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What Is an LLC Operating Agreement?
The Operating Agreement is a document created by the members of a Limited Liability Company (LLC) to provide a framework of how the entity will operate, record the names of the members, their percentage of ownership, how profits and losses are distributed and more.
Most states do not require an LLC to have an Operating Agreement but are worth considering in every state. Since there are no requirements as to what is required to go in an Operating Agreement, members are free to create any type of rules they want. Without an Operating Agreement, the LLC may be subject to generic state rules that may be detrimental to the business. A few other benefits include:
- Enhancing the member’s personal liability protection
- Avoiding misunderstandings and disagreements between members
- Establishing the member’s roles and responsibilities on paper
Here are more details regarding when a business needs an LLC Operating Agreement.
What can be included in an Operating Agreement?
Unlike the Articles of Organization (or Certificate of Organization, Certificate of Formation, etc) that was initially filed with the Secretary of State’s office when forming the LLC, the Operating Agreement is not filed as it is an internal document. What’s interesting is that out of the five states that require an Operating Agreement (California, Delaware, Maine, Missouri, Nebraska and New York) four of those states allow this agreement to be oral. While that is an option, it may be a better idea to write it down to avoid problems down the road.
When setting up the structure of the LLC, the Operating Agreement can be as simple or complex as desired. A few of the most common items that are included in an LLC Operating Agreement (in no particular order) include:
- Legal name of the LLC
- Principal place of business
- Physical address where the main functions of the business are performed
- Business purpose
- A business purpose or statement of purpose s brief description of what the LLC does. This is typically the same information that was filed in the Articles of Organization / Certificate of Formation. Some LLCs will use this to have a more specific purpose as its easier to update the Operating Agreement than the state filing.
- Capital contributions and the percentage of ownership for the members
- In a single-member LLC, the member will show 100% ownership.
- In a multi-member LLC, the percentage of ownership does not have to equal the percentage of personal investment. Sweat equity can be used instead of cash to determine the percentage of ownership.
- For capital contributions, include both cash and non-cash contributions such as vehicles, office furniture, etc.
- Registered Office and Registered Agent
- LLCs in every state require a physical presence. This should be identical to the name of the person indicated in the Articles of Organization / Certificate of Formation. The Registered Agent can be a member, somebody living in the state of formation or a commercial registered agent who can receive legal notices on behalf of the LLC.
- Frequency of meetings
- LLCs are not mandated to hold meetings unless they are specifically listed in the Operating Agreement. It’s a good idea to hold at least an annual meeting and record the minutes, votes and any other decisions made for multi-member LLCs.
- Duration of the LLC
- Most LLCs plan to be in existence forever until the members decide to close or dissolution of the business. In this case, simply list “Perpetual”. Some LLCs only plan to be operating for a set amount of time (typically investment-related businesses) and would indicate the date of closure.
- Tax Classification
- One of the major benefits of the LLC as a business entity is the ability to elect the entity’s tax status. By default, a single-member LLC will be considered a disregarded entity by the IRS and taxed like a sole proprietorship. There is also the option to elect corporation tax status. Multi-member LLCs are taxed as a partnership by default (also a disregarded entity) or can also elect corporation tax status. Whichever status is elected, be sure to include it in the operating agreement.
- Tax Year and Accounting Method
- Most LLCs choose the calendar year for their tax year which runs from January 1 – December 31. The LLC can choose a fiscal year which is any consecutive 365 days.
- Remember that the Limited Liability Company is not typically taxed itself (known as pass-through taxation) and each member is taxed based on the profits or losses of the LLC. Even though a profit was made by the LLC, there may not have been any cash distributed to the member(s), resulting in the member having to come up with cash personally to cover the tax burden.
- The accounting method refers to how income and expenses are tracked. There are two choices which include the cash method or accrual method. Cash basis is going to be the what most LLCs (and most small businesses for that matter) will select. Under the cash method, income is not recognized until cash is actually received and expenses are not deducted until they are paid, while the accrual method requires income to be recognized when the sale occurs and expenses are recorded.
- Membership rules
- What are the roles, duties and responsibilities of each of the LLC members?
- What is the process of allowing new LLC members? Usually, a written consent of that new member must be voted on by the existing members.
- Member voting power – equal votes or based on ownership share?
- Is the LLC Manager Managed or Member Managed?
- How is a member compensated (if at all) should that member leave?
- Manager Managed is when the members hire someone to run the day-to-day operations while Member Managed is an LLC run by the members. If the LLC will be Member Managed, the manager’s roles and powers should be included in the agreement
- Profits and Losses
- How are profits distributed among members and what will members need to do if there are losses and the LLC needs additional operating capital? Often profits or losses are proportional to the member’s financial investment in the LLC
Once the LLC Operating Agreement it’s completed, simply print and have the member’s sign. In some states, a signature isn’t required but still a good idea to document who agreed to the Operating Agreement. The agreement does not have to be notarized. Be sure to keep a signed copy for the business records and store in a safe place.
LLC Operating Agreement Template
There are many free templates available on the internet for a business to use. While these will more than likely suffice for most LLCs, it is a good idea to go over them with a local attorney or a company that has reviewed their agreements by state to be sure the members are sufficiently protected.