How an LLC Operating Agreement Can Be a Business’s Best Friend
“LLC” is an acronym for limited liability company, and is designed to be the simplest and most flexible way of structuring a small business. It protects your personal assets and ownership interest in the event that the business becomes involved in a legal dispute.
LLCs may be owned by one or more individuals, who are referred to as “members.” An LLC with one sole owner is known as a “single-member LLC,” and an LLC with more than one owner is called as a “multi-member LLC.”
Establishing a business as a limited liability company (LLC) helps protect business owners against legal action, and significantly reduces the amount of paperwork compared to corporations and other legal entity types. This event also prevents the company from being taxed twice and helps present the business in a more credible light.
In short, the purpose of an LLC is to allow one or more people to operate a business, enjoy liability protection, and limit the business risk. We’ll take a look at all the advantages of establishing your business as an LLC.
Why Not Incorporate?
LLCs can be significantly easier than corporations for business owners to maintain. LLCs often have fewer formal requirements than other business entities, like corporations, wherein board meetings and other formalities may be necessary.
The LLC structure is based on the “freedom-to-contract.” With this practice, business owners operate an LLC by written agreements rather than traditional by-laws, which are rules designed to protect the shareholders of larger entities like corporations.
The simplistic nature of an LLC also translates into reduced risk for its members. By requiring less formal duties, LLCs also have rarer opportunities for members to make mistakes that could forfeit the limited liability protection of the LLC. Some of the most common ways of losing liability protection include:
- Illegal wrongdoing or fraud
- Failure to maintain separate entities
- Lack of operating agreement
- Undercapitalization of your business
How to Form an LLC
LLC formation is not as daunting a task as you may suspect. You don’t necessarily need to seek legal advice, you only need minimal additional capital, and there are surprisingly few steps to establishing the LLC operating agreement. Those steps include:
- Choosing an unused name for your business that complies with the LLC rules in the state where you will operate.
- Filing the required formal paperwork, usually identified as articles of organization, and pay the filing fees, which range from $100-$800.
- Creating an LLC operating agreement that outlines the rights and fiduciary duties of LLC members.
- Publishing public notice of the intent to form an LLC in local newspapers or magazines. (This may not be necessary for you, but it is required in some states).
- Obtaining the necessary licenses and permits that may be required.
Let’s take a closer look at the steps you’ll need to take to get your LLC up and running.
Choosing a Unique Name
The name of an LLC must comply with the rules of your state’s LLC division. While requirements differ from state to state, generally the name must:
- be unique and cannot be identical to that of another LLC on file with the LLC office.
- end with an LLC designator, such as “Limited Liability Company” or “Limited Company,” or an abbreviation of one of these phrases (such as “LLC,” “L.L.C.,” or “Ltd. Liability Co.”).
- not include certain words prohibited by the state — including Bank, Insurance, Corporation, or City. Additional regulations prohibit the use of words that would confuse the name with a federal or state agency like IRS, EPA, Treasury, etc. Each state’s rules differ on which words are prohibited.
Your state’s LLC office is the best source to identify whether or not the proposed name is available for use.
Once a legal and available name is discovered, the business name will be automatically registered with the state when the articles of organization are filed, which is the next step in legitimizing your entity.
Filing a Company’s Articles of Organization
After deciding on a name, it’s time to prepare then file the articles of organization with the state’s LLC filing office. Most states use the term “articles of organization” to refer to the basic document required to create an LLC. However, some states refer to this as a “certificate of formation” or “certificate of organization.”
Fees for Filing
One disadvantage of forming an LLC instead of a partnership or a sole proprietorship is that a filing fee is required to submit your articles of organization. In most states, the fees are modest — typically around $100. But larger states may have more or higher fees. California, for example, charges a steep $800 annual tax on top of its filing fee.
What Do the Articles of Organization Entail?
Articles of organization are short and fairly simple documents. Business owners usually prepare their own by filling in the blanks and checking the boxes on a form provided by the state’s LLC filing office.
Typically, the only required information is the LLC’s name, address, and occasionally the names of all of the owners — regardless of their ownership percentage or decision-making status — referred to as members. Alternatively, LLC owners may appoint someone to prepare and sign the articles for them.
The Importance of a Registered Agent
A registered agent, or power of attorney, is a responsible third-party who resides in the same state as the business. On behalf of the company, a registered agent can receive process notices and legal documents, correspondences from the Secretary of State, and other official government notifications. These usually include tax forms and notices of lawsuits and other legal matters.
The registered agent, or “agent for service of process,” is a necessary part of the LLC registration journey. When you apply, you’ll have to list the name and address of this party, who is usually one of the LLC’s own members. Alternatively, you may hire an on-call attorney as an independent contractor to assist with the entity’s legal needs.
Creating an LLC Operating Agreement
New members forming an LLC should strongly consider drafting an operating agreement. The operating agreement is essentially a contract between members of an LLC that sets forth how it will operate and conduct business.
State law rarely requires that operating agreements be filed with the state’s LLC filing office, but it is essential that the company create one. In the event of internal disputes or circumstances out of the control of the LLC’s members, an operating agreement could serve as a mediator. An LLC operating agreement sets out rules for the ownership and operation of the business, much like a partnership agreement. In some areas, state default rules will apply if an LLC doesn’t have a written operating agreement in place.
