Although much is built into the process of establishing an LLC
, an operating agreement takes an extra step to define its moving parts.
Essentially, the operating agreement is a contract among the LLC’s members that stipulates 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, and shares of profits and losses.
These agreements also spells out what will happen to the LLC if someone leaves or if a new member wants to come on board. Not only does this increase an organization’s efficiency and effectiveness, it also provides a clear protocol for disagreements and misunderstandings concerning decision-making and financial dealings.
Why is an Operating Agreement Needed?
Even though having an LLC operating agreement isn’t necessarily required by most states, having one anyway is a prudent business practice. The agreement can help define several very important aspects of a business, such as:
- Legal - Having a well written operating agreement in place gives an LLC credibility as a separate entity which is especially important when it comes to the legal system. Even if the LLC has a sole owner, the terms in the agreement help safeguard a limited liability status.
- In some instances, the court may view an LLC as a sole proprietorship without a formal operating agreement, which would negate the increased financial and operational risk benefits enjoyed by LLCs.
- Rules and procedure - Documenting an LLC’s procedures in an operating agreement also allows the members to set the rules, instead of being forced to follow a state’s default rules. Each state has its own laws governing basic operating procedures for LLCs, and while this may happen to fit well with a given business model, an operating agreement is an opportunity for business owners to customize those guidelines.
- In some areas, state default rules will be the controlling factor in how a business runs unless an operating agreement specifies different rules. Having well documented policies also limits misinterpretations or misunderstandings between founding members that may grow out of the normal course of business. It’s far easier to refer to written and agreed upon terms in a conflict than debate over informal agreements.
- Shares - The members/owners of an LLC usually contribute cash, property, or services to the business to help get it started. Operating agreements can cover, in detail, how ownership shares are distributed among members. Each LLC member usually gets a percentage of ownership in the LLC that’s in proportion to their contributions, but sometimes partnerships aren’t always so neat. Operating agreements allow member to divide up ownership any way they see fit.
- Profit and loss - LLC co-owners also receive a share 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. An operating agreement can 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 them by the distributive shares specified in the operating agreement, whether or not those profits were actually paid to the member.
- Control - Since LLCs usually have only a few members, most management decisions are made informally. This is a practical system that is usually sufficient for day-to-day functioning, but sometimes a given decision is so significant or contentious that a formal vote is necessary.
- While some LLCs allot one vote per member regardless of shares (per capita voting), it’s more common for each member to control votes proportionate to his or her shares in the business. An operating agreement can specify how the votes are distributed, whether a simple majority will decide voted questions, or whether unanimous consent is required.
- Roles - An operating agreement can help an LLC build its management structure. This can act as an outline for how everyday business will be run through the LLC’s various agents. Spelling out a hierarchy of decision makers, whether it be through managers, presidents, or a board of directors can ensure that LLC functions efficiently and to the original wishes of its founding members.
- Withdrawal or termination - Whether the members of an LLC part ways amicably or in conflict, an operating agreement can help spell out terms for things like buying out a co-owners shares should they decide to resign or how the LLC will handle the prospect of dissolving the business if it fails to make a profit. These circumstances can be messy if they aren’t planned for, operating agreements build groundwork that make the processes more orderly.
How do Operating Agreements Differ from State to State?
The biggest difference in operating agreements across states is whether or not they’re required. California, New York, Missouri, Maine and Delaware all require the members of an LLC to have an operating agreement at varying levels of complexity and precision. For instance, New York requires LLCs to have a written operating agreement with provisions relating to its business while Delaware only requires that at some time before, during, or after the filing of LLC formation paperwork a written, oral or even implied operating agreement is made — in other words, the law is lenient.
In most states however, operating agreements are not required by law. However, this doesn’t make them any less important or useful. One consideration to make though is the state’s default rules for LLC
, as many of them can be altered slightly by an agreement. 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, operating agreements can spell out how members want to split profits and losses.
Taking the Next Step
Simplicity is a wonderful thing, but in the current business climate it seems in short supply. LLC members may shirk the task of creating an operating agreement because the more contingencies and possibilities it covers, the more complex it is. However, having a concise and well defined plan in both times of upheaval or calm is invaluable.
We’ve only noted a few of the highlights in terms of what an LLC Operating Agreement needs to cover; specific requirements will depend on the laws of an LLC’s home state and exactly how it wants to run its business. A baseline LLC operating agreement is included in most of our packages or can be added to our base package. Examine our options for starting your LLC
today to take the next step in building an your operating agreement.