Operating Agreement Headaches Involving Limited Liability Companies

Tuesday, March 24, 2015

A limited liability company has become the entity of choice for many businesses throughout the United States for tax and liability purposes, but many of the operating agreements governing LLCs could have significant defects.

According to the Uniform Law Commission, which recommends proposed legislation that can be adopted in whole or in part by states and other jurisdictions, there are more LLCs being formed than corporations throughout the United States. The ULC found that every state has adopted some type of LLC legislation.

However, the existing state LLC statutes are far from uniform, according to the ULC. Many state LLC statutes have been amended on a patchwork basis and have not kept up with LLC cases and other legal developments.

One of the most important documents governing the rules involving the operations of an LLC is the operating agreement. An operating agreement is a written agreement of the members of the LLC that covers the rules regarding the operation of the LLC. It includes many items, including the rights, limitations and responsibilities of members and managers.

An operating agreement should be as specific as possible. To the extent agreed upon by the LLC members, it should cover issues such as:

1. What happens when a member dies;
2. What happens when a member becomes permanently disabled;
3. What happens when a member becomes legally incompetent;
4. What happens when a member voluntarily withdraws;
5. What happens when there is an involuntary withdrawal of a member;
6. Whether or not a member may transfer his/her membership interest by gift, assignment or bequest;
7. Whether or not a member may transfer his/her economic interest by gift, assignment or bequest; and
8. Whether or not a member may sell his/her membership interest.

If the operating agreement does not cover a particular issue, then the limited liability law of the particular jurisdiction is triggered. In essence the limited liability statute is for the most part a default statute.

A member’s interest in an LLC has two parts:

1. Economic interest: the right to receive distributions from the LLC and allocations of profits and losses.
2. Management interest: the right to vote and participate in the management of the LLC.

LLC Problem Areas
Many operating agreements for LLCs were done many years ago and may not have been amended to bring them up to date.

I have reviewed over 100 operating agreements for New York LLCs in the last four years and found that most of them have serious defects. The accountants who were involved in the estate planning for their clients who were members of these New York LLCs assumed that the operating agreements were well constructed. In fact the operating agreements were a disaster.

The accountants failed to read the operating agreements for their substantial clients who were members of these New York LLCs. The operating agreements in many cases either precluded bequests of membership interests to spouses or did not provide for bequests of membership interests to heirs or trusts for heirs.

In the event that an operating agreement is silent on what happens when a member dies, then the LLC statute of the jurisdiction must be looked at. For example, if a New York operating agreement is silent on what happens if a member dies, then legal headaches are triggered under the New York Limited Liability Act.

Under New York law, the default statute is Section 608 of the New York LLC Act. Section 608 covers powers of estate of a deceased or incompetent member and provides as follows:

“If a member who is a natural person dies or a court of competent jurisdiction adjudges him or her to be incompetent to manage his or her property, the member’s executor, administrator, guardian, conservator or other legal representative may exercise all of the member’s rights for purposes of settling his or her estate or administering his or her property, including any power under the operating agreement of an assignee to become a member. If a member is a corporation, trust or other entity and is dissolved or terminated, the powers of that member may be exercised by its legal representative or successor.”

On the death of a member of a New York LLC, he or she is no longer a member. The legal representative of his or her estate must then settle his or her estate regarding the disposition of the decedent’s former membership interest in the New York LLC. If the operating agreement does not permit a bequest of the deceased member’s economic interest or the decedent’s membership interest, then the legal representative must look to the estate’s rights under the operating agreement regarding the value of the deceased member’s interest.

If no provisions are provided for regarding the estate’s rights, then Section 608 is applicable. In that case, the legal representative of the estate of the deceased member would attempt to work out a settlement with the LLC.

In any event the economic rights of the decedent’s membership interest should survive the death of the deceased member in the absence of any contrary provisions in the operating agreement. The management interests do not generally survive the deceased member’s interest unless the operating agreement permits it.

If the surviving LLC members initially held minority membership interests, then they would now control the LLC after the death of the majority member. This would happen if the operating agreement failed to adequately protect the deceased member’s interest.

Revised Laws
The Uniform Law Commission drafted a Revised Uniform Limited Liability Company Act in 2006 to help clarify many open issues including fiduciary issues involving LLCs. Further amendments were made by the ULC in 2011 and 2013. The ULC recommends that all jurisdictions consider adopting the suggested changes.

A number of jurisdictions have enacted some version of the Revised Uniform Limited Liability Company Act. These include: Alabama, California, District of Columbia, Florida, Iowa, Minnesota, Nebraska, New Jersey, South Dakota, Utah and Wyoming.

Other states are considering adopting a Revised Limited Liability Company Act as well.

A number of the New York LLCs have problems with their articles of organization as well. An article of organization is the document that is filed with the department of state in order to form a limited liability company. Unfortunately I have found that the articles of organization for a few LLCs had specific dates of dissolution.

In essence, once that date hits, then technically the LLC protection for that LLC may become an issue. This issue can be fixed by amending the articles of organization to provide for the LLC to continue for the maximum period permitted by law or such other words to that effect.

Accountant’s Role
The accountant for an LLC is in a perfect position to review the operating agreement and articles of organization and to bring any obvious defects in the operating agreement and articles of organization to the attention of the LLC members. This is especially important since the operating agreements of an LLC client and articles of organization may have been prepared many years ago.

This could be a significant value-added benefit to the client as well as increase the accountant’s status as a trusted advisor to the LLC client.

Seymour Goldberg, CPA, MBA, JD, is a senior partner in the law firm of Goldberg & Goldberg, P.C., in Long Island, N.Y., and professor emeritus of law and taxation at Long Island University. He has taught many CLE and CPE programs at the state and national level as well as CLE courses for the New York State Bar Association, City Bar Center for Continuing Legal Education, New Jersey Institute for Continuing Legal Education, local bar associations and law schools. He is a member of the IRS Long Island Tax Practitioner Liaison Committee and the Northeast Pension Liaison Group. He was formerly associated with the Internal Revenue Service and has been involved in conducting continuing education outreach programs with the IRS. He has authored guides for the American Bar Association and the American Institute of CPAs on the trust accounting income and principal rules. His most recent guide in 2014 is entitled, “Can You Trust Your Trust? What You Need to Know About the Advantages and Disadvantages of Trusts and Trust Compliance Issues,” published by the American Bar Association. The guide will also be available through Amazon.com and Barnes & Noble on June 10, 2015