Transcription
Hey, before you sign an LLC operating agreement or worse, copy one from the internet, I want you to fix these seven loopholes. Because listen to this. You miss one of them, and you can lose control or blow your entire tax allocations or even pierce your liability shield. In this video, I'm going to share with you those seven loopholes and how to fix them. All right. Let's get started.
Okay, so here's what's shocking. Over 40% of LLCs either don't have an operating agreement at all, or they're using some generic template that somebody downloaded off the internet or a friend gave them. And if that's you, I want you to stop everything and listen carefully, because one of the things I'm about to explain to you could be the difference between keeping your assets safe or actually losing them all in a lawsuit. I recently had a client come to me and we'll call him David, who thought he was protected because he had his rental properties in a limited liability company, and when he got sued by his tenant, his attorney discovered that his operating agreement was basically worthless. It was this one-page template that didn't address any of the specific issues that real estate investors face. And the result was the court was able to pierce his corporate veil. And David lost two rental properties worth over $800,000.
So loophole number one, the generic business purpose trap. And if you watch my other videos, you've actually seen where I've gone through LLC operating agreements. And I've pointed this out that this is a huge mistake that people make when they're creating LLC operating agreements, and it's actually potentially costing you millions of dollars with this loophole, because most operating agreements unfortunately contain vague language like this: "The ability to engage in any lawful business activity." Now, here's the problem with that clause. When you're dragged into court and opposing counsel or judges are scrutinizing every word in your operating agreement because what they want to do is break that operating agreement to get after you personally. So they're looking for weaknesses. A generic clause like that doesn't show intent or prove your LLC was set up for a legitimate business purpose. Even worse, some agreements only list what you can't do without actually clarifying what you can do. And actually, you saw that in that video I cut explaining how a limited liability company operating agreement that somebody sent to me did just that, and if I was attacking it, that's what I would use to pierce the veil. So what ends up happening is that this creates massive gray areas that can be exploited by opposing counsel.
Now, the fix. It's real simple. What you need to do is be as specific as possible on your business purpose. This is a very important clause. So if your LLC, let's say, was set up for real estate investing, spell it out clearly. If you're trading securities, say so. If you're doing short-term rentals, include that in that business purpose, okay? Because this specifically strengthens your asset protection and makes it much easier to work with third parties such as banks, insurance companies, and even title companies when they want to look at that operating agreement.
Okay, so that brings me to loophole number two. And that's called the management authority nightmare. Now, this second loophole involves unclear management structures and decision-making authority. And I see this constantly in multi-member limited liability company operating agreements where no one is ever clearly defined sometimes. And who actually has control? Is it the members or is it managers? And a lot of times in these operating agreements, the agreements are confusing in themselves. Maybe the LLC was set up as a manager-managed LLC, but in reality, in the operating agreement, it states that it's run by the members. You see, again, now we're opening up doors that someone can use to exploit to pierce your LLC. So we don't want to create these dangerous scenarios. In member-managed LLCs, the default rule gives each member equal decision-making rights regardless of their ownership percentages. So imagine this: if you own 75% of a limited liability company, but you're 25% partner in that LLC can block every decision, every major decision, because the operating agreement does not clearly define or specify voting procedures. How difficult is it going to be to get things done in that company, especially when you have 75% ownership in it? So member-managed LLCs, if you're going to go that route, you need to specify what amount of ownership will actually have controlling decisions. And the example I just gave you, 75%. If a 25% member can block your decisions, that's going to be problematic.
Now, on the flip side of this, is a member-managed LLC where you can actually face the opposite problems. You see, managers can have almost unlimited authority to bind the LLC, even if they're acting outside of their intended scope. And I've seen cases where managers sign contracts or agreements that the other members never approved of, because in the operating agreement, it wasn't part of what the LLC was set up for, but the LLC ends up being legally bound to honor them. So if you have a multi-member manager-managed LLC, you have to be very careful here.
So what is the fix to this problem? Well, fix your operating agreements. You clearly define management structures, voting procedures, and specific authority limitations. A lot of times in our operating agreements, what we'll do in a manager-managed scenario like I described is, we'll state that the manager can spend or bind the LLC up to a certain dollar threshold. So that way, we cap what they can do without having to go to the members to seek approval. So the members know, hey, the manager is not out there and going to bind me into doing something that is possibly to put the LLC business at risk or require further capital contribution from me as a member.
Now, one last point here is that you want to make sure that you have a provision when you have multiple managers. So member-managed LLC, we have multiple members, or manager-managed LLCs where there is more than one manager, to break deadlocks. So you have to determine, you know, what that looks like. Specify which decisions require unanimous consent versus majority vote.
