What Is an LLC Operating Agreement?
A limited liability company ("LLC") operating agreement is the foundational document that governs the internal affairs of a limited liability company. An LLC operating agreement is much like corporate bylaws, and should be entered into by all members of the limited liability company. Arizona Revised Statutes Section 29-632 specifically provides that an operating agreement of a limited liability company is controlling over conflicting provisions of other statutes. It also provides that a limited liability company operating agreement may alter or eliminate all of the default fiduciary standards established by the Arizona Revised Statutes.
In other words , an LLC operating agreement:
(1) Controls over otherwise applicable default statutory provisions; and
(2) Allows members to contractually expand, limit or redefine fiduciary duties.
This means that members of a limited liability company in Arizona can agree to eliminate their fiduciary duties to one another, which can be an extremely liberating and productive tool if used properly.
Requirements in Arizona
The law in Arizona does not require single-member or multi-member LLCs to have an operating agreement. Statutorily, the law gives LLCs flexibility to operate without a written agreement and instead may rely solely on the laws contained in the Arizona LLC Act. The relevant statute is A.R.S. § 29-681, which states, in part, that "a limited liability company is not required to maintain records open to access or inspection by any member or other person, except as provided in [A.R.S. § 29-640]…." A.R.S. § 29-640 governs the rights of a member to obtain information about the company.
Some of the required information includes (1) a copy of the articles of organization and any powers of attorney under which they have been signed; (2) the company’s federal, state and local income tax returns for the current and preceding two fiscal years (if filed); (3) complete and accurate books and records of account including a record of daily meetings; and (4) a list of members and their last known address.
While an operating agreement is not mandated by law, it is important to point out that A.R.S. § 29-665 allows for an operating agreement to override the statutory default provisions in the LLC Act. Specifically, "[e]ach member of a limited liability company shall have equal rights in the management of the limited liability company, except to the extent that the operating agreement gives members different voting rights among members." The LLC Act goes on to provide that an operating agreement can provide for the distribution of profits and losses by methods other than the percentage interests of a member.
The Arizona LLC Act is a hybrid of custom and common law tradition.
The laws governing millions of U.S. businesses are tied together by one thing: they are all based on the common law tradition, a body of law made up of customs and decisions that trace their roots to the early judges who gave weight to the way other courts ruled on similar matters.
The Arizona LLC Act is distinctive due to its hybrid nature. In the 1990s, the first edition of the Arizona LLC Act borrowed much from provisions in the California Revised Uniform Limited Liability Company Act of 1994. However, in 1996, the Arizona legislature repealed most of the old law and replaced it with slight modifications to the Delaware LLC Act. That same year, the Arizona legislature enacted A.R.S. § 29-263(A), which states that "[t]his chapter shall be interpreted in a manner consistent with the Colorado Limited Liability Company Act." The latter statute was modified again in 1998 to allow Arizona LLCs to elect to be governed by either the Colorado or Delaware LLC Acts.
Whether or not an operating agreement is mandatory for an LLC under the law, it is always advisable to have a written agreement in place to limit potential risks and exposure. The most successful companies take steps in advance to reduce the chances of future problems. A written operating agreement, even for a single-member LLC, reduces the risks of uncertainty. You can challenge an operating agreement in court, but it’s a lot easier to challenge an verbal agreement, or no agreement at all, which is how many companies begin their journey.
A written operating agreement can address a range of issues, including, but not limited to, the following:
An LLC is a flexible business entity that offers many options in terms of who runs the company and how decisions get made. Each member may or may not have a managerial role in the LLC. The parties to an operating agreement must understand their rights and decide how the LLC will be managed. To this end, it is important to have an operating agreement that accurately reflects how the members intend to proceed.
Key Elements of a Strong Agreement
An operating agreement is vital for establishing the roles and responsibilities of each member of an LLC. Essential elements to be included in an operating agreement include the member’s role and the amount of capital contributed to the business. Another aspect covered is how the business will be managed. In an Arizona LLC, if no management structure is established, members are generally empowered to run the business. However, managers may be identified-including off-site management. Also, the roles of the members will be established. One of the main functions of an Arizona LLC operating agreement is the description and distribution of profits to the members. This includes how profits will be allocated if the LLC owns multiple businesses or facilities. The agreement will also address the allocation and distribution of losses. A well-crafted affordable LLC operating agreement will contain these elements, among others.
Drafting an Operating Agreement in Arizona
While Arizona LLC law does not require operating agreements, it is highly recommended that all members and managers have one to help run the company. LLC members are free to determine how to manage the LLC through an operating agreement. The agreement can be written however the members see fit, as long as it does not contradict the Arizona LLC statutes.
Based on the specific business situation, if an operating agreement is needed, the next step is to identify whether a single member or manager-managed LLC is appropriate. A single member/manager LLC may be controlled by one person whose powers and rights are determined by that individual. For example, a member-managed single-member LLC may allow the owner of the business to have full control over all aspects of the company. A manager-managed single-member LLC, on the other hand, may grant power to a single manager (which may or may not be the same person as the owner) to manage company affairs.
In a multi-member LLC, the members may choose to designate who will be able to manage the business as well. A member-managed multi-member LLC may be operated by all members or only by designated members. A manager-managed multi-member LLC is controlled by a manager or managing committee. In such an LLC, the members delegate certain or all management powers to communicators with each member making relatively few decisions.
