As a business owner an operating agreement or shareholders agreement (an “operating agreement”) is an essential element in the operation of your company. An operating agreement sets out the rules and regulations for the operation and management of the company.
There are many reasons why it may be time to review your operating agreement. If your business has undergone any significant changes, is operating differently, or has faced new financial circumstances since its last operating agreement was signed, it may be time for an update. While there are many reasons that an operating agreement may need to be reviewed and updated, there are five critical circumstances that likely warrant the amendment of your operating agreement.
- There has been a change in ownership of your business.
A change in the ownership of your business may have resulted for numerous different reasons. One of your past owners may have retired from the business or passed away. You may have decided to give a key employee an ownership stake in the business. You or one of your partners may have purchased the ownership interests of another partner. Any one of these events almost certainly necessitates that your operating agreement be revised to reflect and address the current status of ownership. For example, the prior ownership of your company may have been two 50-50 owners. With the addition of a third member owner, you now need to address different buy-sell situations. If an employee became an owner, you may need to add certain provisions to the operating agreement addressing any buyback or surrender obligations that were agreed with the new employer-owner.
- The operation of the business has changed since the time your last operating agreement was signed.
Every business evolves over time. Duties among the owners may have shifted and modified. The business line(s) of the company may have changed. Some of the business owners may no longer be involved in the management of the company. Your operating agreement should be updated to reflect ad hoc changes to the operation and management of the company. One example of a change in circumstances necessitating an update would be if your operating agreement contemplated that all of the owners would agree on all business decisions. That management provision may need to be changed to limit the management consent requirement where there are now passive owners.
- Changes in the law and tax rules.
The law is never static. Every year, new regulations or statutes are enacted by governing bodies that may impact the business operations, management, and finances of a business. It is critically important that a company periodically review its operating agreement to ensure that it is in compliance with the law and taking advantage of any benefits or accommodations afforded it under the law. For instance, the Internal Revenue Code (the “Code”) provides that a business may designate one person to serve as the tax representative for a company. The designation of such a person can help to expedite notices from the Internal Revenue Service (the “Service”) and can streamline the audit and collection dispute process for a company. Until 2018, the Code provided that such a person would be the “tax matters partner” designated by the company. At that time, new regulations were adopted, which provided that such rights would now belong to a “partnership representative” if one was designated by the company. If your operating agreement still references to a tax matters partner, it is likely that such person does not have the rights he otherwise would have as partnership representative which could potentially delay the resolution of any outstanding issues with the Service.
- Sales and acquisitions of significant assets.
If your company has acquired another company or sold off significant assets, you almost certainly need to update your operating agreement to address the structural changes arising from such a transaction. In addition, the acquisition or sale of important assets to or from another business may give rise to the need for an update to your operating agreement. For example, some operating agreements specifically address the distribution of certain assets to specific owners in the event of an owner’s departure from the business or the dissolution of the company. In the event that some of the assets designated for specific distribution may have been sold, the operating agreement should be updated to modify or eliminate any provisions that dealt specifically with those assets. In cases where an operating agreement provides for specific distribution of assets that are no longer are owned by the company, and the operating agreement has not been amended to reflect this change, there could be a disagreement as to the import of that asset lost. Disputes of this nature can be very costly. Conversely, you may want to add certain provisions setting out the allocation of newly acquired assets to a particular owner.
- How to handle succession matters.
As your business and its owners mature, you should consider succession issues to ensure the continued viability of the company. Principal considerations should be what happens to the ownership interests of an owner who retires, dies, or becomes disabled. The owners need to consider if they would be agreeable to having the spouse or children of a deceased or disabled owner as partners in the business. Even if agreeable, who would provide the services that such departed owner provided to the business in the past and would those relatives of the departed or disabled owner have a say in the management of the company?
A periodic review of your operating agreement can be one of the most important actions your business can undertake. Finding out that your operating agreement is outdated, or perhaps even invalid, could leave your business and you and your fellow owners subject to the default rules put in place by the state where your company was formed. This almost certainly is a position where owners would rather not find themselves. Having to negotiate or, worse, litigate a dispute among business owners which could have been addressed in an operating agreement undoubtedly will cost you many times the cost of periodic reviews and updates of your operating agreement.
Please contact Henry Forcier, Esq. at , or 646-247-6792, to discuss updating your operating agreement or shareholders’ agreement.
