No AZ LLC Operating Agreement: a Multi-Member LLC Nightmare

Ned Flanders is a generous, trusting neighbor. Homer and Marge Simpson want to run a family restaurant in Springfield. Ned has the money and the Simpsons have the time and the energy. So they form an Arizona limited liability company to own the restaurant. They shake hands on a simple deal: Ned owns 90% and the Simpsons own 10%.

 

There is just one problem. Nobody signs an Operating Agreement. They file the Articles of Organization, open a bank account and get to work. What follows is a step-by-step look at how Arizona's default LLC rules turn a neighborly handshake into a financial and legal nightmare, and why every multi-member LLC needs a well-written Operating Agreement from day one.

 

The characters are fictional and are used only to illustrate how Arizona LLC law works. This article is general information, not legal advice for your situation.

The Facts

• The LLC: Flanders & Simpson Family Restaurant, LLC, an Arizona member-managed LLC.
• Three members: Ned Flanders, Homer Simpson and Marge Simpson.
• The handshake deal: Ned owns 90%. Homer and Marge together own 10%.
• Contributions: Ned contributes $1,000,000 cash. Homer and Marge contribute only their services.
• The land: The LLC uses Ned's $1,000,000 to buy the land the restaurant sits on.
• Operations: Homer and Marge run the restaurant day to day.
• The paperwork: No written Operating Agreement. Nothing in writing says Ned owns 90%.

When an LLC has no Operating Agreement, the members do not get to decide what their deal was. The Arizona Limited Liability Company Act decides for them. The Act's default rules were written for everyone, which means they were written for no one in particular, and they almost never match what the members intended.

The Handshake Deal vs. What Arizona Law Actually Says

Issue	What Ned and the Simpsons agreed	What Arizona's default rules provide
Control	Ned (90%) controls	Each member has equal management rights; the two Simpsons outvote Ned
Profits	90% Ned / 10% Simpsons	One third to each member
Distributions	90% Ned / 10% Simpsons	Equal shares to each member
Removing a bad member	Never discussed	No removal by vote for misconduct; a lawsuit is required
Death of a member	Never discussed	The heirs get money rights only, no vote, unless all remaining members consent
Buyout	Never discussed	No right to be bought out and no price or formula

Nightmare #1: Ned Put Up 100% of the Money but Has Only One Vote Out of Three

Ned believes he controls the company because he owns 90%. Arizona law does not care what Ned believes. It cares what is written down, and nothing is.

 

Under A.R.S. §29-3407, the management of a member-managed LLC is vested in the members, and within the ordinary course of business each member has the right to manage and conduct the company's affairs. Bigger decisions outside the ordinary course are decided by a "majority in interest" of the members. A.R.S. §29-3102 measures a majority in interest by the members' interests in profits, and without an Operating Agreement each member's share is equal. The practical result is one member, one vote.

 

Consequences: Homer and Marge have two votes to Ned's one. The man who put in every dollar is a permanent minority. The Simpsons can decide the menu, the hours, the vendors, the prices, the remodel, the equipment leases and who gets hired, and Ned can do nothing about it except complain. Worse, because each member can act in the ordinary course, Homer can sign contracts and make commitments that bind the LLC before Ned even hears about them.

Nightmare #2: Profits Are Split in Thirds, Not 90/10

The restaurant has a good first year and earns $100,000 of profit. Under the handshake deal, Ned should be allocated $90,000 and the Simpsons $10,000.

 

Arizona's default rules give each member an equal share of the LLC's profits interest. For income tax purposes the LLC is taxed as a partnership, and with no Operating Agreement stating a different split, the profits follow that equal economic arrangement.

Member	Handshake deal (90/10)	Default rule (equal thirds)
Ned Flanders	$90,000	$33,333
Homer Simpson	$5,000	$33,333
Marge Simpson	$5,000	$33,334
Simpsons combined	$10,000	$66,667

Consequences: Ned loses $56,667 of profit in year one alone, and the same thing happens every year the restaurant makes money. Each Schedule K-1 reports one third of the profit to each member, and each member owes income tax on that share whether or not any cash is actually paid out.

