If you’re looking for a business structure that limits your liability (and is less “formal in nature”) while maximizing tax advantages, you might consider an LLC. An LLC, or a “limited liability company,” is a hybrid between a partnership or corporation, combining the “best of both worlds” and having little disadvantage. While we won’t discuss LLCs in depth here (see LLC Basics article), we will discuss an essential component of an LLC: the operating agreement. This article will discuss what an operating agreement is, why operating agreements are important, and what operating agreements should include.
What is an Operating Agreement?
An operating is a document exclusive to the LLC. Among other things, the operating agreement—much like a partnership agreement—outlines the duties and responsibilities of the LLC’s members, the rules, and regulations the LLC must abide by, explain financial functions of the LLC and describe how business decisions and transactions will be made and conducted, how disputes amongst members will be handled, and more. The operating agreement is signed by all the LLC’s members, and once signed, binds the members to its contents. At its most basic level, the operating agreement can be characterized as a “contractual” point of authority as to the internal operations of an LLC.
Why are Operating Agreements Important?
Here, we will discuss three important reasons to have an operating agreement in place. To begin, LLCs—which bear a significant resemblance to partnerships—differ from partnerships with respect to personal liability. Sometimes an operating agreement will serve as the only mechanism used to differentiate an LLC from a partnership. Next, an operating agreement is essential to prove that the operating agreement—and ostensibly the LLC—exists, and that the members subsequently agreed to the operating agreement’s terms. At minimal, a (written) operating agreement preserves the terms contained within it (importance in a written operating agreement explained and discussed below).
Third, the most basic—yet most important reason—to have an operating agreement is to avoid the state’s “default” regulations. Of course, this doesn’t mean that you are permitted to make agreements that would be illegal and/or totally inconsistent with your state’s public policy or be directly against your state’s regulations. Rather, the goal should be creating an operating agreement that addresses the default regulations of your state. Finally, an operating agreement is critical to the “dissolution”—the decision to terminate—the LLC. Addressing what vote is needed to dissolve the LLC, what should occur in the event that a deadlock is reached on the matter, the consent required to continue on with the LLC, a member’s ability to dissociate (and the dissociation process), limiting liability during the dissolution process, and how and when assets can be distributed once dissolution has commenced, can ultimately avoid the dissolution of an LLC that otherwise could continue. With the understanding that operating agreements are an essential component of the LLC, let’s talk specifics.
The most appealing quality associated with the LLC business type has to be “limited liability.” Limited liability means that the LLCs members will not be held personally liable for the LLCs debts and obligations, and more importantly, that creditors are prevented from attacking the members’ personal assets should the LLC go under. Ultimately, an operating agreement can serve to protect the limited liability of its members.
As discussed above, an LLC can be described as a partnership-corporation hybrid. Unlike a general partnership, partners do not enjoy limited liability and are always liable for both the partnership’s—and the other partner’s—debts. However, like a general partnership, where a partnership agreement is optional, an operating agreement is not necessarily required, but recommended. Here, it can become fuzzy as to whether you are representing yourself as an LLC, whose members maintain limited liability, or a partnership, whose partners bear total liability. Accordingly, there is a strong possibility that an operating agreement could be the only piece of evidence establishing your business as an LLC, and accordingly, limiting your liability. It is important to understand that the more “formal” the business type becomes (by means of reporting and filing requirements), the less liability the business will be subject to. It seems relevant-and maybe even fair that, to limit liability, LLC members should be required to comply with additional paperwork and procedures—even if slightly burdensome—in order to benefit from the privileges an LLC has to offer.
But what about single-member LLCs? Is an operating agreement nonetheless necessary? Surprisingly, the answer is yes. While the single-member LLC doesn’t have the inherent concerns that a multi-member LLC will have, and an operating agreement isn’t necessarily needed to show that the members agreed to the operating agreement’s terms (because there is a single member), an operating agreement is needed to limit the single member’s liability. Specifically, the operating agreement should make clear the single member’s personal assets are to be held separate from the LLC’s assets. Note: In addition, the single-member LLC operating agreement has another important purpose—the designation of managers. While it is probable that a single member of the LLC will likely serve as the initial manager, a successor manager can be appointed.
Knowing that operating agreements are created to protect the most basic—and important aspects of an LLC—you might be surprised to know that most states have no requirement that members enter into operating agreements or that operating agreements be in writing. We discussed in the section above generally why an LLC should create an operating agreement, but why isn’t an oral agreement a good alternative? The old saying, “just because you can doesn’t mean you should” is applicable here. Just because an operating agreement can be made orally, doesn’t mean it should. An oral operating agreement can—and likely will—lead to a number of obvious concerns. The most apparent reason is proving the “agreement’s” existence. Or additionally, that all the members agreed to the operating agreement’s terms.
Remember, the operating agreement is ostensibly a contract to which the signing members are bound. Without proof of the physical operating agreement, or that the members agreed to the operating agreement’s terms, it will be challenging—if not impossible—to prove that the members are contractually bound to the operating agreement. Ultimately, absent a written, signed operating agreement, it will be difficult—at best—for the LLC members to come to any kind of mutual understanding as to how the LLC should function, not to mention the excessive legal fees that would likely be incurred in attempting to resolve the issues that a written agreement would have otherwise prevented.
