Earlier I wrote a quick post praising the ease of use and overall utility of Filing In Oregon, the Oregon Secretary of State’s online portal. While it is an incredibly useful tool, a word of caution: it is not a one stop shop for setting up your new business. There are other important regulatory, tax, and legal concerns that, if mentioned on the site, are not fully addressed nor resolved. An area of particular concern is partnership disputes. A full-blown legal dispute between partners is costly and detrimental to the business, clients, partners, and pretty much anyone else involved. The single most important thing that you can do to avoid and quickly resolve a dispute is to document the relationship between the partners before any dispute occurs. Since the entity of choice for most new businesses is the LLC, a few quick words on operating agreements.

Operating agreements are like the bylaws of a corporation and govern any number of things related to formation, operations, and closing the business, as well as relations between partners (members) in an LLC. ORS Chapter 63 contains default provisions that control in the absence of an agreement to the contrary, possibly to your detriment. Thankfully, most of these provisions are freely modifiable and superseded by a well-drafted operating agreement. So, what should your operating agreement contain?

At a minimum, your operating agreement should address the following:

  1. Management – Member or manager managed? Most LLCs are managed by active members, but companies with passive investor members will often prefer a manager-managed company that behaves more like a corporation or limited partnership.
  2. Contributions – Value and detail each partner’s contribution. Active participation in a limited liability business without any contribution is a classic fact pattern for piercing the veil.
  3. Distributions and Compensation – How much money does each partner get? When? How? Check with your CPA concerning the tax implications of your decision.
  4. Valuation – Book value? Fair market value? How many intangible assets does your business have? Agree ahead of time when, and if, experts will be used and how they will be paid.
  5. Partnership Accounting – What standard will you use for capital accounts: GAAP, tax basis, IRC § 704(b)? How will you comply with Treas. Reg. § 1.704-1(b)(2) (substantial economic effects test for allocation of income, losses, and other items): deficit restoration obligation (DRO) or qualified income offset (QIO)?
  6. Duties and Conflicts – The duties of loyalty and care are required by default and they may be modified, but not entirely eliminated.
  7. Buy Outs – Do you want a push/pull agreement? If not, how will you handle deadlock? If so, should this provision have a limited duration? Should it be re-negotiated or eliminated at a later date once the business matures?
  8. Entering and Exiting – Can new partners join? How? Is a partner’s interest transferable in whole or in part? Can a partner be expelled? How?
  9. Disputes – What is the general dispute resolution process, when is it triggered, and what happens if it fails to achieve resolution?

By having an open and honest discussion of these issues with your partners and documenting your plans in an operating agreement, you will greatly reduce the likelihood of a dispute and, if a dispute occurs, it is more likely to settle before costly litigation.

IRS Circular 230 Disclosure: Any tax advice contained in this communication is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code or promoting, marketing or recommending to another person any tax-related matter.