What Is the Purpose of an Operating Agreement?
It is critical to your new real estate limited liability company that you, as the organizer, have a sound and comprehensive operating agreement in place. The operating agreement serves to define the responsibilities of the various members, set out a management structure and provide for a mechanism to handle conflict. Accordingly, the operating agreement for the real estate LLC or LLCs should be drafted by professionals with expertise in real estate, limited liability companies and complex business transactional agreements, especially since the initial stage of organizing your real estate LLC involves careful examination and analysis of the applicable federal tax code . At this stage, the draft created by your professional is checked against the federal tax code and revised, if necessary. This will ensure that your LLC will be classified by the IRS as a partnership, allowing you to take advantage of the tax benefits of pass-through entities. However, the drafting process does not end there. After the draft operating agreement is complete and reviewed, it becomes the subject of constructive deliberation between you and your attorney. Once the final version is approved, the operating agreement becomes the governing tenets of your new real estate LLC.
The Main Elements of an Operating Agreement
Every operating agreement should include key components that will define the relationship between the members of your real estate LLC. The following is a list of some basic components that will be necessary to ensure you have adequately covered each member’s rights and responsibilities in your LLC:
Member Contributions
All contributions that each member is providing must be specified in the operating agreement, and the relative percentage of the contribution for capital duties must be set forth, unless the contributions are equal. If the contributions vary from one member to another, then the amount contributed for capital duties must be specified generally, and any specific allocations mentioned.
Voting Rights
The voting rights of each member must be specified. The law provides a default rule for voting rights if there is no other specification. Normally, unless there is some other provision, each member has voting rights based on their share of ownership in the LLC. If the members are going to divide up certain responsibilities, such as corporate or bookkeeping duties, then those people should be given more shares, and an unequal split of the voting rights needs to be specified in the operating agreement.
Preferred Return, Distributions and Allocations
If your LLC will be taking on investments, then there needs to be a provision for how preferred payments will be made to investors. There should be a schedule set forth outlining the preference of payments to limited partners. Any distributions made to limited partners will be made on particular dates requested by those investors, after first paying the preferred payment.
Management
There must be a specified section in the operating agreement to set a timeframe for the managers to manage the real estate owned by the LLC. There should be a time period that is usually 4-7 years, at which point the LLC should be terminated, and the property sold off to the members. There is no prohibition on managers serving terms indefinitely, but if they are elected for a specified term, then the managers can still serve after the expiration of their term unless they are removed by the members.
Limiting Manager Liability
The manager’s liability should be limited, to limit the extent to which the manager is liable for the debts of the LLC. Normally, the managers will not be held personally liable for the debts of the LLC, unless they engage in conduct viewed as grossly negligent or fraudulent.
How to Create a Customized Real Estate LLC Operating Agreement
The following steps will help you create a personalized operating agreement for your real estate LLC. Keep in mind that while some things are common between all LLCs, real estate companies have unique considerations that could affect the terms you set. For example, what properties do your members currently own, how often do they buy and sell new properties, and will members be able to serve as property managers?
Addressing these considerations beforehand is essential to keeping the owners happy, because an operating agreement lays out the expected contributions to your company, and the expected distribution of profits to each member.
Set Investment Amounts
An investment schedule specifies how much money various members will contribute to the real estate LLC. For example, member A may own several rental properties before starting the LLC, and plan to contribute these properties. Member B might not own any rental properties, preferring to invest a certain sum of money into the LLC. The operating agreement should specify how much cash and assets each member will contribute as well as the value of any property each member already owns and plans to contribute to the LLC.
Convey Real Estate Title
Some members may own rental properties before starting the LLC. An operating agreement should describe how contributed property will affect the members’ ownership roles in the real estate company.
An LLC is usually owned by the members together, meaning profits from selling company property will be shared equally. If a property is owned by a member before the formation of the LLC, only that member has legal title to it. You should explain how such property will be handled in the future. A member might own 60% of a rental property prior to the formation of the LLC, but once the property is conveyed to the LLC, the proceeds of any property sales will be split equally between the members.
Address Property Management
Depending on everyone’s skill level, you may want to hire a property manager, or members who are more familiar with working with tenants might take on property management roles and simply hire an accountant to handle taxes and finances. An operating agreement will help clarify the roles everyone plays so that you can avoid family disagreement and misunderstandings within the company.
Limit Membership
Diversity of skills is one of the best things about forming a real estate LLC, but you should still limit membership to that which is necessary. It is a good idea to set a maximum number of members as well as a maximum number of members who can manage properties.
Establish Guidelines for Selling
You may have members who want to sell company real estate as soon as they become moderate income properties. Others may want to hold company real estate for a longer period to make more money from it. You should try to set reasonable limitations on company assets to keep members happy, and avoid losing the faith of the ones who do not yet see the full potential in a property.
Legal Issues and Formalities
When drafting an operating agreement for a real estate LLC, it is imperative to consider relevant legal requirements and compliance issues. All states have carve outs in their corporate codes that define the personal and inter-member relationships of LLC members. For these reasons, the operating agreement should be drafted with legal counsel that can ensure all state laws are adhered to.
In addition, different case law from various states should be researched to ensure that any creative provisions of the operating agreement are legally permissible. This research can be crucial in drafting, as some legal provisions may be disallowed by certain state laws, but must be adhered to if incorporated into the operating agreement.
