An LLC operating agreement is a document that customizes the terms of a limited liability company (LLC) according to the specific needs of its members. It also outlines the financial and functional decision-making in a structured manner. It is similar to the articles of incorporation that govern the operations of a corporation.
Although writing an operating agreement is not a mandatory requirement for most states, it is nonetheless considered a crucial document that should be included when setting up a limited liability company. The document, once signed by each member (owner), acts as a binding set of rules for them to adhere to.
The agreement is drafted to allow owners to govern the internal operations according to their own rules and specifications. The absence of an operating agreement means that your business has to be run according to the default rules of your state.
Key Takeaways
- An LLC operating agreement is a legal document that spells out the terms of a limited liability company to the members.
- It sets forth the path for the business to follow and brings clarity in operations and management.
- In some states, the operating agreement is required as part of establishing the business entity.
- LLC operating agreements have some boilerplate sections with standard language, but one size does not necessarily fit all.
- If an LLC does not have an operating agreement, it must be governed according to the default rules of that state.
How LLC Operating Agreements Work
An LLC is a type of U.S. business entity that is easy to form and simple to manage while importantly limiting the liability of owners. Since an LLC is a hybrid of a partnership and corporation, it provides the twin benefit of pass-through taxation with limited liability.
To take full advantage of having an LLC, you should go one step further and write an operating agreement during the startup process. Many tend to overlook this crucial document since it is not mandatory in many states. Only a few states specify the need to register an operating agreement when creating an LLC.
The operating agreement spells out the terms of an LLC according to the members. It sets forth the path for the business to follow and brings clarity in operations and management. A typical LLC operating agreement is a 10- to 20-page contract document that sets up guidelines and rules for the LLC.
In states such as California, Missouri, and New York, it is mandatory to include this document during the incorporation process. While most other states do not insist on including it, drafting an operating agreement is always considered wise. It protects the status of a company, helps resolve misunderstandings, and ensures the business is carried out according to the rules set by the members.
Businesses that do not sign an operating agreement fall under the default rules outlined by the states. In such a case, the rules imposed by the state will be very general and may not suit every business. For example, in the absence of an operating agreement, some states may stipulate that all profits in an LLC are shared equally by each partner regardless of their capital contributions. An agreement can also protect partners from any personal liability if it appears they are operating as a sole proprietorship or a partnership.
An operating agreement, once signed, should be kept safely as an important record of the business.
Benefits of an LLC Operating Agreement
Even if a business venture has only a single owner/employee, it can benefit from codifying the relationship through an LLC operating agreement. Having an operating agreement establishes a legal boundary between the LLC and the owner, protecting the owner from the LLC’s debts or liabilities. Without it, creditors to the LLC may pursue the owner’s personal assets.
An operating agreement also allows the owner to codify the rules of succession for their business and governance procedures such as meetings and voting. Without an operating agreement, ownership of the business is handled according to the state’s default LLC rules.
What to Include in an LLC Operating Agreement
There are many issues that must be covered in the LLC operating agreement. The general format of the document includes the following:
- Each member’s ownership expressed as a percentage
- The members’ responsibilities and voting rights
- A layout of the duties and powers of members
- The profit and loss allocation among members
- The rules related to holding meetings and taking votes
- Issues related to the management of the LLC
- Buyout and buy-sell provisions, including what will happen in the event of a member’s death
LLC operating agreements should also outline the specific definitions of terms used in the agreement, as well as the purpose of the business, a statement of its intent to form, how it will handle new members, how it chooses to be taxed, how long it intends to operate, and where it is located.
Just as “one size doesn’t fit all,” the state default LLC rules don’t suit everyone. The best way to counter this issue is by writing an operating agreement, which offers freedom, protection, and control to your business. While it’s best to include an operating agreement in the initial stages, if you missed on it, it’s never too late to put it in place, provided all members agree. The document can also be modified later with the guidance of an attorney.
Frequently Asked Questions About LLC Operating Agreements
If I Have an LLC Operating Agreement, Do I Need a Business Plan?
There’s no legal requirement for an LLC to have a written business plan, but there are clear advantages to having one. A well-structured business plan sets out the goals and values of an enterprise and provides an objective way of assessing whether those goals are being met.
Does an LLC Have Shares of Stock Like a Corporation?
No. While it is sometimes common to describe LLC membership as a “share,” this is not the same as stock units in a corporation. Members of an LLC have the right to share profits and make decisions regarding their company, but an LLC cannot raise money by issuing stock shares.
What Is the Difference Between a Partnership and an LLC?
A partnership is a comparatively simple vehicle for business relationships. Unlike an LLC, there is no requirement for formal paperwork: a partnership forms whenever two or more partners go into business together.
Also, unlike an LLC, partners may be held personally liable for the partnership’s business obligations—meaning that creditors may seek repayment from the personal assets of individual partners. In contrast, the members of an LLC are legally distinct from their business organization.
Can an LLC Operating Agreement Be Amended?
Yes, LLC operating agreements can generally be amended, but the procedures for doing so will vary. In most cases, the process of amending an operating agreement should be spelled out in the agreement itself. Some LLCs might specify that amendments require a unanimous vote of the members or can only be amended in the fourth quarter of the year. It is even possible for an LLC to have an operating agreement that cannot be amended. If it is not clearly stated, the process for amending an operating agreement is determined by the default rules for LLCs in that state.
Does a Single-Member LLC Need an Operating Agreement?
A handful of states require all LLCs to have an operating agreement, even if they have only one member. These include New York, Missouri, and California. In other states, it is not required but strongly encouraged, as it can protect the members from potential problems the LLC may encounter.
Related Terms: Limited Liability Company, Articles of Incorporation, Incorporation, Partnerships, Business Plan.
References
- Internal Revenue Service. “Taxation of Limited Liability Companies”. Page 2.
- The New York State Senate. “Section 417”.
- Missouri Secretary of State. “Missouri Small Business Startup Guide”.
- California Secretary of State. “Starting a Business – Entity Types”.
