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The operating agreement of a Limited Liability Company (LLC) allows owners to structure working and financial relationships between co-owners so that it suits the business.
In an operating agreement, the co-owners should establish each owner’s ownership percentage share in the LLC, their share of profits, their responsibilities and rights, and how an owner leaving will be handled.
Why an Operating Agreement is Required
Although most states do not require that LLCs have operating agreements, it does not make sense to try and operate an LLC without one in place, even if the company has a sole owner.
Operating agreements help guard the limited liability status, prevent management and financial misunderstandings, and makes sure the business is run according to its own rules rather than default rules administered by the state.
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Guarding the Limited Liability Status
A significant reason for creating operating agreements is to make sure that courts will honor the limited personal liability of the owners. This is especially crucial in an LLC is owned by a single person where the LLC may be mistaken for a sole proprietorship if it does not have an agreement in place. Credibility will be lent to the separate existence of the LLC if it has a formal written operating agreement.
Defining Managerial and Financial Structures
LLCs that are co-owned have to establish their decision-making and profit-sharing protocols, and the procedures that will be used to handle the addition and departure of members. If there is no operating agreement in place, the co-owners will have great difficulty settling misunderstandings over management and finances. The LLC will also have to follow the default operating procedures created by the applicable laws of the state.
Overriding Default State Rules
All states have laws defining the basic rules for operating LLCs. These are known as default rules, and some of them will govern an LLC unless the operating agreement documents something else.
As an example, many states have default rules requiring owners to divide the LLC’s profits and losses equally, irrespective of how much each member invested in the company. For LLCs where the co-owners didn’t spend the same amount in the business, it does not make sense to split profits equally.
This can be avoided by the operating agreement spelling out exactly how profits and losses will be divided amongst the co-owners.
By creating an operating agreement, the members can determine which rules will govern the LLC’s operations, rather than following the default rules that may not be suitable for the business.
What Should An Operating Agreement Include?
Many issues should be covered in the operating agreement of an LLC. Many of these will depend on the business’s specific requirements and situation.
Operating agreements generally include:
- the percentage interest each member has in the LLC
- responsibilities and rights of members
- voting powers of members
- allocation of profits and losses
- management of the LLC
- rules governing how meetings will be held and votes were taken
- provisions that determine what to do when a member wants to sell their interest becomes disabled or dies
Although these points may seem straightforward, they require that important decisions be made upfront. These should then be recorded in detail in the operating agreement, preventing any disagreement later on.
LLC owners typically make contributions of assets such as cash or property, or services when the company starts. Each member of the LLC is then allocated an ownership percentage of the LLC.
Owners generally receive an ownership percentage that is in proportion to their contribution, but LLC members may share ownership in whichever way they want to. These percentage interests and contributions are a crucial part of the operating agreement.
Profit and Loss Distribution
Apart from defining owners’ distributive shares, an operating agreement should also explain the following:
- How much of the distributive shares of the members should be paid out to members annually?
- LLC owners have to pay income tax on the amount of profit that is allotted to them and not only on profit that is paid to them. Even though profits may be reinvested back into the company rather than being paid out, it is still deemed to be the owners’ taxable income. The operating agreement should specify if members can expect the company to pay them at least enough to pay the income taxes they’ll have to spend on the allocation of LLC profits.
- Define whether the owners will be allowed to draw from the business’ profits at will, or if distributions of profits will be made regularly.
As each co-owner will be in different tax brackets and have different financial requirements, specific attention must be paid to profit and loss allocation. To make sure it achieves the results each co-owner has in mind and that there are no surprises, it may be a good idea to have this part of the operating agreement checked by a tax consultant.
Apart from receiving a percentage of ownership interests for their contributions, LLC members also receive distributive shares, which is a share of the profits and losses of the LLC.
Operating agreements usually state that owners’ distributive share is the same as the percentage of LLC ownership, e.g., if Peter owns 25% of the LLC, he will receive 25% of the company’s profits and losses.
LLCs may, however, allocate distributive shares that are not proportional to the percentage interests in the company, but in this case, the individual allocations rules have to be followed.
Rights to Vote
Although management decisions in an LLC are often made informally, a determination is sometimes so controversial or essential that it is necessary to hold a formal vote. Voting power allocated to LLC members can be split in two ways:
- per capita voting where each member gets one vote
- voting power is divided according to each member’s share in the business
Most LLCs split voting power according to the members’ ownership percentage. The operating agreement should not only specify the voting power allocated to each member, but also whether a unanimous decision or a majority vote will be needed to resolve issues.
New business owners often don’t consider what happens if an owner wants to sell their shares in the business, retires, or dies. An operating agreement should include details of the process to be followed when members leave the company.
Creating an Operating Agreement
Although this article has covered the basics of how an operating agreement may be created, it is not enough in itself. There are, however many templates available for LLC operating agreements. Do, however, make sure that the operating agreement is created within the laws of your state and to suit your unique business requirements.