Does An LLC Need An Operating Agreement?

This article is devoted to small and mid-sized business owners based in California and Texas who currently operate their businesses under one or more limited liability companies (“LLCs”) that they formed in either state (as opposed to Delaware or elsewhere), or are early in the LLC formation process with the goal to so operate. 

When it comes to LLC operating agreements, these owners tend to fall into one of three categories: 

Category (1): owners who have an informal, unwritten operating agreement based on some combination of oral and implied understandings among the members of the LLC; 

Category (2): owners who have a written operating agreement that is based off of a free template found online or off another company’s operating agreement, with no input from an attorney and tax advisor who specialize in LLC formation in the applicable U.S. state; or 

Category (3): owners who have a written operating agreement that is based on input from such an attorney and tax advisor that ensures the agreement terms are customized and comprehensive to govern the management and operation of the LLC as per the preferences of the member(s) and to comply with applicable law. 

It’s perfectly understandable, dear reader, for you to find it self-serving for this attorney to persuade owners in Categories (1) or (2) to upgrade to Category (3).  Nevertheless, my goal for this article is to convince those owners that this upgrade is in your best interest, regardless of what type of business(es) you operate or intend to operate, and regardless of whether you are or will be a single member LLC or a multi-member LLC.  To make this case, I even came up with a hokey acronym to offer you: 

“FREEDOM”

Freedom to Contract

Regulatory Compliance 

Excellence in Operations and Management

Evolution of Your Company 

Dispute Mitigation and Resolution

Obtaining loans and opening bank accounts

Minimize Personal Liability 

Let’s dive in, shall we?

Let’s start with an introduction to the key statutory laws that govern the management and operation of LLCs formed and operating in California and Texas. For California, those laws fall under the California Revised Uniform Limited Liability Company Act (“RULLCA”) (Cal. Corp. Code Sections 17701.01 et seq.), a subdivision of the California Corporations Code. For Texas, those laws fall under the Texas Business Organizations Code (“BOC”) (Tex. Bus. Orgs. Code Sections 1.001 et seq.), particularly Title 3, Chapter 101 focused specifically on LLCs. While neither the RULLCA or BOC requires a written operating agreement for an LLC, each contains numerous default provisions that govern the affairs of an LLC on a variety of matters unless an operating agreement provides otherwise. So, unbeknownst to the member(s) of an LLC, these default provisions can impose undesired outcomes for your LLC because your operating agreement fails to address certain matters. 

As such, the first benefit to upgrading to Category (3) is for you to have the full freedom to contract for the management and operation of your LLC by superseding the default provisions of the RULLCA and BOC.  

Here is a non-exhaustive list of some of the more high-profile default provisions that apply to a LLC in the absence of contrary provisions in the operating agreement:

In addition to this freedom to contract and ability to supersede the default provisions of the RULLCA and BOC, LLCs are so-called “eligible entities” whose owners have the right to override the default rules for US businesses regarding these automatic tax classifications (Treas. Reg. § 301.7701-3):

• A single-member LLC is automatically classified as a disregarded entity for federal, state, and local income tax purposes.
• A multi-member LLC is automatically classified as a partnership for federal, state, and local income tax purposes.

For example, a single-member or multi-member LLC may override these default rules by electing S-corporation tax status if it meets the requirements to make that election (the considerations for which tax classification to make for an LLC and the process for making the election are beyond the scope of this article). The key point here is, once the LLC owners make an informed decision on tax classification, making the associated tax status election outside of the operating agreement is necessary but not sufficient: the LLC ought to have an operating agreement that reflects the LLC’s selected tax classification and its intent to preserve the classification and includes tax-related provisions specific to that classification.  

While diving into those tax-related provisions is beyond the scope of this article, I will offer two examples (among many others). First, if you choose for your LLC to be treated as a S-corporation for tax purposes, you will be required to: (a) allocate LLC profits to members on a strict pro-rata basis based on their ownership interest percentage, (b) only issue one class of membership interests, and (c) exclude non-U.S. citizens or residents from LLC members. Items (a) through (c) ought to be reflected in your operating agreement. Second, if you choose for your LLC to be treated as a partnership for tax purposes, you will be required to: (x) refrain from issuing incentive stock options, (y) establish and maintain separate capital accounts for each member, and (z) be subject to the partnership audit rules under the Subchapter C of Chapter 63 of the Internal Revenue Code. Again, items (x) through (z) ought to be reflected in your operating agreement.

