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One of the first steps a new business owner must take is deciding whether to register their business as a sole proprietorship, partnership, LLC, or corporation. While there are advantages and disadvantages to all of these options, the most popular business structure for small business owners is the limited liability company (LLC). In this article, weâre digging deep into one particular aspect of this popular business structure: the LLC operating agreement.
What is an LLC Operating Agreement?
An LLC Operating Agreement is a formal, legally-binding, document that details the financial and management responsibilities of each business owner in the LLC. The document discloses the percent of the business owned by each partner and some basic information about the members and the organization as a whole. The responsibilities for losses and membersâ rights to profits are also spelled out in the agreement along with details about the duties of each LLC member.
The LLC Operating Agreement also covers instructions for multimember LLCs if one or more partners leave the LLC or if the business is dissolved, including rules regarding purchasing rights for partners and liability distribution in the event of dissolution. While LLC Operating Agreements are most common among multimember LLCs, some single-member LLCs also find this legal document helpful as a guideline for operations and dispute resolution.
Why an LLC Operating Agreement is important
Most states do not require small businesses organized as LLCs to file their LLC Operating Agreement with the IRS or the state, but there are many benefits to creating a formal operating agreement for your LLC.
Requirements for LLC Operating Agreements
Since filing these agreements is not required by most legislations, many small businesses wonder if they still need to have an LLC Operating Agreement. The answer depends on the state in which the LLC is registered and your individual business needs.
Each state has its own requirements for an LLC or limited liability partnership (LLP) to be registered. One requirement in all states is filing an article of organization, which lists primary information about the business, including the business structure and owner information. Small businesses formed as LLCs or LLPs cannot legally operate until the articles of organization are filed with the state.
In addition to filing the articles of organization, some states have other requirements for business owners to form an LLC. Those requirements, along with the state tax and sales tax rates, are considered when measuring the best states to form an LLC in. Currently, the following five states require that the LLC has a formal operating agreement created before opening for business.
- New York
While each of these states requires an LLC operating agreement, the specific details included in the agreement vary. Typically, the agreement can be written or verbal, and some states on this short list even allow an agreement that is simply implied by the small business ownerâs behaviors.
Benefits of creating an LLC Operating Agreements
Even if your small business is not registered in one of the states listed above, it is a good idea to have a written LLC Operating Agreement. Formalizing this agreement can clarify each memberâs ownership rights as well as other details that can help the business run more efficiently in the future and benefit the LLC in the following ways.
Prevent and resolve conflict
When disagreements about operations or unexpected circumstances come up, the LLC Operating Agreement can be a point of reference for members and any legal counsel involved. The agreement confirms each memberâs initial and ongoing financial, and equivalent, contributions to the organization and outlines which duties each member is expected to perform within the business.
Outline the division of income
Unlike nonprofit organizations, the purpose of most small businesses is to generate a profit, so it makes sense that deciding how the profit is split should be done proactively. When a business with more than one owner is organized as an S-corporation or C-corporation, the percentage of profit each owner can claim is required to match their documented ownership percentage. However, one of the benefits of incorporating a business as an LLC is that the division of profits can be customized. Having the percentages written in a formal LLC Operating Agreement simplifies the accounting when itâs time to distribute profit and protects each owner.
Solidify limited liability status
Registering a small business as a limited liability company is a simple process, and many lenders, investors, and governing agencies will appreciate seeing that youâve taken additional steps to solidify the business structure of your new company. Providing a written LLC Operating Agreement can act as a supporting document when qualifying for a small business loan or meeting with venture capitalists.
Explain governing rules
Just as every state has different requirements for registering a business, each state also has default rules regarding the ownership and operations of an LLC. In the event of conflict, without a written LLC Operating Agreement, members would be required to default to the stateâs rules on new members, dissolution, or operations. If the agreement addresses the conflict in question, the default rules set by the state can be overridden.
Plan for the future
When starting a new business, it is difficult to plan for the business when you will no longer be able to be an active member. However, most entrepreneurs will want their LLC to continue operating in their absence. A written LLC Operating Agreement can clarify who will take over duties, ownership, and profit distributions in the event one member passes away or can no longer act in the businessâs best interest.
LLC Operating Agreement components
At this point, you probably realize that your LLC needs a written operating agreement. You may even have some idea about which aspects of the business structure need to be discussed in the agreement. But what else should your LLC Operating Agreement include?
General information about the LLC that is included in the articles of organization must also be repeated in the LLC Operating Agreement. This section of the agreement will list the name of the business, any DBAs, place of operations, mailing address, date of incorporation, and the following statements.
