Operating Agreement: What is it?
What is an LLC Operating Agreement?
When forming a Limited Liability Company (LLC), the parties to the company often enter into what is called an operating agreement. In essence, an operating agreement is a contract which lays out how the LLC will be managed, how its income will be distributed, how new members can be added to the LLC, how voting will be accomplished, and how the company can be dissolved, among other things.
In essence, an operating agreement is a contract of sorts between the members of the LLC which clarifies the relationship between the members themselves, what the business will entail, how profits will be divided, how management decisions will be made, and what happens if a member wishes to leave or sell their interest in the LLC .
Having an operating agreement is crucial for most LLCs because the default state of affairs in Colorado (as set forth in the Colorado Limited Liability Company Act) is such that each member has an equal say in the affairs of the company, and profits will be divided (in the absence of agreement to the contrary) equally among those participating in the company. If the LLC will be managed in a certain way other than the default state of affairs, or profits will be divided in some manner other than an equal split (i.e., disproportionately or based on different percentages), then an operating agreement is even more important.
For rental property LLCs, an operating agreement also has certain tax benefits, particularly when it comes to how the rental property will be taxed.
Advantages of an LLC for Rental Property
Private homeownership is as American as it gets purely from a tax planning and generation of retirement benefits perspective. Given how tough the housing market is giving you many, many years of free rent allowing you to save up enough money to put down some sort of deposit is beyond the reach of most people yet alone something that the low wage working class dream of….
From the front you are basically looking at a house in the city but when you realize that its on stilts above the water in a Central Texas lake dammed up to provide the water for the City of Austin and the lovely view is of your boat lift and speedboat the excitement, not to mention the peace of mind knowing you can have a second home are overwhelming.
In the years since this was purchased my family has essentially quadrupled its net worth, and in 2014 we paid 12% less than we did in 2011 for the second home. Its now worth 50% more than we paid. So now we are comin’ in all heavy to borrow a phrase. As crazy as it seems a vacation property can become a major asset in your portfolio.
On a personal note I grew up in a lower middle class family, got a good education but was never exposed to investing in property. By the time I graduated college my parents had not paid off our primary residence but they had paid off my Grandparent’s lake house, so when Grandma died, I inherited the lake house, so when my Siblings and I inherited the lake house, we had choices.
We could sell it and take the cash, but then what? All of us as kids loved our summers at that house, so selling it would not only tear the family apart but would also lose the value generated from how the house was used most of its life.
We could use it as a long term rental, but renting the lake house out for a number of years basically was like just being tenant who bought the house. If I had such a property as the one we have now I would be able to deduct the expenses as a business, pay off the house in a shorter time, and still get to enjoy its use.
After talking with my siblings we decided to purchase the interest of my deceased parent, and buy out the interests of another sibling. We decided to use the property as a long term rental. Although we recently had a bad experience with a bad tenant that basically we could not get rid of for over a year, we now own the property free and clear.
At some point as our lives progress and we do passive income investing so that we can really retire and get away from the 8-5 rat race, this property will be sold, but until then its appreciating and generating income. So the goal now is to manage the asset properly and make sure it continues to generate long term wealth.
The benefit of owning property for many people have existed for many years. Today there are so many more ways to leverage the leveraging of your assets. Using an LLC to own rental property from a legal and tax perspective can be a very beneficial addition to your portfolio. Typically, the LLC is disregarded for federal purposes with an annual tax return that must be prepared similar to a Schedule C depreciation, the LLC taxes the rental income, but then passes the income to the owners without any Federal level taxation. This way the income is taxed at the owner’s individual rate and not subject to the 15% higher corporate tax rate.
Once you have your LLC and it is in place you should keep in mind its business value. For example, if the property is sold and a gain is realized there is a sale of an asset for a business, depending on how much gain the sale generates there may be a tax on that gain. Basically there are three advantages to using an LLC to own Rental Property in the IRS tax world. First, the rental income is taxed at the owner’s personal rate and not the business rate. Second, any gain from a sale of the property is also subject to the individual tax rates of the owner(s) and not the business rate. Third, the LLC entity and agreement governs the actions of the members for the sake of liability protection.
Main Elements of an LLC Operating Agreement
An adequately drafted LLC Operating Agreement is likely to contain these key components:
Management: An Operating Agreement should outline how the LLC will be structured. For instance, even though the default rule under the Michigan LLC Act is that each member has an equal voice in the management of the business, its terms can allow for a different arrangement. In short, an Operating Agreement should spell out how decisions will be made within an LLC.
Powers & Duties: The LLC Operating Agreement is also the best place to spell out the rights and duties of its members. Duties should address what is expected of members and what will happen if a member fails to meet those obligations. Powers generally speak to what actions members can take on behalf of the LLC, including entering into agreements or hiring employees.
Distributions: When it comes to keeping its members happy, a well-drafted Operating Agreement will address how profits are distributed to its members. Generally, distributions can be allocated in proportion to each member’s ownership interests. Depending on the assets involved, however, distributions may need to be tailored to the particular property owned by the LLC. For instance, having a rental property might mean that some members have different (or no) tax consequences from taking their share of profits in the form of a distribution. A symptom of the primary property being owned by an LLC might be an attempt to avoid being dragged into foreclosure by a foreclosure by keeping profits with the LLC.
Liability: In addition to addressing how profits will be divided, an LLC Operating Agreement also generally protects its members where the LLC is liable for certain debts.
Disputes: An Operating Agreement is also a good place to list out how disputes will be addressed should any arise amongst your members.
