Why an Operating Agreement is Essential for LLCs

An operating agreement helps your LLC by guarding your limited liability status, establishing a member’s ownership percentage and share of profits or losses, heading off financial and management misunderstandings, establishing procedures for members being added to or leaving the company, and making sure your business is governed by your own rules -- not the default rules of your state.

One of the main reasons to have an operating agreement is as simple as it is important: It helps to ensure that courts will respect your limited personal liability. This is particularly key in a one-person LLC where, without the formality of an agreement, the LLC will look a lot like a sole proprietorship. Just the fact that you have a formal written operating agreement will lend credibility to your LLC's separate existence.

Co-member LLCs need to document their profit-sharing and decision-making protocols as well as the procedures for handling the departure and addition of members. Without a thorough operating agreement, not only will you and your co-members be ill-equipped to settle misunderstandings over finances and management, but you will also be subject to the default rules of your state law.

Each state has laws that set out basic operating rules for LLCs, some of which will govern your business unless your operating agreement says otherwise. (These are called "default rules.")  Some states, for example, have a default rule that requires owners to divide up LLC profits and losses equally, regardless of each member's investment in the business.  If you and your co-members did not invest equal amounts in the LLC, you may not want profits allocated equally. To avoid this, your operating agreement must spell out how you and your co-members want to split profits and losses.

There's a host of issues that should be covered in your LLC operating agreement, some of which will depend on your business's particular situation and needs. While these items may seem fairly straightforward, each requires important details.  Most operating agreements address the following:

Percentages of Ownership: The members of an LLC ordinarily make financial contributions of cash, property, or services to the business to get it started. Members are usually given ownership percentages in proportion to their contributions of capital, but LLCs are free to divide up ownership in any way they wish.

Distributive Shares: In addition to receiving ownership interests in exchange for their contributions of capital, LLC owners also receive shares of the LLC's profits and losses, called "distributive shares." Most often, an operating agreement will provide that each owner's distributive share corresponds to his or her percentage of ownership in the LLC.  

Distributions of Profits and Losses: In addition to defining each owner's distributive share, your operating agreement should answer these questions:   

• How much, if any, of the allocated profits of the LLC (the members' distributive shares) must be distributed to LLC members each year?
• Can members expect their LLC to pay them at least enough to cover the income taxes they'll owe on each year's allocation of LLC profits? (An LLC owner, like a partner in a partnership, has to pay income taxes on profits that are "allocated" to him or her, not just on profits that are paid out. When profits are plowed back into the business instead of being paid out, they are still treated as income to the owners, in the proportions allocated.)
• Will distributions of profits be made regularly or are the owners entitled to draw at will from the profits of the business?

Because you and your co-owners may have different financial needs and marginal tax rates (tax brackets), the allocation of profits and losses is an area to which you should pay particular attention.  You may want to run the allocation part of your operating agreement by a tax professional, to make sure it achieves the overall results you had in mind.

Voting Rights: While most LLC management decisions are made informally, sometimes a decision is so important or controversial that a formal vote is necessary. There are two ways to split voting power among LLC members: Either each member's voting power corresponds to his or her percentage interest in the business, or each member gets one vote -- called "per capita" voting. Most LLCs assign votes in proportion to the members' ownership interests. Whichever method you choose, make sure your operating agreement specifies how much voting power each member has, as well as whether a majority of the votes or a unanimous decision will be required to resolve an issue.

Ownership Transitions: Many new business owners neglect to think about what will happen if one owner retires, dies, divorces, or decides to sell the owner's interest in the company. These concerns may not be on your mind now, but such situations crop up frequently for small business owners, and it pays to be prepared. Operating agreements should include a buyout scheme - rules for what will happen when one member leaves the LLC for any reason.

Operating agreements can be of immeasurable value to an LLC by protecting the assets of the  members, avoiding conflicts between members, and establishing procedures for adding and removing members.It is highly recommended, however, that you seek legal counsel to assist with the drafting of the operating agreement to ensure it meets the particular needs of your business, state laws and the IRS code.