California limited liability company operating agreements would appear to be a simple topic at first glance. Alas, one should never underestimate the ability of the drafters of laws in California to make errors and overcomplicate the issue at hand. In this post, we explore the necessity of operating agreements for California limited liability companies and the different types of agreements.
California LLC Law Update
State law controls most aspects of the limited liability company. People assume these entities have existed for hundreds of years, but Wyoming was the first state to enact legislation allowing for the creation of a limited liability company and that Act – the Wyoming Limited Liability Company Act – only came into existence on March 4, 1977.
The limited liability company concept was so new that the IRS didn’t have a clue as to handle the business entity and more than a bit of chaos ensued when companies attempted to pay taxes each year to the federal government. Fortunately, states and the federal government now all acknowledge this relatively new business entity and have laws in place to govern it.
California enacted the Beverly-Killea Limited Liability Company Act in 1994. The “Bev” legalized the entity in California but created as many problems as it solved. California has a history of enacting legislation in new matters that is, how shall we say this, “challenged.” For example, the state once passed a law against revenge porn, but exempted selfies. [Selfies make up 80 percent of all revenge porn cases.]
A. New California LLC Law
California enacted the California Revised Uniform Limited Liability Company Act, which became effective on January 1, 2014. The new law replaced the Beverly-Killea Act in its entirety. In enacting the new law, the legislature sought to address several issues that were causing consternation in the legal field and courts. Topics such as the duties owed by members in a member-managed company versus a multimember-managed company were clarified to resolve competing court interpretations.
When considering operating agreements for your California limited liability company, the critical thing to remember is you should look to the California Revised Uniform Limited Liability Company Act. If the founders formed the company and agreement before 2014, then you may need to consult with an attorney to determine if any aspects of the previous law still apply.
Does California Require An LLC Operating Agreement?
Does a California LLC need an operating agreement? Ah, the California legislature strikes again. The 2014 Act does not contain language requiring a company to form one. However, the language of the code seems to assume the founders will negotiate an agreement. For example, California Corp Code Section 17701.10 states the following:
“(a) Except as otherwise provided in this section, the operating agreement governs all of the following:” [list subsequently provided]
As if the drafters hadn’t created enough confusion, they went on to define “operating agreement” to mean anything short of a meaningful look between two or more people:
“(s) “Operating agreement” means the agreement, whether or not referred to as an operating agreement and whether oral, in a record, implied, or in any combination thereof, of all the members of a limited liability company, including a sole member, concerning the matters…”
[California Corp Code Section Section 17701.02(s).]
Now, before you get too excited, forming an “oral” or “implied” operating agreement is a poor option. One of the critical functions of these agreements is to address how members will resolve member conflicts. Memories fade quickly. If a dispute develops between the members, it is unlikely they will share the same recollection of the agreed upon original resolution process, which will ratchet up the conflict as each member thinks the others are trying to rip them off.
The California legislature did a poor job of drafting the 2014 Act. Don’t follow them down the rabbit hole. Anyone who does so is inviting chaos. Founders should always negotiate an operating agreement and put it in writing before launching an LLC.
California Single Member LLC Operating Agreement
One might find a single member LLC operating agreement to be an odd item. After all, why would you need one? Surely the individual member isn’t going to start arguing with themselves over how to run the company.
Well, an operating agreement does serve a purpose in this scenario. A properly drafted operating agreement can assist with preventing third parties from making successful alter ego claims against the entity. As with corporations, the single-member LLC provides a shield between the liabilities of the business and the personal assets of the owner of the company. The alter ego theory states courts should set aside this protection when the failure to do so would create an injustice so long as the party claiming the alter ego meets a two-prong test.
The California Supreme Court set out the two-prong test in a 1985 case known as Mesler v Bragg Mgmt. Co.:
- That there be such unity of interest and ownership that the separate personalities of the corporation and the individual no longer exist, and
- That an inequitable result will follow if the court treats the companies acts as those of the company alone.
A single member of an LLC must be very careful with the first prong of the test. It can be easy for the member to mix personal conduct, assets, and finances in with company business. In doing so, the member provides an opposing party with leverage to assert the alter ego claim. If the opposing party can show a pattern of mixture between the individual and company, then the alter ego claim has a better chance of sticking.
a. Single Member Operating Agreement
What does any of this have to do with an operating agreement? An operating agreement for a single member LLC can act as evidence that a “unity of interest and ownership” between the LLC and member does NOT exist. When properly drafted, the operating agreement can be positioned not as one member agreeing to rules with themselves, but as one owner agreeing to a set of governing rules with a separate stand-alone business entity. By crafting this relationship with an admittedly fictional “person,” a party trying to set aside the LLC under an alter ego doctrine is going to have a much harder time convincing a judge to take such action.