Records: Lastly, it is often useful to outline how records will be kept.
Both new and seasoned investors alike should take time to sit down with their attorneys to draft an Operating Agreement that spells out all of these important details.
How to Create an LLC Operating Agreement
When drafting the Operating Agreement for your LLC, you’ll want to make sure that you have the basic terms laid out. You’ll want to start off with the basic terms such as:
- Formation Date
- Tax Year
- Principal Place of Business
- Member Contributions and Membership Interests
- Cash Distributions
- Management
- Books and Records
- Transfers or Assignments
Once you have these basic terms covered, you’ll want to consider a few additional provisions. You’ll want to add in terms that are specific to your business. Take the time to set out the procedure for transferring a member’s interest. If one member dies or becomes incapacitated, what will happen? We have seen too many situations where there is no plan set up and that leads to future problems down the road. If one member wants to leave, is there a procedure for him or her to leave? If you leave does, another member have the right to purchase the interest before it’s offered on the open market? When an LLC is new no one thinks it is going to fail, but it happens. You want to be better prepared than your competitors. Those eventualities should also be covered in the Operating Agreement.
Some of the general provisions that are in most state’s LLC Acts are as follows:
- Owner – can be an individual or another entity;
- Members in an LLC are not personally liable for the LLC Act (that being said, it is important for the LLC to be set up properly, as a properly formed LLC may limit the liability);
- Duty of Good Faith and Loyalty;
- Voting Rights;
- Distributions;
- Members can vote based on percentage interest, or some other designated method;
- An Individual Manager can be designated, or if there is no designation, all members will have equal management rights;
- Members can remove Managers, or appoint a new Manager, and such removal and appointment can be done by a majority vote of the members;
- Members may amend the Operating Agreement with a majority vote, unless they assign such right to a Manager;
- Upon Dissolution, the assets and liabilities of the LLC will be distributed in the same manner as a dissolution of a corporation;
- Owners agree to indemnify the LLC to the extent the indemnity is not prohibited by the law.
Hopefully this information will help you draft a successful LLC Operating Agreement!
Frequent Errors
Many landlords could reduce the risk in their rental property business by mastering their LLC Operating Agreement. This is a relatively simple process. Even for larger landlords, a well-written Operating Agreement can go a long way in ensuring a smoother operation of your real estate company.
There are a number of common mistakes that most computer generated LLC Operating Agreements have. None of these "red flags" are too hard to correct. But assuming the LLC Operating Agreement is fine without reviewing it is a mistake. Here are some of the provisions that need to be carefully reviewed and understood by all real estate investors, even those who have entity structuring attorneys on retainer:
• Who makes the management decisions? If you start an LLC and assume that you and your partner own the company 50/50, but the LLC Operating Agreement says all management decisions require a 60% vote, you could face problems when the time comes to make the decision. This can even happen if there is one member with a small interest in the LLC. Let’s say you own 51% of an LLC. If a big decision is made by a 60% vote (which requires you to have two other people agree with you), you could be outvoted .
• Are distributions restricted? If your Operating Agreement is written to say all distributions must be equal, then your only option to minimize taxes on real estate is to do "advance distributions." This is where you pay all taxes on the profits generated by the LLC in the year they are generated, but rather than distributing money to your personal bank account, the extra profits are carried forward to your next return. However, this also means you will pay taxes on past profits for the next few years. You can’t have it both ways.
• Can you do an advance distribution for only one member? A good Operating Agreement will have provisions that prevent an "unequal distribution" if any member can do a distribution. So when you take a distribution, you must also give one, or your co-owner might object.
• What if you die? This is a trap many investors fall into. Even if you have Wills and/or Trusts to handle the distribution of your assets at death, your membership interest in the LLC must be properly handled. Use of a Living Trust as a designated member is the best option.
Amendments to and Upkeep of your Operating Agreement
Even if you are simply interested in maximizing your asset protection, you should routinely review your operating agreement to ensure it accounts for the way you currently operate your business. Changes in your business may not necessarily be in writing and can take time to actually consolidate and transfer to your LLC, but your operating agreement needs to have awareness of such changes so that the information within it is consistent with the way you actually run your business. From an asset protection perspective, you should maintain a current operating agreement that at least generally describes when profits will be distributed and who will manage the property. Ideally, you should be using your LLC to enter into all agreements relating to your rental properties, including management agreements, service agreements, and tenant leases. These agreements should include a provision indicating that each agreement is with the LLC only, and the member or principal is not personally liable under the agreement.
FAQs for Rentals and LLC Operating Agreements
How much are the legal fees to draft an LLC Operating Agreement?
This is probably the most popular question I hear on this blog (outside of everyone asking for recommendations, of which there are none in this post, sorry). Every legal professional in the world will cost different, but you should expect to pay between two and ten times your state’s filing fee for a single member or a two member LLC. If you are a larger multi-member LLC, the rate might be more like six to twenty (or more).
Do I need to change my LLC Operating Agreement every time a new member joins?
No . In fact, you don’t need to change it at all when a new member joins. The requirement that you do this would be included in the agreement.
Should I use templates or generic LLC Operating Agreements?
As a rule of thumb, templates are a horrible idea. Many legal clients using generic operating agreements are surprised that their LLC doesn’t work like it should. Fortunately, there are a wide range of business entities that can accomplish real estate investment goals. Some LLCs are better than others, especially for investors. Talk to your attorney as to the best entity for your investment purposes.