Nightmare #3: Distributions Are Paid in Equal Shares

At year end the members vote to distribute the $100,000 profit. Here Arizona law is crystal clear. A.R.S. §29-3404 says any distribution made before the LLC dissolves "must be in equal shares among members and persons dissociated as members."

 

Consequences: Ned receives a check for $33,333. Homer and Marge receive $66,667. Ned's $1,000,000 investment earns him a 3.3% return while the Simpsons, who invested no cash at all, collect two thirds of the money. Ned has no document to prove the deal was 90/10, and a court will not rewrite the statute because Ned says "that's not what we agreed." The same equal split applies to every distribution for the life of the company.

 

The same statute creates a second trap. A member has a right to a distribution only if the company decides to make one. If the Simpsons ever decide to stop paying distributions, their two votes win and Ned gets nothing at all.

Nightmare #4: Homer Is Caught on Video Stealing $20,000, and Ned Can't Kick the Simpsons Out

The security camera shows Homer opening the restaurant's safe and walking out with $20,000. Ned has seen enough. He wants Homer and Marge out of the LLC so he can hire a new manager and run the restaurant himself.

 

Ned has no way to do it. A.R.S. §29-3602 lists the events that end a person's membership. Members can expel another member by unanimous vote only in a few narrow situations, and stealing from the company is not one of them. Even if theft were on the list, a vote to expel Homer would need Marge's vote, and Marge is not going to vote to throw her husband out. Without an Operating Agreement that allows removal for cause, Ned's only option is to file a lawsuit and ask a judge to expel Homer for wrongful conduct.

 

Consequences:

• Homer remains a member, keeps his vote, keeps running the restaurant and keeps receiving one third of every distribution while the lawsuit drags on for months or years.
• Marge did nothing wrong, so Ned has no grounds to remove her at all. Even if Ned wins, Marge stays in the LLC with her vote and her one-third share, and the Simpson household still has a seat at the table.
• Homer has breached his duty of loyalty to the LLC under A.R.S. §29-3409. But the decision whether the LLC sues Homer is a company decision, and Homer and Marge have two votes to Ned's one. The LLC will never vote to sue Homer.
• Ned's only path is a derivative lawsuit on behalf of the LLC under A.R.S. §29-3802, paid for out of Ned's own pocket up front. The legal fees can easily exceed the $20,000 Homer stole.
• Any money recovered goes back to the LLC, not to Ned, and two thirds of it is eventually distributed to Homer and Marge.
• There is no clause that lets the company buy out a wrongdoer at a discount, forfeit his interest or offset the theft against his future distributions.
• Ned must keep trusting the people who run the cash register every day with his $1,000,000 investment while he sues one of them.

Nightmare #5: The Simpsons Vote to Borrow $300,000 Secured by the LLC's Land Bought with Ned's Capital Contribution and Split the Cash Three Ways

Homer and Marge decide the LLC should borrow money. They find a lender willing to loan the LLC $300,000 secured by a deed of trust on the land the LLC bought with Ned's $1,000,000. Ned votes no. Homer and Marge vote yes, and two votes beat one.

 

Under A.R.S. §29-3407, decisions outside the ordinary course of business but within the company's purpose are made by a majority in interest of the members. Borrowing money and pledging the restaurant's land is exactly that kind of decision, and the Simpsons are the majority. Unanimous consent is required only for acts outside the scope of the company's purpose. The lender does not care about Ned's objection. It accepts the loan documents and the deed of trust signed by the members who have the votes.

 

Then the LLC distributes the loan proceeds. Because A.R.S. §29-3404 requires distributions to be made in equal shares, the $300,000 is paid out $100,000 each to Ned, Homer and Marge.