While both the RULLCA and BOC allow much flexibility for LLCs to modify or to waive their respective default provisions, each also includes numerous provisions that an operating agreement is strictly prohibited from modifying or waiving. For the RULLCA, those prohibitions are listed in Section 17701.10, subdivisions (c), (d), and (g). For the BOC, those prohibitions are listed in Section 101.054.  

So LLCs owners that fall under Category (2) run the risk of inadvertently violating the RULLCA or BOC, as applicable. In the event of a legal dispute pertaining to your operating agreement, this runs the risk of a court of competent jurisdiction either removing such violating provisions while enforcing the rest of the agreement, or invalidating the agreement if the violating provisions are deemed integral to the agreement. 

As such, the second benefit to upgrading to Category (3) is for you to avoid the risk of your LLC’s operating agreement being partially or fully invalidated if a legal dispute arises between the members that implicates the terms of the agreement. 

For many business owners, your LLC is your livelihood and you and your fellow members are doing all you can to effectively operate and manage its underlying businesses. By entering into a well-drafted operating agreement from the onset, you and your members can deliberate on your perspectives and align on shared principles when it comes to such day-to-day matters as:

• How will the company be managed, whether member-managed or manager-managed, and what will the division-of-labor be as between members and, if and as applicable, as between one or more managers, employees, contractors, and executive officers?
• What are the rights and obligations of members and, when it comes to member voting, what matters require unanimous consent, versus majority or supermajority consent?
• What approaches will the company take when it comes to initial and additional capital contributions, allocations of profits and losses, and the timing and amounts of cash and tax distributions?
• How committed to excellence will the company be when it comes to maintaining books and records and bank accounts, preparing and abiding by a budget, and furnishing accurate financial statements?

Therefore, the third benefit to upgrading to Category (3) is for you to hold yourself and your fellow members accountable in the operating agreement to a high standard of excellence for your company’s operations and management.

Maintaining excellence in your company’s operations and management can pave the way for your company to grow in success. In time, perhaps some or all of your members may want to:

• Add subsidiaries and/or operate in additional U.S. states or overseas
• Admit new members to invest in your company through the issuance of new membership interest units, while protecting existing members against dilution of their ownership holdings
• Add one or more managers, employees, and officers to the payroll
• Proceed with a merger or sale of most or all of the company 

An operating agreement can provide guidelines to address each of the above scenarios at the level of detail that you and your members prefer, while also considering the level of consent required to proceed with each. 

On the other hand, in the event your company faces adversity, some or all of your members may want to:

• Expel a member or a manager from the LLC or allow for their voluntary withdrawal
• Require additional capital contributions to address budgetary shortfalls, unanticipated expenses, or mounting debt obligations
• Address the consequences of a member’s divorce, disability, or death
• Dissolve, liquidate, and terminate the company 

Again, rather than confronting these challenges from square one with no guidelines, an operating agreement can offer defined solutions that can allow you and your members to overcome the challenge and proceed with growing your company. Of course, no matter how comprehensive and thoughtful your operating agreement is, no draft is futureproof. However, your initial draft can serve you well to set the table for future amendments or perhaps a full restatement, as needed. For example, if you begin as a single-member LLC (in which case you would need a single member LLC operating agreement) and you later decide to admit one or more members, you will need a new, entirely restated operating agreement that properly reflects this new arrangement.

As such, the fourth benefit to upgrading to Category (3) is for you to have an operating agreement that anticipates the potential evolution your company may take, whether positive or negative, to allow you and your members to have guidelines to respond accordingly.

Our firm’s partnership dispute attorneys have represented clients who are experiencing substantial conflict with fellow members of their LLC and the threat of lawsuits, but, unfortunately, the members either have no written operating agreement, or have an operating agreement that fails to offer effective dispute mitigation and resolution mechanisms (often seen when there is no dispute resolution clause in a contract between partners). It is understandable that family members, friends, and long-term business colleagues who enter into business together assume that it is unlikely that the relationship can sour to the point that anyone would attempt to force a member out of the LLC, seek a shift in the power structure with changes to ownership interest ratios, and so on. This is why having a properly structured LLC operating agreement Texas courts will uphold can help avoid future disputes.

As the fifth benefit to upgrading to Category (3), consider the benefit to have an operating agreement that includes these mechanisms as a form of insurance, with no judgment placed on any member for being the reason why any such mechanism would be triggered.

Chances are, if you aim to open one or more bank accounts for your LLC, or take out a loan for your LLC, the bank/lender will require a review and perhaps additions or revisions to your operating agreement. Focusing just on the loan scenario, this review allows for an understanding of your LLC’s ownership and management structure among the members, decision-making authority among the members and, if applicable the manager(s), and the extent which there are limits on the LLC’s ability to borrow money, incur debt, and pledge its assets or membership interests as collateral, among other considerations. Further, this review allows for the lender to comply with certain applicable regulatory compliance requirements. 

