One question we commonly receive from small business clients is, "Why does my single-member limited liability company (LLC) need an operating agreement?" To answer this question, we will briefly take a look at the California Revised Uniform Limited Liability Company Act ("RULLCA"), then address possible reasons why an operating agreement may be beneficial.
Unlike its' predecessor, the Beverly-Killea Limited Liability Company Act ("Beverly-Killea"), RULLCA defines an operating agreement as an "... 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..." In other words, an operating agreement can exist to govern the activities of the LLC, even when there is only one member.
Even though RULLCA provides a set of default rules to govern an LLC, there are quite a few reasons why a single-member limited liability company should still adopt an operating agreement. Three of these important reasons are discussed below.
1. Clarify Management Structure
The California Secretary of State's form Articles of Organization (Form LLC-1) requires that the entity's organizers specify whether the entity will be managed by: (i) one manager, (ii) more than one manager, or (iii) all limited liability company member(s). Under Beverly-Killea, the designation of the LLC as manager-managed in the Articles of Organization was adequate in determining the management structure of the LLC. However, RULLCA states that regardless of the organizer's specification on the Form LLC-1, if the operating agreement is silent on the management structure, the limited liability company will be deemed to be managed by its members. (Corp. Code § 17704.07(a)).
Of course, this change can cause confusion for entities originally organized under Beverly-Killea or for LLCs without an operating agreement, so the creation of an operating agreement can solve any ambiguity for a single-member LLC.
2. Separate the Business From the Individual
As we've noted on this blog before, one of the primary benefits of a limited liability company is the protection of the individual member(s) from personal liability. However, a member of an LLC can be subject to liability under the common law doctrine of "alter ego liability." (Corp. Code § 17703.04). In plain terms, a court can disregard the corporate structure of the LLC and treat the obligations of the company as those of its owners if necessary to protect the rights of third parties and to accomplish justice. (See Minton v. Cavaney (1961) 56 Cal. 2d 576). This common law cause of action will often be alleged by a plaintiff when a claim is asserted against the company and there is some possibility that the company will not be able to satisfy a judgment because it allows them to "pierce the corporate veil" and pursue the personal assets of the company's members.
To avoid potential alter ego liability, LLCs should establish internal controls to prevent the intermingling of personal and business funds and should follow normal corporate procedures. (See McKee v. Peterson (1963) 214 Cal. App. 2d 515, 530-31; Riddle v. Leuschner (1959) 51 Cal. 2d 574, 581). One way a company can establish such procedures is by adopting an operating agreement. In general, an operating agreement sets forth the rules by which the business will be governed. Although many single-member LLCs see this additional layer of governance as unnecessary, it serves an important purpose of separating the corporate entity from the individual owners.
3. Plan For Future Growth
Although many small business owners don't initially plan on taking in investors, future business growth can change their plans. An operating agreement will address how these future members will be treated, including their voting rights, dilution rights, the transferability of their membership interests, and so on. Before a company ever considers taking in another owner or investor, an operating agreement is an absolute must.
As a single-member LLC, adopting an operating agreement is easy (as it only requires your signature) and can save quite a few headaches down the road. While it may seem unnecessary today, don't be fooled - it's an integral part of your protection as a business owner.
Ben Schwefel is an Associate Attorney at The Loftin Firm. For questions relating to a corporate governance, estate planning, or real estate matter, contact Ben at (760) 814-9649.