LLC Operating Agreements - The Basics

How to Create an LLC Operating Agreement

Much like corporate bylaws, an operating agreement governs the workings of an LLC.

An LLC operating agreement allows the owner to structure his financial and working relationships with his co-owners in a way that it suits his business. In the operating agreement, both owner and co-owners establish each owner's percentage of ownership in the LLC, his share of profits (or losses), his rights and responsibilities, and what will happen to the business if one of the owner's leaves.

Why an Operating Agreement Is Necessary

While many states do not legally require an LLC to have an operating agreement, it's foolhardy for someone to run an LLC without one.

An operating agreement helps an LLC by safeguarding its limited liability status, heading off financial and management misunderstandings, and ensuring that business is governed by the owner's own rules, not the default rules of his state.

Protecting Limited Liability Status

The main reason for making an operating agreement is as simple as it is important: An operating agreement helps to ensure that the courts will respect limited personal liability. This is particularly essential in a one-person LLC where, without the formality of an agreement, the LLC will look a lot like a sole proprietorship. Just the fact that the owner has a formal written operating agreement lends credibility to his LLC's separate existence.

Defining Financial and Management Structure

Co-owned LLCs need to document their profit-sharing and decision-making procedures as well as the set of rules for handling the departure and addition of members. Without a thorough operating agreement in place, not only will the owner and co-owners be ill-equipped to settle misunderstandings over finances and management, but he will also be subjected to the default rules of the laws in his state.

Overriding State Default Rules

Every state has laws setting out basic operating rules for LLCs, some of which govern the business unless the operating agreement says otherwise. (These are known as "default rules.").

Many states also have a default rule that requires owners to divide up LLC profits and losses equally, regardless of each member's investment in the business. If an owner and his co-owners did not invest equal amounts in the LLC, it's doubtful he will want the profits allocated equally. In order to avoid this, the operating agreement must dictate how the owner and co-owners want to split profits and losses.

In this same way, many state laws regarding LLCs will not be favorable to the business. An owner should not be tempted to rely on them to structure his LLC; instead, he should decide on the best rules for his situation and put them in a written operating agreement.

What to Include in an Operating Agreement

There are host of issues an owner must cover in an LLC operating agreement, some of which depend on the business's particular situation and needs. Most operating agreements include the following:

Members' percentage interests in the LLC
Members' rights and responsibilities
Members' voting powers
How profits and losses will be allocated
How the Limited Liability Company will be managed
Rules for holding meetings and taking votes, and
Buyout/buy-sell, provisions, which establish a framework for what happens when a member wants to sell his interest, dies, or becomes disabled.

While these items may seem fairly straightforward, each requires important details. It's best to ensure that the particulars are filled out in the following key areas:

Percentages of Ownership

The owners of an LLC ordinarily make financial contributions of cash, property, or services to the business start it up. In return, each member of an LLC member gets a percentage of ownership in the assets of the company. Members are usually given ownership percentages in proportion to their contributions of capital, but LLCs are free to divide up ownership any way they wish. These contributions and percentage interests are an important part of an operating agreement.

Distributive Shares

In addition to receiving ownership interests in exchange for contributions of capital, LLC owners also receive shares of the company's profits and losses, known as "distributive shares." Often, an operating agreement provides that each owner's distributive share corresponds to his percentage of ownership in the LLC. For instance, because one member owns only 35% of his LLC, he receives just 35% of its profits and losses. On the other hand, another member is entitled to 65% of the LLC's profits and losses since he owns 65% of the business. (If an LLC wants to assign distributive shares that disproportionate to the owners' percentage interests in the LLC, then rules for "special allocations" will have to be followed.)

Distributions of Profits and Losses

In addition to defining each owner's distributive share, an operating agreement should answer these questions:

How much of the allocated profits of the LLC (the members' distributive shares) must be distributed to the members each year?
Can members expect their LLC to pay them at least enough to cover the income taxes they'll owe on each year's allocation of company profits? (An LLC owner, like a partner in a partnership, has to pay income taxes on profits that are "allocated" to him, not just on profits that are paid out. When profits are put back into the business instead of being paid out, they are still treated as income to the owners, in the proportions allocated.)
Will distributions of profits be made regularly or are the owners entitled to draw at will from the profits of the business? Because the owner and co-owners may have different financial needs and marginal tax brackets, allocation of profits and losses is an area to which particular attention should be paid.

Because the owner and co-owners may have different financial needs and marginal tax brackets, allocation of profits and losses is an area to which particular attention should be paid.

Voting Rights

While most LLC management decisions are made informally, sometimes a decision is so important or so controversial that a formal vote is necessary. There are two ways to split voting power among the LLC members: Either each member's voting power corresponds to his percentage interest in the business, or each member gets one vote, called "per capita" voting. Most LLCs pass out votes in proportion to the members' ownership interests. Whichever method that is chosen, it's best to make sure the operating agreement specifies how much voting power each member has, as well as whether a majority of the votes or a unanimous decision will be required to resolve an issue.

Ownership Transitions

Many new business owners fail to think about what will happen if one owner retires, dies, or decides to sell his interest in the company. These concerns may not thought of now, but such situations come up frequently for small business owners, and it is best to be prepared. Operating agreements should include a buyout scheme, i.e., rules for what will happen when one member leaves the LLC for any reason. How to Create an Operating Agreement

Obviously, the owner will need assistance to make his own operating agreement. There are many sources for blank or sample LLC operating agreements, but the owner must be sure that his operating agreement is drafted to suit the needs of both his business and the laws of his state.