Contribution by: Jarom Bergeson
Perhaps no other innovation is as indicative of America’s particular devotion to (and knack for) creative capitalism as the limited liability company (“LLC”). Born in America’s smallest state (Wyoming) in 1977, the LLC combines the pass-through taxation of a partnership or sole proprietorship with the limited liability protections of a corporation.
This unique combination of liability protection and pass-through taxation explains why the LLC was quickly adopted in all 50 states, and why it is easily America’s most popular corporate form today. In 2012, more than 2.2 million LLCs filed partnership tax returns, and current estimates are that 55% of LLCs are single-member entities that file no tax returns at all, which means that there are probably somewhere in the neighborhood of 5 million LLCs in existence in America today. Approximately 3,000 new LLCs are created each month … in Utah alone (our home-office state and one of the best LLC laws in the country!).
The big mistake!! Another reason why LLCs are so popular is that they are easy to form, however, this can also be their downfall. Unfortunately, there are thousands of entrepreneurs who believe hitting “submit” and receiving back stamped Articles of Organization from the state completes the formation of the LLC.
In most states an LLC can be established by clicking through a government website and paying a filing fee. Technically, that puts the LLC on the ‘radar’ of the State. However, smart business owners and investors know this is really where the formation process begins.
Every LLC, whether it has one member, five members, or 100 members, should have an Operating Agreement and there are several important reasons why.
First, the Operating Agreement establishes the asset protection veil and the ‘formality’ of signing the Operating Agreement and the initial minutes is critical to show a court and a plaintiff that you took the LLC formation seriously.
Second, is the fact that your LLC Operating Agreement is your chance to write the “law” for your LLC. This is why the LLC is such a great choice for partnerships. The Operating Agreement gives partners the ability to delineate roles, rights, and responsibilities for the LLC owners, and to make specific plans for what happens if a partner dies, becomes incapacitated, or gets divorced.
What happens if you don’t have an Operating Agreement? Well, in their wisdom, the various state legislatures have planned for this, and each state LLC statute provides a set of “default rules” for how LLCs are to be governed if and when the LLC owners don’t take the time or effort to make those decisions for themselves.
However, as with most statutory language, these default rules can be difficult to decipher. In addition, the rules can and do change when the LLC statutes are amended, and all 50 states have different rules within the same framework. To boot, sometimes a state’s particular default rules just don’t make sense.
To illustrate, Utah adopted a new LLC statute in 2013. This statute becomes fully operational, applying to all existing and newly-formed LLCs, on January 1, 2016. While I’m sure the legislature and the governor had good intentions in passing the law, it certainly contains some provisions that create surprising outcomes.
For example, the new statute says: “A manager may be removed at any time by the consent of a majority of the members without notice or cause” (U.C.A. §48-3a-407(3)(d)). It does not say “a majority of the ownership” or “a majority of the profits interests.” This means that in an LLC with three owners, where one owner is the manager and owns 90% of the company, and the other two owners each own 5% of the company, the two 5% owners can get together and vote out the 90% owner as manager … as long as the LLC has no Operating Agreement and the statutory default rules apply. If the LLC does have an Operating Agreement, then the provisions of the Operating Agreement trump the default rules from the statute.
The moral of the story is that if you don’t want your LLC to be subject to potentially odd default rules that can be adopted and changed at the whim of state legislators who have never owned or run their own business, then your LLC needs an Operating Agreement and you need to know what that Operating Agreement says.
Do not create an LLC that does not have an Operating Agreement, and if you have already made that mistake, fix it by having one drafted and adopting it retroactively to the date your LLC was established.