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Nonobvious Reasons Why You Need an Operating Agreement or Shareholder Agreement

Oct 30

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10/30/2013 9:06 AM  RssIcon

Nonobvious Reasons Why You Need an Operating Agreement or Shareholder Agreement

A significant part of my practice consists of advising one business owner or group of business owners of rights with respect to one or more other owners.  A great many business owners don’t put in place an operating agreement for their limited liability company or a shareholder agreement for their corporation because they don’t want to spend the money, they think they get along great and will always be able to work things out, or they just haven’t gotten around to it.  This is great, because the ensuing uncertainty and issues generate a lot more fees for me than drafting an operating agreement or shareholder agreement up front would have.  It is also more interesting and exciting, and gives me a much better repertoire of entertaining war stories.

 First, a brief word about why even business partners who are soulmates/twins separated at birth still need to have an agreement to provide for means to separate.  Even if you and your business partner are always totally aligned:

·         one of you could die, leaving the other(s) in business with the deceased’s spouse or child, who either thinks he or she makes a quite adequate replacement for your partner or is totally content to continue to share in the business’s profits without pitching in to help with the work;

·         one of you could become disabled or ill, leaving you with different opinions as to what adjustments should be made for that; or

·         your life circumstances (and desires for how to run the business) could diverge tremendously due to other circumstances such as divorce, family member illness, troubles with children, or business troubles on other fronts.

 If it is conceivable to you that you and your business partner(s) could have differences at some point in the future, then there are more reasons why it is important to have an agreement among the owners.

What people don’t think about is the fact that if they don’t make arrangements with respect to an issue in an owner agreement, in many cases the law will provide for a default rule that would greatly surprise the parties.  For example, the Georgia Limited Liability Company Act provides that unless provided otherwise in the company’s articles of organization or a written operating agreement:

·         Each member has an equal vote (regardless of amount contributed)

·         Each member shares equally in the profits, losses and distributions (again, regardless of amount contributed)

·         Every member is an agent of the company and the act of any member that is apparently for the carrying on in the usual way the business of the company binds the company (actually this last issue must be addressed in the articles of organization)

A couple more reasons that might not have occurred to you why you might want to have an agreement among owners:

·         Not only will you likely want to restrict your business partner(s) ability to transfer his or her interest to another person with whom you do not want to be in business, but if your business entity is taxed under Subchapter S of the Internal Revenue Code then a transfer by your business partner to a person or entity that is not eligible to be a Subchapter S corporation shareholder could terminate your business’s Subchapter S election – with possibly disastrous tax consequences.

·         If your business is taxed on a flow-through basis, you will have a tax liability for your share of the income whether the earnings are distributed to you or not.  An agreement among owners commonly requires that the business make distributions to owners at least adequate to pay their tax liability on the company’s earnings, lest owners who do not need the cash create a hardship on owners who do need the cash by deciding to have the business retain all earnings.

Now that hopefully you are persuaded of the desirability of having an agreement among owners, let’s talk about why you would want to have a Georgia lawyer prepare it using a form that is tailored for Georgia law.  As mentioned above, there are default rules under the law that will apply if you do not specify otherwise in an agreement.  The issues that are and are not addressed by default rules are different in every state, so if you are not using an agreement specific to your state’s law then the agreement will likely fail to address some issues that it ought to address in order to avoid being governed by default rules.  Further, in every state’s law there are different mandatory provisions that cannot be varied with an operating agreement, and if you are using an agreement tailored to a different state’s law then it might contain provisions contrary to law and therefore ineffective.

 So you see, the reasons for putting an agreement among owners into place go far beyond the usual buy/sell and right of first refusal agreements that most people think about.  The events of life can cause unforeseen changes in ownership or in the parties’ interests and motivations; if you don’t specifically agree otherwise then the law may imply undesirable features of your relationship that you never anticipated; and there are ways that you can be hurt by your business partners’ actions that you probably would never have guessed.  Maybe you ought to think about investing the time and money to put a formal agreement in place after all!

What would any written material coming from a lawyer be without a disclaimer?  Here it comes: This advisory contains general information only.  It is not intended to be and should not be relied upon as legal advice for any specific situation.  Your mileage may vary.  Offer void where prohibited.


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1 comment(s) so far...


Re: Nonobvious Reasons Why You Need an Operating Agreement or Shareholder Agreement

Another reason to have an operating agreement is so that it will be easier to apply discounts for lack of marketability and control when gifting shares or transferring them through an estate event.

Such discounts can reduce the tax basis of the value transferred by 30% or more but without an operating agreement, it's hard to argue that those discounts apply. Applying those discounts can either reduce outright tax liability or use less of your exemption.

By Michael Blake, CFA, ASA, ABAR on   10/30/2013 10:01 AM

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