreement is
absolutely critical. For example:
If the company has non-member
investors, the business owners will want a clear understanding with
the investors as to what their role will be, who will make
decisions, how their share of profits will be determined and how
profits will be distributed. Having a clear understanding about
these sorts of issues from the outset can help avoid lengthy (and
costly) disputes in the future. That is why these issues are
typically addressed in an operating agreement.
An operating agreement is also essential for employers who plan on
rewarding employees by providing them with a small ownership
interest in the business. An operating agreement can give the
majority owners absolute discretion regarding compensation matters,
including distributions to minority owners. On the other hand, the
operating agreement can give minority owners a limited right to
profits that is not affected by distributions to majority owners.
A good operating agreement can be an
extremely useful tool for managing your
business affairs. If you think you might benefit from such an
agreement, contact your legal advisor.