Every LLC owner should have an operating agreement in place. When multiple business owners are involved, setting the rules of the road is crucial. And for solo entrepreneurs, an operating agreement shores up personal liability protections and professional credentials.
This article will answer your questions about operating agreements and show you how to get one.
Key Takeaways
An operating agreement is only required in New York, California, Maine, Missouri, and Delaware, but every LLC should have one.
An operating agreement is an internal legal document that details essential procedures for decision-making, profit allocation, dissolution, and other critical business functions for your LLC.
Single- and multi-member LLCs are advised to maintain operating agreements for limited liability protection and to avoid costly disputes.
What Is an LLC Operating Agreement?
An operating agreement is a signed legal document that serves as a contract between limited liability company (LLC) members. [1] It’s an internal document, meaning it isn’t part of the public record, and it is only required by law in New York, California, Maine, and Missouri. [2, 3, 4, 5]
If your LLC doesn’t adopt an operating agreement, state default rules will apply in the event of a dispute. These state laws could be a poor fit for your business, so it’s wise to establish an LLC operating agreement that addresses your LLC specifically.
Most LLC operating agreements clarify critical details about the business’s structure, governance, and management. [7] For instance, are you and your partners clear on who is responsible for what, the routine procedures for decision-making, and how the allocation of profits will be carried out?
You don’t want to answer these critical questions as you go or let false impressions or assumptions create big problems. Thankfully, an LLC operating agreement is a legally binding document that can help avoid conflict down the road.
Does My Delaware LLC Need an Operating Agreement?
If your business entity is a Delaware LLC, your operating agreement is called a “limited liability company agreement.” By state law, an LLC operating agreement may be “written, oral, or implied” by its members.[6] So, given that an unspoken agreement with your business partners could be legally enforceable, it’s smart to sign a written LLC agreement as soon as possible.
Operating Agreement vs. Articles of Organization
The LLC operating agreement may sound similar to the articles of organization you file with the Secretary of State or business formation office, per state law. But neither is a substitute for the other, and they serve different purposes.
Articles of Organization vs. Operating Agreement
Required by law, the articles of organization officially form your business with the government office in your state that handles business registrations. This can also be called a certificate of formation or articles of incorporation.
An LLC operating agreement does not make your LLC an actual business entity. For that, you must file official incorporation documents with the state office required by law where you live.
Articles of organization are often a matter of public record. You must define your business purpose, state who the members of your LLC are, and whether your business is member-managed or manager-managed.
An operating agreement is an internal document private to the relevant parties in your business entity. It stays between you and is not filed with the Secretary of State or any government agency. [8]
You will probably want to save more sensitive details for your operating agreement and won’t want to give clues to your business plan.
An LLC operating agreement should include details on how you will run the business and make decisions, members’ capital contributions and responsibilities, procedures for adding new members, and more.
Steps To Create an LLC Operating Agreement
Step 1: Decide Between a Template or an Attorney
The first step is to decide whether to choose a template or hire an attorney. There is a best option, which is to opt for customizable templates for LLC operating agreements. Various services offer templates which are vetted by lawyers and applicable in all 50 states.
Step 2: Include Your Business Information
You must include the LLC’s business information in your LLC operating agreement, such as:
- Name
- Address
- Registered agent and their contact info
- The purpose of your business (detailing your business activities)
This keeps your document specific to your LLC and prevents any confusion about business details.
Step 3: List Your LLC’s Members
List the members in your operating agreement. This is also the place to note their ownership percentages, capital contributions, and how profits will be distributed among them.
Step 4: Choose a Management Structure
Decide whether your LLC will be member-managed or manager-managed. This section outlines the management responsibilities of each member as well as who will make the decisions. Clearly state the roles, responsibilities, and compensation if you plan to have managers instead of members running the business.
