Transcription
You know, your LLC operating agreement can look completely clean. It looks professional, official, nothing obviously wrong with it, and still contain the exact words that get your protection stripped away in a lawsuit. That's what makes LLC operating agreements dangerous. You see, they don't read like mistakes, and I just got off reviewing another one. It came in from a client in our platinum program. He sent it in before he signed it.
You know, on the surface, when you first saw it, when it came across, it was clean. You know, it was the kind of document that you would glance at and think, "All right, I'm going to sign this and never think about it again." But you see, when I review something, I don't read these the same way most people read them. I read them the way the other side's attorney is going to read them. Not, "Does this look official?" Official? But where does this leave the door open? Because that's exactly what opposing counsel does. The day your LLC lands in a lawsuit, they'll pull your agreement up, and they're going to go hunting for the clause that lets them in.
So here's what I've done. I've pulled six, right, six clauses from different real estate LLC operating agreements that I've reviewed, and everyone looks normal, but every one of them has a huge problem most people would never catch. So listen, pull up your own operating agreement while you watch this and read along, because I'm not just going to show you what's wrong. I'm going to show you the words, how to fix it. So by the end, you can check your own documents against all six. All right, let's get started.
Okay, quick thing first, in case operating agreements aren't something you deal with every day. So, your operating agreement is a rule book for your LLC. It's the contract that says who owns what, who decides what, how the money moves back and forth between the company and the members, and and what happens in case something goes wrong. That is, if the LLC gets sued or you get sued. Now, most people never write their own. They download a template, they type in their own name. And I've seen this before. People download operating agreements, and sometimes when I'm reviewing them, I will find other individuals' names in them, and I'll ask them, "Who is this person?" "I don't know." "Where did that name come from?" "Your operating agreement." And that's the problem, because the wrong words or the missing words quietly undo the exact protection you formed that LLC to get. And I'm just not just talking about asset protection. Also, it has to do with audits. So there's two things here we have to be conscious of when we're putting together our operating agreement, because both can have meaningful consequences. You see, what I tell people all the time when it comes to LLCs, it's a game of details. And let me show you exactly what I'm referring to right here.
Okay. So you look at this clause. It states this: "Okay, the company shall not engage in the insurance, banking, brokerage, or securities business, or any profession limited by the Wyoming Revised Statutes to a member of a licensed profession such as law (that's me), architecture, medicine, etc., without any pertinent approval from the licensing authority." Okay. Did you see any problems here? I've shown this before in my events, and I've yet to have a person catch the problem. The real problem here. See, there's two problems, and I see both of them instantly. Number one, Wyoming Revised Statute. The green wasn't for a Wyoming limited liability company. You see, somebody grabbed a Wyoming template off the internet and dropped it into an LLC formed in a completely different state. Now your governance document is pointing at the wrong state law. This is a copy-paste tell-all, and a judge will notice it.
Number two, and this is actually the bigger one. Okay. Read it again. If you look at this clause, the whole clause only tells you what the company can't do. And never once states what the company can do or what it actually does. There's no business purpose clause in here at all. And that matters because when your LLC gets challenged, the other side is going to argue, "This isn't a real operating business. All right. It's just a shell you're hiding behind." A clause that clearly defines your purpose is part of how you answer that. So what's the fix? You state the purpose affirmatively first, before any restriction. Name what you actually do, then set the limits if you want to do that. Now, purpose. Personally, I would never set limits in this. In fact, I want to keep my operating agreements wide open to engage, to allow me to engage in all lawful business activity. So typically, when I draft a business purpose clause, I will state, "The business purpose of this company..." and then I'll go on to always close it out. And it's entitled to engage in all lawful business activity. So if you ever change in the future to go a different direction, you don't have to change that clause. Now, with this in mind, when we're talking about the business clause, why this is important as well is because if you don't have a clause in there, then you fall under the default rules. And most of us do not know what the default rules are under state law. And so this is how people challenge it. And they say, "Oh, you're engaging in rental activity. And this was, and you're making decisions upon that. And that wasn't prescribed by your operating agreement." So you've got to be really careful here, and it's something that a lot of people neglect.
