Common LLC Disasters a Good Operating Agreement Prevents

Common LLC Disasters a Good Operating Agreement Prevents 2017-05-14T09:29:16+00:00

by Richard Keyt, an LLC lawyer who has drafted 5,700+ LLC Operating Agreements

I urge you to scroll through the table below to learn about common LLC problem scenarios that could apply to you and your LLC. The problems arise when the members of an LLC do not have an Operating Agreement or they have an Operating Agreement that does not contain provisions that eliminate the problem. If your LLC has an Operating Agreement it is unlikely that it contains language that addresses any of the problems described below because the person who prepared it is not an Operating Agreement expert who has prepared a lot of Arizona LLC Operating Agreements.

How to Eliminate the Problems Described Below

Protect yourself, your family and other members of your LLC by purchasing my Operating Agreement (for to be formed LLCs and LLCs that do not have an OA) or my amended and restated Operating Agreement (for LLCs that have a signed OA).

Warning: If you are a member of an Arizona or California LLC or will form an Arizona or California LLC you owe it to yourself and your loved ones to purchase my Operating Agreement that contains very important provisions that you will not find in any other Operating Agreement. In forming 5,700+ LLCs since the day Arizona’s LLC law became effective in 1992 I have seen LLC owners experience the same problems over and over because their LLC did not have an Operating Agreement or their LLC Operating Agreement was merely a boiler plate document that lacked critically important provisions.

Common LLC Disasters that You Can Prevent by Purchasing the Keyt’s Operating Agreement

LLC ProblemNon-Keyt Operating AgreementKeyt's Operating Agreement
Member's Death Requires Expensive Probate Example 1

Forrest Gump is single. He has one child, Forrest Jr. Forrest is the sole owner of his Arizona LLC. The LLC is worth $100,000. He dies without a Will.

1. The LLC must dissolve because its sole member died. See Arizona Revised Statutes Section 29-781.4.

2. If Forrest Jr. is an adult he can open an expensive ($3,500+) & time-consuming probate to transfer the Forrest's membership from his father's estate to himself so he can try to salvage the assets of the dissolved LLC.

3. If Forrest Jr. is a minor a family member will have to open an expensive ($3,500+) & time-consuming probate to transfer the membership from Forrest's estate to Forrest Jr.'s court appointed conservator ($2,500+) so the conservator can try to salvage the assets of the dissolved LLC.

All the problems described to the left are avoided. The Operating Agreement provides that on Forrest's death his membership interest in the LLC transfers automatically to Forrest Jr. if he is an adult This clause prevents the dissolution of the LLC and eliminates the expensive probate and saves Forrest $3,500+. If Forrest Jr. is a minor the clause would cause the membership to be transferred to a Uniform Gift to Minors account to be held until Forrest Jr. is an adult.
Member's Death Requires Expensive Probate Example 2

Forrest Gump is the sole owner of his Arizona LLC as his separate property. Forrest is married to Jenny and has one child, Forrest Jr. whose mother is Jenny. The LLC is worth $100,000. He dies without a Will.

1. The LLC must dissolve because its sole member died. See Arizona Revised Statutes Section 29-781.4.

2. Jenny must open an expensive ($3,500+) & time-consuming probate to transfer Forrest's membership from Forrest's estate to herself so she can try to salvage the assets of the dissolved LLC.

All the problems described to the left are avoided. The Operating Agreement provides that on Forrest's death his membership interest in the LLC transfers automatically to Jenny, but if she is deceased then it goes to Forrest Jr. if he is an adult This clause prevents the dissolution of the LLC and eliminates the expensive probate. If Forrest Jr. inherits and is a minor the clause would cause the membership to be transferred to a Uniform Gift to Minors account to be held until Forrest Jr. is an adult. This clause eliminates the need for an expensive probate and saves Jenny $3,500+.
Deceased Member's Interest Inherited by Wrong Person

Forrest Gump and Jenny Gump are the sole owners of an LLC. They formed the LLC when they were married residents of Arizona. They do not have any children, but Forrest has a child (Forrest, Jr.) with another woman. Forrest is estranged from his son and has not seen him in 20 years. The LLC is valued at $200,000. Forrest dies.

1. Warning: Ultimate Nightmare: Arizona's law of intestate succession in Arizona Revised Statutes Section 14-2102.2 provides that Forrest's $100,000 community property interest in the LLC is inherited by the estranged son Forrest, Jr., rather than his wife Jenny.

