An LLC Operating Agreement is a legal document that specifies the ownership and member obligations of your LLC.
Although it is not a state requirement, if there are two or more members in your LLC you should have an Operating Agreement. This document provides you with the ability to structure the working and financial arrangements with co-owners of your business. Despite being an important part of starting up a company, this document is not required to be filed with the Secretary of State but a written and signed copy should be kept safely together with all your other important LLC documents.
An Operating Agreement is a legal document that establishes the responsibilities and rights of each member of the LLC. It sets out agreed-upon details of the internal management of the company that includes important things like when meetings are to be held, how decisions are made, how new members are admitted, and many more.
In the agreement, you should set out each member’s ownership percentage in the LLC, their rights and responsibilities, their share of profits or losses, and what will happen in the event of one of the members leaving the business.
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Why Do You Need an Operating Agreement?
While it is not a legal requirement for an LLC to have an Operating Agreement, it is not a good idea to run your business without one, even if you are the sole owner of the LLC.
This important legal document can be used to make sure that your business is run according to your rules and not be subject to the default rules created by the state. It is also essential to help avoid management and financial misunderstandings among members of the LLC.
One of the most important reasons to have an Operating Agreement is to protect the limited liability status of your LLC and ensure that the courts will respect it. This is of particular importance in a single-person LLC where your company could look a lot like a sole proprietorship without the formality of a written Operating Agreement that provides credibility to the separate existence of your LLC.
Defining the Financial and Management Structure of an LLC
In a co-owned LLC, all decision-making and profit-sharing protocols need to be documented as well as the procedures to follow for the addition and departure of members.
Without an Operating Agreement, not only will it be difficult for you and your co-owners to navigate their way around financial and management decisions, but you will also be ill-equipped to settle any misunderstandings or disputes that may arise.
What’s more, without an Operating Agreement your LLC may very well be subject to the default operating rules of state law which is not something you want for your business.
Overriding State Default Rules
In each state, there are laws that govern the basic operating rules of LLCs known as ‘default rules’.
For example, many states have a default rule that requires the profits and losses of LLCs to be divided up equally between members regardless of each owner’s investment share in the business. If all members do not have equal amounts invested in the LLC, co-owners will probably not want the profits of the business to be allocated equally among members.
An LLC Operating Agreement can avoid this by setting out the terms and conditions of how the profits of the business should be allocated to each member.
Drawing up an Operating Agreement provides you with the opportunity to choose the rules that will govern the inner workings of your company and avoid being subject to the default rules of your state that may or may not benefit your business.
What to Include in Your LLC Operating Agreement
There are loads of issues that you may need to cover in the Operating Agreement of your LLC depending on the particular situation and needs of your business, however, most LLC Operating Agreements will include some or all of the following:
- The percentage interests of each member
- The rights and responsibilities of each member
- The voting powers of each member
- The allocation of profits and losses to each member
- How the business will be managed
- Rules for how and when to hold meetings and the taking of votes
- The buy-sell or buyout provisions that determine what happens when a member wishes to sell the interests they hold in the business, becomes disabled, or dies.
While the above issues may seem fairly straightforward, each one will require you to take certain important decisions which should be clearly set out in the Operating Agreement.
• Percentage of Ownership
When an LLC is formed members will generally make financial contributions in the form of cash, property, or services in order to get the business off to a good start. Each member is allocated a percentage of ownership in the assets of the company in proportion to their capital contributions, however, members are free to divide the ownership of the LLC up in any way they wish.
These individual contributions and percentages form an important part of the Operating Agreement.
• Distributive Shares
In addition to ownership interests received for capital contributions, owners will also receive their share of the profits and losses of the business known as ‘distributive shares’.
In most cases, the Operating Agreement will provide each member of the LLC with a distributive share that corresponds to their percentage of ownership in the business. For example, if a member owns 35% of a co-owned LLC he/she will receive 35% of the profits or losses and the other member who owns 65% will be entitled to 65% of the profits or losses.
If you wish to assign distributive shares that are not in proportion to each member’s ownership in the business you will have to follow the rules for ‘Special Allocations’.
• Distribution of Profits and Losses
In addition to setting out each member’s distributive shares your LLC’s Operating Agreement should also address the following questions:
- How much, if any, of the allocated profits (members’ distributive shares) must be distributed each year to members of the LLC?
- Should members expect to receive at least enough cash from the LLC to cover the income taxes they will be liable for on each year’s allocation of profits? (Similar to a partner in a normal business partnership, LLC owners have to pay income tax on the entire amount of allocated profits and not just the actual amount of profits paid out to them by the LLC. Even if owners decide to plow back profits allocated to them instead of taking a payout, it will still be treated as taxable income in the owner’s allocated proportion.
- Will distributions of profits be paid out regularly or will owners be entitled to draw profits from the business at will?
Because each member of the LLC will have different financial needs and tax brackets (marginal tax rates), allocation of profits and losses is something you should pay particular attention to. It may be advisable to run this part of the Operating Agreement by a tax professional to ensure that it achieves the overall results you have in mind for your LLC.
• Voting Rights
While most management decisions in a Limited Liability Company are made informally, sometimes a decision may be controversial or so important that it requires a formal vote. There are two ways in which you can split the voting power between members of the LLC:
- The voting power of each member corresponds to the percentage of interest held in the business;
- Each member is given one vote in a ‘per capita’ voting system.
In most LLCs votes are meted out to members in proportion to their ownership interests in the business. Whichever method you choose, it is important to ensure that the voting power of each member is specified in the Operating Agreement and whether a unanimous decision or a majority vote will be required to settle a dispute.
• Ownership Transitions
Many business owners don’t give enough attention to what will happen in the event that one of the members of the LLC decides to sell their owner’s interest in the company, retires, or dies. Part of the Operating Agreement should specify the rules applicable when a member leaves the business for any reason and should also include the terms for a buy-out scheme.