One main advantage of forming your business as a limited liability company (LLC) instead of a corporation is flexibility. The corporate governance, operations, and tax treatment of an LLC can differ widely depending on the members’ preferences.
However, this flexibility can be a double-edged sword. Running an LLC without operating agreement documents puts the company at risk. A business formation lawyer from Weberman Business Law P.C. will draft or update operating agreement terms so the members can run their business smoothly.
What Happens When a Limited Liability Company Operates Without a Clear Operating Agreement?
Although the structure of an LLC is flexible, limited liability company law sets forth default provisions. If an LLC doesn’t have an operating agreement, these provisions dictate the rules for voting, making capital contributions, and allocating expenses and losses to the members.
They also determine how an LLC adds new members and how it voluntarily or involuntarily removes members. If the company wants to deviate from the default rules outlined in the New York Limited Liability Company Act, it must have an express LLC operating agreement.
Complicating things further, an LLC can be controlled by an oral or implied operating agreement in the absence of a written operating agreement. Specifically, when a court is tasked with resolving a dispute among members of an LLC without operating agreement documents in writing, it can rely on verbal agreements or terms implied from the company’s customs and practices.
For example, suppose the business partners exchanged emails and held meetings before filing the LLC’s articles of organization. However, they never signed a written operating agreement. Instead, they have been running the business based on the information in the emails and oral discussions. The court may use this information to resolve any disputes.
A court may also look to how the members acted to determine the terms of the unwritten agreement. Thus, for a company without written voting provisions, a court might find that the voting process used by the members in the past created a member-managed LLC, and it will force the members to continue to use that process unless they can agree on a new one.
Legal Risks and Disputes That Commonly Arise Without an Updated Operating Agreement
An LLC without operating agreement terms can face the following types of disputes.
Disagreements Among LLC Members
An LLC operating agreement in New York sets out a company’s operating procedures, voting rights, and financial processes.
LLC disputes without an operating agreement can arise over these issues:
- Voting
- Determining member and manager responsibilities
- Admitting new members
- Paying off exiting members
- Transferring and inheriting membership interests
- Allocating profits and losses
- Raising capital through member capital contributions
- Taking on company debt
In multi-member LLCs, members can get on the same page by discussing legal and financial issues, preparing operating agreement drafts, and negotiating the final wording of the agreement.
It’s difficult for a member to claim ignorance of the company’s rules if they helped draft LLC operating agreement documents. By setting out the company’s management and operating structure, the members can reduce the risk of LLC member disputes in New York.
Disputes With Third Parties
A company’s dealings with third parties, such as customers, vendors, and joint venture partners, might be threatened when it lacks an operating agreement.
For example, suppose that Member A commits to supplying a customer with the LLC’s services. However, the other members think that Member A made a bad deal. They want to back out, so they claim that Member A does not have the authority to sign customer contracts. Without an operating agreement to resolve it, this internal dispute might spill over into a lawsuit.
Another potential issue can arise when third parties question whether the LLC qualifies for limited liability protection. Specifically, LLCs normally shield members’ personal assets. If the LLC faces judgments or debts, the other party can only pursue the company’s assets and revenue.
However, LLCs must meet certain minimum standards to qualify for this protection. Without a written operating agreement, the members might inadvertently run the company in a way that fails to comply with the state’s LLC Act, which puts their personal assets at risk.
Issues With the Government
New York is one of the few states that requires LLCs to adopt written operating agreements. Companies that fail to satisfy New York LLC operating agreement requirements will not typically face dissolution. However, they open themselves up to regulatory and tax issues.
Certain industries are highly regulated. Businesses in those industries must be licensed and undergo regular compliance reviews. If an LLC involved in marijuana, alcohol, or gambling lacks an operating agreement, it could fail to comply with mandatory rules and risk losing its license.
Additionally, all LLCs must comply with tax laws. The IRS allows LLCs to elect either pass-through or corporate tax treatment. The members typically outline an accounting method in their operating agreement based on the tax election.
Without an operating agreement, an LLC faces two risks. First, the company risks noncompliance with IRS laws and regulations. Second, the members might fail to realize all of the tax advantages of the company’s election.
How Missing or Outdated LLC Operating Agreements Affect Control, Management, and Decision‑Making Authority
Operating agreements help prevent conflicts between members over control, management, and decision-making. Specifically, the members can avoid disputes by simply referring to the agreement when issues arise.
For example, an operating agreement often dictates which responsibilities fall on management in a manager-managed LLC. If a member believes a manager is overstepping their bounds, they can refer to the agreement to determine the company’s policies.
Similarly, a written agreement will identify which business decisions can be made by an LLC manager and which require a vote of all the members. Thus, an LLC can avoid disputes about who has the authority to incur debt by including specific rules about this and other financial matters in its operating agreement.