All right. So let me just pull up another one here. So this came from a different operating agreement, and it's referred to as duty of loyalty. So read it with me: "No member shall engage directly or indirectly in any business, venture, or transaction that competes directly with the business of the company or that would create a direct conflict or interest with the company." Now, that sounds reasonable, right? You don't want your business partners running off and competing with you. But watch what this does to you. See, say you set up an LLC to hold rental property, Property One LLC, just like I talk about on this channel, right? That's a smart way to do things. You want to isolate the liability, build your system around keeping your property separate, all held by a Wyoming holding company. Now you've got your first LLC set up. Then you go and you buy your next property. And like I've told you to do, you set up a separate LLC for that other property. Okay. Now stop right there. Read that clause again. It states you, the member, just engaged in another venture that competes directly with the business of the first company. So on paper, you just breached your own duty of loyalty to LLC number one. And it isn't just real estate. Run two stores, two consulting practices, two of anything. This clause turns your second business into a breach of your first. That is a real problem. Okay. Essentially, what can happen is somebody who's the first company, they'll say, "You violated the operating agreement." Then you can bring both business activities into that one claim.
Now, like the first clause I talked about, and this clause right here, you see these clauses? Okay. Depending on how you restrict language or put what the company is allowed to do, you may always draft them a little different when you're working with third parties. We're in a joint venture. So take this one for example. There is no joint venture here in this operating agreement. This was a husband and wife. Now, you don't need a duty of loyalty in a situation where it's you and your spouse, or it's just you, because of course, you may go out and compete with yourself and set up multiple businesses in that same business line. But when you're in a joint venture and you have a third party that you're working with, yet you definitely don't want them competing with your business because that's taking away their interest from the activity that you've invested in, and you think they're putting all their effort into. And they may be putting that into other ventures that are competing with you. So in putting these together, understand this, that sometimes these clauses, what I've seen, they're appropriate for a large joint venture, but they're not appropriate, and they hurt the individual investor or business owner.
So the fix, and just a few words, you add a waiver that frees up every member to pursue outside ventures, okay? Even competing ones, with no obligations to hand them over to the company. So, for example, here's something you could put in this clause: "You know, each member engages in or possesses interest in other business ventures of every kind, including ventures that compete with the company, and shall have no obligation to offer any such opportunity to the company or other members." Now, that clause right there covers your butt, and that's what I would put in there. That one sentence frees you up to to continue building your your your businesses without the risk that can come from not having it in there.
Okay. So let's go to the next one. Death of a member. This was the one that really, when I came across this clause in an LLC operating agreement, I knew I was dealing with a cut-and-paste job. Okay. So. So it was not drafted for the business. Here's what it says: "If the member dies, die simultaneously, or upon the death of the surviving members, the entire business interest shall be transferred to you." See that? "Insert trust name, living trust, insert date." Okay. So if you get an operating agreement like this sent to you, and this was actually prepared, so they said by a company, they bought this off the internet from a company that operates out of Utah, and they do a lot with real estate investors. And this was an LLC that was sent to them. Now, you can see here it's a form document, just by the way they frame "insert trust name, living trust, insert date." That's an obvious problem, and it just jumps right off the page, okay? And if they stay blank, the clause does nothing, right? Because then the interest falls into probate. But that's just the symptom here of the issue. That's not the real disease in this clause. You see, the clause assumes that the member is a person, right? It's a human being who's going to pass away. And a lot of the time, that is not how a good structure is built. And the systems that we create here at Andersen, you'll notice that we always use a holding company. We recommend that you use a holding LLC, typically in Wyoming. So you've got your operating LLC that has a rental property, whose member is a Wyoming holding LLC. So here's the issue. You see, a holding company does not die. There's no funeral for the LLC. So this entire "death of a member" provision, okay, the thing that's supposed to control what happens to your ownership, is written for a situation that will never occur. It's dead language in your most important document.
