Operating Agreements

By Jason Watson, CPA
Posted Sunday, October 22, 2023

If you are a single-member LLC or if your business partner is your spouse, this information might not apply. But if you are in business with another person, even a brother or sister-in-law, then a beefy Operating Agreement is a must have, at least eventually.

Operating Agreements are like Bylaws for an LLC, and they protect the rights of the members and define the parameters in which the members can operate. In general, attorneys do an adequate job drafting this critical document, but there are some holes that WCG feels compelled to mention.

Death, Divorce, Incapacitation

Death and divorce are easy, and attorneys have this in their templates all the time however incapacitation is often left out, or only briefly mentioned. Look at the recent Donald Sterling who was found mentally unsound and could not run his business. If your business partner is Donald Sterling who is not dead nor divorced much to Clipper fans’ chagrin, you might want a contractually obligated and legally enforceable plan to get rid of his member interest.

Do you need one doctor? Two doctors? What is the triggering threshold? Traumatic brain injuries are more common that you think and therefore you need to protect yourself if they occur. It is not just incapacity from a mental perspective either; your business might suffer if a member cannot physically perform the role either.

Accounting, Corporate Waste

Most attorneys draft language allowing any member to request a formal accounting of the expenditures and financial records, and this is commonly afforded in most state statutes that govern corporations and LLCs. However, they often neglect to build thresholds where all members must sign off on an expense. For example, let’s say you are a minority shareholder at 25%, and the other three members are also 25% each. Interestingly, the other three members are also a voting block since they are all family members as well. What’s to prevent them from buying a business car for someone other than you?

In Colorado we are seeing a flood of marijuana investors. This is a cash business of course and all these minority investors are pouring their savings into new pot farms. It is not a bad investment; first to market, stake your claim, build mega farms, control the pricing, etc. However, and this is a big however, it is still a cash business. Don’t you want a little assurance that the majority owner is not skimming the till?

Do you know how the IRS can determine your sales volume as a bar? They look at your purchases which is why most bars must buy from a distributor. Determine the cost of goods purchased slap on a regional markup, and boom, you have sales regardless of what the cash deposits say. Same with divorces; we often look at lifestyle and spending to “back into” the income figures.

There are several other examples that fall under the accounting and corporate waste provisions.

Distributions

Oftentimes the business will have income, but no cash since it is re-investing back into the business. However, as a shareholder of an S corporation or a member of a garden variety LLC, you will pay taxes on business income (profits) and not distributions. Theoretically you could have a big tax bill based on income but never see the cash. How does this work?

The business has net income of $100,000 after expenses and everyone decides to put the money back into the business such as inventory purchases. Cool, since everyone agrees but all the owners will have a tax obligation based on the $100,000 (inventory purchases may immediately reduce net income but there are rules, so please play along for now). This means that if you are a 25% owner at a 22% marginal tax rate, you will have a cash out-of-pocket tax bill of $25,000 x 22% or $5,500.

WCG CPAs & Advisors recommends two things when it comes to distributions. First, the definition of working capital. If the business needs working capital to operate or for future purchases or initiatives (what we call capital expenditures or capex for short), how is that calculated? Second, once working capital is defined, what portion is distributed and what is kept in the business?

Let’s run through an example of working capital. Let’s say your law firm specializes in personal injury and as such your revenue is lumpy. To be safe, you and the other partners determine that you need 6 months’ worth of expenses in working capital. Also, the law firm is moving next year into a new office which needs a build-out. You add that up and excess cash is available for distribution.

Sidebar: When you grow working capital, you will have a tax consequence. For example, if you want to increase from $100,000 to $200,000 in working capital next year, you will pay taxes at your tax rate (assuming a pass-through entity such as a partnership or S Corp). As you might know or will soon learn, as an S corporation shareholder or partner in a partnership, you are taxed on the profits earned by the business whether you distribute the earnings or retain them for future bills. Therefore, at a 22% marginal tax rate, your $100,000 growth in working capital will take $22,000 in taxes. The good news if you reduce working capital, that distributable cash is tax-free.

From there, the Operating Agreement could dictate that a minimum of 40% is distributed to the owners unless all owners agree to a different figure. This helps reduce some of the tax sting of net ordinary business income after expenses and deductions being allocated to you without the same amount in cash.

What WCG recommends is-

• Determine working capital (time-based operating expenses + capex + buffer).
• Determine a budget.
• Use math to then determine how much you can safely distribute to the owners.
• True up each quarter or semi-annually to align reality with budget. In other words, if your interim profit is higher than budgeted, perhaps another off-cycle distribution can safely occur.

Another common example is when you are the minority shareholder or member. The majority elects to increase wages for themselves and not pay distributions, basically starving you out. My partner would never do that! Really? Ok. But everyone else not living in fantasy land, an Operating Agreement can protect from this situation.

Dispute Resolution

Templated Operating Agreements usually have language about dispute resolution, and specifically mediation. Mediation is fine, and some courts have a standing order that parties will attend mediation prior to trial. However, mediation is not binding and parties don’t necessarily have to enter into mediation with good faith. Trials take a long time- anywhere from 12 to 24 months, just to get to opening statements.

Arbitration is like mini-court and the rules of discovery and evidence are usually more relaxed including procedure. They can be expensive since you are paying for your attorney plus the arbiter who is usually a retired judge or attorney. However, they can also be efficient.

Regardless of mediation, arbitration or trial, make sure your Operating Agreement has expeditious dispute resolution provisions, and incentives for all parties to be efficient and bargain in good faith.

Business Valuation

If a member wants out, no problem, but what is the value of the business? Should you use a formula to determine the value? Perhaps something based on revenue? A full-blown business valuation (our retainer is $3,000 for a conclusion of value business valuation engagement)? What if you and your business partners cannot agree on the selection of the business valuation expert? Make sure there are provisions in your Operating Agreement.

As a side note, if the value cannot easily be derived from a formula, we often see language where the exiting member and the remaining members each pick a business valuation expert. Then those two experts pick a third as a neutral, or some other seemingly detached and disinterested selection mechanism.

As we’ve said in the past, just because you are working with an attorney or an accountant doesn’t mean you are working with a smart person. WCG CPAs & Advisors can act as a consultant with your attorney when drafting these documents.