Limited Liability Companies Part II
July 1, 2001
by J. Marc Ward

C. Compliance With State Law

    (1) Iowa Limited Liability Company Statute

      (a) Filing Requirements. An LLC is created by filing articles of organization with the Iowa Secretary of State.112 The articles must be accompanied by a filing fee of fifty dollars ($50.00).113 One or persons, including third parties, may sign and file articles of organization.114 Once the person files the articles of organization, the LLC comes into existence.115 The articles or organization must set forth all of the following:116

        1. A name for the limited liability company that satisfies other statutory requirements (discussed below).

        2. The street address of the limited liability company’s initial registered office and the name of its registered agent at that office.

        3. The street address of the principal office of the liability company which may be the same as the registered office, but need not be within this state.

        4. The period of its duration, which may be perpetual.

        5. The articles of organization may set forth any other provision not inconsistent with law, including, but not limited to, a statement of whether there are limitations on the authority of members to bind the limited liability company. Additionally, the articles of organization or an operating agreement (discussed below) may provide that a member’s interest in a limited liability company may be evidenced by a certificate of membership interest issued by the limited liability company and may also provide for assignment or transfer of any membership interest represented by such a certificate and make other provisions with respect to such a certificate.118 Initially, Iowa law required that a LLC have at least two members from the moment of its formation. However, in 1997, Iowa amended the LLC Act to allow for single member LLCs.119

      (b) Name Requirements. As mentioned above, there are rules pertaining to the name of the limited liability company. Those statutory rules are:120

        1. The name must contain the words “Limited Company” or “Limited Liability Company” or the abbreviation “L.C.” or “LLC” or words or abbreviations of like import in another language.

        2. The name cannot contain the words “Corporation”, “Incorporated”, “Limited Partnership”, or the abbreviations “Corp.”, “Inc.” or “L.P.” or words or abbreviations of like import in another language or any word or phrase the use of which is prohibited by law for such a limited liability company.

        3. The name must be distinguishable upon the records of the secretary of state from the name of a limited liability company, limited partnership, or corporation organized under the laws of Iowa or registered as a foreign limited liability company, foreign limited partnership, or foreign corporation in the state of Iowa or the fictitious name adopted by a foreign corporation, foreign limited partnership, or foreign limited liability company authorized to transact business in the state of Iowa, because its real name is unavailable.

          (i) Names of proposed LLCs are to be reserved for 120 days, and the owner of a reserved name may transfer the reservation to another person by delivering a notice of the transfer to the Secretary of State.

      (c) Registered Office and Agent. Each LLC must continuously maintain in this state each of the following:121

        1. A registered office that may be the same as any of its place of business.

        2. A registered agent who may be an individual who is a resident fo the state of Iowa and whose business office is identical with the registered office, a domestic corporation, domestic limited liability company, or non-profit domestic corporation whose business office is identical with the registered office, or a foreign corporation, foreign limited liability company, or non-profit foreign corporation authorized to transact business in this state whose business office is identical with the registered office.

      (d) Purpose and Powers. An LLC may engage in any lawful business except as otherwise provided by law, or as restricted by the articles of organization.122 Unless its articles of organization provide otherwise, a limited liability company has the same powers as an individual to do all things necessary or convenient to carry out its business and affairs.123

      (e) Management of an LLC. The owners, or members, may participate directly in the LLC’s management or they may vest the management in one or more managers elected by the members.124 If all of the members are entitled to manage the business, any member can bind the LLC in dealing with third parties unless specifically limited in the articles of organization.125 If the LLC is to be member-managed, the articles of organization or an operating agreement must specify this choice. 126 If not specified otherwise, the LLC will be deemed to be member-managed.127

      The articles of organization or an operating agreement may specify that a LLC will be managed by one or more managers who may be, but need not be, members.128 A manager may be any person as defined in the Iowa Code. Thus, a corporation or another LLC could be retained to manage an LLC. Managers are elected and vacancies filled by majority vote of the members.129

      (f) Liability of LLC Members. A member or manager of an LLC is not personally liable for the contractual or tort liabilities of an LLC by reason of being a member or manager of an LLC except as otherwise provided in the Act.130

      (g) Finances of LLCs. Contributions to LLCs by a member may be in any form including cash, property, services, notes, or other binding obligations.131 Unless provided otherwise a member is obligated to the limited liability company to perform any enforceable promise to contribute to the company even if the member is unable to perform.132 The only way around this obligation is a compromise by all of the members of the LLC.133 Distributions, profits, and losses shall be shared as written in the articles of organization or an operating agreement, or if no such document exists they shall be shared according to the members contribution.134