So what is the fix? Right. The transfer and succession provisions for what your member actually is. That's it. See, a lot of these form agreements assume it's always going to be an individual. So if a holding company owns the interest, then your succession planning lives at that level, not at the individual's level. Okay. So it's in the holding company's own agreement and your estate plan, not in a clause waiting for a person to pass away. Okay. These need to match the document and the structure. In fact, I never even talk about that in my operating agreements. Right. Because you don't need to say that the member then, when they die, it's going to pass to their living trust. It doesn't even work that way. So the way you handle this is you make your living trust the member of your holding company that holds your upper-tier LLCs. Now, when you pass, you were never the member. It was your living trust. So it avoids probate. Number two, okay, I'm going a little far here, off-script for you, and just going through the clauses. But I want you to understand this, that by naming your living trust, when I say you name your living trust, I'm not to say you don't put your own name into the operating agreement. By all means. When you draft your operating agreements, list yourself as the member, then assign your interest over to the holding company. When you draft your holding company LLC, list yourself as being the member. Then assign your interest with a separate document to your living trust estate plan. That's key in putting these together as well. When you're dealing with third parties, and I will cut a video on that in a few weeks to to drive that point home.
All right. We got to keep moving. Annual report, annual meetings. Okay. So look at this. And I think you should be able to figure this one out. "As soon as practicable after the close of the fiscal year, okay, each fiscal year, the company shall provide each member an annual report showing a full and complete account of the financial condition of the company, a company, a copy of the company's federal income tax return, and a profit and loss statement." And the other clause here is "an annual meeting of the members is required to be held." Now, when I read this at our last event that I taught, and I asked for for feedback on it, okay. A lot of people said, "Hey, this sounds pretty diligent, right? It sounds responsible." And but the problem is, both of these clauses hurt you for the exact same reason. And they were taken from separate operating agreements. So here's the principle. And what is that most people miss? You see, when your operating agreement uses the word "shall," do something. Right? Provide a report. Hold a meeting. You've just written a rule for yourself. And here's a question that matters in the courtroom: "Did you actually do it?" Right? Because if you don't respect your operating agreement and you don't follow your operating agreement and file the annual or providing yourself an annual report, doing the tax returns, holding the meetings, then if you're not respecting the operating agreement, then a court will not respect the operating agreement. So what you have now is a document that lays out formalities you ignore every single year. And that's what the other side is going to focus on in order to pierce the veil of your company, trying to argue that it's not a separate company. That gap that you have right there in that operating agreement is a gift to the other side in the lawsuit. You see, you wrote the rule for yourself in that operating agreement. Well, most of us don't even write these. They're written by somebody else, and we just sign them. And then you just broke the rule, by the way, you run it every year. That's a documented pattern. And that is showing the court that the entity is not being respected.
Okay. So I'm sure you can figure out what the fix is. Okay. Two ways to go. Either you generally do these things, hold the meetings, keep them in its, generate the report, or you change the language right from mandatory to permissive. "The members may, not shall." Okay? Just changes to the word "may." Don't put a single requirement in your operating agreement that you're not going to honor. So when I go through operating agreements, I look for the word "shall" all the time. And then I tell the client, I said, "This is what you have to do every year. Is this something you want to be doing?" Now, there are certain certain certain certain situations, like if it's a joint venture, where you're going to want language like that, and that's why it's not a one-size-fits-all. But a lot of the people, you're probably one of them that's watching this video right now. You've set up an LLC for yourself, and it's just to run your your side gig. It's run your small business. Maybe it's to own your investment real estate. Maybe it's holding your crypto or your trading account. Whatever it is, you need to analyze it. Go through there and see. Is there any language in your operating agreement that imposes an affirmative duty on you? And then ask yourself, "Have I been doing this?" If you find it, it's very simple, right? All you have to do, "The members or the managers, whatever it is in your operating agreement, may they're not required to hold meetings." Okay? Or, "The failure to hold a corporate meeting shall not affect any other validly taken action." Simple language like that can provide a tremendous amount of protection in court because, at the end of the day, the LLC is a shield, but it's a penetrable shield if you're not doing what you need to do. And I can tell you, attorneys like to try to penetrate the shield because then that exposes the individuals' other assets in recovery.
