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Business Owner Exit Planning: LLC Operating Agreements

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Limited liability companies (LLC or LLCs) are an attractive choice of entity for many non-public companies. An LLC is the preferred choice of entity for many advisors, including me, unless the facts warrant something different. The preference toward LLCs is largely due to flexibility and ability to later convert to another entity, if it becomes useful. The owners of an LLC are referred to as “members” and that term will be used throughout this article.

A critical checklist item for an LLC and its members is a well-drafted operating agreement or LLC agreement. For simplicity, we will refer to them as an “operating agreement” but the terminology varies by state. LLCs are a creature of state law. State law generally applies a set of default rules. In most instances, the LLC and its members are free to deviate from the default rules in the operating agreement. Therefore, it is important to have a well-drafted operating agreement that reflects the members’ intent and deviates from the default rules where appropriate.

The intent of this article is to highlight many common operating agreement provisions that facilitate business owner exit planning. The list below is not exhaustive as each situation is unique. It is important to work with competent tax and legal counsel when drafting an operating agreement. As discussed in more detail below, it is imperative that tax and legal counsel work together and ensure the operating agreement aligns with any tax goals or objectives.

Equity Classes

A simple way to structure an LLC is for a single class of membership interest whereby each member owns a specified “percentage interest” in the LLC. In this case, each member shares in the profits, losses, and voting based on their respective percentage interest. This approach may work fine for a small or closely held company where all members are active in the day-to-day operations. However, a straight percentage interest has its limitations when viewed through an exit planning lens. There are circumstances where having multiple equity classes helps facilitate exit planning.

Non-Voting Members. A non-voting equity class may be useful where the sole member of an LLC (the “founder”) is ready to begin transitioning ownership to someone else (the “transferee”). Let us assume the founder is getting ready to retire soon and wants to hand the reins over to an outsider. The founder finds the transferee, but the transferee does not want to fully commit to purchasing the entire business just yet. One potential solution is to create voting and non-voting interests. The founder can sell the non-voting interest to the transferee. The founder retains voting control of the LLC while transitioning the business to the transferee.

Profits Interests. LLCs commonly issue profits interests to employees and service providers as a form of incentive compensation. A detailed discussion of profits interests is beyond the scope of this article. However, profits interests are also a useful tool in exit planning. Again, let us assume the founder is ready to transition ownership, but this time the founder wants to transition the business to a few key employees. The LLC can issue profits interests to these key employees. The founder can lock in the current value of their membership interest, and the key employees participate in any increase in value as they continue to run the business.

Preferred Members. Preferred membership interests function similar to preferred stock in a corporation. An LLC may create a “preferred” class of equity whereby members holding these interests have preferential rights to equity. LLCs and their members have significant flexibility in how they structure preferred interests, including how the LLC will distribute excess cash flow and make liquidating distributions. This flexibility extends to participating, capped participating, and non-participating preferred interests. So where might it make sense to utilize preferred equity in the context of exit planning? Let us continue our profits interests example, whereby the founder wants to transition the business to key employees by issuing profits interests. If the exit horizon for the founder is unknown or could be a number of years into the future, then the founder may not want to truly lock in the present value of the company. Instead, the founder may decide they want some form of a preferred return that accounts for the time value of money. Key employees remain entitled to the profits and appreciation above and beyond the preferred return hurdle.

Management Rights/Removal

Management rights are generally of little concern in a single member LLC. The sole member owns all of the equity and makes all of the decisions. In the context of exit planning and ownership transitions, management rights can become a material consideration. The default rule for many LLCs is that each member shares in the management of the LLC (i.e., member-managed). LLCs may transition from each member sharing in the management rights to a manager-managed LLC. The manager does not need to be a member.

