What is an LLC Operating Agreement & Why Do You Need One

When registering your business as an LLC, your operating agreement imprints the operational guidelines and foundational elements of your company. It’s a customized document that outlines the functional and financial decision-making of the business. Continue reading to learn why creating this agreement is crucial and what operating agreements typically consist of.

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What is an LLC Operating Agreement?

An operating agreement for LLC (Limited Liability Company) is a document that identifies the business, defines member duties, states its ownership, and defines other structural components of the company. It usually includes basic information about the LLC and its owners. Furthermore, it states the company’s elected tax treatment and guidelines for handling specific procedures.

Operating agreements function as legal contracts between the members of a multimember LLC. However, single-member LLCs can benefit from operating agreements, too. The operating agreement, once signed, acts as a binding set of rules for the members of the LLC to follow.

It’s important to note that creating an operating agreement is not mandatory for most states. Nonetheless, it’s a crucial document you should create when starting an LLC.

In essence, the purpose of an operating agreement is to govern the business’s internal operations in a way that adheres to the specific needs of the members.

Why Do You Need an Operating Agreement?

There are several reasons why your LLC needs an operating agreement, including:

Defines key business procedures: Although the articles of organization you file with the state make your LLC official, it describes little about how the company functions. LLC operating agreements get more specific in voting, meetings, day-to-day operations, and conflict resolution procedures.
Strengthens your LLC’s “corporate veil”: If you don’t have an operating agreement, courts may not take your LLC status as seriously. The legal separation, or veil, between a company and its members, is key to limiting personal liability.
Protects members from personal liability: An operating agreement is a formality that projects the members from personal liability.
Clarifies verbal agreements: The LLC operating agreement sets all agreements between the members in writing so there is no future confusion or misunderstandings.
Makes certain you aren’t subject to default state rules: If an LLC doesn’t have an operating agreement in place, the default rules set by your state will apply. For instance, states have standard rules that require companies to divide profits and losses equally.

What’s Included in an LLC Operating Agreement?

While the content and structure of LLC operating agreements vary for each business, here are the types of information they most frequently include:

Each member’s ownership conveyed as a percentage
Each member’s responsibilities and voting rights
Guidelines on the duties and powers of each member
The profit and loss allocation among each member
The rules regarding member meetings and taking votes
The issues regarding the management structure of the LLC
Buyout and buy-sell provisions, when a member wants to exit and sell their share.

However, it’s important to remember that operating agreements are not one size fits all. Your operating agreement should be drafted to provide freedom, control, and protection over your specific type of company.

Let’s take a closer look at what’s included in an LLC operating agreement.

Basic Information About the LLC

Operating agreements further emphasize your LLC’s most basic decisions and premises, many of which may already be set in your company’s “articles of organization”. This information typically includes your LLC’s official name, principal place of business, management structure, duration, registered agent, and statement of purpose.

Member Information

One of the most important functions of an operating agreement is to specify how the LLC’s profits and responsibilities are distributed among the members. The operating agreement typically states basic member information, including names, addresses, and roles within the business.

It may also include the amount and nature of a member’s contributions to the business. These are often financial and should state expectations about compensation, which may be described with ownership percentages.

Tax Treatment Preference

LLCs usually have a single layer of taxation. This means they are, by default, exempt from business taxes, meaning profits are only taxed at the individual level when members report their share of income and expenses on personal tax returns.

Furthermore, LLCs have a bit of autonomy regarding tax treatment, depending on the type of business. For example, LLCs may want to elect corporate status by filing as a C-corp or an S-corp to take advantage of certain incentives. The operating agreement should state the LLC’s initial tax status and define the procedure for modifying tax classification in the future.

Management Structure

LLCs have one of two types of management structures, member-managed or manager-managed. A “member-managed LLC” lets members act as “agents” on behalf of the LLC and relies on members for daily operations. This is ideal for small or startup companies with relatively few members.

A “manager-managed LLC” is the second form of management structure where members elect a smaller set of people to manage the company. The non-elected members still retain passive ownership and voting rights on major decisions. This type of management structure is popular among larger companies with passive investors.