 

Consequences:

• The Simpsons cash out $200,000 of an LLC asset bought with Ned's money. Ned paid for the land. The land secures the loan. Yet two thirds of the borrowed money goes to the two members who never contributed a dollar. Ned gets $100,000 of his own equity back.
• Loan payments come before distributions. Every month the restaurant must make a payment on a loan Ned voted against. Cash that would have been distributed now goes to the lender, so Ned's already-shrunken one-third share of distributions shrinks again or disappears.
• If the restaurant falters, Ned loses the land. A deed of trust lets the lender foreclose through a trustee's sale. The land the LLC bought with the $1,000,000 Ned contributed to the LLC can be sold at auction because Homer and Marge could not make the payments on a loan Ned never wanted.
• Personal guaranties. Lenders frequently require the members to personally guarantee an LLC loan. If Ned signs, he is personally on the hook for money the Simpsons put in their pockets. If he refuses to sign, the Simpsons blame him for killing a deal they already voted to approve.
• It can happen again. Nothing in Arizona's default rules limits how much the LLC may borrow, how often the members may strip equity out of the land or what the money is used for. Next year the Simpsons can vote to borrow another $300,000.
• Everyone's exposure if the company is already shaky. A.R.S. §29-3405 prohibits a distribution if afterward the LLC could not pay its debts as they come due or its liabilities would exceed its assets. A borrow-and-distribute maneuver on a struggling restaurant can be an unlawful distribution, which exposes the members who approved it to claims by the company and its creditors.
• A tax surprise. The tax treatment of a debt-financed distribution depends on each member's basis and share of the debt. A member who receives cash in excess of basis has taxable gain. With no Operating Agreement allocating the debt, nobody knows who owes what until the CPA prepares the returns.

An Operating Agreement drafted for Ned would have required his written consent for any borrowing, any lien on the land, any guaranty and any distribution of loan proceeds, and it would have made distributions follow the 90/10 deal so the Simpsons could not have taken $200,000 of the money.

Nightmare #6: Homer Hires Bart for $80,000 a Year, and Ned Can't Stop It

Homer decides the restaurant needs an "assistant general manager" and hires his son Bart at a salary of $80,000 a year. Bart's qualifications are skateboarding and prank phone calls. Ned objects.

 

Hiring employees is a decision in the ordinary course of running a restaurant. Homer has the right to make that decision under A.R.S. §29-3407, and if Ned pushes it to a vote, Homer and Marge win two to one.

 

Consequences: Bart's $80,000 salary comes straight out of profits before anything is left to distribute. Using the year-one numbers, $100,000 of profit shrinks to $20,000 and Ned's share of distributions drops from $33,333 to $6,667, while $80,000 of the company's money goes to the Simpson household. Ned's only remedy is another lawsuit claiming the hire is a self-dealing breach of the duty of loyalty. Next year, Homer can hire Lisa, Grampa Simpson and Marge's sisters Patty and Selma. A good Operating Agreement would have required Ned's consent for any transaction with a member's family.

Nightmare #7: Ned Dies, and His Estranged Son Bobby Inherits Part of the LLC

Ned dies unexpectedly. He has no will and no living trust. Ned is survived by his wife Edna and his only child, Bobby, a son from an earlier relationship whom Ned has not seen or spoken to in 20 years. Ned's LLC interest is community property.

Ned stops being a member the moment he dies

Under A.R.S. §29-3602, a member's death is a "dissociation" event. Ned is no longer a member. His interest is reduced to what the statute calls a "transferable interest," which is the right to receive distributions and nothing more.

Edna keeps half and Bobby inherits half

Arizona is a community property state. Edna already owns her one-half of the community interest in the LLC. Ned's one-half passes by intestate succession. Because Bobby is Ned's child but not Edna's child, A.R.S. §14-2102 gives the surviving spouse none of Ned's half of the community property. Ned's half goes to Bobby.