2. If Forrest Jr. is an adult he can open an expensive ($3,500+) & time-consuming probate to transfer the Forrest's membership from his father's estate to himself so he can try to salvage the assets of the dissolved LLC.

3. If Forrest Jr. is a minor a family member will have to open an expensive ($3,500+) & time-consuming probate to transfer the membership from Forrest's estate to Forrest Jr.'s court appointed conservator ($2,500+) so the conservator can try to salvage the assets of the dissolved LLC.

All the problems described to the left are avoided. The Operating Agreement provides that on Forrest's death his community property membership interest in the LLC transfers automatically to Jenny, but if she is deceased then it goes to whoever Forrest has named as an alternate heir.
Married Couple Does Not Own LLC as Community Property with Right of Survivorship

Forrest Gump and Jenny Gump are the sole owners of an LLC. They formed the LLC when they were married residents of Arizona. The LLC is valued at $200,000. Forrest dies.

1. Arizona community property law provides that the Gumps owned their interest in the LLC as community property, not as community property with right of survivorship. The LLCs Operating Agreement did not contain language that converted the Gump's community property interest into a community property with right of survivorship interest.

2. Jenny must open an expensive ($3,500+) & time-consuming probate to transfer Forrest's community property interest in the LLC from Forrest's estate to herself.

All the problems described to the left are avoided. The Operating Agreement contains language that causes the Gump's community property interest in the LLC to become community property with right of survivorship. As a result when Forrest died his community property interest in the LLC transferred automatically to Jenny without the need for a probate.
Surviving Spouse Cannot Vote Interest Inherited from Spouse

Forrest Gump and Jenny Gump own 50% of an LLC as community property with right of survivorship. Darth Vader, a single Jedi knight, owns the other 50%. Homer dies and Jenny automatically acquires Forrest's 25% community property interest in the LLC.

Darth now has voting control of the LLC because he has 50 votes and Jenny only has 25 votes. Because Forrest and Jenny were not parties to an Operating Agreement that provided that an inherited interest automatically is a membership interest without any restrictions Jenny inherited an economic right to 25% of the profits, but not full membership & voting rights with respect to the inherited 25%. This is a nighmare for Jenny Darth now has control of the LLC. See "Caution: LLC Membership Interests Held as Community Property" and Arizona Revised Statutes Section 29-731.B.2.All the problems described to the left are avoided. The Operating Agreement contains language that says that if a member dies the person or people who inherit the interest in the LLC acquire full membership rights including voting rights.
Surviving Spouse Does Not Become a Manager of the LLC

Forrest Gump and Jenny Gump own 50% of an LLC as community property with right of survivorship. Darth Vader, a single Jedi knight, owns the other 50%. Homer and Darth are the LLC's two managers. Homer dies. Darth becomes the LLC's sole manager.

Jenny does not become a manager because both members must agree to elect a new manager. The Gump family loses management power.The problem described to the left is avoided because the Operating Agreement provides that if Forrest dies or becomes mentally incapacitated, then Jenny automatically becomes a manager.
Majority Member Wants to Sell but Minority Member Balks

Forrest Gump owns 90% of an LLC. Darth Vader owns 10%. Forrest found a buyer who will buy Forrest's 90% only if he can also buy Darth's 10%.

Forrest cannot force Darth to sell his 10% so the sale dies.The problem described to the left is avoided because the Operating Agreement contains a "drag along" provision. This is a provision that obligates minority members to sell all of their interests in the LLC on the same terms and conditions as the sale of the majority members' interests.
Majority Member Sells Out & Minority Member Has a New Partner

Forrest Gump owns 90% of an LLC. Darth Vader owns 10%. Forrest found a buyer who will buy Forrest's 90%, but the buyer is not interested in buying Darth's 10%.

Forrest sells his 90% of the company to a stranger and Darth becomes partners with the stranger who owns 90% and has voting control of the LLC.The problem described to the left is avoided because the Operating Agreement contains a "tag along" provision. This is a provision that gives minority members the option to prevent the majority members from selling their interests unless the buyer also buys the entire interest of the minority members on the same terms and conditions as the purchase of the majority members' interests.
No Right of First Refusal Clause

Forrest Gump owns 90% of an LLC. Darth Vader owns 10%. Darth wants to sell his 10% to a stranger for $1,000 cash.

