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Part 2 – What Should be Included in Your Operating Agreement?

Part 2 -What Should be Included in Your Operating Agreement?

Our business and tax attorneys frequently draft and modify operating agreements for limited liability companies.  To share some of our knowledge on this subject, we drafted a two part article. In Part 1, we listed the ten most common sections found in an operating agreement and discussed the first four on the list. In this Part 2, we discuss the remaining sections as follows:

5. Allocations
6. Distributions
7. Transfer of Interest and Admission of Members
8. Buy-Sell
9. Dissolution and Liquidation
10. Miscellaneous

A summary of each of the above sections is provided below.

5. Allocations –The allocation section of an operating agreement defines what portion of any income or loss will be allocated to each member’s “book” capital account and tax return. A distribution on the other hand is the receipt of cash or property from the limited liability company (“LLC”). You may not receive any distributions in a particular year, but you will receive an allocation of income or loss, if the LLC (treated as a partnership for tax purposes) has any economic activity.

The allocation section can be the most difficult to understand and draft. This is because there are detailed and complex tax rules under IRC §704 whose purpose it is to ensure that allocations to each member have “economic effect”. In order for an allocation of income to have economic effect, the distributions and allocations must have a certain mathematical relationship if the allocations are to be respected for tax purposes. That is, total distributions to a member must equal a member’s capital contributions plus that member’s share of income, less that member’s share of losses.

A simple example of economic effect is that if you contributed $100, and you are allocated $100 of income, you have a capital account of $200. As a result, you may receive a distribution of cash or other property totaling $200.

Under most operating agreements, income and loss is allocated based on ownership (and ownership is based on the contributions made by each partner). So, if Partner A owns 50% and Partner B owns 50%, this means that all income and loss is allocated 50/50. Then, if each partner receives half of the distributions, the “economic effect” rules will have been met.

Drafting the allocation section becomes more complex in situations where allocations do not follow ownership. This is common for example in real estate investment limited partnerships. In these situations, it is common for limited partners to receive a certain preferred return (i.e., a percentage of their investment) for a number of years, while the general partners may not receive any allocation. Then, when the real estate asset is sold, all partners may receive an allocation of the gain (maybe 80% to the limited partners and 20% to the general partners). In these situations, the allocations do not follow ownership. These allocations are called “special allocations” and drafting to meet the economic effect rules is more complex in those situations.

6. Distributions – As mentioned above, a distribution is the receipt of cash or property from the partnership. The operating agreement often addresses two types of distributions, tax distributions and general distributions.

A tax distribution is a distribution to the members to provide them with cash to pay their tax on the income they are allocated. Without such a distribution, the members could be allocated income but have no cash to pay their tax liability. A tax distribution alleviates this issue.

The other type of distribution is a general distribution. The general distribution terms define when an LLC is considered to have cash available to make a distribution, and when those distributions are to be made. Some operating agreements state that all available cash will be distributed on a certain day of the year. Other operating agreements will leave it to the discretion of the managers whether and when to distribute cash.

7. Transfer of Interest and Admission of Members – Most LLC members do not want to allow other members to transfer their interest to someone else. The reason being they do not want to become business partners with someone they do not know. For this reason, most LLC operating agreements provide that the members cannot transfer their ownership to anyone else, except in certain limited situations, if at all.

8. Buy-Sell – Another common provision in an operating agreement is a buy-sell provision. This provision gives the LLC or another member the right to purchase another member’s interest should certain defined events occur. Those events may include the following: death of a member, bankruptcy of a member, an attempted transfer of a member’s interest, and divorce proceedings that a member is a party. The purpose of the buy-sell provision is to provide a means for members to control who they are members with and provide for a defined mechanism for a member to exist the business at a pre-established methodology for determining the sale price.

9. Dissolution and Liquidation – An LLC is statutorily dissolved upon the occurrence of any of the following (1) an event causing the LLC to dissolved under the operating agreement; (2) if the LLC never had a member, by a majority vote of the organizers under Act Section 57D-2-20(c); (3) if the LLC ever had a member, the 90th day after the day on which the LLC ceases to have any members; (4) entry of a decree of judicial dissolution under Act Section 57D-6-05; or (5) the filing by the Secretary of State of a certificate of dissolution under Act Section 57D-06-06.

In addition to listing the statutory events that cause a dissolution, the operating agreement will list any other events that may require or cause a dissolution. This section also speaks to how the LLC is wound up in terms of disposing of assets, satisfying liabilities, and distributing any remaining assets.

10. Miscellaneous – The miscellaneous section of an operating agreement includes many boilerplate terms commonly found in any agreement between two parties such as, the agreement is the complete understanding of the parties, what state law will be applied, all amendments must be in writing, where to mail or send notices to a party, and so forth. In addition to the common boilerplate provisions, this section may also identify who will represent the LLC with respect to tax matters, and what records will be made available to the members.

If you need help drafting or modifying an operating agreement, please do not hesitate to contact us.

Erik Lincoln is a founding member of Lincoln. In addition to being an attorney he is also a CPA. Erik has consistently been recognized as one of the top attorneys in North Carolina, by Business North Carolina.