How to Draft an LLC Operating Agreement
How to Draft an LLC Operating Agreement
Whether you run a limited liability company on your own or with others, you should have a limited liability company operating agreement.
What is an Operating Agreement?
A business operating agreement sets forth the guidelines for an LLC in the same manner as articles of incorporation govern the operation of a corporation. The details of such operating agreements vary depending upon a number of factors, including tax considerations, the number of members, and the structure of management, investment, and sharing of the profits. If there is more than one member, it becomes a binding contract between the members.
Why You Should Have an Operating Agreement
In some states, an LLC operating agreement is required. Sometimes this is only required if the LLC has more than one member. Even if not required by law, an operating agreement serves three other important purposes:
- It allows you to control your business, rather than your state’s laws. In the absence of an agreement, state laws (called default rules) govern numerous aspects of an LLC. In essence, state law provides 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.
- It protects the limited liability aspect of an LLC. In the absence of an operating agreement LLC owners could be subject to personal liability if it looks like they are operating a sole proprietorship or a partnership.
- A written agreement makes the details of their business arrangement clear to all of the members, thereby minimizing misunderstandings and disputes.
Single Member vs. Multiple Member. An LLC may be owned by one person (a single member LLC) or by two or more owners (a multiple member LLC). A single member LLC operating agreement is more simple than a multiple member agreement. Rather than being taxed as a corporation, single member LLCs may choose to be taxed as a sole proprietorship, and multiple member LLCs may elect to be taxed as a partnership.
Member-managed vs. Manager-managed. A multiple member LLC can be set up so that all of the members have the authority to run the day-to-day operations of the business (member-managed), or so that a manager or management committee is designated to run the business (manager-managed).
Any operating agreement for LLC businesses, even a single member LLC operating agreement, typically includes the following basic types of provisions:
Identifying Information. The name of the LLC, and the addresses of the initial registered office and principal business office.
Statement of Intent. A statement that the agreement is in accordance with the LLC laws of your state, and that the business will come into existence once the official LLC documents have been filed with the state.
Business Purpose. A statement of the purpose of the LLC, which should include 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, this will state that the LLC will continue until it is terminated as provided in the operating 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. State whether the LLC elects to be taxed as a sole proprietorship, partnership, or corporation.
Admission of New Members. Even if you are starting out on your own, there may come a time when you wish to take on one or more partners. This provision outlines the manner in which someone may acquire an interest in the LLC. If there is no such provision and you later wish to add a partner, you can always prepare an entirely new operating agreement.
Other Common Provisions
Other common provisions in operating agreements include:
Identification of Members and Managers. The names, addresses, and titles of the initial members (and managers, if any).
Capital Contributions. List the initial capital contributions (and their values) of each member, which can be in the form cash, property, or services.
Additional Capital Contributions. Sometimes a business must raise additional capital. Some agreements say that no member can be required to make additional contributions, whereas others require it. If additional contributions are made, provision can be made for the adjustment of 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 his or her percentage of interest in the business. This section can also state how often profits will be distributed. Since an LLC’s profits are passed on and taxed to the members, a big consideration can be whether distributions will be sufficient to at least pay the taxes that are owed.
Member Meetings and Voting. State when member meetings will be held, and include any rules regarding how, when, and where votes will be taken, how many members must be present for a quorum, how many votes are required to approve an action, etc. Will each member get one vote, or be allocated a number of votes equal to his or her percentage of interest in the LLC? Will a majority or a unanimous vote be required? Especially with a large number of members, you don’t want a quorum to be too small (allowing a few members to take action), or too large (so that one or two members could prevent action).
Management. Will the LLC will be member-managed or manager-managed? If manager-managed, details may be included such as any salary to be paid, how managers will be elected, how long they will serve, and any limitations on their authority (such as what constitutes a quorum of the committee, and what types of actions require member-approval).
Duties and Compensation of Members. You can designate what services members are expected to perform in operating the business, and indicate whether they will receive additional compensation for the duties they perform.
Admission and Withdrawal of Members. Include provisions for how new members may be admitted, what happens if a member wishes to withdraw, and actions that will justify the expulsion of a member and the procedures for expulsion.
Transfer of Interest. How may a member’s LLC interest may be transferred? Operating agreements generally provide for a “right of first refusal” if a member wishes to sell, which gives the other members the right to buy-out the departing member on the same terms offered by a potential third-party purchaser.
Death of a Member. What happens to a member’s interest upon death? Common provisions include the remaining members purchasing the interest, allowing certain persons (a spouse or child) to acquire the interest, or giving remaining members the right of first refusal before transfer to an heir. A provision can also be made that allows transfer, but only gives the transferee the right to profits; not to participate in business decisions.
Dissolution. Conditions and procedures for dissolving the LLC should be set forth.
While major provisions of LLC operating agreements have been presented, this is not an exhaustive list of provisions that may be in an agreement. Many practical, legal, and tax considerations come into play in tailoring an LLC operating agreement to your specific needs.
LegalZoom can help you draft an operating agreement for your LLC online quickly and affordably.