LLC Withdrawal and the Operating Agreement: Know Where the Exits Are Before Creating Your LLC

LLC Withdrawal and the Operating Agreement – The limited liability company (“LLC”) has become one of the most desired forms of a closely held business organization. As an unincorporated business entity, the LLC is favored because of its pass-through tax treatment as well as its maximum operating flexibility. However, an LLC also demands a well-written and comprehensive operating agreement, especially when it comes to the withdrawal or dissolution of a member.

LLC Withdrawal and the Operating Agreement: Know Where the Exits Are Before Creating Your LLC

The Power to Dissociate and Member LLC Withdrawal

In 2014, California passed the Revised Uniform Limited Liability Company Act (RULLCA), which provides that a member generally has the power to dissociate at any time, rightfully or wrongfully, by withdrawing as a member by express will and giving notice to the LLC. The Act also states that certain events such as the death of a member will automatically result in a member’s dissociation. The withdrawing member may be entitled to payment for the member’s interest; however, the LLC’s operating agreement is given large deference and may provide otherwise, overriding the default rules provided in the RULLCA.

Importance of an LLC’s Operating Agreement

An LLC’s operating agreement is a powerful, legally binding business document that may spell out how a member withdrawal will be handled and therefore, it is crucial that you are aware of the procedures set forth in the operating agreement before signing it. Corporations Code § 17701.10.

Potential Challenges in Member of LLC Withdrawal

Overlooking such a provision may result in finding yourself in an undesirable situation upon voluntary withdrawal. For example, where an operating agreement requires a unanimous agreement for a member’s LLC withdrawal, a withdrawal may not be so plausible. It may not be difficult in an LLC with one or two members. However, if there are multiple members, obtaining unanimity may not be so easy. Essentially, each member is granted a large amount of voting power and it could simply take a single dissenter to prevent you from successfully withdrawing from the LLC with the particular conditions you had in mind.

This could be a highly dangerous trap for unwary minority members of LLCs who could find themselves bound by a subsequently adopted operating agreement they never knew about, much less approved. Even if such a provision seems unfair, courts give large deference to the operating agreement. If the withdrawal is in violation of the operating agreement, the LLC shall have the right to offset any damages for the breach from the amounts that would be distributed to the withdrawn member with respect to its economic interest. Corp. Code § 17706.01, et seq.

Automatic Dissociation and Status Changes

It is also important to be wary that the RULLCA provides that certain events automatically result in a member’s dissociation. For instance, a member who becomes a debtor in bankruptcy is automatically dissociated. The dissociation of a member can also change the member’s status to that of a transferee. As a result, this member will only have limited rights and not the more expansive statutory rights of a member. If the members of an LLC do not want the automatic dissociation provisions to be triggered, the operating agreement should specifically address the statutory provisions.

Additional Considerations in the Operating Agreement

In addition to a member’s LLC withdrawal, there is much more to consider and to be wary of when drafting or entering an operating agreement. Such issues include the possible mergers and acquisitions of your LLC, confidentiality, non-compete, allocation of profit and losses, and what to do in deadlock situations. Look out for provisions in the operating agreement which entails an involuntary dissociation which may occur by events other than a member’s voluntary withdrawal. A member may become dissociated upon the occurrence of an event stated in the operating agreement. Corps Code § 17706.02(b). Dissociation does not trigger a statutory buyout, redemption or forfeiture of the member’s interest. Therefore, it is crucial for the operating agreement to set forth a buyout of a dissociated member’s interest by the LLC and/or other members.

Resolving Member Disputes through the Operating Agreement

Evidently, an LLC’s operating agreement is paramount in deciding how member disputes are to be resolved. Consequently, it is critical you are informed of the procedures in withdrawing from your LLC and are aware of what you agreeing to when signing an operating agreement. If you have any questions regarding your operating agreement or have found yourself in a difficult situation as a result of a poorly devised operating agreement, please do not hesitate to contact our office. We are your Orange County trademarks, copyright, and business litigation attorneys, here to help. If you need an LLC or an operating agreement, contact us.