Why All Arizona LLC's Should Have an Operating Agreement
An operating agreement is generally considered a contract that sets forth the general rules of the Limited Liability Company (LLC). It can be thought of like the constitution of the company. An operating agreement will commonly set forth the relations among the members as members and between the members and the limited liability company. Additionally, if the company is manager managed it will commonly set forth what rights, duties, and responsibilities the manager has in their capacity as the manager.
An operating agreement, or sometimes alternatively called an LLC Company Agreement, is not required to have a valid LLC in Arizona. However, if a company does not setup an Operating Agreement for an Arizona LLC then the company will be governed by the legislative's rules regarding LLC's. The legislative rules can be thought of as "default rules." Thus, if you do not have an operating agreement in place you are electing to abide by what the Arizona legislature has decided, or court has interpreted, the way an LLC should operate. Additionally, if your operating agreement does not expressly address a certain subject, then the default rules can be determinative. Do you want to have a politician determine the way your company runs?
These default rules recently changed in 2019 with the Arizona Limited Liability Act, commonly referred to as the “New LLC Act”. See A.R.S. § 29-3100 et. seq. The New LLC Act now applies to all Arizona LLCs regardless of when the LLC was formed. Under the New LLC Act, several provisions set forth default rules that members of the LLC may not intend. An example under the New LLC Act relates to how distributions are to be made to the members. The default rule provides that distributions made are to be in equal shares to all members. See A.R.S. § 29-3404A. The default rule can show the dramatic effect in an example. Imagine a situation where you own 80% of the LLC and another member owns 20%. Without an operating agreement, if the company wants to make a distribution (i.e. pay profits out of the company to the members), then the distribution must made equally to the parties. For example, if a company profited $100,000 at the end of the year and makes a distribution of the $100,000 to the members, under the default rules such distribution must be made 50% to you and 50% to the other member. Imagine owning 80% of the LLC and only getting 50% of the distributions! Furthermore, the majority member, you in our example, could be responsible for $80,000 in tax liability since you owned 80% of the company! If you do not want this type of treatment under your LLC you should review your operating agreement. An LLC can amend their operating agreement to be consistent with the what the members agree is fair versus the default rules.
There are other additional examples of a provision under the New LLC Act that could have unintended consequences for LLCs without an operating agreement. For example, a fiduciary duty is now created between both the LLC and the members. An individual owing a fiduciary duty must generally put the interest of those to whom a duty is owed before his or her own personal interest when addressing matters that arise within the scope of the relationship. This generally includes the duty of loyalty and care. An example of potential liability could arise wherein a member of a multi-member LLC owns an interest in another LLC. For example, a fiduciary duty could arise if you own an interest in a multi-member LLC that owns rental property and you decide to purchase another rental property on your own outside of the multi-member LLC. In this example, if you did not bring the opportunity to the LLC first, then you could potentially be liable for a breach of the fiduciary duty of loyalty. This could potentially apply if you were unaware that the duty existed. However, under the New LLC Act this whole situation could potentially be avoided by having an operating agreement that expressly disclaims any duty of loyalty that the members of the LLC may have.
Analyzing the risk associated with any fiduciary duties tied to a membership interest in an LLC without an operating agreement would likely be prudent of any member. Thunderbird Law can assist you with a custom operating agreement to set forth the fiduciary duties that apply or may not apply to the members in a manner you prefer instead of the default rules.
If you are interested in a custom operating agreement for your business or amending your operating agreement, click here to get started. Or schedule a thirty minute consultation with Attorney Matt McCabe for only $99 by clicking here.