The most common legal requirements of an operating agreement include:
Mistakes to Avoid When Crafting Operating Agreements
When drafting an operating agreement for a real estate LLC, it’s crucial to steer clear of several common pitfalls to ensure its efficacy. The first major mistake is the omission of the agreement itself. While in some states this is not actually required, in the vast majority, a written operating agreement is what sets a limited liability company (LLC) apart from any other type of unincorporated association. A lot of business owners think that simply filing the Articles of Organization with the state is sufficient. In most cases, however, this is only the first step in starting an LLC. Check your state laws to find out whether or not an operating agreement is required and do not forget it. It’s especially important if you have multiple owners of the business.
Next, you should avoid creating terms that favor one member over all others. For instance, you should never create terms that allow one or more members at the expense of minority owners. This will make the majority owner or owners, or "managing members," legally liable for any debts or obligations for which the members are not legally responsible. In case of bankruptcy, creditors can go after the personal assets of the managing members. To protect yourself, your family members and your business, make sure that the operating agreement you create treats all interested parties fairly.
Another common issue when creating operating agreements for real estate LLCs is failing to account for the unexpected . Plan for all possible contingencies and describe how any severe changes to the business will be handled. For example, what will happen if a member becomes permanently disabled? What if one member wants to leave the business or unexpectedly dies? How could that impact the finances of the company? When you take the time to plan for these and other eventualities, you can avoid ending up in court to settle the dispute. You can usually avoid having the court decide the outcome by creating an operating agreement that includes an arbitration agreement or a buyout clause.
In addition to the above mistakes, it’s important to update your operating agreement when needed. Outdated operating agreements can provoke conflicts between members and open the door to disputes. However, keep in mind that when drafting an operating agreement, you need to include a clause that stipulates how and when the agreement can and cannot change. For example, what if three of the five members want to update the operating agreement, but the other two are opposed to it? If you don’t include how the operating agreement may be amended, such conflicts could lead to lawsuits. To avoid this possibility, include the specific requirements for amending the agreement in the document. These four "don’t make these mistake" tips should help you successfully draft an operating agreement for your real estate LLC that will protect you and other members and avoid problematic situations.
Changing an Operating Agreement for the Future
In a rapidly moving industry like real estate, watch for changes in your market that could impact how your LLC is managed. For instance, if warehouses in your area are beginning to be converted into apartments or retail space, both the market demand and associated legal considerations of your LLC will change as a result of that trend. It is important to update your operating agreement to account for such changes. The same applies to venturing out into different types of investments you have not tackled before.
If your LLC has become more successful as the real estate market has matured, you may want to bring in new members who can help your organization reach the next level. Since the operating agreement reflects the type of relationship that members have with your LLC, it must be updated if new members are brought on board. This scenario also highlights the fact that when members decide to leave, it is often necessary to update the operating agreement in accordance with the terms of their departure.
All these scenarios highlight the need to review and update your operating agreement on a regular basis as your LLC evolves over time.
Examples of Effect Operating Agreements
1. The Tennessean & the Mom
Tennessean Gretchen Emberton formed TN Horse Shows LLC with her teenage son, Garrett. Gretchen and Garrett lease Horse Show Grounds on an annual basis, and then they turn the 13-acre lot into an event space. The not-for-profit Shows for Horses of All Breeds are held in March, and the UTHS World Championship Paint Horse Show is in May, while fundraisers are held throughout the year.
Gretchen and Garrett both serve as managing members. The LLC agreement designates a specific process for selling membership interests if negotiations have not been completed within 60 days of a member deciding to leave the company. And in the event of the death of a member, the agreement specifies the surviving members must purchase the membership from the deceased’s estate at fair market value, which means an appraiser will be called in to value it.
Gretchen and Garrett put a lot of thought into the language in the operating agreement for their LLC, and though not required, they have consulted with an attorney during this process.
2. A Chicago-Bound LLC
The Troupe LLC is based in Chicago and is in the business of publishing picture books. The Troupe’s publishing company sells books of origami and haiku e-book and hardcover formats to libraries, schools and bookstores.
The Troupe Manager publishes all of the books that the Troupe has under contract and manages the dealings with schools, bookstores and other end users.
The Troupe Manager is managed by three members: the founder, the administrator and the accountant. Members take part in the decision-making process at meetings every other month. Members must agree unanimously to add anyone to the LLC or remove members. To fulfill its mission, The Troupe LLC comes up with a plan of action. It outlines what it wants to accomplish , such as getting its books into school and library systems. The Troupe LLC has a two-page, one-year strategic plan that outlines how it will continue to grow.
The members of The Troupe LLC meet with an accountant annually to ensure it is staying on track with its strategic plan.
3. LLC Hires Six Managing Members
A Utah-based real estate company has six members who own the company. The LLC agreement for the real estate firm allows for one of the members to nominate someone from the real estate industry to come on board as a seventh active managing member.
The active managing members will each receive salary and bonuses. The bonuses are calculated based on the profits that the LLC receives from its work. The LLC members understand that bonuses may not be high in certain years or may not be paid at all. In such an event, it has been agreed that the managing members cannot sue or otherwise seek damages from the remaining members, the LLC or its manager.
All but a very few major decisions require a vote by all the active and inactive members, which include:
- Purchase, sale, lease, mortgage or transfer of a substantial portion of the assets of the LLC
- Merger, consolidation or other conversion of the LLC
- Dissolution of the LLC by a member
- Entry into a level III or level IV investment.
If any of the above actions are to be considered, the inactive members wish to approve or disapprove the decisions. Level I investments are those that are core to the LLC. Level II investments are those that have a major impact on an organization’s long-term performance. Level III investments are those that require significant management efforts. Level IV investments have a low impact on bottom-line performance and require little/no senior management effort.
