The 8 Bad ‘D’s of LLCs – Part 1 It’s Essential You Review These Considerations Before

Signing Multiple-Member Agreements

By Jeffery S. Watson

When drafting multiple-member LLC operating agreements for clients, or when reviewing ones that someone else has drafted, I look at them with eight bad “D”s in mind that need to be addressed in detail. In this article, I will cover the first four. Look for my article in the next issue to find out what the other four are.

allowing LLC operating agreements to have language in them saying that the membership certificate transfers on death to a party designated in writing on the membership certificate or set forth in the operating agreement, it can quickly lead to a situation in which the surviving members of the LLC now find themselves in business with someone they did not anticipate working with, nor do they wish to continue to be in business with them.

Plans need to be in place to deal with the issues this scenario brings, such as key person insurance, buyout provisions, and accountability and accounting access. Anyone going into a multiple-member LLC business arrangement needs to consider these provisions in the operating agreement from the perspective of if they were the one who passed away, how would they want the other members of the LLC to treat their heirs or estate? Is there a fair and accurate valuation method to calculate the value of the LLC? Is there transparency as to the business activities, operations, and books and records of the LLC? Is there a clear mechanism as to how distributions will continue to be paid as the membership interest is bought back or transferred from the heirs?

decree so there is a division of the LLC ownership interest between the divorcing parties. The original member will remain a member but at a reduced percentage. The former spouse will get a “profits interest.” This will result in a change to the operating agreement as well as a change to the LLC tax return, meaning an additional K-1 will now be generated. Each of the parties in the divorce, if they divide the membership profits interest of the LLC between them, will now get separate K-1s. It is imperative that this be diligently done as expeditiously as possible. Buyout language should be carefully talked through and included if feasible.

1. DISAGREEMENT

Whenever you have a multiple-member LLC, you have the potential for disagreement among the various member-owners. The operating agreement for the LLC needs to clearly spell out how that disagreement is going to be resolved. The scenario I frequently see, which results from poor draftsmanship, is when there are two 50-50 owners of an LLC and no tiebreaking mechanism has been put in place. Here are some simple but effective mechanisms I’ve seen used:

• When there are three or more member-owners, a vote is held based on percentage of ownership, and a 51 percent or greater majority vote carries. While this sounds simple and effective, it can also lead to a great deal of resentment and distrust by the minority owners.

• Do a coin toss. Seriously, I have seen this suggested for any sort of disagreement on an expenditure of $10,000 or less.

• I personally believe that a neutral third party should be agreed to in advance, someone all LLC owners respect, who will make the tiebreaking decision. Obviously, you want to reach out to that neutral party and get their consent to name them as the tiebreaker or arbitrator. It’s important to set out in the operating agreement the procedures by which each party presents their case to the neutral third party.

When more than one person is involved in a business, things can go sideways when they don’t see eye-to-eye on business strategies, moves, etc. You need to plan in advance for that. If you fail to plan for the disagreements that will eventually happen, you are planning to fail.

All these things need to be thought through, talked through, and carefully drafted into the operating agreement.

4. DISABILITY

The reality is that none of us is getting younger, and with age comes the likelihood of more health problems. Given the uncertainties of life and a myriad of things that can result in some form of physical or mental disability, it is imperative that the operating agreement for an LLC deals with that possibility. What happens if one of the members of the LLC becomes disabled in whole or in part? What if a member is involved in a car accident and sustains a stroke or traumatic brain injury, or they visit the doctor after not feeling well and are diagnosed with some form of cancer?

2. DEATH

The death of a member-owner of an LLC is probably the worst of the eight D’s. With many states now

3. DIVORCE

Given the prevalence of divorce, particularly among individuals who are in the entrepreneurial space, it is a reality that you need to consider when drafting an operating agreement for an LLC. Public policy has pretty much mandated in all family courts that irrespective of how craftily and creatively an LLC operating agreement is drafted, that LLC membership interest is a marital asset unless there is a clear and specific signoff to the contrary by the non-member spouse at the time the LLC is formed.

In the event one of the business partners in an LLC goes through a divorce, you need to be aware of two things. First, that business partner did not go away, but that partner has been severely hampered with things that are draining their time, energy, and focus. Hopefully, you and the other members of the LLC will see things from the perspective of if you were in that business partner’s shoes, and you would extend to that hurting business partner the grace and kindness you would want extended to you if you were in that situation.

Second, you need to understand that part of the LLC or a profits interest in the LLC is now going to end up in the hands of someone who may be hostile by virtue of the way the divorce occurred. That potentially hostile person needs to be bought out or minimized in a fair and equitable manner.

It is very important that the LLC operating agreement be amended pursuant to the terms of the final divorce

Have you drafted your operating agreement to account for disability? Does the LLC provide any sort of disability insurance to its member-employees? Does the LLC rely on the activities of the now-disabled person in order to continue operating? Is there a way to transition and keep the business moving forward? Once again, approach the drafting as if you are the one who becomes disabled and are counting on the income from the LLC to be available to you at the time of your disability.

Look for Part 2 in the next issue.

Jeffery S. Watson is an attorney who has had an active trial and hearing practice for more than 25 years. As a contingent fee trial lawyer, he has a unique perspective on investing and wealth protection. He has tried more than 20 civil jury trials and has handled thousands of contested hearings. Jeff has changed the law in Ohio four times via litigation. Read more of his viewpoints at WatsonInvested.com.