Should I have an operating agreement for my LLC?

The answer to this question is almost always yes. Although some states don’t legally require you to have an operating agreement, you really shouldn’t run an LLC without one.

Why exactly? Well, for starters, an operating agreement proves you and your partners are serious about running your business. That can really help with bank loans and holding onto your limited liability status, just in case something goes wrong.

[pullquote]If the rules aren’t written down, you might find yourself in a series of misunderstandings based on verbal agreements made months or years ago.[/pullquote]

Additionally, an operating agreement will ensure that your LLC is run under consistent rules that you decide on. The rules in your operating agreement will serve as the foundation for your LLC, its owners, and its employees. If the rules aren’t written down anywhere, you might find yourself in a never-ending series of financial and management misunderstandings based on verbal agreements made months or years ago.

That’s never a happy place to find yourself in. If you don’t create an agreement, your LLC will governed by the de facto LLC rules in your state. That could lead to unfair profit splits, infighting, and a whole host of unpleasant issues.

Generic state rules also do not consider your unique circumstances or your goals for the LLC. With an agreement, you’ll know the rules you’ve applied to your business, so you won’t have to worry about the unpredictability of some obscure state rule applying when you least expect it.

What does an operating agreement cover?

LLC operating agreements cover a lot of very important topics. Most of the significant points covered by operating agreements discuss member’s business interests, their rights in running the business, and how the LLC will be managed. No two operating agreements are the same, so you’ll need to choose what’s right for your business.

Here are some things you’ll want to make sure you cover:

Ownership percentage:

Generally, each co-owner’s interest percentage in an LLC is determined by how much money that co-owner contributed to the business when it started compared to how much every co-owner contributed.

There are other ways to split ownership, of course. For example, in your operating agreement you could give 30 percent ownership of your LLC to a co-owner who only contributed 10 percent of the property to the LLC.

There are a number of reasons you might do this—for example, you could incentivize owners who are doing more work to receive a higher percentage of profits—but the way you divide ownership interests ultimately depends on your vision for the LLC and your unique circumstances. Since this will affect who makes important decisions for your company, make sure you give ownership percentage a good deal of thought.

Sharing profits and losses:

LLC co-owners share in the profits and the losses of their LLC. The sharing of profits and losses is done through distributive shares. You’ll choose these percentages in your LLC operating agreement.

Another thing: You should address whether profits will be distributed regularly (like once a month or quarterly, for example) or withdrawn at will from the LLC by owners. If profits are distributed regularly, you’ll want to choose how much of the LLC’s profits will be distributed, and if any will be held by the company itself.

It should also be noted that LLC co-owners have to pay taxes on the LLC’s profits whether they’re distributed or not. Make sure to consider whether or not everyone will have enough money to pay taxes if they don’t have access to their LLC profits.

Management and company roles:

You’ll want to ensure that your operating agreement establishes a managerial structure for your LLC. A good outline for how your LLC will be managed and what your company’s roles will be is really the blueprint for running your business operations from day-to-day.

Address questions like: Will your LLC be run by its members or by a certain number of managers? How will decisions be made? Who will be making the decisions? How will you define your company’s roles? Will there be a board of directors? Who’s really in charge, at the end of the day?

You’ll also want to define the procedures used for making decisions in your LLC. Defining your LLC’s management structure and company roles avoids needless confusion and misunderstandings in the future.

Accounting:

Your LLC operating agreement can also specify your business’s method of accounting and the fiscal year your business will use. You should also consider hiring an accountant who will make sure your fiscal statements are prepared in accordance with GAAP or some other recognized accounting standard.

Operating agreements frequently include a provision requiring the LLC or its members or managers to disclose an audited balance sheet and audited statements of operations and cash flow to their LLC’s co-owners. This helps everyone stay on the same page and keep up with the business’s financial health.

Voting rules:

Usually, the day-to-day business decisions of your LLC will be made informally, without having to put anything in writing or taking votes. However, if a decision will significantly affect the LLC, a formal vote is usually necessary.

You should equip your LLC with the procedures and rules that govern voting by describing them in your operating agreement. To avoid state default rules, make sure to address how much voting power each co-owner or director has.

For example, will each co-owner get only one vote? This is called per capita voting and it is a simple way of establishing voting power but not the only way. Voting power could also correspond with ownership percentage.

