A limited liability company (LLC or LLC) is an attractive entity choice for many private companies. An LLC is the preferred entity choice for many advisors, including myself, unless the facts justify otherwise. The main reason for preferring an LLC is its flexibility and the ability to later convert to another entity if desired. Owners of the LLC are called “members” and this term is used throughout this article.
An important checklist item for LLCs and their members is a well-written Operating Agreement or LLC Agreement. For simplicity, we’ll call them “operating agreements,” but the terminology varies from state to state. LLCs are creatures of state law. State laws typically apply a set of default rules. In most cases, LLCs and their members are free to deviate from the default rules of their operating agreements. Therefore, it is important to develop a well-crafted operating agreement that reflects members’ intentions and deviates from established rules where necessary.
The purpose of this article is to highlight a number of common operating contract clauses that facilitate a business owner’s exit plan. Each situation is unique, so the list below is not exhaustive. It is important to work with a competent tax and legal advisor when drafting the operating agreement. As detailed below, it is imperative that tax and legal counsel work together to ensure that the investment agreement is aligned with tax goals or objectives.
stock class
A simple way to structure an LLC is for the benefit of a single class of membership where each member owns a specified “percentage of benefit” in the LLC. In this case, each member will share profits, losses and votes based on their respective percentages. This approach may work well for small or private companies where all members are actively involved in day-to-day operations. However, when viewed through the lens of exit planning, simple percentage interest has its limits. There are situations where having multiple equity classes can help facilitate exit planning.
non-voting members. Non-voting stock classes are useful when the sole member of the LLC (the “Founder”) is ready to transfer ownership to someone else (the “Transferee”). Let’s assume the founder is preparing to retire soon and wants to hand over the reins to an outsider. The founder has found a transferee, but the transferee is still unwilling to buy the entire business outright.One of the possible solutions, he said, is to create voting and non-voting rights. is. Founders can sell non-voting interests to transferees. The founder retains voting rights in the LLC while transferring the business to the transferee.
interest on profits. LLCs typically issue profit margins to their employees and service providers as a form of incentive compensation. A detailed discussion of profit benefits is beyond the scope of this article. However, profit on profit is also a useful exit planning tool. Again, assume the founders are ready to transfer ownership, but this time they want to transfer the business to a small number of key employees. LLCs can issue profit margins to these key employees. Founders can lock in the current value of membership profits, and key employees participate in increasing value as the business continues.
Preferred Member. Preferred memberships function similarly to preferred stock in a company. An LLC may create a “preferred” class of shares in which the members holding these interests have priority over the shares. LLCs and their members have great flexibility in how they structure their priorities, including how the LLC distributes excess cash flows and makes liquidation distributions. This flexibility extends to participation, limited participation, and non-participation priority benefits. So where does it make sense to use preferred stock in the context of an exit plan? Founders want to transfer the business to key employees by issuing profit margins. If a founder’s exit horizon is unclear or could be years away, the founder may not want to truly lock in the present value of the company. You may decide that you want some form of favorable return that accounts for the time value of Key employees are entitled to benefits and appreciation beyond their desired return hurdles.
Management rights/deletion
Control rights are usually of little concern in a single-member LLC. A single member owns all shares and makes all decisions. In the context of exit planning and ownership transfers, control can be an important consideration. The default rule for many LLCs is that each member shares control of her LLC (i.e. member control). An LLC can transition from having each member share control to being a manager-controlled LLC. Administrators do not have to be members.
Operating agreements typically give the manager general powers to oversee the day-to-day operations of the LLC and may set out a list of activities for which the manager is authorized to act on behalf of the LLC. The operating agreement may also contain a list of activities for which the manager has no authority to act on behalf of the LLC. Members generally vote for actions for which the manager lacks the appropriate authority to act. If the operating contract does not mention manager powers, the LLC and its members should look to default state laws. Default laws may give managers broad powers over the LLC’s activities. For certain items, state law may require member approval for certain items or limit the powers granted to administrators.
There is no one-size-fits-all approach to drafting administrative regulations. Each situation is unique. In the context of exit planning, members transitioning a business may wish to retain significant executive control over day-to-day operations until their chosen successor is competent enough to take the reins. A similar (but important) part of transition planning is whether and under what circumstances the chosen successor can remove his predecessor as manager. A member considering an exit plan should work with an attorney to create a governing clause that meets her specific business needs and objectives.
Contribution to capital
A common clause found in most operating contracts states something to the effect that members are not required to make additional capital contributions. Such provisions are important to preserve limited liability. However, in the context of exit planning, these provisions can be expanded to include which members can (or will) make capital contributions should the LLC or its managers determine that additional capital is required. Founding members who transition their business to one or more new members may not want to be caught on the hook to contribute capital to the LLC.
Alternatively, the founder may be the only member with sufficient cash to make a capital contribution. What if the founders do not want to dilute the ownership of other members? can include operating contract clauses that require a Can another member step up and contribute for them? If so, is their interest in the LLC diluted or treated as a loan from one member to another Are these all considerations for LLCs and their members? After careful consideration, LLC agreements should stipulate what happens if members fail to make capital contributions.
taxation
LLC is not a classification of entity for federal tax purposes. The default classification for single-member LLCs organized in the United States is disregarded entity. A disregarded entity is considered for federal tax purposes and members report taxable income or losses on their tax returns. Note that the disregarded entity still has a taxpayer identification number (TIN) and may pay federal payroll taxes on an individual basis. When an LLC has two or more members of his, the default federal tax classification is changed to partnership. The LLC files IRS Form 1065 and provides Schedule K-1 to its members. Schedule K-1 informs members of the amount of taxable income or loss to report on their individual tax returns. The LLC and its members 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 can do. LLCs and their members must meet various tests. To make and maintain a valid S Corporation election, you meet certain criteria, including certain provisions that must be included in your Operating Agreement. The LLC and its members must make these elections within a specified time frame.
The importance of lawyers working with tax accountants cannot be underestimated. It is imperative to meet deadlines and ensure that operating agreements are consistent with the intended tax classification. Unnecessary or unnecessary clauses in operating agreements can jeopardize intended tax classification. Failure of the LLC and its members to match the intended tax classification with the operating agreement could result in substantial tax and legal costs in the future. Also, serious problems can arise if a founding member wants to leave.
Members considering exit plans should reconsider their LLC tax classification as part of a larger transition plan. Historical classification may no longer be the most tax efficient solution. Alternatively, simply adding a new (second) member may automatically change the tax classification of the LLC. LLC agreements must be revised to reflect changes to the intended classification and not to unintentionally terminate an otherwise valid S Corporation election.
Other provisions
There are additional provisions that LLC members should carefully consider when drafting or revising operating agreements. These items include, among others, voting rights agreements, drag-along rights, tag-along rights, put options, call options, sales agreements, membership assignments, new member approvals, first veto rights, tie-breakers, arbitration/arbitration, Includes non-voting rights. -Competition, non-solicitation and insurance. Most of these items warrant a longer discussion, and we intend to cover them in future articles.
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