Your Guide to An Operating Agreement

Your Guide to an Operating Agreement

Limited liability companies allow business owners and entrepreneurs to reach their professional goals without subjecting their assets to extreme risk. Of course, not every LLC is created equally. Savvy business professionals know they need a strong operating agreement to boost their odds of succeeding in a crowded marketplace.

In this article, we take an in-depth look at operating agreements. Our goal is to provide you with comprehensive information about these legally binding documents. Continue reading to find out more about what makes a successful operating agreement.

Before we start, though, please note that this article is for informational purposes only. While we provide some important thoughts on operating agreements and LLCs, we do not intend to offer legal advice. Simply put, there is no substitute for competent legal counsel. For detailed information about your situation, you should strongly consider contacting a licensed attorney in your area.

What Is a Limited Liability Company?

Most business organizations are inflexible and bulky. Managers in these organizations rely on strict corporate governance documents to conduct everyday business. LLCs are different. Generally speaking, an LLC is significantly more flexible than a corporation or business partnership. With an LLC, members define how they want to do business. They may structure profits and losses in a unique way. They may also safeguard personal assets to protect them from attaching to the liabilities of the business.

While LLCs are flexible, they aren’t perfect. Members frequently disagree about business processes, leading to prolonged and expensive litigation. Before beginning an LLC venture informed businesspeople often choose to write a clear operating agreement.

What Is an Operating Agreement?

For most LLCs, the operating agreement is the foundational document. It spells out the rights and responsibilities of the members of the organization. It also defines the objectives of the organization and designates which members are eligible to make financial and functional decisions. It may help to think of an operating agreement like a corporation’s bylaws. While there are some major differences between the documents, they both outline procedures for the operation of the business.

Who Uses An Operating Agreement?

Members of LLCs often benefit from legal protections that safeguard their assets. Without an operating agreement, though, courts in many states usually look past a nominal LLC title and apply traditional business jurisprudence and rules to the arrangement. As such, anyone looking to benefit from the many advantages of establishing an LLC may decide to draft an operating agreement to protect individual and business interests. Remember, though; business organizations are controlled by state law. Whether your LLC needs an operating agreement depends on the physical location of the business.

Even if there is no legal mandate that your LLC function according to an operating agreement, having a well-written one likely makes good sense. After all, no two individuals are likely to reach the same conclusions about running a business. With an operating agreement, all parties can refer to the controlling document when making essential business decisions.

Someone once said that the only certainties in life are death and taxes. While your operating agreement won’t do much to protect you from dying, it can affect your company’s taxes. With an operating agreement in place, the IRS is likely to treat your organization as an LLC. As such, you get to choose how you want to pay taxes. If your LLC only has one member, you, you can choose to pay taxes either as an individual or a corporation. If it has more than one member, you can pay as a partnership or corporation. Without an operating agreement, though, you are likely stuck paying taxes according to traditional business and tax regulations.

What Topics Do Operating Agreements Typically Cover?

An operating agreement can be written in a variety of ways. While you should do your best to tailor your LLC’s operating agreement to meet the needs of your organization, there are some topics most operating agreements typically cover. Here are seven of them.

1. Ownership Interests

Virtually all operating agreements explain the ownership interests of the parties. This is about more than who owns what, however. For different reasons, many LLC owners choose to describe ownership interests regarding classes. In these situations, classes determine rights and responsibilities within the LLC. For example, one member may have full voting rights, while another may only get a 50 percent say in the operations of the business.

2. Organizational Management

An LLC’s management is critical to its overall success. While good leaders can facilitate business growth, ineffective ones can be disastrous. The LLC’s operating agreement usually expressly defines who manages the business. The options are varied. A board, a member, a hired outsider or another person or group may take control of the day-to-day operations of the LLC.

3. Profit and Loss Allocation

Most operating agreements also describe how LLC profits and losses are distributed between the members of the organization. This part of the operating agreement usually indicates when and how payments are to be made. The language does not have to list specific procedures, though. Many operating agreements merely indicate that profits and losses will be shared among the members at the discretion of organizational leadership. Moreover, operating agreements typically differentiate between mandatory and optional payments.

4. Fiduciary Obligations

Centuries of precedent have established that business partners and corporate owners owe a fiduciary duty to others in the organization. That isn’t necessarily the case with LLCs. With the LLC operating agreement, members of the business can usually confirm or modify traditional fiduciary obligations. If you want to waive or otherwise tamper with traditional notions of fiduciary duty, you likely want to rely on the expertise of a business organization attorney. Case law is complicated, and changing fiduciary duty is fraught with potential pitfalls.

5. A Mechanism for Winding Down

Entrepreneurs and others go into business usually to make money. Still, no business lasts forever. As such, operating agreements usually set forth the circumstances that cause the dissolution of the LLC. Generally, operating agreements require members to vote to dissolve the enterprise.

6. A Procedure for Adding or Subtracting Members

Chances are good any LLC won’t end with the same members with which it started. Therefore, when drafting an operating agreement, it is important to include provisions for adding new members and eliminating existing ones. These may include clauses about admitting members, transferring membership interests, withdrawing entirely from the LLC and other member-related subjects.

7. Capital

Like personal relationships, business partnerships often run into trouble with finances. To avoid a catastrophe, it is important to address capital in the operating agreement. The procedures for raising new funds or acquiring debt are usually discussed inside the agreement.

While LLC members usually include these seven broad topics in the operating agreements, this list is not extensive. You may choose to include additional clauses to better meet the needs of your organization. That’s OK. To draft an operating agreement that works for your LLC, you must consider several contingencies. With a bit of effort, you can likely eliminate much of the discomfort of membership disagreements by clearly identifying policies and procedures in advance in your operating agreement.

Can You Amend, Change or Cancel an Operating Agreement?

It can be impossible to foresee all the needs, opportunities and obstacles an LLC will face during its existence. What may start as a fantastic operating agreement may become inadequate over time? Fortunately, operating agreements don’t have to last forever. On the contrary, you can likely amend, change or cancel your LLC’s operating agreement.

To modify an operating agreement without offending other members or worrying customers, you must follow the amendment process that is specifically outlined in the document. As such, when organizing your LLC, you should pay special attention to the housekeeping parts of your operating agreement. Be sure you add language that makes modifying the agreement, removing outdated provisions and updating the organization possible.

Final Thoughts on Operating Agreements

Starting an LLC makes sense for many. The flexibility and tax benefits of setting up an organization under LLC rules are hard to ignore. Still, LLCs don’t function perfectly on their own. On the contrary, they require diligent members who can look out for the best interests of the organization.

To avoid headaches, many LLC members rely on operating agreements to make everyday business decisions. Of course, not all operating agreements are created equally. Instead, thousands of LLCs likely operate without well-written agreements. Your organization doesn’t have to be one of them.

While each LLC’s operating agreement is different, most have some common clauses. You can probably find some decent form agreements online. These are an excellent resource. Still, they aren’t a substitute for hard work, due diligence, and legal counsel. LLC law varies from state to state. The best way to know whether your agreement complies with the legal framework in your area is to collaborate with a competent attorney. While legal fees can be expensive, they are often significantly less than the cost of protracted litigation stemming from an unclear or ambiguous operating agreement.