By: Mark Mirsky, CPA
How to Deal with Life’s ‘What-Ifs’
Embarking on a new business venture may involve the creation of a Limited Liability Company (LLC), one of several entity types that can help protect you, as an owner, from the risks inherent in owning a business.
Whether your LLC is created for you alone or for you and other owners – perhaps family, friends, business associates or investors – the investment in legal fees and filing costs is an important part of your startup expenses. The cost of not providing this protection could outweigh any up-front investment. Most importantly, forming an LLC provides an opportunity for your attorney and your tax advisor to work together to ensure the tax structure and business structure is properly intact.
Key Considerations in LLC Operating Agreements
In most states, an operating agreement for a Limited Liability Company (LLC) may be used to override state defaults that define many factors, including how and when distributions (both operating and liquidating) are made, allocations of profits and losses, and the entity’s management structure. If the entity does not have an operating agreement, the state will provide one for you – the state statute.
Many attorneys recommend against utilizing the state default operating agreement. KRD also recommends you have an operating agreement written to your specifications to address many business and tax issues, and to make the economics of your deal clear. It’s important to note that an LLC is a legal structure and not a tax structure. An LLC may be taxed as a disregarded entity, partnership, S corporation or C corporation.
Death, Disability, Divorce and Dissolution
All LLC owners should consider several key factors when writing their operating agreements:
The four D’s – death, disability, divorce, and dissolution. Discussing these issues on the front end may seem odd. However, business owners who commit in advance to determining how they might break up if one of life’s what-ifs should occur tend to sleep better at night when life happens (which it always does). More importantly, their businesses typically survive in the long term.
- The death of an active owner can put strain on the business and raise a host of questions. Are you going to redeem the interest from the member’s family or whomever may succeed to the ownership? Do you want to be partners with the deceased’s family? Do members have the ability to buy the interest individually vs. the entity redeeming the interest?
- Similar questions arise when an active member becomes disabled and not able to work. Some LLCs purchase life insurance and/or disability insurance on members to assist with this possibility. While not required, such coverage can assist when cash flow is required. In some cases, it may take two or three people to replace an LLC member who is suddenly gone, since members often wear many hats.
- Divorce can refer to a marriage or a business break-up. Either way, we want to be sure the entity is protected from outside creditors. We recommend you consult your attorney to assist in protecting your entity should either scenario arise. Business owners typically don’t think about a business break-up when they are starting out. But contemplating this and preparing for it does make an amicable parting of ways more likely should it become necessary, especially with family and friends.
- In the event of a dissolution, consider allocating all income or loss pursuant either to the sale or liquidation of the business, or operating profit or loss section of the operating agreement, first. Typically, third-party creditors are paid prior to any partners. Then potentially any member loans could be repaid and, finally, cash distributions allocated based on capital accounts. There can be special allocations here which may require complex targeted allocations of profit or loss annually.
The partnership representative. One member of an LLC should be named as partnership representative and tax matters partner. This is the member the IRS will contact should the partnership be audited, and is the member who has the power to make certain elections that could impact the current and former members of the LLC. The position has a lot of power and should be considered in every operating agreement. Your tax advisor will need to know who this person is as well. Sometimes, while not required, the partnership representative is allowed to make all tax elections, not only those related to audits. Further, you can require certain elections be made by this person unless a super majority of members agree to do otherwise – opt out election, push out election, etc. Another election which should not be made without consulting members would be a 754 election.
In most states LLC members, simply by virtue of being LLC members, are not personally liable for debts of the LLC, but this should be confirmed with your attorney. However, the operating agreement may state that should a member guarantee a debt, they have the right to recoup funds from all members based on their pro-rata percentage ownership of the entity in the event the member is required to make good on the guarantee. Thus, be sure to carefully read all operating agreements to which you may be party.
Tax-related technical language. Finally, there is quite a bit of tax-related technical language we recommend be included in an operating agreement. Some we call safe harbor language to allow for special allocations. Other language would be related to revaluation of capital accounts. Partnerships maintain two sets of books – legally. This is required. By doing so we preserve the economics of the deal, which allows special allocations should they become necessary.
Flexibility of LLCs is great but becomes problematic in compliance. In fact, most templates used to draft an operating agreement are in violation of Subchapter S, which governs S corporations. Consequently, if you use a stock version of an operating agreement, it is possible you have an invalid S-election if you are an LLC making an S election.
KRD is well versed in operating agreements and assists owners proactively on the front end prior to forming an LLC to be sure they think about many of the what-ifs that we have encountered over the years. KRD also assists attorneys in reviewing the operating agreements they draft and suggests language to consider for tax or business purposes.
Considering you’ve made the investment to form your entity, we’d recommend you also spend the funds to properly protect yourself and your LLC by obtaining a properly drafted operating agreement for your state.
Contact your KRD advisor for a discussion about an operating agreement if you are considering forming an LLC.
