Why You Need an Operating Agreement For Your LLC

By
Leela Hopkins
VPM Staff
Updated
July 30, 2020

An operating agreement is a document that works as an instruction manual for your business. When forming a Limited Liability Company (LLC), it is recommended that you create one to protect your business. In this guide, we’ll walk you through drafting an operating agreement and discuss why it is important to have one for your LLC.

What is an Operating Agreement?

An operating agreement is a key legal document every LLC should put together in order to clearly outline the rules and regulations regarding ownership and structure as well as the financial and operational layout for the company.

Once all the members of an LLC have signed the operating agreement, it becomes official and binds the signatories to its terms.

If you are forming an LLC in California, Delaware, New York, Missouri, or Maine you are required to create an operating agreement. Note that no state requires that you file an operating agreement with the Secretary of State. Your operating agreement is an internal contract that you will keep with your company records.

Why is an Operating Agreement Important?

Drafting an operating agreement for your LLC will help set up the organization for how your company will be run. An operating agreement describes the internal operations of the LLC. It details the formation of the business and the procedures to be followed by the business.

The most important reasons to have an operating agreement are:

  • Asset Protection - Having an operating agreement and keeping records of operations helps establish the separateness of the business from the owner for liability and tax purposes. If you don't have an operating agreement, you will find it more difficult to show that your business is separate from you. This is crucial, particularly if there are or might be liability issues.
  • Assignment and limitations of power.
  • Profit and loss sharing.
  • Ownership - The operating agreement will set the rules on how ownership can be sold or purchased and how the ownership shares should be priced. It explains dissolution handling or selling of ownership when closing a company or when a member is leaving. Additionally, it will tell what happens if the owner dies or is unable to run the business. Your operating agreement should include a clause stipulating who will manage the LLC if you are unable to do so. Unless this specific provision is in place, it may be difficult for your family to continue the business or dispose of it without a lengthy legal battle.

Overall, it will alleviate disputes among members and save you time, resources, and trouble in case of unforeseen events and difficulties you may face.

Who Needs My Operating Agreement?

As mentioned above, the operating agreement isn’t a necessary legal document in every state. However, some institutions and professionals may require to see a copy. Examples include:

  • Banks, investors, and lending companies will need an operating agreement to review financials, business structure, and look at what the loan will be used for.
  • Accountants and tax professionals will need an operating agreement for tax and business record keeping. In the case of an audit, it will be necessary for tracking purposes.
  • Lawyers will need an operating agreement to protect you from unfounded accusations if you are involved in a lawsuit.

Did You Know? If an LLC has no operating agreement, it is subject to the "default rules" of the state in which the LLC is organized. In other words, if you don’t have an operating agreement, you are essentially letting the state tell you how to dispose of your business assets.

What is Included in an Operating Agreement?

The contents of an operating agreement may vary greatly depending on the number of members, the nature of the business, and the ownership/management structure. They commonly include sections on organization and ownership, management, voting, contributions, distributions, compensations, and bookkeeping.

Article I - Company Formation

A lot of the information you provide in this section will be the same as your Articles of Organization. We recommend you have that on hand.

  • The name of the LLC - insert the exact name you previously registered on the Secretary of State’s website.
  • The business address of the LLC - this is your principal place of business, the main location of your LLC. The address you provide in the operating agreement may be an office space you lease/own, your home address if you work from a home office, or a virtual office location.
  • The effective date of the LLC - the “birth date” of your business.
  • The registered agent of the LLC - include the name and mailing address of your registered agent. This is a person who receives notices on behalf of your business.
  • The purpose of the LLC - an explanation of why you have established the LLC. This doesn’t have to be highly specific.
  • The duration of the LLC - the length of time your LLC will operate, stated in years. If you don’t plan to end your business endeavor anytime soon, you can say “perpetual” here.
  • How the LLC will be taxed - LLCs are by default taxed as sole proprietorships or partnerships, depending on the number of members.

Article II - Capital Contributions

This section contains the names of all members who have contributed financially to founding the LLC, as well as the total amounts of money they have provided. Members can also provide the LLC with the property. If a member contributes to the LLC in exchange for ownership, this is called a capital interest, and it is normally proportionate to the percentage of the company a member owns.