      (h) Rights of and Assignment by Members. Unless provided for otherwise in the articles of organization or operating agreement, a membership interest is assignable in whole or in part.135 An assignee of an interest may become a member only if the other members unanimously consent.136 If the assigneeassignor. Creditors do not become members automatically they only have the right and powers of an assignee.137

      (i) Right of Member to Bring a Derivative Action. A member may bring an action on behalf of the LLC is all of the following are met:138

        1. Either the management of the LLC is vested in a manager or managers who have the sole authority to cause the LLC to sue in its own right or management is reserved to the members but the plaintiff does not have the ability to bring the action.

        2. The plaintiff has made a demand of such managers to sue.

        3. The members of managers have failed to respond or wrongfully refused to bring suit.

        4. The plaintiff is a member of the LLC at the time suit was brought and was a member when the transaction giving rise to the suit occurred or the plaintiff’s status as a member devolved according to the article of organization.

        5. The plaintiff fairly and adequately represents the members’ interests.

      (j) Amendment of Articles of Organization. A LLC may amend or restate the article of organization at any time as long as no required articles are deleted. To amend the LLC must deliver to the secretary of state for filing:139

        (i) The name of the LLC.

        (ii) The text of each amendment.

        (iii) The date of each amendment’s adoption.

        (iv) A statement that the members voted on the adoption.

      (k) Mergers of LLCs. Any one or more limited liability companies may merge with or into any one or more limited liability companies, limited partnerships, or corporations as long as no member of a merging LLC will become personally liable for the liabilities or obligations of any other person or entity unless that member consents to the liabilities.140

      (l) Dissolution of LLCs. A limited liability company is dissolved and the affairs wound up upon the happening of the first of the following to occur:141

        (i) At the happening of an event specified in this chapter or as provided in the articles of organization or operating agreement.

        (ii) The unanimous written consent of the members.

        (iii) The entry of a decree of judicial dissolution under section 490A.1302.

      Upon the dissolution of a LLC the assets shall be distributed to creditors first and then as provided in the articles of organization and if not provided in the articles of organization to members and former members to satisfy liabilities for distributions and then for the return of their capital.142

D. LLCs - Negotiating and Drafting the Operating Agreement

    (1) Introduction

    While the articles of organization actually create the LLC for state law purposes, the operating agreement is the key document for the LLC. The operating agreement regulates the affairs of the LLC, the conduct of its business, and the relations of its members. An operating agreement may contain any provisions regarding the affairs of a limited liability company and the conduct of its business to the extent that such provisions are not inconsistent with law or the articles of organization.143 Generally, a typical operating will be a blend of partnership agreements and corporate bylaws, with an emphasis on partnership characteristics. Special tax provisions should also be contained in the operating agreement, including a qualified income offset provision, a minimum gain charge back provision, and identification of the tax matters member.

    (2) Agreement Must be in Writing

    Unless the articles of organization specifically permit otherwise, an operating agreement shall be in writing.144 Unless otherwise provided for in the operating agreement, the agreement may be amended only by unanimous consent. A court may enforce an operating agreement through injunctive or other equitable relief.145 As an alternative to injunctive or other equitable relief, if it is not reasonably practicable to carry on the business in conformity with the articles of organization and any operating agreement, the court may order dissolution of the limited liability company.146

    (3) Avoiding Default Rules

    The Iowa Limited Liability Company Act contains both mandatory rules and default rules. The mandatory rules cannot be varied by either the operating agreement or the articles of organization. However, for the following reasons, the careful practitioner will not rely on the default rules when drafting the operating agreement, but will spell out in the operating agreement the provisions the members want:

      (a) The default rules could be changed by the state legislature, thereby changing the agreement among the members without their knowledge or approval.

      (b) A particular default rule likely will not effectively deal with every aspect of an issue.

      (c) In most cases the members will want a result different from the state''s default rule.

