E-2 Investor Series – Operating Agreements

What E-2 Visa Investors Need to Have in Their Operating Agreements and Why They Need One

First, we need to take a quick look at the various types of business entities, and why starting a limited liability company is the type of entity we generally recommend for E-2 investors. We will now examine the various clauses included in an operating agreement.

Types of Business Entities

Sole Proprietorship:

A sole proprietorship is NOT a legal business entity. A sole proprietorship exists when a natural person owns a business (which the person did not formally register as a separate legal entity).  This has no separate existence from its owner, and therefore the owner of the sole proprietorship is personally liable for all acts, debts, or liabilities of the sole proprietorship.  Also, can operate under the owner’s name (frequently without any additional need for registration), or the sole proprietorship may operate under a fictitious name (for example, a “DBA”). A fictitious name or “DBA” does require formal registration with the state where the DBA is operating (usually this is required by law). The lack of liability protection for the owner makes a sole proprietorship.

A sole proprietorship and its owner are the same. For example, taxable income earned by the business is also the income of the owner. Business expenses are deducted from the owner’s income. And they must be reported as such on the owner’s federal (and state, if applicable) income tax return. Sole proprietorships are taxed on all net income. This means that the business cannot retain profits without the owner being taxed on them. If the owner wants to use the business income to grow the business (e.g., to reinvest profits in the business), he or she should consider a different type of legal entity, such as a partnership.

Corporation (C corporations or S corporations):

A corporation IS a legal entity that exists separately from its owners (in this case called “shareholders”), officers, and directors.  The laws of the state of domicile govern corporations. The law constitutes or authorizes companies to do business in the state. To incorporate a business, the founders of the corporation start by filing articles of incorporation with the state’s appropriate entity. After incorporation, shareholders receive the company’s issued shares in exchange for the cash or other assets they transfer to you in exchange for those shares. Once a year, the shareholders elect the board of directors, who meet to discuss and guide corporate affairs anywhere from once a month to once a year.

Corporations offer “limited liability” to their shareholders (also known as owners).  A corporation’s shareholders will generally not be personally liable for the acts or obligations of a corporation.  The shareholders can lose their liability protection if the corporation is merely the “alter ego” of its shareholders or a “mere corporate shell;” or, if the corporation commits an act (or operates in a way) that permits others to “pierce the corporate veil.”  “Piercing the corporate veil” is a situation involving courts setting aside the corporation’s limited liability protections, and holding a corporation’s shareholders or directors personally responsible and liable for the corporation’s actions or debts. Laws governing piercing the corporate veil vary from state to state. And are generally only applied in egregious situations involving misconduct, fraud, undercapitalization (at the time of incorporation), etc.

The formalities required of corporations apply even to small, private, or professional corporations. Professional corporations are reserved for professional services businesses like legal, medical, or dental practices.  A newly formed corporation needs to issue common stock to the shareholders and must elect a board of directors. Even if only one person is part of the corporation. And may elect themselves to the board of directors. Also may elect any other individuals that a single shareholder chooses.

There are two types of corporations in the US:

a C-corp. and an S-corp.  What are the main differences between the two?  A C-corp is taxed as a separate entity, separately from its shareholders (you may have heard of the reference to this concept as “double taxation”). An S-corp. (typically referred to as a “pass-through” entity) is not subject to “double taxation,” at the federal level, and the S-corp. does not pay income tax as an entity.  The profits and losses of an S-corp. are “passed through” to the respective shareholder’s tax returns, using a Form 1120-S.  An S-corp. is also limited to a maximum of 100 shareholders.

Under the US tax code, “a foreigner, non-citizen, resident alien” may be an S-corp. shareholder.  Generally, an S–corp. cannot shareholders who are nonresident aliens.  Therefore, an E-2 visa investor may not be an owner (also known as a shareholder) of an S-corp. An E-2 Visa investor may own a C-corp. or an LLC.

Limited Liability Company (LLC):

We will start by stating that for most individuals (especially E-2 Visa investors) we recommend strongly considering formation as an LLC (although you should always speak with your attorney as your situation may be different).  Corporations have many strict requirements related to structure, with directors and officers, frequency and structure of board meetings, a form of board resolutions, annual meetings, etc.  LLCs do not (generally) require a strict structure. LLCs are generally very flexible and customizable (so long as we adhere to US Treasury Regulations, US tax laws, and the LLC domicile state’s limited liability company act), and the LLC may have foreign owners. 

