Your Guide to an LLC Operating Agreement
Meta Description: If you're contemplating starting a business, you should know the differences in formation types. There are different corporate structures you can adopt to make your company legal in the eyes of the government. An LLC operating agreement is one part of the LLC formation requirements for adequately forming your business. Stock Image: 4771892 What Is an LLC? In business, certain formalities must be completed to form and sustain a legitimate and legal business adequately. These are called formations. There are many different types of formations that can occur. One example is an LLC. You've probably heard those letters after the names of some businesses. Do you know what an LLC is and why you would need one? An LLC is a limited liability company. It is considered the most straightforward way to formally organize and register your business. Its requirements aren't as strict as S corp or C corp formations, and its tax structure is far easier to comply with. It is a blend of a corporation and partnership structure. An LLC is member-owned and operated, and there could be as little as one member (single-member) or as many members as you want (multi-member). Other LLCs can also be members of your LLC. LLC members are owners and not employees. There are some instances where an owner can be considered an employee, and that is something set out in the LLC's operating agreement. Advantages of an LLC Some benefits of forming an LLC are: Asset protection: This type of formation keeps members' personal assets from being collected by business debtors. If your business fails, your own money can't be seized to pay off debts. This type of business structure offers the best personal asset protection. Why is that? Members have to buy into the LLC. That money, as well as the other money contributed by members, is what is used to pay for the running of the business. If the company suffers a massive loss, the membership fees may be lost if there isn't enough money in the account to pay the deficiency. A member can only lose up to its contribution. Hence the term, "limited liability." No corporate tax return: Just like individuals, the government requires most businesses to file a corporate tax return. Not so in an LLC. Since the company is composed of individual member shares and contributions, there is no need for the company to file a tax return as a whole. This is also known as pass-through taxes. No residency requirement: An LLC does not require the members to be residents of the United States or of the state where the company is formed. Some states offer different incentives to incorporate inside their borders. Prices for filing the company's initial incorporation or formation fee differ from state to state. Therefore, if you're looking for the best place to incorporate, do some homework and find which of the 50 states is has the best benefits for you. Credibility: Those who deal with your business understand that an LLC carries more credibility. Doing so means you have fulfilled specific requirementss such as membership interests, capital investments (initial and ongoing), as well as the LLC operating agreement which sets out the way in which the company is run. The entire process can open doors with other businesses. There are also some disadvantages to choosing this type of business structure versus corporations. Disadvantages of LLCs No stocks: An LLC cannot grow by issuing shares to members. Outside interests cannot be enticed to invest with the promise of stock. Costly: Because of the asset protection afforded by an LLC, these types of companies can be more costly to own and operate. Start-up costs can be more than other types of business models, and there are annual fees. Unemployment tax: An LLC is required to pay unemployment tax for each member. Since an LLC can have only one member, this is an increase in outgoing money. A sole proprietorship, an alternative to a single-member LLC, has no unemployment tax requirement. Banking requirements: As with every business, an LLC needs to be able to pay expenses. Doing so with a check is one of the easiest ways. However, a check written from an LLC account cannot be cashed; it must be deposited into a corporate account. Check your bank to see the fees charged depending on the type of account you have. Typically it costs more to have a business account. One of the most important things to remember about your company is you must keep your personal records completely separate. Don't deposit money meant for the LLC into your own account and vice versa. Mixing the two causes significant hassles in the long and with your taxes. Basic Terms of an LLC Operating Agreement Once you decide to form an LLC, there are a few steps required. One is drafting the LLC operating agreement. The operating agreement is a document that sets forth the details of the business. It is the framework for how the business will run. This document is filed with the secretary of state as part of the business formation process. Along with the company's articles of incorporation, the operating agreement is required to make the company formation legal. If the company does not exist on paper with a secretary of state, it does not exist. The following is what goes into a typical LLC operating agreement: The name of the LLC. While this seems like a simple task, it may turn out not to be. It should be meaningful to you and yet professional enough that you won't shrink every time you see it written on formal documents. Who is going to manage the LLC? This decision may be the first your company will have to make when drafting the operating agreement. There are two types of LLC managers: member and manager. A member-managed LLC gives every member an equal voice in the company. It requires all significant decisions to be made by board vote where, typically, majority rules. The procedure for this will be outlined in the board procedures section of the agreement. If the LLC is manager-managed, it means one person is designated as the manager and makes all major decisions. Since the two types are taxed in different ways, it's important to know which way you want the company to run. Members of the LLC are also owners and not employees. Of course, if the company only has one member, that member must also pay unemployment taxes (as stated above). If, though, there are multiple members of the company and they decide to hire someone to manage it, the operating agreement should give the procedure for this process. The initial contribution of each member. This section sets out the monetary investment. This correlates to how many shares the members own. Along with the parameters for initial contributions, the agreement also sets out any conditions relating to additional capital contributions. Division of losses and gains or profits. How will this division work? Many times the standard coincides with the capital contribution of each member. For example, if Bob contributes 65 percent of the money for the LLC, he should receive 65 percent of the profits. Likewise, if there is a loss, Bob takes a 65 percent hit. Letting new members join. You may leave the door open for more members. This section lays out the rules associated with doing so. How much is the capital contribution going to be beyond the initial formation? This section will set out the procedure for letting new members join the company. Procedures for terminating a member's interests. Members may leave. This section sets out the process for the exit and the subsequent transfer of the membership interests, if applicable. If a member chooses to leave the company, what is the process for that member's capital? Is the initial contribution all that's returned or does the member also receive profits? This process should be covered in depth in the agreement. Board meeting formats and procedures. This section states when meetings will occur (monthly, quarterly, annually, etc.), establishes the meeting format, and all necessary procedures. This framework should include who is managing and making decisions, how many people need to be at the meetings to meet the minimum required to make decisions (if it's a member-managed company), and the process for voting on matters. The operating agreement of your company is the framework by which it will be managed and run. The document can be amended as needed, and appropriate documents filed with the secretary of state with which the company was first formed. It is crucial for these documents to be prepared and submitted correctly. If they aren't, your company will not exist in the eyes of the government. Is an LLC a Good Choice for Your Business? In business, there are going to be some risks. Some businesses carry more risk than others. An LLC protects you personally against those risks as it shelters personal assets from being taken. Whether an LLC is the right business for you or not will be something you need to take up with an expert. Consult an attorney or certified public accountant to see which type of business formation is going to be the best fit for your business. While it is easy to think in terms of “now,” it is better to think in terms of tomorrow and beyond. Thus, if you find that it is best to go the LLC route, be sure you have all the documentation you need to do so. Being a business owner can be a challenging but rewarding prospect. Make sure your LLC operating agreement and other formation documents are correct so you can start your company off on the right foot.