However, an operating agreement does more than prevent disputes. It can also lay out a road map for the company’s operations. It can explain the LLC management structure, including areas of responsibility for each member or member-manager.
When used in this way, operating agreement updates are critical during changes in leadership duties. If a member takes on additional responsibility or shifts some of their duties to another member, it’s a good idea for the LLC to update its agreement.
Most LLC operating agreements also describe how votes are handled for significant decisions. The default rule for voting under LLC operating agreement law in New York is that the “majority in interest” controls the LLC. This means that a decision wins if members with at least 50% of the ownership shares agree to it.
However, this default rule does not accommodate the specific needs of all LLCs. Instead, an operating agreement can mandate that certain decisions, such as dissolution or sale of the LLC, require a supermajority of 66% or 75% of the ownership shares. The members might even require unanimous consent for these major business decisions.
Another possible adjustment in the voting rules involves shifting voting from ownership shares to members. If one member owns 51% of the LLC, they control a majority interest and can dictate all of its decisions under default provisions.
This ownership structure helps a founder maintain control of their company even as members are added. However, it may be unattractive to investors because they lack power over company decisions and thus cannot protect their investment from bad moves.
In this case, the operating agreement can outline certain decisions that require a per capita vote, in which each member gets one vote regardless of the size of their ownership share. For these decisions, smaller investors can overrule a founder who has 51% ownership.
Financial Consequences: Taxes, Profit Distribution, and Personal Liability Exposure
To understand the power of an LLC, you must know the default rules for partnerships and corporations.
Generally, partnerships allow for pass-through taxation. Profits and losses are allocated to the individual partners. The partners then include the profit or loss on their individual tax returns. For example, a two-member partnership with equal ownership interests passes 50% of its profits to each partner. These profits are treated as income on the partners’ tax returns.
By contrast, C-corporations suffer from “double taxation.” This means that the corporation is considered a taxpaying entity and files an income tax return for its own profits and losses. When it pays its owners in the form of dividends or salary, the owners pay individual income taxes. Thus, each dollar earned by the corporation and paid to its shareholders is taxed twice.
The IRS allows LLCs to elect which tax structure to use. However, the LLC must implement financial and reporting procedures that match whichever structure it elects. In many cases, the operating agreement describes the process for distributing profits and losses and declaring them to the IRS according to the entity’s tax election.
Another strength of an LLC is that it limits personal liability like a corporation does but can still provide the pass-through tax advantages and flexibility of a partnership.
Therefore, members of an LLC can avoid the double taxation that comes from owning shares in a C-corporation. They can also protect themselves from the personal liability that comes from being a partner in a partnership.
Having an operating agreement helps implement this protection in two respects. First, it clearly defines the business as an LLC and not a partnership, limited partnership, or other entity that may expose members to personal liability.
Second, it implements all of the procedures needed to formalize the business as an entity. For example, the law does not require annual meetings for LLCs. However, you might require one in your operating agreement so that your business can hold votes in a formalized setting.
By documenting your LLC’s votes, you reduce the risk of member disputes. You also reduce the likelihood that a third party can persuade a court to pierce the corporate veil and hold LLC members personally liable for business acts.
Special Concerns for Single‑Member LLCs Without a Formal Operating Agreement
The risk of piercing the corporate veil is particularly high with single-member LLCs.
“Piercing the corporate veil” occurs when a court determines that you failed to observe all the formalities and rules needed to establish your LLC as a separate legal entity. If this happens, you lose many of the protections of the LLC and become personally liable for the company’s judgments and debts.
Courts use three common elements to determine whether to pierce the corporate veil. The first is financial commingling. When you mix your personal income with the company’s income, a court is more likely to find that the LLC was not separate but was instead merely your “alter ego.”
An operating agreement can outline the treatment of company bank accounts and describe who has the authority to make deposits and approve payments. As long as you follow these rules, you reduce the risk of commingling funds.
Second, courts look at whether you observed the “corporate formalities” of having a company. One of the consequences of no LLC operating agreement is that a court might consider your single-member LLC to be nothing more than a sole proprietorship for which you are fully and personally liable.
Single-member LLC liability without an operating agreement can be significant. Conversely, having an LLC operating agreement, regardless of the wording, can reduce the risk that a court will pierce the corporate veil.
Third, a court will examine whether your LLC was undercapitalized. Again, you can include provisions in your operating agreement about when capital calls will be made and how you will contribute capital to your single-member LLC.
Merely having these procedures in writing can help show that an LLC that appears undercapitalized on paper has full access to capital when needed.
Why Updating or Creating an Operating Agreement Now Can Protect Your Business Moving Forward
It is never too late to draft or update an LLC operating agreement. Moreover, the consequences for an LLC without operating agreement terms can be significant.
Whether you have started a new business or recently changed your company’s leadership or operations, contact Weberman Business Law P.C. to discuss how an operating agreement can protect your LLC and its members.