Loophole number three. This comes down to what, what we refer to as capital contribution chaos. And this can create a lot of problems. I just dealt with an issue around this two weeks ago with a client who is now facing a scenario that, again, I warned them about that they needed to address this, but they thought, "Nah, we'll worry about it. It's not going to be a problem for us. Maybe we'll run into this down the road, but I highly doubt it because we're all on the same page." And it had to do with contributing capital. So where we are now is that they're not on the same page, and capital is needed to keep that business going. This is why it's the third loophole, because here's what happens is that when members don't meet their financial obligation to the company, then you're going to end up in disputes and people are going to feel like it's not fair. "I've put more in, but I'm still sharing equally with the people who haven't." So I see a lot of nasty disputes come from this between LLC members when this is not clearly defined. So many agreements don't clearly define these things like such as what counts as a capital contribution, how contributions are valued, or what happens if someone fails to contribute their promised amount. You know, some members contribute cash, others contribute property or services, but without a clear valuation method to say, "Yeah, if you're going to work five hours a week for this company, it's worth this," you're setting yourself up for conflict later on. So these things need to be nailed down because many times I've seen in joint ventures, you know, one party or one member is going to be putting in sweat equity and the other one's putting up cash. Well, what does that sweat equity worth? Define it. Okay. Even worse, I've seen agreements that don't address what happens when the LLC needs additional capital. Like I just described. Like I tried to explain to the client when we set this up. And so when one member contributes more money, as what was happening in this case, while the others don't, well, then how does that affect the percentages? And so when I was dealing with this client, as I explained to them, well, you can have, you guys can treat it as a loan. They said, "Well, the other member objected to having us loan money to the company." And it's just so frustrating because this was an issue that they did not want to confront at the outset. Do not put yourself in the position that this client is in right now, having to deal with this other recalcitrant member.
So your fix. You got it. I would just lead right into it. Your agreement must specify exactly what constitutes a capital contribution. And you know how different types of contributions are valued, the timeliness of those contributions, and procedures for handling failures to contribute, which include provisions for capital calls. And you clearly state that additional capital contributions may affect ownership and may affect distributions. These are, this is one of the more important clauses you'll be addressing if you have a multi-member LLC, okay?
Loophole number four is what I'm going to refer to now as the distribution disaster. This is when we're taking money out of our company, and it involves you, of course, profit and losses. And this is where, again, many operating agreements completely fall apart. And it's a major source of member disputes. Now, the most common mistake that we see is vague language like, "Profits will be distributed fairly." Okay. What does that mean? When you say "fairly," what's fair to me may not be fair to you. In fact, I think what's fair to me is I take 90%, you get 10%. Now, you're probably sitting back thinking, watching this video right now, thinking, "Yeah, it sounds like an attorney." But see, when your LLC becomes profitable, "fairly" can mean many different things to different people. And I've actually run into partnerships before that have been destroyed because the agreement didn't specify when distributions would be made and how much would be distributed. Or worse yet, the tax implications of different distribution methods. So another dangerous provision I typically see frequently is for pro-rata distributions. Now, you've probably seen one of my videos on this where I talked about a baker in Utah who sold his business and he set up an LLC, put all the cash in there, and he got sued and he was taking out distributions, and he was doing it the wrong way. And the creditor who sued him was able to pierce his LLC and get after his assets. You see, these clauses can mandate whenever money is distributed to any member and how that money is going to be distributed. So you have to be very careful here when you're referring to a distribution clause. Avoid mandatory distributions and if, and avoid pro-rata. Now, I say that in the context of if it's your LLC and you and your wife or spouse are the only members in that company. Now, when you're setting up a joint venture LLC with other people, of course, well, maybe you want that type of language in there, or you're going to limit it and provide certain context to it that, for example, "All income less 20% for holdbacks for CapEx or whatever will be distributed to the members on an annual basis," or there would be enough, or income distributed on an annual basis to cover the member's tax liability associated with their ownership interest in the LLC. All this plays into protecting you if you're ever involved in a lawsuit in the future. Like that Utah baker, because of a weak operating agreement, a creditor was able to break that LLC and force those distributions.
So the fix is to be extremely specific about distributions. Timing, amount, procedures. Include tax distribution provisions in there. If you're in a multi-member LLC, to ensure that you can pay your taxes. Because I've seen this LLC used before as a sword to harm members by forcing them to pay taxes on money that was not being distributed. Yeah, a lot of times individuals are shocked to hear that that can happen. Your operating agreement will prevent that if you address this clause.