Operating Procedures

An operating agreement also includes crucial business procedures for running the company.

These procedures include:

Voting
Approving manager actions
Adding new members
Holding member meetings
Facilitating member exits
Dissolving the LLC

Liability Statement

One of the primary benefits of forming a limited liability company is the distinction it makes between the company and its individual members. Although corporate stockholders are protected from their company’s liability, sole proprietors or partnership members assume full personal liability for the risk of operation.

LLCs combine the best traits of both structures, enjoying a corporation’s limited liability without carrying its level of tax and regulatory burdens. Therefore, LLCs must clearly define the limited liability status with a comprehensive liability statement in case this status is challenged in the future. The operating agreement is the best place to declare this statement.

Extra Provisions

The final goal of an operating agreement is to proactively navigate future bumps in the road. For this reason, they usually include provisions describing what happens in the event of unplanned circumstances such as a member’s death, a member’s withdrawal from the LLC, and disputes among members.

Most operating agreements end with a “severability provision,” stating the rest of the operating agreement stays in effect if one part is opposed to state or federal law and is otherwise unenforceable.

How to Create an LLC Operating Agreement?

Creating an operating agreement is a straightforward process as long as you use a template or get help from a business formation service.

Let’s discuss each option:

Do It Yourself

You shouldn’t draft an operating agreement yourself without a legal background. Since an operating agreement is legally binding, you don’t want to make any mistakes. Instead, you can use a blank template or step-by-step instructions. You can find many variations through legal help websites and law libraries.

Use an Online Service

The most efficient way to create an operating agreement is with the help of LLC formation services such as ZenBusiness and Rocket Lawyer. These services offer interactive templates that provide the structure and framework necessary to start a successful business.

These automated business registration services offer an easy way to create an optimized operating agreement for your specific type of business.

Use a Professional Service

If your LLC has unique considerations and a high level of complexity, you may want to consider getting professional legal help. There are plenty of lawyers specializing in operating agreements and offer pricing for individual documents instead of hourly rates.

What Is an Operating Agreement – Frequently Asked Questions (FAQs)

Before you start drafting your operating agreement, there are a few key questions we receive about operating agreements you should know. Here’s a list of some frequently asked questions about operating agreements for LLCs.

Which States Require LLC Operating Agreements?

Five states require LLC operating agreements, including New York, California, Missouri, Maine, and Delaware. Although requirements differ among the states, none require you to file anything with the state office. Instead, they only require an operating agreement to exist.

Do Single-Member LLCs Really Need an Operating Agreement?

Although it’s not necessary for 45 states, it’s strongly recommended. Operating agreements can help a single-member LLC establish credibility and help ensure LLC status. Without a proper operating agreement defining the legal distinction between the LLC and the sole owner, it can be challenging in the event of litigation.

Is an LLC Operating Agreement Legally Binding?

LLC operating agreements are typically treated as legally binding documents once signed. If a member from the LLC ever goes to court to resolve internal issues or disputes with a third party, the court will likely hold members accountable to the guidelines in the operating agreement. Keep in mind that you don’t need to get an operating agreement notarized.

What’s the Difference Between an LLC Operating Agreement and Articles of Organization?

Articles of organization are official documents that you must file with the state when you form an LLC. These documents are relatively minimal and include basic information about the LLC, its management structure, and its members. On the other hand, operating agreements provide more detail about essential business functions and structure.

Can I Modify an Existing LLC Operating Agreement?

Yes, you can amend the operating agreement to ensure it’s up to date at all times. It’s important to keep your operating agreement updated. You can create amendments and, once approved by the members, you can file the amended operating agreement with the secretary of state as needed.

Bottom Line on What is an LLC Operating Agreement

An LLC operating agreement is a legal document that lays out the terms of an LLC to its members. As such, it creates the roadmap for the business to follow and provides clarity in operations and management. It’s important to develop an operating agreement because, without one, your LLC is governed according to your state’s default rules.