ORGANIZING AN LLC
HOT TOPICS IN DRAFTING AN LLC OPERATING AGREEMENT
Joseph D. Masterson
Many of the most important considerations for drafting an LLC operating
agreement are not new, but they continue to be extremely important for the Wisconsin
practitioner. In addition to those continuing topics, recent developments in Wisconsin
case law and a new tax withholding requirement for LLC members who are not
Wisconsin residents have changed the legal landscape for LLC operating agreements.
Topics Warranting New Emphasis
1. Conflict of Interest/Voting Rights/Fiduciary Duty Provisions
The Wisconsin Supreme Court Decision in Gottsacker vs. Monnier, 281 Wis. 2nd
361 (2005) provides a number of insights into the ways Wisconsin courts are
likely to interpret both the LLC law and the provisions of an LLC’s operating
agreement. In particular, the Supreme Court held that the obligation of LLC
members and managers under Section 183.0402(1) to “deal fairly” with the
limited liability company and its members in connection with any matter in which
the member or manager has a material conflict of interest involves both a fair
result and a fair process, which the Court said were “intertwined.” It also
indicated that a member or manager has not dealt fairly if an action or inaction
causes injury in light of both the purpose of the limited liability company and the
justified expectations of its members.
The “fair result” part of the opinion suggests that objective evidence of fairness,
such as third party appraisals or fairness opinions, can be very helpful in an
appropriate situation. For purposes of drafting an LLC operating agreement, the
emphasis on a “fair process” suggests that an LLC action is more likely to be
upheld if there has been reasonable notice and an opportunity for the minority
members to be heard in connection with any transaction involving a material
conflict of interest. The emphasis on the purpose of the LLC and the justified
expectations of its members suggests that these points should also be clearly
described in the operating agreement.
2. Authorization of LLC Suits/Clarity Required to Override Default Rules
The Wisconsin Appeals Court decision in Lenticular Europe, LLC vs. Cunnally,
279 Wis. 2nd 385 (2005 Wi. App.) also provides important new insights for
attorneys drafting an LLC operating agreement. The issue before the Appeals
Court was whether the minority member of an LLC could authorize the LLC itself
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to sue its majority member in connection with a conflict of interest transaction.
Section 183.1101 of the LLC law provides that unless otherwise provided in an
operating agreement, an action on behalf of an LLC may be brought by one or
more members if they are authorized to do so by the affirmative vote described
under Section 183.0404(1)(a), except that the vote of any member who has an
interest in the outcome of the action that is adverse to the interest of the limited
liability company will be excluded. The LLC operating agreement at issue before
the Appeals Court had a provision that generally authorized the controlling
member to vote its member’s interests notwithstanding any conflicts of interest.
However, because the operating agreement provision did not expressly refer to the
authority to bring suits on behalf of the limited liability company, the Appeals
Court found that this provision was at best ambiguous concerning whether
approval by the majority member would be required to bring the suit. The Court
of Appeals then held that clear and unambiguous language is required to override
any of the statutory default provisions included in Chapter 183, and therefore held
that the statutory default rule applied and the minority member, acting alone, had
properly approved the lawsuit.
Chapter 183 includes a great many statutory default provisions that were written
before the “check the box” federal income tax rules provided greater flexibility
for non-corporate entities taxed as partnerships. Most LLCs will override many
of these default provisions in their operating agreements. The Lenticular Europe
case emphasizes that clear and unambiguous language is required to override the
statutory default provisions in an operating agreement.
3. Tax Withholding for Non-Wisconsin Members
Section 71.775 of the Wisconsin Statutes was adopted during 2005 and requires
that non-corporate business entities, including LLCs, withhold and pay to
Wisconsin the state income taxes that accrue based upon the income allocations to
any non-Wisconsin partner or member of an LLC. Although the statute does not
refer to “assignees” as distinguished from members, it apparently applies
whenever a non-resident receives allocations of Wisconsin income from a
Wisconsin pass through entity.
This presents new drafting challenges for virtually all LLCs. Even if the LLC
operating agreement includes transfer restrictions that limit or prohibit
assignments of member interests, current members presumably could move out of
state and trigger this requirement at any time. The withholding requirement may
arise or be discovered late in the tax year after any distributions to members or
assignees have already been made, and it applies even if no distributions are made
or will be made to members or assignees. It also apparently applies whenever the
entity has Wisconsin income that is allocated to a non-Wisconsin resident, even if
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the LLC is insolvent and therefore cannot lawfully make distributions to its
members (see Section 183.0607).
This new requirement can be addressed by expressly permitting the LLC to retain
and pay to the state any required withholding from any distribution otherwise
payable, and to treat any amount paid with respect to a withholding obligation but
not withheld from a concurrent distribution as a loan or advance to the member to
be repaid (possibly with interest) out of any future distributions otherwise due to
that member or assignee.
