An LLC operating agreement is the limited liability company’s counterpart of a corporation’s bylaws or a partnership’s partnership agreement. Without an operating agreement, the default provisions in the Arizona Limited Liability Company Act will govern the relationships and interests within the LLC on many issues, but four are of particular note: profits/losses & distributions, management, voting, and membership changes.
Profits/Losses & Distributions
The default provisions of the Arizona LLC Act provide that LLCs will allocate profits and losses and make distributions in proportion to members’ respective capital contributions until all such contributions have been repaid in full, and thereafter equally to all members, irrespective of capital contributions (ARS § 29-703 & § 29-709). An operating agreement can alter the default LLC provisions so that profit and loss allocations and distributions are based on other factors more appropriate to the circumstances.
Unless otherwise specified in the articles of organization, the default provisions of the Arizona LLC Act provide that the members of an LLC will manage the LLC (ARS § 29-681). In a member-managed LLC that is governed only by the default provisions of the Arizona LLC Act, each member has full authority to bind the LLC. An operating agreement, however, can describe and/or limit the authority of a member to bind the LLC. In the alternative, the members can choose to have the LLC managed by managers and describe and/or limit the managers’ authority in an operating agreement.
The default provisions of the Arizona LLC Act provide that all members will possess the same number of votes, regardless of participation percentages (ARS § 29-681). An operating agreement can allow an LLC to allocate votes to its members in any manner the members’ desire.
In most LLCs, there is a desire to control the LLC’s membership composition. Among the events that can affect an LLC’s membership composition are: 1) inter vivos transfer, 2) death, 3) divorce, and 4) withdrawal.
1) Inter Vivos Transfer
By default, the Arizona LLC Act provides that any recipient of an LLC member’s membership interest transferred during the lifetime of the LLC member, is an assignee and has rights only to the distributions made by the LLC, if any. To gain all the rights of LLC membership, unless an operating agreement provides otherwise, the LLC members must unanimously and affirmatively vote to accept the assignee as a member.
In the absence of an operating agreement, when one of the members of an LLC dies, any recipient of an LLC member’s interest in an LLC is treated as an assignee.
An operating agreement can address death in many different ways, such as requiring or creating an option for a buyout of the deceased member’s interest, sometimes funded by life insurance proceeds, altering the percentage of votes required to approve a new member, or allowing transfers to certain classes of individuals, etc.
In Arizona, divorce is of particular importance to the members of an LLC because of Arizona’s community property laws. Community property law creates a presumption that all property interests acquired during marriage are the property of both spouses except for property acquired by gift or inheritance.
An Arizona LLC operating agreement can address what will happen if one of the LLC members becomes divorced, e.g. either requiring the divorcing member to acquire the spouse’s interest or allowing the other members of the LLC to buy the spouse’s interest in the LLC. However, in order to be effective, not only the members, but also the spouses, must consent to be bound by such a provision.
The Arizona LLC Act’s default provisions do not require an LLC to compensate a withdrawing member for that member’s interet (ARS § 29-734).
An operating agreement can specify whether a duty to repurchase the interest of a withdrawing member exists and any process used to value such interest. It can also include penalties that will result in a diminution of the buyout value because of the effect such a withdrawal will have on the LLC.
Frequently, the default provisions of the Arizona LLC Act do not satisfy the unique needs of an LLC’s members, a customized operating agreement can do so.
This brief overview of some important considerations associated with LLC operating agreements is by no means comprehensive. Always seek the advice of a competent professional when making important financial and legal decisions.