Even though it is not legally required by most states (New York is an exception), having an operating agreement for your LLC is a smart move - and not having one can be dangerous for both you and your business.
An operating agreement is a contract among the LLCs members stipulating its membership, management, operation, and the distribution of the company’s income. It documents the roles, responsibilities, rights, and relationships of the members, as well as their respective ownership percentages, shares of profits and losses, and what will happen to the LLC if someone leaves or if a new member wants to come on board. Not only does this increase your organization’s efficiency and effectiveness, it also helps prevent disagreements and misunderstandings about decision-making and financial dealings.
The Incfile.com LLC Kit has a customizable operating agreement that can be customized to meet the particular needs of your LLC.
Having an operating agreement also gives your LLC credibility as a separate entity, especially when it comes to the legal system. It helps safeguard your limited liability status, so it is a smart idea even if you are the sole owner of your company. If you are a single member LLC but do not have a formal operating agreement, the court may not respect your limited personal liability and may view your operation as a sole proprietorship instead, opening you up to significantly increased financial and operational risk.
Documenting your LLC’s procedures in an operating agreement also allows the members to set the rules, instead of being forced to follow your state’s default rules - which might or might not be a good fit for your particular business. Each state has its own laws governing basic operating procedures for LLCs. In some areas, these state default rules will be the controlling factor in how your business runs unless your operating agreement specifies different rules.
Some states, for instance, have a default rule that requires LLC members to divide profits and losses equally, regardless of the level of each member’s investment in the business. If all members did not invest equal amounts in the LLC, it’s unlikely that all members will want to allocate the profits equally. To avoid this, your operating agreement should spell out how you and your fellow members (sometimes called co-owners) want to split profits and losses.
Another area that your operating agreement needs to cover in detail is how ownership shares are distributed. The members/owners of an LLC usually contribute cash, property, or services to the business to help get it started. In consideration of this, each LLC member gets a percentage of ownership in the LLC—usually in proportion to their contributions, but LLC members are free to divide up ownership any way they want to.
As well as getting a percentage-based ownership interest in exchange for their contribution of capital, LLC co-owners each also receive shares of the LLC’s profits and losses, called distributive shares. Each owner’s distributive share usually corresponds to his or her percentage of ownership in the LLC.
The operating agreement should also specify how much of the LLC’s allocated profits will be actually distributed to the members each year. It’s important to remember that an LLC member has to pay income taxes on the full amount of the profits that are allocated to him by the distributive shares specified in the operating agreement, whether or not those profits were actually paid to the member.
Since LLCs usually have relatively few members, most management decisions are made informally. Sometimes, however, a decision is so significant or contentious that a formal vote is necessary. While some LLCs allot one vote per member regardless of shares - called per capita voting - it’s more common for each member to control votes proportionate to his or her shares in the business. The operating agreement should also specify whether a simple majority will decide voted questions, or whether unanimous consent is required.
The paradox is that the more well-thought-out your operating agreement is—the more contingencies and possibilities it covers - the more complex it is, not to mention longer. This article has mentioned only the highlights of what an LLC needs to cover; specific requirements will depend on the laws of your state and exactly how you want your business to operate. Again, the LLC Kit will answer your more detailed questions.
