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The LLC Operating Agreement is a written record of the rights and responsibilities of the members in addition to a framework on how the LLC will operate. This agreement is between the members and helps to avoid some common business ownership issues.
Sometimes the Operating Agreement is mixed up with the Articles of Organization (Certificate of Formation in some states). The Articles of Organization / Certificate of Formation is the form that is sent to the Secretary of State when filing the LLC. These are the equivalent to the Articles of Incorporation that a corporation would file. The Operating Agreement is the LLC version of the bylaws for a corporation.
It’s important to note that most states don’t require a Limited Liability Company to have an operating agreement. California, Delaware, Maine, Missouri, and New York are the only states that need an LLC to have an operating agreement. While many states don’t require one, it’s definitely recommended for a multi-member LLC but is also advised for many single-member LLCs as well.
For multi-member LLCs, the operating agreement helps to avoid conflicts such as what happens when a member wants to quit, resolving disputes on how important decisions are made, avoiding misunderstandings over how to distribute profits and/or losses, how to handle capital contributions should more money need to be raised and much more.
A single-member LLC Operating Agreement can be beneficial, even though disputes between members isn’t an issue. The operating agreement is beneficial as it helps to formalize the owner’s status as a separate entity. This provides two benefits which are liability protection and the potential to save on taxes.
Liability protection – It can be difficult for an LLC owned by a single member to prove that it is being run as a separate legal entity. The operating agreement along with state and federal registrations are used to document that the business entity and individual are separate. This separation is important to document to keep the owners from having personal liability due to legal action against the business.
Tax savings – By default, the IRS considers the LLC as a pass-through entity. The LLC is a popular business entity because of the choice of taxation. An LLC can elect sole proprietorship or partnership taxation which is known as pass-through taxation. The LLC can also elect taxation like a corporation which may provide tax savings in certain circumstances.
Why is an Operating Agreement Important?
Writing an operating agreement can better protect the member’s personal assets and enhance the liability protections of LLC members. If an operating agreement has not been created and there is legal action against the business, the state will treat the Limited Liability Company with the established state laws which may not be beneficial.
A few other reasons an Operating Agreement include
- Lenders sometimes request one prior to financing
- Title companies may request one prior to purchasing real estate
- Potential investors or partners would want one for due diligence
- In the event of legal action, an operating agreement may be used to review the business operations.
What Should be in an Operating Agreement
The contents of an operating agreement for an LLC will vary by state but here are some common sections to consider.
Information about the LLC such as the formal name, formation date, the purpose of the LLC, selected fiscal year, contact information for the registered agent, etc would go in this section.
This section deals with the ownership of the company, who the members are, how the ownership is structured and so on.
The management section outlines how the LLC is managed. LLCs can be member-managed or manager-managed. Each of the members of a Member-managed LLC participates in the decision making processes. Manager-managed LLCs are those where a the members hire a manager who tends to the day-to-day operations of the business.
Liability of Members
Include which debts and obligations belong to the LLC and which ones belong to the members.
Allocations of Profits, Losses and Distributions
If profits and losses not be distributed by a percentage of ownership interest, details are included in this section.
Changes in Membership
Details on the process for adding or removing members along with whether written consent by all members is required or if a vote by majority is used instead. Buyout provisions would also go in this section should a member want to leave the company or through certain events such as death, disability, etc)
Should the company not succeed, this section will determine how to decide to end operations and the activities required to close.
This catch-all section covers topics such as settling disputes through mediation, how and when to amend the operating agreement, reimbursements of out-of-pocket expenses and so on.
Where is the Operating Agreement Filed?
The Operating Agreement document is only between the members of the LLC. Even though there are a few states that require the creation of an operating agreement, no states require it to be filed.
Operating Agreement Template
While it is highly recommended to have a legal professional review an Operating Agreement. This ensures the members are fully covered and the agreement complies with state laws. Sometimes this expense may not be in the budget when starting a business, so here are some LLC operating agreement templates.