    (4) General Drafting Checklist

    At a minimum, the operating agreement for the LLC should address the following matters:

      (a) The date the LLC was formed

      (b) The name of the LLC

      (c) The address of the principal place of business

      (d) The name of the registered agent and the address of the registered office

      (e) The term of the LLC

      (f) The business of the LLC

      (g) The names and addresses of initial members and any new members

      (h) The manner of electing managers and the percentage of members required

      (i) The duties and responsibilities of managers

      (j) Voting requirements for manager action

      (k) Manager resignation and removal provisions

      (l) Member-retained management rights, if any

      (m) Membership meetings, including record dates, voting requirements, and proxy rules

      (n) Member resignation policies and rights to distributions

      (o) Initial capital contributions, which may be cash, property, or services rendered

      (p) Definition of membership interests (one or more classes can be create(d)

      (q) Definition of profit and loss sharing percentages and distribution rights

      (r) Restrictions on transfers of members'' interests

      (s) Events of dissolution and member rights

      (t) Circumstances under which a dissociation may be wrongful

      (u) Other provisions considered appropriate for management of the LLC

    (5) Key Provisions in the Operating Agreement

      (a) Business purpose. The operating agreement should set forth the business purpose for the LLC, particularly if the IRS could attack the LLC as a tax avoidance device because it results in income or transfer tax savings.

      (b) The economic arrangement among the members. The operating agreement should set forth the economic arrangement among the members of the LLC.

        (i) Classes of membership interests may be established with differences in:

          (1) Management rights;

          (2) Rights to ongoing distributions; and

          (3) Rights to distributions upon liquidation.

        (ii) The method of determining the capital accounts of the members should be stated, which may be based on:

          (1) The fair market value of contributions plus allocated income and gain less the fair market value of distributions and allocated losses;

          (2) The safe harbor under the regulations under I.R.C. §§ 704(b); or

          (3) Some other method.

        (iii) The initial capital contributions of the members should be stated.

        (iv) Provisions for additional capital contributions and any restrictions on additional capital contributions should be considered.

        (v) The operating agreement should set out the terms for capital contribution calls, if desired, as well as any penalties if such contributions are not made.

        (vi) The terms of member loans to the LLC, if permitted, should be stated.

        (vii) Restrictions on distributions of property in kind should be stated.

        (viii) The operating agreement should indicate the method for allocating items of income, gain, loss, deduction and credit for tax purposes.

        (ix) The method of making current distributions should be stated.

        (x) The method for making distributions upon liquidation of the LLC should be stated.

        (xi) Provisions dealing with the transfer of membership interests should be included. Specifically, the operating agreement should cover:

          (1) Permitted transfers or transferees;

          (2) Rights of first refusal;

          (3) Consent requirements by:

            (a) Member-managers; or

            (b) Members; and

          (4) Distinctions between assigning an interest to someone who becomes a mere assignee (entitled to the transferring member''s rights to distributions, but not to voting or management rights) and transfers of all of one''s membership rights to a third party.

        (c) The management structure. The operating agreement should set forth the management structure of the LLC, including:

          (i). Whether the LLC will be member-managed or manager-managed;

          (ii). The voting rights of the members, which may be:

            (1) Per capita (one vote per member);

            (2) Proportionate to capital contributions; or

            (3) On some other basis.

          (iii). If desired, the operating agreement may permit the election or designation of officers or directors or both (who may or may not be member- managers or members).

      (6) Dissolution and liquidation. The operating agreement should cover the dissolution and liquidation of the LLC.

        (a) Iowa’s default rule may be adopted, although it should not be adopted simply by incorporating the statute by reference.

        (b) Complete continuity may be allowed, so that there would be no events that would cause a dissolution of the LLC absent the consent of some or all of the remaining members or member- managers.

        (c) The operating agreement may adopt contingent continuity, by limiting the events that could cause dissolution to one or two specific events, such as the bankruptcy of a member, and by limiting the triggering events to certain persons (such as the member-managers).

        (d) The operating agreement should deal with the situation where there are only two remaining members and one of them dies or withdraws.

    E. General Business LLCs, Professional LLCs and LLCS

      (1) General Business LLCs

        (a) Generally. Because an LLC is a pass-through entity for income tax purposes, eliminating double taxation at the federal level, and has the corporate advantages of limited liability for the owners and managers of th business, the LLC has become the entity of choice for many entrepreneurs. The LLC may be used for virtually any type of business (except certain businesses such as insurance, trust and banking business) which may be restricted by state statutes.

        (b) Use of LLC for Business Joint Ventures. Emerging growth companies often enter into joint ventures with larger corporations, whereby the smaller venture contributes technology, and the larger company provides capital, as well as management and marketing resources. Joint ventures are usually formed as partnerships where the two joint ventures are general partners, permitting distribution of profits from the joint venture to be passed up to the two joint ventures without double taxation. The use of an LLC provides the pass through tax treatment, but at the same time provides limited liability to the two joint ventures.

