Your LLC operating agreement is the rule book that you have to comply with as your LLC wanders down the business road ahead. You'll want to make sure the agreement is written properly to protect you.
If you don’t have an operating agreement for your LLC or a set of bylaws for your corporation, you don’t have any asset protection. If you don’t follow the rules these documents lay out, you don’t have any asset protection. While the LLC operating agreement is equivalent to the corporation’s bylaws and this article will talk about the LLC operating agreement, almost all the principles can be applied to corporate bylaws.
(I have a copy of a free LLC operating agreement that you can use as a template to set up an LLC operating agreement or as a comparison against the LLC operating agreement you already have. Get the free LLC template so you can follow along in this discussion with your operating agreement and the free LLC template side by side.)
An LLC operating agreement is the rule book of your LLC. The neat thing is that you get to write the rule book. The operating agreement should be a document about 20 to 30 pages long. And while I have seen some that are only four or five pages long, the issues that need to be addressed in an LLC operating agreement simply cannot be addressed adequately in so few pages.
If you don’t address the issues in your own document, you get the default position under state law. Your state’s code has a hundred pages addressing the corporate and LLC rules. However, almost all of the provisions in the state code can be “overridden” or customized to fit your needs, but only if you take the time to address them in your LLC operating agreement.
In order to get a one-size-fits-all LLC operating agreement, a lot of websites, and even some attorneys, only address the minimum number of standard provisions, and that can be done in four or five pages. Then the rest of the operation of the LLC is governed by state laws.
It’s not hard to imagine that the state’s provisions are written to protect the state’s interests not yours, so it is a real copout for the internet site or your lawyer to short change your LLC operating agreement with a generic form. Some of the operating agreements actually make a simple statement that they adopt the state provisions, thus justifying the fact that they don’t address hardly any of the issues that must be considered in operating an LLC.
It’s your rule book
Your LLC operating agreement is the rule book that you have to comply with as your LLC wanders down the business road ahead. Many folks, and even some state laws, say that an LLC doesn’t have to follow the “corporate formalities” that are associated with the operation of a corporation. Is it true that an LLC doesn’t have to follow the formalities?
Remember from my last article, Which is Better Asset Protection?, that (in layman’s terms) an LLC is the offspring of the union of a corporation and a partnership. It has the corporate shield (limited liability) of a corporation and the charging order protection of a partnership. Basically, you can get double the asset protection out of an LLC when compared to a corporation. (Check out my eBook, How to Double Your Asset Protection.)
The catch, though, is that if you are going to demand the limited liability of a corporation, then you must follow the corporate formalities. The concept is simple.
When your LLC gets sued and you want the corporate shield to protect you, then you’ll have to defend allegations in court that you are running a sham company. Your opponent will say that your LLC is simply your “alter ego” and that you are not entitled to limited liability protection.
The way you show that the LLC isn’t your alter ego is to prove to the judge that you have treated the company as an independent entity. Did you co-mingle money? Did you hold your company meetings? Did you have the members approve the loan the LLC took out? The list may be long.
How do you get the list? Each list is different. I will send you a list of 16 things that are pretty standard, just ask. You can make your own list by reading your LLC operating agreement. Your LLC operating agreement isn’t just a bunch of papers. You need to read it and become familiar with what is required to run your LLC.
Get some colored markers. When you get to a part in the LLC operating agreement that says the manager will do XXX or must approve XXX, then underline that in one color. When you get to a part that says the members will XXX, then underline that in another color.
Once you have gone through the entire LLC operating agreement, go back and make a list of all the manager items, all of the member items, etc. The lists you come up with will be unique to your LLC. If the issues aren’t specifically addressed in your LLC operating agreement, then you have to go to the state statutes to see what they call for. If you have to go ferret out your list from the state code, then good luck!
Whether the requirements for operation of your LLC come from your operating agreement or the state code, that’s what the judge will look at to determine whether or not you have treated your LLC as a formal business or just your alter ego.
See the must haves for your LLC operating agreement on the next page.
Must haves in LLC operating agreement
Your LLC operating agreement should state that the members’ and managers’ liabilities are limited — you want the limited liability shield of a corporation. If that isn’t stated in your LLC documents, you won’t automatically get it.
The LLC operating agreement should state whether the LLC will be manager managed or member managed. If you choose to be manager managed, your LLC will be considered as having “centralized management.” What it means is a non-member (non-owner) can act as the manager.
The LLC operating agreement should state whether or not the LLC will continue on as a company after the death of one of the members. If it will continue on after the death of one of the members, the LLC is said to have “continuity of life.” Many LLCs are set up to terminate (die) at the death of one of the members.
Your LLC operating agreement should also state whether your membership interest is “transferable.”
You may have concluded that you want to get the best manager possible, whether that person is an owner or not. I am sure you want limited liability, and you probably want your company to survive after the death of one of the owners. You probably even want to be able to transfer your shares. There’s a catch — these are the four elements of a corporation.
If you have all four elements then you have a corporation, not an LLC. It doesn’t matter what title you put on it, it’s a corporation. By law an LLC only gets two of the four. Remember, an LLC is only half corporation. If your “rule book” says you get three of the elements, then you don’t have a corporation or an LLC. Most courts will call it a partnership, because you didn’t follow the law.
When your company gets sued, the opposing counsel will demand a copy of your LLC operating agreement. She or he is going to read your rule book, even if you never did. Does your rule book define a corporation, LLC or partnership?
Did you follow your own LLC operating agreement rules? If not, you obviously didn’t treat your LLC as a “real company,” and you’re probably not entitled to call it anything more than an alter ego. You must be personally liable.
LLCs are really great legal tools. They give you double the asset protection of a corporation, total tax flexibility and maximum legal flexibility, but you’ve got to respect the LLC operating agreement and the daily care and feeding of your LLC.
Lee R. Phillips is a United States Supreme Court Counselor who for the past 30 years has helped high income individuals control their taxes and protect their assets. Call (800) 806-1998 or visit LegaLees.com.