Operating agreements also prevent members from taking on personal liability for the debts of the company and avoid the confusion that often occurs when LLC members and managers do not understand their rights and obligations.
A properly drafted operating agreement can help you circumvent conflicts among members and apply unwanted default rules. A typical operating agreement includes:
- Each member of the company’s percentage in the business: This includes capital contributions, i.e. the amount of money each member has invested in the business. This is also where an approach to raising additional capital in the future will be established.
- All member’s interests and fiduciary duties: This is also known as “duties of trust.” Think of these as company “chores” for each member of the LLC. Two important fiduciary duties include duties of loyalty and duties of care.
- Members’ voting rights: This details whether the LLC will be managed by its members or by an appointed manager, and how members will go about voting on business matters. Typically, each member has one vote, but some companies may wish to give specific members more voting power than others.
- Allocation of profits and losses: The most common option is to distribute profits and debt evenly. If a company wishes to have them divided differently, this should be listed in the agreement.
- How the LLC will be managed: When the LLC is officially formed, the operating agreement will identify who its members are, and how ownership is divided and organized. Multi-member LLCs may utilize an equal ownership structure or assign various members different “units” of ownership.
- Guidelines for holding meetings and taking decision-making votes: Unlike other business entities, members are not required by state LLC statutes to hold an annual meeting and keep minutes. However, in the operating agreement, members may choose to include a clause requiring an annual meeting where someone keeps minutes.
- Dissolution of the company: This identifies “buy-sell” provisions, which determine what the courses of action are if a member decides to sell their interest, or becomes deceased or disabled. Outlining the hypothetical process of dissolving your business is an important aspect of your operating agreement.
For a sample LLC operating agreement, visit LLC University, which offers the trial document in multiple formats for business owners to use at their leisure.
Licenses and Permits
Once the steps above are completed, your LLC is official. But prior to physically opening for business, there are licenses and permits that all new businesses must obtain in order to operate. These may include:
- a business license (or “tax registration certificate”)
- a federal employer identification number
- a sellers’ permit, (or a zoning permit)
Permits are paramount to make sure you don’t fall victim to hefty fines or tax issues.
Now that you’ve done everything safely and by-the-books, it’s important to make sure you protect your limited liability status so you’re not held personally responsible for any business debts.
Protecting Limited Liability Status
Finally, one of the sole purposes of establishing an LLC is to provide liability protection for members and managers. Unlike some business structures, like a sole proprietorship, an LLC has few legal needs, and its structure protects the personal assets of its owners from business liability.
Without any protection in place, potential investors would be reluctant to fund business ventures due to the justifiable fear of losing more than just their original capital contribution. A properly maintained LLC will typically protect the personal assets of its members and managers from a lawsuit or from other claims arising from business activities — as will paying all your business taxes correctly and on time.
Paying Taxes as an LLC
An LLC is a legal business entity, but as far as the IRS is concerned, it’s not a tax structure. Limited Liability Companies can, therefore, be taxed as sole-proprietorships, partnerships, S corporations, or C corporations.
If you operate a single-member LLC, the IRS may automatically default to taxing you as a sole proprietorship, which means you’ll have to pay “self-employment tax.” This tax covers Social Security and Medicare, and is 15.3% of your income (as opposed to the 7.65% that you would pay if you were an employee at another company). As a sole proprietor, you would also need to claim all of your business’s annual income on your personal tax return.
You may reap some tax benefits if you choose to be taxed as an S corp instead of a sole proprietorship. As an LLC S corp, you will have to pay yourself a salary from your business’s income, and it must be a reasonable salary for someone in your field.
Then you will file two tax returns: one for yourself and one for your business. You’ll still pay income tax on all of your business’s profits (part on your personal tax return and part on your business’s tax return), but you will only pay Social Security and Medicare taxes on the portion of your business’s income that serves as your salary.
You will pay 7.65% Social Security and Medicare tax from your salary (this part it will be reflected on your personal tax return), and your business will pay the other 7.65% (reflected on your business’s tax return). Ultimately, you’re still paying 15.3%, but because you can pay this on just part of your business’s incomes instead of on all of your business’s income, you may end up saving some tax dollars.
The S corp tax structure can help you as long as your business will still have a profit after paying you a reasonable salary. If not, then you’re probably better off filing as a sole proprietor because this will allow you to deduct your business expenses on your personal tax return.
Because the tax and legal requirements of LLCs can get complicated, we recommend consulting tax and legal professionals.
Who Can Help?
Verified, affordable legal services are available to answer all your legal questions at the click of a button. If you feel more comfortable getting one-on-one guidance from independent attorneys, there’s a number of resources for on-call online legal services. They can assist you with any legal forms.
Rather than hiring a law firm, consider websites like Rocket Lawyer, or LegalZoom, who offer a wide variety of legal help, including minute consultations for any questions you have about your business formation.
LegalZoom also offers discounted rates for à la carte legal services and has a low monthly subscription fee that’s ideal for small business owners. All you need is a bank account and credit card.
Now You’re Living the American Dream
So you’ve got all your ducks in a row and sent in the appropriate application documents for your LLC. You’ve written an ironclad operating agreement, and have solid plans for responsible maintenance — what’s next? Enjoy running your own business!
Deciding to legitimize your great business idea is something many people dream of, so take a minute to congratulate yourself. Now enjoy your bright future of entrepreneurship!