For an effective vote, you will need to decide whether a majority of votes is good enough to approve a matter or if a supermajority (66.6 percent) of shareholders must consent before a matter is passed. Unanimous decision-making is also an option, but you should speak with someone about the implications of required unanimous decision-making before deciding to choose this option.

Rules, of course, are different for solo LLCs. You should still take care to keep minutes when you make an important decision, just to be on the safe side.

Member withdrawal:

No business remains the same forever, so it’s also smart to make plans in your operating agreement about what will happen if one co-owner leaves the business, voluntarily or involuntarily. You can take care of this contingency in your operating agreement or, if you’d rather, a separate Buy-Sell Agreement.

They work by requiring a co-owner to sell his or her shares to the other co-owners (or simply to have the sale approved by the co-owners), when the owner decides to call it quits. Decide how that will work, who can purchase an owner’s shares, and most importantly, who can’t.

Dissolution:

Nobody invests in a business thinking that the business will end, but of course, it happens. Co-owners go their separate ways or the business fails to make a profit and eventually you might have to close up shop.

Though it might be hard to think about now, you should plan for the end of your LLC in your operating agreement. This is because you don’t want the default rules to apply to the ending of your business, especially at a time when it may seem that things couldn’t get worse.

At the very least, you should address what kind of vote will be required to dissolve the LLC and how you will split the final value of the LLC at the end of its life.

Can I change the operating agreement once my LLC has adopted it?

Yes. Every state has its own rules on how amendments can be made, but to take control of the amendment process, you should include it in your LLC’s operating. The provision should cover amendments, slight modifications, or revocation of the agreement altogether.

You’ll have the discretion in deciding how your LLC will be able to amend, modify, or revoke its operating agreement, though that’s usually done by a majority vote. If you do not include a process to amend your operating agreement in the agreement itself, you will be subject to your state’s default rules. Some default rules are as strict as requiring the unanimous consent of all members before an amendment to the operating agreement is allowed.

How do I create an operating agreement?

Creating an LLC operating agreement isn’t hard. Get together with your co-owners and a lawyer, if you think you should (it’s never a bad idea), and figure out what you want to cover in your agreement. Then, to create an LLC operating agreement yourself, all you need to do is answer a few simple questions and make sure everyone signs it to make it legal.

Have you got any questions about crafting your agreement? Any tips or advice to offer others?

Starting a nonprofit means you want to make a difference. You’re not starting your NPO to hawk silly mobile apps or book infomercial time, you’re trying to make the world a better place. And that’s great!

But, since a nonprofit is meant to serve the public good, the government takes regulation of nonprofits a lot more seriously. You’ll get benefits like free mail and tax breaks, but in return, you’ll need to keep your books in order, stay compliant, and follow your nonprofit charter.

Messing up could mean losing your nonprofit status, which can be both stressful and catastrophic.

Since the most common type of nonprofit is a 501(c)3, we’ll be looking extensively at those.

501(c)3s are public charities and certain private foundations that receive a majority of their income from endowments, donations, and investments. If your nonprofit is classified as a 501(c)4 or any other type, some of these rules may not apply to you. Contact an experienced attorney to learn the subtle differences.

Without further ado, here are a few things you should know about running a successful nonprofit.

Tax Rules and Regulations

As a nonprofit you’ll enjoy a number of tax benefits. 501(c)3s can offer tax-deductible donations to their donors and, if run correctly, are tax-exempt in the eyes of the IRS. They even get to send mail for free!

Of course, with these benefits comes added scrutiny. The first thing you’ll want to know is that even though your nonprofit is tax-exempt you still need to file a 990 form to the IRS every year. If you neglect to do this for three straight years, it will result in the IRS taking your tax-exempt status away. That’s a serious consequence. Take care to speak with an accountant and file your 990 every year.

As for business expenses, you can write most of them off if you’re running a 501(c)3. Nonprofits are exempt from sales and property taxes. However, like any for-profit business, you must pay employee taxes, such as Social Security and Medicare.

If your 501(c)3 nonprofit wants to stay tax-exempt, you should not do the following:

• Contribute to political campaigns
• Heavy lobbying and political activities
• Allow employees, officers, and/or directors to privately or financially benefit from the nonprofit (this doesn’t include reasonable salaries, however)
• Use money for purposes other than for the needs of the nonprofit

Staying Compliant

In addition to keeping your tax obligations squared away, your nonprofit will need to stay on top of a few other compliance responsibilities. Here’s a list of the most important nonprofit compliance requirements, with a quick description of each.

