Changing the Way LLCs Do Business

Small and mid-sized businesses, the majority of which are limited liability companies (LLCs), are the lifeblood of Arizona’s economy. But the way they are doing business — particularly managing themselves — is changing thanks to new rules governing all LLCs in the state going into effect on Sept. 1.

When the Arizona legislature enacted the first Limited Liability Company Act in 1992, tens of thousands of business ventures became formally established as LLCs, offering personal liability protection found in a corporate structure while allowing members to enjoy the state and federal tax benefits provided in a partnership setting.

The Act provided an operational framework, but failed to address fiduciary duties for LLC members or managers to one another and their business. At its core, the Operating Agreement would hold members to a contractual obligation of good faith and fair dealing when it comes to their own conduct and management of the company, particularly in the case of a business’s dissolution.

Initially, it was understood that companies doing business as LLCs would enter into formal comprehensive Operating Agreements when their company was registered. But in the decades since the Act’s passing, many businesses glossed over this unwritten expectation, resulting in agreements that are incomplete, insufficient or altogether absent.

In 2018, the legislature repealed and replaced the existing Act with a new one that specifically addresses several shortcomings. While the law itself is complex and cumbersome, with many of the changes affecting only businesses formed after Sept. 1, 2019, the issue of enacting appropriate Operating Agreements affects all LLCs in Arizona beginning Sept. 1, 2020.

So how can an LLC ensure its interests are best served?

Determine where your business stands. If a company does not have an Operating Agreement, it needs to bring the business into compliance. Even if it established an agreement years ago, revisiting the language and evaluating terms against the guidelines of the new Act can serve as a failsafe to prevent future issues. In some cases, ensuring the Operating Agreement’s language references the new Act may be sufficient. Consulting with an attorney focusing on small and mid-sized business issues can ensure the company’s unique circumstances are sufficiently addressed.

If an Operating Agreement does not exist, or is deemed inappropriate, the Act will define it on the company’s behalf, which could levy unfavorable outcomes (not to mention potential hard feelings) for members.

Discuss key issues affecting the operation of the business with partners. While it may be easier done before an LLC is formed, members should now define all the issues that can and likely will affect the business. Doing so will avoid uncomfortable and potentially highly contentious discussions when emotions may be charged. Topics to add to the agenda include:

• Membership structure, including who members are and how the business’s ownership is structured. Members should also discuss how the structure will adapt to member additions or departures, especially the process of buying out members or replacing them.
• Management, including addressing whether the business will be managed by an appointed individual or collectively by its members through voting. For the latter, it will be important to define how that voting structure will work and whether all votes are equal or if some members have more voting power.
• Investments, specifically, the amount of capital each member has invested in the business and how future funds will be raised if needed.
• Distributions, including discussing how profits will be distributed and losses will be absorbed among members. This could include equally dividing profits and liabilities, or weighting disbursement differently among members.
• Dissolution, which includes tackling the issue of how the company will be officially dissolved should all the members decide they no longer want to be in business. If the Operating Agreement does not address this, the Act requires that distributions prior to dissolution must be divided equally among members, regardless of their ownership stake.

Seek legal advice. Although do-it-yourself forms and online resources exist, consulting with a trusted legal advisor who focuses on small and mid-sized business matters avoids any potential future legal or financial issues in the agreement that could have a significant impact on the business.

Although the new Arizona Limited Liability Company Act of 2018 does not require companies to pursue a new Operating Agreement by law, a clearly written one will save companies a significant amount of time and money if there is ever a dispute. Not having an agreement in place can drastically alter interactions between existing members and managers, often to their detriment.

In Arizona, more than 90 percent of businesses in the state operate as LLCs. Last year, the Arizona Corporation Commission registered nearly 153,000 new LLC businesses. LLCs made up more than 86 percent of all new entity filings in the state.

An attorney with Guidant Law Firm, Stockton Banfield helps small and mid-sized businesses navigate a variety of issues, including commercial leasing, real estate disputes, contractor agreements, employment agreements, asset sales and general operational matters. A licensed real estate agent, he served the Arizona Association of REALTORS as an advisor on its legal hotline.