All right. Let's look at the next one. Profit distribution. Now, this is the big one, okay? And I saved this on last for purpose. This is this is the thing that really causes a lot of problems, and there's been some court cases around this. And I still see this language in operating agreements and reviewing today, even though there's been some notable cases. Okay. So, "The members shall receive a profit distribution in proportion to their ownership interest in the company." That's it. One sentence. Looks completely harmless, right? Well, if you heard my last on the last point, you probably picked up on it as well, the word "shall." But let me explain what this quietly destroys, because it's it's not about just distributing the money out to you, but it has a major impact on the overall asset protection of your LLC. You see, one of the biggest reasons why you form the limited liability company is something called charging order protections. I mean, I hope you set up an LLC in a state that offers strong charging order protections. That's why many of the systems we provide here at Anderson always have that Wyoming limited liability holding company at the bottom for this exact same protection. I want that protecting everything in that. LLC owns all the upper-tier LLCs from your personal creditors.
So what this means in plain English is that if somebody sues you personally, all right. So you've got your Wyoming LLC set up. So you've got the charging order protection, and they're suing you and not the business, and they win. They can't just walk in and take the assets inside of your LLC. You see, the only thing they can do is get what is referred to as a charging order, which is a lien on your distributions. So if your company pays money out to me or you, the creditor stands in line, and they can grab it. Okay. But, and this is the whole point, if the company doesn't pay anything out, the creditor gets nothing, right? They're just stuck waiting until you, as the manager of your LLC, decides to distribute money. And the smart manager in this situation, you're not going to be distributing money to yourself if you're told it has to go to your creditor. So you just hold on to those funds until they release the charging order or it expires. Now, read that clause one more time. Okay? It states, "The members shall receive a profit profit distribution in proportion to their ownership." Okay. "Shall receive." That's mandatory. You'll, you just took away your discretion to not pay out funds. Okay? You wrote this in your own operating agreement. So distributions have to happen. So when that creditor shows up with a charging order, you just can't turn off the tap. Your own document forces the money out the door and right into their hands. You've got your best protection with that one sentence.
Now, what's the fix? Okay, I'm sure you can figure it out, right? You just got to put in their discretion. That's all you need to do. Okay? "Distributions may be made at such times and in such amounts as the manager, in its sole discretion, may determine. No member has a right to any distribution except as declared by the manager." There you go. We just took it, and we fixed the problem, right? Those are six clauses. Other clauses. You've heard me talk about it before. Whenever you have distributions, you know, pro rata versus non-pro rata. These are things that are critical inside of operating agreements, and a lot of times people don't even realize that until they're involved in a lawsuit. So those are six. And here's the takeaway I want you to understand this. Every one of those problems from six separate operating agreements came down to the specific words. I tell people time and time again, when you're setting up an LLC, the words are there for a reason, right? And they do have an implication for you when you're involved in a lawsuit. Okay. What you'll find is that it's a game of details, and the details are where people end up getting hurt. Okay.
If you want a real set of eyes on your operating agreement, and not just six clauses like I've shown you in this video. Okay? Then here's what we do here at Andersen. Okay. If you're working with us, we'll review your operating agreements. We'll show you what's wrong with them. We'll tell you exactly where you're exposed. Now, if you want to set up a free strategy session, go to the show notes. There's a link in there. Click on that link, and we can send start a conversation to figure out what we can do to fix any situation you may have. So I'm going to leave you with this. You've gone to the trouble of creating a limited liability company. Make sure you've set it up the right way so it's there when you need it. Guys, if you liked the video, be sure to hit the like button. I wish you the very best with your asset protection and tax planning. Take care.