All right. You loophole number five is the exit strategy black hole. Okay. So the fifth loophole involves member exit strategies and buy-sell provisions. Most operating agreements either completely ignore this, how members can leave the LLC, or or they include poorly drafted buyout provisions that create more problems than they actually end up solving. I recently reviewed an operating agreement where the buy-sell provisions stated that any member could be forced to sell their interest for $1 if they breached any provision of that agreement, no matter how minor. Now, while this might sound like strong asset protection, first off, courts are going to refuse to enforce this because it's so disproportionate to the penalty provisions as violations of public policy. But more importantly, think about the position you're putting someone in, right? Trying to force them to sell their interest for $1 because they violated something, however innocuous. You can actually, you know, kick people out of an LLC. Or you could be the one being kicked out of your LLC if such a clause was in there. And so you have to understand, this is another issue that can come up with LLCs when these businesses are being run, you know, typically in two, three or four years into the future. So what does this really mean then, is that agreements without clear exit strategies leave members trapped in bad situations with no proper way to exit without expensive litigation. Heck, as an attorney, that doesn't sound too bad. Anyways, I don't want to see you in that position.
So here's the fix for this problem, okay? Include comprehensive buy-sell provisions that address disability, death, retirement, voluntary disputes, or voluntary, I'm not voluntary de seats, but voluntary departures, and specific valuation methods. This is really important as well. What is that value worth if you're going to buy someone out? You know, maybe earlier in the business, they have to take a haircut or a discount if they're going to leave the LLC because buying someone else is going to be more difficult when the business is just getting started, whereas maybe five or 10 years down the road, then you could have it valued. So there's a lot to play here when it comes to dealing with members who are departing an LLC. And as I stated, oftentimes it's something that people are not even considering when they're putting together their operating agreement.
All right. The sixth one is really important. And that is the tax selection trap that you see in a lot of LLC operating agreements. And this involves a misalignment between the operating agreement and your tax election. So what do I, what, what is that referring to? When you set up a limited liability company, it's a hybrid entity from an IRS perspective. So you can elect to treat it as a partnership, disregarded entity, C Corp, or S Corp. Now, this can be particularly dangerous for LLCs that make an S election. In fact, most of the LLCs that we review here at Anderson or I've run into before where they're actually running a business through it and it's not holding rental property, although some rental property investors make this same mistake, is that they've made an S election because they want to save on employment taxes. Now, that's great. And we do that a lot with our LLCs that we set up. But what's critical here, it goes back to the general purpose of this video, is that it's not a one-size-fits-all, and that in your LLC operating agreement, you need to make sure you have very specific provisions in there that align with your tax election. Because if you fail to do this, the operating agreement itself can automatically terminate your selection, creating greater tax liabilities for you. For example, if your agreement allows for different classes of membership interests or special allocations of profits and losses, you could lose your S corporation election without even knowing it. I've seen these tax court cases before that have cost individuals tens of thousands of dollars in unexpected taxes and penalties. Plus, just think of the administrative nightmare of trying to fix it. The problem with the IRS.
So the fix: Make sure that your operating agreement aligns with the tax election you're making with the IRS. Okay? So if you're electing S corporation tax status, your agreement must meet strict requirements regarding ownership structures and profit allocations, or you risk blowing this.
All right. Now, my last loophole, number seven, is the amendment and recordkeeping failure. You see, the seventh and final loophole involves amendment procedures and recordkeeping requirements. Many agreements don't typically specify how they, how they can be amended, or they create such rigid amendment and bookkeeping or recordkeeping procedures that make it nearly impossible for someone to comply with the operating agreement. You see, when you're operating agreement, it needs to be flexible because your business is going to be evolving. And so maybe you need to add members in the future. Maybe you need to change a management structure or modify distribution methods. Without having a proper amendment procedure in there, you can find yourself stuck with, without needed terms that no longer serve your business. Now, recordkeeping, that's equally as critical. And I've seen situations before where people have operating agreements that state they have to have quarterly meetings, and the individuals who have the LLC aren't even aware of that. Now, what does this mean? Well, if you're not doing it, that means you're failing to follow your LLC's business formalities. And if you're not following and respecting your business, then the court will not follow and respect that business, and they'll be able to pierce it.
