A major benefit of operating your business as a limited liability company (LLC) is the flexibility you’ll have to operate the company as you like. Your written operating agreement is where you’ll describe how you want to run your company, by setting the internal rules for the owners, known as members. Even if your state does not require you to draft an operating agreement, your company can benefit from having one in place.
In some states, every LLC must have an operating agreement. In the majority of the states, it is optional. However, you will find a number of reasons to draft an operating agreement, even for single-member LLCs and even when state law does not require it. A few of the reasons include:
An operating agreement also serves to protect your liability. Many people form LLCs to ensure that their personal assets, like their cars and bank accounts, will not be on the line to satisfy the debts of the business. However, if you do not treat the LLC as a separate business entity, but instead like a sole proprietorship or partnership, you can lose personal liability protection. The existence of an operating agreement is a factor that courts will consider when determining whether the business owners in practice kept their business separate from their personal finances and dealings.
Even when state law requires an operating agreement, the law does not mandate many, if any, provisions to include. Take time to consider the following provisions as you decide which ones to include in your agreement. You should tailor your operating agreement to the unique needs of your company.
Company Information: Here, list the key formation information about the company, including the name of the LLC, the state where you filed the formation paperwork, the registered agent (the person or entity the LLC designates to receive government correspondences and legal notices), the tax treatment (sole proprietorship, partnership, or corporation), and the overall purpose of the company.
Percentage of Ownership: Allocate a percentage of ownership to each member. The allocation may be in proportion to the members’ contributions and/or profit and loss distributions, or an entirely different percentage.
Management Structure: The LLC is either member-managed or manager-managed. Member-managed means the owners of the company are responsible for the day-to-day operations, while manager-managed LLCs bring in a third party to handle daily affairs. In either case, you might also list the particular rights and responsibilities of each member.
Member Contributions: List any contributions from the members at the time of formation. Contributions might include monetary contributions, loans to be repaid, and physical assets (with agreed-upon fair market value).
Profit and Loss Distributions: Determine how and when to distribute profits to members. Distributions might be in proportion to member contributions, but not necessarily. If the LLC operates at a loss, you will also distribute the loss among the members at the end of the fiscal year, which the members will report on their individual tax returns. To prepare for a tax year that ends in a loss, the operating agreement should allocate a percentage of potential loss to each member.
Transferring Ownership: Decide whether members can transfer their interests to a third party or another member, and how you will value a member’s interest. If you prohibit transfers, consider what will happen if a member dies or becomes incapacitated—will these events result in the LLC’s dissolution, or will an heir or beneficiary step into the member’s shoes?
Meetings and Votes: List whether you will have regularly scheduled meetings for the members and how you will make decisions. You might list which decisions require unanimous votes, and which decisions require only a majority. Also consider whether each member has one vote, or if votes are in proportion to the percentage of ownership.
Dissolution: Decide when and how the company will end. Some LLCs will dissolve after a specific date or after an event, while others will continue indefinitely until the members agree to close the business. List how the members will distribute the remaining assets after dissolution.
Non-Compete and Non-Disclosure Agreements: You can include additional provisions that will protect your business, such as a non-compete agreement to prohibit members from working for competitors (state law might limit you in this regard). You might add a non-disclosure agreement if you want to protect the trade secrets of the company.
Take time to create your operating agreement, and include all members in the process. When the agreement is complete, all members must review and sign it. An operating agreement is an internal document, so you do not file it with the state. You do want to ensure it is easily accessible to all the owners.
Whenever your LLC faces a major change, like bringing on a new owner or expanding your services, it is a good idea to review the operating agreement. Even if you do not experience any major changes in the business, take a look at the agreement every year to see if it continues to reflect the needs of your operation.
To get started, review our free operating agreement sample.