What is an LLC Operating Agreement?
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Most states do not require an LLC to have an Operating Agreement (in fact, many states do not require an Operating Agreement to be in writing). As a result, the law is pretty silent on what is required within an operating agreement. Whether or not your business is located in a state that requires an operating agreement, it is always wise to have a written operating agreement for any LLC. An operating agreement protects your limited liability status, helps prevent any financial and management disputes, and ensures that the LLC is conducted the way you want, and not by the state's default rules.
Limited Liability Status
An operating agreement that specifies the LLC's limited liability status gives further assurance that the courts will find your business as an LLC. The operating agreement becomes even more important if the LLC is a single-member LLC.
Rights and Responsibilities of Members
It is important to specify the expectations of the members and the manner in which the LLC will be governed.
For accounting purposes, the operating agreement should specify the LLC's accounting method.
Generally, ownership percentages are in proportion to the investment capital given to the LLC. The more capital a particular party puts into the LLC, the higher the party's ownership percentage. However, LLC are free to distribute its ownership percentages on its own terms and so it is imperative for an LLC to specify the differing ownership percentages especially when a party's stake is disproportional to his or her capital investment.
Ownership entails the LLC's assets. The LLC's profits and losses are not necessarily its assets and so it is a good idea to specify how the LLC's profits and losses will be distributed. Generally, the ownership percentages correspond to the distributive shares of the LLC. However, the LLC is free to specify its own distributive share scheme and should do so explicitly within the operating agreement.
Distribution of Actual Profits and Losses
Beyond distributing the shares of the LLC, the operating agreement should specify the conditions for distributing the actual profits and losses to its members. Unlike a corporation, the profits and losses of an LLC is recorded as income for the LLC members. Whether the profits and losses remain with the LLC or are distributed to the members, the members remain liable for the profits and losses. Due to this unique circumstance, the operating agreement should specify how much and how often profits and losses will be distributed to the members. Members may consider their individual tax bracket to determine the amount to be distributed (may want the distribution to be just enough to pay for the taxes on the profits).
Voting Rights of Members
There may be times members disagree about a particular business decision and there may be times an agreement over a controversy cannot be made. During these times, specifying the voting rights of every member may help resolve any issue as painless as possible. Generally, ownership percentages determine voting percentages, but LLCs are free to allocate its voting rights to its members. Beyond specifying the voting rights of the members, it is also important to include any tie-breaker mechanism within the operating agreement.
The operating agreement should specify how ownership of the LLC can be transferred. Should a member be free to transfer his or her interest to any other party? Or should the LLC have the first opportunity to buy-out a member's ownership interest? What happens if a member no longer has the capacity to be a member (i.e. severe illness, incarceration, death, etc.)?
Dissolution of the LLC
The operating agreement should specify under what conditions an LLC will be dissolved. It should also specify how the LLC will be liquidated.
In the happenstance a provision within the operating agreement is contrary to state or federal law, the operating agreement should specify that all other aspects of the operating agreement that are not contrary to state or federal law should survive. Without this provision, an invalidation of one part of the operating agreement threatens to invalidate the entire agreement and thus the LLC will fall under the state's default rules. Any special provisions within the operating agreement should be protected through a severability provision.
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