Forrest cannot prevent Darth from selling his 10% to the stranger. Forrest becomes partners with the stranger. The good news for Forrest, but bad news for the stranger is that if Forrest does not agree to let the stranger become a member the stranger is a mere assignee of Darth's right to receive 10% of the profits of the LLC and not a member of the LLC. See Arizona Revised Statutes ARS Section 29-731.The problem described to the left is avoided because the Operating Agreement contains "right of first refusal" clause. This is a provision that says if a member desires to sell or transfer the member's interest in the LLC the other member has the option to purchase the transferring member's interest on the same terms and conditions offered to the prospective new owner.
Member Files a False Document with the Arizona Corporation Commission

Forrest Gump owns 81% of an LLC. Darth Vader owns 19%. Without the knowledge or consent of Forrest Darth files and amendment to the Articles of Organization with the Arizona Corporation Commission that removes Forrest and a member, names Darth as the sole member. Darth then opens a new bank account with only Darth as the signer on the account.

Forrest can file a lawsuit under Arizona Revised Statutes Section 29-858. and ask the court to award him damages as a result of Darth's filing the false document with the ACC. The problem the lawsuit will be very expensive and is it will be hard to prove damages.The problem described to the left is avoided because the Operating Agreement contains a provision that says that if a member files a false document with the Arizona Corporation Commission that member owes every other member liquidated damages and if the damages are not paid the member who filed the false document will cease to be a member.
Member Strips LLC's Bank Account & Opens New Account

Forrest and Darth are the two members of an LLC. Without Forrest's knowledge or consent Darth takes all of the money out of the LLC's account and deposits it in a new account that only Darth can access.

Forrest no longer has access to LLC funds. Darth is freezing Forrest out.The problem described to the left is avoided because the Operating Agreement contains a provision that says that if a member opens a bank account without the approval of the members the member must pay liquidated damages to the other members and if the damages are not paid the member who opened the bank account without the authority will cease to be a member.
IRS Appoints LLC's Agent for an Audit

Forrest Gump is a member of a multi-member LLC that is taxed as a partnership. The members have not agreed on who will be the LLC's "partnership representative."

Beginning on January 1, 2018, the IRS will change its partnership tax audit rules. If the LLC taxed as a partnership is audited and it has not named a partnership representative the IRS can designate a person to be the LLC's partnership representative who has the authority to bind the LLC with respect to the results of the tax audit. Warning: You do not want the IRS to name the person who can agree with the IRS that the LLC owes back taxes.The problem described to the left is avoided because the Operating Agreement contains a provision that names a member of the LLC as the LLC's partnership representative.
IRS Audit Assesses Tax & Former Member Escapes Liability

Forrest Gump and Darth Vader each own 50% of an LLC taxed as a partnership. In 2017 Forrest purchases Darth's 50% membership interest. In 2018 the IRS audits the LLC for its 2016 tax year and assesses $10,000 in back taxes against the LLC for 2016.

Beginning January 1, 2018, when the IRS assesses back taxes against an LLC taxed as a partnership the LLC becomes obligated to pay the back taxes. This means Forrest bears the entire $10,000 loss because Darth is no longer a member of the LLC.The problem described to the left is avoided because the Operating Agreement contains a provision that says if a member ceases to be a member and the IRS assesses a tax against the LLC the members of the LLC during the year of the assessment will pay the tax based on their proportionate membership interests in the LLC. This provision would obligate Darth to pay $5,000 of the back taxes.
LLC Taxed as an S Corporation or Partnership Does not Distribute Money to Members They Need to Pay Taxes

Forrest owns 60% of an LLC and Garth owns 40%. LLC has $100,000 of profits. Forrest as majority owner decides that the members will not be paid any distributions for the year because the money is needed for the business.

Forrest must report $60,000 on his tax return as income. Darth must report $40,000 on his tax return as income. Neither member will have any money from the LLC to pay the tax on the income.The problem described to the left is avoided because the Operating Agreement contains a provision that requires the LLC to pay to each member an amount equal to the member's estimated federal and state income taxes on the member's share of the profits.

How to Hire Richard Keyt and his son Richard C. Keyt to Prepare an Arizona or California LLC Operating Agreement

  • 1st Option: Call Richard (father) at 480-664-7478 or Richard C. (son) at 480-664-7472 if you have any questions or you are ready to order your Operating Agreement
  • 2nd Option: Complete our Operating Agreement Questionnaire and click o the submit button.