Here's What's Wrong with Your Operating Agreement (and How to Fix It)

Here's What's Wrong with Your Operating Agreement (and How to Fix It)

by Brette Sember, J.D., February 2016

A business operating agreement is to your LLC what a prenuptial agreement is to your marriage. Your plan is that everything will go smoothly and everyone will live happily ever after, but you're putting the agreement together just in case, heaven forbid, things go south. Many people tend to gloss over the operating agreement LLC and just toss something together, assuming it doesn't really matter and so what. The limited liability company operating agreement actually is important, so you should you force yourself to really read it and ensure that it reflects the plan for the business.

The Biggest Mistake

If your first question when reading this article is “What is an operating agreement?" then, Houston, you have a problem. If you don't have an operating agreement for LLC, you have created a huge liability.

The agreement creates ground rules, not only for managing the company but also for resolving any disputes that could come up in the future. No one wants to assume disputes are going to happen but the truth is protecting yourself and your company is just smart.

The operating agreement can be created from a good operating agreement template. You also want to make sure everyone actually signs the agreement so that it is legally binding.

Death and Taxes

The LLC operating agreement is key in establishing your tax status. If you are a sole proprietorship, you can be taxed as an individual or as a corporation. If there is more than one member, you can choose to be taxed as a partnership or a corporation. The provisions of your simple operating agreement must match the tax designation filings you have made.

Words Matter

When creating an LLC operating agreements, it's important to get the terminology correct. Examples of common mistakes include referring to members' “operating interests" when each member has only one membership interest. The most correct term is to refer to it as a limited liability company interest.

Another mistake a lawyer may have an issue with is the difference between allocations and distributions. Technically, an allocation can only be made out of the company's income and losses. A distribution can come from earnings or contributed capital. Duh.
Members and Partners

Another place many people trip up is in designating who is an employee and who is a member. This is a tricky area of law and it's pretty common for these roles to overlap. Many members try to designate themselves as employees. For tax purposes, you can only be one or the other. Make sure your operating agreement is clear.

Bankruptcy Issues

No one plans on going bankrupt, but it's always a possibility and one you need to plan for. Because of this, you need to be sure the operating agreement is an executory contract that includes contractual obligations that have a material business purpose and apply to any member or a creditor or trustee who takes over a member's interest. But you probably knew that already.

Updating Agreements

Many people create solid operating agreements, but then forget to update them when there are changes to members, tax status, and buy-sell agreements. This can lead to all kinds of trouble.

Including All the Details

An operating agreement is supposed to detail everything about your company. This is a tall order and one of the reasons why so many people fail to get it right.

It needs to include not only the bare basics about the LLC, but also details such as the roles of managers, who can vote, what happens if expected contributions are not made, procedures for cashing out members, dissolution of the company, and more. The more details that are included, the more ironclad the contract is and the fewer headaches you will have to face down the line.

Don't fool around. Get a solid operating agreement in place. Even if it's just you and you have a single member LLC operating agreement, you want to make sure it protects you from creditors, bankruptcy, and taxes.

LegalZoom can help you obtain an operating agreement for your business quickly and affordably. Get started by answering a few questions about your business. We'll create and review your operating agreement for consistency and completeness, and send it to you with instructions on how to properly sign it.