Is a single member LLC required to have operating agreement?

September 11, 2017 - Posted by: admin - In category:

taxes - 1

Afterall, why should a single member[1] need a rulebook for himself or herself?

Fair point.  However, please remember that an LLC operating agreement is more than just a “rule book” for the LLC.  Also, keep in mind that what is today a single member (i.e., sole owner) business entity will, hopefully, grow and expand over the course of time. Or at least there is a good chance that for a significant number of start-up ventures, as the business achieves success, the owner of that company will eventually bring on partners, perhaps permit employees to obtain partial ownership, etc. In other words, the ownership and structure of a company will change over time. It will be easier to navigate through such expansion and growth if there is a solid framework (legal, accounting, tax planning and otherwise) in place at the start (or at least towards the beginning part of the equation).

In the context of making rules, it is not difficult to see that the process of formulating and accepting rules is MUCH easier when it is being done by only one person (vs. a group of persons). It, therefore, makes sense that as the founder and sole owner of your company, you will want to take the time in the beginning phase to project out into the future, assume that your plans come to fruition and that your company becomes a smashing success. In that vein, you will want to establish, in writing, specific foundational rules, principles and framework doctrines that will control for your company. This is your idea and your vision, so you get to decide what will be written in the rulebook. Said another way, you have the prerogative to make the rules now that others will be required to follow in the future.

You might also think of your operating agreement as the “constitution” for your company. To analogize to the Founding Fathers, while that was a collection of brilliant minds (a large group who debated and agreed on the contents of the Constitution), this was done at the beginning of our nation. Compared to the size, diversity, and complexity of our nation today, the Constitution was written while the “enterprise” of our country was still in its infancy.  What if the Founders had decided that things were still too “unsettled” at that time, that the nation was still small and unproven and therefore had elected to wait until things were further developed before the Constitution was drafted? Can you imagine trying to have a Constitutional Convention even a few years later?

While that may seem like an extreme and unrelated example, there are a great many business owners who mistakenly believe that while their company is small and is owned by only one person, there is no need to have an LLC operating agreement. You can imagine how much more difficult it then becomes later to do this when the company has been in operation for several years, has multiple owners and many employees. It can then be very challenging to formulate and agree on the “rules” when things have progressed to that stage (kind of like trying to put toothpaste back in the tube).

To summarize this critical point–remember that foundations are best laid in the beginning. This remains true (in most instances) even when the company ownership (and perhaps company itself) consists of only one person. What better time to hold an organizational meeting? Hopefully, such a meeting, with one person, will be short, simple and to the point…:)

Another important reason why a single member LLC should have an operating agreement is to ensure that the business looks like, acts like and at all times (especially in times of trouble, i.e., when there are threatened or actual legal claims) is in every way deemed to be a REAL business. This includes having proper foundational legal papers, especially an LLC operating agreement. If your company were ever to be subject to some legal claim, the plaintiff’s attorney would almost certainly focus on whether all the necessary and customary “corporate formalities” have been followed by you in the establishment, ownership, and management of your company. In other words, the focus would be on whether your business was treated by you and others as a separate legal entity or whether it was instead just a d/b/a for you acting as yourself (and doing some business stuff on the side).

Am I saying that just having a valid, customized operating agreement provides some measure of extra-legal liability protection[2] to your company, its assets and you personally? Yes. That is exactly what I am saying. This is true whether you have a single-member LLC or a multiple-member LLC. Does it mean that once you have your operating agreement, you can cancel your insurance coverage and operate in a very casual and haphazard manner–that your operating agreement, by itself, is a panacea of protection? No, let’s not get crazy.[3] You will still want to retain your liability insurance, make sure your accountant follows sound practices in helping you manage cash flow, banking, tax planning and related matters. However, having an operating agreement will be a very good fact in your favor in the event your limited liability structure is ever called into question, whether in the context of court, IRS audit or otherwise. Though a self-serving comment,[4] I believe that the legal liability protections afforded by an operating agreement are greatly enhanced in situations where people have undertaken the care and investment of commissioning a customized legal document.

My self-interest aside, its just common sense that in a situation where much is at stake in a courtroom, that the argument in favor of LLC protections will be much stronger when the owner has a customized legal document that is the product of much time and effort of the client and his or her attorney.  In stark contrast, it would be a much weaker argument in favor of honoring the LLC structure where the “foundation” for the LLC is a LegalZoom or other internet form legal document that names the incorrect company, person and has provisions which are wholly irrelevant and incompatible with the LLC.

To conclude, there are other reasons and direct benefits from a single member LLC having an operating agreement, including the method of setting for succession planning terms (i.e., what happens with ownership of the company upon the disability or death of the owner) and also to opt out of default statutory provisions.  On that latter point, there are a great many LLC members who have unknowingly opted into the state default rules governing the ownership, management, succession, and termination of their LLC (among other matters) by not having an operating agreement that specifies the desired choice regarding such matters. While there are certain non-waivable and mandatory statutory provisions applicable to an LLC, a great many (if not most) statutory provisions can be modified or waived through an operating agreement. Why would anyone choose to be governed by rules of which they are ignorant or to be required to play by a set rules they oppose? Yet, that is exactly what happens in instances where a single member LLC owner has no operating agreement through which to opt out or otherwise modify the application of many such statutory provisions.

By the way, please note that this post deals with the laws of the State of Utah.  As mentioned earlier, LLCs are creatures of state law.  And in contrast with the requirements of Utah law, there are a few states which do require LLCs to have operating agreements, written or oral,  Further, it is my understanding that New York law requires that LLCs have a written operating agreement.

To return to the original question, a single member LLC is not required to have an operating agreement, but having one is certainly is the best and most prudent course of action.  The same is true for a mult-member LLC.  More on multi-member LLCs another time.

[1] Both by law and by common reference, an owner of an LLC is most often referred to as a member.

[2] (After all, you have an LLC in large part so that it will act as a legal liability firewall in the case of one or more legal liability claims.)

[3] I believe in moderation in all things, and we should be moderate in our assessment of the ultimate level of protection offered by an LLC operating agreement.

[4] I routinely counsel clients in such matters and drafts customized operating agreements, so naturally, I am ready to espouse the benefits of these wonderful legal instruments.

Ryan L. Jensen
Pharos Law Group, PLLC
Salt Lake and Logan, Utah
855-239-8015 | pharoslaw.com

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