Limited Liability Company

You may have heard this before, but LLCs are creatures of contract. It is critical for LLCs to understand the statutory defaults and protections (or lack thereof) so members and managers may comport themselves in a way that protects themselves, and the company, and in a way that is consistent with their desires for the operation of the entity.

So what statute are we dealing with?
While there are a few exceptions, after January 1, 2016, the 2014 Utah Revised Uniform Limited Liability Company Act, Utah Code Ann. § 48-3a-101, et seq., (the “2014 LLC Act”) will govern all Utah LLCs as well as all foreign LLCs qualified to do business in Utah, replacing the Utah Revised Limited Liability Company Act (the “Old LLC Act”). Prior to January 1st, 2016, the 2014 LLC Act will govern those LLCs organized after January 1, 2014 and those that have elected to be governed under the act that was organized prior to January 1, 2014. So while there are two LLC acts that are effective currently, that will end in a few short months.

The verbiage
Just as a matter of house-cleaning, let’s get some of the verbiage out of the way that commonly trips up young companies. Many people are familiar with the common terms in corporations, so I will use these terms as a comparison. In corporations the equity holders of the Company are called shareholders and the securities they possess are called shares or stock. Corporations are governed by management: a CEO, a president, a vice president, etc. Additionally, corporations are required to have a board of directors. The board of directors allocates capital, and selects and oversees management, while the management team, well, they “manage” the everyday business affairs of the corporation. There are some actions upon which management must receive approval from the board of directors, and some things on which the corporation must receive shareholder approval. On a very high-level, this is how a corporation functions.

By contrast, in an LLC the equity holders are called unitholders or members and the equity they possess may be called an interest which is represented in percentages or may be referred to as a unit. The governance of LLCs is only generally specified by the statute and is more fully described in the Operating Agreement. LLCs do not typically have the management and board dynamic, although it is possible to set up a similar structure. All LLCs have members and by default an LLC is member-managed, unless the Operating Agreement expressly provides otherwise. This is an important default rule to note.

Member-Managed LLCs
Under the 2014 LLC Act, all LLCs are member-managed by default.2 But what does member-managed mean? Does it mean that each member can bind the Company in a transaction? Does it mean that a majority vote must be taken? Let’s look at the statute to let our confusion set in a little bit more.

The 2014 LLC Act specifically states that in a member-managed LLC “each member has equal rights in the management and conduct of the limited liability company’s activities and affairs.” However, the 2014 LLC Act also states that “A member is not an agent of a limited liability company solely by reason of being a member.” And finally the 2014 LLC Act states that: “[a] difference arising among members as to a matter in the ordinary course of the activities of the limited liability company shall be decided by a majority of the members;” and “[a]n act outside the ordinary course of the activities and affairs of the limited liability company may be undertaken with the affirmative vote or consent of all members.” Ok, well at least we know that unusual activities require a unanimous vote of members, but what about activities in the ordinary course of business? The 2014 LLC Act seems to say that all members have equal authority, but no members have authority just by being members. Hmm. There’s a bit of space for conjecture in there. I’ll talk about the filing of a statement of authority in a section below, but barring the filing of this document, can one member of a member-managed LLC just enter into a contract that binds the company? Most likely the answer is no, but you can see how there is some confusion in this area. The filing of the statement of authority, as discussed below would help this tremendously, but for even greater clarity, even a member-managed LLC should spell out who has authority to do what, and how in the operating agreement. And be prepared for persons dealing with your LLC to ask for proof of your authority to act.

Manager-Managed LLCs
Complexities arise as the number of members increase, and complexities or conflicts may by virtue of the fact that some members may be more involved in the Company than others. Therefore, LLCs may want to consider whether the structure of a manager-managed LLC would more appropriately suit their potential for growth. In manager-managed LLCs the managers typically act like management of a corporation. The Manager is exclusively in charge of the activities and affairs of the LLC, or if there is more than one Manager, the activities are typically handled by a majority vote of Managers. Just as in member- managed LLCs, in manager-managed LLCs members are still required to approved mergers or other activities outside the ordinary course of business. Additionally, the Operating Agreement may not be amended without the approval of the members.

Nothing is certain except death and taxes
One of the reason founders choose the LLC format is for tax purposes. People often refer to corporations as having “double taxation.”

That term means that corporate income is taxed twice: once to the corporation itself, and again to shareholders when earnings are paid-out as dividends. However, this is only true for earnings that are paid. In closely held corporations a difference between earnings and distributions rarely occurs because these small corporations rarely pay out dividends. Rather, corporations usually choose to pay salaries to employees or wages to consultants, which are deductible as ordinary business expenses, and therefore avoid corporate taxation.

Aside from the double-taxation concern, there are still good tax reasons to adopt the form of an LLC. LLCs are pass-through entities, meaning that losses too are passed on to individual members in their personal capacity. Early stage founders may know that the first year or two may produce losses and may wish to be able to deduct those losses on their personal taxes.

S corporations are also pass-through entities and may be more favorable then an LLC, but there are many limitations on S corporations including the number and type of shareholders and the unavailability of preferred interests, which we won’t get into, as that entity choice is beyond the scope of this article. LLCs may have as many members as they would like and can also have preferred interests and participating debt.

