Economic issues when forming an LLC.

• Author: Owen, Sheila
• Position: Limited liability company

A review of a limited liability company's (LLC's) organizational documents should address the LLC's relationship with its members, its operations, its capital structure, its management structure, tax issues, and the following economic issues.

Compensation for capital

If the organizers of an LLC decide to pay interest on members' capital, the operating agreement should set the interest rate to be paid or provide a formula for computing the interest rate (for example, 2% over prime). When an interest rate is tied to an index, such as prime, the operating agreement should specify the index to be used (e.g., the prime index of First State Bank).

When setting the rate, the organizers should consider the opportunities for other investment, the risk associated with the LLC's operations, and the likelihood capital will be tied up for an extended period. If the articles and operating agreement permit the contribution of noncash assets, the agreement should specify how such contributions will be valued, establishing the amount on which interest will be computed and paid. When capital contributions can be made throughout the year, the agreement should include a provision that interest starts to accrue on the date the contribution is made. The agreement should also address how and when distributions reduce the amount of capital on which interest is accrued.

Compensation for services

If members will render services to the LLC, the operating agreement should provide that the LLC can compensate the members for services rendered. Any limits the organizers want to impose on the amount or timing of compensation should also be included. If member compensation is based on a standard or formula, such as hours worked or revenues generated, the terms and method used to determine the compensation should be spelled out in the agreement.

Allocation of income and loss

Many state statutes default to an allocation of income or loss based on capital. For many closely held businesses, this may be an appropriate allocation mechanism. However, if the organizers want to allocate operating income or losses in some other way or provide for special allocations of particular items (such as depreciation), the operating agreement should include provisions that govern the allocation of income and loss among the members. Any special allocations of gain or loss on the disposition of LLC assets also need to be included in the operating agreement.

Note: Many operating agreements do not distinguish allocations and distributions of income and cash flow from operations and from other transactions (e.g., a refinance of a commercial building). However, in many instances it is advisable to address in greater detail and sophistication the allocation and distribution of different types of cash flow. Practitioners should help ensure that the provisions are reasonable, coordinated with any separate definition sections of the agreement, and are carefully tailored to the particular...