A second reason exists for creating an operating agreement where only one owner exists. California law looks kindly upon single ownership of this class of companies. Other states may be less forgiving. It is a rare company that does not conduct business in multiple states in this Internet age. Just because you’ve formed an LLC in California does not mean that you will not be dragged into court in another state should a dispute arise. What if the opposing party files a lawsuit in Florida, and the laws of Florida are stricter than those in California? An operating agreement is going to provide legitimacy to your limited liability company and may well be the piece of evidence that prevents a successful alter ego claim.
In summary – yes, an operating agreement for a single member LLC sounds like an odd bird, but it serves a critical purpose. Get one!
California Multi-Member LLC Operating Agreement
The purpose of an operating agreement becomes apparent when we turn to the multi-member LLC. The essential characteristic of this entity is multiple owners are forming the entity – known as members. The question then becomes how the members will configure the organization and run the business over time? The company needs a set of rules. The owners negotiate a deal and then draft an operating agreement incorporating the rules. The agreement can cover a wide variety of issues, but always includes the following:
- Who will manage the company;
- Member meeting procedures;
- Member voting rights;
- Appointment of officers;
- Economic and distribution rights;
- Classes of interests;
- Member withdrawal from the company;
- Transfers of interest;
- The companies favorite superhero [just making sure you are paying attention];
- Admission of new members;
- Capital requirements;
- Tax designation; and
- The dissolution of the company.
Allow me to state this as clearly as possible. An LLC with multiple owners should have an operating agreement in place before you launch the company. It is much easier for members to negotiate tricky issues when the company isn’t yet functioning versus when it is. Trust me on this one.
California Manager-Managed LLC Operating Agreement
A California manager-managed LLC operating agreement serves the same purpose as an agreement for a multi-member organization. However, there is one significant difference – the management of the company.
California sets specific defaults for limited liability companies. In the case of a multi-member founders group, the law automatically designates each member as a manager of the company. This designation can be problematic because allowing each member to, oh, sign contracts with third parties can lead to a host of legal and financial problems. One member might agree to a deal on the spot that might violate the language of another contract the company has entered. The members should tightly control the decision making power and, particularly, the authority to bind the organization contractually. You can accomplish this goal by creating a single manager position in the operating agreement.
According to California Corp Code Section 17704.07(a), members can convert the company to a manager-managed LLC by adding a section to the operating agreement indicating as much. The manager does not need to be one of the members. You should be clear that once a manager is designated, the members no longer will have the ability to act on behalf of the LLC. The members, however, can decide to replace the manager.
Members do not always need a manager-managed designation for an LLC. If you do, however, make sure your attorney adds the appropriate language to the operating agreement.
California Real Estate LLC Operating Agreement
The LLC has become the entity of choice for holding real estate in most states. A deep dive into the benefits of this choice is beyond the scope of this article, but one can generally say investors prefer LLCs because of the pass-through taxation and asset protection benefits.
Of course, these benefits only exist if a lawyer drafts the operating agreement correctly. The tax designation is of particular concern. Many people understand founders can designate an LLC as a corporation, partnership, or sole proprietor for tax purposes depending on the makeup of the members. The tax designation becomes a bit trickier with real estate investments because one often runs into scenarios where a married couple, for example, might be the members. Should the couple designate the entity as a sole proprietorship for tax purposes? A partnership? The operating agreement needs to reflect the answer to this and other questions to position the company to maximize the benefits to the real estate investments.
Common Operating Agreement Questions
A. Does A California LLC Operating Agreement Need To Be Filed?
Nope. The operating agreement is an internal document of the company. You do not file it with the state.
B. Can You Amend An LLC Operating Agreement?
Yes. The initial operating agreement should set forth a method for amendments.
C. Can I Write My Operating Agreement?
Yes. You can also conduct surgery on yourself. Is either action advisable? No. Both are likely to result in significant pain. An operating agreement governs the daily operations of an LLC and must contain particular provisions required by law. Do you really want to “wing it” with such a document? If you contradict language you’ve included in the operating agreement, a party suing you will have a much better chance of arguing the company should be set aside as a sham. Cutting costs is natural when launching a business, but this is one area to spend the money to get the document prepared correctly.
D. Does The Operating Agreement or Articles of Organization Control?
The incorporator or the founders will file Articles of Organization with the California Secretary of State to register and launch the company officially. The operating agreement is a separate document the founders negotiate. If the two documents conflict, which one prevails?
To their credit, the drafters addressed the issue in the California Revised Uniform Limited Liability Act, specifically Corp Code Section 17701.12(d). The operating agreement metaphorically outranks the Articles of Organization and controls in any conflict.
LLC Operating Agreements – Other States
Given the length of this article, I would be remiss if I didn’t again mention that state law controls the functioning of an LLC. California law is the basis for this educational article. An LLC formed and run in another state would be subject to the laws of that state, not California. This fact is particularly true for operating agreements, which state law controls completely.
The limited liability company is a flexible and popular business entity. If you form this entity, make sure your California limited liability company operating agreements are in writing and appropriate for the members and business model.
Contact me for assistance today.
Richard A. Chapo, Esq.