An operating agreement is a core founding document of a limited liability company (LLC). While most states don't require them, entrepreneurs should think twice before deciding to operate without one.
We'll explain what an LLC operating agreement does, how to make one, and why it's a valuable consideration for the LLC's members.
What is a limited liability company and an LLC operating agreement?
A limited liability company is a flexible business structure that offers its owners, who are called members, limited personal liability protection that separates their personal assets from the company's debts and legal liabilities. When establishing the LLC, you can create a single-member or multi-member LLC.
So, what is an LLC operating agreement? In essence, an LLC operating agreement is a business plan that typically defines a manager's duties, expectations for a member's contributions, and the distribution of the company's profits while outlining how to handle company assets, new members, internal operations, and other company affairs.
If there are multiple members in the LLC, this LLC agreement becomes a binding contract among all the members. A single-member LLC can (and may be required to) create a single-member LLC operating agreement as well, but the provisions will only apply to one member of the sole proprietorship.
How to create an LLC operating agreement in 9 steps
Drafting an operating agreement for your limited liability company isn't necessarily difficult, but it can be involved. Follow these nine steps for guidance.
Step 1. Decide between a template or an attorney
The first step in creating your operating agreement involves determining whether you'll draft it yourself or hire an attorney to do it for you.
If you have a single-member LLC, you may decide to create it on your own using a single-member LLC operating agreement template. After all, single-member LLCs tend to be less complicated than multiple-member LLCs since you don't have to worry about other member's contributions. If you go this route, we recommend using LegalZoom’s Operating Agreement service.
The other option is to hire an attorney to draft your operating agreement. This helps ensure you address all the important elements that can be difficult to navigate on your own, such as legal procedures and tax considerations. Attorneys have the knowledge and expertise to help you establish a legally sound and effective operating agreement. Another option is to turn to our LegalZoom services, where a legal expert will draft your document for you.
Even if you plan to use a free LLC operating agreement and draft your own, it doesn't hurt to consult an attorney to ensure you're on the right path.
Step 2. Include your business information
The next step involves including your business information in the agreement. You'll include basic information, such as your LLC name, address, the name of your registered agent, and your registered agent's address.
It's also important to state your LLC's purpose, which includes describing your business activities.
Step 3. List your LLC’s members
If your LLC has more than one owner, you'll need to list your LLC members in your operating agreement. This is the section where you'll address ownership percentages, capital contributions, and profit distributions.
The ownership percentage, or share in the company, is usually determined by the member's initial capital contributions (how much they invested). This, in turn, decides profit distributions.
You can't rely solely on verbal agreements for this kind of information, so it's essential to have it outlined in your agreement to help prevent disagreements and conflicts.
Step 4. Choose a management structure
Next, you'll determine your management structure. This describes how your business operates and should explain roles and responsibilities.
This section will be the meat of the operating agreement: It should address everything from manager duties and daily operations to voting rights and decision-making processes. It can also cover meeting guidelines, such as how often you meet, who can call the meeting, and who sets the agenda.
Step 5. Outline ownership transfers and dissolution
Now, it's time to define member admission and ownership transfers. What are the procedures for admitting a new member or transferring ownership? This part should provide guidelines to follow in certain scenarios, such as if a member dies or relinquishes their ownership, and set terms for buying and selling ownership interest.
Even if you're overseeing a single-member LLC, it's a good idea to include these terms in case you decide to acquire new members down the road.
At this point in the process, you'll also need to determine procedures for dissolution. For example, what can trigger a dissolution, who do you need to notify during the dissolution, and how will you distribute your assets?
Step 6. Determine tax structure
When you reach the tax structure portion of your operating agreement, you may find it especially helpful to consult with an attorney who specializes in tax laws.
During this stage, you'll decide how you plan to distribute your LLC's profits and losses among members for tax purposes. Usually, LLCs operate as "pass-through" entities, so you can use this as an opportunity to establish the terms.
Step 7. Gather LLC members to sign the agreement
Once you've completed and reviewed the entire agreement with your LLC members, it's time to sign it. By signing the document, everyone agrees to its terms and conditions, and the signed acknowledgment can help prevent disagreements and conflicts in the future.
Step 8. Distribute copies
Even if your limited liability company is doing business where operating agreements are required, you don't need to file them with the state.
However, it is important to distribute copies to your members, managers, and stakeholders. You may also want to make a copy for your lawyer and any other interested parties, such as lenders and investors.
Step 9. Revise your operating agreement as needed
Your operating agreement is not set in stone. You can (and should) make changes when necessary. For example, if you add new members, then you should revise your operating agreement to include their information. Or, if your business operations change, you should reflect those updates in the document, too.