This flexibility makes LLC formation an attractive option for E-2 investors. Also, LLCs are similar to S-corps. And they are generally not taxed as an entity. The profits and losses “pass-through” to the individual members (also known as owners).  A US limited liability company provides limited legal liability to its owners, similarly to a C-corp., although the type of entity you select greatly affects US tax filing obligations and ultimately changes the total amount of income tax due on the organization’s profits.  The tax savings alone make the limited liability company a great option for E-2 Visa investors.

Limited Liability Company Operating Agreements

Why Limited Liability Companies Need Operating Agreements

An LLC’s operating agreement is a contract between the members (a/k/a owners) of the LLC, which also states all of the details about the operations of the LLC.  All limited liability companies should have an operating agreement, even if the LLC is a single-member LLC, but especially if the LLC has two or more members.  The operating agreement governs the LLC, and controls the outcomes in a variety of situations including (but not limited to): members’ rights and restrictions regarding the management and control of the LLC; equity structure; allocations of profits and losses; succession planning issues (such as limitations on the transfer of membership interests, exit strategy, buy-sell provisions, creditor’s rights issues, etc.); which members approval is required for issues regarding management of the LLC (such as veto rights, special voting requirements, formal process for conducting votes, etc.); and, other tax or governance issues.

Let’s take a closer look at some of the more important provisions of an LLC operating agreement:

Members’ Rights and Restrictions (Management and Control):

LLC operating agreements may name any member (a/k/a owner) as the manager (also referred to as “member-manager” or “managing member”) of the LLC. The managing member will then have specific control and management power over the LLC. Generally, members can customize this within the operating agreement. The agreement expresses a member’s participation in percentage or units. The managing member may also create special classes of members to accommodate the addition of investors or new members.  

LLC membership interests are made up of two overlapping interests:

(i) an economic interest; and, (ii) a management interest.  It is important to note that members of an operating agreement can further customize it to provide unique economic rights. In an operating agreement, the members can even specify different allocations among themselves (as long as those specific allocations meet the “substantial economic effect test”, which we will discuss later in this post). The E-2 Visa investor (or a fellow national of the same country) must maintain control to maintain eligibility for the E-2 investor visa. In addition, the E-2 visa investor actively participates in the business.

Equity Structure:

Equity Structure can play many roles in the operations of an LLC.  First, we will discuss classes of membership interests, then we will discuss how equity structure affects the contributions and capital accounts of each member.

Classes of Membership Interests:

LLCs have a flexible capital structure allowing the members to create the equivalents of equity structures of either traditional partnerships or corporations.  An LLC may have voting or non-voting interests, common interests, preferred interests, convertible interests, profits interests, etc. The parties involved must establish all these interests in the operating agreement. Each class will have specific abilities and rights based on the provisions in the operating agreement.

For example, a convertible interest might occur if an E-2 investor purchases an interest in a successful property management franchise business (let’s call it ABC LLC), becoming one of ABC LLC’s members.  ABC LLC starts to grow and attract investors.  If ABC LLC wants to take on additional investors but does not want to grant control of the company to those investors ABC LLC might issue nonvoting membership interests to new investors.  ABC LLC might have a hard time attracting new investors because those new investors may be reluctant to invest in an LLC without some form of control over ABC LLC (that is where the voting rights come into play). 

Therefore, ABC LLC might instead opt to make the investment opportunity more appealing by offering convertible interests instead.  A convertible interest is essentially a loan from a potential investor to ABC LLC, where ABC LLC agrees to grant the new investor the right (at either any time or a set time) to convert the note (a/k/a the loan) into a specified voting or nonvoting interest in ABC LLC.

A convertible interest is much more attractive to a potential investor than mere nonvoting rights.  If the LLC takes off and grows exponentially, the investor will convert the note (that is the “convertible” part) into equity so the investor can receive a larger amount of gain.  If the LLC fails, the investor can hold onto the note, as a creditor, to recoup their investment either by earning interest on the payments or by receiving their lump sum before others do (this option is heavily dependent on the terms of the note and convertible interest).

Contributions and Capital Accounts:

LLCs have capital accounts to show each member’s capital contributions and ownership in the LLC.  The value of the assets contributed as seed capital contributions (by the founding members) determines the seed capital accounts. The initial contributions and percentages (or several units) are also part of the operating agreement.

If a member contributes property or something other than cash, the value of the contribution should generally be the asset’s fair market value.  The operating agreement should also indicate whether there will be only initial capital contributions or members will make ongoing contributions. Careful attention to drafting the operating agreement is necessary to avoid litigation among the members at a later time.

Distribution of profits and losses:

In general, the partners distribute profits and losses proportionally (according to ownership percentages). The website operating agreement may include several provisions. These could modify the default rule of proportional allocations if the members choose to do so.