Profits and losses can be both allocated and distributed. These are different concepts and taxable income without cash to pay tax is never pleasant. The important thing is that with proper planning, alternatives are possible that would not be self-evident to the lay person.

Taxation of LLCs and Corporations are complex enough, and founders’ personal estates may be complex enough that advice from a tax professional may be warranted.

Governing Documents
In a limited liability company, the entity must only file with the State a short certificate of organization. What’s interesting is that, under the 2014 LLC Act this certificate no longer specifies the management structure of the LLC, as was done under the Old LLC Act. This is an interesting wrinkle because third-parties and banks may not know if they are dealing with an authorized party or not when entering into transactions with an LLC (see the complexity mentioned previously in the member-managed section). The 2014 LLC Act attempts to resolve this dilemma by allowing for a Statement of Authority to be filed with the Division of Corporations that identifies the managers or members with authority to act on behalf of the LLC (including any limitations on authority, such as the ability to transfer real property). This Statement of Authority may also be filed with the County Recorder in which the LLC owns real property and this certified copy is conclusive. Therefore, any third-parties may want to search for a Statement of Authority at both the Division of Corporations and the County Recorder’s office to ensure they are conducting business with an authorized representative of the LLC. Kind of a mess.

Beyond the required Certificate of Organization and the optional Statement of Authority, there are no requirements for documentation for an LLC. While corporations must file Articles of Incorporation and internal By-Laws, each of which can be lengthy and complex, the lack of required documentation for LLCs is a draw for many young companies. However, the reference that LLCs are “creatures of contract” refers to one specific document—the Operating Agreement—and remarkably, this is not filed with the State but is internal to the Company and its members and managers. This is the contact to rule them all. Anything and everything related to the structure and management of the LLC can be and should be in this document. Under both the Old LLC Act and the 2014 LLC Act the Operating Agreement addresses everything from tax structure, to management to the winding up to allocation of profits and losses. Some of these items have default rules under both the Old LLC Act and the 2014 LLC Act, but making sure you are choosing and documenting the right rules for your LLC is critically important.

Oral Operating Agreement
One interesting development in the 2014 LLC Act is the recognition of “oral operating agreements.” While oral operating agreements and amendments are authorized, you can see that these types of agreements are much harder to enforce than a signed document.

The Utah evidentiary rule is by a “preponderance of evidence”—which means that more than 50% of the evidence points one way or another. If you have a two member LLC and both members agree that the members should waive fiduciary duties to the highest extent of the law, would you be comfortable knowing that without documentation it may be your word versus the other member’s word? So while the prospect of oral operating agreements may have the potential to protect those that haven’t gotten around to documenting their decisions, it is much safer and more advisable to have a written and adopted operating agreement.

Fiduciary duties
Fiduciary duties are legal obligations imposed on those who manage a business to act in the interest of the entity or the interest of the owners of the entity. The scope of these duties changes from state to state and between different entities. However, fiduciary duties usually include the “duty of care” and the “duty of loyalty.” A third duty of good faith and fair dealing is also described by writers and court cases.

The Old LLC Act adopted these two basic fiduciary duties for persons who manage or control LLC’s—the duty of care and the duty of loyalty. The duty of care under the old LLC act requires members and managers to expressly refrain from gross negligence and willful misconduct; additionally, higher standards could be enumerated in the operating agreement or articles of organization. The Old LLC Act also defines the duty of loyalty as refraining from any self-dealing. These duties cannot be reduced or eliminated under any governing documents of the LLC; however the obligation of good faith and fair dealing may be redefined by members in a written agreement if the standard is not unreasonable.

Under the 2014 LLC Act, managers and members owe a duty of care which is defined as refraining from grossly negligent or reckless conduct, intentional misconduct or knowing violation of the law. The 2014 LLC Act also imposes on managers and members the duty of loyalty which includes 1) accounting to the LLC for any benefit received by a member or manager in the winding up of the LLC’s affairs, from using the LLC’s property, or from usurping business opportunities that should go to the LLC; 2) refraining from working with persons

whose interests are adverse to the LLC in dealings with the LLC; and

3) refraining from competition with the LLC prior to dissolution. What is interesting and complex about the 2014 LLC Act is that these duties may be altered or eliminated in an operating agreement so long as such alterations or eliminations are not unconscionable or against public policy and assuming the operating agreement does not authorize intentional misconduct or knowing violations of the law. Additionally, the operating agreement may not waive liability for conduct involving bad faith, willful misconduct or recklessness. Many commentators have noted that this portion of the 2014 LLC Act seems unclear and may allow for an uncomfortable amount of leeway on behalf of judges to hold management liable for misconduct that the LLC had intended to eliminate. Here, again, advice of a legal advisor may be desirable before adopting or changing rules of conduct.

Conclusion
This article barely scratches the surface of important things to know about LLCs. The intent is to give you enough information to help you understand that this area of law is complex and engaging counsel who is intimately familiar with this area of law is well worth your time and money. It is much easier to build a sturdy foundation at the start of an LLC than to clean-up the ill-begotten LLC. But don’t let that stop you from cleaning up your LLC either!