When revising your operating agreement, you must obtain consent from all members, revise the document, gather signatures, and distribute new copies.
What to include in an LLC operating agreement
Any operating agreement for LLC businesses—including a single-member LLC operating agreement—typically includes these basic types of provisions.
Identifying information
The LLC operating agreement will include the name of the LLC; the addresses of the initial registered office and principal business office; and the names, addresses, and titles of the initial members (and managers, if any).
Statement of intent
The agreement will also have a statement explaining that the business complies with state laws and that it will become an established entity after filing the appropriate documents with the state.
Business purpose
The legal document should have a statement of the purpose of the LLC, which includes the nature of the business. It often includes an additional statement, such as "and for any other lawful business purpose," in order to cover any changes you may wish to make later.
Term
For most LLCs, the operating agreement will state that the LLC will continue until it is terminated as provided in the agreement or until dissolved according to state law.
An LLC formed for a specific purpose, such as constructing and selling a commercial building, may exist for a set period of time or until a certain event occurs.
Tax treatment
The agreement will have a tax statement specifying whether the LLC elects to be taxed as a sole proprietorship, partnership, or corporation.
Admission of new members
The operating agreement may also include a provision that outlines the manner in which someone may acquire an ownership interest in the LLC.
If your agreement doesn't have such a provision and you later wish to add a partner, you can prepare a new operating agreement to define all the details all members must agree on.
Other common provisions in LLC operating agreements
You may also find it useful to include the following provisions in your operating agreement.
Initial capital contributions
Each partner may have contributed a certain amount of capital when they started the business, and it's a good idea to record these amounts, as they may influence other factors of the agreement. List the initial capital contributions of each member, which can be in the form of cash, property, or services.
Additional capital contributions
Sometimes, a business must raise additional capital. Some LLC operating agreements say that no member can be required to make additional capital contributions themselves, whereas other operating agreements require it.
If members make additional capital contributions, they can adjust each member's percentage of interest in the business.
Distribution of profits and losses
Typically, each member shares in the profits or losses according to their percentage of interest in the business. This section of an LLC operating agreement can also state how often profits will be distributed. Since an LLC's profits are passed on to and taxed on the members' personal tax returns, distributions must be sufficient to at least pay the taxes that each member owes.
If you don't establish rules to divide the profits and losses, it goes back to the default. In most states, the default is to divide profits and losses to match each member's portion of ownership. If levels of ownership aren't defined in the agreement, the default may be to divide things equally, such that each member of a three-member LLC gets one-third of profits and losses.
However, if you want a different arrangement, such as a 60/20/20 split, this must be laid out in the operating agreement.
Member meetings and voting
The LLC operating agreement should state if and when member meetings will be held and include rules regarding how, when, and where votes will be taken; who has voting rights; how many voting members must be present for a quorum; how many votes are required to approve an action; and whether members can vote by proxy.
The operating agreement can lay out specific details about meetings and voting, such as whether each member will get one vote or be allocated a number of votes equal to his or her percentage of interest in the LLC. The operating agreement can also state whether a majority or a unanimous vote is required to make a decision. It can also define the appropriate size for a quorum based on the size of the business.
Furthermore, the LLC operating agreement can lay out what should happen in the event of a deadlock, which happens when a decision is impossible under the rules of the agreement. For example, a vote may be impossible if unanimity is required and one member disagrees. If the decision is important, such as whether to agree to a buyout offer, it's essential that there's some way to break the deadlock. Therefore, you should have protocols in place for deciding a deadlock, such as bringing in a mediator or arbitrator.
Management
The LLC operating agreement can state whether the LLC will be member-managed or manager-managed. Details of member management can also be included in the operating agreement, such as what services members are expected to perform in operating the business and what salaries they will be paid. You can also lay out how managers will be elected, how long they will serve, and any limitations on their authority.
The operating agreement can also set guidelines about what kinds of decisions each person gets to make and in what circumstances. An example is a stipulation that members can make independent decisions up to a certain dollar amount but must get unanimous approval for decisions that involve more money.
Admission and withdrawal of members
An operating agreement should include provisions for how new members may be admitted, what happens if a member wishes to withdraw, actions that will justify the expulsion of a member, and the procedures for expulsion. All in all, the document should include instructions on how to navigate these changes in membership.
Restrictions on members
Members in the LLC may face a variety of restrictions that dictate how they can behave when doing business. Examples are noncompete, nonsolicitation, and noncircumvention agreements. The operating agreement should lay out whether these can or should be in place. In some cases, members may want to avoid these stipulations, such as if a member already owns a competing business. In such a case, the operating agreement could stipulate a more limited restricted clause.