Avoidance of “Default” Provisions
Every state has regulations controlling LLCs. These default regulations unarguably will not provide you with the flexibility you desire. This is where the operating agreement comes in: it ostensibly eliminates your state regulations and replaces them with regulations designed by you, to meet your (and the members’) needs, and the needs of your business. To fully evade your state’s default rules, the terms contained in the LLC’s operating agreement should meet the minimum requirements outlined in the state’s LLC rules. For example, if your state’s rules regarding operating agreements address the process in which a member must engage to sell and/or buy their interest in the LLC, then your operating agreement should lay out the procedures in which a member must engage to sell and/or buy a member’s interest. Any specific provisions that the LLC’s operating agreement does not cover—but the state’s LLC provisions do—will be subject to the state’s default provisions. For this reason, it is essential that the operating agreement be thorough and address every rule that the state’s default rules speak to.
Dissolution is the first step in the termination process of an LLC. Once the LLC enters dissolution, the “decision” has been made to end the LLC. The decision to dissolve the LLC does not serve to instantly end the LLC. Rather, once the members have agreed that the LLC will eventually terminate, “dissolution” represents a complete shift in purpose of the LLC. The LLC is no longer in existence for the purpose of carrying on the LLCs usual business activities; the LLC’s existence merely continues for the purpose of “winding-up” the LLC. Winding-up is the process of discharging the LLCs debts, paying out creditors, closing out the LLC’s business activities, and distributing the LLC’s remaining assets (should there be remaining assets). Once the LLC has been wound-up, the LLC ends (“terminates”). Once the LLC has been terminated, the operating agreement automatically lapses and will no longer be valid (or necessary), as the operating agreement cannot continue to serve its purpose.
An operating agreement is essential when it comes to the topic of dissolution. For instance, many states’ LLC default rules require that an LLC be dissolved if a majority of the LLC’s members—or even two-thirds of the LLC members—vote in favor of dissolution. More likely than not, at least one member will contest the election to dissolve the LLC. However, what would occur if a deadlock were to result with half the LLC’s members voting in favor of dissolution and the other half voting against dissolution? While your state’s LLC’s default rules would likely weigh against dissolution of the LLC, it is important to address how a deadlock would be handled—and, more—what options remain for those LLC members who want to liquidate their interest.
Generally, the death, removal, or withdrawal of any one member will result in dissolution of the LLC pursuant to the LLC default rules. However, with the unanimous consent of the remaining members, the LLC will likely be permitted to continue. It could be that one or more of the remaining partners—jaded by the members’ voting in favor of the dissolution decision—decline to consent to the continuation of the LLC. For this reason, the operating agreement should set out the number or percentage of partners required to consent to the continuation of the LLC, therefore avoiding dissolution. Or, even more drastically, the operating agreement could provide each member with the individual right to continue in the LLC or dissociate. Closely related to dissolution is the concept of disassociation, which occurs when a member of the LLC voluntarily or involuntarily resigns from the LLC. Typically, an LLC and its members are afforded the opportunity to determine when and how a member is dissociated—avoiding any messy “breakup” at the outset of the LLC.
Also, absent an operating agreement, a risk remains that the LLC’s members could engage in transactions that result in personal liability for other LLC members. Generally, members and managers retain the ability to bind the LLC to contracts past the point of dissolution. For this reason, it is necessary to limit the liability of members during the dissolution process. Finally, the priority of distributions made when dissolution occurs can be determined in the operating agreement. While public policy would prevent members from being paid before creditors, once the LLC’s creditors have been paid, and the members have received the assets amounting to their initial capital contribution, the LLC’s members are free to decide via the operating agreement who receives priority as to the remaining assets.
What Should an Operating Agreement Include?
What is required in an operating agreement varies by state (if they require an operating agreement at all). Don’t let your state’s minimum requirements prevent you from thinking beyond them. Meaning, for example, even if your state doesn’t require that you have buy-out or sell-out provisions (rules governing what will happen if a member dies or leaves the LLC with an ownership interest), that doesn’t mean you can’t, or shouldn’t, consider using a buy-out or sell-out provision in your operating agreement.
Among other things, an operating agreement should include: each member’s ownership interest (which will correlate with their capital contribution; see LLC Basics), the voting rights of the LLCs members, the powers and duties of the members and/or managers (depending on whether the LLC is member-managed, or manager managed, as discussed in depth in the “LLC Basics Article”), how profits and losses will be split, and more.
Other Operating Agreement Tips
Interestingly, though ostensibly essential to the LLC, an operating agreement, unlike “Articles of Organization,” are not required to be filed with the state. In fact, the state (regardless of what state you reside in and/or the state where your business is located), will not accept your operating agreement. This is due in part to the requirement that—like most legal documents—the operating agreement and its terms should remain confidential. To that end, the operating agreement should be held in a place where it can remain safe, like with the LLC’s business records, for example.
Ultimately, the best tip for operating agreements is simple: be smart and make an operating agreement. Don’t let the state decide how you run your business, and even more importantly, don’t let yourself be subject to a messy situation or legal conundrum with other LLC members. Operating agreements are not only recommended to protect you from the state and state regulations, but they are also recommended to protect you from liability and any disgruntled co-members. To conclude, if you’re considering forming an LLC, it is important to speak to an attorney experienced in the formation of LLCs to understand exactly what an operating agreement in your state requires.