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Avoid Disaster With Your Single-Member LLC

Pad lock and chain securing handles to Single-Member LLC business

Do you own a single-member LLC? If so, your business can become paralyzed if you become incapacitated or die. Even a short paralysis may cause a business to collapse. Avoid this problem by doing the following:

  1. organizing single-member LLCs as manager-managed,
  2. drafting an operating agreement that both appoints a successor manager in the event of the manager’s incapacitation or death,
  3. either having the membership interest owned by a trust, or including a “transfer on death” registration for the membership interest in the operating agreement.

Why a Single-Member LLC Should Be Manager Managed?

Essentially, there are only two choices for management of an Arizona LLC: member managed or manager managed. A.R.S. 29-681. When an LLC has a single member who is active in the business, it may seem unnecessary to designate that member as the manager. After all, a member of a member-managed LLC has all of the powers of a member and all of the powers of a manager. A member of a member-managed LLC, however, cannot easily delegate management authority to a third party when the member is incapacitated, is disabled or dies. Further, on the member’s death, the management authority may suddenly be split between multiple heirs. In a manager-managed LLC, the operating agreement provides the needed flexibility and continuity of business operations to keep the business running.

Example:

Assume a 50-year-old married man who has two children is the sole owner and member of a member-managed LLC that owns and operates a profitable business. If the owner becomes incapacitated or dies, there may be initial uncertainty as to who has the authority to operate the business. Even if the spouse or children are best suited to run the business, they may not have the authority to do so. If a trusted employee is best suited to run the business, he or she also may not have the authority to do so. Leaving this issue to be sorted out by the member’s conservator, trustee, or personal representative will take time and will likely result in unnecessary business interruption and conflict. But, if the LLC was manager-managed, the member could have appointed a successor manager and eliminated the uncertainty, delay, and, hopefully, conflict regarding who will run the business.

Why Have an LLC?

A sole proprietor can form either an LLC or a “S” corporation and receive many of the same benefits discussed in this article—namely business continuity and transfer on death registration. An LLC provides more flexibility, however, for the varying situations that a business owner may encounter. Through a carefully constructed operating agreement, the owner of an LLC can designate or appoint a successor manager to act when the owner becomes disabled, incapacitated, or dies. An officer of a corporation, on the other hand, is appointed by the Board of Directors, A.R.S. 10-3840, and the (likely) sole director is elected by the sole shareholder. When the sole shareholder is also the sole director and sole officer, the business may be stuck without anyone who has clear authority to run the business or take other necessary actions to keep the business afloat upon that shareholder’s disability or incapacity. In addition, the flexibility of the LLC operating agreement presents a preferable opportunity to give a successor manager limited, but specific, powers to deal with the real-life duties of the business owner.

The Single-Member LLC Operating Agreement.

Appointment of the Successor Manager.

Arizona’s Limited Liability Company Act states that a manager shall be designated or elected and may be removed or replaced in the manner provided in an operating agreement. A.R.S. 29-681. This seems to imply that the operating agreement can designate or appoint the successor manager by including a provision similar to the following:

MANAGEMENT. The Manager shall manage the business and affairs of the Company. The Member shall serve as the Manager. The Manager shall serve as Manager until the Manager is terminated, resigns, becomes incapacitated, or dies, at which time the successor manager, if any, becomes Manager. The Member may, by vote, remove any Manager without cause and elect a successor manager. The Member may appoint a successor manager and may at any time revoke an appointment and appoint a different successor manager or no successor manager. The Member hereby appoints _____________ as successor Manager.

Transfer on Death Registration.

As with any security, a membership interest in an LLC can be registered as transfer on death. See A.R.S. 44-1801 (26) and 29-732. Transfer on death registration can simplify this succession by eliminating: (1) any guesswork about who is the holder of the deceased member’s interest; and (2) the need to probate the member’s interest in the LLC. A.R.S. 14-6307. Of course, care should be taken to ensure such registration fits in with the member’s overall estate plan. The following provision can be added to the operating agreement:

REGISTRATION OF MEMBERSHIP. The registration of the membership of the Member, [Name of member], shall be as follows:

[Name of member], transfer on death to ______________.

Practical Guidance for Who Should be Successor Manager.

There are three important points to consider when counseling the owner as to whom to appoint as successor manager.

Choose Someone Who Knows How to Run a Business.

The owner obviously will want to leave the business in the hands of someone who can actually run it. As a practical matter, the successor manager must be someone who knows the business, knows what must be done, at a minimum, to keep the business running on a day-to-day level, and must be someone the owner trusts. When the successor manager is in charge, by design, the owner is probably unable to provide any effective oversight or guidance for the successor manager or the business. In addition, many people may be perfectly suited to run the business for a short time in normal circumstances but may not be good successor managers. For instance, a spouse may be too distraught upon the incapacity of the owner to be an effective manager.

Spell Out the Successor Manager’s Role.