Step 5: Outline Ownership Transfers and Dissolution
This step outlines how ownership can be transferred, such as in the case of death, sale, or transfer of shares. You will also need to define the terms under which your LLC could be dissolved. Step 6: Determine Your Tax Structure
Step 6: Determine Your Tax Structure
Most LLCs choose pass-through taxation for tax purposes. This means that profits are taxed at the individual member level, not at the LLC level. However, your LLC operating agreement should specify how taxes are handled if you are considering different tax treatment options.
Step 7: Gather LLC Members to Sign the Agreement
All members should sign the document once the agreement is ready and all terms have been reviewed.
Step 8: Distribute Copies
Distribute copies of the signed operating agreement to all members, managers, and interested parties, such as investors or lenders.
Step 9: Revise as Needed
It is important to revise the agreement if your LLC adds new members or experiences significant changes in structure.
Four Benefits of Having an LLC Operating Agreement
The limited liability company business structure gives business owners great freedom to control their business while protecting their personal assets. An operating agreement generally strengthens each of these advantages and reduces potential risks.
These are the LLC operating agreement’s four main benefits:
1. Boost Your Personal Liability Protections
Your LLC protects your personal assets from business debts or losses. But these protections are not ironclad, especially if you were recently a sole proprietor and haven’t done much to alter your operations. Without a legal document that strengthens these protections, creditors or prosecutors could still come after your personal assets.
An LLC operating agreement clearly separates your personal assets from those of your business. This is the main advantage of an LLC operating agreement for a single-member LLC.
2. Make Business Operations More Smooth and Efficient
What slows down a small business? Long meetings and discussions that go nowhere.
With an operating agreement, you’ll clearly define the rules of the road from the get-go so that when it comes time to go to work, everyone can put their head down and do their job.
3. Avoid Disputes
It’s not nice to think of the nasty things that can happen during money disagreements. But when you form your business entity as an LLC, you enter a management “gray area” with your business.
A written operating agreement is a legal contract that can help you resolve these conflicts before they get started. You can detail aspects of the business, such as member ownership percentages and ownership interest, allocation of profits, responsibilities, and compensation. [9]
4. Think About the End Game Early On
An operating agreement for your LLC will ask some big-picture questions that you and your fellow members may not otherwise consider, which could strengthen your business strategy.
For instance, an operating agreement will specify conditions for the liquidation or dissolution of your business. This way, you’ll have thought about wrapping things up correctly and when to call it quits.
What Sections Are Included in an LLC Operating Agreement?
These are some of the areas your LLC operating agreement will cover. It will depend on your specific business which of these proves most important.
Member Ownership and Compensation
Every member’s ownership share is typically based on their contributions to the LLC, whether in the form of:
- Cash
- Property
- Services
- Intellectual property
The operating agreement should clearly outline each member’s ownership percentage, how these percentages affect profit allocation, and how decisions are made.
Capital Contributions
Record the initial contributions of each member. They may influence other factors like voting rights and profit sharing.
Voting Rights
Define who has voting rights and how decisions will be made. Voting rights are often proportional to ownership. This can be customized based on your business needs.
Detailed Management Plan
The LLC business structure allows for two types of basic management configurations. Your operating agreement should be clear about which one you have chosen, with details on how it works.
Member-Managed LLC
In a member-managed LLC, the business owners, known as members, take responsibility for the day-to-day LLC operations. A single-member LLC with no employees is member-managed.
The operating agreement would spell out which managers are responsible for what parts of the business and how they’ll be compensated for their work.
Manager-Managed LLC
A manager-managed LLC employs the work of managers who are not owners of the business to carry out the business operations according to their expertise.
A manager-managed LLC needs to make the responsibilities of a manager clear compared to the duties of members. The managers must be sure of what they’re being hired to do.
Members should also spell out a manager hiring procedure and allocate responsibilities for that procedure to one or more members.
Profit Allocation and Distribution
It is common for profits to be allocated based on ownership percentages. LLCs can decide on alternative methods. The operating agreement should specify the method for distributing profits and how often distributions will occur. Clarifying the base profit sharing on ownership, work contributions, or another metric helps to avoid future disputes.