        (c) Use of an LLC as the General Partner of a Limited Partnership.

          1. Traditional Use of Corporate General Partner. Emerging companies, particularly technology-oriented companies, often form research and development limited partnerships or marketing limited partnerships to raise capital for some specific project. This is also true of real estate investments, oil and gas and mineral ventures and transactions involving international investors. In order for a limited partnership to be taxed as a partnership, at least one general partner must be liable for the debts and obligations of the limited partnership. The company or promoter desiring to form the limited partnership often use a corporation to act as the general partner. If the corporation chooses to be taxed as an S Corporation, the income and losses of the limited partnership can be passed through to the owners of the corporate general partner, subject to the usual S Corporation restrictions and limitations.

          However, in order to preserve pass-through tax treatment, the corporate general partner is often required to have a substantial net worth in order to avoid being characterized as a “dummy” or “straw man” general partner because of its insubstantial amount of net assets is not in effect generally liable for the debts and obligations of limited partnership.

          2. The LLC Alternative. An alternative form for a general partner of a limited partnership would be an LLC. As such, the promoters would not necessarily need to capitalize the LLC in order for the limited partnership to lack corporate characteristic of limited liability, so long as the promoters were able to own all of their interests in the limited partnership indirectly through the LLC. Because the LLC itself is taxed as a partnership, pass-through tax treatment from the limited partnership is assured.

          3. Alternative to Two-Tiered Approach. An alternative to using the two-tiered approach of a limited partnership with an LLC as a general partner would be to have an LLC itself as a single entity, where the party performing the managerial function would be the manager of the LLC, rather than be a general partner of a limited partnership. The non-management members would be the equivalent of the limited partners in the limited partnership. The use of an LLC as a single entity avoids the use of a partnership, articles of incorporation, bylaws and shareholder agreements. Instead, the LLC would require only a simple articles of the organization and an operating agreement. Also, one set of federal income tax returns would have to be filed each year instead of two, one for the limited partnership and one for the LLC partner.

      (2) Professional Corporations

        (a) Introduction. Many professionals, particularly lawyers and accountants, have traditionally practiced in general partnerships. In general partnership, every partner is jointly and severally liable for all obligations and liabilities incurred by the partnership, including liabilities arising from any wrongful act or omission by any employee or any other partner acting in the ordinary course of business of the partnership. Professionals became increasingly concerned about this vicarious personal liability due to large malpractice awards and the increasing cost of malpractice insurance. With the passage of the Iowa Professional Corporation Act (“ICA”),147 many professionals organized as PCs. Under the ICA, "profession" means the profession of certified public accountancy, architecture, chiropractic, dentistry, physical therapy, psychology, professional engineering, land surveying, landscape architecture, law, medicine and surgery, optometry, osteopathy, osteopathic medicine and surgery, accounting practitioner, podiatry, speech pathology, audiology, veterinary medicine, pharmacy and the practice of nursing.

        PCs were primarily attractive because they allowed professionals to contribute more to retirement plans than if they were in a partnership. Although the Tax Equity and Fiscal Responsibility Act of 1982 equalized the contributions allowable to partnerships and corporations, PCs remained attractive because they provided insulation from personal liability for the obligations of the corporation.

        (b) Limitations of PCs. Although PCs are appropriate for many professionals, they are not the ideal organizational format for some professionals for several reasons.

          1. A PC typically chooses S Corporation status to avoid tax at the corporate level and a higher tax rate. However, some PCs are ineligible for S Corporation status because they have more than 75 shareholders or their organization requires more than one class of stock. Even though the corporate tax on a C Corporation could be minimized by paying out substantially all of its income as salaries as bonuses, issues of reasonable compensation and difficult year-end planning discourage the use of C Corporations.

          2. Incorporating a professional partnership imposes the governance structure mandated by corporate law.

          3. There is a substantial cost for liquidating a C Corporation if converting to another format ever becomes desirable.

          4. Many professional firms have a mandatory retirement age for partners. While this is not considered a violation of federal or most state anti-discrimination laws, it might be deemed illegal if the owner is considered an employee of a corporation rather than a partner in a partnership. Courts are split on this issue.