• Conflict of interest policy: Your nonprofit must sign a document, verifying that none of your officers or directors are privately benefiting from the organization.
• Annual board meetings: When you first formed your nonprofit, you had to create governing documents like Articles of Incorporation and Nonprofit Bylaws. These documents should’ve listed how often your board of directors meet every year to make high-level decisions like budgets and policies. At the very least, they must meet once a year.
• Nonprofit minutes: In those meetings we mentioned above, you should make sure you’re keeping minutes for every meeting. This habit helps you stay on top of record-keeping requirements and allows you to show how your board arrived at important decisions that affect your growing nonprofit.

In most states, you won’t need to file all these documents. Just keep them with your records in case you need to prove that decisions were voted on or in case the IRS or other regulatory agency is checking up on your organization.

Employees and Volunteers

Nonprofits often rely heavily on a staff of volunteers who are willing to commit their free time for the organization’s cause and mission. But there are certain positions you’ll need to hire full-time employees for to ensure that your nonprofit runs successfully.

Think about roles that may need more than volunteer assistance. Does your NPO need an accountant? A lawyer on retainer? Delivery drivers? No two nonprofits are alike, so take some time and consider what’s best for yours.

Though volunteers don’t receive compensation for their time (just that warm, fuzzy feeling), employees are allowed by law to receive a reasonable compensation. The keyword is “reasonable,” and the IRS will compare your salaries to similar nonprofits in similar circumstances to make sure.

Fundraising

Though a 501(c)3 doesn’t exist to generate profit, it still needs capital to function and accomplish its mission. At the end of the day, every business—even ones that don’t look for revenue windfalls—need to pay the rent and stay cash flow positive.

Here are some standard methods nonprofits use to generate capital for their mission:

1. Donations

Nonprofits often depend on donations to survive, so it’s important that you not only raise money for your NPO, but that you raise it in accordance with the laws in your area.

There are plenty of different ways to secure capital for your nonprofit—from bake sales to fundraisers to traditional mailers—so make sure you’re clear on the rules before you get started.

An event, like a benefit dinner, is a great way to receive large donations.It’s much more likely that someone will donate a large amount of money if they’re getting something in return (like food and entertainment). And the best part? 501(c)3 donations are tax deductible!

If you’re sending out mailers, you’ll want to include your tax ID number, 501c status, state of operations, and your actual address. Keep in mind that federally recognized nonprofits get free mail from the US Post Office.

An important point: You’ll need to send receipts to your donors so that they have a record of their gift. It’s a smart idea to send these receipts just once a year. For starters, you’ll save on paperwork and hassle. But if you send these early in the year (like January or February), that’s when a lot of donors are filling out their own taxes. Not only is that convenient for them, but it can help incentivize them to donate more the next year for additional deductions.

2. Grant writing

Certain government departments, foundations, and trusts offer grants to nonprofits. To request funds, you must apply by writing a proposal or submission. It’s usually a smart idea to employ a professional grant writer to help you with the applications.

3. Fees for services

If you’re offering a service for a fee, you need to make sure that the service is related to your mission. Let’s say, for example, you’re running an animal shelter. You may want to offer rabies shots for a fee. Since this service is directly related to your mission as a nonprofit, the money you generate is tax deductible.

Dissolution, if it comes to that

Whether your nonprofit has reached its mission or encountered irreconcilable differences within the organization, there are rules you need to abide by when dissolving it.

The remaining money you have in your nonprofit cannot be disbursed amongst the board of directors. Instead, it must be given to another nonprofit. Think of it as charities doing charity. On the flip side, if your nonprofit has accrued debts or liabilities, no one—not even the board of directors—is personally responsible for them.

Keep in mind that these are just basic guidelines. It’s always best to speak to a lawyer if you have any questions about the tips above, or the guidelines in your state. And, of course, good luck! There’s nothing as rewarding as helping other people out. Keep your paperwork and taxes in order and you can be doing it for a very long time.

Where to next?

If you’re already running a nonprofit, have you had a chance to look at Google Apps for nonprofits? It’s free and is a good starting point for anyone looking to learn more, or for a bit of extra help.

Do you have a question about starting or running a nonprofit business? Any advice to share from your own experiences? Let us know in the comments below.