Operating agreement

An operating agreement is a key document used by limited liability companies (LLCs) to outline the business’ financial and functional decisions including rules, regulations and provisions. The purpose of the document is to govern the internal operations of the business in a way that suits the specific needs of the business owners, called “members”. Once the document is signed by the members of the limited liability company, it acts as an official contract binding them to its terms. An operating agreement is mandatory as per laws in only 5 states: California, Delaware, Maine, Missouri, and New York. LLCs operating without an operating agreement are governed by the state’s default rules contained in the relevant statute and developed through state court decisions. An operating agreement is similar in function to corporate by-laws, or analogous to a partnership agreement in multi-member LLCs. In single-member LLC, an operating agreement is a declaration of the structure that the member has chosen for the company and sometimes used to prove in court that the LLC structure is separate from that of the individual owner and thus necessary so that the owner has documentation to prove that he or she is indeed separate from the entity itself.[1]

Most states do not require operating agreements. However, an operating agreement is highly recommended for multi-member LLCs because it structures an LLC’s finances and organization, and provides rules and regulations for smooth operation. The operating agreement usually includes percentage of interests, allocation of profits and losses, member’s rights and responsibilities and other provisions.[2]

Without an operating agreement, state statute dictates how the limited liability company is to be operated, managed, and controlled by the members. If the members do not operate, manage and/or control the LLC according to statutory requirements, the members risk liability between themselves, third-parties seeking to pierce the corporate veil, and taxing authorities (especially the IRS). Therefore, an operating agreement is important to help define how to operate, manage and control the LLC if the members desire to do so in a manner different from statutory requirements.

There are two primary sources for operating agreements: templates (freely available on the Internet or provided by an incorporation company) and attorneys.

Template operating agreements are very popular, because most people do not understand the importance of the document, and they are freely available on the Internet or provided by Internet companies who form LLCs for others. Most template operating agreements will not possess the right language for tax status, especially if disregarded, S-Corporation or C-Corporation tax status is desired. Such template operating agreements should be carefully reviewed by a professional to determine if they meet the business practices and circumstances of the business and its members.

Tax considerations

A LLC can maintain one of four different tax treatments: disregarded, partnership, S-Corporation and C-Corporation, and most state statutes involving LLCs either disregard tax treatment entirely or assume partnership tax treatment. Each tax treatment requires very different language in the operating agreement. The proper language in the operating agreement is critical to establishing and maintaining the proper tax status of the LLC.

Important clauses

An operating agreement should have language to address, at a minimum, the following:

Tax status of the LLC (i.e. disregarded, partnership, S-Corp or C-Corp)
If partnership tax treatment desired, language regarding “Capital Accounts” and “Partnership Representative”[3] Powers and duties of the manager (if manager-managed) or the members (if member-managed)
Member restrictions (i.e. non-compete, confidentiality, etc)
How votes are conducted and interpreted, and how to resolve deadlocks
How to resolve disputes between members (and managers, if manager-managed)
How to allocate and distribute profits and losses
How capital contributions are handled
Dissolution and dissociation circumstances
Preventing estates and spouses from taking ownership
Whether membership is restricted, and whether the sale of ownership requires right of first refusal to other members