How an LLC Operating Agreement Can Protect Your Business
What’s the first thing owners consult every time they have a hard time figuring out how a new gadget works?
That’s right, the product manual.
It contains instructions on everything you can (and can’t do) with the device and shows you how to do it. It even includes steps for troubleshooting in the event of a malfunction.
Now imagine you work for the company who built the product and wrote the manual. Naturally, you want to make the manual clear and packed with information for the user’s benefit. You want to make sure that you’ll cover everything that the customer needs to know about it. It helps avoid complaints that may escalate to more significant issues that lead to customers avoiding from your product.
Having company-approved instructions on how to operate and fix a device gives users peace of mind. If they have any specific needs or want to know how certain features work, the handy product manual will be there to assist them.
When building a business, there’s a document that serves a similar purpose. It’s called an operating agreement. It acts as a reference, showing specific steps to take for each potential issue that could happen. It contains rules and provisions on how to perform particular tasks within the company so everyone will be on the same page.
In this article, we’ll explain what LLC operating agreements are, why you need to have one for your business, and what topics to include when you’re making one. To get a better understanding of this subject, however, it’s necessary to first discuss what an LLC is and why business owners choose to have it as their company’s legal structure. We’ll also go over how to establish your business as an LLC, which is an essential step for your business.
What Does LLC Stand For?
LLC stands for Limited Liability Company. It’s a type of business structure that gives business owners liability protection against debt and lawsuits. Sole proprietorships and partnerships don’t have this feature, which could lead to the IRS seizing the owners’ personal assets if the company goes bankrupt.
Most small businesses choose LLC as their business entity as it comes with benefits found in a corporation, albeit in a limited manner. But like the owners of corporations, LLC members can still get penalized if they’re negligent in their roles or engage in illegal activities.
Limited liability companies can be taxed as an S corporation or C corporation. If the owners choose to have the company taxed like an S corporation, they can take advantage of certain tax benefits like lower corporate tax rates and pass-through taxation.
Pass-through taxation is a feature that permits LLC owners to avoid double taxation by having corporate taxes “pass through” the business, so the business doesn’t have to pay taxes. If it’s a single-member LLC, the owner must report all profits and losses on Schedule C and submit it with their personal 1040 tax return. For multi-member LLCs, each member will pay taxes on their share of the company’s earnings on their personal tax returns.
How to Start an LLC
Establishing your business as an LLC isn’t hard. Keep in mind, however, that each state will have its own set of steps and guidelines, so it’s a good idea to check with the secretary of state’s office. Here are the five main steps for setting up your business as an LLC.
Step 1: Choose the state where you’ll establish the business
Locations like Delaware or Nevada have business-friendly environments that make it appealing to business owners to establish their company there. However, most new business owners prefer to set up shop where they live as it makes it easier to run the company.
Step 2: Choose a Name for Your LLC
The most important rule for choosing a name is to include “Limited Liability Company” or LLC in the official business name. Words like “Treasury,” “Trust,” “Banking,” “Engineering,” and similar terms that could confuse your business with an institution or agency are not allowed in some states or may require additional paperwork to get approved.
Step 3: Choose Your Registered Agent
A registered agent refers to a person who is authorized to receive legal correspondence on the business’s behalf. He or she is required to live in the state where the company is operating.
Step 4: File Your State Documents
Commonly referred to as articles of incorporation, articles of organization, or certificate of formation, it contains all the relevant information about the company, including the type of business, business structure, names of the business owners, the first board of directors, and more. You file the articles of organization with the secretary of state.
Step 5: Create Your Operating Agreement
The last step is to make the operating agreement for your business. The following sections will explain what it is, why it’s important, and what you should include when making one.
What Is an Operating Agreement?
An Operating Agreement is a legal document that explains ownership and member responsibilities within a Limited Liability Company. It contains specific instructions on how to execute certain tasks and serves as a reference when making decisions within the company. While it’s not mandatory for all companies to have an operating agreement, it’s a good idea to make one so that the business can avoid potential roadblocks and headaches caused by your state’s default rules.
Why Does an LLC Need an Operating Agreement?
One of the main reasons business owners choose an LLC for its legal structure is to protect themselves from personal liability like debt or legal charges (hence the “limited liability” part in the name). An operating agreement helps define the business as a separate entity from its owners. This is especially crucial if you’re a single-member LLC because your business might look like a sole-proprietorship in terms of business structure. With an LLC operating agreement in place, you can clearly define your business as an LLC and protect your limited liability status.