 

Consequences:

• Probate. Ned's half of the LLC interest is stuck in probate court. A personal representative must be appointed, and under A.R.S. §29-3504 that person has only limited rights, mainly to receive information needed to settle the estate. A funded revocable living trust holding Ned's LLC interest would have avoided probate entirely.
• No vote for Edna or Bobby. Under A.R.S. §29-3502, a transferee has no right to participate in management. Under A.R.S. §29-3401, a new member can be admitted only with the consent of all the members, and the only remaining members are Homer and Marge.
• The Simpsons now own 100% of the control. The $1,000,000 land and the restaurant are run entirely by Homer and Marge. Edna, who holds the family's investment, has no say at all.
• Edna gets one sixth. Distributions are still split equally: one third to Homer, one third to Marge and one third to the Ned interest, which Edna and Bobby share. Edna receives one sixth of the distributions from a company her husband paid for entirely.
• Freeze-out and phantom income. Homer and Marge can simply vote to stop making distributions. Edna still receives a K-1 and owes income tax on her share of the LLC's profits, even though she receives no cash to pay the tax.
• No buyout. Nothing requires the LLC or the Simpsons to buy Edna's or Bobby's interest, and nothing sets a price. Few outside buyers will pay anything for a minority money-only interest with no vote in a restaurant controlled by the Simpsons.

Nightmare #8: Nobody Can Find Bobby

The personal representative searches for Bobby and comes up empty. No address, no phone number, no email, no social media. Bobby never signs anything, never accepts his inheritance and never becomes a member.

 

Consequences:

• Ned's probate cannot close on schedule. Edna pays the personal representative, the lawyers and possibly an investigator or court-appointed representative for Bobby while the estate sits open.
• Bobby's one-sixth share of every distribution must be held and cannot be paid to anyone else. Eventually unclaimed funds may be turned over to the State of Arizona.
• The LLC cannot properly issue Bobby's K-1 because it has no Social Security number or address for him.
• Selling the restaurant, the land or the entire company becomes much harder. Buyers and title companies want every interest holder accounted for, and one of them is missing.
• If Bobby turns up ten years later, he can demand his share of everything that was withheld and question every decision made while he was gone.

More Nightmares Waiting to Happen

Nightmare #9: The Simpsons Work for Free

The deal cuts both ways. A.R.S. §29-3407(G) says a member of a member-managed LLC is not entitled to be paid for services, except reasonable compensation for winding up the company. Homer and Marge work 70 hours a week and have no legal right to a salary. When they vote themselves salaries anyway, Ned has a new reason to sue, and the relationship gets even worse.

Nightmare #10: Ned Can't Get His $1,000,000 Back

Ned is fed up and wants out. Under Arizona law, Ned can withdraw as a member, but withdrawing does not entitle him to be paid anything. He simply becomes a transferee with money rights only and gives up his vote. There is no put right, no buyout formula and no appraisal procedure. His $1,000,000 stays locked in a company controlled by the Simpsons.

Nightmare #11: The Fight Over What the Simpsons Contributed

If the LLC is dissolved, A.R.S. §29-3707 first returns each person's unreturned contributions and then splits what is left in proportion to their distribution rights, which are equal. That sounds like good news for Ned. But the Simpsons contributed services, and nothing in writing states the value of those services. Expect Homer and Marge to claim their years of work were worth hundreds of thousands of dollars, reducing what Ned gets back. Without required records showing each member's contribution, that argument ends up in court.

Nightmare #12: Deadlock and a Forced Sale of the Land

When the members can no longer work together, any member can ask a court to dissolve the LLC under A.R.S. §29-3701. The restaurant closes, the employees lose their jobs and the land is sold, possibly at a fire-sale price. Everyone loses, and the lawyers get paid first.