Article III - Describe How Profits and Loss are Distributed

In this section you will specify the way profits and losses are to be shared among the members. The definition of a company’s profits and losses are the money raised and lost in a given year. If you are the sole member of an LLC, 100% of profits and losses go to you.

This section also determines the percentage of distributions the members receive instead of salary, and how often (yearly or quarterly). It also clarifies how LLC funds are contributed and distributed to the owner. This is helpful to the owner and a good way to ensure that appropriate records are being kept.

Article IV - Choose a Management Structure

This part of the document determines the power given to individual members, managers, and officers. It should specify who may sign legally binding contracts and crucial documents and set up bank accounts, and what kind of authority they have over the LLC’s affairs.

Additionally, this section regulates the voting process for decision making within the company: how the votes are allocated and the number of votes needed to come to a decision on particular actions.

Article V - Identify Your Officers

An LLC’s officers are in charge of day-to-day tasks and operations under managerial or owner supervision. One company may have only one or several officers, and there is no limit to how many the organization may have. The same member can hold all the offices, but if you have two or more officers, the president and the secretary should not be the same person. It is also not legally required for an LLC to appoint officers, but if it has, they should be named and their role described in this part of the operating agreement.

Identify the responsibilities and tasks of members who get leadership roles and how they’ll be selected for these roles.

Article VI - Compensation Structure

This section determines how much members will be paid and ways they can be compensated for their work.

Requirements in the compensation structure should include the following details:

  • Salary amount.
  • A share of the profit (if applicable).
  • Payout frequency based on a monthly, quarterly, or yearly basis, or per closed project.
  • Conditions they have to meet in order to get a raise or bonus.

Noting everything down in the operating agreement prevents potential feuds and gives a stable set of rules to work by.

Article VII - Describe Bookkeeping

This part of the operating agreement describes the bookkeeping system which will be utilized to keep track of the expenses. It addresses record keeping and the rights of members to inspect the company’s corporate and accounting records.

Article VIII - Establish Transfer Procedures

This section defines what happens when a member exits the company. It should state how their shares are split, distributed, and reimbursed. Also, it should note how their interest will be valued for the purpose of a transfer. Additionally, specify if members can transfer their part of the ownership of the LLC and in what way.

Other Possible Sections to Include in your Operating Agreement

  • Nominee - A nominee is a third-party public representative for an LLC that allows the LLC to own property without it becoming public knowledge. This section states that the title to the company’s assets should be held in the LLC’s name or in the name of a nominee, like an attorney or title company.
  • Company Information - This describes the rights that each LLC member has to access books, records, and materials regarding the LLC’s activities.
  • Exculpation - This relieves an LLC’s members or managers from liability to the members for damage caused by actions taken in good faith and to promote the best interests of the company.
  • Indemnification - This states that the LLC will compensate members or third parties acting on behalf of the company for harm, liability, or losses stemming from their good faith actions with respect to the company.

Maintaining Your Operating Agreement

Even simple changes such as an address change should be noted. The best practice is to neatly store all important files, documents, receipts, and previous versions of the operating agreement in a designated space. For complex changes, it is best to hire professionals.

Also, you should keep your records on file for 3-5 years. The IRS states that, in general, you need to keep records until the period of limitations runs out. This applies to tax returns and property-related records. Some creditors, investors, or insurance companies may require you to keep the records longer than the IRS does.

Resources for Creating an LLC Operating Agreement

We’ve provided a list of websites that will allow you to easily create an operating agreement below.

Free Operating Agreement Templates

Generate Your Own Operating Agreement

The Overall Need for an Operating Agreement

Putting an operating agreement together is a critical task for the success of your business and we strongly advise that you create one. An operating agreement provides a clear set of rules that help map out the structure of how your company will be run. Most importantly it will enforce asset protection, assignment and limitations of powers, profit/loss sharing, and ownership.

Moreover, the operating agreement will set the process on dissolution handling, how ownership can be sold or purchased, and how the ownership shares should be priced.

In conclusion, an operating agreement will protect your business from potential internal and external disputes that you may face during, before, and after the formation of your LLC.

Are You Registering Your Business and Need a Business Address?

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