The LLC Operating Agreement
An LLC (limited liability company) operating agreement allows you to structure your financial and working relationships with your co-owners in a way that suits your business. In your operating agreement, you and your co-owners establish each owner’s percentage of ownership in the LLC, his or her share of profits (or losses), his or her rights and responsibilities, and what will happen to the business if one of you leaves.
For general information on limited liability companies (LLCs), see LLC Basics.
Why You Need an Operating Agreement
While many states do not legally require your LLC to have an operating agreement, it’s foolish to run an LLC without one, even if you’re the sole owner of your company.
An operating agreement will help you guard your limited liability status, head off financial and management misunderstandings, and make sure your business is governed by your own rules — not default rules created by your state.
Protecting Your Limited Liability Status
The main reason to make an operating agreement is to help ensure that courts will respect your limited personal liability. This is particularly key in a one-person LLC where, without the formality of an agreement, the LLC will look a lot like a sole proprietorship. Having a formal written operating agreement will lend credibility to your LLC’s separate existence.
Defining Financial and Management Structure
Co-owned LLCs need to document their profit-sharing and decision-making protocols as well as their procedures for handling the departure and addition of members. Without an operating agreement, you and your co-owners will be ill-equipped to settle misunderstandings over finances and management. What’s more, your LLC will be subject to the default operating rules created by your state law.
Overriding State Default Rules
Each state has laws that set out basic operating rules for LLCs, some of which will govern your business unless your operating agreement says otherwise. (These are called “default rules.”)
Many states, for example, 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 you and your co-owners did not invest equal amounts in the LLC, you probably don’t want to allocate profits equally. To avoid this, your operating agreement must spell out how you and your co-owners will split profits and losses.
By writing an operating agreement, you can choose the rules that will govern your LLC’s inner workings, rather than having to follow default rules that may or may not be right for your LLC.
What to Include in Your Operating Agreement
There’s a host of issues you must cover in your LLC operating agreement, some of which will depend on your business’s particular situation and needs. Most operating agreements include the following:
- the members’ percentage interests in the LLC
- the members’ rights and responsibilities
- the members’ voting powers
- how profits and losses will be allocated
- how the LLC will be managed
- rules for holding meetings and taking votes, and
- buyout, or buy-sell, provisions, which determine what happens when a member wants to sell his or her interest, dies, or becomes disabled.
While these items may seem fairly straightforward, each requires you to make some important decisions, which you should spell out in your operating agreement.
Percentages of Ownership
The owners of an LLC ordinarily make financial contributions of cash, property, or services to the business to get it started. In return, each LLC member gets a percentage of ownership in the assets of the LLC. Members usually receive ownership percentages in proportion to their contributions of capital, but LLC members are free to divide up ownership in any way they wish. These contributions and percentage interests are an important part of your operating agreement.
In addition to receiving ownership interests in exchange for their contributions of capital, LLC owners also receive shares of the LLC’s profits and losses, called “distributive shares.”
Most often, operating agreements provide that each owner’s distributive share corresponds to his or her percentage of ownership in the LLC. For example, because Tony owns only 35% of his LLC, he receives just 35% of its profits and losses. Najate, on the other hand, is entitled to 65% of the LLC’s profits and losses because she owns 65% of the business.
(If your LLC wants to assign distributive shares that aren’t in proportion to the owners’ percentage interests in the LLC, you’ll have to follow rules for “special allocations.” For more information, see Making Special Allocations.)
Distributions of Profits and Losses
In addition to defining each owner’s distributive share, your operating agreement should answer these questions:
- How much — if any — of the LLC’s allocated profits (the members’ distributive shares) must be distributed to LLC members each year?
- Can members expect the LLC to pay them at least enough to cover the income taxes they’ll owe on each year’s allocation of LLC profits? (An LLC owner, like a partner in a partnership, has to pay income taxes on the full amount of profits that are “allocated” to him or her, not just on profits that are actually paid out. When profits are plowed back into the business instead of being paid out, they are still treated as taxable 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 you and your co-owners may have different financial needs and marginal tax rates (tax brackets), the allocation of profits and losses is an area to which you should pay particular attention. You may want to run the allocation part of your operating agreement by a tax professional, to make sure it achieves the overall results you had in mind.
While most LLC management decisions are made informally, sometimes a decision is so important or controversial that a formal vote is necessary. There are two ways to split voting power among LLC members:
- each member’s voting power corresponds to his or her percentage interest in the business, or
- each member gets one vote — called “per capita” voting.
Most LLCs mete out votes in proportion to the members’ ownership interests. Whichever method you choose, make sure your 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.
Many new business owners neglect to think about what will happen if one owner retires, dies, or decides to sell the owner’s interest in the company. Operating agreements should include a buyout scheme — rules for what will happen when a member leaves the LLC for any reason.