Traps for the Unwary in DIY LLC Operating Agreements

I’m all for saving money where you can, but using one of those do-it-yourself LLC operating agreements is what they call “penny-wise and pound foolish.” 

I have had many conversations with LLC members who have fallen out with the other LLC members. They usually want to know what their rights are.  Then we look at the LLC’s operating agreement and realize that it offers little to no protection for their situation.  Often, these operating agreements came with whatever legal service they used to form the LLC, and no one paid much attention to it.  Or someone was proactive and downloaded something from the internet, but the agreement is still woefully insufficient. This can have disastrous consequences.

Unfortunately, the New York limited liability company is a complex entity that relies on its members to shape its rules and governance by contract; that contract is called an operating agreement.   Drafting a proper operating agreement requires that you know the situation and wishes of its members, the business they are planning to conduct, and the New York limited liability company law and case law.  A template can never do all of that. 

Let’s review where these templates often come short:

Sloppy drafting errors result in conflicts

I recently reviewed an agreement given to my client by Legalzoom.  With respect to the management of the LLC, it provides

“Unless greater or other authorization is required pursuant to the Agreement or under the New York Limited Liability Company law for the Company to engage in an activity or transaction, all activities or transactions must be approved by the Members, to constitute the act of the Company or serve to bind the Company.” 

Ok, so let’s say we want to buy a new copy machine and you are a 45% member. Can the 55% member buy a copy machine against your consent? (btw, this sort of provision is very unpractical, you don’t want a situation where every single decision and act by the LLC requires a member vote).

There are no other provisions in the LegalZoom agreement that require greater authorization for buying a copy machine. Even though I don’t really understand the sentence in the first place, “greater authorization” than what? But what sort of approval is then required? 

Another provision states:

“Unless otherwise stated in this Agreement….., the vote of the Members holding at least a majority of the Voting Interest of the Company is required to approve or carry out an action.” 

Alright, what does “Voting Interest” mean?  It is capitalized so that means it should have a defined meaning.  I look under definitions, and there are plenty of definitions, for example, “Member,” “Percentage Interest,” and “Ownership Interest” but no definition for Voting Interest.  Really, Legalzoom?  So what do you do?  It is not a good position to be in.  If the copy machine were the purchase of a multimillion-dollar property, you would not want to be unclear on who has to approve what.

The undefined term “Voting Interest” is used multiple times in the agreement, for example when it comes to who has to approve the dissolution of the Company.  

There are other inconsistencies in that agreement, but you get the gist; it is very important to have an operating agreement where all defined terms have a definition, and all provisions work with each other and don’t leave ambiguities.

Imke Ratschko Small Business Lawyer

For legal advice, call 212 2531027 or contact me here.

You can’t get money out of the LLC

Can you ever rely on getting any kind of payout from the LLC?  Only if the operating agreement says so. Many operating agreements (including the LegalZoom one) remain completely silent on that issue.  Then it is essentially within the control of the majority to make such distributions, and they may decide never to distribute any money to the members.  If that wasn’t bad enough, you could be liable for taxes without ever having received any money from the LLC.  Why?

A multi-member LLC is usually treated like a partnership which means it is a “pass-through entity.”  The entity doesn’t realize any income; all income flows through to its members.  So worst case scenario: The LLC realized 100k in profits in one year.  You are a 33% owner of the LLC, and thus 33% of that profit is allocated to you.  You are liable to pay taxes on that amount, whether you EVER RECEIVED THAT MONEY OR NOT.  So if the majority decides not to pay out any money to its members, you are left with a tax liability but no income to show for it.

Many operating agreements do not provide clear rules about the distribution of profits.  Then you are left with what the LLC law says, which also does not give the minority member a right to money distributions against the will of the majority member.

Back to the LegalZoom agreement.  The LegalZoom agreement just refers to the LLC law by saying:

“The timing and amount of distributions will be determined by the Members in accordance with the New York Limited Liability Company Law.” 

So essentially, again, you got nothing.

You are stuck with a member who abandons the ship

I’ve seen this drama play out:  Two members form an LLC and loosely agree to both work for the LLC.  Each gets a 50% membership.  Then one member just takes off.  Guess what? The member is still entitled to be a member and receive 50% of the profits.  You can’t kick out the member.  Yeah, maybe something could be argued that the member abandoned the LLC and is thus responsible for a breach of fiduciary duties, but it would be much easier if the operating agreement made it clear that each member has certain areas of responsibility and duties.  The agreement would then also state that a breach of those responsibilities would have consequences, for example, a buyout right by the hard-working remaining member. 

Of course, the Legalzoom agreement has nothing of this sort.

You are stuck with a member who can’t agree on anything

If you are 50/50 members of an LLC, there is a very likely possibility that you will reach a deadlock on some decision down the road.  What do you do then? If you have nothing in your operating agreement, you are most likely stuck in the situation.  Courts will most likely not grant you dissolution based on a deadlock between members alone.  You are stuck. A proper operating agreement can provide several mechanisms to resolve deadlocks among LLC members.

Again, the Legalzoom agreement has no provisions for resolving deadlocks.

Imke Ratschko Small Business Lawyer

For legal advice, call 212 2531027 or contact me here.

Your heirs get close to nothing when you die

When an LLC member dies, and the operating agreement does not have specific provisions about if and how your membership interest transfers to your heirs, your heirs may be in for a bad surprise.  Pursuant to Section 603 of the NY LLC Law, they only inherit the economic interest, but no voting rights and not even rights to inspect the books and records of the LLC.  They are completely dependent on the goodwill of the remaining members and if there is no such goodwill, may well never see any benefit from having inherited your membership interest. Of course, the LegalZoom agreement has no provisions dealing with the death of a member.