What Is an LLC Operating Agreement and How Do You Create One?

Setting up a company as an LLC (Limited Liability Company) provides the simplicity of just a few compliance requirements. Still, it also provides peace of mind, as your personal assets are protected. To establish your LLC, you will need to file articles of organization with the state. However, you should also consider creating some internal rules for how to manage and run your LLC.

This will help all the LLC members, including yourself, to understand their roles and responsibilities. Most states do not require this operating agreement, but it is worth considering. An operating agreement provides evidence that you keep your personal and business affairs separate. It can also help to avoid arguments and misunderstandings between the business partners.

What is an LLC operating agreement?

An LLC or Limited Liability Company operating agreement allows you to structure financial and working relationships with your co-owners in a way to suit your business. Your operating agreement should clearly state how profits and losses will be allocated among the LLC members. It should also provide a framework for how and when profits will be distributed.

As part of the operating agreement, you and your co-owners will need to establish the percentage of ownership, the share of profits, the rights and responsibilities, and what will happen to the business should one of you leave. It can be a written document or simply an oral understanding.

What Must Be Included in an LLC Operating Agreement?

The details of the LLC operating agreement can vary considerably, depending on a number of factors. It generally shows who owns and manages the LLC, the business purposes, number of members, management structure including ownership, voting rights and classes of interest, how to replace owners, tax considerations, sharing of profits, and what happens should the LLC agreement be canceled. Here are the most important sections:

Management Structure, Roles And Responsibilities – Will your LLC be member managed or manager managed? If you opt for manager managed, you will need to include details such as the salary to be paid, how a manager will be elected, how long he or she will serve, and the limitations on their authority. For example, what constitutes a committee quorum and what actions require member approval. Your agreement should state when you will hold member meetings and the rules on how, when, and where a vote will be taken. You will also need to make a note of how many members should be present for a quorum and the votes required for approval of an action.

Membership Changes – This section will describe the process to add or remove a member. It will also state if and when ownership of the company can be transferred. For example, you should specify what happens if a member goes bankrupt or dies or two members divorce.

Allocation of Profits, Losses, and Distributions – Your operating agreement may alter the default proportional allocation rules for profits, losses, and distributions among the members. The agreement can provide each unit class with unique economic rights. You can even alter the allocation rules for members of the same class. For example, it is possible that a member holding 50% of the LLC interest to be allocated 100% of the profits or losses for the LLC in a given year or receive preferred returns.

Ownership – Typically, ownership of an LLC is divided up according to the initial investment. If you put 60% of the capital necessary to start the LLC, you would own 60% of the company. However, there are scenarios where people don’t want to divide the company ownership in this way. For example, if a business is built on one person’s idea and the other partner put in a little capital to get the business off the ground, the idea person is probably entitled to a large share of the company. However, if you assign your company ownership in a disproportional way to what is invested, you will need to clarify the reasons in your operating agreement.

Severability provision, dissolution – You should close the operating agreement for your LLC with a severability provision. This standard legal boilerplate states that in the event that a provision of the agreement proves contrary to state or federal law, all of the other aspects not contrary to law should remain in effect.

The inclusion of a severability provision ensures that any minor oversights don’t invalidate the entire agreement. Finally, the operating agreement must address the possibility of dissolving the business. Typically, members need to vote to trigger any dissolution proceedings. Ending an LLC as a business entity can be complicated, and it usually involves filing the appropriate paperwork with the state, paying creditors, liquidating assets, and more. The member share assets remaining after all of the creditors have been paid will need to be divided. Your agreement should outline the preferred wind down procedure.

Why is it important to have an LLC operating agreement?

Firstly, an LLC operating agreement protects your limited liability status. There is no point of registering a limited liability company if you remain personally liable for any lawsuits resulting from your business activities. If an operating agreement is in place, a court of law is more likely to keep the limited liability protection in place, making the distinction between the company and its owners. This is particularly true in cases where there is only one member of the LLC.

Also, it provides a clear guide on how the company will be run, including the percentage of shares that will go to each member, banking account and financial structure as well as the structure of the company ownership. Finally, it ensures that the best interests of your business are protected at all times including stressful financial situations.

In many cases, an entrepreneur wants his or her business to carry on after retirement or they pass away. An operating agreement should clearly specify who will take over the business and on what terms if you are no longer running the company.

How do you create an LLC operating agreement?

There are many sample or blank LLC operating agreements available, but you must ensure that your agreement is drafted to suit your specific business needs and the laws in your state. There are online sources offering forms that can be used to create a custom operating agreement for your business.

Here are the most common ways to create an LLC operating agreement

  1. Free template

If you search for “LLC operating agreements template” with Google or any major search engine, you’ll likely find dozens of templates that can be used freely. However, most of these are basic and mainly applicable for a single owner or basic business scenarios.

2. Premium template

The free versions are typically unsuitable for multiple members or where there are more accounting or ownership requirements. In this case, if you don’t want to pay for a lawyer that will create your agreement from scratch, you can get help from a paid service offered by many companies. Most of these services require filling in a basic template and supplying more details about your business.

Depending on the complexity and length of your agreement, you’ll need to pay a fee for a lawyer to adjust the agreement to your specific needs. You may use an online service such as RocketLawyer or LegalZoom to create an operating agreement for your LLC. These services can walk you through creating an operating agreement. There is often a step by step questionnaire to ensure your agreement is customized to the requirements in your home state.

3. Hiring a lawyer

In some cases, it can be risky to use a business contract or agreement unless it’s been written specifically for your business and for your state.

If you want to ensure 100% protection, particularly if you have a complicated or unusual situation, you should have it reviewed by a certified lawyer. This will ensure it is drafted to suit the specific needs of your business and laws in your state.

Many lawyers can help you to file the articles of organization and creating your operating agreement. This usually involves a flat fee, but they will ensure it includes all clauses that are relevant to your business, and the agreement complies with any specific requirements

Bottom Line

Creating an operating agreement may feel like an unnecessary formality, particularly when you first start out. However, if you have a business partner or you may want to bring someone into the business at a later date, it is crucial that you have an operating agreement to ensure everything runs smoothly. Additionally, state governments to see that an LLC has an operating agreement.

It helps to define the business as a separate entity rather than a standard partnership or sole proprietorship. An operating agreement is well worth the time needed to draw one up. So, before you start operating as an LLC, ensure you have an agreement drawn up and in place.

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Author: Baruch Silvermann

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