      (3) LLC Alternative to PC Status

        (a) Introduction. If properly organized, an LLC is not taxed as a corporation and provides its members with insulation from vicarious liability. The Iowa Limited Liability Company Act permits professionals, such as attorneys and accountants, to organized as LLCs.148 The Iowa Supreme Court permitted lawyers to organize as LLCs.149 Additionally, the conversion of a partnership to an LLC can be accomplished tax-free. With LLCs, lawyers can insulate their personal assets from the malpractice of their colleagues and still maintain the financial flexibility of operating as a partnership.

        (b) Professional LLCs Under Iowa Law

          1. Purposes and Powers. A professional limited liability company (“PLC”) may engage in the practice of one specific profession, or two or more specific professions which could lawfully be practiced together by a licensed individual or partnership of licensed individuals.150 A PLC may engage in all lawful activities that may be incidental, necessary or convenient to the practice of a profession around which it is organized.151 The PLC’s articles of organization must state that the purpose for which it was formed was to engage in the general practice of a specialized profession or professions, and to engage in all lawful activities which may be incidental, necessary, or convenient to the practice of the profession or professions.152 A PLC may only operate through members, managers, employees, and agents who are licensed in Iowa to practice a profession which the PLC is authorized to practice.153

          2. Name. The name of any PLC must contain either the words “Professional Limited Company” or the abbreviation “P.L.C.”154 The name must be one that a licensed individual or partnership of licensed individuals could lawfully use in the practice of the profession which the PLC is authorized to practice.155 Regulating boards may adopt additional name requirements at their discretion.156

          3. Professional Regulation. PLCs are not required to register with or to obtain any license, registration, certificate, or other legal authorization from a regulating board in order to practice a profession.157 However, the authority or duties of a regulating board are not restricted or limited with respect to individual members of the PLC practicing a profession which is within that regulating board’s jurisdiction.158

          4. Liability. The ethical standards, codes of conduct, and laws governing the relationship between an individual practicing a profession and a person receiving those services (including liability laws) that apply to individual practitioners are also applicable to the members, managers, employees, and agents through whom a PLC operates.159

          5. Membership Interests. Membership interests may only be issued to individuals who are licensed in any state to practice a profession which the PLC is authorized to practice.160 Membership interests may not be issued in, transferred into, or held in joint tenancy, tenancy in common, or any other form of joint ownership or co-ownership.161 The Iowa Uniform Securities Act neither applies to nor governs any transaction relating to any of a PLC’s membership interests.162

          Membership interests may only be voluntarily assigned to either the PLC or to an individual who is licensed in Iowa to practice a profession which the PLC is authorized to practice.163 A voluntary assignment requires the unanimous consent of the PLC’s members unless otherwise specified in the articles of organization.164 The PLC’s articles of organization or operating agreement may contain additional provisions restricting the assignment of membership interests.165

          A PLC may not create or issue any interests that are convertible into a membership interest.166 This applies to the creation, issuance, and transfer of any rights or options entitling the holder to purchase from a PLC any of its membership interests.167 Rights or options are not transferrable in any manner.168 Rights or options therefore expire upon the death of the holder, or when the holder ceases to be licensed in Iowa to practice a profession for which the PLC is authorized.169

          Each certificate representing membership interests must state that the certificate represents membership interests in a PLC, and that it is not transferrable except as provided in the Iowa Code and in the PLC’s articles or organization or operating agreement.170

          6. Voting Trusts and Proxies. A member may not create or enter into a voting trust or any other agreement conferring upon any other person the right to vote or otherwise represent any membership interest of a PLC, and no such voting trust or agreement is valid or effective.171 A proxy of a PLC member must be an individual licensed in Iowa to practice a profession which the PLC is authorized to practice.172 Proxy instruments cannot contain provisions denying the right of the member to revoke the proxy at any time or for any period of time.173 The PLC’s articles of organization may impose additional constraints or deny the right to vote by proxy.174

          7. Required Purchase by a PLC of Its Own Membership Interests. A PLC is required to purchase its own membership interests in the following situations:

            (i) Upon the death of a member, the PLC shall immediately purchase all membership interest held by that member.175

            (ii) When a member of the PLC loses his license to practice in Iowa a profession which the PLC is authorized to practice, the PLC must immediately purchase the interests held by that member.176

            (iii) When a person other than a member of record becomes entitled to have membership interests of a PLC transferred into that person’s name or to exercise voting rights (except as a proxy) with respect to membership interests of the PLC, the PLC interests.177

          8. Management. All managers of a PLC must at all times by licensed in Iowa to practice a profession which the PLC is authorized to practice.178 A person who is not so licensed may not have any authority or duties in the mana

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