Decision-Making Procedures
How will your LLC make decisions about the business? Typically, members will meet on a specific schedule and take votes on important issues. Here are some things to consider as you design that process:
- Who has voting rights on decisions?
- Will a majority vote or a unanimous vote be required for a decision to move forward?
- What decisions can be made without a vote, and which will require one?
A Tax Treatment Plan
Pass-through taxation is the preferred tax treatment for most LLCs, where members pay income tax for the LLC on their personal tax returns. But the LLC can technically choose to be taxed as a corporation or file for S-corp status. Your operating agreement may stipulate when and how the LLC will choose its tax treatment each year.
An Indemnity Clause
An operating agreement is great, but what if a member violates it? Members should add a clause to their operating agreement that would indemnify members who suffer damages or financial losses when another member violates the agreement. [10]
Tools For Big Changes to Your LLC
Your LLC operating agreement can anticipate certain changes in your business and make them smoother if and when the time comes. [11] Otherwise, relying on state default rules could make these changes painful.
Such changes might include:
- Performing liquidations or mergers if the business is sold or buys another business
- Adding new members to the business or offering buyouts to departing members
- Making amendments to the operating agreement or articles of organization
Single-Member vs. Multi-Member LLC Operating Agreements
A written operating agreement is simple for single-member LLCs regarding ownership interest, amendments, and voting policies. But the primary purpose of an LLC operating agreement for a single-member LLC is to clarify the separation between your small business and your personal assets and finances.
On the other hand, multi-member LLCs have much more to cover in their operating agreements, from profit allocations to decision-making.
Let Us Create Your LLC Operating Agreement
You don’t have to create your LLC operating agreement from scratch. For only $35, Swyft Filings will draw from a high-quality operating agreement template to produce a tailored version for your LLC. That’s the cost of about ten minutes with an average lawyer.
Get your LLC operating agreement in three simple steps:
- Answer a few easy questions related to LLC’s members, structure, and management.
- Trust us to use an attorney-prepared template to create a custom operating agreement for you.
- View your LLC operating agreement online with secure access and ready to be signed and adopted by all LLC members.
Order your LLC operating agreement from Swyft Filings today.
FAQs
Can I make my own operating agreement?
You can create an operating agreement yourself, but unless you’re an attorney, it could be full of holes you’re unaware of. For just $35, Swyft Filings will create a custom operating agreement tailored to your business based on our powerful templates. All you have to do is answer some plain-English questions about your business.
What should an operating agreement include?
Operating agreements should detail the management structure of your business, how ownership and profits are distributed, how decisions are made, and many other factors.
What is the purpose of an operating agreement?
An operating agreement serves as a legal contract between the members of an LLC, creating a framework for settling disagreements and clarifying essential questions about the business’s functions.
What is the difference between an operating agreement and bylaws?
Bylaws are required by law for corporations, while operating agreements apply to LLCs. These documents serve a similar purpose of detailing the rules and procedures of a given business, but they’re fundamentally different as the internal structures of corporations are different from those of LLCs.
What is the difference between a member and a manager?
An LLC member is an owner of the business, while a manager is employed by the business to execute or oversee day-to-day operations. An LLC member can also be a manager, but a manager has no inherent ownership over the LLC.
What happens if you don’t have an operating agreement?
Your LLC will have to follow state rules, which could lead to unfair profit sharing, unclear management, personal liability, disputes, tax issues, and confusion about what happens if a member leaves or passes away.
Can you amend your operating agreement?
Yes, you can amend your LLC operating agreement, but the process requires following the rules in the original agreement and documenting changes formally in writing.
What is the difference between voting rights and ownership percentage?
The main difference is that not all shares have equal votes. A person can own a large percentage but have little voting power or own less control over the vote, due to different share classes.
Do you need an operating agreement for a business loan?
Yes, you will need an operating agreement if you are seeking a business loan. It proves legitimacy, defines ownership, and satisfies the lender's due diligence requirements for KYC.