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You wouldn't lavish time and money on a building with a bad foundation, would you? That's what many new business owners do when they form a limited liability company (LLC) without giving real time and consideration to their business operating agreements.
Why is an operating agreement so important to your new LLC? First, it helps to guarantee that the legal protections you're looking for actually work for you when the need arises.
Second, it walks you through much of the thinking you need to do before you register an LLC with the state. Even single-member LLCs need an operating agreement structured to fit their needs.
Learn what goes into an LLC operating agreement and how to create one that will carry your business through good times and bad.
An operating agreement is a legal contract between members of an LLC that spells out how the business will be governed, financed, and managed.
In most states, you do not have to submit an operating agreement when creating an LLC. You can simply file articles of organization with the secretary of state to register your legal business entity.
At this time, only California, Delaware, Maine, Missouri, and New York require you to submit an operating agreement along with your formation paperwork.
If you don't draft a written operating agreement, the default laws of your state of formation will apply to your company. This means that even if all of your members want something different, if you don't have written documentation, state laws may override them.
In addition to being required in a few states, operating agreements protect your LLC business from everyday hazards.
Your operating agreement is a critical document that should be tailored to fit your business needs and the LLC laws of your state of formation. Generally, operating agreements cover these areas.
The operating agreement spells out each member's capital investment or contribution to the LLC. This is expressed as a percentage of ownership in the company. This is important because it governs how profits and losses are allocated.
The operating agreement should clearly define each member's financial interest in the company and the rights and responsibilities that come with it.
LLCs can be managed several different ways depending on the laws of your state. A member-managed LLC means that all members manage the business's day-to-day operations together. This is the default setup of an LLC.
In a manager-managed LLC, one or more members are merely investors, or silent members, who don't actively manage the business. The business may be managed by a professional manager or by one or more of the remaining members.
Control over the business is a frequent area of dispute. It usually starts with a casual arrangement in which one member is the main driver of the business.
As time goes on, another member takes on a more active role, or maybe an investor assumes that some decision-making power should come with that investment, and suddenly the members are at odds. That's why it's so important to set clear expectations up front.
You can find templates for operating agreements online, but your agreement should be tailored for your business and reviewed by an attorney. Image source: Author
Corporate governance concerns how a business entity runs itself, rather than how its people manage the business. Governance helps to separate your business from your personal affairs. Your operating agreement should establish key governance guidelines including:
LLCs are pass-through entities, with income and losses passing through to their owners' personal income.
In many states, profits and losses are automatically distributed to an LLC's members based on their shares of ownership, but your operating agreement may lay out different terms.
Your operating agreement should cover these important financial decisions:
Your operating agreement should include provisions for buying out members who want to leave or who suffer a major change such as divorce or bankruptcy. It should also include measures for new members to buy in.
This section is especially important because in many states, your LLC may be automatically dissolved if a member leaves or dies.
Your operating agreement should address these concerns:
IRS Publication 3402 walks you through the many tax options for LLCs. Image source: Author
An operating agreement should provide a noncompetition or noncompete clause, if desired, to prevent members from using knowledge or assets from the LLC to engage in competing ventures.
When registering your business, you may be asked on your LLC forms to specify a duration for your LLC. Most LLCs elect perpetual duration if it is available. Even with perpetual duration, you need to spell out what happens to your LLC following the death or retirement of its last member.
Without processes for winding down the company's affairs, the LLC's assets may be in legal limbo if a sole member dies.
This is another example of why it's important for even a single-member LLC to have a written operating agreement as part of its founding corporate records.
Get the answers to your questions about this legal documentation.
Articles of incorporation are not used in LLCs. LLCs and corporations have parallel but different formation documents:
Entity type |
Formation document (filed with the secretary of state) |
Governing document |
---|---|---|
Corporation | articles of incorporation | bylaws |
LLC | articles of organization | operating agreement |
Only if you are forming your entity in California, New York, Missouri, Maine, or Delaware. In all other states, it is highly advisable, but not legally required.
If you don't file an operating agreement, your LLC is ruled by the LLC laws of your state by default. Since these may or may not fit your needs, skipping your operating agreement is risky.
Yes, even a single-member LLC should create an operating agreement to: establish the parameters of your business as a separate financial and legal entity; provide for bringing in future owners; and facilitate dissolution upon your death.
Yes. The operating agreement is a contract between the parties who sign it. You can change it anytime with the parties' consent, according to the terms of the agreement. If you live in a jurisdiction where the operating agreement is filed with the state, you will likely need to submit the new agreement whenever changes occur.
Sample operating agreements can provide a good starting point, but your LLC paperwork should be drafted or reviewed by an attorney. This is a small but critical investment in the life of your business.
With a sound legal agreement between members, your LLC has the best chance of starting strong and staying that way through the inevitable seasons of life.
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