The Complete Guide to Real Estate LLC Operating Agreements

What Is a Real Estate LLC Operating Agreement?

A Real Estate LLC Operating Agreement is a legal document that spells out the rights and responsibilities of real estate investors who have formed an LLC together. It operates in much the same way as the bylaws of any other business entity or partnership agreement. It defines the respective ownership percentage, financial obligations, and other factors that can be critical if a dispute arises or a major change to the business occurs. A Real Estate LLC Operating Agreement is an essential document that protects the rights of all those who have contributed money or time to an investment group. This is especially vital for real estate investments, which typically are illiquid and may not produce returns in the early years. The start-up years of most real estate investments typically are characterized by negative cash flow . Consequently, having a clear understanding of the respective roles and the performance expectations of the members is critical. The best time to start thinking about a Real Estate LLC Operating Agreement is before the group has been formally constituted and is ready to invest. Many investors have entered into informal agreements with their friends or family members, only to find later that ambiguities in the initial agreement have led to major disputes among those involved. Assembling a Real Estate LLC Operating Agreement on the front end will help clarify exactly how the investment group will operate. In addition to spelling out the respective ownership percentages of each member, the Real Estate LLC Operating Agreement will set forth expectations and performance guidelines for the group. It is also the place where key contingencies and worst-case scenarios can be addressed in advance.

Main Elements of an LLC Operating Agreement

The operating agreement of a real estate LLC is a contract between the owners of the company. This means its contents can be as simple or complex as the participating members consider appropriate. In any case, an operating agreement should at a minimum address some fundamental issues concerning the ownership and operation of the LLC, including:

• Members and Capital Contributions. The names and contact information of all members should be listed along with their contribution to the LLC (which could be in the form of cash, property or services), the percentage of ownership of the LLC by each member, and the type of membership they each hold (for example, Class A or Class B).
• Management Structure. There are two general types of management structures – member-managed and manager-managed. LLCs can either be run by the members or have designated managers who oversee the operations. The operating agreement should clearly set forth the management structure by naming the managers and detailing their specific powers.
• Distributions. LLC members should determine how distributions will be made within the agreement. Owners typically receive distributions in proportion to their ownership percentages. These distributions are often taxable to the member upon receipt. Thus, although not included in the LLC agreement, the members may wish to include language in the articles of organization providing that they intend the LLC to be treated as a partnership because the resulting business entity will be a pass-through for tax purposes. If the members plan to distribute amounts unevenly, the operating agreement should detail the formula behind this decision.
• Compensation – Manager, Member and Employees. Operating agreements generally state whether the managers or members will be compensated for their service in such positions. Often, the managers will draw a salary, especially if the LLC is manager-managed. But outside managers may also be compensated on a salary basis or receive a percentage of the profit. The operating agreement should also address whether the members of the LLC will be compensated for their service. Members are generally not paid for services but receive distributions as the business profits.
• Buy-Sell Agreement. The buy-sell agreement outlines the procedures for buying out a member’s interest in the LLC. Because the death of a member can have a drastic impact on the value of an LLC, most buy-sell agreements require that owners first offer their shares to the LLC at pre-established amounts before they can sell the shares outside the company.

Advantages of Drafting an Operating Agreement

Although the law does not require a real estate LLC to have an operating agreement, it is a good idea. For one thing, if there are other members in the LLC, having a formal operating agreement will minimize the likelihood of future disagreements. An operating agreement will help to avoid disputes about the management and direction of the business. For example, the agreement can be used to specify how profits and losses will be allocated, and how voting rights will be given.
Aside from the fact that it can help to avoid disputes among the members and avoid confusion about the business’ direction, an operating agreement is well worth the effort for one big reason: liability protection. Members of an LLC are afforded protection from personal liability if the business is sued. However, this protection can be lost if the members don’t make a good-faith effort to comply with basic legal formalities. One of those formalities is keeping minutes for all member formalities, just like those who incorporate must keep minutes. Without an operating agreement, there is an increased risk that the LLC’s protection against liability will be lost.
An operating agreement cannot prevent all possible disputes, but it can help to resolve potential problems before they arise. That way, everyone knows their rights, responsibilities and obligations.

How to Write a Real Estate LLC Operating Agreement

For the operating agreement of a real estate LLC, the first step is to draft the agreement with all of the relevant terms between the parties. This involves discussing everything from the economic rights for distributions and profits to management terms and decision-making processes for selling property or bringing in new members. A few of the considerations for the LLC operating agreement include:
Next, for the agreement, the parties must determine how much funds will be required to form the LLC and how much each member will make as an initial contribution to the business.
Additionally, it is important for the members to account for transfers of property to the LLC that are made in exchange for membership interest. Such transfers should be structured correctly so that the new members do not owe estate or gift taxes or file any returns unless absolutely necessary.
For tax purposes, each LLC must have a tax ID number assigned by the IRS. The operating agreement will address how the entity and the members will be treated for tax purposes. For example, the agreement will state whether the members will be treated as partners, whether the entity is a corporation, sole proprietorship or partnership, and whether it is subject to an alternative tax.