It is important that both the owner and the successor manager understand, in a general sense, what an LLC manager does and does not do. The manager, unless otherwise provided in the operating agreement, has the sole right of management and conduct over the LLC business. A.R.S. 29-654. Except as provided below or in the operating agreement, the manager exclusively decides all matters relating to the business of the LLC. Some pertinent exceptions to the manager’s authority provide that, except as provided in the operating agreement, the members have the right to amend the articles of organization or the operating agreement, to dissolve the LLC, to make interim distributions, to admit a new member, to dispose of all or substantially all of the LLC assets, to merge or convert the LLC, to incur debt outside the ordinary course of business, to approve conflicts of interest, or to change the nature of the LLC business. If left to the defaults in the LLC statutes, then, the successor manager essentially has the right to run the business on a day-to-day basis in the ordinary way in which it has been run in the past. The operating agreement, however, may (and perhaps should) provide for a very different sort of management structure by both augmenting and limiting the successor manager’s authority to better suit the situation (as explained more fully below).

Hold Successor Manager to High Standard.

Just as the client does not want to set the LLC up for failure, the owner does not want to set up the successor manager for failure (or liability) either. The best practice would be for the operating agreement should specifically set forth duties of loyalty, fairness, good faith and fair dealing. However, an unreported Arizona Court of Appeals case from 2008 suggests that Arizona courts may imply such duties where the operating agreement is silent.  While the incapacitated owner would probably assert a cause of action against a successor manager only for intentionally wrongful conduct, the heirs of the owner may well try to recoup damages for a business venture that loses value while in the hands of the successor manager. To alleviate concerns that the successor manager may have, the operating agreement should fully indemnify the successor manager to the extent allowed, and the successor manager should be carefully selected for the job. The successor manager should also be informed as to who the owner’s heirs are and, if applicable, their personality “quirks.”

Of course, this arrangement will work only if the person appointed as successor manager knows that he or she has been appointed the successor manager and actually agrees to be the successor manager! Make sure that the owner has talked with this person and communicated both what the job entails and the triggers for when the job “begins.”

Ultimately, the owner of the business will know who best fits the qualifications for acting as successor manager. The practitioner’s job is to make sure they understand what those qualifications are.

Not all Managers are Created Equal.

The operating agreement can specify exactly what powers a successor manger possesses. A single-member operating agreement should take advantage of this flexibility by delineating different powers for a manager who is a member and a successor, non-member manager. As explained above, even though by default the manager manages the day-to-day operations of the business and the members retain control for major decisions, these defaults can be modified by the operating agreement.

In the first instance, the owner as manager will always have complete power over the business, and the operating agreement can (but need not2) make this explicit. In contrast, the powers of the successor manager should be explicit. Particularly if the operating agreement grants the owner-manager unfettered authority over the business of the LLC, the operating agreement should limit the successor manager’s powers, perhaps to the statutory defaults of a manager. Those powers should then be explicitly augmented. Some augmentations that may be warranted include the power to allow (or require) the successor manager to make distributions for particular circumstances, such as to pay the owner’s recurring debts; to liquidate or sell the business if the owner has significant expenses for longer term, ongoing care; or to incur debt or engage in other activities that are outside the ordinary course of business but may be needed in dire circumstances.

Here’s an Example:

Imagine an 85-year old woman who has four children is the sole owner and manager of a manager-managed LLC that owns an apartment building. She has appointed her oldest son as successor manager and her youngest daughter as next successor manager (her other two children live outside the area). All four children are her heirs. The operating agreement grants her the full power to conduct the business of the LLC, inside or outside of the ordinary course. The owner has started to show signs of dementia, and she has saved funds to stay in a long-term care facility. The operating agreement could provide that the successor manager takes over when the owner-manager is incapacitated, disabled, or dies. The operating agreement can also provide that, if the owner-manager is incapacitated and living in a long-term care facility, the successor manager will make regular distributions of a certain amount and interim distributions to pay for the costs of the facility (and other debts) not covered by insurance or savings. The operating agreement can further provide that, upon sudden incapacity or disability requiring acute care, the successor manager is authorized to sell the property as needed to pay for procedures or acute care facilities for treating the owner or to refinance the property’s mortgage. In addition, when the member dies, the successor manager has the clear authority to collect rents, execute leases, terminate leases, pay the mortgage and the like.

Two Warnings.

First, the use of a successor manager may not work or may require special treatment in the case of a business with a specialized license. For instance, not just anyone can become the successor manager and run a construction business, law firm, medical practice, or real estate brokerage, unless they have the appropriate license.

Second, in most cases, the owner of a single-member LLC will guarantee some of the debts and obligations of the LLC, such as long-term loans or lines of credit. A likely possibility is that those guarantees or original documents will default when the owner dies or becomes incapacitated. In this situation, a successor manager will not only face the difficulty of caring for the owner and trying to run the business, but may also be trying to deal with creditors (most likely secured with the assets of the business) who are legitimately concerned with the continued viability of the business as a going concern.

Conclusion.

While a manager-managed LLC may not be a panacea for ensuring that a business owned by a single individual survives the disability, incapacity, or death of that owner, it provides sufficient flexibility to give a business a good chance to continue. The flexibility provided by the LLC statutes can and should be utilized to provide for the client and the client’s business when such disasters strike.

Please contact Magellan Law with any questions about this article, or any other issues relating to business organizations.

This article provides general information. You should not construe this article as legal advice or a legal opinion on any specific facts or circumstances. If you have specific legal questions, consult with counsel concerning your own situation.

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