Succession Planning:

Succession planning is another very complicated area, which we will expand on further in later blog posts.  For this discussion, we will focus on the important operating agreement provisions we generally recommend that our clients consider. Business Succession Planning refers to the practice of planning for a transition (or succession) in the business using estate planning strategies, exit planning strategies, buy-sell agreements, limitations on the transfer of LLC membership interests, and to deal with the potential sale (or liquidation or dissolution) of the business. 

Appropriate succession planning increases the chances of the survival of the LLC. Upon disability, retirement, sale, or (worse) the death of one of the members. Succession planning helps plan for eventual transitions in the LLC. And trust us when we say that everyone will eventually transition from their business ownership or investment at some point.

A well-planned succession strategy, even at the early stages of an LLC (for example, when you are initially preparing your operating agreement) can help the members ensure that some of the tough discussions about what happens to the LLC when one of the members must leave (forced sale, sometimes because of bankruptcy, the death of a member, etc.) or if a member wants to sell their interest.  Additionally, a solid succession plan encourages the members to determine who is realistically capable of taking over and running the LLC if one of the founding members leaves.

Here is an example (although, keep in mind that there are many different possible scenarios to consider):

Looking at ABC LLC (from earlier), let’s say that hypothetically there are 3 founding members: Alice, Li, and Jorge.  Alice and Jan are married (who are not involved in any aspect of ABC LLC). And Li and Jorge are married to each other.  ABC LLC manufactures organic health supplements and distributes them to a variety of small organic markets and a large chain called Entire Foods LLC. (That is enough of a hypothetical to create a large number of issues)

Now, let’s take this to the fifth year of ABC LLC. And let’s assume that in the fifth year ABC LLC is doing well. First, we can start with the fairy tale’s happy ending. That is the successful growth of the business with an eventual buyout offer from an outside entity. Great news to the founders’ right?  Maybe not.  What if Alice and Li want to sell, but Jorge loves the business and wants to keep going?  Not so great of a situation.  With properly drafted buy-sell provisions in the operating agreement, the partners can avoid an unpleasant situation. Buy-sell provisions facilitate the transfer of membership interests by providing a mechanism for orderly business succession.

Buy-sell provisions, in an operating agreement, can cover a large variety of succession planning scenarios. Including (but not limited to): a member deciding to transfer their interest due to a voluntary event (such as retirement, sale of the interest, etc.). Or an involuntary event (such as disability, incapacity, bankruptcy, or death). To avoid internal conflict and a smooth transition in situations where one or all owners desire to leave the business, a good buy-sell agreement may have any of the following additional provisions:

• Call rights. (The LLC may elect to purchase a member’s interest for a premium)
• Put rights. (A member may demand that LLC purchase their interest at a loss – minimizing risk for the member in question)
• Deadlock provisions. (For example, how to resolve a dispute among the members who refuse to agree on a resolution under the voting rights of the members)
• Rights of first refusal. (For example, if a member wants to sell their interest, they may have the obligation to present any bona fide offers to the LLC or the other members, with an option that they purchase the interest instead)

(Back to our example)

Let’s take a look at what else might happen to ABC LLC, from a different perspective. What if couples decide to divorce? Alice may have an obligation to split her interest with Jan, her spouse. Jan may have no idea how to properly run ABC LLC). This would be a terrible scenario. How could they avoid it? With a well-drafted operating agreement. ABC LLC could draft their operating agreement to require a right of first refusal. Can be in the event of a divorce or death of one of the members. Jan might still be entitled to the economic interest, (the cash value of Alice’s ABC LLC membership interest). But we could at least minimize the risk of losing control of the LLC membership interests.

Management of the LLC:

As we mentioned earlier, there are many operating agreement provisions that we can customize to fit our specific LLC. Some of those provisions, relating to LLC management are veto rights, special voting requirements, formal process for conducting votes. Also, proxies, meetings of the members, etc.  To properly plan for growth we need to prepare a solid foundation. In there, everyone must understand their roles, obligations, accountability. And can list out the details of each member’s responsibilities. Operating agreements can lay out the specific details of the way members must act toward the LLC and each other.

Other Tax or Governance Issues:

Other issues to consider are how we will resolve disputes among the members (or between a member and the LLC). We might add provisions covering indemnification of the members if they are sued while acting on behalf of the LLC. Confidentiality provisions, and restrictive covenants. For example, a non-compete, non-solicitation, or other provision restricting the members from acting against the LLC, etc. Lastly, there are many other issues to consider. Including potential tax issues related to the specific finances of each of the members.