Once it has been determined how the LLC will operate, the next step is the actual drafting of the agreement. Operating agreements can be created and adjusted as needed. Frequently, when establishing an LLC, the members choose a lawyer or other unofficial representative to act on their behalf in running the LLC. However, the members may choose to get together to negotiate the terms of the operating agreement. Alternatively, they may draft an agreement separately and come together to agree on the provisions. Once the members establish the negotiations, adjustments and the agreement is finalized, the agreement is recorded.
Why Every Business Needs an Operating Agreement
It’s best to have an LLC Operating Agreement in Arizona to minimize the risk of personal liability. If an LLC doesn’t have an Operating Agreement it will be governed by Arizona’s LLC statutes. Therefore, an LLC without an Operating Agreement is highly reliant on the Arizona revised statutes. However, LLCs don’t have to rely on Arizona’s statutes and can create an Operating Agreement customized to meet the needs of the business and its members.
A customized Operating Agreement should be drafted by an attorney familiar with Arizona’s laws and the specific business at hand. The Operating Agreement can address common conflict-of-interest issues that may arise between the members. It can also provide direction should the members need to dissolve the LLC.
I view having an LLC Operating Agreement similar to having a wedding ceremony. Wedding ceremonies are rarely necessary and aren’t legally binding. Nonetheless, a marriage cannot happen without a wedding ceremony. It’s not legally required but socially expected . In the same way, an Operating Agreement is not legally required, but it can put your LLC in the best position to do business and ensure that the Members have the legal rights that they believe they have.
What I mean by best position to do business is this: An LLC Operating Agreement is the most important thing to have when opening an LLC bank account; it will set the tone for the LLC members; if there any litigation arises concerning the LLC a judge will look at it and use it to determine the intentions of the LLC members; if a member attempts to sell his or her interest in the LLC it may prevent future litigation if the sale is allowed under the Operating Agreement; and, it can help resolve a conflict of interest.
An Arizona LLC may in fact decide that they want to follow one of the default provisions in the Arizona statutes, in which case you can incorporate the provision into the Operating Agreement. However, it is always better to create an Operating Agreement than rely solely on the Arizona statutes.
If you believe you own or are planning to own an Arizona LLC, you should contact an Arizona business lawyer immediately to see if an Operating Agreement is right for you.
Common LLC Mistakes and Avoiding Them
When drafting an operating agreement for an Arizona LLC, there are a few pitfalls that are constantly popping up that can create issues down the line. From our experience, the most common mistakes are:
1. Excluding a member buyout or withdrawal provision.
Most of the time, all the owners of the business intend on staying involved in the long term, but life happens. It is always best to have a procedure in place setting the process for when a member is no longer involved with the business, whether voluntarily or involuntarily.
2. Not having a procedure for deciding whether or not to allow admission of a new member.
Like number one, it’s great if everyone is on board with taking on new members. But again, life happens. Stipulating how to add new members will help to avoid issues that arise when one member wants a new person involved in the company and other members disagree.
3. Not including the ability to buy out a member or members who fail to make capital contributions.
Sometimes life gets in the way and a member can’t fulfill their obligation to pay for their percentage of ownership interest in the company. Having a provision allowing the company to buy out the non-contributing member(s) will protect the company from fights between members and loss of the business enterprise.
4. Not sufficiently addressing what happens if a member gets arrested or convicted of a crime.
Many times, if a member or manager is charged with a felony, they don’t want to remain a member or manager of the company after they’re released from imprisonment. However, if that is not addressed in the operating agreement and the other members and/or managers have not signed off on the removal of that individual, the company could be stuck with someone involved with the business who cannot make decisions about the future of the enterprise.
5. Not including a provision that allows the Company to declare a member’s position vacant if they fail to pay assessments or attend a certain number of meetings.
This provision will give the Company, and other members, the ability to remove a member who is no longer participating in the company without a lengthy buyout procedure.
6. Not including a provision explaining how often the company needs to hold meetings or how consent is specifically obtained.
If you need to make major decisions for the company, be it in your Articles of Incorporation or in your operating agreement, it is necessary to specify how often meetings are held (or consent obtained) to address company decisions that require a vote by the company’s members or managers. "Not often enough" is just not a good enough answer.
Where to Seek Assistance with Operating Agreements
For Arizona LLCs that still have questions on LLC operating agreements, there are a variety of places to obtain help in understanding the legal document. The best place to start is always with a knowledgeable business attorney. A good attorney will be able to draft an operating agreement or advise you on how to use a template operating agreement effectively. Ideally, your attorney will have experience both drafting operating agreements and litigating them. A litigator will understand the kinds of things that get people in trouble down the road. While it is not critical for litigation, if you do a lot of business, your attorney should also understand estate planning. A good estate planning attorney can make help you with the tax questions, if necessary.
If you feel you simply need a small amount of help, there are many places you can start before you pay an attorney for an hour of work . The Arizona Corporations Commission website has a free guide to operating agreements (as well as other resources for business). Additionally, the Arizona Department of Revenue and the Arizona Department of Revenue have both published manuals for new businesses. The Arizona Department of Revenue refers to operating agreements as operating or partnership agreements.
A quick online search of "operating agreement" and "Arizona" will bring up several potential templates worth looking at. It is important with these templates, however, to review the document carefully to avoid using language that isn’t relevant. Additionally, there are many online resources that go through the process of creating an operating agreement step-by-step. These are worth a quick look if you do not feel comfortable getting started.