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The Importance of LLC Operating Agreements

March 23, 2022

Many people dream of one day starting their own business, the attraction of doing so being unique to the individual. For some, the notion of being their own boss is sufficient to cause them to start looking at prospective office spaces. For others convinced by visions of the business quickly becoming wildly successful, the claim to a substantially bigger piece of the proverbial pie is what might be most appealing. Yet for others, it could simply be a genuine belief that their new concept or idea could potentially change the world. Whatever the unique appeal and motivation behind someone’s decision to start a business might be, rarely are the people taking that leap not beaming with anxious excitement due to the thrilling uncertainty associated with their dream becoming a reality.

Once the decision to move forward with creating a business is made, selecting an appropriate legal entity that aligns with the owners’ short- and long-term goals for the business is the next step of the journey. Each of the various types of entities have, among other distinguishing factors, different liability, ownership, management, and tax characteristics. Due to being a desirable combination of both corporation and partnership characteristics, the limited liability company (“LLC”) is highly regarded as the entity form of choice for new businesses. Specifically, an LLC is treated as a pass-through entity for tax purposes with no federal income tax imposed at the entity level and is highly flexible, both in terms of how the members may structure and operate the LLC, and the extent to which the LLC observes routinely corporate formalities; i.e. conducting meetings and keeping minutes. While those features of an LLC described above are customary of partnerships, LLCs further provide the corporate characteristic of limited liability to members, shielding them from the threat of being personally liable for debts, obligations, or liabilities of the LLC.

Forming a legally recognized LLC in Wisconsin is accomplished by filing articles of organization for the LLC with the Wisconsin Department of Financial Institutions and paying the applicable filing fee. The principal purpose of the articles of organization is to set forth the LLC’s name and contact information, the LLC’s registered agent and registered office where legal notices are to be sent, and whether the LLC is member- or manager-managed. Once the business entity has been established the members of an LLC have significant decisions to make concerning how the operations of the business enterprise will be structured. Despite the attention, focus, and careful consideration required at this most vulnerable stage of an LLC’s inception, it is this stage that people creating a new LLC sometimes partially or entirely ignore. While there are many reasons why the importance of this stage may be overlooked by members of a newly formed LLC; typically, it is a combined consequence of their misunderstanding of Wisconsin’s laws governing LLCs, the desire to avoid the cost of a lawyer, poor planning and shortsightedness.

Wisconsin’s laws governing LLCs, known as the Wisconsin Limited Liability Company Act (the “Act”), are contained in Wisconsin Statutes Chapter 183 and spell out how an LLC is to operate. Various provisions of the Act contain what commonly are known as the “default rules,” which control how courts will interpret the actions of an LLC in the absence of an operating agreement. An operating agreement is a written contract executed by the members of an LLC for the purpose of altering the default rules applicable to the LLC regarding matters such as the admission of members, capital contributions, distributions, allocation of profit, management, and ability to transfer ownership interests. Considered by most as vital to the success of the LLC, an operating agreement should be comprehensive and carefully tailored to reflect the unique goals, business plan, and culture of the business and its members from its inception. While the use of operating agreements is quite common, they are not required under the Act. This could be construed as being an “out” that justifies the LLC not pursuing an operating agreement by a member that disagrees with allocating assets, or focus and attention, towards anything other than the LLC becoming profitable. Without a comprehensive operating agreement, the Act’s default rules threaten to kick in, which could lead to highly undesirable results that conflict with the members’ stated vision and goals for the business.

The default rules should not be exclusively relied on to govern how your LLC operates. Instead, those provisions in the Act should only be perceived as being a “one size fits all” alternative to proper planning.

This article was published in the March issue of The Business News