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As an attorney who helps small business owners who have disputes with their co-owners, I see a lot of California limited liability company operating agreements. Many are well-prepared and thoughtful documents that help founders protect themselves and their company. But many LLCs have problems that can lead to major disputes including expensive lawsuits between the owners down the line. One of those problems is in the way members are compensated.

What is an LLC Operating Agreement

An LLC operating agreement is a contract between the members of a limited liability company setting out the rights, powers, and obligations of the members. It also addresses important issues such as the buyout rights of any members who want to sell their shares, what happens if a member dies, and the process for resolving disputes between members. It is important to note that the operating agreement is not filed with the state but is a private contract between members. This means that if someone sues the company, they can’t go to the state and get a copy of the operating agreement. It’s a good idea to have a lawyer review the operating agreement before it is signed.

How LLC Members Are Paid

The owners of an LLC are called “members.” By default in California, an LLC works like a partnership: members are paid a percentage of the profits of the LLC based on how much of the LLC they own. The operating agreement typically sets out exactly how this works, including how much of the LLC each member owns, what percentage of profits each owner will be paid, and how often the company pays out these distributions. Some operating agreements do not specify when distributions will happen instead simply proving that the members will vote to decide when to take distributions, but this is a mistake. If the operating agreement doesn’t say when distributions will happen, it can become a major point of dispute between members – and if one member can block the payment of distributions by voting against them, that member could stop the other members from being paid at all if some other dispute arises.

Notably, by default, IRS rules prohibit an LLC from paying wages to its members. That’s because LLCs are treated as partnerships by default, and partners can only take profits, not wages.

Many LLCs are formed with the assumption that all members will put in equal work, but that rarely turns out to be the case

As explained above, LLC members typically receive distributions based on their ownership interest in the company — not based on how much work they put in. Many LLC owners I talk to simply assume going into the business that all members will work hard or at least put in an equivalent amount of labor. For instance, many LLCs are formed between two people, each of whom have a 50% interest. I often see businesses set up with the assumption that one member will handle day-to-day operations and another will handle “marketing and finance” or something like that. In that case, it almost always turns out that the “day-to-day” person ends up working 12 hour days and the “marketing and finance” person works a couple hours a week. But they are both paid the same!

It doens’t take long for this type of situation to dissolve into resentment and acrimony. And that’s when I get the call from one member asking about how to sue the other one. That’s exactly what you don’t want to happen in your LLC. So how to avoid it?

IRS treatment as a corporation allows hiring members as employees

The IRS allows an LLC to elect to be treated as a corporation for federal tax purposes instead of as a partnership. This allows you to pay your partners wages as employees of your company. This can be a good solution if one member is contributing more than the other, since an employee is entitled to be paid wages based on how much work they put in.

Why to include treatment as a corporation in the Operating Agreement

Your operating agreement should specify that the members agree they will elect to treat the LLC as a corporation for purposes of IRS tax treatment. Why? Because this election can only happen after the LLC is created, and by that time you may already have a dispute. I recently helped a company that ran into this problem within a couple of months after forming. They had not gotten around to looking at any IRS forms yet. But already the day-to-day person was angry that the “marketing and finance” person was working so little while the day-to-day person worked without pay for 12 hours a day. And the “marketing and finance” person realized they had a great situation: they could sit back and let the day-to-day person do all the work without pay, and get 50% of the profits for doing almost nothing. So the “marketing and finance” person refused to allow the company to elect to be treated as a corporation – and because they had a 50% vote, they could successfully stop the day-to-day person ever from being paid a wage.

If these founders had considered this issue and had specified in the operating agreement that the company would elect to be treated as a corporation — or even if they had found any other way to ensure that a member would be compensated for their hours of work — they could have avoided this conflict that tore apart their LLC.

Conclusion

Your operating agreement is a critical document that will help you launch and operate your business and protect yourself and your partners from lawsuits. If you haven’t already, now is as good a time as any to get started on your operating agreement. And make sure that you include provisions for paying members for their labor and specifying what type of work each member is doing.