As such, the sixth benefit to upgrading to Category (3) is to avoid the scenario in which an operating agreement that is poorly-drafted and full of gaps on provisions required by a would-be lender is the reason that lender decides not to provide with you a much-needed loan for your company. 

Of course, there is no guarantee your operating agreement prevents such a scenario. However, a well-crafted operating agreement can offer a strong baseline from which you can amend it as required by a lender in order to obtain that critical loan.

Anyone reading this article likely knows that a key advantage of forming a LLC is that, generally, its members and, if any, manager(s), are not personally liable to the LLC for the LLC’s debts, liabilities, and obligations. (This of course doesn’t apply to a member who opts to personally guarantee a loan or contractual obligations on behalf of the LLC.) The RULLCA and BOC both affirm this notion in Section 17703.04, subdivision (a) and  Section 101.114, respectively, and extend the assurance to an LLC’s members and manager(s) even if the LLC does not have an operating agreement with provisions to that effect. 

Nevertheless, it would be prudent to have an operating agreement that both bolsters this assurance, while also recognizing the exceptions to it under the RULLCA and BOC, as applicable, and other applicable law. For an example of bolstering, to avoid any future ambiguity among the members, an operating agreement could make explicit that no member bears responsibility of the LLC’s debts or liabilities to an outside party in excess of the amount of the member’s: (a) unpaid required capital contributions, (b) unrecovered capital contributions, and (c) share of any undistributed LLC profits. As for recognizing the exceptions, the general rule of thumb is to include an “Except as otherwise provided in the [RULLCA/BOC], by applicable law, or expressly in this Agreement” proviso as an opener to the provision in the operating agreement that lays out the “no personal liability” statement for members, managers, and, at the members’ discretion, officers. These exceptions include, among others, a member’s or manager’s acts of fraud, negligence, or misconduct, even if committed on behalf of the LLC, none of which can be excused or waived in an operating agreement. 

Another example of an exception to the “no personal liability” assurance is a member or manager’s breach of its fiduciary duties, such as the duty of loyalty and the duty of care. This is a nuanced matter because a determination of whether or not this breach was committed will depend in part on whether the members chose to: 

(a) Remain silent, whether intentionally or not, in the operating agreement on the topic of member and manager fiduciary duties owed to each other and to the LLC, such that the default fiduciary duties provided by applicable law apply, which is a murky and complicated landscape; 

(b) Modify such default fiduciary duties in the operating agreement, whether by expanding or limiting them, without expressly waiving those default fiduciary duties, such that uncertainty may exist as to which set of duties supersedes the other;

(c) Option (b), except that the operating agreement expressly waives those default fiduciary duties such that only duties expressly set forth in the operating agreement apply, but without a consideration of the restrictions imposed by applicable law on modifications that limit or eliminate fiduciary duties; or

(d) Option (c), except that the operating agreement takes into consideration the foregoing restrictions imposed by applicable law to ensure legal compliance. 

Of these four options, Option (d) is the optimal choice. The broader point here is to emphasize the importance of having a well-drafted operating agreement that properly captures the nuances inherent in Option (d) such that the members and, if any, manager(s) are all on notice as to the unambiguous scope of their fiduciary duties owed to each other and to the LLC for sake of minimizing both the risk of internal disputes and the risk of bearing personal liability for alleged breaches of any of those duties. 

As such, the seventh and final benefit to upgrading to Category (3) is to ensure that your LLC’s operating agreement properly distinguishes the scenarios in which a LLC member or manager would and would not bear personal liability to the LLC and to each other.

Now, if you, dear reader, are convinced that these seven benefits merit upgrading to Category (3), feel free to contact me at joel@aminiconant.com to discuss these next five steps in the process:

• Properly selecting your LLC’s type of operating agreement
• Properly customizing your selected type of operating agreement
• Considering various procedures to include in your operating agreement to resolve member disputes and voting deadlocks if and when they may occur
• Considering various scenarios of transferring membership interests to address in your operating agreement
• To expand your business, consider when to add passive investors as non-voting members to your LLC, or converting to a c-corporation to seek out VC and institutional investors.

This publication is provided by Amini & Conant, LLP for educational and informational purposes only and is not intended and should not be construed as legal advice. Should the reader seek further analysis of the subject matter or answers to specific questions about the subject matter, please contact the author at joel@aminiconant.com. This publication is considered advertising under applicable state laws.

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