Common Errors to Avoid

Material omissions and lack of flexibility in real estate LLC operating agreements are two common mistakes people make when drafting them. Often, these mistakes are the result of doing it yourself with little to no legal assistance. Operating agreements are sometimes drafted to comply with the terms of a contract, but this should not be the sole reason as they serve multiple purposes.
For example, if one member has more ownership than the other(s), but the voting power is equal, the operating agreement needs to address how those conflicting rights should be determined. Similarly, many people who own property together end up owning property through their single-member LLCs, but still treat themselves as 50/50 owners when it comes to making decisions about the property. If the LLC owns the property jointly with the other(s), the membership percentage should reflect this ownership – regardless of the practicalities discussed above.
Another pitfall seen often are companies whose ownership percentages are based on the amount of capital being contributed to the capital. However, if the company needs to borrow money to purchase the property, and the selling member does not want to or cannot guarantee repayment, the company needs to find alternative financing, which may require the approval of the members. If the parent company has a majority interest in the selling member, but not in the second member, the parent company’s members may find their control limited by the right of even a minority member to block certain actions.
A less common mistake is failing to make clear whether the company or the members will be taxed. S corporations are taxed as pass-through entities , but with increased revenue the company may want to switch to a C Corporation and pay tax at the entity level. Although there is no legislative action to increase the corporate tax from 15 to 21% (at least not yet), a change in tax status is often advantageous when substantial revenues are being generated.
While it may be necessary to alter the standard language in each section of the agreement, payments of distributions and the return of capital must be specified. The agreement must also address the process for capital contributions in the future, and how these contributions can be diluted in the event of a capital call.
For any issues not covered by the operating agreement that come up down the road, the members need a mechanism to resolve disputes. Depending on the ownership percentages of the members, arbitration may swiftly resolve what could become a lengthy court battle. Where the main goal is to keep the company out of the courtroom, the decision-making authority and dispute resolution provisions must support this goal.
Executive directors and managers usually have a fiduciary duty to their company, but an operating agreement is needed to specify the particulars. The agreement should cover appointment and removal of executive officers and managers, powers of the board and the ability to delegate these powers, compensation, and any limitations on their authority.
Late amendments to the operating agreement remain a common problem, and is usually the result of a failure to start with a template. Members should ensure that the agreement is reviewed prior to every major event to eliminate the need to amend the document.

When to Revise Your Operating Agreement

A real estate LLC operating agreement is not a static document. It should change over time to reflect changes in your business, your investment strategy, your assets, your partners, and the law. Of course, we all have limited time and a tolerance for administrative activities that is lower than it should be—so how do you know if it’s time to review and revise your operating agreement? Here are some indicators.
When one or more of the members have a significant change in financial situation, family situation, health, or other circumstances, it is a good time to review and update the agreement, regardless of whether the specific terms are likely to change or not.
Has there been a significant change in the law of LLCs? Such as a change in the state pursuit of charging orders as a remedy for LLC creditor claims?
If you don’t remember the last time you brought the operating agreement out of the file cabinet, it’s time to refresh your memory and read through the terms again. How did you start the company? What business did you have in mind? Are there any terms that aren’t working for you? Do you feel confident about what you need to do if things go wrong? How often do you need to meet with the other members? What decision-making process is followed when you need to take action for the company? If you can’t answer these questions and find yourself hesitating about what to do when something needs to be done, then it’s time to review and revise your operating agreement to make sure you understand how to act as a Member and Manager of the company.

Help in Writing Agreements

It is important that LLC operating agreements are structured to meet the needs of the particular business and its members. It is never good enough to just copy a form you found on the internet or from a book. That is why I strongly recommend having an operating agreement prepared by your attorney. This is especially true in complex situations where there are many provisions that require specialized drafting or where there are partners with lawyer-like expectations as to how their partnership should be structured.
Members may also have special needs that require the use of an attorney to address. When I structure a company with multiple members , I like to think about the individual members and the business as well. For example, with families that own businesses, you want to think about the company, not just from the perspective of a family business, but also as an asset that may need to be divided someday between ex-spouses.
Your attorney can advise you on the proper treatment and terms of your operating agreement. He or she may be able to point out specific provisions that will be important to your particular situation. Often times this will include tax planning as well.
In any event, it is a good idea to have an operating agreement prepared by your attorney, and then review it regularly to make sure it still meets your needs.