The LLC Operating Agreement should include a brief section about the purpose of the business entity. This will give details about the industry the LLC competes in and the products or services that are being offered.
A statement of intent is important to include in the agreement because it confirms the LLC is following state regulations, including submitting any required documents during formation.
When registering an LLC, the business owners must also decide which tax selection they are making. Typically, LLCs donât pay business tax on income, but each member reports the business income as part of their personal tax return. However, some LLCs chose to be taxed as a corporation. This selection will appear on paperwork like the W-9, impact state and federal income tax returns, and be included in the operating agreement.
Registered agent selection
To be legally registered in any state, you must select a registered agent to accept legal service of process on behalf of the LLC. Include the name and address of the registered agent in the LLC Operating Agreement.
Following the basic information about the company, the LLC Operating Agreement should include details about each member including names, addresses, ownership percentages, titles, and the following information.
LLC management can be set up to be member-managed where the owners of the company work together to manage daily business operations or manager-managed where a manager is elected internally or from an outside search. This information should be included in the operating agreement, along with the designated responsibilities of the selected manager.
Contributions and compensation
The LLC operating agreement should include information about membersâ contributions. The listed contributions can be monetary or investments of property, time, personal assets, knowledge, or equipment. Each non-financial contribution and capital contributions should be assigned a monetary value.
The compensation of each member that has been agreed upon should also be listed in the agreement. Most LLCs, that do not file business tax returns, must pay members of the LLC through distributions. LLCs that elect to be taxed as a corporation can compensate members through distributions and a salary.
Voting rights and member meetings
The voting rights and decision-making responsibilities of each LLC member should be spelled out in the operating agreement. Voting provisions will include the weight, or voting share, of each member as well as some information about the approval process. The operating agreement should state if a meeting is required to take a vote and whether a certain majority is required to finalize a vote.
Changes in ownership
The LLC Operating Agreement should outline the process for adding new members or removing current members from the company. The agreement should state whether members are allowed to sell their ownership shares and if there are any qualifications required for purchasers. It is common to list a right of first refusal clause in the agreement that allows remaining members of an LLC to purchase the shares of leaving members.
Also included in the operating agreement are possible dissolution procedures including assigning duties to members like, filing the necessary paperwork, liquidating assets, paying debts, capital allocation, and other actions needed to end the existence of the company.
In addition to the information about the company, members, and management, the LLC operating agreement can include other relevant provisions including:
The liability statement is important because it protects the business owners from personal liability for losses or lawsuits.
Procedures that will be followed in the event of a dispute, including legal requirements, should be included in the agreement.
Death of a member
In the event one LLC member passes away, the operating agreement should outline the process of dividing or passing along ownership interest.
Some LLCs include state laws and regulations that apply to their business in the operating agreement as well as a statement of disagreement for state rules that will be overridden by the agreement. State default rules can be found at the Secretary of stateâs office.
Any special agreements or LLC laws and bylaws should also be written into the agreement, these may include non-disclosure agreements or non-compete clauses.
How to create an LLC Operating Agreement
Many new business owners have an interest in creating a formal operating agreement but donât know how to get started. There is no right way to document the operating agreement, LLC members can choose any of the following methods to create an LLC operating agreement.
Hire a professional
Hiring an attorney or other qualified professional service is the most common, and most expensive, way to create an LLC operating agreement. You can choose to use a law firm for a simple preliminary consultation to discuss the components of your operating agreement or have a lawyer or other service write the entire agreement. This is a good choice for LLCs that have special provisions or are multi-member LLCs where the owners are unrelated.
Use a website
Many websites offer interactive legal services including LLC operating agreements. Using a website like Legal Zoom will allow the LLC member or members to create the agreement by answering questions and completing the fillable online form. This is an adequate and affordable option for startup LLCs.
Write your own
Depending on your legal and organizational experience, writing your own LLC operating agreement is the most affordable option for new LLCs. Many business owners chose to follow a template or an example agreement provided by another LLC to complete their new LLCs first agreement.
While a written operating agreement is not a legal requirement in all states to complete your LLC formation, there are benefits to the agreement including solidifying LLC status, dispute resolution, and clarifying governing rules.
Whether you write your own or hire a professional, it is likely your LLC operating agreement will serve many purposes, like finding a loan. Many small business owners, like Rafael Cuellar, that turn to Biz2Credit for small business financing are also able to use their operating agreement to complete the loan application requirements and secure financing.