Texas LLC Operating Agreements - 3 Critical Mistakes That Could Cost You Everything
- Chris Johnsen
- 5 days ago
- 5 min read
If you used an online template or an AI tool to form your Texas LLC, your business may be at risk. Online templates and AI tools are fine for getting the basic structure of an LLC right, but they often lack the critical, tested language that can help safeguard the assets of owners in the event of a lawsuit.
The Company Agreement, also known as the operating agreement, is essentially a rulebook for the company. If the rules are incomplete, however, the default laws of the state where the company is organized can have a disastrous impact.
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Why Your Template Isn't Enough
Most entrepreneurs view the operating agreement as a fill-out form, much like incorporating a company. However, as a law firm that both drafts operating agreements and litigates disputes over them, we can attest to the fact that “ boilerplate language” does not translate to “boilerplate results.” An effective agreement is not just another piece of paper that goes into a business’s file; it is an insurance policy that prevents what would otherwise be a disastrous legal event.
1. The Missing Exit Strategy: Buy-Sell and Transfer Provisions
Controlling Who Enters Your Business
Do not allow the default rule to permit the transfer of a member interest by any means. If a member’s interest can be transferred with the consent of the majority, a soon to be ex-spouse could accept an assignment of duty before divorce is final, or a child seeking to avoid obligations to parents could quickly transfer shares after a parent’s death during probate.
Planning for the "What-Ifs"
There is a "belt and suspenders" attitude required when drafting the involuntary transfer provisions of the member agreement. The agreement needs to clearly set out what steps are required where a member is to be involuntarily transferred. This might include reference to specific steps the Co-operative will take, how much notice must be given, and even how the transfer fee will be determined. Your agreement must define exactly what happens if a member:
Passes away or becomes disabled.
Files for bankruptcy.
Steals from the company or tries to poach a client.
This is a big one: Don’t just say people can or can’t transfer shares. Say what you mean to say: how are you going to value the shares if someone tries to transfer them (and in your contract, the transfers are valid despite your disagreement) and then buy out those transferred shares. The last thing you want is for a catastrophic and expensive dispute over the value of your company.
2. Vague Voting and Decision-Making Powers
Defining Authority Beyond "One Person, One Vote"
In Texas, the default method of voting is one vote per person. However, with an operating agreement, you can establish a method of voting by membership interest (i.e. percentage of ownership). You should also establish the percentage of action required in the operating agreement.
Majority: For day-to-day operational decisions.
Supermajority (e.g., 67% or 80%): For significant milestones.
Unanimous Consent (at your house): For "existential" decisions like selling the company.
Deadlock Provisions and Management Structure
In a 50/50 ownership situation, a deadlock provision, known as a tie-breaker or method of company exit, is generally required to avoid a complete deadlock or dissolution of the company. Also, be certain to specify whether your LLC is to be Member-Managed or Manager-Managed.
Pro Tip: Don’t select the wrong management structure for your LLC when you file for your Certificate of Formation (it can cost more to fix later).
3. The "Phantom Income" Trap: Distribution and Tax Allocations
The Danger of Minority "Squeeze-Outs"
In a Texas LLC, income is passed through to the members for income tax purposes. Therefore, even if the LLC has not made a distribution to the member for a particular year, the member will be required to report his share of the LLC’s profit and pay income tax on it. Often, the majority member(s) will hold off on making distributions to the minority member(s) when the LLC is profitable. As a result, the minority member may have to pay a large tax bill out of his own pocket when he has little or no cash available. This phenomenon has been referred to as “phantom income.”
Mandatory Tax Advances
Agreements often have to be written to prevent majority partners from “squeezing out” minority partners. One provision that should be included is a requirement for a tax advance. This ensures that the company will have to distribute at least enough cash to its members to pay the specific tax attributed to that member on the company’s profits.
Customizing the "Waterfall"
While the distribution percentages don't have to add up to 100 percent, there are instances where a distribution formula could account for a return of capital for a partner who supplied the initial capital to begin the business. The return of capital would be distributed prior to other owners receiving a share of profit.
Looking Ahead: Protect Your Business Before the Dispute Starts
Addressing LLC transfers, voting, and tax distributions can be the difference between a positive LLC operating agreement and a 10-year legal battle. As with most LLC agreements, it is advisable to have a lawyer review your document to ensure everything is in compliance and that the agreement is fair to all members.
However, having a lawyer draw up an agreement from scratch that addresses LLC transfers, voting, and tax distributions can be much more cost-effective if done by an experienced lawyer, as he can negotiate the terms and ensure that the agreement is fair and that the LLC member has the option to have the agreement enforced should there be a dispute.
Are you sure your Texas LLC is properly protected? Let an experienced commercial litigation attorney here at Johnsen Law review your Company Agreement to patch any leaks before they cause damage.
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