Why an operating agreement is necessary
While many states do not legally require your LLC to have an operating agreement, it’s foolish to run an LLC without one, even if you’re the sole owner of your company. An operating agreement helps your LLC by guarding your limited liability status, heading off financial and management misunderstandings, and making sure your business is governed by your own rules — not the default rules of your state.
Protecting your limited liability status
The main reason to make an operating agreement is as simple as it is important: It helps to ensure that courts will respect your limited personal liability. This is particularly key in a one-person LLC, where, without the formality of an agreement, the LLC will look a lot like a sole proprietorship. Just the fact that you have a formal written operating agreement will lend credibility to your LLC’s separate existence.
Defining financial and management structure
Co-owned LLCs need to document their profit-sharing and decision-making protocols as well as the procedures for handling the departure and addition of members. Without a thorough operating agreement, not only will you and your co-owners be ill-equipped to settle misunderstandings over finances and management, but you will also be subject to the rules of your state law (see below).
Overriding state default rules
Each state has laws that set out basic operating rules for LLCs, some of which will govern your business unless your operating agreement says otherwise (these are called “default rules”). Many states, for example, have a default rule that requires owners to divide up LLC profits and losses equally, regardless of each member’s investment in the business. Unless you and your co-owners invest equal amounts in the LLC, it’s doubtful you’ll want profits allocated this way. To avoid this, your operating agreement must spell out how you and your co-owners want to split profits and losses.
In this same way, many state laws regarding LLCs will not be favorable to your business. Don’t be tempted to rely on them to structure your LLC; instead, decide on the best rules for your situation and put them in a written operating agreement.
What to include in your operating agreement
There’s a host of issues you must cover in your operating agreement, some of which will depend on your business’s particular situation and needs. Most operating agreements include the following:
- the members’ percentage interests in the LLC
- the members’ rights and responsibilities
- the members’ voting power
- how profits and losses will be allocated
- how the LLC will be managed
- rules for holding meetings and taking votes, and
- “buy-sell” provisions, which establish a framework for what happens when a member wants to sell his interest, dies or becomes disabled.
While these items may seem fairly straightforward, each is rife with details. Make sure you fill out the particulars in the following key areas.
Percentages of ownership
The owners of an LLC ordinarily make financial contributions of cash, property or services to the business to get it started. In return, each LLC member gets a percentage of ownership in the assets of the LLC. Each member is usually given an ownership percentage that’s in proportion to his contribution of capital, but LLCs are free to divide up ownership in any way they wish. These contributions and percentage interests are an important part of your operating agreement.
In addition to receiving an ownership interest in exchange for his investment of capital, each LLC owner also receives a share of its profits and losses, called a “distributive share.” Most often, an operating agreement will provide that each owner’s distributive share corresponds to his percentage of ownership in the LLC. For example, because Tony owns only 35% of his LLC, he receives just 35% of its profits and losses. Najate, on the other hand, is entitled to 65% of the LLC’s profits and losses since she owns 65% of the business. (If your LLC wants to assign distributive shares that aren’t in proportion to the owners’ percentage interests in the LLC, you’ll have to follow rules for “special allocations.”)
Distributions of profits and losses
In addition to defining each owner’s distributive share, your operating agreement should answer these questions:
- How much — if any — of the allocated profits of the LLC (the members’ distributive shares) must be distributed to LLC members each year?
- Can members expect their LLC to pay them at least enough to cover the income taxes they’ll owe on each year’s allocation of LLC profits?
- When will distributions of profits be made?
- Or are the owners entitled to draw periodically from the profits of the business?
Because you and your co-owners may have different financial needs and marginal tax rates (tax brackets), the allocation of profits and losses is an area to which you should pay particular attention.
While most LLC management decisions are made informally, sometimes a decision is so important or controversial that a formal vote is necessary. There are two ways to split voting power among LLC members: either each member’s voting power corresponds to her percentage interest in the business or each member gets one vote — called “per capita” voting. Most LLCs mete out votes in proportion to the members’ ownership interests. Whichever method you choose, make sure your operating agreement specifies how much voting power each member has as well as whether a majority of the votes or a unanimous decision will be required to resolve an issue.
Many new business owners neglect to think about what will happen if one owner retires, dies or decides to sell his interest in the company. These concerns may not be on your mind now, but such situations crop up frequently for small business owners, and it pays to be prepared. Operating agreements should include a buyout scheme — rules for what will happen when one member leaves the LLC for any reason. For more information, see Plan for changes in LLC ownership with buy-sell provisions.
How to create an operating agreement
Obviously, you’ll need help beyond this article to make your own operating agreement. There are many sources for blank or sample LLC operating agreements, but you must be sure that your operating agreement is drafted to suit the needs of your business and the laws of your state.
Law libraries are a good source of state LLC law as well as technical material on preparing an operating agreement, but since the material is written for lawyers, you may find it more confusing than helpful.
You can pay a business lawyer for assistance, and in fact we recommend this for LLCs with more than five owners, or for those that opt to have a special manager or management group run the LLC. Lawyers typically have several types of standard agreements on hand that can be customized for your LLC.
If expense is an issue, software that helps you create your own LLC may be your best alternative. For example, LLC Maker (from Nolo.com) will use your input to customize an operating agreement that suits the needs of you and your co-owners and meets the requirements of your state’s laws.