Typically, the operating agreement gives the manager general authority to oversee day-to-day operations of the LLC and may set forth a list of activities whereby the manager has authority to act on the LLC’s behalf. The operating agreement may also set forth a list of activities whereby the manager does not have any authority to act on behalf of the LLC. Members typically vote on actions where the manager lacks proper authority to act. If the operating agreement is silent as to manager authority, the LLC and its members should look to the default state law. The default law may grant the manager broad authority over the LLC’s activities. For certain items, state law may require member approval for certain items or limit the authority granted to a manager.

There is no one-size-fits-all approach to drafting management provisions. Each situation is unique. In the context of exit planning, a member transitioning the business may want to retain significant management control over the day-to-day operations until a chosen successor is competent enough to take the reins. A similar—yet important—part of the transition plan is whether a chosen successor should be able to remove a predecessor as manager and under what circumstances. A member contemplating an exit plan should work with legal counsel to draft management provisions that meet their specific business needs and objectives.

Contributions to Capital

A common provision found in most operating agreements says something to the effect of members are not required to make additional capital contributions. A provision like this is important to retain limited liability. However, in the context of exit planning, these provisions can be expanded upon to designate which members may (or will) make capital contributions when the LLC or manager determines there is a need for additional capital. A founding member transitioning the business to one or more new members may not want to be on the hook for contributing capital to the LLC.

Alternatively, the founder may be the only member with sufficient cash to make a capital contribution. What happens if the founder does not want to dilute the ownership interests of the other members? The founder may consider loaning the capital to the LLC or include operating agreement provisions requiring capital contributions when approved by some percentage of the members. In this case, the members should consider what happens if a member fails to make a required capital contribution. Can another member step up and make a contribution for them? If so, is their interest in the LLC diluted or is it treated as a loan from one member to the other? These are all things the LLC and its members should consider. After careful consideration, the LLC agreement should set forth provisions covering what happens when a member fails to make a capital contribution.

Taxation

An LLC is not an entity classification for federal tax purposes. The default classification for a single member LLC organized within the U.S. is a disregarded entity. A disregarded entity is disregarded for federal tax purposes, and the member reports taxable income or losses on their tax return. Note that a disregarded entity may still have a taxpayer identification number (TIN) and pay federal payroll taxes on an individual basis. Once an LLC has two or more members, the default federal tax classification changes to a partnership. The LLC files IRS Form 1065 and provides members with a Schedule K-1—telling the members how much taxable income or loss to report on their individual tax returns. An LLC and its members may elect to classify the entity as a corporation by filing IRS Form 8832, or elect to be a small business corporation (S Corporation) by filing IRS Form 2553. An LLC and its members must meet a variety of tests to make a valid S Corporation election and meet certain criteria in order to retain it, including certain provisions required to be included in the operating agreement. LLCs and its members must make these elections within specified timeframes.

The importance of having legal counsel working with tax counsel cannot be understated. It is imperative to ensure deadlines do not get missed, and the operating agreement aligns with the intended tax classification. Unwanted or unnecessary provisions in an operating agreement may jeopardize the intended tax classification. The failure of an LLC and its members to align the intended tax classification and the operating agreement may result in significant future tax and legal costs. It may also give rise to material issues when a founding member wants to exit.

A member contemplating his or her exit plan should revisit the LLC’s tax classification as part of the larger transition plan. The historic classification may no longer be the most tax-efficient solution going forward. Alternatively, simply adding a new (second) member may automatically change the tax classification of the LLC. The LLC agreement should be revised to reflect any changes to the intended classification and avoid inadvertently terminating an otherwise valid S Corporation election.

Other Provisions

There are additional provisions LLC members should carefully consider when drafting or revising an operating agreement. These items include, among others, voting agreements, drag along rights, tag along rights, put options, call options, buy-sell agreements, membership transfers, admitting new members, rights of first refusal, tie-breakers, arbitration/mediation, non-compete, non-solicitation, and insurance. Most of these items warrant a longer discussion and our intent is to cover them in future articles.

This article is provided for informational purposes only—it does not constitute legal advice and does not create an attorney-client relationship between the firm and the reader. Readers should consult legal counsel before taking action relating to the subject matter of this article.