Topics Warranting Continuing Emphasis
1. Right and Power to Withdraw and Be Paid Fair Value
Section 183.0823(b) provides that if a member acquired an interest in a limited
liability company for no or nominal consideration or owns an interest as to which
the power to withdraw is prohibited or otherwise restricted in the operating
agreement, the member may withdraw from the limited liability company with
respect to that interest only in accordance with the operating agreement and only
at the time or upon the occurrence of an event specified in the operating
agreement. Note the significance of restricting the power to withdraw, not just
the right to do so. Otherwise Sections 183.0821(a) and 183.0823(a) allow a
member to voluntarily withdraw and disassociate from a limited liability company
at any time. Section 183.0604 provides that, if not otherwise provided in an
operating agreement, a dissociating member is entitled to receive in complete
redemption the fair value of the member’s interest in the LLC as of the date of
dissociation, all within a reasonable time after dissociation.
Whether and on what circumstances an LLC member has the right or power to
withdraw as a member, and when and in what amount a withdrawing member is
entitled to be paid for the member’s interest, can be extremely important to the
LLC and to all of the members. The ability to have an enforceable agreement
about all of these matters is an important difference between limited liability
companies on the one hand and limited liability partnerships on the other (a
partnership agreement can restrict the right to withdraw but not the power to do
so), but it requires thoughtful negotiation and careful drafting to achieve a
reasonable and fair result for everyone involved.
2. Tax Allocations and Distributions
Like any entity that is taxed as a partnership, careful attention to the provisions
that control tax allocations and distributions is extremely important. The new
emphasis on tax withholding for non-Wisconsin members, discussed above, is one
small aspect of this larger topic.
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3. Voting Rights
Section 183.0404(1) states that, unless otherwise provided in an operating
agreement, members’ voting power is based upon their contributions to the
limited liability company. Section 183.0404(2) states that, unless otherwise
provided in an operating agreement, eight specific matters require unanimous
approval of the members, and all other matters are determined by a majority vote.
Section 183.0404(3) indicates that, unless otherwise provided in an operating
agreement, members can be precluded from voting with respect to some matters,
and Gottsacker vs. Monnier, 281 Wis. 2nd 361 (2005) suggests that the courts may
look to Section 183.0402(1) for circumstances in which a member may be
precluded from voting. Finally, Section 183.0404(4) states that, unless otherwise
provided in an operating agreement, a member who makes an assignment of an
interest continues to be the owner of the assigned interest for purposes of
determining voting rights until the assignee of the interest becomes a member.
All of these default provisions can be revised in the operating agreement. As
noted above, Lenticular Europe, LLC vs. Cunnally, 279 Wis. 2nd 385 (2005 Wi.
App.) indicates that any operating agreement provisions that are intended to
modify the statutory default rules need to be clearly and unambiguously drafted.
4. Restrictions on Assignment of LLC Interests
Section 183.0704(1) states that, unless otherwise provided in an operating
agreement, a limited liability company interest is assignable in whole or in part,
and that the assignor continues to be a member and to have the power to exercise
the rights of a member until and unless the assignee becomes a member of the
LLC. Section 183.0706 states that, unless otherwise provided in an operating
agreement, an assignee may become a member only if the other members
Many limited liability companies and their members will want to include express
provisions in their operating agreements concerning both the assignability of
interests and the rights of an assignee to become a substitute member. Rights of
first refusal for the LLC or the other members, and “put” or “call” rights under
specified circumstances, should also be considered.
5. Limitation of Liability, Indemnification and Scope of Duties
Section 183.0403, although entitled “Limitation of Liability and Indemnification
of Members and Managers,” actually deals exclusively with indemnification.
Subsection 4 specifies that the LLC may not indemnify a member or manager for
liabilities unless it is determined that the liabilities did not result from the member
or manager’s breach or failure to perform a duty to the LLC as provided in
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Section 183.0402. Section 183.0402 specifies the default rules for duties of
members and managers to the LLC and the other members, unless otherwise
provided in an operating agreement.
The operating agreement should include thoughtful and unambiguous provisions
concerning the scope and limitations of duties of members and managers to the
LLC and to each other, recognizing that indemnification and payment of expenses
may be unavailable to the extent the remaining duties are not satisfied. It should
also include clear provisions describing the scope of the indemnification that is
permitted or required and the circumstances in which advancement of expenses
will be permitted or required in the event of a lawsuit.
6. Mergers and Conversions
Subchapter XII of Chapter 183 permits specified kinds of mergers and
conversions involving limited liability companies. Under Section 183.1202(1),
unless otherwise provided in an operating agreement, a merger requires approval
of members whose interests in the LLC represent contributions of more than 50%
of the value of the total contributions made to the LLC. In contrast, Section
183.0404(2)(fm) provides that, unless otherwise provided in an operating
agreement, consent or approval of all of the members is required to convert an
LLC to a new form of business entity.
Mergers and conversions of an LLC can result in fundamental changes of
virtually all aspects of the relationships between and among the owners and the
LLC itself. Because a merger or conversion can have such a profound effect,
careful consideration should be given to whether and under what circumstances a
merger or conversion approved by less than all of the owners should be permitted,
and what limitations (if any) should be placed on the changes to economic and
control relationships that may result from the merger or conversion.
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