I Mean, Who Writes This Stuff?

I Mean, Who Writes This Stuff?

      A significant portion of my practice is devoted to both writing operating agreements and as well reading operating agreements written by others.  Sometimes, in the latter role, I am just shocked by what I read.

      For example, recently I was reading an operating agreement written by an attorney in another firm here in Louisville (I’m not going to disclose either the attorney or the firm).  This operating agreement, for a multiple-member LLC, elected that the LLC would be taxed as an S corporation.  Why that election was made is not discussed in the agreement (not that it need be). Typically, I think that the LLC with an S corporation election is an unnecessary complexity that seldom addresses an actual problem. HERE is a link to an article I wrote on that topic.  I do, however, freely acknowledge that there are, typically in highly lawyered transactions, an occasional use for this structure.  Whether this LLC was one is open to debate.

      But setting aside the question of policy, there is the clear question of implementation. This operating agreement for an LLC that has elected to be taxed as an S corporation provides for a “tax matters partner” (a “TMP”). The only problem with this provision is that the TMP is a creation of TEFRA, and those aspects of TEFRA are not applicable to S corporation.  Rather, the TMP relates to certain special procedures applicable to some partnerships (including LLCs taxed as partnerships) under what is called a “TEFRA audit.”  That can’t happen to an S corporation.

      While the inclusion of the TMP in an S corporation LLC operating agreement may fall under the category of “no hit no foul,” another provision of the operating agreement was not so innocuous.  S corporations are held to a “single class of stock” rule to the effect that each share/membership interest must have identical economic interests in the company.  The way the waterfall is written for this operating agreement with respect to liquidating distributions violates that rule and in effect creates two classes of stock. Thereby, at minimum, this agreement potentially violates the S corporation rules and in so doing terminates the election of the LLC to be taxed as an S corporation (there may be an opportunity for cure).  In that instance, the LLC ends up being classified as a C corporation.

      I am always amazed at the willingness of general practitioners to draft operating agreements.  While nobody will “take a stab” at writing a 401(k) plan, it seems everybody thinks they can write an operating agreement.