What You Should Know about an LLC Operating Agreement

When starting a business, you have to deal with several legalities and formalities. Of all these, the operating agreement is one of the most important yet perhaps the most overlooked. This is particularly true for those who are forming Limited Liability Companies (LLCs). 

In this all-inclusive guide, you will learn everything about operating agreements. From their purpose and importance to the characteristics that make them crucial for your LLC. 

Plus, we’ve provided a sample template for your use, which will make it easier to create one for your organization.

What Is an Operating Agreement?

At its core, an operating agreement is a legal instrument that defines the ownership of an LLC as well as how it works. You can think of it as the constitution of your company. It governs how your business operates, makes decisions, and how it handles certain situations.

The most obvious point to make is that this type of agreement is most common for LLCs. However, there are similar documents for other types of organizations as well. Companies have charters, and partnerships have partnership agreements. Even individual entrepreneurs have a business plan that serves the same function.

The primary functions of this agreement include:

1. Indicating the ownership percentages and the rights.

2. Setting up organization-wide management structure and decision-making processes

3. Outlining financial structure, such as how the profits will be split and how losses will be shared

4. Setting corporate measures for the admission of new members or procedures followed for the discharge of a member or members

5. Providing regulations regarding conflict resolution.

6. Protecting the limited liability status of the company.

What To Include in an LLC Operating Agreement

To fully understand the scope and importance of an operating agreement, let's break down its essential elements:

1. Basic Company Information

2. Membership Details

3. Management Structure

4. Capital Contributions

5. Profit and Loss Allocation

6. Transfer of Ownership

7. Dissolution Procedures

8. Dispute Resolution

9. Amendment Procedures

10. Confidentiality and Non-Compete Clauses

11. Tax Treatment

12. Record-keeping Requirements

13. Indemnification Provisions

14. Severability Clause

15. Governing Law

16. Signatures of All Members

Why Do You Need an Operating Agreement?

Now, why is having an operating agreement crucial for your LLC:

1. Legal Protection

An operating agreement assists in keeping your limited liability company’s status. It clearly separates the entity from its members. This is important to ensure your personal assets are not subject to the business’s liabilities. When there is no clear agreement, members may be subject to “Piercing of the Corporate Veil” in legal disputes. This may expose them to liability. 

2. Customized Rules

If you don’t have an operating agreement, then your LLC will be subject to the state’s default laws. These generic rules may not align with your business requirements. It may also contradict the agreements you have made with your business associates. Having one allows you to customize the rules to fit your own business.

3. Conflict Prevention and Resolution

This document clarifies each member’s responsibility, role, or procedures. It maps out who does what and how disagreements and important decisions will be made and solved. This helps avoid conflicts that will end up consuming a lot of time and resources.

4. Credibility and Professionalism

A well-drafted operating agreement shows professionalism. This may be useful when dealing with banks, potential investors, or business partners. It shows that you have taken your time and thought through how you want your business to be structured. This can help you gain the trust of people you do business with. 

5. Flexibility and Adaptability

Operating agreements can be updated, so you can always make modifications to your rules and regulations. This flexibility helps your governance structure to grow with your business. You can accommodate new members, rules, business models, or market environments.

6. Succession Planning

For single-member LLCs, an operating agreement can give specific guidelines for the future of that business. This is very valuable in the event of the owner’s passing or incapacity. This is important for other members of the family or partners, who may have to take over the business or sell it.

7. Tax Flexibility

Your agreement can state how your LLC is to be taxed either as a partnership, S-corporation, or C-corporation. This flexibility can greatly affect your tax liability, as well as how profits are divided among the members.

8. Easier Transition to Multi-Member LLC

For single-member LLCs, if you form partnerships, the transition will be easier if there is an operating agreement already. You will have a framework in place that may be adapted to allow for the inclusion of new members.

Is an Operating Agreement Required?

The requirement of an operating agreement varies by state, so you need to understand the laws in your state. Here's a breakdown of the requirements:

States Requiring Operating Agreements:

• California: While all LLCs are required to have an operating agreement in place, it does not necessarily have to be written.

• New York: In general, members need to have the written agreement within 90 days of the formation of the LLC.

• Missouri: There must be an operating agreement, which can still be oral or written.

• Delaware: There must be an operating agreement, but it can be oral or written.

States Not Requiring Operating Agreements:

In many other states, there is no legal necessity for LLCs to have an operating agreement. However, it should be noted that in these states, having one is advised for the reasons mentioned above. You should treat it as vital to your company’s operations regardless of location. The gains derived from preparing it dwarf the time and energy necessary to prepare it.

Key Considerations When Drafting Your Agreement

These are important factors to keep in mind while drafting your operating agreement:

1. Be Specific and Comprehensive

The more elaborate your agreement is, the fewer the chances of misunderstanding or disagreements later. Never assume something is basic; make sure you express even the simplest elements of whatever you are describing. Include all activities of your company, including how it is run on a daily basis and major long-term decisions.

2. Plan for the Future

Think of real-life possibilities that might happen as your business develops. What measures have you provided in your plan to cope with the addition of new members? What do you suppose would happen if a member wishes to exit the business or sell his stakes? What if the business requires more capital to be reinvested in the business? Dealing with these possibilities can provide protection from serious disputes in the future.

3. Address Potential Conflicts

Provide information on how the members will handle disputes. This can involve mediation clauses or voting methods for other controversial matters. It also includes buy-sell agreements that describe how a member’s interest can be bought if they are exiting the company.

4. Consider Tax Implications

The document should also state how your LLC will be taxed. Will it be a partnership, a corporation, or a disregarded entity in the case of single-member LLCs? The choice of tax treatment can impact the distribution of profits and taxes paid by you and your business.

