Limited liability companies (LLC’s) have become the business organization of choice for most small business owners. This is primarily because of their flexibility and simplicity. LLC’s are separate legal entities apart from its members, like corporations, but are treated as “pass-through” entities for taxes purposes, such as sole proprietorships and partnerships, unless they have elected to be treated as taxable entities by the IRS.
Members of LLC’s are typically shielded from personal liability for the company’s debts. Profits and losses are passed directly to the members, which avoids the issue of double taxation because the LLC does not pay taxes itself.
The most essential element to any properly functioning LLC is the operating agreement. An LLC operating agreement will provide provisions that allow for the effective and efficient governance of the LLC and its members. While an Ohio LLC can be organized without a written operating agreement, if there is no written agreement, Chapter 1705 of the Ohio Revised Code will govern the operation of the LLC and govern the relationship between its members. These default statutory rules will leave open many issues that may impact your business.
A well-drafted LLC operating agreement is very important because it will reduce the potential for disputes between the LLC members in the future. Every LLC operating agreement should contain these essential provisions:
Transferability of Membership Interests and Admission of New Members
The operating agreement of the LLC should describe the restrictions on the transferability of membership interests and explain the rules governing the admission of new members.
The rights for withdrawing from the LLC, as well as the conditions and terms that will govern the withdrawal, needs to be addressed in the operating agreement.
Divorce, Bankruptcy, and Death of a Member
The operating agreement must address what occurs to a person’s membership interest upon the divorce, bankruptcy or death of a member. If the operating agreement does not, a number of outcomes could occur that would be undesirable for the other members of the LLC. For example, a divorced member’s spouse, an heir of the deceased, or a creditor could become a member of the LLC.
Contributions of Members
Many statutory rights of the members are based on their capital contributions. Thus, it is very important that this information be stated in the operating agreement. If contributions are to be in a form other than capital, such as services, it is important that the operating agreement clearly state the form and value of the non-capital contributions.
Management and Voting Rights
It is critical that the operating agreement state how the LLC will be managed. For example, will the LLC be managed by its members or by elected members. If managers are elected, the operating agreement should clearly state which actions these managers may take on behalf of the LLC (such as the day-to-day operation of the business) and which actions require the approval of the members (such as business acquisitions or financing). The operating agreement should also clearly specify how the voting rights of members are established, such as based on capital contributions, per capita (each member gets one vote), or determined in another manner.
Allocation of Profits, Losses and Distributions
Often members wish to allocate profits, losses and distributions in a manner other than based on the capital contributions of each member. If the members wish to do this, the operating agreement should address these issues to ensure that the allocations are fair to all its members.
The operating agreement should address restrictions on a member’s rights to use or disclose the LLC’s confidential information.
The operating agreement should outline the terms and conditions regarding indemnification of the members by the LLC for actions taken on behalf of the LLC.
Covenants Not to Compete
The operating agreement should address any restrictions on a member’s right to compete with the LLC’s business or pursue business opportunities that that should be made available to the LLC first. While there are fiduciary duties that members owe to the LLC, these duties can be modified or discarded by the terms of the operating agreement. However, certain provisions of Ohio’s LLC statute cannot be modified by the operating agreement, but can be clarified. These include:
- Manager Duties – The operating agreement may describe the standards by which performance by the manager will be measured and state activities that will not violate the manager’s duties to the LLC.
- Duty of Loyalty – The operating agreement may state the activities that do not violate the duty of loyalty and can provide procedures to address possible exceptions to this duty.
- Duty of Care – The operating agreement can enumerate the standards by which the duty of care will be judged.
- Obligation of Good Faith and Fair Dealing – Similar to the duty of care, the operating agreement can prescribe the standards by which the performance of these obligations will be measured.
Columbus and Delaware, Ohio Small Business Attorney
If you own your own business, or are contemplating doing so, there are a number of things you need to consider. This includes whether a variety of agreements, including operating, buy-sell, non-compete, and confidentiality agreements, should be drafted for your business. Consultation with an experienced and dedicated small business attorney will help make this process simpler. Call Johnson Legal, LLC at (614) 987-0192 to discuss your small business needs.