So what is the fix here? Hey, it's really simple, right? Make sure you include reasonable amendment procedures that require written consent from a specified percentage of the members to change anything in the LLC. And more importantly, if you're, when it comes down to meetings and recordkeeping, if you want to do that, put it in there, but use language that gives you wiggle room, such as, "The members may have the following recordkeeping requirements." So, "The members may meet on an annual basis." Don't make it a requirement, otherwise it may come back to haunt you if you're ever involved in a lawsuit.
So the million-dollar question, if you made it this far in my video, is probably, "What's at stake?" Well, I'll tell you this: if you don't fix these loopholes, is it going to blow everything for you? Not necessarily. Okay. But first, you could lose your limited liability protection entirely if you have enough of these problems inside of your operating agreement. Because when you go into court, that operating agreement is going to be scrutinized. We just dealt with that with a client who had to bring in all of their entities that we'd created for them, because the opposing counsel was looking for a way to break through their structures. Now, they had all this in front of the court. They had it up on screens. They went through it word by word, line by line, and they weren't able to pierce our client's structures. This is what I'm talking about, all right. You want to make sure that you're setting these structures up to protect your assets, right? That's why we're going through this problem. Don't let the operating agreement become that weak point in your structure. Poorly drafted operating agreements create internal conflicts that can destroy your business. And we've seen this time and time again with clients that have come to us seeking assistance. And the last thing you know about this is that, you know, these loopholes expose you to opportunistic creditors who will look to, to, to exploit it, just like I described with that with our client who just had to go through this scenario, okay? They're going to look for any excuse to reach your personal assets. And so a flawed operating agreement is that key. That's the ammunition they need. Let's take that away.
All right. So here's your action plan. This is what I want you to do immediately: review your current operating agreement against these seven loopholes. If you don't have an operating agreement, or if you're using a generic template, schedule a consultation with someone here at Anderson, and we can help put into place a plan for you that will address the issues I just described. In order to do that, all you have to do is go into the show notes below. I have a link there. It's a free strategy session. Now, step two: I don't want you to try to fix these issues with online forms or AI tools, because these loopholes require sophisticated legal knowledge. Okay? You might be thinking I'm just plugging Anderson as an attorney's law firm. Yes, I am, but I'm being serious here. Is that, you know, the money you save on legal fees upfront could cost you everything later on. And I've seen what people have tried to put together on their own, and they don't realize is that many times these clauses, or clauses, are dependent on other clauses inside that operating agreement.
So, step three: Consider your specific business needs. So, real estate investors, okay? Need different protections than stock traders or an e-commerce business or a plumbing company. So your operating agreement should reflect your actual business activities and your risk profile. And that should all be spelled out inside of there. I can always tell when someone's using a generic operating agreement that was prepared by, someone at one of those entity mills that you find on the internet, because they never get specific to the business activity that's being run out of that LLC or in the, in the, in the LLC.
So the last step here is, hey, let's plan for regular reviews and updates because your operating agreement isn't set in stone and it's not something you just put it in place and forget it. As your business grows, changes to your operating agreement should evolve with it. So your LLC operating agreement is either your strongest asset protection tool or your biggest liability. And there's really no middle ground. And I've seen these loopholes cost individuals hundreds of thousands, if not millions of dollars, because they didn't understand what could have been preventable if they only knew what to look for and take action. So remember, asset protection isn't about hiding assets or doing anything shady. It's about using legitimate legal structures to protect everything you've worked hard to build. But those structures are only as strong as the documents that you use to create them. So I hope this video's opened your eyes to the problems and current structures and don't wait. All right. The best time to fix these issues is before something happens. Because just like that story I shared with you with my client, those operating agreements were set in stone on day one. They were trying to fix this stuff after they were already informed they're about to be sued. Then it's too late. All right. You need to get it done sooner rather than later.
And here's something else to consider: If you're serious about building wealth or real estate, or investing with your business, you need more than just basic asset protection. You need comprehensive strategies that can integrate tax planning, estate planning, and business structuring. And that's exactly what we cover at our free tax and asset protection workshop. So I'd like to invite you to this. It's completely free. We hold these on Saturdays. You'll learn advanced strategies that most common investors never discover, including how to structure multiple LLCs through entity stacks for maximum protection, how to become anonymous, how to use holding companies to not only reduce your taxes, but create an impenetrable shield around your upper-level assets that will protect you from creditors and ensure that those businesses can be passed on an efficient manner to your beneficiaries. Again, check out the link in the show notes. Register for that event. It's completely free and I guarantee you, after attending that one event, you'll say, "This was the best Saturday I ever spent learning from Anderson on how to protect my assets and reduce taxes." Take care.