What is an Operating Agreement?
An Operating Agreement is a contract between the owners of an LLC – the LLC’s members. The Operating Agreement may also include the LLC as a party to the contract. The Operating Agreement is the LLC’s governing document.
What terms and matters are covered in an Operating Agreement?
It addresses the necessary approvals, voting rights, and ownership percentages for making decisions and taking action. It delegates authority to specific members or managers to take action on behalf of the LLC. The Operating Agreement outlines key financial matters – how profits and losses will be allocated, describes with how frequently and under what circumstances cash and non-cash distributions will be made, and what transfers of LLC ownership interests are permissible and what requirements must be met for transfers to be made. Most Operating Agreements also address the termination and liquidation of the LLC and exit by its members. As with prenuptual agreements for couples, the terms of the dissolution of an LLC can be particularly important to address upfront.
Operating Agreements also include dispute resolution mechanisms, events triggering deadlock, indemnification and reimbursement, tax provisions, and limitation of liability. Some also incorporate advanced asset protection mechanisms.
Why does your LLC need an Operating Agreement?
An Operating Agreement may serve to protect the personal assets of LLC members. An Operating Agreement is particularly relevant to single-member LLCs that have only one owner. Having a written Operating Agreement is one of the formalities indicating that the LLC is created and the member intends to operate the LLC as a business.
When you enter into any kind of business arrangement with others, you would be wise to document the terms of the arrangement in writing. Otherwise, proving what you agreed to can be incredibly difficult based on a handshake or a verbal agreement. That applies with full force to agreements to own and operate an LLC with co-owners who are your business partners. The members of a multi-member LLC should enter into a written Operating Agreement to address how they will allocate profits, when they will receive cash distributions, how they will handle tax issues, how disputes will be resolved, what obligations they owe to each other, what ownership rights they have, among others.
What happens if my LLC does not have a written Operating Agreement?
If you do not have a written Operating Agreement, the state LLC laws would apply and the result may not always be what you wished for. At the very least, you may not know what rules apply under state law and what the result would be until you take steps to find out.
If you do not have a written Operating Agreement, you may become subject to liability and your personal assets may be exposed.
The Operating Agreement, as the governing document of your LLC, shows that the LLC and its members operate the LLC and the business according to a specific set of rules as opposed to making decisions on a whim. Without an Operating Agreement, it gets more challenging to differentiate between you in your personal capacity and your LLC as a business entity.
When the boundaries between you – as the owner – and your LLC – as the business entity – are not clearly established or maintained, the limited liability shield offered by your LLC is weakened. That means that it can be easier for potential creditors who may try to “pierce the corporate veil” to reach your personal assets in a lawsuit against your LLC.
What does singing an Operating Agreement mean for me?
You may be signing an Operating Agreement in various capacities – as a member (owner), as a manager (authorized to manage the affairs of the LLC), Because an Operating Agreement is a contract, the LLC’s members should act in accordance with the terms of the Operating Agreement throughout the entire life cycle of the business – startup, operation, and exit.
For the Operating Agreement to be the most effective, your LLC should follow the terms of the Operating Agreement as closely as possible.
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It is always a good idea to have an attorney draft or review your Operating Agreement in order to ensure that your personal and professional interests are protected.
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Petrova Law is a boutique business law firm focused exclusively on tax and business law matters. The firm assists businesses with tax strategy, IRS representation, sales and purchases of businesses (M&A), and general corporate law from startup launch through growth and maturation to exit and succession.
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