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In Good Form

Drafting an LLC Agreement.

By James L. Leet and James Clarke

July/August 2007 Table of Contents

 

Editor’s note: The documents described and boldfaced in this article are available by clicking on the form's name in the article or by visiting the "Forms" section of our Web site. The forms in this article include:

  1. Opt-In Checklist

  2. Drafting Outline

  3. Letter Hiring Attorney to Form LLC

  4. Attorney Conflict of Interest Letter

  5. Agreement for Services

  6. Ownership Interest Escrow Agreement

  7. Delaware Operating Agreement

  8. Single-Member, Member-Managed Delaware Agreement (Short Form)

  9. Multiple-Members, Member-Managed,  Delaware Agreement (Short Form)

  10. Delaware Series Agreement

 


 

A limited liability company agreement controls the internal management of a company because LLC statutes allow the members great latitude in shaping the structure of the LLC. The agreement is a company’s answer to the partnership agreement and combines the features of corporate bylaws and a shareholders’ agreement or buy-sell agreement. It is a contract among members, and between the members and the LLC, concerning the organization of the business. It should be negotiated, in writing, and signed by all ­parties. Unlike corporations, where the bylaws are adopted by and subject to the power of the directors, LLC members can be granted significant and binding power over daily management decision­making via the agreement.

The LLC agreement is an integrated document that describes the rights and obligations of the members. It’s the logical place to set out those things that occur as a matter of law, such as dissolution on withdrawal of a member, to memorialize agreements of the members relating to aspects of the operation of the company or to set out the default rules. Since an LLC’s articles are publicly recorded, the LLC agreement is a more confidential location to specify the terms of the members’ agreement.

Most states have amended their LLC statutes to allow one-person LLCs. These amendments generally are found in the LLC provisions dealing with the contents of Articles of Organization, replacing the language “two or more members” with “one or more members.” Single-member LLCs should have and maintain written LLC agreements. Some might question the need of the sole owner to have a written LLC agreement controlling his or her conduct. However, the single-member owner is not signing the document with himself or herself. Practically, the formality is required, as the LLC deals with third parties, such as lenders. The rationale for this is that the owner is signing the LLC agreement with another legal person. The existence of a written LLC agreement evidences the separation between the entity and the owner with absolute control.

Paralegals can play an important role in drafting the initial version of an LLC agreement and should be well-versed in the different components that need to be considered to put a complete agreement together.

Getting Organized

Several useful forms are provided at www.legalassistanttoday.com for the steps preceding creation of LLC agreements. The first is an Opt-In Checklist [Form 6:120] of categories that might be included in the LLC agreement, and is designed to suggest drafting possibilities. The second is a Drafting Outline [Form 6:140] from which the drafter can customize the LLC agreement. Both documents are designed for use by paralegals as well as attorney-advisors. Other helpful pre-formation documents available are:

Other Drafting Considerations

Interaction of provisions. The analysis of the LLC agreement provisions requires an understanding of the interaction of all  provisions. For example, while a financially strong member might be obliged to undertake a certain activ­ity having substantial economic consequence to the LLC, the LLC agreement might permit assignments to affiliates of the member. If a member is permitted to assign rights and duties to an affiliate without recourse, then that assigning member might be able to frustrate efforts of the other members to hold him or
her accountable should the affiliate fail
to perform.

Focus on the business purpose. Make a concerted effort to conform the LLC agreement to the underlying business purposes of the LLC. The business purposes accommodate the possible structure of multi tiered entities to carry out the purposes. For example, if the business is to develop real property either directly or through joint ventures with others, the purposes should state that the LLC may hold an interest in another entity that engages in the desired development in addition to engaging in the development directly.

Moreover, the agreement should be sensitive to prevent exit strategies of a member to interfere with the business plan of the LLC. For example, if an LLC is formed primarily to preserve family property, it makes no sense to allow members to withdraw at will since the voluntary withdrawal provisions will normally require a purchase of a withdrawn member’s interest and destroy the parties’ ability to preserve the property.

Avoid Management Problems. A management problem can be disastrous to the LLC if the problem lingers. LLC agreements offer a significant opportunity to avoid future management problems. Effective methods that can be used in the LLC agreement to deal with potential problems include:

  • buyout arrangements;

  • arbitration;

  • financial penalties for certain conduct; and

  • dissolution procedures.

These methods can be used individually or in unison.

The buyout provisions can be similar to those contained in partnership agreements or corporate buy-sell agreements. To avoid uncertainties, the buyout provisions should specify the events triggering the buyout and provide mechanisms to determine the price and payment terms.

Plan for deadlock events. It’s common for LLCs to have one, or less than all of the members who actually operate the company on a daily basis either as managers or as managing members. Try to avoid having an even number of managers or managing members. This might diminish the opportunity for deadlock in daily affairs.