It also acts as a guide on how particular tasks and duties will be divided among the owners. Without it, any owner or member can make company decisions on their own, which can prove troublesome for the entire business.
To explain this better, consider the following scenario:
Say you partner up with your best buddy, John, to start a food truck business. You’re both excited. You’re already drumming up a menu in your heads and thinking of all the places where you’ll be selling your tacos. You both decide that filing for an LLC is the way to go and take the necessary steps to register your small business as such.
A few months in, John is approached by one of his friends who wants to sell him a bigger food truck. The business is booming so John decides it’s a good idea. He leaves all the decision-making to himself, buys the truck, and then tells you about it after. Distraught with the news, you immediately order John to take it back. The conversation spirals into a serious argument about how the business should be managed.
The problem could have been avoided if there was an operating agreement in place. The document will state how business purchases will be made along with who gets to decide. It can also provide clear instructions about when specific purchases should happen and guidelines on how and where to make them. So instead of deciding on his own, John will consult with you because that’s what is written in your LLC operating agreement.
Depending on where your business is located, you may or may not be required by state laws to create an operating agreement. If you fail to make one, the state’s default rules will apply. In Oregon, for example, if you don’t have specific instructions with regards to voting rights, a “one member, one vote rule” will apply by default. Imagine having someone who only has a 2% stake in the company but has the same voting power as the owners.
Business owners are usually not required to file their limited liability company’s operating agreement with the secretary of state. Unlike articles of organization, your LLC operating agreement is mainly an internal document that outlines how to run the business. In your operating agreement document, you should:
- Outline specific provisions within the company (voting rights, fiduciary duties, ownership percentage, distributions, and more)
- Define how the business is going to be shared among owners and LLC members.
- Explain how the company will decide on crucial decisions like purchases and acquisitions
- Provide directives in the event of the dissolution of the company
What Are the Contents of an Operating Agreement?
There are no specific rules or guidelines for constructing operating agreements. However, to come up with a comprehensive document that will cover what most businesses need, the following categories are crucial to your operating agreement.
Organization and Member’s Interest
This section covers all the details about how the company started, including key dates, members, business structure, and related information. This section should also discuss how ownership will be divided among the members of the LLC. This is called membership interest and encompasses the collective rights of each member of the LLC. It includes the member’s voting power, right to receive distributions, and share of the company’s profits and losses.
Voting rights and Company Management
This section contains information on how the members will vote when it comes to company decisions. Some choose to have their members’ voting power dependent on their percentage of ownership. It should also discuss how and who will manage the company’s day to day operations (members or managers). If the company opts to appoint a manager, this section should include all provisions detailing all actions related to the manager — everything from the manager’s duties and responsibilities to the hiring and removal process.
This section shows who among the company’s board of members have contributed to the business. It reveals how much capital each member has provided as well as plans for how additional funding will be raised (if needed). It also describes how the member contributed — it can take the form of money, services provided, property, or a combination of all of these.
Distributions, Profits, and Losses
The allocation of profits, distributions, and losses are equal among a multi-member LLC by default. An operating agreement can alter this provision and set specific rules on how to allocate these three elements among the members. With LLCs, profits and losses are passed through the owners by default. If a member owns 50% of the company, then they will receive 50% of the profits and 50% of the losses. Should the members wish to change this rule, they should indicate the provisions and conditions within the LLC operating agreement.
This section will explain how the company will add new members and how to remove members. It includes provisions for when a member dies and how the business will manage the member’s ownership of the company.
For example, a company can set a rule stating that a member should first distribute his or her ownership interest to another member before they can leave the company. Alternatively, when a member dies, the other members should be consulted first to decide if the recipient of the benefits in the member’s will is worthy. It should also include instructions on how the business will handle the situation if a member files for bankruptcy.
Dissolution of the LLC
This section reveals the plans and strategy to dissolve the company. It includes provisions on how to distribute assets and debt among the members and details on who gets what. The events that will trigger a dissolution should be stated as well, whether it’s that the members provide a unanimous written consent or that a court orders a dissolution.
Make Sure to Have an Operating Agreement for Your Business
An operating agreement serves as a “playbook” that contains everything members need to know and do (or not do) within the company. During a business’s lifetime, the operating agreement should be reviewed and updated to suit the company’s needs.
We recommend seeking professional legal advice when drafting your LLC’s operating agreement to make sure you have all the essentials covered and to avoid future problems. Online services like LegalZoom and Rocket Lawyer can help you set up your company’s operating agreement for a fee. If you want to see what an operating agreement looks like, you can download and view a sample template. With your operating agreement in place, you’ll be ready to take the business world by storm.