Drafting Operating Agreements For A New York Limited Liability Company
This is an article on one aspect of business agreements, that of drafting an operating agreement for a New York limited liability company. In particular, the article will cover an aspect of the operating agreement that is frequently overlooked when the operating agreement is drafted and signed.
In New York, after you form the limited liability company, you are required to adopt an operating agreement. The operating agreement is to set forth the relative rights, obligations and liabilities of the members of the limited liability company, as between themselves and as between themselves and the limited liability company. As an aside, note that the operating agreement is not a public document, that is, it is not filed with the New York Department of State as are certain other limited liability company documents.
In the event an issue arises that is not covered by the operating agreement, the limited liability company will then need to look to the Limited Liability Company Law to see if the issue is addressed in the statute. There are several obvious issues that may well arise which are not covered by the Limited Liability Company Law.
One issue is, what happens at the death of a member of the limited liability company?
At the death of a member, the estate of the deceased member is not substituted as member and does not become a member. The estate would only have what is known as a membership interest, that is, it is more or less a financial interest in the profits that the limited liability company may make. For example, if there are three members and one member dies, and they were all equal members, then the estate of the deceased member would have a one-third interest in whatever profits the limited liability company may make.
However, an estate is a liquidating entity, that is, its mission is to, among other things, realize value for assets and to distribute and in effect, when the administration is complete, to go out of business. An estate should not be kept open simply because it has a membership interest in an ongoing limited liability company. Therefore, from the point of view of the estate of a deceased member, the operating agreement should have a provision addressing what happens upon the death of a member. Presumably, the provision would be along the lines of some kind of a buy out agreement. The agreement could have a complex formula for the buy out or could have something much simpler, such as that the estate of a deceased member would be entitled to the value of his or her capital account in the limited liability company at death.
From the point of view of the limited liability company, the operating agreement should also address the issue of what happens upon the death of a deceased member. This is because, if the estate retains a financial interest, the other members are in effect working for the estate of the deceased member but the member is deceased and is not actually contributing any money or effort to the ongoing business of the limited liability company. Also, there is the matter of section 608 of the Limited Liability Company Law, which provides that the executor of a deceased members estate may exercise all of the members rights for the purpose of settling the estate and for the purpose of administering the deceased members property.
The effect of the statute is that, in some situations, the estate will have a vote in whether or not assets of the limited liability company are to be sold. For example, assume again that there are three members, all equal, in the limited liability company and one of the members dies. This would leave only two voting members, each with an equal vote. Assume further that one of the members would like to sell the business of the limited liability company but that the other would like to continue the business. The member who wishes to sell the business could get together with the estate of the deceased member and the executor of the estate could vote to sell the business or assets of the limited liability company. This would result in a two-thirds vote to sell the assets of the limited liability company. This in turn means that there would be a nonparticipating entity, the estate, having a substantial say in the limited liability company. The executor would have the right to cast a vote to sell the assets because the executor has a valuable property interest and is required to make a diligent effort to obtain value for the interest.
The lesson here is to address the issues surrounding the death of a member in the operating agreement and not to leave these issues to be dealt with at a later time, when a member dies.
Wayne Burton has been practicing law in the Albany, New York area since 1978. His practice areas have been estate planning, probate and estate administration and contested proceedings, business, including buying, selling or starting a business and business litigation, professional practices, buying or selling real property, and fire districts. He is of counsel to the law firm of Buckley, Mendleson, Criscione & Quinn, P.C., and represents that firm in its general corporate and other matters.