Intellectual property
The operating agreement may want to define the ownership and other details of the company's intellectual property. For example, who owns the logo and the name? Who has the rights to any processes the company develops? And who has the right to the trade dress of the business? The trade dress refers to the look and feel of the product or service that sets it apart from other business designs.
Transfer of interest
An operating agreement should define how a member's LLC interest may be transferred, which is typically a "right of first refusal." That means that if a member wishes to sell, the other members have the right to buy out the departing member on the same terms offered by a potential third-party purchaser.
The operating agreement could list various ways to do that valuation, including designating a person to assist in evaluation or using a formula to predetermine how you're going to calculate the fair market value. Alternatively, the operating agreement could say that you will use a mediator, an arbitrator, or some other third-party valuation company.
The LLC operating agreement should also include protocols to follow when someone sells their shares. That could include the right of first refusal and the type of notice the seller must give for that offer, as well as any other provisions that define how the situation should play out.
Death of a member
The LLC operating agreement can define what happens to a member's interest upon death. Common provisions include the remaining members purchasing the interest, allowing certain people (a spouse or child) to acquire the interest, or giving remaining members the right of first refusal before transfer to an heir.
Dissolution
An operating agreement should set out conditions and procedures for dissolving the LLC. It's important to assess the types of situations that could trigger the company's closing. Such situations include the death of a member, members breaching the rules, and a deadlock that triggers a dissolution provision.
The operating agreement should also lay out the procedures for closing the business once a situation or decision has been put in motion.
For example, if a valuation of the assets is required, the agreement can lay out the number of days allotted for that and require all members to agree on which company will do the valuation. The operating agreement can stipulate that all members need to approve the buyer of the assets, or it can say that one member will be responsible for handling the sale at a “reasonable price."
Detailing all these procedures and guidelines can make the difference between a streamlined dissolution and a messy one.
Amending the agreement
Your operating agreement is not a static document that can never be changed. It's a good idea to amend your agreement as your company grows and evolves.
For this reason, the LLC operating agreement should contain information about what kind of vote is required to amend it.
Why do I need an operating agreement for my LLC?
An operating agreement can be beneficial to your LLC in many ways, but some of the top reasons are to establish control, provide clarity, ensure legal protection, and comply with state regulations.
1. Establish control
An operating agreement allows you to decide how your business will work instead of those details being dictated by state tax laws and other regulations.
In the absence of an agreement, state rules govern numerous aspects of a limited liability company. In essence, state laws provide a standard operating agreement if you don't create your own. For example, some state default rules provide that members share equally in the profits, regardless of each member's contribution of capital or each member's interest in the company.
With an operating agreement, you can define your own rules on that question and many others.
2. Offer clarity
An operating agreement minimizes misunderstandings and disputes by making the details of your business arrangement clear to all members.
While it's helpful for a single-member LLC to have an operating agreement, the document really becomes invaluable in businesses with multiple members. An operating agreement ensures that each LLC member has the same understanding of their rights and responsibilities and agrees to how decisions and disputes should be handled within the business entity. Many issues may come up in multiple-member LLCs that are going forward without an operating agreement.
3. Ensure protection
An operating agreement ensures that you have legal protection from personal liability for any business-related legal challenges.
Setting up your LLC properly—including by having an operating agreement in place—helps you maintain an official separation, known as the corporate veil, between your personal and business affairs. Establishing a corporate veil can make a huge difference if your business is sued or acquires debts.
It's best to create a business structure with a separation between your company's business and personal property and assets. This can include your company's property and funds.
4. Comply with state rules
Is an LLC operating agreement legally required for my business? It depends.
Whether your LLC is required by law to have an operating agreement in place varies by state, but having an LLC operating agreement is almost never a requirement. The statutes in most states define what an operating agreement is for and what provisions one should have but don't typically require its creation.
LLC operating agreements are only required by statute in California, Delaware, Missouri, New York, and Maine. And, even in these states, there are no requirements to file the agreement with the Secretary of State; the LLC agreement is considered to be an internal document. In some states, LLCs can have verbal or even "implied" operating agreements, though that is not necessarily best practice.
Many LLC owners aren't aware of the benefits of an operating agreement. And even in the states that require one, many LLC owners don't realize they must have one and end up unknowingly breaking the law.
Do I need an LLC operating agreement if I'm a single-member business?
A single-member LLC is considered the same as a multiple-member LLC from a legal perspective, so both types of LLCs must have an operating agreement in the states where it is required by statute. In all other states, sole proprietorships and LLCs with two or more members are not required to have an operating agreement.
However, creating one is still a good business practice, even if you have no other members or aren't planning to take on new members.
The main reason a sole proprietorship might want an operating agreement is to establish that the company is being run properly, which reduces the chance of someone successfully suing the owner personally for a business mishap.
