LLC formation requires two essential documents; a formation document filed with the state and an operating agreement. The operating agreement is vital to the planning of the business and directs its internal affairs.
What is an operating agreement for LLC?
The LLC formation process requires a structure and this can be customized by its members to the individual needs and those of the LLC in the operating agreement. Even single-member LLCs need one to define their management structure, but an operating agreement is vital in a multi-member LLC.
In the operating agreement, the members are forming a contract between themselves. In this contract, they define the LLC’s operations, including its management and the economic relationship between the members. Other important issues include profit distributions, obligations, and rights of each member, and how their interests can be transferred. The operating agreement also defines how new owners can be admitted.
Benefits of an operating agreement
Not all states require an operating agreement for LLCs. However, in California, Delaware, Maine, Missouri, Nebraska, and New York, it is required by law. In most states, the operating agreement does not need to be filed with the state.
Attorneys emphasize that many LLC owners think that their formation document covers them legally, but it is only a document that establishes the company with the state. Operating agreements are often requested by third parties like lenders, title companies, investors, accountants, and when drawing up legal documents.
If there is a lawsuit against the LLC or an internal disagreement, the operating agreement defines how the LLC is viewed by state laws. Otherwise, when the state needs to decide on an internal issue of the LLC or determine liability for a third party, the law falls back on the provisions of the state laws on LLCs. Also, if an LLC has interstate commercial activities, the laws of the states they do business in will apply if there is no LLC agreement.
Contents of an operating agreement
Even though the contents of an operating agreement can vary, depending on the issues needed to be addressed by each LLC, these are the six key sections that must be included to prevent conflict down the line:
1. Creation of the company
This section covers the vital statistics about the company’s creation. It includes the date when the LLC was created, the member names, how their ownership is structured, and what percentage of the LLC each member owns.
In the operating agreement, the LLC can also determine how it will be taxed and can define whether it will be as a default LLC, S Corp, or any other tax structure allowed to LLCs.
2. Company management and voting rights
Depending on if the company is to be managed by one or all the members, then the operating agreement must specify which role each member will have. Additionally, if the members decide to appoint managers, it must be stated in the agreement.
If it is decided that decisions are to be made through a voting process, the operating agreement must allocate how the votes will be allocated to members, and how many votes are required to pass any actions.
3. Initial and further capital contributions
All capital contributions made by each member toward starting the LLC must be covered in this section. The members need to also define the terms of how any additional money contributions to the LLC will be made at any later stage.
4. Profit and loss distributions
Profits and losses need to be shared among members and this is also laid out in the operating agreement. At this point, it is vital to define what percentage of profit distributions will be reinvested into the business or paid out as income to members.
5. Changes to membership
Sometimes death, bankruptcy, divorce, or retirement may require changes among the members of an LLC. The operating agreement needs to define the process of adding or removing members and especially when each member can transfer their ownership. This consensus from the start can help prevent disagreements in the future.
6. Dissolving the LLC
Here the members define the circumstances that may require the company to be dissolved.
LLC operating agreement template
Startup owners of smaller businesses don’t need an attorney to draw up an operating agreement for their LLC. Operating agreement templates are available online and are easy to download. By completing one, each LLC can use it to define all the important basic elements and add custom clauses and sections of their own to suit their LLC.
TRUiC, the company that offers useful business information, has a free, easy to use LLC operating agreement template with features for single and multi-member LLCs. Their templates can also be used for member-managed and manager-managed LLCs.
Operating agreements ensure that an LLC continues to operate smoothly without member disputes. Operating agreements can also be updated at any point if certain circumstances call for it. This can be done in the presence of all the members of the LLC and with their agreement.