With the recent passage of a tax overhaul giving preferential income tax treatment to members of limited liability companies ("LLCs"), understanding how an LLC operates, and how it can avoid pitfalls that lead to litigation, are more important than ever. In this article we will cover the basics of what an LLC is, and how certain provisions of a well-drafted Operating Agreement can safeguard against disputes that could otherwise lead to costly litigation.
What is an LLC?
An LLC is a form of business entity authorized under state law, and can be formed in Texas for virtually any business purpose save for banking- and insurance-related businesses, title companies and certain cemetery services. In Texas, the formation and operation of LLCs is governed by Title 3 of the Business Organizations Code.
LLCs are popular as a business entity because they combine the liability-limiting protections of a corporation with the operational flexibility of a partnership. Conducting business through an LLC shields the assets of the LLC's "Members" from liability for the LLC's business obligations, in the same manner as corporate shareholders. But, unlike the rigid strictures state law imposes on corporations and their shareholders, Members of an LLC also are entitled to agree among themselves exactly how the LLC will be operated and governed. Under Texas law, that agreement is formally known as the "Company Agreement," but it is more commonly referred to as the "Operating Agreement".
Litigation-Avoidance Provisions of an LLC Operating Agreement
The Operating Agreement is the defining characteristic of an LLC. Subject to a few statutory exceptions, it can contain a virtually unlimited variety of provisions "concerning the affairs or conduct of the business" of the LLC. Importantly, that means that an Operating Agreement can address areas that, in the absence of specific agreement, commonly lead to disputes among business owners. As a general principle, the more detailed and forward-looking an Operating Agreement can be about the following potential flash points, the lower the likelihood that litigation will arise around them:
- Membership and Voting: An Operating Agreement can set the requirements for becoming a Member of an LLC, and tailor the voting rights of Members. Precise drafting of these provisions avoids disputes over, for example, whether a corporation can be a Member, whether Membership is contingent on making a capital contribution, and what voting rights a Membership interest carries under any number of specific conditions.
- Economic Rights/Obligations, and Distributions: An Operating Agreement can contain specific provisions detailing what rights Members have to share in business assets, whether, when and how Members can be required to make contributions to the business, and the circumstances under which the LLC can (or must) distribute assets to the Members - all common areas of discord among business owners in the absence of clarity.
- Management: An Operating Agreement typically names a Manager and Officers (who may or may not be Members), and details their powers, including those that may be exercised at the Manger's or Officer's discretion, and those that must be approved by the Members. These provisions, when forward-thinking, tend to be particularly useful in avoiding dispute over material business events, such as when and how an LLC can dispose of capital assets or take on debt.
- Fiduciary Duties: An Operating Agreement can spell out the extent of the fiduciary duties that Members, Managers, or Officers owe to the LLC and/or to one another. Importantly, the Operating Agreement can limit these duties dramatically, closing off the paths to dispute over issues such as conflicts of interest, management discretion, and related-party transactions that are otherwise common sources of conflict.
- Admissions and Withdrawals: An Operating Agreement should spell out if and how Members can join the LLC after execution of the Operating Agreement, the procedures and economic consequences when Members withdraw or are forced from the LLC, whether Membership interests can be sold or transferred, and the survival of Membership interests when a Member dies or dissolves. Without such provisions, predictable changes in the life or circumstances of a Member can cause considerable difficulty.
- Dissolution: An Operating Agreement should also provide for the specific conditions and procedures under which the LLC dissolves, including events that automatically trigger dissolution, a dispute resolution mechanism for determining if a dissolution event has occurred, and a waterfall for distribution of LLC assets or ownership of trade secrets and other intellectual property. Without clarity on these and related points, many dissolutions turn into nasty fights.
The above is far from a complete list. The benefit of organizing your business as an LLC is that the Operating Agreement can cover a diverse range of topics, including ones that are unique to the particular business or Members involved. (Conversely, without an Operating Agreement, or with an incomplete one, an LLC's operation and governance are dictated by the (relatively bare-bones) provisions of state law.) And, of course, an Operating Agreement is not a panacea against all business owner disputes. As mentioned above, some basic protections that the law provides to members of any business entity cannot be waived, such as rights to access to records, and protections against fraud and criminality.
At Hendershot, Cannon & Hisey, P.C., we focus not only in business litigation, but also in crafting Operating Agreements to help you avoid litigation in the first place. Contact our Houston Business law firm to schedule a consultation.