However, often in these agreements all of the members determine certain decisions that are described as major decisions. The LLC agreement must plan for deadlock events. The goal is to resolve the deadlock as quickly as possible but make timelines realistic in the course of the resolution. Provisions to speedily end deadlock in an agreement can be as simple as a coin flip between the opposing factions. While that provides speed, it does not provide an opportunity to present a reasonable basis for objection as with an arbitration.

For members who are in an equal financial position, the deadlock might trigger an exercise of a put/call where one faction offers a price to buy or sell and the other party can choose to sell or purchase at the same price. Because a deadlock can lead to dissolution or trigger economic problems, use great caution in drafting the LLC agreement so as to clarify what steps must be taken in the event of a deadlock.

Consider voting rights and voting percentages. Voting rights and voting percentages such as super-majorities should be considered for inclusion in the LLC agreement. Different percentages may be applied for different business decisions. For example, 100 percent to amend the articles, 51 percent to approve a transaction, 75 percent to hire a man­ager, 25 percent to call a meeting, 51 percent to allow a new member, and 100 percent to admit an owner of a transferred interest as a member. The LLC agreement should also clearly define how voting rights are to be calculated, whether by majority by percentage interest, by a simple numerical majority of members, or whether multiple classes of members are intended for voting or management participation purposes. JTB Enters., L.C. v. D & B Venture, L.C. (In re DeLuca), 194 B.R. 79 (Bankr. E.D. Va. 1996).

Agreements Under Delaware Law

Delaware is an attractive jurisdiction because of its flexibility in determining standard of care for managers. For an LLC formed under Delaware law, the agreement may provide for the limitation or elimination of any and all liabilities for breach of contract and breach of duties (including fiduciary duties). This statutory regime would be concerning for non-managing owners, but a relief to managers or managing members concerned with risk of liability such as when making a decision involving self-interest.

The limits in drafting the Delaware LLC agreement are that “a limited liability company agreement may not limit or eliminate liability for any act or omission that constitutes a bad faith violation of the implied contractual covenant of good faith and fair dealing.” Del. Corp. Code §18-1101(e).

A 59-page Delaware Operating Agreement [Form 2:83] is available, along with these other Delaware agreements:

Maintenance of the LLC Agreement

The completed LLC agreement should be signed by all members and by any managers. The agreement may be signed in counterparts if permitted by the LLC agreement. The agreement with a complete set of members’ signatures should be kept in a secure location and be accessible at reasonable times to all members. Copies of the signed LLC agreement should be provided to the members. Any unsigned or draft copies either should be destroyed or clearly marked “draft” to avoid confusion.

Generally, the LLC agreement is a private document. However, on occasion, third parties are going to want to see the agreement. Litigation might require that the document be produced for copying and study. Absent lawsuit discovery, it may be possible that the entire document does not have to be produced. Provisions that authorize company and member action or management provisions can be segregated out of the entire document and provided to necessary third parties.

Modifications to the LLC agreement are permitted in all states; however, the adviser must assure that the proper votes of the members are obtained and preserved in written format when changing the LLC agreement. All amendments or modifications to the agreement should be dated so that a historical record can be maintained. For third-party matters, seldom can amendments or modifications relate back to an earlier date. Therefore it’s important to have a written record of changes to the LLC agreement. If new members are admitted to the LLC, they must sign the LLC agreement and consent to be bound by it.

LLCs are now the entity of choice for most practitioners in the United States. In fact, for the first time in 2002, LLCs were the most common partnership ent­ity type, totaling 946,130, about 42.2 percent of all partnership-type entities. IRS News Release IR-2005-5. As LLCs continue to grow in popularity, it’s more important than ever for legal assistants to keep up-to-date on the different considerations in drafting LLC agreements.

 


Tax Provisions in LLC Agreements

In multi-member LLCs, consideration should be given to the types of income tax provisions that the drafter includes in the LLC agreement. A thorough discussion of these tax provisions with the members prior to the drafting of the LLC agreement can  generate prospective members and eliminate sources of disagreement or confusion later. There are nine key tax issues that the drafter should discuss with members and consider placing in the LLC agreement:

  • tax planning and compliance;

  • tax distributions;

  • self-employment tax;

  • profits interest and special election for admission of members providing services;

  • IRC Section 704(b) (special allocations);

  • special distributions;

  • IRC Section 704(c) (issues);

  • IRC Section 754 (elections); and

  • the tax matters partner.


 

James L. Leet and James Clarke are shareholders at McDonough Holland & Allen in Sacramento, Calif., and are both listed in "Best Lawyers in America." They are authors of "The Limited Liability Company" (www.jamespublishing.com or 800-440-4780), from which this article and the forms are excerpted.

 

Visit the Forms Directory page for links to the forms discussed in this article, as well as over 100 forms relating to a variety of other topics.

 

 

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