Such a company may want to have an operating agreement in place to lay out how to deal with outside contractors, like accountants or freelancers, or to lay the groundwork for adding additional members in the future. Adding additional members or bringing in another owner can complicate things. It's beneficial to set rules around these scenarios, so everyone understands the expectations.
Can I create my own operating agreement for my LLC?
Many LLC owners ask, "How do I make a simple LLC operating agreement?" While an operating agreement is a legal document, you don't necessarily need a lawyer to help you, but acquiring legal expertise is always a good idea.
It is possible to create your own operating agreement. As we previously mentioned, you can hire LegalZoom to draft one for you, or work with a lawyer.
Lawyers are valuable in that they have the expertise to help business owners sift through what provisions are necessary and which will actually be enforceable. They understand the ins and outs of the law, can explain the legal implications of certain actions, and can help tailor your operating agreement to suit your LLC's unique needs and goals.
What are some potential pitfalls of not having an LLC operating agreement?
LLC operating agreements outline rules and recommendations for internal operations and specific scenarios. Basically, this document acts as the North Star that can help guide your business operations and decisions. Without an operating agreement, your limited liability company may lack guidance, which can cause confusion, disagreements, and conflicts.
The following are just a few of the many issues that could arise when an LLC doesn't have a proper operating agreement in place.
Lack of control over your business
You may feel like you have control over your company without an operating agreement, but as soon as something goes wrong or changes in a way you don't know how to handle, it will become clear that your control only extends so far.
That is because a state's default rules are in place in situations where you haven't defined your own way of doing things. Creating an operating agreement with your own rules and approaches laid out clearly is the best way to maintain as much control as possible and prevent any liability from arising.
Confusion over ownership
Without an operating agreement, there may be confusion about what should happen when something changes in terms of ownership, such as when one member dies. If that member was married, the spouse may believe they are the new owner of the deceased's shares. Or perhaps a legal skirmish causes the remaining LLC members to prove their joint ownership of the business, but there is no paperwork that lays this out clearly, leaving them vulnerable to unintended consequences.
However, if there were an operating agreement in place, you could consult the document for specific instructions on addressing the situation.
Questions about what to do when someone leaves
If the names of the owners and the amounts of their ownership shares are not enshrined in an operating agreement, there can easily be disagreement about membership interest and initial contributions when one of them decides to depart. The withdrawing member may claim initial contributions that can't be backed up by financial records. And in this case, verbal agreements aren’t always legally binding, so you’ll want to document the terms ahead of time.
This is the reason that an operating agreement should memorialize the contribution that each partner made.
No guidance about how to resolve disputes
It's likely that every multi-member business will eventually face a dispute among its partners. When that happens, everyone will be relieved to have procedures for resolution spelled out in an operating agreement. The agreement should outline steps for mediation, whether that's hiring a third-party mediator or engaging in arbitration.
The idea is to head off ugly legal battles before they begin. Without an operating agreement, such issues may occur.
Vulnerability to piercing the corporate veil
Considering that one of the main reasons entrepreneurs set up LLCs is to secure some liability protection, it's in their best interest to ensure that protection is as robust as possible. Lack of an operating agreement, especially in states that require it, puts LLCs at risk.
For example, someone pursuing the business in court could make a plausible argument that the business is improperly run and that the business owner should be personally liable. Therefore, it's important to have an LLC operating agreement in place for personal protection.
FAQs
Is an LLC operating agreement legally required?
An LLC operating agreement is only legally required in California, Delaware, Maine, Missouri, and New York. This means you must create an operating agreement and maintain a copy of it for your records, but you are not required to file it with the state.
Although operating agreements are required in other states, drafting one is a good business practice as it can help provide legal protection, establish expectations, and prevent internal conflicts.
Who signs an operating agreement?
All LLC members should sign the document to make it a binding agreement. Any new members who join your LLC should sign a revised version of the operating agreement.
Do you file an operating agreement with the state?
No, even though some states require operating agreements, you do not need to file them with the state. Instead, you simply need to maintain a copy of one in your records.
How are member-managed and manager-managed LLCs different?
With a member-managed LLC, the LLC members oversee the day-to-day operations, acting as both members and managers, but with a manager-managed LLC, the members hire managers to oversee those daily operations. The main difference is how involved the LLC members are in the business' everyday activities.
What happens if someone leaves the LLC?
This is where an operating agreement comes in handy, as it could outline the procedure for departing members.
If there is an operating agreement in place, it should outline details, such as how assets are distributed, who needs to be notified, and what happens to the departing member's interest.
If there is no operating agreement, then state laws will oversee the process and determine which protocols to follow.
Katherine Gustafson contributed to this article.
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