5. Review and Update Regularly

Your agreement isn't set in stone and should be updated periodically. This should be done particularly after significant changes in your business or membership. You should schedule a review annually or every two years to check if the agreement is still relevant.

6. Align with State Laws

Before finalizing your operating agreement, make sure that it is within the requirements of the LLC laws in your state. The provisions of state legislation may give you complete autonomy in some areas. It may also prohibit certain activities. Read through your state’s guidelines, or speak with an attorney if needed to meet the state’s guidelines.

7. Consider Industry-Specific Needs

Some business industries require specific provisions in the operating agreement. For instance, a professional service LLC that provides a specialized service such as the practice of law or medicine. They may encounter pecuniary implications regarding licensing or liability. These are inherent in the occupational specialty of the firm.

8. Balance Flexibility and Stability

You do not want your agreement to be very rigid. Don’t use provisions that make it difficult to adapt to change as business grows. On the same note, make sure some fundamental features of your business structure and member rights are protected.

Common Mistakes To Avoid in Operating Agreements

As you draft your agreement, be aware of these common pitfalls:

• Vague Language: Do not use terms that may have ambiguous meanings. Provide explanations for any technical or industry-specific word used.

• Overlooking Important Provisions: Don’t forget to add important and relevant regulations. This can include buy-sell agreements, non-compete clauses, or confidentiality provisions. 

• Contradicting State Laws: These could make some of the provisions of the agreement non-enforceable or cause you to lose the status of an LLC.

• Failing to Get All Members' Signatures: Your agreement may not be fully effective if all the members have not signed it. It is recommended that each member sign and you retain a copy for your business records.

• Neglecting to Update: When your business grows, its operating agreement should also evolve. Agreement reviews and updates are needed to keep it relevant and efficient.

• Ignoring Tax Consequences: By not factoring this in, you can expose the LLC to unexpected financial burdens.

• Unequal Treatment of Members: Strive for a fair balance that reflects each member's contributions.

• Overlooking Exit Strategies: Without such provisions, departures can lead to litigation or conflicts. This can be disruptive to the business.

Enforcing Your Operating Agreement

When you have your agreement in place, you need to know how it can be enforced. They are considered to be internal documents. This means the members mainly enforced them.

 

If one of the members violates the terms, other members can approach the law courts to enforce the provisions. However, the courts generally won’t interfere with the internal operations of the LLC. The exception is if there is a clear violation of the agreement or state laws.

To ensure your agreement is enforceable:

1. Ensure all members sign it and keep copies.

2. Updated always and either record any change or amendments done properly

3. Comply with it strictly

4. Prescribe clear procedures for handling disputes and enforcement

 

While your operating agreement is a binding contract between members, it cannot override state or federal laws. Any provisions that conflict with these laws may be deemed unenforceable.

Free Operating Agreement Template

As promised, here's a basic template to get you started with your LLC operating agreement.
 

(LLC NAME) OPERATING AGREEMENT

 

Effective Date: (DATE)

 

ARTICLE I: FORMATION

1.1 The undersigned execute and become members of a Limited Liability Company (“LLC”) under (STATE) law.

1.2 The LLC's name is (LLC NAME).

1.3 The LLC's purpose will be (BRIEF DESCRIPTION).

1.4 The principal place of business is (ADDRESS).

1.5 The registered agent of this LLC is (NAME AND ADDRESS).

 

ARTICLE II: MEMBERSHIP

2.1 Details of the initial members and their contributions are in Schedule A.

2.2 New members can be admitted if all current members agree.

 

ARTICLE III: MANAGEMENT

3.1 The LLC is member-managed.

3.2 Any major decision shall require a majority vote of the members.

 

ARTICLE IV: CAPITAL CONTRIBUTIONS

4.1 Initial contributions are provided in Schedule A.

4.2 Additional contributions can be made if all members agree. 

 

ARTICLE V: ALLOCATIONS AND DISTRIBUTIONS

5.1 Distribution of profits and losses is with reference to the capital contribution.

5.2 Distributions as determined by members.

 

ARTICLE VI: RECORDS

6.1 The LLC will keep necessary books and records.

 

ARTICLE VII: TAXATION

7.1 The LLC will be taxed as (PARTNERSHIP/S-CORP/C-CORP).

 

ARTICLE VIII: DISSOLUTION

8.1 Dissolution may only be done with the consensus of all the members or as prescribed by the law.

8.2 Distribution of assets should be to creditors first and members proportionally.

 

ARTICLE IX: AMENDMENTS

9.1 The provisions of this agreement may be altered or amended by unanimous written consent at any time.

 

(MEMBER SIGNATURES)

 

SCHEDULE A

 

Member 1:

• Capital Contribution: $(Amount)

• Ownership %: (%)

 

Member 2:

• Capital Contribution: $(Amount)

• Ownership %: (%)

 

This template provides a basic structure for an LLC operating agreement. Ensure you customize this template to fit your specific business needs and ensure compliance with your state's laws. Note that it's always advisable to have a legal professional review your final document.

Final Thoughts

Drafting an operating agreement for your LLC might seem like a herculean task, but it will form a strong foundation for your business. Your operating agreement is a living document. You need to know that as your business evolves and develops, it should be reviewed and updated. This way, you'll be better equipped to handle the challenges and opportunities that come with running a successful LLC.

Having the right tools at your disposal can make all the difference if you’re just starting up your LLC. This is also important if you’re looking to refine your existing operating agreement. Our online paystub generator supports entrepreneurs by simplifying essential business tasks from designing professional pay stubs to managing payroll. This easy-to-use software ensures you can stay in touch with the elements that matter most—realizing your entrepreneurial vision. Explore our services and stay on top of all your documentation needs to keep your LLC running smoothly.

*Photo by Cytonn Photography on Unsplash