Nightmare #13: An Unexpected Tax Bill for the Simpsons

Receiving an ownership interest in exchange for services can be taxable compensation income. Because the default rules give Homer and Marge a large share of the value of a company funded with $1,000,000 of Ned's cash, they may face a tax bill on an interest they never paid for. A properly drafted Operating Agreement, prepared with tax advice, structures a service member's interest to avoid that surprise.

Nightmare #14: Homer's Personal Problems Become the LLC's Problems

If Homer and Marge divorce, their LLC interests become part of the property division. If Homer is sued personally or files bankruptcy, his creditors and a bankruptcy trustee enter the picture. Without transfer restrictions, buy-sell provisions and a right of first refusal, Ned has no way to keep outsiders from acquiring rights in the company.

How a Good Operating Agreement Would Have Prevented Every Nightmare

Nightmare	Operating Agreement solution
One vote per member	Voting by percentage interest, or Ned as manager, with major decisions requiring his consent
Equal profits and distributions	Allocations and distributions stated as 90% Ned and 10% Simpsons, with a preferred return of Ned's capital
Theft by a member	Removal for cause by vote of the other members, with a forced buyout at a discounted price
Borrowing and liens on the land	No loan, deed of trust, guaranty or distribution of loan proceeds without Ned's written consent
Hiring family	Related-party hiring and compensation require approval of the non-interested members
Death of a member	Buy-sell provisions funded by life insurance, a purchase price formula and rules on admitting heirs
Missing heir	Mandatory buyout of a deceased member's interest, so the company deals with the estate and not with lost heirs
Unpaid services	Written guaranteed payments or salaries for the operating members
No exit for Ned	Put and call rights, appraisal procedure and payment terms
Disputed contributions	A schedule stating each member's contribution, agreed value and percentage interest
Deadlock	Tie-breaking procedures, mediation and a "shotgun" buy-sell clause
Divorce, creditors, bankruptcy	Transfer restrictions, spousal consents and a right of first refusal

Ned also needed his own estate plan. A revocable living trust owning his LLC interest would have kept that interest out of probate, and a will or trust would have let Ned decide whether his estranged son Bobby received anything.

Frequently Asked Questions

Does an Arizona LLC legally have to have an Operating Agreement?

 

No. Arizona does not require one, which is exactly why so many LLCs don't have one. Without it, the default rules of the Arizona Limited Liability Company Act control voting, profits, distributions, death of a member and buyouts.

 

If there is no Operating Agreement, how are distributions split among Arizona LLC members?

 

A.R.S. §29-3404 requires distributions made before dissolution to be paid in equal shares among the members and persons dissociated as members, no matter how much money each member contributed.

 

Can members of an Arizona LLC vote to kick out a member who steals from the company?

 

Not without an Operating Agreement that allows it. The statute permits expulsion by unanimous vote only in narrow situations. Otherwise, the members must ask a court to expel the member for wrongful conduct.

 

Does my heir become a member of my LLC when I die?

 

Not automatically. Your heir receives only a transferable interest, which is the right to receive distributions. The heir has no vote and becomes a member only with the consent of all the remaining members, unless the Operating Agreement says otherwise.

 

Can we sign an Operating Agreement after the LLC has already been operating?

 

Yes, if all the members agree and sign it. The problem is that once money has been invested and the business is running, the members who benefit from the default rules have little reason to sign. The best time to sign is before anyone contributes a dollar.

Protect Your LLC Before the Nightmare Starts

Arizona LLC attorneys Richard Keyt and his son, attorney and former CPA Richard C. Keyt, have formed 10,000+ Arizona LLCs and have prepared Operating Agreements designed to prevent the problems described in this article.

 

See a detailed description of the 8 Bronze LLC services, 12 Silver LLC services & 20 Gold LLC services we provide when we are hired to form an LLC or PLLC.

 

To hire us to form an LLC submit our online questionnaire at keytlaw.com/llcq. Questions? Call 480-664-7478 or email rk@keytlaw.com.